SEC Charges Investment Advisory Firms and Broker-Dealers With Exchange-Traded Product Violations

Ethan CoreyLegal Insights

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Authored by Ethan Corey, Financial Services Partner

Introduction and Overview

On November 13, 2020, the Securities and Exchange Commission (SEC) filed settled actions against three registered investment advisers, one broker-dealer and an investment adviser under common control, and one dual-registered broker-dealer and investment adviser for violations that related to unsuitable sales of complex exchange-traded products to retail investors.1  The sales occurred between January 2016 and April 2020.  These actions are the first arising from investigations generated by the SEC Division of Enforcement’s Exchange-Traded Products Initiative (Initiative).

On November 16, 2020, the SEC’s Office of Compliance Inspections and Examinations issued a Public Statement on the SEC’s enforcement actions.2  

There are several noteworthy aspects to the enforcement actions: 

  1. the Initiative utilized trading data analytics to uncover potential unsuitable sales;
  2. while the Enforcement actions come in the wake of the SEC’s adoption of Regulation Best Interest and determination not to adopt special broker-dealer and investment adviser sales practices rules for leveraged or inverse investment vehicles, the investigations relate to conduct that took place before Regulation Best Interest or the sales practices rules would have taken effect; and
  3. while, unlike an investment adviser, a broker-dealer has no continuing duty to monitor its customer’s accounts, the SEC’s sanctions against broker-dealers that permitted their customers to continue to hold complex exchange-traded products did not differ from its sanctions against investment advisers that permitted their clients to continue to hold complex exchange-traded products.

Discussion

The five actions concern sales of volatility-linked exchange-traded products – both exchange traded notes (ETNs) and exchange-traded funds (ETFs) (collectively, Complex ETPs).  The value of the products attempted to track short-term volatility expectations in the market, typically measured against derivatives of the CBOE volatility index, rather than against the index itself.  The offering documents for the Complex ETPs warned that the short-term nature of these products made investments in the products more likely to experience a decline in value when held over a longer period.  The orders find that, contrary to these warnings, and without understanding the Complex ETPs, representatives of the firms recommended their customers and clients buy and hold the Complex ETPs for longer periods, including in some circumstances, for months and years. 

1. Obligations of Broker-Dealers and Investment Advisers

Investment advisers owe a fiduciary duty to their clients under the Investment Advisers Act of 1940.  The investment adviser’s fiduciary duty is broad and applies to the entire adviser-client relationship.  The fiduciary duty encompasses both a duty of care and a duty of loyalty.  The investment adviser must act in the best interests of its client and cannot place its own interests ahead of its client.  The investment adviser’s duty of care involves, among other things, the duty to provide advice that is in the best interest of the client and the duty to provide advice and monitoring over the course of the relationship.  

Even before Regulation Best Interest was adopted, a broker-dealer was required to deal fairly with its customers.  Among other things, a central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of its customer.  The reasonable basis obligation requires a broker-dealer to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.  Customer-specific suitability requires a broker- dealer to make recommendations based on a customer’s financial situation and needs as well as other security holdings, to the extent known.  However, unlike an investment adviser, a broker-dealer ordinarily has no duty to monitor a non discretionary account, or to give advice to such a customer on an ongoing basis.  A broker-dealer generally has no duty to offer unsolicited information, advice, or warnings concerning the customer’s investments.

2. SEC Sanctions Against Broker-Dealers and Investment Advisers

The SEC’s sanctions against the dual-registrants did not distinguish between their conduct as broker-dealers and as investment advisers:  conduct that violated an investment adviser’s obligations was also found to obligate a broker-dealer’s obligations.  In particular, the SEC found that:

 a. With respect to the broker-dealer and investment adviser under common control:

  1. the broker-dealer failed reasonably to supervise certain of its registered representatives who recommended their brokerage customers buy and hold a Complex ETP without a reasonable basis for believing the recommendation was suitable for those customers. 
  2. the broker-dealer failed reasonably to implement its supervisory policies and procedures to address whether the registered representatives understood the product sufficiently to be able to form a reasonable basis to recommend that retail brokerage customers buy and hold the Complex ETP; and 
  3. the investment adviser failed to adopt and implement policies and procedures regarding the suitability of Complex ETPs for advisory clients.

b. With respect to the dually-registered broker-dealer and investment adviser:

  • the dual registrant failed reasonably to supervise certain of its registered representatives (brokerage representatives) and investment advisory representatives (advisory representatives) who made unsuitable recommendations to its retail brokerage customers and advisory clients that they buy and hold for extended periods two Complex ETPs. 
    • the brokerage representatives made these recommendations to buy and hold the Complex ETPs without having a reasonable basis to do so; and
    • both the brokerage representatives and advisory representatives failed to make a reasonable determination that these investments were suitable for certain of the customers and clients to whom they recommended the Complex ETPs, based on those retail customers’ and clients’ investment objectives, risk tolerance, and financial condition;  
  • the dual registrant failed reasonably to implement its supervisory policies and procedures to prevent and detect these violations; 
  • the dual registrant failed reasonably to implement its supervisory policies and procedures that were intended to provide assurance that its brokerage representatives had a reasonable basis to recommend complex products such as the Complex ETPs to their customers; and
  • the dual registrant failed to implement policies and procedures reasonably designed to prevent its advisory representatives from making unsuitable recommendations to its clients.

