The SEC has brought charges against Cetera Investment Advisers LLC, a registered investment adviser based in Illinois, and First Allied Advisory Services, Inc., formerly a registered investment adviser based in California, settling a cease and desist order with both firms agreeing to pay $200,00 each to settle the claims.
William D Carlton and Hans K Hernandez, both of whom were investment adviser representatives associated with First Allied and later Cetera, were charged and served with complaints filed in two different US district courts for conducting separate, multi-year cherry-picking schemes that defrauded their clients. In both actions, the SEC seeks permanent injunctions, disgorgement with prejudgment interest, and court-determined civil penalties.
First Allied and Cetera charges
First Allied and Cetera were charged by the securities regulator with:
- failing to reasonably to supervise Carlton and Hernandez, both of whom were investment adviser representatives associated with First Allied and later Cetera who engaged in separate fraudulent trade allocation or “cherry-picking” schemes at both firms;
- failing to adopt and implement policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules; and
- making false and misleading statements in First Allied’s and Cetera’s disclosure brochures concerning supposed safeguards in place to prevent their investment adviser representatives from placing their own interests ahead of those of advisory clients.
The SEC’s order against First Allied and Cetera found that each violated Sections 206(2) and 206(4) of the Investment Advisers of 1940 Act and Rule 206(4)-7 thereunder (“Compliance Program Rule”) for failing to supervise their registered advisers.
Cherry-picking scheme
Carlton and Hernandez were associated with First Allied, an investment adviser registered with the SEC, until November 2020, when they became associated with the advisory firm Cetera, also registered with the Commission.
The SEC alleges that Carlton engaged in a cherry-picking scheme in which he unfairly allocated purchases of securities to benefit his personal accounts at the expense of his clients’ accounts from 2015 through approximately August 2022, and Hernandez engaged in a cherry-picking scheme in which he unfairly allocated purchases of securities to benefit his personal account at the expense of his clients’ accounts from July 2020 through approximately February 2022.
Both First Allied and Cetera had policies that prohibited investment adviser representatives from disadvantaging their clients when trading securities for their own accounts.
The SEC said Carlton and Hernandez both purchased stocks in their personal accounts and then, later in the day and after having the opportunity to observe price movements, allocated shares among personal and clients’ accounts. Hernandez also sometimes made the initial purchase in an account in the name of one or more of his largest clients before making a belated allocation of shares.
Carlton and Hernandez disproportionately allocated profitable trades to personal accounts and disproportionately allocated unprofitable trades to their advisory clients, the SEC alleged.
In a telling snapshot of the alleged scheme, the SEC said Carlton’s personal accounts obtained average first-day returns of approximately 0.50% on equity trades, while Carlton’s clients’ accounts obtained average first-day returns of approximately –2.10% on equity trades. The SEC observed that the difference between Carlton’s allocations of profitable trades and unprofitable trades is statistically significant, with the probability of these results occurring by chance being nearly zero.
Both First Allied and Cetera had policies that prohibited investment adviser representatives from disadvantaging their clients when trading securities for their own accounts. And First Allied and Cetera informed advisory clients of these policies in their firm brochures, which stated that investment adviser representatives were “not permitted to disadvantage clients while trading in their own accounts.”
Complaints against Carlton and Hernandez
The SEC said that by waiting and watching the price movements of the stocks the two advisers purchased in their personal accounts before deciding whether to keep the trades for themselves or allocate the trades to their clients, both Carlton and Hernandez, in their own ways, were able to “cherry pick” trades that were immediately profitable for themselves, to the detriment of their clients to whom they each owed a fiduciary duty.
The SEC charged each of them with violating the bedrock fraud rules – SEC Rules 10b-5(a) and (c) relating to fraudulent manipulation with regard to the purchase and sales of securities and SEC Rules 206(1) and (2) relating to fraudulent schemes.
Carlton’s lawsuit has been filed in federal district court in Washington State, and Hernandez has been sued in the federal district court of New Jersey, with jury trials requested in both cases.
The SEC is surveilling for it
In an effort to warn other brokers and investment advisors about the SEC’s ability to detect cherry-picking schemes, an SEC official last September had a stern warning in a press release attending announced charges against advisory firm GlennCap LLC.
Commenting on the settlement order and focusing on the firm’s owner and CEO, the Co-Chief of the SEC Enforcement Division’s Asset Management Unit, Andrew Dean, said: “Glenn allocated millions of dollars from profitable trades to accounts benefitting himself while unloading unprofitable trades on GlennCap’s clients. …The SEC has the means to identify investment advisers that abuse their position through cherry-picking, as Glenn and GlennCap did. We use these methods to ensure investor trust in our markets.”