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From Securities Regulation Daily, June 19, 2018

Merrill Lynch admits to misleading customers and agrees to pay $42 million penalty

By Brad Rosen, J.D.

The SEC entered an order charging Merrill Lynch, Pierce, Fenner & Smith with misleading customers about how it handled their orders in violation of Sections 17(a)(2) and 17(a)(3) of the Securities Act. Merrill Lynch agreed to settle the charges, admit wrongdoing, and pay a $42 million penalty (In the Matter of Merrill Lynch, Pierce, Fenner & Smith IncorporatedRelease No. 33-10507, June 19, 2018).

Masking and false reports. According to the SEC’s order, Merrill Lynch falsely informed customers that it had executed millions of orders internally when it actually had routed them for execution at other broker-dealers, including proprietary trading firms and wholesale market makers ("External Liquidity Providers" or "ELPs"). Merrill Lynch called this practice "masking", and it entailed reprogramming the company’s systems to falsely report execution venues, altering records and reports, and providing misleading responses to customer inquiries. According to the order, by masking the broker-dealers who had executed customers’ orders, Merrill Lynch made itself appear to be a more active trading center and reduced access fees it typically paid to exchanges.

Customer impact. Merrill Lynch masked the ELP executions of the firm’s "direct strategy access" (DSA) customers. These customers typically were financial institutions such as asset managers, mutual fund investment advisers, and public pension funds. Moreover, Merrill Lynch received DSA customer orders and typically sliced them into smaller "child" orders that it routed to various trading centers, including exchanges, Alternative Trading Systems (ATSs), and ELPs. During the five years that masking was in place (2008-2013), Merrill Lynch’s DSA customers received more than 15.8 million child order executions at ELPs. These transactions involved more than 5.4 billion shares and had a notional value of over $141 billion. Merrill Lynch falsely reported to customers that all of these transactions occurred at Merrill Lynch.

The order noted that as a result of Merrill Lynch’s masking practice, Merrill Lynch’s customers did not know that some of their orders were executed at ELPs; and other orders were exposed to ELPs before being executed at other venues. These customers wanted to know, and expected Merrill Lynch to inform them, if Merrill Lynch sent their orders to ELPs. Accordingly, this information was material. Additionally, certain customers used the execution venue information provided by Merrill Lynch to assess its performance and make strategic choices about their broker-dealer relationships and tactical routing decisions. Certain customers were also concerned that orders routed to ELPs could be subject to information leakage.

Further deception. After Merrill Lynch stopped its masking practices in May 2013, it did not inform customers about its past practices, but rather took additional steps to hide its misconduct. Instead, Merrill Lynch configured systems so that future reports to customers, typically provided on a monthly or quarterly basis, and continued to mask ELP executions that occurred prior to May 2013. More than 30 percent of the total number of subsequently identified masked executions occurred from May 2012 through May 2013.

Enforcement officials’ comments. Joseph Sansone, Chief of the SEC’s Enforcement Division’s Market Abuse Unit noted, "Institutional traders often make careful choices about how and where their orders are sent out of a concern for information leakage…[b]ecause of masking, customers who had instructed Merrill Lynch not to route their orders to third-party broker-dealers did not know that Merrill Lynch had disregarded their instructions."

Stephanie Avakian, Co-Director of the SEC’s Enforcement Division had this to say about Merrill Lynch’s conduct, "By misleading customers about where their trades were executed, Merrill Lynch deprived them of the ability to make informed decisions regarding their orders and broker-dealer relationships." She added, "Merrill Lynch, which admitted that it took steps to ensure that customers did not learn about this misconduct, fell far short of the standards expected of broker-dealers in our markets."

The release is No. 33-10507.

Companies: Merrill Lynch, Pierce, Fenner & Smith Incorporated

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