Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, July 28, 2009

FINRA Fines Merrill & UBS for Unsuitable CEF Sales

FINRA announced today that it fined Merrill Lynch, Pierce, Fenner & Smith, Inc. $150,000 and UBS Financial Services, Inc. $100,000 for supervisory failures that led to unsuitable short-term sales of closed-end funds (CEF) purchased at the funds' initial public offerings.  FINRA also suspended five Merrill Lynch brokers each for 15 days and fined them $10,000 for making unsuitable CEF recommendations to customers. FINRA's investigation into the activities of former UBS brokers involved in the short-term sales of CEFs continues.

 CEFs are investment companies that sell a fixed number of shares in an initial public offering (IPO), subject to built-in sales charges. After the offering, the shares trade in the secondary market, typically at a discount from the initial offering price. The CEFs at issue had sales charges of 4.5 percent, as well as a "penalty bid period" of generally 30 to 90 days immediately following the IPO.  During this period, brokers would lose their sales commission if their clients sold the CEFs purchased at the offering. One regulatory concern related to CEFs is the potential for brokers to earn high fees at their customers' expense by soliciting their customers to purchase CEFs at the IPO and then later, after the expiration of the penalty bid period, recommend that customers sell the CEFs, often at a loss, using the proceeds to purchase yet another CEF at an initial offering.

 FINRA found that despite being aware that CEFs purchased at the IPO are more suitable for long-term investments - and that the sales charges applied to purchases at the IPO make short-term trading of these CEFs generally unsuitable - Merrill Lynch and UBS did not have adequate supervisory systems and procedures designed to detect and prevent unsuitable short-term trading of CEFs.  The firms also failed to provide supervisors with any guidance or warning about the potential abuses and disadvantages relating to short-term trading of CEFs purchased at the IPO. Without adequate guidance, branch managers were not on notice that there were potential problems with short-term sales of CEFs bought at the IPO.

 FINRA also found that the firms failed to provide guidance or training to its registered persons regarding the impact of the sales charges on the short-term sales of CEFs purchased at the IPO. As a result, certain UBS and Merrill brokers recommended CEF purchases at the IPO and subsequent short-term sales without having a sufficient understanding of the effects that the sales charges and other pricing considerations had on the clients' investments.

 In determining the appropriate sanctions against the firms, FINRA considered the firms' remediation efforts, which included payments to customers in excess of $3 million by Merrill Lynch and more than $2 million by UBS. Also, FINRA considered the firms' self-reviews and prompt remedial measures to correct systems and procedures to prevent future violations.

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