SEC fines securities firm in connection with sales of volatility linked ETNs

Introduction

In July 2021, the SEC settled an action brought under the Investment Advisers Act of 1940 against a dual-registered broker-dealer and investment adviser relating to compliance failures arising from the firm's sales of a volatility-linked exchange-traded note ("ETN"). The ETN in question is linked to S&P VIX short-term futures contracts. The SEC's order relating to the action may be found here.

The SEC's action is one of a series of actions in recent years arising from an initiative launched by the SEC's division of enforcement relating to exchange traded structured products, which relate in large measure to the same ETNs, and the brokers and investment advisers that have effected transactions in them.

These SEC actions may be found at the following links:

• https://www.sec.gov/litigation/admin/2020/34-90411.pdf
• https://www.sec.gov/litigation/admin/2020/34-90413.pdf
• https://www.sec.gov/litigation/admin/2020/ia-5626.pdf
• https://www.sec.gov/litigation/admin/2020/ia-5627.pdf
• https://www.sec.gov/litigation/admin/2020/ia-5629.pdf

The Improper Sales

Consistent with several of the prior cases, the firm was aware that the ETN was designed to track short-term volatility expectations, was not appropriate to hold for extended periods, and would likely to decline in value when held for a longer period due to the roll costs associated with buying and selling the relevant futures contracts. The firm had prohibited its brokerage representatives from soliciting sales of the product, and placed other restrictions on sales of the product to brokerage customers, demonstrating that it was aware of the relevant risks; however, it did not place similar restrictions on certain of its financial advisers’ purchases of the product for discretionary managed client accounts. Although the firm adopted a concentration limit on volatility-linked ETNs, it did not implement a system for monitoring and enforcing that limit for several years.

The SEC also found that certain of the firm's financial advisers had a flawed understanding of the appropriate use of the ETN, and did not take sufficient steps to understand the risks associated with holding the ETN for extended periods. As a result, these advisers purchased and held the ETN in client accounts for lengthy periods, resulting in investor losses.

In light of these circumstances, the SEC concluded that the firm violated Section 206(4) of the Investment Advisers Act and related Rule 206(4)-7. These provisions prohibit deceptive practices by an investment adviser, and require investment advisers to adopt written procedures to avoid such practices.

Conclusion

We note that the sales at issue in this matter took place between January 2016 and January 2018. Since that time, many broker-dealers and investment advisers have become increasingly aware of the risks relating to these types of products, and have reviewed and updated their policies and procedures accordingly to help ensure compliance. For example, the SEC order notes that the firm in question took remedial actions prior to being contacted by the SEC as to these sales.