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Jack Duval

Jack is the CEO of Accelerant, a securities litigation consulting firm.
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The Historical Origins of Fiduciary Duties

Posted by Jack Duval

Jun 21, 2018 8:36:41 AM

This post continues my blog post series on fiduciary duties and the changing regulatory landscape around a unified fiduciary standard of care for investors.

Accelerant - Jack Duval - Fiduciary Duties Expert Witness

Statue of Cicero

Given the tremendous amount of ink that has been spilled regarding the DOL Fiduciary Rule and now SEC Regulation Best Interest, I thought it would be useful to review the existence of fiduciary rules throughout history.

The idea of a fiduciary duty has existed from the beginning of humanity’s codification of the rules by which it would live.  Indeed, fiduciary duties have been central to the functioning of societies from ancient to modern times and from East to West.

In the most simple terms, a fiduciary duty arises when one person relies on another to perform a task or service for them.  The duty arises from the dependence of the one on the other.  In more modern language, trust and confidence is being reposed by the principal in the agent to carry out the agreed upon work.

Fiduciary Duties Throughout History

Perhaps the first known fiduciary duties exist in Hammurabi's Code from 1790 BC.[1]

Rules of agency, reflected in Hammurabi’s laws, developed along with commerce in Ancient Mesopotamia.  The laws primarily discuss situations in which a tamkarum, or principal/merchant, gives a samallum, or agent, either money to use for travel and for investments or purchases, or goods for trading or selling.

The Bible also has many fiduciary-related quotes, the most famous of which may be:[2]

No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other.  Ye cannot serve God and mammon.

Jumping to the East, somewhere between 475 and 220 BC, Confucius wrote in The Analects a heuristic for fiduciaries: “In acting on behalf of others, have I always been loyal to their interest?”[3]

From Ancient Greece, Plato’s Republic could be read as a metaphor for the fiduciary duties of leaders to their constituents, and the whole education process of philosopher-kings as instilling these virtues. 

The Roman’s coined the term “fiduciary” in their laws and defined it to mean:[4]

a person holding the character of a trustee, or a character analogous of a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires.

Cicero also wrote of fiduciary obligations between agent and principal, known by the expressive terms: “mandatory” and “mandator”, respectively.  “An agent who shows carelessness in his execution of trust behaves very dishonorably and ‘is undermining the entire basis of our social system’.”[5]

Making a great leap across time, we come to Anglo-American law and the English Courts of Equity.  Scholars Aikin and Fausti write:[6]

Courts of Equity granted relief in numerous circumstances involving one person's abuse of confidence and, over time, concrete rules and precise terms related to fiduciary relationships began to form as Equity evolved.

The term "fiduciary" itself was adopted to apply to situations falling short of "trusts" but in which one person was nonetheless obliged to act like a trustee.

The second point makes sense because in non-trust fiduciary situations, the principle still owns the property, whereas in the trust situation, ownership of the asset(s) have been transferred to a trust which the trustee oversees.

Lastly, we get to American Law and Benjamin Cardozo, who, in Meinhard v. Salmon, wrote what are probably the most cited words on fiduciary duties:

Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties.  A trustee is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.  As to this there has developed a tradition that is unbending and inveterate.  Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the "disintegrating erosion" of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher that that trodden by the crowd.  It will not consciously be lowered by any judgment of this court.

Interestingly, the undermining of “the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions” is what is now contemplated in SEC Regulation Best Interest.  The SEC seeks to dress up FINRA suitability rules in the raiment of fiduciary language without the “uncompromising rigidity” of fiduciary law.

_______

Notes:

[1]       Keith Loveland, JD, AIFA, CIDA.  Available at: http://solisinvicti.com/books/Law/Fiduciary%20Law.pdf.  Accessed June 19, 2018.

[2]       Matthew 6:24; KJV.  Available at: http://biblehub.com/kjv/matthew/6.htm.  Accessed June 19. 2018.

[3]       Confucius; The Analects; Translated by Arthur Waley; Routledge; London and New York; 1938; 84.

[4]       Blain F. Aikin et al; Fiduciary: A Historically Significant Standard; B.U. Law Review; 158.  Available at: https://www.fi360.com/main/pdf/BULawReview_AikinFausti_Fall2010.pdf; Accessed June 21, 2018.

[5]       Id.

[6]       Id. at 159.

