REPORT OF INVESTIGATION
IN THE MATTER OF
MERRILL LYNCH, PIERCE, FENNER & SMITH, INC.
COMMODITY FUTURES TRADING COMMISSION
Report Pursuant To Section 8(a)(1) Of The Commodity Exchange Act.
March 19, 1997
I. INTRODUCTION
The staff of the Division of Enforcement ("Division") of the
Commodity Futures Trading Commission ("Commission") has conducted
an investigation into certain events involving Merrill Lynch,
Pierce, Fenner & Smith, Inc. ("Merrill Lynch"), and the manner in
which the management of Merrill Lynch fulfilled its obligations
under the Commodity Exchange Act, as amended ("Act"), and
Regulation 166.3 thereunder. 1
Based upon information obtained
during the investigation, the Commission deems it appropriate and
in the public interest to issue this Report of Investigation
("Report") pursuant to Section 8(a)(1) of the Act. 2
The investigation on which this Report is based was not an
adjudicatory proceeding and no hearing has been conducted by the
Commission regarding any of the issues of fact or law contained
herein. Merrill Lynch has not admitted the facts or conclusions
stated in this Report.
II. FACTS
Background
In November 1989, Merrill Lynch hired Richard Conroy Bell
("Bell") as a financial consultant ("FC") at its Tulsa, Oklahoma
"Kensington" branch office. Bell became registered with the
Commission as an associated person ("AP") of Merrill Lynch in the
summer of 1990.
During 1990, without the knowledge or consent of Merrill
Lynch, Bell began operating a commodity pool without registering
with the Commission as a commodity pool operator ("CPO"), as
required by the Act. Bell received approximately $16 million
from investors, which was to be pooled and used to trade
commodity futures. Instead of investing customer funds, Bell
operated a classic "Ponzi" scheme, using later investors' funds
to pay fictitious profits to earlier investors. No commodity
futures or options were ever actually traded. A significant
portion of investor funds was used by Bell for personal
purchases, including his house, cars, and an airplane. In total,
Bell solicited and defrauded approximately 110 participants in
the pool.
Bell, without the knowledge or consent of Merrill Lynch,
operated his fraudulent scheme from Merrill Lynch's Kensington
Branch office for approximately two years until he incorporated
another entity and opened an office in Midland, Texas in
approximately April 1992. At no time did Bell represent to
investors or potential investors that his pool was a Merrill
Lynch sponsored investment. Rather, he stated that the
investment opportunity that he was offering was a separate and
distinct outside business venture, of which Merrill Lynch was
aware and permitted him to pursue.
Bell's fraudulent commodity pool continued to operate until
approximately November 1993, when the Commission filed an
injunctive action in the United States District Court for the
Northern District of Oklahoma against defendants Bell and other
related entities. Bell admitted to the wrongdoing charged in the
Commission's Complaint, and an Agreed Order of Preliminary
Injunction was entered against all defendants as to all counts of
the Complaint by the U.S. District Court. On October 20, 1994,
the United States Attorney for the Northern District of Oklahoma
charged Bell with wire fraud in a single-count information. Bell
pled guilty to the count and was sentenced to a forty-four month
prison term. Bell is currently incarcerated. 3
Merrill Lynch's Knowledge of Bell's Activities
At the time he entered into employment with Merrill Lynch,
Bell was required to disclose to the firm all outside business
activities. Merrill Lynch required its personnel to complete an
"outside interest questionnaire" annually. The purpose of the
questionnaire was to identify all outside activities engaged in
by the employee which "would be in conflict with [Merrill Lynch]
policy or Exchange rules." Merrill Lynch required such
information in order to determine whether there was a possible
conflict of interest between an employee's outside business
activities and the activities conducted by the employee on behalf
of the firm.
All outside interests were required to be reviewed and
approved by Merrill Lynch's Law and Compliance Department.
Although Merrill Lynch required its personnel to file outside
interest questionnaires annually, it was unable to produce to the
Commission any questionnaires executed by Bell prior to October
8, 1991. In his October 1991 questionnaire, Bell stated that he
was a "participant in oil & gas venture: on interests held prior
to joining firm." He described his position as "working interest
& royalty owner." The questionnaire response contained no other
specific information as to this outside interest. Bell did not
provide any information concerning compensation received from the
outside activity, as required by the questionnaire. The Division
investigation revealed no evidence that this outside interest was
ever approved by Merrill Lynch.
Inquiries Regarding Bell's Activities
In March and April of 1992, Merrill Lynch received inquiries
regarding Bell's conduct from three different sources. In early
March 1992, the branch manager of the Kensington office was
contacted by an acquaintance who informed him that Bell had
solicited an investment from his secretary for a transaction
which involved the sale of oil futures.
Approximately three weeks later, the same branch manager was
contacted by a Professor of Finance at the University of Tulsa
Business School. According to the branch manager, the Professor
said that Bell had solicited one of his students "for an
investment in Mr. Bell's oil deal that sounded 'too good to be
true'...." The Professor conveyed his skepticism about the
legitimacy of this investment. The Professor also told the
branch manager that approximately two dozen of his student's
fellow employees had already invested with Bell. He questioned
whether permitting a stockbroker to offer investments not
sponsored by Merrill Lynch violated securities regulations.
