The terms “broker” and “dealer” are defined under the Securities Exchange Act of 1934. Under the Exchange Act, a broker is defined as “any person engaged in the business of effecting transactions in securities for the account of others.” [1] The Exchange Act defines a dealer as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” [2]
The legal definition of a broker is a person who conducts transactions on behalf of someone else. However, in some situations whether a person is a broker may not be clear.[3] The SEC has provided a non-exhaustive list of additional activities that would require broker registration. Included in this list are:
(a) Providing investment advice or financial consultant services,
(b) Controlling or operating a platform to trade securities,
(c) Providing support services to registered broker-dealers, and
(d) Providing “finder” services such as finding investors or investment companies for customers.[4]
Unlike a broker, a dealer is someone who conducts transactions for his own account. Some business activities that a dealer may be engaged in include:
(a) Advertising a willingness to purchase and sell securities on a continuous basis, or
(b) Issuing or originating securities.
Registration Under State and Federal Law
Dealers are subject to registration requirements under state and federal law. The most important action that brokers and dealers must take is to register with the SEC and the appropriate state agencies. Brokers and dealers must also join a self-regulatory organization, such as FINRA.
A failure to comply with these requirements can result in serious consequences such as government sanctions, fines and being banned from the securities industry.
Self-Regulatory Organization Membership Process
Brokers and dealers must apply to become members of a self-regulatory organization. For example, to become a member of FINRA, the broker or dealer must submit a standardized form called a new member application. The self-regulatory organization has the authority to approve or deny a membership application. At FINRA, membership approval is based on the applicant’s ability to meet certain standards, including submission of a complete and accurate application, the applicant’s ability to comply with industry rules, regulations and laws, the applicant’s business facilities, the applicant’s capital and the applicant’s recordkeeping system.[5]
SEC Registration Process
The Exchange Act states that it is unlawful for any broker or dealer to conduct or attempt to conduct any securities transaction if the broker or dealer is not registered.[6] Brokers and dealers apply for registration with the SEC by submitting a registration application. This application is created by the SEC and is referred to as “Form BD” or the Uniform Application for Broker-Dealer Registration. The Form BD requires disclosure of extensive information about the background of the applicant. Some information the applicant must disclose includes:
(1) The nature of his business,
(2) the ownership structure of the business, and
(3) any information regarding criminal prosecutions, regulatory actions, or civil actions that have been brought against the applicant or his affiliates.
The completed Form BD must be filed through the Central Registration Depository system which is operated by FINRA. After the broker-dealer has submitted the registration application, the SEC has forty-five days to either grant the registration or initiate proceedings to determine whether the registration should be denied.
Before denial proceedings, the applicant is provided with a notice outlining the reasons for the pending denial. The applicant will then have an opportunity to attend a hearing before the SEC, where he will have the opportunity to present his case and argue why his application should not be denied.[7]
If a person has engaged in certain misconduct, his application is subject to automatic denial. This type of disqualification is referred to as “statutory disqualification” under the Exchange Act. Some examples of misconduct that may result in a statutory disqualification include:
(1) Expulsion or suspension from membership or participation in any self-regulatory organization, including a foreign equivalent of a self-regulatory organization,
(2) Being ordered by a court to stop committing future violations of securities laws,
(3) Being barred or suspended from association with a broker-dealer with the SEC,
(4) Being convicted of a felony or misdemeanor in the last ten years, and
(5) Making false statements or omissions in any application, report, or proceeding.[8]
If an applicant is subject to a statutory disqualification, he can request that the SEC grant him relief from the denial. After reviewing the facts of the case, the SEC can elect to grant the applicant relief from the disqualification statute and, if granted, the application will be approved and the applicant will be allowed to work in the securities industry.
In addition to the federal regulation requirements, the broker or dealer is responsible for ensuring that he complies with each state’s laws. Similar to the federal law, under state law, a broker or dealer’s registration can be denied, revoked, or suspended for misconduct. For example, under Kentucky law, some reasons why a broker or dealer’s registration may be denied, revoked or suspended include:
(1) Conviction of a felony or initiation of felony prosecution proceedings against the broker-dealer,
(2) Violation of state administrative regulations, and
(3) Engaging in dishonest or unethical practices in the securities or related industry.[9]
Exemptions from Registration
Depending on the broker or dealer’s business, he may be exempt from the SEC’s registration requirements. Business activities and industries that are exempt include:
(1) Conducting business solely in commercial paper, banker’s acceptances and commercial bills,
(2) Conducting business solely in one state, which is also referred to as the “intrastate” broker exception,
(3) Foreign persons who are not associated with a U.S. registered broker or dealer,
(4) Acting as an issuer who sells securities for one’s own account only and not the accounts of others, and
(5) Insurance agencies. [10]
Conduct Requirement
The laws governing a broker or dealer’s suitability to work in the securities industry are focused on conduct and misdeeds. Securities laws are designed to protect the public interest and to protect consumers from bad actors in the securities industry.
