Tag Archives: registration

Hedge Fund Law Blog Notes For Week

Adviser Registration, Accredited Investors, Carried Interest, Insider Trading, Cap and Trade

Below are some thoughts on some of the major issues over the last couple of weeks.

Have a great Memorial Day Weekend!


Hedge Fund Regulation and Registration – While the Private Fund Investment Advisers Registration Act of 2010 was passed this month in the Senate, there has not been as much discussion in the news about this issue and manager registration.  I expected that we would hear more, especially with regard to the following issues:

  • Section 407 – Exemption of VC Funds
  • Section 408 – Exemption from Reporting Requirements for Private Equity Funds
  • Section 410 – State Authority for Managers with AUM of up $100MM (this is generally a bad idea in my opinion and we will be writing a post about this soon…)
  • Section 412 – Adjusting Definition of Accredited Investor (see also below)

I imagine we will hear more as the Senate and House begin to reconcile their two bills and before President Obama signs the final Financial Reform bill into law, which some think may happen before the July 4th holiday.


Definition of Accredited Investor – The Senate version of the Financial Reform bill will change the definition of an “accredited investor” in the future.  Generally “accredited investors” are those individuals with a net worth of $1,000,000.  Under current regulations, individuals can include the equity in their private residence when determining their net worth.  In the future, they will need to exclude the equity in their private residence when determining their net worth.  This potentially may have a deleterious effect on the hedge fund industry, but also on other industries which rely on private placements.

According to some sources, at least one Senator is asking that the definition of accredited investor be expanded to include state and local governments.  I agree with this approach – if the Senate is taking the time to mess with the definition right now then the Senate should spend a little time addressing other issues.  For instance, the definition of accredited investor should also be expanded to include Native American Tribes.  I have specifically talked with the SEC staff about this issue a couple of years ago and they have categorically refused to issue a no-action or other interpretive release on this issue – we believe that now is the time to include Native American Tribes in the definition of accredited investor.

For more information, please see the Native American Capital, LP policy briefing and the National Congress of American Indians letter to the SEC on this issue.

See also Perkins Coie discussion of this issue.


Carried-Interest Issue -it looks like the carried interest tax laws will be changing in 2011.  In addition to hedge fund managers, managers to other pooled investment vehicles will be greatly affected (such as VC and private equity fund managers, as well as real estate fund managers).  The change in the laws will likely affect more VC and PE managers than hedge fund managers because of the nature of the underlying gains in the respective investment vehicles (VC and PE fund managers typically have mostly long term capital gains and hedge fund managers may have a combination of long term and short term capital gains).  There is likely to be a large number of industry groups which come out in opposition to the changes in the next couple of weeks.

We do not agree with the proposed changes – it seems as though Congress is specifically attacking an easy target  in the investment management community.


Insider Trading Issue – just today the SEC announced an insider trading case brought against a hedge fund manager Pequot Capital Management, Inc., and its Chairman and CEO Arthur Samberg.  This issue has been thoroughly discussed most recently after the Galleon affair.  Hedge funds managers and compliance personnel need to be even more vigilant about establishing comprehensive compliance programs and making sure that traders are not engaging in insider trading.  Please see our previous thoughts on Hedge Funds and Insider Trading.


Green Tech/ Cap and Trade – clean and green tech continue to gain traction in the investment management industry as a bill which would create federal carbon cap and trade system was introduced recently.  Next weekend the South Asian Bar in San Francisco will have a panel discussion. entitled “Green 2 Green: Carbon Credits, Renewable Energy Certificates and the New Markets driving the Clean Energy Economy”.  According to the program,

Attendees will receive a quick primer on market-based regulatory responses to climate change designed to foster the development of renewable power plants and spur long term investment in clean and sustainable energy. Panelists will address state and federal legislation setting green house gas emission caps, establishing renewable portfolio standards, and creating new markets for carbon credits and renewable energy certificates. We’ll discuss the regulatory origins and key characteristics of these and other green commodities, as well as the structure and rules of markets created to transition industry and consumers from the present carbon economy toward tomorrow’s clean energy economy.

Mallon P.C. will be represented at the panel discussion so please come and talk to us there.


Other related hedge fund law articles:

Cole-Frieman & Mallon LLP works with many managers who invest in various commodities and with groups who work in the clean tech space.  Mallon P.C. is a top hedge fund law firm which provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Obama Moves Forward with Hedge Fund Registration Legislation

Bart Mallon, Esq.

Treasury Announces New “Private Fund Investment Advisers Registration Act of 2009”

After much discussion in the press over the last 8 to 10 months abut the possibility for hedge fund registration, the Treasury today announced the Obama Administration’s bill which requires managers to “private funds” to register with the SEC.  This registration requirement would apply to managers of all funds relying on the Section 3(c)(1) or Section 3(c)(7) which includes managers to private equity and venture capital funds.  Additionally, all registered managers would need to provide the SEC with certain reports on the funds which they manage.

The Treasury release is below and can be found here.  We will post the text of the new act shortly.  [Update: we have just published the text of the Private Fund Investment Advisers Registration Act of 2009.]


Fact Sheet: Administration’s Regulatory Reform Agenda Moves Forward: Legislation for the Registration of Hedge Funds Delivered to Capitol Hill

Continuing its push to establish new rules of the road and make the financial system more fair across the board, the Administration today delivered proposed legislation to Capitol Hill to require all advisers to hedge funds and other private pools of capital, including private equity and venture capital funds, to register with the Securities and Exchange Commission (SEC). In recent years, the United States has seen explosive growth in a variety of privately-owned investment funds, including hedge funds, private equity funds, and venture capital funds. At various points in the financial crisis, de-leveraging by such funds contributed to the strain on financial markets.  Because these funds were not required to register with regulators, the government lacked the reliable, comprehensive data necessary to monitor funds’ activity and assess potential risks in the market.  The Administration’s legislation would help protect investors from fraud and abuse, provide increased transparency, and provide the information necessary to assess whether risks in the aggregate or risks in any particular fund pose a threat to our overall financial stability.

Protect Investors From Fraud And Abuse

Require Advisers To Private Investment Funds to Register With The SEC.  Although some advisers to hedge funds and other private investment funds are required to register with the Commodity Futures Trading Commission (CFTC), and some register voluntarily with the SEC, current law generally does not require private fund advisers to register with any federal financial regulator. The Administration’s legislation would, for the first time, require that all investment advisers with more than $30 million of assets under management to register with the SEC.  Once registered with the SEC, investment advisers to private funds will be subject to important requirements such as:

  • Substantial regulatory reporting requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised private funds
  • Disclosure requirements to investors, creditors, and counterparties of their advised private funds
  • Strong conflict-of-interest and anti-fraud prohibitions
  • Robust SEC examination and enforcement authority and recordkeeping requirements
  • Requirements to establish a comprehensive compliance program

Require Increased Disclosure Requirements. The Administration’s legislation would require that all investment funds advised by an SEC-registered investment adviser be subject to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements.

Protect Financial System From Systemic Risk

Monitor Hedge Funds For Potential Systemic Risk. Under the Administration’s legislation, the regulatory requirements mentioned above would include confidential reporting of amount of assets under management, borrowings, off-balance sheet exposures, counterparty credit risk exposures, trading and investment positions, and other important information relevant to determining potential systemic risk and potential threats to our overall financial stability. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk. In addition, the SEC would share the disclosure reports received from funds with the Federal Reserve and the Financial Services Oversight Council. This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to our overall financial stability and should therefore be supervised and regulated as Tier 1 Financial Holding Companies.


Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions.  If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510.  Other related hedge fund law articles include:

Hedge Fund Registration Quick Facts

Hedge Fund Transparency Act of 2009 Overview

This article provides an overview of the major provisions of the Hedge Fund Transparency Act of 2009.  There are two major things that the HFTA does: (1) increases regulation of hedge funds under the Investment Company Act and (2) requires hedge funds to adopt anti-money laundering programs.

Changes under the Investment Company Act

The HFTA replaces Section 3(c)(1) of the Investment Company Act  with a new Section 6(a)(6).  Section 3(c)(7) is replaced by new Section 6(a)(6).  These new sections, which are functionally equivalent to Section 3(c)(1) and Section 3(c)(7) respectively, will exempt hedge funds from the mutual fund regulations that are found in the Investment Company Act, provided that the hedge funds comply with the provisions of Section 6(g).

Section 6(g) applies to hedge funds with assets under management (AUM) of $50 million or more.  Those hedge funds which have less than $50 million of AUM will not be subject to Section 6(g).  Section 6(g) requires:

1.  The hedge fund manager to register with the SEC.  (HFLB note: I believe the statute is not clearly written.  It seems that the hedge fund itself would be required to register with the SEC which does not make sense.)

2.  Maintain certain books and records as required by the SEC.  This requirements is likely to look like the current books and records rule of the Investment Advisors Act (Rule 204-2), for more background please see article on Investment Advisor Compliance Information.

3.  Cooperate with the SEC with regard to any request for information or examination.

4.  File the following information with the SEC on a no less than annual basis:

a.  The name and current address of each investor in the fund.

b.  The name and current address of the primary accountant and broker of the fund.

c.  An overview of the fund’s ownership structure.

d.  An overview of the fund’s affiliations, if any, with financial institutions.

e.  A statement of the fund’s terms (i.e. minimum investment).

f.  Other information including the total number of investors and the current value of the fund’s assets.

The SEC is charged with issuing forms and guidance on the implementation of the above.  Such forms and guidance must be issued within 180 days from the enactment of the HFTA.

New AML Requirements

The HFTA requires the Secretary of the Treasury (in consultations with the Chairman of the SEC and the Chairman of the CFTC) to establish AML requirements for hedge funds.  The bill sets aggressive timelines for drafting and implementation of the rules.

Hedge Fund Transparency Act Analysis

In the current politically charged environment it is not surprising that a hedge fund regulation law is being contemplated.  What is interesting, however, is the way that Grassley and Levin have chosen to regulate hedge funds.  The prior hedge fund registration rule, promulgated by the SEC, was enacted under the Investment Advisors Act – in essence requiring hedge fund managers (and not the hedge fund itself) to register as Investment Advisors with the SEC.  The Hedge Fund Transparency Act does not follow this path – instead, it regulates hedge funds under the Investment Company Act by modifying the current exemptions which hedge funds enjoy under the act.  In essence the changes subject hedge funds to a kind of light version of the mutual fund regulations.  In this way Congress is going past previous registration by regulating the hedge fund vehicle, as well as the hedge fund management company through the registration requirement.

While it is no surprise that regulation and registration has reached the hedge fund industry, one aspect of the bill is surprising.  The act would require hedge funds to disclose the names and addresses of each investor in the fund.  These names and addresses would be made available to the general public through an electronic searchable format to be developed by the SEC.  Hedge fund investors are notoriously protective of their privacy and I cannot imagine that there will not be pushback by the hedge fund industry on this point.

Another consequence of investment advisor registration is that hedge fund managers (if not currently regulated by the state in which their business resides) may be subject to certain state investment advisory rules including a “notice” filing requirement.  Depending on the nature of the management company’s business, some employees may need to register as investment advisor representatives at the state level which generally requires an employee to have passed the Series 65 exam.  We will keep you updated on this possibility as we learn more about the HFTA over time.


Please contact us if you have any questions releted to this post or registering your management company as an investment advisor with the SEC.  Other related posts include:

Hedge Fund Registration Bill Announced

Senators Grassley and Levin Introduced Bill Requiring Hedge Fund Registration

A new bill called the Hedge Fund Transparency Act was introduced today by Senators Chuck Grassley and Carl Levin.  A press release from Grassley’s website explains the bill.

More to be forthcoming…


For Immediate Release
January 29, 2009

Grassley and Levin introduce hedge fund transparency bill

WASHINGTON – Senators Chuck Grassley and Carl Levin introduced legislation today to close a loophole in securities law that allows hedge funds to operate under a cloak of secrecy.

The Hedge Fund Transparency Act of 2009 would clarify current law to remove any doubt that the Securities and Exchange Commission has the authority to require hedge funds to register, so the government knows who they are and what they’re doing. It would close the loophole previously used by hedge funds to escape the definition of an “investment company” under the Investment Company Act of 1940. Hedge funds that want to avoid the requirements of the Investment Company Act would be exempt only if they file basic disclosure forms and cooperate with requests for information from the Securities and Exchange Commission.

