Investment adviser Merrill Lynch (Merrill) and derivatives specialist Harvest Volatility Management LLC (Harvest) agreed to pay $9.3m for failing to follow “basic client instructions,” according to the SEC.  

The charges arise from Harvest’s management of its Collateral Yield Enhancement Strategy (CYES), a variation of the Iron Condor investing strategy. 

Failure to respect client instructions

In 2011, Merrill approved the CYES and introduced ultra-high net worth clients to Harvest. In return, Merrill received 30% of the CYES’s incentive fees and trading commissions as part of a Solicitation Agreement.

When instructing Harvest to invest their funds in the CYES program clients set designated market exposure levels as part of an Investment Management Agreement (IMA), which Merrill cosigned.

However, according to the SEC’s order, Harvest often allowed accounts to exceed clients’ designated limits, sometimes by as much as 50% or more. The SEC also stated that Harvest failed to adopt written compliance policies and procedures that could have prevented such mishaps from happening.

Merrill was accused of having actual or constructive knowledge of the fact that Harvest was breaching the client-designated exposure levels, and for failing to inform investors.

During a two-year window beginning in March 2016, Harvest identified that client accounts were exceeding their designated limits due to S&P increases, but failed to take decisive remedial efforts to “rebalance” them until Q2 2018.

The SEC also identified significant breakdowns of communication between Harvest and Merrill during this period.

This pattern of fiduciary negligence led to clients paying higher fees and being subjected to increased market exposure and investment losses greater than those they would have experienced had Harvest maintained the client-directed limits in their IMAs.

Throughout it all, Harvest charged about $4m in excess fees, and Merrill netted about $1m in excess commissions, the SEC said.  

“We ended all new enrollments with Harvest in 2019 and recommended that existing clients unwind their positions,” Merrill said in a statement.

Harvest now seems to be out of business, according to Barron’s.

“In this case, 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,” said Mark Cave, Associate Director of the SEC’s Enforcement Division. 

Fines

Harvest Volatility Management: A total fine of $5.5m; comprising a disgorgement of $2.5m and prejudgment interest of $1m, plus a civil monetary penalty of $2m.

Merrill: A total fine of $3.8; comprising a disgorgement of $2m and prejudgment interest of $800,000, plus a civil monetary penalty of $1m.

Rule violations

For their roles in misleading investors, Merrill and Harvest were charged with violating Sections 206(2) and 206(4) of the Advisers Act, both covering fraud and deceit.

Both firms were also charged with violating Rule 206(4)-7 of the advisers act, which requires registered investment advisers to adopt and implement written compliance policies and procedures.