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Investment giant Merrill Lynch, a unit Bank of America Corp (NYSE:BAC), has been assessed a total of $430 million in fines by the U.S. Securities and Exchange Commission and The Financial Industry Regulatory Authority (FINRA).
The fines relate to a misuse of client funds by Merrill Lynch, as well as misleading investors in the sale of structured notes to retail clients.
1) Misuse of Client Funds
The SEC today announced that Merrill Lynch has agreed to pay $415 million and admit wrongdoing to settle charges that it misused customer cash to generate profits for the firm and failed to safeguard customer securities from the claims of its creditors.
An SEC investigation found that Merrill Lynch violated the SEC’s Customer Protection Rule by misusing customer cash that rightfully should have been deposited in a reserve account. Merrill Lynch engaged in complex options trades that lacked economic substance and artificially reduced the required deposit of customer cash in the reserve account. The maneuver freed up billions of dollars per week from 2009 to 2012 that Merrill Lynch used to finance its own trading activities. Had Merrill Lynch failed in the midst of these trades, the firm’s customers would have been exposed to a massive shortfall in the reserve account.
According to the SEC’s order instituting a settled administrative proceeding, Merrill Lynch further violated the Customer Protection Rule by failing to adhere to requirements that fully-paid for customer securities be held in lien-free accounts and shielded from claims by third parties should a firm collapse. From 2009 to 2015, Merrill Lynch held up to $58 billion per day of customer securities in a clearing account that was subject to a general lien by its clearing bank and held additional customer securities in accounts worldwide that similarly were subject to liens. Had Merrill Lynch collapsed at any point, customers would have been exposed to significant risk and uncertainty of getting back their own securities.
“The rules concerning the safety of customer cash and securities are fundamental protections for investors and impose lines that simply can never be crossed,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement. “Merrill Lynch violated these rules, including during the heart of the financial crisis, and the significant relief imposed today reflects the severity of its failures.”
In conjunction with this case, the SEC announced a two-part initiative designed to uncover additional abuses of the Customer Protection Rule. The first encourages broker-dealers to proactively report potential violations of the rule to the SEC and provides for cooperation credit and favorable settlement terms in any enforcement recommendations arising from self-reporting. Second, the Enforcement Division, in coordination with the Division of Trading and Markets and the Office of Compliance Inspections and Examinations, will conduct risk-based examinations of certain broker-dealers to assess their compliance with the Customer Protection Rule.
The SEC separately announced a litigated administrative proceeding against William Tirrell, who served as Merrill Lynch’s Head of Regulatory Reporting when the firm was misusing customer cash in violation of the Customer Protection Rule. he SEC’s Enforcement Division alleges that Tirrell was ultimately responsible for determining how much money Merrill Lynch 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. The litigated administrative proceeding against Tirrell will be scheduled for a public hearing before an administrative law judge who will issue an initial decision stating what, if any, remedial actions are appropriate.
Merrill Lynch cooperated fully with the SEC’s investigation and has engaged in extensive remediation, including by retaining an independent compliance consultant to review its compliance with the Customer Protection Rule. Merrill Lynch agreed to pay $57 million in disgorgement and interest plus a $358 million penalty, and publicly acknowledged violations of the federal securities laws.
2) Misleading investors in sale of Structured Notes
The SEC today announced that Merrill Lynch has agreed to pay a $10 million penalty 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. FINRA also fined Merrill Lynch an additional $5 million in the matter.
According to the SEC’s order instituting a settled administrative proceeding, the offering materials emphasized that the notes were subject to a 2 percent sales commission and 0.75 percent annual fee. Due to the impact of these costs over the five-year term of the notes, the volatility index would need to increase by 5.93 percent from its starting value in order for investors to earn back their original investment on the maturity date. But the offering materials failed to adequately disclose a third cost included in the volatility index known as the “execution factor” that imposed a cost of 1.5 percent of the index value each quarter.
The notes were issued by Merrill Lynch’s parent company Bank of America Corporation, and Merrill Lynch had principal responsibility for drafting and reviewing the retail pricing supplements. The SEC’s order finds that Merrill Lynch did not have in place effective policies or procedures to ensure its personnel drafted and approved disclosures that adequately disclosed the impact of the execution factor.
This is the agency’s second case involving misleading statements by a seller of structured notes. In October 2015, UBS AG agreed to pay $19.5 million to settle charges that it made false or misleading statements and omissions in offering materials provided to U.S. investors in structured notes linked to a proprietary foreign exchange trading strategy.
“This case continues our focus on disclosures relating to retail investments in structured notes and other complex financial products. Offering materials for such products must be accurate and complete, and firms must implement systems and policies to ensure investors receive all material facts,” said Andrew J. Ceresney, Director of the SEC Enforcement Division.
Michael J. Osnato, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, added, “This case demonstrates the SEC’s ongoing commitment to creating a level playing field when it comes to the sale of highly complex financial products to retail investors.”
The SEC’s order finds that Merrill Lynch violated Section 17(a)(2) of the Securities Act of 1933, which prohibits obtaining money or property by means of material misstatements and omissions in the offer or sale of securities. Without admitting or denying the findings, Merrill Lynch agreed to cease and desist from committing or causing any similar future violations and pay a penalty of $10 million.