In its first ever National Exam Risk Alert, the SEC Office of Compliance Inspections and Examinations has singled out the commonly used and widely accepted master/sub-account structure as subject to heightened potential risk of abuse and therefore the focus of examinations with respect to recently enacted SEC Rule 15c3-5 (“Market Access Rule”). Similar to Regulatory Notice 10-18 issued by FINRA in 2010, the Alert was issued without explanation and without being subject to comment and the rulemaking process, and places under heightened scrutiny a structure that is widely used by broker-dealers and investment advisers throughout the industry.
The Alert identifies six areas of concern and advises broker-dealers to consider appropriate controls and procedures, providing specific examples of due diligence. Less clear, however, is the motivation behind the Alert and how the Staff intends to enforce its “views.” Firms need to be mindful of the Alert and the impact on future interactions with the examination staff.
The September 29, 2011, Risk Alert warns of “significant concerns regarding trading through sub-accounts.” The specific concerns include the risk of money laundering, insider trading, market manipulation, account intrusion, excessive leverage and unregistered broker-dealer activity. One has to wonder why the Alert is confined to the master/sub-account model, because these risks appear to apply equally to all types of accounts. Indeed, these same risks have vexed the industry for years and exist for any account for which a broker-dealer provides market access. The Alert appears to be a continuation of the assault on master/sub-account relationships and trading by international investors and “day traders” that began with a few, isolated enforcement actions and continued last year with FINRA’s issuance of Regulatory Notice 10-18.1
In order to address the concerns related to the master/sub-account trading model, the Staff, among other things, recommends that broker-dealers consider the following:
The reasonableness and practicality of the Staff’s recommendations would have benefitted greatly by public comment. For example, there are significant limits on a firm’s ability to design procedures to identify potential patterns of insider trading. Indeed, this task requires complex analysis of market activity and routinely is performed by market professionals with access to much greater information (i.e., FINRA). Moreover, as acknowledged in the Alert, information regarding the sub-accounts responsible for individual trades already is obtainable by regulators by inquiry or subpoena.
Moreover, it is wholly unclear the extent to which the Staff’s views will affect the scenario in which an investment adviser establishes master/sub-account relationships, in which multiple underlying accounts may be maintained on behalf of the underlying investors and sub-advisers may be authorized to effect transactions without the intermediation of the master account owner. Other scenarios potentially affected include those in which an individual or entity sets up sub-accounts for separate trading strategies or algorithms.
The Alert focuses on customers who open master accounts with different sub-accounts used by individual traders or groups of traders. The Alert advises that examination staff will examine for compliance with the Market Access Rule as a means to identify potentially violative conduct in master/sub-account relationships. In particular, examiners intend to scrutinize firms’ systems of risk management controls and supervisory procedures to determine whether firms are appropriately vetting the master account customers and sub-accounts. The Alert provides specific examples of effective practices for a firm to evidence its due diligence. Broker-dealers that provide market access will be required to supply information regarding their risk assessment and support for their conclusions. Examination staff may also request evidence to support a firm’s finding that persons associated with the master account customers are not themselves customers.
It is unclear why OCIE has targeted master/sub-accounts for special treatment. It also is notable that the Staff’s view, if intended to increase substantially firms’ due diligence obligations and overall treatment of accounts, was not subject to the typical rule promulgation process with opportunity for notice and comment. As a result, the Alert provides no clarity as to what additional rules, if any, are applicable in the event that a firm determines to treat a sub-account holder as a customer for purposes of a CIP or the Staff’s views on the impact to other traditional master/sub-account arrangements, such as investment adviser and hedge fund relationships.
Broker-dealers are encouraged to review the Alert, a copy of which is available at http://www.sec.gov/about/offices/ocie/riskalert-mastersubaccounts.pdf, and to be prepared to respond to inquiries from examination staff regarding master/sub-account relationships.
For more information, please contact any of the following lawyers:
Amy Natterson Kroll, Partner, Broker-DealerTim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
timothy.burke@bingham.com, 617.951.8620
1 In a related example of standard-setting without the benefit of the notice and comment process, Regulation Notice 10-18 advised that, in FINRA’s view, under some (but not all) circumstances, a broker-dealer had to treat each subaccount in a master/sub-account structure as being a separate account.
2 While Section 15(g) of the Exchange Act requires broker-dealers to adopt procedures reasonably designed to prevent the misuse of material non-public information, generally this duty has been understood to require controls over material non-public information already within the firm, not to detect potential insider trading by customers.
This article was originally published by Bingham McCutchen LLP.