Merrill Lynch, Pierce Fenner & Smith, Inc. headquartered in New York, New York, was censured and fined $5,000,000.00 by the Financial Industry Regulatory Authority (FINRA) after consenting to findings that the firm failed to properly disclose costs associated with strategic return notes. Letter of Acceptance, Waiver and Consent, No. 2012032967901 (June 23, 2016).
According to the AWC, from September 1, 2010 through July 5, 2011, the firm had sold an estimated $168,000,000.00 worth of strategic return notes (SRNs) without disclosing the costs associated with a volatility index that the SRNs were linked to. The AWC stated that $150,000,000.00 in SRNs were sold via initial offerings, with an additional estimated $18,000,000.00 sold in the secondary market. FINRA noted in the AWC that the SRNs were complex investments that were sold to institutional and retail investors. Merrill Lynch reportedly received an estimated $5,500,000.00 in connection with the sales, which was comprised of underwriting fees and other compensation through an index adjustment factor.
The AWC stated that Merrill Lynch had the responsibility of preparing offering documents between 2009 through 2011, which included prospectuses, pricing supplements, and fact sheets. The AWC stated that the SRNs held terms of five years and provided for early redemptions. The products allowed for investors to receive a cash payment upon the SRN maturity or via redemption periods depending on the level of a VOL, which was a measure of equity market volatility.
Apparently, the firm did not disclose to investors that in addition to paying a 2% sales charge and annual 0.75% fee associated with the SNRS, investors were subject to a cost, called the Execution Factor, which was designed to reflect transaction fees incurred through the firm’s strategy of replicating the index. FINRA noted that the firm failed to properly explain the Execution Factor in the fact sheet that accompanied a pricing supplement.
According to FINRA, given the Execution Factor would impose a fee of 1.5% of the index each quarter, such information should have been disclosed to investors and was important to a reasonable investor in considering the information available when deciding to purchase the SRNs. FINRA found that the firm’s representations concerning the total costs of the SRNs was materially misleading as a result of not specifying the Execution Factor costs.
The firm was found to have failed to adequately disclose the Execution Factor in violation of Securities Act Section 17(a)(2) and FINRA Rule 2010. Consequently, FINRA claimed that the fact sheet and pricing supplements did not contain balanced and fair information or provide investors with an adequate basis to evaluate the SRNS. FINRA found that the firm violated NASD Rule 2210(d) in this regard. FINRA additionally found the firm to have violated NASD Rule 3010(a) and FINRA Rule 2010 as a result of failing to maintain supervisory protocol which would ensure compliance with disclosures concerning the sale of SRNs.
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