Wednesday, June 5, 2013

FINRA Fines Wells Fargo and Banc of America Over Unsuitable Sales of Floating-Rate Bank Loan Funds

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday, the Financial Industry Regulatory Authority (FINRA) announced fines totalling more than $2.1 million levied against Wells Fargo and Banc of America. In addition, FINRA has ordered the two institutions to pay restitution in excess $3 million to customers who suffered "losses incurred from unsuitable sales of floating-rate bank loan funds."

A floating-rate bank loan fund is a mutual fund that mainly invests in floating-rate high-yield senior secured loans. The floating-rate on the underlying loans typically resets every month or every quarter and is often quoted as a spread above some reference rate like LIBOR. The funds typically have "relatively low interest rate risk but significant credit and liquidity risk." The credit risk stems from the fact that the debtors are generally rated below investment-grade.

According to their Letter of Acceptance, Waiver and Consent (PDF), Wells Fargo Investments, LLC (now Wells Fargo Advisors, LLC) "made unsuitable recommendations to customers to purchase floating rate loan funds." During 2007 and 2008, sales of these funds constituted a significant part of total mutual fund sales (much more than competing brokerage firms). According to the Letter, the product team became concerned in August 2007 when it was found that ""financial advisors are positioning these funds as an alternative to Bank CDs or money market funds instead of part of an overall diversification strategy." The product team's recommendations were largely ignored and unsuitable recommendations continued. As the value of the funds subsequently declined, hundreds of investors collectively lost more than $1.9 million. Wells Fargo has been fined $1.25 million for their supervisory failures and has been ordered to pay restitution to the affected customers.

Banc of America Investment Services (now Merrill Lynch) submitted a similar Letter of Acceptance, Waiver and Consent (PDF). According to the letter, Banc of America "did not provide guidance to its employees about the special features, credit risk, or liquidity risks of floating rate loan funds, or the customers for whom these products would be suitable" and failed to alter their supervisory practices even after the increased volatility of these funds following the financial crisis. Hundreds of customers collectively lost approximately $1.1 million in these unsuitable transactions. Merrill Lynch has been fined $900,000 and has been ordered to pay restitution to the affected customers.

Investors need to ask their broker the question: if I'm getting higher returns, what additional risk am I bearing?

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