On August 20, 2018, Merrill Lynch agreed to pay $8.9 million in disgorgement, interest and penalties to settle an SEC enforcement action. https://www.sec.gov/litigation/admin/2018/34-83886.pdf. According to the SEC's press release, Merrill "failed to disclose a conflict of interest arising out of its own business interests in deciding whether to continue to offer clients products managed by an outside third-party advisory firm." https://www.sec.gov/news/press-release/2018-159 Sounds bad. Well, now I've read the settlement, and let me just say, in my best Cockney accent, "Bollocks!"First, some context. Before this settlement, the SEC had extracted over $59 million from Merrill through three settled enforcement actions between March 8 and June 19. See
So, maybe we can just take it for granted that Merrill, a bit punch drunk, didn't care what the SEC said, just so they'd be gone.
Still, the story is worth telling, even if it is a bit convoluted. All the quoted terms below are from the text of the settlement.Merrill restricts advisory customers to choose from a list of approved private funds. Merrill had on its approved list certain funds, the "Products," sponsored by a "US Subsidiary" of a foreign bank. In late 2012, the US Subsidiary advised Merrill it was changing the Products' investment managers to a "New Team." That prompted Merrill "Due Diligence" to recommend removing the Products from Merrill's platform, and to recommend that Merrill's customers switch from the Products to certain alternative funds. The actual termination could only be made by the supervising "Governance Committee." Some members of the Governance Committee were from Due Diligence and others were from the business.
The US Subsidiary got wind of the prospective termination. Its "Officer A" lobbied a Merrill "Senior Executive" for more time to show that the New Team knew what it was doing. In the course of these discussions, Officer A brought up the larger relationship between Merrill and the US Subsidiary. It so happened that Merrill's parent, Bank of America was pitching to be named active book-runner on a proposed offering by the US Subsidiary. The SEC strongly suggested (without actually saying it) that that prospective piece of business was the elephant in the room during these discussions.
Two Governance Committee members reported to the Merrill Senior Executive who got the earful from Officer A. So -- surprise! -- the Governance Committee voted to delay terminating the Products. Instead, the Products were put on "hold." Existing investors could stay in them, but no new investors could be accepted.
The state of the teapot after this tempest?
Let's be clear. The only thing that happened here is that the US Subsidiary complained to Merrill management that Due Diligence had not conducted a fair review of the New Team, and Merrill accommodated that complaint by granting more time. Both the complaint and the response were perfectly reasonable, because on the very face of it Due Diligence had not conducted a fair review. Due Diligence recommended terminating the Products because "the New Team had previously been responsible for institutional accounts with a minimum of $100 million invested in diversified portfolios of approximately 150 bonds whereas the Products were historically held in retail accounts with a minimum of $100,000 invested in portfolios of 20-25 bonds." Which is something like saying "You're not competent to play in the Minors because all you've ever done was pitch for the Yankees." Really?
The Products' actual performance in 2013 proved Due Diligence wrong. With a little less hubris, Due Diligence might have considered that's why the US Subsidiary chose the New Team in the first place! But here's the real issue. As the SEC would have it, the business was wrong to influence the Governance Committee not to approve Due Diligence's recommendation. And since it is clear from the settlement that the Governance Committee always voted to approve Due Diligence's recommendations, the SEC is essentially saying that Due Diligence's recommendation should have been accepted without quibble.
That completely misapprehends the purpose of due diligence. Due diligence is primarily a fact-gathering enterprise. Due diligence is not supposed to make business decisions. Merrill's Due Diligence presented this fact: The New Team knew how to run large institutional portfolios but had no experience running smaller retail portfolios. That's it. The conclusion that a manager of large portfolios wouldn't know how to manage small portfolios was not only stupid, it was outside Due Diligence's jurisdiction. Only the Governance Committee could make that judgment, and the Governance Committee would not be properly discharging its fiduciary duty to do right by the customers if it simply rubber stamped Due Diligence's recommendations, no matter how dumb.
What bothered the SEC was that Bank of America and the US Subsidiary had other fish frying at the same time. BofA's prospective role in the US Subsidiary's offering was the "conflict" that, by the SEC's lights, fouled Merrill's Governance Committee process. I think that's ridiculous. First, it conflates Merrill with BofA, attributing the business objectives of one to the other, with no supporting evidence. From my experience, corporate parents, subsidiaries and siblings are as often in discord as they are in harmony. Second, there is no indication anywhere in the settlement that US Subsidiary actually promised, or even suggested, that BofA would be appointed active bookrunner if Merrill delayed terminating the Products. That BofA was not chosen active bookrunner pretty much proves that. And third, Wall Street firms are always talking to each other about prospective deals. If that constant but seldom material chatter poses a "conflict of interest," then we may as well quit the business. Some prospective deals work out and most don't. Merrill's Senior Executive reportedly took the news of BofA's loss "in stride." Of course he did. Only the SEC would get worked up about stuff like that.
Civilization could not exist without finance, and unregulated finance will always lead to fraud. We all know that. But honest finance is not advanced by so minutely regulating firms that they choke on their own processes. The SEC touted the recent Merrill settlement as vindication for customers' right to "unbiased financial advice," full disclosure of conflicts of interest, and that advisers are "fulfilling their fiduciary duties." It wasn't. Nothing there suggested that Merrill was not taking the best interests of its customers into account in making its decisions. No -- this was the SEC micromanaging the internal review processes of an adviser, declaiming fiduciary duty from the heights of pedantry despite no tangible conflict of interest and no actual risk to customers. Talk about fake news!