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).