July 2015

The Securities and Exchange Commission recently announced its first fraud charges involving what some have called an attempt at “Robocop”, derived from tracking behavior using data analytics of large volumes of investment advisors’ trade allocation detail.  The enforcement target is Welhouse & Associates Inc. and its owner Mark P. Welhouse.

Mr. Welhouse is accused of “cherry-picking”, a practice whereby one improperly allocates option trades that appreciated in value during the course of a trading day to personal and/or business accounts, while allocating those that depreciated in value to client accounts.  The SEC’s Division of Economic and Risk Analysis has been analyzing large volumes of such data to ascertain instances of seemingly disproportionate allocations, which thereby trigger further investigation.  While Mr. Welhouse’s personal trades in an S&P 500 exchange-traded fund named SPY averaged 6.28% first-day returns, his clients lost an average of 5.05% in the first day.

The difference between Mr. Welhouse’s first-day profit and that of his clients was highly statistically significant.  The SEC ran one million simulations and found Mr. Welhouse’s actual profit was substantially higher than the result in every one.  Comparing the proportion of profitable trades allocated to Mr. Welhouse’s accounts to the proportion of profitable trades allocated to Mr. Welhouse’s clients’ accounts, the likelihood of the results actually obtained occurring by random chance was less than one in one trillion.  Therefore the SEC concluded that the disparate results obtained were not the result of coincidence or luck, nor the result of his admitted “mistakes” in allocation.

The SEC alleges that Mr. Welhouse benefitted $442,319 via his repeated unfairly allocated options trades.  This substantial differential was allegedly achieved because the options were all purchased in an omnibus or master account and only allocated to individual accounts after results were ascertainable.  Instead of following a prescribed pro rata allocation, Mr. Welhouse allegedly “cherry-picked” the winners for his own accounts and day-traded them for a profit.

While the failure to allocate fairly was a violation of the firm’s written policies and procedures, such failure was exacerbated by the fact that Welhouse & Associates informed clients that the firm did not trade for its own account.  The SEC has charged Mr. Welhouse and his firm with violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, Section 17(a) of the Securities Act of 1933, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940.

Fraudulent activity such as cherry-picking can often long go undetected.  The SEC’s ability to proactively identify possible perpetrators using data analytics instead of waiting for whistleblower tips or other indicators of fraud will undoubtedly lead to more enforcement activity in this arena.

Fulcrum Inquiry performs forensic accounting and other financial investigations and related damages calculations.