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Topics: FINRA, Investment Suitability, dol fiduciary rule, fiduciary duties, SEC Regulation Best Interest

FINRA's Proposed Changes to the Churning Rule

Posted by Jack Duval

May 29, 2018 8:03:39 AM

Accelerant - FINRA - Churning - Quantitative Suitability - Jack Duval

On April 20, 2018, FINRA issued Regulatory Notice 18-13 – Quantitative Suitability, requesting comments on amendments to Suitability Rule 2111.  This is the first FINRA response to SEC Regulation Best Interest.  In it, FINRA is trying to square the existing suitability rule with a new proposal in SEC Regulation Best Interest.[1]  (My writings on SEC Regulation Best Interest can be found here.)

Proposed Changes to FINRA Suitability Rule 2111.05(c) – Quantitative Suitability

The proposed changes would be made to the Supplementary Material to Rule 2111 dealing with quantitative suitability found in under section .05(c).  In short, section .05(c) would be amended to "remove the element of control that currently must be proved to demonstrate a violation (of the suitability rule) ..."[2]  What would remain are "… the obligations to prove that the transactions were recommended and that the level of trading was excessive and unsuitable in light of the customer's investment profile."[3]

The comment period expires on June 19, 2018.

According to FINRA, it is removing the control element from the rule because it is unnecessary.  FINRA writes (from the enforcement action perspective):[4]

The inclusion of the control element has its historic roots, in part, in the perceived need to ensure that the culpability for excessive trading rested with the party responsible for initiating the transactions in actions brought pursuant to the antifraud provisions of the federal securities laws.  That concern is not present under FINRA's suitability rule.  Because FINRA must show that the broker recommended the transactions in order to prove a Rule 2111 violation, culpability for excessive trading will still rest with the appropriate party even absent the control element.

... FINRA's suitability rule will continue to require FINRA to prove that the broker recommended the transactions and that the transactions were excessive and unsuitable in light of the customer's investment profile.

… The control element is an unnecessary layer of proof regarding the identity of the responsible party (i.e., the party initiating the transactions) and does not in any way touch on the proof needed to establish the underlying, substantive misconduct (i.e., the excessive trading activity inconsistent with the customer's investment profile.)  (Emphasis in the original, notes omitted)

Defining Churning

Churning is the effectuating of a trade for the sole purpose of generating a commission.  It can be for one transaction and does not have to be for multiple transactions, although the high transaction version is far more common.  (My previous post on churning can be found here.)

Critically, the level of activity and costs associated with the trading strategy must be judged against the individual client's profile, investment objective, risk tolerance, and involvement.  FINRA writes:[5]

Although no single test defines excessive activity, factors such as turnover rate, cost-to-equity ratio or the use of in-and-out trading may provide a basis for a finding of excessive trading.  A turnover rate of six or a cost-to-equity ratio above 20 percent generally is indicative of excessive trading.  However, lower ratios have supported findings of excessive trading for customers with very conservative investment objectives, while somewhat higher ratios have not supported findings of excessive trading for some customers with highly speculative investment objectives and the financial resources to withstand potential losses.

Most clients are buy-and-hold type of investors with moderate risk tolerances.  In these cases, even low levels of turnover and cost/equity ratios can be indicative of churning.  For example, I have seen such clients churned in portfolios laden with structured products.  These products were tax-inefficient and resulted in costs of 1.5 to 2 percent per year, when publicly traded equivalents would have cost a small fraction of that.

Alternately, a client with a speculative investment objective that wanted to trade actively (especially with only a portion of her assets) could have much higher turnover and cost/equity ratios without them be indicative of churning.

Another indicator is the level of commissions being assessed on each trade.  Is the broker charging full freight commissions (even if only on the buys)?  If so, this is more likely to be abusive than a broker charging firm minimum (or heavily discounted) commissions on each trade.

Ultimately, the assessment of any recommended investment strategy will be based on its comportment with the client's investment objective, risk tolerance, and overall profile.

Very few investors want to actively trade.  Most have no interest in the markets and even fewer have the leisure time to devote to following individual securities on a tick-by-tick basis.

These types of clients give their money to an investment professional and pay that professional to manage the money for them.  If speculative trading develops in these accounts, it is likely to be churning, even at low levels of turnover and cost/equity ratios.

Where an investor chooses a speculative trading strategy and knowingly takes the risks and is willing to pay the costs (which can add up quickly, even at low commission levels), that is their right.

