CORRECTED-UPDATE 2-FINRA fines four brokerages $9.1 mln over ETF sales

Tue May 1, 2012 2:08pm EDT

By Jessica Toonkel and Suzanne Barlyn

NEW YORK May 1 (Reuters) - Citigroup Inc Morgan Stanley, UBS AG and Wells Fargo & Co on Tuesday agreed to pay more than $9.1 million in fines and restitution for selling leveraged and inverse exchange-traded funds "without reasonable supervision."

The Financial Industry Regulatory Authority, which levied the sanctions, said the firms sold these ETFs without "a reasonable basis for recommending the securities," according to a statement.

Leveraged and inverse ETFs are designed to amplify short-term returns by using debt and derivatives and are considered more suitable for professional traders than for long-term retail investors. They make up only $29.3 billion of the $1.15 trillion U.S. ETF market, according to Lipper.

FINRA found that, from January 2008 through June 2009, the brokerage firms did not have the supervisory systems in place to properly monitor the sales of leveraged and inverse ETFs and failed to conduct adequate due diligence regarding the risks and features of the ETFs, according to the statement.

Settlement agreements the four brokerages signed with FINRA show the extent to which customers invested billions in the risky securities as the market grew. Investors bought and sold about $27.1 billion collectively in the risky ETFs from the four brokerages during period, according to a review of the settlements.

Wells Fargo customers transacted the most business of the four groups, buying and selling a total of $9.9 billion, followed by Citi ($7.9 bi llion), Morgan Stanley ($4.8 billion) and UBS ($4.5 billion).

In all of the cases, the regulator found that the brokerages did not have adequate supervision systems for their brokers, and other procedures in place to ensure that sales of the ETFs complied with FINRA rules, according to a settlement.

Citigroup was fined $2 million and ordered to pay $146,431 in restitution. Wells Fargo was fined $2.1 million and ordered to pay $641,489 in restitution. Morgan Stanley was fined $1.75 million and ordered to pay $604,584, and UBS was fined $1.5 million and ordered to pay $431,488. FINRA determines fines for its members based on a series of sanctioning guidelines.

The firms said they supervised these non-traditional ETFs the same way they supervised traditional ETFs, but that the general supervisory systems in place were not tailored enough to address the risks and unique features involved with these products.

Each firm's settlement refers to investors who had purchased the risky ETFs recommended by their broker -- even though they were not buy-and-hold investments. The investors were mostly in their mid-50s or older who had conservative investment profiles with limited or no risk tolerance.

For example:

* At Citi, a 59-year-old investor with a conservative risk profile and net worth less than $600,000 held one of the securities for 122 days in an IRA account and lost more than $4,500.

* A 65-year-old conservative customer of Wells Fargo with a stated net worth less than $50,000 held a non-traditional ETF for 43 days and sustained losses of more than $25,000.

* At Morgan Stanley, an 89-year-old investor with a net worth under $200,000, allocated nearly 60 percent of an account to non-traditional ETFs for 39 days, losing more than $10,000.

* A 64-year-old UBS customer with a conservative risk tolerance profile and net worth of $290,000 held a non-traditional ETF for 139 days in his IRA account and sustained losses of more than $5,700 -- 43 percent of his initial investment.

Spokespeople from the four brokerages said they were pleased to resolve the matter.

"More than two years ago, UBS developed and implemented enhanced training, suitability and supervisory policies and procedures regarding leveraged, inverse, and inverse-leveraged ETFs," a spokeswoman said in a statement.

UBS has adopted training, supervisory and other policies, according to spokeswoman Karina Byrne. Morgan Stanley has "substantially limited its sale of "these specific types of investments and enhanced our tools to supervise them," said spokeswoman Christine Pollak. The action, she said, relates to investments sold three to four years ago.

Leveraged and inverse ETFs "became increasingly popular with a wider range of retail investors" during a short period that coincided with market volatility, a Wells Fargo spokesman said, adding the firm has enhanced its procedures since then.