EXAMS Observations Related to Regulation NMS Rule 606 Disclosures

The U.S. Securities and Exchange Commission (SEC) Division of Examinations (EXAMS) issued a risk alert (Alert) on November 10, 2022 regarding examination observations related to Regulation NMS Rule 606 disclosures.

Regulation NMS Rule 606 disclosures

The SEC adopted an amendment to Rule 606 in November 2018 that requires broker-dealers to provide enhanced disclosures in their Rule 606(a) reports regarding how they handle customer orders.¹ The amended rule requires broker-dealers to provide publicly available quarterly reports on their routing of nondirected orders from customers submitted on a held basis for a National Market System (NMS) security that is an option contract with a market value less than $50,000. The reports provided to customers must include material aspects of a firm’s payment for order flow (PFOF) arrangements and disclosures about how the firm routes nondirected orders for execution.  

In addition, the report must discuss the material aspects of the broker-dealers’ relationships with each specified venue, including a description of any arrangement for payment for order flow and any profit-sharing. This disclosure is required to prevent relationships that may affect or distort how customer orders are routed. The report’s disclosures are aggregated across all qualifying orders routed by the broker-dealers on behalf of their customers.  

Details of the alert 

According to the staff observations, the expectation is that firms should disclose the PFOF, Price Improvement (PI), and Execution Quality (EQ) trade-off in their Rule 606 reports. Refusal to route orders to execution venues, unless such venues agree to pay a level of PFOF specified by the firm, also triggers a disclosure obligation when the PFOF negotiated by the firms reduces the PI and EQ opportunities for the firms’ customers. This disclosure is required regardless of any specific conversation with execution venues surrounding a trade-off between PFOF and PI or EQ. 

The Alert notes the following observations made during the SEC examinations of Rule 606(a) disclosures since the first quarter of 2020. 

Quantifiable disclosures 

The examination staff noted the following issues with how firms identified venues, classified orders, and calculated aggregate net rebates in reports required by Rule 606(a)(1): 

1. Firms routed orders to a clearing firm without creating a Rule 606 report or incorporating, by reference, the clearing firm’s Rule 606 report. 
2. Firms improperly identified routing firms rather than the venues to which they routed orders “for execution” as required by Rule 606(a)(1)(ii). For example, they identified a routing-only broker-dealer as a venue per Rule 606(a)(1)(ii) on the 606 reports and omitted the names of the actual venues to which the routing-only broker-dealer relayed orders for execution. 
3. Firms inaccurately classified order percentages among the four order type categories (market orders, marketable limit orders, nonmarketable limit orders, and other orders), including using conflicting methods to classify order percentages. 
4. Firms disclosed inaccurate amounts of the net aggregate rebates received for each of the four order types. 
5. Firms used incorrect dates for determining the inclusion of a stock in the S&P 500 index. 

Issues raised about material aspects disclosures

The examination staff noted that firms did not disclose the material aspects of their relationship with their routing broker or execution venues as required by Rule 606(a)(1)(iv). As an example, the firms omitted a description of any payment for order flow arrangement and any profit-sharing relationship that may influence their routing decisions. 

Firms’ PFOF arrangements with non-exchange venues did not disclose the specific per share rebates applicable to different sizes and order types under each arrangement. Instead, the examined firms: 

1. Stated generally that they received PFOF 
2. Provided average per share rebates 
3. Used “may receive” when they in fact received PFOF 
4. Relied on references to the remuneration contained in the 606 report tables 
5. Generally stated that they received the same rebate from all market makers 

The staff also noted that firms did not disclose they had arrangements with or provided attestations to venues to route retail orders. Such deficiencies included firms that did not disclose they represented to their routing or executing brokers that they would exclusively provide retail order flow to the routing broker to receive PFOF under arrangements with their routing brokers. 

Firms also did not disclose they had a rebate arrangement and a rebate split with their venues. Such deficiencies included firms that did not disclose the details of PFOF revenue split arrangements with their clearing firm or routing broker. This disclosure is applicable to firms that have PFOF arrangements with their routing brokers even if the firm chooses to adopt by reference the routing brokers’ reports. 

The staff noted that firms did not include newly added venues under Rule 606(a)(1)(ii) despite those venues having PFOF arrangements with the firms. 

Finally, the staff observed that firms did not disclose any material terms of the PFOF arrangements with exchanges or include hyperlinks to exchanges’ fee schedules, which did not describe the firms’ incentive for routing to exchanges along with the quantifiable terms. An exchange’s fee schedule may include many available tiers with different requirements to earn specified rebates. Therefore, as part of the firm’s material aspects discussion, they should describe the specific rebate tier applicable. 

Supervision 

The Rule 606 examinations noted deficiencies regarding FINRA Rule 3110(b)(1) and its requirement to establish or enforce an adequate system of supervisory controls reasonably designed to ensure compliance with Rule 606(a)(1). Specifically: 

1. Firms did not adopt adequate written supervisory procedures (WSPs) and did not sufficiently review the data quality underlying the reports, which led to incorrect disclosures 
2. Firms that rely on outside vendors to produce some or all of the reports failed to appropriately review the accuracy of the report disclosures 

How we help 

We can you to navigate the evolving regulatory landscape while considering the complexity of your firm’s unique compliance requirements. Our Broker-Dealer advisory team advisory team can assist you with developing and maintaining your compliance manual, policies, and procedures for a range of topical challenges, including Regulation NMS Rule 606 disclosures. 

For more information about this risk alert, or to find out how ACA can help you comply with these disclosure requirements, please contact your ACA consultant or contact us here.

^{1 Securities Exchange Act Release No. 34-84528 (Nov. 2, 2018), 83 FR 58338 (Nov. 19, 2018), Final Rule:  Disclosure of Order Handling Information (“Adopting Release”) [https://www.sec.gov/rules/final/2018/34-84528.pdf. 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) Final Rule; Extension of Compliance Date for Certain Requirements [https://www.sec.gov/rules/final/2019/34-85714.pdf].}