Unfortunately, most speculative trading strategies don't work.  The investor is up against buildings full of computer servers engaged in algorithmic trading strategies that get the price data faster, and process their trades nearly instantaneously, before the client can even start typing in an order.[6]

Supervision

As always, broker-dealer supervisors will need to monitor accounts for churning.  These efforts should trigger red flags for accounts with high turnover and cost/equity ratios, those with a significant amount of the client's investable assets involved in the trading, those with large amounts of losses, and those where the trading does not comport with the client's profile.

Almost all compliance systems today can monitor for these triggers and generate exception reports for supervisors on an automated basis.

_______

Notes:

[1]      SEC Regulation Best Interest; Release No. 34-83062; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf;  Accessed May 24, 2018; 150.  “… Regulation Best Interest would include the existing ‘quantitative suitability’ obligation, but without the ‘control’ element.”

[2]      FINRA Regulatory Notice 18-13 – Quantitative Suitability; April 20, 2018; 1.  Available at: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-13.pdf; Accessed May 24, 2018.

[3]      Id.

[4]      Id. at 3-4.

[5]      Id. at 3.

[6]      See Michael Lewis’ Flash Boys: A Wall Street Revolt explaining how algorithmic traders are scalping even the largest institutional investors.

 

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Topics: FINRA, supervision, Quantitative Suitability, Churning, turnover ratio, cost/equity ratio

Comparing SEC Regulation Best Interest to Existing FINRA Rules

Posted by Jack Duval

Apr 27, 2018 9:30:35 AM

 

SEC Regulation Best Interest - Commissioner Kara Stein

AGENCE FRANCE-PRESSE/GETTY IMAGES US Securities and Exchange Commissioner Kara Stein.

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  The DOL Rule posts can be found here and the SEC Rule post can be found here.

The SEC's proposed Regulation Best Interest ("RBI") is remarkable in how poorly it is crafted.  Indeed, it is a disaster.

If passed in it's current form, RBI will:

  • Not create a unified fiduciary standard as it was supposed to under the Dodd-Frank Act Section 913;
  • Confuse clients as to the duties of broker-dealers compared to investment advisors, and;
  • Pass off existing FINRA Rules and interpretations as some kind of heightened standard.

Table 1:  Comparing SEC Regulation Best Interest to Existing FINRA Rules

SEC Regulation Best Interest v. Existing FINRA Rules

For a PDF of this table click here.

As can be seen above, the only thing RBI adds are the disclosures relating to the scope and terms of the relationship and material conflicts of interest.  While these are good additions, they fall far short of increasing investor protections.

Everything else in RBI already exists within the FINRA rules.

Kara M. Stein Comments

SEC Commissioner Kara M. Stein has savaged RBI in her public statement:

... does this proposal require financial professionals to put their customers' interest first, and fully and fairly disclose any conflicting interests? No.  Does this proposal require all financial professionals who make investment recommendations related to retail customers to do so as fiduciaries? No.  Does this proposal require financial professionals to provide retail customers with the best available options? No.

Commissioner Stein also points out, as have others, that nowhere in the 1,000+ pages of related documents does RBI define what "best interest" means.  Instead, the RBI states the best interest obligation will be satisfied "if the broker-dealer complies with four component requirements: a Disclosure Obligation, a Care Obligation,and two Conflict of Interest Obligations."  (96)

Thus, broker-dealers will be able to check the boxes to prove that they complied with an undefined "best interest" obligation that already exists under FINRA rules.  This can only weaken investor protection.

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Topics: FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, fiduciary obligations, erisa fiduciary expert, Securities Exchange Commission, Regulation Best Interest, fiduciary expert

SEC Regulation Best Interest

Posted by Jack Duval

Apr 20, 2018 8:18:52 AM

Accelerant SEC Regulation Best Interest - Logo 

 

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  My previous blog posts can be found here.

On Wednesday, April 18, 2018, the SEC issued a number of rule proposals designed, in theory, to "unify" the obligations of registered representatives of broker dealers with those of registered investment advisors.

It does no such thing.

Broker-dealers and their registered representatives will not be fiduciaries under Regulation Best Interest.  Investment advisors will remain fiduciaries.

