Leveraged and Inverse ETF Investment Loss Investigation

Regulatory Scrutiny of Leveraged ETF Access through Broker-Dealers

For over 15 years, FINRA, the Securities & Exchange Commission, and state securities regulators have repeatedly raised the alarm to broker-dealers about investor protection concerns regarding leveraged ETFs due to their speculative nature, holding period issues, and lack of disclosures to customers.

For instance, FINRA’s Regulatory Notice 09-31 is among the more notable regulatory warnings about these products. There, FINRA notified broker-dealers like Respondent of the importance of making sure its customers were aware of the risks associated with leveraged ETFs:

FINRA reminds firms that, as new complex and non-traditional ETFs are introduced to the market, firms should also keep in mind IM-2310-2(e) (Fair Dealing with Customers with Regard to Derivative Products or New Financial Products), which states that “[a]s new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer’s financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products.

Later, in June 2015, the SEC requested comments on Release No. 75165 regarding exchange-traded products, noting their increased prevalence and soliciting comment regarding, among other things, the ways in which broker-dealers market ETPs, especially to retail investors and the extent to which individual investors understand the nature and operation of ETPs. See SEC Release No. 75165.

In July 2019, the North American Securities Administrators Association (“NASAA”) published a key report on Broker-Dealer Policies and Procedures for Leveraged and/or Inverse Exchange-Traded Funds, which advised broker-dealers of how to address the risks associated with leveraged ETFs with their customers. In the report, NASAA encouraged firms to guard against inappropriate holding periods for its customers and stated that broker-dealers should consider incorporating procedures to address, in part, the following:

• Providing customers with educational materials regarding the risks of leveraged and/or inverse ETFs prior to the first sale;
• Imposing holding period time frames to prompt a supervisory review when leveraged and/or inverse ETFs are held longer than 1 day, 1 week, 1 month, etc.; and
• Creating trade reports, exception reports and alerts designed to attract supervisory attention when leveraged and/or inverse ETFs are held for longer than one day and/or held by customers who do not meet specific suitability criteria

To make its message clear, state, and federal regulators over the past decade have brought dozens of enforcement actions against brokerage firms and investment advisory firms, fining them tens of millions of dollars for their failures relating to their lack of disclosures on leveraged ETFs and not protecting against the risks of holding these securities beyond one trading session. In other words, brokerage firms have been on notice for years about their need to appropriately protect their customers from these speculative products.