Tag Archives: SEC

Blue sky laws and filings for hedge funds

The term “blue sky laws” refers, generically, to any of the securities laws of the individual states.  Each state has a set of laws on its books dealing with securities.  These laws have many similarities to the securities laws at the federal level (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act of 1940); in fact, many of the state blue sky laws are based on the laws at the federal level.  The state blue sky laws are enforced by the state securities administrator which is the state’s enforcement agency – it serves a similar function as the SEC does at the federal level.  Additionally, the state securities administrator may work in conjunction with the SEC in certain matters.

There are two distinct instances when, in virtually all of the states, blue sky laws become applicable to hedge fund managers (even unregistered hedge fund managers).

Blue Sky Anti-Fraud Authority

The first instance is when the state administrator pursues an action (i.e. request information, etc.) against a hedge fund manager (even if the hedge fund manager is unregistered) pursuant to its anti-fraud authority.  While each state’s anti-fraud statutes will differ, they are all drafted very broadly to give the state administrator wide lattitude for going after potential hedge fund frauds.  However, under this authority, the state administrator can also go after honest hedge fund managers.  While uncommon, it may happen in certain instances.  If it does, you should contact an experienced attorney immediately.  For most all unregistered hedge fund managers, this should not be something to worry about.

Blue Sky Filing Requirements

The second and more common instance when blue sky laws are implicated is when a fund will need to make a “blue sky filing.” As a general statement, a hedge fund will need to make a “blue sky filing” in each state where one of its investors resides.  The filing will generally need to be made within 15 days of the date of the investment into the hedge fund and the investment manager will need to pay a fee which will usually range anywhere from $75-$300 or more.  (Please note: for investors from New York a manager will need to make the blue sky filing prior to an initial investment into the fund.  The New York filing fee is going to be approzimately $1,400.)

To make a blue sky filing, you will first need to provide your hedge fund attorney or your compliance consultant with a few items of information including:

1. state where the investor resides
2. amount of the investment (including the amount of all previous investments)
3. the minimum investment amount (can be found in the hedge fund offering documents)
4. the management fee (can be found in the hedge fund offering documents)

After recieving this information your lawyer will complete a Form D and a Form U-2 and will help coordinate the filing of these documents with the appropriate state administrator.  The lawyer will also send a copy of Form D to the SEC for filing.  Form D filings are searchable through the SEC Edgar search engine.

Blue Sky Questions

Question: Does the fund or the management company pay the blue sky filing fees?

Answer: Most all offering documents which I have seen specifically name blue sky filing fees as an expense of the fund.  However, if this is not specifically named as a fund expense in your fund’s offering documents, it will likely still be a fund expense as most fund’s have a general catch-all for expenses like these.  If you have any specific questions, it is best to get clarity from your attorney.

Question: Does a manager have to pay the blue sky filing fee to each state on a yearly basis?

Answer: This is a good question.  As with many blue sky questions, it will depend on the specific state.  Some states only require a one-time filing fee, other states require that the filing fee be paid on an annual basis.  New York is a combination of these two as its filing fee is good for four years.  Your attorney or compliance professional should be able to discuss this with you on a state by state basis.

Important compliance information for registered investment advisors

Many registered investment advisors are happy once a registration has gone through. The individual, or firm, has gone through all of the following:

  • Receiving entitlement to the IARD system
  • Passing the Series 65 exam (tips on the series 65 exam)
  • Completing both the investment advisory firm’s Form ADV and Form ADV Part II (the investment advisor brochure)
  • Filing Form ADV through the IARD system
  • Notice filing in the state of the firm’s principal place of business

Once a firm has become registered as an investment advisor with the SEC, however, the important work is not over. The firm and the principals of the firm must make sure that all of the investment advisor rules are followed. Below is an overview of the laws a SEC registered investment advisor must follow; it was prepared by the SEC and serves as a good guide for the newly registered investment advisor. In addition to the following guide for newly registered investment advisors, it is also recommended that you thoroughly review your investment advisor compliance manual with your lawyer or your compliance professional.
Full article can be found here.

For the presentation below, I have changed the SEC’s spelling of “investment adviser” to “investment advisor” as appropriate.  Which begs the question: What is the difference between an “investment adviser” and an “investment advisor”?

There is no difference between the term “investment adviser” and “investment advisor” despite the incongruent spellings. The term “investment advisor” is most commonly used within the securities industry, however the SEC uses spelling “investment adviser”. It is likely that the reason the SEC uses this spelling is because the laws passed by congress specifically use the term.

Please feel free to contact us if you have any questions regarding any of the items below.  We will try to answer all questions in another blog post.  Also, we can provide you with help if you need assistance with an SEC mock examination and help with your compliance manual or code of ethics.

Information for Newly-Registered Investment Advisors

Prepared by the Staff of the Securities and Exchange Commission’s Division of Investment Management and Office of Compliance Inspections and Examinations

This information sheet contains general information about certain provisions of the Investment Advisers Act of 1940 (also called the “Advisers Act”) and selected rules under the Advisers Act. It is intended to assist newly-registered investment advisors in understanding their compliance obligations with respect to these provisions. This information sheet also provides information about the resources available to investment advisors from the SEC to help advisers understand and comply with these laws and rules.

As an adviser registered with the SEC, you have an obligation to comply with all of the applicable provisions of the Advisers Act and the rules that have been adopted by the SEC. This information sheet does not provide a complete description of all of the obligations of SEC-registered advisers under the law. To access the Advisers Act and rules and other information, visit the SEC’s website at www.sec.gov (the Advisers Act and rules are available at http://www.sec.gov/divisions/investment.shtml).

Investment advisors Are Fiduciaries

As an investment advisor, you are a “fiduciary” to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients. Generally, facts are “material” if a reasonable investor would consider them to be important. You must eliminate, or at least disclose, all conflicts of interest that might incline you — consciously or unconsciously — to render advice that is not disinterested. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict. You cannot use your clients’ assets for your own benefit or the benefit of other clients, at least without client consent. Departure from this fiduciary standard may constitute “fraud” upon your clients (under Section 206 of the Advisers Act).

Investment Advisors Must Have Compliance Programs

As a registered investment advisor, you are required to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act. The Commission has said that it expects that these policies and procedures would be designed to prevent, detect, and correct violations of the Advisers Act. You must review those policies and procedures at least annually for their adequacy and the effectiveness of their implementation, and designate a chief compliance officer (“CCO”) to be responsible for administering your policies and procedures (under the “Compliance Rule” — Rule 206(4)-7).

