Advisory Firm Settles Cherry Picking Fraud Charges With the SEC

The U.S. Securities and Exchange Commission (SEC) announced on September 14, 2023, that an investment advisory firm settled fraud charges related to the practice of cherry picking. While neither admitting nor denying the SEC’s findings, under the cease-and-desist order the firm will pay nearly $3.5 million in disgorgement and civil penalties.

Cherry picking is the fraudulent practice whereby winning trades are allocated to favored accounts, and/or losing trades to disfavored accounts – i.e., after the trades have been executed and the prices are known. Per the SEC’s order, between January 2020 and March 2022, the owner and investor adviser representative (IAR) engaged in block trading, allowing him to pool funds from multiple client accounts and determine which favored accounts would receive the more profitable trades.

In the September 14, 2023 SEC Press Release, it stated:

The SEC has the means to identify investment advisers that abuse their position through cherry picking... We use these methods to ensure investor trust in our markets.

What is particularly notable in this enforcement action is the fact that the SEC focused their efforts on a small, state registered investment adviser and was able to use their NEAT (National Exam Analytic Tool) to uncover these actions. This should give pause to firms of all sizes who should be stopping to evaluate what they are doing to proactively detect potential market abuse on their own.

Key takeaways

The regulatory aspects of this case are a current reminder of the importance of order allocation practices and controls. However, other aspects of this case portray the importance of operational configuration and data governance, particularly for independent contractor investment advisers. Investment advisers that allow IARs to independently serve as their own portfolio manager rather than centralizing such decisions through an investment committee, and, in turn, provide allocation instructions themselves directly to their executing brokers and/or clearing firms without adequate and timely transparency to the supervisors of the investment adviser, enable risk of inappropriate allocation instructions being processed, thereby putting the firm at risk for inadequate supervision. If firms allow IARs to send allocation instructions themselves without either requiring pre-approval by a supervisor, or operational configuration by the executing broker/clearing firm to ensure an allocation that does not prefer any one investor or groups of investors over another, then the onus is placed on the investment adviser to ensure its supervisory framework can detect and correct inappropriate allocations.      

Our guidance

Firms should consider incorporating technology into their processes to keep pace with the SEC, confirm they are in compliance with regulatory requirements, and provide the necessary information to the regulator to prove their compliance when necessary.

As seen in this enforcement action, regulators are using cutting-edge technology to surface potential market abuse, insider trading, and other misconduct, leading to record-breaking fines and other enforcement actions.  It is more important than ever for firms to be proactive about detecting issues on their own. 

How we help

ACA’s ComplianceAlpha^®Market Abuse Surveillance (MAS) solution helps firms manage their trading risk in a way that meets regulatory expectations in line with industry best practices. MAS identifies items of interest (IOI) based on algorithmic searches across multiple asset classes, including equities, fixed income, currencies and derivatives.

In relation to this enforcement action, the MAS Cherry Picking algorithm, which is part of a suite of “Fairness in Dealing” algorithms, could have been used to detect this abuse. This algorithm looks at client trades and allocations, combined with security pricing data and other security level information to look for cherry picking.  The case management tools would then allow you to document your investigation and findings.

Watch our on demand demo to see our MAS solution in action.

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ComplianceAlpha is an award-winning regulatory technology platform that integrates risk and compliance activities to better assess fairness in dealing across allocation and execution, providing an integrated surveillance solution which automates ongoing monitoring by providing flexible workflows, enhanced analytics and managed services delivery. ComplianceAlpha is used by over 1,200 leading financial services firms worldwide to build more scalable and resilient compliance programs.

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