When the Brakes of Heavy Regulation Work on Only One Side of the Car

When the Brakes of Heavy Regulation Work on Only One Side of the Car

How is this as a “reward” for cooperation: you’re a financial institution who learns that some of your customers have violated the terms of their loan agreement with an affiliate and used borrowed funds to invest in the stock market, some even having invested on margin.  In fact, over a four-year period, more than 121,000 of your customers established credit lines with the affiliate, allowing them to borrow (in the aggregate) upwards of $85 billion.  Many of them took advantage of the loans to do so.

For example, one “high net worth” individual, alone, borrowed approximately $282 million over several years to make unsolicited stock market transactions, on margin, without any encouragement from you.  And, in one nine-month period, 545 of your customers borrowed and invested $74 million in securities, the majority of it for margin transactions, without incident or customer harm.

After conducting an internal investigation to determine how the numbers grew so large, you elect to impose limitations on future borrow-and-invest activity, to preclude another substantial build-up.  You then voluntarily report what you’ve discovered to your primary regulator, and share with them the details of your internal investigation.  The regulator then conducts its own review of the matter, and at the end of it thanks you for your efforts, but notes that because you didn’t originally “prevent, deter or detect” your customers’ activity, but instead allowed them, alone, to determine their risk tolerance, investment interest and ability to manage their own affairs, you must be censured and ordered to pay a $6,250,000 fine.

Quite bizarre, no?  Yet, this is where Merrill Lynch found itself in late November 2016, when it signed a Letter of Acceptance, Waiver and Consent (“ACW”) i.e., an administrative settlement with the Financial Industry Regulatory Authority (“FINRA”).

To repeat: No customer was harmed. Merrill voluntarily investigated the activity, tightened its internal processes and self-reported its findings to FINRA.  And, it was the customers who, with no encouragement from Merrill, breached their loan agreements by borrowing and investing more on margin than their agreements allowed – a term of which they all were well aware.

Such is the heavy regulatory environment that has led so many to bemoan how excessive regulation represents a drag on economic growth.  Surely, the regulator’s aim is laudable: namely, to curb the types of excesses that led to two tremendous market upheavals in less than a decade – the “tech wreck” of 2000 and the Great Recession of 2008.  And, just as those epochal eruptions resulted in part from investors’ hunger for growth and returns, here again the driving force behind Merrill’s eventual punishment were credit worthy investors who came into the marketplace seeking growth through investments in government and private industry, and were willing, without encouragement, to take on the attendant risk to achieve it.

How is this Merrill’s problem?  Isn’t this capitalism 101: identify an opportunity, evaluate its potential, make an investment decision and let the market do the rest?  Yet, what we see instead is the hunger of an overzealous regulator eager to deputize and press financial industry actors into service as nannies to second guess and oversee the decision making of informed, credit worthy investors.

The AWC does not allege that Merrill brokers steered customers to open bank lines of credit.  In fact, the AWC says Merrill employees were not compensated when customers opened such accounts.  Nor does it claim that any Merrill employee encouraged any customer to take a loan or buy securities on margin.  Rather, it appears much of the activity was unsolicited, as with the individual who borrowed and invested $282 million.  Surely he had no need for Merrill to intervene and scold him about what his risk tolerance should be.

We have clearly passed through the looking glass when informed, credit worthy investors, willing to invest in government and industry, are given gratuitous over-the-shoulder advice from third parties about how much risk they should and should not assume, and when self-correction, self-reporting and cooperation with regulators is met with sanctions in a case where no one got hurt.

Another component of the Merrill settlement focused on how some of the loans, which were secured by investments in the borrower’s Merrill Lynch account and  provided by Bank of America, Merrill’s parent and corporate affiliate, were used by Puerto Rican nationals to respond to various Puerto Rican government incentives to encourage investment in Puerto Rican bonds and other Puerto Rican securities, at a time when Puerto Rico needed all of the financial support it could get.  When local investors responded to such incentives, out of patriotism, hunger for gain, or both, some became concentrated in Puerto Rican positions as the value of the bonds declined, leaving margin positions without sufficient equity, resulting in calls for more collateral.  Merrill was also hit for this turn of the events, which affected approximately 50 investors, 25 of whom suffered losses totaling $1.2 million.  Though Merrill settled with some of the investors, FINRA ordered it to pay $780,000 in restitution to 22 others.

Sometimes, in a bad relationship, you hold back your righteous indignation in order to move on to live (or fight) another day.   Seems that’s what Merrill did here.

Ron Wood

Ron Wood

Ron Wood is a partner with Brown White & Osborn LLP. A former Assistant Director in the SEC's Division of Enforcement, Executive Director in the Law Division at Morgan Stanley, and litigation partner with Proskauer LLP, he practices securities law with a focus on regulatory and enforcement matters. He also conducts internal investigations and complex commercial litigation.
Ron Wood