FINRA recently announced a disciplinary proceeding that underscores its continuing concerns about unsuitable retail sales of structured products. In a recently settled formal disciplinary proceeding, FINRA censured a registered broker-dealer and ordered it to pay restitution to customers and others who lost money trading in, among other things, non-traditional exchange-traded funds (ETFs).
FINRA’s action relates to sales of leveraged ETFs (which deliver a daily return based on multiples of the performance of a benchmark or index), inverse ETFs (which deliver the opposite of the daily performance of a specific benchmark or index), and ETFs that are both inverse and leveraged. A daily “reset” feature of such non-traditional ETFs means that these products are designed to meet their objective only on a daily basis. As a result, their performance over time may differ significantly from the performance of the underlying index or benchmark. This effect can be magnified in volatile markets.
The order notes the growth in popularity of non-traditional ETFs after 2006, and finds that the sales at issue occurred between January 2008 and August 2009. FINRA found that the broker-dealer firm failed to establish and maintain a supervisory system and written procedures reasonably designed to monitor transactions in non-traditional ETFs. Rather, FINRA said that the firm monitored non-traditional ETFs in the same way that it monitored traditional ETFs until FINRA issued a Regulatory Notice regarding non-traditional ETFs in 2009, and failed to take into consideration, for example, risks associated with longer-term holding periods. FINRA also found that the firm failed to provide adequate formal training to its brokers and supervisors regarding the features, risks and characteristics of non-traditional ETFs until after FINRA issued its Regulatory Notice.
FINRA found that the firm failed to satisfy its reasonable-basis suitability obligation by allowing its brokers to recommend the non-traditional ETFs without performing reasonable diligence to understand the risks and features of the products. FINRA also found that the firm failed to determine customer-specific suitability for at least 27 customers who lost money. The products were unsuitable, FINRA found, because they were held in those customers’ accounts for extended time periods, subjecting the customers to the effect of compounding and daily resets.
FINRA also found that certain of the firm’s registered representatives engaged in a pattern of unsuitable mutual fund switching and that it failed to maintain adequate supervisory procedures designed to prevent such switching.