Regulation of Broker-Dealers

Definition of a broker-dealer — USA §401

The Uniform Securities Act defines a broker-dealer as any person engaged in the business of effecting transactions in securities for the account of others (broker) or for its own account (dealer). Most BDs do both, and the term travels as one concept — “broker-dealer” or “BD” — not two separate registrations.

Federal law keeps two separate definitions — SEA §3(a)(4) and §3(a)(5) — but the state-law treatment under USA §401(c) folds them into one.

Key elements of the definition:

• "Person" — under the USA, this includes individuals, corporations, partnerships, associations, joint stock companies, trusts, and unincorporated organizations. Most BDs are entities; sole proprietorships are uncommon.
• "Engaged in the business" — a one-off transaction does not make a person a BD. There must be a regular pattern of securities transactions for a business purpose.
• "Effecting transactions" — consummating purchases or sales of securities, or any preparatory activity that culminates in a transaction (soliciting, taking orders, executing, settling).
• "For the account of others or for its own account" — "broker" covers agency transactions for customers; "dealer" covers principal transactions where the firm trades for its own account. Both fall under the unified BD definition.

The point that trips people up: an individual is not a broker-dealer. Individuals who effect transactions for a BD are agents (the next chapter's subject). Only entities — and the rare sole-proprietor BD — can be broker-dealers themselves.

Activities that require BD registration

An entity must register as a broker-dealer in any state where it does any of these, for compensation:

• Effecting securities transactions for customers — agency business, taking orders, matching buyers and sellers
• Trading securities for the firm's own account with the public — principal/dealer activity, including market making
• Underwriting securities offerings — participating in syndicates that distribute new issues to the public
• Holding customer funds or securities — clearing and carrying activity (triggers heightened net-capital and customer-protection rules)
• Operating a securities trading platform — whether traditional, online, or alternative trading system (ATS)

Compensation matters. What usually trips the BD definition is transaction-based pay — commissions, markups, markdowns, fees, spreads on principal trades. An entity that effects securities transactions for no compensation may fall outside the definition, but that line is narrow and very fact-specific.

Exclusions from the broker-dealer definition

USA §401(c)(1) lists the persons excluded from the BD definition. The exam leans on these because they describe entities that do effect securities transactions yet aren't regulated as BDs.

Excluded persons:

• Agents. Individuals representing a BD are agents, not BDs themselves. They register separately under the agent provisions (USA §401(b)).
• Issuers. Companies selling their own securities, when not using the services of a BD intermediary. An issuer-direct offering of its own stock to existing shareholders is not BD activity, though the issuer's officers who solicit may need agent registration unless an issuer-rep exclusion applies.
• Banks, savings institutions, and trust companies. When acting within their banking capacity, these entities are excluded from the BD definition. The "push-out" provisions of the Gramm-Leach-Bliley Act limit how much securities activity a bank can conduct without separating it into a registered BD.
• No-place-of-business limited clientele exclusion. A BD with no office and no direct business presence in the state, dealing exclusively with (a) other broker-dealers, (b) institutional investors (banks, insurance companies, investment companies, pension funds, certain trusts), or (c) existing customers temporarily in the state.

The exclusion holds only when every condition is met. A BD with no in-state office that does business with even one retail customer in the state has to register.

Place of business and the de minimis exclusion

State BD registration is jurisdictional. Two things trip it: having a “place of business” in the state, or effecting transactions with retail customers there. The de minimis exclusion above carves out a few narrow categories that fall short of both triggers.

Place of business means any office, branch, or other location where the firm regularly conducts business — including any address it publicly holds out as a business address. A registered rep's home office can count as a firm place of business too, depending on what happens there.

The no-place-of-business + limited-clientele exclusion (USA §401(c)(1)(D)) requires ALL of these:

• The BD must have no place of business in the state at issue
• The BD's customers in that state must be limited to one or more of these categories:
  • Other broker-dealers
  • Institutional investors — banks, savings institutions, trust companies, insurance companies, investment companies, employee benefit plans with $1M+ in assets, government agencies, and certain other large institutions
  • Existing customers temporarily in the state (the BD-side parallel of the agent snowbird exemption)

What does NOT qualify for the exclusion:

• Any retail customer who is a resident of the state — even a single one — defeats the exclusion
• An office, branch, or regular meeting location in the state defeats the exclusion regardless of clientele
• Solicitation directed into the state from out of state (e.g., direct mail, cold calls targeting state residents) generally defeats the exclusion

Federal and state registration — SEA §15 and USA §201

A broker-dealer operating in interstate commerce must register both with the SEC federally and with each state where its activity triggers state registration. The two regimes run parallel but separate — federal registration doesn't stand in for state, and state doesn't stand in for federal.