We note that your policies and procedures are not required to contain specific elements. Rather, you should analyze your individual operations and identify conflicts and other compliance factors that create risks for your firm and then design policies and procedures that address those risks. The Commission has stated that it expects your policies and procedures, at a minimum, to address the following issues to the extent that they are relevant to your business:

  • Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, your disclosures to clients, and applicable regulatory restrictions;
  • The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
  • Proprietary trading by you and the personal trading activities of your supervised persons;
  • Safeguarding of client assets from conversion or inappropriate use by your personnel;
  • The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • Safeguards for the privacy protection of client records and information;
  • Trading practices, including procedures by which you satisfy your best execution obligation, use client brokerage to obtain research and other services (referred to as “soft dollar arrangements”), and allocate aggregated trades among clients;
  • Marketing advisory services, including the use of solicitors;
  • Processes to value client holdings and assess fees based on those valuations; and
  • Business continuity plans.

Investment Advisers Are Required to Prepare Certain Reports and to File Certain Reports with the SEC

As a registered investment advisor, you are required to file an annual update of Part 1A of your registration form (Form ADV) through the Investment Advisers Registration Depository (IARD). You must file an annual updating amendment to your Form ADV within 90 days after the end of your fiscal year. In addition to making annual filings, you must promptly file an amendment to your Form ADV whenever certain information contained in your Form ADV becomes inaccurate (the Form ADV filing requirements are contained in Rule 204-1 of the Advisers Act, and in the instructions to the Form).

  • Make sure your Form ADV is complete and current. Inaccurate, misleading, or omitted Form ADV disclosure is the most frequently cited finding from our examinations of investment advisors.
  • Please keep the e-mail address of your contact person current (Form ADV, Part 1A, Item 1J). We use this e-mail address to keep you apprised of important developments (including when it’s time to file an amendment to your Form ADV).
  • Accurately report the amount of assets that you have under management (Form ADV, Part 1A, Item 5F(2)). Advisers who have less than $25 million of assets under management, who are not otherwise eligible to maintain their registration with the SEC, or who stop doing business as an investment advisor, should file a Form ADV-W through IARD to withdraw their registration.

With respect to Part II of your Form ADV, you are not required to file it through IARD at this time. Rather, it is considered to be ‘filed’ with the SEC when you update the form and place a copy in your files. As with Part 1A, you must update Part II annually within 90 days of the end of your fiscal year and whenever it becomes materially inaccurate.

You may also be subject to other reporting obligations. For example, an adviser that exercises investment discretion (or that shares investment discretion with others) over certain equity securities (including convertible debt and options), which have a fair market value in the aggregate of $100 million or more, must file a Form 13F each quarter that discloses these holdings. “Discretionary authority” means that you have the authority to decide which securities to purchase, sell, and/or retain for your clients.

You should also be aware that it is unlawful to make any untrue statement or omit any material facts in an application or a report filed with the SEC (under Section 207 of the Advisers Act), including in Form ADV and Form ADV-W.

Investment Advisors Must Provide Clients and Prospective Clients with a Written Disclosure Statement

Registered investment advisors are required to provide their advisory clients and prospective clients with a written disclosure document (these requirements, and a few exceptions, are set forth in Rule 204-3 under the Advisers Act). As a registered adviser, you may comply with this requirement either by providing advisory clients and prospective clients with Part II of your Form ADV or with another document that contains, at a minimum, the information that is required to be disclosed in Form ADV, Part II. This written disclosure document should be delivered to your prospective clients at least 48 hours before entering into an advisory contract or, if it is delivered at the time the client enters into the contract, the client should be given five business days after entering into the advisory contract to terminate the contract without penalty (under certain conditions, you may comply with the delivery requirements through electronic media).

Each year, you must also deliver or offer (in writing) to deliver a disclosure document to each client, without charge. You are required to maintain a copy of each disclosure document and each amendment or revision to it that was given or sent to clients or prospective clients, along with a record reflecting the dates on which such disclosure was given or offered to be given to any client or prospective client who subsequently became a client (under Rule 204-2(a)(14)).

Investment Advisors Must Have a Code of Ethics Governing Their Employees and Enforce Certain Insider Trading Procedures

As a registered investment advisor, you are required to adopt a code of ethics (under the “Code of Ethics Rule” — Rule 204A-1 under the Advisers Act). Your code of ethics should set forth the standards of business conduct expected of your “supervised persons” (i.e., your employees, officers, directors and other people that you are required to supervise), and it must address personal securities trading by these people.
We note that you are not required to adopt a particular standard of business ethics. Rather, the standard that you choose should reflect your fiduciary obligations to your advisory clients and the fiduciary obligations of the people you supervise, and require compliance with the federal securities laws. In adopting a code of ethics, investment advisors may set higher ethical standards than the requirements under the law.
In order to prevent unlawful trading and promote ethical conduct by advisory employees, advisers’ codes of ethics should include certain provisions relating to personal securities trading by advisory personnel. Your code of ethics must include the following requirements:

  • Your “access persons” must report their personal securities transactions to your CCO or to another designated person each quarter. “Access persons” are any of your supervised persons who have access to non-public information regarding client transactions or holdings, make securities recommendations to clients or have access to such recommendations, and, for most advisers, all officers, directors and partners.
  • Your access persons must submit a complete report of the securities that they hold at the time they first become an access person, and then at least once each year after that.3 Your code of ethics must also require that your access persons obtain your approval prior to investing in initial public offerings or private placements or other limited offerings, including pooled investment vehicles (except if your firm has only one access person).
  • Your CCO or another person you designate in addition to your CCO must review these personal securities transaction reports.
  • Your supervised persons must promptly report violations of your code of ethics (i.e., including the federal securities laws) to the CCO or to another person you designate (provided your CCO also receives a report on such issues). You must also maintain a record of these breaches.

Also, as a registered investment advisor, you are required to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the misuse of material non-public information (under Section 204A of the Advisers Act). These policies and procedures must encompass your activities and those of your supervised persons. Advisers often include this prohibition on insider trading in their code of ethics.

Provide each of the people that you supervise with a copy of your code of ethics (and any amendments that you subsequently make to it), and also obtain a written acknowledgement from the supervised person that he/she has received it. In addition, you must describe your code of ethics in your Form ADV, Part II, Item 9 and provide a copy to your advisory clients, if they request it.

