FINRA Fines Broker-Dealer Firm for Sales of Non-Traditional ETFs and Mutual Fund Switching (with Lofchie Comment)

FINRA has ordered a broker-dealer firm to pay restitution to 84 customers for sales of unsuitable leveraged and inverse exchange-traded funds ("ETFs") and for excessive mutual fund switches. FINRA found that the broker-dealer failed to establish and maintain a reasonable supervisory system and instead supervised leveraged and inverse ETFs ("Non-Traditional ETFs") in the same manner that it supervised traditional ETFs. In addition to not providing adequate training regarding ETFs, the firm allowed its registered representatives to recommend these complex ETFs without performing reasonable diligence to understand the risks and features associated with the products. As a result, the firm's customers held leveraged and inverse ETFs for several months.

FINRA also found that the firm engaged in a pattern of unsuitable mutual fund switching. Additionally, the firm failed to establish and maintain a reasonable supervisory system designed to prevent such unsuitable mutual fund switching and lacked sufficient procedures to adequately monitor for trends or patterns involving such mutual fund switches. FINRA stated that, despite the presence of several red flags, the firm failed to reject any of the more than 2,800 mutual fund switches that appeared on the firm's switch exception reports, which led to customers paying over $500,000 in unsuitable mutual fund switches.

Lofchie Comment:A couple of FINRA's statements in the settlement order are worth mentioning. First, FINRA criticized the disciplined firm as having inadequately trained registered representatives who did not understand the products that they sold to investors. This seems to be a frequent theme of FINRA enforcement actions: that investors misunderstand what they are buying, but representatives also misunderstand what they are selling. According to FINRA, when registered representatives do not understand the products they sell, they cannot fulfill their obligations as to "reasonable-basis [product] suitability," since they have no basis for evaluating the products. (For a general discussion of suitability issues, see Lofchie's Guide to Broker-Dealer Regulation; Dealing with Customers Chapter.)The other notable remark in the disciplinary action was the statement that the disciplined firm's customers had held the Non-Traditional ETFs for "longer periods" than was prudent. According to FINRA, "Non-Traditional ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets." Given that the purchase of the Non-Traditional ETFs seems to have been inherently unsuitable in this case, it is surprising that FINRA would criticize a long holding period specifically. It is certainly not obvious from the facts of the case that a shorter holding period would have been an improvement.

See: FINRA Action Letter; FINRA Press Release.