Investor Losses from Oil Pricing War Could Trigger FINRA and SEC Exam Scrutiny

As the saying goes, “a rising tide lifts all boats.” This expression is commonly used in the investment world to mean that in bull markets, all portfolios tend to rise, no matter how poorly constructed. However, when the market changes directions sharply, as it has over the last thirteen trading days, poorly constructed portfolios sink more precipitously than the overall market.

The stock market has never before plunged by 18% off of its all-time high over such a short time frame. The main driver of the decline had been, prior to this week, concern over the impact that the spreading Coronavirus will have on the US economy. On Monday, March 9, however, news of an oil trade war caused a further, more precipitous decline. But the 18% decline in the market in the last few trading days represents the broad equity markets. Investors whose portfolios are overconcentrated in individual stocks or market sectors are experiencing even worse declines. To continue the boat metaphor, some portfolios will be sunk or will crash against the rocks.

Relative to the market, portfolios that are overconcentrated in equities of industries with bleak outlooks are usually the hardest hit. In 2000 it was the technology stock bubble that spurred the market crash, and those tech stocks were the hardest hit in the decline. In the 2008 time frame, financial stocks were among the hardest hit. In the current market crash, oil and other energy stocks are taking the brunt of the punishment. The recent oil price war resulting from the breakdown of the Saudi Arabia – Russia Oil Alliance Known as OPEC+ has sent oil and gas stocks plummeting today, down by 18% today at the time of this writing. And oil stocks were already under pressure prior to today. The Dow Jones US Oil and Gas Total Stock Market Index is down 36% over the past month and 47% over the past year.

Investors overconcentrated in that sector will see their personal portfolios devastated by the most recent events, and undoubtedly many will seek to recover their losses through arbitration. This will force many firms and their individual advisers to justify the overconcentration of oil and other energy stocks in the clients’ portfolios, and those unable to do so may have to pay substantial awards to their investor clients. In fact, many oil and gas investment failures have already resulted in substantial awards in recent years.

Additionally, examiners at both the SEC and FINRA are likely to review the accounts of firms’ worst-performing portfolios. While overconcentration is not expressly mentioned in the SEC’s list of 2020 examination priorities, in prior years the Commission’s examination staff has prioritized examining advisory firms for cases in which the portfolio manager exceeded the “risk tolerance levels or stated objectives in the prospectus, such as overconcentration in a single issuer or sector.” The SEC’s Enforcement Division has consistently brought actions against advisory firms whose clients suffered severe losses due to overconcentration. The SEC’s Office of Compliance Inspections and Examinations and has also consistently evaluated firms with respect to overconcentration in alternative investments, many of which over the past ten years have been focused in the energy sector.

Advisers who have clients that suffered outsized risks due to oil and gas exposure should take this opportunity to re-evaluate their risk management processes relative to overconcentration and diversification. A responsible policy will place asset diversification levels for specific investment objectives and risks, as well as industry and single-issuer limits, and will require compliance approval prior to exceeding such limits. Additionally, in times like these, advisers often learn more about their clients’ risk tolerance than they can learn in a hundred “suitability forms” or online risk exercises. If a client can’t sleep at night, you have been overestimating their risk appetite and should take the opportunity to adjust both the client’s portfolio and your internal documentation.


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.