Course Project: Merrill Lynch Fraud Case 1

Course Project: Merrill Lynch Fraud Case

Tara A. Chambers

Kaplan University
 Course Project: Merrill Lynch Fraud Case 2

ABSTRACT

Merrill Lynch seems to be a repeat offender when it comes to fraud against the public

by violating their trust and manipulating their customer information and transactions for their

own benefit or the benefit of the highest bidder. If caught, they just throw some money at the

problem.

Lynch was indirectly linked to the Bernard Madoff Ponzi scheme, directly to the

securities fraud that bankrupted Orange County, CA, and most tragically, assisted Enron in

inflating profits with unsystematic options that inflated Enrons income by approximately $50

billion.

Although Bank of America acquired Merrill Lynch in 2009 and proposed new

restructuring policies and procedures, I firmly believe that the tone at the top has been severely

inadequate, and therefore, complete turn-around without complete dissolution is unattainable, for

Merrill Lynchs name is synonymous with fraud itself.

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There are several fraud cases involving Merrill Lynch, which made it hard to choose just

one instance. Merrill Lynch was indirectly linked to the Bernard Madoff Ponzi scheme for

allowing the infamous fraudster to trade using feeder funds issued by Merrill Lynch (Touryalai,

2011, pg. 1). Irving Picard, the Trustee seeking retribution for Madoffs victims, claimed Merrill

Lynch was aware of possible fraud within Bernard L. Madoff Investment Securities. However,

Merrill turned a blind eye to the transactions, even though the parent company had denied

opportunities to previously invest with Madoff. A lawsuit was enacted, asking Merrill Lynch to

pay back $16 million.

The Securities and Exchange Commission (S.E.C.) also went after Merrill Lynch for

securities fraud in connection with the 1994 bankruptcy of Orange County, CA. Basically,

Merrill Lynch invested the county securities into an investment pool that failed, which resulted in

$1.6 billion in losses. Also, Merrill Lynch underwrote bond offerings that violated anti-fraud

provisions of Federal securities laws (Wayne, 1996, pg. 1). In its report, the S.E.C. said investors

were not told that the county's investment pool was filled with volatile securities that were

sinking in value. Investors in those bonds, in particular, a $600 million taxable note offering

underwritten by Merrill, were not told that the proceeds of their investments would be put in the

county's risky investment pool and that the pool had already suffered significant losses.

The highest payout in a lawsuit without denial by Merrill Lynch was that of $80 million

for distribution to injured investors as part of Merrill Lynch aiding and abetting Enron fraud

(2010, pg. 1). The action included an individual civil action against Daniel H. Bayly, former

global head of investment banking at Merrill Lynch & Co., Inc., who was personally sued for

$300,000, along with three other executives.

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In late December 1999, senior Enron executives approached Merrill Lynch with the two

transactions it had designed. As alleged, the first transaction was an asset-parking arrangement

whereby on December 29, 1999, Merrill Lynch bought an interest in certain Nigerian barges

from Enron with an express understanding that Enron would arrange for the sale of this interest

by Merrill Lynch within six months at a specified rate of return. In substance, this transaction

was, at best, a bridge loan because the risks and rewards of ownership of the interest in the

barges did not pass to Merrill Lynch. In the second transaction, also closed in the last days of

December 1999, Merrill Lynch and Enron entered into two energy options one physical and

one financial that Merrill Lynch knew had the purpose and effect of inflating Enron's income

by approximately $50 million. The complaint details that, at year-end 1999, the trading under

these options were not scheduled to begin for approximately nine months. Before the transaction

was closed, the complaint alleges, Enron told Merrill Lynch that, despite a nominal term of four

years, it might want to unwind this transaction early.

Enron Corporation (former NYSE ticker symbol ENE) was an American energy company

based in Houston, Texas. Before its bankruptcy in late 2001, Enron employed approximately

22,000 and was one of the world's leading electricity, natural gas, pulp and paper, and

communications companies, with claimed revenues of nearly $101 billion in 2000. Fortune

named Enron "America's Most Innovative Company" for six consecutive years. At the end of

2001 it was revealed that its reported financial condition was sustained substantially by

institutionalized, systematic, and creatively planned accounting fraud, known as the "Enron

scandal". Enron has since become a popular symbol of willful corporate fraud and corruption.
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The scandal also brought into question the accounting practices of many corporations throughout

the United States and was a factor in the creation of the Sarbanes-Oxley Act of 2002.

