FINRA: Firms Failed to Supervise Alt Mutual Fund Sales

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FINRA censured three firms for failing to supervise reps who recommended an alternative mutual fund that lost some 80% of its value in two days when the market moved against it.

The regulatory agency proposed settlements with Securities America, Cambridge Investment Research and J.W. Cole Financial for the alleged violations. According to FINRA, the firms’ supervisory lapses came when reps sold the LJM Preservation & Growth Fund to clients. Of the three firms, Cambridge reps sold more than $18 million of LJM to customers (80% of which came from a single buyer), while J.W. Cole about $1 million and Securities America sold more than $616,000 in total.

LJM was an alternative mutual fund marketed as a way for retail investors to invest in strategies meant to perform well in a variety of market conditions. Managed by Anish Parvataneni and Anthony Caine of Chicago-based LJM Partners, the fund launched in January 2013, touting that it would profit from the difference between investors’ forecast of market volatility vs. the market’s actual volatility using options. The fund managers said there were certain markets in which it would do “well” (i.e. ‘flat,’ ‘choppy’ or ‘slowing rising or falling markets’), as well as markets in which it would be “challenged” (which included ‘sustained upward trending equity markets’ or ‘extreme volatility spikes or market moves’). The fund also disclosed the uncertainty that its risk mitigation strategies would reduce risk or be “either available or cost effective,” according to the FINRA letters.

On Feb. 5, 2018, the S&P 500 fell 113 points and market volatility increased by the largest one day rise in its history, according CBOE Volatility Index. The fund lost about 80% of its value in two days. On Feb. 7, the fund closed to new investors, and by the end of March, it was liquidated and dissolved. At the time, it was among the most significant funds to “fall victim to the popular ‘short vol trade,’” according to CNBC.

But FINRA argued the three firms in question had fallen short on properly supervising how reps pushed the fund to clients. In the case of Cambridge, FINRA said the firm had no system in place to determine whether a new mutual fund was a “complex product” or an alternative fund which might demand more due diligence. 

The regulatory agency also knocked Cambridge for not having enough guidance in place to train reps on the risks and rewards of alternative mutual funds, and said an electronic trade review system the firm used to help supervise trading activity was not properly designed for reviewing alternative mutual funds employing complex strategies. Similar lapses were found at Securities American and J.W. Cole, as well, according to FINRA. As a part of the settlements, all agreed to a censure, as well as fines and restitution ranging from $163,527 in the case of J.W. Cole Financial to more than $3.1 million in the case of Cambridge Investment Research.

“Without admitting or denying  FINRA findings, Cambridge entered into this Letter of Acceptance, Waiver, and Consent in which FINRA notes Cambridge provided considerable assistance,” Cindy Schaus, a VP for public relations for Cambridge Investment Research said in a statement (both Securities America and J.W. Cole Financial did not comment). 

Bill Singer, a securities attorney and the author of the BrokeAndBroker.com blog, questioned whether these types of sanctions achieve “anything of value.” The alternative mutual fund’s strategy was based on uncovered, or “naked” options, and it should have been apparent to anyone that no one should be investing in such a strategy unless they had a high risk tolerance, Singer said.

The settlements demonstrate a broader problem with state and national regulators who fail to prevent these kind of events in the first place. In LJM’s case, these FINRA sanctions are coming down three years after the fund’s demise.

“The problem is we regulate Wall Street by looking at the toe tags in the morgue,” he said.