Merrill Lynch, Pierce, Fenner & Smith Inc. has been fined $450,000 by the Financial Industry Regulatory Authority (FINRA) for failure to supervise operations to prevent unsuitably high concentrations of structured products from building up in customer accounts.
The firm submitted a Letter of Acceptance, Waiver and Consent (AWC) to settle alleged violations of FINRA rules. Merrill Lynch accepted and consented to the fine and to be censured without admitting or denying FINRA’s findings.
A Failure to Supervise
From January 2006 through March 2009, Merrill Lynch failed to implement or maintain a reasonable supervisory system to flag potentially unsuitable concentration levels of structured products in customer accounts, the AWC said. The firm’s failure to have a system that would flag unsuitable concentrations on an automated-exception basis violated National Association of Securities Dealers (NASD) and FINRA rules.
A member of FINRA since 1937, Merrill Lynch is full-service broker-dealer based in New York that employs over 31,000 registered representatives and has over 1,200 branch offices. In January 2009, the firm was acquired by Bank of America Corp.
Structured Products
Structured products are securities that are often based on or derived from a reference asset. This can be single security, a basket of securities, an index, a commodity, a debt issuance or a foreign currency, the AWC explained.
Monitoring accounts to ensure that customers invest only appropriate amounts in structured products is important because they are often unsecured debt, meaning investors are fully exposed to the credit risk of the issuer.
These products differ as to the level of principal protection offered, and may offer no protection at all. Structured products also vary as to the interest paid and how they will be affected by the performance of the reference asset. The AWC noted that a defining characteristic of all structured products is that they do not represent an ownership interest in the reference asset, unlike a mutual fund.
FINRA Cautioned About Structured Products
FINRA cautioned its members about structured products in September 2005 because of concerns that broker-dealers were not fulfilling their obligations as they sold these products, particularly to retail customers, the AWC said.
Notice to Members 05-59 advised them that some structured products carry risks similar to options. Firms were told to develop procedures to make sure structured products were sold only to those investors with the appropriate appetite for risk. Firms were also reminded to perform reasonable basis suitability determinations on structured products before recommending them, in addition to customer-specific suitability determinations.
Moreover, the notice stated that firms needed to establish, maintain, and enforce procedures to determine which customers were eligible to purchase structured products.
Merrill Lynch Offers Four Categories of Structure Products
- enhanced return
- enhanced income
- market downside protection
- market access
From January 2006 through March 2009, Merrill Lynch customers purchased — or caused to be purchased — about 650,000 structured products. More than 50 percent of these transactions involved offerings issued by the parent company of the firm.
Merrill Lynch Supervising Systems In Place
To supervise retail sales of securities, Merrill Lynch maintains automated exception-based reporting systems that flag transactions or accounts according to pre-defined criteria.
Review teams within the firm monitor these systems and are required to investigate the flagged exceptions. Of the several exception-based reporting systems Merrill Lynch had in place, not a single one of them — prior to March 1, 2009 – was set up to monitor for potentially unsuitable concentration levels of structured products in customer accounts, the AWC said.
Merrill Lynch Violated NASD & FINRA Rules
As a result, Merrill Lynch violated NASD Conduct Rule 3010 covering supervision and FINRA Rule 2010 concerning standards of commercial honor and principles of trade.
According to the Corrective Action Statement that Merrill Lynch was permitted to file with its AWC, the firm set out to develop an automated supervisory system in late 2008 to generate reports on client accounts when they exceed predetermined concentration levels of structured products. This reporting system was implemented in March 2009, and remains in use, the statement said, although this information does not constitute a finding by FINRA.
The AWC also recounted a past supervisory problem at Merrill Lynch. In May 2009, FINRA found that the firm had failed to maintain systems and procedures that would adequately detect and prevent unsuitable short-term trading in closed-end funds purchased in initial public offerings. FINRA censured Merrill Lynch and fined the firm $150,000 for its failure to supervise. For a complete history of disciplinary actions involving Merrill Lynch, see FINRA public disclosure records.
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