Many investors are not aware that the broker-dealer firm with whom their financial advisor is registered has a legal obligation to reasonably supervise its employees. Accordingly, firms that fail to adequately supervise agents may be fined and penalized by regulators.
Last month, the Financial Industry Regulatory Authority (FINRA) published its Regulatory and Examinations Priorities Letter. While the express purpose of this letter is to advise stock brokers and compliance officers about the focus of the accreditation exams many of them will be taking in 2015, the letter also indirectly puts investors and securities professionals on notice.
Each month and again on a quarterly basis, the agency that regulates the financial industry, FINRA (Financial Industry Regulatory Authority), produces a detailed report that runs down all disciplinary actions recently taken against brokerage firms and brokers. This long list of alleged wrongdoing and misconduct reads a lot like a police blotter. We strongly encourage any investor who suspects their broker and/or broker-dealer of having lost them money on dubious terms to at least skim this report to see if you recognize any names.
For our part, we like to highlight certain actions from each report. Specifically, we’re looking for schemes or abuses that might be more far-reaching than the individual cases processed by FINRA. In other words, we name names here because we hope to raise awareness out there about certain brokers and products that might otherwise go unnoticed except for the case appearing in the report.
For example, if you peruse this month’s list of offenses, you’ll find one particularly tricky security popping up repeatedly: the non-traditional ETF. For more information on non-traditional ETFs, please visit our webpage dedicated to the subject here.
Here are the latest disciplinary actions related to non-traditional ETFs as announced by FINRA:
PNC Investments LLC (CRD #129052, Pittsburgh, Pennsylvania) submitted a Letter of
Acceptance, Waiver and Consent in which the firm was censured, fined $275,000 and
ordered to pay $33,183.72, plus interest, in restitution to customers. Without admitting
or denying the findings, the firm consented to the described sanctions and to the entry of
findings that it failed to establish and maintain a supervisory system, including written
procedures, reasonably designed to achieve compliance with applicable NASD and/or FINRA
rules in connection with the sale of leveraged, inverse and inverse-leveraged ETFs (nontraditional ETFs). The findings stated that non-traditional ETFs have certain risks that are
not found in traditional ETFs, such as the risks associated with a daily reset, leverage and
compounding. The performance of non-traditional ETFs over longer periods of time can
differ significantly from the performance of their underlying index or benchmark, especially
in volatile markets. Nonetheless, the firm supervised non-traditional ETFs the same way
it supervised traditional ETFs. The firm relied on its general supervisory procedures to
supervise transactions in non-traditional ETFs. However, the general supervisory system
the firm had in place was not sufficiently tailored to address the unique features and
risks involved with these products. The findings also stated that the firm failed to provide
adequate formal training to registered representatives and supervisors regarding the
features, risks and characteristics of non-traditional ETFs. The firm allowed certain of its
registered representatives to recommend to customers a non-traditional ETF without
performing reasonable diligence to understand the risks and features associated with it.
(FINRA Case #2011028232801)
Silver Oak Securities, Incorporated (CRD #46947, Jackson, Tennessee) submitted a Letter
of Acceptance, Waiver and Consent in which the firm was censured and fined $10,000.
Without admitting or denying the findings, the firm consented to the described sanctions
and to the entry of findings that it permitted a registered representative to recommend and
sell non-traditional ETFs to some of the firm’s customers. The findings stated that the firm
did not investigate the characteristics and risk factors of such products before allowing its
representative to recommend them to customers or provide its representatives any training
or other guidance specific to whether and when non-traditional ETFs might be appropriate
for their customers. The firm did not implement any procedures for supervising the firm’s
purchase and trading of non-traditional ETFs. Instead, it relied on supervisory systems
that were already in place. The findings also stated that as a result of the firm’s failure to
implement a supervisory system tailored to non-traditional ETFs, the firm did not monitor
transactions involving non-traditional ETFs, which would include tracking the volume of
customers’ holdings in non-traditional ETFs, as well as tracking the length of time open
positions were maintained in non-traditional ETFs, and any resulting unrealized losses. The
firm did not impose any limitations on trading or holding non-traditional ETFs. (FINRA Case
Stuart Alan Epley (CRD #3104478, Registered Representative, Rogers, Arkansas) submitted
a Letter of Acceptance, Waiver and Consent in which he was suspended from association
with any FINRA member in any capacity for three months. In light of Epley’s financial
status, no monetary sanction has been imposed. Without admitting or denying the
findings, Epley consented to the described sanction and to the entry of findings that he
exercised discretion without written authorization by effecting transactions in customers’
accounts without obtaining the customers’ prior written authorization and without having
his member firm’s acceptance of the accounts as discretionary. The firm did not permit
discretionary trading with the exception of very limited use of time and price discretion.
The findings stated that Epley solicited unapproved securities in customers’ accounts. Epley
mismarked order tickets in order to purchase leveraged ETFs in the customers’ accounts.
The ETF transactions were all listed as unsolicited even though Epley had solicited them. Epley mismarked the leveraged ETF transactions as unsolicited because the firm prohibited
registered representatives from recommending leveraged ETFs. Epley’s mismarking of the
order tickets caused the firm’s books and records to be inaccurate regarding these trades.
