FINRA Levies Leveraged ETF-Related Fines

May 02, 2012

FINRA fines brokers for sales of leveraged and inverse ETFs, closing a brief chapter of abuses.

The Financial Industry Regulatory Authority closed a brief and well-publicized episode of cowboy capitalism this week by sanctioning a number of big Wall Street brokerages for a total of $9.1 million for violating the regulator’s rules for improper sales of leveraged and inverse ETFs in 2008 and 2009.

Firms, including Morgan Stanley, Citigroup, UBS AG and Wells Fargo & Co., were fined more than $7.3 million and must pay a total of $1.8 million in restitution to certain customers who made unsuitable purchases of leveraged and inverse ETFs, FINRA said this week in a press release. Such ETFs now account for about 2.5 percent of the $1.208 trillion in U.S.-listed ETF assets.

The representatives in question also failed to properly supervise the investments once they were made, FINRA said. It also said the banks failed to establish formal training programs to teach brokers about the ETFs. Still, the regulator said that, on balance, the damage done was slight.

Leveraged and inverse ETFs caused a stir when they first gained traction in 2008, as investors and brokers alike were enticed by the prospect of owning securities designed to double or triple returns or generate profits in falling markets without having to actually short-sell. But such ETFs have complex return profiles that can deviate hugely from indexes, and that’s where the problems began.

When investors began to grasp how quickly their dreams of outsized profits were being derailed by the hard reality of how these funds were actually designed, they began filing lawsuits.

Most were against the two biggest purveyors of inverse and leveraged ETF—Bethesda, Md.-based ProShares; and Newton, Mass.-based Direxion.

Tempest In A Teapot

FINRA said that despite the violations, investors weren’t significantly harmed.

Further, FINRA officials stressed that the fines only apply to violations that occurred from January 2008 to June 2009, and the regulator went out of its way to say that the brokerage houses have reformed their practices.

“We know that we chose the right time period because in June 2009 we put out notice to members,” a FINRA official said in a telephone interview. “From that day on, the firms changed their practices and changed who they were selling it to and put in more modifications to their programs, so any harm would have taken place before 2009.”

Indeed, brokers at big banks were flooded with email and snail-mail notices in 2008 and 2009 about the hazards of leveraged and inverse funds.

Prospectuses for leveraged and inverse ETFs emphasize their volatility and the need pay close attention to their price fluctuations that’s all related to the fact that most of these types of funds reset on a daily basis.

In the wake of the whole episode, such funds are routinely described in regulatory paperwork and marketing materials as only being appropriate for professional investors with diversified portfolios.



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