U.S. Securities Regulators Extend Reach Over Non-Securities Activities of Broker-Dealers

U.S. Securities Regulators Extend Reach Over Non-Securities Activities of Broker-Dealers



Over the past few months, U.S. securities regulators have shown an increased readiness to regulate and investigate matters involving non-securities activities of broker-dealers. For example, in December 2008, the Securities and Exchange Commission (SEC) settled an administrative proceeding against a derivatives trader concerning natural gas options trading.1 Although the alleged conduct did not involve securities products, the SEC brought and settled the action for violations of the antifraud and recordkeeping provisions of the securities laws, among other violations.

More recently, on January 21, 2009, the Financial Industry Regulatory Authority (FINRA) published a regulatory notice (Notice 09-06) proposing a rule to establish leverage limits for retail foreign exchange (forex).2 This proposed rule, coupled with other recent FINRA regulatory notices, reflects FINRA's increased interest in extending its regulatory authority over the non-securities activities of its members.

If these developments represent a coalescing view among securities regulators regarding oversight of non-securities activities, broker-dealers should examine both their securities and non-securities activities to better ensure compliance with securities regulators' expectations.

This Client Alert discusses (i) FINRA's rule proposal and other guidance regarding retail forex–guidance that could more generally apply to other non-securities activities, and (ii) the regulators' apparent expectations regarding supervision and control of broker-dealers' non-securities products and non-securities activities–including examples of enforcement actions by securities regulators.

1. FINRA Notices Regarding Forex

Forex transactions occur primarily in the over-the-counter (OTC) interbank market among commercial and central banks, currency speculators, corporations, governments and other institutions. A retail forex market has arisen as an electronic secondary OTC spot contract market. Under the Commodity Exchange Act (CEA), futures commission merchants (FCMs), retail forex dealers, financial institutions, broker-dealers and certain other entities may act as counterparties to retail forex contracts.3 Retail forex transactions conducted through an SEC-registered broker-dealer generally are excluded from CFTC jurisdiction.4

In Notice 09-06, FINRA cited the potential migration of retail forex activity from FCMs to broker-dealers as the reason for its proposed limitation on retail forex leverage. The proposed limitation would prohibit any FINRA member from permitting a customer who does not qualify as an "eligible contract participant" under Section 1a(12) of the CEA to (i) initiate any forex position with a leverage ratio of greater than 1.5 to 1; and (ii) withdraw money from an open forex position that would cause the leverage ratio for such a position to be greater than 1.5 to 1.5 According to FINRA, the purpose of these limitations is to reduce the risks of excessive speculation and to protect investors by reducing the likelihood that a small adverse percentage change in a foreign currency exchange rate will exhaust an investor's funds.6 Note: The proposed 1.5 to 1 ratio permits less leverage than currently is permitted for securities products under federal margin regulations. Also, the definition of "eligible contract participant" is not identical to FINRA's definition of "institutional investor" in NASD Rule 2211(a)(3).

Notice 09-06 builds on FINRA's guidance from last year regarding retail forex activities, published in November 2008 (Notice 08-66).7 In that notice, FINRA identified five areas where FINRA rules apply to member firms' retail forex activities, all of which areas could also be applied to other non-securities activities:

  • Just and Equitable Principles of Trade: NASD Rule 2110 requires members to observe high standards of commercial honor and just and equitable principles of trade in the conduct of their business. FINRA takes the position that "Rule 2110 applies to all of a member broker-dealer's business, not only its securities and investment banking business."8 FINRA will look to the forex-related rules and interpretations adopted by the NFA to govern the retail forex activities of its members as a basis for determining whether the same activities, when conducted by a broker-dealer, meet FINRA's standards of commercial honor and principles of just and equitable principles of trade. Notice 08-66 outlines forex-related conduct that would constitute a violation of Rule 2110, including, but not limited to, disclosure failures, misappropriation of funds, fraudulent activity, and due diligence failures.

  • Communiations with the Public: NASD Rule 2210 prohibits firms from making any false, exaggerated, unwarranted or misleading statements or claims in any communication with the public. FINRA takes the position that this prohibition is not limited to a broker-dealer's securities and investment banking business and, to that end, applies to forex-related communications as well.

  • Membership Rules: FINRA considers expansion by current members into retail forex to be a material change in business operations under NASD Rule 1010(i). Applications for FINRA membership must include a detailed business plan description that describes all material aspects of proposed business activities, as well as the nature and source of the firm's capital.

  • Net Capital Calculation and Customer Protection Rule: FINRA outlines a series of requirements regarding net capital and customer protection related to forex, including currency conversion and currency charge requirements, treatment of receivables as non-allowable or allowable assets, and Rule 15c3-3's reserve formula treatment.

  • Anti-Money Laundering: NASD Rule 3011(a) requires members to establish and implement policies and procedures reasonably expected to detect and cause the reporting of suspicious transactions. FINRA reminds firms that this requirement applies to retail forex activities.

2. Expectations for Supervision and Control; NYSE and SEC Enforcement Actions Involving Non-Securities Products

FINRA's statements regarding retail forex appear to be a targeted extension of its relatively recent position regarding a member's supervisory responsibilities for all business activities in which the member engages. NASD Rule 3010(a) currently requires a member to designate an appropriate registered principal(s) with authority to supervise broker-dealer activities only with respect to activities for which registration as a broker-dealer is required. As part of the Consolidated Rulebook,9 however, proposed FINRA Rule 3110(a) would broaden this supervisory obligation significantly. Rule 3110(a) instead would require a member to designate an appropriately registered principal(s) with authority to supervise each type of business in which the member engages, which would include non-securities activities.