“There wasn’t much of an appetite for this sort of legislation before the financial crisis. I hope attitudes have changed and that Congress takes up this important legislation without delay,” Grassley said. “A major cause of the current crisis is a lack of transparency. The wizards on Wall Street figured out a million clever ways to avoid the transparency sought by the securities regulations adopted during the 1930s. Instead of the free flow of reliable information that markets need to function properly, today we have confusion and uncertainty fueling an economic crisis.” The bill introduced today is a version of legislation filed in two years ago by Grassley (S.1402) but never considered by Congress.

“Hedge funds control massive sums of money, and although they can cause serious damage to investors, other financial firms, and to the entire U.S. financial market, they are largely unregulated,” said Levin. “If the events of the last year have taught us anything, it’s that we need to regulate firms that are big enough to destabilize our economy if they fail. It’s time to subject financial heavyweights like hedge funds to federal regulation and oversight to protect our investors, markets, and financial system.”

Grassley said that Levin made an important addition to the transparency legislation in making clear that hedge funds have the same obligations under our money laundering statutes as other financial institutions. The bill introduced today would require hedge funds to establish anti-money laundering programs and report suspicious transactions.

The senators said their legislation is needed because of a 2006 decision by the D.C. Circuit Court of Appeals which overturned a regulation imposed by the Securities and Exchange Commission requiring hedge funds to register. The court said the Securities and Exchange Commission was going beyond its statutory authority and effectively ended all mandatory registration of hedge funds with the Securities and Exchange Commission unless and until Congress takes action.

A summary of the legislation introduced today and floor statements by Grassley and Levin are below. The text of the bill is posted here. The bill will be referred to the Senate Committee on Banking, Housing and Urban Affairs.

Hedge Fund Transparency Act of 2009

Background: This bill is a revised version of S. 1402, which Sen. Grassley introduced in the 110th Congress. While the previous bill amended the Investment Advisers Act of 1940, this bill amends the Investment Company Act of 1940 (“ICA”). However, the purpose is the same: to make it clear that the Securities and Exchange Commission has the authority to require hedge fund registration. This version also adds a provision authored by Sen. Levin to require hedge funds to establish anti-money laundering programs and report suspicious transactions.

Hedge Fund Registration Requirements

Definition of an Investment Company: Hedge Funds typically avoid regulatory requirements by claiming the exceptions to the definition of an investment company contained in §3(c)(1) or §3(c)(7) of the ICA. This bill would remove those exceptions to the definition, transforming them to exemptions by moving the provisions, without substantive change, to new sections §6(a)(6) and §6(a)(7) of the ICA.

Requirements for Exemptions: An investment company that satisfies either §6(a)(6) or §6(a)(7) will be exempted from the normal registration and filing requirements of the ICA.  Instead, a company that meets the criteria in §6(a)(6) or §6(a)(7) but has assets under management of $50,000,000 or more, must meet several requirements in order to maintain its exemption. These requirements include:

1.     Registering with the SEC.

2.     Maintaining books and records that the SEC may require.

3.     Cooperating with any request by the SEC for information or examination.

4.     Filing an information form with the SEC electronically, at least once a year. This form must be made freely available to the public in an electronic, searchable format. The form must include:

a.      The name and current address of each individual who is a beneficial owner of the investment company.

b.     The name and current address of any company with an ownership interest in the investment company.

c.      An explanation of the structure of ownership interests in the investment company.

d.     Information on any affiliation with another financial institution.

e.      The name and current address of the investment company’s primary accountant and primary broker.

f.      A statement of any minimum investment commitment required of a limited partner, member, or investor.

g.     The total number of any limited partners, members, or other investors.

h.     The current value of the assets of the company and the assets under management by the company.

Timeframe and Rulemaking Authority: The SEC must issue forms and guidance to carry out this Act within 180 days after its enactment. The SEC also has the authority to make a rule to carry out this Act.

Anti-Money Laundering Obligations: An investment company exempt under §6(a)(6) or §6(a)(7) must establish an anti-money laundering program and report suspicious transactions under 31 U.S.C.A 5318(g) and (h). The Treasury Secretary must establish a rule within 180 days of the enactment of the Act setting forth minimum requirements for the anti-money laundering programs. The rule must require exempted investment companies to “use risk-based due diligence policies, procedures, and controls that are reasonably designed to ascertain the identity of and evaluate any foreign person that supplies funds or plans to supply funds to be invested with the advice or assistance of such investment company.” The rule must also require exempted investment companies to comply with the same requirements as other financial institutions for producing records requested by a federal regulator under 31 U.S.C. 5318(k)(2).

Floor Statement of Senator Chuck Grassley of Iowa

Thursday, January 29, 2009

Mr. President, three years ago, I started conducting oversight of the SEC. That oversight began in response to a whistleblower that came to my office complaining that SEC supervisors were impeding an investigation into a major hedge fund. Soon afterward, I came to this floor to introduce an important piece of legislation based on what I learned from my oversight. The bill was aimed at closing a loophole in our securities laws that allows hedge funds to operate under a cloak of secrecy. Unfortunately, that bill, S. 1402, was never taken-up by the Banking Committee in the last Congress.

In light of the current instability in our financial system, I think it is critical for the Senate to deal with this issue in the near future. Therefore, I am pleased that Senator Levin and I worked together to produce an even better version of the bill for the 111th Congress, which we are introducing today.

This new bill, the Hedge Fund Transparency Act, does everything the previous version did and a bit more. Like the previous version, it clarifies current law to remove any doubt that the Securities and Exchange Commission (SEC) has the authority to require hedge funds to register, so the government knows who they are and what they’re doing. It removes the loophole previously used by hedge funds to escape the definition of an “investment company” under the Investment Company Act of 1940.

Under this legislation, hedge funds that want to avoid the stringent requirements of the Investment Company Act will only be exempt if: one, they file basic disclosure forms and two, cooperate with requests for information from the Securities and Exchange Commission.

I want to thank Senator Levin for not only co-sponsoring this legislation, but also contributing a key addition to this new version of the bill. In addition to requiring basic disclosure, this version also makes it clear that hedge funds have the same obligations under our money laundering statutes as other financial institutions. They must report suspicious transactions and establish anti-money laundering programs.

One major cause of the current crisis is a lack of transparency. Markets need a free flow of reliable information to function properly. Transparency was the focus of our system of securities regulations adopted in the 1930’s. Unfortunately, over time, the wizards on Wall Street figured out a million clever ways to avoid transparency. The result is the confusion and uncertainty fueling the crisis we see today.

This bill is an important step toward renewing the commitment to transparency on Wall Street. Unfortunately, there was not much of an appetite for this sort of common sense legislation when I first introduced it before the financial crisis erupted. Hopefully, attitudes have changed given all that has happened since the collapse of Bear Stearns last March.

Hedge funds are pooled investment companies that manage billions of dollars for groups of wealthy investors in total secrecy. Hedge funds affect regular investors. They affect the markets as a whole. My oversight of the SEC convinces me that the Commission needs much more information about the activities of hedge funds in order to protect the markets. Any group of organizations that can wield hundreds of billions of dollars in market power every day should be transparent and disclose basic information about their operations to the agency that Americans rely on as their watchdog for our nations’ financial markets.

As I explained when I first introduced this bill, the SEC already attempted to oversee the hedge fund industry by regulation. Congress needs to act now because of a decision by a federal appeals court. In 2006, the D.C. Circuit Court of Appeals overturned an SEC administrative rule requiring the registration of hedge funds. That decision effectively ended all registration of hedge funds with the SEC, unless and until Congress takes action.

The Hedge Fund Transparency Act would respond to that court decision by: 1. including hedge funds in the definition of an investment company and 2. Bringing much needed transparency to this super secretive industry.

The Hedge Fund Transparency Act is a first step in ensuring that the SEC has clear authority to do what it already tried to do. Congress must act to ensure that our laws are kept up to date as new types of investments appear.

Unfortunately, this legislation hasn’t had many friends. These funds don’t want people to know what they do or who participates in them. They have fought hard to keep it that way. Well, I think that’s all the more reason to shed some sunlight on them to see what they’re up to.

I urge my colleagues to co-sponsor and support this legislation, as we work to protect all investors, large and small.

Mr. President, I yield the floor.

Floor Statement of Senator Carl Levin of Michigan (as prepared)

Thursday, January 29, 2009

Mr. President, history has proven time and again that markets are not self-policing. Today’s financial crisis is due in part to the government’s failure to regulate key market participants, including hedge funds that have become unregulated financial heavyweights in the U.S. economy. That’s why I am joining today with my colleague Senator Grassley to introduce The Hedge Fund Transparency Act.

Hedge funds sound complicated, but they are simply private investment funds in which the investors have agreed to pool their money under the control of an investment manager. What distinguishes them from other investment funds is that hedge funds are typically open only to “qualified purchasers,” an SEC term referring to institutional investors like pension funds and wealthy individuals with assets over a specified minimum amount. In addition, most hedge funds have one hundred or fewer beneficial owners. By limiting the number of their beneficial owners and accepting funds only from investors of means, hedge funds have been able to qualify for the statutory exclusions provided in Sections 80a-3(c)(1) and (7) of the Investment Company Act, and avoid the obligation to comply with that law’s statutory and regulatory requirements. In short, hedge funds have been able to operate outside the reach of the SEC.

The primary argument for allowing these funds to operate outside SEC regulation and oversight is that, because their investors are generally more experienced than the general public, they need fewer government protections and their investment funds should be permitted to take greater risks than investment funds open to the investing public which needs greater SEC protection. Indeed, the ability of hedge funds to take on more risk is the reason that many individuals and institutions choose to invest in them. These investors accept more risk because that might lead to bigger rewards.

The compensation system employed by most hedge funds encourages that risk taking. Typically, investors agree to pay hedge fund investment managers a management fee of 2 percent of the fund’s total assets, plus 20 percent of the fund’s profits. The hedge fund managers profit enormously if the fund does well, but due to the guaranteed management fee, get a hefty payment even when the fund underperforms or fails. The analysis up to now has been that if wealthy people want to take big risks with their money, all else being equal, they should be allowed to do so without the safeguards normally required for the general public. So what’s the problem with allowing their investment funds to operate outside federal regulation and oversight?

The problem is that hedge funds have gotten so big and are so entrenched in U.S. financial markets, that their actions can now significantly impact market prices, damage other market participants, and can even endanger the U.S. financial system and economy as a whole.

The systemic risks posed by hedge funds first became obvious ten years ago, in 1998. Back then, Long-Term Capital Management (LTCM) was a hedge fund that, at its peak, had more than $125 billion in assets under management and, due to massive borrowing, a total market position of roughly $1.3 trillion. When it began to falter, the Federal Reserve worried that it might unload its assets in a rush, drive down prices, and end up damaging not only other firms, but U.S. markets as a whole. To prevent a financial meltdown, the Federal Reserve worked with the private sector to engineer a rescue package.

That was just over a decade ago. Since then, according to a recent report issued by the Congressional Research Service, the hedge fund industry has expanded roughly tenfold. In 2006, the SEC testified that hedge funds represented 5 percent of all U.S. assets under management, and 30 percent of all equity trading volume in the United States. By 2007, an estimated 8,000 hedge funds were managing assets totaling roughly $1.5 trillion. The most current estimate is that 10,000 hedge funds are managing approximately $1.8 trillion in assets, after suffering losses over the last year of over $1 trillion.

In addition, over the last ten years, billions of dollars being managed by hedge funds have been provided by pension plans. A 2007 report by the U.S. Government Accountability Office (GAO) found that the amount of money that defined-benefit pension plans have invested in hedge funds has risen from about $3.2 billion in 2000, to more than $50 billion in 2006. That total is probably much higher now. And while most individual pension plans invest only a small slice of their money in hedge funds, a few go farther. For example, according to the GAO report, as of September 2006, the Missouri State Employees Retirement System had invested over 30 percent of its assets in hedge funds. Universities and charities have also directed significant assets to hedge funds. The result is that hedge fund losses threaten every economic sector in America, from the wealthy to the working class relying on pensions to our institutions of higher learning to our non-profit charities.

