The firm is paying an $8 million penalty to the SEC for alleged improper sales of inverse ETFs. In 2012, FINRA fined the firm $1.75 million and made it pay more than $600,000 in restitution for essentially the same behavior.
Morgan Stanley Smith Barney (MSSB) will pay an $8 million penalty and has admitted wrongdoing to settle charges related to single inverse Exchange Traded Fund (ETF) investments it recommended to advisory clients, according to the SEC, which finds that Morgan Stanley “did not adequately implement its policies and procedures to ensure that clients understood the risks involved with purchasing inverse ETFs.”
This penalty and these charges concern the mid-2010 to mid-2015 period. (MSSB became the broker-dealer for Morgan Stanley Wealth Management in 2012.)
Even before that, however, “MSSB knew the solicitation of these securities was a concern for regulators,” the commission says, pointing out that “MSSB’s parent company, Morgan Stanley & Co. LLC … was sanctioned by FINRA [the Financial Industry Regulatory Authority] in May 2012 and by the New Jersey Bureau of Securities in July 2013 for its lack of compliance policies prior to June 2009 specifically addressing the sale of non-traditional ETFs, including the single inverse ETFs at issue in this Order.”
In 2012, Morgan Stanley was one of four firms that were fined “more than $7.3 million and [were] required to pay a total of $1.8 million in restitution to certain customers who made unsuitable leveraged and inverse ETF purchases,” according to FINRA, which specifies that Morgan’s part of that total was a “$1.75 million fine and $604,584 in restitution.”
(The other three firms were Wells Fargo, Citigroup and UBS. At that time, the firms neither admitted nor denied the charges, FINRA says.)
“At the time it settled these matters, Morgan Stanley publicly stated that after June 2009, it took several steps to remedy its deficient supervisory systems and policies,” according to SEC officials.
However, the commission now charges — and Morgan Stanley does not dispute — that in the years following that settlement the firm “failed to obtain from several hundred clients a signed client disclosure notice, which stated that single inverse ETFs were typically unsuitable for investors planning to hold them longer than one trading session unless used as part of a trading or hedging strategy,” according to the commission.
The SEC also notes that the firm “solicited clients to purchase single inverse ETFs in retirement and other accounts, the securities were held long-term, and many of the clients experienced losses.”
“Unlike traditional mutual funds, shares of ETFs typically trade throughout the day on a securities exchange at prices established by the market,” the commission says in an investor alert issued jointly with FINRA. In turn, inverse ETFs “seek to deliver the opposite of the performance of the index or benchmark they track,” the commission says. “Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets.”
For example, a “2x (two times) leveraged inverse ETF seeks to deliver double the opposite of that index’s performance,” according to the commission. “To accomplish their objectives, leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts, and other derivative instruments.”
The SEC specifically warns investors that “because leveraged and inverse ETFs reset each day, their performance can quickly diverge from the performance of the underlying index or benchmark. In other words, it is possible that you could suffer significant losses even if the long-term performance of the index showed a gain.”
The applicable FINRA rule for this warning is rule 2111, which is known informally as the “suitability rule.” Rule 2111 requires any authority member to have “reasonable grounds for believing that [its] recommendation is suitable” for a non-broker-dealer, or non-institutional, customer “upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.”
For such a non-institutional customer, the FINRA rule calls for “reasonable efforts” to obtain information regarding:
— a customer’s financial status;
— a customer’s tax status;
— a customer’s investment objectives; and
— such other information used or considered to be reasonable by such member or registered representative in making recommendations to a customer.
Accordingly, the securities firm “must determine if the product is suitable for any customer,” FINRA says. That requires considering “how the fund is designed to perform, how it achieves that objective, the impact on performance from market volatility, the use of leverage and the appropriate holding period.”
In addition to its general suitability, the firm must also perform a specific customer suitability analysis. “This analysis includes making reasonable efforts to get information on the customer’s financial and tax status, investment objectives and other information deemed reasonable to make the determination, per FINRA.
Specifically, the SEC says that from mid-2010 to mid-2015, Morgan Stanley “solicited advisory clients with over 600 non-discretionary advisory accounts to purchase single-inverse exchange-traded funds … without implementing MSSB’s written compliance policies and procedures, which were designed to prevent violations of the of the Advisers Act, including its antifraud provisions.”
Furthermore, Morgan Stanley “failed to follow through on another key policy and procedure requiring a supervisor to conduct risk reviews to evaluate the suitability of inverse ETFs for each advisory client,” the SEC adds. “Among other compliance failures, Morgan Stanley did not monitor the single-inverse ETF positions on an ongoing basis and did not ensure that certain financial advisers completed single inverse ETF training.”
Many of MSSB’s non-discretionary advisory clients held the securities for months or years, despite a Client Disclosure Notice warning that single-inverse ETFs are generally not for investors that want to hold them for more than one trading session “unless used as part of a trading or hedging strategy,” according to the commission’s cease-and-desist order. “MSSB solicited some of these clients to purchase single-inverse ETFs in retirement accounts with long-term time horizons. Many of the clients experienced losses associated with their investments in the single-inverse ETFs.”
“Morgan Stanley recommended securities with unique risks and failed to follow its policies and procedures to ensure they were suitable for all clients,” Antonia Chion, associate director of the SEC Enforcement Division, says in a statement.
FTF News asked Morgan Stanley’s media relations office to explain how the firm came to “essentially repeat the behavior” for which it received a $1.75 million fine and paid $604,584 in restitution in 2012.
“We are pleased to have resolved this matter,” a Morgan Stanley spokesperson replied. And an interested individual pointed out that the current settlement was with the SEC, while the 2012 sanctions were from FINRA.
(In its current order, the SEC does reference the 2012 FINRA sanctions, saying “MSSB’s parent company, Morgan Stanley & Co. LLC … was sanctioned by FINRA in May 2012 … for its lack of compliance policies prior to June 2009 specifically addressing the sale of non-traditional ETFs, including the single inverse ETFs at issue in this Order.”)
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