Essentially, Regulation Best Interest will take many of the obligations that already exist in the FINRA Rules and Regulatory Notices and bring them under the SEC's aegis.  Indeed, the SEC stated:

As discussed herein, some of the enhancements that Regulation Best Interest would make to existing suitability obligations under the federal securities laws, such as the collection of information requirement related to a customer's investment profile, the inability to disclose away a broker-dealer's suitability obligation, and a requirement to make recommendations that are "consistent with his customers' best interest," reflect obligations that already exist under the FINRA suitability rule or have been articulated in related FINRA interpretations and case law.  (Emphasis added.  Regulation Best Interest; 10)

This means the suitability standard will remain for registered representatives with some additional language about the "best interests" of the client.  I will try to define exactly what the additional "best interest" language actually means in subsequent posts.

The SEC has released approximately 1,000 pages relating to this proposal.  You can find the three related releases here:

Release No. 34-83062; Regulation Best Interest;

Release No. IA-4889; Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation;

Release No. 34-83063; form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles.

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Topics: FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, fiduciary obligations, Securities Exchange Commission, Regulation Best Interest

Premeditated "C" Share Churning at Morgan Stanley?

Posted by Jack Duval

Apr 5, 2018 10:06:49 AM

Accelerant Jack Duval Securities Litigation Expert

On March 29, 2018, AdvisorHub broke a story about Morgan Stanley’s decision to convert all Class "C" mutual fund shares held for six or more years into load-waived "A" shares.  This is a beneficial move for clients, who will see their funds expenses ratios cut by about 1.5 percent.

Morgan Stanley brokers were not pleased with the move, which will reduce their 12b-1 fees from one percent to 25 basis points.

Some of them vowed to churn their clients in order to avoid the conversion.  (This was not an April Fool’s joke.)

Understanding “C” Share Mutual Funds

In theory, “C” shares are designed for clients who will be relatively short-term holders and want to avoid the front-end load on "A" shares and the back-end load on "B" shares.

In reality, they are an anachronistic holdover from the mid- to late-90's.  Back then, broker-dealers where trying to grow their fee-based business and saw "C" shares as a way for transactional brokers to become more annuitized.

Today, clients can get the same investment exposures at a fraction of the costs of "C" shares in ETFs, which are also much more tax-efficient.

The truth is that "C" share funds shouldn't be held for six years, and probably not at all.  Clients would be much better off in ETFs.  “C” shares have a full one percent 12b-1 fee charged annually to the customer in addition to the management fee and other expenses.  They are extremely high-fee and in almost all cases should be avoided.

Some "C" share mutual funds from other companies convert into "A" shares after 10 years, but again, 10 years in a “C” shares is unsuitable.

For a more detailed take on fees, see The Tyranny of High Fees blog post from our sister company, Bantam Inc.

Premeditated Churning                 

In what hopefully has Morgan Stanley CEO James Gorman losing sleep at night, AdvisorHub wrote:[1]              

Several Morgan Stanley brokers told AdvisorHub that they plan to "flip C shares, selling out of one fund into another's similar share class as they approach conversion date so that they can continue collecting the higher so-called 12b-1 fee, or trail.                                                  

"Losing 75 basis points on every six-year-old share on my team's book will cost us $300,000 in gross and $120,000 in commissions," lamented one broker, who said the team expects to "flip til the cows go home."

These brokers would be selling the "C" share funds before they convert into "A" shares, thus continuing the one percent 12b-1 fee instead of having it reduced to 25 basis points.          

This would be an unabashed churn of client accounts, and after a nine-year bull market, one that would likely have serious adverse tax consequences for the clients.

Belden Decision                       

The SEC has considered share class issues long ago and has clearly stated their position.  The share class most advantageous to the client must be purchased, or in this case, held.                      

In Belden, the SEC found that a broker buying "B" shares for a client who could have purchased load-waived "A" shares because of the amount to be invested, was violative of FINRA rules.  The Commission’s opinion stated:[2]

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.  The test for whether Belden’s recommended investments were suitable is not whether Book acquiesced in them, but whether Belden’s recommendations to him were consistent with Book’s financial situation and needs.

FINRA concurs:[3]

NASD (now FINRA) construes Belden as supporting the principle that the manner of purchase of a recommended security by an associated person, where that security otherwise would be suitable based on the investor’s investment objectives, risk tolerance, and financial means, can render that recommendation unsuitable, and therefore violative of 2310 (now 2110), if there is an alternative basis upon which the security can be purchased to the pecuniary advantage of the investor.  (Emphasis added)

There is no way the selling of "C" shares to prevent them from converting into load-waived "A" shares can be in the customer’s best interest.

