FINRA Sanctions Brokerage Firms$9.1 Million For Leveraged ETF Sales

The Financial Industry Regulatory Authority ("FINRA") announced on May 1, 2012 that it ordered brokerage firms Citigroup Inc. (C), Morgan Stanley (MS), UBS AG (UBS) and Wells Fargo & Co. (WFC) to pay a combined $9.1 million for allegedly improper sales of leveraged and inverse exchange-traded funds ("ETFs"). FINRA fined the brokerage firms a total of more than $7.3 million and also ordered them to pay $1.8 million in restitution to investors who bought the ETFs. This could be the tip of the iceberg in holding brokerage firms responsible for ETF investment losses.

FINRA said the brokerage firms failed to reasonably supervise sales of leveraged and inverse ETFs. Leveraged and inverse ETFs are designed for short-term trading, rather than for long-term investors. Unfortunately, many stockbrokers do not fully understand the products and improperly recommended them to investors as long-term, buy-and-hold investments, similar to mutual funds.

Leveraged ETFs use futures or derivatives in an effort to double or triple the return of an index. Inverse leveraged ETFs seek to return double or triple the opposite of the return of the index. For example, a 3X inverse leveraged ETF would seek to achieve growth of 30% when an index declines by 10%. Over periods longer than a day, the compounding effect of leveraged ETFs can lead to results that vary significantly from the one-day outcome, making them unpredictable and highly risky to hold for more than one day. Again, however, many stockbrokers did not appreciate the nature of leveraged ETFs or the risks associated with them. In turn, many stockbrokers failed to adequately explain leveraged ETFs to investors, resulting in misrepresentations and omissions about the risks and nature of ETFs.

FINRA said that each of the four brokerage firms sold billions of dollars of leveraged ETFs to investors. FINRA found that the brokerage firms did not have adequate supervisory systems to monitor the sales of the ETFs and did not conduct adequate due diligence on ETFs' risks and features. Because of this, the brokerage firms did not have a reasonable basis to recommend the ETFs to their retail customers, FINRA said. In addition, the stockbrokers made unsuitable recommendations of leveraged and inverse ETFs to some customers who had conservative investment objectives and risk profiles, FINRA said.

As a result of the improper way in which leveraged ETFs were recommended and sold to investors, many brokerage firms have increased their oversight over their brokers' sales of these products or have prohibited their sale altogether.

As is typical in settlements with FINRA, the brokerage firms consented to FINRA's findings, but neither admitted nor denied the charges. Notwithstanding that the brokerage firms did not admit to any wrongdoing, we believe that there likely will be numerous FINRA arbitration claims filed against brokerage firms by investors who lost money in leveraged and inverse leveraged ETFs.

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