Enron filed for bankruptcy protection in the Southern District of New York in late 2001

and selected Weil, Gotshal & Manges as its bankruptcy counsel. It emerged from bankruptcy in

November 2004 after one of the biggest and most complex bankruptcy cases in U.S. history. On

September 7, 2006, Enron sold Prisma Energy International Inc., its last remaining business, to

Ashmore Energy International Ltd. Following the scandal, lawsuits against Enron's directors

were notable because the directors settled the suits by paying very significant sums of money

personally. The scandal also caused the dissolution of the Arthur Andersen accounting firm,

affecting the wider business world.

Merrill Lynch believed that the two trades were essentially a wash and knew that the

transaction would have a significant impact on Enron's reported results, bonuses, and stock price.

Merrill Lynch demanded a multi-million dollar fee for entering into this transaction; Enron

ultimately agreed to pay Merrill Lynch a structured fee to be paid over four years with a net

present value of $17 million. In 2000, Enron approached Merrill Lynch seeking to unwind the

transaction before trading under the energy options was scheduled to begin. The deal was

unwound in June 2000 after Merrill Lynch agreed to reduce its fee to $8.5 million to terminate

the transaction.

The complaint alleges that Merrill Lynch and the named executives aided and abetted

Enron's violations of the anti-fraud, reporting, books and records, and internal controls

provisions of the federal securities laws. For these violations, the Commission seeks in its

complaint a permanent injunction, disgorgement, and civil penalties with respect to Merrill
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Lynch and, with respect to the individual defendants, permanent injunctions, civil penalties, and

permanent officer and director bars.

Once again, Merrill Lynch acted inappropriately, according to the S.E.C., by making

trades based on information gathered from trades made for their clients. Merrill Lynch paid $10

million settlement emanating from charges of civil securities fraud, which accuses the firm of

misusing the order data of its customers and charging them with trading fees that went

undisclosed from 2002 to 2007. Merrill Lynch had misused the order data of institutional

customers from other traders obtained through its equity strategy desk to place trades on behalf

of its own account.

Under the new regulation implemented last summer, banks are prohibited from making

excessive proprietary trading on its own behalf. The SEC initially considered remedial actions

taken by Merrill Lynch following its $20 billion acquisition by Bank of America in 2009, before

it handed out the $10 million settlement. Merrill Lynch violated the securities laws when it

traded using the order data of the customers while it had previously told them that such

information would be kept on a need-to-know basis, added SEC. The firm agreed to settle the

SEC charges without admitting or denying them, though it vowed not to commit future securities

laws violations. The SEC also accused Merrill Lynch of failing to disclose the trading fees it

collected from select wealthy customers on the basis of prices less favorable to the customer

than the prices at which Merrill purchased or sold the securities (Humphrey, 2011).
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However, upon Bank of America acquiring Merrill Lynch, the following problems in

internal control were addressed:

Separation of Duties Merrill Lynch had previously failed to maintain proper firewalls

between its trading desks enabling the equity strategy desk traders to track customer

transactions and encouraging its market making desk traders to share profitable trading

ideas with the equity desk traders. This information isnt supposed to be shared

between these two groups, as it violates the Vlocker Rule. The Dodd-Frank Wall Street

Reform and Consumer Protection Act, which was enacted on July 21, 2010, includes a

section ( 619), the "Volcker Rule," that prohibits any banking entity, including affiliates

of banks, from:
o sponsoring, or investing in, a hedge fund, private equity fund, and potentially

numerous other types of privately offered funds and pooled investment vehicles,

including venture capital funds, real estate funds, structured finance vehicles and

some types of special purpose vehicles used in project finance transactions, except

for funds that are organized or offered by the banking entity, subject to:
the banking entity owning no more than 3% of the fund;
an overall limit of 3% of the banking entity's Tier 1 capital invested in

private funds;
other limitations, including as to the name of the fund, and affiliated

transactions.

