New York Stock Exchange Regulation has fined Merrill Lynch, Pierce, Fenner & Smith Inc. US$13.5 million for failing to supervise a group of brokers in its Fort Lee, NJ office who engaged in improper market timing of mutual funds.

During the period January through April of 2002, the brokers executed over 3,700 short-term mutual fund transactions in multiple accounts held for a single hedge fund client at Merrill Lynch. When some of the mutual funds began to complain about market timing, the firm instructed the brokers to refrain from engaging in market timing transactions in the client’s Merrill Lynch accounts.

As a result, in August 2002, with the consultation of Merrill Lynch managers, the brokers facilitated the opening of accounts for the hedge fund client at various mutual funds and then moved mutual fund positions held at Merrill Lynch to the accounts held outside the firm. The brokers continued to execute frequent trades on the hedge fund’s behalf in the accounts held at those funds. And, they later moved the positions back to fee-based accounts at Merrill Lynch.

Notwithstanding these trading patterns and the receipt of commissions paid by the mutual funds in connection with the brokers’ trading, Merrill Lynch failed to recognize that its brokers were continuing to engage in frequent mutual fund trading in outside accounts.

The Merrill Lynch managers eventually did become aware of the brokers’ trading in the outside accounts in November 2002 based on market timing complaints from several mutual funds. The brokers were then instructed to take no role in effecting trades at the various mutual funds. However, the NYSE says the firm took no additional steps to ensure that the brokers complied with that instruction. In fact, the brokers did not comply and continued to execute trades on behalf of the hedge fund in outside accounts until at least April 2003.

An NYSE hearing panel found that, between January 2002 and October 2003 the firm failed to adequately supervise certain business activities involving the trading of mutual funds, failed to review and maintain certain incoming and outgoing communications with the public and failed to make and/or preserve accurate books and records relating to variable annuity product sub-accounts transactions executed by firm employees in accounts outside the firm. The firm consented without admitting or denying guilt.

“When a firm discovers that brokers have engaged in misconduct, the exchange expects and demands that the firm will heighten supervision and take all necessary action to ensure that the conduct has ceased,” said Susan Merrill, chief of enforcement, NYSE Regulation.

The NYSE imposed a penalty of a censure, $13.5 million fine, and a requirement that the firm review its procedures regarding the creation and retention of documents relating to orders placed on behalf of firm clients in accounts outside of Merrill Lynch. Merrill Lynch consented to the penalty. The fine imposed by the exchange will be satisfied by the payment of a $10 million fine to the state of New Jersey, also being announced today in a related proceeding, and a total of $3.5 million in furtherance of a pending settlement with the State of Connecticut.