Cherry on Top, Clients on Bottom
Investment adviser cherry-picking cases sort of sit on a spectrum. Sometimes the SEC sues a firm for cherry picking but describes it as a “compliance failure” and settles to non-scienter-based charges. Here’s one of those. Sometimes they open up the toolbox and sue a guy with everything they have. That’s what they did last month when they settled with SeaCrest Wealth Management and sued its representative Eric Cobb in the S.D.N.Y. for using block trades in omnibus accounts to execute a long-running cherry-picking scheme.
Why Block Trades? Why Omnibus Accounts?
Investment advisers (and brokers and others) sometimes hold omnibus accounts on behalf of multiple investors, with each investor having their own unique identifier within the account structure. This can increase efficiency and can reduce the costs and administrative burdens associated with managing entirely separate advisory accounts
Sometimes advisers use “block trades” to trade a bunch of the same securities for different clients. But those blocks can’t always be executed at exactly the same time and at the same price. If you’re trying to buy 100,000 shares of XYZ at $50, the actual numbers might not work out to precisely that. It’s entirely possible that a seller is not out there with 100,000 XYZ shares to sell right at that moment. Maybe the trades roll in like this:
30,000 at $50 at 10:00 a.m.,
40,000 at $50.10 at 10:45 a.m.
30,000 at $49.95 at 11:30 a.m.
A client would of course want the $49.95 shares instead of the $50.10 ones if they could get them. Now, the adviser doesn’t have to allocate these shares to different clients’ specific accounts immediately. To be sure, it’s much better if they do, and the SEC’s recent shift to a T+1 settlement cycle has increased pressure on advisers to allocate trades quickly. But in the pretty recent past advisers had some more leeway and could (1) make a bunch of block purchases, (2) see how the prices move over the next few hours or even overnight, and (3) then allocate the trades in a way that advantages one client, or even someone associated with the adviser, over other clients. This is called “cherry-picking”. Obviously advisers should not do this, but we live in an imperfect world.
Cherry-Picking at SeaCrest
SeaCrest is a New York investment adviser with a decentralized business model, with 26 offices and IARs scattered across the country. Eric Cobb, in Spartanburg, South Carolina, was one of those. The SEC says:[i]
Cobb did cherry picking from 2019 to 2022, allocating profitable trades to some personal and family accounts he controlled, and disproportionately allocating unprofitable trades to the accounts of unrelated advisory clients.
Cobb routinely placed some of his clients in unsuitable, highly volatile and highly risky securities that were contrary to their indicated risk tolerances. (We might address the unsuitability allegations in a later post, but will focus on the cherry picking here.)
SeaCrest didn’t have sufficient policies and procedures in place to prevent this activity, even though their Form ADV said they did, and didn’t reasonably supervise him.
The Scheme
Cobb managed advisory client accounts on a discretionary basis, meaning he had authority to make investment decisions and execute trades in those accounts. Some of these were in his own name or in the names of family members, but most were not. Cobb used an omnibus account to place “block” trades for all of these accounts and then allocated securities to client accounts. In fact, that was usually how he traded for his clients, with only about 17% of his trading going to buy securities directly into client accounts.
Of course, SeaCrest had policies and procedures requiring that block trades be allocated such that:
some accounts were not favored over others;
each participating account received individual investment advice; and
the allocation method be specified in writing before making a block trade.
Cobb routinely waited until the day following his entry of block trades (or later) to allocate those trades to client accounts, when he was able to see whether share prices had gone up or down. Then he disproportionately assigned “winning” trades to his and his family’s accounts and “losing” trades to the other accounts. The SEC uses a score called the “dollar-weighted win rate” to measure the trades in the different accounts. The calculation is: total money invested in winning trades/total money invested. The trades Cobb allocated to his accounts had a dollar-weighted win rate of about 75% and a post-allocation return of 4.7%, while the ones allocated to the other accounts had a dollar-weighted win rate of 47%, and a post-allocation return of 0.1%. You can’t do this!
The SEC says the likelihood that Cobb would have earned these returns for his accounts without cherry-picking and trade allocations determined by chance, is less than 1%.
Compliance Issues
SeaCrest had an idea this was going on. Their custodian sent SeaCrest at least 12 alerts about possible unallocated block trading by Cobb, but the employee receiving them never elevated the issue to the firm’s CCO. Eventually the custodian bypassed that employee and went straight to the CCO in May 2020, when SeaCrest conducted its own independent compliance review and issued a warning to Cobb. At that point, nearly all of Cobb’s block trades were allocated the following day. After that, Cobb continued to allocate some of his block trades the following day, although more allocations were done on the same day as the trades were executed.
The press release says the case “demonstrates the importance of decentralized firms having robust compliance oversight with regard to employees who may be located elsewhere.”
In any event, Cobb didn’t want to answer questions about it. The SEC sent him a subpoena for documents and his testimony in June 2023, and, getting no response, filed a subpoena enforcement action ten months later.
The Upshot
The result was not the sort of compliance-based case linked above. Instead, the SEC sued Cobb in federal court in New York and is charging him with scienter-based fraud under Rule 10b-5, Securities Act Section 17(a)(1), and Advisers Act Section 206(1), as well as the softer Securities Act Section 17(a)(3) and Advisers Act Section 206(2).
SeaCrest itself is settling an administrative order with negligence-based charges under Securities Act Section 17(a)(2), Advisers Act Sections 206(2) and 206(4) and Rule 206(4)-7, and a failure-to-supervise charge under Section 203(e)(6). SeaCrest will pay a $375,000 civil penalty.
The SEC says Cobb garnered $170,000 in illicit profits and that his clients incurred $188,000 in losses from this cherry-picking scheme. We’ll see what happens to him.
In re Seacrest Wealth Management, LLC, Admin. Proc. File No. 3-22346 (Dec. 12, 2024)
SEC v. Eric McKenzie Cobb, 1:24-cv-09494 (S.D.N.Y., filed Dec. 12, 2024)
T+1 Settlement Cycle: Implications for Investment Advisers, Seward & Kissel (May 2, 2024)
[i] All of the “facts” that follow are really just allegations. Who knows if they’re true? We do not.