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Enforcement News: Investment Advisory Firms and Dually-Registered Broker-Dealers Charged in Connection with Sales of Unsuitable Exchange-Traded Products

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  • Posted on: Nov 18 2020

Brokerage firms, financial institutions and investment advisers are required to provide suitable investment recommendations and strategies to a customer that are consistent with the customer’s investment objectives, risk tolerance and financial needs. See, e.g., here and here (FINRA Rule 2111). This requirement is based on the “know your customer” rule (here (FINRA Rule 2090)), which requires brokerage firms, financial institutions and investment professionals to be aware of all factors that affect a customer’s financial situation.

The suitability rule applies to an investment professional’s investment advice regardless of the type of recommendation (e.g., a buy, sell or hold), the complexity of the investment product, and the sophistication of the customer. The rule is not dependent on a particular transaction or the compensation generated from the transaction. The investment professional must understand the investment or strategy being recommended and the customer’s ability to understand and assume the risks associated with the investment or strategy. The investment professional is required to exercise reasonable diligence in gathering all information necessary to make the recommendation or strategy.  Such information includes the customer’s age, investment portfolio, employment status, tax status, investment objectives, financial situation and needs, investment experience, investment time horizon, liquidity needs, and risk tolerance. The investment professional should consider any other information disclosed by the customer in connection with the recommendation or strategy to determine the customer’s ability to understand and assume the risks associated with the investment or strategy.

Investment losses resulting from unsuitable investment advice can serve as the basis for a claim in a FINRA arbitration and/or an enforcement action by the Securities and Exchange Commission (“SEC”), FINRA or other regulatory body. In today’s article, we examine five settled enforcement actions brought by the SEC involving the suitability of complex exchange-traded products for the subject firms’ retail investors.

On November 13, 2020, the SEC announced (here) that it filed actions, all of which settled, against three investment advisory firms and two dually-registered broker-dealer and advisory firms for violations that related to unsuitable sales of complex exchange-traded products to retail investors (the “Actions”). The advisory firms and broker-dealers involved in the Actions are American Portfolios Financial Services/American Portfolios Advisors Inc., Benjamin F. Edwards & Company Inc., Royal Alliance Associates Inc., Securities America Advisors Inc., and Summit Financial Group Inc. Under the settlements, the advisory firms and broker-dealers agreed to return in total over $3 million to harmed investors.

The Actions concerned the sale of volatility-linked exchange-traded products between January 2016 and April 2020. As set forth in the orders (here, here, here, here, and here), the firms attempted to track short-term volatility expectations in the market, which are typically measured against derivatives of the CBOE volatility index. 

According to the SEC, the offering documents for the products made clear that the short-term nature of the products made investments in the products more likely to experience a decline in value when held over a longer period. The SEC found that, contrary to these warnings, and without understanding the products, representatives of the firms recommended their customers and clients buy and hold the products for longer periods, including in some circumstances, for months and years. E.g., American Portfolios (“APFS registered representatives who recommended their brokerage customers buy and hold a complex exchange traded product (“ETP”) [did so] without a reasonable basis for believing the recommendation was suitable for their customers” and “did not understand the product, misrepresented its risks and recommended it for a purpose inconsistent with that described in the product’s offering materials.”); Benjamin Edwards (“[T]he Benjamin Edwards brokerage representatives and advisory representatives failed to make a reasonable determination that these investments were suitable for certain of the customers and clients to whom they recommended the Complex ETPs, based on those retail customers’ and clients’ investment objectives, risk tolerance, and financial condition. A number of these brokerage and advisory representatives also misled their customers and clients about the Complex ETPs’ benefits and risks.”)

The SEC further found that the firms failed to adopt or implement policies and procedures regarding suitability and volatility-linked exchange-traded products.

“It is important for firms to put the appropriate protections in place to ensure complex products are properly evaluated and understood by their representatives. Failing to do so puts investors at risk,” said Stephanie Avakian, Director of the SEC’s Division of Enforcement. “We take these failures seriously, and we will continue to look for sales that expose customers to unsuitable investments.”  

The Actions were the first to be brought following the investigations by the Division of Enforcement’s Exchange-Traded Products Initiative, which used trading data analytics to uncover potential unsuitable sales. 

“These cases demonstrate the importance of data analytics in our efforts to surveil the market and pinpoint unsuitable sales of complex financial products,” said Daniel Michael, Chief of the Enforcement Division’s Complex Financial Instruments Unit.  “We will continue to use these tools to protect retail investors.”

The SEC’s orders found that each firm failed to implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 and its rules. 

The order against American Portfolios found that the firm failed reasonably to supervise certain brokerage representatives who recommended their customers buy and hold a volatility-linked product. The order against Benjamin Edwards found that the firm failed reasonably to supervise certain brokerage and advisory representatives who recommended their clients buy and hold two volatility-linked products.

Without admitting or denying the findings, each firm agreed to cease and desist from future violations of the charged provisions, a censure, and to pay disgorgement and prejudgment interest. American Portfolios and Benjamin Edwards each agreed to pay a civil penalty of $650,000, Securities America and Summit each agreed to pay a civil penalty of $600,000 and Royal Alliance agreed to pay a civil penalty of $500,000.

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