By John Filar Atwood
In its most recent review of Regulation NMS Rule 606 disclosure practices, the staff of the SEC’s Division of Examinations found deficiencies in how broker-dealers are reporting on their payment-for-order-flow (PFOF) arrangements. The staff has outlined its findings in a new risk alert, which it hopes will serve as incentive for brokers to reevaluate the accuracy and specificity of their Rule 606 reports.
Rule 606 requires broker-dealers to disclose in a public report how they handle customers’ orders, including the routing of non-directed orders from its customers that are for national market system shares and submitted on a held basis or for a national market system security that is an option contract with a market value less than $50,000. In particular, the reports should contain the material aspects of a broker’s PFOF arrangements and disclosures on how the firm routes non-directed orders for execution.
The staff noted that PFOF may present a conflict of interest because the PFOF receiving firm may be incentivized to route order flow to maximize PFOF revenue, including only routing orders to venues that agree to pay a certain level of PFOF, which may come at the expense of customers’ order execution quality. Rule 606 reports are intended to allow broker-dealer customers to better evaluate their firm’s routing services and how well they manage potential conflicts of interest.
PFOF disclosure. The staff found that some broker-dealers did not disclose the material aspects of their relationship with their routing broker or execution venues, which included omitting a description of any PFOF arrangement and any profit-sharing relationship that may influence a firm’s routing decision.
Specifically, the staff observed that some broker-dealers, with respect to PFOF arrangements with non-exchange venues, did not disclose the specific per share PFOF rebate applicable to different sizes and order types under each PFOF arrangement. Instead, the firms included general information that the firm received PFOF, average per share rebates, and use of the language “may receive” when the firm in fact received PFOF. Broker-dealers also relied on references to the remuneration in the tables contained within the Rule 606 report and stated generally that the firm received the same rebate from all market makers, the staff found.
The staff also observed instances where broker-dealers did not disclose that they had arrangements with or provided attestations to venues to route retail orders. Deficiencies included firms that did not disclose that they represented to their routing or executing brokers that they would provide exclusively retail order flow to the routing broker in order to receive PFOF under arrangements with their routing brokers, according to the staff.
Further, some firms did not disclose that they had a rebate arrangement and a rebate split with their venues. The staff identified instances where firms did not disclose the details of PFOF revenue split arrangements with their clearing firm or routing broker, which is required even if the firm chooses the approach of adopting by reference the routing brokers’ reports.
Price improvement/execution quality. The staff stated that while firms had discussions with their execution venues regarding an increase or decrease in PFOF for a corresponding decrease or increase in price improvement (PI) and thereby lower or higher execution quality (EQ), the firms did not disclose the PFOF and PI/EQ trade-off in their Rule 606 reports.
In addition, the staff advised that broker-dealers that refuse to route orders to execution venues unless those venues agree to pay a level of PFOF specified by the firm must disclose when the PFOF negotiated by the firms reduces the PI and EQ opportunities for the firms’ customers. The staff emphasized that this disclosure is required regardless of any specific conversation with execution venues surrounding a trade-off between PFOF and PI or EQ.
The staff further stated that Rule 606’s requirement that a firm describe the material aspects of its relationship with the executing venue along with a description of the terms of any PFOF arrangements, imposes a duty to disclose that trade-off. Accordingly, failure to disclose such a trade-off in a firm’s Rule 606 reports could be interpreted by a firm’s customers as a representation that the level of PFOF required by a firm as a condition for routing customer orders to an execution venue does not affect the customers’ PI or EQ opportunities, the staff said.
Another deficiency identified by the staff was when a broker-dealer added new venues to its Rule 606 report without including corresponding material aspects disclosures for the newly added venues despite the venues having PFOF arrangements with the firm.
The staff also outlined instances where broker-dealers did not disclose the material aspects of their PFOF arrangements with exchange venues. These included firms either not disclosing the material terms of the PFOF arrangements with exchanges, or including hyperlinks to exchanges’ fee schedules which did not describe the firms’ incentive for routing to particular exchanges along with the quantifiable terms. The staff noted that as part of a firm’s material aspects discussion, firms should describe the specific rebate tier applicable to the firm.
Non-PFOF deficiencies. The staff also discussed deficiencies it observed outside of the PFOF disclosure requirements. In some cases, firms routed all orders to a clearing firm without either creating a Rule 606 report or incorporating by reference the clearing firm’s Rule 606 report. In addition, some broker-dealers improperly identified routing firms rather than the venues to which they routed orders for execution, including identifying a routing-only broker-dealer as a venue but omitting the names of the actual venues to which the routing-only broker-dealer relayed orders for execution.
The staff said that it also found that some firms inaccurately classifying order percentages among the four order type categories—market orders, marketable limit orders, non-marketable limit orders, and other orders—including use of conflicting methods for classifying order percentages and aggregate amounts of net rebates received in terms of the four order types. Some firms disclosed inaccurate amounts of net aggregate rebates received for each of the four order types, while others used incorrect dates for determining inclusion of a stock in the S&P 500 index, the staff said.
A final general observation in the risk alert is that broker-dealers did not have adequate written supervisory procedures to ensure the accuracy of the Rule 606(a) reports or the accuracy of the material aspects disclosures. In addition, some firms did not sufficiently review the data quality underlying the reports, which led to inconsistent disclosures in the reports, the staff stated.