Exchange-Traded Product Probe Results in Fines for Investment Advisory Firms

Late last year, the SEC announced the settlement of five enforcement cases against RIA firms relating to their recommendations and purchases of complex exchange-traded products (ETPs) in clients’ accounts. The settlements – against Benjamin F. Edwards & Co., Royal Alliance Associates, Inc., Securities America Advisors, Inc, Summit Financial Group, Inc., and American Portfolios Financial Services. The actions were announced in connection with the SEC’s ETP initiative.

These cases may be the first of many, and they followed a joint statement from SEC Chairman and division heads in October of last year indicating that firms would be examined relating to their use of complex ETPs. However, the SEC has not formally announced a new initiative on the subject. Earlier in 2020, the SEC had resolved a similar charge against Wells Fargo resulting in a $35 million fine.

Generally, the products in question were those that track market volatility and are designed as short-term investments. Typically, these products are tied to the CBOE volatility index or VIX. Examples of such products are the VelocityShares Daily Inverse VIX Short Term Exchange-Traded Notes and the ProShares VIX Short-Term Futures ETF, both of which are tied to the performance of the S&P 500 VIX Short-Term Futures Index. The product offering materials describe the objectives of these products as to manage trading risks on a daily basis, and warn that their use over periods longer than a single day is not suitable, as the risk control objective will not be met by using them over such longer period. The issuers’ materials clearly describe that the products could lead to substantial losses when held in portfolios over periods longer than a single day.

As is often the case, the firm conduct that led to the enforcement action was a combination of failure to train individual advisors of the risks of such products and the lack of supervisory oversight by the firm itself in failing to discover misuse of the products. While the offering material clearly described that the ETPs in question were designed as short-term investment products and that holding them over a long period of time exposed a portfolio to significant risk, individual representatives from the firms recommended the products to be held in clients’ accounts for months or, in some cases, years. The Firms often were aware that such products were being used over longer terms, yet failed to intervene to lower risks to clients and prevent losses.

The SEC concluded that all the subject firms had inadequate training and supervision policies in place to protect investors from losses from the misuse of the products. In many instances, the SEC also conclude the representatives did not understand the products and that clients were either mislead about them or failed to understand how the products were designed to work. The firms failed to meet the standard of “reasonable basis” to conclude that the products were suitable for their clients.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.

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