SEC Staff Risk Alert Criticizes Broker-Dealer Reports on Best Execution and Payment for Order Flow

The SEC Division of Examinations recently published a Risk Alert on quarterly reports required under Exchange Act Rule 606, which are published by broker-dealers to provide customers with insight into factors influencing order routing decisions. The Risk Alert follows a FINRA Report earlier this year highlighting deficiencies in 606 Reports and comes on the heels of criticism by SEC Chairman Gary Gensler of current best execution and payment for order flow (PFOF) practices, as well as a lack of competition for retail order flow. The Risk Alert also came just a few weeks before the SEC announced its highly anticipated slate of proposals for sweeping market structure reforms covering best execution, Rule 605 disclosures by market centers, and routing retail equity orders into auctions to increase competition. 

Background & Purpose of 606 Reports

The SEC adopted amendments to Rule 606 in November 2018, requiring broker-dealers to provide enhanced disclosures regarding the handling of certain customers’ orders. 606 Reports must discuss material aspects of the broker-dealer’s relationships with each specified venue, including a description of any PFOF arrangement and any profit-sharing relationship and a description of any terms of such arrangements, written or oral, that may influence a broker-dealer’s order routing decisions. 606 Reports are intended, among other things, to: (i) allow broker-dealer customers to view the material aspects of their firm’s PFOF arrangements and disclosures on how the firm routes non-directed orders for execution; and (ii) allow broker-dealer customers to better evaluate their firm’s routing services and how well they manage potential conflicts of interest.

Deficiencies Identified

The Risk Alert identified 606 Report deficiencies with broker-dealer reporting of routing venues, order classifications, and rebate disclosures. The SEC staff observed that certain broker-dealers:

• Incorrectly identified routing firms as order execution venues 
• Published inaccurate amounts of net aggregate rebates received for market orders, marketable limit orders, non-marketable limit orders, and other orders
• Provided general information about, but did not disclose the specific per share PFOF rebates applicable to, different size and order types under PFOF arrangements with non-exchange venues
• Did not disclose that they represented to routing or executing brokers that they would provide exclusively retail order flow to the routing broker to receive PFOF under arrangements with routing brokers
• Did not disclose that the broker-dealer could refuse to route orders to execution venues unless the venues agreed to pay a specified level of PFOF, which the SEC staff alleged could result in decreased price improvement or lower execution quality for customers
• Failed to disclose material terms of PFOF agreements including the specific rebate tier applicable to the broker-dealer
• Did not establish adequate written supervisory procedures to ensure the accuracy of their 606 Reports and the disclosures required therein

The FINRA Report identified many of these same issues but also provided examples of effective practices, including regular reviews of 606 Reports for compliance with disclosure requirements, and performing due diligence of all vendors that assist broker-dealers with the creation and publication of 606 Reports. The Risk Alert also specifically noted that broker-dealers that rely on commercial vendors to produce some or all aspects of their reports remain responsible for the accuracy of the report itself and all report disclosures.

What’s Next?

First and foremost, firms should consider enhancements to their 606 Reports to fill in any gaps identified in the Risk Alert. Not doing so would serve as an easy “gotcha” during future exams.

Second, firms may gain some additional insight related to scrutiny in this area when the SEC’s Division of Examinations publishes its list of priorities for 2023 and FINRA publishes its 2023 Report on its Examination and Risk Monitoring Program.

Finally, on December 14, 2022, the SEC will host an Open Meeting to discuss rule proposals on disclosure of order execution information pursuant to Rule 605, an “Order Competition Rule” that would require certain retail equity orders to be exposed in auctions before being internalized, and the SEC’s first ever “Regulation Best Execution,” which would establish a best execution standard and require robust policies and procedures for firms engaging in certain conflicted transactions with retail customers. Each proposal touches on one or more of the deficiencies identified by the SEC staff in its Risk Alert. This suggests that the timing of the Risk Alert was not coincidental and that the upcoming rule proposals may include specific measures to explicitly address deficiencies identified in the Risk Alert (e.g., refusing to route orders to execution venues absent sufficient payment for the order flow and the impact such refusal may have on customer price improvement and/or execution quality). The SEC may even float outright bans on certain order routing practices, although an outright ban on PFOF would encounter strong industry headwinds and is unlikely.

We anticipate significant public comments following the Open Meeting and will provide updates on emerging market structure developments as they occur.