Morgan Stanley & Co. LLC has consented to be fined $1.75 million by the Financial Industry Regulatory Authority (FINRA) for its 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.
|Morgan Stanley failed to adequately supervise sales of risky exchange-traded funds.
In addition to the fine, Morgan Stanley consented to a censure, and to pay $604,584 in restitution to customers.
This firm 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., UBS Financial Services Inc. 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.
To return to Morgan Stanley, the firm 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, Morgan Stanley consented to the entry of the findings in the AWC, which was accepted by FINRA 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.
Despite this fact, some Morgan Stanley customers held non-traditional ETFs for several months, the AWC said.
For example, a 74-year-old customer whose primary investment objective was to generate income, and whose net worth was under $300,000, sank over 25 percent of an account into a single non-traditional ETF that was then held for 128 trading days, leading to losses in excess of $13,000.
Another customer with income as a primary investment objective -- this person was 89 years old with a net worth under $200,000 -- allocated over 59 percent of an account to a single non-traditional ETF that was held for 39 trading days, leading to losses in excess of $10,000.
Both these customers were solicited by Morgan Stanley brokers to buy the non-traditional ETFs, the AWC said.
From January 2008 through June 2009, Morgan Stanley 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, Morgan Stanley 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 Morgan Stanley did not fully understand non-traditional ETFs before they recommended these products to retail brokerage customers.
As a result, Morgan Stanley 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.
Morgan Stanley's 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 the number of non-traditional ETFs surged, so did the number of transactions involving these products at Morgan Stanley. From January 2008 to June 2009, Morgan Stanley customers bought and sold more than $4.78 billion's worth of shares in non-traditional ETFs, the AWC said.
Morgan Stanley supervised sales of non-traditional ETFs the same way it supervised traditional ETFs until FINRA issued its June 2009 Regulatory Notice, the AWC said. The firm's general system was not adequately designed to handle the unique features and risks of non-traditional ETFs, however.
In particular, Morgan Stanley had no procedures in place to deal with the risks represented by holding non-traditional ETFs for periods of weeks or months, the AWC said. Thus, Morgan Stanley's system, including written procedure, 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 devised no tools to educate its personnel about these complex products, and provides no guidance.
Perhaps as a result, Morgan Stanley violated NASD Rule 2310 regarding unsuitable recommendations, the AWC said. In addition to demanding 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. Morgan Stanley failed to meet these requirements, the AWC said.
Morgan Stanley has been fined for failure to supervise before. In April 2011, the predecessor of the firm -- Morgan Stanley & Co. Inc. -- consented to pay $100,000 for its failure to establish effective procedures to make sure that customers received the correct discounts on purchases of unit investment trusts.
In March 2009, Morgan Stanley & Co. Inc. agreed to a $3 million fine and to pay more than $2 million in restitution to customers who were retirees or potential retirees. This discipline resulted from the firm's failure to supervise certain brokers who made unsuitable recommendations and who did not adequately disclose the risks connected with their handling of retirement accounts.
Finally, pursuant to a New York Stock Exchange Hearing Board Decision in June 2007, Morgan Stanley & Co. Inc. consented to findings that it had failed to adequately monitor customer accounts for suitability, including guardian accounts set up for minors by court order to implement medical malpractice settlements. The same decision found that Morgan Stanley lacked proper written procedures to review and approve block trades. The firm was censured and fined $500,000.
For a detailed report on regulatory and disciplinary actions involving Morgan Stanley, as well as customer disputes, see FINRA 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.