Finra: Merrill omitted key costs for five-year strategic return notes

By Susanna Moon

Chicago, June 23 – Financial Industry Regulatory Authority (Finra) said it has charged Merrill Lynch, Pierce, Fenner & Smith, Inc. with failure to disclose costs to retail investors in the sale of its five-year strategic return notes linked to its proprietary volatility index.

The company has been fined $5 million for “negligent disclosure failures,” which made the fixed costs appear lower than they were, according to a Finra notice.

The index is structured to track volatility in the equities markets by rebalancing, or rolling, S&P 500 index options contracts through a series of simulated trades, the release noted.

During the period in question, the firm reportedly sold about $168 million worth of the notes to its retail customers, “promoting them as a hedge against potential downturns in the equities markets,” Finra contended.

The costs include an “execution factor,” a index feature intended to replicate transaction costs incurred in the simulated buying and selling of S&P 500 index options. These transaction costs accrued on a daily basis and totaled 1.5% per quarter.

“In buying the notes, a reasonable retail customer would have considered it important that the execution factor imposed these costs,” the release said.

Finra said that Merrill Lynch did not adequately disclose the execution factor in the offering documents or sales material. Instead, the firm emphasized a 2% sales commission and a 0.75% annual fee, which “therefore made it appear as if the notes had relatively low fixed costs” and added that the disclosures were therefore “were materially misleading.”

“Firms must take extra care when marketing unusually complex products to retail customers,” Brad Bennett, Finra’s executive vice president and chief of enforcement, said in a statement.

“Given the importance of costs and expenses to investment performance, firms must ensure that all costs are disclosed clearly and plainly so that retail customers can fully understand and assess the investment.”

In settling the matter, Merrill Lynch neither admitted nor denied the charges, but consented to the entry of Finra’s findings, the release noted.

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