Investment Advisors are Required to Maintain Certain Books and Records

As a registered adviser, you must make and keep true, accurate and current certain books and records relating to your investment advisory business (under “the Books and Records Rule” — Rule 204-2). The books and records that you must make and keep are quite specific, and are described below in part:

  • Advisory business financial and accounting records, including: cash receipts and disbursements journals; income and expense account ledgers; checkbooks; bank account statements; advisory business bills; and financial statements.
  • Records that pertain to providing investment advice and transactions in client accounts with respect to such advice, including: orders to trade in client accounts (referred to as “order memoranda”); trade confirmation statements received from broker-dealers; documentation of proxy vote decisions; written requests for withdrawals or documentation of deposits received from clients; and written correspondence you sent to or received from clients or potential clients discussing your recommendations or suggestions.
  • Records that document your authority to conduct business in client accounts, including: a list of accounts in which you have discretionary authority; documentation granting you discretionary authority; and written agreements with clients, such as advisory contracts.
  • Advertising and performance records, including: newsletters; articles; and computational worksheets demonstrating performance returns.
  • Records related to the Code of Ethics Rule, including those addressing personal securities transaction reporting by access persons.
  • Records regarding the maintenance and delivery of your written disclosure document and disclosure documents provided by certain solicitors who seek clients on your behalf.
  • Policies and procedures adopted and implemented under the Compliance Rule, including any documentation prepared in the course of your annual review.

Some advisers are required to maintain additional records. For example, advisers that have custody and possession of clients’ funds and/or securities must make and keep additional records that are described in the Books and Records Rule (Rule 204-2, paragraph (b)), and advisers who provide investment supervisory or management services to any client must also make and keep specific additional records (which are described in Rule 204-2, paragraph (c)).

You must keep these records for specified periods of time. Generally, most books and records must be kept for five years from the last day of the fiscal year in which the last entry was made on the document or the document was disseminated. You may be required to keep certain records for longer periods, such as records that support performance calculations used in advertisements (as described in Rule 204-2, paragraph (e)).

You are required to keep your records in an easily accessible location. In addition, for the first two of these years, you must keep your records in your office(s). If you maintain some of your original books and records somewhere other than your principal office and place of business, you must note this practice and identify the alternative location on your Form ADV (in Section 1K of Schedule D). Many advisers store duplicate copies of their advisory records in a location separate from their principal office in order to ensure the continuity of their business in the case of a disaster.

You may store your original books and records by using either micrographic media or electronic media. These media generally include microfilm or digital formats (e.g., electronic text, digital images, proprietary and off-the-shelf software, and email). If you use email or instant messaging to make and keep the records that are required under the Advisers Act, you should keep the email, including all attachments that are required records, as examiners may request a copy of the complete record. In dealing with electronic records, you must also take precautions to ensure that they are secure from unauthorized access and theft or unintended destruction (similar safeguarding provisions regarding client information obtained by you is required by Regulation S-P under the Gramm-Leach-Bliley Act). In general, you should be able to promptly (generally within 24 hours) produce required electronic records that may be requested by the SEC staff, including email. In order to do so, the Advisers Act requires that you arrange and index required electronic records in a way that permits easy location, access, and retrieval of any particular electronic record.

Investment Advisors Must Seek to Obtain the Best Price and Execution for Their Clients’ Securities Transactions

As a fiduciary, you are required to act in the best interests of your advisory clients, and to seek to obtain the best price and execution for their securities transactions. The term “best execution” means seeking the best price for a security in the marketplace as well as ensuring that, in executing client transactions, clients do not incur unnecessary brokerage costs and charges. You are not obligated to get the lowest possible commission cost, but rather, you should determine whether the transaction represents the best qualitative execution for your clients. In addition, whenever trading may create a conflicting interest between you and your clients, you have an obligation, before engaging in the activity, to obtain the informed consent from your clients after providing full and fair disclosure of all material facts. The Commission has described the requirement for advisers to seek best execution in various situations.

In selecting a broker-dealer, you should consider the full range and quality of the services offered by the broker-dealer, including the value of the research provided, the execution capability, the commission rate charged, the broker-dealer’s financial responsibility, and its responsiveness to you. To seek to ensure that you are obtaining the best execution for your clients’ securities trades, you must periodically evaluate the execution performance of the broker-dealers you use to execute clients’ transactions.

You may determine that it is reasonable for your clients to pay commission rates that are higher than the lowest commission rate available in order to obtain certain products or services from a broker-dealer (i.e., soft dollar arrangement). To qualify for a “safe harbor” from possible charges that you have breached your fiduciary duty by causing your clients to pay more than the lowest commission rate, you must use clients’ brokerage commissions to pay for certain defined “brokerage or research” products and services, use such products and services in making investment decisions, make a good faith determination that the commissions that clients will pay are reasonable in relation to the value of the products and services received, and disclose these arrangements.

The SEC staff has stated that, in directing orders for the purchase or sale of securities, you may aggregate or “bunch” orders on behalf of two or more client accounts, so long as the bunching is done for the purpose of achieving best execution, and no client is systematically advantaged or disadvantaged by the bunching. The SEC staff has also said that, if you decide not to aggregate orders for client accounts, you should disclose to your clients that you will not aggregate and the potential consequences of not aggregating orders.

If your clients impose limitations on how you will execute securities transactions on their behalf, such as by directing you to exclusively use a specific broker-dealer to execute their securities transactions, you have an obligation to fully disclose the effects of these limitations to the client. For example, if you negotiate volume commission discounts on bunched orders, a client that has directed you to use a specific broker should be informed that he/she will forego any benefit from savings on execution costs that you might obtain for your other clients through this practice.

You should also seek to obtain the best price and execution when you enter into transactions for clients on a “principal” or “agency cross” basis. If you have acted as a principal for your own account by buying securities from, or selling securities to, a client, you must disclose the arrangement and the conflicts of interest in this practice (in writing) and also obtain the client’s consent for each transaction prior to the time that the trade settles. There are also explicit conditions under which you may cross your advisory clients’ transactions in securities with securities transactions of others on an agency basis (under Rule 206(3)-2). For example, you must obtain advance written authorization from the client to execute such transactions, and also provide clients with specific written disclosures. Compliance with Rule 206(3)-2 is generally not required for transactions internally crossed or effected between two or more clients you advise and for which you receive no additional compensation (i.e., commissions or transaction-based compensation); however, full disclosure regarding this practice should be made to your clients.

