By Christina Mitsopoulos
March 26, 2020 at 5:00 am ET
The Securities and Exchange Commission (SEC) is sitting on a proposal that would render a class of investment products unavailable for all but the uber-wealthy. Nestled in the release is a troubling pair of “sales practices rules” that constitute an unprecedented and unnecessary restriction on the average American investor’s access to the public market.
Leverage/inverse ETFs, referred to as geared vehicles, represent an asset class that enables investors to achieve returns in excess of the market average. Generally regarded as short-term investments, retail investors incorporate these products in a portfolio to hedge against risk and increase returns. The SEC, however, wants to turn access to geared vehicles into a privilege reserved only for wealthy investors.
The “sales practices rules” encompass two pre-requisites to geared products facilitated by broker-dealers or investment advisors. First, investors must complete an invasive client questionnaire and disclose personal information. Second, financial professionals will inherit a “due diligence” standard of liability to review the questionnaires and decide whether to allow the investor to proceed with the investment.
Only if the financial professional determines that the client has the capacity to understand geared investments can he approve future transactions. What merits the acceptable “capacity” for an investor to purchase the product is not set out in the rule — rather, a facts-and-circumstances approach is suggested.
Screening investors for approval is unheard of in the public market.
The SEC is clinging to the idea that only investors who can prove the requisite — but undefined — capacity to understand the risks and costs associated should be allowed to access geared investments. Yet the questionnaire pries into investors’ personal finances, net worth and liquidity, without actually gauging “investment knowledge” in the slightest. If the proposal is implemented in its current form, the result will be approval for wealthy investors, while middle class investors are denied.
The rules are inconsistent with investor protection mechanisms, which generally focus on disclosure requirements and anti-fraud statutes. Instead, the SEC will restrict access to investment opportunities to only those with enough money to insulate their financial professionals from liability, as wealthy investors are perceived as low-risk clients.
The standard of conduct for broker-dealers handling retail accounts was updated in 2019 by Regulation Best Interest. Broker-dealers must now make recommendations that are in the best interest of, and serve first and foremost, their client, rather than following the outdated “suitability” standard. The SEC has not exposed or identified any unsavory activity with respect to geared investment vehicles, yet the Commission is still promulgating a duplicitous and vague “due diligence” standard.
The sheer fact that financial professionals can potentially trigger liability through any approval of geared vehicle investment will shut out middle-class investors.
SEC Chairman Jay Clayton’s support for the proposal is out of touch with his focus on looking out for “Mr. and Mrs. 401(k).” After vowing to “make sure Main Street investors have the best possible mix of investment opportunities,” Chairman Clayton now endorses a rule that would deny those very investors access to beneficial assets. The SEC’s Republican Commissioners Hester Peirce and Elad Roisman publicly commented in opposition to such a “blunt, overly-paternalistic approach to investor protection.”
In fact, nowhere in the proposal is there a single reference to the need for regulation now. Rather, the SEC is hiding behind the guise of “investor protection” to justify preternatural and outlandish regulations in the public market.
The proposal stands in stark contrast to the Trump administration’s goal of freeing the economy with less red tape. For these reasons, the Shareholder Advocacy Forum has submitted comments to the SEC emphasizing our concerns and urging the Commission to, at a minimum, take a narrowly tailored approach, but encouraging the full withdrawal of the proposed rule.
Christina Mitsopoulos is a Securities Regulation Advisor at the Shareholder Advocacy Forum.
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