Monday, August 12, 2013

Morgan Stanley Fined By NJ for ETF Sales

Morgan Stanley and Co. has agreed to pay $100,000 to the New Jersey Bureau of Securities in a consent order on July 29, after the Bureau found the company was in violation of state securities laws and regulations in its sale of non-traditional exchange-traded funds to investors.

Non-Traditional ETFs are leveraged funds which are designed to deliver multiples oft the performance (usually 2x or 3x) of the index or benchmark they track. For example, a leveraged EFT which tracks the Dow Jones Industrial average is designed to deliver 2 or 3 times the return of the Dow Jones 30. There are also non-traditional ETFs which deliver the reverse of the tracked index.

These Non-Traditional ETFs can deliver significant returns, but also have the potential for significant losses. While an ETF may go up three times more than the Dow 30 goes up, it will also go down three times more. The loss potential is significant. We represented an investor who lost millions of dollars in a few months following the advice of a broker who was recommending the use of Non-Traditional ETFs, including ProShares Ultras and ProShares Ultra Shorts. We were able to obtain recovery for the investor after filing a FINRA arbitration against the broker and his firm.

One of the risks in Non-Traditional ETFs that is no obvious to investors is the fact that they “reset” daily, meaning that the value of a Non-Traditional ETF is adjusted daily in order to maintain the proportional exposure to the index or benchmark it is designed to track. Due to the effects ofthis daily “reset”, Non-Traditional ETFs are intended to achieve their stated objectives only on a daily basis. When held for periods longer than a single day, Non-Traditional ETFs can begin to generate returns that differ significantly from the performance ofthe underlying indices or benchmarks that they are designed to track.

Tracking error in Non-Traditional ETFs is particularly evident in volatile markets due to the magnified effects of compounding. When held for periods longer than a single day, the volatility present in the index or benchmark that the Non-Traditional ETF tracks can affect the returns generated by the Non-Traditional ETF, even when the index or sector moves in the general direction that the purchaser predicted or expected. The greater the volatility in the market during a particular period, the greater the likelihood that a particular Non-Traditional ETF will produce an extreme and unpredictable result — thereby increasing the risk associated with that product.

Because of this issue, and the lack of broker and investor awareness of this hidden risk, in June 2009 FINRA released Regulatory Notice 09- 31 reminding member firms of their sales and supervisory practice obligations in connection with Non-Traditional ETFs. The Notice described Non-Traditional ETFs as “highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis.” The Notice concluded that “due to the effects of compounding, [Non Traditional ETF] performance over longer periods oftime can differ significantly from their stated daily objective,” and that “therefore, inverse and leveraged ETFs that reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

The Bureau found violations in Morgan Stanley's sale of ETFs to investors included a failure to provide adequate training to its sales force,  the failure to properly supervise the sales of Non-Traditional ETFs, and the recommendation of unsuitable ETFs to investors.

The settlement is $65,000 in civil penalties, $25,000 for reimbursement of the Bureau's investigative costs and $10,000 for Bureau use in investor education. New Jersey investors previously received $96,940.34 in restitution from Morgan Stanley.

The Morgan Stanley Consent Order is available at the Bureau's website.

The attorneys at Sallah Astarita & Cox include veteran securities litigators and former SEC Enforcement Attorneys. We have decades of experience in securities litigation matters, including the defense of enforcement actions. We represent investors, financial professionals and investment firms and brokers nationwide. For more information contact Mark Astarita at 212-509-6544 or at email us
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