You better sit down before you read today's BrokeAndBroker.com Blog. Publisher Bill Singer has something complimentary to say about both an AWC and FINRA! Yeah, shocking. Equally odd is the fact pattern involving a stockbroker's misunderstanding of the mechanics of the VXX. Of course, Bill still felt the need to take a couple of shots at FINRA near the end of his comment but, you know, old habits die hard.
Case In Point
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, James Flower submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of James Flower, Respondent(AWC 2014040644001, June 12, 2017).
The AWC asserts that Flower was first registered in 1997 and by 2010 he became registered with FINRA member firm Global Arena Capital Corp. The AWC asserts that "Flower has no disciplinary history."
SIDE BAR: Read about the variations in FINRA AWCs pertaining to the presentation of a respondent's background: "FINRA's Foolish Inconsistency" (BrokeAndBroker.com Blog,June 9, 2017)
It Ain't Vice Versa VXX
The AWC asserts that in 2013 and 2014, Flower recommended to 13 customers that they invest in the iPath S&P 500 VIX Short-Term Futures Exchange Traded Note, which is more commonly known as the VXX. Pursuant to Flower's recommendation, those 13 customers made 58 purchases and 39 sales (holding periods purportedly ran from two weeks to over a year) of the VXX. As alleged in the AWC:
At the time he was recommending the VXX, Flower incorrectly believed that it traded inverse to the S&P 500 index. This erroneous perception led him to recommend that customers purchase and hold the VXX as a hedge to an anticipated overall market decline.
Now that's one hell of an oops. You ever see a video of those folks walking up the down escalator?
The AWC asserts that the thirteen customer who had invested in VXX pursuant to Flower's recommendation sustained over $249,000 in losses.
FINRA deemed that Flower's misunderstanding of the VXX resulted in his inability to form a reasonable basis upon which to recommend the purchase of the VXX to his customers, thus constituting an unsuitable recommendation in violation of FINRA Rule 2111(a) and 2010. Pointedly, the AWC states that:
The VXX is an exchange-traded note that offers investors exposure to the returns of one- and two-month futures contracts on the CBOE Volatility Index (the "VIX Index"). The VIX Index is designed to measure the market's expectations of volatility in large cap U.S. stocks over the next 30-day period. Although the VXX moves in the opposite direction of the index it tracks, it has its own independent risks. Most significantly, it is generally expected to lose value as time moves on, and thus it is rarely if ever considered to be a prudent long-term investment. The value of futures contracts on the VIX Index generally decreases over time. As a result, the VXX is rarely if ever suitable as a long-term investment, but instead is generally held for brief periods measured in days for short-term speculation or to hedge a portfolio against a market downturn, rather than months or even weeks.
In accordance with the terms of the AWC, FINRA imposed upon Flower a three-month suspension from association with any FINRA member firm in any capacity. The AWC noted that on February 10, 2016, Flower was granted a discharge in bankruptcy; accordingly, no fine was imposed. The AWC additionally imposed a requirement that within 60 days of the notice of the AWC that Flower will:
undertake to attend and satisfactorily complete ten hours (10) hours of continuing education concerning complex products, which includes exchange traded notes, by a provider not unacceptable to FINRA. Within 30 days of following completion of such training, Flower will submit written proof that the continuing education program has been satisfactorily completed. . .
Bill Singer's Comment
Now that's what a published, public regulatory settlement should look like! Bravo to FINRA!!
This AWC offers sufficient content and context so that readers come away with a very clear understanding of what went wrong and FINRA's rationale for imposing sanctions. Further, the sanctions imposed are not only appropriately measured to fit the misconduct but FINRA came up with a superb bespoke undertaking that could not be better tailored to address the underlying lack of competency.
Exchange-traded funds (ETFs) that offer leverage or that are designed to perform inversely to the index or benchmark they track-or both-are growing in number and popularity. While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.
This Notice reminds firms of their sales practice obligations in connection with leveraged and inverse ETFs. In particular, recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended; sales materials related to leveraged and inverse ETFs must be fair and accurate; and firms must have adequate supervisory procedures in place to ensure that these obligations are met. . .
In contrast to FINRA's VXX description, let's consider what's provided on the iPath website's Product Summary:
The iPath S&P 500 VIX Short-Term FuturesTM ETNs (the "ETNs") are designed to provide exposure to the S&P 500 VIX Short-Term FuturesTM Index Total Return (the "Index"). The ETNs are riskier than ordinary unsecured debt securities and have no principal protection. The ETNs are unsecured debt obligations of the issuer, Barclays Bank PLC, and are not, either directly or indirectly, an obligation of or guaranteed by any third party. Any payment to be made on the ETNs, including any payment at maturity or upon redemption, depends on the ability of Barclays Bank PLC to satisfy its obligations as they come due. An investment in the ETNs involves significant risks, including possible loss of principal and may not be suitable for all investors.
