When it comes to trading in your firm’s own investment accounts (proprietary trading), it’s never cherry-picking season. Instead, when allocating investment opportunities, you should follow the golden rule – treat your clients like you want to be treated.
What does this mean? As an investment adviser, your fiduciary duty requires you to allocate securities and advisory recommendations among clients in a fair and equitable manner, with no particular group of clients or the adviser’s proprietary account being favored or disfavored over any other clients.
What happens if you don’t? The SEC has brought a number of enforcement actions against investment advisers that have been found to cherry-pick profitable investments. For example, in one case, the SEC alleged that an investment adviser purchased blocks of securities in an omnibus account that included both proprietary and client accounts and did not allocate the securities purchased until later in the day after the adviser had determined whether the securities had appreciated. The SEC further alleged that the adviser allocated more of the profitable trades to proprietary accounts than to client accounts. As a result, the agency barred the adviser from the securities industry and ordered the adviser to pay a civil penalty and “disgorge” (pay back) the ill-gotten gains.
Adopting and following fair and equitable trade allocation policies and procedures can help protect you and your firm from a similar fate. And for robo-advisers, which automate many of their trading and allocation processes, those policies and procedures must be built in to the trading programs and algorithms used to build client portfolios. In building out such a policy, consider including the following elements:
- Adopt a policy flatly prohibiting proprietary and employee accounts, or any group of client accounts, from profiting from trade allocations at the expense of other accounts
- Permit the blocking of trades to allow for increased efficiency and reduction of overall commission costs to clients
- Prepare allocation statements that specify how securities from an aggregated transaction will be allocated before the order is placed
- Require that participants participating in an aggregated order receive an average share price and share in transaction costs equally and on a pro rata basis
- Adopt procedures to handle fairly allocations of only partially filled orders
- Require and document periodic review of allocations to determine whether any accounts are systematically disadvantaged
Robust allocation policies and procedures, when followed, will significantly reduce the risk of intentional or inadvertent disfavoring of accounts and help you continue to meet your fiduciary obligations to clients. We hope you’ll join us next time, when Josh will discuss the practical ways you can ensure the accuracy of the disclosures you make to clients and regulators.