On May 1, 2012, FINRA announced that it had sanctioned four member firms a total of 9.1 million, including fines of $7.3 million and restitution of $1.8 million, for selling leveraged and inverse exchange-traded funds (“ETFs”) without reasonable supervision and without a reasonable basis for recommending the securities. Each firm entered into an Acceptance, Waiver and Consent (“AWC”) resolving the FINRA investigation. In settling the matters, the firms neither admitted nor denied the charges, but consented to the entry of FINRA’s findings.
Background. ETFs typically invest in a portfolio of securities that track an underlying benchmark or index. Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs seek to deliver performance that is the opposite of the performance of the index or benchmark they track (e.g., by using short positions in derivatives to profit from a falling market). In FINRA Regulatory Notice 09‑31, published in June 2009, FINRA explained that most leveraged and inverse ETFs reset daily, meaning that they are designed to achieve their stated objectives on a daily basis. Firms are required to perform a customer-specific suitability review before recommending securities to customers and, in the view of FINRA, inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.
Findings. FINRA found that from January 2008 through June 2009, the firms did not have adequate supervisory systems in place to monitor the sale of leveraged and inverse ETFs, and failed to conduct adequate due diligence regarding the risks and features of the ETFs. As a result, the firms did not have a reasonable basis to recommend the ETFs to their retail customers. FINRA also found that the firms’ registered representatives made unsuitable recommendations of leveraged and inverse ETFs to some customers with conservative investment objectives or risk profiles. According to FINRA, each of the firms sold billions of dollars of leveraged and inverse ETFs to customers, some of whom held them for extended periods when the markets were volatile.
FINRA’S findings covered sales during the period ending June 2009, when it first cautioned members in Regulatory Notice 09-31 with respect to leveraged and inverse ETFs. The penalties levied by FINRA reflect a determination that the firms should have known that the investments were unsuitable for some retail customers even in the absence of notice by FINRA. FINRA has more recently advised member firms about the obligation to provide heightened supervision with respect to complex products generally, in Regulatory Notice 12-03 .