September 6, 2018 / 1:49 PM / a month ago

SEC and CFTC cases indicate scrutiny of trade allocations and 'cherry picking'

NEW YORK(Thomson Reuters Regulatory Intelligence) - Bunching customer orders into larger block trades and allocating the executed order into multiple customer accounts is a common practice for investment advisers, regulators often find unscrupulous acts of allocating winning trades to favored accounts and vice versa. The practice commonly referred to as “cherry picking” has again surfaced in recent regulatory actions at the Commodity Futures Trading Commission and the Securities and Exchange Commission.

A trader reacts as he watches screens on the floor of the New York Stock Exchange in New York, U.S., February 5, 2018.

The recent cases — involving a commodities sales agent and an investment adviser — signal that the two primary regulators continue to unearth violations in trade allocation where investment managers or trading personnel cherry-picked the winning trades for themselves or other favored accounts. They serve as a reminder to firms that the handling of trade break-downs, or allocations, is a process the industry cannot take lightly, and that intentional acts of cherry picking are being detected.

NUTS AND BOLTS OF BLOCK TRADES AND ALLOCATIONS

In an effort to treat all advisory clients equally, investment managers commonly aggregate or “bunch” orders together into a block order for all customer accounts and then purchase or sell for all accounts at the same time in a block trade. After execution, the manager must break down the block into the various client accounts. This is known as the allocation process. It is commonly done electronically through order management systems (OMSs) designed to make the process more efficient and avert errors.

Because prices fluctuate throughout the day, often at the end of the day a trade can be measured as a profit or loss, depending on the price executed and the closing price. This has occasionally tempted some unscrupulous advisors to “cherry pick” winning or losing trades and allocate them in a preferential manner to preferred accounts or even their own personal or firm accounts.

Because of those who try to circumvent or take advantage of this structural vulnerability through cherry picking, regulators subject the block trade allocation process to heavy scrutiny. The key to avoiding problems is determining the allocation before the trade is executed and not changing it afterward to benefit certain accounts to the detriment of others.

THE CFTC CASE INVOLVING CHRISTIAN ROBERT MAYER

Although a recently announced settlement involving Christian Robert Mayer{here}, has little to do with order bunching, fraudulent allocation practices akin to cherry picking were at the heart of the case. According to the CFTC, Mayer allegedly conducted unauthorized trading in client accounts then later transferred the winners to his own account. He said they were inadvertently placed in the wrong account, while leaving the losing trades in the customer accounts.

The CFTC said, Mayer, an associated person of an unnamed Minneapolis commodity trading advisor and introducing broker (IB), placed trades in cattle, crude oil, and wheat futures contracts between October 29, 2014, and September 28, 2016. Mayer …”logged on to the online portal of the Futures Commission Merchant which carried all the accounts, accessed the transfer section of the portal, and fraudulently indicated that the reason for the trade transfer request was that he had placed the trade in the wrong account,” the CFTC said.

Eventually the firm discovered the unauthorized trades and transfers and promptly reimbursed the defrauded customers $105,090, the CFTC said. This represented the amount of the losing trades that Mayer left in their trading accounts, plus the profitable trades that Mayer improperly transferred from the customers’ accounts, the CFTC said. Mayer paid this amount to the IB for purposes of reimbursing the defrauded customers, according to the order.

The CFTC order required Mayer to pay a $100,000 fine and imposed permanent trading and registration bans on him.

THE SEC CASES INVOLVING ROGER T DENHA AND BKS ADVISORS LLC

According to the settlement orders involving Roger T. Denha{here} and BKS Advisors, LLC{here}, Denha was employed by BKS as an investment adviser representative from August 2003 until November 30, 2017 and had no prior disciplinary history. Denha was not an owner or principal of BKS. However, Denha had 197 clients and $202 million in assets under management (AUM), representing more than half of the firm's $365 million AUM as reported in March 2018.

The SEC alleged that from January 2012 to November 2017, Denha engaged in cherry picking. Denha unfairly allocated purchases of securities among his favored accounts — which included his personal and family accounts — and his other BKS clients’ accounts. It said he disproportionately allocated profitable trades to the favored accounts, and disproportionately allocated unprofitable trades to the accounts of certain advisory clients. “He executed his scheme by buying the securities in an omnibus account and then waiting to allocate until after he had an opportunity to see whether the securities had increased in price,” the SEC said.

