FINRA Investigating Broker Dealers over Sales Practices and Supervision of Sales of VIX Related Products

Sonn Law Group has learned that FINRA has launched an investigation into the sales practices and supervision of broker dealers relating to the sale of VIX linked products.

This is a very important investigation because it will likely reveal deficiencies in supervision of products linked to the VIX, such as XIV and SVXY that resulted in devastating losses for many investors who were wrongly permitted to trade these financial time-bombs on margin.

In my humble opinion, broker dealers that permitted investors to trade XIV and SVXY on margin were assisting in the proliferation of weapons of mass financial destruction. The fact is that broker dealers have a “reasonable basis suitability” obligation to ensure that products receive appropriate due diligence review before any product is offered to ensure that they are suitable for at least some investors. In this matter, the reality is that SVXY and XIV on margin were not suitable for any retail investor.

Even the chairman of Credit Suisse admitted that these products were designed for professional or institutional traders to manager risk on a daily basis, inferring that they really were not suitable for any nonprofessional retail investor. Almost all of the retail investors I talked to held these products for more than one day, which is completely unsuitable for any investor, as it was not designed for that purpose.

I have to believe that broker dealers had risk systems in place to detect that retail investors held these products for more than one day, on margin, which is clearly unsuitable. Yet they continued to extend margin on products that in my humble opinion are financial weapons of mass destruction; which I also believe was against the suitability rule, and against FINRA Rule 2010, that states that broker dealers who are member of FINRA, “in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.”

In my opinion, broker dealers that allowed retail investors to trade XIV and SVXY for more than one day, especially on margin, violated FINRA Rule 2010 and 2111.

Unfortunately, like many FINRA investigations, due to the fact there are 5000 broker dealers, and over 660,000 financial advisors, I would not expect any regulatory findings for one to two years, and in the meantime, many investors will be sued to repay margin obligations that they should not have to repay.

One of the most difficult parts of the investigation will be of the online discount broker dealers, because they always disclaim any responsibility for losses by their customers in online trading. But this time should be different, because I believe these products should never have been offered to any non-professional or non-institutional retail investor, at all, in my opinion.

I also think this is a critical opportunity for FINRA to show that the “reasonable basis suitability” obligation has some teeth. If they don’t fine broker dealers for violating that rule then I thinkIt will be a license for broker dealers to sell any product they want to sell, regardless of the fact that not all products should be offered, especially those that are actually designed to go to a zero valuation, like XIV, for example.

If not, that would mean, theoretically, that a broker dealer could sell a derivative product off the income of a ponzi scheme, which obviously should not be permitted. Ponzi schemes eventually all go to zero. Similarly, XIV was designed to go to zero. So the repercussions and moral hazard of failing to fine firms for offering XIV and SVXY, on margin, is astounding.

It is critical that FINRA take a firm stance that these products should not have been offered to typical retail investors that are non-professional or non-institutional to show that it stands for investor protection; and if it fails to act decisively, then I think retail investors will lose confidence in the fairness of the marketplace and self regulation.

But I believe that FINRA will do the right thing. I have to believe that FINRA will uphold the principals of the “reasonable basis suitability” rule and find that it was not appropriate to sell to any non-institutional investor.

To read the statement from FINRA on their investigation into sales practices and supervision of VIX linked products click here.