A third key development is that, over the last ten years, some of the largest U.S. banks and securities firms have set up their own hedge funds and used them to invest not only client funds, but also their own cash. In some cases, these hedge funds have commingled client and institutional funds and linked the fate of both to high-risk investment strategies. These hedge fund affiliates are typically owned by the same holding companies that own federally insured banks or federally regulated broker-dealers.

Because of their ownership, size and reach, their clientele, and the high-risk nature of their investments, the failure of a hedge fund today can imperil not only its direct investors, but also the financial institutions that own them, lent them money, or did business with them. From there, the effects can ripple through the markets and impact the entire economy.

Take, for example, the June 2007 collapse of two offshore hedge funds established by Bear Stearns. Those two hedge funds were not particularly large, but were heavily invested in complex financial instruments tied to subprime mortgages. When the housing market weakened and mortgage-backed securities lost value, it wasn’t just the hedge funds that suffered losses. It was also a number of large financial institutions which had lent them money or entered into business transactions with them, including its parent company, Bear Stearns.

As Bear Stearns began reporting losses and market confidence in the firm began dropping, the Federal Reserve and Treasury Department helped broker a deal allowing JPMorgan Chase to purchase the company. As part of that deal, the government agreed to take over $30 billion in troubled assets off the books of Bear Stearns, hiring an asset manager and putting taxpayers on the hook for them financially.

But the problems didn’t stop there. Another financial institution, Merrill Lynch, had invested in the Bear Stearns hedge funds and also suffered losses. Those losses, when added to others, so damaged the company’s bottom line that, despite a promise of $10 billion in new capital from the Troubled Asset Relief Program or TARP, Merrill Lynch was viewed by the market as teetering on the brink of collapse.  With the government’s encouragement, Bank of America stepped in and bought the company. As the extent of the Merrill Lynch losses became apparent, Bank of America itself began to lose market confidence. To counteract the Merrill Lynch losses, Bank of America wound up taking billions more taxpayer dollars under the TARP Program.

In the meantime, two managers of the Bear Stearns hedge funds were arrested on charges of conspiracy, securities fraud, and wire fraud. Their cases have yet to go to trial. But prosecutors allege that as the hedge funds were losing value, their managers were telling investors a very different story. “[B]elieve it or not,” one of the financiers allegedly wrote in an e-mail to a colleague, “I’ve been able to convince people to add more money.”

The two Bear Stearns hedge funds offer a sobering set of facts, but they represent only a small part of the story. Other hedge funds are contracting or folding as clients demand their money back. To meet client demands, hedge funds are selling lots of assets, further weakening stock and bond prices. As one leading hedge fund owner, George Soros, testified before Congress in November: “It has to be recognized that hedge funds were … an integral part of the bubble which now has burst.”

Add on top of all that the Madoff scandal, and you’ve got to ask how anyone in their right mind could believe that the current regulatory exemption for hedge funds makes sense.

Four years ago, the Securities and Exchange Commission (SEC) tried on its own to beef up its regulation of hedge funds. In December 2004, the SEC issued a rule requiring hedge funds to register under the Investment Advisers Act, comply with the related regulations, and file a public disclosure form with basic information. The rule took effect on February 1, 2006, and by June 2006, over 2,500 hedge fund advisers had registered with the Commission. However, on June 23, 2006, the U.S. Court of Appeals for the District of Columbia Circuit vacated the SEC rule on the basis that it was not compatible with the Investment Advisers Act. Despite the SEC’s asserting in the case reasons why hedge funds necessitated greater federal regulation and oversight, no further effort was made by either the SEC or the Congress to step into the breach.

As SEC Commissioner Luis Aguillar stated in a speech on January 9, 2009, the SEC “currently lacks tools in the hedge fund arena to provide effective oversight and supervision.”

It is time for Congress to step into the breach and establish clear authority for federal regulation and oversight of hedge funds.

That is the backdrop for the introduction of the Grassley-Levin Hedge Fund Transparency Act. The purpose of this bill is to institute a reasonable and practical regulatory regime for hedge funds.

The bill contains four basic requirements to make hedge funds subject to SEC regulation and oversight. It requires them to register with the SEC, to file an annual disclosure form with basic information that will be made publicly available, to maintain books and records required by the SEC, and to cooperate with any SEC information request or examination.

The information to be made available to the public must include, at a minimum, the names of the companies and natural individuals who are the beneficial owners of the hedge fund and an explanation of the ownership structure; the names of any financial institutions with which the hedge fund is affiliated; the minimum investment commitment required from an investor; the total number of investors in the fund; the name of the fund’s primary accountant and broker; and the current value of the fund’s assets and assets under management. This information is similar to what was required in the disclosure form under the SEC’s 2004 regulatory effort. The bill also authorizes the SEC to require additional information it deems appropriate.

In addition, the bill directs Treasury to issue a final rule requiring hedge funds to establish anti-money laundering programs and, in particular, to guard against allowing suspect offshore funds into the U.S. financial system. The Bush Administration issued a proposed anti-money laundering rule for hedge funds seven years ago, in 2002, but never finalized it. A 2006 investigation by the Permanent Subcommittee on Investigations, which I chair, showed how two hedge funds brought millions of dollars in suspect funds into the United States, without any U.S. controls or reporting obligations, and called on a bipartisan basis for the proposed hedge fund anti-money laundering regulations to be finalized, but no action was taken. Hedge funds are the last major U.S. financial players without anti-money laundering obligations, and it is time for this unacceptable regulatory gap to be eliminated.

Our bill imposes a set of basic disclosure obligations on hedge funds and makes it clear they are subject to full SEC oversight while, at the same time, exempting them from many of the obligations that the Investment Company Act imposes on other types of investment companies, such as mutual funds that are open for investment by all members of the public. The bill imposes a more limited set of obligations on hedge funds in recognition of the fact that hedge funds do not open their doors to all members of the public, but limit themselves to investors of means. The bill also, however, gives the SEC the authority it needs to impose additional regulatory obligations and exercise the level of oversight it sees fit over hedge funds to protect investors, other financial institutions, and the U.S. financial system as a whole.

The bill imposes these requirements on all entities that rely on Sections 80a-3(c)(1) or (7) to avoid compliance with the full set of the Investment Company Act requirements. A wide variety of entities invoke those sections to avoid those requirements and SEC oversight, and they refer to themselves by a wide variety of terms – hedge funds, private equity funds, venture capitalists, small investment banks, and so forth. Rather than attempt a futile exercise of trying to define the specific set of companies covered by the bill and thereby invite future claims by parties that they are outside the definitions and thus outside the SEC’s authority, the bill applies to any investment company that has at least $50 million in assets or assets under its management and relies on Sections 80a-3(1) or (7) to avoid compliance with the full set of Investment Company Act requirements. Instead, those companies under the bill have to comply with a reduced set of obligations, which include filing an annual public disclosure form, maintaining books and records specified by the SEC, and cooperating with any SEC information request or examination.

Finally, our bill makes an important technical change. It moves paragraphs (c)(1) and (7) – the two paragraphs that hedge companies use to avoid complying with the full set of Investment Act Company requirements — from Section 80a-3 to Section 80a-6 of the Investment Company Act. While our bill preserves both paragraphs and makes no substantive changes to them, it moves them from the part of the bill that defines “investment company” to the part of the bill that exempts certain investment companies from the Investment Company Act’s full set of requirements.

The bill makes this technical change to make it clear that hedge funds really are investment companies, and they are not excluded from the coverage of the Investment Company Act. Instead, they are being given an exemption from many of that law’s requirements, because they are investment companies which have voluntarily limited themselves to one hundred or fewer beneficial owners and to accepting funds only from investors of means. Under current law, the two paragraphs allow hedge funds to claim they are excluded from the Investment Company Act – they are not investment companies at all and are outside the SEC’s reach. Under our bill, the hedge funds would qualify as investment companies – which they plainly are — but would qualify for exemptions from many of the Act’s requirements by meeting certain criteria.

It is time to bring hedge funds under the federal regulatory umbrella. With their massive investments, entanglements with U.S. banks, securities firms, pension funds, and other large investors, and their potential impact on market equilibrium, we cannot afford to allow these financial heavyweights to continue to operate free of government regulation and oversight.

When asked at a recent hearing of the Senate Homeland Security and Government Affairs Committee whether hedge funds should be regulated, two expert witnesses gave the exact same one-word answer: “Yes.” One law professor, after noting that disclosure requirements don’t apply to hedge funds, told the Committee: “[I]f you asked a regulator what … role did hedge funds play in the current financial crisis, I think they would look at you like a deer in the headlights, because we just don’t know.” It is essential that federal financial regulators know what hedge funds are doing and that they have the authority to prevent missteps and misconduct.

The “Hedge Fund Transparency Act” will protect investors, and it will help protect our financial system. I hope our colleagues will join us in support of this bill and its inclusion in the regulatory reform efforts that Congress will be undertaking later this year.

SEC and Registered Hedge Fund Investment Advisors: Report by the GAO

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds.  The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

There are many important items in the except below.  While many hedge fund investment advisors are no longer registered with the SEC because the hedge fund registration rule was vacated by a circuit court judge, many hedge fund managers are registered.  As I have done with certain previous articles (see SEC Emphasizes IA Compliance for Hedge Funds), I believe that the following excerpt should be required reading for all investment advisor chief compliance officers (CCOs). The article discusses, the areas which the SEC examiners are likely to emphasize during an examination.  Such areas include: soft dollars, prime brokerage, calculation of the performance fee, valuation of hedge fund assets, and custody of hedge fund assets.

Continue reading

Overview of Hedge Fund Investment Advisors

It is often said that hedge funds are unregistered or lightly regulated investment pools.  While this is correct, there are certain regulations which an investment manager must follow, including certain regulations under the Investment Advisers Act of 1940 (and the securities laws of the hedge fund manager’s state of residence).  These regulations may require a hedge fund manager to be registered as an investment advisor.


In general terms, an investment advisor is any person (or company) which receives remuneration for providing investment advice to a client.  This will include all hedge fund managers.

Registration or Exemption

While all hedge fund managers will fall within the definition of investment advisor, not all hedge fund managers will need to be registered. An investment advisor will need to be registered with the U.S. Securities and Exchange Commission or with the state securities division if the advisor does not fall within an exemption from the registration provisions.  The exemption may be at the federal level, the state level, or both.  (Please see this article on the Section 203(b)(3) exemption.)

Other Requirements

All investment advisors are fiduciaries and must act in the best interest of their clients.  Investment advisors (whether or not such advisor is registered) will need to adhere to the anti-fraud provision of the Investment Adviser’s Act of 1940.

Other helpful articles on investment advisors include:

Please contact us if you have any questions.

SEC’s guide to Broker-Dealer registration


The Securities Exchange Act of 1934 (“Exchange Act” or “Act”) governs the way in which the nation’s securities markets and its brokers and dealers operate. We have prepared this guide to summarize some of the significant provisions of the Act and its rules. You will find information about whether you need to register as a broker-dealer and how you can register, as well as what standards of conduct and financial responsibility rules broker-dealers must follow.


Most “brokers” and “dealers” must register with the SEC and join a “self-regulatory organization,” or SRO. This section covers the factors that determine whether a person is a broker or dealer. It also describes the types of brokers and dealers that do not have to register with the SEC. Self-regulatory organizations are described in Part III, below.

A note about banks: The Exchange Act also contains special provisions relating to brokerage and dealing activities of banks. Please see Sections 3(a)(4)(B) and 3(a)(5)(C) and related provisions, and consult with counsel. Aspects of bank dealer activity are discussed in a publication issued by the SEC’s Division of Trading and Markets, entitled “Staff Compliance Guide to Banks on Dealer Statutory Exceptions and Rules,” which is available on the SEC’s website at: http://www.sec.gov/divisions/marketreg/bankdealerguide.htm. Bank brokerage activity is addressed in Regulation R, which was adopted jointly by the Commission and the Board of Governors of the Federal Reserve System. See Exchange Act Release No. 56501 (September 24, 2007) http://www.sec.gov/rules/final/2007/34-56501.pdf.

A. Who is a “Broker”

Section 3(a)(4)(A) of the Act generally defines a “broker” broadly as “any person engaged in the business of effecting transactions in securities for the account of others.”

