Traders enjoy complaining about regulation and are justified in doing so. There is hardly any action that a trader can take during the day, no matter how basic, that is not the subject of some regulation. And, with every regulation, there is a cost. We lawyers may commiserate with our clients about regulation, but regulation is good for us.
Heavily regulated industries need lawyers to help decipher their responsibilities and defend them when they run afoul of the regulations. Complex regulation requires smarter and higher-priced lawyers.
As much as traders complain about regulation (and lawyers), however, the truth is that the financial services industry receives one enormous benefit from regulation. Regulation offers a competitive advantage to the regulated. The unregulated are not permitted to play. And that’s what raises the importance to the SEC’s recent proposed changes to Exchange Act Rule 15a-6. The proposal would permit foreign broker-dealers that are not registered with the SEC to invade turf that currently can only be occupied by registered broker-dealers.
At present, a U.S. person is free to open a foreign brokerage account with a foreign broker-dealer and trade foreign securities. But, the U.S. person has to take the initiative. The foreign broker-dealer cannot advertise its services or provide research to U.S. persons, make sales calls on U.S. persons or do any of the activities that fall within the broad category of “solicitation.”
There is a limited exception to all of this for “major U.S. institutional investors,” generally defined as investment companies and registered investment advisers with assets under management greater than $100 million. Note that hedge funds with unregistered investment managers are not included in this definition. If a foreign broker-dealer wishes to make a sales call on a major U.S. institutional investor, a U.S. broker-dealer must accompany them. The U.S. broker-dealer must review any research for compliance with U.S. rules. If the solicitation results in an order, that order must be executed through a U.S. broker-dealer, the customer’s assets must be in the custody of a U.S. broker-dealer and the assets are subject to U.S. customer protection rules. Finally, any margin must be provided by the U.S. broker-dealer, rather than by the foreign broker-dealer.
The proposed new rule would expand this exemption significantly. First, the exemption for solicitation would apply to just about any company, partnership, trust or high net worth individual with an investment portfolio greater than $25 million. These institutions and high net worth individuals are defined in the rule as “qualified investors.” Second, and most importantly for the trading community, the proposed rule would also reduce the role of U.S. broker-dealers in this process.
The proposal divides the world of foreign broker-dealers into two camps: Foreign broker-dealers that conduct a “foreign business” and other foreign broker-dealers. A foreign broker-dealer conducts a “foreign business” if 85 percent of the securities purchased and sold by or on behalf of its clients are “foreign securities.”
Foreign broker-dealers that conduct a “foreign business” could engage in a wide range of solicitation activities to U.S. “qualified investors.” The rule would permit them to provide research, make sales calls, maintain custody of client cash and securities, provide margin and execute trades. They would be required to agree to provide a U.S. broker-dealer with access to the foreign broker-dealer’s records so that the SEC could obtain them easily. However, those records need not comply with the elaborate record-keeping requirements of Exchange Act Rules 17a-3 and 17a-4. Instead, the foreign broker-dealer would only have to comply with its home country record-keeping regulations. Serving as go-between for SEC records requests would be the extent of the U.S. broker-dealer’s role in dealing with U.S. customers.
Foreign broker-dealers that do not conduct a “foreign business” would be permitted to provide research, make sales calls and execute trades for qualified investors. They would not be permitted to maintain custody of client assets or provide margin to U.S. clients, and a U.S. broker-dealer would be required to maintain books and records for the client.
It is true that U.S. broker-dealer registration would still be required for membership in a national securities exchange or providing quotes in interdealer quotation systems in the over-the-counter market. But, as we all know, access for non-member firms through member firms has eased considerably. A lack of market access can no longer be considered a serious barrier to entry.
The part of the rule that permits foreign broker-dealers that do not conduct a “foreign business” to solicit U.S. qualified investors should be the most interesting for the U.S. broker-dealer community. This would permit any foreign broker-dealer to establish an introducing relationship with a U.S. clearing firm and compete for institutional order flow. Most mid-size and smaller U.S. broker-dealers are introducing firms, and many of them compete for institutional and high net worth order flow. If the compliance costs of U.S. introducing firms are greater than those of foreign broker-dealers, and I suspect they are, U.S. broker-dealers will be placed at a competitive disadvantage to their foreign competitors. You should expect to see institutional introducing firms relocate “off-shore” in places like Bermuda or the Cayman Islands to take advantage of the reduced cost of regulation available in such jurisdictions.
So, why is the SEC doing this?
In the release for the proposed rule, the SEC refers to a roundtable conducted last year. Some of the firms invited to participate in the roundtable probably would be competitively harmed by the proposal, but those participants really pressing for the rule change belonged to large international firms or were members of the law firms that represent them. Many “Wall Street” investment banks have overseas operations in London, Paris or Tokyo that are larger than their U.S. operations. The proposal will allow them to effectively “opt out” of U.S. regulation without losing their access to U.S. customers.
I believe this proposal will become the rule with some amendments. The big question is what happens next. My guess is that the same pressures to allow foreign competition for institutional order flow will be directed at competition for retail business. Retail customers will clamor to be allowed the same access to foreign broker-dealers as high net-worth individuals. If I am right, the entire world of broker-dealers will end up competing for U.S. clients.
Unfortunately, U.S. broker-dealers do not have the same ability to compete for foreign clients without obtaining licenses from foreign regulators. Many other jurisdictions see it as their mandate to protect local firms from competition. Larger firms have been able to obtain foreign permissions in most parts of the world, but the process is way too expensive and difficult for mid-size and smaller firms.
It seems to me that the proposal could be improved substantially by balancing the scales. It should not be enough that a foreign broker-dealer is regulated by a foreign regulatory authority; the SEC should require that the foreign regulatory authority be one that also provides the same level of access to foreign clients for U.S.-regulated broker-dealers.
Ultimately, the benefits of regulation must exceed their costs.
Stephen J. Nelson is a principal of The Nelson Law Firm in White Plains, N.Y. Nelson is a weekly contributor and columnist to Traders Magazine’s online edition. He can be reached at sjnelson@nelsonlf.com
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