Issuers of index-linked structured products rely on the index providers' publicly available documents, such as methodologies, for material disclosures about the underlying index. Under some license agreements, the index provider requires that the issuer submit any offering documents or marketing materials to the index provider for pre-review. What if those methodologies don't disclose a key provision, and the index provider doesn't tell the issuer about that provision? In the current case, the negligent omission was found by the Securities and Exchange Commission ("SEC") to constitute a violation of Section 17(a)(3) of the Securities Act of 1933, which prohibits engaging in any transaction, practice or course of business which operates or would operate as a fraud or deceit upon the purchaser.

In a recent SEC Cease and Desist Order ("the Order"), the index in question was a volatility index measuring the return from a rolling long position for certain VIX futures contracts (the "Index").13 One of the structured products linked to the Index was the Credit Suisse AG VelocityShares Daily Inverse VIX Short Term ETN linked to the S&P 500 VIX Short-Term Futures Index due December 4, 2030 (the "ETN").

On February 5, 2018, there was extreme volatility in the VIX futures contracts market. However, at certain times between 4:00 p.m. and 5:08 p.m. EST, the published Index level remained static. The reason was an undisclosed Index feature called "Auto Hold," which was not described in any publicly available methodology, and unknown to the ETN's issuer.

The Auto Hold feature comes into effect if the Index level breaches a certain threshold. The result is that the prior Index level continues to be reported until the actual current Index level comes back to a level under the threshold, or personnel at the Index provider ("Index Provider") manually override the Auto Hold. When Auto Hold is in effect, the result is that the published Index level is static, or flat, while the actual Index level is quite different.

The ETN had a discretionary issuer acceleration provision triggered when the ETN's intraday indicative value, which was inversely based on the Index level, was equal to or less than 20% of the prior trading day's closing indicative value. Due to the Auto Hold feature, on February 5, 2018, when the Index was undergoing extreme volatility, at the end of the trading day, starting around 4:13 p.m. and continuing to about 4:45 p.m., the published intraday indicative value was unchanged at 24.8933. But, when the closing indicative intraday value was published, based on the actual Index level, it was 4.2217. The issuer accelerated the ETN the next day.

In the Order, it was explained that the Index Provider had a set of procedures governing the Auto Hold feature, which were not publicly disclosed. When the Index is subject to Auto Hold, no indication of such is publicized. On February 5, 2018, according to the Order, the Index Provider was somewhat short staffed, and the manager tasked with managing the Index was instructed to prioritize end-of-day validations of many indices over real-time Index monitoring (including overriding the Auto Hold feature of the Index). In response to questions from the ETN's issuer about the Index level after the close of market on February 5, 2018, the Index Provider, for the first time, told the issuer about the Auto Hold feature and how it affected the Index.

ETN holders did not know when the Index level was published at a static level that the ETN was actually worth less than its published intraday indicative value. ETN investors who purchased or held their ETNs during the time that Auto Hold was in effect did not know the ETN's true value and did not know that the ETN's indicative value was actually so low that the Issuer would accelerate the ETN at the actual lower indicative value.

Without admitting or denying the SEC's findings, the Index Provider agreed to the Order and to payment of a monetary penalty.

A Dissenting Voice

On the same day that the SEC issued the Order and related press release, SEC Commissioner Hester M. Pierce, in a Public Statement, questioned the SEC's rationale and disagreed on the applicability of Section 17(a)(3) to the Index Provider's actions.14

Commissioner Pierce's argument is, essentially, that the Index Provider's role vis-à-vis the ETN investors was too attenuated to satisfy the requirements of Section 17(a)(3). She states that the Index Provider did not engage in the offer or sale of a security, nor was it alleged that the Index Provider interacted with investors.

Perhaps the non-disclosure was a violation of its license agreement with the issuer. But the failure by the Index Provider not to inform the issuer of the Auto Hold feature in advance was not a violation of Section 17(a)(3). As she states:

The charges against [the Index Provider] suggest that any person who knows another party will use her product or service to build a security could be charged under Section 17(a)(3) for omissions or misstatements about that product or service. Securities laws are not meant to address every wrong. [The issuer] was obligated to its investors. [The Index Provider's] obligations ran to [the issuer].

Footnotes

13. The SEC Cease and Desist Order is available at: https://www.sec.gov/litigation/admin/2021/33-10943.pdf

14. Commissioner Pierce's Public Statement is available at: https://www.sec.gov/news/public-statement/peirce-statement-sp-dow-jones- indices-051721

Originally published in REVERSEinquiries: Volume 4, Issue 3.
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