Sometimes you can easily determine if someone is a broker. For instance, a person who executes transactions for others on a securities exchange clearly is a broker. However, other situations are less clear. For example, each of the following individuals and businesses may need to register as a broker, depending on a number of factors:

  • “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
    • Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
    • Finding investment banking clients for registered broker-dealers;
    • Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
    • Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
    • Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);

  • investment advisers and financial consultants;
  • foreign broker-dealers that cannot rely on Rule 15a-6 under the Act (discussed below);
  • persons that operate or control electronic or other platforms to trade securities;
  • persons that market real-estate investment interests, such as tenancy-in-common interests, that are securities;
  • persons that act as “placement agents” for private placements of securities;
  • persons that market or effect transactions in insurance products that are securities, such as variable annuities, or other investment products that are securities;
  • persons that effect securities transactions for the account of others for a fee, even when those other people are friends or family members;
  • persons that provide support services to registered broker-dealers; and
  • persons that act as “independent contractors,” but are not “associated persons” of a broker-dealer (for information on “associated persons,” see below).

In order to determine whether any of these individuals (or any other person or business) is a broker, we look at the activities that the person or business actually performs. You can find analyses of various activities in the decisions of federal courts and our own no-action and interpretive letters. Here are some of the questions that you should ask to determine whether you are acting as a broker:

Do you participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction?

Does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal? Do you receive trailing commissions, such as 12b-1 fees? Do you receive any other transaction-related compensation?

Are you otherwise engaged in the business of effecting or facilitating securities transactions?

Do you handle the securities or funds of others in connection with securities transactions?

A “yes” answer to any of these questions indicates that you may need to register as a broker.

C. What To Do If You Think You May Be a Broker or a Dealer

If you are doing, or may do, any of the activities of a broker or dealer, you should find out whether you need to register. Information on the broker-dealer registration process is provided below. If you are not certain, you may want to review SEC interpretations, consult with private counsel, or ask for advice from the SEC’s Division of Trading and Markets by calling (202) 551-5777 or by sending an e-mail to [email protected] (Please be sure to include your telephone number.)

Note: If you will be acting as a “broker” or “dealer,” you must not engage in securities business until you are properly registered. If you are already engaged in the business and are not yet registered, you should cease all activities until you are properly registered. For further information, please see Part II.D and Part III, below.

D. Brokers and Dealers Generally Must Register with the SEC

Section 15(a)(1) of the Act generally makes it unlawful for any broker or dealer to use the mails (or any other means of interstate commerce, such as the telephone, facsimiles, or the Internet) to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker or dealer is registered with the Commission in accordance with Section 15(b) of the Act. There are a few exceptions to this general rule that we discuss below. In addition, we discuss the special registration requirements that apply to broker-dealers of government and municipal securities, including repurchase agreements, below.

1. “Associated Persons” of a Broker-Dealer

We call individuals who work for a registered broker-dealer “associated persons.” This is the case whether such individuals are employees, independent contractors, or are otherwise working with a broker-dealer. These individuals may also be called “stock brokers” or “registered representatives.” Although associated persons usually do not have to register separately with the SEC, they must be properly supervised by a currently registered broker-dealer. They may also have to register with the self-regulatory organizations of which their employer is a member — for example, the Financial Industry Regulatory Authority, Inc. (“FINRA”) (f/k/a the National Association of Securities Dealers, Inc. (“NASD”)) or a national securities exchange. To the extent that associated persons engage in securities activities outside of the supervision of their broker-dealer, they would have to register separately as broker-dealers. Part III, below, provides a discussion of how to register as a broker-dealer.

We do not differentiate between employees and other associated persons for securities law purposes. Broker-dealers must supervise the securities activities of their personnel regardless of whether they are considered “employees” or “independent contractors” as defined under state law. See, for example, In the matter of William V. Giordano, Securities Exchange Act Release No. 36742 (January 19, 1996).

The law also does not permit unregistered entities to receive commission income on behalf of a registered representative. For example, associated persons cannot set up a separate entity to receive commission checks. An unregistered entity that receives commission income in this situation must register as a broker-dealer. See, for example, Wolff Juall Investments, LLC (May 17, 2005). Under certain circumstances, unregistered entities may engage in payroll administration services involving broker-dealers. See, for example, letter re: ADP TotalSource, Inc. (December 4, 2007). In those circumstances, the broker-dealer employer generally hires and supervises all aspects of the employees’ work and uses the payroll and benefits administrator merely as a means to centralize personnel services.

2. Intrastate Broker-Dealers

A broker-dealer that conducts all of its business in one state does not have to register with the SEC. (State registration is another matter. See Part III, below.) The exception provided for intrastate broker-dealer activity is very narrow. To qualify, all aspects of all transactions must be done within the borders of one state. This means that, without SEC registration, a broker-dealer cannot participate in any transaction executed on a national securities exchange or Nasdaq. Also, information posted on the Internet that is accessible by persons in another state would be considered an interstate offer of securities or investment services that would require Federal broker-dealer registration.

A word about municipal and government securities. There is no intrastate exception from registration for municipal securities dealers or government securities brokers and dealers.

3. Broker-Dealers that Limit their Business to Excluded and Exempted Securities

A broker-dealer that transacts business only in commercial paper, bankers’ acceptances, and commercial bills does not need to register with the SEC under Section 15(b) or any other section of the Act. On the other hand, persons transacting business only in certain “exempted securities,” as defined in Section 3(a)(12) of the Act, do not have to register under Section 15(b), but may have to register under other provisions of the Act. For example, some broker-dealers of government securities, which are “exempted securities,” must register as government securities brokers or dealers under Section 15C of the Act, as described in Part II.E, below.

4. Broker-Dealers Must Register Before Selling Unregistered Securities Including Private Placements (or Regulation D offerings)

A security sold in a transaction that is exempt from registration under the Securities Act of 1933 (the “1933 Act”) is not necessarily an “exempted security” under the Exchange Act. For example, a person who sells securities that are exempt from registration under Regulation D of the 1933 Act must nevertheless register as a broker-dealer. In other words, “placement agents” are not exempt from broker-dealer registration.

5. Issuer’s “Exemption” and Associated Persons of Issuers (Rule 3a4-1)

Issuers generally are not “brokers” because they sell securities for their own accounts and not for the accounts of others. Moreover, issuers generally are not “dealers” because they do not buy and sell their securities for their own accounts as part of a regular business. Issuers whose activities go beyond selling their own securities, however, need to consider whether they would need to register as broker-dealers. This includes issuers that purchase their securities from investors, as well as issuers that effectively operate markets in their own securities or in securities whose features or terms can change or be altered. The so-called issuer’s exemption does not apply to the personnel of a company who routinely engage in the business of effecting securities transactions for the company or related companies (such as general partners seeking investors in limited partnerships). The employees and other related persons of an issuer who assist in selling its securities may be “brokers,” especially if they are paid for selling these securities and have few other duties.

Exchange Act Rule 3a4-1 provides that an associated person (or employee) of an issuer who participates in the sale of the issuer’s securities would not have to register as a broker-dealer if that person, at the time of participation: (1) is not subject to a “statutory disqualification,” as defined in Section 3(a)(39) of the Act; (2) is not compensated by payment of commissions or other remuneration based directly or indirectly on securities transactions; (3) is not an associated person of a broker or dealer; and (4) limits its sales activities as set forth in the rule.

Some issuers offer dividend reinvestment and stock purchase programs. Under certain conditions, an issuer may purchase and sell its own securities through a dividend reinvestment or stock purchase program without registering as a broker-dealer. These conditions, regarding solicitation, fees and expenses, and handling of participants’ funds and securities, are explained in Securities Exchange Act Release No. 35041 (December 1, 1994), 59 FR 63393 (“1994 STA Letter”). Although Regulation M2 replaced Rule 10b-6 and superseded the 1994 STA Letter, the staff positions taken in this letter regarding the application of Section 15(a) of the Exchange Act remain in effect. See 17 CFR 242.102(c) and Securities Exchange Act Release No. 38067 (December 20, 1996), 62 FR 520, 532 n.100 (January 3, 1997).

6. Foreign Broker-Dealer Exemption (Rule 15a-6)

The SEC generally uses a territorial approach in applying registration requirements to the international operations of broker-dealers. Under this approach, all broker-dealers physically operating within the United States that induce or attempt to induce securities transactions must register with the SEC, even if their activities are directed only to foreign investors outside of the United States. In addition, foreign broker-dealers that, from outside of the United States, induce or attempt to induce securities transactions by any person in the United States, or that use the means or instrumentalities of interstate commerce of the United States for this purpose, also must register. This includes the use of the internet to offer securities, solicit securities transactions, or advertise investment services to U.S. persons. See Securities Exchange Act Release No. 39779 (March 23, 1998) http://www.sec.gov/rules/interp/33-7516.htm.

Foreign broker-dealers that limit their activities to those permitted under Rule 15a-6 of the Act, however, may be exempt from U.S. broker-dealer registration. Foreign broker-dealers that wish to rely on this exemption should review Securities Exchange Act Release No. 27017 (effective August 15, 1989), 54 FR 30013, to determine whether they meet the conditions of Rule 15a-6. See also letters re: Securities Activities of U.S.-Affiliated Foreign Dealers (April 9 and April 28, 1997). In addition, in April 2005, the Division of Market Regulation staff issued responses to frequently asked questions concerning Rule 15a-6 in relation to Regulation AC. See http://www.sec.gov/divisions/marketreg/mregacfaq0803.htm#partb. (Regulation AC is discussed in Part V.B, below.)

E. Requirements Regarding Brokers and Dealers of Government and Municipal Securities, including Repurchase Agreements

Broker-dealers that limit their activity to government or municipal securities require specialized registration. Those that limit their activity to government securities do not have to register as “general-purpose” broker-dealers under Section 15(b) of the Act. General-purpose broker-dealers that conduct a government securities business, however, must note this activity on their Form BD. (Form BD is discussed below.) All firms that are brokers or dealers in government securities must comply with rules adopted by the Secretary of the Treasury, as well as SEC rules.

Firms that limit their securities business to buying and selling municipal securities for their own account (municipal securities dealers) must register as general-purpose broker-dealers. If, however, these entities are banks or meet the requirements of the intrastate exemption discussed in Part II.D.2. above, they must register as municipal securities dealers. Municipal securities brokers (other than banks) must register as general-purpose broker-dealers unless they qualify for the intrastate exception. See Part II.D.2 above.

Firms that run a matched book of repurchase agreements or other stock loans are considered dealers. Because a “book running dealer” holds itself out as willing to buy and sell securities, and is thus engaged in the business of buying and selling securities, it must register as a broker-dealer.

F. Special Rules That Apply to Banks and Similar Financial Institutions

Note: Banks, thrifts, and other financial institutions should be aware that the Commission has adopted rules that may affect them. See Regulation R, Securities Exchange Act Release No. 34-56501 (Sept. 24, 2007), 72 FR 56514 (Oct. 3, 2007), www.sec.gov/rules/final/2007/34-56501.pdf and Securities Exchange Act Release No. 34-56502 (Sept. 24, 2007) 72 FR 56562 (Oct. 3, 2007), www.sec.gov/rules/final/2007/34-56502.pdf.

Banks. Prior to the enactment of the “Gramm-Leach-Bliley Act” (“GLBA”) in 1999, U.S. banks were excepted from the definitions of “broker” and “dealer” under the Act. The GLBA amended the Exchange Act, and banks now have certain targeted exceptions and exemptions from broker-dealer registration. Currently, as a result of Commission rulemaking, banks are undergoing a phase-in period for compliance with the new law. Since October 1, 2003, banks that buy and sell securities must consider whether they are “dealers” under the federal securities laws. The Division of Trading and Markets has issued a special compliance guide for banks, entitled “Staff Compliance Guide to Banks on Dealer Statutory Exceptions and Rules,” which is available on the SEC’s website at: http://www.sec.gov/divisions/marketreg/bankdealerguide.htm. Bank brokerage activity is addressed in Regulation R, which was adopted jointly by the Commission and the Board of Governors of the Federal Reserve System. See Exchange Act Release No. 56501 (September 24, 2007) (which can be found at http://www.sec.gov/rules/final/2007/34-56501.pdf).

