On June 7, 2016, FINRA settled proceedings against a New York-based investment firm for alleged violations of its suitability and related rules, namely NASD Rule 2310¹ and FINRA Rules 2111² and 2010.

According to FINRA, the firm allegedly failed to, among other things:

  • establish, maintain, and enforce a reasonably designed supervisory system and written supervisory procedures (WSPs) regarding nontraditional exchange-traded funds (ETFs); or
  • enforce its WSPs.

Without admitting or denying FINRA’s findings, and to settle the proceedings, the firm consented to a censure and a $2,250,000 fine, in addition to $716,831.80, plus interest, in restitution for certain of its customers.

Nontraditional or “alternative” ETFs, such as leveraged, inverse, and inverse-leveraged ETFs, utilize investment strategies that often entail returns and performance that can differ significantly from those of their underlying indices or benchmarks during the same period of time. In FINRA Regulatory Notice 09-31, FINRA advised broker-dealers and their representatives that nontraditional ETFs “typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.” FINRA has previously sanctioned broker-dealers in somewhat similar circumstances.

Background

According to FINRA, from August 4, 2009 to September 30, 2013, the firm allegedly executed $1.7 billion of nontraditional ETF transactions in 30,740 retail brokerage accounts, with trading occurring in approximately 1,713 customer accounts serviced by more than 760 registered representatives. We note that the relevant period of the broker-dealer’s activity ended approximately three years ago; since that time, many market participants have tightened their practices and procedures as to complex products.

FINRA alleged that during this period, the firm failed to establish, maintain, and enforce a reasonably designed supervisory system or WSPs regarding the sales of nontraditional ETFs. FINRA also alleged that the firm allowed its representatives to recommend nontraditional ETFs:

  • without performing reasonable diligence to understand their risks and features; and
  • that were unsuitable for certain customers based on their age, investment objective, and financial situation.

Failure to Adequately Supervise

According to FINRA, the investment firm allegedly instituted WSPs that prohibited its representatives from soliciting retail customers to purchase nontraditional ETFs. For unsolicited purchases of nontraditional ETFs by retail purchasers, the WSPs allegedly required customer prequalification, which entailed: (1) liquid assets in excess of $500,000; (2) annual income of at least $200,000 ($300,000 combined spousal income) in the past two years; and (3) at least one year of experience trading in options.

Despite the WSPs, the investment firm, according to FINRA’s allegations, failed to enforce its requirements when it did not: (1) adequately train supervisors and registered representatives on these prohibitions; (2) prevent representatives from entering trades in the firm’s order-entry system; or (3) use an effective surveillance report to identify potentially problematic trades in violation of the firm’s policies.

According to FINRA, in certain instances, the firm allegedly allowed retail customers to make purchases of nontraditional ETFs, even though the relevant customers were not qualified — either because there was no prequalification letter on file or because the customer did not meet the prequalification criteria.

As we have pointed out from time-to-time, WSPs may be on target as to a particular rule or particular guidance from FINRA; however, following through consistently on these WSPs can be a challenge at times.

Unsuitable Nontraditional ETF Transactions

Certain alleged examples cited by FINRA include the purchase of nontraditional ETFs by an 89-year-old “conservative” customer with an annual income of $50,000 holding 96 solicited nontraditional ETF positions (for a net loss of $51,847), and the purchase by a 91-year-old “conservative” customer with an annual income of $30,000 holding 56 solicited nontraditional ETF positions (for a net loss of $11,161).

Based upon the alleged conduct, FINRA alleged that the firm violated NASD Rule 2310 and FINRA Rule 2111. In addition, FINRA alleged a violation of FINRA Rule 2010, which requires that FINRA members, in the conduct of their business, “observe high standards of commercial honor and just and equitable principles of trade.”

Conclusion

FINRA continues to review broker-dealer compliance with appropriate policies and procedures in connection with sales of complex products. Brokers should be considering both the adequacy of their WSPs as to these products, and whether they are following procedures that will ensure compliance with these WSPs.