Wells Fargo Advisors and its related firms have agreed to pay a fine of $2.1 million to settle a disciplinary action brought by the Financial Industry Regulatory Authority (FINRA) for the companies’ failure to supervise the sale of complex financial products known as non-traditional exchange-traded funds, as well as for making unsuitable recommendations of these funds.
The group of companies comprises Wells Fargo Advisors LLC, Wells Fargo Advisors Financial Network LLC and Wells Fargo Investments LLC, or collectively, Wells Fargo.
In addition to the fine, Wells Fargo agreed to pay $641,489 in restitution to customers, and to be censured.
Wells Fargo is not the only entity offering brokerage services to be fined for inadequate supervision of the sales of non-traditional ETFs. FINRA also disciplined Citigroup Global Markets Inc., Morgan Stanley & Co. LLC and UBS Financial Services Inc. The four giant brokerage firms together agreed to pay a total of $7.3 million in fines and $1.8 in restitution, according to a May 3 report from Investment News.
In addition, FINRA’s big disciplinary splash has attracted the attention of at least one member of the U.S. Senate, as well as the Securities and Exchange Commission, the report said.
The parent company of the Wells Fargo brokerage firms is St. Louis, Mo.-based Wells Fargo & Co. The firms are FINRA-regulated broker-dealers employing more than 15,000 financial advisors in about 5,000 branch offices. They have over six million active customer accounts with more than $1 trillion in assets under management.
Wells Fargo submitted a Letter of Acceptance, Waiver and Consent (AWC) to settle the FINRA disciplinary action related to sales of non-traditional exchange-traded funds (ETFs). Without admitting or denying anything, Wells Fargo consented to the entry of the findings in the AWC, which was accepted by FINRA on May 1.
The ETFs in question are leveraged, inverse, and inverse-leveraged, all considered to be non-traditional. These ETFs reset daily and are meant to be held for only short periods of time. Keeping a non-traditional ETF for longer periods can result in significant divergence from the performance of the index or benchmark the fund is meant to track, according to the AWC.
Despite this fact, some Wells Fargo customers held non-traditional ETFs for several months, the AWC said. These customers had conservative investment objectives. Some had income as their goal, and others had a goal of growth and income combined, the AWC said.
These customer sustained losses as a result of holding the non-traditional ETFs for periods longer than they were designed to be held.
For instance, a 65-year old conservative customer with a net worth of under $50,000 held a non-Traditional ETF for 43 days and lost more than $25,000 as a result.
In another example in the AWC, a 92-year old customer with a net worth of under $500,000 and a conservative investment objective held a non-traditional ETF for 135 days and sustained a loss of more than a $2,000.
From January 2008 through June 2009, Wells Fargo failed to create and maintain a supervisory system reasonably designed to comply with FINRA rules and the rules of the National Association of Securities Dealers (NASD), a FINRA predecessor, in connection with the sale of non-traditional ETFs, according to the AWC.
Traditional ETFs track underlying benchmarks or indexes in a straightforward manner. Non-traditional ETFs carry risks that traditional ETFs do not, such as those associated with a daily reset, leverage and compounding.
Moreover, the performance of non-traditional ETFs over periods of say, weeks or months, can substantially diverge from the performance of their underlying indexes or benchmarks, especially when markets are volatile.
Despite this, Wells Fargo did not tailor its supervisory system for non-traditional ETFs. Thus, it failed to establish a reasonable supervisory system for the sale of non-traditional ETFs, and failed to devise written procedures to monitor sales of these risky products, the AWC said.
Wells Fargo also failed to institute an adequate training program for its personnel regarding these products during the period in question, the AWC said. Perhaps as a result, certain Wells Fargo brokers made unsuitable recommendations of non-traditional ETFs to customers with conservative investment objectives or risk tolerances.
The above described conduct violated NASD Rules 3010, 2310, and 2110 and FINRA Rule 2010.
NASD Rule 3010(a) requires in relevant part that each FINRA-member firm establish and maintain a system to supervise the activities of all its brokers and other associated persons that is reasonably designed to comply with securities laws and regulations and NASD and FINRA rules.
NASD Rule 3010(b)(1) requires that such a system include written procedures to supervise the specific types of business in which the firm engages as well as the activities of all associated persons in order to ensure compliance with all applicable laws, rules regulations.
NASD Rule 2310 prohibits unsuitable recommendations, the AWC said.
