Statistics showing favorable trades being allocated to a favored client could have other explanations, but at this stage, the irregularities were sufficient to show a knowing scheme.
A district court found that the SEC successfully pleaded that an investment adviser engaged in a cherry-picking scheme. According to the Commission, the firm's sole trader disproportionately allocated profitable trades to accounts held by a favored new client, while allocated less profitable trades to other clients. Based on a statistical analysis performed by the Commission, the court concluded that the allegations were sufficient to show a knowing scheme to deliberately allocate profitable trades in a specific way (SEC v. RRBB Asset Management, LLC, July 20, 2021, McNulty, K.).
RRBB Asset Management managed investments for clients. The firm's sole officer was Carl Schwartz, who, in addition to doing the trading, was a direct owner of 49 percent of RRBB and a co-managing partner of an accounting firm that owned the other 51 percent of the firm. As a result, Schwartz received at least one-third of RRBB's profits.
Cherry-picking scheme. The Commission alleged that Schwartz, and RRBB through him, engaged in a cherry-picking scheme to allocate favorable trades to a new client. To do this, Schwartz traded in an omnibus account that allowed him to buy and sell on behalf of multiple clients without identifying for which account a trade was intended. After seeing how the securities performed that day, he allocated the trade to the new client if its price rose; if the stock was not profitable, that trade was allocated to other clients. These trades occurred on an online platform provided by Charles Schwab & Co., which eventually kicked RRBB off the platform based on concerns about cherry-picking.
According to the Commission, Schwartz allocated the favorable trades to the new client, a high net-worth couple, to induce them to invest additional funds. In their SEC filings, however, RRBB and Schwartz said that shares would be distributed in "a fair and equitable manner." After an investigation, the Commission brought claims under the Securities Act, Exchange Act, and the Investment Advisers Act, seeking a permanent injunction, disgorgement, and civil penalties.
Scienter. RRBB and Schwartz moved for dismissal, arguing that the Commission failed to adequately allege scienter. The court disagreed, finding that the complaint alleged a cherry-picking scheme with the requisite particularity. The court observed that cherry-picking, which involves the deliberate allocation of profitable trades, involves knowing conduct by its very nature. In this case, the Commission performed a statistical analysis of Schwartz's trades to show that the return rates for the favored accounts were higher than those for other RRBB accounts. These irregularities tended to show a knowing scheme, the court said, and this was bolstered by Schwab's removal of RRBB from its platform. The court acknowledged that the statistical disparities could be the result of a legitimate strategy, but the allegations were sufficient to raise an inference of cherry-picking at the pleading stage.
While the court found that the allegations sufficed to establish a conscious scheme, it went on to find that the Commission also showed that Schwartz had a motive to allocate the trades as he did. RRBB and Schwartz argued that the profitable trades went to the clients, so Schwartz's only benefit was management fees. Such generic motives have been found to be insufficient, but the court noted that these cases were: (1) from outside of the Third Circuit; and (2) private actions subject to a higher pleading standard than actions brought by the SEC. Consequently, the fact that Schwartz stood to profit handsomely from the trades was sufficient at this stage, the court concluded. Moreover, as a 49 percent owner of RRBB, Schwartz was no ordinary officer or manager, and the increased fees were a concrete and personal benefit to him.
The case is No. 20-12523.
Attorneys: Donald Searles for the SEC. Gary R. Shendell (Shendell & Pollock) for RRBB Asset Management, LLC and Carl Schwartz.
Companies: RRBB Asset Management, LLC
MainStory: TopStory Enforcement FraudManipulation GCNNews InvestmentAdvisers InvestmentCompanies NewJerseyNews
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