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Investment Allocation Testing Implications of the Leech / WAMCO case
Background:
- On November 25, 2024, the Securities and Exchange Commission (“SEC”) filed a federal complaint against a portfolio manager in the Southern District of New York alleging investment allocation fraud1. A parallel criminal complaint was filed by the Department of Justice.
- The allegations claim that the portfolio manager waited until the end of the trading day to allocate highly liquid investments, directing them to either favored or disfavored accounts based on their first-day performance.
- The allegations did not appear to be supported by emails or other communications.
Key Allegations:
- The portfolio manager selectively allocated certain liquid trades at the end of the trading day, instead of before the trade or in real time.
- Favored accounts were assigned trades with embedded daily gains, while disfavored accounts were given trades with embedded daily losses.
- The portfolio manager traded highly liquid trades and was able to observe price movements at the end of each day.
- The portfolio manager traded in omnibus accounts which could contain trades for multiple clients.
- The SEC’s analysis has 4 components: (1) circumstantial evidence of cherry picking; (2) conflicts of interest; (3) lack of appropriate disclosure;(4) non-compliance with the firm’s allocation policy.
| Circumstantial Evidence of Cherry Picking | Conflicts of Interest | Lack of Appropriate Disclosure / Concealment | Non-Compliance With the Firm’s Allocation Policy |
|---|---|---|---|
| During the relevant period, $600 million in trades with embedded first-day gains were allocated to favored portfolios, while over $600 million in trades with embedded first-day losses were assigned to disfavored portfolios. The SEC calculated that the likelihood of these allocations occurring randomly was one in a trillion. The portfolio manager traded identical instruments in the same direction at different prices throughout the day. Gains (or smaller losses) were allocated to favored portfolios, while losses (or smaller gains) were assigned wholly or partially to disfavored portfolios. Favored portfolios experienced 34 consecutive months of net first-day gains, while disfavored portfolios consistently recorded net first-day losses during the same period. In 2023, the portfolio manager’s authority to allocate trades was revoked, and the favored portfolios’ outperformance immediately ceased. | The portfolio manager established the favored portfolios and had a strong reputational link to its performance. A significant portion of the portfolio manager’s deferred compensation was invested in the favored portfolios. The favored portfolios charged considerably higher fees compared to the disfavored portfolios. | The portfolio manager failed to disclose to clients that trades with first-day gains were consistently allocated to favored portfolios, while trades with first-day losses were consistently allocated to disfavored portfolios. The firm’s ADV claimed, “Investment allocations are done in a manner that [The Firm] believes is fair and equitable, with the presumption that similarly situated clients should generally participate in similar investment opportunities and trades.” This statement was false, as were similar representations made in the firm’s DDQs. The allocation decisions were partially based on an undisclosed factor: embedded first-day gains. | The firm conducted multiple compliance training and issued reminders about trade allocation policies, explicitly instructing staff not to delay trade allocations until the end of the day. The portfolio manager disregarded these instructions. Although the firm provided a trading system that allowed for pre-trade allocations, the portfolio manager chose not to use it. The portfolio manager often ignored phone calls from his trading assistant requesting allocation instructions and delayed providing those instructions until the end of the day, after observing market prices. |
Takeaways and Analysis:
- Investment Allocation Testing – This case appears to be largely constructed through data analysis and could serve as a valuable guide for designing effective investment allocation testing:
- Focus on Conflict Areas: The case underscores the importance of concentrating allocation testing on areas where conflicts of interest exist, such as higher fees, reputational stakes, and personal capital involvement.
- Address Red Flags: This case highlights the necessity of investigating red flags, such as the portfolio manager’s poor communication and evasiveness with his trading assistant in this case.
- Utilize Statistical Analysis: The case provides examples of statistical analyses that can help identify potential allocation issues. These analyses are a starting point and must be supplemented with interviews and further investigation before drawing conclusions about misallocation.
- Consider Remedial Steps: The case suggests potential remedies for detected misallocation, such as disclosing specific allocation factors like “first-day gains.” However, such disclosures can only prevent future misallocation and do not rectify past misallocations.
- Reduction of Risk Through Compliance and Training – The firm provided comprehensive compliance training, issued regular compliance reminders, and promptly launched an internal investigation as soon as the allocation misconduct was discovered. As a result, the firm was not charged. This case serves as a strong example of how robust compliance programs can protect firms, while individuals who bypass such programs forfeit the protections they offer.
1 In the Matter of Stephen Kenneth Leech Case 1:24-cv-09017