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November 13, 2007

OCIE Expands Use of Trade Blotters

By Nina Mehta

Staff examiners at the Securities and Exchange Commission's Office of Compliance Inspections and Examinations are moving into data-crunching mode. OCIE is beginning to standardize its analysis of information in trading blotters in its examinations of investment companies and investment advisers. This is driven by the recognition that the trade blotter "provides staff with a wealth of information," said Gene Gohlke, associate director of OCIE.

OCIE staff have been getting and analyzing trade blotter data for the last five years. What's new is that there's now a "basic set of analysis criteria" across the entire examination program, available through OCIE's internal Web site, "so there could be increased use of the information among staff," Gohlke told Traders Magazine. Previously, all staff examiners did not have access to the same methodologies and could choose to analyze trading blotters in different ways.

What Gohlke called the "electronic file" or "electronic download" is vital in the inspection process. "We run a variety of tests against that electronic file-looking for patterns [and] for trades that seem aberrant," he told attendees at a recent Investment Company Institute conference in New York. OCIE now has at least a dozen basic "standardized routines" it runs on the electronic file to analyze trading information.

One of OCIE's current tests focuses on cross-trading activity among the clients of an investment adviser or among funds within a group. Gohlke said examiners use the blotter to search for patterns such as whether certain funds are typically buyers in cross trades, and whether those funds usually realize a loss when the positions are disposed of down the road. The concern is that some funds may be "dumping securities" or selling securities well above market prices.

A blotter test OCIE added in the last year revolves around an adviser's most profitable trades during the inspection period. Examiners look at the 10 most profitable positions within each investment style, and map the initial trades to public announcements by those issuers. If six or seven trades were put on right before a significant announcement, Gohlke said, that may suggest "significant information coming into the firm." In those cases, examiners will investigate how, by whom and under what circumstances the investment decision was made to determine if "inappropriate action" occurred.

Another OCIE test focuses on commission rates. OCIE staff look at all the trades placed for an adviser's clients during a yearlong period. After ranking the brokers by their average commission rate, they look for those with rates "significantly above" the others, and examine why those brokers were paid more on average, according to Gohlke. He noted that there may be reasons for a higher rate, such as bundled research arrangements or client referral relationships. But in some cases, those differences may require more disclosure to clients and perhaps some "remedial action."

OCIE staff also use the blotter to flush out "portfolio pumping" and "window dressing," Gohlke said. The former refers to efforts to jack up fund performance right before a reporting date, while the latter refers to alterations in a portfolio's composition or strategy just before a reporting date. The SEC has long considered both deceptive practices that compromise market integrity.

Gohlke noted that investment advisers may want to consider running tests on their portfolios in advance of OCIE examinations to assess trading practices and identify behavior that might warrant further attention. "That would be really a great solution, but we don't see it very often," he said. He added that OCIE will consider weaving a discussion of various tests into regional meetings and seminars for compliance officers.