Compliance Risks With Leveraged and Inverse ETF Sales

FINRA has ordered Atlanta-based broker-dealer, J.P. Turner & Company, L.L.C. to pay $707,559 in restitution to 84 customers for sales of unsuitable leveraged and inverse exchange-traded funds (ETFs) and for excessive mutual fund switches.

FINRA’s action against J.P. Turner is another reminder of the need for broker-dealers to carefully scrutinize the suitability of such non-conventional investments products like inverse exchange-traded funds.

While FINRA mutual fund switch violation cases (a practice FINRA has addressed repeatedly) are more common, inverse ETFs sales practice violations case have not been as prominent, but should come as no less a surprise.

In fact, back in 2009 in FINRA Regulatory Notice 09-31, FINRA warned member firms that the sale of many inverse exchange-traded funds raised concerns:

This Notice reminds firms of their sales practice obligations in connection with leveraged and inverse ETFs. In particular, recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended; sales materials related to leveraged and inverse ETFs must be fair and accurate; and firms must have adequate supervisory procedures in place to ensure that these obligations are met.

FINRA Regulatory Notice 09-31, Non-Traditional ETFs: FINRA Reminds Firms of Sales Practice Obligations Relating to Leveraged and Inverse Exchanged-Traded Funds (June 2009) 

In addition to supervising leveraged and inverse ETFs in the same manner that it supervised traditional ETFs, FINRA found that J.P. Turner had no procedures, failed to provide adequate training on the ETFs, failed to determine whether the ETFs were suitable for at least 27 customers, including retirees and conservative customers, who sustained losses and allowed its registered representatives to recommend the inverse and leveraged ETFs without performing reasonable diligence to understand the risks and features of the products.

What supervisory and suitability precautions ought to be considered?  FINRA has suggested that member firms look back at NASD IM-2310-2(e) (Fair Dealing with Customers with Regard to Derivative Products or New Financial Products) which states

[a]s new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer’s financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products.

Another source for firms recommending or selling these type ETFs may also find Notice to Members 05-26 helpful. The Notice highlights best practices for vetting new products.

Author: Dexter Johnson

The author is a an attorney who for the past 14 years has concentrated his practice in representing, successfully, investment advisers, broker-dealers, corporations and individuals who are subject to SEC, FINRA, State or other regulations and who may be the subject of regulatory examination, review or investigation. He formerly worked at the SEC. His regulatory and litigation experience has encompassed virtually every type of securities issue in the industry. He has also negotiated favorable outcomes in many of these matters for his clients.