BUSINESS & SECURITIES
The Merrill Lynch Lesson: Broker-Dealer Incurs $500,000; Agrees to Arbitration and Compliance Review
July 2002
By Denis J. Maloney*
Merrill Lynch, Pierce, Fenner & Smith, Inc. recently entered into a Consent Order with the New Hampshire Bureau of Securities Regulation in settlement of allegations that a registered representative of Merrill recommended and solicited customers to purchase highly speculative and risky equity securities that were not registered and/or legal for purchase in the State of New Hampshire. Merrill has agreed to pay an administrative fine of $500,000 (the highest ever paid in New Hampshire for a securities violation), reimburse the Bureau for its expenses of $75,000, and perhaps more importantly, to
- Engage in binding arbitration with affected customers to determine if they were in fact solicited to purchase certain stocks;
- Offer rescission of the purchase to customers who were so solicited for the return of the total purchase price plus interest at the statutory rate of 10%;
- Engage an independent consultant acceptable to the New Hampshire Bureau to review the current compliance and policy procedures at its local office; and
- Circulate a company-wide “Global Compliance Alert” to all Merrill U.S. personnel addressing the issues raised in the Order.
The Order recites that Merrill’s compliance policies are based on the premise that its customers will receive the benefit of Merrill stock research and that all registered representatives working for Merrill have a reasonable basis to recommend the purchase of a security to their customers. Stocks were to be recommended only when covered by Merrill’s research and when the securities were legal for purchase in a particular state. Further, Merrill maintained an internal rating system for stocks covered by Merrill research, designating a multi-digit code representing the appreciation potential for the stock and its income rating. Despite the existence of the compliance policy, John David, a registered representative of Merrill, allegedly solicited his customers to purchase and they did purchase five unregistered equity stocks that were not recommended or followed by Merrill research. In addition, these stocks were ‘highly speculative and risky’ and were recommended, solicited and purchased “without a reasonable basis to do so.” A separate Consent Order with Mr. David also recites that he engaged in fraudulent and deceitful practices in that he mismarked his order tickets as unsolicited transactions when in fact they were solicited transactions.
A stock that is listed on the NASDAQ national market system, the New York Stock Exchange or on the list of OTC-margin stocks published by the Federal Reserve Board is exempt from registration under most state securities laws. Customers will not be entitled to a rescission offer from Merrill if Merrill can show that any of the five sold stocks were so listed. Further, even if not listed, under New Hampshire’s securities law a purchase of such a non-listed security is nonetheless legal if the registered representative was in fact executing an ‘unsolicited’ order placed in the first instance by the customer. The Order requires Merrill to notify the affected customers and to engage in arbitration to determine whether or not such customers were solicited by Mr. David. If solicited, Merrill has agreed to offer rescission of the purchase to such customer in an amount equal to the “purchase price plus interest at New Hampshire’s statutory rate at the time of transaction, less any sale proceeds and dividends.” This provision shall not apply to any client who at the time of the execution of the Order had settled a claim against Merrill for the conduct of Mr. David.
Importantly, Merrill has agreed to retain an independent consultant to review the current compliance and policy procedures as implemented in its branch office in New Hampshire. The consultant is required to focus on certain enumerated items, including procedures for the solicitation of ‘risky’ stocks not internally rated by Merrill; the proper designation of order tickets; a review of standards used to determine whether a transaction is solicited or not solicited; unregistered securities that should have been registered under New Hampshire law; and, a review of the compliance hierarchy within the branch office itself to determine the appropriateness of a “non-producing” branch manager. The consultant will also review the “adequacy of supervision” at the subject office; Merrill is required to undertake two annual “follow-up” reviews of its subject practices. Under a separate order, Mr. David has been barred from the securities business in New Hampshire for life.
Importantly, while Merrill has not admitted in the Order that its compliance procedures were inadequate to properly supervise its registered representatives in New Hampshire, it has agreed to review its overall internal policies and procedures for the sale of speculative or ‘risky’ stocks, to review the standards used to determine whether a sale is solicited or unsolicited, and to essentially determine whether a branch office of a certain size should be managed and supervised by a non-producing manager. Merrill must also circulate a Global Compliance Alert to all its branch offices in the United States addressing the Order and the issues to be reviewed by the independent consultant.
The size of the administrative fine paid by Merrill, together with the potential expense associated with the rescission offer (i.e., total purchase price plus statutory interest from the time of purchase, less any sale proceeds — press reports estimate Merrill’s potential reimbursements at up to $2 million), should cause broker-dealers to revisit and reinvigorate their compliance procedures to assure that their policies and procedures are adequate for the nature of the securities business conducted and registered agents are conducting themselves in accordance with such procedures — anything less may well prove to be very expensive.
*Denis J. Maloney is admitted in New Hampshire.
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