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SEC Deals Merrill a $425M Wallop; Other Firms Could Be Next

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The Securities and Exchange Commission said early Thursday that Merrill Lynch has agreed to pay $415 million and to admit wrongdoing in the abuse of customer cash used to generate profits for the firm and for its failure to safeguard customer securities from creditors’ claims.

In addition, the regulator says it will conduct a sweep of broker-dealers regarding their compliance with the Customer Protection Rule broken by Merrill Lynch, Rule 15c3-3, and that BDs can self-report noncompliance by Nov. 1.

“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,” said Michael J. Osnato, chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, in a statement.

SEC also announced Thursday that it had fined Merrill $10 million and the Financial Industry Regulatory Authority had fined it $5 million for misleading customers on sales of structured notes.

In the customer protection case, an SEC investigation found that Merrill Lynch, instead of putting customer cash into a reserve account, used it for “complex options trades that lacked economic substance and artificially reduced the required deposit of customer cash in the reserve account” while financing its own trading activities from 2009 to 2012. If Merrill Lynch gone under, the regulatory group says, clients would have been exposed to “a massive shortfall” in the reserve account.

Furthermore, Merrill violated the Customer Protection Rule by not holding client securities that had been fully paid for in lien-free accounts and not shielding the securities from claims by third parties during and after the financial crisis, the SEC says.

“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 SEC explained in the order.

“This is by far the largest customer protection settlement in SEC history, and the severity of the misconduct is much more significant than prior cases,” said Andrew Ceresney, director of the SEC’s Enforcement Division, during a press conference on Thursday.

For its part, Merrill Lynch said in a statement, “While no customers were harmed and no losses were incurred, our responsibility is to protect customer assets and we have dedicated significant resources to reviewing and enhancing our processes. The issues related to our procedures and controls have been corrected. We have cooperated fully with the SEC staff throughout this investigation.”

The broker-dealer adds that it discussed the matter in two recent regulatory filings and that it “will have no impact on 2Q earnings.”

In a separate matter on Thursday, the SEC imposed a fine of $10 million on Merrill Lynch for misleading customers on sales of structured notes linked to a proprietary volatility index; the Financial Industry Regulatory Authority ordered the BD to pay $5 million to settle the issue. (The firm declined to comment on these $15 million fines.)

“The second settlement [of $10 million] … involves the firm’s sale of complex structured notes to retail investors. This is our second structured-note settlement, coming on the heels of our case against UBS last year,” Ceresney explained. (UBS agreed to pay $19.5 million in October to settle the charges.)

The $425 million in combined SEC fines represents the second-largest penalty imposed by the regulatory group against Merrill Lynch in its history, he says.

Also on Thursday, the SEC filed a cease-and-desist action against William Tirrell, head of regulatory reporting for Merrill Lynch from 2004 to April 2016, in connection with the use of client cash to conduct leveraged conversion trades — conversion trades that used listed options financed by customers through margin loans extended by Merrill Lynch.

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.”  

To resolve the matter, Tirrell must appear before an administrative law judge.

“Mr. Tirrell is justifiably proud of his distinguished 35-year career‎ and leadership positions in the securities industry.‎ While we are disappointed that the SEC filed this action, Mr. Tirrell looks forward to the opportunity to vindicate himself at trial,” said Steven M. Witzel of the law firm Fried Frank, in a statement. Tirrrell is still employed by Merrill.

In addition, the SEC says Merrill violated an SEC rule by impeding employees from voluntarily providing information to the regulator in its severance contracts.

“Merrill Lynch also engaged in significant remediation in response to the [whistleblower rule] 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,” the SEC said in a statement.

The SEC declined to acknowledge the role of whistleblowers in the case. 

However, an attorney representing some of the individuals who came forward, Jordan Thomas of the law firm Labaton Sucharow, said in a statement, “After the global financial crisis, the importance of protecting customers’ assets from misuse or insolvency cannot be overstated. 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.”

BD Self-Reporting

In addition to highlighting its plan of looking into possible Customer Protection Rule violations at other firms, the SEC is encouraging firms to come forward with noncompliance.

The CPR, the groups says, aims to avoid “a delay in returning customer securities or worse, a shortfall in which customers are not made whole, by requiring broker-dealers to safeguard both the cash and securities of their customers,” to protect them in the event of a broker-dealer failure. It does so by “eliminat[ing] the use by broker-dealers of customer funds and securities to finance firm overhead and such firm activities as trading and underwriting through the separation of customer related activities from other broker-dealer operations.”

For customer cash, for instance, broker-dealers must have a reserve of funds or qualified securities in an account at a bank that is “at least equal in value to the net cash owed to customers,” it says, in accordance with a specific formula contained in the rule. “While the formula itself is somewhat complex, it embodies a simple concept for the responsible stewardship of customer cash: If a broker-dealer owes more to its customers than its customers owe to it, the broker-dealer must set aside at least an amount equal to that difference so that it is readily available to repay customers,” the SEC explained on Thursday.

Any “device, window dressing or restructuring of transactions made solely to reduce an excess of credits over debits in the Rule 15c3-3 formula computation and not otherwise a normal business transaction” may be considered a circumvention of the rule, it added in its order against Merrill Lynch.

The rule also requires that BDs have physical possession or control over clients’ fully paid and excess margin securities. “Physical possession or control generally means that the broker-dealer must hold these securities in one of several locations specified in the rule and that they be held free of liens or any other interest that could be exercised by a third-party to secure an obligation of the broker-dealer,” the SEC stated.

Furthermore, broker-dealers must inform the SEC if they fail to comply or have material weaknesses in controls that hinder their compliance efforts. “If a broker-dealer fails to maintain the minimum required amount in its customer reserve account, Rule 15c3-3(i) states that the broker-dealer must immediately notify the commission and FINRA of this failure.”

The governing body notes that the “significant” fine imposed on Merrill “reflects the seriousness with which the commission views failures to comply with Rule 15c3-3’s provisions.”

During the financial crisis, the Customer Protection Rule had “a critical role in the orderly liquidation of Lehman Brothers,” according to the SEC.

The SEC says that its CPR initiative aims to minimize risks to investors and to the industry while giving incentives to broker-dealers “to examine their adherence to the Customer Protection Rule’s requirements to ensure there is robust compliance.”

For those BDs that self-report by Nov. 1 and appear to be noncompliant, the SEC may offer guidance, examine the firm’s compliance operations or investigate the firm for possible enforcement.

“If the Division of Enforcement decides to recommend enforcement action for any violation reported, it will recommend that the [SEC] accept a settlement pursuant to which the broker-dealer consents to the institution of a cease-and-desist proceeding,” the group explained.

In such a case, the broker-dealer will neither admit nor deny the findings; move to set up appropriate policies, procedures and training; cooperate with any subsequent investigation; and retain an independent consultant to conduct a compliance review, if required.

Furthermore, the broker-dealer “will pay disgorgement of any ill-gotten gains and penalties [and] meaningful cooperation credit, including in the form of reduced penalties, will be given,” the SEC stated. But for broker-dealers that do not self-report, the SEC’s Division of Enforcement “offers no assurances that it will recommend the above terms in any subsequent enforcement recommendation.”

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