On September 25, 2024, the SEC charged two firms with ignoring clients’ instructions and exceeding their designated investment limits for over two years. The two firms charged were Merrill Lynch, Pierce, Fenner & Smith Inc. (“Merrill Lynch”), a registered broker-dealer and investment adviser headquartered in New York City, and a Registered Investment Adviser (RIA) in Norwalk, Connecticut that provided sub-advisory services to eligible ultra-high-net-worth clients of Merrill Lynch by giving them access to an options overlay trading strategy.
On September 26, 2024, the SEC announced that it settled charges against an RIA for entering into agreements with candidates for employment and a former employee that made it more difficult for them to report potential securities law violations to the SEC. This practice was a clear violation of the SEC’s whistleblower protection Rule 21F-17(a), which prohibits any action to impede an individual from communicating directly with the SEC staff about a possible securities law violation.
Misconduct That Led to the SEC’s Action Against Merrill Lynch
The sub-adviser used by Merrill Lynch failed to adhere to the terms of the investment management agreement between the firm and certain clients referred by Merrill Lynch. The RIA violated the agreement by purchasing and selling options contracts at levels materially higher than what clients authorized. By failing to comply with the agreement, the RIA caused hundreds of clients to be overexposed to the strategy, which resulted in higher fees and financial losses during certain periods.
The RIA was the primary investment adviser and portfolio manager for the Collateral Yield Enhancement Strategy (CYES). The stated objective of CYES was to generate incremental returns for enrolled investors by harvesting options premiums. The investors were not required to commit new money to participate in the strategy. Many investors who were introduced to CYES by Merrill Lynch had existing investment advisory account relationships with the dually registered firm. Many of those accounts were pledged as collateral for CYES.
According to the SEC’s orders, the RIA’s strategy was to trade options in a volatility index to increase returns for participants. The RIA allegedly allowed scores of accounts to exceed the exposure levels that investors chose when they signed up for the CYES strategy. Dozens of those accounts exceeded the designated limit by 50 percent or more. Merrill Lynch and the RIA received larger management fees when investors’ exposure levels climbed above pre-established levels.
Both the RIA and Merrill Lynch profited from these violations of the investment management agreement. When Merrill Lynch introduced its clients to the RIA, it received part of the adviser’s management and incentive fees, as well as trading commissions. Merrill Lynch was aware that investors’ exposure to CYES exceeded pre-set exposure levels and failed to inform them of deviations from the contract. Furthermore, Merrill Lynch failed to communicate to clients that it had received material information from the RIA regarding potential mismanagement and trading beyond contractual limits.
The SEC’s orders also found that the firms failed to adopt and implement policies and procedures that were reasonably designed to ensure that they disclosed all material facts to their clients and alerted them to the excessive exposure. Both firms exceeded clients’ designated investment limits over a two-year period, which caused the following harm to them:
- Clients paid higher fees;
- Clients were subjected to increased market exposure and risk; and
- Clients suffered investment losses.
In separate settlements, the RIA and Merrill Lynch agreed to pay a combined $9.3 million in penalties and disgorgement to resolve the SEC’s claims.
Whistleblower Protection Rule Violation
According to the SEC’s order, from November 2020 through September 2023, the RIA entered into non-disclosure agreements with 12 candidates for employment that prohibited them from disclosing confidential information about the firm, including to government agencies. While the agreements permitted the candidates to respond to requests for information from the Commission, it required notification to the firm of any such request and prohibited responding to requests arising from a candidate’s voluntary disclosure.
The SEC’s order finds that the RIA also entered into a settlement agreement with a former employee whose counsel had told the RIA that he or she intended to report alleged securities law violations to the Commission. Specifically, the settlement agreement said that it permitted reporting possible securities law violations to government agencies, including the Commission; however, it also required the former employee to affirm that he or she had not done so; and was not aware of facts that would support an investigation; and would withdraw any statements already made that might support an investigation. These provisions violated the whistleblower protection rule.
Takeaways
The Merrill Lynch Case
According to Mark Cave, Associate Director of the SEC’s Enforcement Division, “In this case, two investment advisers allegedly sold a complex options trading strategy to their clients but failed to abide by basic client instructions or implement and adhere to appropriate policies and procedures.” According to Cave, both firms dropped the ball “in executing these basic duties to their clients, even as their clients’ financial exposure grew well beyond predetermined limits.” We remind our clients that they have a fiduciary obligation to abide by all instructions or restrictions placed by clients on their accounts.
The SEC’s orders concluded that the RIA and Merrill Lynch violated Sections 206(2) and 206(4) of the Investment Advisers Act and Rule 206(4)-7 thereunder. Without admitting or denying the findings, both firms agreed to be censured, agreed to cease-and-desist orders, and penalties of $2 million and $1 million respectively. In addition, the RIA was ordered to pay $3.5 million in disgorgement and prejudgment interest. Merrill Lynch was ordered to pay $2.8 million in disgorgement and prejudgment interest.
The SEC’s actions can be viewed HERE.
Whistleblower Protection Rule
According to Corey Schuster, Co-Chief of the Division of Enforcement’s Asset Management Unit, “Whether through agreements or otherwise, firms cannot impose barriers to persons providing evidence about possible securities law violations to the SEC.” According to Schuster, “Even agreements that contain carve-out language allowing people to voluntarily report to the SEC can be violative if restrictive language in a separate provision impedes voluntary reporting to the Commission staff.”
Without admitting or denying the SEC’s findings, the RIA agreed to be censured, to cease and desist from violating the whistleblower protection rule, and to pay a $500,000 civil penalty.
The SEC’s actions can be viewed HERE.
In an unrelated development, on September 24, 2024, the SEC announced yet another series of charges against twelve broker-dealers, investment advisers, and one dually registered related to off-channel communications. These charges were based on widespread and longstanding failures to maintain and preserve electronic communications, which violates recordkeeping provisions of the federal securities laws. These most recent enforcement actions are the latest in a string of similar cases brought against RIAs and broker-dealers. These latest cases can be found at HERE.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com
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