FINRA, the Financial Industry Regulatory Authority, issued an eye-catching warning in Regulatory Notice 20-14 about a particularly complex and risky type of security: Oil and Gas Exchange Traded Products, or ETPs. High concentrations in the oil and gas sector, especially with complex, risky, and volatile products like ETPs, may become a frequent subject for investor litigation in the upcoming year and fallout of the Coronavirus pandemic. To quote FINRA, “the performance of such products may be linked to unfamiliar indices or reference benchmarks, making them difficult for the average investor to comprehend.”
Oil and Gas-linked ETPs
These products are engineered to be complicated, risky, and volatile. While potentially paying out well above conservative fixed income investments, they carry the risk of massive and sudden drops in valuation. ETPs may be indexed to futures contracts or other market benchmarks, so their “value” is a few steps away from the actual daily value of the underlying commodity. More exotic offerings include leveraged and inverse commodities-linked ETPs, which seek to deliver multiples or the opposite of the return of an oil linked index.
This particular underlying commodity – oil – comes with its own set of risks. The benchmark price of oil was already under severe downward pressure at the end of 2019, before the jolting drop in demand from the impact of COVID-19. The combination has meant that one ETP shed 41{45ef85514356201a9665f05d22c09675e96dde607afc20c57d108fe109b047b6} of its value in one week in April. Others have been forced to liquidate, or reconfigure their investment objectives.
It’s all there in FINRA’s authoritative detail in RN 20-14, should you want a refresher on the oil market’s conditions of “contango” (future prospects dim), or “backwardation” (with good investment opportunities) or “super-contango” (where we were in April).
Suitability
Scratching your head over “contango”? The term itself is a good warning sign. The average retail investor looking to put their retirement savings in a safe, moderate or conservative portfolio, should not be making decisions that require a technical dictionary for every other word. And if a financial professional cannot adequately analyze and explain the function and risks of betting on the futures market with an ETP, or why that is an appropriate risk compared to other investments, the recommendation may fail FINRA’s suitability standard.
FINRA has been clear in interpreting its own Rule 2111 regarding suitability: if a broker does not sufficiently understand the product, then a recommendation to purchase that product is not suitable for ANY investor:
A member’s or associated person’s reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the suitability rule.
I noted in a prior post that it is wise to review investment statements during market volatility. When the market is acting like a roller coaster, it can reveal otherwise hidden problem areas. That might include over-concentration in a certain sector, or investments in complex products such as commodity-linked ETPs. Unsuitable investment recommendations may lead to claims against an advisor or firm for recoverable losses.
And if you are a financial advisor taking on a new client with a portfolio that has been inappropriately allocated, consider suggesting to your client a confidential review with a securities attorney. You may be able to help your client recover some of the damage caused by a prior advisor’s poor investment recommendations.
Darlene Pasieczny is a fiduciary and securities litigator at Samuels Yoelin Kantor LLP. She represents clients in Oregon and Washington with matters regarding trust and estate disputes, financial elder abuse cases, and securities litigation. She also represents investors nationwide in FINRA arbitration to recover losses caused unlawful broker conduct. Her article, New Tools Help Financial Professionals Prevent Elder Abuse, was featured in the January 2019, Oregon State Bar Elder Law Newsletter.
Victoria Blachly is a partner and chair of SYK’s Fiduciary Practice Group. She is a trial attorney, representing individual trustees, corporate trustees, beneficiaries, and personal representatives in often difficult and challenging cases.
