Broker-Dealer Formation & Registration

What Is a Broker-Dealer (BD) under the securities laws?

Section 3 of the Securities Exchange Act of 1934 defines a broker generally as “any person engaged in the business of effecting transactions in securities for the account of others.”

The same statute defines a dealer as “any person engaged in the business of buying and selling securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible contract participants) for such person’s own account through a broker or otherwise.”

The Securities Exchange Commission issues a combined broker-dealer license to qualifying persons.

What Is a Security under Federal securities law?

Under the Securities Exchange Act of 1934, the term “security” is broadly defined as “term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.”

Do Broker-Dealers Need to Register?

Section 15 of the Securities Exchange Act of 1934 requires broker-dealers to register by making it “unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section.”

Those engaging in the foregoing defined activities encompassed within the definitions of “broker” or “dealer” must comply with the Exchange Act of 1934 by registering their broker-dealer (BD) with the SEC, and 1 or more states through application to a self-regulatory organization, e.g., FINRA.

The Importance of State Regulation of Broker-Dealers

It is imperative to bear in mind that states also regulate both “broker-dealers”, and “securities”, often providing different definitions of these terms.

For example California’s Corporate Securities Law of 1968 defines a broker-dealer as:

“Broker-dealer” means any person engaged in the business of effecting transactions in securities in this state for the account of others or for his own account. “Broker-dealer” also includes a person engaged in the regular business of issuing or guaranteeing options with regard to securities not of his own issue.

In California, a “security” is defined as:

“Security” means any note; stock; treasury stock; membership in an incorporated or unincorporated association; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; viatical settlement contract or a fractionalized or pooled interest therein; life settlement contract or a fractionalized or pooled interest therein; voting trust certificate; certificate of deposit for a security; interest in a limited liability company and any class or series of those interests (including any fractional or other interest in that interest), except a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company; provided that evidence that members vote or have the right to vote, or the right to information concerning the business and affairs of the limited liability company, or the right to participate in management, shall not establish, without more, that all members are actively engaged in the management of the limited liability company; certificate of interest or participation in an oil, gas or mining title or lease or in payments out of production under that title or lease; put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof); or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; any beneficial interest or other security issued in connection with a funded employees’ pension, profit sharing, stock bonus, or similar benefit plan; or, in general, any interest or instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. All of the foregoing are securities whether or not evidenced by a written document. “Security” does not include: (1) any beneficial interest in any voluntary inter vivos trust which is not created for the purpose of carrying on any business or solely for the purpose of voting, or (2) any beneficial interest in any testamentary trust, or (3) any insurance or endowment policy or annuity contract under which an insurance company admitted in this state promises to pay a sum of money (whether or not based upon the investment performance of a segregated fund) either in a lump sum or periodically for life or some other specified period, or (4) any franchise subject to registration under the Franchise Investment Law (Division 5 (commencing with Section 31000)), or exempted from registration by Section 31100 or 31101.

Consequences of the Failure to Register as a Broker-Dealer

A person’s failure to register as a broker-dealer can have adverse consequences.

Under California Corporations Code Section 25501.5, “[a] person who purchases a security from or sells a security to a broker-dealer that is required to be licensed and has not, at the time of the sale or purchase, applied for and secured from the commissioner a certificate under Part 3 (commencing with Section 25200), that is in effect at the time of the sale or purchase authorizing that broker-dealer to act in that capacity, may bring an action for rescission of the sale or purchase or, if the plaintiff or the defendant no longer owns the security, for damages.”

Therefore, an issuer who uses an unlicensed broker-dealer has merely sold a ‘put’ to the buyer. To be clear, the buyers of securities sold by an unlicensed broker dealer can sue the issuer to recover their investment, rescission being legal jargon for a ’do over’. Additionally, the broker-dealer could be liable for the issuer for the consequences of its failure to secure the necessary broker-dealer license. In any event, the use of an unlicensed broker-dealer in California gives the investor a cause of action to rescind the investment, an undesirable result for the issuer, and broker-dealer.

Thus, securities issuers should avoid working with unlicensed broker-dealers by confirming their licensure prior to retaining their services to avoid the prospect of having to face a rescission cause of action.

In addition to rescission, the unlicensed broker-dealer faces potential prosecution under California Corporations Code Section 25540 subd. (a) which states “[e]xcept as provided for in subdivision (b), any person who willfully violates any provision of this division, or who willfully violates any rule or order under this division, shall upon conviction be fined not more than one million dollars ($1,000,000), or imprisoned pursuant to subdivision (h) of Section 1170 of the Penal Code, or in a county jail for not more than one year, or be punished by both that fine and imprisonment; but no person may be imprisoned for the violation of any rule or order if he or she proves that he or she had no knowledge of the rule or order.”

As a further downside to failing to register, California provides a cause of action against an unlicensed person who causes damages in the course of providing services that require a license. “Any unlicensed person who causes injury or damage to another person as a result of providing goods or performing services for which a license is required under Division 2 (commencing with Section 500) or any initiative act referred to therein, Division 3 (commencing with Section 5000), or Chapter 2 (commencing with Section 18600) or Chapter 3 (commencing with Section 19000) of Division 8, of the Business and Professions Code, or Chapter 2 (commencing with Section 25210) or Chapter 3 (commencing with Section 25230) of Part 3 of Division 1 of Title 4 of the Corporations Code, shall be liable to the injured person for treble the amount of damages assessed in a civil action in any court having proper jurisdiction. The court may, in its discretion, award all costs and attorney’s fees to the injured person if that person prevails in the action.”

Possible exceptions to the licensing rule, e.g., the ‘finder’s exception’ but very often the unlicensed broker-dealer makes this exception inapplicable through conduct exceeding the boundaries of the law’s definition of a ‘finder.’ California law will permit the issuer to sue the broker-dealer for damages, $10,000 in damages, and attorney’s fees.

As an example, the Securities and Exchange Commission inquired into numerous sales of Neogenix, an issuer, who used finders to sell their shares. Given the large contingent liability associated with rescission, and associated disclosure, Neogenix reorganized under Chapter 11 the Bankruptcy Code, resulting in the elimination of the liability, but a realization of a substantial reduction in the value of Neogenix’s shareholdings.

Broker Dealer Formation

Like federal securities laws and the blue sky laws of other states, the Corporate Securities Law of 1968 is intended to protect the public from fraud and deception in transactions involving securities. The Corporate Securities Law of 1968 achieves this regulation in part by providing statutory remedies in addition to common law remedies for those damaged in securities transactions that violate the Corporate Securities Law of 1968.

Given the importance placed upon the broker-dealer, and the issuance of securities, forming a broker-dealer constitutes a substantial endeavor.

Our firm is prepared to assist you with setting up your broker-dealer, maintaining an existing broker-dealer, or providing associated services including representation in arbitration or litigation.

The firm’s principal has the following FINRA qualifications:

  • General Securities Representative – (FINRA Series 7)
  • Uniform Securities Agent State Law Examination – (FINRA Series 63) – FINRA
  • Certified Fraud Examiner (CFE) – Association of Certified Fraud Examiners
  • General Securities Principal – (FINRA Series 24)
  • Introducing Broker/Dealer Financial and Operations Principal (FINRA Series 28)

We can provide services to the new (Form NMA, NASD Rule 1010 et seq.), and existing broker-dealer (Form CMA, NASD Rule 1017) by helping you complete and submit a thorough application with FINRA, and the SEC including:

  • Form BD;
  • Form NMA;
  • Business plan;
  • Communications and operations plans;
  • Supervisory procedures; &
  • Anti-money laundering (AML) procedures.