A recent opinion in an SEC administrative proceeding (SEC v. J.S. Oliver Capital Management, LP & Mausner, June 2016) highlights how an investment adviser can get in trouble through acts of its own. The commission held, among other holdings, that the registered investment adviser and its principal in question violated antifraud provisions by “cherry picking,” profitable transactions for favored accounts, by failing to disclose uses of soft dollars to their client, and by engaging in compliance and record keeping violations.
Cherry picking is a practice in which securities professionals allocate profitable trades to a preferred account (like there own) and less profitable or unprofitable trades to a non-preferred account (like a customer’s). In that way, an investment adviser can increase the performance of favored accounts, or at least make it more likely that they will out perform other accounts.
One form of cherry picking involves an adviser’s allocation of block trades. When an adviser executives a block trade at multiple prices, it may allocate the highest-price sales to favored accounts and the lowest-price sales to disfavored accounts. An Adviser can also cherry pick by allocating profitable trades entirely to favored accounts.
This is what happened in this case even after the brokerage firm where trades occurred informed and warned that investment adviser that the record of trades show bias trade allocation. Moreover, in the hearing, an expert witness confirmed this statistically undeniable fact. Even though there was in place an order management system, the principal went into the accounts and made manual allocations, despite written policy to allocate trades fair and equitable.
The commission found that the investment adviser had scientor when allocating trades. Scientor is a mental state embracing intent to deceive, manipulate or defraud, and includes recklessness defined as conduct that is an extreme departure from the standards of ordinary care.
The investment adviser and the principal were also liable for using soft dollars to pay expenses to benefit them without disclosing these uses to clients. Soft dollar practices are arrangements under which products or services other than execution of securities transactions are obtained by an adviser from or through a broker in exchange for the direction by the adviser of client brokerage transactions to the broker. The Exchange Act creates a limited safe harbor that applies to certain payments of research and brokerage expenses.
The liable use of soft dollars in this case included making payments to a former spouse and to a residence club for a timeshare. Even without these egregious acts, the commission held that the investment adviser did not abide by its duty to disclose soft dollar arrangements to its clients, or to disclose potential conflicts of interests accurately and completely.
The commission also held that the investment adviser violated compliance and record keeping requirements and the principal aided, abetted and caused these violations. For one, the investment adviser did not adhere to its own written policy. Also, the commission found that there was a failure to maintain trade blotters and a failure to comply with document retention obligations.
The moral of the story
No matter how hard your personal life gets complicated and how you want to live at a high standard of living, or how hard you want to please certain clients over other clients, violating anti-fraud provisions or even poor record keeping can lead to a finding of liability (and to large damages and to the removal from the industry).
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