The bank exceptions and exemptions only apply to banks, and not to related entities. It is important to note that exceptions applicable to banks under the Exchange Act, as amended by the GLBA, are not applicable to other entities, including bank subsidiaries and affiliates, that are not themselves banks. As such, subsidiaries and affiliates of banks that engage in broker-dealer activities are required to register as broker-dealers under the Act. Also, banks that act as municipal securities dealers or as government securities brokers or dealers continue to be required to register under the Act.

Thrifts. By statute, thrifts (savings associations) have the same status as banks, and may avail themselves of the same targeted exceptions and exemptions from broker-dealer registration as banks. (For further information, See the “Staff Compliance Guide to Banks on Dealer Statutory Exceptions and Rules,” noted above.) As with banks, it is important to note that exceptions and exemptions applicable to thrifts are not applicable to other entities, including subsidiaries and affiliates that are not thrifts. As such, subsidiaries and affiliates of thrifts that engage in broker-dealer activities are required to register as broker-dealers under the Act.

Credit Unions and Financial Institution “Networking” Arrangements. The exceptions and exemptions applicable to banks under the Exchange Act do not apply to other kinds of financial institutions, such as credit unions. The SEC staff, however, has permitted certain financial institutions, such as credit unions, to make securities available to their customers without registering as broker-dealers. This is done through “networking” arrangements, where an affiliated or third-party broker-dealer provides brokerage services for the financial institution’s customers, according to conditions stated in no-action letters and NASD Rule 2350.

Under a networking arrangement, financial institutions can share in the commissions generated by their referred customers, under certain conditions. The financial institution engaging in such networking must be in strict compliance with applicable law and Commission staff guidance. See, for example, letter re: Chubb Securities Corporation (November 24, 1993) and NASD Rule 2350 (applicable to broker-dealers that enter into networking arrangements with banks, thrifts, and credit unions).

G. Insurance Agency Networking

The SEC staff has permitted insurance agencies to make insurance products that are also securities (such as variable annuities) available to their customers without registering as broker-dealers under certain conditions. This again is done through “networking” arrangements, where an affiliated or third-party broker-dealer provides brokerage services for the insurance agency’s customers, according to conditions stated in no-action letters. These arrangements are designed to address the difficulties of dual state and federal laws applicable to the sale of these products. Through networking arrangements, insurance agencies can share in the commissions generated by their referred customers under certain conditions. Insurance agencies engaging in such networking must be in strict compliance with applicable law and Commission staff guidance. Insurance companies should consult the letter re: First of America Brokerage Services, Inc. (September 28, 1995). Those interested in structuring such an arrangement should contact private counsel or the SEC staff for further information.

Notably, insurance networking arrangements are limited to insurance products that are also securities. They do not encompass sales of mutual funds and other securities that do not present the same regulatory difficulties. See letter re: Lincoln Financial Advisors Corp. (February 20, 1998).

H. Real Estate Securities and Real Estate Brokers/Agents

The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security. When the real estate is offered in conjunction with certain services, however, it may constitute an investment contract, and thus, a security. See generally, Securities Act Release No. 5347 (Jan. 4, 1973) (providing guidelines as to the applicability of the federal securities laws to offers and sales of condominiums or units in a real estate development).

There is no general exception from the broker-dealer registration requirements for licensed real estate brokers or agents who engage in the business of effecting transactions in real estate securities. In the past, the Division staff has granted no-action relief from the registration requirements to licensed real estate personnel that engage in limited activities with respect to the sale of condominium units coupled with an offer or agreement to perform or arrange certain rental or other services for the purchaser. The relief provided in these letters is limited solely to their facts and should not be relied upon for activities relating to sales of other types of real estate securities, including tenants-in-common interests in real property. See generally, NASD Notice to Members 05-18, http://www.nasd.com/web/groups/rules_regs/documents/notice_to_members/

nasdw_013455.pdf (addressing tenants-in-common interests in real property).

I. Broker-Dealer Relationships with Affinity Groups

Broker-dealers may enter into arrangements to offer services to members of certain non-profit groups, including civic organizations, charities, and educational institutions that rely upon private donations. These arrangements are subject to certain conditions to ensure that the organizations, or “affinity groups,” do not develop a salesman’s stake with respect to the sale of securities. See, for example, letter re: Attkisson, Carter & Akers (June 23, 1998).


A broker-dealer may not begin business until:

it has properly filed Form BD, and the SEC has granted its registration;

it has become a member of an SRO;

it has become a member of SIPC, the Securities Investor Protection Corporation;

it complies with all applicable state requirements; and

its “associated persons” have satisfied applicable qualification requirements.

A. Form BD

If a broker-dealer does not qualify for any of the exceptions or exemptions outlined in the sections above, it must register with the Commission under Section 15(b) of the Act. Broker-dealers register by filing an application on Form BD, which you may obtain from the SEC’s webpage at http://www.sec.gov/about/forms/formbd.pdf or through the SEC’s Publications Office at (202) 551-4040. You also use Form BD to:

apply for membership in an SRO, such as FINRA or a registered national securities exchange;

give notice that you conduct government securities activities; or

apply for broker-dealer registration with each state in which you plan to do business.

Form BD asks questions about the background of the broker-dealer and its principals, controlling persons, and employees. The broker-dealer must meet the statutory requirements to engage in a business that involves high professional standards, and quite often includes the more rigorous responsibilities of a fiduciary.

To apply for registration, you must file one executed copy of Form BD through the Central Registration Depository (“CRD”), which is operated by FINRA. (The only exception is for banks registering as municipal securities dealers, which file Form MSD directly with the SEC and with their appropriate banking regulator.) Form BD contains additional filing instructions. The SEC does not charge a filing fee, but the SROs and the states may. Applicants that reside outside the U.S. must also appoint the SEC as agent for service of process using a standard form. Incomplete applications are not considered “filed” and will be returned to the applicant for completion and re-submission.

Within 45 days of filing a completed application, the SEC will either grant registration or begin proceedings to determine whether it should deny registration. An SEC registration may be granted with the condition that SRO membership must be obtained. The SROs have independent membership application procedures and are not required to act within 45 days of the filing of a completed application. In addition, state registrations may be required. A broker-dealer must comply with relevant state law as well as federal law and applicable SRO rules. Timeframes for registration with individual states may differ from the federal and SRO timeframes. As such, when deciding to register as a broker-dealer, it is important to plan for the time required for processing Federal, state, and SRO registration or membership applications.

Duty to update Form BD. A registered broker-dealer must keep its Form BD current. Thus, it must promptly update its Form BD by filing amendments whenever the information on file becomes inaccurate or incomplete for any reason.

Prohibited Broker-Dealer Names. Title 18, Section 709 of the United States Code makes it a criminal offense to use the words “National,” “Federal,” “United States,” “Reserve,” or “Deposit Insurance” in the name of a person or organization in the brokerage business, unless otherwise allowed by federal law. Further, a broker-dealer name that is otherwise materially misleading would become subject to scrutiny under Exchange Act Section 10(b), and Rule 10b-5 thereunder, the general antifraud rules, and any other applicable provisions.

B. SRO Membership (Section 15(b)(8) and Rule 15b9-1)

Before it begins doing business, a broker-dealer must become a member of an SRO. SROs assist the SEC in regulating the activities of broker-dealers. FINRA and the national securities exchanges are all SROs. If a broker-dealer restricts its transactions to the national securities exchanges of which it is a member and meets certain other conditions, it may be required only to be a member of those exchanges. If a broker-dealer effects securities transactions other than on a national securities exchange of which it is a member, however, including any over-the-counter business, it must become a member of FINRA, unless it qualifies for the exemption in Rule 15b9-1. FINRA’s webpage at www.finra.org provides detailed information on the FINRA membership process. You may also wish to consult the web pages of the individual exchanges for additional information.

Firms that engage in transactions in municipal securities must also comply with the rules of the Municipal Securities Rulemaking Board, or MSRB. The MSRB is an SRO that makes rules governing transactions in municipal securities, but, unlike other SROs, it does not enforce compliance with its rules. Compliance with MSRB rules is monitored and enforced by FINRA and the SEC (in the case of broker-dealers), and the Federal bank regulators and the SEC (in the case of banks). You may wish to consult the MSRB’s website at www.msrb.org for additional information, or you can call the MSRB at (703) 797-6600.

C. SIPC Membership

Every registered broker-dealer must be a member of the Securities Investor Protection Corporation, or SIPC, unless its principal business is conducted outside of the United States or consists exclusively of the sale or distribution of investment company shares, variable annuities, or insurance. Each SIPC member must pay an annual fee to SIPC. SIPC insures that its members’ customers receive back their cash and securities in the event of a member’s liquidation, up to $500,000 per customer for cash and securities. (Claims for cash are limited to $100,000.) For further information, contact SIPC, 805 15th St., NW, Suite 800, Washington, DC 20005. Telephone: (202) 371-8300, fax: (202) 371-6728, or visit SIPC’s website at www.sipc.org.

D. State Requirements

Every state has its own requirements for a person conducting business as a broker-dealer within that state. Each state’s securities regulator can provide you with information about that state’s requirements. You can obtain contact information for these regulators from the North American Securities Administrators Association, Inc. (NASAA), 750 First Street, NE, Suite 1140, Washington, DC 20002. Telephone: (202) 737-0900, or visit NASAA’s website at www.nasaa.org.

E. Associated Persons (Section 3(a)(18); Rule 15b7-1)

The Act defines an “associated person” of a broker-dealer as any partner, officer, director, branch manager, or employee of the broker-dealer, any person performing similar functions, or any person controlling, controlled by, or under common control with, the broker-dealer. A broker-dealer must file a Form U-4 with the applicable SRO for each associated person who will effect transactions in securities when that person is hired or otherwise becomes associated. Form U-4 is used to register individuals and to record these individuals’ prior employment and disciplinary history.

An associated person who effects or is involved in effecting securities transactions also must meet qualification requirements. These include passing an SRO securities qualification examination. Many individuals take the comprehensive “Series 7” exam. If individuals engage only in activities involving sales of particular types of securities, such as municipal securities, direct participation programs (limited partnerships) or mutual funds, they may wish to take a specialized examination focused on that type of security, instead of the general securities examination. There is also a special exam for assistant representatives, whose activities are limited to accepting unsolicited customer orders for execution by the firm. Supervisory personnel, and those who engage in specialized activities such as options trading, must take additional exams that cover those areas. These examinations require the Series 7 exam as a prerequisite.

You can obtain copies of Form U-4, as well as information on securities qualification examinations, from an SRO. FINRA’s website at www.finra.org contains detailed information and guidance for individuals who wish to obtain a series license through FINRA. Also note that individual states have their own licensing and registration requirements, so you should consult with the applicable state securities regulators for further information.

Note: If you hold a series license, you must be properly associated with a registered broker-dealer to effect securities transactions. It is not sufficient merely to hold a series license when engaging in securities business. If you hold a series license and wish to start an independent securities business, or otherwise wish to effect securities transactions outside of an “associated person” relationship, you would first need to register as a broker-dealer.

F. Successor Broker-Dealer Registration (Rules 15b1-3, 15Ba2-4, and 15Ca2-3)

A successor broker-dealer assumes substantially all of the assets and liabilities, and continues the business, of a registered predecessor broker-dealer. A successor broker-dealer must file a new Form BD (or, in special instances, amend the predecessor broker-dealer’s Form BD) within 30 days after such succession. The filing should indicate that the applicant is a successor. See Securities Exchange Act Release No. 31661 (December 28, 1992), 58 FR 11. See also, the instructions to Form BD.

G. Withdrawal from Registration (Rule 15b6-1); Cancellation of Registration

When a registered broker-dealer stops doing business, it must file a Form BDW (http://www.sec.gov/about/forms/formbdw.pdf) to withdraw its registration with the SEC and with the states and SROs of which it is a member. This form requires the broker-dealer to disclose the amount of any funds or securities it owes customers, and whether it is the subject of any proceedings, unsatisfied judgments, liens, or customer claims. These disclosures help to ensure that a broker-dealer’s business is concluded in an orderly manner and that customers’ funds and securities are protected. In most cases, a broker-dealer must also file a final FOCUS report. Form BDW may also be used by a broker-dealer to withdraw from membership with particular SROs, or to withdraw from registration with particular states, without withdrawing all of its registrations and memberships.

