RIAs and IARs must comply with care obligations when recommending products with unique risks
On May 4, 2023, the SEC announced that the Commission had settled charges against a Registered Investment Adviser (RIA) based in Fargo, North Dakota, as well as an Investment Adviser Representative (IAR) who was an indirect part-owner. The SEC’s complaint alleged that the parties breached their fiduciary duty of care related to leveraged exchange traded funds (ETFs) in discretionary client accounts.
According to the SEC’s order, from at least 2017 through December 2020, the RIA and the IAR invested advisory clients in leveraged ETFs for extended periods of time. In many cases, the RIA and the IAR overinvested clients’ funds in products in significant concentrations that carried unique risks. The RIA and IAR ignored the funds’ prospectuses, which warned that the products:
- Raised unique risks;
- Were designed to be held for no more than a single trading day; and
- Required frequent monitoring.
The SEC alleged that the RIA and the IAR misunderstood these fundamental characteristics of the leveraged ETFs. Therefore, they lacked a reasonable belief that the leveraged ETFs were in their clients’ best interests. Furthermore, the RIA and IAR failed to appropriately monitor the performance of these products. As a result, they did not evaluate whether the leveraged ETFs were in their clients’ best interests throughout the holding period. In addition, the SEC concluded that the RIA failed to adopt and implement policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act.
According to the SEC, complex products present unique risks. RIAs and IARs must ensure that there is a reasonable basis to recommend these products before purchasing them for clients.
Without admitting or denying the SEC’s findings, the RIA and the IAR agreed to a cease-and-decision order and censures. The parties also agreed to pay $195,228 and $738,113 respectively in disgorgement, prejudgment interest, and civil penalties. In addition, the RIA agreed to conduct a distribution to harmed investors.
SEC staff bulletin articulates the standard of care owed when giving advice and making recommendations to retail investors
The SEC’s enforcement action against the RIA and IAR followed on the heels of an April 20, 2023, staff bulletin that reinforced the standards of conduct owed by broker-dealers and investment advisers when giving investment advice and making recommendations to retail investors. The bulletin focused on the Regulation Best Interest (Reg BI) Care Obligation, as well as the duty of care owed pursuant to the Investment Advisers Act, which is referred to as the “IA fiduciary standard.”
These care obligations under Reg BI and the IA fiduciary standard include three components:
- Understanding the potential risks, rewards, and costs arising from a product, investment strategy, account type, or series of transactions;
- Having a reasonable understanding of the retail investor’s investment profile; and
- Based on their understanding of the first two components and after considering reasonably available alternatives, firms and financial professionals must have a reasonable basis to conclude that the recommendation or advice provided is in the retail investor’s best interest.
Firms and their financial professionals must decide if a recommendation made or advice given satisfies their care obligations. They must conduct an objective evaluation that is based upon the facts and circumstances surrounding the specific recommendation or advice, including the investment profile of the retail investor. When adopting and implementing reasonably designed policies and procedures to articulate their care obligations, broker-dealers and RIAs should tailor them to their business models and retail investor relationships.
Takeaways
An investment adviser’s fiduciary duty includes the obligation to act in the retail investor’s best interest, and the RIA and IAR in this case failed to meet that standard. IARs need to have a complete understanding of an investment before recommending it, especially one that carries unique risks. In addition, RIAs must adopt robust policies and procedures to ensure that these fiduciary obligations are satisfied.
Neither the RIA nor the IAR had a reasonable basis for concluding that the leveraged ETFs were suitable for their clients. The RIA and the IAR did not fully appreciate the most important attributes of leveraged ETFs. They did not appear to recognize that leveraged ETFs were designed as short-term trading tools. Furthermore, they apparently failed to realize that there were material risks to holding them in significant amounts for much longer periods than those timeframes recommended by the issuers. As an example, the RIA and the IAR ignored unique risks discussed in the prospectuses. They allegedly used the leveraged ETFs in an unsuitable manner, including concentrating clients’ portfolios in that investment and holding them for extended periods of time.
Although the RIA permitted its representatives to invest in complex products like the leveraged ETFs, the firm’s policies and procedures failed to address due diligence, product-specific disclosures to clients, or suitability evaluations for these investments. Furthermore, the RIA did not implement policies and procedures pertaining to the training required for IARs recommending leveraged ETFs. Moreover, they did not adopt policies and procedures for supervising recommendations or purchases of leveraged ETFs or monitoring these products.
The enforcement action can be reviewed here. https://www.sec.gov/litigation/admin/2023/34-97427.pdf
The SEC’s staff bulletin can be found here. https://www.sec.gov/tm/standards-conduct-broker-dealers-and-investment-advisers#_ftn1
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com
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