An AWC issued on July 1, 2021, reflects that FINRA suspended an FA formerly registered with David A. Noyes & Company (now known as Sanctuary Securities) for three-months and imposed a deferred fine of $5,000. This AWC demonstrates FINRAs ongoing concerns around the sale of leveraged and inverse exchange traded funds to retail customers. This week’s AWC is the book-end to an AWC issued in May 2021 against Sanctuary for a variety of violations, including the failure to establish, maintain and enforce a supervisory system designed to meet FINRAs suitability standards for non-traditional ETFs. Sanctuary was fined $160,000 and ordered to pay customer restitution of $370,161.

By way of background, the broker-dealer permitted FA Stuart Pearl to resign in March 2019. According to statements on BrokerCheck, Mr. Pearl resigned while on heightened supervision and the firm alleged that Mr. Pearl had not followed the heightened supervision plan.

Product at Issue: Non-Traditional ETFs

NT-ETFs are designed to return a multiple of an underlying index or benchmark, the inverse of that benchmark, or both, over only the course of one trading session — usually a single day. NT-ETFs typically rebalance their portfolios on a daily basis (also known as the “daily reset”). Due to the effects of compounding of daily returns during the holding period, the performance of NT-ETFs over periods longer than a single trading session “can differ significantly from the performance … of their underlying index or benchmark during the same period of time.” FINRA Regulatory Notice 09-31, FINRA Reminds Firm of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds (June 2009). Because of that feature, FINRA has stated that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.” FINRA Regulatory Notice 09-31 at 1. Rule at Issue: FINRA Rule 2111

To make a suitable recommendation, FINRA requires that FAs first understand the risks and rewards of a proposed investment. FINRA deems this a “reasonable-basis suitability obligation.” Thus, an FA can run afoul of Rule 2111 if the FA lacks an understanding of the product even if the product was otherwise appropriate given the investor’s wealth, willingness to bear risk, age, or other individual characteristics.

Facts at Issue

With the Pearl AWC, FINRA found that the FA failed to perform a reasonable basis suitability analysis for two reasons: (a) the customers held the NT-ETFs for periods ranging from 100 to 600 days; and (b) Pearl did not understand that losses in NT-ETFs compounded because of how valuations reset each day.

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On January 3, 2020, FINRA released an AWC for Robert James D’Andria, Case No. 2017056579502. At first blush the AWC seems rather plain vanilla. The FA recommended high-risk products, in this case leveraged and inverse exchange-traded notes and funds, to retail investors and FINRA deemed those recommendations to be unsuitable. FINRA suspended the FA for 2 months and fined him $5,000.

In a typical suitability case, FINRA would claim that the account was over-concentrated in a given sector, or the position was too large relative to the portfolio as a whole, or the account was over-traded, or the investment was inconsistent with the investor’s stated investment objectives. And, in a typical case, FINRA would claim that the customer suffered meaningful losses.

In this AWC, however, FINRA does not claim that the investments were inconsistent with the customers’ investment objectives. Nor does FINRA claim that the investors were unsophisticated or otherwise lacked the ability to assess the merits of these investments. So, this begs the question: where’s the violation?

FINRA tips their hand by stating: “a representative may violate the suitability if he or she has no reasonable basis to make the recommendation to any customer, regardless of the investor’s wealth, willingness to bear risk, age, or other individual characteristics.”

Ok, so FINRA believes this guy didn’t have a “reasonable basis” for recommending the products he sold. And why is that? Well, here’s where things get interesting.

FINRA Rule 2111 has a reasonable-basis suitability obligation which requires, among other things, “associates person’s familiarity with the security or investment strategy.” Ah, so here’s where FINRA dinged the FA. They claimed he failed to do his homework before recommending the product. According to FINRA, the FA failed “to understand the unique features and specific risks associated with these products before offering them to his customers.”

So, what’s the takeaway lesson here: you better understand the product you are recommending and be able to explain the rationale for your recommendations to your firm and your regulator. Because if you can’t explain why you did what you did, an otherwise suitable recommendation can morph into an unsuitable recommendation in the land of FINRA.

The sanction assessed against the FA in this case was essentially middle-of-the-road for a suitability violation. For a Rule 2111 violation, FINRA’s Sanction Guidelines call for a fine of between $2,500 and $116,000 and a suspension of 10 days to 2 years. Given that FINRA suspended D’Andria for 2 months, the Enforcement attorneys must have concluded that some aggravating factors existed.

