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Regulatory Sanctions

Were Merrill Traders Wrong to Mislead Institutional Customers?

June 15, 2018

by Howard Haykin


Apparently, the SEC thinks so, which prompted Merrill Lynch, Pierce, Fenner & Smith to settle SEC charges that its traders and salespersons misled customers into overpaying for Residential Mortgage Backed Securities (“RMBSs”) – i.e., paying undisclosed excessive markups or incurring undisclosed excessive markdowns. The firm was also charged with failing reasonably to supervise its personnel so as to prevent and detect such violative conduct.


For its troubles, Merrill agreed to pay nearly $16 million in fines, disgorgement and prejudgment interest, in addition to certain remedial action.


SEC FINDINGS.    From June 2009 through December 2012, Merrill was a broker-dealer engaged in secondary market trading of non-agency RMBSs. In trading non-agency RMBSs, Merrill purchased the securities for its own account and then sold them from its own account to its customers. All of the customers with whom Merrill traded non-agency RMBS in the instant matter were institutions - i.e., qualified institutional buyers (“QIBs”).


Merrill did not charge a commission on the trades. Instead, it applied a mark-up on any given transaction. In many instances, Merrill's purchase of the security and its sale to the QIB took place within minutes or hours and involved little or no risk to the firm. The false or misleading statements led customers to accept less, or pay more, for securities than they otherwise might have accepted or paid.


Merrill’s Supervision of Communications.   During the relevant 3-1/2 year period, Merrill had both policies that prohibited false or misleading statements and the means to monitor communications for such statements.


  • A group of 6 to 9 individuals were responsible for reviewing communications of personnel in 70 to 80 groups - including the traders and salespersons who purchased and sold non-agency RMBS. There were approximately 10,000 people in those 70 to 80 groups.
  • Daily reviews took place 1 to 2 days after the communications were sent and covered a sample of approximately 1% of each of the 70 to 80 groups’ communications.


That said, there was no requirement for these communications to be reviewed for the types of false or misleading statements at issue in this Order. Reviews were limited to determining whether each individual communication reflected a potential violation of Firm policy rather than determining whether a communication, when considered together with other communications related to the same transaction, reflected a potential false or misleading statement related to that transaction.  Merrill’s surveillance systems never detected any of the false or misleading statements at issue in this Order.


Merrill’s Supervision of Mark-Ups.   Merrill had policies that prohibited its personnel from making false or misleading statements and from charging unreasonable mark-ups, which made reference to positions taken by the SEC and FINRA that:


  • Mark-ups on debt securities generally should be less than 5% and should be lower than mark-ups on an equivalent dollar amount of equity securities.
  • Depending upon the circumstances, mark-ups of less than 5% may still be considered unfair and unreasonable.
  • FINRA rules and interpretive materials provided an exemption from its mark-up rules for transactions in non-investment grade debt securities, such as non-agency RMBS, sold to QIBs.
  • Consideration should be given to SEC’s anti-fraud rules for mark-ups above 10%.


Accordingly, Merrill’s policies gave the impression that mark-ups of (but not exceeding) 10% were in some way reasonable. Yet, beyond that flawed logic, Merrill’s review procedures were hampered by the fact that compliance personnel essentially disregarded excessive mark-up alerts that were triggered by the firm’s electronic monitoring system.


Often working from a drop-down menu, these individuals used resolution codes such as “within the context of the market,” “isolated incident,” “odd lot trade,” or “other” to explain many of the determinations made. And, in some cases, they simply referenced FINRA policy that disregarded the 5% mark-up limitations on transactions with QIBs”.



FINANCIALISH TAKE AWAYS.    Presuming that the charges are true, there's little if any doubt that Merrill’s traders and salespersons were fully aware that they were “illegally profited from excessive, undisclosed commissions – called ‘mark-ups’ – which in some cases were more than twice the amount the customers should have paid." And, perhaps, Merrill’s supervisory and/or compliance personnel were aware of the violative conduct of the traders and salespersons.


That said, the SEC, like FINRA, does not state whether any individuals were sanctioned pertaining to the circumstances in this case – either by the regulator or the employer. Which is unfortunate because by disclosing the names of responsible individuals – or at least providing cross-references to related regulatory investigations – regulators might help to deter future violations. HOW SO? By alerting individuals in similar positions – i.e., ‘stakeholders’ - to the fact that more is 'at stake’ if and when they knowingly engage in violative conduct.


[For further details, click on SEC Administrative Order.]