On June 8, 2016, FINRA published a News Release to announce that it had fined Oppenheimer & Co. Inc. (“Oppenheimer”) $2.25 million for failing to reasonably supervise transactions in nontraditional exchange-traded funds (“ETFs”). Through this disciplinary action, FINRA has made its expectations abundantly clear: A broker-dealer offering nontraditional ETFs must establish, maintain, and enforce an effective system for supervising transactions in these complex products. In this blog post, we identify what Oppenheimer did wrong so that your firm does not make the same mistakes. We then describe how your firm can use “suitability guidelines” to mitigate the risk of unsuitable recommendations involving nontraditional ETFs.
What Are Nontraditional ETFs?
The term “nontraditional” is commonly used to describe ETFs that are leveraged, inverse, or use other complex strategies to gain access to an index or underlying asset class. Nontraditional ETFs are generally designed for short-term holding periods, most commonly one day. They are complex financial instruments designed to meet a stated investment objective, though their performance can change significantly from their stated objective on a daily or monthly basis, depending upon the trading session. Some key types of nontraditional ETFs are summarized below:
- Leveraged ETFs. Many leveraged ETFs attempt to track a multiple of the daily returns of an index. They may be two times (2x) or three times (3x) leveraged, which means it attempts to provide two or three times the daily index return or loss, respectively.
- Inverse ETFs. Some ETFs are inverse or “short” funds, meaning that they seek to deliver the opposite of the performance of the index or benchmark they track. An inverse ETF seeks to deliver the inverse (-1x) of the index’s performance, while a two times (-2x) or three times (-3x) leveraged inverse ETF seeks to deliver two or three times the opposite of the index’s performance, respectively.
- Volatility-Linked ETFs. There are also volatility-linked ETFs, which offer exposure to futures contracts tied to the CBOE SPX Volatility Index (better known as the VIX). These ETFs use various complex methodologies to gain exposure to the VIX, and are not designed to be long-term investments. It is not possible to invest directly in the VIX, and the use of VIX futures contracts in these products creates potential for significant long-term deviation from the VIX.
Failure to Enforce Procedures
When it comes to supervising nontraditional ETFs, many broker-dealers fail to establish procedures. That was not the case with Oppenheimer. Indeed, the Letter of Acceptance, Waiver and Consent (“AWC”) stated that Oppenheimer instituted written supervisory procedures soon after FINRA published Regulatory Notice 09-31 to remind broker-dealers of their sales practice obligations. The AWC even described some of the procedures that were promptly adopted by Oppenheimer in response to the Regulatory Notice. These procedures included prohibiting registered representatives from soliciting retail customers to purchase nontraditional ETFs, and requiring retail customers purchasing on an unsolicited basis to acknowledge in writing that they met certain criteria with respect to liquid assets, annual income, and experience.
So, how did things go so wrong for a broker-dealer that promptly adopted procedures to address FINRA’s concerns? Oppenheimer failed to enforce the procedures it had adopted. The supervisory shortcomings included, among other things, failing to prevent registered representatives from entering solicited nontraditional ETFs into the order-entry system, failing to use exception reports to identify solicited nontraditional ETF transactions, and failing to train its supervisors on the prohibition against solicited purchases of nontraditional ETFs.
Failure to Establish an Adequate Supervisory System
Failure to enforce its procedures was not the sole issue with Oppenheimer’s supervisory system. FINRA stated that Oppenheimer also failed to establish an adequate supervisory system. It is not enough to establish, maintain, and enforce procedures; a broker-dealer must also make sure those procedures are adequate. In this case, the supervisory system was deemed inadequate because it was not designed to monitor the holding periods of nontraditional ETFs. Holding period is a key risk because performance can vary significantly from the performance of the underlying index or benchmark over longer periods, especially in volatile markets.
Suitability Guidelines
Broker-dealers effecting transactions in nontraditional ETFs (or other complex products) should generally adopt and implement suitability guidelines as part of their supervisory systems. The term “suitability guidelines” is not defined in any statute or rule, but it is commonly used within the securities industry to refer to the internal guidelines established by a broker-dealer to help registered representatives discharge their suitability obligations when recommending a particular type of investment. Suitability guidelines, which may vary greatly from one firm to the next, typically establish suitability criteria that must be met before a registered representative can recommend a transaction.
Examples of Suitability Guidelines for Nontraditional ETFs
Each recommended transaction involving a nontraditional ETF should be consistent with FINRA’s suitability requirements and the stated objectives of the customer account. To prevent suitability violations, a broker-dealer would be wise to adopt and implement suitability guidelines establishing criteria that must be met in one or more of the following areas:
- Short Holding Period. Nontraditional ETFs are not intended to be long-term investments. Suitability guidelines should generally prohibit long holding periods.
- Speculative Investments. Daily rebalancing and market volatility can have a significant impact on realized return. A customer can quickly lose a significant amount of principal in these securities. Suitability guidelines should prohibit or restrict the use of nontraditional ETFs by customers who have a low risk tolerance or a conservative investment objective (g., principal protection).
- Margin Requirements. In light of the increased volatility of leveraged ETFs compared to their non-leveraged counterparts, FINRA prescribes higher initial and maintenance margin requirements on leveraged ETFs. Suitability guidelines may impose margin requirements that are even higher than those required by regulators or a broker-dealer’s clearing firm.
- Net Worth Requirement. Net worth is generally defined as the amount by which assets exceed liabilities, excluding the value of the customer’s primary residence. To ensure that the customer is able to absorb the potentially significant losses, suitability guidelines should generally require the customer to meet a minimum net worth (or liquid net worth) requirement.
- Concentration Limits. Suitability guidelines for nontraditional ETFs may impose concentration limits, which generally restrict an investor’s aggregate investments in nontraditional ETFs.
- Senior Investors and Diminished Mental Capacity. A broker-dealer’s guidelines may impose special suitability standards on the use of nontraditional ETFs in the accounts of senior investors. It is a good practice to restrict or prohibit sales to any customer who, regardless of age, has a mental capacity so diminished that he or she cannot reasonably be expected to understand the key features and risks of nontraditional ETFs.
- Approved Product List. The reasonable-basis suitability obligation requires a broker-dealer to have a reasonable basis to believe, based on reasonable diligence, that the recommendation of a particular nontraditional ETF is suitable for at least some investors. A broker-dealer should maintain a list of approved nontraditional ETFs or have an alternative means for making their registered representatives aware of the nontraditional ETFs that may be recommended to customers.
- Investment Experience. Due to the complexity of nontraditional ETFs, a broker-dealer may elect to include an experience requirement in its suitability guidelines.
- Point of Sale Disclosures. Suitability guidelines may require the delivery of certain disclosure documents to customers. It is a good practice to provide first-time investors in nontraditional ETFs with a disclosure document apprising them of the risks. Broker-dealers commonly require their customers to acknowledge, in writing, their receipt and understanding of the disclosures.
- Training. A registered representative cannot be expected to make a suitable recommendation if he or she does not know and understand the key features, including risks, of the particular nontraditional ETF. Therefore, a firm should verify that registered representatives have been trained or are otherwise qualified to apply the firm’s suitability guidelines to the types of nontraditional ETFs offered by the firm.
Concluding Thoughts
Oppenheimer is not the only broker-dealer to have been severely disciplined for failing to supervise nontraditional ETFs—and it likely won’t be the last. If your firm effects transactions in nontraditional ETFs, we urge you to consider the benefits of establishing and implementing suitability guidelines.