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SEC Investigating Whether Bank of America Broke Customer-Protection Rules
April 28, 2015 8:09 a.m. ET
The Securities and Exchange Commission is investigating whether Bank of America Corp. BAC 0.13 % broke rules designed to safeguard client accounts, potentially putting retail-brokerage funds at risk in order to generate more profits, according to people familiar with the inquiry.
For at least three years, the bank used large, complex trades and loans to save tens of millions of dollars a year in funding costs and to free up billions of dollars in cash and securities for trading that Bank of America otherwise would have needed to keep off-limits, these people said.
Now, the SEC is investigating whether the bank’s unusual strategy violated customer-protection rules and whether the bank misled regulators about what it was doing, these people said.
Bank of America, the second-largest U.S. lender by assets, stopped the strategy in mid-2012, amid internal debate about its potential regulatory and other risks, they said. The trades took place in Bank of America’s Merrill Lynch unit, which it bought in 2009.
“These transactions, which began at Merrill Lynch before the acquisition by Bank of America, received extensive review and approval,” a spokeswoman for the Charlotte, N.C.-based bank said. “The firm fully complied with the rules designed to safeguard client funds.”
The SEC declined to comment on communications with Bank of America.
The previously unreported SEC inquiry is being conducted by a specialized unit of the agency’s enforcement staff focused on complex financial instruments, people familiar with the inquiry said. It is the latest regulatory headache for Bank of America and, in particular, for an obscure corner of the company’s investment bank that pushed financial arrangements now under scrutiny from U.S. and European authorities. Among those are controversial trades crafted to help clients avoid taxes on dividends, at times funded by Bank of America’s federally-insured banking arm. The bank says it no longer uses that banking unit to fund tax-minimization trades.
The SEC inquiry is focused on Bank of America’s compliance with a 1972 rule designed to ensure that investment banks and trading firms set aside enough cash and easy-to-sell securities that, in the event of failure, they can readily repay whatever they owe their customers.
The risk is more than theoretical. The collapse of Lehman Brothers in 2008 and of MF Global Inc. in 2011 left some brokerage customers waiting for the return of billions of dollars, leading regulators to strengthen the long-standing customer-protection rule.
Known in industry circles as Rule 15c3-3, a reference to the section where it is tucked within the Securities Exchange Act of 1934, the policy requires banks and other financial firms that handle customer trades to calculate at least once a week their net liabilities to clients—in other words, how much more banks owe to clients, in the form of deposits and other funds, than they are owed from clients, in the form of assets such as loans.
The greater the overall—or net—amount that the banks owe to their clients, the more money the banks need to set aside in reserve funds, known as “lockup” accounts, to pay their customers in an emergency. Funds in those lockup accounts must be segregated from other accounts, including the banks’ own.
Having billions of dollars idling in lockup is expensive for banks, partly because the money generally can’t be put to other profitable but potentially risky uses such as trading.
New York-based executives in Bank of America’s Merrill Lynch brokerage arm devised an array of complex trades and loans to reduce the amount of money trapped in lockup, according to people familiar with the trades.
One variety of the strategy, launched around 2009, was called “leveraged conversion.” A small team from Bank of America’s equities desk recruited a handful of clients, including wealthy individuals, to put up token amounts of their own money—a few million dollars in some cases—and in exchange receive loans of nearly 100 times those amounts, the people said.
Then Bank of America would arrange large trades, with those customers taking the opposite side, in ways that satisfied other financing needs at the bank. For example, if the bank needed to hedge its exposure to a multibillion-dollar position in, say, Apple Inc. AAPL 0.66 % ’s shares, perhaps because of a trade with another client, the bank might arrange for one of the leveraged-conversion customers to do a big Apple-centric trade using the loan the bank had provided.
One result of the trades was to dramatically increase the amounts of money that customers owed to the bank, thereby reducing the net amount that the bank owed its clients. That in turn reduced how much Bank of America had to stash in the 15c3-3 lockup.
Another benefit: Bank of America was able to curtail its use of more expensive funding from alternate sources such as the debt markets or other parts of the bank.
From 2009 to 2012, Bank of America completed billions of dollars’ worth of such trades, the people said. At times, the trades reduced the amount the bank had in lockup accounts by as much as $ 5 billion out of a total of up to about $ 20 billion in lockup, they said.
John Addis, an architect of the trading strategy, told colleagues that it saved Bank of America about $ 20 million a year due to lower funding costs, the people said. Mr. Addis, who left the company in March after 16 years, also designed some of Bank of America’s tax-trading strategies that are under regulatory scrutiny. He didn’t respond to requests for comment.
Questions arose inside the bank’s New York office about regulatory and other risks involved in the strategy, the people said. Some traders dubbed it “fugazi P&L,” slang for phony profit-and-loss math, the people said. Clients earned a slice of what the bank saved, they said.
Sylvan Chackman, who previously was Mr. Addis’s boss and who remains a senior equities executive at Bank of America, has defended the leveraged-conversion trades, the people said. At times, bank managers assured colleagues that they had obtained an outside legal opinion supporting the trades’ legality and that the SEC also had signed off.
Mr. Chackman didn’t respond to requests for comment.
Among the subjects being investigated by the SEC, the people familiar with the inquiry said, is the accuracy of the bank’s prior statements to the agency.
