SEC Focus on RIA and BD Compliance & Complex Financial Products: What You Need to Know

The SEC has been focused on protecting retail investors when it comes to investing in complex financial products, including by evaluating the adequacy of systems of controls and policies and procedures at registered investment advisers (RIAs) and broker dealers (BDs) designed to provide protection to their clients.  While the SEC's recent activity in this area began with issuing a statement about regulatory obligations applicable to RIAs and BDs when advising or recommending complex financial products, it has progressed to (i) a review of the regulatory landscape for potential rulemaking, guidance and other policy actions to further protect investors; (ii) the formation of the Division of Enforcement's Exchange-Traded Products Initiative, a coalition of several SEC divisions that monitors for unsuitable sales and compliance with the federal securities laws; (iii) a recent statement by the Office of Compliance Inspection and Examinations (OCIE) Staff about applicable securities laws and regulations and its examinations of systems of controls and policies and procedures related to complex financial products; and (iv) five settled enforcement actions this month against RIAs and BDs for violating federal securities laws in relation to exchange-traded investments.

Overview of Recent SEC Activity

On October 28, 2020, SEC Chairman Jay Clayton and the directors of the SEC's Division of Investment Management, Division of Corporation Finance and Division of Trading and Markets issued a joint statement asserting that complex financial products may present investor protection issues, especially for retail investors who may not fully appreciate the risks.¹ The statement asserted that Regulation Best Interest obligations apply when BDs recommend a complex financial product to a retail customer,² and RIA fiduciary duty obligations apply when RIAs provide investment advice related to complex financial products.³ The statement also announced that the SEC will be reviewing, and invited input regarding, the effectiveness of existing regulatory requirements in protecting investors who invest in complex financial products. 

On November 13, 2020, the SEC settled five different enforcement actions against three RIAs and two dually-registered BDs for failing to adopt or implement policies and procedures regarding suitability and volatility linked exchange-traded investments.⁴ The violations described in the orders, which were settled on a no admit or deny basis, all stemmed from the alleged (i) failure to train firm representatives on the product, (ii) failure to determine suitability for each client and (iii) failure to appropriately review the transactions at issue.  The orders state that firm representatives recommended high-volatility exchange-traded products to broad client bases and held the investments long-term even though the product disclosures stated that the products were intended for short-term investing and that the risks were heightened when the products were held long-term—and, as a result, the firms were required by the orders to return over $3 million to investors, with each firm repaying $500,000 or more.  These enforcement actions resulted from the SEC's use of trading data analytics to review trading activity for unsuitable sales and were the first undertaking of the Division of Enforcement's Exchange-Traded Products Initiative, which is being led by the Complex Financial Instruments Unit—a specialized unit within the Division of Enforcement that is using data analytic tools "to surveil the market and pinpoint unsuitable sales of complex financial products."⁵ We can expect more actions of this nature to come out of this initiative. 

On November 16, 2020, OCIE issued a statement discussing these recent enforcement matters, which made it clear that it is "critically important" for RIAs and BDs to "implement robust and effective policies and procedures" that are reasonably designed to prevent violations of the federal securities laws.⁶ In that statement, OCIE provided insight into how RIAs and BDs can implement and continue to maintain robust and effective policies and procedures that are reasonably designed to prevent violations and what OCIE looks for during its inspections and examinations.  Among the practices, policies and procedures suggested are:

• Implementing a committee, consisting of representatives from compliance, legal, risk, marketing, portfolio management, and/or operations, to assess how and when complex financial products should be used by clients and customers;
• Training firm financial professionals on the availability and suitability of complex financial products, including discussion of the firm's obligations under Regulation Best Interest and its obligation to provide heightened scrutiny to understand the terms, features and risks of the product and whether the product fits within the client's risk tolerance and trading objective; and
• Monitoring investments in complex financial products daily.

Most importantly, OCIE emphasized that systems of controls and policies and procedures are more susceptible to failing when they are static. 

Key Takeaways

Given the SEC's current focus on complex financial products, it is important for RIAs and BDs to consider the following:

• Firms should be conscious of the Division of Enforcement's active use of technology to pinpoint and identify specific firms that may be selling unsuitable investments involving complex financial products.
• Systems of controls and policies and procedures should be dynamic and evolve with developments in the marketplace and offerings.
• This means that firms should continually review their existing systems of controls and policies and procedures and consider areas of enhancement, including with respect to assessing, monitoring, and training on complex financial product investments.
• Staying up-to-date on developments in the area of complex financial products, as well as other developments with respect to other securities laws, should go hand-in-hand with the continual review, so that firms are aware of changes that they should make to their systems of controls and policies and procedures.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.