Federal registration — SEA §15(a):

• Any BD using "any means of interstate commerce" to effect securities transactions must register with the SEC
• The application is Form BD, filed electronically through the CRD
• SEC registration requires the BD to also become a FINRA member (or an exchange member); FINRA conducts the substantive review of the application
• The BD must satisfy net capital (SEC Rule 15c3-1), customer protection (SEC Rule 15c3-3), books and records (SEC Rules 17a-3/17a-4), and SIPC membership requirements

State registration — USA §201:

• Required in any state where the BD has a place of business or transacts business with state residents (subject to the de minimis exclusion)
• The same Form BD satisfies the state application through CRD; states accept the same filing
• State filing fee and supplemental jurisdictional information are submitted alongside the federal application

How they interact: an out-of-state BD dealing only with in-state institutional investors may need federal registration (interstate commerce is triggered) but not state registration (the de minimis exclusion applies). The reverse — state but not federal — is rare, since almost any BD with state-resident customers is using interstate commerce.

Form BD — the application

Form BD (the Uniform Application for Broker-Dealer Registration) is the centralized application the SEC, FINRA, every state, and many other SROs use to register broker-dealers. It's filed electronically through the Central Registration Depository (CRD).

Information collected on Form BD:

• Identifying information — full legal name, business name, principal place of business, contact information, fiscal year end, organizational form (corporation, partnership, LLC), tax identification number
• Control affiliates and direct owners — persons or entities owning 5% or more of the BD, control affiliates, indirect owners
• Successions — if the BD was formed from a prior entity, the succession is disclosed
• Type of business — product types, customer types, financial industry affiliations
• Disclosure questions — firm-level criminal, regulatory, civil judicial, financial, and bond/insurance matters (parallel to but firm-scoped, not individual-scoped, the Form U4 disclosures)
• Jurisdictions sought — the SEC, FINRA membership, exchanges, and each state in which registration is sought

Form BD amendments: once it's filed, Form BD has to be amended promptly for any material change. There's no single deadline — the standard is “promptly” — and many disclosure events carry their own timelines under FINRA membership rules (say, 30 days for general changes, faster for big events like a change of control or a triggering disciplinary action).

USA §201 — effectiveness and the 30-day rule

Under USA §201(d), an application for BD registration becomes effective at noon on the 30th day after a complete application is filed — unless:

• The administrator denies the application within the 30-day window (with notice and opportunity for hearing under USA §204), or
• The administrator issues a stop order or proceeding that delays effectiveness, or
• The administrator accelerates effectiveness — some states will grant immediate effectiveness for BDs in good federal/FINRA standing

That 30-day automatic effectiveness is a critical exam point: registration is presumed approved unless the administrator affirmatively acts within the window. The burden to act sits on the regulator, not the applicant.

Bonding and minimum financial requirements under USA §202:

• The administrator may require a BD to post a surety bond as a condition of registration
• State minimum financial requirements may be set independently of federal net capital requirements, but cannot impose requirements that conflict with the federal rules
• An out-of-state BD that satisfies SEC requirements is generally deemed to satisfy state minimum financial requirements (a NSMIA-derived federal preemption principle)

Net capital — SEC Rule 15c3-1

SEC Rule 15c3-1 (the Net Capital Rule) requires every registered BD to hold a minimum of liquid net capital at all times. It's the cornerstone of BD financial-responsibility regulation — built to make sure a firm can meet its obligations to customers and counterparties even under stress.

Minimum dollar amounts (the basic floor) depend on BD type:

• $250,000 — clearing/carrying BDs (firms that hold customer funds and securities)
• $100,000 — market makers in OTC equity securities (subject to additional formulas based on number of securities)
• $50,000 — introducing BDs that promptly forward customer business to a clearing firm and do not receive customer funds or securities
• $5,000 — BDs that effect only certain limited transactions (mutual fund sales without holding customer funds)

Aggregate indebtedness limit: net capital must be at least 6 2/3 percent of aggregate indebtedness (the “basic method”) or 2 percent of aggregate debit items (the “alternative method”). Whichever method the firm uses, it can never drop below the dollar minimums above.

