Two Wells Fargo brokerage units have agreed to pay roughly $3.4 million in restitution to clients for allegedly making unsuitable recommendations to buy financial products that were risky to hold on to for long periods of time.
The unique features and risks of the products at issue have also prompted the Financial Industry Regulatory Authority (Finra) to issue a notice to firms this week reminding them of their sales practice obligations.
In a recent filing, Finra alleges that between July l, 2010 and May l, 2012 registered representatives of Wells Fargo Clearing Services and Wells Fargo Advisors Financial Network recommended volatility-linked exchange-traded products (volatility ETPs) to brokerage customers without fully understanding their risks and features.
The firm settled without admitting or denying wrongdoing.
Finra notes in the filing that the growing ETP market has given retail investors access to trading in volatility. Volatility ETPs seek to provide exposure to the Chicago Board Options Exchange Volatility Index (VIX) through VIX futures contracts of varying maturities, and although correlated to the VIX, volatility ETPs do not track it on a one-to-one basis.
‘Since their introduction in 2009, volatility ETP sponsors have warned about the risks associated with such securities,’ officials write in the regulatory filing. ‘Additionally, by June 2010, the financial media discussed such risks, including the risks of contango and of holding the products for long periods of time.’
In ‘contango’ markets, the prices of futures contracts are higher in the distant delivery months than in the nearer delivery months. Therefore, the cost to roll futures contracts from one month to the next will adversely affect performance over time, so any volatility ETP held for a long period of time is highly likely to lose value, officials write.
According to the self-regulatory organization (SRO), certain reps mistakenly believed that volatility ETPs could be used as a long-term hedge on their customers’ equity positions in the event of a market downturn. In fact, they are generally short-term trading products that degrade significantly over time and should not be used as part of a long-term buy-and-hold investment strategy, Finra states.
As such, the reps in those situations did not have a reasonable basis to recommend volatility ETPs as suitable to customers with conservative or moderate risk profiles and investment objectives, and they also failed to appropriately recommend leaving these positions within a timely manner, the SRO says.
Finra also alleges that, during the time at issue, the firm failed to establish and maintain a supervisory system, including written policies and procedures, reasonably designed to achieve compliance with NASD Rule 2310 in connection with its sale of volatility ETPs. The rule addresses the suitability of recommendations to brokerage clients.
Although the Wells Fargo units should have been aware of the complexity and unique risks and features associated with volatility ETPs by July 2010, they failed to implement a reasonable system to supervise reps’ solicited sales of the products, according to Finra. In addition, the SRO says the units failed to provide reasonable training to registered reps on the features and risks associated with volatility ETPs.
‘ONBOARDING’
Wells Fargo in 2009 began developing ‘onboarding’ procedures to vet non-traditional ETPs that had become available in the market, Finra says. As part of the onboarding process, the firm gathered information from non-traditional ETP sponsors and an internal product review group then decided whether to make the product available for its retail brokerage customers and whether to impose any restrictions, such as limiting recommendations and sales to customers with certain risk profiles and investment objectives, according to the SRO.
These procedures were implemented in August 2009, after Finra issued an initial regulatory notice reminding firms about their sales practice obligations relating to such products, the SRO says. Despite this, the firm failed to vet or impose any restrictions on the volatility ETPs that became available in early 2009 until May 2012, Finra alleges, so the products were made available to retail brokerage customers during that time regardless of their risk profile and investment objective.
Around May 2012, Finra says the firm enhanced its supervisory systems and procedures by imposing restrictions on the sale of volatility ETPs, limiting solicited sales to only customers with an investment objective and the risk profile ‘trading and speculation’, and by requiring managers to contact customers after 30 days from the transaction to reiterate the risks of these products.
Officials write that Finra decided not to impose a fine on Wells Fargo because:
- The firm corrected its supervisory deficiencies relating to volatility ETPs in May 2012 before being detected by the SRO
- The firm was previously fined $2.1 million in May 2012 – after the alleged misconduct and its remediation in the latest settlement – for similar violations relating to non-traditional ETPs. The firm settled that action without admitting or denying wrongdoing
- The firm ‘provided substantial assistance’ to Finra by, among other things, engaging a consulting firm to review, compile and calculate large amounts of data pertaining to sales of volatility ETPs for use in determining the appropriate restitution.
A spokesperson for Wells Fargo Advisors says in a statement: ‘We are committed to helping our clients achieve their investment goals through advice that is regularly reviewed and aligned to their objectives and risk tolerances. In co-operating fully with Finra, we have made significant policy and supervision changes, including the discontinuation of the ETPs in focus.’
‘We…credit firms that proactively detect and correct issues prior to detection by Finra, as Wells Fargo did in this matter,’ says Susan Schroeder, executive vice president of Finra’s enforcement department. ‘Firms soliciting sales of volatility ETPs should already be well aware of the unique risks they pose – but Finra’s Regulatory Notice 17-32 is intended to further educate the industry so that member firms can assess their own practices and take appropriate remedial action if necessary.’
Ben Maiden
Ben Maiden is the editor-at-large of Governance Intelligence, an IR Media publication, having joined the company in December 2016. He is based in New York. Ben was previously managing editor of Compliance Reporter, covering regulatory and compliance...
