Protect Your Firm from the SEC’s Cherry-Picking Initiative
The SEC is going after firms that misallocate trades to favor certain clients or the traders themselves – a practice known as cherry-picking. Chief compliance officers can stay one step ahead of the crackdown by taking steps to ensure they detect the practice before the agency does.
Cherry-picking can occur at advisory firms when a portfolio manager allocates trades with high returns to proprietary accounts, as well as to accounts that pay performance fees instead of, or in addition to, management fees, said K&L Gates partner Michael Caccese. They hope to collect the increase in fee revenue that such trades are likely to bring. "The problem is when you favor the house over the clients," he said.
"We have been working closely across Divisions on a cherry-picking initiative to scour data to identify potential unfair allocation of trades," said SEC Philadelphia Regional Office director Sharon Binger at a recent industry conference. Administrative proceedings against Wisconsin-based adviser Welhouse & Associates and its owner, Mark Welhouse (ACA Insight, 7/20/15), the first parties charged under the initiative, are scheduled to be held later this month.
Advisers can rest assured that this case will not be the last in the agency’s cherry-picking crackdown.
A second type of cherry-picking involves creating a "representative account" with high returns, or a time period when an account appears to have high returns, in both cases to bolster performance claims in a firm’s advertising, said Caccese. This sort of cherry-picking does not sit well with the SEC, which scrutinizes performance claims used in advertising and marketing.
What advisers can do
There are a number of steps advisers can take to mitigate the chance that cherry-picking is going on in their firms. These include:
Understand your firm’s accounts and stated allocation principles. Most of the screening that can be done to catch cherry-picking will depend on a CCO’s knowledge of this, said Shearman & Sterling partner Nathan Greene. By knowing which accounts your firm has and its position on trade allocation, anomalies will be easier to spot. Caccese stated that allocation procedures need to be established prior to any trades and implemented accordingly. "If there is an exception to the procedures, it should be monitored and documented," he said.
Screen for high-performing trades. A trade-blotter analysis is one way to do this. "If the firm allocates pro-rata among accounts, screen for anything that is not pro-rata," Greene said. Of course, be aware that there are times when trades may not be applied pro-rata, even when that is the firm’s general policy. Depending on the policy and related facts, such instances could include trading for a new fund that was expected to receive a higher allotment of trades, or high-volatility trades going to a fund that is structured for such trades, he said.
Check pre-allocation documents. Are portfolio managers generating these documents, which set out a fund’s allocation plans, prior to trades taking place? If so, findings of post-trade allocations could be a red flag. Pre-allocation documents "present a valuable paper trail for the compliance team," said Greene, who suggested that teams select a few of the documents and see if they were correctly followed. Again, don’t assume that a variance from pre-allocation documents means that cherry-picking is going on. There are exceptions where such changes are acceptable, such as an unexpected trade result, movements in the market, or changes in needs among accounts, he said.
Investigate master account/personal account arrangements. Check to see if there is a possibility of allocating trades from a master account to a personal account. If you find such trades, consider that a red flag deserving of more inquiry. One solution to avoid the problem entirely would be structurally walling off the master account, so such trade allocations could not be made.
Beware the gap. If CCOs see a significant time gap between market trades and allocations, it is likely that SEC examiners will want to know more about it. Time gaps longer than usual may mean that the extra time is being used to facilitate cherry-picking. The longer the gap, the greater the need for the compliance team to find out why.
Check high-performing trades. These should be scrutinized simply because high returns may be a risk factor for misallocations simply because some want a larger share of the proceeds. Options trades may yield such returns and, Greene said, if CCOs in firms that usually do not invest in options find such trades, they should ask themselves, "If our firm does not regularly invest in options, why is it doing so now?" If the options trades are all in one account, that is even more worthy of investigating, he said.
Provide all results from all accounts. In terms of performance reporting, make sure your firm shows results for all portfolios from the full period managed by the firm, rather than simply show a representative account or using a select time period, Caccese said. If your marketing people want to focus on just one account’s returns, it should be highlighted only within the context of showing all the returns, and explained in the advertising why that account is being highlighted.
The Welhouse case
Welhouse and his firm were accused by the SEC of receiving more than $442,000 in ill-gotten gains from February 2010 to January 2013 by unfairly allocating options trades in an S&P 500 exchange-traded fund. According to the administrative order instituting administrative proceedings, Mark Welhouse’s personal trades had an average first-day positive return of 6.28 percent, while his clients’ trades in the same option had an average first-day loss of negative 5.05 percent. The SEC, when recently asked, did not have a listing for an attorney representing Welhouse or his firm. A call to the firm itself reached a recording saying the phone number was no longer in service.
The enforcement action was the first under the data-driven initiative to identify potential cherry-picking, the SEC said. Under the initiative, enforcement investigators from the SEC’s Division of Enforcement work with economists from the agency’s Division of Economic and Risk Analysis to "analyze large volumes of investment advisers’ trade allocation data and identify instances where it appears an adviser is disproportionately allocating profitable trades to favored accounts," the agency said.