Finally, in early April 1992, the Oklahoma Department of
Securities ("ODS") contacted Merrill Lynch. ODS informed Merrill
Lynch that it was investigating the Professor's complaint and
sought information regarding Bell's outside business activities.
According to ODS, Merrill Lynch's branch manager acknowledged
receiving the call from the Professor and stated that he had
reviewed with Bell his outside business activities. Bell told
the branch manager and ODS that he would take immediate steps to
take all of his customers out of the deal by refunding all of
their money.
After receiving these inquiries, Merrill Lynch initiated an
internal investigation into Bell's activities. As part of that
investigation, Merrill Lynch reviewed Bell's October 1991 outside
interest questionnaire, which had never been revised. In
describing his outside activity, Bell had not disclosed that he
was soliciting investors. Instead, he had stated that he was
only a "participant" and that his position was "working interest
and royalty owner."
Merrill Lynch interviewed Bell and received both oral and
written representations from him pertaining to his outside
business activity. Bell falsely represented that he was a
passive investor and that he had not solicited investors, but
rather had limited contact with eight local individuals on behalf
of the business entity, headquartered in Midland, Texas. Bell
also falsely represented to Merrill Lynch that his outside
business venture did not involve futures trading and that all
eight investors with whom he had communicated had been refunded
their investments.
In response to the ODS inquiry, Bell drafted a written
response, dated May 19, 1992, which he gave to Merrill Lynch for
its review. Merrill Lynch told Bell that his response was
inadequate. Bell redrafted his response, dated May 20, 1992,
falsely stating that the outside business activity was intended
to be "a private placement and that the parties involved were all
knowledgeable individuals... none of which were clients of [his]
at Merrill Lynch." He added that he "did not solicit
participants... nor did [he] profit from their participation or
charge a commission." Merrill Lynch determined that the redraft
was acceptable, and Bell sent it to ODS.
Merrill Lynch did nothing to confirm or corroborate any of
the oral or written representations prepared by Bell. It did not
contact any of the named investors. Instead, Merrill Lynch's Law
and Compliance Department instructed one of Bell's supervisors to
check the names of the eight investors that Bell had disclosed
against Merrill Lynch's customer list. When it determined that
none of the eight investors which Bell disclosed were Merrill
Lynch customers, Merrill Lynch concluded that nothing more was
required of it because Bell's outside activity did not conflict
with Merrill Lynch offered investments. 4
At the direction of Merrill Lynch management, Bell completed
a new outside interest questionnaire disclosing in more detail
his interest in this outside business venture, consistent with
his prior oral and written misrepresentations to Merrill Lynch.
After reviewing Bell's new disclosure and accepting Bell's
representations, without any further inquiry, Merrill Lynch
approved Bell's outside business activity.
Termination of Bell's Employment
In November 1992 and January 1993, Merrill Lynch became
aware of substantial deposits made by Bell to his own Merrill
Lynch cash management account totalling approximately $66,000.
These deposits were inconsistent with Bell's known income
level. 5 The branch manager at the Kensington office asked Bell
for an explanation. Bell stated that the source of the income
was his outside business venture which was paying more than
anticipated (as previously disclosed in his newly completed
outside interest questionnaire) because of a second recovery
drilling technique. Once again, Merrill Lynch simply accepted
Bell's explanation without further investigation.
In April 1993, Merrill Lynch discovered that Bell had been
falsifying financial foundation applications for a Merrill Lynch
financial service which analyzes the applicant's financial
condition and makes investment recommendations. Specifically,
Bell had been submitting financial foundation applications for
fictitious people. On April 30, 1993, at the request of Merrill
Lynch, Bell resigned his position as a FC and terminated his
registration as an AP.
III. ANALYSIS
Requirements of Regulation 166.3
Commission Regulation 166.3 requires that:
Each Commission registrant, except an
associated person who has no supervisory
duties, must diligently supervise the
handling by its partners, officers, employees
and agents (or persons occupying a similar
status or performing a similar function) of
all commodity interest accounts carried,
operated, advised or introduced by the
registrant and all other activities of its
partners, officers, employees and agents (or
persons occupying a similar status or
performing a similar function) relating to
its business as a Commission registrant.
Regulation 166.3 was intended "to provide some protection to
customers by requiring that APs - who directly solicit the public
- be supervised by an entity registered with the Commission."
CFTC v. Commodities Fluctuation Systems, Inc., 583 F. Supp. 1382,
1384-85 (S.D.N.Y. 1984).
In many instances, the outside business activities of
individual employees may have direct impact on an FCM's duty to
supervise activities relating to its business as a Commission
registrant. For instance, information regarding an employee's
outside activity which raises questions about whether the
employee has deceived or misled either his employer or others
with regard to activities relating to the employer's business as
a Commission registrant may be relevant to an assessment of the
employee's ability to perform activities which are required to be
supervised. Once issues of honesty and integrity relating to or
impacting upon the FCM's business as a Commission registrant are
brought to the registrant's attention, the registrant must
conduct sufficient inquiry in order to determine what impact that
information will have on the employee's ability to perform duties
within the scope of employment and the appropriate level of
supervision required of that employee. Such information
necessarily relates to a firm's duty to provide diligent
supervision over activities relating to its "business as a
Commission registrant."
