Two Merrill Lynch entities agreed to pay sanctions of US $415 million to resolve charges brought by the Securities and Exchange Commission that, contrary to SEC requirements, they failed to set aside sufficient funds for the benefit of their customers from 2009-2012 in its so-called “reserve account,” and failed to hold fully-paid-for securities of their customers in certain approved locations in lien-free accounts from 2009 to 2016. The SEC’s requirements are encapsulated in its so-called “Customer Protection Rule” (Rule 15c3-3; click here to access).
The two ML entities are Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and its wholly owned subsidiary, Merrill Lynch Professional Clearing Corp. MLPF&S is itself a wholly owned subsidiary of Bank of America Corporation.
According to the SEC, during the relevant time, ML engaged in certain transactions with customers – known as “Leveraged Conversion Trades” to finance certain of its own business transactions. The SEC said the companies accomplished this by including margin loans to its customers as part of these trades, which had the effect of reducing the amount of cash or securities ML itself had to maintain in its customer reserve account. ML used this freed-up cash to finance inventory that was used in the trades and “ML considered the difference between the cost of financing the position through traditional means and through a Leveraged Conversion Trade as profit,” alleged the SEC.
In addition, the SEC charged that, during the relevant time, MLPF&S held a substantial amount of fully-paid-for and excess margin customer securities in clearing banks or other approved depositories subject to liens, contrary to SEC rule.
To resolve the SEC’s allegations, ML agreed to pay a fine of US $358 million, disgorgement of US $50 million and US $7 million in interest. The SEC acknowledged ML’s voluntary retention of an independent consultant to review its handling of customer funds and securities during the course of its investigation of the two companies.
The SEC commenced a separate enforcement action against William Tirrell, the Head of Regulatory Reporting and Financial and Operations Principal for MLPF&S during the relevant time where he oversaw the regulatory reporting for both companies. The SEC charged that Mr. Tirrell willfully aided and abetted ML’s violations. This action is pending.
Simultaneously with disclosing its actions against ML and Mr. Tirrell, the SEC announced a “Customer Protection Rule Initiative” to encourage broker-dealers to review their handling of customer funds and securities, and to self-report to it by November 1, 2016, any potential violation in order to receive favorable settlement terms in a potential enforcement action. For broker-dealers to benefit from favorable settlement terms, they must advise the SEC, among other things, of the period of noncompliance; the nature of the noncompliance; the amount of cash and/or securities at issue; and all remedial measures taken. At the same time it encouraged broker-dealers firms to self-report, the SEC announced it is embarking on a “risk-based sweep” of broker-dealers to assess their compliance with the Customer Protection Rule.
Unrelatedly, MLPF&S also settled separate actions brought by the SEC and the Financial Industry Regulatory Authority for allegedly not disclosing certain recurring costs in a structured note product based on a proprietary volatility index it sold to retail clients in 2010 and 2011.
According to both the SEC and FINRA, during this time, MLPF&S disclosed to investors they would be subject to a 2 percent sales commission and a 0.75 percent annual fee in connection with the structured notes, but did not disclose that there would be a recurring fixed cost known as the “execution factor” that was equivalent to the transaction costs that an investor would incur by pursuing the strategy underlying the notes.
MLPF&S agreed to pay the SEC US $10 million and FINRA, US $5 million, to resolve these two additional matters.
(Click here to access information about another recent enforcement action by the Financial Industry Regulatory Authority against a broker-dealer for an alleged Customer Protection Rule violation in the article, “Broker-Dealer Charged by FINRA for Failing to Protect Customer Assets” in the June 5, 2016 edition of Bridging the Week.)
Compliance Weeds: Under the SEC’s Customer Protection Rule, a broker-dealer must promptly obtain and maintain physical possession or control of fully-paid-for securities and excess margin securities carried for its customers (its so-called “segregation requirement”), and to set aside on at least a weekly basis in a special account for the benefit of its customers – its so-called “reserve account” – funds or qualified securities at least equal in value to the net cash it owes its customers. According to the SEC, a broker-dealer maintains physical possession or control of securities when they are held in an approved location specified in the rule and they are held “free of liens or any other interest that could be exercised by a third party to secure an obligation of the broker dealer.” In assessing its reserve account obligations, a broker-dealer may not employ any “device, window dressing or restructuring of transactions” solely to reduce the amount of customer credits over debits and enable it to set aside less cash or qualified securities for its customers. The requirement under the Customer Protection Rule that calculations related to the reserve account and required funding must be performed only once each week contrasts with requirements under rules of the Commodity Futures Trading Commission which mandate that such calculations and funding for its equivalent customer segregated accounts must be undertaken daily. (Click here for an overview of the customer funds protection regime for futures and cleared swaps in the November 2014 FIA publication, "Protection of Customer Funds.")