Merrill Lynch today 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 SEC said. “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, 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,” the SEC said. “Had Merrill Lynch collapsed at any point, customers would have been exposed to significant risk and uncertainty of getting back their own securities.”

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. 

Secondly, the SEC’s 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.  

“Simultaneous with today’s action, SEC staff will begin a coordinated effort across divisions to find potential violations by other firms through a targeted sweep and by encouraging firms to self-report any potential violations of the Customer Protection Rule,” Michael Osnato, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, said in a statement.

Other violations

In addition to the Customer Protection Rule violations, the SEC said Merrill Lynch violated Exchange Act Rule 21F-17 by using language in severance agreements that operated to impede employees from voluntarily providing information to the SEC. Merrill Lynch also engaged in significant remediation in response to the Rule 21F-17 violation, including the revision of its agreements, policies and procedures, and the implementation of a mandatory annual whistleblower-training program for all employees of Merrill Lynch and its parent corporation, Bank of America.  Merrill Lynch and Bank of America also agreed to provide employees, on an annual basis, with a summary of their rights and protections under the SEC’s Whistleblower Program.

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. The 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.

The SEC said Merrill Lynch cooperated fully with the investigation and 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.

Parallel case

In a parallel case, the SEC charged Merrill Lynch for misleading statements in offering materials provided to retail investors for structured notes linked to a proprietary volatility index. 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. 

According to the SEC’s order, the offering materials emphasized that the notes were subject to a two 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, 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 case continues our focus on disclosures relating to retail investments in structured notes and other complex financial products,” Andrew Ceresney, Director of the SEC Enforcement Division, said in a statement. “Offering materials for such products must be accurate and complete, and firms must implement systems and policies to ensure investors receive all material facts.”

“After the global financial crisis, the importance of protecting customers’ assets from misuse or insolvency cannot be overstated,” says Jordan Thomas, chair of Labaton Sucharow’s whistleblower representation practice who represented the SEC whistleblowers in this case. “This case will serve as a cautionary tale for other financial institutions about how quickly little mistakes, breakdowns in judgment and old-fashioned greed can snowball into expensive front-page scandals.”

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