The controversy surrounding leveraged exchange traded funds (ETFs) shows no sign of letting up, and on Sept. 1, the Financial Industry Regulatory Authority (FINRA) announced plans to raise margin requirements for leveraged ETFs beginning Dec 1. FINRA’s Regulatory Notice 09-53 states that the “inherent volatility” of leveraged ETFs is one of the reasons for the new requirements.

The change in regulations comes on the heels of a lawsuit filed by a group of investors in August against ProShares and one of its leveraged inverse ETFs. The investors allege that ProShares misrepresented the UltraShort Financials ProShares Fund and that they were never informed shares in the fund should not be held for more than one single trading day.

Leveraged ETFs are considered a subset of traditional ETFs and attempt to generate multiples (i.e. 200%, 300% or greater) of the performance of the underlying index or benchmark they track. Some leveraged ETFs are “inverse” funds, which means they try to deliver the opposite of the performance of the index or benchmark they track. Leveraged ETFs can include among their holdings high-risk derivative instruments such as options, futures or swaps.

The complexity and potential risks associated with leveraged ETFs have garnered both the media spotlight and the attention of regulators who contend many retail investors do not fully understand how the products work. Both FINRA and the Securities and Exchange Commission (SEC) recently issued warnings highlighting the risks for investors in leveraged ETFs, particularly those who invest for the long term. In response, some brokerage firms announced new sales limits on client investments in leveraged ETFs, while others halted sales altogether.

In July, Massachusetts’ Secretary of State William Galvin launched an inquiry into how three leveraged ETF providers – Rydex, ProShares and Direxion – marketed and sold leveraged ETFs, as well as what they were telling brokers who sold the funds to clients. Detractors of leveraged ETFs, including FINRA and the Securities and Exchange Commission (SEC), contend retail investors may not fully understand the complexity of ETFs nor realize the products must be monitored on a daily or near daily basis.

Three years ago, there were no leveraged ETFs in existence. Today, there are more than 140 leveraged ETFs with about $30 billion in assets.

The widow of a 77-year-old man has filed an arbitration claim with the Financial Industry Regulatory Authority (FINRA) against Ameriprise Financial Services on allegations an Ameriprise broker failed to appropriately advise her elderly husband about a variable annuity purchase and further botched the beneficiary designation on the investment.

According to the claim, Deborah Amilowski, a broker with Ameriprise’s Hauppauge, New York office, recommended an unsuitable RiverSource variable annuity as an initial investment to the woman’s husband. As reported Aug. 27 by Investment News, when the client purchased the annuity in 2005, he was over the maximum age allowed for the guaranteed death benefit. As a result, any heirs would only be eligible to receive the market value of the annuity at time of his death, according to the claim.

The investor placed $850,000 into the annuity over a one-year period, according the Investment News article.

The original beneficiary on the annuity was an irrevocable trust, according to the claim, but the investor had instructed the Ameriprise broker to change the beneficiary designation to a revocable trust. Ameriprise reportedly informed the client (whose name has not been released) that his change request had been fulfilled. However, at the time of his death in March 2008, his family discovered that the change never made it to processing.

During the time that Ameriprise investigated the beneficiary designation issue, the account’s value went from more than $1 million to a little more than $750,000. The annuity was liquidated in October, 2008.

The widow is seeking damages for the unsuitable annuity recommendation, as well as for Ameriprise’s alleged negligence in failing to either pay out the benefit in a timely manner or to protect the annuity’s value.

Marcus Schrenker was Indiana’s own version of Bernie Madoff. Before his arrest in January, Schrenker had built a successful investment advisory business off of the money and trust of family and friends. Behind the scenes, however was a different story, with Schrenker selling nonexistent foreign currency funds, creating false account information, and using clients’ money to fund a lavish lifestyle that included a private plane and a luxurious lakeside estate. On Aug. 19, during federal sentencing in Pensacola, Fla., Schrenker was given 51 months in prison for charges stemming to the Jan. 11 plane crash in which Schrenker tried to fake his own death near Florida.

Schrenker’s legal issues are far from over, however. He still faces 11 felony counts related to his investment businesses in Indiana.

Schrenker’s victims include his aunt, Rita Schilling, who transferred more than $200,000 to one of Schrenker’s investment companies in August 2008. Another victim is a long-time friend, Charles Black. In 2004, Schrenker moved $100,000 out of Black’s account without his consent, according to a probable cause affidavit.

As in the case of Bernie Madoff, Schrenker’s roster of clients never became suspicious of the Indiana money manager because they knew him personally or had been introduced to him by people they trusted. Also like Madoff, Schrenker’s facade of investing prowess was aided by personal images of wealth and success.

