In August 2017, FINRA entered into a consent agreement with a Georgia-based broker-dealer arising from improper practices and procedures relating to its sales of leveraged ETFs.12 The sales included ETFs that were leveraged, inverse, or both inverse and leveraged, and that were sold to retail accounts. The action reflects FINRA's continuing concerns about the procedures that its members have used to approve and monitor sales of these products.13
This action follows a somewhat similar action in June 2017. In the June 2017 proceeding, FINRA determined that a broker-dealer did not perform adequate pre-sale due diligence or post-sale reviews in connection with sales of these types of ETFs, in contravention of its own written supervisory procedures.14
Supervisory Procedures and Reasonable Basis Suitability
FINRA determined that the broker-dealer did not establish and maintain a supervisory system, including written procedures, reasonably designed to ensure that its offerings of the ETFs complied with relevant rules. The firm had permitted its representatives to recommend the ETFs without establishing a general supervisory system that was sufficiently tailored to address the unique features and risks involved with these products, in violation of FINRA Rule 2010. The firm did not perform any reasonable basis suitability analysis of these ETFs in order to understand these features and risks before offering them to retail customers. FINRA also found that the broker-dealer and its registered representatives did not fully understand the features and risks of these products, resulting in unsuitable recommendations to customers that had conservative and moderate investment objectives and risk tolerances, including a number of elderly investors, in violation of FINRA's suitability rules, including Rules 2111 and 2010.
In 2009, when publicity increased about the risks of these products, the broker-dealer did not maintain any reasonable supervisory system or written procedures to monitor their recommendations. However, at the end of 2009, following the release of FINRA Notice 09-31, the broker-dealer prohibited the offering of these ETFs that had more than 2x leveraged and/or inverse performance of the relevant underlying index and revised its written procedures to address this prohibition. However, the broker-dealer did not revise its procedures to address the risks posed by these ETFs that involved 2x or less leveraged and/or inverse performance of an underlying index. Accordingly, these recommendations continued.
Similarly, the broker-dealer did not produce exception reports or any alerts in its trade review system that addressed the risks of these ETFs.15 It did not implement a supervisory system to review the recommendations of the ETFs arising from a customer's age, investment objective, risk tolerance, or financial profile. These failures resulted in recommendations to retail investors for whom they were not suitable.
Extended Holding Periods
FINRA determined that the broker-dealer's general supervisory procedures were insufficient to address the unique features and risks involved with these products, including that their performance over longer periods of time can differ significantly from the performance of their underlying index. Accordingly, for several years, the broker-dealer did not develop any system or procedure to monitor, review, or evaluate the length of their holding periods.
In May 2012, the broker-dealer implemented a monthly report reflecting the holdings of these ETFs in retail customer accounts. However, FINRA determined that the broker-dealer's supervisors did not receive guidance on how to evaluate holding periods or address the risks related to long-term holding periods. As a result, even after these reports were generated, many retail customer accounts held these ETFs for long periods (in some cases, more than 1,000 days).16 Retail customers holding these ETFs for extended periods of time incurred significant losses.
Accordingly, FINRA determined that the broker-dealer violated, for example, FINRA Rule 2010, due to its failure to establish and maintain a supervisory system, including written procedures, reasonably designed to achieve compliance with applicable rules for the sales of these products.
· As a result of these factors, the broker-dealer consented to several sanctions:
· a fine of $100,000; and
· restitution to certain customers in the amount of approximately $500,000.
FINRA's notices have made clear that it intends to carefully scrutinize broker-dealer procedures when complex securities are sold, particularly when they result in losses to vulnerable investors. Broker-dealers are strongly encouraged to periodically review their written supervisory procedures to ensure that they reflect the products that are being offered and FINRA's guidance.
In particular, broker-dealers, before offering complex products to retail customers, should be able to demonstrate that they conducted an adequate reasonable basis suitability analysis and trained their registered representatives as to their features and risks. Some products, such as the ETFs in question, are not designed to be held for significant periods of time; monitoring systems must be appropriately tailored to monitor the holding periods for these products and to determine whether they are consistent with firm recommendations.