SEC Cherry-Picking Dragnet Yields Adviser Plea Bargain and Civil Settlement
Allocation of trade results that consistently favor an adviserís own accounts over his clients are likely to gain the attention of government enforcement officials. One adviser just found that out the hard way.
Michael Breton, founder, managing partner and chief compliance officer of Massachusetts-based adviser Strategic Capital Management is facing both criminal and civil enforcement actions. On the criminal side, a plea bargain, filed January 25 with the U.S. Attorneyís Office for the District of Massachusetts, although still awaiting court approval, leaves him facing up to three years in jail, disgorgement of†$1.3 million dollars, and a fine yet to be determined.
On the civil side, the SEC on January 25 announced that Breton will be permanently barred from the securities industry. The bar is one of the results from a partial civil settlement of an agency complaint filed by the SEC against Breton and Strategic Capital Management the same day in federal district court. Monetary sanctions are left to be determined at a later date.
"Breton and Strategic Capital Management owed a fiduciary duty to Strategic Capital Managementís clients," the agency said. "Breton and Strategic Capital Management also promised [the advisory firmís] clients that Bretonís personal securities transactions would not disadvantage Strategic Capital Managementís clients."
"Breton assured clients that he would put their interests first but did just the opposite, taking the firmís most profitable trades for himself and dumping the losing trades on his clients," said agency Division of Enforcement Market Abuse Unit co-chief Joseph Sansone.
"This is another case developed with assistance from the SECís Division of Economic and Risk Analysis, and reflects the SECís ever-improving ability to identify fraudulent trading patterns conducted by advisers," said Rogers & Hardin partner Stephen Councill. "Every advisory firm should have a solid trade allocation program that allows the adviser to demonstrate that all trades are fairly allocated, and not based on the benefit of hindsight. While cherry-picking has long been a concern for the SEC, this case demonstrates how the SEC is investing significant resources into finding this kind of activity. The parallel criminal action also reflects an†increasing willingness of prosecutors to pursue this kind of case, which they have not historically done."
There was clearly cooperation between the agency and the Justice Department, with the SEC, in its†announcement of the partial civil settlement, saying that it "appreciates the assistance of the U.S. Attorneyís Office for the District of Massachusetts and the Boston
field office of the Federal Bureau of Investigation."
The cherry-picking crackdown
Cherry-picking has been a target of the SEC since October 2015, when the agency settled with adviser Welhouse & Associates (ACA Insight, 11/2/15). More recent cases have included an enforcement action against Laurence Balter and Oracle Investment Research (ACA Insight, 10/24/16), and a settlement with adviser Simpson Hughes Financial (ACA Insight, 8/8/16).
"The SEC has touted its data analysis capability," said K&L Gates partner Vince Martinez. "Aberrant or anomalous data or results can be found through analyses of Forms ADV and PF. The data found doesnít have to be dead-on evidence of a violation, but if an adviserís performance appears materially better or different than its peers, that could result in increased scrutiny or a special examination."
Cherry-picking occurs when an investment adviser purchases securities and then waits to see if the stock prices goes up or down, and then keeps the best trades for himself or favored accounts, and places the less profitable trades with other clients. That, the Justice Department and the SEC charged, was what Breton did, although their time frames differ. The Justice Department alleged that the cherry-picking began prior to November 2011 and ended in "at least July 2016,"while the SEC took the position that the bad behavior began in "at least January 2010" and ended in March 2016.
"Specifically, Breton often purchased securities of public companies through a block trading omnibus account during regular market hours on days that those public companies were scheduled to make quarterly and/or annual earnings announcements after regular market hours," the SEC said. "Breton typically waited to decide whether to allocate the trade to the Breton Accounts or the Client Accounts until after the public companies made their earnings announcements. This delay enabled Breton to assess whether the earnings news caused or would likely cause an increase, or a decrease, to the price per share of the purchased securities."
"With this information in hand, Breton and [Strategic Capital Management] defrauded at least 30 of [the†advisory firmís] clients by cherry-picking more than 200 profitable trades for the Breton Accounts, and†allocating more than 200 unprofitable trades to the Client Accounts," the agency continued. "Bretonís fraudulent scheme worked: Breton made more than $1.3 million in profits derived from trades that he fraudulently did not allocate to the Client Accounts."
"Chief compliance officers need to be very vigilant about the use of primary trading in master accounts," said Martinez. "They will need to keep good records associated with the accounts to show that trades originally meant for particular clients were in fact allocated to those clients."
Both the Justice Department and the SEC alleged that Breton violated Section 10(b) of the Exchange Act and its Rule 10b-5, which prohibits fraud, although the SEC charged both Breton and Strategic Capital Management, while the Justice Department charged just Breton. The SEC also charged both parties with violating Sections 206(1) and (2) of the Advisers Act, which prohibit fraud, while the Justice Department leveled the same charges against only Breton. An attorney representing Breton and Strategic Capital Management did not respond to a voice mail or email seeking comment.