Financial Institution Settles SEC Claims Related To Allegedly Unsuitable Investments In Complex Exchange-Traded Product
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  • Financial Institution Settles SEC Claims Related To Allegedly Unsuitable Investments In Complex Exchange-Traded Product

    On Monday, July 19, 2021, the SEC announced that it had settled an action involving an alleged failure to prevent what the SEC contended were unsuitable investments by the respondent’s clients in a volatility-linked exchange-traded product (ETP).  As part of the settlement, the respondent agreed to pay a civil penalty of $8 million and disgorgement and prejudgment interest of $112,274.

    The SEC alleged that, between January 2016 and January 2018, the respondent, a registered broker-dealer and investment advisor, failed to adopt and implement written policies and procedures reasonably designed to prevent unsuitable investments in ETPs, which the SEC claimed resulted in unsuitable investments in a product called VXX.  VXX, which was listed on the NYSE Arca, Inc. exchange, is a volatility-linked, complex, exchange-traded note that offers exposure to futures contracts of specified maturities on the VIX, which attempts to track the expected volatility of the S&P 500.

    At all relevant times, the respondent had an ETP Committee responsible for conducting due diligence on ETPs, monitoring the ETPs on the system, and educating financial advisors about ETPs.  The ETP Committee allegedly initially permitted VXX to be sold on its brokerage platform, but over time, it placed increased restrictions on the sales of VXX to brokerage customers.

    Notwithstanding the restrictions placed on the respondent’s broker-dealer customers’ use of VXX, the SEC found that it did not apply similarly important restrictions in connection with its investment advisory clients.  Specifically, the SEC found that the respondent understood and appreciated the risks of holding the ETPs for extended periods, as reflected by these restrictions for brokerage customers, but allowed financial advisors in its managed discretionary account advisory program to purchase VXX without adequate restrictions.  The SEC found that the only restrictions that the respondent placed on a financial advisor’s discretion with respect to investing in VXX was that ETPs in accounts in the discretionary account advisory program could not exceed 3% of account sales.  According to the SEC, this only limited the purchase of ETPs and did not prevent their purchase, nor did this address the length of time that VXX was held in an account.  As a result of this, financial advisers at the respondent allegedly purchased and held the ETP in client accounts for an extended period of time, as the product’s value would decrease in value.

    Without admitting or denying the SEC’s findings, the respondent agreed to cease and desist from violations of Rule 206(4)-7 of the Investment Advisers Act of 1940, a censure, and disgorgement and prejudgment interest of $112,274 and a civil penalty of $8 million, which will be distributed to investors harmed by the conduct at issue.  The settlement is the sixth matter arising from investigations conducted by the SEC’s ETP Initiative, which uses trading data analytics to uncover potential unsuitable sales, and demonstrates the SEC’s continued interest in ETPs, particularly in the investment advisory space.