Merrill is paying the SEC nearly $4 million over an investment plan that saw its clients become overconcentrated in a complicated options trading strategy.
The Securities and Exchange Commission announced Wednesday it's hitting Bank of America's Merrill with a $3.8 million penalty for an investment plan it ran from March 2016 to April 2018 with a Norwalk, Connecticut-based firm named Harvest Volatility Management. Harvest, which agreed to pay $5.5 million as part of the same settlement, had enlisted Merrill to solicit clients for a collateral yield enhancement strategy, or a CYES, meant to use options trading both to juice returns and mitigate risks.
The SEC said Merrill and Harvard let clients specify through investment management agreements just how much exposure they wanted to the CYES. Despite having those explicit instructions, the firms allowed those limits to be exceeded, the regulator alleged.
The result was higher fee collections. Harvest, according to the SEC, generated $4 million in excess management fees, of which roughly $2 million was shared with Merrill in return for client solicitation. Merrill, according to the SEC, also brought in $1 million in excess commission from options transactions.
"In this case, two investment advisors allegedly sold a complex options trading strategy to their clients, but failed to abide by basic client instructions or implement and adhere to appropriate policies and procedures," said Mark Cave, associate director of the SEC's enforcement division.
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A spokesperson for Merrill, which neither admitted to nor denied the charges, said, "We ended all new enrollments with Harvest in 2019 and recommended that existing clients unwind their positions."
Harvest Volatility Management couldn't be reached for comment. The firm's latest Form ADV, filed with the SEC on March 22, lists $216.6 million of assets under management, mostly for high net worth clients.
A phone whose number was listed in the same document wasn't picked up and the firm's website appears to have been taken down. Attempts to reach Chief Compliance Officer Patrick Joseph Clough by phone and email were also unsuccessful.
The sort of yield enhancement strategies in the Merrill case have come into regulators' crosshairs before. UBS found itself dragged before FINRA arbitration panels more than a dozen times several years ago over allegations that it had recommended
The particular CYES offered by Harvest relied on an "options overlay" strategy known as iron condor. For clients, this involved selling stock options to collect premiums and then buying other options to mitigate risk.
Clients did not have to contribute new money to take part in the CYES. Instead, they could put up their existing stocks and other assets as collateral.
Harvest, in turn, generated management and incentive fees from running the iron condor; Merrill, which approved the investment strategy for high net worth clients in 2011, received 30% of those fees for every client it directed to Harvest, according to the SEC.
Every participating client entered in an investment management agreement laying out what they wanted the "notional amount" of their allocation to the CYES to be. Harvest's management fees were set as a percentage of this notional amount, according to the SEC.
The notional amount was calculated by looking at the S&P 500 stock index on a given day. When the S&P fluctuated in value, as happened almost every day, clients' exposure to the CYES plan should have been adjusted in response, according to the SEC.
The S&P, for instance, rose more than 25% in the two years leading up to April 2018, and Merrill and Harvest should have been lowering their clients' exposure to the CYES to an equal extent, the regulator said. Those adjustments, however, were not made.
"By the end of 2017, 186 pre-2017 CYES accounts introduced by Merrill were 30% or more above the client-specified Notional Amounts, and 74 of those accounts were 50% or more above client-specified Notional Amounts," according to the SEC's settlement with Merrill.
Despite knowing of this defects, according to the SEC, Harvest waited until 2018 to make changes to its CYES plan to make sure clients' exposure to the strategy corresponded to their previously set notional amount. By then, it was too late, regulators alleged.
"As a result of having greater exposure to the CYES strategy, some Harvest clients experienced elevated losses when the strategy had negative returns and elevated gains when the strategy had positive returns," according to the SEC. "Between the first quarter of 2016 and the first quarter of 2018, the CYES strategy experienced a net loss of approximately 1.05% on total notional exposure."
Regulators accused both Merrill and Harvest of violating provisions of the Investment Advisers Act of 1940 banning fraudulent and deceitful practices. As a result of its settlement, Merrill is paying $2 million in disgorgement and $800,000 in prejudgment interest, along with a $1 million civil penalty. Harvest must pay $2.5 million in disgorgement and $1 million in prejudgment interest, as well as a $2 million civil penalty.