The suspension is in effect from January 6, 2014, through April 5, 2014. (FINRA Case
FINRA Orders J.P. Turner to Pay More Than $700,000 in Restitution for Unsuitable Sales o fLeveraged and Inverse ETFs and for Excessive Mutual Fund Switching
The Financial Industry Regulatory Authority (FINRA) has ordered Atlanta-based brokerdealer
J.P. Turner & Company, L.L.C. to pay $707,559 in restitution to 84 customers for sales
of unsuitable leveraged and inverse exchange-traded funds (ETFs) and for excessive mutual
Brad Bennett, FINRA Executive Vice President and Chief of Enforcement, said, “Securities
firms and their registered reps must understand the complex products they are selling and
the risks inherent to the products, and be able to determine if they are suitable for investors
before recommending them to retail customers. Firms also have a fundamental obligation
to monitor conservative investments such as mutual funds to ensure that investors are not
abused by excessive trading.”
Leverged and inverse ETFs “reset” daily, meaning that they are designed to achieve
their stated objectives on a daily basis so their performance can quickly diverge from the
performance of the underlying index or benchmark. It is possible that investors could suffer
significant losses even if the long-term performance of the index showed a gain. This effect
can be magnified in volatile markets.
FINRA found that J.P. Turner failed to establish and maintain a reasonable supervisory
system and instead, supervised leveraged and inverse ETFs in the same manner that it
supervised traditional ETFs. The firm also failed to provide adequate training regarding
these ETFs. In addition, J.P. Turner allowed its registered representatives to recommend
these complex ETFs without performing reasonable diligence to understand the risks
and features associated with the products. As a result, many J.P. Turner customers held
leveraged and inverse ETFs for several months. J.P. Turner also failed to determine whether
the ETFs were suitable for at least 27 customers, including retirees and conservative
customers, who sustained collective net losses of more than $200,000.
FINRA’s investigation was conducted by the departments of Enforcement and Member Regulation
For the full February report by FINRA, please visit their website: www.finra.org
News of the perils for retail investors of the complex financial products known as non-traditional ETFs has been fast and furious this year. This shouldn’t be too surprising. Non-traditional ETFs are the “it” investment these days: they have continued to grow in popularity, with their largest year-end proportion ever in 2013. According to Morningstar reporting, these exotic funds now account for 13.2% of all fund assets as of November. If you’re not familiar with non-traditional ETFs, chances are you will be soon: their popularity, in spite of several high profile lawsuits related to inappropriate use and unsuitability claims, seems unstoppable. The latest lawsuit involves a broker-dealer called “Stifel Financial Corporation.” According to a recent article, the securities industry watchdog FINRA (Financial Industry Regulatory Authority), fined and censured Stifel Nicolaus and Century Securities $550,000 and ordered restitution payments of $475,000 to a combined more than 60 customers for misconduct related to the recommendation and sale of leveraged and inverse ETFs.
And it’s happening all the time.
For the very simple reason that far too many brokers who recommend and sell non-traditional ETFs to customers do not understand how they work. And their brokerage firms do not educate and/or supervise these brokers adequately.
FINRA’s crackdown on offenses connected to non-traditional ETFs is good news for investors whose portfolios have been damaged by these products and their improper use by clueless brokers.
Now, we’ve already said a lot about the havoc non-traditional ETFs have wreaked--but what are they?
Well, since you asked… Non-traditional ETFs are complex financial products designed to achieve specific performance results on a daily basis. An ETF or “Exchange-Traded Fund” is typically a registered investment company whose shares represent an interest in a portfolio of securities that are linked to a specific benchmark or index. (Some ETFs, for example, those invested in commodities or currencies, may not however be registered). ETFs are funds, but unlike traditional mutual funds, they are traded throughout the day on a securities exchange at market prices.
Non-traditional ETFs include both leveraged and inverse ETFs as well as leveraged inverse ETFs. Leveraged ETFs aim to deliver multiples of the performances of the underlying index or benchmark that the fund is tracking. Inverse ETFs or “short funds” on the other hand deliver the opposite of the index or benchmark. Some ETFs are both leveraged and inverse, in which case they combine qualities from both categories of ETFs, hoping to deliver multiples on the inverse of the performance of the index or benchmark. These are called “leveraged inverse ETFs” or “ultra-short funds.” To achieve results, non-traditional ETFs deploy various investment strategies that include swaps, futures contracts, and other derivative instruments. Again, and most crucially, both leveraged and inverse ETFs are designed to give results on a daily basis only.
On a daily basis, non-traditional ETFs “reset.” This key characteristic of the product is the one most often misunderstood or misapplied by investors and professional financial advisors alike. Since leveraged and inverse ETFs are intended for daily use only, holding shares in them for longer-term investment can be dangerous due to the effects of compounding, particularly in volatile markets. Non-traditional ETFs can be an effective means of trading and shorting within a complex investment strategy when closely monitored by a financial professional. However, they are typically not suitable for intermediate or long-term investment and any financial advisor who uses them in this way may be guilty of misconduct and/or unsuitability.
If you’ve gotten this far, you now probably know more than most brokers about how this product works.
If you or anyone you know has been the victim of broker misconduct or investment fraud, please contact us immediately at 1-855-462-3330.