SEC: Wells Fargo Advisors settles charges for market-tied investments

By Susanna Moon

Chicago, June 26 – The Securities and Exchange Commission said in a statement that Wells Fargo Advisors LLC will settle charges related to the sale of market-linked investments, or MLIs, to retail investors.

Without admitting or denying the findings in the SEC’s order, Wells Fargo agreed to return $930,377 of “ill-gotten gains” plus $178,064 of interest and to pay a $4 million penalty, according to the statement issued by the SEC.

Wells Fargo used a strategy to generate “substantial fees” by encouraging retail customers to actively trade products that were intended to be held to maturity, the release said.

The trading strategy required selling the MLIs before maturity and investing those proceeds in new MLIs, which created large fees for Wells Fargo and reduced the customers’ investment returns, the commission said in the press release.

What’s more, the Wells Fargo representatives “did not reasonably investigate or understand the significant costs of the recommendations” and supervisors “routinely approved these transactions despite internal policies prohibiting short-term trading or ‘flipping’ of the products,” the release noted.

“It is important that brokers do their homework before they recommend that their retail customers buy or sell complex structured products,” Daniel Michael, chief of the Enforcement Division’s complex financial instruments unit, said in the release.

“The products sold by Wells Fargo came with high fees and commissions, which Wells Fargo should have taken into account before advising retail customers to sell their investments and reinvest the proceeds in similar products.”

Wells Fargo also agreed to a “censure and to cease and desist from committing or causing any violations and any future violations of certain antifraud provisions of the federal securities laws.”

“The order recognizes that Wells Fargo took remedial steps to address the allegedly improper sales practices,” the release noted.

According to the SEC’s order, from at least January 2009 through June 2013, some registered representatives at Wells Fargo Advisors, LLC and its predecessor Wells Fargo Investments, LLC “improperly solicited customers to redeem their market-linked investments early and purchase new MLIs without adequate analysis or consideration of the substantial costs associated with such transactions.”

An MLI has a fixed maturity and the interest is based on the performance of a reference asset or market measure such as an equity or commodity index over the term of the product. MLIs have limited liquidity and significant upfront fees, the filing noted.

The structured financial products were offered beginning in 2002 with a fixed maturity, and are composed of two components: a certificate of deposit or a zero-coupon bond and an embedded derivative or combination of derivatives, typically options, providing synthetic exposure to the performance of an unrelated reference asset or market measure, the order noted.

The structured products are thus intended to be held to maturity and the company implemented a policy in 2011 prohibiting representatives from “short-term trading” or “flipping” of the products.

“Notwithstanding WFA’s internal guidance and policy, and despite the adverse economic consequences to WFA customers, certain WFA representatives did not reasonably investigate or understand the significant costs of MLI exchanges,” the filing noted.

“Nevertheless, they recommended to their customers that they redeem their MLIs early, typically to realize profits, and to use the proceeds from those redemptions to purchase new MLIs.”

Wells Fargo mainly sold two types of MLIs: market-linked certificates of deposit and market-linked notes.

With these products, “investors traded the stability of guaranteed fixed returns available in CDs and bonds for the upside potential of higher investment returns should the reference asset increase in value.”

According to the company’s product disclosures, MLIs were unsuitable for short-term trading due to their limited liquidity, the order noted.

Also, the costs typically incurred to purchase the products were about 5% to 6% of the principal amount. These costs consisted of a selling commission of up to 3% paid to Wells Fargo plus 2% to 3% of structuring and hedging costs received by affiliates. The costs were imbedded into the price of the MLI rather than separately charged to the customer. As a result, a customer who purchased an MLI at a $100 par value would receive an MLI worth between $94 and $95 on the purchase date.

There were additional costs for redeeming the products early. First, before September 2011, the company’s representatives could charge a sales commission on early redemptions with their supervisor’s approval. Second, the price at which the company or its affiliates were willing to buy back the MLIs in the affiliated secondary market was typically lower than the current valuation with repurchases marked down between 2% and 3% on average.

From Jan. 1, 2009 through Aug. 31, 2012, certain representatives “engaged in a sustained practice of soliciting customers across their customer base to purchase MLIs, to redeem them prior to maturity and to purchase new MLIs using the proceeds from the early redemption.

“In many cases, the solicited redemptions occurred as little as a year into the life of MLIs with multi-year terms,” the order noted.

The SEC said that a “substantial number of the solicited MLI exchanges involved MLIs with identical or similar reference assets, such as moves from one MLI linked to the S&P 500 to another linked to the S&P 500 or the Dow Jones Industrial Average, at considerable expense to customers.”

Also, some WFA representatives “engaged in a practice of repeatedly ‘locking in gains’ for their customers across their MLI portfolios as the MLIs appreciated in value. In many cases, when the new MLI that the customer exchanged into appreciated from its original value of approximately $95 on a $100 par value investment to a gain position, the WFA representatives solicited the customer to engage in a second MLI exchange, which led to additional costs for the customer and further limited portfolio growth.”

One representative recommended that her customers “lock in their gains to protect against future market downturns. However, the 5% to 10% realized gains exceeded the 5% to 6% costs of repurchasing a new MLI by only a small margin, leaving customers with nominal gains net of their reinvestment costs.”

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