Perhaps in anticipation of the Securities and Exchange Commission’s four rulemakings on order execution and handlings, the staff of the SEC’s Division of Examinations (Division) released a risk alert (Risk Alert)¹ on November 10, 2022, addressing the staff’s observations following its recent examinations of broker-dealer compliance with Regulation NMS Rule 606 (Rule 606). The staff’s observations focus on two aspects of the public reports broker-dealers prepare under Rule 606(a): the numerical data reported by a firm in its public Rule 606 disclosures; and the descriptions of the material aspects of the firm’s relationships with each of the 10 venues to which it routes the largest total number of non-directed customer orders for execution, together with any venue to which the firm routes five percent or more of its non-directed orders for execution.² The Risk Alert includes a number of important considerations and is intended to remind broker-dealers of their obligations under Rule 606.

Background

The SEC amended Rule 606 in November 2018 as part of an effort to “facilitate enhanced transparency regarding broker-dealers’ handling and routing of orders in NMS stock.”³ Rule 606 requires broker-dealers to disclose (in publicly available quarterly reports) certain information regarding their handling of “non-directed” customer orders for NMS stocks submitted on a held basis and for NMS securities that are option contracts having a market value less than $50,000.⁴ For purposes of the Rule, a “non-directed order” is a customer order for which the customer did not specifically instruct the broker-dealer to route to a particular execution venue.⁵ The 606 reports also must describe material aspects of a broker-dealer’s relationship with each routing broker or execution venue, particularly details of the firm’s payment for order flow (PFOF) arrangements and disclosures regarding how the firm routes non-directed orders. The Rule 606 disclosure requirements are intended to allow broker-dealers’ customers to better evaluate: their firm’s routing services; the factors influencing their firm’s order routing decisions; and how well the firm manages potential conflicts of interest.⁶

Staff Observations

The Examination staff identified three main points of concern: issues with quantifiable disclosures; issues with material aspect disclosures; and issues with supervision.

Issues with Quantifiable Disclosures

With respect to how firms identify venues, classify orders and calculate aggregate net rebates in their 606 reports, the Staff observed the following inadequacies with respect to firms’ quantifiable disclosures:

• Introducing brokers routing all orders to their clearing firms without creating their own 606 reports or incorporating by reference the clearing firm’s Rule 606 reports;
• Firms identifying routing-only brokers as execution venues, rather than identifying the execution venues to which the routing-only brokers transmitted orders;
• Erroneously and inconsistently classifying order percentages among the four categories of market orders, marketable limit orders, non-marketable limit orders, and other orders;
• Inaccurately disclosing aggregate amounts of net rebates received for each of the above four order types; and
• Using the incorrect dates for determining inclusion of a stock in the S&P 500 index.

Issues with Material Aspects Disclosures

The Staff also observed several issues relating to firms’ failure to disclose the material aspects of their relationship with the routing broker or execution venue where required by Rule 606. The identified deficiencies included:

• Using general terms in the firm’s material aspects disclosures instead of specific per order share PFOF rebate information. For example, the Risk Alert identified a firm’s statement that it “may receive” PFOF when the firm has in fact received PFOF as an example of insufficiently specific disclosure;
• Failing to disclose that the firm had arrangements with, or provided attestations to, venues to route retail orders (such as agreements to route exclusively retail order flow in order to receive PFOF);
• Not disclosing that the firm had rebate arrangements and rebate splits with their routing brokers and execution venues;
• Not providing disclosures regarding the impact on customers’ price improvement and execution quality in connection with negotiated changes to execution venues’ PFOF;
• Not including the required material aspects disclosures for newly added execution venues despite those venues having PFOF arrangements with the firms; and
• Failing to disclose material aspects of PFOF arrangements with exchange venues, such as only including hyperlinks to exchanges’ fee schedules without describing the broker’s particular incentive for routing orders to the specific exchange, or not identifying the specific rebate tier applicable to the broker-dealer.

Issues with Supervision

Further, the Staff observed issues regarding FINRA Rule 3110(b)(1) and its requirement to establish or enforce a system of controls designed to ensure compliance with Rule 606. The Staff found that many firms did not have adequate written supervisory controls in place to ensure Rule 606(a) reports, (including their material aspects disclosures) were accurate, or processes were in place to verify the underlying data quality. The Division also expected concern about over reliance on commercial vendors that prepare all or some of firms’ 606 reports.⁷

In this connection, it may be noted that FINRA’s 2022 Report on Examination and Risk Monitoring (FINRA Report) also addresses a number of the issues identified in the Risk Alert, such as whether firms are publishing accurate quarterly reports to their websites for the required retention period and, in the case of firms not required to publish a quarterly report under Rule 606(a), whether firms had effective processes in place for determining that no such report is necessary.⁸ A more complete list of FINRA Rule 606 considerations can be found in the FINRA Report, among other items for broker-dealers’ consideration.

Key Takeaways

The Risk Alert provides helpful guidance for broker-dealers seeking to assure compliance with Rule 606, and firms should consider whether any of their Rule 606 reporting processes require additional disclosure enhancements in light of the topics raised in the Risk Alert. The Division’s observations provide insights into the practices and controls that the Division may expect to see in connection with Rule 606.

Footnotes:

1) SEC Division of Examinations, Risk Alert, Observations Related to Regulation NMS Rule 606 Disclosures (Nov.10, 2022).

2) Id.

3) Securities Exchange Act Release No. 34-84528, Disclosure of Order Handling Information (Nov. 2, 2018), 83 FR 58338 (Nov. 19, 2018)(Adopting Release). The effective date was January 18, 2019, but the compliance date was later postponed to May 29, 2020 for Q1 2020 Rule 606 firm disclosures. See Securities Exchange Act Release No. 34-85714 (Apr. 24, 2019), 84 FR 18136 (Apr. 30, 2019).

4) See Adopting Release.

5) See 17 CFR §§ 242.600(b)(48) and 242.600(b)(27).

6) Securities Exchange Act Release No. 34-84528 (Nov. 2, 2018).

7) Id.

8) Report on FINRA’s Examination and Risk Monitoring Program (February, 2022).