RIA Cherry Picking Case Rings Alarm (Anyone Listening?)

September 15, 2017

You live in an expensive condo apartment building. They put in smoke alarms. They put in fire alarms. They got a full-time guy on duty 24/7 just to watch over everything. One night, all the alarms go off. A fire has started and is beginning to spread. You don't do anything because, well, because it's just an alarm. They go off when someone cooks a steak next door. The guy on duty re-sets the alarms because he doesn't actually smell any smoke or see any fire and there's a big game on and he's watching it on his iPad, which he's not supposed to be doing, but the job doesn't pay all that much and like who the hell's gonna know? 

All of which leads us to a recent SEC settlement involving an investment adviser who kept a lot of good trades for himself and dumped a lot of his goofs into the unknowing accounts of his customers. Which bothered his custodian enough to send him packing. But it didn't bother another custodian enough to offer him refuge. And it didn't seem to bother the industry's regulators for about five years.

Case In Point

Jeremy A. Licht is the founder, principal, chief compliance officer, and sole owner of JL Capital Management, a sole proprietorship registered investment adviser ("RIA"). In the course of trading for the accounts of his clients, Licht also traded for his personal accounts -- a not uncommon practice in the industry. Licht's customer and personal accounts were handled by a custodian, which was a registered broker dealer.Unfortunately for Licht, the Securities and Exchange Commission ("SEC") wasn't thrilled with certain aspects of his trading practices. Pointedly, the SEC alleged that from at least January 2011 through November 2015, Licht realized at least $88,504 in ill-gotten gains by "cherry picking" certain favorable trades to his own account while allocating certain unfavorable trades to the accounts of his clients. In anticipation of the institution of proceedings by the Securities and Exchange Commission ("SEC") but without admitting or denying the findings, Jeremy A. Licht d/b/a JL Capital Management submitted an Offer of Settlement, which the federal regulator accepted. In the Matter of Jeremy A. Licht d/b/a JL Capital Management, Respondent (Order Instituting Administrative And Cease-And-Desist Proceedings, Making Findings, And Imposing Remedial Sanctions And A Cease-And-Desist Order; '34 Act Rel. No. 81584; Invest. Adv. Act Rel. No. 4767; Invest. Co. Act Rel. No. 32815; Admin. Proc. File No. 3-18171 / September 12, 2017) (the "OIP"). 

The OIP is a very well-crafted document and I have opted to cite to the quoted pertinent paragraphs below rather than offer an unnecessary rewording. Note that curing the relevant times the custodians were "Broker 1" from approximately January 2011 to September 2012; and "Broker 2" from approximately October 2012 to March 2016. :

4. Licht submitted trades and allocated them using an online platform provided by a brokerage. He carried out his fraudulent scheme by trading in an omnibus account and delaying allocation of those trades to a specific account until he had an opportunity to observe the security's intraday performance. In many cases, when the price of a stock rose on the purchase date, Licht sold the security the same day, locking in a day-trading profit that he allocated to himself. By contrast, Licht disproportionately allocated purchases that were not profitable on the purchase date to clients. Licht often waited several hours and/or until after the close of the trading day to allocate trades from his omnibus account.

5. Licht's cherry-picking financially benefitted him and disadvantaged his clients. Between January 2011 and September 2012, when Licht's personal and client accounts were custodied at Broker 1, Licht's total first-day profits (realized and unrealized) were at least $35,933, representing a 1.01% return on his investment. In contrast, Licht's clients suffered aggregate unrealized first-day losses of $77,700, representing a -2.15% return. Then, from October 2012 to March 2016, when Licht's managed accounts were custodied at Broker 2, Licht's total first-day profit (realized and unrealized) was at least $52,731, or a 2.07% return on his investment, while his clients had aggregate unrealized first-day losses of $72,816, or a -1.06% return.

6. The difference between Licht's first-day returns and that of his clients is statistically significant. The probability that the disproportionate allocation of favorable trades to Licht at Broker 1 was due to random chance is less than one in a trillion. The probability that the disproportionate allocation of trades at Broker 2 was attributable to random chance is less than one in a million.

7. Since January 2012, Licht reaped at least $88,504 in ill-gotten gains from his cherry-picking scheme.

8. Both Broker 1 and Broker 2 terminated their relationships with Licht because they suspected that he was improperly allocating trades on their platforms. Broker 1 terminated the relationship in August 2012 (effective October 2012), and Licht moved his business to Broker 2's platform, where he continued cherry-picking profitable trades for his own account to his clients' detriment for another three years. Broker 2 terminated its relationship with Licht in January 2016. Licht never informed his clients that the two firms had unilaterally terminated him, nor did he disclose the reason why the brokerages ended their relationship with him.