The devil is in the details. This is especially true for leveraged and inverse exchanged traded funds, or ETFs. These aggressive and complicated financial products have evolved from straightforward instruments to funds that use baskets of derivatives and risky credit swaps to provide inverse, leveraged, leveraged-inverse, and commodity-linked returns. Unlike traditional ETFs, inverse and leverage ETFs have “leverage” inherently embodied into their product design. Translation: Increased risks for investors.

Leveraged ETFs use credit swaps or derivatives to amplify daily index returns, while inverse ETFs are designed to profit from a decline in the value of the underlying assets that the fund mirrors. This could be a stock index, currency, commodity or specific industry sector like real estate. If the underlying index declines by 1%, the inverse ETF should, in theory, increase 1% on that same trading day.

Investing in leveraged and inverse ETFs can be tricky, not to mention potentially dangerous for the average investor. These types of ETFs are meant to reflect the underlying asset moves on a daily basis. When held longer for a day, the end result can spell financial disaster.

Leveraged and inverse ETFs are big business for investment firms and financial advisers. Assets in leveraged and inverse funds increased 51% this year, reaching $32.8 billion. This explosive growth prompted the Financial Industry Regulatory Authority (FINRA) to issue a warning to brokers in June that leveraged and inverse ETFs may not be an appropriate investment for long-term investors because returns can deviate from underlying indexes if held for longer than a day.

Since then, several investment firms have halted their sales of leveraged ETFs. Among them: UBS, Edward Jones and Ameriprise Financial.

Yesterday, a class-action lawsuit was filed against ProShares – one of the top sellers of inverse and leveraged ETFs – over one of its inverse leveraged exchange traded funds. According to the complaint, the ProShares UltraShort Real Estate fund did not disclose a series of risks associated with the fund, including a “spectacular tracking error.” The lawsuit also says the company markets its leveraged funds as “simple directional plays.”

The ProShares UltraShort Real Estate fund was designed to deliver amplified returns against an index, which in its case was the Dow Jones Real Estate Index. The returns were supposed to be twice the opposite of that index. In 2008, however, the index fell 39%, yet the fund fell 48%.

New York-based Prime Capital Services (PCS) and several of its brokers – Eric J. Brown, Matthew J. Collins, Kevin J. Walsh and Mark W. Wells – face enforcement action by the Securities and Exchange Commission (SEC) for allegedly luring senior citizens and retirees to buy unsuitable variable annuities.

According to the SEC complaint, Prime Capital Services and its parent company, Gilman Ciocia of Poughkeepsie, New York, recruited the majority of clients by offering free-lunch seminars in Florida, encouraging elderly investors to schedule private appointments with PCS representatives. What the meetings reportedly failed to reveal, however, was key information relating to the variable annuities, including their high costs and lock-in periods.

The SEC contends Prime Capital Services and its brokers earned millions of dollars in sales commissions and that many of the variable annuities sold were unsuitable investments for customers due to their age, liquidity, and investment objectives.

In addition, the SEC says representatives from Prime Capital Services told customers that the annuities were “guaranteed” not to lose money, while failing to disclose the fact that the guarantee only occurs upon the death of the person holding the annuity. Prior to that, the value of a variable annuity can fluctuate widely depending on the performance of a portfolio’s securities.

The SEC also named Prime Capital Services’ President Michael P. Ryan in its complaint, along with PCS employees Rose M. Rudden and Christie A. Andersen.

In 2005, Prime Capital Services faced similar allegations and settled with the Financial Industry Regulatory Authority (FINRA). Without admitting any wrongdoing, the company paid a $200,000 fine, replaced the firm’s compliance officer and reportedly enhanced its compliance policies.

On March 23, 2009, a St. Louis, Missouri, FINRA arbitration panel awarded investor Philip Rein $220,944 plus interest on his claims of fraud, breach of fiduciary duty and negligence against Stifel, Nicolaus & Company. 

According to award documents (FINRA # 07-01495), the claimant alleged that St. Louis-based Stifel Nicolaus failed to heed his stated investing objectives, which were focused on generating money for retirement income. Instead, Stifel created a retirement portfolio for Rein by investing a portion of his assets in a Pacific Life Variable Annuity and another portion of assets in three aggressive, all equity, money-management funds.

Ultimately, because of the Stifel’s selected investments, the investor said he lost the majority of his principal.

A group for attorneys representing individual and institutional investors in securities arbitration disputes has formally petitioned the Securities and Exchange Commission (SEC) to remove a requirement that allows representatives from the securities industry to serve as arbitrators on Financial Industry Regulatory Association (FINRA) panels. 

The Public Investors Arbitration Bar Association, or PIABA, filed its petition with the SEC on June 11. 

Currently, FINRA rules mandate that any investor case involving $100,000 or more in damages must be heard by a three-person FINRA arbitration panel, with one of the panelists affiliated with the securities industry. PIABA wants investors to have the right to strike industry representatives from hearing their cases. 

