RIA Compliance Blog
Last month Wells Fargo Advisors Financial Network LLC agreed to settle administrative charges brought by the SEC, and will pay a $35 million civil penalty in order to resolve the matter. According to the allegations, Wells Fargo failed to supervise investment adviser representatives who recommended inverse exchange-traded funds to their customers, leading to investor losses.
Inverse ETFs allow investors to short the entire market or a sub-market, depending on the ETF involved. However, because they usually “re-set” every day, inverse ETFs are not designed to be held for longer than a single trading day. Instead, they are designed to be used by traders to implement risk hedges on an intra-day basis. If they are held on a long-term basis, they will not necessarily perform consistently with the long-term direction of the market being shorted. This is especially true in volatile markets.
These risks are often described in detail in the product prospectuses but are not often explained sufficiently by financial advisers. In fact, advisers who are not specifically trained on the products often do not understand their unique characteristics. For example, a single-inverse ETF based on a particular index will usually lose money even if the index performance remains flat. In fact, even if the index falls the ETF can lose money.
SEC, FINRA and state regulators have been sanctioning firms for failing to supervise the sale and/or recommendation of inverse or leveraged ETFs since approximately 2009, when FINRA issues an investor alert on the subject. In fact, Wells Fargo had already been sanctioned by FINRA in 2012 for conduct occurring prior to 2009. As a result of the prior settlement, Wells Fargo announced that it had modified its compliance procedures and enhanced its training in order to meet its obligations to its clients and to comply with regulatory guidance.
In the recent action, however, the SEC found that Wells Fargo had failed to implement reasonable procedures to prevent and detect the misuse of single leverage ETFs. The SEC cited Wells Fargo’s failure to take reasonable steps to ensure investors were properly educated, or to establish procedures that would permit supervisors to adequately monitor positions in the ETFs.
The SEC alleged that Wells Fargo advisers recommended leveraged ETFs between April 2012 and September 2019 to both brokerage and advisory clients. No adequate adviser training program was in place regarding the features and risks of the products. The positions, which according to most prospectuses should be monitored daily, were not monitored by Wells Fargo, and the clients involved often held the positions for long periods – sometimes months or years. The SEC found many of the recommendations were unsuitable and caused large losses in the clients’ portfolios, particularly clients with conservative or moderate risk tolerances. Many of the affected clients were senior citizens, retirees, or others who had either limited incomes or low net worth, or both. According to the SEC, the $35 million in civil penalties will be distributed to the affected investors.
The action against Wells Fargo follows other similar actions, including a 2017 settlement in which Morgan Stanley Smith Barney agreed to pay $8 million. Morgan Stanley had been sanctioned by FINRA and New Jersey’s Securities Bureau in May 2012 for failure to design and implement compliance policies that addressed non-traditional ETFs.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.