Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News June 26, 2017 Issue

Latest Cherry-Picking Case Includes Improper Fee, Investment Strategy Charges

It’s no secret that the SEC’s Division of Enforcement is targeting advisers that misallocate trade results to favor themselves, a practice known as cherry-picking. What is also turning up in some of these enforcement actions are additional charges, such as improper fees and deviations from investment limitations.

Just ask Laurence Balter, the founder, sole proprietor and chief compliance officer of Washington State-based advisory firm Oracle Investment Research. He and his firm last month reached a settlement with the SEC that, according to the agency, involved just those charges. Balter allegedly stole approximately $490,000 from clients, an amount he was ordered to disgorge, along with approximately $10,080 in interest and a $50,000 civil money penalty, as part of the settlement. He was also permanently barred from the securities industry.

The SEC, in its administrative order instituting the settlement, charged that from January 2011 to April 2014, Balter, who managed both a mutual fund and between 100 to 120 separate accounts, "engaged in three distinct violations." Specifically, the agency said that he:

  • Fraudulently allocated profitable trades to his own accounts, thereby hurting several client accounts;
  • Falsely told his separately managed account clients who had invested in the mutual fund he managed that they would not pay both advisory fees and fund management fees; and
  • Made trades for the mutual fund that deviated from two of the fund’s investment limitations.

"Together, the violations cause significant harm to Balter’s clients," the SEC said.

"This case represents a couple of bête noires for the SEC: conflicts of interest and conduct that differs from representations to investors," said Paul Hastings partner Nicolas Morgan. "When an adviser makes material representations about issues like fees and expenses, trading priority, and investment strategies or allocations and the SEC identifies conduct that deviates from those representations, some unwanted attention from the Enforcement Division will likely follow."

"This case also demonstrates that the SEC will scrutinize Forms ADV, investment company registration statements and emails with clients and executing brokers for suspect representations," he said. "The potential issues are multiplied when, as in this case, an adviser has individual clients and fund clients that the individual clients have invested in. Particular care must be given to potential conflicts in such situations."

Cherry-picking is a particularly egregious form of breach of fiduciary duty and it may be that the agency perceives it to be somewhat widespread," said Shartsis Friese partner Jahan Raissi. Cracking down on the practice by the SEC may be low-hanging fruit for enforcers, as "it is a relatively easy matter to mathematically show the cherry picking – the better trades consistently go to the adviser."

The clients, the fund and the fees

Most of Balter’s clients were individual investors, according to the agency’s administrative order, "many of whom were over 60 years old, retired or nearing retirement, and unsophisticated investors with little investment experience." These clients were typically charged an annual management fee of 1.5 to 1.7 percent of their assets under management. According to the SEC, Balter used a buy-and-hold strategy for most of his clients and primarily invested them in large-cap securities and in the mutual fund he managed, Oracle Mutual Fund.

Oracle Mutual Fund’s stated strategy, spelled out in its prospectus, was "long-term capital appreciation while secondarily striving for income,’" the agency said. Oracle Investment Research, as the fund’s adviser, was allowed to charge management fees of 0.7 percent of average daily net assets, and, as the administrator of the fund, 0.2 percent of net assets.

However – and this is an important fact to remember, if what the SEC said is correct – "to the extent that the fund’s operating expenses, including Oracle’s management and administrator fees, exceeded 1 percent (1.5 percent after January 1, 2013) of the fund’s average net assets, Balter agreed to reimburse certain fund operating expenses."

The trades

Balter made use of both day trades and omnibus accounts. Beginning in May 2012, the agency said, he began executing day trades for himself and a few of his SMA clients at omnibus accounts held at two different broker-dealers, identified by the SEC only as "broker 1" and "broker 2." Broker 1 also served as the custodian for Balter’s advisory clients from June 2010 through June 2013, at which time the broker "unilaterally terminated" it relationship with Balter and Oracle, the agency said, with broker 2 then performing that role from July 2013 through December 2013.

