The SEC’s New Rule 605 Amendments, Enforcement Actions and Other Key Impacts on the Alternative Investment Industry

In recent regulatory developments, the Securities and Exchange Commission (SEC) has adopted amendments to Rule 605 of Regulation NMS (National Market System), marking a significant shift in the landscape of best execution disclosures for NMS securities.

The SEC recently finalized significant amendments to Rule 605 of Regulation NMS, aimed at enhancing disclosure requirements for order execution in NMS securities. The SEC announced these changes in a press release on March 6, 2024, with the final new rule effective on June 14, 2024, 60 days after it was published in the Federal Register. The compliance date will be 18 months after the effective date, on December 14, 2025. These amendments represent substantial updates to the initial rule adopted in 2000, reflecting the evolution of modern equity markets driven by advancements in technology and evolving business paradigms. Enhanced disclosures will provide investors with more relevant and valuable information through expanding reporting entities, modernization of reporting content, and the wider accessibility of the reporting information.

As the compliance date approaches, understanding the nuances of these amendments becomes crucial for market participants to align their operations with the new regulatory expectations. Arootah Advisor Michelle McGurk walks us through this month’s Regulatory Roundup and breaks down what you need to know to remain compliant.

What is Rule 605?

Rule 605 was formerly known as Rule 11Ac1-5 and mandates market centers to produce monthly reports containing standardized statistical data on covered orders received for execution in NMS stocks. It was initially designed to bolster market dynamics, fostering a more competitive and efficient NMS system for investors, thereby reducing trading costs and improving market quality, which a study on the impact of Rule 605 concluded to be effective. By mandating transparency on order execution and routing practices, the rule has empowered investors with invaluable insights into the operational modalities of various broker-dealers. Additional transparency encourages investors to be more engaged and informed in their decision-making to route and improve investor outcomes.

Key Amendments and Their Impact

The amendments to Rule 605 increases the scope of reporting institutions subject to the rule, requiring broker-dealers with many customer accounts (100,000 or more) to produce monthly execution quality reports. Additionally, broker-dealers operating single-dealer platforms must now prepare separate reports for activity specific to these platforms. By broadening the scope of reporting entities, the SEC aims to capture a more comprehensive view of execution quality across the market.

Furthermore, the amendments modify the definition of “covered order” to include certain orders submitted outside of regular trading hours, non-exempt short sale orders, and certain orders submitted with stop prices. Also subject to the new rule are non-marketable orders and orders submitted with stop prices if they become executable during regular trading hours. This expansion ensures that a wider range of order types are subject to disclosure requirements, providing investors with more thorough information about execution quality.

Another significant change is the modification of order size categories, now based on notional dollar value and order type, rather than the number of shares. This modification allows for more accurate categorization of orders, including fractional share orders, odd-lot orders, and larger-sized orders. Additionally, the amendments introduce new order type categories and replace existing ones to better reflect the variety of order types in today’s market.

The enhanced disclosures also must be published in a publicly available summary report that summarizes execution quality statistics in the most recent versions of CVS and PDF format.

Enhanced Reporting Requirements

In addition to expanding the scope of reporting entities and order types, the amendments enhance the content of the reports required under Rule 605. Reporting firms will now be required to provide more detailed execution quality statistics, including average effective divided by average quoted spread, percentage-based effective and realized spread statistics, a size improvement benchmark, a size improvement statistic, certain statistical measures that could measure execution quality of non-marketable orders and additional price improvement statistics. These additional metrics give investors a more comprehensive understanding of execution quality and allow for better market comparison.

Practical Guidelines for Investment Advisers

In light of the amended Rule 605, investment advisers should reassess their internal best execution policies and procedures to leverage the additional disclosures effectively. These amendments aim to provide investors with more relevant and actionable information by expanding the scope of reporting establishments, updating the content of reports, and enhancing accessibility.

