FINRA recently announced another settled disciplinary proceeding alleging unsuitable sales of levered and inverse exchange-traded funds (ETFs). This second such announcement in recent months involving non-traditional ETFs sends the clear message that FINRA continues to be intensely focused on the retail sale of complex structured products.
In the recent consent order, two brokerage firms agreed to pay substantial fines and restitution to customers who experienced net losses from purchasing the complex ETF products. FINRA alleges that between January 2009 and June 2013, certain registered representatives recommended levered and inverse ETFs to customers without fully understanding the unique features of the products. As a result, FINRA claims that the representatives lacked "reasonable-basis" suitability for recommending the non-traditional ETFs to customers, some of whom had conservative investment objectives. Moreover, FINRA claims that the firms lacked sufficient supervisory procedures over, and did not provide adequate training for, their representatives with respect to sales of the leveraged and inverse ETFs.
While traditional ETFs typically seek to track an underlying benchmark or index, the non-traditional ETFs sold in the recent case seek to return a multiple of the inverse of the return of the benchmark. The non-traditional ETFs use swaps, futures contracts and other derivative instruments to achieve their goals. And the non-traditional ETFs have a "daily reset" feature under which the fund rebalances its holdings to achieve its goals on a daily basis. Small "tracking errors" – or differences from the intended inverse result from the benchmark – are thus magnified over time, particularly since the ETFs at issue in the recent case used leverage. Due to the unique features of this type of product, FINRA advised its membership in a 2009 Regulatory Notice that non-traditional ETFs "typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."
Indeed, this recent action is FINRA's second announced enforcement foray into non-traditional ETFs in as many months. As noted in one of our posts from last month, FINRA announced that it censured another registered broker-dealer and ordered it to pay restitution to customers for the alleged unsuitable sales of non-traditional ETFs. (Interestingly, FINRA did not impose a fine on the respondent in this prior action.) FINRA also alleged deficiencies in the firm's training of its brokers and supervisors regarding the features, risks and characteristics of non-traditional ETFs.
FINRA's multiple actions in this area should clearly alert its membership that recommendations of non-traditional ETFs, and firms' supervision and training thereof, will be closely scrutinized.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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