Thursday, August 24, 2023

SEC tightens broker-dealer exemption from FINRA membership

By Rodney F. Tonkovic, J.D.

By a 3-2 vote, the SEC adopted rule amendments tightening the exemption from FINRA membership for broker-dealers. The Commission has narrowed the decades-old exemption from a requirement that brokers or dealers become a member of a national securities association (i.e., FINRA) unless the broker or dealer effects transactions in securities solely on an exchange of which it is a member. The amendments are meant to close a regulatory gap brought on by substantial changes in the securities markets since the rule's adoption. The amendments will become effective 60 days after publication in the Federal Register and the compliance date will be 365 days later (Exemption for Certain Exchange Members, Release No. 34-98202, August 23, 2023).

The exemption. Exchange Act Section 15(b)(8) requires registered brokers or dealers to become a member of a national securities association unless the broker or dealer effects securities transactions solely on an exchange where it is a member. Currently, the only national securities association is FINRA.

Adopted in 1968, Rule 15b9-1 exempts certain proprietary trading dealers that effect securities transactions other than on an exchange where they are members from joining FINRA. so long as the dealer is a member of a national securities exchange, carries no customer accounts, and its proprietary trading is conducted through another registered broker-dealer. At the time of the rule's adoption, the exemption was meant to address limited proprietary trading activity ancillary to dealers' floor-based business.

The Commission found that in the decades since the exemption was adopted, the securities markets have evolved towards mostly electronic trading and that some Commission-registered dealers engage in significant proprietary, off-member-exchange trading, including in U.S. Treasuries. Originally proposed in 2015, and re-proposed in July 2022, the amendments are intended to narrow the existing exemption and require broker-dealers who engage in off-exchange proprietary trading to become members of a national securities association. The amendments have been adopted as re-proposed in 2022.

Amendments to Rule 15b9-1. The Commission noted that the securities markets have changed dramatically since the rule was adopted. As Chair Gensler put it, the rule was expanded in 1976, and since then there have been "eight presidents and six Rocky movies." Little trading is now floor-based, and broker-dealers no longer trade primarily on a single exchange. Securities trading is highly-automated and dispersed among many trading centers including 24 registered exchanges and a myriad off-exchange venues, the Commission said.

As of April 2022, 65 broker-dealers were exchange members, but not FINRA members, and 43 initiated orders that were executed on or off an exchange. Several firms effect significant off-member-exchange securities transaction volume yet, in reliance on Rule 15b9-1, are not FINRA members and are thus not subject to FINRA's oversight.

Recognizing these changes, the amendments rescind the exemption for proprietary trading and replace it with a narrower exemption. A Commission-registered broker or dealer must comply with Section 15(b)(8) by joining FINRA if it effects securities transactions other than on an exchange where it is a member, unless:
  • It is a member of a national securities exchange;
  • It carries no customer accounts; and
  • The transactions (i) result solely from orders that are routed by a national securities exchange of which the broker or dealer is a member to comply with Rule 611 of Regulation NMS or the Options Order Protection and Locked/Crossed Market Plan; or (ii) are solely for the purpose of executing the stock leg of a stock-option order.
"Some of today's broker-dealers continue to rely on an exemption from national securities association registration that’s older than the cell phone era," said SEC Chair Gary Gensler. "This has led to a regulatory gap whereby a number of firms that have cross-market, monthly trading volume valued in the hundreds of billions of dollars are exempt from national securities association oversight. These amendments update and narrow the circumstances in which broker-dealers do not need to register with a national securities association. National securities association membership will help enhance robust and consistent oversight, particularly with regard to cross-market and off-exchange oversight."

Objections. Commissioners Peirce and Uyeda both dissented, with both noting that there was no showing that imposing FINRA membership would be an advantage over the way things are done now, or in another alternative and less-burdensome way. As acknowledged in the release and pointed out by the commissioners, the firms to which the exemption applies already have an SRO responsible for overseeing their conduct and are subject to the SEC's jurisdiction.

Commissioner Uyeda noted in particular that the rulemaking creates concerns under the Administrative Procedure Act. The key question, he said, is whether FINRA is better at achieving the desired outcomes when overseeing proprietary trading firms than the other SROs. The Commission's analysis in this respect was unsupported and conclusory, and presents little to no evidence of FINRA's comparative advantage. This lack of evidence-based comparison creates concerns under the APA, Uyeda said, because there must be a rational connection between the facts found and the choices made (citing the D.C. Circuit).

Uyeda also remarked that the Commission's findings in favor of expanding FINRA membership are based largely on FINRA's own submission—and FINRA would benefit through increased revenues. He also predicted that the courts will ultimately have to decide whether FINRA should be considered a state actor if membership is effectively mandatory.

The release is No. 34-98202.