The allocation of advisory transactions has and continues to be one of the biggest risk areas for registered investment advisors. This has especially been the case for advisors with performance fee or proprietary accounts trading side by side with non-performance fee accounts. A strong and comprehensive trade allocation policy can go a long way towards mitigating this risk, helping ensure that allocations are made in a fair and equitable manner for all clients. Full and accurate disclosure of these allocation policies and practices and the maintenance of adequate books and records are just as important, particularly as the SEC’s Enforcement Division has stepped up it efforts to combat cherry-picking in recent years.
BACKGROUND
Trade allocation practices have long been on the radar of the Securities and Exchange Commission and its Office of Compliance Inspections and Examinations (OCIE). Advisors with performance fee and proprietary accounts and those trading in illiquid securities are especially a high risk in the eyes of SEC examiners. This focus is largely due to the potential for abuse that exists when advisors allocate trades to their clients. In some cases, investment advisors have engaged in “cherry-picking,” where they have systematically allocated profitable trades to favored accounts (usually proprietary or personal accounts of an employee) at a disproportionate rate. In these cases, which are notoriously difficult for clients to detect, the advisor generally makes the allocations after the trades have been executed.
In the last couple of years, the SEC’s Enforcement Division, working alongside the agency’s Division of Economic and Risk Analysis, has launched a data-driven initiative to combat cherry-picking by analyzing large volumes of trade allocation data. According to Julie M. Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, the initiative was devised “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.” In 2015, the SEC brought charges against a Wisconsin based investment advisor for cherry-picking that was a direct result of this initiative.
When bringing allocation cases against investment advisors, the SEC has been able to rely upon Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 and Section 10(b) of the Securiities Exchange Act of 1934. Another rule the SEC has had at its disposal is Rule 206(4)-7, if an adviser has been found to not have adequate policies and procedures and/or failed to supervise employees engaged in inappropriate activities.
ALLOCATION BEST PRACTICES
Due to the significant risks associated with trade allocations, advisors should ensure that they have robust policies and procedures, taking into account their portfolio management and trading processes, their types of clients and accounts, and other characteristics specific to their firm. While the SEC doesn’t mandate any specific allocation practice or methodology, there are certain best practices that advisors should consider when drafting or reviewing their allocation policies and procedures.
As a starting point, your policies and procedures should require that all allocations be made and documented prior to the time the trade is placed. You should also decide on an allocation methodology or formula that is both suitable and fair. If you place block orders on behalf of multiple accounts, a pro rata allocation based on the net assets of each participating account is generally considered to be a fair and equitable method. If a block order is placed on behalf of 5 accounts, for instance, and Account A has 30% of the total net assets of all 5 accounts, a pro rata allocation to Account A would be 30% of the total shares that were executed from the order. If instead orders are placed separately for each account, rotating the order that accounts are filled is generally the fairest way to allocate orders. As a result, the same account won’t always be the first or last account in line to receive an execution.
Be sure to document whatever methodology your firm has adopted in your policies and procedures as well as the reasons, if any, why exceptions may be made. Valid exceptions may include accounts not participating because they are in a different investment strategy, have investment restrictions (e.g., no tobacco stocks), or have significantly larger or smaller cash balances (e.g, because of subscriptions or redemptions). A partial fill on a block order is another common reason for not allocating to certain accounts or allocating on a non-pro rata basis.
Another best practice is to have the portfolio management, trading, and compliance departments review on a daily basis a report showing all allocations and exceptions to your policies and procedures for the day. The report might highlight, for instance, which accounts in a strategy were excluded from a trade as well as whether any allocations were not made on a pro rata basis. Reviewing such data and investigating exceptions on a daily basis allows you to promptly identify and address any trade errors arising from trade allocations.
BOOKS AND RECORDS
An investment advisor should also ensure that it is maintaining all required books and records pertaining to its allocations. To begin with, you should be able to document the time of the initial allocation of a trade, the time the order is placed with the broker, and the time the trade is executed. Most order management systems (OMS) today automatically capture and retain this information. If there is an exception to your allocation policy, it is a good idea to add a note to your trade ticket explaining the reason for the exception and maintain supporting documentation. Similarly, if the allocation is modified after the order is placed, an audit trail of the trade should be maintained together with supporting documentation.
FORENSIC TESTING
While you may be confident that your allocation policies and procedures are adequate, you should also perform forensic testing to help identify any patterns or trends that may indicate that certain accounts are being favored over others. Most importantly, your firm should be periodically (e.g., quarterly) comparing the performance returns of your accounts within each strategy to determine whether there is any performance dispersion. Be sure that you are comparing returns gross of management and performance fees as the inclusion of fees may skew the returns of certain accounts. In those cases where dispersion does exist, be sure to document the results of your investigation regarding the reasons for the dispersion as well as any corrective action taken. Some valid reasons for performance dispersion may include different inception dates, subscriptions and/or redemptions, and investment restrictions specific to a client. An attribution analysis through FactSet or other vendors should help identify the reasons for any difference in performance between any two accounts.
Another good forensic test is to sample a percentage of all allocations during the previous month or year (e.g., 10%) and determine whether certain accounts are repeatedly being excluded or receiving non pro rata allocations. Depending on your portfolio accounting software, you may be able to configure your trade blotter to show the actual and pro rata allocation percentages for each trade to help facilitate this analysis. Remember to pay special attention to performance fee and proprietary accounts.
You can also sample trades where the initial and final allocation are different and investigate whether the reasons for the change are legitimate. If your firm participates in a large number of initial public offerings (IPOs), you should also review these allocations to determine whether certain IPO eligible accounts are repeatedly receiving a disproportionate amount of allocations to “hot” IPOs. Finally, depending on your portfolio accounting system, you should consider calculating the percentage of trades allocated to each account that were profitable. This test, together with the other tests mentioned above, can help identify cherry-picking and other wrongdoing with respect to trade allocations.
DISCLOSURE
Perhaps most importantly, you should ensure that your actual allocation practices not only mirror your written policies and procedures but also what you have disclosed to clients. A definite red flag to regulators is if there are inconsistencies between your disclosure documents and how you are actually allocating trades. Remember to not only check your Form ADV but also private placement memorandums, due diligence questionnaires, marketing materials, and other disclosure documents you are providing to clients and prospective clients.
SUMMARY
With the SEC increasingly focusing on problematic allocation practices such as cherry-picking, registered investment advisors, more than ever, should ensure that they have strong allocation policies and procedures. These policies and procedures should address the firm’s allocation methodology and when and how exceptions should be made. Potential conflicts of interest, such as the existence of performance fee and proprietary accounts, should also be addressed. Advisors must also ensure that they maintain adequate books and records that can support any allocations and exceptions made in the past. Finally, advisors must fully and accurately disclose their allocation practices to clients and verify that all disclosure documents are consistent with these practices. In doing so, advisors can help mitigate one of their most significant risk areas.
Hayley Nelson is the President and Principal Consultant of NCA Compliance, Inc. She has 20 years of regulatory and industry experience and received a national award from the SEC for outstanding service.
