Navigating Regulatory Risks: Leveraged and Inverse ETFs Targeted by Pennsylvania Department of Banking and Securities

The Pennsylvania Department of Banking and Securities (Department) has recently targeted registered investment advisers who utilize leveraged and inverse exchange traded funds (ETFs). Advisers should be aware of the Department’s position, potential penalties, and proactive measures to ensure compliance.

What Are Leveraged and Inverse ETFs?

A leveraged ETF “is a security that uses financial derivatives and debt to amplify the returns of an underlying index or other assets it tracks. While a traditional ETF typically tracks the securities in its underlying index on a one-to-one basis”[1] “over time,” a leveraged ETF “attempt[s] to double or triple the daily returns of the [underlying] index.”[2]

An inverse leveraged ETF is “designed to produce positive returns when a benchmark index declines. Inverse leveraged ETFs are thus designed to... move [two or three times] in the opposite, or ‘inverse,’ direction [from] the benchmark index.”[3]?

Although these funds are designated with daily investment objectives, many of the prospectuses declare that they may be held for longer than one day if the adviser believes that doing so aligns with the client’s goals and objectives. However, the Department has taken the arbitrary position that holding these funds for longer periods of time renders them “unsuitable.” As a result, it has instituted numerous enforcement actions against advisers who hold these investments for longer durations, alleging that holding these investments for extended periods constitutes “dishonest and unethical practices” under the Pennsylvania Securities Act of 1972 (the Act) and related regulations, particularly 10 Pa. Code § 305.019(c)(3)(i).

FINRA’s Guidance on Suitability

According to the Financial Industry Regulatory Authority (FINRA), to determine whether an investment is suitable, an adviser should consider at least “the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose[.]”[4] FINRA thus recommends that suitability be determined on a case-by-case basis, taking all relevant factors into account.

Despite the recommendations of FINRA, the Department has asserted that merely holding these funds for a certain number of days renders them, per se, unsuitable. Although the Department has published no guidance on these investments to date, and these funds remain legal securities in the Commonwealth, advisers who hold leveraged and inverse ETFs for longer periods of time may be at risk—regardless of the investment outcome for the affected client. Indeed, the Department has brought enforcement actions against advisers with no client complaints and even advisers who achieved substantial returns on investment utilizing these funds.

Potential Penalties for Non-Compliance

The possible penalties can be quite onerous. An administrative assessment is calculated per violation of the Act. And each violation can incur an assessment of up to $100,000. If the affected client is over 60 years of age, the Act authorizes an additional penalty of $50,000 per occurrence. This means that, in the ordinary case, the Department could (and does) seek millions of dollars in penalties. The Department may also seek to revoke or suspend an adviser’s registration.

Steps Advisers Can Take to Ensure Suitability

Advisers who use leveraged and inverse ETFs should take proactive steps to reduce regulatory risk. Consider implementing the following best practices:

Establish written guidelines for determining which client accounts are suitable for investing in leveraged and inverse ETFs.

• For example, an adviser could set a minimum account value requirement for utilizing these securities or implement an internal policy restricting these investments to clients who have expressed certain investment objectives.
• Advisers should also routinely update their clients’ documented investment objectives.

Create written guidelines for determining the percentage of a client’s total assets under management that will be placed in leveraged and inverse ETFs.

• An adviser could set a maximum for the percentage of assets under management that they will place in these ETFs.

Provide clients with written disclaimers outlining the risks of investing in leveraged and inverse ETFs.

• An adviser should document the disclaimer itself and the provision of these disclaimers, either by requiring the client to sign and return them or saving the relevant correspondence to the client file. ?

Establish written procedures to mitigate the risks associated with investing in leveraged and inverse ETFs.

• An adviser could implement a stop-loss order process and establish backup procedures for potential failures.?

Establish procedures for monitoring the status of investments in leveraged and inverse ETFs on a daily or frequent basis.

• An adviser may consider keeping a log of each time they or someone under their direction checks an account that has invested in leveraged or inverse ETFs.

Create guidelines for determining or setting the appropriate holding period for these investments.

• Based on the Department’s unwritten policy of scrutinizing advisers who hold these funds for longer than a few days, advisers may consider permanently limiting their retention to under 21 days.?

Seeking Legal Assistance in Case of Investigation

If you are targeted by an audit or investigation initiated by the Department, it is critical to contact an attorney immediately. The McNees White Collar Defense team has extensive experience defending advisers facing enforcement actions by the Department of Banking and Securities and is fully prepared to provide you with the guidance and support you need to protect your business and reputation.

[1] James Chen, Leveraged ETFs: The Potential for Big Gains—and Bigger Losses, Investopedia, Jul. 24, 2024, https://www.investopedia.com/terms/l/leveraged-etf.asp - toc-understanding-leveraged-etfs.

[2] Kent Thune, Leveraged ETFs: What They Are & How They Work, Seeking Alpha, Jul. 29, 2022, https://seekingalpha.com/article/4439037 (emphasis omitted).

[3] Id.

[4] FINRA Rule 2111, https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111.

About the authors

Sarah Hyser-Staub is an experienced attorney and Chair of the White Collar Defense, Public Corruption & Investigations Group. She represents clients in grand jury proceedings, defends against criminal and regulatory violations, and advises on compliance with ethics and anti-corruption laws. Sarah also defends public and private entities in civil rights cases and complex commercial disputes. She provides strategic counsel in government investigations and internal compliance matters, helping clients navigate high-stakes legal challenges.

Matthew L. Hoke?is a civil litigator who leverages his federal court and governmental experiences, as well as his strong legal research, writing, and advocacy skills, to advance his clients’ positions.

About the firm

McNees is a multidisciplinary law firm founded in 1935 with more than 150 attorneys representing businesses, associations, institutions, municipalities, and individuals. The firm serves clients worldwide from offices in Devon, Harrisburg, Lancaster, Pittsburgh, Scranton, State College, and York, Pa.; Columbus, Ohio; Frederick and Towson, Md.; and Washington, D.C. McNees is a member of the ALFA International Global Legal Network.

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