After Merrill Lynch was contacted by three parties,
including a state regulatory agency, Merrill Lynch, at a minimum,
was on notice that Bell was involved in an outside business
venture that may have been related to Merrill Lynch's business as
a Commission registrant -- that is, the sale of oil futures --
that was possibly different in material respects from the outside
interest that he had disclosed on his questionnaire. Merrill was
also on notice that serious questions had been raised concerning
his conduct of that business.
The Commission believes that, consistent with Regulation
166.3, when a registrant becomes aware, as Merrill Lynch did
here, that the disclosures of an employee regarding such outside
business activity are found to be incomplete or inaccurate in
some material respect or raise material issues that might impact
the performance of his duties relating to the registrant's
business as a registrant, the registrant has a duty to
investigate sufficiently in order to permit it to make an
informed determination whether the employee's outside activity
actually does or does not relate to or impact upon the FCM's
"business as a Commission registrant." If the sole source of
the information is the employee engaging in such outside
activity, the registrant must perform adequate additional inquiry
to ensure that the employee's disclosure is accurate in all
material respects. 6 The scope of such additional inquiry will
depend upon the facts and circumstances of each case.
The testimony of Merrill Lynch officials reflects that the
scope of the inquiry into Bell's activities was limited to
determining 1) whether Bell had a conflict of interest with
Merrill Lynch; and 2) whether his outside activity involved any
Merrill Lynch customers. An inquiry limited to these two areas
would not necessarily be sufficient to determine whether or not
the outside activity in question related to or impacts upon an
FCM's "business as a Commission registrant." For example, an
employer may receive information concerning the conduct of an
employee in business activity which is outside the scope of his
or her duties at an FCM which may raise issues regarding the
employee's fitness to perform his or her duties on behalf of that
FCM or the level of supervision required by that employee. Under
those circumstances, the FCM needs to satisfy itself as to those
issues. This will be the case regardless of whether or not the
registrant had a duty to supervise directly the outside
activities in question. See Lobb v. J.T. McKerr & Co. [1987-1990
Transfer Binder] Comm. Fut. L. Rep. (CCH) &24,568 at 36,444
(CFTC May 28, 1989).
Thus, after interviewing Bell, and determining that the
activity that he was conducting had not been adequately and fully
disclosed on his outside interest questionnaire and that it
raised issues relating to Merrill Lynch's business as a
Commission registrant, Merrill Lynch could not rely solely on
Bell's representations in determining that his outside activity
did not, in fact, relate to its "business as a Commission
registrant."
CONCLUSION
Adequate systems of supervision by registrants are not
required to detect all instances of violative conduct. 7
While there has been no judicial or administrative adjudication
in this matter, the Commission believes that the investigation
done by Merrill Lynch concerning Bell's outside business
activities, in light of the information that had come to its
attention, especially inquiries from a state regulatory
authority, was inadequate. Because the issue of what level of
inquiry a registrant is required to make regarding the outside
business activities of its employees when those activities appear
to raise issues relating to its business as a Commission
registrant, is one of first impression, the Commission, in its
discretion, has determined to issue this Report, in lieu of
bringing an enforcement action against Merrill Lynch.
By the Commission, Commissioner Tull dissenting.
___________________________
Jean A. Webb
Secretary to the Commission
Dated: March 19, 1997
Footnotes:
1 Merrill Lynch has been registered with the Commission as a
futures commission merchant ("FCM") since at least 1982.
2 Section 8(a)(1) of the Act authorizes the Commission to
"publish from time to time the results of any... investigation...
as it deems of interest to the public."
3 The Commission notes that Merrill Lynch has paid a total of
approximately $3.5 million to investors through the Receiver in
the Commission's injunctive action against Bell. This represents
approximately 44% of total investor losses.
4 In fact, several of the approximately 110 investors in Bell's
scheme were Merrill Lynch customers.
5 Merrill Lynch reviews all employee accounts maintained at
Merrill Lynch on a monthly basis. One of the purposes of this
review is to identify those employees with a cash flow exceeding
their income. Such employees may be engaged in illegal activity
or activity that conflicts with Merrill Lynch's policies or
interests.
6 An adequate investigation must go beyond questioning an
employee and taking his word. See In the Matter of GNP
Commodities Inc., [1990-1992 Transfer Binder] Comm. Fut. L. Rep.
(CCH) &25,360 at 39,219 (August 11, 1992), aff'd sub nom.
Monieson v. GNP, 996 F.2d 852 (7th Cir. 1993).
7 See, e.g., Callahan v. Delphi Commodities, [1987-1990
Transfer Binder] Comm. Fut. L. Rep. (CCH) &24,060 (CFTC December
18, 1987); Bunch v. First Commodity Corp., [1990-1992 Transfer
Binder] Comm. Fut. L. Rep. (CCH) &25,352 at 39,168 (CFTC August
5, 1992).