The Securities and Exchange Commission released a major report last week reviewing the inside information controls at major broker dealers. While the SEC found improvements in the information controls of the firms examined, the report cites areas of major concern, such as the frequent undocumented interactions between internal groups which have regular exposure to material non-public information (MNPI) and staff in sales and trading. For research firms, whether registered broker dealers or not, the report offers insights into compliance best practices.
The Office of Compliance Inspections and Examinations (OCIE) of the SEC compiled the report based on their reviews of the information control practices of six of the largest broker dealers (unnamed). The report was supplemented by observations contributed by FINRA and the New York Stock Exchange’s Division of Market Regulation, after their examinations of an additional thirteen broker-dealers.
The current report is the first major review of inside information controls in over two decades. The last SEC report was released in 1990, not long after the Insider Trading and Securities Fraud Enforcement Act of 1988 was implemented. The 1990 Report provided an overview of then-current broker-dealer information barrier practices and identified common practices, including the maintenance of watch and restricted lists and the accompanying review of employee and proprietary trading, written procedures, and documentation of reviews.
The current report details all the potential areas where MNPI can be received, which, given the size and complexity of large broker dealers, are many. Besides the obvious areas such as origination and financial advisory, the SEC highlights the risks in areas dealing with bank loans, derivative sales, proprietary trading groups, prime brokerage, syndicates, and the internal group which controls the credit extended to corporate and asset management clients, to name just a few cited in the report.
Support groups, such as information technology, operations, and risk monitoring groups, also gain access to MNPI through their interactions with the departments they support. Further complexity is added by the compliance process itself, which monitors MNPI and must be protected from leaks.
The report also enumerates the various and subtle forms of MNPI. For one thing, MNPI is not limited to equities. The SEC report spends equal time on all capital markets areas: fixed income, derivatives and structured products. While MNPI is received from entities that issue traded instruments, it can come from other sources, such as asset manager clients: “information on the positions held by the institutional investor, including large short positions, as well as institutional investors’ trading strategy, may be material.”
The SEC finds that, in general, compliance controls in large broker dealers have improved as the size and complexity of the business has grown. However, it cites areas of concern. First on the list are the internal interactions with sales and trading. The SEC found that there is extensive contact between bankers and others with regular access to MNPI and the sales and trading groups, with little or no compliance oversight:
“A significant amount of interaction between groups that have MNPI and internal and external groups that have sales and trading responsibilities occurred on an informal (undocumented) basis…the frequency of the discussions and the absence of documentation may make it difficult to trace any inadvertent (or even intentional) disclosures that may occur.”
The SEC also highlighted senior executives, referred to as “above-the-wall,” who receive MNPI with no related monitoring or restrictions. “The absence of any documentation that these executives were receiving MNPI, in view of the natural motivation to have business units within one’s areas of responsibility excel, as well as the apparent absence of related monitoring or other controls, raises serious concerns about the ability of broker-dealers to guard adequately against misuse of MNPI.”
In particular, the SEC mentions that senior managers of research operations are sometimes deemed “above the wall” and expresses concern with this situation.
The SEC also faulted broker-dealers which did not review trading within accounts of institutional customers, asset management affiliates, or retail customers. It also mentioned that some firms did not review outside business activities such as participation in bankruptcy committees, employees serving on the boards of directors of public companies, or insiders of companies placing unusual trades.
The SEC cited research ratings changes as an area where it found deficiencies. At large broker dealers, changes in research ratings, particularly sell recommendations given their rarity, can be market moving. The SEC report indicates that broker dealers were not adequately monitoring research activities.
Besides ratings changes, other research activities could also be material:
“Information within Research, such as the initiation of research coverage or changes in price targets, may be MNPI. Broker-dealers are starting to incorporate into their information barriers programs other publications and ratings systems that may be material. For example, Research may maintain lists containing a subset of their buy and sell recommendations to highlight certain ratings for investors. The addition or deletion of names from the list may be material. Research may issue short term views on securities, with an analyst having recommendations for both a short term investment horizon and longer term investing. The short term rating may raise concerns if it, in effect, provides advanced notice of a change in a long term rating to a select group.”
It is important to note that while trading on inside information is a common determinant of securities fraud, the dissemination of MNPI through research reports also qualifies: “…misuse may occur through, among other activities, insider trading prohibited under Exchange Act Section 10(b) and Rule 10b-5; through trading during a tender offer in violation of Exchange Act Rules 14e-3 and14e-5; or through issuance of a research report based on MNPI.” (italics added)
The area of most concern to independent research providers, which typically do not move markets with their research, is also mentioned with the SEC report:
“While Research may routinely have MNPI (e.g., changes to research ratings), broker-dealers may need to address the adequacy of controls over the group’s receipt of MNPI from external sources, which could impact the ability to issue research.”
Implications For Research Firms
The SEC report provides a general outline for compliance best practices, whether firms are registered broker dealers or not. Good compliance practices include clearly communicated policies, training, trading reviews, and ongoing surveillance: “Information barrier programs, as described in the 1990 Report and as currently observed by the staff, have certain common features: employee training in legal and firm requirements; review and restrictions on trading; physical barriers; formal over-the-wall procedures prior to sharing information with public-side employees; and surveillance.”
The process is not static, but needs to be adapted as the business evolves. Also, compliance practices need to be tailored to the firm. What makes sense for one firm, may not be appropriate or necessary for another: “Importantly, written and implemented controls that are deemed reasonable may likely vary among broker-dealers depending on factors such as size and business model.”
The timing of the SEC report, while not surprising, underscores the ongoing scrutiny of information controls. We have heard that the SEC has been sending out a flurry of pre-examination notices to hedge funds, so we can expect that the next area of focus for examiners will be hedge funds and their information controls, including the use of external research.