Requirements for Investment Advisors’ Contracts with Clients

As a registered investment advisor, your contracts with your advisory clients must include some specific provisions (which are set forth in Section 205 of the Advisers Act). Your advisory contracts (whether oral or written) must convey that the advisory services that you provide to the client may not be assigned by you to any other person without the prior consent of the client. With limited exceptions, contracts cannot include provisions providing for your compensation to be based on the performance of the client’s account. In addition, the SEC staff has stated that an adviser should not enter into contracts with clients, except with certain sophisticated clients, that contain terms or clauses commonly referred to as a “hedge clause” because such clauses or provisions are likely to lead other clients to believe that they have waived their rights of legal action, whether under the federal securities laws or common law.

Investment Advisors May be Examined by the SEC Staff

As a registered investment advisor, your books and records are subject to compliance examinations by the SEC staff (under Section 204 of the Advisers Act). The purpose of SEC examinations is to protect investors by determining whether registered firms are complying with the law, adhering to the disclosures that they have provided to their clients, and maintaining appropriate compliance programs to ensure compliance with the law. If you are examined, you are required to provide examiners with access to all requested advisory records that you maintain (under certain conditions, documents may remain private under the attorney-client privilege).

More information about examinations by the SEC and the examination process is provided in the brochure, “Examination Information for Broker-Dealers, Transfer Agents, Clearing Agencies, Investment Advisers and Investment Companies,” which is available on the SEC’s website at http://www.sec.gov/info/cco/ccons2006exambrochure.pdf.

Requirements for Investment Advisors that Vote Proxies of Clients’ Securities

As a registered investment advisor, if you have voting authority over proxies for clients’ securities, you must adopt policies and procedures reasonably designed to ensure that you: vote proxies in the best interests of clients; disclose information to clients about those policies and procedures; and describe to clients how they may obtain information about how you have voted their proxies (these requirements are in Rule 206(4)-6 under the Advisers Act).

If you vote proxies on behalf of your clients, you must also retain certain records. You must keep: your proxy voting policies and procedures; the proxy statements you received regarding your client’s securities (the Rule provides some alternative arrangements); records of the votes you cast on behalf of your clients; records of client requests for proxy voting information; and any documents that you prepared that were material to making a decision as to how to vote or that memorialized the basis for your decision (these requirements are described in Advisers Act Rule 204-2(c)(2)).

Requirements for Investment Advisors that Advertise their Services

To protect investors, the SEC prohibits certain types of advertising practices by advisers. An “advertisement” includes any communication addressed to more than one person that offers any investment advisory service with regard to securities (under “the Advertising Rule” — Rule 206(4)-1). An advertisement could include both a written publication (such as a website, newsletter or marketing brochure) as well as oral communications (such as an announcement made on radio or television).

Advertising must not be false or misleading and must not contain any untrue statement of a material fact. Advertising, like all statements made to advisory clients and prospective clients, is subject to the general prohibition on fraud (Section 206 as well as other anti-fraud provisions under the federal securities laws). Specifically prohibited are: testimonials; the use of past specific recommendations that were profitable, unless the adviser includes a list of all recommendations made during the past year; a representation that any graph, chart, or formula can in and of itself be used to determine which securities to buy or sell; and advertisements stating that any report, analysis, or service is free, unless it really is free.

The SEC staff has said that, if you advertise your past investment performance record, you should disclose all material facts necessary to avoid any unwarranted inference. For example, SEC staff has indicated that it may view performance data to be misleading if it:

  • does not disclose prominently that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material;
  • does not disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in value 25% without disclosing that the market generally appreciated 40% during the same period);
  • does not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that accounts would have or actually paid;
  • does not disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
  • suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
  • compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g., an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio); and
  • does not disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation).

In addition, as a registered adviser, you may not imply that the SEC or another agency has sponsored, recommended or approved you, based upon your registration (under Section 208 of the Advisers Act). You should not use the term “registered investment advisor” unless you are registered, and you should not use this term to imply that as a registered adviser, you have a level of professional competence, education or special training. For example, the SEC staff has stated that advisers should not use the term “RIA” after a person’s name because using initials after a name usually indicates a degree or a licensed professional position for which there are certain qualifications; however, there are no federal qualifications for becoming an SEC-registered adviser.

Requirements for Investment Advisors that Pay Others to Solicit New Clients

Registered investment advisors may pay cash compensation to others to seek out new clients on their behalf, commonly called “solicitors” or “finders,” if they meet certain conditions (under Rule 206(4)-3 of the Advisers Act):

  • The solicitor is not subject to certain disciplinary actions.
  • The fee is paid pursuant to a written agreement to which you are a party and (with limited exceptions) the agreement must: describe the solicitor’s activities and compensation arrangement; require that the solicitor perform the duties you assign and in compliance with the Advisers Act; require the solicitor to provide clients with a current copy of your disclosure document; and, if seeking clients for personalized advisory services, require the solicitor to provide clients with a separate written disclosure document containing specific information.
  • You receive from the solicited client, prior to or at the time you enter into an agreement, a signed and dated notice confirming that he/she was provided with your disclosure document and, if required, the solicitor’s disclosure document.
  • You have a reasonable basis for believing that the solicitor has complied with the terms of your agreement.

Requirements for Investment Advisors that have Custody or Possession of Clients’ Funds or Securities

Registered investment advisors that have “custody” or “possession” of client assets must take specific measures to protect client assets from loss or theft (under “the Custody Rule” — Rule 206(4)-2(c)(1) under the Advisers Act).

The first step is to determine whether you have custody or possession of client assets. “Custody” is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” This includes situations in which you:

  • have physical possession of client funds or securities, even temporarily;
  • enter into arrangements (including a general power of attorney) authorizing you to withdraw funds or securities from the client’s account (note that if you are authorized to deduct your advisory fees or other expenses directly from clients’ accounts, you have custody); and
  • serve in a capacity that gives you or a supervised person legal ownership or access to client funds or securities (note that if you are a general partner to a privately-offered pooled investment vehicle, you have custody).