9. Licht made false statements to his clients in his Forms ADV. In particular, Licht's Forms ADV Part 2A falsely stated that "[n]o Client/investor, account or fund will be favored over any other Client/investor, account or fund as the result of the allocation" of block orders. It also represented that Licht reviewed all personal trading to ensure "that clients of the firm receive preferential treatment." These statements were false and misleading because Licht allocated trades in a manner that favored his personal account and disadvantaged clients.

10. Licht's Forms ADV also represented that "[p]re-allocation statement(s) specifying the participating Client/investor accounts and the proposed method to allocate the order among the clients/investors, accounts or funds are required prior to any allocated order" and that "[a]ggregated orders filled in their entirety shall be allocated among clients/investors, accounts or funds in accordance with an allocation statement created prior to the execution of the transaction(s)." These statements were false and misleading because Licht did not create or employ pre-allocation statements.  

The SEC deemed Licht's allegedly knowing and reckless allocation scheme to constituting a willful violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Advisers Act. In accordance with the terms of the settlement, the SEC ordered  that he cease and desist from future violations of securities laws, pay $88,504 disgorgement plus $8,714.34 in prejudgment interest and $181,071 in a civil money penalty. Further, the SEC ordered Licht:
  • barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization; and 
  • prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.
Bill Singer's Comment

So much for the fiduciary standard. Licht offers a chilling glimpse behind the curtains, which RIA clients should find as a sobering warning that the conflicts and compromises in the broker-dealer arena are not always eliminated in the RIA arena. Now that you know about cherry picking, don't be so shy about asking your RIA to explain its trading allocation policies and don't be too intimidated to challenge any trades that raise questions. 

The good news from the OIP is that we get a sense that the SEC is doing its job. This settlement sends yet another warning to the industry about parsing through a day's trades and allocating the juicy, sweet cherries of profitable trades to your personal accounts and sticking the sour cherries with the mold on them into your customers' accounts. I say "yet another warning" because we've have several of these in recent years. It's good for the SEC to publish these settlements because they remind the RIA community that it can't hide behind its authorized use of "discretion." Further, this settlement and others is a wake-up call to those who view the omnibus trading account as something akin to a rainy-day piggy-bank. Regardless of how clever you are in hiding your cherry picking, keep in mind that the SEC ferreted out the fraud in Licht (and other cases), so maybe you're not as clever as you think and maybe the regulators aren't as stupid as you had supposed. Someone did indeed ring the alarm!


On the other hand, certain revelations in Licht don't exactly instill confidence in Wall Street's compliance and regulatory regimes. For example, consider this:

8. Both Broker 1 and Broker 2 terminated their relationships with Licht because they suspected that he was improperly allocating trades on their platforms. Broker 1 terminated the relationship in August 2012 (effective October 2012), and Licht moved his business to Broker 2's platform, where he continued cherry-picking profitable trades for his own account to his clients' detriment for another three years. Broker 2 terminated its relationship with Licht in January 2016. Licht never informed his clients that the two firms had unilaterally terminated him, nor did he disclose the reason why the brokerages ended their relationship with him.

As early as August 2012, some five years before the Licht SEC settlement, Broker 1 had terminated its relationship with Licht. According to the OIP, Broker 1 fired its customer because it had determined that Licht was "improperly allocating trades." In terms of Broker 1's compliance oversight, bravo! In terms of the effectiveness of that custodian having sounded the alarm? Not so bravo. Consider that Licht simply moved his cherry-picking to Broker 2. What the hell? Didn't any regulator look into the circumstances prompting the change of custodians? Look into as in any time from August 2012? Y'all know that this case settled in September 2017 right? Did anyone ring an alarm? Did anyone hear an alarm? Consider some of my questions below:

  • Did Custodian Broker 2 inquire as to the circumstances of Broker 1's severance of its prior relationship with Licht? 
  • Given the compliance/regulatory misconduct inherent in cherry-picking, was there any report generated by Broker 1 that put Broker 2 on notice and also put Wall Street's regulatory community on notice? 
  • Did any regulator conduct any inquiry of Licht following his August 2012 termination by custodian Broker 1? 
  • Did any regulator note the glaring omission in Licht's customer disclosure documents about the reason for Broker 1's termination of his relationship?