The SEC, Trading In Opaque Markets And Compliance

The Commission filed settled administrative proceedings centered on a large brokerage firm’s trading in the market for residential mortgage backed securities or RMBS. The factual allegations may be familiar for many. Traders of RBMS lied to their counter-parties during the bond transactions against the backdrop of opaque markets. Thus the counter-parties were defrauded. The Order does not charge fraud however. Rather, it alleges a failure by the brokerage to effectively implement its compliance procedures and thus properly supervise its traders. In the Matter of Merrill Lynch, Pierce, Fenner & Smith Inc., File No. 3-18538 (June 12, 2018).

The Order

The Order centers on trading by Merrill Lynch personnel of RMBS bonds. In each instance the firm had purchased “the securities for its own account and then sold them . . .” based on a mark-up. All of the customers or counter-parties were “institutions.” All of the RMBS were non-agency, defined as “residential mortgage-backed securities that are sponsored by private entities and not government-sponsored entities.” The time period for the Order is post market crisis, 2009 through 2012.

The Order alleges that these “proceedings arise out of Merrill’s failure reasonably to supervise Firm personnel so as to prevent and detect violations of antifraud provisions of the federal securities laws . . .” in connection with non-agency RMBS bond transactions in the secondary markets by Merrill for its own account. In those transactions Merrill personnel either made false and misleading statements or charged excessive mark-ups in the context of intra-day trading:

False and misleading statements: The false statements occurred in connection with the purchase and sale of the bonds. The wrongful statements concerned the price at which the securities were purchased or sold, the amount of profit Merrill would make on the transaction and the status of negotiations with other counter-parties.

Excessive mark-ups: On certain transactions Merrill traders charged customers “mark-ups that bore no reasonable relationship to the prevailing market prices,” according to the Order.

Merrill had policies and procedures in place during the period which prohibited personnel from making false or misleading statements to customers and charging unreasonable mark-ups. Various steps were taken to implement those policies and procedures. Those policies and procedures provided for a review of electronic communications with third parties. Firm personnel conducted a daily review about one to five days after the communication took place. Merrill personnel never detected any of the false and misleading statements cited in the Order. “Under these circumstances, Merrill failed reasonably to implement procedures for the review of communications that reasonably would be expected to prevent and detect false or misleading statements . . .” the Order alleges.

Merrill’s procedures for monitoring for excessive mark-ups were also flawed. The firm used an electronic monitoring system to detect mark-ups outside certain parameters which, if exceeded, were to be reviewed by the compliance department. Despite charging mark-ups that were “significantly in excess of industry and Merrill averages, Merrill did not perform a reasonable review of the trades for which alerts were generated to determine whether the mark-ups were excessive. . .” according to the Order.

In resolving the matter Merrill undertook remedial efforts designed to address the compliance deficiencies cited above. The firm also agreed to cooperate with the staff.

The Order alleges violations of Exchange Act section 15(b)(4)(E) regarding supervision. To resolve the proceedings Merrill consented to the entry of a cease and desist order based on the section cited in the Order. The firm will also pay disgorgement of $2,311,392 and pre-judgment interest of $513,884 tied to the false and misleading statements. In addition, the firm will pay disgorgement of $6,318,914 and pre-judgment interest of $1,391,251 tied to the excessive mark-ups. Merrill will also pay a penalty of $5,267,720.


The Commission’s action here is written on the history of government enforcement actions centered on the RMBS markets. A series of cases have been brought that center on those markets such as the action against Jeffery’s trader Jesse Litvak and those naming as defendants three Nomura Securities traders. See, e.g., U.S. v. Litvak, No. 13-cr-00019 (D. Conn. Filed Jan. 25, 2013); U.S. v. Shapiro, No. 15-cr-00155 (D. Conn. Filed Sept. 3, 2015); SEC v. Shapiro, Civil Action No. 15-cv-07045 (S.D.N.Y. Filed Sept. 8, 2015); see also SEC v. Im, Civil Action No. 1:16-cv-0313 (S.D.N.Y. Filed May 17, 2017)(action against two other Nomura traders).

Essentially, Litvak, Shapiro and Im each allege that the traders defrauded their counterparties in the RMBS markets by making misrepresentations. Most, if not all, of the false statements were recorded. The defense countered those statements with expert and factual testimony. That testimony demonstrated that statements made by the traders were not relevant to the purchase or sale decisions by the counterparties because they were relying on sophisticated economic pricing models which guided their decisions on whether to buy or sell and as to price. Based on this testimony the juries rejected virtually all of the criminal charges, although the cases are still going on as discussed here.

The testimony in these case also demonstrated that in many instances traders utilized a kind of “wild west” trading approach tied to repeated misstatements believing not just that “everyone does it,” but more importantly, that the firm’s compliance department knew about the approach. Under those circumstances, while some traders expressed reservations about employing such tactics, they felt virtually compelled to do so.

The Commission’s action against Merrill Lynch reflects the teachings of these cases. The root issue is not the “wild west tactics” but compliance. These cases all begin and end with effective, fully implemented compliance procedures. By focusing directly on that issue rather than the tactics as in Litvak and Shapiro the Commission’s Merrill Order addresses the key issue and begins to end the problem rather than just launching another series of near endless cases.

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