If you have custody, with limited exceptions, you must maintain these client funds and securities at a “qualified custodian.” Generally, qualified custodians include most banks and insured savings associations, SEC-registered broker-dealers, Commodity Exchange Act-registered futures commission merchants, and certain foreign financial institutions. With a limited exception, for client accounts over which you have custody, you must have a reasonable basis for believing that the client (or a designated representative) receives periodic reports directly from the custodian that contain specific information with respect to the funds and securities in custody. With respect to pooled investment vehicles over which you have custody, the qualified custodian must send account statements for the pooled vehicle directly to each investor.
If you, rather than a qualified custodian, send account statements directly to your clients, you must have a “surprise verification” by an independent public accountant. The independent public accountant must verify the funds and securities in your custody or possession at least once each calendar year, and must then promptly file a “certificate of examination” with Form ADV-E with the SEC.4

Requirements for Investment Advisors to Disclose Certain Financial and Disciplinary Information

Registered investment advisors may be required to disclose certain financial and disciplinary information (under Rule 206(4)-4 under the Advisers Act). These requirements are described below.
Registered advisers that have custody or discretionary authority over client funds or securities, or that require prepayment six months or more in advance of more than $500 in advisory fees, must promptly disclose to clients and any prospective clients any financial conditions that are reasonably likely to impair their ability to meet their contractual commitments to their clients.

All registered advisers must also promptly disclose any legal or disciplinary events that would be material to a client’s or a prospective client’s evaluation of the adviser’s integrity or its ability to meet its commitments to clients (regardless of whether the adviser has custody or requires prepayment of fees). The types of legal and disciplinary events that may be material include:

  • Criminal or civil actions, where the adviser or a management person of the adviser was convicted, pleaded guilty or “no contest,” or was subject to certain disciplinary actions with respect to conduct involving investment-related businesses, statutes, regulations, or activities; fraud, false statements, or omissions; wrongful taking of property; or bribery, forgery, counterfeiting, or extortion.
  • Administrative proceedings before the SEC, other federal regulatory agencies, or any state agency where the adviser’s or a management person’s activities were found to have caused an investment-related business to lose its authorization to do business or where such person was involved in a violation of an investment-related statute or regulation and was the subject of specific disciplinary actions taken by the agency.
  • Self-regulatory organization (SRO) proceedings in which the adviser or a management person was found to have caused an investment-related business to lose its authorization to do business; or was found to have been involved in a violation of the SRO’s rules and was the subject of specific disciplinary actions taken by the organization.

Informational Resources Available From the SEC

The SEC provides a great deal of helpful information about the compliance obligations of investment advisors on the SEC’s website at http://www.sec.gov/divisions/investment.shtml. This information includes links to relevant laws and rules, staff guidance and studies, enforcement cases, and staff no-action and interpretive letters (generally from 2001 — present). In addition, the SEC’s website contains a list of the source materials that were used in preparing this information sheet.

To assist chief compliance officers of investment advisors and investment companies in meeting their compliance responsibilities and to help enhance compliance in the securities industry, the SEC has established the “CCOutreach Program.” This program includes regional and national seminars on compliance issues of concern to CCOs. Information about CCOutreach and any scheduled events is available at http://www.sec.gov/info/ccoutreach.htm.

Finally, the SEC staff regularly receive calls and correspondence concerning the application of the federal securities laws, and advisers and other registrants are encouraged to communicate any questions or issues to SEC staff. To ensure that you reach the right person at the SEC, the SEC’s website lists the names and contact information for SEC staff in the Division of Investment Management who are responsible for responding to communication from the public about specific topics (http://www.sec.gov/divisions/investment/imcontact.htm).

With respect to issues or questions that arise in the context of a compliance examination by the SEC, advisers are encouraged to raise any questions or issues directly with the SEC examination team, or with examination supervisors in their local SEC office (contact information for senior examination staff is available at http://www.sec.gov/about/offices/ocie/ocie_org.htm).

SEC files complaint against forex fraud

Summary:

Last Wednesday the SEC filed a complaint against a forex hedge fund manager who was supposedly using a “trading robot” to generate huge returns. It turns out the forex hedge fund manager and the trading robot did not generate the outsized returns, but instead lost investor money. There are two very important items to note here:

1. It is scams like this that has the SEC and CFTC on the offensive to regulate the spot forex market.

2. Again, it is so important for all investors to do proper due diligence on managers and to make sure they know what they are investing in. These fraudsters give a bad name to all hedge fund managers and, sometimes, they can be stopped if the right questions are asked in the beginning.

SEC Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20688 / August 22, 2008

Securities and Exchange Commission v. Royal Forex Management, LLC and Patrick H. Haxton, (U.S.D.C., Northern District of Texas, Dallas Division, Civil Action No. 3:08-CV-1467-L)

SEC Accuses Carrolton, Texas, Man of Selling Fraudulent Securities Involving Foreign Currency Trading

On August 20, 2008, the Securities and Exchange Commission filed an action in Dallas federal court to halt an alleged unregistered and fraudulent offering of securities by Patrick H. Haxton of Carrollton, Texas, and his company Royal Forex Management, LLC (“Royal”). The securities were investment contracts involving the trading of foreign currencies on the Forex market. On August 21, 2008, United States District Judge Sam A. Lindsay entered a temporary restraining order suspending the offering and orders freezing the defendants’ assets, requiring sworn accountings, prohibiting any alteration or destruction of documents and expediting discovery. The court set a hearing for September 4, 2008 to consider the Commission’s application for preliminary injunctive relief.

The defendants named in the Commission’s Complaint are: Patrick H. Haxton, age 51, of Carrollton, Texas, the owner and sole manager of Royal; and Royal Forex Management, LLC, a Texas limited liability corporation operated out of Haxton’s Carrollton home.

The Commission’s Complaint alleges that from at least June 2007 to the present Haxton, personally and through Royal, raised at least $305,000 from 8 investors in three states. Haxton offers the Forex investments through the Royal web site (www.royalforexmanagement.com), advertising on his work truck and personal contacts. Royal’s promotional materials and Haxton’s oral statements are replete with representations of phenomenal past trading returns, including claims of 400% to 500% annual returns, generated by a complex software program named “The Currency Trading Robot” (“Trading Robot”), purportedly created by Haxton. On the web site, Haxton claims to have a great history and to have been a very successful trader since 2000. Haxton and the web site also represent that there is very little risk of loss.

The Commission alleges, however, that these representations are materially false and misleading. For instance, the Commission contends that Haxton and Royal never generated the claimed phenomenal returns by trading currency. Indeed, according to the Complaint, Haxton lost a significant portion of investor funds trading foreign currencies and misappropriated the remaining funds for his own personal use. In some instances, investor funds were never traded, but were used to pay business and personal expenses.