Supervision

Churning is the effectuating of any trade for the reason of making commissions.  Many churning claims involve high turnover (trading) of securities in a client account.  However, churning does not have to involve a series of trades.  Indeed, it can be one trade.

In the event a registered representative sells a “C” share fund before its conversion to a load-waived “A” share, it would constitute a one-trade churn.

Morgan Stanley supervisory systems should be able to flag any "C" share trades that occur close to a conversion, however, some brokers may preemptively sell "C" shares when they are further away from the six-year marker.

These will also be churns, but will very likely not be flagged.

Morgan Stanley supervisors should closely monitor all “C” share transactions for abuses.

_______

Notes:

[1]       Jed Horowitz; Morgan Stanley to Squeeze Mutual Fund Sales Compensation; AdvisorHub; March 29, 2018; Available at: https://advisorhub.com/morgan-stanley-to-squeeze-mutual-fund-sales-compensation/; Accessed April 4, 2018.

[2]       See Wendell Belden, Exchange Act Release No. 47859; May 14, 2003.

[3]       NASD NTM 03-69; Fee-Based Compensation; November 2003; 746 at footnote 5.

 

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Topics: FINRA, supervision, C Share, Securities Exchange Commission, Morgan Stanley, Churning, Wendell Belden

Protecting Senior Investors - 2nd Circuit Decision

Posted by Jack Duval

Mar 20, 2018 8:04:09 AM

 

Accelerant - Protecting Senior Investors.png

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

A recent 2nd Circuit decision is of interest to Broker-Dealers (“BDs”) implementing policies and procedures necessary to protect senior investors.

In brief, Claimant Alba T. Pfeffer filed a FINRA arbitration claim against Wells Fargo Advisors, LLC (“WFC”) and its Registered Representative Andre Mirkine.  The claim was based upon WFC and Mirkine’s refusal to transfer money from a trust account of Claimant Pfeffer’s husband that benefited their children to a trust account that benefited only Claimant Pfeffer.

“Mirkine explained that he did not transfer the assets because he became concerned following conversations with Mr. Pfeffer and Mr. Pferrer's son that Mr. Pfeffer was not competent and was being unduly influenced by Mrs. Pfeffer.  After receiving two letters from physicians opining that Mr. Pfeffer was not capable of making financial decisions, Wells Fargo froze both trusts."[1]

The FINRA arbitration panel denied all of Pfeffer’s claims.  Pfeffer then attempted to have the district court vacate the award and was there also denied.  Finally, Pfeffer appealed the district court’s decision to the 2nd Circuit Court of Appeals, which affirmed the district court’s ruling.[2]

There are a number of interesting items in the 2nd Circuit’s decision.

Refusing to Transfer Client Funds

Primarily, the decision to affirm the district court's denial of the vacature claim should bolster BDs in their efforts to protect senior investors.  It appears that WFC broker Mirkine and WFC supervisors did their job well by making a decision that would leave them open to potential litigation - refusing a request from an account holder to transfer money.[3]

This goes directly to FINRA Rule 2165 - Financial Exploitation of Specified Adults, which "provides a safe harbor for a member to place a temporary hold on a disbursement of funds or securities from the account... if the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted."[4]

Manifest Disregard of the Law and Evidence?

Secondarily, the 2nd Circuit wrote:[5]

"On appeal, Mrs. Pfeffer argues that the award was procured by undue means, evident partiality, and misconduct because the Panel was intimidated by defense counsel and refused to consider relevant evidence.  She alleges that the Panel exhibited manifest disregard for the law and facts…

This Circuit does not recognize manifest disregard of the evidence as proper ground for vacating an arbitration panel's award and will only find a manifest disregard of the law where there is no colorable justification for a panel's conclusion."  (Emphasis added)

The 2nd Circuit found that the FINRA panel did not disregard evidence.  However, the fact that manifest disregard of evidence is not proper ground for vacating an award is bracing.

Finally, the 2nd Circuit sets the “manifest disregard of the law” standard so low at “no colorable justification” that it would seem highly remote to meet it.

Supervision

While it is no trivial matter to stop client distributions, supervisors should take quick action to stop suspect activity and to seek input from medical professionals and, if necessary, make referrals to law enforcement.

----------

Notes:

[1]       United States Court of Appeals for the Second Circuit; Summary Order; Alba T. Pfeffer Plaintiff-Appellant v. Wells Fargo Advisors, LLC, et al. Defendants-Appellees; 17-1819-cv; February 15, 2018; 3.  Available at: http://caselaw.findlaw.com/us-2nd-circuit/1889422.html; Accessed March 20, 2018.

