Views on improving the integrity of global capital markets
15 July 2016

SEC Fines Merrill Lynch $425M for Flouting Regulations, Putting Investors at Risk

Ever since the Dodd–Frank Act was signed into law six years ago, banks have complained loudly, frequently, and in high places about the regulatory burdens the law created for them. The burdens, they pointed out, were hurting not only the banks but also the wider economy because banks were forced to invest in systems to comply with regulations rather than being able to invest in new loans to foster business activity. Those complaints about the burdens makes the callous actions of Bank of America subsidiary, Merrill Lynch, revealed by the SEC on 23 June 2016, so maddening, not to mention self-defeating.

The inexcusable flouting of existing regulations and customer agreements creates a breeding ground for investor distrust and even more regulatory oversight and paperwork because it seems that firms like Merrill still need it.

In this case, the SEC fined Merrill $425 million for significant violations of the Commission’s Customer Protection Rule. The infractions showed general disregard for the good of its customers and the financial system in the pursuit of short-term trading gains.

The Violations: Putting Investors at Risk

The SEC found that instead of depositing customer cash in a reserve account as the protection rule requires, Merrill invested it in “complex option trades that lacked economic substance.” The trades artificially reduced the size of the required deposits, thus enabling the broker to use billions of customer’s cash to finance its own trading activities.

If that was all Merrill did, it would have been bad enough. Sadly, there was more. In the second violation, the SEC penalized Merrill for putting up to $58 billion a day of lien-free, fully paid-for customer securities in accounts that are subject to a general lien by its clearing bank rather than holding the securities in lien-free accounts that shielded them from third-party claims. The firm also treated customer securities held in accounts worldwide in a similar reckless fashion.

Bloomberg View columnist, Matt Levine, described the trades as a lot of work to achieve nothing. But in both cases, the SEC said they would have produced a great deal of pain for investors had Merrill failed. It also noted that Merrill, which Bank of America purchased during the stress and uncertainty of the 2008 financial crisis, engaged in these activities soon after its acquisition and continued until the end of 2015.

The SEC further charged Merrill with violating Exchange Act Rule 21F-17 (Staff Communications with Whistleblowers) by using language in severance agreements that sought to impede employees from voluntarily providing information to the SEC. Keeping employees quiet about the firm’s misdeeds is not the best way to build investor trust.

There Is Even More!

Merrill has to pay another separate fine of $10 million “to settle charges that it was responsible for misleading statements in offering materials provided to retail investors for structured notes linked to a proprietary volatility index.” At a time when the US Department of Labor’s final rules are encouraging — imprudently, perhaps — putting investors’ retirement funds into low-cost index mutual and exchange-traded funds, the Merrill structured notes charged a robust 2% sales commission on top of a 0.75% annual fee. But those outsized costs weren’t what raised the SEC’s ire — and it’s a good thing, too; regulators have no expertise to set prices on such things. What got the firm in trouble was not disclosing an additional 1.5% quarterly fee assessed on the value of the index.

Fallout from Merrill’s Misdeeds

Compared with the enormous fees the firm charged its often unsuspecting customers, the SEC’s fines amount to a mere 0.17% of Merrill’s capital as of 31 December 2015. More troubling, though, is that the cost of Merrill’s misdeeds will be paid primarily by all brokerage firms, and ultimately their customers, over the long term through higher regulatory costs for oversight and paperwork.

To that end, the SEC will require broker/dealers to “proactively report” potential violations of SEC regulations, with incentives of reduced penalties for good behavior. Also, they, as with all broker/dealers, will face risk-based examinations from a coordinated team of the Commission’s divisions of Enforcement and Trading and Markets and its Office of Compliance Inspections and Examinations. These exams will assess firms’ compliance with the additions to the SEC’s Customer Protection Rule.

To its credit, Merrill did change its internal policies and procedures to address the violations, and implemented a mandatory annual whistleblowing program for itself and its parent. And litigated administrative proceedings have been launched against William Tirrell, Merrill’s Head of Regulatory Reporting, during the time the misuse of customer cash occurred. The SEC contends that Tirrell “was ultimately responsible for determining how much money Merrill would reserve in its special account, and failed to adequately monitor the trades and provide specific information to the firm’s regulators about the substance and mechanics of the trades.” His public hearing will be scheduled before an administrative law judge who will issue an initial decision, including potential remedial actions.

Our natural inclination is to be sympathetic to the banks argument about the burden regulatory of such laws as Dodd–Frank, and we would likely support reduced burdens if firms like Merrill truly put their customers’ interests ahead of their own. Unfortunately, they don’t, and the rest of the economy will bear the burden of the higher regulatory requirements needed to combat their misdeeds for years to come.

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Image Credit: © Muellek

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

1 thought on “SEC Fines Merrill Lynch $425M for Flouting Regulations, Putting Investors at Risk”

  1. Raimondo Eggink says:

    Unbelievable this s*** still happens. These people have lost all sense of decency. Were any charterholders involved?

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