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Sunday, November 5 2017

FINRA Brings Enforcement Action Against Wells Fargo Advisors Financial Network for Failure to Vet Volatility-Linked ETPs

FINRA has censured Wells Fargo Advisors Financial Network (“Wells Fargo” and “the Firm”) and ordered more than $3 million in restitution over the firm’s failure to perform the due diligence regarding the suitability of investment products it recommend to clients from 2009-2012. According to the settlement announced October 16, Wells Fargo and certain registered representatives of the firm did not perform reasonable diligence with respect to the nature and potential risks of the “Volatility ETPs” it recommended to clients and, as a result, many Wells Fargo customers suffered significant losses from their investment in the products.

Over a period of about three years, Wells Fargo “failed to vet or impose any restrictions on the Volatility ETPs that became available.” Without the appropriate restrictions or guidelines in place, some Registered Representatives of firm caused “customers with conservative or moderate risk profiles and investment objectives to purchase and hold Volatility ETPs for extended periods.” Some Wells Fargo Representatives “mistakenly believed that the volatility ETPs could be used as a long-term hedge on their customers’ equity positions in the event of a market downturn.” However, Volatility ETPs are generally short-term trading products with a value that degrades significantly over long periods of time; such products are not suitable for use as part of long-term buy-and-hold investment strategy.

As the FINRA settlement explains, “Volatility ETPs attempt to provide exposure to the Chicago Board Options Exchange Volatility Index (the “VIX”)” through “futures contracts of varying maturities.” Exposure to the VIX is desirable because it “tends to be negatively correlated with broader financial markets and rises in periods of market distress.” However,” ETPs do not track the VIX on a one-to-one basis.” Rather, Volatility ETPs track VIX futures, and “many of the futures contracts have historically traded in ‘Contango Markets’” where “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, [in order to maintain continuous, targeted exposure to the VIX], adversely affect[s] performances over time,” and “any volatility ETP that is held for a long period of time is highly likely to lose value.”

The reasonable-basis suitability obligation under NASD Rule 2111 requires a broker-dealer and its registered representatives to perform reasonable diligence to understand the nature of a recommended security as well as the potential risks and rewards. Although the SEC does not have an express suitability rule for Investment advisers, Advisers do retain a fiduciary duty to clients which, similarly, requires them to reasonably determine that the investment advice or services they provide are suitable and in the client’s best interest. Moreover, Registered Investment Advisers, like Broker-Dealers, are required to maintain written supervisory procedures that are reasonably designed to achieve compliance with applicable laws and rules.

If you are an investment adviser or broker-dealer with questions/concerns about meeting your suitability obligations or questions/concerns about the suitability of ETPs or any other investment products, please call us at 888.302.4594 or email us at sales@redoakcompliance.com, and we will be happy to assist.