In addition, the banking entity may make seed investments in a fund, including owning

100% of a fund, for up to one year; or

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o (ii) engaging in "proprietary trading," defined mainly as engaging in short-

term trading, subject to a number of exceptions that allow a banking entity

significant leeway to engage in some short-term trading, including trading:

in U.S. government, state and municipal obligations;
in connection with underwriting or market-making related

activities;
in connection with certain risk-mitigating hedging activities; and of

any security or instrument on behalf of customers.

Training and Policy Changes After the Bank of America acquisition, Merrill

Lynch adopted a number of policy changes to ensure separation of proprietary and

other trading and to address the SECs concerns. Merrill Lynch also voluntarily

implemented enhanced training and supervision to improve the principal trading

processes at the firm.

Transparency and Information Privacy - Companies need to be transparent in order to

gain the trust of clients and customers. You need to let them know exactly where their

money is going or what is being done with their information. People trusted Merrill

Lynch to take their information and make trades for them, not to have the information

shared with anyone else in the company for their benefit. These actions fail to promote

transparency with the client and violated the companys responsibility to maintain

privacy over client information.

I selected this case for information in Merrill Lynchs history and its affiliation with Bank

of America. I recently have suffered some financial difficulties at the hands of the economy

and a previous job, where my pay was reduced, in order to make me resign. Upon leaving

that company, I invested my 401K in an IRA account in Merrill Edge, the trading affiliate
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available to Bank of America customers. However, due to these financial difficulties, I lost

my home to foreclosure and proceeded to cut all ties with Bank of America and its

affiliations, including Merrill Lynch.

After researching this company and its repetitive accusations of customer confidentially

and trust violations, I firmly believe that I have made the appropriate decision in cutting all

ties with Bank of America and Merrill Lynch. Hurt me once, shame on you. Hurt me twice,

shame on me. However, it seems that the general tone at the top is Ill do what I want,

regardless of the circumstances. Frankly, you can try to implement changes, as Bank of

America is doing, but Merrill Lynch is a repeat violator, and they show no shame in the harm

that they have caused. They just pay the fines and move on.

I am not willing to take that risk with the money that Ive worked hard to retain.
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REFERENCES

- Unknown, (2011), Customer Betrayal: Lessons from the Merrill Lynch Fraud Case, i-Sight,

Retrieved from http://i-sight.com/investigation/merrill-lynch-fraud/.

- Unknown, (2003), SEC Charges Merrill Lynch, Four Merrill Lynch Executives with Aiding

and Abetting Enron Accounting Fraud, 2003-32, Retrieved from

http://www.sec.gov/news/press/2003-32.htm.
- Unknown, (2010), SEC Settles with Former Merrill Lynch Executive for Aiding and

Abetting Enron Fraud, Investment Fraud Times, Retrieved from

http://www.investmentfraudtimes.com/accounting/3069.html.
- Chadbourne & Parke, LLP., (2010), Summary and Analysis of the Vlocker Rule in the Dodd-

Frank Act, ClientAlert, Iss. 7/29/2010. Retrieved from

http://www.chadbourne.com/files/Publication/ad549554-9229-4f77-ae1e-

461f43f28338/Presentation/PublicationAttachment/3591ff9a-cc61-4c94-b0d9-

48a89f09796f/Volker%20Rule%20ca-%20Gale.pdf.
- Humphrey, J., (2011), Merrill Lynch Charged with Misusing Customers Order Data, Hiding

Trading Fees, In Audit, Retrieved from http://inaudit.com/regulatory/sec/merrill-lynch-

charged-with-misusing-customers-order-data-hiding-trading-fees-4396/.
- Touryalai, H., (2011), Merrill Lynch Accused of Ignoring Madoff Fraud, Forbes Magazine,

Iss. 3/2011, Retrieved from http://www.forbes.com/sites/halahtouryalai/2011/03/01/merrill-

lynch-accused-of-ignoring-madoff-fraud/2/.
- Wayne, L., (1996), S.E.C. is Said to Plan Fraud Case Against Merrill Lynch, The New York

Times, Iss. 9/20/1996, Retrieved from http://www.nytimes.com/1996/09/20/business/sec-is-

said-to-plan-fraud-case-against-merrill-lynch.html?scp=2&sq=Merrill+Lynch&st=nyt.