NASD announced today that it has fined Merrill Lynch, Pierce, Fenner & Smith Inc. $5 million for supervisory failures, registration violations, impermissible sales contests and other violations in connection with the operation of its Financial Advisory Center (FAC) located in Hopewell, NJ and Jacksonville, FL. The firm was also prohibited from staging any sales contests for FAC personnel for three years.
In addition, Merrill Lynch was ordered to retain, at its own expense, an independent consultant to recommend corrective measures to firm policies and supervisory and compliance procedures and systems for the FAC. Until those corrective measures are implemented, Merrill Lynch must impose special supervisory procedures, including monitoring calls between FAC personnel and customers.
In connection with today's announcement, NASD is releasing a new Investor Alert, Customer Advisory Centers: Not Your Typical Securities Firm Call Center.
"Regardless of the size of their brokerage account, all investors are entitled to services from registered representatives acting in their clients' best interests who are reasonably supervised by properly registered professionals," said NASD Senior Vice President and Acting Head of Enforcement James Shorris. "In this case, Merrill Lynch failed to meet these basic standards by permitting its call center to function without proper supervisory controls, which gave rise to impermissible sales contests, unsuitable mutual fund switches, and other systemic failures."
NASD found that, from 2001 to 2004, Merrill Lynch did not have an adequate supervisory system and procedures that were reasonably designed to oversee the trading activities of its registered representatives at the FAC, referred to within the firm as Investment Service Advisors (ISAs). Certain of the ISAs engaged in a pattern of mutual fund switch recommendations that were accompanied by misrepresentations and omissions of facts to customers. Further, Merrill Lynch permitted individuals lacking the proper securities licenses and qualifications to be responsible for the supervision of the ISAs. Merrill Lynch also conducted several sales contests which improperly awarded non-cash compensation to ISAs in the form of rock concert tickets, sporting events and dinners based solely on the sale of the firm's proprietary mutual funds.
The FAC was originally designed as a centralized "call center," where customers could call with questions or requests about their accounts and which initially held only a small number of customer accounts. NASD found that the character of the FAC changed in 2001. As a result of an overall Merrill Lynch strategy to improve its retail business by "segmenting" customer accounts, the firm began relocating thousands of customer accounts from branch offices throughout the country to the FAC. Generally, smaller accounts with assets of $100,000 or less, or those with minimal transactional activity, were moved to the FAC, in part so that Merrill Lynch's full service Financial Advisors in branch offices could devote more attention to larger accounts.
NASD found that between March 2001 and August 2002, more than 1 million customers were transferred to the FAC. At its peak size in 2002, the FAC had approximately 1.3 million accounts holding approximately $20 billion in assets. That year, the FAC had gross revenues of approximately $210 million.
For new FAC accounts, Merrill Lynch promised around-the-clock customized financial advice from a "team of Merrill Lynch professionals." NASD found that Merrill Lynch failed to disclose that the ISAs often had five years or less brokerage experience, and that when making recommendations regarding securities, they were limited to mutual funds. ISAs were prohibited from soliciting orders in equities or bonds, unless requested to do so by a client.
ISAs solicited securities transactions from the newly transferred customers, generating millions of dollars in annual gross revenues for Merrill Lynch. There was significant mutual fund switching activity. For example, in one week in March 2002, there were approximately 1,324 mutual fund switches reported by the FAC. Moreover, NASD found that several ISAs recommended mutual fund switches that were not suitable for their customers. The ISAs recommended many of those switches without first considering whether comparable funds that met the customers' investment objectives and performance requirements were available within their existing mutual fund families without paying additional loads. NASD also found that, in connection with the unsuitable switches, certain of the ISAs made false representations to customers, and/or omitted material facts, concerning costs and other important information.
NASD found that, from 2001 through 2004, Merrill Lynch lacked an adequate supervisory system and procedures reasonably designed to supervise the ISAs, particularly given the growth of the FAC. Merrill Lynch, among other things, lacked adequate written supervisory procedures regarding mutual fund recommendations (including switch transactions); did not employ a sufficient number of properly trained and qualified supervisors to monitor activities within the FAC; and failed to conduct annual compliance audits for the FAC's two most active years. Thousands of mutual fund switches were not reviewed or were not adequately reviewed by Merrill Lynch principals.
NASD also found that Merrill Lynch's form "switch letters" sent to customers were often inaccurate. Specifically, the letters represented that that the administrative manager signing the letter had discussed the mutual fund switch with the ISA to confirm that proper disclosure of costs had been made to the customer. In fact, the administrative managers rarely discussed this issue with the ISA before sending the switch letters.
Merrill Lynch allowed its FAC sales managers to exercise direct supervisory responsibility over the ISAs. The majority of those sales managers, however, were not properly registered as securities principals. They were therefore not qualified to supervise ISAs. NASD also found that, even with approximately 300 ISAs generating thousands of trades per day, Merrill Lynch employed only three to six registered principals to review all of the transactions.
NASD's investigation showed that, in 2002, the FAC conducted three sales contests that violated the non-cash compensation rule because they favored the sale of Merrill Lynch's proprietary mutual funds. NASD rules prohibit non- cash compensation arrangements between firms and their brokers for sales of mutual funds and variable contracts that are not based on concepts of "total production" and "equal weighting" -- that is, the contests must be based on total sales of all products within a single category, such as mutual funds.
NASD found that the firm offered and awarded various forms of non-cash compensation to the contest winners. For example, one contest rewarded the six ISAs who sold the most proprietary mutual fund products with tickets to a rock concert. Another offered a total of $10,000 in expense credits to the top four teams of ISAs in total of proprietary product sales. These contests, along with several other contests based on overall production, contributed to a dramatic increase in the volume of proprietary mutual fund sales by the FAC. For example, in the first half of 2002, gross sales of proprietary products increased from $36.4 million in the first quarter to $138.7 million in the second quarter -- an increase of nearly 300 percent.
In settling this matter, the firm neither admitted nor denied the charges, but consented to the entry of NASD's findings.