On November 25, 2019, the Securities and Exchange Commission ("SEC") re-proposed Rule 18f-4, a new rule under the Investment Company Act of 1940 (the "1940 Act"), which is designed to address the investor protection purposes and concerns underlying Section 18 of the 1940 Act, and update the SEC's approach to the regulation of funds' use of derivatives. The proposed rule would apply to, among others, exchange-traded funds ("ETFs").15
The Release also proposed two new sales practice rules, which would require a broker, dealer or investment adviser that is registered (or required to be registered) with the SEC (a "RIA") under the Investment Advisers Act of 1940 (the "Advisers Act") to exercise due diligence in approving a retail customer's or client's account to buy or sell shares of certain "leveraged/inverse investment vehicles" before accepting any order from, or placing an order for, the customer or client to engage in these transactions. 16 The proposed sales practice rules are designed to address specific risks posed by "leveraged/inverse investment vehicles," which include registered investment companies and exchange-listed or commodity- or currency-based trusts or funds that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specific multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time, generally on a daily basis. 17
Proposed Rule 15l-2 under the Securities Exchange Act of 1934 ("the Exchange Act") would require a broker-dealer (or any of its associated persons) to exercise due diligence to ascertain certain essential facts about a customer who is a retail investor before accepting the customer's order to buy or sell shares of a leveraged/inverse ETF, or approving the customer's account to engage in those transactions. Proposed Rule 211(h)-1 under the Advisers Act would have a similar effect on an RIA. Under both of these proposed rules, a firm could approve the retail investor's account to buy or sell shares of a leveraged/inverse ETF only if the firm had a reasonable basis to believe that the investor is capable of evaluating the risks associated with these products. 18
The SEC noted in the Release that compliance with the proposed rules would not supplant, by itself, other broker-dealer or investment adviser obligations, such as a broker-dealer's obligations under Regulation Best Interest or a RIA's fiduciary duty under the Advisers Act. The Release did not mention broker-dealers' obligations under Financial Industry Regulatory Authority, Inc. ("FINRA") Rule 2111 (Suitability), perhaps because the market anticipates that Regulation Best Interest will essentially supplant FINRA Rule 2111's suitability requirements.
The proposed sales practice rules are modeled on current FINRA rules governing options account approval requirements for broker-dealers. 19 Under these FINRA rules, a broker-dealer may not accept a customer's options order unless the broker-dealer has approved the customer's account for options trading. The SEC used these FINRA rules as a model because leveraged/inverse ETFs, when held over longer periods of time, may have certain similarities to options. Like the FINRA rules, the proposed sales practice rules would not require firms to evaluate retail investors' eligibility to transact in these products on a transaction-by-transaction basis.
In the Release, the SEC requested comments on a number of aspects of the proposed sales practice rules, including the definition of "leveraged/inverse investment vehicle." Request for comment number 173 asks whether the scope of the definition should be expanded to include exchange traded notes ("ETNs") with the same or similar return profile as, for example, a leverage/inverse ETF. The same request for comment also asks whether additional "complex products," such as those discussed in FINRA Regulatory Notice 12-03 (including, among others, certain structured or asset-backed notes, unlisted REITs, securitized products, and products that offer exposure to stock market volatility) should be subject to the same due diligence and account approval requirements as in the proposed sales practice rules. 20
The proposed due diligence requirement provides that a broker-dealer must exercise due diligence to ascertain the essential facts relative to the retail investor, his or her financial situation, and investment objectives. At a minimum, a firm must seek to obtain information about a retail investor's:
- investment objectives and time horizon;
- employment status;
- estimated annual income;
- estimated net worth;
- estimated liquid net worth;
- percentage of the retail investor's liquid net worth that he or she intends to invest in the leveraged/inverse investment vehicles; and
- investment experience and knowledge regarding leveraged/inverse investment vehicles, options, stocks and bonds, commodities and other financial instruments.21
After evaluating this information, a firm would be required to specifically approve or disapprove the retail investor's account for purchase or sale of a leveraged/inverse ETF. An approval must be in writing. The firm must have a reasonable basis for believing that the retail investor has the financial knowledge and experience to be reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse ETFs. According to the SEC, this would not be a bright-line determination; rather, it would be based on all relevant facts and circumstances.
