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December 23, 2013 at 07:00 PM
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.
