Here’s a thing I think I know about billionaires: They’ve made piles and piles of money doing something someone somewhere surely advised them not to do because it was a dumb idea. Then later, actually dumb ideas come along and the billionaires are not dissuaded because they have a billion dollars and who’s going to tell them what to do now? Which is why I was very excited late last year when Sacramento Kings owner Vivek Ranadivé proposed that his team play only four players on defense, keeping one back to cherrypick easy baskets. Never mind that it’s hard enough to play defense with five NBA players, or, as Barry Petchesky suggested, “you’d probably have DeMarcus Cousins and Rudy Gay get into a fistfight over who got to hang out under the opponent’s basket.” I just want to see somebody try it, and it’s too bad that the Kings didn’t actually employ this strategy. Maybe their experimentation in the D League will bubble up into something I can watch with my own eyes . . . . In the meantime, do you know who else is big into cherrypicking? According to the SEC, Wisconsin-based investment adviser Welhouse & Associates. On Monday the SEC sued the firm and its principal Mark Welhouse for allegedly “improperly allocating to his personal and business accounts certain options trades that appreciated in value during the course of a trading day while allocating to his clients other trades that depreciated in value.” That is, a different kind of cherrypicking. The SEC’s order assumes some knowledge about how cherrypicking works. Here’s what I think is a fair description of what the order alleges: On any particular day, Welhouse & Associates and Mark Welhouse (together here, “Welhouse”) made proprietary trades for itself and trades for its advisory clients. Often these were options trades in an S&P 500 exchange-traded fund called SPY that would change in value over the course of the day. Importantly, these trades did not have to be allocated to a particular account until later in the afternoon, and Welhouse generally allocated them after 2:00 p.m. or 3:00 p.m. All of this is fine as far as it goes, but the SEC didn’t love how Welhouse allocated these trades when measured against how it said it would allocate the trades. In several instances, the SEC alleges, Welhouse said it would allocate the SPY trades on a pro rata basis among client accounts and Welhouse proprietary accounts:
- Mark Welhouse stated, apparently in testimony before the SEC staff, that he allocated all trades pro rata across all accounts for a particular model (including pro rata across Mr. Welhouse’s own accounts and his clients’ accounts that were on the same model);
- He also said that Welhouse’s January 2012 Form ADV Part 2A’s reference to fair and equitable trade allocation is a reference to Mr. Welhouse’s pro rata allocation across a model.
- Welhouse’s firm brochures on Form ADV said Welhouse did not trade for its own account at all.
- Welhouse’s written policies and procedures for trade allocation state: (1) “[a]ll clients are assigned to a model portfolio. . .”; and (2) “[w]hen a trade is put on the trade is purchased by the model portfolio and automatically allocated to the clients account” on a pro rata basis.
In fact, the SEC alleges, Welhouse did not allocate SPY options trades pro rata. Once the trades went up or down, Welhouse allocated a disproportionate number of profitable SPY options trades to favored accounts (accounts belonging to Mr. Welhouse or another person with the last name Welhouse), while allocating unprofitable SPY options trades to client accounts. The Commission has accused Welhouse of violating the antifraud provision of the Exchange Act and the Advisers Act, and claims the firm reaped $442,000 in ill-gotten gains from these undisclosed allocations. Two weird things about this case: First, the testimony Mark Welhouse gave apparently occurred without a court reporter present. Instead, he “was interviewed by the Commission staff on January 28, 2014. Mr. Welhouse agreed that the interview could be recorded, and the staff recorded the interview.” Like with a tape recorder? An iPhone? It’s not unlawful, but it’s an odd procedure. The order doesn’t make clear whether this interview was on the phone or in person. It doesn’t sound like an attorney for Welhouse was present, but it’s hard to tell. Did the staff just call him on the phone and then ask if they could record the call? He might have said things he otherwise would not have if the setting had been more formal administrative testimony. Second, Welhouse & Associates is registered with the State of Wisconsin as investment adviser, not with the SEC. It’s on the hook for violations of the antifraud provisions no matter where it’s registered, but it seems a little odd that the SEC is handling this case and not the Wisconsin Department of Financial Institutions.