What is a Broker-Dealer? - Davis Polk & Wardwell

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§ 1A:3.2 BROKER-DEALER REGULATION Dodd-Frank introduces new requirements for dealers in security-based swaps. The SEC’s “net capital rule” for broker-dealers (Exchange Act Rule 15c3-1) is particularly onerous for OTC derivatives activities. Accordingly, securities firms typically organize their OTC derivatives activities wherever possible to avoid conducting these activities in a registered broker-dealer, by separating non-securities derivatives activities into a non-broker-dealer affiliate, and by conducting securities derivatives through an affiliated bank 234 or from offshore entities pursuant to Rule 15a-6 under the Exchange Act. 235 The fragmentation of business hindered firms’ ability to manage risk and operate a competitive OTC derivatives business when compared to banks. To help address these concerns, in 1998, the SEC adopted a separate regulatory regime for OTC derivatives dealers with lessened requirements. This regime has acquired the nickname of “broker-dealer lite.” Registration as an OTC derivatives dealer under these rules is optional and is an alternative to registration as a broker-dealer under the traditional broker-dealer regulatory structure. Under the “broker-dealer lite” regimen, U.S. securities firms are allowed to establish separately capitalized affiliates that may engage in dealer activities in “eligible OTC derivative instruments,” 236 which include both securities and non-securities OTC derivative instruments. 237 These entities, as affiliates of fully regulated broker-dealers, can register with the SEC under section 15(b) of the Exchange Act as OTC derivatives dealers, subject to specially tailored capital, margin, and various other requirements. 238 OTC derivatives dealers that register under this special regime are exempt from certain regulatory requirements for broker-dealers, including: (i) membership in a SRO; (ii) regular broker-dealer margin rules; and (iii) application of the Securities Investor Protection Act of 1970, including membership in the SIPC. Certain transactions effected by a fully regulated broker-dealer for the account of an OTC derivatives dealer affiliate are exempted from 234. For a discussion of the ability of banks to engage in swaps under their authority to deal in “identified banking products” under GLB push-out rules, see infra section 1A:7.3, note 408 and accompanying text. 235. For a discussion of Rule 15a-6, see infra section 1A:7.2. 236. “Eligible OTC derivative instrument” is defined in Rule 3b-13. 237. OTC Derivative Dealers Adopting Release, supra note 233. 238. Id. 1A–54
the requirements of section 11(a) of the Exchange Act, which generally prohibits a member of a national securities exchange from effecting transactions on the exchange for the accounts of affiliates. However, registered OTC derivatives dealers are subject to special requirements, including specified internal risk management control systems, recordkeeping obligations, reporting responsibilities, and alternative net capital treatment. Unless otherwise provided by the broker-dealer lite rules, an OTC derivatives dealer remains subject to all other rules applicable to “fully regulated broker-dealers” under the Exchange Act. 239 Dodd-Frank was signed into law by President Obama on July 21, 2010. When it is effective, Dodd-Frank will bring under regulation previously unregulated “swaps” and “security-based swaps,” modify the definition of “security” to include “security-based swaps,” introduce new regimes for “swap dealers,” “security-based swap dealers,” “major swap participants” and “major security-based swap participants,” and exclude certain security-based swaps from the definition of “dealer.” Not all derivatives are affected by Dodd-Frank. Dodd-Frank is discussed further in infra section 1A:4.4. § 1A:4 What Is a Security? § 1A:4.1 Statutory Definition To be a “broker” or “dealer,” a person must be engaged in the business of effecting transactions in securities. Therefore, in analyzing whether an entity must register under section 15 of the Exchange Act, it is often necessary to consider the status of the instruments in which it deals. The body of law on whether particular instruments are securities under the Exchange Act is vast, and the following discussion provides only a general overview. The term “security” is defined in section 3(a)(10) of the Exchange Act as: . . . any note, stock, treasury stock, security future, 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 239. Id. (Broker-Dealer Reg., Rel. #9, 9/10) What Is a Broker-Dealer? § 1A:4.1 1A–55
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