To enhance best execution practices, investment advisers can:

1. Review Broker Selection Criteria: With access to more comprehensive information on order execution and routing practices, advisers can redefine and refine their selection criteria. They can prioritize brokers with demonstrated efficiency and transparency in executing client orders.
2. Optimize Order Routing Decisions: By analyzing the data provided in the enhanced disclosures, advisers can identify patterns in order routing practices. They can then adjust strategies to ensure orders are routed to venues that consistently offer the best execution quality.
3. Monitor Execution Performance: Advisers can use the updated reports to monitor the performance of their selected brokers in executing client orders. This ongoing analysis can help identify deviations from expected execution quality and prompt adjustments to optimize outcomes.
4. Educate Investors: With more transparent information on order execution practices, advisers can educate their clients about the factors influencing order routing decisions to achieve the best execution and reduce trading costs. This transparency can foster trust and confidence in the adviser-client relationship.
5. Benchmarking and Comparison: The expanded disclosures enable advisers to benchmark the execution quality provided by different brokers against industry standards. This comparative analysis can inform decisions on broker relationships and provide insights into potential areas for improvement.

Investment advisers might utilize the new information by regularly reviewing execution data, comparing performance across different brokers, and incorporating insights into their decision-making processes. Additionally, they may collaborate with their clients to align execution priorities and ensure their strategies align with client objectives.

For investment advisers dually registered as broker-dealers who may be subject to the enhanced disclosure requirements, the following guidelines should be considered ahead of the Rule 605 amendment compliance date:

1. Assess the scope of reporting obligations: Determine whether your firm meets the criteria for reporting under the amended rule, including the number of customer accounts and the operation of single dealer platforms. The 100,000 customer accounts include both accounts that a broker executes on behalf of clients and accounts that the broker introduces to the market.
2. Review order categorization: Ensure your firm accurately categorizes orders based on notional dollar value and order type, as the amended rule specifies. Update reporting procedures accordingly to capture all relevant order types.
3. Enhance reporting metrics: Expand the range of execution quality statistics provided in monthly reports to include new metrics such as average effective divided by average quoted spread and size improvement benchmarks. Implement systems to collect and analyze this data effectively.
4. Publicly available summary report: As required by the amended rule, prepare a summary report of execution quality statistics in the most recent versions of CSV and PDF formats. Make this report easily accessible to investors on your firm’s website or through other channels.

By following these guidelines and proactively adapting to the amended Rule 605 requirements, investment advisers can ensure compliance and provide investors with valuable transparency into execution quality. Compliance with the enhanced disclosure requirements not only meets regulatory obligations but also enhances trust and confidence in the integrity of the trading process, ultimately benefiting both investors and market participants alike.

SEC Marketing Rule: Second Round of Enforcement Actions & Recent Risk Alert

The SEC Division of Examinations released a risk alert on April 17, 2024, summarizing recent observations from investment adviser exams and compliance deficiencies related to Rule 206(4)-1, commonly known as the Marketing Rule. This follows the recent announcement of a second round of charges in an ongoing targeted sweep on Marketing Rule compliance, following similar enforcement action in September 2023. The five firms involved in the latest enforcement action include GeaSphere LLC ($86 million RAUM), Bradesco Global Advisors Inc. ($200 million RAUM), Credicorp Capital Advisors LLC ($516 million RAUM), InSight Securities Inc. ($126 million RAUM), and Monex Asset Management Inc.($160 million RAUM). Collectively, they have agreed to pay $200,000 in total fines to settle the SEC’s charges.

The enforcement actions primarily centered around improperly using hypothetical performance data in public advertisements on the firms’ websites. According to the SEC orders, these firms failed to implement adequate policies and procedures to ensure that the hypothetical performance presented was relevant to the likely financial situation and investment objectives of the intended audience, as required by the Marketing Rule.

While four firms undertook corrective measures before being contacted by the SEC, GeaSphere faced allegations of additional violations. These included accusations of disseminating false and deceptive information in advisory advertisements and a fund prospectus, promoting misleading model performance, and failing to provide evidence to support the performance figures presented in its advertisements. Furthermore, the firm allegedly failed to formalize agreements with compensated solicitors and failed to meet specified recordkeeping and annual review obligations. As a result, GeaSphere incurred a civil penalty of $100,000, while the other firms faced penalties ranging from $20,000 to $30,000.

