Merrill’s Gatekeeping Failures in the Unregistered Sales of Securities

Merrill Lynch Settles Charges with SEC for Merrill’s Failure to Perform Required Gatekeeping Functions in the Unregistered Sales of Securities on behalf of Longtop Financial

The SEC announced on March 8, 2018 that it settled charges against Merrill Lynch, Pierce, Fenner & Smith Inc. for its failure to perform required gatekeeping functions in the unregistered sales of securities on behalf of a China-based issuer and its affiliates.

Merrill Lynch Sold Almost Three Million Shares of Longtop Financial Technological Limited’s Securities Despite “Red Flags” Indicating Sales Could be Part of an Unlawful Unregistered Distribution

The SEC’s Order found that Merrill Lynch sold almost three million shares of Longtop Financial Technological Limited’s (“Longtop”) securities into the market despite red flags indicating that the sales could be part of an unlawful unregistered distribution.  The distribution, ultimately, generated almost $38 million in proceeds for the overseas issuer and its affiliates.

SEC’s Order Finds Merrill Lynch Violated Sections 5(a) and 5(c) of Securities Act of 1933

The SEC’s Order found that Merrill Lynch violated Sections 5(a) and 5(c) of the Securities Act of 1933.  In settlement, without admitting or denying the SEC’s findings, the firm agreed to be censured and consented to the order requiring it to cease and desist from committing or causing any future violations of the registration provisions of the Securities Act.  The Order also requires Merrill Lynch to pay a penalty of $1.25 million and more than $154,000 in disgorgement and prejudgment interest from commissions and fees earned on the improper sales.

Summary of the SEC’s Order Against Merrill Lynch

According to the SEC’s Order:

From January 24, 2011 to August 18, 2011 Merrill violated the registration provisions of the federal securities laws by effecting unregistered sales of almost 3 million shares of Longtop . . .  securities for a customer. Longtop’s securities were trading in the United States as American Depositary Shares (“ADSs”). Longtop’s Chairman had obtained the 3 million unregistered shares from Longtop as one of its founders. In the summer of 2010, the Chairman purported to gift Longtop ordinary shares through a trust to existing and ex-employees of Longtop, who were the purported beneficiaries of that trust. The related ADSs were then sold in about 68 transactions through an account at Merrill’s Singapore branch office held in the name of the trust’s nominee (“Nominee”).

Section 5 of the Securities Act generally requires registration of securities offerings, or an available exemption from registration, including for resales such as the sales through the Nominee account at Merrill. Although brokers frequently rely on an exemption under Section 4(a)(4) of the Securities Act, known as the brokers’ transaction exemption, this exemption was not available to Merrill for any of the Longtop ADS sales through the Nominee account. For this exemption to be available, Merrill was required, before selling securities on its customers’ behalf, to engage in a reasonable inquiry into the facts surrounding the customers’ proposed sales to determine if the customers were engaging in an unlawful distribution of securities. The amount of inquiry a broker must conduct as part of this reasonable inquiry varies with the facts and circumstances of each transaction. The requirement that a broker conduct a reasonable inquiry is not limited to penny stock transactions.

Here, the Merrill team evaluating the proposed sales engaged in some inquiry before the first sales that revealed red flags that Longtop, its management, and the Chairman maintained control of the securities, thus indicating the purported gifts were not bona fide and the sales could be part of an unlawful unregistered distribution by Longtop and its affiliates. Nevertheless, Merrill did not properly investigate, failed to inquire about the identities of the purported sellers and whether they were affiliates of Longtop, and instead allowed the sales to go forward.

In January 2011, Merrill cleared a block of almost 1 million Longtop ADSs for future sales through the Nominee account by unknown sellers. Merrill did not conduct any subsequent reviews when these ADSs were sold between January 24, 2011 and May 4, 2011. During this time, Merrill was presented with additional red flags that should have prompted the firm to conduct further inquiry and consider whether an exemption from securities offering registration was available. For instance, Merrill failed to perform any inquiry after an April 2011 online report accused Longtop of financial fraud and questioned the legitimacy of the Chairman’s gift of shares.

Likewise, in early May 2011, when nearly 2 million more Longtop unregistered securities were deposited into the Nominee account, Merrill failed to conduct any inquiry before effecting additional sales of the Longtop ADSs. Even after learning of more red flags, including that Longtop’s auditor resigned in late May 2011, citing the Chairman’s admissions of fraud, and Longtop’s securities were delisted by the NYSE in August 2011, Merrill still made no inquiry to determine whether the ADSs could be sold without registration.

Accordingly, Merrill did not perform a reasonable inquiry and was not entitled to rely on the brokers’ transaction exemption. Merrill engaged in an unregistered distribution through the Nominee account, generating approximately $38 million in proceeds for the benefit of Longtop and its affiliates. Merrill wired the proceeds from the Nominee account to a Hong Kong bank account in the name of a different entity. This entity also was controlled by Longtop management. Merrill received over $127,000 in commissions and fees during the relevant period. By virtue of its conduct, Merrill willfully violated Sections 5(a) and 5(c) of the Securities Act.[]

SEC Has Revoked the Registration of Longtop’s Securities

The SEC has revoked the registration of Longtop’s securities, and for additional information, please see the SEC’s Order Making Findings and Revoking Registration by Default.

Source: SEC.gov

Kehoe Law Firm, P.C.