In the end, FINRA didn't like the way a member firm supervised its sales of leveraged- and inverse-Exchange Traded Funds; and, the regulator dragged up that old standby "suitability" charge. What could have been another droll bit of regulation, however, winds up opening your eyes and making your jaw drop when you read through some of the examples of ETF investments cited by FINRA. All in all, an excellent bit of regulation with some helpful warnings to both the industry and unwary investors.
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, Broker Dealer Financial Services Corp., submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Broker Dealer Financial Services Corp., Respondent (AWC 2012030436501, May 21, 2015).
Broker Dealer Financial Services Corp. ("BDFS") has been a FINRA member firm since 1979 and presently employs about 270 registered representatives. The AWC asserts that the firm had no prior relevant disciplinary history.
Investigate, Train, Supervise, and Monitor
The AWC alleges that between March 1, 2009 and April 30, 2012, BDFS failed to establish and maintain a supervisory system reasonably designed to ensure that the firm's sales of leveraged or inverse exchange-traded funds ("NETFs") were compliant. Pointedly, the AWC asserts that BDFS did not:
investigate NETFs before allowing its registered representatives to recommend them to customers;
train its personnel in the appropriate use of NETFs, and
adequately supervise and monitor NETF activity in customer accounts.
FINRA deemed BDFS's conduct to be in violation of NASD Conduct Rule 2010 and FINRA Rule 2010.
Further, the AWC alleges that between March 2009 and April 2012, BDFS, acting through some of its registered representatives, recommended NETFs to more than 200 customers. The AWC asserts that the firm had not previously investigated the features and risks associated with NETFs and lacked a reasonable basis for believing that the recommended transactions were suitable for any investor.
FINRA deemed BDFS's conduct to be in violation of NASD Conduct Rule 2310 and FINRA Rules 2111 and 2010.
As with many published regulatory settlements, the AWC sets forth a somewhat dry, prosaic version of events that wags a finger at failures to investigate, train, supervise, monitor -- all of which sort of culminates in the over-filled catch basin of "suitability." In this AWC, however, FINRA offers us some stunning examples of how BDFS's cited misconduct manifested itself in the real world:
In 2010, following the recommendation of a BDFS registered representative, a customer bought shares of two inverse, triple leveraged ETFs for a total of $7,544. The customer's stated net worth was under $49,000 and primary investment objective was "conservative growth & income." The customer held the positions for two and a half years before selling them for a total of $848 -a loss of nearly 90%.
ln early 2011, a BDFS registered representative recommended that a 73-year-old customer with a stated net worth of $100,000- $199,000 and a primary investment objective of "conservative growth & income" purchase an ETF designed to return three times the inverse of the daily performance of the Russell 1000 Financial Services Index. The customer purchased shares of the ETF for $5,015 and held the position for more than three years before selling at a loss of $4,535.24 - approximately 90% of the original purchase price.
In late 2009 and early 2010, on the recommendation of a BDFS registered representative, a customer purchased 300 shares of an inverse, double-leveraged ETF for a total of $12,768. The customer, who had a liquid net worth of less than $49,000 and a primary investment objective of"conservative growth & income," held the shares for more than three years before selling them at a loss of $8,586.82, which constituted nearly two-thirds of the original investment.
FINRA's 2009 Warning
In order to better understand the issues in this matter, read:
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 accordance with the terms of the AWC, FINRA imposed upon BDFS a Censure and $75,000 fine. Additionally, BDFS made $24,564.18 in restitution to five customers with conservative investment objectives who had suffered losses in NETF positions held for extended time periods.
Statement of Corrective Action of Broker Dealer Financial Services Corp.
This matter concerns certain practices by Broker Dealer Financial Services Corp. ("BDFS") regarding certain exchange-traded funds ("non-traditional ETFs") during the period identified in the AWC, March 1, 2009 -April 30, 2012 ("the relevant period"), which ended over three (3) years ago. Although, as indicated in the AWC, BDFS's procedures during the relevant period contained a brief mention of nontraditional ETFs, these transactions comprised an extremely small portion of BDFS's revenue during the relevant period. Nevertheless, BDFS, beginning in 2012, instituted a policy whereby it does not permit transactions involving non-traditional ETFs, except in instances in which a client wants to liquidate an open position. Consequently, the conduct at issue in this matter is unlikely to occur again in the future. Further, as reflected in the AWC, BDFS has already made restitution to certain customers who suffered losses in their BDFS accounts relating to non-traditional ETFs. BDFS has also already provided FINRA with proof of such restitution payment amounts.
This Statement of Corrective Action is submitted by BDFS. It does not constitute factual or legal findings by FINRA, nor does it reflect the views of FINRA or FINRA Staff.
Bill Singer's Comment
FINRA AWCs permit the attachment of a Corrective Action Statement to demonstrate the steps taken by a respondent to prevent future misconduct subject to the understanding that such an attachment may not deny the charges or make any statement that is inconsistent with the AWC. Further the Corrective Action Statement does not constitute factual or legal findings by FINRA, nor does it reflect the views of FINRA or its staff.
What are we to make of BDFS's Corrective Action Statement? For starters, the member firm seems to try to make the point that it had supervisory procedures addressing NETFs. Apparently not wanting to invoke the ire of FINRA, having made that favorable point, the member firm characterizes the nature of the NETFs procedures as a "brief mention."
On top of the "brief" reference, we are then told that the cited NETFs "comprised an extremely small portion of BDFS's revenue." Frankly, not only is that beside the point but it tends to inappropriately minimize the detriment suffered by investors who were deemed to have made unsuitable investments based upon the firm's inappropriate recommendations. The way I see it, an alleged murderer could similarly argue that the shooting of the victim only took a brief, few seconds and the entry wound from the bullet was extremely small. As is often the case, a customer's life savings can suffer financial devastation in a brief period of time based upon a small number of trades. Frankly, I'm a bit surprised that FINRA permitted those two references in the Corrective Action Statement. It may be a small world from BDFS's view but I wish that FINRA had not allowed that assertion to go unchallenged.
I am no fan of Corrective Action Statements and rarely, if ever, advocate their use. Given that the premise of an AWC is a settlement made without admitting or denying the findings, I don't understand why anyone would prepare a statement that tends to typically make admissions, promises to correct situations that have not necessarily been acknowledged, and, in the end, simply draws more undesired attention to the matter. If you feel compelled to attach a Corrective Action Statement, then you may want to pause before signing the AWC and ask yourself if you might not be better advised to argue your case before a Hearing Panel and, if necessary, on appeal afterwards.
If you conclude that the costs and/or risks of contesting the charges aren't worth it, then just sign the damn AWC and get over it. There's no need whatsoever to engage in a post-game, public analysis. Some think that this after-the-fact statement gives you a parting shot at unfair regulation or an opportunity to put your own spin on the matter. I would suggest that you simply avoid the temptation. Keep in mind that a Corrective Action Statement may actually set you and your firm up for heavier sanctions down the road if you acknowledge wrongdoing and propose a set of remedial actions. If during subsequent examinations, a regulator finds that you engaged in similar misconduct to that discussed in the statement, or, it is alleged that you failed to implement the promised revised policies and procedures, your own words may prove blunt instruments used to beat you into submission. Notwithstanding my opinion, BDFS apparently determined that it was advisable to submit a Corrective Action Statement.