Balter regularly executed trades for himself and some of his clients in the same omnibus account, "without pre-allocating or making an equitable allocation of the trades," the SEC said. "Indeed in virtually all instances in which Balter made trades in the omnibus trading account, he did not allocate the trades until after they were executed – in other words, after he knew the profitability of the trade. Moreover, Balter disproportionately allocated profitable trades to his own accounts and unprofitable trades to his client accounts."

This was done, the agency said, despite a representation by Balter in his Form ADV that he would trade for clients before he traded for himself. From January 2011 to April 2014, according to the SEC, "there [were] multiple days on which he traded before his clients in the same securities. On many of those days, he received a better price for his trades than he did for his clients’ trades. Almost all of the trades in which Balter traded before his clients and received a better price for the same security were made from his omnibus account and then allocated manually to his and his clients’ accounts, respectively, later in the day."

Clients and dollars

Nor, the SEC said, were any of Balter’s clients aware that Balter was executing his own trades in a single account that also included client trades, or that he was cherry-picking the best trades for himself. "Balter sent daily emails to [one of his clients], purporting to report the results from that day’s trading in [that client’s] accounts, that underreported the losses that [the client] sustained from Balter’s reckless cherry-picking scheme."

These alleged misrepresentations and omissions – both the cherry-picking and the conflict with disclosures in Balter’s Form ADV, as well as with his firm’s written policies and procedures – "constituted breaches of Balter’s fiduciary duty to his clients," the agency said.

The SEC offered the following numbers to back up its case:

  • April 2012 through May 2013. During this period when Balter worked with broker 1, he "earned first-day returns in the omnibus account of approximately $220,000, or about a 0.63 return on his investment," according to the SEC. "At the same time, [one of his clients] suffered first-day losses of approximately $1,365,000, or about a -0.38 percent return. Other clients collectively suffered total losses of more than $34,000, representing about a -0.14 percent return on their investments."
  • July 2013 through December 2013. This was when Balter worked with broker 2. During this period, the agency said, "his account had total net profits of approximately $118,000, or about a 1.39 percent return on his investment, while [one of his clients] had total losses of more than $700,000, or about a -0.78 percent return."

Broker 2 in December 2013 made clear to Balter that it had concerns about the trading. "Shortly thereafter, broker 2 notified Balter that it was terminating its relationship with him and that he would need to move his client accounts off of broker 2’s platform," the SEC said.

Fee credits and investment limits

But cherry-picking was not all that Balter was charged with. There were also allegations involving fee credits and investment limits.

Contrary to representations to clients, the agency said. Balter did not credit their quarterly management fees by subtracting some of their fund management fees. "By making these misrepresentations, Balter breached his fiduciary duty to those clients."

As for investment limits, Balter allegedly caused the mutual fund he managed to deviate from its fundamental investment limitations. Section 8(b) of the Investment Company Act requires that a registered investment company’s registration statement include certain investment policies, including its subclassification as either "diversified" or "non-diversified," and its concentration of investments in a particular industry or group of industries. Once this is done, the investment company needs to seek authorization from the board of directors to either change its classification of its diversification categorization or for a deviation in its investment concentration.

"In many quarters beginning no later than March 2012, Balter made investments for the fund that resulted in the fund changing from a diversified to a non-diversified company, and in many quarters, he also purchased securities that caused the fund to deviate from its concentration policy," the SEC said. "By making these investments, Balter breached his fiduciary duty to his clients."

"Balter’s violations had a significant impact on the fund’s performance," the agency said. "As a result, the fund’s investors suffered harm as a result of the fund’s failure to comply with the diversification and industry concentration limitations."

Violations

Balter was charged with willfully violating a number of securities laws and regulations, including Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Sections 206(1), (2) and (4) of the Advisers Act, as well as its Rule 206(4)-8, all of which prohibit fraud. In addition, he was charged with willfully violating Section 207, for making an untrue statement of material fact on its registration application, and Section 13(a) of the Investment Company Act for deviating from the investment company’s diversification classification without board approval. An attorney representing the firm did not respond to a message seeking comment.