Herskovits PLLC has a nationwide practice representing individuals and firm facing a FINRA inquiry or disciplinary action. For a consultation, feel free to call us at 212-897-5410.

FINRA wants a member firm to enforce its written supervisory procedures. And FINRA wants a member firm to recommend securities that fit within the customer’s investment objectives. And certainly FINRA wants a member firm to avoid falsification of business records. So what happens when a member firm doesn’t quite live up to FINRA’s expectations? Let’s play the over / under game and try to guess the size of the FINRA sanction when a member engages in the following misconduct:

• Failure to enforce WSPs governing the sale of high-risk mutual funds subject to significant volatility
• Failure to reallocate portfolios to reduce risk or otherwise update investment objectives to correspond with the assumption of additional risk
• Failure to properly investigate exception report alerts
• And here’s the real ugly one: “adjustment” of customers’ risk tolerances and investment objectives without first seeking the customers’ input. Rest assured, it was clever lawyering that got FINRA to delete the word “falsification” and instead use the word “adjustment.”

Well, if the respondent were an individual, as opposed to NY Life, and the broker sold unsuitable securities, disregarded firm policy, and falsified new account forms, what would FINRA do? According to FINRA’s Sanction Guidelines: (a) “recordkeeping violations” can lead to a bar if aggravating factors predominate; and (b) unsuitable recommendations will likely lead to a bar if aggravating factors predominate.

Given that FINRA would wallop an individual, surely they’ll do the same with an institution that can readily pay a sizable fine….right?? Given FINRA’s allegations, we must be talking about a significant seven-figure fine, right?

Well….read on.

Case In Point

In the Matter of NYLIFE Securities LLC, FINRA Matter No. 2016050685102 (click here to read the AWC) Sanctions

• A fine of $250,000
• Restitution and rescission to 28 customers. The restitution amount equals $76,643. The rescission offer pertains to customers with unrealized losses totaling approximately $250,000.
• Censure

Hmmm….it looks to me like NYLIFE cut a sweetheart deal with FINRA.

Underlying Facts

From September 2014 to December 2016, NYLIFE had procedures for supervising the sale of higher-risk mutual funds as measured by volatility. The procedures, as one would expect, required such sales to align with the customers’ risk tolerances and investment objectives. During this time period, NYLIFE’s automated surveillance system flagged potentially unsuitable trades. For example, an alert was generated if a customer with an investment objective of “income with moderate growth” and a risk tolerance of “moderately conservative” sought to purchase a higher-risk mutual fund in an amount that exceeded 30% of the customer’s overall portfolio.

The alerts were reviewed by a group of “reviewers” who, in conjunction with registered persons, offered customers a choice: reallocate the portfolio to reduce risk, or change your investment profile to reflect a higher risk tolerance and more aggressive investment objective.

All of that was well enough; however, NYLIFE apparently didn’t allocate sufficient resources to the “reviewer” department and un-reviewed alerts began to pile up. To rectify this:

“Respondent’s reviewers adjusted customers’ investment profiles to accommodate a sale of higher-risk mutual funds without determining whether a representative had discussed the option of reallocation with the customer and typically without first contacting the customer. In fact, some customers’ investment profiles were changed before Respondent obtained information about the customers’ true risk tolerance and investment objective.”

The upshot of this was that the portfolio for a number of customers (approximately “four dozen” according to FINRA) with relatively conservative investment objectives was excessively weighted with high-risk mutual funds.

Analysis

I get that a $250,000 is not chump change. And I also recognize that the BD has to offer restitution and restitution, and apparently settled other customer complaints prior to FINRA’s intervention. Nonetheless, the allegations present a fairly damning fact pattern. FINRA alleges a complete breakdown of the system of supervision. And brazenly mismarking a customer’s investment objectives is conduct one expects from a bucket shop, not from a highly regarded financial institution.

Based on the facts alleged, along with the guidance in FINRAs Sanction Guidelines, it really seems like NYLIFE got off easily. According to the Sanction Guidelines:

Failure to Supervise – for systemic supervisory failures, the adjudicator should consider imposing an undertaking, such as engaging an independent consultant to revamp the supervisory systems. Where aggravating factors predominate, the adjudicator should consider suspending or even barring the firm. Additionally, the adjudicator should consider a fine of up to $310,000, or higher if aggravating factors predominate.

Suitability – the adjudicator should consider a monetary sanction of up $116,000 and consider suspecting a firm with respect to a set of activities for up to 90 days.

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