Articles Posted in ETFs

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On June 29, 2015, Jeffrey D. Daggett (“Daggett”) submitted a Letter of Acceptance, Waiver, and Consent (“AWC”) to settle allegations made by the Financial Industry Regulatory Authority, Inc. (“FINRA”)  The FINRA AWC alleged that Daggett, while registered with Wells Fargo Advisors, LLC made numerous unsuitable recommendations of exchange traded products to his customers in violation of FINRA rules.  To settle the FINRA allegations, Daggett submitted to censure, a fine of $20,000 and a suspension for four (4) months.  A copy of the FINRA AWC is available here.

Specifically, FINRA alleged that from March 2010 through September 2011, Daggett recommended and traded in a volatile and speculative exchange traded note (“ETN”), an inverse triple leveraged exchange traded fund (“ETF”), and a triple leveraged ETF in customer accounts that were inconsistent with the customer’s investment objectives of moderate growth and income.  The ETN was tied to long positions in futures contracts on the Chicago Board Options Exchange Volatility Index, and stated in the prospectus that it was intended for short-term trading and may not be appropriate for intermediate or long-term investment time horizons.  Similarly, the ETF prospectuses also stated that they were intended for short-term trading.  Nevertheless, the ETN and ETF positions were held in the customer account for periods ranging from one (1) month, to two (2) years.  FINRA alleged that Daggett lacked a reasonable basis for believing that the ETN and ETF purchases were suitable for his customer, and as such, violated NASD Conduct Rules 2310 and IM-2310-2, as well as FINRA Rule 2010.

ETFs, ETNs and other exchange traded products are very popular among investment advisers who seek to expose their customers to a particular index or sector of the economy.  However, these complex products and the trading strategies utilizing them are difficult for retail investors to fully grasp, and therefore, understand the risk accompanying them.  Many investment advisers utilize intraday trading strategies regarding these products, including complex hedging strategies whereby they hedge them against futures contracts regarding the basket of underlying securities or contracts that the ETF tracks.  Additionally, many of these products have a “resetting” function that makes them unsuitable for many investors as part of a buy-and-hold strategy.  Recently, we covered the Securities and Exchange Commission’s request for public comment on ETFs and ETNs.

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On June 5, 2015, E1 Asset Management, Inc. (“E1 Asset Management”), Ron Y. itin (“Itin”), and Ahsan R. Shaikh (“Shaikh”) submitted a Letter of Acceptance Waiver and Consent (“AWC”) to settle allegations by the Financial Industry Regulatory Authority (“FINRA”) that they collectively failed to maintain a reasonable supervisory system at E1 Asset Management.  Both Itin and Shakih are employed by E1 Asset Management in supervisory capacities.  A copy of the FINRA AWC may be found here.

FINRA alleged that E1 Asset Management, Itin, and Shaikah violated NASD Rules 3010, 2110 and FINRA Rule 2010 by failing to establish and maintain E1 Asset Management’s supervisory systems.  According to the AWC, from July 2008 to April 2012, Itin and Shaikh failed to establish a supervisory system reasonably designed to: 1) review registered representatives’ communications with the public; 2) review trading to detect and monitor potential churning activity; 3) review the new account opening process to ensure customer suitability profiles were properly established; 4) perform adequate suitability review for leveraged exchange traded funds (“ETFs”) in customer accounts; and 5) supervise the activities of registered representatives subject to E1 Asset Management’s heightened supervision program.

The FINRA allegations of supervisory failures came after numerous customers commenced FINRA arbitrations alleging sales practice abuses by E1 Asset Management registered representatives.  According to FINRA, many of these arbitrations concluded in settlements.  However, the form release agreements that E1 Asset Management utilized during this time contained ambiguous language that could have been interpreted by the customers as prohibiting them from cooperating with regulatory investigations.  Specifically, those agreements stated that customers must not “[c]ommence or prosecute, or assist in the filing, commencement or prosecution in any government agency, arbitral tribunal, self-regulatory body or court in any claim or charge against E1 Asset Management.”  FINRA alleged that E1 Asset Management, Itin, and Shaikah violated NASD Rule 2111 and FINRA Rule 2010 for including impermissible confidentiality provisions in its form settlement and release agreements.

