by T. GormanPosted on Posted in SECActions

SEC Files Its First Robocop Cherry Picking Action

When the SEC announced its financial fraud task force and a related data initiative to facilitate the identification of situations where the company “cooked the books,” many dubbed the data program “Robocop.” While the SEC may be continuing to work on that initiative, to date the agency has not created a computer to identify financial fraud. Robocop may, however, be appearing in another form. Not only does the agency use a big data approach to help sort out possible insider trading, but now it has created a program to analyze trading by investment advisers and identify wrongful conduct such as cherry picking. After test running calculations where it appeared an investment adviser had cherry picked certain option trades, a simulation designed to verify the point was run one million times. The first proceeding based the new program was filed, In the Matter of Welhouse & Associates, Inc., Adm. Proc. File No. 3-16657 (June 29, 2015).

Welhouse & Associates, Inc. is a state registered investment adviser. Respondent Mark Welhouse is its owner, principal and CCO. Custody of client accounts and assets is at a brokerage firm.

From at least February 2010, and continuing through January 2013, the firm executed trades in an S&P 500 ETF called SPY for client accounts as well as Mr. Welhouse’s personal accounts. Mr. Welhouse told the staff that he created a daily spreadsheet of the trade allocations between client accounts and his which was furnished to the brokerage firm to make the allocations. According to Mr. Welhouse, the trades were allocated on a pro rata basis before 5:00 p.m. each day.

Contrary to Mr. Welhouse’s claims, however, an analysis of all of the accounts demonstrates that in fact the allocations were not made on a pro rata basis. For trades that increased in value on the day of purchase, frequently Mr. Welhouse day-traded by selling the options on the day of purchase. A disproportionate share of the profits were then allocated to his accounts. Trades that decreased in value frequently were not sold on the day of purchase. A disproportionate share of these trades were allocated to client accounts. During this period the brokerage firm warned Mr. Welhouse several times regarding the allocations and threatened to terminate its relationship with him and his firm. Mr. Welhouse told the staff that if the allocations were disproportionate it was a mistake.

A statistical analysis of the accounts suggests that there was no mistake. During the period Mr. Welhouse allocated 496 SPY option trades to his personal accounts and 1,127 to his clients. The total cost of the trades was $7.25 million for the personal accounts and $8.46 million for the client accounts. Yet the total first-day profits for the personal accounts was $455,277 in contrast to the total first day losses for the client accounts of $427,190. Stated differently, the first day returns for the personal accounts of Mr. Welhouse was 6.28% in contrast to a -5.05% for client accounts. This compares to a return of 0.18% for all of the first day trade transactions.

The first day returns were statistically significant, according to the Order. This was verified through a simulation run, testing the possibilities. The results showed that the chance of receiving the results shown in the personal accounts was less than one in one million. The simulation was run one million times.

Finally, clients were unaware of the allocation process. Indeed, the firm’s Form ADV and related documents stated that Welhouse did not trade for its own account. The firm’s written policies and procedures stated that trades were allocated on a pro rata basis. The Order alleges violations of Exchange Act Section 10(b) and Advisers Act Sections 206(1) and 206(2). The proceeding will be set for hearing.

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by T. GormanPosted on Posted in SECActions

The SEC filed another action based on its market access rule. This time the Respondent is Goldman, Sachs & Co., a wholly owned subsidiary of The Goldman Sachs Group, Inc. In the Matter of Goldman, Sachs & Co., Adm. Proc. File No. 3-16665 (June 30, 2015).

The action centers on erroneously sending 16,000 mispriced options orders to various option exchanges in less than an hour on August 20, 2013. Respondent Goldman is a registered broker dealer and a member of FINRA. One of the client service functions performed by the firm is the provision of options liquidity to electronic trading customers. This service was done in part through the use of a matching engine that attempts to pair the firm’s indications of interest against customer orders for the particular option contract. If there was a match the paired order was sent to an exchange for execution. If there was no match the customer order was routed to an exchange. The firm’s indications of interest, called axes, were contingent in price, size and other parameters. They were not intended to go to the exchanges unless paired with a customer order. To the contrary, axes were intended to remain in the matching engine and search for customer orders to pair-off.

On August 20, 2013, as a result of a configuration error in one of the firm’s options order routers, Goldman sent thousands of $1 limit orders to options exchanges prior to the start of regular market trading. Before the market opened the firm halted the creation of orders and began canceling the erroneous ones that had been sent for execution.

Shortly after the opening a portion of the orders were executed. Specifically, about 1.5 million options contracts representing 150 million underlying shares were executed. Goldman faced a potential $500 million loss, although in the end it was about $38 million in view of cancellations or price adjustments for erroneous trades.

The error resulted from a series of failures, according to the Order, which included:

  • The price checks in the options order matching system failed to prevent the entry of the erroneously priced pre-market orders;
  • Goldman’s circuit breakers did not effectively block the orders because its control staff repeatedly lifted them during the pre-market and for two minutes after the open;
  • The firm’s policies relating to the manual lifting of the circuit breakers were not disseminated to, or fully understood by, the responsible employees; and
  • The firm had inadequate policies and procedures with regard to software changes that impacted its order flow.

Goldman also had inadequate risk management controls and supervisory procedures relating to the prevention of orders that exceeded the firm’s pre-set capital threshold. The Order alleges Exchange Act Section 15(c)(3) and Rule 15c-3-5.

To resolve the proceeding Goldman consented to the entry of a cease and desist order based on the Section and Rule cited in the Order as well as to a censure. In addition, the firm agreed to pay a civil penalty of $7 million.

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