A just-announced fine levied by the Financial Industry Regulatory Authority against two broker-dealers for improper sales of leveraged and inverse ETFs is highlighting the need for BD reps to brush up on their knowledge of these products, and which clients they're suitable for.
FINRA announced Thursday that it has ordered two St. Louis-based broker-dealers — Stifel, Nicolaus & Co. Inc. and Century Securities Associates Inc.— to pay combined fines of $550,000 and a total of nearly $475,000 in restitution to 65 customers in connection with sales of leveraged and inverse ETFs.
Brad Bennett, FINRA's executive vice president and chief of enforcement, warned in announcing the fine that "the complexity of leveraged and inverse exchange-traded products makes it essential for securities firms and their representatives to understand these products before recommending them to their customers." Firms, he said, must also conduct "reasonable due diligence on these and other complex products, sufficiently train their sales force and have adequate supervisory systems in place before offering them to retail investors."
In 2013, FINRA brought 19 cases involving ETFs with fines totaling more than $1.5 million and restitution of nearly $780,000.
Two recent fines that were levied involving leveraged and inverse ETFs include FINRA's order in December that J.P. Turner pay more than $700,000 in restitution for unsuitable sales of the funds and for excessive mutual fund switching. FINRA also fined in May 2012 Citigroup Global Markets Inc., Morgan Stanley & Co. LLC, UBS Financial Services and Wells Fargo Advisors LLC a total of more than $9.1 million for selling leveraged and inverse ETFs without reasonable supervision and for not having a reasonable basis for recommending the securities.
Leveraged and inverse ETFs "reset" daily, meaning that they are designed to achieve their stated objectives on a daily basis so their performance can quickly diverge from the performance of the underlying index or benchmark, FINRA explains. "It is possible that investors could suffer significant losses even if the long-term performance of the index showed a gain," the regulator says. "This effect can be magnified in volatile markets."
Between January 2009 and June 2013, FINRA found that Stifel and Century made unsuitable recommendations of nontraditional ETFs to certain customers because some reps "did not fully understand the unique features and specific risks associated with leveraged and inverse ETFs." Customers with conservative investment objectives who bought one or more nontraditional ETFs based on recommendations made by the firms' representatives, and who held those investments for longer periods of time, experienced net losses.
FINRA also found that Stifel and Century did not have reasonable supervisory systems in place, including written procedures, for sales of leveraged and inverse ETFs. The two firms generally supervised transactions in those funds in the same manner that they supervised traditional ETFs, and neither firm created a procedure to address the risk associated with longer-term holding periods in the products.
Stifel and Century neither admitted nor denied the charges but consented to the entry of FINRA's findings.
