UBS Financial Services Inc. has agreed to pay a $1.5 million fine after the Financial Industry Regulatory Authority (FINRA) charged the firm with 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.
In addition to the fine, UBS Financial Services consented to a censure, and to pay $431,488 in restitution to customers.
This firm is not the only broker dealer to be fined for its shoddy supervision of sales of non-traditional ETFs. FINRA also fined Citigroup Global Markets Inc., Morgan Stanley & Co. LLC 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.
Like the other firms, UBS Financial Services submitted a Letter of Acceptance, Waiver and Consent (AWC) to settle a FINRA disciplinary action related to sales of non-traditional exchange-traded funds (ETFs). Without admitting or denying anything, the firm consented to the entry of the findings in the AWC, which was accepted by FINRA on May 1.
Non-traditional ETFs comprise leveraged, inverse, and inverse-leveraged ETFs. These funds reset daily and are meant to be held for only short periods of time. Holding a non-traditional ETF for longer periods can result in substantial divergence from the performance of the index or benchmark the fund is meant to track, the AWC explained.
Despite this fact, some UBS Financial Services customers with conservative risk tolerance profiles held non-traditional ETFs for several months, the AWC said.
For example, a 64-year old customer with a conservative risk tolerance and a modest net worth of $290,000 held a non-traditional ETF for 139 days in his individual retirement account and suffered more than $5,700 in losses as a result. These losses represented 43 percent of this customer's initial investment., the AWC said.
Another customer – a 54 year old with a conservative risk tolerance profile and a net worth of $400,000 -- held a non-traditional ETF for 21 days and lost more then $5,000.
UBS Financial Services has been a FINRA-registered broker-dealer since October 1936, including its predecessor PaineWebber & Co. UBS Financial Services is a full service brokerage firm based in Weehawken, N.J., with about 385 branch offices that employ about 7,000 registered financial advisors.
From January 2008 through June 2009, UBS Financial Services 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, 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, UBS Financial Services used the same supervisory system it had set up for traditional ETFs for non-traditional ETFs. In doing so, it failed to establish a reasonable supervisory system for the sale of non-traditional ETFs, the AWC said. The firm also failed to devise written procedures to monitor sales of non-traditional ETFs as well as failed to institute an adequate training program for it personnel regarding these products during the period in question.
Certain brokers with UBS Financial Services did not fully understand non-traditional ETFs before they unsuitably recommended these products to retail brokerage customers with conservative risk tolerance profiles, the AWC said.
As a result, UBS Financial Services 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) 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.
UBS Financial Services 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.
As non-traditional ETFs grew in popularity, the number of these transactions by customers at UBS Financial Services surged. From January 2008 through June 2009, the firm's customers bought and sold more than $4.5 billion in non-traditional ETFs.
As sale of non-traditional ETFs exploded, the firm supervised them in the same way that it supervised sales of traditional ETFs until June 2009 when FINRA issued a Regulatory Notice regarding these products, the AWC said. The firm's general system was not adequately designed to handle the unique features and risks of non-traditional ETFs, however.
UBS Financial Services 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, the firm's system, including its written procedures, was not reasonably designed to ensure compliance with NASD and FINRA rules.
The firm also failed to provide sufficient training to its brokers and supervisors regarding the risks and characteristics of non-traditional ETFs, the AWC said. Before June 2009, the firm provided no tools or guidance to brokers to educate them about these complex products.
Perhaps as a result, UBS Financial Services violated NASD Rule 2310 regarding 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.
As far as leveraged and inverse ETFs are concerned, 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. UBS Financial Services failed to meet these requirements, the AWC said.
This disciplinary action is not the first time sanction UBS Financial Services has run afoul of FINRA. In April 2011, the firm consented to a $2.5 million fine and restitution of $8.25 million for its failure to establish an adequate supervisory system for the marketing and sale of Lehman Brothers Principal Protection Notes. The firm also failed to sufficiently examine the suitability of the note before its brokers sold them to certain customers.
In June 2009, UBS Financial Services agreed to a $100,000 fine for inadequate supervision of short-term sales of closed-end funds purchased during their initial public offering. The products were unsuitable for the customers, and the customers lost of more than $2 million as a result.
For a detailed report on the disciplinary history of UBS Financial Services, see FINRA's 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.