More On Legal & Compliancefrom The Advisor's Professional Library
- RIAs and Customer Identification Just as RIAs owe a duty to diligently protect their clients privacy and guard against theft, firms also play a vital role in customer identification. Although RIAs are not subject to an anti-money laundering rule, securities regulators expect advisors to address these issues in their policies and procedures.
- The Need for Thorough and Effective Policies and Procedures Whethere an advisor is SEC or state-registered, RIAs must revise their policies and procedures to address significant compliance problems occurring during the year, changes in business arrangements, and regulatory developments.
As fiduciaries, registered investment advisors must always put their clients’ interests ahead of their own. An RIA must work diligently to ensure that the firm’s trading practices meet the standard owed by a fiduciary.
During examinations, the SEC and state securities regulators scrutinize firms’ trade allocation practices because there is a potential for clients to be harmed or defrauded. Securities examiners also expect RIAs to disclose fully their trade allocation practices in their Form ADV disclosure brochure and to implement policies and procedures that are designed to ensure clients are treated fairly when trades are executed.
An RIA should never wait for subsequent market movements before deciding how to allocate trades among clients. Regulators are concerned that the RIA might allocate the trades to favored clients if prices go up and to less-favored clients if prices go down. This practice, known as “cherry picking,” violates the Investment Advisers Act and the RIA’s fiduciary obligations.
On rare occasions, unscrupulous advisors will allocate profitable trades to themselves, not a favored client. Last May, the SEC charged a father and son and their RIA with perpetrating a cherry-picking scheme that netted nearly $2 million in illicit profits.
Sec Complaint Charges RIA With Cherry Picking
In its complaint, the SEC alleged that the father and son placed millions of dollars in securities trades without documenting in advance whether they were trading client funds or personal funds. According to the complaint, they delayed allocating the trades for one or more days, enabling them to cherry pick winning trades for their personal accounts while dumping unprofitable trades on their clients.
The RIA misrepresented the firm’s proprietary trading activities to clients, many of whom were senior investors. These misrepresentations occurred in a brochure that was included with the RIA’s Form ADV. The brochure falsely stated that the firm did not aggregate client and employee orders. In fact, when orders were placed, the father and son made block purchases in the RIA’s brokerage accounts that were allocated later to personal and client accounts, depending upon the profitability of the trades.
For 17 consecutive quarters, the father and son achieved positive returns at allocation, while managing to assign most losses to their clients. One of the father’s personal accounts increased in value by almost 25,000% from 2008 to 2011. During that time, many of the firm’s clients saw their accounts decrease in value.
The father, an investment advisor representative (IAR), and the RIA owed a fiduciary duty to their clients. The SEC’s complaint further alleged that they owed a duty to refrain from cherry picking. The securities allocated to client accounts were largely the same as those allocated to personal accounts. The SEC charged that the primary difference was the profitability of the trades, not the securities traded.
Designating Personal and Client Orders
RIAs must enter trades as either a client or personal order before the trade is executed. Firms should create a written record to document whether they are trading personal or client funds. In this case, the allocation did not occur until the father and son monitored market prices to determine if the trades were profitable.
The performance of their accounts and client accounts was significantly different. From 2008 to 2012, the father and son placed more than 13,500 trades. More than 75% of their trades were profitable at allocation. In contrast, fewer than 25% of trades allocated to the RIA’s clients were profitable at the time of allocation.
When the father and son entered orders, they did not create a contemporaneous record identifying whether they were trading for clients or themselves. In contrast, other members of the RIA placed client trades through order management software that required the user to designate the account placing the order before executing the trade.
Front Running and Other Breaches of Fiduciary Duty
On May 24, the SEC charged a Dallas-based trader with engaging in front running and other forms of securities fraud. The trader failed to comply with the obligations owed to his firm and breached his fiduciary duties to clients by using inside information to gain an unfair trading advantage.
The accused trader worked for an SEC-registered RIA that specialized in master limited partnerships and energy-related securities. The trader allegedly defrauded the RIA and its clients by using confidential information to trade ahead of the firm’s clients. The trader was privy to material, non-public information relating to the size and timing of those trades.
The trader concealed his front-running scheme by failing to disclose his wife’s accounts to the RIA. By not disclosing those accounts, he violated the firm’s procedures and was able to avoid pre-clearance of his lucrative trades. He allegedly placed approximately 132 trades ahead of his clients.
RIAs face significant compliance problems when they fail to fully disclose their trade allocation polices or misrepresent their trading practices. Additionally, an RIA may defraud its clients when it disproportionately allocates potentially lucrative initial public offerings to proprietary or favored accounts. RIAs that charge performance fees to certain clients might be tempted to allocate IPOs or winning trades to those accounts. Those accounts will pay higher advisory fees if returns exceed a specified amount.
Neither RIAs nor their associated persons should ever take advantage of investment opportunities that would otherwise be available to clients. An RIA’s chief compliance officer, or a designee, should periodically review trade allocations to monitor and prevent trading improprieties, such as cherry picking, front running and insider trading. Proprietary accounts must never be given preferential treatment.
One of the SEC’s rulemaking priorities is adoption of the Volcker Rule. The primary focus of the rule is to prevent banks and their affiliates from engaging in proprietary trading for their own gain. RIAs that are affiliated with banks should monitor the SEC’s progress with the Volcker Rule and be prepared to implement compliance procedures to effectively address all relevant rule requirements. As of press time, the SEC was expected to issue a ruling the week of Dec. 9.