A master/sub-account arrangement exists where the same beneficial owner maintains multiple sub-accounts; the beneficial ownership interests in the various sub-accounts may or may not be identified to a broker-dealer. On September 29, the Securities and Exchange Commision’s Office of Compliance Inspections and Examinations released a National Exam Risk Alert (the Alert) on risks associated with master/sub-account arrangements. In the Alert, the SEC’s National Exam Program (NEP) identified a number of potential risks associated with master/sub-account arrangements. Specifically, NEP identified the following potential risks:

  • Money Laundering, Terrorist Financing, and Other Illicit Activity – NEP noted that a broker-dealer’s Anti-Money Laundering program should evaluate the risks potentially presented by master/sub-accounts. For example, the master/sub-account arrangement could affect a broker-dealer’s ability to comply with the requirement to monitor, detect, and file reports of suspicious activity, or its ability to meet obligations under the Customer Identification Program rule.
  • Insider Trading – NEP expressed a concern that master/sub-account arrangements could be used as vehicles for insider trading schemes, and it offered suggestions to address potential weaknesses.
  • Market Manipulation – NEP noted that a sub-account trader may open multiple accounts under a single master account or accounts under different master accounts and at different broker-dealers and use them to create the false appearance of activity or volume, thereby fraudulently influencing the price of a security. NEP stated that broker-dealers should apply their market manipulation surveillance parameters to trading activity at both the master account and sub-account levels.
  • Information Security – NEP observed that master/sub-account arrangements pose a greater risk of hacking based on the risk that a larger population of persons with access to a broker-dealer’s trading systems is more likely to include either bad actors or persons who are careless about information security. NEP stated that broker-dealers must take reasonable measures to address risks to information security.
  • Unregistered Broker-Dealer Activity – NEP noted that many master/sub-account arrangements may permit the master account owner, and possibly a sub-account owner, to act as unregistered broker-dealers in violation of Section 15(a) of the Securities Exchange Act of 1934.
  • Excessive Leverage and Other Risks – In addition to unregistered broker-dealer activity, the SEC is concerned that master/sub-account arrangements can be inappropriately used to offer excessive leverage to pattern day-traders who may have inadequate equity balances for such leverage.

With respect to each risk identified above, the Alert includes further suggestions for broker-dealers to address concerns arising from trading in sub-accounts.

Additionally, the Alert addresses the obligation that broker-dealers—including broker-dealers that offer master/sub-accounts—have under the Market Access Rule, i.e., the obligation to establish, document and maintain a system of risk management controls and supervisory procedures associated with offering market access to customers. In particular, NEP stated that, in examining for compliance with the Market Access Rule, the staff intends to “scrutinize” (i) the system of risk management controls and supervisory procedures that addresses master account customers to which a broker-dealer offers market access, and (ii) whether, in accordance with such controls and procedures, a subject broker-dealer is appropriately vetting the master account customer and sub-accounts identified as customers engaged in the trading business, or proprietary accounts, and individual traders with access to the broker-dealer’s Market Participant ID (or MPID), trading system and technology providing market access.

In addition to supplying its examination focus with respect to master/sub-account arrangements, NEP highlighted effective practices that it believes could be helpful to firms in meeting their obligations under the Market Access Rule.

While the alert does not have the same impact as an official SEC pronouncement, broker-dealers should be aware that regulators will look to it in analyzing broker-dealer compliance with applicable rules. Click here to read the Alert.