Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC (collectively, "Wells Fargo") agreed to pay over $3.4 million in restitution to settle FINRA charges of making unsuitable recommendations in connection with volatility-linked exchange-traded products ("ETPs"). In response to the "unique" risks of volatility-linked ETPs, FINRA contemporaneously issued guidance reminding all member firms of their sales practice obligations around such ETPs.
FINRA asserted that Wells Fargo representatives solicited and effected purchases of volatility-linked ETPs for customers with "conservative or moderate risk profiles" as such representatives "mistakenly believed that [these products] could be used as a long-term hedge on customers' equity positions in the event of a market downturn." As a result, FINRA concluded that the representatives lacked a "reasonable basis to recommend" these products as suitable investments for certain customers.
Further, FINRA charged that Wells Fargo did not establish and maintain an adequate supervisory system to oversee its representatives' sales of volatility-linked ETPs. FINRA alleged that Wells Fargo failed to implement restrictions on purchasing and recommending volatility-linked ETPs, and did not have appropriate training measures in place for employees regarding these products. In resolving the matter without issuing a fine (but requiring restitution), FINRA noted Wells Fargo's (i) correction of supervisory deficiencies before detection, (ii) previous $2.1 million fine for similar conduct (paid in 2012), and (iii) cooperative efforts throughout the FINRA investigation.
In Regulatory Notice 17-32, FINRA explained that volatility-linked ETPs are designed to track Chicago Board Options Exchange Volatility Index ("VIX") futures instead of the VIX itself. While the VIX is negatively correlated with the broader market, volatility-linked ETPs often provide volatility exposure by "tracking short- and mid-term VIX futures indices." Volatility-linked ETPs that seek to maintain a targeted maturity exposure to VIX futures will either track or hold VIX futures contracts on a rolling basis, meaning that they will sell shorter-term contracts or contracts about to expire with contracts that have more distant or deferred maturity dates in order to maintain the desired exposure. This trading strategy may result in a negative roll yield and, as a result, volatility-linked ETPs often lose value over time. These products are often extremely risky and do not possess as strong of a correlation to the VIX as investors may believe.
As a result, FINRA reminded firms that volatility-linked ETPs are considered "complex products," and pointed to Regulatory Notice 12-03 for general guidance on applicable heightened regulatory requirements, including with respect to a firm's obligation to (i) vet complex products, (ii) put reasonable supervisory controls in place, and (iii) train registered representatives and supervisors to ensure that suitability and other obligations under FINRA rules are met.
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