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On June 12, 2015, the Securities and Exchange Commission (“SEC”) solicited public comment on its approval and regulation of exchange traded products (“ETPs”).  ETPs are similar to open-ended mutual funds, but can be bought and sold throughout the day at market prices, rather than net-asset value.  ETPs include, but are not limited to, exchange-traded funds, pooled investments, and exchange-traded notes.  The SEC’s request for comment asked fifty-three (53) sets of questions touching on subjects such as arbitrage mechanisms, pricing, listing standards, legal exemptions, suitability requirements, and broker-dealer marketing and sales practices with respect to ETPs among other subjects.

According to the SEC, the number of ETPs available to retail customers rose dramatically from 2006-2013.  As of 2014, the SEC estimates there are approximately 1,664 ETPs listed on U.S. exchanges, with a market value surpassing $2 trillion.  Some financial firms design complex ETPs and market them to retail clients in an effort to outperform the market.  In a press release accompanying the SEC’s request for industry comment, SEC Chairwoman Mary Jo White stated,  “[a]s new products are developed and their complexity grows, it is critical that we have broad public input to inform our evaluation of how they should be listed, traded and marketed to investors, especially retail investors.”

In line with the SEC’s concern for retail investors, the SEC solicited industry comment regarding broker-dealer sales practices and investors’ understanding and use of ETPs that generally focused on:

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On May 6, 2015, LPL Financial LLC (“LPL”) submitted a Letter of Acceptance, Waiver and Consent (“AWC”) to the Financial Industry Regulatory Authority’s (“FINRA”) Department of Enforcement to settle allegations that LPL violated FINRA supervisory rules.  The AWC was submitted “without admitting or denying the findings,” and on the condition that, if accepted, “FINRA will not bring any future actions against LPL alleging violations based on the same factual findings.”

LPL has been a FINRA member firm since 1973, is headquartered in Boston, MA and has approximately 18,343 registered representatives operating from approximately 10,702 registered branch office locations and 18,396 non-registered office locations.  LPL is the largest organization of independent financial advisors in the United States based on total revenue.   In 2007, LPL Financial Holdings, Inc., LPL’s parent company, expanded LPL’s broker-dealer business by acquiring other financial services firms and recruiting registered representatives from other broker-dealers.  From 2007 to 2013, the number of registered representatives at LPL more than doubled from 8,322 to 17,601 and LPL’s revenue increased from $2.28 billion to $4.05 billion.  According to FINRA, while LPL’s business grew, LPL failed to similarly increase its supervisory resources, resulting in inadequate supervisory systems and procedures.

Specifically, according to FINRA, LPL failed to properly supervise its representative’s sale of non-traditional exchange traded funds (“non-traditional ETFs”), variable annuities, mutual funds, and illiquid or non-exchange-traded real estate investment trusts (“non-traded REITs”).  Non-traditional ETFs are a class of complex products that include leveraged, inverse and inverse-leveraged ETFs, which seek to earn a multiple of the performance of the underlying index or benchmark or earn a return inverse to the return of the benchmark’s performance, or both.  Generally, non-traditional ETFs utilize swaps, futures contracts, and other derivatives instruments to achieve these objectives.  According to FINRA, LPL failed to review the length of time for which these securities were held by customers, despite written supervisory procedures which require monitoring non-traditional ETFs on a daily basis.  This is especially important because many of these products “reset” daily and over time, that resetting function can cause the specific non-traditional ETF’s performance to deviate significantly from the index it tracks.  Additionally, the short positions taken by inverse ETFs contain more risk than a corresponding long position because the potential for loss in a short position is limitless.  FINRA further alleged that LPL failed to enforce its written supervisory procedures with respect to account allocation limits for non-traditional ETFs, and failed to ensure that its registered representatives were adequately trained to sell non-traditional ETFs.  FINRA alleged that LPL violated National Association of Securities Dealers (“NASD”) Rule 3010(b) and FINRA Rule 2010, which state that “[a] member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.”

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