Although the case involved broker-dealers and not a Registered Investment Adviser (RIA), a recent FINRA enforcement action underscores the importance of implementing and enforcing supervisory systems, including written supervisory procedures (WSPs), to ensure compliance with suitability obligations. The enforcement action sends a message to all financial professionals who recommend non-traditional ETFs and other non-traditional exchange-traded products (NT-ETPs).

On March 25, 2024, FINRA sanctioned a St. Louis-based brokerage firm, as well as its independent broker-dealer affiliate. The firms agreed to significant fines and sanctions. The firms’ lack of supervision over NT-ETPs resulted in substantial customer losses.

FINRA’s charges targeted the firms’ recommendations of NT-ETPs, which are tied to underlying indices or benchmarks. Holding these short-term investments for longer periods can produce negative performance, no matter what the underlying index is. Leveraged and inverse ETPs are intended for short-term investing, usually a day or one month. Although they had been under regulatory scrutiny for over a decade or even earlier, the firms failed to identify and address numerous unsuitable recommendations by their representatives arising from recommendations of NT-ETPs.

The firms’ compliance problems pertaining to NT-ETPs emerged in 2014. At that time, the firms were sanctioned for failing to implement an adequate system for supervising sales of complex products. FINRA determined that the firms failed to establish and maintain supervisory systems for monitoring representatives’ recommendations of NT-ETPs. The firms agreed to pay more than $1 million in fines and restitution.

According to FINRA, the firms’ took remedial actions following the 2014 settlement, such as revising their WSPs and utilizing an automated alert to monitor holding periods for NT-ETPs. Soon thereafter, representatives were again recommending that NT-ETPs be held for far too long. To correct this problem, the firms began tracking investment positions held for longer than thirty days.

The firms instituted a system that automatically flagged any NT-ETPs held for more than a month. To deal with the hundreds of hits per day, the firms gave supervisors broad discretion to resolve the alerts. Many supervisors simply dismissed the alerts with vague comments. The firms did not provide any training on how to evaluate red flags triggered by NT-ETPs.

The firms’ WSPs recognized that the products were complex, risky, and usually not suitable for retail investors. Nevertheless, the firms did not require supervisors to evaluate whether representatives’ recommendations of NT-ETPs were consistent with the recommended holding periods specified in the investments’ prospectuses.

 

Firms’ latest encounter with FINRA costs them $2.3 million

In its latest encounter with FINRA, the firm was ordered to pay $1 million in fines and $1.3 million in restitution, plus interest, to settle the case. According to FINRA, the firms’ representatives frequently recommended long-term holdings of funds that reset daily to hundreds of customers. These complex products were intended to be held for only short periods of time, usually a day or a single month. The firm failed to take reasonable steps to detect and address hundreds of potentially unsuitable recommendations that customers buy and hold NT-ETFs for longer periods of time than they were designed to be held. These recommendations caused their customers to lose money.

The firms’ compliance personnel learned that representatives were often recommending long-term holding periods for NT-ETPs. Compliance personnel could not stop representatives from recommending that customers hold them for much longer periods than they should have. The firms’ supervisory failures failed to detect hundreds of instances where representatives recommended that clients buy and hold NT-ETPs for too long.

Some of the affected customers were senior investors with conservative investment objectives or moderate risk tolerances. One was an 87-year-old with a conservative risk tolerance who held the investment for 454 days and lost about $5,000. Another victim was a 77-year-old who held the investment for more than a year and lost about $13,000.

 

Suitability issues involving leveraged and inverse ETPs

Recommending NT-ETPs can raise compliance issues for RIAs and Investment Adviser Representatives (IARs), not just broker-dealers and registered representatives. Pursuant to Regulation Best Interest (Reg BI), a financial professional’s duty of care requires them to:

  1. Understand the potential risks, rewards, and costs connected to a product, investment strategy, account type, or series of transactions; and
  2. Have a reasonable understanding of the retail investor’s investment profile.

Based on their understanding of these two requirements and after considering reasonably available alternatives, firms and financial professionals must have a reasonable basis to conclude that the recommendation or advice provided is in the retail investor’s best interest.

Firms and financial professionals must determine whether their recommendations or advice satisfy these care obligations. They must conduct an objective evaluation that is based upon the facts and circumstances of the specific recommendation or advice, as well as the investment profile of the retail investor at the time the recommendation is made or when the advice is given. To satisfy their care obligations, broker-dealers and RIAs should tailor their policies and procedures to their specific business models and their relationships with retail investors.

Firms and financial professionals must develop a sufficient understanding of the potential risks, rewards, and costs of the investment or investment strategy, so they have a reasonable basis to believe they are acting in a retail investor’s best interest. Without this understanding, firms and their financial professionals will not have a reasonable basis for believing that their recommendation or advice aligns with a retail investor’s investment profile. Where there is an ongoing monitoring obligation, firms and their financial professionals must continue their analysis throughout the course of the relationship.

 

Recommendations regarding risky investments

Neither Reg BI nor the IA fiduciary standard prohibits recommendations or advice regarding complex or risky products where the financial professional has established a reasonable basis to believe they are in the best interest of the retail investor. These products may not be in the best interest of a client unless there is an identified, short-term, customer-specific trading objective. Firms and their financial professionals should consider whether less complex, less risky, or lower-cost alternatives can achieve the same objectives for their retail customers. Generally, they should apply heightened scrutiny to evaluate whether a risky or complex product is in the retail investor’s best interest.

Certain products are more complex or have additional risk features. As a result, it may be more difficult for firms and their financial professionals to develop an understanding of the terms, features, and risks of those products in order to have a reasonable basis to believe that they are in the best interest of retail investors. In addition to developing an understanding of the product, firms, and their financial professionals should obtain information about the retail investor to substantiate why a complex or risky product would be in the retail investor’s best interest.

A firm’s written policies and procedures should be tailored to the firm’s business model. Those policies and procedures might articulate the due diligence process for complex or risky financial products to ensure that they are evaluated by qualified and experienced firm personnel. In addition, firms should consider establishing procedures for evaluating reasonably available alternatives to complex or risky products they give advice about or recommend.

According to FINRA’s Frequently Asked Question (FAQ) dealing with non-traditional exchange-traded funds (NT-ETFs), most leveraged and inverse products reset every day, which means they are designed to achieve their stated objective on a daily basis. FINRA’s FAQ said this:

 

Because they reset each day, leveraged and inverse ETFs typically are inappropriate as an intermediate or long-term investment. They may be appropriate, however, if recommended as part of a sophisticated trading or hedging strategy that will be closely monitored by a financial professional. At times, these strategies might justify a decision to hold a leveraged or inverse ETF longer than one day. However, a registered representative must carefully address the question of how to engage in these strategies in a manner consistent with the suitability rule.

 

FINRA’s FAQ on this topic can be found at Non-Traditional ETFs FAQ | FINRA.org.

Because of compounding, the performance of NT-ETFs for periods longer than the intended holding period can differ significantly from the performance of their underlying index or benchmark. They are not suitable for retail investors who plan to hold them for more than one trading session.

 

Takeaways

Just as broker-dealers and registered representatives must fully understand the complex products they recommend and determine whether they are suitable for their clients, RIAs and IARs owe a similar obligation. The fiduciary duty owed by RIAs and IARs includes an obligation to recommend only suitable investments and act in clients’ best interest. This obligation will never be satisfied if IARs and their firms do not fully understand the limitations of complex products like NT-ETPs. It will always be more challenging for financial professionals to justify the suitability of non-traditional investment products.

 

About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.

RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com