SEC Weighs Protections for Self-Directed Trades

The proliferation of online, “zero commission” stock trading apps has made it easier than ever for the average person to direct their own stock trades. As the level of self-directed trading by retail investors continues to rise and trading volume has surged during lockdowns associated with the coronavirus pandemic, the Securities and Exchange Commission has voiced its concerns that these investors are not being adequately protected by existing safeguards, especially for individual trading in so-called “complex products.”

Notably, the SEC appears poised to make some dramatic changes to the existing notion that investors who make unsolicited, self-directed trades can, in essence, fend for themselves.

In a recent joint statement issued by the leaders of several divisions of the SEC staff, the securities regulator emphasized its concerns about the investment industry’s and investing public’s apparent lack of understanding of complex products, such as “leveraged/inverse” products that are designed to produce amplified or inverse results pegged to a specific multiple of an underlying market benchmark, or commodity-linked products, which provide investors exposure to commodities like crude oil.

This joint statement was closely followed by SEC enforcement actions and guidance from the SEC’s examination arm, the Office of Compliance Inspections and Examinations (OCIE), regarding sales of volatility-linked and other complex products. In those matters, several financial firms were faulted for failing to supervise sales of volatility-linked complex products, which were designed to be held for only short periods of time but were allowed to be held by those firms’ customers over longer periods of time.

New ‘Best Interest Standard’

These developments come at an interesting time in securities regulation in the U.S., with the SEC’s new “best interest” standard having taken full effect within the past six months and the new administration widely anticipated to increase enforcement by the SEC staff.

Piling on top of these changes, the SEC’s concept proposal for complex products would significantly alter—albeit in a targeted, product-specific manner—the existing standard of conduct, which is only triggered by a recommendation made to an investor. Currently, if a broker does not make a recommendation—which is generally true for a retail investor self-directing trades through online brokerage account—they generally aren’t accountable for a client’s judgment in making a particular investment, even when the trade involves complex products.

Importantly, the current proposals and actions taken by the SEC track closely with past regulatory actions taken after the historic market declines in 2008-2009, including several large actions taken by the Financial Industry Regulatory Authority regarding complex products sales, focusing on how complex-product performance compares to investor expectations during extreme market volatility.

As noted by OCIE’s review of the recent enforcement actions around volatility-linked products, SEC examiners remain focused on “inappropriate use of complex investment products” and, in particular, whether financial professionals who recommend complex products understand all of their features and how they fit into a given client’s profiles and objectives, and if the resulting positions are being monitored with necessary frequency by the professional.

Intent to Extend Client Protections

The SEC’s joint statement around complex products, however, takes this approach even further and shows that the SEC staff intends to expand protections for clients who trade independently.

In particular, the SEC has a heightened awareness of the increased ability of investors to directly trade complex products, explaining that where “once it was nearly impossible for a retail investor to trade without the aid of a registered representative or investment adviser, technological advancements have increased investor access as well as investor choice.”

At the same time, the SEC cautions that increased access to trading does not appear to have caused an increased understanding of complex products, with the SEC citing investor complaints regarding the performance of certain complex products during pandemic-related volatility, even though, as the regulator notes, the products were performing as designed.

As a result, the SEC now appears prepared to extend protections to all trades in complex products, regardless of whether they are initiated at the recommendation of a financial professional. While the SEC appears to be considering all options on the table, it specifically highlights “point-of-sale disclosures or policies and procedures tailored to the risks of complex products.”

As it customarily does, the SEC is inviting all market participants, as well as members of the public, to provide their views on the statement.

A Signal to Evaluate Existing Procedures

In the meantime, the cluster of SEC attention and action regarding trading in complex products provides a clear signal of the regulator’s expectation that investment firms and professionals evaluate their existing procedures for their clients’ trading in complex products, in particular, what systems they have in place to control for recommendations made by their registered professionals.

As indicated in the SEC’s statement and reflected in past and recent regulatory actions, broker-dealers and investment advisers are obligated to ensure they conduct general due diligence on the products they sell and ensure that their financial professionals understand the products they recommend.

Also, the initial due diligence conducted on complex products may yield insight into certain product features, such as daily resets of the leverage/inverse formulation, that could be used to dictate account-type or customer-profile restrictions on investment in complex products, or programmatic monitoring of “stale” holdings in complex products.

Finally, as acknowledged in the SEC’s statement, while no standard-of-care obligations currently apply to self-directed trading, financial firms should assess the potential impact of any new regulatory action relating to self-trading in complex products in order to provide comment and stand prepared for further action in this area.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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Tim Foley is counsel at Alston & Bird LLP in Washington, D.C., in the firm’s Financial Services & Products group. He advises broker-dealers and other financial institutions in regulatory compliance and enforcement matters involving the SEC, FINRA, self-regulatory (SRO) agencies and state and foreign regulatory agencies.