Financial investment advisors and stockbrokers could face new rules and regulations in the future under draft legislation sent to Capitol Hill by the U.S. Treasury. The legislation is designed to strengthen investor protections and includes such provisions as establishing consistent standards for anyone who gives investment advice about securities, improving the timing and quality of disclosures, and requiring accountability from securities professionals. The legislation also would establish a permanent Investor Advisory Committee to keep the voice of investors present at the Securities and Exchange Commission (SEC).

To view the draft legislation in its entirety, go to treas.gov/press/releases/tg205.htm

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.

As expected, H. David Kotz, Inspector General of the Securities and Exchange Commission (SEC), has delivered a scathing report on the agency’s mishandling of the Bernie Madoff scandal. The much-anticipated report is 450 pages in length, and blasts the SEC for never conducting “a thorough and competent investigation or examination” of Madoff and his investment advisory businesses. The inspector general goes on to reveal how the agency’s “inexperienced” attorneys remained oblivious to Madoff’s $65 billion Ponzi scam, accepting Madoff’s answers to their questions even when the responses were “seemingly implausible.”

The report also notes that during the course of several examinations by SEC staff members into Madoff, the financier made overt efforts to “impress and even intimidate the junior examiners from the SEC.” According to the report, Madoff emphasized his role in the securities industry, emphasizing his ties with high-ranking members at the agency. One of the examiners characterized Madoff as “a wonderful storyteller” and “very captivating speaker” and noted that he had “an incredible background of knowledge in the industry.”

Read the executive summary of the report here.

In March, Madoff was sentenced to 150 years in a North Carolina federal prison for his role in masterminding what is considered the biggest Ponzi scheme in history. Investors, including ordinary citizens, hedge funds, charities, famous names in the entertainment world and others, lost more than $65 billion to Madoff’s scheme.

These are scary times for investors. Stories of stockbroker negligence, record Ponzi schemes, investment fraud, and client misrepresentation have become an everyday occurrence. It’s no wonder investors – seasoned pros and novices alike – are increasingly wary when it comes to seeking advice from an investment advisor or financial representative, questioning if anyone associated with Wall Street can be trusted nowadays. I’m reminded of a scene from the 1976 film Network in which fictitious newsman Howard Beale (played by the late actor Peter Finch) delivers his “mad as hell and I’m not going to take this anymore” speech.

Jo L. Wright no doubt felt the way of Finch’s character. Wright, a church secretary from Whitestown, Indiana, lost thousands of dollars in a bond fund formerly managed by Morgan Keegan & Company. Wright’s initial introduction to the Memphis-based brokerage was through her local Indiana Regions bank branch manager. At the time of the referral, Wright had her money in what she deemed “safe” and “secure” investments: a certificate of deposit and a savings account.

That all changed based on the recommendation of the bank manager and Morgan Keegan. Wright transferred her money into the Morgan Keegan Select Intermediate Bond Fund. Relying on the information provided by Morgan Keegan and her Regions Bank manager, she believed the fund was a safe, conservative investment and that any risk of principal loss was virtually non-existent.

In truth, Wright actually put her money into a high-risk and speculative financial product, one with significant ties to complex structured finance investments that included subprime mortgage securities. In no way was it the kind of investment that a conservative-minded investor like Wright should have been advised to purchase.

Wright didn’t know that, however, because her financial advisor allegedly didn’t tell her. Nor did Wright receive a prospectus about her investment before purchase.

Wright eventually filed a complaint against Morgan Keegan with the Financial Industry Regulatory Authority (FINRA), and in March 2009 was awarded $18,000 for the financial losses she suffered. Her case underscores several important issues, however, when it comes to investing your money and selecting a financial advisor.

First, it’s your money. That means investors need to do some due diligence of their own. This includes asking your financial advisor some tough questions. Chief among them: Where has your advisor worked in the past? Is there a pattern of multiple jobs in a short period of time? If the answer is yes, it could be a red flag.

Another key question concerns compensation. How is the financial advisor paid for his or her services? Is it based on an hourly rate, flat fee, or commission? In addition, find out if the advisor is given bonuses for selling certain investment products. If so, this clearly could be a conflict of interest if one of those products is pushed to become part of your investment portfolio.

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.

Two Nobel laureates have entered into the valuation debate and are calling upon financial institutions to provide a more accurate portrait of their illiquid assets to investors. Robert Merton first commented on the issue in a column for the Financial Times on Aug. 18 in which he said banks that opposed mark to market accounting were simply looking to conceal depressed prices.

Myron Scholes echoed those comments in an Aug. 19 interview with Bloomberg, with both men urging banks to mark more securities to market and put any hard-to-value securities on public exchanges wherever possible.

According to Scholes and Merton, such a move would give investors better data on prices to more accurately reflect the value of an institution’s debt and equity securities.

