SEC Releases Annual Examination Priorities for Broker-Dealers

March 01, 2013

On February 21, 2013, the Securities Exchange Commission (SEC) published a statement listing its regulatory priorities for the upcoming year. The statement identifies key risks that the SEC will examine and can help financial institutions find gaps in their compliance programs before the SEC does. The list of priorities is a product of the SEC Office of Compliance Inspections and Examinations’ (OCIE) and the National Examination Program’s (NEP) discussions with SEC division leaders, the results of prior examinations, SEC filings, media reports, and communications with customers and investors.

The SEC will continue its monitoring of issues related to fraud detection, corporate governance and enterprise risk management, conflicts of interest, and high-speed trading failures. In addition, it will emphasize broker-dealers’ compliance with the new Market Access Rule. Compliance officers should take note of these principal areas of concern and address them promptly. A copy of the list is available here.

Below is an overview the SEC’s broker-dealer, transfer agent and clearing firm, and market-wide priorities. A separate alert discussing the investment management priorities can be found here.

Broker-Dealer Priorities
The Broker-Dealer (B-D) Program identified areas where it will continue surveillance, including:

  • Trading Practices. B-D remains concerned about fraud in retail investor transactions. Firms should examine practices with regard to recommendations for high-yield products and leveraged or inverse exchange-traded funds. Firms should also pay particular attention to disclosures of conflicts of interest.
  • High-Speed Trading. Firms are reminded to have proper controls on the use of technology in high-speed trading, algorithmic trading, and alternative trading systems. In particular, firms should examine if they are properly disclosing risks and order routing practices to customers. The SEC also noted that computer errors have caused significant losses and eroded customer confidence. Firms are advised to investigate the adequacy of protocols designed to deal with technology-related errors.
  • Capital Requirements. B-D will conduct exams of firms engaging in high-speed trading focusing on their internal controls for managing intraday liquidity risks and net capital risks. Accordingly, firms should monitor and control liquidity risk exposures.
  • Anti-Money Laundering. Firms should review their due diligence procedures and practices to flag suspicious activity.

While B-D targets broker-dealers for examination based on a risk analysis of their activities, compliance officers in all firms should tackle these issues to avoid disciplinary action. Firms should be aware of the collateral consequences of an examination — the results may be referred to SEC Enforcement.

Market Access Programs
In addition to the ongoing priorities, B-D will emphasize firms’ compliance with the new Market Access Rule (SEC Rule 15c3-5).2 Even if a firm does not provide access to third parties, it is still bound by the Rule if it has market access by virtue of its exchange member status. Under the Rule, broker-dealers are required, among other things, to establish a risk management system and supervisory procedures reasonably designed to manage the risks of this business activity.

The examiners further noted that master/sub-account structures potentially enable customers to avoid or minimize regulatory scrutiny. Because broker-dealers may not know the identity of underlying traders, firms providing such access to customers should remain mindful of the risks involved with such arrangements. In particular, the SEC has pointed out that master/sub-accounts raise issues related to money laundering, market manipulation, insider trading, unregistered broker-dealer activity, excessive leverage, and inadequate minimum equity for pattern day traders.

Broker-dealers using master/sub-account structures should perform appropriate due diligence on sub-account holders and monitor transactions for suspicious activity. In addition, the SEC put firms on notice that the Market Access Rule requires capital thresholds on proprietary trading, including thresholds for error accounts. Firms should review their risk management controls and supervisory procedures to prevent the entry of orders exceeding capital thresholds.

Clearance and Settlement Exam Program
The SEC will examine risks associated with transfer agents and clearing firms. Critical functions requiring compliance such as timely turnaround of transactions, accurate recordkeeping, and safeguarding funds will receive the brunt of scrutiny. Firms should ensure that if they provide purchase and sale services, they do not engage in unregistered broker-dealer or investment adviser activity. In addition, transfer agents should examine their recordkeeping protocols related to electronic storage, third party vendor access and security, appropriate redundancy, and business continuity procedures.

Besides the ongoing priorities, the SEC has identified new areas of concern in its examination of transfer agents, including:

  • Microcap Securities and Private Placements. Firms should have policies and procedures to prevent unregistered offerings as well as conflicts of interest. Potential conflicts may arise if transfer agents are affiliated with issuers or brokers. Transfer agents should review whether they have implemented effective formal written policies and procedures to identify, disclose, and mitigate conflicts.
  • Hybrid Securities. Transfer agents should evaluate their formal written policies and procedures to reflect the complexity of transferring or converting hybrid securities.
  • Outsourcing. For firms that transfer processing activities to non-U.S. locations, the SEC will examine whether the written formal policies and procedures effectively ensure compliance.
  • Third Party Administration. If transfer agents perform recordkeeping functions for non-issuers, firms should ensure that they are not engaged in unregistered broker-dealer or investment advisor activity.

Clearing Agencies under Dodd-Frank
The SEC will examine clearing agencies designated as systemically important as required under the Dodd-Frank Act. The annual examination program will employ a risk-based approach and will be based on cooperation and coordination as necessary with other regulators, including the Federal Reserve Board, the Federal Reserve Banks of New York and Chicago, and the CFTC. Clearing firms will be asked to share information on the safety and soundness of the agency, risk management reports, internal audit reports, and compliance reports.

Market-Wide Priorities
Certain regulatory priorities apply to all market participants. Among them, fraud detection and conflicts of interest rank high on the list. The SEC will also engage corporate boards to evaluate firms’ approaches to enterprise risk management and to conduct an overall risk assessment. In light of certain market failures when Hurricane Sandy struck, this review might encompass business continuity plans in the event of an emergency. In addition, firms are advised to review their technology systems for issues, including operational capability, market access, and information security.

The SEC statement outlines areas where examinations will be focused. Firms should scrutinize their written supervisory procedures and policies to ensure compliance with SEC rules. Even if an examination is not immediately forthcoming, a firm may be forced to answer questions about its practices at any time.

*This alert was co-authored by W. Hardy Callcott, Michael Wolk, Timothy Nagy and Sumahn Das.


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2 Rule 15c3-5, 17 C.F.R. § 240.15c3-5

This article was originally published by Bingham McCutchen LLP.