The SEC’s Increasing Use of Data Analysis

The Commission has increasingly focused on data analysis as an aid to its enforcement program. Two recent cases brought against investment advisers for cherry picking illustrate different facets of the approach.

In the Matter of Bruce A. Hartshorn, Adm. Proc. File No. 32075 (April 20, 2016) is a proceeding which named Mr. Hartshorn, a registered investment adviser representative, as a Respondent. He is the founder of registered adviser Hartshorn & Co., Inc. The firm’s trade allocation policies, as disclosed in its Form ADV, provided that when it aggregates client orders it will allocate the executions in a manner which is equitable to all accounts. This included firm accounts.

The Commission’s analysis of its trade allocations from January 2010 through March 2011 demonstrated that the policy was not followed. During the period Mr. Hartshorn purchased blocks of securities in the Firm’s omnibus account at a brokerage that had custody of the accounts. Allocations were not made until later in the day. When making those allocations Mr. Hartshorn allocated a greater proportion of trades which had a positive first-day return to proprietary accounts. A greater proportion of trades that had a negative first-day return were allocated to client accounts.

An analysis of the trades during the period demonstrated when allocating the entire block trade to proprietary accounts the transaction was profitable 85% of the time. When the allocation was solely to client accounts, however, the transaction was unprofitable 100% of the time. When the allocations were split among the accounts the results were the same. Specifically, when the block purchased had positive first day returns, 68% of the securities were allocated to proprietary accounts. When there were negative first day returns Mr. Hartshorn allocated 81% of the securities to client accounts.

As a result of these practices the proprietary accounts had an average first day gain of 0.26% while client accounts had an average first day loss of 1.02%. The Order alleges violations of Exchange Act Section 10(b) and Advisers Act Section 201(1).

Respondent resolve the proceeding, consenting to the entry of a cease and desist order based on the Sections cited in the Order. In addition, he is barred from the securities business and will pay a penalty of $75,000.

In the Matter of TPG Advisors LLC, Adm. Proc. File No. 3-17216 (April 19, 2016) is a proceeding which names as Respondents the firm, a registered investment adviser, and its owner and principal, Larry M. Phillips. The firm’s trade allocation policies, as reflected in its Form ADV as well as its internal written policies and procedures, required that trades be allocated in the most equitable manner possible.

From January 2010 through August 2014 the firm failed to adhere to its disclosed trade allocation policies by favoring six accounts held by four favored clients, according to the Order. Mr. Phillips placed trades in a master account without making any specific allocation. If the security could be bought and sold in a day for a profit, the position would be closed in the master account. The profits would be allocated to a favored account. If the position could not be closed for a gain that day it was usually allocated to one of the disfavored accounts.

The favored clients had first day profits on day trades that were virtually impossible to have been achieved by chance, according to the Order. Certain accounts had a large proportion of day trades while others had almost none. For the six favored account over 90% of the trades were day trades that had single day profits. In eleven accounts which had only a small proportion of the day trades, the vast majority had unrealized first day losses.

The likelihood that the profitability of the favored accounts occurred by random chance is less than 1%, according to the Order. In contrast, the performance in each of the eleven disfavored accounts is a statistical anomaly. Random change would have given them a better performance with a probability exceeding 99%.

The third party broker that held the accounts warned the adviser about the allocations. In at least 21 instances during the period the firm was warned for suspicious trades. The Order alleges violations of Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 207. The proceeding will be set for hearing.

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