Merrill Lynch has been ordered to pay nearly $3.7 million in compensatory damages and attorney’s fees to clients who complained that unsuitable investments in private equity vehicles harmed their portfolios.
A three-member Financial Industry Regulatory Authority arbitration panel last week decided Merrill should pay over $2.7 million in damages — the disputed securities’ value on April 30 — and more than $954,600 in attorney’s fees to Qun He and Haihui Zhang.
The FINRA panel also unanimously declined to expunge the customer dispute from the record of the former Merrill advisor involved in the matter, although she wasn’t named as a party to the arbitration.
Merrill essentially will repurchase the securities in question. The company, which had denied the claims, made no statement on the decision.
The clients had sought compensatory damages for the harm they contended was caused to their portfolio — an estimated $3.5 million — by comparing the actual results to what they would have gained from “a suitable portfolio,” according to the FINRA ruling.
“The award should serve as a warning sign to firms that would sell private equity investments or illiquid investments to retail investors that if they misrepresent these products or recommend them against their customer’s best interest that they do so at their own peril,” the customers’ lawyer, Michael Bixby, told ThinkAdvisor by email Thursday.
“Investors who have been sold private equity investments or other illiquid investments by their financial advisor should be asking whether they are sitting on a ticking time bomb,” he said.
The case involves investments in private equity “feeder funds” that pool capital from multiple investors into larger vehicles, according to Bixby.
Typical private equity funds have high commitment minimums in the millions, but feeder funds effectively allow investments as low as $100,000, he explained. This, however, brings additional layers of fees and costs to clients, he added.
“This is the largest FINRA customer award against Merrill Lynch this decade, so I am quite pleased with the result,” Bixby said.
The products at dispute in the case are sponsored by Blackstone, KKR, Apollo and others, sold in the form of feeder funds administered by Merrill, Bixby said, noting that other big investment firms offer similar products.
“As far as I know it is the first FINRA arbitration award involving these types of private equity investments sold to retail investors. I think it is particularly interesting given the broader conversation about increasing sales of private equity investments to retail investors and opening up 401(k)s to such investments,” he said.
Opening up 401(k)s and selling more private equity investments to retail investors “is extremely dangerous for retail investors,” Bixby added, saying FINRA has long warned brokerage firms to be careful in recommending such complex products to them.
The PE investments he sees sold to retail investors are very complex, illiquid, fee-laden, opaque, “and are highly speculative and risky to boot,” he said. The feeder funds “seem to provide a fee bonanza for the private equity sponsors, brokerage firms, and brokers who sell them.”
Those fees come at clients’ expense, he said, adding that the expert he used in the case showed the vehicles recommended by Merrill averaged returns lower than 3% annually, “which was a drastic difference from the represented return expectation of 15-20% per year.”
The only disclosure on the FINRA record for the advisor involved in the investments, Chelsea Deng, indicates the clients had alleged she made “certain misrepresentations and unsuitable investment recommendations.”
In response, Deng, now associated with Morgan Stanley, responded to FINRA, “I vehemently deny the allegations stated in the arbitration. The customers understood and appreciated the investments, which were appropriate given the customers' age, liquidity, net worth, risk tolerance and time horizon. It is my understanding that the private equity investments at issue have performed as expected and have generated a positive return.”
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