The defendants are charged with securities fraud under Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and with conducting an unregistered offering under Section 5 of the Securities Act. The Complaint also seeks permanent injunctions, civil penalties and disgorgement of ill-gotten gains, among other relief, against each defendant.

The Commission would like to thank and acknowledge the assistance of the Texas State Securities Board in this matter.

Hedge fund author fined $100k by the SEC for fraudulent hedge fund

Summary:

Mark J.P. Boucher, the author of the book The Hedge Fund Edge, was involved in a hedge fund scam where he lured investors into a real-estate hedge fund which was was supposed to be secured by real property. The fund was not and investors lost millions of dollars. This underscores the necessity for hedge fund investors to protect themselves from these fraudsters by completing proper hedge fund due diligence. Please contact us if you have questions on hedge fund due diligence.

SEC Release:

Litigation Release No. 20689 / August 27, 2008
Securities and Exchange Commission v. Mark Joseph Peterson Boucher and Gary Paul Johnson,, Case No. CV 08-4088 (N.D. Cal. filed August 27, 2008); Securities and Exchange Commission v. John E. Brake,, Case No. CV 08-4089 (N.D. Cal. filed August 27, 2008)

SEC Charges Bay Area Investment Adviser, Others in Real Estate Investment Scam

The Securities and Exchange Commission today charged a Portola Valley investment adviser and newsletter publisher, Mark J.P. Boucher, with misleading clients into investing in two failed real estate development companies.

According to the Commission, Boucher helped raise around $20 million for the companies by falsely representing that the investments were secured by real estate, when in reality one of the companies owned no property, and the other owned a single property that was wholly underwater in debt. The Commission also sued the owners of each company, John E. Brake and Gary P. Johnson (both of Southern California) for misappropriating millions of dollars of investor funds to finance everything from beachfront homes to undisclosed side businesses. Boucher and Johnson have settled with the Commission without admitting or denying the allegations.

According to complaints filed today in federal district court in San Francisco, from 1999 through 2005, the defendants collectively raised about $20 million from investors based upon misrepresentations that the money would be used to fund large-scale real estate development projects and that the investments were secured by real property. In reality, the investments were not secured: one development company never owned property, and by the summer of 2002, the other company’s lone property was so heavily debt laden that its debts exceeded potential profits. In the end, neither company successfully developed a real estate project, and investors lost millions of dollars.

The Commission alleges that many investors became interested because Boucher — a hedge fund manager and the author of the book The Hedge Fund Edge — recommended the investments in a monthly newsletter he circulated to his advisory clients.

The Commission’s complaints allege that the defendants misused investor funds to pay for a wide variety of personal expenses. Among other things, Brake allegedly used investor funds to pay for a beachfront home rental in Carmel, California, luxury automobiles, a personal chauffeur, private jet travel, jewelry and designer clothing, while Johnson used investor funds to launch a failed furniture business. The Commission also alleges that Boucher used investor money to pay a portion of the mortgage on his personal residence.

Boucher, without admitting or denying the allegations in the Commission’s complaint, has agreed to a permanent injunction from further violations of Sections 17(a) and 17(b) of the Securities Act of 1933 (“Securities Act”), Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder (“Exchange Act”), and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. Boucher will also pay a $100,000 civil penalty. In addition, Boucher has consented to the institution of public administrative proceedings against him in which he will be barred from serving as an investment adviser with a right to reapply after five years.

Johnson, without admitting or denying the allegations, has likewise agreed to a permanent injunction from further violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Johnson has also consented to an order requiring him to disgorge more than $1.8 million in ill-gotten gains and approximately $700,000 in prejudgment interest, and to pay a civil penalty of $120,000.

Brake is charged with violating Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The Commission is seeking injunctive relief, disgorgement, and civil money penalties against Brake.

SEC fines adviser and revokes registration

The SEC fined an investment adviser and revoked its registration because of willful refusal to follow simple investment adviser rules such as updating form ADV and submitting to a reasonable examination of its books and records.

From SEC website:

Commission Declares Decision as to Amaroq Asset Management, LLC and Dwight Andre Sean O’Neal Jones Final

The decision of an administrative law judge ordering Amaroq Asset Management, LLC, and Dwight Andree Sean O’Neal Jones to cease and desist from committing or causing any violations or future violations of Section 204 of the Investment Advisers Act of 1940 and Advisers Act Rule 204-1 has been declared final. The law judge further ordered that the registration of Amaroq Asset Management, LLC be revoked; that Dwight Andree Sean O’Neal Jones be barred from association with any investment adviser, with a right to apply for association after one year; and ordered that Jones pay a civil penalty in the amount of $15,000.

The law judge concluded that Jones willfully aided and abetted and was a cause of Amaroq’s failure to: (1) file annual amendments to Form ADV; (2) promptly update its Form ADV to reflect its current business address; (3) submit to a reasonable examination and failing to furnish copies of the required books and records in connection with the scheduled examination. The law judge found that Jones showed indifference and/or a series of broken promises, when Commission attorneys repeatedly and explicitly informed him of the law’s requirements, thereby demonstrating extreme recklessness. (Rel. IA-2770) Finality Order; File No. 3-12822)

For final decision, click here.

SEC to replace ancient EDGAR database

Summary:

On Tuesday the SEC announced that a new company filing database which will be faster and easier to use than the current EDGAR system. The new system is called IDEA, short for Interactive Data Electronic Applications. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

Press Release:

SEC Announces Successor to EDGAR Database
“IDEA” Will Make Company and Fund Information Interactive
FOR IMMEDIATE RELEASE
2008-179

Washington, D.C., Aug. 19, 2008 — Securities and Exchange Commission Chairman Christopher Cox today unveiled the successor to the agency’s 1980s-era EDGAR database, which will give investors far faster and easier access to key financial information about public companies and mutual funds.

The new system is called IDEA, short for Interactive Data Electronic Applications. Based on a completely new architecture being built from the ground up, it will at first supplement and then eventually replace the EDGAR system. The decision to replace EDGAR marks the SEC’s transition from collecting forms and documents to making the information itself freely available to investors to give them better and more up-to-date financial disclosure in a form they can readily use.

Currently, most SEC filings are available only in government-prescribed forms through EDGAR. Investors looking for information must sift through one form at a time, and then re-keyboard the information — a painstaking task. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

IDEA will ensure that both the SEC and the investors who rely upon the financial reporting the agency demands are ready for the new world of financial disclosure that will soon arrive when financial information is presented in interactive data format. The SEC has formally proposed requiring U.S. companies to provide financial information using interactive data beginning as early as next year, and separately has proposed requiring mutual funds to submit their public filings using interactive data.

