Monday, May 08, 2023

Adviser misunderstood unique characteristics of LETFs

By Rodney F. Tonkovic, J.D.

An investment adviser has settled SEC charges for breach of fiduciary duty in connection with its use of leveraged ETFs. The firm and one of its owners invested clients in leveraged exchange-traded funds in a manner contraindicated in the funds' prospectuses. The Commission found that the respondents misunderstood the characteristics of the leveraged ETFs and so lacked a reasonable belief that they were in their clients' best interests. They also failed to appropriately monitor the performance of the ETFs throughout the holding period. In addition to a cease-and-desist order and censure, the respondents were ordered to pay disgorgement and civil penalties (In the Matter of Classic Asset Management, LLC and Douglas G. Schmitz, Release No. 34-97427, May 4, 2023).

Classic Asset Management, LLC is a North Dakota-based registered investment adviser. Douglas Schmitz is a one-third owner and investment adviser representative of the firm.

LETFs. Between January 2017 and December 2020, CAM held leveraged exchange-traded funds in advisory client accounts. These complex securities included at least 15 different funds seeking to deliver multiples of the performance of the index or benchmark they tracked. Schmitz reviewed the prospectuses for the LETFs, which warned—on the first page, in bold type— of the risks inherent in the products. Among other warnings, the prospectuses cautioned that the products were not meant to be held longer than one trading day and required frequent monitoring.

CAM and Schmitz made investments for their clients in LETFs to the point that the clients' portfolios were highly concentrated in them. Plus, CAM caused the portfolios to hold these positions for much longer than one day—some were held for months and even years. As a result, certain clients suffered substantial losses.

No reasonable basis. According to the Commission, CAM and Schmitz had no reasonable basis to concluded that LETFs were suitable for their clients, even if used as intended. The respondents failed to fully consider fundamental characteristics of the LETFs, especially the material risks associated with holding them for too long, which could, for example, magnify the compounding risk, which can result in substantial index tracking error as volatility increases.

In addition, despite warnings in the prospectuses highlighting the need for frequent monitoring, the respondents failed to assess whether they were in their clients' best interest throughout the holding period. Schmitz, the Commission says, was generally aware of the performance of the reference index and market conditions, but did not monitor the actual LETFs' performance or consider the unique risks associated with the structure and daily rebalancing of the LETFs. Finally, CAM lacked written policies and procedures to ensure that its representatives’ policies and procedures that were reasonably designed to ensure CAM’s representatives understood the material features and risks of products like LETFs before purchasing them for advisory clients.

"Investment advisers have fiduciary duties to act in their clients’ best interest, and this is particularly important when investing clients in complex products such as leveraged ETFs," said Jason J. Burt, Director of the SEC’s Denver Regional Office. "Complex products present unique risks, and investment advisers must ensure that there is a reasonable basis to recommend these products before purchasing them for clients."

Violations. The Commission found that CAM and Schmitz violated Section 206(2) of the Investment Advisers Act and that CAM also violated the Act's compliance provision in Rule 206(4)-7. In addition to a cease-and-desist order and censure, CAM was ordered to pay disgorgement of $81,824 plus prejudgment interest of $13,404, and a civil monetary penalty of $100,000. Schmitz will disgorge $523,086 plus $13,404 in prejudgment interest, and to pay a $100,000 civil penalty.

The release is No. 34-97427.