The Index is designed to provide access to equity market volatility through CBOE Volatility Index (the "VIX Index") futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects market participants' views of the future direction of the VIX index at the time of expiration of the VIX futures contracts comprising the Index. Owning the ETNs is not the same as owning interests in the index components included in the Index or a security directly linked to the performance of the Index. For additional information regarding the risks associated with the ETNs, please see "Selected Risk Considerations" below.
Under the Correlations Tab for the Product Summary (as of "05/31/2017"), we are informed on the iPath webpage that:
Correlation is a term used to describe the statistical relationship between two or more quantities or variables. Perfectly correlated assets will have a correlation coefficient of one, while the correlation coefficient will be zero when returns on two assets are completely independent.
The "Correlations" presented on that webpage for the VXX disclose:
S&P 500 VIX Short-Term Futures Index TR: 1.00
Barclays US Aggregate Bond Index: 0.00
Bloomberg Commodity Index Total Return: -0.23
MSCI Emerging Markets Net Total Return Index: -0.52
MSCI EAFE Net Total Return Index: -0.74
S&P 500 Total Return Index: -0.79
So . . . what are we to make of this? How do we reconcile FINRA's warnings about the use and suitability of the VXX with the online disclosures by iPath?
Many market professionals question the utility and integrity of VXX. As such, given FINRA's ongoing concerns about the efficacy and suitability of VXX for some investors, why is this product allowed to trade -- or allowed to trade without more regulatory restrictions? We have specific approval protocols for trading options and pennystocks, why are there not similar restrictions on this ETN and other similar so-called exotic instruments? Mind you, I am not necessarily calling for such restrictions but in the role of an agent provocateur raising the issue.
Assuming that, arguendo, Flower is personally liable for the unsuitability of his VXX recommendations, where was his firm's Compliance Department? After all, if the unsuitability of this product - or this product as a suggested hedge - is so clear to FINRA, why didn't a compliance officer immediately reject or cancel the trade as patently unsuitable as a hedge? Sometimes the answer is that the compliance staff didn't know and had no reason to. Sometimes the answer is that compliance staff wasn't properly supervising (or was overwhelmed and understaffed). Sometimes the answer is that compliance staff didn't care.
As readers of the BrokeAndBroker.com Blog know, I have long advocated for a re-tooling of Wall Street's registration system and have pointedly called for "licensing" individuals on a product by product basis rather than the overly expansive registration "Series" that is presently in favor. Keep in mind that Flower is a 20-year-industry-veteran stockbroker and was unleashed upon the investing public with a vice-versa understanding of the VXX. Sure, it's funny; however, it's also very sobering and a bit scary. It underscore how meaningless Wall Street's professed registration and continuing education system truly is. See, for example: "Wall Street Critic Bill Singer Revisits His 2009 Reform Proposals" (BrokeAndBroker.com Blog, April 22, 2016)., in which I referenced the following 2009 proposals that FINRA never pursued or consulted with me about:
Two-year program (Compliance/regulatory component; product updates; third-party, industry groups, regulators, and employer providers)
initial certification of individuals to sell each designated product
bi-annual update module every two-years (limited to materially new product developments or regulatory events)
. . .
The Financial Services Professional (FSP)
In furtherance of that approach, I urge the implementation of a uniform licensing model. For starters, most financial professionals should be required to pass an entry-level examination that tests for basic knowledge of the building-block financial products and the regulations governing their sale. You pass that test, and you are entitled to bill yourself as a Financial Services Professional (FSP).
Once you have that base title, the FSP has to earn the right to sell more sophisticated products, or offer more sophisticated services. Just as folks looking to hold themselves out as Certified Financial Planners (CFPs) must study, gain certification, and abide by professional rules, we should look to extend that form of certification. We should implement a system whereby the right to sell specific financial products requires the passing of product-specific examination with attendant continuing education obligations. If you haven't passed the test and don't maintain your continuing education credits, then you lose the right to use the titles and engage in the product solicitations.
Accordingly, we must create a rigid system by which FSPs disclose to the public their specific product/service qualifications: everyone uses the same title and only that title. You pass the options certification, perhaps you can note on your business card or during presentations that you are an FSP with the additional designation of an Options-FSP -- but that's it. No options specialist or options investment counselor. One size fits all.