In November 2015, FINRA fined a member firm after the member firm published inaccurate levels for a proprietary index. In this case,2 FINRA demonstrated that index levels published by a member firm can be subject to review and enforcement under FINRA’s communication rules.
The member firm maintained a variety of indices that related to certain European asset-backed securities. The indices were used by approximately 40 institutional investors in Europe and were not the underlying asset for any structured notes or derivative products. However, for several years, the indices were published with inaccurate coupon return information. The relevant division of the member firm became aware of these errors and the fact that they would need to revise the historic index levels. However, the member firm continued to publish the indices for several months, without disclosing the inaccuracies to subscribers. Later, the member firm restated the index levels, disclosing that it had understated coupon returns on the relevant securities.
The index errors arose following a variety of calculation and process changes made by the member firm.
On the basis of these facts, FINRA determined that several of its rules were violated.
Just and Equitable Principles of Trade (FINRA Rule 2010). FINRA concluded that the member firm violated this rule in that index subscribers had a reasonable expectation that the member firm would inform them of significant inaccuracies. However, the member firm did not do so and continued to publish the index with inaccurate levels.
Supervision (NASD Rule 3010(a) and FINRA Rule 2010). FINRA concluded that the member firm violated these rules by failing to properly test the index methodology after its calculation changes were made.
Communications with the Public (NASD Rule 2210 and FINRA Rules 2210 and 2010). FINRA concluded that the member firm violated these rules, particularly because the member firm knew it was providing inaccurate information.
Application to Other Indices and Other Materials
The case is relevant to proprietary indices and other statistical information that broker-dealers engaged in the structured products industry provide to their customers. For example, in addition to disseminating the levels of proprietary indices, some broker-dealers make available to customers information about the performance since the pricing date of the underlying asset for an outstanding structured note’s reference asset or the performance of particular notes that have matured. This type of information may help an investor evaluate the value of its current holdings or to assess future investment opportunities.
Of course, knowingly providing incorrect information would be highly problematic under any standard. However, the case stands for the principle that, even if incorrect information is unintentionally disseminated, FINRA will scrutinize a member firm’s procedures to determine whether they were carefully designed to prevent this from happening. FINRA’s communications rules can be applied to these types of documentation, and an appropriate process should be in place to ensure the accuracy of the information that is set forth.
In this case, the index wasn’t used as a reference asset for a structured note or similar product. The inclusion of erroneous index data in an FWP or pricing supplement for a structured note would be even more problematic, as it could also be a basis for a claim for damages or rescission under the federal securities laws.