SEC Enforcement Action – ETFs and Failure to Follow Policies and Procedures

February 15, 2017

The U.S. Securities and Exchange Commission (SEC) issued a press release announcing that an investment adviser, Morgan Stanley Smith Barney, agreed to pay an $8 million penalty to settle charges under the Investment Advisers Act of 1940 relating to single inverse ETF investments it had recommended to investment advisory clients. Click here to for the entire press release and here for the SEC’s order.

According to the SEC, the investment adviser allegedly failed to adequately implement its policies and procedures to ensure that clients understood the risks involved with purchasing single inverse ETFs. The investment adviser allegedly failed to provide disclosure notices to hundreds of their clients stating that single inverse ETFs are typically unsuitable for longer term investors, and many of Morgan Stanley’s clients held onto their single inverse ETFs over the long-term and experienced losses.

The SEC also determined that the investment adviser allegedly neglected a different policy and procedure that requires a supervisor to conduct risk reviews to evaluate the suitability of inverse ETFs for each advisory client, and the investment adviser allegedly did not monitor the investments on an ongoing basis and did not ensure its financial advisers completed single inverse ETF training.

In the SEC’s Examination Priorities for 2017, the SEC staff explained that it will continue to examine the use of ETFs with niche strategies.  Click here to read the SEC’s Examination Priorities for 2017.   Moreover, the SEC staff also recently issued a Risk Alert which specifically identified an investment adviser’s failure to tailor its compliance manual to the investment adviser’s business model and failure to then follow the compliance policies and procedures as examples of the most frequent compliance deficiencies. Click here to review the SEC’s Risk Alert: The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers. Click here to read this recent SEC Risk Alert.

In light of this SEC enforcement action against an investment adviser regarding the use of inverse ETFs, the SEC staff’s announcement that it will continue to focus upon leveraged and inverse ETFs during examinations and the SEC’s risk alert about inadequate investment adviser policies and procedures, we recommend that your investment adviser firm review whether it (a) uses leveraged or inverse ETFs in an appropriate manner, (b) has adequate policies and procedures regarding the use of such ETFs,  (c) properly trains its investment adviser representative on leveraged and inverse ETFs and (d) follows any written policies and procedures as it relates to ETFs.

RIA Compliance Consultants is available to assist your investment adviser in reviewing its practices and creating written policies and procedures related to leveraged or inverse ETFs. Please contact your consultant or click here to schedule an introductory call.

Posted by Grant Parr
Labels: Enforcement, SEC