New York, NY – Last week Bank of America Corp. agreed to settle accusations by the Securities and Exchange Commission that Merrill Lynch’s proprietary trading desk illegally traded based on direct knowledge of what the firm’s institutional customers were doing. While SEC enforcement cases targeting this type of activity are rare, this settlement is likely to raise concerns among buy-side investors that proprietary trading desks at sell-side investment banks have long been profiting from their knowledge of their clients trading activity.
The SEC’s Allegations
According to the SEC, between 2003 and 2005 Merrill Lynch operated a proprietary trading desk known as the Equity Strategy Desk (ESD) that traded more than $1.0 bln of the firm’s own capital, and had no role in executing customer orders. The ESD was located on Merrill Lynch’s equity trading floor. The SEC alleged that:
“While Merrill represented to customers that their order information would be maintained on a strict need-to-know basis, the firm’s ESD traders obtained information about institutional customer orders from traders on the market making desk. They then used it to place trades on Merrill’s behalf after executing the customers’ trades. In doing so, Merrill misused this information and acted contrary to its representations to customers.”
Because ESD’s trades took place after their client’s, what Merrill Lynch did is not considered to be front-running, though it was still (allegedly) trading over the “Chinese Wall” that is meant to be in place. According to the SEC filing, one trader on Merrill’s ESD wrote an electronic message explaining his actions by saying, “I always like to do what the smart guys are doing.”
The SEC also alleged that although Merrill had agreements with certain customers that it would only charge commissions equivalent for executing riskless principal trades, this did not take place. The SEC explains:
“However, in some instances, Merrill also charged customers undisclosed mark-ups and mark-downs by filling customer orders at prices less favorable to the customer than the prices at which Merrill purchased or sold the securities in the market.”
“Charging these undisclosed mark-ups and mark-downs was improper and contrary to Merrill’s agreements with its customers,” said Robert Kaplan, co-chief of the SEC’s Asset Management Unit, in a written statement. “Brokers must act honestly and transparently when charging fees to their customers. There is no place in our markets for charging investors undisclosed trading fees.”
Merrill’s Settlement
Merrill Lynch agreed to pay the SEC $10 million to settle these charges, though the firm neither admitted nor denied the SEC’s allegations. Bank of America said that Merrill Lynch has “adopted a number of policy changes to ensure separation of proprietary and other trading and to address the SEC’s concerns.” Merrill Lynch also voluntarily implemented enhanced training and supervision to improve the principal-trading processes at the securities firm.
The ESD was shut down in 2005 after the SEC began its investigation. The employees who worked on the proprietary trading desk no longer work at Bank of America.
Possible Backlash
Most commentators acknowledge that the $10 mln SEC settlement is merely a “traffic ticket” or a “slap on the wrist” for Merrill Lynch given the extent of the alleged wrongdoing. However, it could be that the real consequences for Merrill and the rest of Wall Street could be market driven.
For many years, institutional investors have feared that bulge bracket firms were misusing and profiting from their knowledge of their clients’ order flow through their prop trading operations. In fact, a number of hedge funds have argued that their biggest competitors are their broker-dealers’ proprietary trading arms. The Merrill settlement might confirm that this fear has merit.
Consequently, some buy-side clients might try to direct less of their execution business to the sell-side firms that maintain aggressive prop trading operations in the future. Many bulge bracket firms have been scaling back their prop trading desks in past months due to the inclusion of the “Volker Rule” in last year’s Dodd-Frank law.