ETF Sales Cost Firms Millions - Analyst Blog

By Zacks | May 02, 2012 AAA

Sale of Exchange Traded Funds (ETFs) has cost major Wall Street firms millions in fines. The firms - Citigroup Inc. C), Morgan Stanley (MS), UBS AG (UBS) and Wells Fargo & Company (WFC) - have been penalized by the Financial Industry Regulatory Authority (FINRA) over the sale of leveraged and inverse exchange-traded funds.

They must pay a total of $9.1 million, of which $7.3 million is the penalty amount, and the remaining $1.8 million will be reimbursed to the customers who bought the ETFs.

The Allegations

According to FINRA, the brokerage units of these firms - Citigroup Global Markets Inc, Morgan Stanley & Co. LLC, UBS Financial Services and Wells Fargo Advisors LLC - have been accused of selling the leveraged and inverse exchange-traded funds in an improper fashion between 2008 and 2009. FINRA claimed that these firms lacked a sufficient supervision mechanism for this variety of ETF sales.

Sufficient due diligence were not performed on the risks and characteristics of the ETFs. Therefore, there was no reasonable basis to advise the ETFs to retail customers. Moreover, it was found that some of the customers with a conservative risk appetite and investment targets were recommended this type of ETFs by the firms' representatives.

The charges were neither admitted nor denied by the firms. They consented to the FINRA findings.

Leveraged and Inverse ETFs

ETFs are a type of security that trades on stock exchanges like stocks. They mostly track an index or benchmark and hold assets such as stocks, commodities, or bonds. Leveraged ETFs particularly make use of the financial derivatives and debt to magnify the returns of an index or the benchmark, while Inverse ETFs seek to return the opposite of the index or benchmark they track.

Notably, complexity and added risks are present in leveraged and inverse ETFs which make them unsuitable for holding them long. As a result of risks related to daily reset, leverage and compounding, if these instruments are held for long periods and specifically in volatile markets, then their performances substantially vary from the underlying index or benchmark performance. It was found that the customers held leveraged and inverse ETFs at such times.

Penalties in Detail

Among the four firms, Wells Fargo's penalty is the highest. The company needs to pay a $2.1 million fine and $641,489 in restitution. Next is Citigroup, which needs to pay a $2 million fine and $146,431 in reimbursement. Morgan Stanley has to pay a $1.75 million fine and $604,584 in restitution while UBS will pay $1.5 million as fine and $431,488 as reimbursement.

Conclusion

Post financial crisis, financial firms have witnessed increased scrutiny by regulators, and penalization for misguiding investors either through suppression of information regarding the risky profile of the instruments sold or though any other fraudulent activities. We believe that such efforts on part of the regulators are in the best interest of the investors.

As a matter of fact, FINRA had warned about the sale of these instruments earlier and the firms have accordingly implemented policies, procedures and training for better supervision and to satisfy regulatory requirements. We believe such efforts will instill investors' confidence in the market for such instruments.

 
CITIGROUP INC C): Free Stock Analysis Report
 
MORGAN STANLEY (MS): Free Stock Analysis Report
 
UBS AG (UBS): Free Stock Analysis Report
 
WELLS FARGO-NEW (WFC): Free Stock Analysis Report
 
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