In the BKS order, the SEC said, “BKS failed to implement policies and procedures reasonably designed to prevent Denha from allocating trades unfairly and failed reasonably to supervise Denha.” The SEC also charged that Denha’s cherry picking scheme, resulted in BKS making misleading and false statements to its investment advisory clients and prospective clients particularly in its Form ADV Part 2A.

In settling with BKS, the SEC noted the cooperation and voluntary remedial acts undertaken by BKS.

The remedial acts included BKS conducting its own internal investigation, hiring an outside law firm and new outside compliance consultant, amending its Form ADV, and implementing new trade allocation policies. BKS consented to the order without admitting or denying the findings. It was censured and agreed to pay a $75,000 fine. It also agreed not to violate Sections 206(2), 206(4){here} and 207{here} of the Advisers Act and Rule 206(4)-7{here}.

Denha also consented to the order without admitting or denying the findings, and to not violate Section 10(b) of the Exchange Act{here} and Rules 10b-5(a) and 10b-5(c) thereunder and Sections 206(1) and 206(2) of the Advisers Act{here}.

Denha agreed to pay disgorgement of $412,230.00 and prejudgment interest of $35,388.00 to the SEC and a fine of $169,000 to the SEC. He was also barred from association with any investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization.

Funds collected from the proceedings are to be distributed through a “Fair Fund” to harmed investors.

TAKEAWAYS AND SUGGESTIONS

Because trade allocation practices are always subject to the highest level of scrutiny by regulators as high-risk areas for potential abuse, advisers on the buy-side and brokers on the sell-side rigorously follow strong policies and procedures.

Portfolio management, trading, and compliance departments must review daily all allocations and exceptions to any policies and procedures. Any exceptions or exclusions from a trade as well as any allocations not made on a pro-rata basis must be documented and clearly justified. A daily review will keep track of any trade errors arising from trade allocations and will serve as evidence in the event of an examination by regulators.

Accounts considered higher-risk include accounts trading in illiquid securities, proprietary or personal accounts of the manager or employee, and pooled investment accounts where a portfolio manager, adviser, or trader may have a higher economic interest than other client accounts.

Although there is no regulator-mandated specific allocation practice or methodology, advisers should be certain that whatever practice they use rigorously follows their policies and procedures. Current best practices for trade allocations will show that the policies and procedures, above all else, are fair to all clients. Any preference for a client is an enormous red flag.

All trade allocations and policies and procedures should require that allocations be determined before entering an order. Exceptions to such policies are allowed and in some cases may be required for specific client accounts, but all exceptions must be thoroughly documented.

In the event of partial fills which will require a partial allocation to all participating accounts, a formula determining the pro-rata allocation and any exclusions must also be followed.

If an adviser is attempting to trade multiple blocks at multiple brokers for various groups of client accounts, there should be a rotational order policy as well so that no group of clients at any particular brokerage firm are always first or last in line, for example.

The maintaining of accurate books and records and evidence of trade allocations is essential. Firms must be able to document essentially that every trade was allocated properly. Most order management systems will do this automatically and offer the ability to note any exceptions or unusual circumstances.

Although firms may lack any intent to cherry pick and feel their policies and procedures are adequate, testing should also be done regularly as evidence of effectiveness. At BKS, the firm showed no intent and evidently saw its policies procedures and filings as adequate. However, Denha allegedly managed to circumvent the policies and the firm failed to supervise and detect his actions.

Finally, firms must be able to document that they are doing what their policies and client disclosure documents say. Any variation between a policy, actual practice, and what clients have been told either by client advisory agreements, on Form ADV, or in the “brochure” Form ADV part 2 may result in a violation in the eyes of the regulator.

Regardless of the asset being traded firms must consider trade allocations to be a high-risk area that will surely be reviewed with a fine-tooth comb by regulators. There is zero margin for error. Policies, procedures, and systems must be rigorous, thorough, and above all completely defensible.

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence based in New York.)

This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Aug 27. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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