We’re a little behind on our posts lately due to a serious family illness. That’s why we only just saw the May 1 notice from the Financial Industry Regulatory Authority (FINRA) that it recently assessed Citigroup; Morgan Stanley; UBS; and Wells Fargo Advisors a total of more than $9 million in sanctions and restitution for selling leveraged and inverse exchange-traded funds (ETFs) without reasonable supervision and without having a reasonable basis for recommending the securities.
As we’ve written before, ETF shares represent an interest 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 the opposite of the performance of the index or benchmark they track, profiting from short positions in derivatives in a falling market. Some ETFs are even leveraged and inverse.
Each of the four sanctioned firms sold billions of dollars of these ETFs to customers, some of whom held them for extended periods when the markets were volatile. As we explained in this blog back on March 6, 2012, it’s almost never appropriate to hold these things for longer than a day or two. Leveraged and inverse ETFs have their market exposure reset on a daily basis, and when held for longer periods of time, particularly in volatile markets, investors are subjected to the risk that the performance will differ significantly from the performance of the underlying index or benchmark.
FINRA’s Chief of Enforcement said in the regulator’s May 1 notice, “The added complexity of leveraged and inverse exchange-traded products makes it essential that brokerage firms have an adequate understanding of the products and sufficiently train their sales force before the products are offered to retail customers. Firms must conduct reasonable due diligence and ensure that their representatives have an understanding of these products.” But FINRA found that the sanctioned firms didn’t 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 didn’t have a reasonable basis to recommend the ETFs to their retail customers. Moreover, the firms’ brokers made unsuitable recommendations of leveraged and inverse ETFs to some customers who had conservative investment objectives or risk profiles.
In other words, brokers at these firms and the firms themselves didn’t understand what they were selling, had no real interest in learning about what they were selling, and sold what they were selling to lots of people who had no business buying it. In the old days, deceived townfolk used to tar and feather snake-oil salesmen. Now the snake-oil peddlers get fined the equivalent of a few cents and someone issues a notice about it.
Don’t be filled with confidence in your brokerage firm just because only these four firms were sanctioned. Others may be next, and you can bet that if sales abuses involving leveraged and inverse ETFs are occurring at these four big wire houses, they’re occurring pretty much everywhere. If you haven’t purchased these investments, you’re lucky. If you have purchased them and haven’t yet taken much loss, get rid of them and consider finding a new broker. If you’ve lost money holding leveraged or inverse ETFs in your account – the names might include words like Ultra, 2X, 3X, Double Long, or Inverse – call us. We may be able to help you recover your losses.
Hugh Berkson is a Securities Attorney with McCarthy, Lebit, Crystal & Liffman, Co. LPA. Hugh is rated AV® Preeminent™ by Martindale-Hubbell®.
He obtained a business degree in Finance from the University of Texas at Austin in 1989, and is a 1994 graduate of Case Western Reserve University School of Law, where he was a member of the Order of the Barristers and received both the American Jurisprudence Award, (National Mock Trial) in 1993 and the Jonathan M. Ault Mock Trial Prize for 1993-1994.
