SEC’s Exchange Traded Products Initiative
Data analytics has evolved into a key tool of the SEC’s enforcement program. The most recent example of this is a series of settled administrative proceedings centered on the use of Exchange Traded Products. The products are complex. The theory, however, is detailed in the prospectus issued with each product. Understanding it takes time and study. Unfortunately neither the market professionals nor their clients in the Commission’s actions seem to have put in the study. The results were predictable: losses for the investors.
Typical of these proceedings is In the Matter of American Financial Services, Inc., Adm. Proc. File No. 3-20151 (Nov. 13, 2020). Respondents in this proceeding are American Financial or APFS and American Portfolios Advisors, Inc. or APA, respectively, a registered broker dealer and an investment adviser. The Exchange Traded Product involved is iPath S&P 500 VIX Short-Term Futures ETN or VXX.
VXX is traded on the NYSE Arca, Inc. It is a volatility-linked, complex exchange traded note which “offers exposure to futures contracts” of specific maturities on the VIX — the CBOE. The VIX tries to track the expected volatility of the S&P 500 but not its price level. The performance of VXX is not directly linked to the VIX. It is linked to a separate Index that tracks the price of futures contracts on the exchange. That Index is based on a “rolling portfolio of one-month and two-month futures contracts to target a constant weighted average of one-month maturity.” To do this each day the Index sells futures contracts that are the closest to the expiration and buys the next month out.
The VXX prospectus made it clear that that historically the exchange was in contango – the farther out contracts priced higher than those of the near-term contracts. When the market is in backwardation the reverse is true. Since the exchange is typically in contango, a significant cost is incurred over time from the daily roll of the futures contracts.
At times the VIX performance may vary from that of the Index and may have a positive performance during periods when the Index experiences poor performance. On the other hand, the VXX may experience a significant decline over time. In those instances, the risk increases the longer the VXX is held. In the end, however, the VXX has a limited upside potential, according to the prospectus, because over the longer term it usually reverts to a historical mean and its absolute level has been constrained within a band.
Registered representatives began early in 2016 to recommend investors buy and hold the VXX as a part of their overall portfolio. At the time there was a fear that political and other events would cause the market to drop. Many of the clients followed the advice, purchased the VXX and held it for over a year.
The VXX was viewed as a kind of hedge that would guard against the feared price drop. In making those recommendations the registered representatives failed to understand that the investments were not suitable for use as a short term hedge. Yet customers were told the opposite — buy and hold for the long term to protect against downward market risk. No mention was made of what is effectively a monthly reset and the resulting costs incurred in each instance.
The firms did have policies and procedures regarding complex products. Those policies and procedures mandated that representatives understand the products prior to making a recommended. The policies and procedures were ineffective in preventing the losses incurred by customers here because they were not properly implemented. Supervisory failure also facilitated the client losses. The Order alleges violations of Exchange Act Section 15(b)(4)(E) and Advisers Act Section 206(4) and Rule 206(4)-7.
To resolve the matter Respondents implemented certain remedial efforts. Respondent APA consented to the entry of a cease-and-desist order based on the Advisers Act Section and Rule cited in the Order. APFS consented to the entry of a cease-and-desist order based on the Exchange Act section cited in the Order. The two firms were censured and will also pay, jointly and severally, a civil monetary penalty of $650,000. A fair fund will be created for the portion of the losses tied to the product.
The Commission filed four similar cases at the same time this action was initiated. See In the Matter of Benjamin F. Edwards & Co., Inc., Adm. Proc. File No. 3-20153 (Nov. 13, 2020)(action tied to same product; settled with a series of remedial efforts, a consent to the entry of a cease and desist order based on the same Advisers Act Section and Rule, a censure and the payment of disgorgement of $31,417.62, prejudgment interest of $3,716.74 and a penalty of $650,000; $685,134.36 went to a fair fund); In the Matter of Summit Financial Group, Inc., Adm. Proc. File No. 3-20149 (Nov. 13, 2020)(based on same product; resolved with a cease and desist order based on the same Advisers Act Section and Rule and a censure; Respondent will also pay disgorgement of $3,083.59, prejudgment interest of $715.49 and a penalty of $602,799.08; a sum for client losses was paid into a Fair Fund); In the Matter of Securities America Advisors, Inc., Adm. Proc. File No. 3-20150 (Nov. 13, 2020)(based on two similar products; resolved with consent to entry of a cease and desist order based on same Adviser Section and Rule and a censure; payment of disgorgement of $3,399.42, prejudgment interest of $377.40 and a penalty of $600,000; fair fund created); and In the Matter of Royal Alliance Associates, Inc., Adm. Proc. File No. 3-20152 (Nov. 13, 2020)(based on VXX; settled with consent based on same Section and Rule; payment of $1,953.00 in disgorgement, $447.29 in prejudgment interest; and a penalty of $500,000; a fair fund was established). See also In the Matter of Morgan Wilshire Securities, Inc., Adm. Proc. File No. 3-29954 (Sept. 24, 2020)(Action centered on purchasing inverse EFTs without regard to the holding period where firm staff not properly trained).