The Securities and Exchange Commission is taking administrative action against an investment advisor alleged to have engaged in a so-called "cherry-picking" scheme that funneled gains from day trades in an omnibus account into the advisor's personal and business accounts, while saddling clients with the losses from the trades that went sour.
The agency's order initiating administrative proceedings alleges that Noah Myers, president of MiddleCove Capital, netted "ill-gotten gains" of about $460,000, while his clients lost more than $2 million from around October 2008 through February 2011, when an employee threatened to report the activity to the SEC.
"He did this by purchasing securities in an omnibus account and delaying allocation of the purchases until later in the day (and sometimes the next day), after he saw whether the securities appreciated in value," the SEC order states.
Myers referred a request for comment to his attorney, Hugh Keefe, managing partner with the firm Lynch, Traube, Keefe & Errante. Keefe did not respond to a request for comment.
Over the period in question, Myers' holdings increased by 67 basis points, while his clients saw their positions slip by 32 basis points, a gap the SEC describes as "highly statistically significant." According to the agency, the odds that such a disparity would occur by sheer luck are less than one in 10 million.
According to the SEC, Myers would commonly allocate the sale of securities that appreciated on the day of the trade to his personal or business accounts. But when the securities dipped in value, he would allocate a disproportionate amount of the loss to his clients, on whose behalf he would often hold the position for longer than a day.
The SEC alleges that the cherry-picking scheme was carried out across multiple securities, but the much of the activity involved a leveraged, inverse and highly volatile exchange-traded fund, ProShares UltraShort Financials, or SKF.
The SEC has ordered a hearing before an administrative law judge for the alleged violations of the Securities Exchange Act and the Investment Advisers Act.
MiddleCove, which caters to individuals and families, has been registered with the SEC since its founding in 2008. The firm oversaw about $53 million in assets for roughly 350 clients as of Sept. 31, 2011, according to the SEC, well below its peak volume of client holdings. Myers, the sole owner of MiddleCove, is now the firm's only employee. The SEC said that many of MiddleCove's clients were relying on their account with the firm as a portion of their retirement funding, and had little tolerance for risk.
In testimony in the SEC's investigation, Myers invoked his right against self-incrimination, the agency said.
Two months after founding MiddleCove, Myers began using an omnibus account held with Charles Schwab, which became the custodian for all of the firm's holdings. The SEC's order alleges that securities purchased through that master account would be allocated to his personal and clients' accounts. The order describes a dramatic spike in day-trading activity involving his personal account beginning in October 2008.
According to the SEC, Myers would commonly purchase a given security for several days -- and sometimes weeks or months -- in a row, and then allocate the holdings based on variations in performance.
"If it increased in value on the day of purchase, he disproportionately allocated the security to his own accounts. If the security decreased in value on the day of purchase, Myers disproportionately allocated it to his clients' accounts," the SEC order states. "Thus, the securities on which Myers was disproportionately making money were the same securities on which his clients were disproportionately losing money."
The alleged scheme came to light when a program that Schwab maintains to monitor allocation flagged the MiddleCove omnibus account for appearing to give preferential treatment to certain portions of the block trades, while disadvantaging others.
After receiving a call from Schwab about the irregularities, a MiddleCove employee analyzed Myers' trading history, which appeared to confirm the pattern that Schwab had flagged. The employee, along with his three coworkers, brought his findings to Myers in December 2010.
After being confronted by his staff, Myers committed to use a specific Schwab trading application for clients' transactions, and a separate method for his personal activity. But then in February 2011, the same MiddleCove employee first notified by Schwab discovered a transaction that Myers had executed for his personal account through the trading application he had agreed to use only for clients, according to the SEC. Myers reallocated the trade after the employee threatened to report him to the agency, and trading activity in his personal accounts dropped off considerably at that point.
But by November 2011, the SEC was already looking into Myers' trading activity. "Myers admitted that he had a day-trading strategy in one of his personal accounts that was profitable about 95% of the time, but he did not offer a plausible explanation for his stellar day-trading performance," the agency's order alleges.
Sarah Bulgatz, a spokeswoman for Schwab, declined to comment on the MiddleCove case, citing company policy concerning such matters, but said that "we are extremely vigilant when it comes to account security, and we use a combination of automated and manual systems to identify red flags that could point to potential fraud." Bulgatz declined to elaborate on how the monitoring program operates.
"We don't provide additional details on our methodologies for security reasons," she said.
The SEC is also citing MiddleCove for violating the terms of the ADV form it filed to register with the agency.
The SEC directed Myers and MiddleCove to file responses to a series of questions about the charges by mid-September, and slated a hearing before an administrative law judge to occur between 30 days and 60 days from the issuance of its order.
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