On September 27, 2012 the SEC’s Office of Compliance, Inspections, and Examinations (“OCIE”) issued a report (the “Report”) discussing the findings made by OCIE, FINRA, and the New York Stock Exchange’s Division of Market Regulation (the “examiners”) in their examinations of programs implemented by broker-dealers to protect against the misuse of material, non-public information (“MNPI”).
Building on “Broker-Dealer Policies and Procedures Designed to Segment the Flow and Prevent the Misuse of Material Nonpublic Information,” a report issued by the SEC’s Division of Market Regulation in March 1990, the Report notes that in many instances broker-dealers may receive MNPI regarding their clients and market events in the course of their business operations – such as investment banking services, the creation and issuance of financial instruments, including debt, and trading activities – often under circumstances in which a duty of trust and confidentiality may be owed to the client or another party.
In broad terms, the Report cites conflicts of interest and other issues of concern found by the examiners and highlights effective practices the examiners observed at some broker-dealers.
Concerns cited by the examiners include:
- A significant amount of informal, undocumented interaction occurred between groups that have MNPI and internal and external groups with sales and trading responsibilities that might profit from the misuse of such MNPI;
- Senior management with access to MNPI from one business unit also oversaw other business units that could potentially profit from misuse of the MNPI, and there were few, if any, restrictions or monitoring to help prevent such misuse;
- Risk controls were not implemented to address (i) certain business units that possess MNPI such as sales, trading or research personnel who receive MNPI for business purposes; (ii) institutional and retail customers or asset management affiliates with access to MNPI; or (iii) firm personnel who receive MNPI through business activities outside of investment banking, such as sitting on bankruptcy committees or sitting on the boards of public companies;
- Some broker-dealers did not review the trading activity within accounts of institutional customers, asset management affiliates, or retail customers when certain business units came into possession of MNPI; and
- Some broker-dealers had no formal controls in place to manage instances where employees transitioned from business units with MNPI to business units that were restricted from receiving MNPI. Instead, several broker-dealers relied on “self reporting” by employees.
While recognizing that these concerns by themselves may not necessarily suggest violations of Section 15(g) of the Securities Exchange Act of 1934, which requires broker-dealers to adopt procedures to prevent the misuse of MNPI, the Report states that the broker-dealers engaging in behaviors giving rise to the concerns may find it helpful to review their policies and procedures in light of the practices the examiners found to be effective.
Generally speaking, these effective practices include:
- Developing processes that differentiate between types of MNPI based on the source from which the information originated within the broker-dealer (e.g., the business unit) or the nature of the information (e.g., transaction type), and creating tailored exception reports that take into account the differing nature of the information;
- Monitoring access rights for key cards and computer networks to help ensure that only authorized personnel have access to sensitive areas;
- Expanding the scope of instruments reviewed for potential misuse of MNPI by traders beyond the traditional types of securities to include credit default swaps, equity or total return swaps, loans, and components of pooled securities, ETFs, warrants, and bond options;
- Monitoring employee access to electronic MNPI;
- Implementing restrictions on employee access to the “Printing and Production” areas within broker-dealers when such areas are producing private-side documents, such as mergers/acquisitions term sheets, or offering memoranda and pitch books for IPOs; and
- Implementing controls on private-side e-mails to protect against inadvertent electronic disclosure of MNPI to those without a legitimate business need for it.
The Report concludes that while broker-dealers are enhancing their controls in response to developments in business activities, technologies and business structures, the examiners were able to identify gaps in controls, which they brought to the attention of the broker-dealers at the conclusion of their examinations. OCIE further stated that it is the SEC staff’s intention to continue to review broker-dealers’ Section 15(g) policies and procedures going forward.