Form BDW is not considered “filed” unless it is deemed complete by the SEC and the SRO that reviews the filing. The SEC may also cancel a broker-dealer’s registration if it finds that the firm is no longer in existence or has ceased doing business as a broker-dealer.


Security futures, which are contracts of sale for future delivery of a single security or a narrow-based security index, are regulated as both securities by the SEC and as futures by the Commodity Futures Trading Commission (“CFTC”). As a result, firms that conduct business in security futures must be registered with both the SEC and the CFTC. Federal law permits firms already registered with either the SEC or the CFTC to register with the other agency, for the limited purpose of trading security futures, by filing a notice. Specifically, firms registered as general purpose broker-dealers under Section 15(b) of the Act may “notice” register with the CFTC. Likewise, futures commission merchants and introducing brokers registered with the CFTC may notice register with the SEC. (Section 15(b)(12) of the Act provides a limited exception to this notice registration requirement for certain natural persons who are members of security futures exchanges). However, futures commission merchants or introducing brokers that conduct a business in securities other than security futures must be registered as general-purpose broker-dealers. For more information on this topic, See Exchange Act Release No. 44730 (effective August 27, 2001), 66 FR 45138, and 66 FR 43080 (effective September 17, 2001).


Broker-dealers, like other securities market participants, must comply with the general “antifraud” provisions of the federal securities laws. Broker-dealers must also comply with many requirements that are designed to maintain high industry standards. We discuss some of these provisions below.

A. Antifraud Provisions (Sections 9(a), 10(b), and 15(c)(1) and (2))

The “antifraud” provisions prohibit misstatements or misleading omissions of material facts, and fraudulent or manipulative acts and practices, in connection with the purchase or sale of securities.3 While these provisions are very broad, the Commission has adopted rules, issued interpretations, and brought enforcement actions that define some of the activities we consider manipulative, deceptive, fraudulent, or otherwise unlawful.4 Broker-dealers must conduct their activities so as to avoid these kinds of practices.

1. Duty of Fair Dealing

Broker-dealers owe their customers a duty of fair dealing. This fundamental duty derives from the Act’s antifraud provisions mentioned above. Under the so-called “shingle” theory, by virtue of engaging in the brokerage profession (e.g., hanging out the broker-dealer’s business sign, or “shingle”), a broker-dealer represents to its customers that it will deal fairly with them, consistent with the standards of the profession. Based on this important representation, the SEC, through interpretive statements and enforcement actions, and the courts, through case law, have set forth over time certain duties for broker-dealers. These include the duties to execute orders promptly, disclose certain material information (i.e., information the customer would consider important as an investor), charge prices reasonably related to the prevailing market, and fully disclose any conflict of interest.

SRO rules also reflect the importance of fair dealing. For example, FINRA members must comply with NASD’s Rules of Fair Practice. These rules generally require broker-dealers to observe high standards of commercial honor and just and equitable principles of trade in conducting their business. The exchanges and the MSRB have similar rules.

2. Suitability Requirements

Broker-dealers generally have an obligation to recommend only those specific investments or overall investment strategies that are suitable for their customers. The concept of suitability appears in specific SRO rules such as NASD Rule 2310 and has been interpreted as an obligation under the antifraud provisions of the federal securities laws. Under suitability requirements, a broker-dealer must have an “adequate and reasonable basis” for any recommendation that it makes. Reasonable basis suitability, or the reasonable basis test, relates to the particular security or strategy recommended. Therefore, the broker-dealer has an obligation to investigate and obtain adequate information about the security it is recommending.

A broker-dealer also has an obligation to determine customer-specific suitability. In particular, a broker-dealer must make recommendations based on a customer’s financial situation, needs, and other security holdings. This requirement has been construed to impose a duty of inquiry on broker-dealers to obtain relevant information from customers relating to their financial situations and to keep such information current. SROs consider recommendations to be unsuitable when they are inconsistent with the customer’s investment objectives.

3. Duty of Best Execution

The duty of best execution, which also stems from the Act’s antifraud provisions, requires a broker-dealer to seek to obtain the most favorable terms available under the circumstances for its customer orders. This applies whether the broker-dealer is acting as agent or as principal.

The SRO rules also include a duty of best execution. For example, FINRA members must use “reasonable diligence” to determine the best market for a security and buy or sell the security in that market, so that the price to the customer is as favorable as possible under prevailing market conditions.

4. Customer Confirmation Rule (Rule 10b-10 and MSRB rule G-15)

A broker-dealer must provide its customers, at or before the completion of a transaction, with certain information, including:

* the date, time, identity, price, and number of shares involved;

* its capacity (agent or principal) and its compensation (for agency trades, compensation includes its commission and whether it receives payment for order flow;5 and for principal trades, mark-up disclosure may be required);

* the source and amount of any third party remuneration it has received or will receive;6

* other information, both general (such as, if the broker-dealer is not a SIPC member) and transaction-specific (such as the yield, in most transactions involving debt securities).

A broker-dealer may also be obligated under the antifraud provisions of the Act to disclose additional information to the customer at the time of his or her investment decision.

5. Disclosure of Credit Terms (Rule 10b-16)

Broker-dealers must notify customers purchasing securities on credit about the credit terms and the status of their accounts. A broker-dealer must establish procedures for disclosing this information before it extends credit to a customer for the purchase of securities. A broker-dealer must give the customer this information at the time the account is opened, and must also provide credit customers with account statements at least quarterly.

6. Restrictions on Short Sales (Regulation SHO)

A “short sale” is generally a sale of a security that the seller doesn’t own or for which the seller delivers borrowed shares. Regulation SHO was adopted in 2004 to update short sale regulation in light of numerous market developments since short sale regulation was first adopted in 1938. Compliance with Regulation SHO began on January 3, 2005. Some of the goals of Regulation SHO include:


Establishing uniform “locate” and “close-out” requirements in order to address problems associated with failures to deliver, including potentially abusive “naked” short selling.

Locate Requirement: Regulation SHO requires a broker-dealer to have reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due before effecting a short sale order in any equity security. This “locate” must be made and documented prior to effecting the short sale. Market makers engaged in bona fide market making are exempted from the “locate” requirement.

“Close-out” Requirement: Regulation SHO imposes additional delivery requirements on broker-dealers for securities in which there are a relatively substantial number of extended delivery failures at a registered clearing agency (“threshold securities”). For instance, with limited exception, Regulation SHO requires brokers and dealers that are participants of a registered clearing agency to take action to “close-out” failure-to-deliver positions (“open fails”) in threshold securities that have persisted for 13 consecutive settlement days. Closing out requires the broker or dealer to purchase securities of like kind and quantity. Until the position is closed out, the broker or dealer and any broker or dealer for which it clears transactions (for example, an introducing broker) may not effect further short sales in that threshold security without borrowing or entering into a bona fide agreement to borrow the security (known as the “pre-borrowing” requirement).


Creating uniform order marking requirements for sales of all equity securities. This means that a broker-dealer must mark orders as “long” or “short.”

For further information, please see the adopting release for Regulation SHO, as well as Frequently Asked Questions, Key Points, and other related materials at http://www.sec.gov/spotlight/shortsales.htm.

7. Trading During an Offering (Regulation M)

Regulation M is designed to protect the integrity of the securities trading market as an independent pricing mechanism by governing the activities of underwriters, issuers, selling security holders, and other participants in connection with a securities offering. These rules are aimed at preventing persons having an interest in an offering from influencing the market price for the offered security in order to facilitate a distribution. The adopting release for Regulation M is available at http://www.sec.gov/rules/final/34-38067.txt.

Rule 101 of Regulation M generally prohibits underwriters, broker-dealers and other distribution participants from bidding for, purchasing, or attempting to induce any person to bid for or purchase, any security which is the subject of a distribution until the applicable restricted period has ended. An offering’s “restricted period” begins either one or five business days (depending on the trading volume value of the offered security and the public float value of the issuer) before the day of the offering’s pricing and ends upon completion of the distribution.

Rule 101 contains various exceptions that are designed to permit an orderly distribution of securities and limit disruption in the market for the securities being distributed. For example, underwriters can continue to trade in actively-traded securities of larger issuers (securities with an average daily trading volume, or ADTV, value of $1 million or more and whose issuers have a public float value of at least $150 million). In addition, the following activities, among others, may be excepted from Rule 101, if they meet specified conditions:

* disseminating research reports;

* making unsolicited purchases;

* purchasing a group, or “basket” of 20 or more securities;

* exercising options, warrants, rights, and convertible securities;

* effecting transactions that total less than 2% of the security’s ADTV; and

* effecting transactions in securities sold to “qualified institutional buyers.”

Rule 102 of Regulation M prohibits issuers, selling security holders, and their affiliated purchasers from bidding for, purchasing, or attempting to induce any person to bid for or purchase, any security which is the subject of a distribution until after the applicable restricted period.

Rule 103 of Regulation M governs passive market making by broker-dealers participating in an offering of a Nasdaq security.

Rule 104 of Regulation M governs stabilization transactions, syndicate short covering activity, and penalty bids.

Rule 105 of Regulation M prevents manipulative short sales prior to pricing an offering by prohibiting the purchase of offering securities if a person sold short the security that is the subject of the offering during the Rule 105 restricted period. The rule contains exceptions for bona fide purchases, separate accounts, and investment companies.

For frequently asked questions about Regulation M, see Staff Legal Bulletin No. 9 at http://www.sec.gov/interps/legal/mrslb9.htm.

8. Restrictions on Insider Trading

The SEC and the courts interpret Section 10(b) and Rule 10b-5 under the Act to bar the use by any person of material non-public information in the purchase or sale of securities, whenever that use violates a duty of trust and confidence owed to a third party. Section 15(f) of the Act specifically requires broker-dealers to have and enforce written policies and procedures reasonably designed to prevent their employees from misusing material non-public information. Because employees in the investment banking operations of broker-dealers frequently have access to material non-public information, firms need to create procedures designed to limit the flow of this information so that their employees cannot use the information in the trading of securities. Broker-dealers can use these information barriers as a defense to a claim of insider trading. Such procedures typically include:

* training to make employees aware of these restrictions;

* employee trading restrictions;

* physical barriers;

* isolation of certain departments; and

* limitations on investment bank proprietary trading.7

9. Restrictions on Private Securities Transactions

NASD Rule 3040 provides that “no person associated with a member shall participate in any manner in a private securities transaction” except in accordance with the provisions of the rule. To the extent that any such transactions are permitted under the rule, prior to participating in any private securities transaction, the associated person must provide written notice to the member firm as described in the rule. If compensation is involved, the member firm must approve or disapprove the proposed transaction, record it in its books and records, and supervise the transaction as if it were executed on behalf of the member firm. Other conditions may also apply. In addition, private securities transactions of an associated person may be subject to an analysis under Exchange Act Section 10(b) and Rule 10b-5, as well as the broker-dealer supervisory provisions of Section 15(f) (described in Part V.A.8, above) and Section 15(b)(4)(E), and other relevant statutory or regulatory provisions.

B. Analysts and Regulation AC

Regulation AC (or Regulation Analyst Certification) requires brokers, dealers, and persons associated with brokers or dealers that publish, distribute, or circulate research reports to include in those reports a certification that the views expressed in the report accurately reflect the analyst’s personal views. The report must also disclose whether the analyst received compensation for the views expressed in the report. If the analyst has received related compensation, the broker, dealer, or associated person must disclose its amount, source, and purpose. Regulation AC applies to all brokers and dealers, as well as to those persons associated with a broker or dealer that fall within the definition of “covered person.” Regulation AC also requires that broker-dealers keep records of analyst certifications relating to public appearances.

In addition to Commission rules, analyst conduct is governed by SRO rules, such as NASD Rule 2711 and NYSE Rule 472. The SRO rules impose restrictions on analyst compensation, personal trading activities, and involvement in investment banking activities. The SRO rules also include disclosure requirements for research reports and public appearances.

For further information, including investor guidance, SEC releases, and SRO rules, see http://www.sec.gov/divisions/marketreg/securitiesanalysts.htm. In addition, staff responses to frequently asked questions are available at http://www.sec.gov/divisions/marketreg/mregacfaq0803.htm.

