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News January 14, 2008 Issue

Adviser That Failed to Supervise Cherry-Picking Trader Hit With Fines

If you set up a compensation system whereby a trader will be incentivized to cherry-pick profitable trades for one account over another, you’ve got to have procedures in place to monitor the trader’s actual trading.

That’s the lesson from an SEC enforcement proceeding against two advisory firms and an affiliated broker-dealer, all run by Kenneth Brown and his wife. Back in 2003, the Browns hired a day trader to manage their own proprietary account. The trader got to keep 50 percent of the proprietary account’s profits. The trader also had responsibility for executing trades in the Browns’ advisory clients’ accounts, but was paid only 1 percent of the commissions generated by those trades.

Guess where the trader put the most profitable trades?

The SEC cited the firms for failing to have policies or procedures to address the conflicts created by the proprietary account and the compensation structure. The SEC also sued Brown, alleging that he "knew or was extremely reckless in not knowing that this conflict of interest and improper trading was occurring."

On December 19, a federal judge ordered the Browns and their firms to disgorge close to $6 million in profits and interest, and to pay a substantial $4.85 million in combined civil penalties.