Securities Fraud: Cherry-Picking & Soft Dollars
In a decision issued on August 5, 2014 in an administrative proceeding (the “Decision”), J.S. Oliver Capital Management, L.P. and Ian O. Mausner were found to have willfully violated the antifraud provisions of the Securities Act of 1933, Securities Exchange Act of 1934 (the “Exchange Act”), and the Investment Advisers Act of 1940 by “cherry-picking” trades for favored clients to the detriment of other unfavored clients and willfully misusing “soft dollars.” J.S. Oliver Capital Management, L.P. (“Adviser”) was a registered investment adviser, and Mausner was the Adviser’s chief executive officer, portfolio manager and ultimate decision maker. In the Decision, Brenda P. Murphy, Chief Administrative Law Judge, ordered that the Adviser and Mausner pay civil monetary penalties of $14,975,000 and $3,040,000, respectively. Judge Murphy also revoked the Adviser’s registration as an investment adviser and permanently barred Mausner from association with an investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent or nationally recognized statistical rating organization.
After executing trades with an executing broker, the Adviser used its prime broker, BNP Paribas Prime Brokerage, Inc. (“BNP”) to allocate the shares among the Adviser’s clients using BNP’s Order Management System (“OMS”). Although OMS has a predefined allocation schema for allocating trades among clients, the Decision notes that the use of OMS “does not exclude the possibility of cherry-picking because an investment adviser could change the allocation schema or manually allocate trades after they are purchased.” Further, the Decision points out that although manual allocations do not necessarily indicate wrongdoing, manual allocations tend to be an exception rather than a rule. In this particular case, the Adviser was the subject to numerous potential cherry-picking reviews from BNP. In fact, BNP generated more than 4,000 instances of potential cherry-picking with respect to the Adviser, and BNP had recommended to Mausner that he allocate with average prices. Ultimately, the expert witness in this case found statistical evidence that the Adviser “systematically allocated a disproportionately large share of equity trades with positive first-day returns to six favored client accounts and systematically allocated a disproportionately large share of equity trades with negative first-day returns to three other client accounts.” Unsurprisingly, the Decision noted that the clients that benefitted from the favorable allocations coincided with the funds that paid more fees to the Adviser while the disfavored clients generally paid lower management fees or had caps on performance fees.
In the Decision, Judge Murphy also found that Mausner willfully misused soft dollars by using soft dollars generated by the Adviser’s client trading activities to pay marital settlement amounts to Mausner’s ex-wife, rental payments of the Adviser for space used by the Adviser in Mausner’s personal house, consulting payments for purported research, and timeshare payments for Mausner’s personal timeshare at the St. Regis in New York. Furthermore, the Decision noted that Mausner failed to adequately disclose his use of soft dollars for the foregoing purposes to his clients.
Investment advisers need to take particular care in allocating trades, particularly in instances where investment advisers manually override any pre-trade determination allocation schema. Best practices would be to adhere to pre-trading allocation schema, and if an override is appropriate, to document the justification in a memorandum to file. If overrides become frequent, the default schema should be revisited.
Investment advisers need to be very careful in their use of soft dollars, as the SEC views the practice very critically and perceives soft dollars to be fraught with potential conflicts of interest.
 Despite Mausner’s responsibilities with respect to his various roles at the Adviser, Mausner also apparently found time to author a book. Mausner tweeted on July 17, 2014 that his book entitled “Getting Back on Top: The Uncensored Guide to Sex, Dating and Relationships After Divorce” had launched. As of August 13, 2014, the book averaged a five star review on Amazon.
 See CounselWorks’ blog regarding the SEC’s increased use of administrative judges due to losses at trial. www.hedgeco.net/blogs/2014/08/05/sec-prosecuting-via-alj-hearings/Advertisement