This Week in FinTech & Compliance #4: SEC Charges Classic Asset Management for Breach of Fiduciary Duty
On May 4th, the Securities and Exchange Commission (“SEC”) announced that it had settled charges against Classic Asset Management (“CAM”), a North Dakota-based investment adviser, and CAM indirect part-owner and investment adviser representative Douglas G. Schmitz. The charges brought by the SEC were for breach of fiduciary duty in connection with the use of leveraged exchange traded funds (“ETFs”) in discretionary client accounts. These charges and subsequent settlement appeared less than a week after the SEC staff released a bulletin on broker-dealer and investment adviser Duty of Care.
The Duty to Understand the Investment
According to the SEC’s order, the Staff found that from 2017 to near the end of 2020, CAM and Mr. Schmitz invested advisory client funds in leveraged ETFs for extended periods, often in high concentration, despite warnings in each of the funds’ prospectuses that these leveraged ETFs carry unique risks, required frequent and diligent monitoring, and were specifically designed to be held for no more than a single trading day.
After reviewing the details of the trades over the period, the SEC found that CAM and Schmitz misunderstood the characteristics of these investments and therefore didn’t have the reasonable belief that the investments in these leveraged ETFs were in the best interests of their clients. On top of this, the SEC states that CAM and Schmitz failed to properly monitor the performance of the investments and didn’t evaluate or determine whether these leveraged ETFs were in the clients’ best interests throughout the holding period.
Speaking on the case, Jason J. Burt, Director of the SEC’s Denver Regional Office stated, “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.” Mr. Burt also commented on an investment adviser’s fiduciary duty to act, advise, and manage in a client’s best interests – especially when dealing with complex and potentially risky products like leveraged ETFs.
The SEC's Verdict
The SEC determined that CAM and Mr. Schmitz’s lack of diligence, monitoring and proper management of client funds found both parties in violation of the Investment Advisers Act of 1940 as well as finding CAM in violation of the compliance provision of the Advisers Act.
While both CAM and Mr. Schmitz neither admitted or denied the SEC’s findings, they did however agree to a cease-and-desist order and censures. CAM and Mr. Schmitz each agreed to pay $195,228 and $738,113, respectively, in disgorgement, prejudgment interest, and civil penalties, with CAM also agreeing to conduct a respondent administered distribution.
In the SEC’s recent Duty of Care Bulletin, the first, and arguably most important, point the staff makes is the necessity for investment advisers to clearly understand the investment products or investment strategies on which they are advising clients. It’s then the job of the investment adviser to dictate to the client all the potential risks, costs, or rewards of these products or strategies. The Staff mentions that with complex products or strategies, financial professionals still have the responsibility of seeking out the best interests of their clients. The Staff recommends that investment adviser representatives review these complex products or strategies and consider any less risky, costly, or more practical solutions for their clients that could achieve similar or same investment objectives.
By not taking the time to properly understand these leveraged ETFs and to properly monitor these products, CAM and Mr. Schmitz ultimately breached their client Duty of Care as financial professionals. The complexity of the products and lack of oversight didn’t meet the best interests of their clients and unfortunately garnered a lack of trust from the SEC and both current and future clients.