Citigroup Global Markets Inc. has been fined $2 million by the Financial Industry Regulatory Authority (FINRA) for failure to supervise and for making unsuitable recommendations in connection with the sale of complex financial products known as non-traditional exchange-traded funds.
The firm submitted a Letter of Acceptance, Waiver and Consent (AWC) to settle a FINRA disciplinary action related to its sales of non-traditional exchange-traded funds (ETFs), which comprise leveraged, inverse, and inverse-leveraged ETFs. These funds reset daily and are meant to be held for only short periods of time.
Without admitting or denying anything, Citigroup Global Markets Inc. (CGMI) consented to the entry of the findings in the AWC, which was accepted by FINRA May 1. The firm also consented to be censured and to pay $146,431 in restitution to customers as well as the $2 million fine.
CGMI is not the only broker dealer to be fined for its shoddy supervision of sales of non-traditional ETFs. FINRA also fined Morgan Stanley & Co. LLC, UBS Financial Services and Wells Fargo Advisors LLC. Together the four giant brokerage firms agreed to pay $7.3 million in fines and $1.8 in restitution to customers, according to a May 3 report from Investment News.
Moreover, FINRA's big disciplinary splash has attracted the attention of the Securities and Exchange Commission and at least one member of the U.S. Senate, the report said.
According to the AWC, from January 2008 through June 2009, CGMI failed to create and sustain 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.
In addition, the AWC said CGMI brokers -- who were poorly trained in the ins and outs of these complex products -- sold non-traditional ETFs to customers for whom they were not suitable investments.
For example, one 59-year old customer with a conservative investment objective and a low-risk profile held a non-traditional ETF for 283 days, which led to losses of more than $3,500. Another 59-year-old customer with net worth of less than $600,000 and a similarly conservative objective held a non-traditional ETF for 122 days in an Individual Retirement Account and lost more than $4,500 as a result.
Non-traditional ETFs bear risks not found in traditional ETFs, which track underlying benchmarks or indexes in a straightforward way, without using leverage or inversion.
Not only do non-traditional ETFs carry risks tied to leverage, but they carry the risks associated with daily resetting and compounding, the AWC said.
The performance of non-traditional ETFs over weeks or months can substantially diverge from the performance of the underlying index or benchmark they were designed to track, especially during periods of volatility such as the market conditions that emerged after the financial crisis hit in 2008.
Despite the unique risks of non-traditional ETFs, CGMI supervised these products the same way it supervised traditional ETFs. Therefore, it failed to establish a reasonable supervisory system and failed to devise written procedures to monitor the sales of these risk-laden products, the AWC said.
Moreover, CGMI failed to give its brokers sufficient formal training regarding non-traditional ETFs from January 2008 to June 2009, , the AWC said. Some CGMI brokers did not understand non-traditional ETFs enough to recommend them to retail brokerage customers.
The firm's failure to reasonably supervise non-traditional ETFs continued until FINRA issued a Regulatory Notice in June 2009 that laid out all the risks and made it clear that non-traditional ETFs were suitable for only certain kinds of customers, the AWC said.
As a result of its failure to supervise, CGMI violated NASD Rules 3010, 2310, and 2110 and FINRA Rule 2010, the AWC said.
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) require 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.
CGMI's conduct also violated of 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.
The FINRA Regulatory Notice issued 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.
As the numbers grew, so did the number of non-traditional ETF transactions at CGMI. From January 2008 through June 2009, CGMI customers bought and sold a total of more than $7.9 billion in non-traditional ETFs, the AWC said.
Despite the risks associated with holding non-traditional ETFs for long periods, certain CGMI customers with conservative investment objectives and risk tolerances wound up holding non-traditional ETFs for several months.
As noted, the firm relied on its general supervisory procedures regarding non-traditional ETFs until FINRA issued its Regulatory Notice. That system failed to address the unique features and risks involved with these products, however.
For example, from January 2008 to June 2009, CGMI did nothing to address the risks associated with holding non-traditional ETFs for weeks or months, and so failed to design a supervisory system designed to comply with the NASD and FINRA rules.
CGMI also failed to provide adequate training to its brokers, the AWC said. For example, before June 2009, the firm failed to provide sufficient guidance or tools for brokers to learn about non-traditional ETFs.
The firm also violated NASD Rules 2310 and 2110 and FINRA Rule 2010 by making unsuitable recommendations. NASD Rule 2310 requires broker-dealers and their registered representatives to exercise reasonable diligence as far as understanding the nature of a recommended product and its risks and possible rewards, but CGMI brokers recommended non-traditional ETFs to customers without performing the reasonable diligence needed to fully understand the product or their risks, the AWC said.
This AWC was not CGMI's first. In July 2011, the firm consented to a $500,000 fine and the entry of findings that it violated NASD rules by failing to respond to red flags that should have alerted CGMI to a misappropriation scheme being run by a sales assistant.
In February 2010, CGMI was fined $650,000 pursuant to an AWC that said, among other things, that CGMI violated NASD rules when it failed to supervise its Direct Borrow Program from 2005 to 2008.
For a detailed report on regulatory actions involving CGMI, as well as customer disputes with the firm, see FINRA public disclosure records.
If you have been the victim of securities fraud you should consult with an attorney. The practice of Nicholas J. Guiliano, Esq., and The Guiliano Law Firm, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.