Enforcement News: SEC Charges Former Co-Chief Investment Officer of Investment Adviser With Cherry-Picking Scheme
Print Article- Posted on: Dec 4 2024
By: Jeffrey M. Haber
It has been some time since we have examined cherry-picking – a practice that can be an effective way to generate returns as well as a practice that is fraudulent and violative of the federal securities laws. Therefore, today, we examine SEC v. Leech, Case 1:24-cv-09017 (S.D.N.Y. Nov. 25, 2024), a case involving the former co-chief investment officer of an investment adviser, who has been charged with running a more than $600 million cherry-picking scheme in which he allegedly favored some clients’ accounts over others when allocating trades.
[Eds. Note: the discussion on cherry-picking below appeared in a prior article (here) and is reprinted as a primer for our readers on the practice.]
Cherry picking is the process of selecting securities to invest in by mirroring the trading of other investors (both individual and institutions) who are successful over a long period of time. In other words, cherry-pickers base their trading around the techniques and strategies of other investors.
Anyone can implement a cherry-picking strategy. Indeed, cherry-picking is used by both professional and retail investors alike.
Cherry picking can be an effective way to generate returns. It can also be helpful for people who are relatively new to investing – i.e., investors who are unfamiliar with the process of stock selection and investment research.
Cherry picking can also be used by investment advisers in a fraudulent way. Under this scenario, an investment adviser will allocate winning trades to his/her personal account or to a favored client(s) at the expense of other clients.
Typically, an investment adviser trades in securities through an omnibus trading account. An omnibus trading account allows an investment adviser to buy and sell securities on behalf of multiple clients simultaneously, without identifying to the broker in advance the specific accounts for which a trade is intended. For example, if an adviser separately purchases the same security for several clients on the same day, the adviser might obtain different prices on each transaction as a result of normal market fluctuation. Rather than placing individual orders in each client account, the adviser can place an aggregated order, or “block trade,” in the omnibus account and subsequently allocate the trade among multiple accounts using an average price. When used properly, an adviser will fairly and equitably allocate the block trade among client accounts, ensuring that no account receives preferential treatment over another.
The fraudulent act of cherry-picking involves an investment adviser selecting specific profitable or unprofitable trades and allocating them in a manner of their choosing. For example, the investment adviser might allocate the profitable trades to his/her personal account or to certain clients in order to give them preferential treatment. Conversely, trades that incur losses might be allocated to the accounts of less preferred clients of the investment adviser.
When used fraudulently, cherry-picking violates the securities laws. Over the past several years, the Securities and Exchange Commission (“SEC” or the “Commission”) has been vigilant in cracking down on investment advisors who engage in fraudulent cherry-picking. [Eds. Note: in a prior article (here), we discussed some of the SEC’s enforcement actions against investment advisers who were charged with cherry-picking.[1]]
Cherry-picking can occur in all types of investment vehicles. We examine a few of them below, as they are relevant to the enforcement action discussed herein.
Mutual Funds
A mutual fund is a type of SEC-registered investment company that pools money from many investors and invests the money in some combination of stocks, bonds, short-term money-market instruments, and/or other assets. The securities and other assets owned by a mutual fund are known collectively as the fund’s portfolio.
A mutual fund’s portfolio is managed by an SEC-registered investment adviser. A mutual fund’s investment adviser owes a fiduciary duty to its client, i.e., the fund. Each mutual fund share represents an investor’s proportionate ownership of the mutual fund’s portfolio and of the income and capital gains the portfolio generates.
Investors in mutual funds buy their shares from, and sell or redeem their shares to, the mutual funds themselves. Mutual fund shares are typically purchased from the fund directly or through investment professionals, such as brokers.
Private Funds
A private fund is another type of entity that pools money from multiple investors and invests the money in various securities and other assets.
Private funds may rely on one of the exemptions from the definition of investment company set forth in Section 3 of the Investment Company Act.[2]
Private funds are not registered with the Commission. They are not subject to the Investment Company Act and its associated regulations, which are applicable to mutual funds and other registered investment companies. However, private funds and their advisers are subject to the same prohibitions against fraud as other market participants. Additionally, all investment advisers, including advisers to mutual funds and private funds, owe a fiduciary duty to the funds that they manage.