C. Trading by Members of Exchanges, Brokers and Dealers (Section 11(a))

Broker-dealers that are members of national securities exchanges are subject to additional regulations regarding transactions they effect on exchanges. For example, except under certain conditions, they generally cannot effect transactions on exchanges for their own accounts, the accounts of their associated persons, or accounts that they or their associated persons manage. Exceptions from this general rule include transactions by market makers, transactions routed through other members, and transactions that yield to other orders. Exchange members may wish to seek guidance from their exchange regarding these provisions.

D. Extending Credit on New Issues; Disclosure of Capacity as Broker or Dealer (Section 11(d))

Section 11(d)(1) of the Act generally prohibits a broker-dealer that participates in the distribution of a new issue of securities from extending credit to customers in connection with the new issue during the distribution period and for 30 days thereafter. Sales by a broker-dealer of mutual fund shares and variable insurance product units are deemed to constitute participation in the distribution of a new issue. Therefore, purchase of mutual fund shares or variable product units using credit extended or arranged by the broker-dealer during the distribution period is a violation of Section 11(d)(1). However, Exchange Act Rule 11d1-2 permits a broker-dealer to extend credit to a customer on newly sold mutual fund shares and variable insurance product units after the customer has owned the shares or units for 30 days.

Section 11(d)(2) of the Act requires a broker-dealer to disclose in writing, at or before the completion of each transaction with a customer, whether the broker-dealer is acting in the capacity of broker or dealer with regard to the transaction.

E. Regulation NMS

Regulation NMS addresses four interrelated topics that are designed to modernize the regulatory structure of the U.S. equity markets: (1) order protection, (2) intermarket access, (3) sub-penny pricing, and (4) market data.

1. The “Order Protection Rule” requires trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers, subject to an applicable exception. To be protected, a quotation must be immediately and automatically accessible.

2. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations across different trading centers, and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations.

3. The “Sub-Penny Rule” prohibits market participants from accepting, ranking, or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny, except for orders, quotations, or indications of interest that are priced at less than $1.00 per share.

4. The “Market Data Rules” update the requirements for consolidating, distributing, and displaying market information. In addition, amendments to the joint industry plans for disseminating market information modify the formulas for allocating plan revenues among the self-regulatory organizations and broaden participation in plan governance.

Regulation NMS also updates and streamlines the existing Exchange Act rules governing the national market system previously adopted under Section 11A of the Exchange Act, and consolidates them into a single regulation.

For additional details regarding Regulation NMS, see http://www.sec.gov/rules/final/34-51808fr.pdf and http://www.sec.gov/spotlight/regnms.htm.

F. Order Execution Obligations (Rules 602-604 of Regulation NMS)

Broker-dealers that are exchange specialists or Nasdaq market makers must comply with particular rules regarding publishing quotes and handling customer orders. These two types of broker-dealers have special functions in the securities markets, particularly because they trade for their own accounts while also handling orders for customers. These rules, which include the “Quote Rule” and the “Limit Order Display Rule,” increase the information that is publicly available concerning the prices at which investors may buy and sell exchange-listed and Nasdaq National Market System securities.

The Quote Rule requires specialists and market makers to provide quotation information to their self-regulatory organization for dissemination to the public. The quote information that the specialist or market maker provides must reflect the best prices at which he is willing to trade (the lowest price the dealer will accept from a customer to sell the securities and the highest price the dealer will pay a customer to purchase the securities). A specialist or market maker may still trade at better prices in certain private trading systems, called electronic communications networks, or “ECNs,” without publishing an improved quote. This is true only when the ECN itself publishes the improved prices and makes those prices available to the investing public. Thus, the Quote Rule ensures that the public has access to the best prices at which specialists and market makers are willing to trade even if those prices are in private trading systems.

Limit orders are orders to buy or sell securities at a specified price. The Limit Order Display Rule requires that specialists and market makers publicly display certain limit orders they receive from customers. If the limit order is for a price that is better than the specialist’s or market maker’s quote, the specialist or market maker must publicly display it. The rule benefits investors because the publication of trading interest at prices that improve specialists’ and market makers’ quotes present investors with improved pricing opportunities.

G. Regulation ATS: Broker-Dealer Trading Systems

Regulation ATS (17 CFR 242.300 et seq.) provides a means for broker-dealers to operate automated trading platforms, to collect and execute orders in securities electronically, without registering as a national securities exchange under Section 6 of the Exchange Act or as an exempt exchange pursuant to Section 5 of the Act. For purposes of the regulation, an alternative trading system or ATS is any organization, association, person, group of persons, or system that constitutes, maintains, or provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as defined in Rule 3b-16 under the Exchange Act. See 17 CFR 242.300. Further, for purposes of the regulation, an ATS may not set rules governing the conduct of subscribers (other than with respect to the use of the particular trading system), or discipline subscribers other than by exclusion from trading. To the extent that an ATS or the sponsoring broker-dealer seeks to establish conduct or disciplinary rules, the entity may be required to register as a national securities exchange or obtain a Commission exemption from exchange registration based on limited trading volume.

In order to acquire the status of an ATS, a firm must first be registered as a broker-dealer, and it must file an initial operation report with respect to the trading system on Form ATS at least 20 days before commencing operation. The initial operation report must be accurate and kept current. The Commission does not issue approval orders for Form ATS filings; however, the Form ATS is not considered filed unless it complies with all applicable requirements under the Regulation. Regulation ATS contains provisions concerning the system’s operations, including: fair access to the trading system; fees charged; the display of orders and the ability to execute orders; system capacity, integrity and security; record keeping and reporting; and procedures to ensure the confidential treatment of trading information.

An ATS must file with the Division of Trading and Markets quarterly reports regarding its operations on Form ATS-R. An ATS must also comply with any applicable SRO rules and with state laws relating to alternative trading systems and relating to the offer or sale of securities or the registration or regulation of persons or entities effecting securities transactions.

Finally, an ATS may not use in its name the word “exchange,” or terms similar to the word “exchange,” such as the term “stock market.” See 17 CFR 242.301. For further information on the operation and regulation of alternative trading systems, see the adopting release for Regulation ATS at http://www.sec.gov/rules/final/34-40760.txt.

H. Penny Stock Rules (Rules 15g-2 through 15g-9, Schedule 15G)

Most broker-dealers that effect transactions in “penny stocks” have certain enhanced suitability and disclosure obligations to their customers.8 A penny stock is generally defined as any equity security other than a security that: (a) is an NMS stock (See Rule 600(b)(47)) listed on a “grandfathered” national securities exchange, (b) is an NMS stock listed on a national securities exchange or an automated quotation system sponsored by a registered national securities association (including Nasdaq) that satisfies certain minimum quantitative listing standards, (c) has a transaction price of five dollars or more, (d) is issued by a registered investment company or by the Options Clearing Corporation, (e) is a listed security futures product, or (f) is a security whose issuer has met certain net tangible assets or average revenues (See Rule 3a51-1). Penny stocks include the equity securities of private companies with no active trading market if they do not qualify for one of the exclusions from the definition of penny stock.

Before a broker-dealer that does not qualify for an exemption9 may effect a solicited transaction in a penny stock for or with the account of a customer it must: (1) provide the customer with a risk disclosure document, as set forth in Schedule 15G, and receive a signed and dated acknowledgement of receipt of that document from the customer (See Rule 15g-2); (2) approve the customer’s account for transactions in penny stocks, provide the customer with a suitability statement, and receive a signed a dated copy of that statement from the customer; and (3) receive the customer’s written agreement to the transaction (See Rule 15g-9). The broker-dealer also must wait at least two business days after sending the customer the risk disclosure document and the suitability statement before effecting the transaction. In addition, Exchange Act Rules 15g-3 through 15g-6 generally require a broker-dealer to give each penny stock customer:

* information on market quotations and, where appropriate, offer and bid prices;

* the aggregate amount of any compensation received by the broker-dealer in connection with such transaction;

* the aggregate amount of cash compensation that any associated person of the broker-dealer, who is a natural person and who has communicated with the customer concerning the transaction at or prior to the customers transaction order, other than a person whose function is solely clerical or ministerial, has received or will receive from any source in connection with the transaction; and

* monthly account statements showing the market value of each penny stock held in the customers account.

I. Privacy of Consumer Financial Information (Regulation S-P)

Broker-dealers, including foreign broker-dealers registered with the Commission and unregistered broker-dealers in the United States, must comply with Regulation S-P, (See 17 CFR Part 248) even if their consumers are non-U.S. persons or if they conduct their activities through non-U.S. offices or branches.

Regulation S‑P generally requires a broker-dealer to provide its customers with initial, annual and revised notices containing specified information about the broker-dealer’s privacy policies and practices. These notices must be clear and conspicuous, and must accurately reflect the broker-dealer’s policies and practices. See 17 CFR 248.4, 248.5, 248.6 and 248.8. Before disclosing nonpublic personal information about a consumer to a nonaffiliated third party, a broker-dealer must first give a consumer an opt-out notice and a reasonable opportunity to opt out of the disclosure. See 17 CFR 248.7 and 248.10. There are exceptions from these notice and opt-out requirements for disclosures to other financial institutions under joint marketing agreements and to certain service providers. See 17 CFR 248.13. There also are exceptions for disclosures made for purposes such as maintaining or servicing accounts, and disclosures made with the consent or at the direction of a consumer, or for purposes such as protecting against fraud, reporting to consumer reporting agencies, and providing information to law enforcement agencies. See 17 CFR 248.14 and 248.15.

Regulation S‑P also imposes limits on the re-disclosure and re-use of information, and on sharing account number information with nonaffiliated third parties for use in telemarketing, direct mail marketing and email marketing. See 17 CFR 248.11 and 248.12. In addition, it includes a safeguards rule that requires a broker-dealer to adopt written policies and procedures for administrative, technical, and physical safeguards to protect customer records and information. See 17 CFR 248.30(a). Further, it includes a disposal rule that requires a broker-dealer (other than a broker-dealer registered by notice with the Commission to engage solely in transactions in securities futures) that maintains or possesses consumer report information for a business purpose to take reasonable measures to protect against unauthorized access to or use of the information in connection with its disposal. See 17 CFR 248.30(b).

Recently proposed amendments which would further strengthen the privacy protections under Regulation S-P are available at http://www.sec.gov/rules/proposed/2008/34-57427.pdf.

J. Investment Adviser Registration

Broker-dealers offering certain types of accounts and services may also be subject to regulation under the Investment Advisers Act.10 (An investment adviser is defined as a person who receives compensation for providing advice about securities as part of a regular business.) (See Section 202(a)(11) of the Investment Advisers Act .) In general, a broker-dealer whose performance of advisory services is “solely incidental” to the conduct of its business as a broker-dealer and that receives no “special compensation” is excepted from the definition of investment adviser. Thus, for example, a broker-dealer that provides advice and offers fee-based accounts (i.e., accounts that charge an asset-based or fixed fee rather than a commission, mark-up, or mark-down) must treat those accounts as advisory because an asset-based fee is considered “special compensation.” Also, under a recently proposed rule, a broker-dealer would be required to treat (1) each account over which it exercises investment discretion as an advisory account, unless the investment discretion is granted by a customer on a temporary or limited basis and (2) an account as advisory if the broker-dealer charges a separate fee for, or separately contracts to provide, advisory services. (See http://www.sec.gov/rules/proposed/2007/ia-2652.pdf.) Finally, under the same proposed rule, a broker-dealer that is registered under the Exchange Act and registered under the Investment Advisers Act would be an investment adviser solely with respect to those accounts for which it provides services that subject the broker-dealer to the Investment Advisers Act.


Pursuant to the rules of self-regulatory organizations, broker-dealers are required to arbitrate disputes with their customers, if the customer chooses to arbitrate. See e.g., NASD Code of Arbitration Procedure for Customer Disputes, Rule 12200; American Stock Exchange, Rule 600; and Chicago Board of Options Exchange, Rule 18.1.


Broker-dealers must meet certain financial responsibility requirements, including:

* maintaining minimum amounts of liquid assets, or net capital;

* taking certain steps to safeguard the customer funds and securities; and

* making and preserving accurate books and records.