[2]       Plaintiff Pfeffer was pro se for all three proceedings.

[3]       The FINRA panel denied Respondent Mirkine’s request for expungement of his CRD records and applied all forum fees to Respondent WFC.  This could indicate the Panel’s displeasure with some aspect of Respondent’s actions, however, without a reasoned award this is speculation.  See FINRA Award at: https://www.finra.org/sites/default/files/aao_documents/15-00294.pdf; Accessed March 20, 2018.

[4]       See FINRA Rule 2165 FAQs; Available at: http://www.finra.org/industry/frequently-asked-questions-regarding-finra-rules-relating-financial-exploitation-seniors; Accessed March 20, 2018.

[5]        See Supra Note 1 at 4-5.

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation, 2nd Circuit

Leveraged and Inverse ETFs - Tracking Error

Posted by Jack Duval

Mar 12, 2018 8:07:34 AM

This blog post continues a series exploring leveraged and inverse ETFs.  Our previous posts can be read here and here.

February was a volatile month for the S&P 500.  Leveraged and inverse ETFs that track the S&P 500 saw volatility commensurate with their leverage.  However, compared to their un-leveraged peers, the major leveraged and inverse ETFs did not track the market closely.

Because of the constant leverage trap, we know that leveraged and inverse ETFs are forced to buy high and sell low on a daily basis.  This, plus the management fees of the funds, essentially lock in losses.

On a day to day basis, these factors are de minimis.  Over time, they are fatal.

Table 1: Leveraged and Inverse ETF Performance - February 2018

Screen Shot 2018-03-12 at 7.44.04 AM.png

Source: Bloomberg

As can be seen in Table 1, all the ETFs underperformed.  The underperformance increased with leverage and being directionally wrong.

As with all investments, volatility hurts returns.  For investors in leveraged and inverse ETFs, volatility leads to significant underperformance even over short holding periods.

Because of this complexity risk, these products are only suitable for sophisticated investors wishing to speculate by day trading or for one-day holding periods.

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Topics: suitability, Leveraged and Inverse ETF, Complexity Risk, Tracking Error

Jack Duval Launches RIA Firm Bantam Inc.

Posted by Jack Duval

Mar 4, 2018 7:28:11 AM

Bantam Logo Web-07.png

 

I'm pleased to announce the official launch of Bantam Inc. a registered investment advisory firm.

Bantam is brining a new level of fiduciary guidance to our clients for all aspects of their finances and investments.

A number of traits set Bantam apart:

  • Flat-fee pricing;
  • Ability to consult with clients on stand-alone projects without them having to move their assets;
  • Bantam is registered as a New York benefit corporation.  This means the firm is fiduciary bound at the advice level (as an RIA) and at the corporate level (as a benefit corporation).

To learn more, please visit the Bantam website.

As a side note, I am still very much in the litigation consulting business and will be taking cases for the foreseeable future.  Please feel free to reach out to discuss Bantam or potential cases.

Careers

I am in the process of hiring an investment advisor. I'm looking for someone who wants to join a dynamic startup and can grow with the firm.  The position would include salary, bonus, and equity that vests over time.

If you know anyone with a legal and/or accounting background, who is interested in working with high- and ultra-high net worth investors on complex problems, please forward their names to me.

We are securing office space in Manhattan, close to Grand Central Terminal.  More information is available on our Careers page.

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Topics: Bantam Inc.

Protecting Senior Investors - Nationwide Elder Fraud Sweep

Posted by Jack Duval

Feb 27, 2018 7:49:13 AM

Accelerant - Senior Investors DOJ Image-1.jpeg 

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

On February 22, 2018, the Justice Department announced a nationwide sweep that resulted in over 200 criminal charges for financial crimes targeting the elderly.

Attorney General Jeff Sessions was quoted, saying:

The Justice Department and its partners are taking unprecedented, coordinated action to protect elderly Americans from financial threats, both foreign and domestic... Today's actions send a clear message:  we will hold perpetrators of elder fraud schemes accountable wherever they are.  When criminals steal the hard-earned life savings of older Americans, we will respond with all the tools at the Department's disposal - criminal prosecutions to punish offenders, civil injunctions to shut the schemes down, and asset forfeiture to take back ill-gotten gains.

Today is only the beginning.  I have directed Department prosecutors to coordinate with both domestic law enforcement partners and foreign counterparts to stop these criminals from exploiting our seniors.

