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From Securities Regulation Daily, March 8, 2013

SEC Proposes Regulation SCI in Response to Technology Failures

By Matthew Garza, J.D.

The SEC today posted a 377-page rule proposal containing new Regulation Systems Compliance and Integrity (Reg SCI), which is intended to help protect investors from technology systems failures that have troubled the markets in recent years. These events include the May 6, 2010, flash crash, problems with the initial public offerings of Facebook in May 2012 and BATS Global Markets in March 2012, Knight Capital Group's $440-million trading loss in August 2012, cyber attacks on NASDAQ's systems, and Hurricane Sandy, which shut down the markets on October 29 and 30 of 2012. The proposed regulation would codify the SEC's Automation Review Policy and provide a safe harbor for entities and individuals who meet certain requirements (Release No. 34-69077, March 8, 2013).

SCI entities. Proposed Regulation SCI would apply to "SCI entities," defined to include FINRA, MSRB, the registered national securities exchanges, and registered clearing agencies. It would also apply to alternative trading systems that exceed specified volume thresholds, disseminators of market data under certain National Market Systems plans, and certain clearing agencies exempt from SEC registration.

Requirements. The proposal would add Rule 242.1000, which would require SCI entities to establish written policies and procedures reasonably designed to ensure that their systems have levels of capacity, integrity, resiliency, availability, and security adequate to maintain their operational capability and promote the maintenance of fair and orderly markets, and that they operate in the manner intended. It would also require scheduled testing of the operation of business-continuity and disaster-recovery plans, including backup systems, and require the entities to coordinate testing with other SCI entities.

Form SCI. The proposal would also add Form SCI, which would require five separate types of filings. The five types of filings refer to subsections of Rule 242.1000: (1) "SCI events" or "(b)(4)" filings, for notifications regarding systems disruptions, systems compliance issues, or systems intrusions; (2) "(b)(6)" filings, for notifications of planned material systems changes; (3) "(b)(8)(i)" filings, for reports of SCI reviews; (4) "(b)(8)(ii)" filings, for semi-annual reports of material systems changes; and (5) "(b)(9)(iii)" filings, for notifications of designations and standards under Rule 1000(b)(9).

Safe harbor. The rule includes a safe harbor for both SCI entities and individuals. An entity would meet the requirements of the safe harbor if it: (1) tested all SCI systems prior to implementation; (2) did periodic testing of systems; (3) established a system of internal controls over changes to the systems; (4) monitored the functionality the systems; (5) assessed system compliance with applicable federal securities laws and regulations; and (6) reviewed systems design, changes, testing, and controls to detect and address actions that do not comply with applicable federal securities laws and regulations.

A safe harbor is provided for individuals if the person has reasonably discharged their duties and obligations and had no reasonable cause to believe that the policies and procedures were not being complied with in any material respect.

Commissioner's views. SEC Chairman Elisse B. Walter said that "[w]hile it's not possible to prevent every technological error that market participants may commit, we must ensure that our regulations are designed to minimize their impact on our markets and ultimately investors."

Commissioner Aguilar said the proposal wasn't tough enough, specifically criticizing a safe harbor provision included in the rules. "In my view, an unprecedented safe harbor in a rule that does not require clear, identifiable, and meaningful standards, and that does not require policies and procedures to be reviewed by an independent third party and certified by senior officers, will result in a rule proposal that falls short of its goal—which is to ensure that our capital markets develop and maintain appropriate systems," he said.

Commissioner Gallagher praised the safe harbor, saying "[g]iven the amazing complexity of today's trading systems and the myriad laws and rules that touch upon the operation of those systems, the Commission should place its emphasis on encouraging good behavior and adherence to industry standards. Proposed Regulation SCI appropriately focuses on such providing encouragement, rather than on creating a hindsight game of 'gotcha' in which market participants are subjected to strict liability for problems arising in incredibly complex systems notwithstanding their good faith efforts to maintain full compliance with the new rules."

Commissioner Paredes remarked at the open meeting that while Regulation SCI will help to ensure technological continuity, it is unlikely that securities firms operating complex systems will be able to achieve "zero glitches."

Comments are requested by 60 days after the release is published in the Federal Register.

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