If net capital falls below the minimum:

• The BD must cease operations at once
• The BD must immediately notify the SEC and its designated examining authority (FINRA, or an exchange)
• Continued operation while under-capitalized is a serious violation that can result in immediate sanctions, including license revocation

Customer protection — SEC Rule 15c3-3

SEC Rule 15c3-3 (the Customer Protection Rule) protects the customer funds and securities a broker-dealer holds. It bites hardest on firms that actually hold customer assets — clearing and carrying firms — and applies more narrowly to firms that promptly hand customer assets off to a clearing broker.

Two operational pillars of the Rule:

• Customer Reserve Bank Account — the BD must compute a weekly (or in some cases monthly) reserve formula that compares customer credit items (cash owed to customers) against customer debit items (margin loans). The excess must be deposited in a special account "for the exclusive benefit of customers" at a qualified bank.
• Possession or control of customer securities — fully-paid and excess-margin customer securities must be segregated from firm assets and held in a qualified location (e.g., the BD's own vault, DTC, or another approved depository). This prevents the BD from using customer securities for its own purposes without consent.

Loan consent agreement (a margin cross-reference): a customer can let the BD lend out their securities (usually for short selling) by signing a Loan Consent Agreement — the customer-side authorization that pulls those specific securities out of the 15c3-3 segregation requirement for that customer.

SIPC membership and coverage

The Securities Investor Protection Corporation (SIPC) is a nonprofit, member-funded corporation created by the Securities Investor Protection Act (SIPA) of 1970. Every SEC-registered BD that holds customer accounts — apart from a few narrowly-exempted categories — has to be a SIPC member.

What SIPC covers:

• Customer claims against a failed or insolvent BD, up to:
  • $500,000 total per customer (combined securities and cash)
  • $250,000 cash sublimit within that total
• Coverage applies per customer per capacity — an individual account and a joint account, or different beneficial owners, are typically treated as separate customers

What SIPC does NOT cover:

• Market losses — SIPC is not a guarantor of investment returns or against decline in value
• Commodity futures contracts — covered by the CFTC's parallel regime, not SIPC
• Currency, fixed annuities, and certain alternative investments — outside SIPC's scope
• Unregistered securities — generally not covered

Passing SIPC off as deposit insurance — or as a guarantee against market losses — violates FINRA Rule 2210 and the NASAA Statement of Policy. SIPC is insolvency protection for customer claims against a failed BD, not a guarantee of returns.

Withdrawal, denial, suspension, and revocation — USA §204

BD registration can end four ways, mirroring the agent regime — and the exam tests the procedural protections attached to each.

• Withdrawal — voluntary termination by the BD. Becomes effective 30 days after filing, unless the administrator institutes a proceeding to deny or revoke registration first.
• Denial — administrator's refusal to grant initial registration. Grounds include false statements on the application, insolvency, statutory disqualification of control persons, lack of qualifications, or a "not in the public interest" finding.
• Suspension — temporary halt of an existing registration, typically for a stated period or pending the outcome of an investigation.
• Revocation — permanent termination of registration by administrative order.

Procedural protections under USA §204:

• The administrator may not deny, suspend, or revoke without prior written notice and opportunity for a hearing within 15 days of request
• Emergency cease-and-desist orders may be entered without prior hearing if the administrator finds substantial harm is likely; a hearing must follow promptly
• Most administrative orders are subject to judicial review in state court
• An administrator may also impose lesser sanctions (censure, fines, restitution) without revoking registration

BD business types — introducing, clearing, market making

Not every broker-dealer does the same work. The Series 66 expects you to know three main business types, each with its own capital and operational requirements.

Introducing broker-dealer:

• Solicits and accepts customer orders; "introduces" them to a clearing firm for execution and settlement
• Does not hold customer funds or securities; assets flow to the clearing firm directly
• Net capital minimum: $50,000 (substantially lower because of reduced risk profile)
• Most retail-facing BDs that lack their own clearing infrastructure operate this way; the relationship is governed by a clearing agreement between the introducing and clearing firms

Clearing (carrying) broker-dealer:

• Holds customer funds and securities; clears and settles trades; sends confirmations and statements to customers of introducing firms
• Bears the heaviest regulatory burden: full Customer Protection Rule (15c3-3), Customer Reserve Bank Account, possession-or-control segregation
• Net capital minimum: $250,000
• Examples include large firms such as Pershing, National Financial Services, and other custodial platforms used by introducing BDs and IAs

Market maker:

• Stands ready to buy and sell specified securities for its own account on a continuous basis, providing liquidity to the market
• Earns the spread between bid and ask; subject to firm-quote rules under SEA Rule 11Ac1-1
• Net capital minimum: $100,000 (with additional formula based on number of securities in which the firm makes markets)
• Many market makers also act as dealers in their own account and may participate in trading desks within larger BD organizations

FINRA Rule 3110 — firm-level supervision

FINRA Rule 3110 (Supervision) is the central rule for how a broker-dealer must supervise its own operations and its agents. The agent chapter came at supervision from the agent's side; this same rule frames the obligations from the firm's side.