Scholes and Merton shared the Nobel Prize for economics in 1997 for helping invent a model for pricing options. They also learned about the danger of leverage firsthand. Merton and Scholes were the creators of Long-Term Capital Management, whose collapse in 1998 was the largest-ever hedge fund failure at the time.

At one point, Long-Term Capital Management held more than $100 billion in assets. However, the firm was highly leveraged, borrowing billions to make big bets on esoteric securities. When the markets took a turn for the worse in 1998, the bets backfired and Long-Term Capital Management lost most its money. Fearing that its collapse could set off a full-scale market meltdown, the U.S. Federal Reserve stepped in to orchestrate a bailout by 14 lenders.

Ironically, there was only one naysayer among the 14 banks that agreed to the rescue: Bear Stearns.

Leveraged and inverse exchange-traded funds (ETFs) have come under fire recently for the potential dangers these complex financial products may hold for individual investors. ETFs are designed to capture two or three times the movement in a particular stock index or, in the case of an inverse ETF, provide results that are 100% opposite. In the current economic climate, however, many investors are discovering huge distortions in the stated performance objectives of these investments.

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) both issued investor alerts recently on leveraged and inverse ETFs, cautioning individuals about the investing pitfalls these highly specialized and complex products can create.

Specifically, leveraged and inverse ETFs provide leverage on a daily basis. Many investors fail to understand this concept and, instead, wind up buying an ETF and holding it for a year, which can put them at a huge financial risk.

In a recent SEC alert, two real-life examples were depicted of how returns on a leveraged or inverse ETF over longer periods of time can be widely different from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.

Example 1: Between December 1, 2008, and April 30, 2009, a particular index gained 2%. However, a leveraged ETF seeking to deliver twice that index’s daily return fell by 6% – and an inverse ETF seeking to deliver twice the inverse of the index’s daily return fell by 25%.

Example 2: During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53%, while the underlying index actually gained around 8%. An ETF seeking to deliver three times the inverse of the index’s daily return declined by 90% over the same period.

The SEC’s advice to individual investors who may be considering a leveraged or inverse ETF is to thoroughly do their homework. Make sure to understand the ETF’s stated objectives, as well as its potential risks. It’s also important to know that leveraged or inverse ETFs may be more costly in terms of fees than traditional ETFs. FINRA’s Fund Analyzer can estimate the impact of fees and expenses on your investment.

In addition, there can be significant tax consequences associated with leveraged or inverse ETFs that are less tax-efficient than traditional ETFs.

In the face of regulatory inquiries and pronouncements by the Financial Industry Regulatory Authority (FINRA) on the inherent risks they pose to retail investors, more brokerages are curtailing their activity in leveraged and inverse exchange traded funds (ETFs).

FINRA initially raised questions about inverse and leveraged ETFs when it issued a notice to brokers/dealers on June 11, cautioning them that the instruments may not be suitable investments for retail investors who plan to hold onto the instruments for more than one trading session.

Shortly after FINRA’s edict, Saint-Louis based Edward D. Jones announced its intent to halt sales of leveraged ETFs. UBS and Ameriprise soon followed. Other brokerages, including Charles Schwab, Raymond James Financial and LPL Financial are reviewing their policies concerning ETFs, with some firms posting information on their respective Web sites that inverse and leveraged ETFs “are not right for everyone.”

Leveraged ETFs allow investors to amplify bets on a wide range of markets, while inverse ETFs make profits when prices fall.

Many investors, however, are unaware about the complexities and underlying risks of inverse and leveraged ETFs. Leveraged ETFs, for example, are designed to deliver their stated leverage on a daily basis. If an investor holds the ETF longer than one trading session, it potentially could lead to financial disaster. Leveraged ETFs also employ, as their name implies, leverage. This, in turn, increases the level of financial risk for investors.

On August 5, a lawsuit involving ETFs was filed in New York, accusing ProShare Advisors LLC and others of violating a securities act by failing to disclose the risks of its ProShares UltraShort Real Estate fund (SRS). Among the risks that the complaint contends the inverse leveraged exchange traded fund failed to cite: “Spectacular tracking error.”

Specifically, the lawsuit alleges that the fund’s index fell 39.2% from January 2008 to December 2008, but the fund fell 48.2%, which was not in accordance with ProShares’ stated objective that UltraShort ETFs go up when markets go down.

The complaint is seeking class-action status, according to an Aug. 6 article in the Wall Street Journal.

The dramatic losses of the SRS fund reiterate the inherent risks posed by inverse and leveraged ETFs, especially in times of a volatile market. In the 12 months through July 23, the Dow Jones U.S. Real Estate Index shed 38%, but the ProShares UltraShort Real Estate fund lost 82%, according to the Wall Street Journal article. This year through July 23, the index is down 3.5%, but the fund has slipped 67%.

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%.