SEC Report: Broker-Dealers’ Handling of Material NonPublic Information

The Securities and Exchange Commission, through the Office of Compliance Inspections and Examinations (OCIE), has announced and issued a staff report aimed at aiding broker-dealers in safeguarding confidential information from misuse.

Taken from examinations of broker-dealers conducted by the SEC, FINRA, and the NYSE’s Division of Market Regulation, the report reflects strengths and weaknesses OCIE identified in examining how broker-dealers handle material nonpublic information to prevent improper uses.  Misuses might include insider trading, trading during a tender offer in violation of SEC rules or through issuance of a research report based on  material non-public information.

When facing the challenge of designing their controls, the report may be particularly beneficial to broker-dealers dually-registered as investment advisers or who are closely integrated with an affiliated investment adviser.

Carefully pointing out that no one size fits all, and from a “best practices” perspective, OCIE found two practices among some broker-dealers to be particularly effective. The first involved those included broker-dealers who developed processes that differentiated between types of material non-public information based on the source of information coming from within the broker-dealer or the nature (e.g., transaction type) of the information.  In certain instances, the report notes, ” broker-dealers were creating tailored exception reports that took into account the different characteristics of the information.”

The second practice involves broker-dealers who expanded the scope of instruments that they reviewed for potential material non-public information misuse  by traders.  Included are credit default swaps, equity or total return swaps, loans, components of pooled securities such as unit investment trusts and exchange traded funds, warrants, and bond options.

In addition to defining  many of the sources of material non-public information, the report also provides an overview of broker-dealers’ controls structure and their controls – both in terms of  public versus private side of transactions, and in how firms limit and prevent authorized and unauthorized access (physical and technical barriers) to such information.

A look at SEC litigation releases, in the past few six months alone, show no shortage of cases involving misuse of material nonpublic information being either filed or settled.   As the report states, look for OCIE to continue reviewing broker-dealer practices in these areas in future examinations.

NASAA: 2012 Compliance Best Practices For Broker-Dealers

Using results from problems found during a nationwide examinations of broker-dealers conducted by state securities examiners from 24 North American Securities Administrators Association (NASAA) jurisdictions that revealed significant problems, NASAA  has identified what it believes are top compliance violations and made recommendations to solve them.

With the 2012 Coordinated Broker-Dealer Examinations Project, NASAA addresses problem areas while offering 10 recommended best practices that broker-dealers should consider to improve their compliance practices and procedures.

In its  release, NASAA highlights the project’s finding that “the greatest frequency of violations (29 percent) involved books and records, followed by supervision (27 percent), sales practices (24 percent), registration & licensing (14 percent), and operations (6 percent).”  NASAA found the top five types of violations included “failure to follow written supervisory policies and procedures, suitability, correspondence/e-mail, maintenance of customer account information, and internal audits.”

While these findings and recommendations may prove useful, they should come as no surprise to broker-dealers who, in the past few years, have been examined by either FINRA, the SEC or any state for that matter. 


Revenue Sharing Arrangements to Get Heightened SEC Scrutiny

Investment advisers and broker-dealer should be aware that SEC through its Asset Management Unit has commenced an initiative aimed at shedding more light on revenue-sharing arrangements between investment advisers and brokers.

The SEC has announced that it will continue to focus enforcement and examination efforts on uncovering arrangements between advisers and broker-dealers where advisers receive undisclosed compensation and conceal such conflicts of interest from clients.

The Commission recently instituted a settled administrative proceeding against  Focus Point Solutions and The H Group, two Portland, Oregon-based investment advisory firms, and their owner over their failure to disclose to clients a revenue-sharing agreement and other potential conflicts of interest.

The SEC’s investigation found that the two firms and their owner failed to disclose to customers that they were receiving revenue-sharing payments from a brokerage firm that managed a particular category of mutual funds being recommended to Focus Point’s clients.  Since Focus Point received a percentage of every dollar that its clients invested in the mutual funds, there was an incentive to recommend these funds over other investment  opportunities in order to generate additional revenue for the firm.

 As part of the arrangement , the broker agreed to pay Focus Point for all client assets that Focus Point invested in certain mutual funds.  In exchange, Focus Point agreed to provide certain custodial support services to the broker.  The SEC found that the agreement created incentives for Focus Point to favor a particular category of mutual funds over other investments.

 Focus Point also provided misleading information about its fee structure to  trustees of a mutual fund Focus Point for whom was seeking approval to become the sub-adviser.  During the sub-adviser to the fund hiring process,  Focus Point told the trustees that Focus Point would not receive any compensation beyond its sub-advisory fee.  This was not true.  Unbeknownst to the trustees, Focus Point had an arrangement with the fund’s primary adviser whereby the primary adviser would compensate Focus Point.

As part of the SEC’s Order entered in the case, Focus Point, The H Group and its owner were censured and agreed to pay a combined $1.1 million to settle the case.

SEC Issues New Alert on Political Contributions

Political contributions continue to be a primary source of concern for regulators like the SEC and the Municipal Securities Rulemaking Board…….

The SEC has recently issued another Risk Alert concerning Municipal Securities Rulemaking Board’s Rule G-37,  a rule that limits political contributions by municipal securities professionals to campaigns of public officials of issuers whom they do or seek to do business.  Typically, the illegal practice, known as “pay-to-play, involves public officials granting public contracts to their campaign contributors, or contractors, by attempting to influence the award of a contract, making contributions to an official who can influence the contracting process.

In issuing the alert, the SEC’s Office of Compliance Inspections and Examination noted the Commission’s concern with certain practices its examiners in the field have observed that may crossed the line violating the rule.   These so-called “pay to play”practices include:

  • firms that may have engaged in municipal securities business with issuers within two years of  making contributions (other than  de minimis contributions) to officials of the issuer.
  • firms that may not have maintained accurate and complete lists of their municipal financial professionals (MFPs) and non-MFP professional executive officers as required by MSRB Rule G-8.

  • firms that may have failed to file accurate and complete Form G-37s, by  identifiying on the form all municipal securities business that a firm has  engaged or all political contributions made to issuer officials by MFP and non-MFP executive officers.

  • firms that may have failed to create or implement supervisory procedures adequate enough to comply with Rules G-37 and G-38.

In addition to addressing the above issues, for some investment advisers this will mean taking steps to review political contribution reports related to any government client, reviewing any pattern of contributions by certain employee or group of employees, and other relevant factors.  In addition,  any review should  include any known external information, such as public contribution reports required by the MSRB, state and local law in relevant jurisdictions.