“IDEA will ensure that the SEC continues to stay ahead of the needs of investors,” said Chairman Cox. “This new SEC resource powered by interactive data will give investors far faster, more accurate, and more meaningful information about the companies and mutual funds they own. IDEA’s launch represents a fundamental change in the way the SEC collects and publishes company and fund information – and in the way that investors will be able to use it.”

Interactive data relies on computer “tags,” similar in function to bar codes, which identify individual items in a company’s financial disclosures. With every number on an income statement or balance sheet individually labeled, information about thousands of companies contained on thousands of forms could be easily searched on the Internet, downloaded into spreadsheets, reorganized in databases, and put to any number of other comparative and analytical uses by investors, analysts, journalists, and financial intermediaries.

The ease with which interactive data will make financial information available also is expected to generate many new Web-based services and products for investors.

As he unveiled the new IDEA platform at a Washington news conference today, Chairman Cox announced that the IDEA logo will begin to appear immediately on the SEC’s Web site as the agency transitions to making IDEA the new primary source for all SEC filings. Companies’ interactive data filings are expected to be available through IDEA beginning late this year.

Investors and others who currently use EDGAR will be able to continue doing so for the indefinite future. During the transition to IDEA, investors will be able to take advantage of new interactive, IDEA-like features that will be grafted onto EDGAR in the short run. This will make it possible for investors to tap IDEA’s advanced search capabilities, and to use the information from EDGAR within spreadsheets and analytical software – something that was never possible with EDGAR. The EDGAR database also will continue to be available as an archive of company filings for past years.

“When Congress created the SEC, and even when EDGAR was launched, the markets worked on paper and by mail. Today, the marketplace works online and by e-mail,” explained disclosure and transparency expert Dr. William D. Lutz, who is leading the SEC’s 21st Century Disclosure Initiative. “Companies and investors alike compile, analyze, and produce information and reports electronically. With the move to an electronic data-based filing system, the SEC will not only keep pace with the markets, but will provide investors with a dynamic system they can use to get the information they need, rather than having to wade through an avalanche of paper forms, legalese, and doublespeak.”

David Blaszkowsky, Director of the SEC’s Office of Interactive Disclosure, added, “After 75 years of document-based static financial reporting, whether in paper documents or in electronic equivalents, it is exciting to see the SEC poised to cross the ‘data threshold’ and help investors receive financial information that is dynamic, usable and ready to go as they make their investment decisions. And when the investor wins, so does the public company, fund, or other filer who simultaneously benefits from greater transparency and trust in our markets. By tapping the power of interactive data to tear down barriers to quick and meaningful investment information, markets can become fairer and more efficient while investors can possess far better quality data than was ever possible before.”

New York based Hedge Fund Group mulls self-regulatory regime

A group of New York based hedge fund professionals (the New York Hedge Fund Roundtable) are establishing a group to explore the possibility of instituting a hedge fund professional society/ self-regulatory organization. Such a group might be welcome in the hedge fund landscape, which is seeing greater strides by state and federal securities regulation to reign in (and regulate) the industry.

According to their website,

The New York Hedge Fund Roundtable was founded on three governing principles:

1. Continuously educating roundtable members from the investing & hedge fund worlds on relevant industry topics & forecasts.
2. Initiating Best Practices & knowledge transfer to the broader hedge fund world, allowing members to leverage peer information exchange and positively affecting both the profession and others.
3. Creating an environment to support social networking, allowing members to effectively engage with peers while helping them build their own careers & businesses.

A SRO would hopefully stem the rise of future regulation. However, the hedge fund industry has proved to be a hard sell on any sort of self-regulation and with the SEC maxed out with other crises (i.e. investment banks), any legitimate push for hedge fund regulation at the federal level is likely years away.

For more information see: http://www.reuters.com/article/fundsFundsNews/idUSN3135262220080806

For more information on the New York Hedge Fund Roundtable, plesee see: http://www.newyorkhedgefundroundtable.org

Cox testifys to Congress: discusses hedge funds

Jul. 24, 2008

Testimony Concerning Reform of the Financial Regulatory System, Before the Committee on Financial Services, U.S. House of Representatives

Given these business, accounting, and regulatory differences, imposing the existing commercial bank regulatory regime on investment banks would be a mistake. It is conceivable that Congress could create a framework for investment banking that would intentionally discourage risk taking, reduce leverage, and restrict lines of business, but this would fundamentally alter the role that investment banks play in the capital formation that has fueled economic growth and innovation domestically and abroad. Such a course could be justified, if at all, only on the grounds that, like commercial banks which have long enjoyed explicit access to government-provided liquidity, investment banks’ activities must be controlled in order to protect the taxpayer.

This, however, makes clear that the more fundamental question is not whether investment banks should be regulated like commercial banks, but whether they should have permanent access to government-provided backstop liquidity. And if Congress were to answer that question in the affirmative, it is difficult to imagine that our markets would not produce new entities, perhaps hedge funds or other non-regulated firms, to take over the higher-risk capital markets functions of the formerly robust investment banks. That, in turn, would simply raise today’s questions anew.

SEC releases Q&A on naked shorting rule

The SEC has released guidance on the new naked shorting rules.

Division of Trading and Markets:

Guidance Regarding the Commission’s Emergency Order Concerning Short Selling

I. Introduction

Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934, on July 15, 2008, the Securities and Exchange Commission (“Commission”) issued an Emergency Order (the “Order”) related to short selling securities of the companies identified in Appendix A of the Order. Also pursuant to Section 12(k)(2), on July 18, 2008, the Commission issued an amendment to the Order. The following questions and answers regarding the Order as amended have been prepared by and represent the views of the Staff of the Division of Trading and Markets (“Staff”) to assist in the understanding and application of the Order. They are not rules, regulations, or statements of the Commission. Further, the Commission has neither approved nor disapproved these interpretive answers and is not bound by them.

II. Responses to Questions Regarding the Order

Question 1: What securities are covered by the Order?

Answer: The Order applies to the publicly traded securities traded under the ticker symbols listed in Appendix A to the Order.

Question 2: Is an “arrangement to borrow” the equivalent of having reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due as required in Rule 203(b)(1) of Regulation SHO?