The conduct also violated NASD Rule 2110 and FINRA Rule 2010. Both rules require firms to observe high standards of commercial honor and just and equitable principles of trade.
A Regulatory Notice issued by FINRA in June 2009 described typical ETFs as unit investment trusts or open-end investment companies with shares that represent an interest in a portfolio of securities that track an underlying benchmark or index. These shares are usually listed on national securities exchanges and trade each day at market prices.
Leveraged ETFs aim to deliver multiples of the performance of the index or benchmark they track. Some non-traditional ETFs are inverse funds or short funds. Their goal is to deliver the opposite of the performance of the index or benchmark they track.
Some non-traditional ETFs are both inverse and leveraged. These seek to achieve a return that is a multiple of the inverse performance of the underlying index or benchmark.
Non-traditional ETFs normally use swaps, futures contracts and other derivative instruments to reach their goals. Most of them reset daily, meaning that they are structured to reach their stated objectives on a daily basis.
FINRA’s Regulatory Notice stated that the effects of compounding can cause the performance of non-traditional ETFs to widely diverge from the performance of their underlying indexes or benchmarks over weeks or months. Volatile markets can magnify this effect.
For example, the Dow Jones U.S. Oil & Gas Index gained two percent between Dec. 1, 2008 and April 30, 2009, but an ETF designed to double the index’s daily return fell by six percent, while another ETF that sought to deliver double the inverse of the index’s daily return fell by 26 percent, the AWC said.
The popularity of non-traditional ETFs has surged since 2006. Only a handful of these ETFs were trading on national securities exchanges as of June of that year, but within nine months, 40 more were on the market. By April 2009, over 100 non-traditional ETFs were trading on national securities exchanges, with total assets under management of roughly $22 billion, the AWC said.
While the number of non-traditional ETFs grew overall, so did the number of transactions by customers at Wells Fargo. From January 2008 through June 2009, Wells Fargo customers traded more than $9.9 billion in shares of non-traditional ETFs.
As sales of non-traditional ETFs exploded within Wells Fargo, the firms supervised these sales the same way they supervised sales of traditional ETFs until June 2009 when FINRA issued its ETF Regulatory Notice, the AWC said. Wells Fargo’s general system was not adequately designed to handle the unique features and risks of non-traditional ETFs, however.
Wells Fargo lacked the proper procedures to deal with the risks presented by the practice of holding non-traditional ETFs for periods of weeks or months, the AWC said. Thus, Wells Fargo’s system was not reasonably designed to ensure compliance with NASD and FINRA rules and its written procedures were also inadequate.
The firms also failed to provide sufficient training to their brokers and supervisors regarding the risks and characteristics of non-traditional ETFs, the AWC said. Before June 2009, Wells Fargo provided no tools or guidance to educate brokers about these complex products.
Perhaps as a consequence, Wells Fargo violated NASD Rule 2310 prohibiting unsuitable recommendations, the AWC said. In addition to suitability, the rule requires a broker-dealer and its registered representatives to undertake reasonable diligence to make sure they understand the characteristics of any product they are recommending, as well as its risks and potential upside.
Regarding leveraged and inverse ETFs, FINRA has said a firm and its brokers and supervisors must understand the ETFs’ features and terms, including their performance objectives, how they are supposed to achieve that objective, and the effect of market volatility. They also need to understand the ETFs’ use of leverage, and how the customer’s intended holding period may affect performance. Wells Fargo failed to meet these requirements, the AWC said.
Wells Fargo has been subjected to FINRA disciplinary actions before through Wachovia Securities, which was acquired by Wells Fargo at the end of 2008.
In August 2009, Wachovia Securities — which later changed its name to Wells Fargo Advisors — agreed to a fine of $350,000 for using supervisory systems and written procedures that failed to detect abusive sales practices involving variable annuities.
In May 2009, Wachovia Securities agreed to pay $1.4 million for failing to deliver prospectuses and investment product descriptions to customers, and for its failure to establish supervisory systems and procedures to make sure that the proper offering documents were being sent to customers who were buying securities, the AWC said.
In February 2009, Wachovia Securities agreed to pay a fine of $4.41 million for failing to consider the appropriate breakpoints, fees and expenses when recommending certain classes of mutual fund shares to customers. The firm also failed to establish and maintain sufficient supervisory and compliance policies and procedures.
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