The Securities and Exchange Commission (SEC) has fined Merrill Lynch $3.8 million for allowing clients to become overexposed to a complex options trading strategy. The strategy, known as the Collateral Yield Enhancement Strategy (CYES), was offered in partnership with Harvest Volatility Management. Clients could participate in the CYES without contributing new money by using their existing assets as collateral.
They specified the extent of their exposure to the strategy in their investment management agreements. However, Merrill and Harvest allowed those limits to be exceeded, resulting in higher fee collections. In this case, two investment advisors allegedly sold their clients a complex options trading strategy 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.
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 were 50% or more above client-specified notional amounts.
Merrill Lynch fined for overexposure
Harvest waited until 2018 to make adjustments to align clients’ exposure with their agreed notional amounts.
As a result, some clients experienced elevated losses when the strategy had negative returns and elevated gains when the strategy had positive returns. 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. Merrill and Harvest were charged with violating provisions of the Investment Advisers Act of 1940 prohibiting fraudulent and deceitful practices.
Merrill will pay $2 million in disgorgement, $800,000 in prejudgment interest, and a $1 million civil penalty as part of the settlement. Harvest will pay $2.5 million in disgorgement, $1 million in prejudgment interest, and a $2 million civil penalty. A spokesperson for Merrill, which neither admitted nor denied the charges, said, “We ended all new enrollments with Harvest in 2019 and recommended that existing clients unwind their positions.” Attempts to reach Harvest Volatility Management for comment were unsuccessful, as the firm’s latest regulatory filings show $216.6 million in assets under management, and its website appears to have been taken down.
