Cherry-Picking Initiative Yields First Settlement
The first catch in the SEC’s cherry-picking initiative has resulted in the adviser in the case being barred from the securities industry and having to pay a $300,000 fine, plus disgorgement and interest of about $418,000.
The October 16 settlement brings to a close an administrative action announced June 29 (ACA Insight, 7/20/15), when the SEC instituted proceedings against Welhouse & Associates, and its owner/chief compliance officer Mark Welhouse. The agency touted the case as an example of how it used its high-tech analytical tools to demonstrate that the investment results the firm produced could not be replicated in a statistical analysis, which the agency said that in this case it ran one million times.
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.
"It is clear from the settlement that the SEC is using the case as a shot across the bow to give a warning to the industry that the SEC means business and will not tolerate advisers that are fiduciaries benefitting themselves to the detriment of their clients," said K&L Gates partner Michael Caccese. "The SEC is also showing to the industry that ‘violators’ cannot hide since the agency has elaborate forensic tools that enable them to find improper practices that harm investors that in the past were very difficult to find."
"With a disgorgement amount of over $400,000, a civil monetary penalty of less than that amount is quite modest," said Zaccaro Morgan partner Nicolas Morgan. He accredited the relatively small fine to the SEC crediting Welhouse and his firm with having already reimbursed a harmed investor.
"While the securities industry bar against the individual respondent is consistent with similar SEC cases alleging fraud," he said, "the fact that the SEC merely censured the firm, a firm owned and controlled by the individual respondent, actually suggests some lenient prosecutorial discretion on the SEC’s part."
Under the SEC’s 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.
"Cherry-picking schemes can be extremely difficult to detect without an investor astutely noticing that something may be amiss and coming to us with a complaint about the adviser," said Enforcement Division Asset Management Unit co-chief Julie Riewe at the time.
"We devised this initiative to identify specific custodians providing services to investment advisers and their clients and leverage their trading records and other data to efficiently target preferential trade allocations occurring outside the detection of even the most observant client," she said.
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 charged Welhouse and Mark Welhouse with willfully violating Section 10(b) of the Exchange Act and its Rule 10b-5, which prohibit fraud. In addition, the two parties were charged with violating Sections 206(1) and (2) of the Advisers Act, for allegedly committing fraud. An attorney representing the firm or Welhouse could not be located, and a call to the firm itself reached a recording saying the phone number was no longer in service.