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Regulatory Sanctions

Firm Prohibited Sales of the Most Volatile Non-Traditional ETFs – But It Wasn’t Enough

November 21, 2017

by Howard Haykin


FSC Securities Corporation agreed to pay nearly $600,000 in fines and restitution (to customers) to settle FINRA charges that it executed approximately 6,500 purchases of leveraged, or inverse, or both inverse and leveraged exchange-traded funds (Non-Traditional ETFs) in approximately 1,400 retail customer accounts without establishing and maintaining a supervisory system.


BACKGROUND.    FSC Securities, based in Atlanta, GA, has been a FINRA member since 1977. The firm conducts a general securities business employing an independent contractor model. FSC Securities has over 1,300 registered individuals operating out of more than 650 branch offices located nationwide. FSC has no relevant disciplinary history.


FINRA FINDINGS.    From January 2009 through September 2014 (the “Relevant Period"), FSC Securities executed around 6,500 purchases of leveraged, or inverse, or both inverse and leveraged ETFs - collectively, "Non-Traditional ETFs" - in approximately 1,400 retail customer accounts. Those purchases were worth approximately $92 million and generated approximately $603,000 in commissions.


Many of the customers to whom the Firm recommended these products had primary investment objectives of income or growth and conservative/moderate risk tolerances. Many customers also held their Non-Traditional ETF positions for extended periods of time, often months and sometime years, and suffered net losses in those positions.


  • From January 2009 through November 2009, despite publicity surrounding the risks of these products, the Firm did not employ a reasonable supervisory system or written procedures to monitor the recommendation of Non-Traditional ETFs.


  • In December 2009, FSC prohibited the offering of Non-Traditional ETFs that were greater than 2X (two times) leveraged and/or inverse of the daily performance of an underlying index - 6 months after FINRA issued Regulatory Notice 09-31, “Non-Traditional ETFs.”   


  • In February 2010, FSC revised its WSPs, incorporating this prohibition. However, the Firm did not at that time establish a reasonable system, including written procedures, to address the risks posed by other Non-Traditional ETFs – i.e., those that sought to deliver, two times or less, leveraged and/or inverse of the daily performance of an underlying index.


  • Hence, throughout the Relevant Period, the Firm allowed its registered reps, without any monitoring, to recommend Non-Traditional ETFs that sought to deliver, two times or less, leveraged and/or inverse the daily performance of an underlying index.


►    During most of the Relevant Period, the Firm did not: (i) have exception reports or any alerts in the Firm's electronic trade review system addressing the risks posed by Non-Traditional ETFs; and, (ii) reasonably implement a supervisory system to review the recommendations of Non-Traditional ETFs based on a customer's age, investment objective, risk tolerance or financial profile such as net worth or net income.


  • As a result, during the Relevant Period, FSC's representatives recommended NonTraditional ErFs to retail customers for whom they were not suitable investments, as detailed below.


FINANCIALISH TAKE AWAYS.    FSC Securities earned $603,000 selling Non-Traditional ETFs from January 2009 to September 2014 - 5-1/2 years. In 2017, the firm is giving those earnings back to FINRA and its retail customers.


It's probably small consolation that many other broker-dealers have been sanctioned for sales of Non-Traditional ETFS. But, the firm probably thought it was doing the right thing in December 2009 when it enacted safeguards to prevent the sale of the most volatile Non-Traditional ETFs to its retail customers.


However, FSC Securities' efforts were, essentially half-way measures, that failed to address the attendant risks associated with all Non-Traditional ETFs. For example, why did FSC implement control procedures a full 6 months after FINRA published its Red Flags? And why did FSC not go all the way and establish adequate supervisory procedures for all Non-Traditional ETFs'?


It's as if FINRA provided the broker-dealer with a roadmap or blueprints for setting up adequate written supervisory procedures (WSPs), but its Chief Compliance Officer opted to read only the "Executive Summary." And it's obvious that FSC Securities failed to identify and fully focus on FINRA's priorities, which is unfortunate - because these sanctions were largely avoidable.


So while I'd like to say, "LET THIS BE A LESSON TO FSC SECURITIES," we all know that such advice is easier said than done, and that history has a way of repeating itself. 


This case was reported in FINRA Disciplinary Actions for October 2017.

For details on this case, go to ...  FINRA Disciplinary Actions Online, and refer to Case #2010024620303.