The Securities and Exchange Commission today announced fraud charges against a Wisconsin-based investment advisory firm and its owner accused of improperly allocating to his personal and business accounts certain options trades that appreciated in value during the course of a trading day while allocating to his clients other trades that depreciated in value.
The SEC Enforcement Division has engaged in a data-driven initiative to identify potentially fraudulent trade allocations known as “cherry-picking,” and this enforcement action is the first arising from that effort. Working with economists in the agency’s Division of Economic and Risk Analysis, enforcement investigators analyze large volumes of investment advisers’ trade allocation data and identify instances where it appears an adviser is disproportionately allocating profitable trades to favored accounts.
The SEC Enforcement Division alleges that Mark P. Welhouse purchased options in an omnibus or master account for Welhouse & Associates Inc. and delayed allocation of the purchases to either his or his clients’ accounts until later in the day after he saw whether or not the securities appreciated in value. Welhouse allegedly reaped $442,319 in ill-gotten gains by unfairly allocating options trades in an S&P 500 exchange-traded fund named SPY. His personal trades in these options had an average first-day positive return of 6.28 percent while his clients’ trades in these options had an average first-day loss of 5.05 percent.
As described in the SEC order instituting administrative proceedings against Welhouse and his firm, SEC staff conducted a statistical analysis to determine whether Welhouse’s profitability in these accounts could have resulted from a coincidental or lucky combination of trades. After running a simulation test one million times, the staff concluded it could not.
“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,” said Julie M. Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit. “We devised this initiative to identify specific custodians providing services to investment advisers and their clients and leverage their trading records and other data to efficiently target preferential trade allocations occurring outside the detection of even the most observant client.”
The SEC Enforcement Division alleges that Welhouse and his firm violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, Section 17(a) of the Securities Act of 1933, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. The matter will be scheduled for a public hearing before an administrative law judge for proceedings to adjudicate the Enforcement Division’s allegations and determine what, if any, remedial actions are appropriate.
The SEC’s data-driven enforcement initiative to combat cherry-picking has been led by the Asset Management Unit and the regional offices in Boston and Los Angeles. The investigation into Welhouse and his firm has been conducted by Robert Baker of the Asset Management Unit and Rachel Hershfang of the Boston Regional Office. The Enforcement Division’s litigation will be led by Ms. Hershfang, Mr. Baker, and Cynthia Baran of the Asset Management Unit.