The SEC settled public administrative and cease and desist proceedings against a registered investment adviser (the “Adviser”) and its majority owner, who also acted as the Adviser’s CEO, Co-CIO and CCO (the “Executive” and collectively with the Adviser, the “Respondents”) during various times between January 1, 2007 and September 3, 2009 (the “Relevant Period”). The SEC’s findings related primarily to the Adviser’s practices regarding the allocation of block trades when participating client accounts had insufficient funds to purchase their allocation. This article summarizes the SEC’s findings, which the Respondents neither admitted nor denied.
Background. The Adviser, an SEC-registered investment adviser, offered its clients active investment portfolio management using several model portfolios designed to meet particular investment goals. The Adviser’s clients chose particular model portfolios based on their needs and risk tolerance and delegated to the Adviser the discretionary authority to manage their accounts. During the Relevant Period, client accounts grew from approximately 1,000 accounts representing approximately $300 million in assets to over 7,000 accounts representing over $742 million in assets under management.
Aggregation of Client Orders in Block Trades. In connection with the Adviser’s management of client accounts, the Adviser reserved the discretion to aggregate client orders into block trades. The Adviser exercised this discretion by buying and selling securities for all clients assigned to a particular investment strategy in large block trades. The Adviser would allocate shares in a block trade among clients based upon the clients’ chosen model portfolios and their account balances.
The Adviser’s trade management system was not compatible with the trading platform at the custodian for the majority of client accounts through which the Adviser executed most of the block trades on behalf of its clients. The resulting real-time trade reconciliation issues meant that the Adviser’s traders did not possess accurate real-time information from the custodian regarding clients’ actual current account balances at the time the Adviser was making initial allocations to clients for block trades. During the Relevant Period, due to this inaccurate information, some clients who participated in block trades did not have sufficient funds in their accounts to purchase the allocated shares, resulting in unallocated shares (a “Block Trade Surplus”). The Adviser typically learned of the existence of a Block Trade Surplus between three and five days after the original block trade was placed. The SEC found that, in approximately July 2007, the Executive was advised of the trade reconciliation issue.
Adviser’s Block Trade Surplus Allocation Practice. During the Relevant Period, the Adviser followed an unwritten practice of allocating any Block Trade Surplus among those clients who fell within the same investment model portfolio and whose cash positions exceeded a previously designated cash threshold. Client accounts purchasing securities from a Block Trade Surplus did so at the execution price for the block trade, without consideration for any change in the securities’ price in the interim. At the end of this process, any portion of a Block Trade Surplus that remained unallocated was sold through the Adviser’s error account.
The Adviser did not categorize Block Trade Surpluses as trade errors, but treated them as administrative errors. If Block Trade Surpluses had been labeled as trade errors, the Adviser’s compliance procedures required the Adviser to document them as such and perform a profit and loss analysis for the trade. The Adviser’s written policy also required it to make any client whole if any trade error resulted in a loss to the client.
In over 400 instances during the Relevant Period, the Adviser allocated Block Trade Surpluses to clients other than those originally intended to receive the shares. The SEC found that these clients suffered approximately $20,183 in losses as a direct result of those allocations.
Annual Compliance Review and Books and Records Violations. The SEC found that, the Respondents failed to conduct on a timely basis the 2007 review of the Adviser’s compliance policies and procedures. The SEC also found that the Adviser did not maintain complete and accurate records concerning its trading practices or the allocation of Block Trade Surpluses: the SEC determined that neither the Adviser’s trade allocation spreadsheet, nor its trading records contained complete records of allocation of Block Trade Surpluses, and that no formal records of these allocations were kept or maintained.
SEC Examination and Enforcement Referral. The SEC’s examination staff conducted an examination of the Adviser in 2009 and alerted it to deficiencies regarding its compliance program, including: the Adviser’s failure to follow its stated policies and procedures in its compliance manual; the Adviser’s failure to maintain adequate records of its trading; and the Adviser’s failure to timely conduct a required annual compliance review. The SEC’s examination staff referred the matter to enforcement staff for further investigation and enforcement staff determined that the Adviser’s deficiencies continued after the examination period.
Remedial Efforts. In determining to accept the Offers of Settlement, the SEC considered the cooperation afforded the SEC staff and the following remedial acts undertaken by the Adviser: (1) the Adviser changed its primary custodian in 2008 and upgraded its trading platform in 2009 (effectively eliminating its trade reconciliation issues by September 2009); (2) the Respondents hired a compliance consultant to perform the 2007 and 2008 annual compliance reviews and to evaluate and give guidance regarding the Adviser’s compliance practices and procedures; (3) the Adviser currently has a third party compliance consultant serving as its Chief Compliance Officer; and (4) the Adviser hired an independent accountant to analyze the impact of the Adviser’s reallocation process on its clients.
Violations. The SEC found that the Adviser willfully violated:
- Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which requires, among other things, that a registered investment adviser (a) implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules and (b) review at least annually its written policies and procedures and the effectiveness of their implementation; and
- Section 204 of the Advisers Act and Rule 204-2(a)(3) thereunder which requires, among other things, that a registered investment adviser make and keep true, accurate and current records relating to its business including: a memorandum of each order given by the investment adviser for the purchase or sale of any security; of any instruction received by the investment adviser from the client concerning the purchase, sale, receipt or delivery of any particular security, and of any modification or cancellation of any such order or instruction.
The SEC also found that the Executive, in his roles as CEO, CCO and Co-CIO, willfully aided and abetted and caused the Adviser’s violations of Sections 204 and 206(4) of the Advisers Act and Rules 204-2(a)(3) and 206(4)-7 thereunder.
Sanctions. In addition to censure and a cease-and-desist order, (i) the Adviser agreed to disgorge $20,183 (the approximate amount of client losses determined by the SEC), plus prejudgment interest, and pay a civil penalty in the amount of $100,000 and (ii) the Executive agreed to pay a civil penalty in the amount of $25,000.