SEC Proposes to Expand FINRA Oversight of Proprietary Trading Firms

Background

Section 15(b)(8) of the Exchange Act requires a broker-dealer to register with a national securities association (i.e., FINRA) unless it effects transactions solely on a national securities exchange of which it is a member.⁵ Currently, Rule 15b9-1 further exempts a broker-dealer from FINRA membership if the broker-dealer (1) is a member of a national securities exchange, (2) does not carry customer accounts, and (3) derives an annual gross income of $1,000 or less from securities transactions that are not effected on the national securities exchange of which it is a member (the de minimis allowance).⁶ However, excluded from the de minimis allowance is all income derived from a broker-dealer’s proprietary transactions conducted with or through another registered broker-dealer.⁷ As a result, broker-dealers today are effectively able to engage in an unlimited number of proprietary transactions OTC without being a FINRA member provided the broker-dealer is an exchange member, does not carry customer accounts, and effects its OTC trades with or through another broker-dealer. 

Rule 15b9-1 was initially adopted to allow for exchange specialists and other floor traders to receive a portion of commissions on occasional off-exchange transactions referred to other broker-dealers or to hedge positions arising from on-exchange trading. In making the Proposal, the SEC is indicating that the current use of the Rule 15b9-1 exemption by proprietary trading firms that trade actively OTC is not consistent with the original purpose of Rule 15b9-1.⁸

Proposed Changes to Rule 15b9-1

The Proposal would amend Rule 15b9-1 by eliminating the de minimis allowance and establishing a more narrow exemption from Section 15(b)(8). Specifically, under the Proposal a broker-dealer would be required to join FINRA if it effects securities transactions other than on an exchange of which it is a member unless it

• is a member of a national securities exchange
• carries no customer accounts
• limits its OTC trading to transactions that are solely for the purpose of
  1. routing orders by an 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 (Options Linkage Plan) or
  2. executing the stock leg of a stock-option order⁹

As a result of this proposed narrowing, the only purpose for which a broker-dealer relying on the exemption could transact OTC would be to prevent trade-throughs or for the purpose of hedging an options transaction through the use of a stock-option order.¹⁰ Notably, broker-dealers relying on the exemption for routing to avoid trade-throughs would be required to use the exchange’s affiliated routing broker-dealer rather than a broker-dealer of their choosing.

The SEC estimates that if adopted, the Proposal would affect approximately 65 broker-dealers that are not FINRA members that routinely transact in the OTC securities market. As noted above, the impact of the Proposal would be much greater if the Dealer-Trader Proposal is also adopted. 

¹ Exchange Act Release No. 95388 (July 29, 2022), https://www.sec.gov/rules/proposed/2022/34-95388.pdf.

² The SEC estimates that non-FINRA-member broker-dealers accounted for 4.6% of OTC trading volume in exchange-listed equities and as much as 2% of transactions in U.S. Treasury securities during April 2022. Proposal at 27-30.

³ See Sidley’s client alert, https://www.sidley.com/en/insights/newsupdates/2022/04/sec-proposes-significant-expansion-of-firms-that-must-register-as-dealers.

⁴ Id.

⁵ 15 U.S.C. 78o(b)(8). FINRA is currently the only registered national securities association. 

⁶ 17 CFR 240.15b9-1.

⁷ Id.

⁸ In 2015, the SEC proposed amendments to Rule 15b9-1 that are substantially similar to the current Proposal, but these amendments were never adopted. Exchange Act Release No. 74581, 80 FR 18036 (April 2, 2015). The current Proposal differs from the 2015 proposal in two notable respects. First, the 2015 proposal allowed for a broader exemption allowing for floor-based broker-dealers to transact OTC for the purpose of hedging risks of its floor-based activities, which is not contemplated under the current Proposal. Second, the 2015 proposal defined “off-exchange” to refer to transactions in exchange-listed securities occurring other than on an exchange, whereas under the current Proposal, the term “off-exchange” would encompass both exchange-listed and non-exchange-listed securities, such as OTC equity securities and U.S. Treasury securities. See Proposal at n.6. In submitting any comments on the Proposal, it would therefore be appropriate for firms to consider whether they believe the SEC should instead adopt changes to Rule 15b9-1 that would be consistent with the 2015 proposal.

⁹ In addition, a broker-dealer relying on the exception for stock-option orders would be required to establish written policies and procedures reasonably designed to ensure and demonstrate that such transactions are solely for the purpose of executing the stock leg of a stock-option order as well as preserve copies of such policies and procedures consistent with Rule 17a-4 until three years after the date the policies and procedures are replaced with updated policies and procedures.  

¹⁰ Rule 611 of Regulation NMS and the Options Linkage Plan are designed to prevent a transaction from occurring at a price that would “trade through” a better-priced quotation in that same security. See 17 CFR 242.611 and Exchange Act Release No. 60405, 74 FR 39362 (August 6, 2009). As a result, Rule 611 and the Options Linkage Plan generally require that broker-dealers route to execute against the full size of any better-priced displayed quotation unless an exception applies.