Wall Street has been selling what one lawyer calls a "mind-numbingly complex" deal to retail investors for years, but now, it may come back to bite big banks.
Bank of America's brokerage arm, operated by Merrill Lynch, has a growing number of investors suing it for a volatility-focused structured product which charged double-digit fees as it lost retail buyers millions, one lawyer said. Now, according to a report in The Wall Street Journal, Merrill's Strategic Return Notes, which it sold to retail investors years ago, has also earned the bank a potential Securities and Exchange Commission civil enforcement action after whistleblowers turned on their former employer.
The whistleblowers, a pair of Merrill Lynch brokers who sold the volatility structured product beginning in 2010, taped conversations with other bank staffers before tipping off investigators. All in all, Merrill clients lost most of their investments in a $150 million fund.
The majority of the complaints about Merrill Lynch's volatility structured product came from customers of the brokers who went on to leave the bank and later act as whistleblowers, according to a spokesman for the firm.
The bank says it adequately disclosed risks to structured product investors and that it aims to defend itself from allegations and arbitration proceedings. Further, the product, by design, aimed to capture returns on market losses, which means that in a scenario where stocks outperformed, the investment would incur losses, the spokesman said.
The structured product Merrill Lynch sold is just a drop in the bucket, say industry observers.
A late 2015 JPMorgan analyst note tracked the asset class' enormous growth. From 2007 through last year, roughly $500 billion to $600 billion worth of structured products were sold by banks every year, with Asia Pacific investing in a growing portion of the deals. That compares to the 2000-2005 time frame, in which the report showed structured product sales rising from less than $100 billion to more than $200 billion annually.
"The sales of structured products have dramatically increased in the last five to seven years," said Andrew Stoltmann, the attorney representing dozens of Merrill Lynch clients who filed claims against it with the Financial Industry Regulatory Authority.
"These used to be sold to hedge funds and high net worth individuals," he said. "Now, brokerages firms target retail investors."
Officials at the SEC declined to comment.
Stoltmann, whom The Wall Street Journal quoted as having had 44 Finra complaints against Merrill for its volatility structured product, said he received more than a dozen additional investor inquiries as of Wednesday morning. He called the structured product his clients and others invested in "mind-numbingly complex."
Next, other investors in unrelated structured products could push for arbitration if they allege they were misled and incurred losses.
"Some products are inappropriate for 99 percent of retail investors, even with full disclosure of their risks," said Erik Gordon, clinical assistant professor at the University of Michigan's Ross School of Business.
"Some risks are difficult to disclose in a way that puts retail investors in a position to make informed decisions," he said. "Houses that reach for commissions or that move their inventory by selling inappropriate products to retail investors should expect to end up in front of the SEC and a judge."
— By Jon Marino, Wall Street reporter