This position is not entirely new among regulators–(NYSE) members already should be familiar with the potential reach that securities regulators may exercise regarding non-securities activities. The NYSE has long required its members to supervise and control each activity in which they engage,10 and has brought enforcement actions in the past against its members for failing to supervise non-securities activities.

  • NYSE Enforcement Action: In 2006, the NYSE censured and fined Citigroup Global Markets, Inc. $500,000 for failure to reasonably supervise its precious metals trading desk.11 The NYSE hearing officer found that the firm's only precious metals trader engaged in proprietary trading in excess of her authorized limits and hid that unauthorized trading and losses by concealing forward positions and mis-marking the value of precious metals positions. The NYSE alleged that while a 2000 internal audit and risk review report identified control weaknesses regarding the precious metals trading desk, the firm implemented insufficient procedures to remedy the weaknesses, resulting in continued misconduct by the precious metals trader. As a result, the NYSE found that the firm had, among other things, violated NYSE Rule 342 in its failure to (i) reasonably supervise and control the precious metals trading desk and related business activities, (ii) provide for appropriate procedures of supervision and control, and (iii) establish a separate system of follow-up and review to determine that delegated authority and responsibility was being properly exercised.12

  • SEC Enforcement Action: More recently, in late 2008, the SEC issued an Order Instituting Administrative Proceedings Pursuant to Section 15(b) of the Securities Exchange Act of 1934, Making Findings and Imposing Remedial Sanction against a commodities trader employed by BMO Capital Markets Corp., an SEC-registered broker-dealer.13 Although the trader's alleged misconduct did not directly involve securities products, the SEC alleged he violated the federal securities laws by engaging in a scheme to overvalue a commodity derivatives trading portfolio of Bank of Montreal (BMO). According to the SEC's complaint, filed in the U.S. District Court for the Southern District of New York, the trader mis-marked positions in a natural gas option portfolio at BMO and colluded with others to have an independent commodities brokerage firm (Optionable, Inc.) falsely validate the inflated marks. The false values of the commodities portfolio inflated BMO's publicly reported financial results and, after the scheme was discovered, BMO was forced to restate its results by reducing net income for the first quarter of its 2007 fiscal year by approximately $204 million U.S. dollars. As a result of these activities, the SEC alleged that the commodities trader and others violated and/or aided and abetted violations of the antifraud, corporate reporting, recordkeeping and internal controls provisions of the federal securities laws. The SEC subsequently barred the trader from association with any SEC-registered broker-dealer.14


Recent statements by FINRA and actions by the SEC and NYSE reflect an increasing willingness by U.S. securities regulators to apply securities-based standards and regulations to the non-securities activities of broker-dealers. Although these regulators may draw the line if the non-securities products or activities are covered by another regulator (e.g., the banking regulators or the CFTC), broker-dealers would be well served to examine the supervisory and internal control structures they have in place for both securities and non-securities activities.


1In the Matter of David Lee, SEC Administrative Proceeding, Exchange Act Rel. No. 59107 (Dec. 16, 2008).

2 FINRA Regulatory Notice 09-06 (Jan. 21, 2009) (Notice 09-06). The regulatory notices discussed herein are available here. Comments on FINRA's retail forex rule proposal were due February 20, 2009.

3 7 U.S.C. § 2(c)(2). The Commodity Futures Modernization Act of 2000 (CFMA) and the CFTC Reauthorization Act of 2008 together allow only certain specified regulated entities to act as counterparties to retail forex contracts. See Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763, 2763A-378 (2001); CFTC Reauthorization Act of 2008, Pub. L. No. 110-246, 122 Stat. 1651 (2008). The Commodity Futures Trading Commission (CFTC) regulates the activities of FCMs.

4See 7 U.S.C. § 2(c)(2).

5See Notice 09-06.


7 FINRA Regulatory Notice 08-66 (Nov. 4, 2008) (Notice 08-66). In issuing this guidance, FINRA noted that it has seen an increase in membership applications from firms interested in conducting retail forex business, as well as an increase in retail forex activities among current FINRA members, including broker-dealers acquired by forex dealers.

8 Notice 08-66, at p.3 (emphasis added).

9 FINRA's existing rulebook, the "Transitional Rulebook," consists of the NASD rules applicable to all FINRA members, and certain rules incorporated from the New York Stock Exchange (NYSE) Rulebook that are applicable to FINRA members that are also NYSE members. FINRA is in the process of proposing rules as part of the "Consolidated Rulebook," which will eventually replace the Transitional Rulebook in its entirety. See FINRA Information Notice: Rulebook Consolidation Process (Mar. 12, 2008) for a description of the rulebook consolidation process.

10See NYSE Rule 342.

11 Citigroup Global Markets, Inc., NYSE Hearing Board Decision 06-141 (Sept. 13, 2006).

12 Id.

13 In the Matter of David Lee, SEC Administrative Proceeding, Exchange Act Rel. No. 59107 (Dec. 16, 2008).Previously, in November 2008, the SEC filed a civil injunction action against the trader and top senior executive officers of Optionable, Inc., charging them with engaging in a fraudulent scheme to overvalue the commodity derivatives trading portfolio at BMO and thereby inflate BMO's publicly reported financial results. See SEC Litigation Rel. No. 20811 (Nov. 18, 2008); SEC v. Lee, et al., 08-civ-9961 (Nov. 18, 2008).

14 In the Matter of David Lee, SEC Administrative Proceeding, Exchange Act Rel. No. 59107 (Dec. 16, 2008).