Regulators Plan Legal Actions Over Improper Sales of ETFs and ETNs


The Financial Industry Regulatory Authority (FINRA) announced plans to file enforcement actions against certain brokerages in connection with unsuitable sales of leveraged and inverse leveraged exchange-traded funds (ETFs), as well as for failure to train their brokers who sell them (see Reuters article by Suzanne Barlyn and Jessica Toonkel entitled “FINRA to bring cases over leveraged, inverse ETFs”). The article cites FINRA enforcement chief Bradley Bennett as the source of this information, and notes that he refused to identify the broker-dealers that FINRA plans to sue.

Bennett reportedly told lawyers at a Practising Law Institute (PLI) seminar in New York that the enforcement actions will “make statements” about how broker-dealers should ensure that registered representatives are properly trained about these complex products and the types of customers for whom they may or may not be suitable.

Leveraged and inverse exchange traded funds are designed to magnify short-term returns of a fund’s underlying assets by a factor of 2 or more. They employ derivatives and are generally considered to be unsuitable for ordinary buy-and-hold investors.

FINRA is concerned that brokers are selling these products to long-term retail investors, despite their unsuitability for those investors. FINRA is also concerned that the selling brokers are not properly trained and do not explain the risks of these ETFs to potential purchasers.

“We don’t have a qualm with the product,” Bennett was quoted as saying, adding: “We just want to make sure that people who are selling them understand them.” If brokers do not understand them, they cannot explain to customers how they work or what the risks are.

Leveraged and inverse ETFs have long been on regulators “worry list,” but enforcement actions have been rare. In July 2011, the Massachusetts Securities Division filed an enforcement action against RBC Capital Markets LLC and one of its brokers for selling leveraged ETFs to clients who did not understand them. Similarly, in March, FINRA barred a former Morgan Keegan broker for making excessive and inappropriate leveraged and inverse ETF trading in clients’ accounts.

Exchange traded notes (ETNs) are also on FINRA’s radar screen. FINRA is reportedly examining how firms market and sell them. Last month, Credit Suisse’s VelocityShares Daily 2x Short-Term exchange-traded note lost half its value in just two days. FINRA hopes to get “ahead of the curve” before that happens to other investors, according to Bennett.

“Most people agree certain investor protections are required” in this area, Paul Justice, an ETF analyst at Morningstar, was quoted as saying. BlackRock Inc., the world’s largest ETF manager, has urged regulators and legislators to require investment firms to clearly explain to investors the risks involving complex ETFs and ETNs.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.