The SEC Cracks Down on Illegal Activity: Protecting Investor Securities and Cash

By Majda Muhic, Fall 2016 Student Intern

Among SEC’s most significant enforcement actions in 2016 were its charges against Merrill Lynch for its Customer Protection Rule violations. According to Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, “The rules concerning the safety of customer cash and securities are fundamental protections for investors and impose lines that simply can never be crossed.” The SEC’s Customer Protection Rule is particularly salient in times of financial crisis.

An SEC 2016 investigation showed that Merrill Lynch crossed these lines when it used customer cash to generate firm profits and failed to protect customer securities from creditor claims. The investigation showed that the financial giant’s misconduct occurred as early as 2009 – at the height of the financial crisis – and continued through 2015.

The Violations

  1. Misuse of Customer Cash

Rather than depositing customer cash in a reserve account, Merrill Lynch engaged in trades that artificially reduced the required reserve amount and then used the customer cash – billions of dollars per week – to finance its own trading activities. Had Merrill Lynch collapsed during this time, the customers would have faced a massive shortfall in the reserve account.

  1. Failure to Protect Customer Securities

The SEC requires that customer securities be held in lien-free accounts, so that they are protected from third-party claims in case the firm collapses. Merrill Lynch failed to follow this requirement and instead held customer securities – $58 billion per day – in accounts subject to liens, including a clearing account subject to a general lien by its clearing bank. Had Merrill Lynch collapsed, its customers may not have been able to get back their own securities.

The Repercussions

  1. Severe Punishments for Severe Violations

These severe violations warranted severe punishment. Following the SEC investigation, Merrill Lynch agreed to pay $57 million in disgorgement and interest plus a $358 million penalty, for a total of $415 million. The financial giant also publicly admitted the violations of the federal securities laws and retained an independent consultant to ensure its compliance with the Customer Protection Rule.

  1. SEC’s Targeted Sweep to Uncover Similar Abuses

Following the uncovering of these severe Customer Protection Rule violations, the SEC set forth a coordinated two-part initiative to uncover additional abuses: first, encouraging self-reporting of potential violations with cooperation credit and favorable settlement terms; and, second, examining certain broker-dealers to ascertain their compliance. Its efforts reveal a commitment to both uncover and prevent violations that may directly affect your cash and your securities.