Required supervisory system components:

• Written Supervisory Procedures (WSPs) — a written document covering each line of business and each rule the firm must comply with; updated for new rules, products, and processes
• Designation of registered principals — for each line of business, with specific responsibility allocated and recorded in the WSPs
• Office of Supervisory Jurisdiction (OSJ) designations for offices conducting customer order handling, market making, or supervisory activities
• Annual compliance meeting with each registered person discussing the firm's compliance and supervisory program (FINRA Rule 3110(a)(7))
• CEO annual certification — FINRA Rule 3130 requires the chief executive to certify that the firm has procedures reasonably designed to achieve compliance

Office inspections:

• OSJs and supervisory branch offices must be inspected at least annually
• Non-OSJ branch offices must be inspected at least every three years
• Non-branch locations on a periodic basis defined by the firm based on risk

Principal qualifications:

• Series 24 — General Securities Principal, the most common principal license, required for supervisors of most retail and institutional securities activity
• Series 26 — Investment Company/Variable Contracts Principal, for firms whose products are limited to mutual funds and variable annuities
• Series 53 — Municipal Securities Principal, for firms with municipal securities activity
• Series 27 / 28 — Financial and Operations Principal (FINOP) for clearing firms and introducing firms respectively, responsible for net capital and recordkeeping

Books and records — cross-reference

The detailed mechanics of broker-dealer recordkeeping live in SEC Rules 17a-3 (records to be made) and 17a-4 (records to be preserved). The Communications chapter develops them in depth, since they govern the records of customer communications, account information, and trade activity.

Key recordkeeping timelines a BD must meet:

• Customer account records (Rule 4512 information) — 6 years, with the first 2 years easily accessible
• Order tickets, trade confirmations, and 2210 communications — 3 years, with the first 2 years easily accessible
• Organizational documents — lifetime of the firm plus 2 years
• Customer complaints — 4 years (under FINRA Rule 4513) plus the SEC's 3-year requirement

FOCUS reports (Financial and Operational Combined Uniform Single):

• BDs must file periodic FOCUS reports with FINRA and the SEC, summarizing financial condition, net capital, and operational metrics
• Most BDs file Part II or Part IIA monthly or quarterly depending on size and business type
• An annual audit by an independent PCAOB-registered accounting firm must be filed as Form X-17A-5 Part III, due within 60 days of fiscal year end

Definition of Broker-Dealer

Under the Uniform Securities Act, a broker-dealer is any person engaged in the business of effecting transactions in securities for the account of others (broker) or for its own account (dealer).

Exclusions from the Definition

• Agents (individuals) acting on behalf of a BD
• Issuers (when selling their own securities)
• Banks and trust companies (when not acting as BD)
• Persons who have no place of business in the state and deal exclusively with other BDs, institutional investors, or existing clients

Registration and Supervision

• BDs must register in states where they have a place of business or direct business to more than a de minimis number of clients
• File Form BD through CRD (Central Registration Depository)
• Must maintain minimum net capital requirements
• Agent supervision: BDs are responsible for supervising all agents, ensuring compliance, and maintaining written supervisory procedures

BD Registration Exclusions — Complete List

The following persons are excluded from the broker-dealer definition under the Uniform Securities Act:

• Agents — individuals representing a BD are not themselves BDs
• Issuers — companies selling their own securities (unless using the services of a BD)
• Banks, savings institutions, trust companies — when acting within their banking capacity
• No place of business + limited clientele: A BD with no office in the state that deals only with:
  • Other broker-dealers
  • Existing clients who are temporarily in the state
  • Institutional buyers (banks, insurance companies, investment companies, pension funds)

Key exam point: The "no place of business" exclusion is the most commonly tested. If a BD has any office or regular presence in the state, it must register regardless of client type.

Net Capital Requirements

Broker-dealers must maintain minimum net capital to protect customers and ensure the firm can meet its obligations:

• Net capital rules are set by the SEC (Rule 15c3-1) and supplemented by FINRA
• The amount required depends on the type of BD activity (introducing vs. carrying, market making, etc.)
• If net capital falls below required minimums, the BD must immediately cease operations and notify regulators
• The State Administrator can also set minimum capital or bonding requirements for state-registered BDs