A. Net Capital Rule (Rule 15c3-1)

The purpose of this rule is to require a broker-dealer to have at all times enough liquid assets to promptly satisfy the claims of customers if the broker-dealer goes out of business. Under this rule, broker-dealers must maintain minimum net capital levels based upon the type of securities activities they conduct and based on certain financial ratios. For example, broker-dealers that clear and carry customer accounts generally must maintain net capital equal to the greater of $250,000 or two percent of aggregate debit items. Broker-dealers that do not clear and carry customer accounts can operate with lower levels of net capital.

B. Use of Customer Balances (Rule 15c3-2)

Broker-dealers that use customers’ free credit balances in their business must establish procedures to provide specified information to those customers, including:

* the amount due to those customers;

* the fact that such funds are not segregated and may be used by the broker-dealer in its business; and

* the fact that such funds are payable on demand of the customer.

C. Customer Protection Rule (Rule 15c3-3)

This rule protects customer funds and securities held by broker-dealers. Under the rule, a broker-dealer must have possession or control of all fully-paid or excess margin securities held for the account of customers, and determine daily that it is in compliance with this requirement. The broker-dealer must also make periodic computations to determine how much money it is holding that is either customer money or obtained from the use of customer securities. If this amount exceeds the amount that it is owed by customers or by other broker-dealers relating to customer transactions, the broker-dealer must deposit the excess into a special reserve bank account for the exclusive benefit of customers. This rule thus prevents a broker-dealer from using customer funds to finance its business.

D. Required Books, Records, and Reports (Rules 17a-3, 17a-4, 17a-5, 17a-11)11

Broker-dealers must make and keep current books and records detailing, among other things, securities transactions, money balances, and securities positions. They also must keep records for required periods and furnish copies of those records to the SEC on request. These records include e-mail. Broker-dealers also must file with the SEC periodic reports, including quarterly and annual financial statements. The annual statements generally must be certified by an independent public accountant. In addition, broker-dealers must notify the SEC and the appropriate SRO12 regarding net capital, recordkeeping, and other operational problems, and in some cases file reports regarding those problems, within certain time periods. This gives us and the SROs early warning of these problems.

E. Risk Assessment Requirements (Rules 17h-1T and 17h-2T)

Certain broker-dealers must maintain and preserve certain information regarding those affiliates, subsidiaries and holding companies whose business activities are reasonably likely to have a material impact on their own financial and operating condition (including the broker-dealer’s net capital, liquidity, or ability to conduct or finance operations). Broker-dealers must also file a quarterly summary of this information. This information is designed to permit the SEC to assess the impact these entities may have on the broker-dealer.


In addition to the provisions discussed above, broker-dealers must comply with other requirements. These include:

* submitting to Commission and SRO examinations;

* participating in the lost and stolen securities program;

* complying with the fingerprinting requirement;

* maintaining and reporting information regarding their affiliates;

* following certain guidelines when using electronic media to deliver information; and

* maintaining an anti-money laundering program.

A. Examinations and Inspections (Rules 15b2-2 and 17d-1)

Broker-dealers are subject to examination by the SEC and the SROs. The appropriate SRO generally inspects newly-registered broker-dealers for compliance with applicable financial responsibility rules within six months of registration, and for compliance with all other regulatory requirements within twelve months of registration. A broker-dealer must permit the SEC to inspect its books and records at any reasonable time.

B. Lost and Stolen Securities Program (Rule 17f-1)

In general, all broker-dealers must register in the lost and stolen securities program. The limited exceptions include broker-dealers that effect securities transactions exclusively on the floor of a national securities exchange solely for other exchange members and do not receive or hold customer securities, and broker-dealers whose business does not involve handling securities certificates. Broker-dealers must report losses, thefts, and instances of counterfeiting of securities certificates on Form X-17F-1A, and, in some cases, broker-dealers must make inquiries regarding securities certificates coming into their possession. Broker-dealers must file these reports and inquiries with the Securities Information Center (SIC), which operates the program for the SEC. A registration form can be obtained from Securities Information Center, P.O. Box 55151, Boston, MA 02205-5151. For registration and additional information, see the SIC’s website at https://www.secic.com.

C. Fingerprinting Requirement (Rule 17f-2)

Generally, every partner, officer, director, or employee of a broker-dealer must be fingerprinted and submit his or her fingerprints to the U.S. Attorney General. This requirement does not apply, however, to broker-dealers that sell only certain securities that are not ordinarily evidenced by certificates (such as mutual funds and variable annuities) or to persons who do not sell securities, have access to securities, money or original books and records, and do not supervise persons engaged in such activities. A broker-dealer claiming an exemption must comply with the notice requirements of Rule 17f-2. Broker-dealers may obtain fingerprint cards from their SRO and should submit completed fingerprint cards to the SRO for forwarding to the FBI on behalf of the Attorney General.

D. Use of Electronic Media by Broker-Dealers

The Commission has issued two interpretive releases discussing the issues that broker-dealers should consider in using electronic media for delivering information to customers. These issues include the following:

* Will the customer have notice of and access to the communication?

* Will there be evidence of delivery?

* Did the broker-dealer take reasonable precautions to ensure the integrity, confidentiality, and security of any personal financial information?

See Securities Exchange Act Release No. 37182 (May 15, 1996), 61 FR 24644. See also, Securities Exchange Act Release No. 39779 (March 23, 1998), 63 FR 14806 (http://www.sec.gov/rules/interp/33-7516.htm).

E. Electronic Signatures (E-SIGN)

Broker-dealers should also consider the impact, if any, that the Electronic Signatures in Global and National Commerce Act (commonly known as E-SIGN), Pub. L. No. 106-229, 114 Stat. 464 (2000) [15 U.S.C. §7001], has on their ability to deliver information to customers electronically.

F. Anti-Money Laundering Program

Broker-dealers have broad obligations under the Bank Secrecy Act (“BSA”)13 to guard against money laundering and terrorist financing through their firms. The BSA, its implementing regulations, and Rule 17a-8 under the Exchange Act require broker-dealers to file reports or retain records relating to suspicious transactions, customer identity, large cash transactions, cross-border currency movement, foreign bank accounts and wire transfers, among other things.

The BSA, as amended by the USA PATRIOT Act, as well as SRO rules (e.g., NASD Rule 3011 and NYSE Rule 445), also requires all broker-dealers to have anti-money laundering compliance programs in place. Firms must develop and implement a written anti-money laundering compliance program, approved in writing by a member of senior management, which is reasonably designed to achieve and monitor the member’s ongoing compliance with the requirements of the BSA and its implementing regulations. Under this obligation, firms must:

* establish and implement policies and procedures that can be reasonably expected to detect and cause the reporting of suspicious transactions;

* establish and implement policies, procedures, and internal controls reasonably designed to achieve compliance with the BSA and implementing regulations;

* provide for independent testing for compliance, to be conducted by member personnel or by a qualified outside party;

* designate and identify to the SROs an individual or individuals responsible for implementing and monitoring the day-to-day operations and internal controls of the program and provide prompt notification regarding any change in such designation(s); and

* provide ongoing training for appropriate personnel.

For a compilation of key anti-money laundering laws, rules and guidance applicable to broker-dealers, see Anti-Money Laundering Source Tool http://www.sec.gov/about/offices/ocie/amlsourcetool.htm; see also, FINRA Anti-Money Laundering Issue Center http://www.finra.org/RulesRegulation/IssueCenter/Anti-MoneyLaundering/index.htm. In addition, the Financial Crimes Enforcement Network (“FinCEN”), the division within the Department of the Treasury that administers the BSA, provides useful information for helping financial institutions, including broker-dealers, meet their BSA obligations. See FinCEN Web site http://fincen.gov/.

G. Office of Foreign Assets Control

Broker-dealers have an obligation to comply with the sanctions programs administered by the Department of Treasury’s Office of Foreign Assets Control (OFAC). OFAC administers and enforces economic and trade sanctions based on US foreign policy and national security goals against targeted foreign countries, terrorists, international narcotics traffickers, and those engaged in activities related to the proliferation of weapons of mass destruction.14 OFAC acts under Presidential wartime and national emergency powers, as well as authority granted by specific legislation, to impose controls on transactions and freeze foreign assets under US jurisdiction.

OFAC’s sanctions programs are separate and distinct from, and in addition to, the anti-money laundering requirements imposed under the BSA on broker-dealers.15 Unlike the BSA, OFAC programs apply to all U.S. persons and are applicable across business lines. OFAC programs are also strict liability programs — there are no safe harbors and no de minimis standards, although having a comprehensive compliance program in place could act as a mitigating factor in any enforcement action. OFAC publishes regulations implementing each of its programs, which include trade restrictions and asset blockings against particular countries and parties tied to terrorism, narcotics trafficking, proliferation of weapons of mass destruction, as well as a number of programs targeting members of certain foreign jurisdictions. As part of its efforts to implement these programs, OFAC publishes a list of Specially Designated Nationals, which is frequently updated on an as-needed basis.16 In general, OFAC regulations require you to do the following:

* block accounts and other property of specified countries, entities, and individuals;

* prohibit or reject unlicensed trade and financial transactions with specified countries, entities, and individuals; and

* report all blockings and rejections of prohibited transactions to OFAC within ten days of the occurrence and annually.17

OFAC has the authority to impose civil penalties of over $1,000,000 per count for violations of its sanctions programs. OFAC has stated that it will take into account the adequacy of your OFAC compliance program when it evaluates whether to impose a penalty if an OFAC violation occurs. To guard against engaging in OFAC prohibited transactions, you should generally follow a best practice of “screening against” the OFAC lists.18 Consistent with this best practice, you should take care to screen all new accounts, existing accounts, customers and relationships against the OFAC lists, including any updates to the lists. This screening should include originators or recipients of wire and securities transfers.19

H. Business Continuity Planning

The Commission, Federal Reserve Board, and Comptroller of the Currency published an interagency White Paper emphasizing the importance of core clearing and settlement organizations and establishing guidelines for their capacity and ability to restore operations within a short time of a wide-scale disruption.20 Separately, the Commission also published a Policy Statement urging the organized securities markets to improve their business continuity arrangements,21 and encouraging SRO-operated markets and electronic communications networks, or ECNs to establish plans to enable the restoration of trading no later than the business day following a wide-scale disruption.

In 2004, NASD and the NYSE adopted rules requiring every member to establish and maintain a business continuity plan, with elements as specified in the rules, and to provide the respective SROs with emergency contact information. See NASD Rule 3510 and NYSE Rule 446. See also, http://www.sec.gov/rules/sro/nasd/34-49537.pdf.


For general questions regarding broker-dealer registration and regulation:

Office of Interpretation and Guidance

Division of Trading and Markets

U.S. Securities and Exchange Commission

100 F Street, NE

Washington, DC 20549

(202) 551-5777

e-mail: [email protected]

For additional information about how to obtain official publications of SEC rules and regulations, and for on-line access to SEC rules:

Superintendent of Documents

Government Printing Office

Washington, DC 20402-9325


For copies of SEC forms and recent SEC releases,

See www.sec.gov, or contact:

Publications Section

U.S. Securities and Exchange Commission

100 F Street, NE

Washington, DC 20549

(202) 551-4040

Other useful addresses, telephone numbers, and websites:

SEC’s website: www.sec.gov

The SEC’s website contains contact numbers for SEC offices in Washington and for the SEC’s regional offices: http://www.sec.gov/contact/addresses.htm.

Financial Industry Regulatory Authority

9509 Key West Avenue

Rockville, MD 20850

(301) 590-6500 (call center)

(800) 289-9999 (to check on the registration status of a firm or individual)


New York Stock Exchange, Inc.

20 Broad Street

New York, NY 10005

(212) 656-3000


North American Securities Administrators Association, Inc.

750 First Street, NE, Suite 1140

Washington, DC 20002

(202) 737-0900


Municipal Securities Rulemaking Board

>1900 Duke Street, Suite 600

Alexandria, VA 22314

(703) 797-6600


Securities Investor Protection Corporation

805 15th Street, N.W. Suite 800

Washington, D.C. 20005-2215



e-mail: [email protected]

We wish to stress that we have published this guide as an introduction to the federal securities laws that apply to brokers and dealers. It only highlights and summarizes certain provisions, and does not relieve anyone from complying with all applicable regulatory requirements. You should not rely on this guide without referring to the actual statutes, rules, regulations, and interpretations.