A recent cease-and-desist order from the Securities and Exchange Commission (SEC) illustrates the types of activities and compliance issues that should be causes for concern for registered investment advisers (RIAs) when recommending non-traditional exchange traded funds (ETFs).2
In this case, the SEC determined that the RIA:
- did not properly address the concerns of regulators about non-traditional ETFs;
- solicited sales of single-inverse ETFs to non-discretionary advisory accounts with long-term time horizons;
- did not follow its own compliance policies and procedures regarding the suitability of such sales;
- did not follow its own compliance policies requiring its financial advisers to monitor their clients' positions on an ongoing basis;
- made some of those recommendations through financial advisors who were inadequately trained;
- did not sufficiently address concerns relating to these sales in response to the findings of its own internal audit; and
- did not sufficiently respond to examiners' concerns about such sales.
As a result, the RIA was the subject of a SEC cease-and-desist order for violations of the Investment Advisors Act of 1940 (Advisers Act), and remedial sanctions.
A History of Regulatory Concerns with Non-Traditional ETFs
Non-traditional ETFs and single inverse ETFs have been a concern for regulators for years.3 In June 2009, the Financial Industry Regulatory Authority, Inc. (FINRA) issued Regulatory Notice 09-31, in which it reminded member brokerage firms of their sales obligations with respect to such ETFs. Among other items, Regulatory Notice 09-31 highlighted the importance of a FINRA member's suitable recommendations and adequate supervisory policies in connection with sales of such ETFs. In particular, Regulatory Notice 09-31 stated that "inverse and leveraged ETFs typically are not suitable for retail clients who plan to hold them for more than one trading session, particularly in volatile markets."
Here, the RIA's parent company, a FINRA member, was sanctioned by FINRA in 2012 and by a state securities regulator in 2013 for its lack of compliance policies prior to 2009 with respect to sales of non-traditional ETFs, including single inverse ETFs.
The RIA's Response A Comprehensive Set of Compliance Policies
After Regulatory Notice 09-31 was issued, the RIA created a comprehensive set of compliance policies intended to protect against its financial advisers making unsuitable recommendations of non-traditional ETFs, including single-inverse ETFs, to advisory clients. The compliance policies were designed to prevent violations of the Advisers Act, including its anti-fraud provisions. However, over time, the initially strict policy was weakened.
In 2010, the RIA allowed its advisers to recommend certain single-inverse ETFs to non-discretionary accounts, but only if particular safeguards were satisfied. Prior to placing a single inverse ETF into a non-discretionary advisory account, the RIA was to obtain from the client an executed "Client Disclosure Notice," which explained the risks involved with such ETFs, including that these products were unsuitable for clients planning to hold them for more than one trading session, unless part of a hedging strategy. The Client Disclosure Notice also warned that the performance of the ETF over periods of greater than one day could differ significantly than the performance of the underlying reference asset. Clients were required to sign the notice, acknowledging that they understood the risks involved with single-inverse ETFs and that they agreed to make the investment, and the RIA was to maintain a record of the executed notice.
As a further safeguard, the RIA's policy required that the financial adviser consider whether an investment in a singleinverse ETF would be appropriate for the client under a suitability analysis, and that the financial adviser complete training in single-inverse ETFs prior to recommending an investment. Prior to a client's purchase, a manager of the RIA was to conduct a risk review, considering the client's investment experience, whether the Client Disclosure Notice had been signed, whether the client's stated investment objectives and time horizon were consistent with the transaction, the size of the transaction/position relative to the client's financial position, and any other relevant considerations. The financial adviser was also supposed to monitor the index or benchmark underlying the ETF and the ETF's performance relative to the benchmark and to consider the appropriateness of the hedging strategy.
Recommendations of purchases of non-traditional ETFs were limited to client's using them as part of a hedging strategy, rather than for speculation purposes. However, in 2014, the hedging requirement was dropped.
Inconsistent Application of the Compliance Policies
Despite the best intentions, the RIA did not consistently enforce its own well-designed set of compliance procedures. The RIA did not obtain executed Client Disclosure Notices for sales of single-inverse ETFs into about 44% of its nondiscretionary trading accounts, which was a violation of the books and records provisions of the Advisers Act. Many of these accounts held the ETFs for at least 30 days, and incurred significant losses. Some of these accounts were retirement accounts with long-term time horizons. Risk reviews by managers were deemed by the SEC's Office of Compliance Inspections and Examinations (OCIE) to be deficient, or did not happen at all. Even prior to dropping the hedging requirement in 2014, implementation of that requirement was not enforced to the extent deemed appropriate by the OCIE.
Examiners' Concerns Inadequately Addressed
In 2010, the OCIE conducted an examination of the RIA and identified weaknesses and made best practice recommendations regarding the RIA's monitoring of transactions in single-inverse ETFs. The OCIE noted weaknesses with the RIA's documentation of risk reviews and monitoring of the hedging requirement. The RIA responded to both of the OCIE's concerns by stating that it did not believe that further enhancements to its procedures were necessary.
Starting in 2012, the RIA performed internal testing of its ETF strategy, finding a number of deficiencies. The RIA addressed the deficiencies on a branch-by-branch basis, but did not address the issues firmwide. The RIA's internal audit found that management lacked effective controls to monitor the ongoing review of single-inverse ETFs. Limited steps were taken by the RIA to improve implementation of its policies, but compliance deficiencies continued.
In mid-2015, after the SEC enforcement staff completed its investigation, the RIA revised its compliance policy to prohibit the recommendation of any single-inverse ETFs to clients in non-discretionary advisory accounts.
Investment Advisers Act Violations
The SEC's cease-and-desist order stated that the RIA willfully violated the anti-fraud provisions of Section 206(4) of the Advisers Act and the requirements to maintain policies and procedures designed to prevent violations of the Advisers Act under Rule 206(4)-7.
The lesson is clear: well-designed compliance procedures must be properly followed in order to adequately protect investors and to avoid negative attention from regulators.