SEC Risk Alert: Observations of Marketing Rule Compliance

The SEC Risk Alert highlighted the staff’s focus on written policies and procedures in recent examinations, assessing their ability to prevent Marketing Rule violations. While some investment advisers had effective protocols in place, including thorough advertisement reviews, preapproval processes, and staff training, others exhibited deficiencies that left gaps in their ability to prevent violations of the Marketing Rule and Books and Records Rule. Specifically, some observed policies and procedures were overly general and lacked specificity related to the Marketing Rule. Others failed to cover the various marketing channels used by advisers, such as websites and social media platforms. Additionally, some policies were informal rather than documented, while others were incomplete or outdated, leaving important topics only partially addressed.

Furthermore, many policies were not tailored to specific advertisements, neglecting key requirements such as the SEC’s guidelines for testimonials, endorsements, and third-party ratings and the Marketing Rule’s General Prohibitions. The General Prohibitions include making untrue statements of material fact, omitting material facts, providing misleading inferences, discussing potential benefits without fair treatment of associated risks, referencing specific investment advice unfairly, presenting performance results, and including otherwise materially misleading information.

Some examples of violations noted in recent exams include advertisements claiming to be “free of conflicts” when actual conflicts existed, those that presented performance information without adequate disclosure regarding the share classes included in the performance returns, using lower fees in calculations for net performance returns than were offered to the intended audience, advertising third-party ratings without disclosing that the methodologies for those ratings were not related to the quality of investment advice (i.e. AUM, number of clients, self-nomination), and materially misleading advertisements as disclosures were presented in unreadable font on firm websites.

Moreover, inadequate measures were noted regarding the preservation and maintenance of advertisements and related documents, including copies of information posted to social media, websites, documentation to support performance claims included in advertisements, and questionnaires completed as part of a third-party rating.

The SEC also noted observations related to Marketing Rule deficiencies on Form ADV Part 1A, which resulted from inaccurate reporting of the use of hypothetical performance, third-party ratings, and performance results.

Takeaways for Investment Advisers

The recent enforcement actions serve as a stark reminder for investment advisers to prioritize compliance with the Marketing Rule. The SEC’s continued scrutiny underscores the importance of implementing robust policies and procedures to disseminate hypothetical performance data and ensure that advertisements are appropriately targeted to the intended audience. Investment advisers should conduct internal self-assessment reviews to strengthen their compliance frameworks concerning the recent Risk Alert and make necessary adjustments to their training, oversight, and compliance programs. Moreover, these actions highlight the significant financial and reputational risks associated with Marketing Rule violations, emphasizing the urgency for investment advisers to proactively address any potential compliance shortcomings to avoid similar enforcement actions.

UK FCA Proposes Significant Changes to Publicize Investigations

The Financial Conduct Authority (FCA) is presenting significant revisions to its Enforcement Guide (EG) in Consultation Paper (CP) 24/2 titled ‘Our Enforcement Guide’. This proposal involves the public disclosure of ongoing enforcement investigations of regulated firms. This measure has sparked debate among industry stakeholders who argue it could ultimately harm investors. However, the FCA believes the additional transparency will have a deterrent effect, reducing the likelihood of harm to investors and markets by increasing public confidence in the financial system and enabling the FCA to address risks more effectively.

Summary of the Proposed Changes

Section 4 of the proposed new EG outlines the most notable changes and centers on publicizing FCA investigations. This aims to increase transparency in enforcement processes and ensure that market participants are promptly informed about instances of serious misconduct. Currently, the FCA rarely discloses ongoing investigations unless under exceptional circumstances. However, under the proposed reforms, the FCA intends to publicly announce the commencement, ongoing progress, and closure of investigations of regulated firms when it deems it is in the public interest.

These changes are accompanied by a list of public interest factors, or the FCA’s proposed “public interest framework,” which will be considered when deciding whether to publicize an investigation. These factors include protecting affected parties, encouraging witnesses or whistle-blowers to come forward, addressing concerns or speculation, reassuring the public about FCA actions, and advancing statutory objectives. The FCA proposes that announcements or updates may be withheld if they could negatively impact the investigation, harm consumer interests, or threaten the stability of the UK financial system.

