By Christopher Condon and Joshua Gallu – May 1, 2012, 4:47 PM ET
Citigroup Inc. (C), Morgan Stanley, UBS AG (UBSN) and Wells Fargo & Co. (WFC) agreed to pay a combined $9.1 million to settle regulatory claims they failed to adequately supervise the sale of leveraged and inverse exchange-traded funds in 2008 and 2009.
The firms also didn’t have a reasonable basis for recommending the securities to their clients, the Financial Industry Regulatory Authority said today in a statement. They will pay fines of about $7.3 million and reimburse $1.8 million to customers.
Wells Fargo, based in San Francisco, was assessed the highest fine by Finra at $2.1 million and must pay $641,489 in restitution. Photographer: David Paul Morris/Bloomberg
“The added complexity of leveraged and inverse exchange-traded products makes it essential that brokerage firms have an adequate understanding of the products and sufficiently train their sales force before the products are offered to retail customers,” Brad Bennett, Finra’s chief of enforcement, said in the statement.
Finra warned brokers in June 2009 that leveraged and inverse ETFs were difficult to understand and not a good fit for long-term investors. ETFs typically track indexes and trade throughout the day on an exchange like stocks. Leveraged versions use swaps or derivatives to amplify daily index returns, while the inverse funds are designed to move in the opposite direction of their benchmark.
Because gains or losses in the funds are compounded daily, returns over more than one day can differ from returns implied by the underlying index.
UBS suspended its sales of leveraged and inverse ETFs following the Finra warning, the company said in a July 2009 statement. It has resumed selling them and no longer recommends them to clients, Karina Byrne, a spokeswoman, said. Morgan Stanley (MS) said the following month it would restrict its sales.
Wells Fargo continues to sell leveraged and inverse ETFs. Tony Mattera, a company spokesman, said the firm had “enhanced its policies and procedures” to meet regulatory responsibilities.
Citigroup spokeswoman Liz Fogarty said the firm has since 2009 enhanced training, policies, and procedures in connection with the sale of the products to incorporate Finra’s guidance.
Wells Fargo, based in San Francisco, was assessed the highest fine at $2.1 million and must pay $641,489 in restitution. Citigroup, based in New York, received a $2 million fine and must pay $146,431 in restitution; New York-based Morgan Stanley will pay a $1.75 million fine and $604,584 in restitution, and Zurich-based UBS will pay a $1.5 million fine and $431,488 in restitution.
In settling the claims, the firms neither admitted nor denied the charges, said Washington-based Finra, the brokerage industry’s self-funded regulator.
“Wells Fargo Advisors cooperated fully with Finra throughout this matter and is pleased to have reached this settlement,” Mattera said in an e-mailed statement. “Wells Fargo Advisors has enhanced its policies and procedures and is confident that it has appropriate supervisory processes and training to meet our regulatory responsibilities and clients’ investment needs.”
“UBS is pleased to have resolved this Finra matter,” Byrne said in an e-mailed statement. “More than two years ago, UBS developed and implemented enhanced training, suitability and supervisory policies and procedures regarding leveraged, inverse, and inverse-leveraged ETFs.”
“Morgan Stanley strives for high standards of supervision and is pleased to settle this matter, which pertains to investments sold three to four years ago,” James Wiggins, a spokesman, said in an e-mailed statement. “Since 2009, we substantially limited our sale of these specific types of investments and enhanced our tools to supervise them.”
“We are pleased to have this matter resolved,” Citigroup’s Fogarty said in an e-mailed statement.
Finra said each of the four firms sold “billions of dollars of these ETFs to customers, some of whom held them for extended periods when the markets were volatile.”
In its warning to brokers, Finra cited the differing returns of the Dow Jones U.S. Oil & Gas Index, which gained 1.6 percent between Dec. 1 and April 30, and the ProShares Ultra Oil & Gas (DUG) ETF, which seeks to deliver twice the index’s daily return. The fund fell 5.6 percent, including reinvested dividends, in the same period.
Leveraged and inverse ETFs in the U.S. hold $29.3 billion, according to data compiled by Bloomberg. Bethesda, Maryland- based ProShare Advisors is the largest provider with about $22.2 billion under management. ETF providers, unlike mutual fund sponsors, don’t sell shares directly to retail investors.
The fines don’t apply to the sale of exchange-traded notes. Finra is examining how those securities are being marketed after a Credit Suisse AG (CSGN)‘s volatility ETN lost half its value in two days. ETNs are backed by the issuer’s credit, unlike exchange-traded funds, which hold assets.