May 1, 2012 / 2:12 PM / 5 years ago

FINRA fines four brokerages $9.1 million over ETF sales

NEW YORK (Reuters) - Citigroup Inc Morgan Stanley, UBS AG and Wells Fargo & Co 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 said.

The settlements announced on Tuesday are the latest move by regulators to clamp down on these complex investments. But some investor advocates wonder if the fines go far enough in a case involving $27.1 billion in transactions.

The brokerages likely earned much more in commissions from selling the products than they are now paying in fines, said industry observers.

“What kind of deterrence does this serve if they can still keep (nearly all) of the profits from the trading...?” said Jill Gross, director of the Investor Rights Clinic at Pace Law School in New York.

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

Bradley Bennett, director of enforcement at FINRA, told Reuters that the sanctions are severe for a case involving suitability of investments. Bennett said steeper penalties were not appropriate because the products in question have not collapsed and the securities had not inflicted significant losses on investors.

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 just $29.3 billion of the $1.15 trillion U.S. ETF market, according to Lipper.

In 2009, FINRA and other regulators began issuing warnings about the sale of these investments because they worried that brokers were selling them to buy-and-hold investors.

In July 2011, Massachusetts’ top securities regulator sued RBC Capital Markets LLC and one of its brokers over its sales of leveraged ETFs to clients who did not understand them. And last March, FINRA barred a former broker for Morgan Keegan & Co for making excessive and inappropriate trades in a group of leveraged and inverse ETFs for clients. Meanwhile, in 2010 the SEC stopped approving new ETFs that use derivatives.

As a result of the increased regulatory scrutiny, brokerage firms have placed restrictions on how they sell leveraged and inverse ETFs.

For example, Bank of America Corp’s Merrill Lynch unit only allows investors to buy leveraged and inverse ETFs if they request them, a policy in place since 2009. The firm also requires its employees to complete and pass a training course on the products. UBS, Wells Fargo and Morgan Stanley have instituted similar restrictions in the past few years, spokeswomen for the companies said.

In Tuesday’s settlement, FINRA found that from January 2008 through June 2009, UBS, Morgan Stanley, Wells Fargo and Citi 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.

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 its sanctioning guidelines.

The firms said they supervised these non-traditional ETFs the same way they did traditional ETFs, but that the 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. Most were in their 50s or older and 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 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 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 profile and net worth of $290,000 held a non-traditional ETF for 139 days and sustained losses of more than $5,700 -- 43 percent of his initial investment.

Representatives of the four brokerages said the firms were pleased to have resolved the matter.

Reporting By Jessica Toonkel; Editing by Walden Siew, Jennifer Merritt, and Tim Dobbyn

Our Standards:The Thomson Reuters Trust Principles.
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