Merrill Lynch and Harvest Volatility Traded Derivatives With $9.3 Million in Fines

According to the SEC, over a two-year period starting in March 2016, clients were charged additional fees and subjected to increased market exposure and potential investment losses due to the mishandling of their options trades. The focus of the SEC’s investigation was on the actions of Merrill Lynch and Harvest in relation to a specific strategy they offered to investors, known as the Collateral Yield Enhancement Strategy (CYES).

‍

Mark Cave, the SEC’s Associate Director of the enforcement division, explained the core of the issue: “Two investment advisers allegedly sold a complex options trading strategy to their clients, but failed to abide by basic client instructions or implement and adhere to appropriate policies and procedures.” Essentially, the SEC found that both Merrill Lynch and Harvest did not follow client guidelines or implement adequate risk management practices.

‍

Neither Merrill Lynch nor Harvest admitted or denied the SEC’s findings, but they did agree to settle the matter through the penalties and disgorgement, or the repayment of ill-gotten gains, that were imposed.

‍

At the center of the SEC's investigation was the CYES, an options trading strategy focused on volatility. The goal of this strategy was to generate incremental returns for investors by trading options in a volatility index. Harvest, in its role as the primary investment adviser and portfolio manager for the CYES strategy, was responsible for ensuring that client instructions and risk tolerance levels were followed.

‍

However, the SEC found that Harvest failed to manage client accounts within the risk limits designated by investors. According to the SEC, many client accounts were allowed to exceed their exposure limits, with some exceeding those limits by 50% or more. This excessive exposure was a violation of the clients' instructions, which aimed to limit their investment risks.

‍

The SEC emphasized that these actions had a direct financial impact. When Harvest allowed client accounts to go beyond their designated risk levels, both Harvest and Merrill Lynch benefited from larger management fees. In turn, the clients were exposed to greater risks than they had agreed to, and the firms gained financially as a result of this mismanagement.

‍

Merrill Lynch, which introduced its clients to the CYES strategy managed by Harvest, also played a significant role in the violations. The SEC noted that Merrill Lynch earned trading commissions as well as a portion of the management and incentive fees generated by Harvest’s management of the CYES strategy.

‍

However, Merrill Lynch was aware that investors’ exposure levels were exceeding the pre-set limits established by clients. Despite this knowledge, Merrill Lynch failed to adequately inform the affected investors. Most of these clients had existing advisory relationships with Merrill Lynch, which placed the firm in a position of trust and responsibility. Nevertheless, Merrill failed to communicate the increased exposure to investors, potentially leaving them vulnerable to greater market risk than they had anticipated.

‍

In the settlement agreement, both Harvest and Merrill Lynch agreed to pay significant penalties and disgorgements. Harvest will pay a $2 million penalty along with $3.5 million in disgorgement and prejudgment interest. Merrill Lynch, for its part, will pay a $1 million penalty in addition to $2.8 million in disgorgement and prejudgment interest.

‍

The penalties reflect the seriousness of the violations, particularly given that the actions of both firms exposed clients to risks that they had not consented to. By allowing accounts to exceed their exposure limits, Harvest and Merrill Lynch not only increased client risk but also enriched themselves through higher fees and commissions.

‍

This case underscores the SEC’s ongoing commitment to protecting investors from financial advisors and institutions that fail to adhere to client instructions or implement proper risk management procedures. As Mark Cave pointed out, investment advisors are expected to act in the best interests of their clients, particularly when dealing with complex strategies such as options trading.

‍

The SEC's decision to pursue action against Merrill Lynch and Harvest demonstrates that the agency is focused on ensuring transparency and accountability in the financial services industry. Clients entrust their advisors to manage their investments according to their risk tolerance and financial goals, and when that trust is violated, the consequences can be severe.

‍

The fines and disgorgements levied in this case also send a clear message to other financial firms: failure to comply with client instructions and risk management protocols will not be tolerated, and those who violate these standards will face significant penalties.

‍

The $9.3 million settlement between the SEC, Merrill Lynch, and Harvest Volatility Management highlights the importance of adhering to client instructions, especially when managing complex strategies like options trading. The case serves as a reminder to investment advisers and portfolio managers of their duty to follow basic client guidelines and to implement robust risk management practices. By failing to do so, Merrill Lynch and Harvest exposed their clients to unnecessary risks while profiting from their mismanagement. The penalties imposed by the SEC emphasize the need for transparency, accountability, and client protection in the financial industry.

‍