Merrill Lynch has been fined $1.5 million by the Financial Industry Regulatory Authority (“FINRA”) for its failure to implement written supervisory procedures and systems reasonably designed to achieve compliance with industry regulations and preventing the consequences of short positions in municipal securities.

FINRA’s Requirements

In February 2015, FINRA advised Merrill to take prompt action to cover its existing short positions in municipal securities by the end of the month. In March 2015, the firm informed FINRA that it had 255 short positions aged more than 30 days and not within the firm’s possession or control, including 83 short positions in municipal securities.

In July 2015, FINRA reminded member firms that their written supervisory procedures must include processes for detecting, resolving, and preventing the consequences of municipal short positions and comply with law requiring firms to take prompt steps to obtain physical possession or control of municipal securities that are short more than 30 days.

Between March and December 2015, the number of short positions in municipal securities on Merrill’s books and records that were aged more than 30 days increased from 83 to 231. The 231 short positions had an associated par value of $29,599,788, and many were aged for a year or longer.

In September 2015, and again in May 2016, FINRA advised Merrill that it needed to implement supervisory systems and written supervisory procedures reasonably designed to promptly detect and resolve short positions in municipal securities, and prevent their consequences. FINRA also informed Merrill it needed to provide notice to customers of the taxable status of the substitute interest they received.

Merrill’s Failures

According to FINRA, however, from approximately February 2015 until October 2016, Merrill did not establish or maintain supervisory systems or written supervisory procedures specifically designed to detect and resolve short positions in municipal securities on the firm’s books and records, or to prevent their effects on customers who hold these securities.

As of September 2016, Merrill had 164 short positions in municipal securities with an associated par value of $27,726,712 that were aged over 30 days. Through June 6, 2017, the associated par value of Merrill’s short positions exceeded $28 million. From July 2017 through December 2018, Merrill’s aged short positions ranged from 130 to 190 with an associated par value ranging from $3.1 million to $7.2 million. As of May 2019, seven of the 83 municipal securities short positions the Firm first identified in March 2015 in response to FINRA’s inquiry remained outside of the firm’s possession or control. By June 2021, Merrill had 69 municipal securities short positions with an associated par value of $2,182,854.00.

From January 2015 through December 2018, the aged short positions in municipal securities described above required Merrill to pay at least $796,000 in substitute interest to more than 1,500 customers. In February 2015 and September 2015, FINRA informed Merrill it needed
to provide prompt disclosures to its customers holding municipal securities of their receipt of substitute interest.

From February 2015 to June 2017, Merrill provided customers who received substitute interest with a “gross-up” (adjusted) payment each year to address any resulting federal taxes. The customers’ account statements and Form 1099s described the substitute interest and gross-up payments associated with the municipal securities held by the customers as “Misc. Income.” In June 2017, Merrill updated the language in its customers’ account statements to include a specific reference to the taxable nature of these substitute interest payments.

Until then, Merrill did not provide these customers with express notice that the substitute interest paid to them was taxable. As a result, customers receiving these payments prior to June 2017 were unable, among other things, to render an informed decision on whether they wished to continue holding the security, cancel the trade, or purchase a comparable security so as to avoid receiving taxable interest. In June 2021, Merrill provided customers with notice that their receipt of substitute interest may also create state and local tax liability, and how the “gross up” payment aims to cover any federal, state, or local tax liabilities customers may incur.

FINRA’s Findings and Sanctions

FINRA found that Merrill’s failure to implement supervisory systems and procedures designed to detect and resolve short positions in municipal securities, and to prevent their consequences, and to take prompt steps to bring short positions in municipal securities within its control, was not reasonable considering the municipal securities business the firm conducted.

As a result of its findings, FINRA censured Merrill, fined it $1,500,000, and required Merrill within 180 days to certify compliance with rules and regulations requiring firms to take prompt steps to obtain physical possession or control of municipal securities that are short more than 30 days, and to certify distribution of revised written supervisory procedures to all personnel responsible for compliance with the laws concerning possession of municipal securities short more than 30 days.