RIA Compliance Blog
The Securities and Exchange Commission (SEC) issued a Risk Alert on February 27 designed to help firms detect and prevent unauthorized trading in brokerage and advisory accounts. Carlo di Florio, director of the Office of Compliance Inspections and Examination, stated, “Unauthorized trading is not a new problem, and the risks it poses should be a perennial concern to financial firms as well as to regulators. We hope that the observations shared in the Risk Alert will be helpful for firms as they review their compliance and supervisory controls to detect and deter unauthorized trading.”
The Risk Alert defines the term “unauthorized trading” as a broad range of activities, including: (1) rogue or other unauthorized trading or trade execution in customer or client or propriety accounts, (2) exceeding firm limits on position exposures, risk tolerances and losses, (3) intentional mismarking of positions, and (4) creating records of nonexistent (or sham) transactions. If a firm notices a change in trading patterns, a high volume of trade cancellations or corrections, manual trade adjustments, or unexplained profits for a particular trader or client, then the firm may need to apply additional scrutiny.
Firms should be aware that there are a number of individuals that may participate in unauthorized trades, including traders, trade assistants, portfolio managers, brokers, investment advisers, order placement personnel (i.e. trading desks), mid- or back- office personnel, risk management and other personnel. The alert discusses the importance of having independent and mutually reinforcing controls in order to mitigate the risks posed by unauthorized trading. It may also be important for firms to review and test their internal controls and asses their adequacy on a regular basis to prevent unauthorized trading.
The Risk Alert includes a non-exhaustive list of practices that firms may implement in order to prevent and mitigate unauthorized trading. It is intended as a guideline and not a mandatory provision; however, firms should keep in mind that complying with the list does not constitute a safe harbor.
The most important control is front office supervision. The elements listed that can be considered when a firm assesses its supervision systems in this area include: define independent and clear reporting lines, knowledge of complex securities and trading strategies, discussions with direct and indirect reports, structuring of incentives, disaggregation of functions, management “open door” policy, and trading a booking systems review. The other factors that are included in the Risk Alert are:
- Transfer of personnel into trading positions;
- Extended settlements and rolling of positions which may be a cause for concern;
- Trade confirmations;
- Mandatory vacations;
- Independent trading reviews;
- Silo systems; and
- Control testing.
The Risk Alert also considers that brokers and advisers have different regulatory requirements; however, both professions still face “financial and reputation losses” from unauthorized trading. The SEC is encouraging individuals to make comments and suggestions about how its examination program can be improved. The SEC’s overall goal is to promote compliance, prevent fraud, monitor risk and inform SEC policy.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with the complex issues that arise in the course of their businesses, including compliance with federal and state laws and rules.