Most importantly, brokers and dealers must comply with all anti-fraud provisions under the federal and state securities laws. These laws prohibit brokers and dealers from engaging in misconduct such as intentionally making misstatements or failing to disclose important information. Brokers and dealers are also prohibited from engaging in fraudulent or manipulative acts and practices in connection with the sale or purchase of securities.
Brokers and dealers owe their clients certain duties, including a duty of fair dealing. The scope of this duty includes the mandate to do the following:
(1) Execute orders promptly, disclosing important information
(2) Charge prices reasonably related to the prevailing market, and
(3) Fully disclose any conflict of interest.[11]
Additional duties that brokers and dealers owe their customers include a duty of suitability and a duty of best execution. Under the duty of suitability, brokers and dealers must recommend specific investments or investment strategies that are suitable for their customer’s needs and must have a reasonable basis for their recommendations. The duty of best execution means they must strive to get the most favorable terms available for their customers.[12]
Financial Responsibility Rules
Brokers and dealers must also comply with several financial responsibility rules under the Exchange Act and the SEC’s regulations. These rules are designed to protect customers from harm caused by failures of the broker or dealer’s business.
Under these rules, brokers and dealers must maintain minimum capital levels and must safeguard a customer’s funds. The minimum capital rule means there must always be more net capital than the minimum required to operate a securities business.[13] Rule 15c3-1 outlines the net capital amounts that are required for brokers and dealers, which are:
- $250,000 for a broker-dealer that holds customer funds or securities,
- $100,000 for a broker-dealer that clears customer transactions on a delivery versus payment basis and does not offer margin accounts or trade as principal for its own account,
- $50,000 for a broker-dealer that introduces customer transactions and accounts to another registered broker-dealer that carries the accounts on a fully disclosed basis; or
- $5,000 for a broker-dealer that does not receive, hold or owe customer funds or securities or carry customer accounts or trade securities other than on an agency or riskless principal basis.[14]
Brokers and dealers must also retain certain records, including:
(1) trade blotters itemizing trades, receipts, or delivers of securities,
(2) trial balances,
(3) records of brokerage firm’s calculations of net capital and total indebtedness,
(4) compliance records, and
(5) records of complaints.[15]
Brokers and dealers are subject to significant rules and regulation. So how does a customer know that a broker or dealer follows the law? Fortunately, consumers have the ability to gather information about brokerage firms and individual brokers through FINRA’s BrokerCheck program. Through this program, a customer can obtain information such as:
(1) A summary report that provides an overview of the firm,
(2) A profile of the firm’s ownership,
(3) A firm history, including any mergers, acquisitions or name changes,
(4) A description of the firm’s operations, listing its active licenses and registrations, the types of businesses it conducts and other details, and
(5) Arbitration awards and any regulatory or disciplinary events on the firm’s records.[16]
Customers may also access investment advisor information through the SEC’s Investment Adviser Public Disclosure Program. Through this program, an investor may:
(1) Search for an investment adviser firm,
(2) Check the adviser’s registration status,
(3) View the adviser’s current disclosures made through its Form ADV filing,
(4) Find the state regulator’s website, and
(5) Find the FINRA BrokerCheck website.[17]
In addition to the federal resources provided by FINRA and the SEC, a consumer can obtain information about investment advisors and broker-dealers by contacting his state regulators.
Types of Stock Purchase Plans
Direct Stock Purchase Plans
Buyers can purchase stocks without the assistance of a stock broker. A direct stock purchase plan is one way that a consumer can purchase stocks directly from a company.
The benefits of a direct stock purchase plan are that the purchaser does not have to pay broker fees or commission and may be able to purchase a company’s stock by investing a specific dollar amount instead of paying for an entire share.[18] Stocks also can be purchased through automatic checking account debits. For example, under Home Depot’s direct stock purchase plan, stocks can be purchased by making a minimum payment of $500, and additional shares can be purchased in $50 increments through automatic monthly payments.[19] If allowed under the direct stock purchase plan, the purchaser can elect to have his dividends automatically reinvested in the company’s stock.
The disadvantage of a direct stock purchase plan is that the shareholder does not get the benefit of financial advice or account management from a broker. While the shareholder does not have to pay broker fees, he is still required to pay account service fees. Still, direct stock purchase plans provide a way for people to make stock purchases with a minimal initial investment.
