FINRA Sanctions Merrill Lynch and UBS for Failing to Supervise the Sale of Closed-End Funds

Before discussing the Financial Industry Regulatory Authority’s (FINRA’s) latest action against Merrill Lynch and UBS, I want to share a related story about a client at my San Mateo, California, securities law practice who had invested a substantial part of her portfolio in a Closed-End Fund (CEF) that, unknown to her, was purchased as part of an Initial Public Offering (IPO). The client, who had recently been widowed, had made a large deposit in her brokerage account following the sale of her deceased husband’s business. Needless to say, the widow wanted to proceed cautiously and preserve her capital. Unfortunately for the widow, the broker did not share with her the “dirty little secret” about investing in CEFs:

Customers who invest in Closed-End Funds at the IPO almost always suffer an immediate loss.

This came as a shock to the widow, but it is a well known fact within the industry and is supported by a large body of research going back over 20 years. The reason is simple. CEFs almost always trade at a discount to their Net Asset Value (NAV) in the secondary market. However, when an IPO is structured, the fund’s offering price is typically set at or above the NAV. Thus, the fund’s price usually plunges after the IPO when the shares begin trading in the secondary market. See e.g., Lipper Research Report, “Buying a Closed-End Fund Initial Public Offering: Caveat Emptor!” (November 8, 2004)

The moral of the story is, never be in a hurry to invest in a newly launched CEF. By waiting several months after the IPO, an investor can purchase the fund at a discount and avoid paying an underwriting charge. The only way to conceivably benefit from buying a CEF at the IPO is to hold onto it for a period of time that is long enough to recoup the higher price paid at the IPO.

Back to FINRA’s Recent Action Against Merrill Lynch and UBS

As part of the settlement with FINRA, Merrill Lynch and UBS consented to FINRA’s findings that the brokers had earned high fees through short-term trading of CEFs by recommending that their clients invest in CEFs at the IPO and sell them a few months later, usually at a loss, so that the proceeds could be invested in yet another CEF-IPO. FINRA determined that both Merrill Lynch and UBS failed to adequately supervise, monitor and detect the broker’s improper activities. Without admitting any fault, Merrill Lynch and UBS agreed to pay fines of $150,000 and $100,000, respectively. They also agreed to repay a total of $5 million to victims that were identified during the investigation.

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