Settlement Shines New Light on Old Practice of Scalping
With ever-more sophisticated securities transactions seemingly becoming the norm, the SEC increasingly relies on its own high-tech abilities to identify fraud. Elaborate new ways of investing and transacting should not, however, distract compliance departments from monitoring their firms for some of the most basic kinds of fraud. The practice known as "scalping" is a case in point.
A recent agency settlement with an advisory firm makes it clear that the agency, despite its oft-stated reliance on data analysis and other tech-driven solutions to catch fraud, is still going after the low-hanging fruit.
Miami-based unregistered investment adviser and independent stock analyst Mark Gomes, as a result of the settlement, finds himself approximately $273,000 poorer and barred from the industry for five years. The SEC charged that Gomes, on at least five occasions between February and July 2014, engaged in scalping. The agency defines scalping as an advisory firm’s failure to disclose, when it recommends to investors that they purchase a security, that it has also purchased the security and, after the investor purchases have driven the security’s price up, sells it at a profit.
"At the end of the day, scalping falls under the category of ‘conflict of interest,’" said Mayer Brown attorney Adam Kanter, as do certain other kinds of basic fraud. These include cherry picking (when an adviser allocates the best trading results for his own or other favored accounts); front running (when an adviser buys or sells a security before his client does, thereby influencing the sales price); and window dressing (when an adviser artificially heightens the value of a security, perhaps by making a large number of trades, just before a regularly scheduled report to investors, thereby making the stock look more active).
While the agency still takes action against scalping when it finds it occurring – in addition to last month’s Gomes settlement, check out a federal district court’s February 2014 judgment against unregistered adviser and stock promoter Jerry Williams – it "doesn’t come up that much anymore because most people are not dumb enough to do it," said Stradley Ronon partner Lawrence Stadulis.
"You see it more with smaller shops, many of which are unregistered advisers," said Kanter. In addition, noted King & Spalding partner Alec Koch, scalping tends to occur with smaller stocks, since client purchases of shares of large companies, like Google or IBM, would not be likely to make a material difference to each company’s stock price.
Despite this, CCOs would be remiss if they did not check for it at their firms – and let it be known that they monitor for all types of fraud, basic or otherwise, he said.
The Capital Gains case
Aside from the fact that it is fraud, scalping holds a special place in investment adviser enforcement history. It was the subject of one of the first court decisions that tied investment advisers to a fiduciary duty.
The Supreme Court in its December 1963 decision in SEC v. Capital Gains Research Bureau overturned two lower courts’ decisions when it ruled that "the practice – known in the trade as ‘scalping’ – ‘operates as a fraud or deceit upon any client or prospective client’ within the meaning of the [Advisers] Act," wrote Justice Arthur Goldberg for the majority. "We hold that it does and that the Commission may ‘enforce compliance’ with the Act by obtaining an injunction requiring the adviser to make full disclosure of the practice to his clients."
Prior to this ruling, known as a certiorari because it sent the case from the Supreme Court back to the lower courts to re-adjudicate in light of the high court’s stance, scalping was not commonly understood to be fraudulent under the Advisers Act, said Stadulis. An adviser simply purchasing and then selling the same securities as its clients "was not seen as something done with the intent to injure clients or cause an actual loss of money to their clients."
"The Investment Advisers Act of 1940 . . . reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested," Goldberg wrote. "It would defeat the manifest purpose of the Investment Advisers Act of 1940 for us to hold, therefore, that Congress, in empowering the courts to enjoin any practice which operates ‘as a fraud or deceit,’ intended to require proof of intent to injure and actual injury to clients."
The high court ruling, said Stadulis, "was the first and seminal case in which the Supreme Court held that the Advisers Act recognizes the delicate fiduciary nature of the relationship between investment adviser and client, that the defendant violated that duty and, thus, committed fraud under Section 206 of the Advisers Act for failure to properly disclose its practice of scalping."
What to do
There are several ways that advisory firm compliance departments can monitor for scalping activity:
Compare account transactions. Match the proprietary account transactions and the personal account transactions of the investment advisory representative involved with the recommendations made to clients, said Kanter. "Are they buying the same securities within the same period of time?"
Confirm proper disclosure. Seek legal advice to ensure that the amount and type of information your firm is disclosing regarding trading is adequate in terms of informing clients of personal and proprietary trading within the firm, said Koch.
Set blackout periods. During such periods, such as seven days, neither the firm nor any of the firm’s "access persons" would be permitted to buy or sell any security traded by a client, Kanter said.
Gomes and the scalping allegations
Gomes, according to the SEC’s administrative order instituting the settlement, distributed investment recommendations and other analyses and reports on a regular basis through websites. Those sites were operated by what the agency described as "Company A," which was formed by Gomes in 2013 and in which he held a 50 percent interest, as well as through a third-party website.
Company A compensated Gomes with funds that were generated from subscriptions to Company A’s two websites, one of which required a paid subscription and another of which was free. The paid subscription offered clients benefits such as earlier access to reports and direct contact with Gomes, the SEC said. "Gomes interacted directly with subscribers through emails, video conferences and online forums. Gomes held shares of the stocks that were the subject of his recommendations and analyses, so his recommendations and analyses were not disinterested." Gomes also distributed recommendations and analyses through the third-party site, according to the agency.
"On at least five occasions between February 2014 and July 2014, Gomes purchased shares in a stock, recommended buying that stock, and then sold shares in his personal accounts within days of his recommendation," the SEC said. "In at least one instance, Gomes began selling shares only a few hours after posting his recommendation. Gomes never disclosed that he planned to or was selling his shares."
As an example, the agency noted that in April 2014, Gomes issued a recommendation to clients on Company A’s paid subscriber site that investors purchase shares of a certain issuer’s stock. "That same day and the following day," the agency said, "he sold shares of the stock at a profit. Gomes repeated the process later in the month, recommending the stock on Company A’s free site and on a third-party website and then selling shares two days later at a profit."
"By recommending investments, but failing to disclose that he would trade in the opposite direction of his recommendations, Gomes omitted material information necessary in order to make his recommendations not misleading," the SEC said.
Under the settlement, Gomes was found to have willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and its Rule 10b-5, and Sections 206(1) and (2) of the Advisers Act, all of which prohibit fraud. In addition to being banned from the securities industry for five years, Gomes agreed to pay disgorgement and prejudgment interest of more than $142,000 and a civil money penalty of $130,670. An attorney representing him, when reached, chose not to comment on the settlement.