A "retail investor" is limited to a "natural person" or "a legal representative of a natural person," with the definitions aligning with the definitions used in Regulation Best Interest. High net worth individuals are considered retail investors.
The proposed rules would require firms to adopt and implement written policies and procedures addressing compliance with the applicable rule.
One of the requests for comment (number 187) asks whether the proposed rule should require firms to provide a short, plain-English disclosure generally describing the risks associated with inverse/leveraged ETFs (such as risks relating to compounding and other risks that the inverse/leveraged ETFs disclose in their prospectuses).
Why the concern about leveraged/inverse ETFs?
As discussed in the Release, leveraged/inverse ETFs rebalance their portfolios on a daily (or other predetermined) basis to achieve a constant leverage ratio. As a result, the reset, and the effects of compounding, can result in performance over longer holding periods (even for longer than one day) that differs significantly from the leveraged or inverse performance of the underlying reference asset (such as an index) over the same holding periods. Consequently, buy-and-hold investors who have an intermediate- or long-term time horizon, and who may not evaluate their portfolios frequently, may experience large and unexpected losses or otherwise experience returns that are different from what was expected. 22
As a result, inappropriate sales of leveraged/inverse ETFs and ETNs have been the focus of regulatory scrutiny for a long time. Both FINRA and the SEC have issued investor alerts regarding leveraged/inverse ETFs and ETNs with daily resets. 23 There have also been a number of enforcement actions relating to inappropriate sales to retail investors of leveraged/inverse ETFs and ETNs, including sales into retirement accounts. 24
Issuers are well aware of the regulatory concerns about leveraged/inverse ETFs and ETNs, particularly those with daily resets. Offering documents for leveraged/inverse ETNs with daily resets normally include fulsome risk factor disclosure about the potential negative effects of compounding and leveraged inverse exposure, and also warnings that they should not be purchased by investors as a buy-and-hold investment. These offering documents also warn investors that they should not purchase the leveraged/inverse ETNs unless they are sophisticated investors who plan to monitor their investments on a daily basis.
With the proposed sales practice rules, the SEC is adding another layer of protection for retail investors in leveraged/inverse ETFs. However, structured notes issuers should take note of potential regulatory over-reach, particularly request for comment 173, which asks whether ETNs and certain "complex products" covered in FINRA Regulatory Notice 12-03 should also be subject to the proposed sales practice rules.
14 The preamble to the Proposal notes that the FDIC is considering further modifications to its deposit insurance assessment regulations.
15 Release No. 34-87607 (Nov. 25, 2019) (the "Release") is available at: http://bit.ly/39BkXKu.
16 The proposed sales practice rules are contained in Rule 15l2 under the Securities Exchange Act of 1934 and Rule 211(h)-1 under the Advisers Act.
17 See the Release at 13 and FN13. For the purposes of this article, we will refer only to ETFs.
18 See the Release at 181-182.
19 See FINRA Rule 2360(b)(16), (17) (requirements for options accounts firm approval, diligence and recordkeeping). Release at 183.
20 See the Release at 186-187.
21 See the Release at 188.
22 Release at 178-179.
23 See FINRA Regulatory Notice 09-31 (FINRA Reminds Firms of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds); SEC Investor Alert (Aug. 1. 2009) (Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors); FINRA Investor Alert (July 10, 2012) (Exchange-Traded Notes-Avoid Unpleasant Surprise); and SEC Investor Bulletin (Dec, 1, 2015) (Exchange Traded Notes (ETNs)).
24 See Reverse Inquiries, Vol. 2, Issue 9, available at: http://bit.ly/2VbyzWf, discussing a FINRA Letter of Acceptance, Waiver and Consent. See also the Release at FN 315.
Originally published in REVERSEinquiries: Volume 3, Issue
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