The Perpetrators

As I have written about before, many of the perpetrators were known to the victims.  The DOJ press release gave this description:

The actions charged a variety of fraud schemes, ranging from mass mailing, telemarketing and investment frauds to individual incidences of identity theft and theft by guardians.  A number of cases involved transnational criminal organizations that defrauded hundreds of thousands of elderly victims, while others involved a single relative or fiduciary who took advantage of an individual victim.  (Emphasis added)

While few crimes could be more heinous than those targeting senior investors, those perpetrated by guardians, relatives, or fiduciaries would qualify.

Supervisory Implications

The financial abuse of senior investors is not an isolated problem.  The DOJ press release stated that the schemes undertaken by the alleged criminals caused more than $500 million in losses to over a million victims.  

These sweep results should be a call to action to broker-dealers, RIA firms, and banks across the country to raise their supervisory oversight of senior investors accounts.

In the past, there has rightfully been significant focus on cases that involve senior investors with Alzheimer's or dementia.  However, unsophisticated and wholly trusting senior investors, who do not have the wherewithal to question recommendations, can also be subject to abuse by unscrupulous advisors.

Compliance and supervisory personnel at all financial firms need to be aware of the potential for abuse and should have special policies and procedures in place to monitor the activity in the accounts of senior investors.  At a minimum, these policies and procedures should detect financial fraud such as: unnecessary trading, unsuitable investments, and suspicious withdrawals.

For information about securities expert Jack Duval, click here.

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation, Justice Department

Volatility-Linked Products - Complexity Risk Strikes Again

Posted by Jack Duval

Feb 6, 2018 10:41:24 AM

This blog post continues a series exploring volatility-linked exchange-traded products.  Our previous posts can be read here, here, and here.

The VIX S&P 500 volatility index ripped higher by 115 percent yesterday.  This effectively destroyed most, if not all, inverse VIX ETPs.

Common sense will inform that if an index increases by more than 100 percent, an investment vehicle designed to give the opposite (inverse) performance should decline to zero.  (In most cases, if an investment doesn't use leverage, a potential loss is limited to 100 percent.)

Indeed, experience is now bearing this out.

VelocityShares Inverse VIX Short Term ETNs (XIV)

The XIV ETN halted trading yesterday and fund manager Credit Suisse is almost certain to close the fund.

The prospectus language allows Credit Suisse to shutter the fund if the Intraday Indicative Value is equal to or less than 20 percent of the prior day's Closing Indicative Value (among other reasons).  That has happened.

Table 1: XIV Indicative Value

XIV - Indicative Value.gif

Source: Bloomberg

The XIV Indicative Value collapsed from 108.37 to 4.22, a 96 percent decline, and well under the 20 percent threshold.

The difference in the XIV price and indicative value was widening over the past few days of the market selloff, and then blew out yesterday.

Chart 1: XIV Price and Indicative Value

XIV Price v. XIV Indicative Value Chart.gif

Source: Bloomberg

Unfortunately, a significant amount of hot money had been flowing into this ETN due to it's returns over the past few years.  The XIV market cap was just off its all-time high, at $1.48B yesterday.

Chart 2: XIV Historical Market Cap

XIV Market Cap Chart.gif

Source: Bloomberg

A Bitter Irony

In a classic example of complexity risk, investors who bought the XIV at the close yesterday (thinking that the VIX had risen too far, too fast), will be wiped out, just like longer term holders.

As of this writing at 10:20am, the XIV is down 31 percent, meaning that those buyers would have been directionally correct, but will suffer virtually complete losses anyway with no chance to get out.

Suitability and Supervision of Volatility-Linked Products

For years, investors have been seeing their principal destroyed as unknowing advisors bought and held inverse and leveraged ETPs.  Indeed, the XIV prospectus (PS-16) gives this warning:

Screen Shot 2018-02-06 at 9.16.52 AM.png

Advisors putting their clients into inverse and leveraged ETPs should have known about the risks of long-term holding and the risk of complete overnight ruin.

Likewise, firms that allowed their advisors to sell these products should have implemented special training for them.  Furthermore, specific policies and procedures should have been written to insure these products were only utilized in speculative accounts, and for sophisticated investors, who were aware of, and accepted the risk of, total loss.

For information about securities expert Jack Duval, click here.

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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products, XIV, VelocityShares Inverse Short Term ETN

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