The FCA’s rationale behind these changes is to utilize transparency as a regulatory tool, protect consumers by raising awareness, and enhance its effectiveness and accountability. However, several proposals by the FCA have been deemed contentious. Firstly, while the FCA acknowledges that starting an investigation doesn’t indicate guilt, this distinction may be lost on the public. Media coverage could unjustly damage a firm’s reputation before evidence is presented. Moreover, if the FCA announces an investigation, investors might reasonably question the firm’s integrity or withdraw their investments due to regulatory uncertainty.

Firms and practitioners in the financial sector have reason to appreciate the FCA’s aim to improve the pace and transparency around enforcement cases, making them more manageable, as they announced in a press release in February. However, while the FCA argues for increased transparency in investigations, some of its justifications are less convincing. Although the pace of FCA investigations has been notably slow in recent years, the solution will unlikely come from heightened publicity but from strategic case selection and better-resourced enforcement teams.

FCA Investigation Announcements

The investigation announcements will be published on the FCA’s website and include information it believes will enable consumers, firms, and relevant market participants to understand the nature of the investigation and the regulator’s concerns. This will include the identity of the investigation’s subject (typically excluding individuals), the industry sector, the relevant regulatory or legal provisions, and a summary of the suspected misconduct. The announcement will clarify that the investigation’s initiation does not imply a conclusion of wrongdoing. A public update will be provided if the investigation is closed without action.

The FCA proposes to give the subject of an investigation no more than one business day’s notice before announcing or updating the public. In urgent situations, no notice will be given. For market-sensitive information, the FCA will typically inform the subject after market hours and publish the announcement at 7:00 a.m. on its website and through its approved information provider. If the subject is a listed company in another jurisdiction, the FCA will aim to avoid publication during that jurisdiction’s stock exchange hours.

Historical Effects of Early Enforcement Announcements

Misinformation circulating publicly can prejudice outcomes, hinder fair hearings, and hurt a firm’s share prices, even if they are later deemed compliant. In a study of early-stage European Union Antitrust investigations, a surprise inspection reduced a firm’s share price by 2.89%, on average, while an infringement decision reduced it by 3.57%. There was also a study performed by Bosch and Eckard in 1991 which examined the impact of the market price of a share of stock following the announcement of an indictment of 127 firms from 1962-1980. The average abnormal return around the WSJ indictment announcement and the day before shows a statistically significant decline of -1.08%. This resulted in a total loss of value amounting to $2.18 billion ($1982). Only about 13% of this loss can be directly attributed to legal costs like fines and damages. These historical trends can provide some insight into the expected impact of an FCA enforcement announcement on a named firm.

Key Takeaways and Next Steps

The House of Lords Financial Services Regulation Committee has raised concerns about the market impact of the FCA proposals, marking its first intervention since the committee was created earlier this year. Additionally, 16 trade associations, including the UK Finance and the City of London Corporation, have responded with comments collectively saying the proposals will have an undeservedly negative impact on the reputation of firms. Suppose a firm is named at the outset. In that case, it will undoubtedly suffer reputational and probable commercial damage while the investigation occurs and possibly beyond, even if it results in no disciplinary action. The Financial Services Regulation Committee issued an additional letter to the FCA on May 1, 2024, and invites written submissions to its inquiry by June 4, 2024.

While the FCA’s proposals aim to enhance transparency and accountability, they also raise important considerations about fairness, investor confidence, and market stability. By pushing for greater transparency, the FCA may inadvertently deter firms from engaging with the UK market compared to global counterparts. Investment managers, even those not currently operating in the UK, should closely monitor these developments as regulators seek to increase transparency and evolve regulatory environments globally. The proposed changes by the FCA underscore the broader trend of regulatory intensification worldwide, emphasizing the need for proactive risk management and compliance strategies in the financial sector.

Bottom Line

Investment advisers, in particular, must reassess their internal policies and procedures to leverage the additional disclosures effectively. As the industry adapts to these changes, the overarching goal remains clear: to foster a more transparent, competitive, and efficient market that upholds the best interests of investors. To learn more about Arootah’s outsourcing and advisory services, schedule a strategy call today.