Companies that offer a direct stock purchase plan allow an investor to enroll online or through submission of paper enrollment forms. Some well-known companies that offer these plans include Exxon Mobil, Coca-Cola, Walmart, AT&T, Verizon and Ford.[20]
Employee Stock Purchase Plans
An employee stock purchase plan is a benefit that allows a company’s employees to purchase stock at a discounted rate.
Home Depot’s employee stock purchase plan provides an illustration of how a typical plan works. Employees may set aside up to 20% of their pay to purchase Home Depot stock at a discounted rate. After 6 months, the amount set aside is used to purchase company stock.[21]
As with direct stock purchase plans, one of the benefits of an employee stock purchase plan is that the purchaser does not have to pay broker fees or commissions. However, the shareholder does not have the benefit of receiving financial advice and account management from a broker, and account management fees must be paid.
Many publicly traded companies offer their employees the opportunity to participate in employee stock purchase plans, including Computershare, Nordstrom and Intuit. Each plan has its own discount rates and holding periods for contributions.[22]
Dividend Reinvestment Plans
Dividend reinvestment plans allow the stock owner to have dividends automatically reinvested in more company stock. Under this type of plan, the stock owner can increase earnings by taking advantage of compounding.[23] Dividend reinvestment plans are also referred to as “DRIP” plans. To have the dividends automatically reinvested, the stock owner must sign an agreement with the company, though not all companies pay dividends or offer DRIP plans. Stocks can be purchased under a DRIP plan through a broker or through some other type of plan. For example, a direct stock purchase plan can also be a DRIP plan if the plan allows the shareholder to reinvest dividends.
Non-Dividend Paying Stock Plans
Some stock plans do not pay dividends. If a stock does not pay dividends, then the stockholder’s potential profits are limited to capital gains, which are the positive net profits from the sale of stock.[24] Some well-known companies do not pay dividends, including Facebook.[25] These rely on the company quickly growing in value to attract investors.
In our next module, we’ll turn to the dynamics of stock transfers, the restrictions on transfers and the rules that govern the transfers.
[1] See 15 U.S.C. § 78c (a)(4)(A).
[2] See 15 U.S.C. § 78c (a)(5)(A).
[3] Guide to Broker-Dealer Registration, U.S. Securities and Exchange Commission, https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html#I
[4] Id.
[5] Standards For Admission, FINRA, http://www.finra.org/industry/standards-admission
[6] 15 U.S.C. § 78o(a)(1).
[7] 15 U.S.C. §78o(b)(1)(A)(B).
[8] Statutory Disqualification Review Process, U.S. Securities and Exchange Commission, https://www.sec.gov/oig/reportspubs/aboutoigaudit363finhtm.html
[9] KRS 292.337.
[10] Guide to Broker-Dealer Registration, U.S. Securities and Exchange Commission, https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html
[11] Hester Peirce andBenjamin Klutsey, Reframing Financial Regulation, pg. 143
[12] Id. at 143-144.
[13] Id. at 140.
[14] Broker-Dealer Registration and FINRA Membership Application, http://www.finra.org/industry/new-bd-firm-registration
[15] Id. at 141-142.
[16] Checking Out a Brokerage Firm, Individual Broker, Investment Adviser Firm, or Individual Investment Adviser, U.S. Securities and Exchange Commission, https://www.sec.gov/fast-answers/answerscrdhtm.html
[17] Id.
[18] Direct Investment Plans: Buying Stock Directly From the Company, U.S Securities and Exchange Commission, https://www.sec.gov/fast-answers/answersdriphtm.html
[19] Home Depot Direct Stock Purchase Plan,http://ir.homedepot.com/shareholder-services/direct-stock-purchase-plan
[20] See https://www-us.computershare.com/Investor/#directstock.
[21] Employee Stock Purchase Plan (ESPP), The Home Depot, https://secure.livethehealthyorangelife.com/financial_wellness/save/employee-stock-purchase-plan
[22] Employee Stock Purchase Plan (ESPP), The Home Depot, https://secure.livethehealthyorangelife.com/financial_wellness/save/employee-stock-purchase-plan
[23] Direct Investment Plans: Buying Stock Directly From the Company, U.S Securities and Exchange Commission, https://www.sec.gov/fast-answers/answersdriphtm.html
[24] What are Capital Gains?, FindLaw, https://tax.findlaw.com/federal-taxes/what-are-capital-gains-.html
[25] 5 Stocks That Should Start Paying Dividends, Kiplinger, https://www.kiplinger.com/slideshow/investing/T018-S001-5-stocks-that-should-start-paying-dividends/index.html