Corporate Finance & Securities

Basics of Broker-Dealer Regulation

New York Stock ExchangeGenerally speaking, broker-dealers are people that are in the business of buying and selling securities or in the business of helping others buy and sell securities. Brokers and dealers are subject to extensive regulation by the Securities Exchange Commission and state regulators.

The broker-dealer regulations are designed to make sure that people in the business of buying and selling securities meet professional standards, have adequate capital, and provide adequate disclosures to investors.

What is a broker?

The Exchange Act, in Section 3(a)(4)(A), defines a broker as any person or company that is engaged in the business of effecting transactions in securities for the account of others. This definition is analyzed in three parts. A broker must:

  1. be “engaged in the business,”
  2. of “effecting transactions in securities”
  3. “for the account of others.”

The Exchange Act does not define what it means to be “engaged in the business,” or “effecting transactions.” Courts apply a facts and circumstances test (meaning there’s not a bright-line rule), and the courts have generally taken an expansive view of these terms (meaning they err on the side of inclusion).

What does it mean to be effecting transactions?

A person or company “effects transactions in securities” if he or she or it participates in transactions “at key points in the chain of distribution.” That participation may include:

  • assisting with the structuring of securities offerings
  • helping a company issuing securities to identify potential investors
  • screening potential investors
  • soliciting investment in securities
  • negotiating terms between the company and the investor
  • giving advice on the merits of an investment
  • facilitating the execution of securities agreements
  • handling the funds or securities of an investor or a company issuing securities
  • preparing and sending transaction confirmations

Not all factors are equal–for example you are more likely to be a broker if you structure and negotiate transactions than you are if you only prepare and send transaction confirmations.

New York Stock Exchange Trading FloorWhat does it mean to be in the business of effecting transactions in securities?

Generally, people or companies must regularly purchase and sell securities to be a broker. There are two primary factors in determining whether there is the requisite “regularity of business” to be a broker:

  1. The number of transactions and clients; and
  2. The dollar amount of securities sold.

Other relevant but less important factors include (3) whether investors were solicited or advertised to; (4) whether the potential broker receives transaction-related compensation; and (5) whether the person or company holds itself out to the public as a broker, as someone who executes securities trades, or who assists others in settling securities transactions. But, none of these factors is by itself determinative.

In a 1995 no-action letter, the SEC said “if the securities activities are engaged in for commissions or other compensation with sufficient recurrence to justify the inference that the activities are part of the person’s business, he will be deemed to be engaged in the business.” The no-action letter spells out the rule  (there needs to be sufficient recurrence of the securities activities they receive compensation for), but there’s still a sizable gray area: what is sufficient recurrence?

What is a dealer?

The Exchange Act, in Section 3(a)(5)(A), defines a “dealer” as a person or company engaged in the business of buying and selling securities for their own account. This definition is analyzed in two parts:

  1. Whether a person or company is “buying and selling securities for its own account,” and
  2. Whether a person is engaged in that activity as part of a regular business.

To be a dealer, a person or company has to both buy and sell securities. Generally, a dealer buys securities from customers for its own inventory, and then sells those securities back to customers. This can be distinguished from “traders” who buy and sell securities for their own investment accounts and do not carry on a public securities business. Whether someone is a trader or a dealer can be a close call. This is also a facts and circumstances test. The SEC, in its no action letters, have noted many factors which may be important. If a person does any of the following he or she would be more likely to be considered a dealer:

  • issues securities
  • has a regular clientele
  • advertises his or herself to be  buying and selling securities on a regular basis
  • actively solicits clients
  • has a regular inventory turnover
  • provides liquidity services in transactions with investors

A person is more likely to be considered a trader if he or she does the following:

  • does not buy and sell securities simultaneously
  • has a substantial part of its business which is not engaging in securities activities
  • does not handle others’ money or securities
  • only engages in securities transactions with registered broker dealers

What do you have to do if you are a broker-dealer?

If you’re a broker-dealer, you’re generally subject to a multitude of state and federal regulations. As an initial matter, you’ll have to go through a lengthy and expensive registration process. Once you’re registered you’ll have to meet competency requirements, become a member of FINRA, be subject to investigations, comply with net capital requirements and customer protection regulation, and keep detailed records including financial records. You’ll also need to have policies in place to prevent insider trading and over extension of credit.

You can find the SEC’s guide to broker-dealer registration here.

You can find information on broker-dealer registration for the state of Washington here.

Bad ThingsWhat happens if you’re a broker dealer that doesn’t comply with registration requirements?

The short answer: bad things. More specifically, you may find yourself facing:

  • cease-and-desist orders from the SEC or state regulators
  • court injunctions to cease your activities
  • civil penalties including fines and disgorgement (disgorgement is a fancy word for taking back ill-gotten gains)
  • criminal liability
  • rescission claims from investors (a common remedy for investors is to be able to get their money back from those they did business with that didn’t comply with securities regulations–this remedy is called rescission)
  • harm to reputation and brand

If you think you might be subject to broker-dealer registration, or if you want to find out more about regulation of brokers and dealers, feel free to contact us at 206-745-5229 or send us an email at team@invigorlaw.com.

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Kyle Hulten

When I'm not in the office I enjoy cooking, gardening, and watching my toddler son explore his little universe.


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