Government regulators have ordered Merrill Lynch, Pierce, Fenner & Smith Inc. and Harvest Volatility Management to fork over $9.3 million in fines and disgorgement after accusing the firms of exceeding clients’ investment limits for an options trading strategy.
According to a complaint by the Securities and Exchange Commission, clients ended up paying higher fees in the strategy and ended up overexposed to markets where they suffered losses.
The fines include $6.3 million in recovered fees tied to the complex options trading strategy, used by the two firms starting in 2016. Those monies will be distributed to harmed investors, the agency said. New York City-based Harvest has $216 billion in assets under management, while Merrill has $1.8 trillion.
“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, in a statement.
"We ended all new enrollments with Harvest in 2019 and recommended that existing clients unwind their positions," Merrill Lynch/Bank of America spokesperson Naomi Patton told Financial Advisor.
According to the SEC, Harvest was the primary investment advisor and portfolio manager for the Collateral Yield Enhancement Strategy (CYES), which traded options in a volatility index with the aim of generating incremental returns.
Starting in 2016, the SEC said, “Harvest allowed scores of accounts to exceed the exposure levels that investors designated when they signed up to the CYES strategy, including dozens of accounts that exceeded the limit by 50% or more.”
The violations yielded larger fees for both Merrill and Harvest, “which received higher management fees when investors’ exposure levels climbed above preset levels, thereby exposing investors to greater financial risks,” the regulator said.
The agency said Merrill introduced clients to Harvest and received part of its management and incentive fees, as well as trading commissions.
“As a result of Harvest’s failure to adjust options contracts for certain clients introduced by Merrill … Harvest charged those clients excessive management fees, of which Harvest paid approximately $2 million to Merrill under the solicitation agreement. Merrill also received approximately $1 million in excess commissions to execute options transactions directed by Harvest,” the SEC said.
The regulator also found that Merrill had conversations with Harvest and was aware that investors’ exposure to the options strategy was exceeding preset levels. The firm also failed to inform affected investors of the violations, even though most of the clients had existing advisory relationships with Merrill.
“Harvest and Merrill neglected to adopt and implement policies and procedures reasonably designed to ensure that they disclosed all material facts to their clients and alerted them to the excessive exposure,” according to the SEC settlement.
The SEC said the two firms thus violated the Investment Advisers Act of 1940. Without admitting or denying the findings, Harvest and Merrill agreed to be censured and submitted to cease and desist orders, as well as agreeing to penalties of $2 million and $1 million, respectively. Harvest will also pay $3.5 million in disgorgement and prejudgment interest, while Merrill will pay $2.8 million in disgorgement and prejudgment interest.