A general securities representative settled Financial Industry Regulatory Authority ("FINRA") charges for advising customers to purchase Leveraged and Inverse Exchange Traded Funds ("LIETFs") without understanding the specific risks and unique features. The member firm with which the representative was associated also settled charges for failure to supervise. The parties executed a Letter of Acceptance, Waiver and Consent1 (the "AWC") in early September.
According to the AWC, the representative recommended his customers hold LIETF shares for several weeks, which was contrary to published guidance on LIETFs and resulted in losses. LIETFs are considered non-traditional ETFs—they seek to deliver returns that are multiples of the performance of their underlying index or benchmark. Non-traditional ETFs are financial instruments that typically "reset" daily, meaning they are designed to achieve their stated objectives only on a daily basis. Accordingly, their performance over longer periods can differ significantly from their stated daily objective. Non-traditional ETFs that reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session.
FINRA Regulatory Notice 09-312 (the "Notice") provides specific guidance regarding the risks and suitability concerns associated with non-traditional ETFs and the need for a supervisory system to address those issues. The Notice stresses that firms and associated representatives must "understand the terms and features of [non-traditional ETFs], including how they are designed to perform, how they achieve that objective, and the impact that market volatility, the ETF's use of leverage, and the customer's intended holding period will have on their performance." Moreover, the Notice cautions member firms to establish a reasonable supervision system to ensure that associated persons comply with all applicable FINRA and Securities Exchange Commission ("SEC") rules when recommending any product, including non-traditional ETFs, and to implement written supervisory procedures ("WSPs") that, among other things, require that associated persons perform appropriate individualized suitability reviews.
Between August 2011 and January 2015, the representative recommended 19 LIETF purchases in 17 customer accounts. Following the representative's recommendation, his customers held these positions for periods ranging from 294 days to, in one case, almost six years. The average holding period was 722 days. These extended holding periods resulted in customer losses.
According to FINRA, the representative failed to perform a reasonable basis suitability analysis of LIETFs before offering the products to his customers. FINRA also contends that the representative failed to understand that LIETFs are generally expected to lose value over time and that losses are compounded because of how LIETFs' valuations reset each day. FINRA charged the member firm with which the representative was associated with failure to maintain a supervisory system and WSPs reasonably designed to ensure that sales of LIETFs complied with applicable securities laws and regulations, National Association of Securities Dealers, Inc. and FINRA rules, or tailored to the unique features and risks of LIETFs. While the firm's WSPs described the general characteristics of LIETFs, they did not specifically address suitability, supervision or training related to the sale of LIETFs. The firm also failed to provide formal training to representatives before permitting them to sell LIETFs to retail customers. The firm did not have procedures to monitor LIETFs for potentially unsuitable holding periods. As a result, the representative did not have the proper training on LIETFs before recommending them to customers, and the firm's inadequate supervisory system allowed the representative's customers to hold LIETFs for unsuitably long periods of time.
FINRA did not allege any malicious intent on the part of the representative. The AWC simply contends that the representative was ignorant as to the key features of the products he had been selling. Representatives should ensure that they understand the products they recommend—especially complex products. Broker-dealers should also put in place the appropriate supervisory policies and training programs to ensure their representatives understand the risks and investment strategies associated with complex financial products. This is especially important for firms that operate under an independent contractor model, as was the case here.
Footnotes
Originally published in REVERSEinquiries: Volume 2, Issue
9.
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