New York Securities Lawyer Blog
The Financial Industry Regulatory Authority’s (“FINRA”) February 2015 disciplinary actions release reported that on December 9, 2014, Citigroup Global Markets, Inc. (“Citigroup”) submitted a letter of Acceptance Waiver and Consent (“AWC”) to settle allegations that it failed to deliver prospectuses to its customers who purchased shares in Exchange Traded Funds, (“ETFs”) in violation of Section 5(b)(2) of the Securities Act of 1933, FINRA Rule 2010, and NASD Rules 3010(a) and 3012. The full AWC can be found here. Citigroup submitted the AWC without admitting or denying the findings and solely for the purpose of settling the allegations brought by FINRA. Along with submitting the AWC, Citigroup consented to censure and a fine of $3,000,000—paid jointly to FINRA and the New York Stock Exchange (“NYSE”).
An ETF is typically a registered unit investment trusts or open-end investment company whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. However, some ETFs, known as “Short” or “Bear” ETFs, seek to achieve the opposite performance of their benchmark. In other words, the value of a Short ETF tracking the price of gold should go down when the price of gold rises, and vice versa. When an ETF utilizes debt and complex financial derivatives to amplify their returns, they are known as a “Leveraged ETF.” It is important for customers to know both the benchmark the ETFs tracks and the way that the ETF utilizes leverage prior to purchasing shares in an ETF.
While ETF shares are typically listed on national securities exchanges and trade throughout the day, they trade at prices established by the market, not the net-asset-value of the ETF’s portfolio. However, many ETFs “reset” daily, and as such, their long term performance may not reflect the benchmark they follow. Because of this resetting feature, ETFs may not be appropriate for long term investing. Under Section 5(b)(2) of the Securities Act of 1933, delivery of shares in an ETF is prohibited unless it is accompanied or preceded by a copy of a prospectus, or a written description, but only then if certain conditions are met.
The Citigroup AWC arose of out Citigroup’s failure to deliver ETF prospectuses for approximately 255,000 customer purchases of approximately 160 ETFs from September to November 2010. Additionally, FINRA estimates that from 2009 through April 2011, Citigroup could have failed to deliver prospectuses for over 1.5 million customer purchases of ETFs. FINRA alleged that the the violation occurred because Citigroup’s supervisory system was not reasonably designed to ensure ongoing compliance with the prospectus delivery rules after key personnel left in 2008.
FINRA alleged that each time Citigroup failed to deliver a prospectus to a customer who purchased an ETF, it violated federal law. As discussed above, Section 5(b)(2) of the Securities Act of 1933, which prohibits anyone from conveying a security through the mail or interstate commerce “for the purpose of sale or for delivery after sale, unless accompanied or preceded by a prospectus.” Additionally, FINRA alleged that Citigroup violated FINRA Rule 2010 and NASD Rule 3010 because Citigroup’s supervisory systems concerning ETF prospectus delivery were not reasonably designed to achieve compliance with prospectus delivery requirements during the relevant period. Both FINRA Rule 2010 and NASD Rule 3010 (while the NASD rule is no longer in effect, it was in effect during the relevant period) require that all members, in the conduct of business, shall observe high standards of commercial honor, just and equitable principles of trade, and that FINRA member firms must establish and maintain a system to supervise its employees that is reasonably designed to achieve compliance with the federal securities laws and self-regulatory organization rules. Finally, FINRA alleged Citigroup failed to adequately audit its compliance procedures, which might have revealed that customers were not receiving ETF prospectuses earlier, in violation of NASD Rule 3012(a)(1)(B), (also in effect during the relevant period), which requires that member firms test their supervisory procedures to ensure they are reasonably designed to achieve compliance with applicable securities laws and regulations.
According to FINRA, this recent enforcement action is not the first time Citigroup has been fined for failing to deliver ETF prospectuses to its customers. In September 2007, in connection with New York Stock Exchange Hearing Board Decision 07-143, Citigroup entered into a Stipulation of Facts and Consent to Penalty whereby it agreed to pay a civil penalty of a $2,250,000 for failing to have appropriate policies and procedures relating to the delivery of product descriptions or any other disclosure documents, such as a prospectus, to customers who purchased ETFs. Additionally, in the previous settlement, Citigroup agreed to provide NYSE with a written certification that the firm’s compliance policies and procedures regarding the delivery of prospectuses were being reasonably designed to ensure compliance with the applicable federal securities laws and NYSE rules. Citigroup timely submitted confirmation that its compliance procedures were updated and adequate in December 2007. However, FINRA alleged that Citigroup’s compliance procedures concerning delivery of ETF prospectuses were still inadequate. In 2008, after key compliance personnel left Citigroup, responsibility for ensuring ETF prospectuses were delivered to customers became undefined, leading to the recent AWC.
ETFs are complicated products that may not be suitable for all investors. If you have any questions about ETFs or have invested in, contact the attorneys at Lax & Neville today by calling (212) 969 1999.