Last week, a New York City panel of arbitrators with the Financial Industry Regulatory Authority (FINRA) unanimously awarded an investor represented by Malecki Law over $200,000 in damages, plus attorneys’ fees of $67,000 and 5% interest dating back to May 2018. The panel’s award found the New Jersey-based brokerage firm Network 1 Financial Securities Inc. to be liable in connection with the investor’s allegations of unsuitable investment recommendations, misrepresentations (NY General Business Law § 349), and failure to supervise its broker/financial adviser, Robert Ciaccio, who now has 7 disclosures on his public FINRA BrokerCheck disciplinary record (5 customer complaints and 2 regulatory censures). The investment at issue was Proshares Ultra Bloomberg Crude Oil 2X (otherwise known by its stock symbol UCO), which Mr. Ciaccio recommended to the investor but failed to disclose the numerous risks associated with this product, which belongs to a group of products known as Non-Traditional Exchange Traded Funds (or Non-Traditional ETFs).
FINRA, the Securities and Exchange Commission (SEC), and other regulators have repeatedly warned firms against selling Non-Traditional ETFs because they are difficult to understand and carry risks that are not easily understood by the typical investor. Unlike a simple investment like a stock or bond, Non-Traditional ETFs are fee-laden, structured products, built with derivatives and complex mathematical formulas, which, in “simplest” terms, offer leverage and are designed to perform inversely to an outside benchmark index (e.g., the S&P 500, VIX, etc.). Noting the popularity of these high-risk, high-cost products, FINRA has issued numerous investor alerts and warnings to member brokerage firms about Non-Traditional ETFs, stating:
“While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets…. In particular, recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended; sales materials related to leveraged and inverse ETFs must be fair and accurate; and firms must have adequate supervisory procedures in place to ensure that these obligations are met.”
FINRA issued the above warning in June 2009, yet numerous firms have since been fined tens of millions of dollars for supervisory failures regarding the recommendation and sale of Non-Traditional ETFs. FINRA even fined and sanctioned Network 1 in 2017, stating that “Network 1 failed to establish, maintain and enforce a supervisory system…reasonably designed to supervise representatives’ sales of leveraged, inverse, and inverse-leveraged exchange-traded funds (‘Non-Traditional ETFs’).” Despite this, Network 1 continued “business as usual” by selling and making ill-advised hold recommendations of Non-Traditional ETFs to other investors.
Contrary to FINRA’s warning and the UCO prospectus, Mr. Ciaccio, the Network 1 broker at issue in last week’s award, made repeated recommendations to hold UCO, which, due to the derivative-based compounding effect alluded to above, makes recovery from any investment losses increasingly more difficult with each day held. In a volatile market where the market is down, the compounding effect of UCO’s 2X multiplier makes recovery at 2X more difficult, especially in a long-term hold with the ongoing expenses and fees built into UCO. Non-Traditional ETFs and other Proshares products like UCO may “track” underlying indices like crude oil futures, for example, but that does not mean they move up and down and perform in tandem with the ascribed index. As often happens in these complex product cases, the brokers are as uninformed about the products as the unsuspecting investors. At trial, a troubling fact for Network 1 was that its branch office supervisor proved equally uninformed about the product’s risks: in a clear conflict of interest, the arbitration panel witnessed testimony by Mr. Ciaccio’s identical twin brother, Michael Ciaccio, who was the Network 1 supervisor responsible for Robert, the broker.
What is notable about last week’s award against Network 1 is that the arbitrators were unanimous in awarding full damages and attorneys’ fees to the investor, a high-level, “sophisticated” accounting consultant. The “sophisticated investor” is a frequent defense strategy employed by brokerage firms at trial, however, the arbitration panel in this instance was not persuaded because the investor, despite his decades of knowledge and experience in corporate accounting, did not have any understanding about UCO or Non-Traditional ETFs. As the SEC and courts have previously held, being sophisticated in one area does not make someone sophisticated in another.
Moreover, it is not unusual for educated investors to fall prey to investment fraud, as research, such as the 2006 study by the NASD (National Association of Securities Dealers) Investor Education Foundation, shows that investment victims are more susceptible to fraud when they have higher levels of income and are more educated than the general population, including scoring higher on traditional financial literacy tests than non-victims in the general population. Financial literacy and “sophistication,” thus, do not inoculate investors from being victimized by a broker’s misleading investment pitch.
Malecki Law represents retirees and investors of all backgrounds, whether sophisticated or not. If you have incurred investment losses with your financial adviser and in non-conventional exchange-traded products (e.g., by issuers like Proshares, Direxion, iPath, VelocityShares), call us for a free assessment. Many of our clients choose a contingency fee arrangement, which means you do not pay unless we recover.