Separately Managed Accounts
A separately managed account (“SMA”) is a portfolio that includes securities or other assets managed by an investment adviser on behalf of an advisory client. Unlike pooled investment vehicles, wherein investors own a share of the fund, the investor in an SMA directly owns the securities or other assets in the portfolio, which is managed by the adviser.
SEC v. Leech
On November 25, 2024, the SEC announced (here) that it filed fraud charges against the former co-chief investment officer of Western Asset Management Company LLC (“Western Asset”), for engaging in a multi-year cherry-picking scheme wherein he allocated favorable trades to certain portfolios, while allocating unfavorable trades to other portfolios.
In its complaint (here), the SEC alleged that from at least January 2021 through October 2023 (the “Relevant Period”), defendant placed trades with brokers and then routinely waited until later in the trading day to allocate the trades among clients in the portfolios he managed.[3] According to the complaint, defendant’s delay between placing and allocating trades gave him the opportunity to observe price movements, and then disproportionally allocate trades at a first-day gain to favored portfolios and trades at a first-day loss to disfavored portfolios. As alleged, defendant allocated hundreds of millions of dollars of net first-day gains to favored portfolios, which also benefited defendant personally,[4] and a similar amount of net first-day losses to disfavored portfolios.
Commenting on the alleged scheme, Sanjay Wadhwa, Acting Director of the SEC’s Division of Enforcement said: “The scale and duration of [defendant]’s allegedly fraudulent conduct amounts to a shocking betrayal of his fiduciary obligations to his clients, who paid dearly for his transgressions. Investment advisers are at all times obliged to perform their functions, including trade allocations, in a manner that puts their clients’ interests first. As alleged, [defendant] abdicated that all-important duty for years.”
“This alleged behavior is an egregious abuse of power,” said Andrew Dean, Co-Chief of the Division of Enforcement’s Asset Management Unit. “By hand-picking trades and sending them to portfolios he favored, [defendant] allegedly stood to profit personally and professionally.”
The SEC filed its complaint in the United States District Court for the Southern District of New York. The SEC charged defendant with violating antifraud and other provisions of the federal securities laws. The SEC seeks permanent and conduct-based injunctions, an officer-and-director bar, disgorgement, prejudgment interest, civil penalties, and other relief.
In a parallel action, the U.S. Attorney’s Office for the Southern District of New York announced the filing of charges against defendant (here).[5] In that regard, defendant was charged with one count of investment adviser fraud and one count of securities fraud; one count of commodity trading adviser fraud and one count commodities fraud; and one count of making false statements to the SEC.
__________________________________
Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP. This article is for informational purposes and is not intended to be and should not be taken as legal advice.
[1] In addition to the article mentioned above, we previously examined the illegal practice of cherry-picking here.
[2] The Section 3(c)(1) exemption is available to funds that are (i) beneficially owned by not more than 100 persons and (ii) not making nor intending to make a public offering. The Section 3(c)(7) exemption is available to funds that are (i) owned exclusively by “qualified purchasers” and (ii) not making nor intending to make a public offering. There is no limit to the number of qualified purchasers under this exemption.
[3] According to the SEC, during the Relevant Period, Western Asset employed multiple investment strategies for its portfolios, including (a) the Western Asset Macro Opportunities strategy (“Macro Opps”); (b) the Western Asset US Core strategy (“Core”); and (c) the Western Asset US Core Plus strategy (“Core Plus”) (collectively, the “Strategies”). The portfolio clients within the Strategies included mutual funds and other registered investment companies (“Registered Funds”), private funds, and other investment funds (collectively with the Registered Funds and private funds, the “Funds”), as well as SMAs. Favored Portfolios (i.e., portfolios to which first-day gains were allocated) primarily included portfolios in the Macro Opps strategy, whereas Disfavored Portfolios (i.e., portfolio to which first-day losses were allocated) primarily included portfolios in the Core and Core Plus strategies, said the SEC.
[4] According to the SEC, defendant personally benefitted from the fraudulent scheme by allocating $19 million from his deferred compensation plan into the Macro Opps strategy. Defendant also benefited in terms of his compensation (i.e., bonus), which was tied to the Western Asset’s allegedly inflated management fees.
[5] See U.S. v. Leech, No. 24-cr-00658 (S.D.N.Y.). The indictment and the description of the indictment set forth in the release constitute only allegations, which the DOJ is required to prove at trial.