The SEC orders note that as a result of these recommendations, both brokerage customers and advisory clients bought and held Complex ETPs for extended periods of times and lost significant amounts of their investments.  It is important to note that the SEC viewed brokerage customers’ extended holdings of Complex ETPs as an important element in demonstrating unlawful conduct by the registered representative.

3. But I Thought Broker-Dealers Had No Duty to Monitor????

Of course, our intrepid reader is insistently asking “is the SEC actually sanctioning the broker-dealers for not monitoring their customers’ investments in Complex ETPs?”  A close examination of the enforcement actions indicates that, no, the SEC does not actually appear to be creating a new duty for broker-dealers to monitor their customers’ accounts. 

Instead, the enforcement actions focused on the buy-and-hold recommendations themselves.  In particular, the SEC concluded that the broker-dealers’ registered representatives:

  • did not understand that the Complex ETPs tended to decline significantly in value when held for extended periods of time; 
  • recommended that brokerage customers buy and hold the Complex ETPs – sometimes, in order to hedge against a downturn in the market; and
  • failed to warn customers of the specific potential risk of investing in a Complex ETP on a buy and hold basis.

None of the conduct sanctioned by the SEC involved a failure to revisit the recommendation or a failure to act to recommend that brokerage customers sell the Complex ETPs.  

4. OCIE Public Statement

The OCIE Public Statement noted that it is critically important that registered investment advisers and broker-dealers implement robust and effective policies and procedures reasonably designed to prevent violations of the federal securities laws.  It stated that the policies must:

  • ensure that their financial professionals understand the risks and purposes of the products they advise on and/or recommend to firm clients and customers; and
  • ensure that their financial professionals, including independent contractors acting on their behalf, actually follow in practice those firm policies and procedures.

OCIE contrasted dynamic compliance programs with compliance programs based upon product features, such as leverage or inverse correlation.  It stated that firms with dynamic compliance programs have policies and procedures and practices for onboarding new products, including complex products.  These policies and procedures and related practices often include, at the firm level, an assessment as to whether and how the product should be used by clients and customers and the training and monitoring of financial professionals necessary for the firm to meet its legal obligations.  OCIE admonished firms to review the design and implementation of their policies and procedures so that product analysis is not solely left to each financial professional.

OCIE argued that firms must have in place policies and procedures reasonably designed so that their financial professionals: 

  • understand the risks and purpose of the products they recommend to firm clients and customers; 
  • apply the necessary heightened scrutiny to complex products:
    • that are suitable only for sophisticated investors;
    • that are not suitable for investors who plan to hold them for longer than one trading session or not suitable for longer-term investment; 
  • only recommend products in compliance with legal standards; and 
  • monitor the investment daily, as applicable – OCIE cited to the Regulation Best Interest adopting release noting that products that are reset daily may not be “may not be suitable for, and as a consequence also not in the best interest of, [a broker-dealer’s] retail customers who plan to hold them for longer than one trading session” and to the SEC’s fiduciary duty interpretation noting that to the extent that complex products “are in the best interest of a retail client initially, they would require daily monitoring by the adviser.”

It should be noted that while the SEC recognized a duty to monitor on the part of investment advisers that it did not recognize on the part of broker-dealers, the practical effect of this difference appears to be that the SEC will scrutinize whether a broker has determined whether a customer intends to hold a complex product longer than one trading session before it recommends the product, while it will scrutinize whether an adviser monitors a complex product at least daily.

Conclusion

These enforcement cases brought against broker-dealers and investment advisers should serve as a warning to both that, in instances when either is recommending a complex financial product, the broker or adviser should have robust policies and procedures in place reasonably designed to assure that:  (a) it has approved the product for sale by its registered representatives or advisory representatives and has placed appropriate limits or safeguards on its unrestricted use by said representatives; (b) no representative may sell the product without being thoroughly trained in the product; and (c) the determination that the product being recommended is suitable for the client given the client’s circumstances and objectives be thoroughly documented.  

Moreover, in situations where a broker-dealer intends to recommend a complex financial product to a customer, the fact that the broker-dealer generally has no legal duty to monitor its customer’s investments arguably has no practical impact on the extent of the broker-dealer’s liability if it is determined that the recommendation and any associated sale was unsuitable in light of future developments (or just time itself).  If the customer is a retail customer and, consequently, the recommendation is subject to Regulation Best Interest, we are concerned that the lack of a duty to monitor might not mitigate the broker-dealer’s liability for a product that was not necessarily suitable on an extended basis (or at some point in the future).

About the Author

attorney ethan-corey

Ethan Corey has spent 22 years as an investment management lawyer specializing in distribution issues (including FINRA rules) as well as 1940 Act and Advisers Act issues.

He is familiar with ERISA, MSRB and CFTC rules, as well as FCA Conduct of Business Rules and MiFID II. He has been an effective advocate with regulators as a member of industry trade groups.

 

Attorneys Phone Email
Ethan Corey (301) 580-6489 Ethan.Corey@Practus.com

Article Footnotes


  1.  SEC Charges Investment Advisory Firms and Broker-Dealers in Connection with Sales of Complex Exchange-Traded Products, SEC Press Release 2020-282 (Nov. 13, 2020).
  2. Statement on Recent Enforcement Matters Involving “VIX-Related” and Other Complex Exchange Traded Products (ETPs) from the SEC Office of Compliance Inspections and Examinations, (Nov. 16, 2020) (https://www.sec.gov/news/public-statement/ocie-vix-matters-2020-11-16).

Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.