Cherry Picking: The SEC Warns Investors to Look Out for This Type of Fraud
“Cherry picking” describes a dishonest trading practice that allows brokers to allocate the best trades to their customer accounts as they see fit, instead of following the rules and fairly distributing the securities across accounts. Investment advisors can buy trades at the start of the day and observe their performance to see which trades are the most profitable. They might allocate the better trades to their personal accounts or use them to disguise their clients’ losses. Not only is this dishonest, it also goes against a financial adviser’s duties as a fiduciary. As fiduciaries, financial advisers are legally required to act in their client’s best interests. Unfortunately, cherry picking is difficult to catch, and investors largely rely on trading platforms and the Securities Exchange Commission to catch cherry-picking investment advisers.
How Cherry-Picking Works
When brokers make trades on a broker-dealer platform — like Charles Schwab, for instance — they make trades via omnibus or “block” accounts, which allows them to place trades for multiple client accounts. Once the trades are placed, the broker can see how the prices move throughout the day before they allocate the trades to their client’s accounts. Brokers who care more about their own bottom line than professional ethics might allocate the winning trades to their own accounts and allocate the less successful trades to their clients. This allows them to reap the benefits of completely risk-free trading, to the detriment of their client’s bank accounts.
Brokers normally have an agreement specifically stating that they will not favor any one account over another. For instance, financial services firm Continuum provided a disclosure that specifically stated, “[Continuum] will always document any transactions that could be construed as conflicts of interest and will never engage in trading that operates to the client’s disadvantage when similar securities are being bought or sold.” They also disclosed to investors that they would conduct periodic reviews to make sure there were no conflicts of interest. But these promises didn’t stop Continuum investment adviser Corbin Lambert from engaging in a cherry-picking scheme, according to the SEC. These disclosures highlight how allegedly unscrupulous brokers work to create the appearance of trustworthiness.
How Cherry-Pickers Gets Caught
There are systems in place designed to catch cherry picking, but it’s difficult to say for certain how often they work. Brokers like Donald Kellen can go undetected for years, and according to his BrokerCheck record, he engaged in a cherry-picking scheme for over 3 years before getting caught. And Kellen isn’t a newbie to the industry — he first registered as a broker in 1968.
The SEC does have fraud detection in place to catch cherry picking. Joseph Sansone, the head of the SEC’s Enforcement Division’s Market Abuse Unit, said in 2018, “SEC data analysis played an important role in identifying the alleged securities law violations. We will continue to develop and use data analytics to root out cherry-picking and other frauds.” Sansone made this statement following an SEC investigation of Michael Bressman, who has since been barred by FINRA following his failure to request the termination of his suspension. The SEC alleged that Bressman engaged in a cherry-picking scheme that allowed him to pocket $700,000 in ill-gotten gains. Bressman pled guilty to criminal securities fraud charges in 2019.
The data analysis performed by the SEC determines if the trades’ profitability could happen due to chance. Co-Chief of the SEC Enforcement Division Asset Management Unit Julie Riewe said in a statement: “Cherry-picking schemes can be extremely difficult to detect without an investor astutely noticing that something may be amiss and coming to us with a complaint about the adviser.”
It’s not always the SEC or an investor that catches cherry-picking frauds. Trading platforms have noted suspicious patterns and removed the offending broker from their platform. On January 31, 2018, Corbin Lambert placed a purchase order in the omnibus account for 30 contracts of SPY. The price rose by over 18%, at which point Lambert closed out the position and allocated the entire trade to himself, yielding riskless profits of $1,200. In a similar situation, when the price of a contract declined, he allocated the trade to a client, which amounted to a 42% loss on the investment. This happened on several occasions, to the point that Charles Schwab’s anti-fraud alert system caught on to the suspicious activity. According to the SEC, the odds of these allocations happening by chance are less than one in twenty.
But even if the broker-dealer catches the fraud, clients may not hear about it. When Strong Investment Management (SIM) investment advisor Joseph Bronson was terminated from broker platform over suspicions of cherry picking, he simply told his clients that SIM was too small for the platform. He switched to another broker platform and continued his deceptive practices.
Unfortunately, it’s extremely difficult for investors to notice these types of frauds. According to the SEC, it is the firm’s responsibility to keep an eye out for cherry picking. The SEC alleged that as SIM’s Chief Compliance Officer, Joseph Engebretson “was responsible for ensuring that the firm complied with its trading policies and procedures that, in part, forbid any cherry-picking.” According to the SEC, Engebretson “essentially did nothing to ensure that SIM’s trading policies and procedures were followed, other than occasionally ‘spot-checking’ trade paperwork on Bronson’s desk, while repeatedly ignoring numerous red flags relating to SIM’s trade allocation practices.”
What Can Investors Do?
Investors should keep on top of financial advisor news and follow up with a securities attorney if they hear that their financial adviser has been the subject of cherry-picking allegations. Unfortunately, investors can’t exclusively rely on the SEC’s supervision, and should monitor their investments to the best of their ability.
Meanwhile, investment advisers should take note: The SEC is looking for these types of frauds. Hopefully, with increased exposure, more investors will learn which brokers need to have their investment strategies carefully reviewed.
If you are concerned that your broker has engaged in cherry picking, don’t hesitate to reach out to the attorneys at Fitapelli Kurta for a free consultation. Call (877) 238–4175 or email info@fkesq.com.
