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Regulation and Compliance > Federal Regulation

SEC Hits Firm, Advisor Over Leveraged ETFs in Portfolios

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An RIA and an advisor have agreed to pay more than $900,000 to the Securities and Exchange Commission to settle allegations it recommended large holdings of leveraged ETFs to investors without understanding the funds’ risks.

The SEC said Thursday it has settled charges against Fargo, North Dakota-based registered investment advisor Classic Asset Management LLC and part owner and investment advisor representative Douglas G. Schmitz for breach of fiduciary duty.

The firm and Schmitz agreed, without admitting or denying the SEC’s findings, to a cease-and-desist order and censures. Classic Asset Management and Schmitz also agreed to pay $195,228 and $738,113, respectively, in disgorgement, prejudgment interest and civil penalties.

The RIA had 917 clients and about $158 million in assets under management as of March 16, according to a Form ADV cited in the SEC’s order.

From at least 2017 through December 2020, Classic Asset Management and Schmitz invested advisory clients in leveraged ETFs for long periods, often in significant concentrations, despite warnings in fund prospectuses that the products carried unique risks, were designed to be held for no more than a single trading day and required frequent monitoring, according to the SEC order.

The order finds that the firm and Schmitz misunderstood these fundamental characteristics of the leveraged ETFs and therefore lacked a reasonable belief that the funds were in their clients’ best interests, the SEC said in a statement.

The leveraged ETFs “are complex securities that carry significant risks and included at least 15 different funds, all of which seek to deliver multiples of the performance of the index or benchmark they track,” the agency’s order said.

One such fund was the ProShares UltraPro Dow 30 (UDOW), a fund intended to capture three times the daily performance of the Dow Jones Industrial Average.

Classic Asset Management and Schmitz failed to appropriately monitor the ETFs’ performance and consequently didn’t evaluate whether the investments were in their clients’ best interests throughout the holding period, the order found. The SEC said the firm failed to adopt and implement policies and procedures to prevent violations of the Advisers Act.

Fiduciary Duties and Risky Investments

“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,”  Jason J. Burt, director of the SEC’s Denver regional office, said. “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.”

The SEC’s order finds that the asset manager and Schmitz violated the Investment Advisers Act of 1940 and that the firm also violated the compliance provision of the Advisers Act.

Andrew Shedlock, the attorney representing Classic Asset Management, had no comment on the case, saying his client referred ThinkAdvisor to the SEC’s order. An attorney for Schmitz didn’t immediately respond to an emailed request for comment.

Of the approximately 290 clients Schmitz advised during the relevant period, he invested roughly 220, or 76%, in leveraged ETFs, according to the order.

At one point, leveraged ETFs comprised about 56% of the total market value of the client accounts that Schmitz managed, the agency said.

The firm and Schmitz “routinely held LETFs in client accounts for weeks, months, and years,” and fewer than 1% were sold in one day, the SEC reported.

Some clients “experienced substantial losses during the relevant period,” the order stated.

In deciding to accept settlement offers from the firm and the individual advisor, the SEC said it “considered remedial acts promptly undertaken by respondents and cooperation afforded the commission staff.”


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