“Requiring customers who believe they have been wronged by the securities industry to have claims decided by panels that must include a representative of that securities industry creates at the least the appearance of bias, if not outright bias,” said PIABA in its petition to the SEC.

As reported June 21 by Investment News, PIABA essentially is asking FINRA to expand a two-year pilot program that it launched in October 2008. The program entails 11 major brokerage firms that agreed to allow up to 276 investor plaintiffs a year choose all-public arbitration panels. 

Year-to-date through May 2009, 3,163 arbitration cases have been filed with FINRA. That is up 85% from the same period last year.

If you are an individual or institutional investor and have concerns about your investments, contact Maddox Hargett & Caruso at 800-505.5515. We can evaluate your situation to determine if you have a claim.

It’s official. The Financial Accounting Standards Board (FASB) has approved relaxing fair value, or mark to market, accounting rules, a move that gives banks leeway to assign a value to investments based on their own internal model of what the assets might sell for in the future rather than in current market conditions.

Revising the accounting standard will be a boost to banks, which stand to see a 20% or more gain in their quarterly operating profits. 

The FASB voted on easing the mark to market rule on April 2. 

Critics of the rule change say it will lessen the transparency of a company’s fiscal health and may encourage some institutions to inappropriately raise the value of certain assets to give the appearance of rosier balance sheets.

As for investors, without the early warning signs created by mark to market accounting, they could very well find themselves left in the dark when it comes to detecting potential problems of a particular financial market. If problems do arise, it may be too late for them to do anything about it. 

Proposed revisions to the fair value accounting standard known as FAS 157 have garnered harsh criticism from those who say the changes are ambiguous and undefined, lack substance and will create further inconsistencies as banks assign value to some assets. 

Under current FAS 157 rules, three different valuation levels exist for banks to price their mark-to-market holdings. Level 1 assets have readily observable prices and trade in active markets. Level 2 assets do not trade actively nor do they have easily obtainable prices. Level 3 assets include the most problematic holdings, such as collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs) and other exotic derivatives created by prime and subprime mortgages.  

Level 3 holdings are considered illiquid, with market prices so scarce that companies use internal models to gauge their value. In other words, placing a value on these assets is subjective and largely depends on assumptions or opinions. For this reason, Level 3 valuation is often referred to as “mark-to-myth” or “mark-to-imagination.” 

The new proposals for FAS 157 assume that “inactive” markets are the same as “distressed” markets. Moreover, the revisions essentially would allow banks to move more hard-to-value assets into Level 3. This means a company will be able to “handpick” the most appealing value for its assets, while casting aside any that might cause them financial turmoil. 

The bottom line: The proposed amendments to FAS 157 appear to squash the intended purpose of fair value accounting altogether. 

The Financial Accounting Standards Board plans to vote on the revisions to FAS 157 on April 2.

Dozens of retirees from Xerox Corp. and Eastman Kodak will soon share in a welcome pay-out after the Financial Industry Regulatory Authority (FINRA) ruled investment firm Morgan Stanley must pay $7.2 million to settle charges that two of its brokers wrongly persuaded 90 Rochester, New York, employees to take early retirement. Ultimately, the false promises of big profits and unsuitable investing strategies cost many of the investors their life savings. 

FINRA’s ruling breaks down to $3 million in fines and $4.2 million in restitution to the retirees. In addition, former Morgan Stanley broker Michael Kazacos is permanently barred from the securities industry. The second former Morgan Stanley broker, David Isabella, was charged with misconduct. His case must still go before a three-person FINRA hearing panel. Ira Miller, who managed both Kazacos and Isabella, has been suspended from acting as a supervisor for one year and fined $50,000. 

According to a March 25 statement issued by FINRA, from the years of 1998 to 2003, Kazacos allegedly solicited potential clients from Kodak and Xerox by promising them at least 10% annual returns on their investments with Morgan Stanley. He also reportedly told clients they would be able to keep up their current lifestyles by withdrawing 10% every year and not touch their principal.  

FINRA has charged Isabella with similar misconduct. As reported March 26 by 13WHAM-TV in Rochester, New York, Gerald Miller is one of the individuals who followed Isabella’s advice. Miller, who worked for Xerox, was told by the former Morgan Stanley broker that he would “make him a millionaire in 10 years.” Instead, three years after investing with Isabella, Miller learned that he and his wife needed to drop their 10 percent draw and that they were “going to run out of money in five years.” 

The Millers were later told by Isabella that they might need to sell the lakefront home they previously purchased for their retirement years, according to 13WHAM-TV. 

Other retirees are in the same predicament as the Millers. Some have financial issues, while others are headed toward bankruptcy because they retired too early. 

Morgan Stanley’s settlement with FINRA comes out to approximately $45,000 a person, far below the amount of money many retirees actually lost in the early retirement investment promotion.