On November 16, 2020, the Office of Compliance Inspections and Examinations (OCIE) of the US Securities and Exchange Commission (SEC) issued a public statement (Public Statement)1 regarding the recent settled enforcement actions against three SEC-registered investment advisers and two dual-registrants related to certain exchange-traded products (ETPs). These enforcement actions were published on November 13, 2020 (Enforcement Actions).2
The Enforcement Actions
According to the SEC, the Enforcement Actions related to unsuitable sales of volatility-linked ETPs to retail investors. They are the first actions generated by the Division of Enforcement's Exchange-Traded Products Initiative. The SEC was quick to point out that the SEC used trading data analytics to uncover potential unsuitable sales.
The ETPs at issue attempted to track short-term volatility expectations in the market. Apparently, the offering documents for the ETPs disclosed the short-term nature of these products and further disclosed that these products are more likely to experience a decline in value when held over a longer period. According to the SEC, contrary to the warnings in the offering documents and apparently without understanding the products, representatives of the firms recommended that their clients and customers buy and hold the products for longer periods, including, in some circumstances, for months and years. The SEC also found that the firms failed to adopt or implement policies and procedures regarding suitability of volatility-linked ETPs.
The orders against each firm found that the firm failed to implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 and the rules thereunder. One order further found that the firm failed reasonably to supervise the brokerage representatives who recommended that customers buy and hold a volatility-linked ETP. Another order further found that the firm failed reasonably to supervise the brokerage and advisory representatives who recommended that clients buy and hold volatility-linked ETPs.
Without admitting or denying the SEC's findings, each firm agreed to cease and desist from future violations of the charged provisions, a censure, and to pay disgorgement and prejudgment interest. The civil penalties ranged from $500,000 to $650,000.
The Public Statement
The Public Statement focused on the importance of registered investment advisers and registered broker-dealers having robust and effective policies and procedures, including policies that ensure that their "financial professionals understand the risks and purposes of the products they advise on and/or recommend to clients and customers." The Public Statement also specifically called out the need for firms to "ensure that their financial professionals, including independent contractors acting on their behalf, actually follow in practice those firm policies and procedures."
From OCIE's perspective, the Enforcement Actions "reflect instances where financial professionals recommended complex investment products to retail clients and customers that were intended for short-term use, but were not used as designed causing financial harm to their clients and customers." OCIE pointed out that the ETPs at issue in the Enforcement Actions had disclosed in their prospectuses and supplements that these products were intended as short-term investments and that risks heightened when holding these products for longer periods.
OCIE offered some observations regarding complex products and related policies and procedures:
- Complex products and investment strategies continuously evolve in structure and risk.
- Registrants that have static compliance programs are more susceptible to having compliance failures.
- There are firms that have dynamic compliance programs "with policies and procedures and practices for onboarding new products, including complex products."
- These policies and procedures "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."
- This assessment, often done by a committee, typically calls for the active involvement of senior managers and includes participation from compliance, legal, risk, marketing, portfolio management and/or operations.
- There are firms that provide financial professionals with the training and tools such that the financial professional is sufficiently familiar with the product to discharge the firm's and his or her own legal obligations.
OCIE then offered some advice:
- Firms that offer their financial professionals access to a full scope of products on a platform made available by the firm's clearing or executing broker should review the design and implementation of their policies and procedures.
- Product analysis should not be left solely to each financial professional.
- In the case of both existing products and new products, firms should consider which products are complex, suitable only for sophisticated investors, not suitable for investors who plan to hold them for longer than one trading session or not suitable for longer-term investment.
- Firms should take appropriate steps concerning financial professional access to certain products, product training, and/or compliance monitoring and review.
OCIE then warned that it will continue to review for the inappropriate use of complex investment products, evaluate related policies and procedures, and evaluate compliance with Regulation Best Interest and an investment adviser's federal fiduciary duty. Perhaps most importantly, OCIE then provided more explicit advice (and warnings) to registrants regarding complex products:
- Under applicable legal standards, a financial professional recommending a complex or risky product should apply heightened scrutiny to understand the terms, features and risks of the product and whether such product fits within the client or customer's risk tolerance and specific-trading objective and whether it would require daily monitoring by the investor or the financial professional.
- A recommendation by a firm's financial professional is a recommendation of the firm.
- In order to fulfill their legal
obligations, it is critically important
for firms to implement 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;
- Only recommend products in compliance with legal standards; and
- Monitor the investment daily, as applicable.
Recent Joint Statement
On October 28, 2020, the Chairman and the Directors of the Divisions of Investment Management, Corporation Finance and Trading and Markets (Divisions) issued a public statement addressing the application of Regulation Best Interest and an investment adviser's federal fiduciary duty in the context of complex products (including ETPs and leveraged/inverse products) and retail investors (Joint Statement).3 The Joint Statement set out a number of regulatory concerns in this regard, including:
- Differences in Regulatory Structure – Some complex products are registered investment companies and thus subject to the Investment Company Act of 1940 (1940 Act), including investor protection requirements. Other complex products are not subject to the 1940 Act but may be subject to other federal securities laws. Retail investors (and financial professionals who serve retail investors) may not appreciate that the investor protection elements of these regulatory structures differ.
- Operation of Complex Products; Volatility and Market Stress – Retail investors, and in certain cases financial professionals, may not fully appreciate how complex products operate or function or the unique risks associated with these products. This concern can be heightened in times of market stress, and this can have a greater and unexpected impact on some products, depending on their operation/function.
- Self-Directed Trading – Retail investors have direct access to stocks, bonds and complex products and have a choice regarding the level of advice they receive from financial professionals. As a result, many self-directed retail investors are typically making investment decisions on their own, without the assistance of a financial professional.
The Joint Statement concluded by reviewing the best interest standard of conduct for broker-dealers under Regulation Best Interest and the fiduciary obligations of investment advisers, as described in the SEC's 2019 interpretive release, and its application to complex products recommended for retail investors. In that regard, registrants were reminded of the following:
- A broker-dealer or an investment adviser recommending or advising on complex products must have a reasonable basis to believe that the recommendation or advice provided is in the best interest of the retail investor.
- Complex products, such as leveraged/inverse products that are designed primarily as short-term trading tools for sophisticated investors, may not be in the best interest of a retail investor absent an identified, short-term, investor-specific trading objective.
Lastly, for retail investors who are independently selecting complex products, the Joint Statement voiced a concern that such investors may not fully appreciate the unique characteristics and risks of those products. Accordingly, the staff in the Divisions will be reviewing the effectiveness of the existing regulatory requirements in protecting investors and will make recommendations to the Commission for potential new rulemakings, guidance or other policy actions, if appropriate (which could include additional obligations for broker-dealers and investment advisers relating to complex products, as well as point-of-sale disclosures or policies and procedures tailored to the risks of complex products).
Registrants now have fair warning on the SEC's concerns regarding ETPs and complex products. Accordingly, registrants may want to review the Public Statement and the Joint Statement, and use each as a checklist of sorts, against which to compare current practices, and related policies, procedures and controls (including, but not limited to, controls regarding how to determine which products should be treated as "complex" or otherwise receive "heightened scrutiny" and possibly also daily monitoring).
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