May 27, 2014
Infinex Investments, Inc. is a full-service broker-dealer that primarily sells mutual funds and variable annuities. It employs approximately 400 registered representatives in about 500 branches. From April 2009 through March 2011, Infinex allowed 35 registered representatives to recommend to 229 customers approximately 835 transactions in inverse and inverse-leveraged Exchange-Traded Funds (“Non-traditional ETFs”). According to a Letter of Acceptance, Waiver and Consent that Infinex submitted to FINRA in March 2014, these registered representatives had minimal knowledge and training of Non-Traditional ETFs. The recommendations therefore lacked a “reasonable basis” and were unsuitable. Some of the recommendations were also unsuitable on a customer-specific basis. FINRA further alleged that Infinex failed to establish and maintain an effective supervisory system.
ETFs are typically registered investment trusts or open-ended investment companies whose shares represent an interest in a portfolio of securities that tracks an underlying benchmark or index. Non-traditional ETFs use swaps, futures contracts, and other derivative instruments to achieve some stated objective, usually only on a daily basis. This means that performance of these funds over long periods of time can differ significantly from the performance of their underlying benchmark or index, particularly during a volatile market. Most of the Non-Traditional ETFs that Infinex sold were inverse-leveraged funds that sought returns for a single day. Therefore, the Infinex customers that invested in these Non-Traditional ETFs were subjected to an increased risk that they would lose money if their relative benchmark indices stayed flat or rose. By recommending these investments without the proper due diligence, Infinex made unsuitable securities sales. Infinex violated both its reasonable-basis and customer-specific suitability obligations.
Under NASD Conduct Rule 2301(a), a broker-dealer and its registered representatives must perform reasonable diligence to understand the nature of any security they recommend, as well as the potential risks and rewards. With respect to inverse-leveraged ETFs, FINRA has specifically stated that the firm must understand how the fund is designed to perform, how it intends to achieve its objective, the impact of market volatility, and how a customer’s holding period will impact performance. But Infinex didn’t subject Non-Traditional ETFs to any harder level of review than its other new products offered for sale. Infinex’s registered representatives also received minimal training on Non-Traditional ETFs and failed to perform reasonable diligence to learn the risks of the product. These failures prevented Infinex from evaluating critical aspects of Non-Traditional ETFs, including the implications of a daily reset and leverage components, in order to establish appropriate training and supervision protocols. Accordingly, Infinex’s Non-Traditional ETF recommendations lacked a reasonable basis and were unsuitable for its customers.
According to the AWC, almost 20% of the Non-Traditional ETF recommendations were also unsuitable under a customer-specific suitability theory. Recommendations were made to 87 customers that had conservative investment objectives. Moreover, 143 Non-Traditional ETFs that were purchased were maintained in customer accounts for longer than advised in the prospectus. More than 70 customers with conservative objectives whose ETFs were held for more than the prospectus’ recommended seven days lost money on their investments. In addition to recommending unsuitable investments, Infinex also failed to maintain a reasonable supervisory system concerning the sales of Non-Traditional ETFs. Infinex failed to timely implement any specific, written supervisory procedure for the review of Non-Traditional ETF transactions. It also had inadequate supervisory reviews for Non-Traditional ETF suitability. Infinex failed to incorporate the complexities and unique risks associated with Non-Traditional ETFs. Infinex’s principals that completed the suitability reviews used the same procedure they used to review Infinex’s trading of any other securities products. FINRA has warned firms about the additional diligence required when recommending Non-Traditional ETFs, but Infinex made insufficient changes to its supervisory system to incorporate this guidance. Infinex also failed to conduct any training or provide written guidance to its registered representatives regarding the sale and supervision of Non-Traditional ETFs. Infinex agreed to a censure, a $75,000 fine, and to pay restitution to customers in the amount of $287,171.
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