On September 27, 2012, the staff of the Office of Compliance Inspections and Examinations (the “Staff”) of the Securities and Exchange Commission issued a report titled “Staff Summary Report on Examinations of Information Barriers: Broker-Dealer Practices under Section 15(g) of the Securities Exchange Act of 1934” (the “Report”).1 The Report is intended to help broker-dealers safeguard material non-public information (“MNPI”) from misuse, including insider trading, and to manage the inherent conflict of interest that arises from a broker-dealer’s obligation to its client to safeguard MNPI provided for business purposes and the potential misuse of that MNPI for other purposes.
Section 15(g) of the Securities Exchange Act of 1934 requires that registered broker-dealers establish, maintain and enforce written policies and procedures, reasonably designed, taking into consideration the nature of their business, to prevent the misuse of MNPI.
Information that is deemed to be MNPI is typically placed on a broker-dealer’s monitoring list to check for possible improper trading. In reviewing the controls reasonably designed to prevent the potential misuse of MNPI, the staff analyzed the types of surveillance triggered by the placement of a matter on a broker-dealer’s monitoring list and whether the scope of the surveillance was sufficient to capture trading in all products that could benefit from the misuse of MNPI.
Broker-dealers conduct surveillance on products that could be used to profit from MNPI relating to particular companies, such as related derivatives and interests in such companies held through loans or as components of unit investment trusts or exchange traded funds. The Staff cited one example of a security that did not seem to be within the scope of surveillance – structured products issued by the broker-dealer or an affiliated entity. If the broker-dealer is in possession of MNPI with respect to a security underlying a structured product, the broker-dealer may need to have controls in place to prevent the issuance of that structured product from being based on MNPI. The lack of surveillance of such structured products, however, was not cited in the Staff’s “Potential Concerns” included in Annex B to the Report.
Broker-dealers should have existing procedures to protect against misuse of MNPI in connection with the issuance of structured products by the broker-dealer or an affiliate. These “window cleaning” procedures are also designed to prevent, for example, violations of Regulation M in connection with hedging activities by the broker-dealer or an affiliate, issuances during the blackout period prior to the release of the broker-dealer’s or affiliate’s financial results, unauthorized use of marketing materials or an unauthorized release of research prior to the issuance of a structured product. Window cleaning procedures should be checked to ensure that they prevent the unauthorized use of MNPI relating to a security underlying a structured product and should generally be tested to ensure that the procedures are being followed and produce the intended results.