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Enforcement News: SEC Charges Wells Fargo In Connection With Single-Inverse ETF Investment Recommendations to Retail Investors

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  • Posted on: Mar 9 2020

On February 27, 2020, the Securities and Exchange Commission (“SEC”) announced (here) that it settled charges against Wells Fargo Clearing Services and Wells Fargo Advisors Financial Network (collectively, “Wells Fargo”) for failing to supervise investment advisers and registered representatives who recommended single-inverse ETF investments to retail investors, and for lacking adequate compliance policies and procedures with respect to the suitability of those recommendations. The SEC ordered Wells Fargo to pay a $35 million penalty, which will be distributed to harmed investors.

Single-inverse exchange-traded funds (“single-inverse ETFs”) are complex financial instruments that seek investment results that are the opposite of the performance of an index for a stated trading period, typically one day. When held longer than a day, particularly in volatile markets, investors may experience large and unexpected losses – i.e., single-inverse ETFs will lose money when the level of the index is flat. Even if the index performance is zero percent, the single-inverse ETF based on that index will lose money. Single-inverse ETFs can lose money even if the level of the index falls. For this reason, single-inverse ETFs may not be suitable for all investors and should be used only by knowledgeable investors who understand the risk. 

In June 2009, FINRA issued Regulatory Notice 09-31 (the “Notice”), which Wells Fargo received, reminding securities firms of their sales practice obligations in connection with single-inverse and other non-traditional ETFs. Among other things, the notice provided that “recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended” and that “firms must have adequate supervisory procedures in place to ensure that these obligations are met.” The notice also advised that most “inverse ETFs ‘reset’ daily, meaning that they are designed to achieve their stated objectives on a daily basis. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.” The notice cautioned, “inverse and leveraged ETFs typically are not suitable for retail clients who plan to hold them for more than one trading session, particularly in volatile markets.” The notice therefore advised firms to establish an appropriate supervisory system, and train registered persons on these products and the factors that would make such products suitable or unsuitable for certain investors.

In August 2009, FINRA and the SEC issued a joint alert, which Wells Fargo also received, highlighting the risk associated with holding non-traditional ETFs, including single-inverse ETFs, for weeks, months or years.

On April 13, 2012, Wells Fargo updated its compliance policies and procedures to include certain volatility and other ETFs.

Wells Fargo’s 2012 policies and procedures provided that single-inverse ETFs are speculative trading vehicles and generally not suitable for investors who intend to hold them as long-term positions. Wells Fargo’s 2012 policies and procedures stated that non-traditional ETFs that reset daily typically should not be held more than one trading session or as a long-term investment. The policies and procedures subjected single-inverse ETFs to additional suitability requirements. Specifically, the policies and procedures required financial advisors to determine the suitability of the product for the client considering, among other things, the characteristics and risks of non-traditional ETFs; the client’s investment experience and familiarity with complex investment products; the client’s financial ability and willingness to absorb potentially significant losses; and the client’s ability and intent to actively monitor and manage the investment on a daily basis.

The 2012 policies and procedures required financial advisors to have a reasonable belief that the client was capable of understanding the complexities of the product, including the consequences of seeking periodic inverse investment results, and that the single-inverse ETFs performance may not track the underlying index over periods longer than a day.

The 2012 policies and procedures further provided that single-inverse ETFs may be appropriate as part of a sophisticated investment strategy but should be closely monitored by the financial advisor.

In 2012, Wells Fargo received information indicating that its policies and procedures were not as robust as those of certain other large brokerage and investment advisory firms, which had procedures such as: reviewing products held long term; requiring financial advisors to complete training; and providing risk disclosure notices to investors. 

At the time, Wells Fargo did not require training for its financial advisors and supervisors about single-inverse ETFs and Wells Fargo’s related policies and procedures nor did it adopt any other process to sufficiently educate them about the products and their risks.

In May 2012, Wells Fargo Advisors, LLC, Wells Fargo FiNet, and Wells Fargo Investments, LLC, were sanctioned by FINRA and paid over $2.7 million in fines and restitution for conduct that occurred before July 2009. FINRA disciplined these Wells Fargo entities for (1) failing to establish a reasonable supervisory system and written procedures to monitor the sale of non-traditional ETFs; (2) failing to provide adequate formal training and guidance to registered representatives and supervisors regarding non-traditional ETFs; and (3) certain Wells Fargo registered representatives making unsuitable recommendations of non-traditional ETFs to certain customers with conservative risk tolerances.

At the time of the settlement with FINRA, Wells Fargo publicly asserted it “ha[d] enhanced its policies and procedures and [wa]s confident that it ha[d] appropriate supervisory processes and training to meet [its] regulatory responsibilities and clients’ investment needs.” However, as noted by the SEC, significant shortcomings remained with the firms’ policies and procedures relating to single-inverse ETFs.

From April 2012 through September 2019, the SEC found that Wells Fargo’s policies and procedures were not reasonably designed to prevent and detect unsuitable recommendations of single-inverse ETFs (here). The SEC also found that Wells Fargo failed to supervise its employees’ recommendations regarding single-inverse ETFs and did not adequately train them concerning those products. The SEC further found that some Wells Fargo brokers and advisers did not fully understand the risk of losses these complex products posed when held long term. As a result, certain Wells Fargo investment advisers and registered representatives made unsuitable recommendations to certain clients to buy and hold single-inverse ETFs for months or years. According to the SEC, a number of these clients were senior citizens and retirees who had limited incomes and net worth, and conservative or moderate risk tolerances.

“Firms must maintain effective compliance and supervisory programs to ensure that the securities they recommend are suitable for their clients,” said Antonia Chion, Associate Director of the SEC Enforcement Division. “As a result of Wells Fargo’s failure to meet these important obligations, some of its employees recommended complex instruments to retail investors who did not understand the risks involved.”

Without admitting or denying the findings, Wells Fargo agreed to pay a $35 million penalty and distribute the funds to certain clients who were recommended to buy single-inverse ETFs and suffered losses after holding the positions for longer periods. The SEC order also censured Wells Fargo and required Wells Fargo to cease and desist from committing or causing any future violations of the federal securities laws at issue in the proceeding.

Takeaway

“Inverse exchange-traded funds (ETFs) seek to deliver inverse returns of underlying indexes.” (Steven Nickolas, The Risks of Investing in Inverse ETFs, Investopedia (Aug. 29, 2019) (here).) “To achieve their investment results, inverse ETFs generally use derivative securities, such as swap agreements, forwards, futures contracts and options.” (Id.) “Inverse ETFs are designed for speculative traders and investors seeking tactical day trades against their respective underlying indexes.” (Id.) As shown by the SEC’s order in Wells Fargo, inverse ETFs are not suitable for investors having modest incomes and net worth, having conservative or moderate risk tolerances and lacking prior investing experience with complex products. Without proper training and supervision, these investors are susceptible to substantial losses to their portfolios – in many instances, losses to their life’s savings.

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