On November 25, the U.S. Securities and Exchange Commission (SEC) issued a release (Proposing Release) proposing new Rule 211(h)-1 under the Investment Advisers Act of 1940, as amended (Advisers Act) (the sales practices rule), that would require an investment adviser that is registered (or required to be registered) with the SEC to exercise due diligence in approving a retail client’s account to buy or sell shares of certain “leveraged/inverse investment vehicles.”1 This is the first rule to be proposed pursuant to Section 211(h) of the Advisers Act.
The term “leveraged/inverse investment vehicles” includes certain entities that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index over a predetermined period of time. The entities included in the proposed scope of the sales practices rule would include registered investment companies and certain exchange-listed commodity- or currency-based trusts or funds regulated by the Commodity Futures Trading Commission.
The term “retail client” refers to any natural person or the legal representative of any natural person (but not regulated financial services industry professionals retained by natural persons to exercise independent professional judgment), regardless of their net worth.
Specifically, the proposed sales practices rule would require the investment adviser to: (i) approve the retail client’s account for buying and selling shares of leveraged/inverse investment vehicles pursuant to a due diligence requirement and (ii) adopt and implement policies and procedures designed to achieve compliance with the proposed rule.
The rule would require an investment adviser to exercise due diligence to ascertain a set of “essential facts” about a retail client and his or her financial situation and investment objectives before placing an order for that client’s account to buy or sell shares of a leveraged/inverse investment vehicle. An investment adviser could approve the retail client’s account to buy or sell shares of leveraged/inverse investment vehicles only if the investment adviser had a reasonable basis to believe that the investor is capable of evaluating the risks associated with leveraged/inverse investment vehicles. The rules are modeled after current Financial Industry Regulatory Authority options account approval requirements for broker-dealers.
The investment adviser must seek to obtain, at a minimum, certain information about its retail client’s:
- investment objectives (e.g., safety of principal, income, growth, trading profits, speculation) and time horizon;
- employment status (name of employer, self-employed or retired);
- estimated annual income from all sources;
- estimated net worth (exclusive of family residence);
- estimated liquid net worth (cash, liquid securities, other);
- percentage of the retail client’s liquid net worth proposed to be invested in leveraged/inverse vehicles; and
- investment experience and knowledge (e.g., number of years, size, frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, stocks and bonds, commodities and other financial instruments.
For joint accounts, the investment adviser must seek to obtain the information for all participants in joint retail client accounts.
This information is designed to provide a comprehensive picture of the retail client to allow an investment adviser to evaluate whether the retail client has the financial knowledge and experience to be reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse vehicles.
Based on an evaluation of this information, the investment adviser would be required to approve or disapprove the retail client’s account for buying or selling shares of leveraged/inverse products. If the investment adviser approves the client, the approval must be in writing. To provide approval, the investment adviser must have a reasonable basis for believing that the retail client has the financial knowledge and experience to be reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse vehicles. This determination must be based on the totality of the relevant facts and circumstances, and the SEC is not proposing a bright line test for this determination. There are recordkeeping requirements.
The SEC has proposed a one-year transition period (from the publication of any final rule in the Federal Register) to allow investment advisers time to bring their operations into compliance with the new rule.
Comments should be submitted on or before 60 days after publication in the Federal Register.
1 The Proposing Release also proposed new Rule 15l-2 under the Securities Exchange Act of 1934, as amended, which would impose a substantially identical requirement on a broker or dealer that is registered (or required to be registered) with the SEC.
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