Three firms settled separate but largely similar FINRA charges for failing to reasonably supervise recommendations of the "alternative" mutual fund, the LJM Preservation and Growth Fund ("LJM"). (There is no legal definition of an "alternative" mutual fund.)
In the enforcement releases, FINRA defined alternative mutual funds as publicly offered funds seeking "to accomplish the funds' objectives through non-traditional investments and trading strategies." According to the enforcement releases, LJM "sold volatility," profiting from the difference between implied and realized market volatility, and was typically "net short or short volatility." Morningstar characterized LJM as "relatively aggressive and exposed to a steep rise in equity volatility," evidenced when the S&P 500 fell in February 2018 and caused an "unprecedented increase" in market volatility. This in turn dramatically increased the value of the short option positions, resulting in LJM losing about 80% of its value in 24 hours and being liquidated and dissolved by the end of March 2018.
All three firms sold LJM: the first in 2017, the second from 2016 to February 2018, and the third also from 2016 to February 2018.
In the Letters of Acceptance, Waiver and Consent ("AWCs"), FINRA found that two of the firms had no supervisory system to identify whether a new mutual fund was an "alternative" mutual fund, instead relying on their clearing firms to conduct due diligence. FINRA found that the third firm did have a supervisory system in place to identify new mutual funds as alternative, but its system did not trigger a heightened review of the fund's strategy. Additionally, all firms failed to provide guidance to representatives on the risks and features of alternative mutual funds, and failed to advise firm principals on how to supervise recommendations.
Furthermore, the firms utilized electronic trade review systems, but did not "consider" whether the rules of the review system should be tailored for alternative mutual funds, which inherently utilize a more complex strategy than traditional mutual funds. FINRA stated that, "generally," the systems did not flag transactions for additional suitability review, even for customers with moderately conservative risk tolerances.
As a result, the firms each violated FINRA Rules 3110 ("Supervision") and 2010 ("Standards of Commercial Honor and Principles of Trade").
To settle the charges, the firms each agreed to a censure, a fine, restitution and the certification of a supervisory system designed to address the violations described in their respective AWCs. (The first firm agreed to a $50,000 fine and restitution of $163,527; the second firm agreed to a $400,000 fine and restitution of $3,134,354.82; the third firm agreed to a $100,000 fine and restitution of $235,979.77.)
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