In September 2019, FINRA censured and fined a Florida-based broker-dealer, including for failing to reasonably supervise sales of complex securities such as structured products and leveraged, inverse and inverse-leveraged exchange-traded funds ("Non-Traditional ETFs"). The broker and its Director of Investment Banking, without admitting or denying FINRA's findings, accepted FINRA's sanctions in a Letter of Acceptance, Waiver, and Consent (the "AWC"). A copy of the AWC can be found here.
FAILURE TO REASONABLY SUPERVISE SALE OF STRUCTURED PRODUCTS
According to the AWC, for a period of approximately two years, a significant portion of the broker's business consisted of the sale of structured products, including mainly non-principal protected structured notes (most commonly, "steepeners"), which are often understood to carry much greater risk compared with, for example, principal protected products.
According to FINRA's findings, the broker established a system to supervise the suitability of recommendations of structured products. The system centered on "product profiles" that described the risks and characteristics of each structured product, and restricted the sale of each such product to certain types of customers. However, the broker failed to have supervisory system or written procedures in place to ensure that its representatives would comply with the product profiles when making structured product recommendations.
FAILURE TO REASONABLY SUPERVISE SALE OF NONTRADITIONAL ETFS
Non-Traditional ETFs are designed to offer a return that is a multiple of an underlying index or benchmark, the inverse of that benchmark, or both over the course of one trading session (usually a single day). Because the performance of NonTraditional ETFs over periods longer than a single trading session can correlate poorly with the performance of their underlying index or benchmark, these products carry significant risks and are typically not suitable for retail investors who plan to hold them for more than one trading session.
The broker apparently appreciated the risks associated with Non-Traditional ETFs, and prohibited solicited sales of Non-Traditional ETFs. However, according to FINRA's findings, for approximately three years, the broker failed to reasonably enforce this prohibition, as it allowed its surveillance software relating to Non-Traditional ETFs to become outdated. As a result, at least 95 undetected prohibited Non-Traditional ETF sales were executed during the relevant period.
With no supervisory system in place other than the prohibition, FINRA determined that the broker failed to supervise recommendations by its representatives to purchase these undetected sales of Non-Traditional ETFs; in a majority of these sales, customers held these products for extended periods up to two years or more.
The AWC confirmed FINRA's censure of the broker for violating FINRA and NASD rules and the imposition of a $250,000 fine.1
This case illustrates the importance for brokerdealers to establish and enforce proper surveillance systems and written procedures to ensure the suitability of its sale recommendations, especially when dealing with complex securities. In this case, the risks associated with structured products and Non-Traditional ETFs were generally understood and appreciated by the broker. However, due to an inadequate surveillance system, which was not properly updated, the broker's representatives, who made the relevant sale recommendations, did not similarly understand the high risk and were allowed to make undetected unsuitable sales.