Answer: No. An arrangement to borrow requires more than a reasonable grounds to believe that the security can be borrowed. An arrangement to borrow means a bona fide agreement to borrow the security such that the security being borrowed is set aside at the time of the arrangement solely for the person requesting the security.

Question 3: May a person effecting a short sale on behalf of a customer rely on a customer’s representation that the customer has arranged to borrow the security from another source?

Answer: Yes. As permitted under Regulation SHO, a person effecting a short sale may obtain an assurance from a customer that such party has borrowed or arranged to borrow the security being sold short from another identified source provided the person effecting the short sale documents that it is relying on a customer’s assurance and that the person effecting the short sale has reasonable grounds to believe that the customer has borrowed or arranged to borrow the security. Customers are reminded, however, that they are also subject to the requirements of the Order.

Question 4: How does the requirement to borrow or arrange to borrow securities apply to options exercises and assignments?

Answer: Footnote 3 of the Order states that “[s]hort sales to be effected as a result of a put options exercise are subject to the Order.” Accordingly, any person that sells a security short pursuant to the exercise of a put option (including automatic exercises), where the exercise is not in connection with hedging activities by an options market maker, must comply with all the requirements of the Order. The exercise of a put option in a market maker account is exempt from the borrow or arrangement-to-borrow requirement but not from the delivery requirement.

A person will not have violated the Order if it sells short pursuant to the assignment of a call option and does not borrow or arrange to borrow the security prior to effecting such short sale. Such person, however, must deliver the security by settlement date.

Question 5: May a person effecting a short sale re-apply a borrow or arrangement to borrow for intra-day buy-to-cover trades?

Answer: Yes. A person effecting a short sale in a security of a company listed in Appendix A to the Order that has borrowed or arranged to borrow the security prior to effecting the short sale in compliance with the Order may re-apply the borrow or arrangement to borrow for an intra-day buy-to-cover trade as illustrated in the following scenario:

Prior to a customer’s short sale of 100 shares of XYZ stock, at 10 a.m., the broker-dealer effecting the short sale arranges to borrow the shares. The short sale is then executed. Later that same day, at 11 a.m., the broker-dealer purchases 100 shares of XYZ stock for the same customer. As a result, the customer’s net trading position becomes flat.

If the same customer wants to then sell short another 100 shares of XYZ stock that day, at 3 p.m., the broker-dealer effecting the short sale may apply the original arrangement to borrow shares to that later sale, provided that such subsequent short sale is for an amount of securities that is no greater than the amount of securities obtained in the original arrangement to borrow shares (thus, in the above example, the second short sale at 3 p.m. cannot exceed 100 shares unless the broker-dealer makes another arrangement to borrow additional shares prior to effecting the short sale).

Question 6: How does the Order apply to overseas transactions?

Answer: The Order provides that no person may effect a short sale in the securities of companies identified in Appendix A to the Order using the means or instrumentalities of interstate commerce unless the person or its agent has borrowed or arranged to borrow the security or otherwise has the security available to borrow in its inventory prior to effecting such short sale and delivers the security on settlement date. Accordingly, the Order applies to any short sale transaction in the publicly traded securities traded under the ticker symbols listed in Appendix A to the Order if the trade is agreed to in the United States, even if the trade is booked overseas. In addition, the Order applies to any short sale transaction involving a customer located in the United States and to any broker-dealer (regardless of whether the broker-dealer is registered with the Commission or relying on an exemption from registration) using the means or instrumentalities of interstate commerce in the United States to effect short sales in the publicly traded securities traded under the ticker symbols listed in Appendix A to the Order.

Question 7: How does the Order apply if a broker-dealer that has a delivery obligation with respect to a short sale of a security subject to this Order has a deficit in its possession-and-control obligation for that security under Exchange Act Rule 15c3-3(b)?

Answer: The broker-dealer must comply with the applicable provisions of Rule 15c3-3(b). Generally, a delivery of securities that are in a possession-and-control deficit is prohibited if it would create or increase a deficiency in the quantity of securities by class and issuer required to be in possession and control. The Commission staff has issued no-action relief from certain possession and control provisions of Rule 15c3-3 to broker-dealers that conduct a securities-borrowed-and-loan-“conduit” business. That relief also applies to the publicly traded securities traded under the ticker symbols listed in Appendix A to the Order.

Question 8: How can I comment on the Commission’s emergency orders, or any potential rulemaking the Commission may undertake to expand the duration of the naked short sale protections or the number of companies covered?

Answer: The Commission welcomes such comments, which will be considered in any action the Commission may take with respect to naked short sales.

People wishing to submit such comments can use any of the following methods:

Electronic Comments:

Use the Commission’s Internet comment form (http://www.sec.gov/cgi-bin/ruling-comments?ruling=s72008&rule_path=/comments/s7-20-08&file_num=S7-20-08&action=Show_Form&title=Emergency%20Order%20Short%20Sales); or

Send an e-mail to [email protected]. Please include File Number S7-20-08 on the subject line; or

Paper Comments:

Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All submissions should refer to File Number S7-20-08. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (http://www.sec.gov/). Comments are also available for public inspection and copying in the Commission’s Public Reference Room, 100 F Street, NE, Washington, DC 20549 on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

http://www.sec.gov/divisions/marketreg/emordershortsalesfaq.htm

SEC’s guide to Broker-Dealer registration

I. INTRODUCTION

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.

II. WHO IS REQUIRED TO REGISTER

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).

III. HOW TO REGISTER AS A BROKER-DEALER

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.

IV. SECURITY FUTURES

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).

V. CONDUCT REGULATION OF BROKER-DEALERS

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.

VI. ARBITRATION

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.

VII. FINANCIAL RESPONSIBILITY OF BROKER-DEALERS

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.

VIII. OTHER REQUIREMENTS

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.

IX. WHERE TO GET FURTHER INFORMATION

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

www.gpo.gov

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)

www.finra.org

New York Stock Exchange, Inc.

20 Broad Street

New York, NY 10005

(212) 656-3000

www.nyse.com

North American Securities Administrators Association, Inc.

750 First Street, NE, Suite 1140

Washington, DC 20002

(202) 737-0900

www.nasaa.org

Municipal Securities Rulemaking Board

>1900 Duke Street, Suite 600

Alexandria, VA 22314

(703) 797-6600

www.msrb.org

Securities Investor Protection Corporation

805 15th Street, N.W. Suite 800

Washington, D.C. 20005-2215

(202)371-8300

www.sipc.org

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.