Fair Dealing or Foul Play? Preventing Trade Allocation Pitfalls

Fair trade allocation is a critical pillar of ethical practice and regulatory compliance in the investment advisory industry. Investment advisers are entrusted with managing client assets prudently, ensuring that trades are allocated equitably among clients. However, without strong policies, procedures and ongoing testing of trade allocation practices, firms risk regulatory action, reputational damage and financial loss.

The recent Western Asset Management Company (WAMCO) case underscores the severe consequences of failing to maintain fair allocation policies. The SEC accused WAMCO and its former co-chief investment officer (CIO) of engaging in improper trade allocation practices, often referred to as “cherry-picking.” This practice involves favoring specific accounts over others when allocating profitable trades. According to the SEC, WAMCO allocated profitable trades disproportionately to certain preferred accounts while disadvantaging others, violating WAMCO’s fiduciary duty to treat all clients fairly.

As a result of the SEC’s enforcement action, WAMCO faced significant financial and reputational damage, including substantial client withdrawals, legal scrutiny and regulatory penalties.

The WAMCO case — among others — highlights the importance of implementing and enforcing robust trade allocation policies to ensure compliance with SEC regulations and maintain client trust. These policies should be designed to be reasonable to the business and should cover:

• Fiduciary duty: Investment advisers are legally bound by their fiduciary duty to act in their clients’ best interests. Fair trade allocation is a fundamental aspect of this duty, as clients expect their assets to be managed without bias or favoritism.
• Preventing conflicts of interest: Without clear policies, advisers may face conflicts of interest that could lead to preferential trade allocation. Firms must proactively design and implement policies that prevent even the perception of unfair practices.
• Regulatory compliance: The SEC and other regulatory bodies have intensified their focus on trade allocation practices. Firms that fail to implement strong policies risk severe penalties, legal action and reputational harm.

Key components of effective trade allocation control framework

While organizations grapple with a changing regulatory agenda under new SEC leadership, there is little doubt that questionable trade allocation cases will continue to be investigated. As a result, financial advisers should implement critical components of a trade allocation control framework, including:

• Clear allocation criteria: Advisers must establish transparent, objective and documented criteria for trade allocation (e.g., pro rata). These criteria should outline when trades are allocated and how trades are distributed among accounts, ensuring fairness and preventing conflicts of interest.
• Segregation of duties: Ensure that responsibilities for the trade allocation process, including authorization, execution and review of allocations, are divided among multiple people and that no single person has complete control over the entire process.
• Authorization and approval processes: Firms should establish levels of authorization protocols based on specific limits for transaction allocations, especially for non-standard methodologies.    
• Documentation and record-keeping: Comprehensive record-keeping is essential for demonstrating compliance with trade allocation policies. Firms should maintain logs of trade allocation decisions that deviate from their allocation policies, timestamps and relevant approvals to establish a reliable audit trail.
• Regular monitoring and review: Firms should conduct periodic reviews to ensure trade allocations adhere to established policies and corrective action is taken if necessary.

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Encouraging a sustainable culture of compliance

As the regulatory landscape and market conditions continuously evolve, investment firms should conduct periodic assessments to refine trade allocation frameworks and update existing policies to adapt to emerging risks. These assessments can include periodic audits to assess whether trade allocations are aligned with established policies. The audits should be conducted by independent compliance teams and reviewed at the executive level. Investment advisers should also consider what tools are available to help encourage a sustainable compliance program, including:

• Technology: The SEC and other government regulators have demonstrated they are using data analytics and new technologies to identify malfeasance. Organizations should use data analytics or AI for enhanced monitoring to detect anomalies in trade allocations, management fees or excessive losses and flag potential compliance violations and generate reports in real time.
• Testing and tuning: Prior to implementation, the technological solutions should be tested in an offline controlled environment to confirm the completeness and accuracy of the trading data, establish desired detection trading patterns and calibrate model thresholds to filter out the noise. Ongoing testing and tuning of the systems are equally important once deployed and operating in a live environment to ensure they are appropriately modified to account for new trading strategies, portfolio changes and potential regulatory changes.
• Training and education: Compliance is only as strong as the people enforcing it. Firms should provide consistent, ongoing training for investment professionals and compliance staff on trade allocation best practices, regulatory requirements and ethical considerations. This helps ensure that organizations are not just implementing policies and procedures but regularly emphasizing their importance in the overall health of the business through action.
• Effective whistleblower programs: A strong compliance culture includes mechanisms for employees to report concerns without fear of retaliation. Anonymous reporting channels and whistleblower protections can help firms identify and address issues before they escalate and ensure stakeholders feel protected.
• Timely remediation, documentation and reporting: If misallocation or wrongdoing occurs, teams should contemporaneously document and report to management the corrective actions taken to evidence that the issue was identified, remediation efforts were completed and tested and there was proper management oversight. This can aid in future regulatory examinations and help alleviate potential fines and penalties.   

Tone at the top

Not to be forgotten, fostering a culture of compliance begins at the top. Firm leadership must actively endorse and enforce ethical trade allocation practices, setting a clear example for employees by “walking the talk.” The WAMCO case highlights the importance of implementing strong policies, procedures and rigorous testing in trade allocation practices. Investment advisers must ensure that their trade allocations are fair, well-documented and subject to continuous oversight. By prioritizing compliance, firms not only mitigate regulatory risks but also reinforce trust with clients and other stakeholders.