Broker-dealers must have in place, and implement, written supervisory policies designed to prevent unsuitable sales of complex exchange traded products to retail investors. Two recent regulatory actions illustrate how this guidance can be imperfectly applied.
In a recent Securities and Exchange Commission ("SEC") cease and desist order (the "Order"), investment advisers ("RIAs") registered under the Investment Advisers Act of 1940 (the "Advisers Act") in a dual registered broker-dealer were found exercising their discretionary authority over their clients' advisory accounts to purchase exchange-traded notes ("ETNs") linked to short-term VIX futures and keeping these ETNs in the clients' accounts for inappropriately long periods of time.1
The ETNs were "designed to provide exposure to the implied volatility of the S&P 500 by replicating a strategy of continuously maintaining a rolling portfolio of one- and two-month futures contracts on the CBOE volatility index (the "VIX")."2 As fully disclosed in the prospectus for the ETN, the buying and selling of futures contracts created roll costs, which had a negative effect on the ETNs' returns. Due to these roll costs, and the historical tendency for the futures contracts to be in "contango" (during which it is more expensive to replace the current futures contract with the new futures contract), the value of the ETN would, and did, decrease over extended periods, even if the VIX remained flat or positive during the same period. Consequently, these ETNs were an inappropriate investment for an investor with a "buy and hold" strategy.
This was well known in the broker-dealer arm of the firm. Indeed, there were internal communications on the broker-dealer side discussing how the ETN was an inappropriate investment if held for a period of greater than two days. Associated persons of the broker-dealer described the ETN as "only meant as an extremely short trading vehicle, not a way to hedge equity products."3
However, this guidance (and the associated written supervisory procedures) on the broker-dealer side of the firm did not prevent the RIAs from purchasing the ETNs for their advisory clients, and holding the ETNs for long periods of time, many for over one year. The supervisory procedures for the RIAs were focused more on concentration limits, rather than holding periods. The monitoring system was also faulty, in that after the ETN's CUSIP changed due to a reverse stock split, holdings of the ETNs in the RIAs advisory accounts were not monitored for a period of five years. Even then, the system did not look back at the clients' holding periods of the ETNs during the preceding five years, but started counting days from when the system was fixed. According to the SEC, these procedures were not reasonably designed to prevent holding period risk.
In addition to the concerns regarding the supervisory procedures, some of the RIAs did not understand the appropriate use of the ETNs, with a misunderstanding of the investment time horizon. As stated in the Order, the RIAs "could not make a reasonable determination as to whether [the ETN] was a suitable investment for their clients. ... [the RIAs] could not determine whether it was reasonable to hold [the ETN] for extended periods as a hedge against a potential market downturn or other unpredictable future events."4
The failure of the firm to require the RIAs to adopt and implement written policies and procedures to prevent violations of the Advisers Act and its rules were violations of Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder.
In a separate matter, the Financial Industry Regulatory Authority, Inc. ("FINRA") disciplined one of its member firms in a letter of acceptance, waiver and consent relating to the failure to establish and maintain a supervisory system reasonably designed to achieve compliance with the firm's suitability obligations in connection with sales of non-traditional and volatility-linked exchange traded products.5 Non-traditional and volatility-linked exchange traded products ("ETPs") are described by FINRA as "complex products intended to be held for short periods of time as part of a trading strategy rather than as buy-and-hold investments."6 FINRA has advised its members that non-traditional ETPs are not suitable for retail investors who plan to hold them for more than one trading session.7
As a FINRA member, the broker-dealer was required, under FINRA Rule 3110(a), to establish and maintain a system to supervise the activities of each associated person, which system is reasonably designed to achieve compliance with applicable securities laws and regulations and with applicable FINRA rules. The broker-dealer's supervisory obligations included establishing a reasonable system to supervise for compliance with FINRA Rule 2111 (Suitability), under which the firm and its associated persons must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer.
Although the broker-dealer did adopt written procedures requiring it to conduct a reasonable basis suitability review of each non-traditional ETP that it offered and to establish written supervisory guidelines for each product, no suitability reviews were conducted, and the written supervisory guidelines were not produced. A portion of the non-traditional ETP transactions were reviewed only on an ad hoc basis. The firm did not have systems in place to identify non-traditional ETPs. Instead, supervisory principals conducted a manual review, which required them to recognize the ticker symbol for each non-traditional ETP. All inverse leveraged ETPs escaped review under this system, as did many leveraged ETPs. Consequently, customers held these ETPs for inappropriately long periods of time.
Last, the registered representatives were not trained to understand the features of non-traditional ETPs, despite a requirement for such training in the firm's written supervisory procedures.
As a result, unsuitable recommendations of non-traditional ETPs were made to customers, without the registered representatives understanding that these products were only meant to be held on a short-term basis. The customers held the ETPs for long periods of time, incurring losses.
The broker-dealer was found to be in violation of FINRA Rule 3010(a) (Supervision), 2010 (Standards of Commercial Honor and Principles of Trade) and 2111 (Suitability).
Conclusion
Inverse, leveraged and inverse leveraged exchange-traded products have been a focus of regulators for years. Sales of these types of products to investors with a buy and hold viewpoint regularly bring negative attention to the industry. Given this, firms recommending and selling these products need to have in place and consistently enforce written supervisory procedures designed to prevent sales to investors who do not understand exactly how these products work.
Footnotes
1. The Order is available at: https://www.sec.gov/litigation/admin/2021/ia-5781.pdf.
2. See the Order at 2.
3. See the Order at 4.
4. See the Order at 7.
5. The Letter of Acceptance, Waiver and Consent (the "FINRA Letter") can be found at: https://bit.ly/3jNmZOt.
6. See the FINRA Letter at 1.
7. See the FINRA Letter at 2, citing FINRA Regulatory Notice 09-31.
Originally published in REVERSEinquiries: Volume 4, Issue
5.
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