Complex ETFs land North Dakota firm with nearly $1M SEC fine

A North Dakota financial firm and one of its advisors will have to pay nearly $1 million for placing clients' money in complex exchange traded funds that weren't in their best interest.

The Securities and Exchange Commission, which regulates financial planners, announced Thursday that Classic Asset Management in Fargo, North Dakota, and Douglas Schmitz, an indirect part owner of the firm and investment advisor, had agreed to pay $933,341 to resolve allegations that they had violated their fiduciary duties in their use of complex investment vehicles known as leveraged exchange traded funds. These products, known as LETFs for short, use borrowed money to amplify the sorts of returns that can be had from standard exchange traded funds, which often track stock market indexes like the S&P 500.

The funds Classic Asset Management and Schmitz invested clients' money in often had prospectuses warning they were not meant to be held for more than a single day. Maintaining them for longer periods, according to the documents, was unusually risky and would require close monitoring and management.

Despite the warning, Classic Asset Management and Schmitz held clients in the funds for "weeks, months, and years," according to the SEC. The regulator looked particularly at a period stretching from January 2017 to December 2020.

During those nearly four years, clients' money was held in LETFs for an average of 331 days. Of the 290 clients Schmitz advised during that period, roughly 76% were invested in the funds, according to the SEC.

"Neither (Classic Asset Management) nor Schmitz had a reasonable basis to conclude that the LETFs were suitable for their clients either generally or in the manner in which they intended to use them," the SEC wrote.

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Chase Carlson, the founder of Miami-based Carlson Law and a securities fraud lawyer, said many firms simply won't let their advisors put clients' money into LETFs.

"For the average investor, it's just not suitable to have that level of risk," Carlson said. "It's a concentrated and leveraged bet, and a highly directional bet. You're betting: I'm going to be really right about the direction of this."

The firm's share of the penalty consists of $81,824 in disgorgement, $13,404 in prejudgement interest and a $100,000 civil penalty. Schmitz will have to pay $523,086 in disgorgement, $115,027 in prejudgement interest and a $100,000 civil penalty.

"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," said Jason Burt, the director of the SEC's Denver Regional Office. "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."

According to Classic Asset Management's latest Form ADV, filed with the SEC on March 16, the firm has $158.4 million in assets under management. It also listed 12 full- and part-time employees. 

Schmitz, who also has a broker license, has three customer disputes listed on the SEC's Investment Adviser Public Disclosure database. The first of those, over allegations of failed trades, was settled in April 2020 for $275,000. The second, over allegations that Schmitz hadn't followed orders to shut down an account, was closed in July 2020 with no action. And the third, over charges that Schmitz hadn't lived up to his fiduciary responsibilities, is still pending. The SEC's database also lists a bankruptcy from 2015.

Attempts to reach Class Asset Management and Schmitz were unsuccessful.