Introducing Broker-Dealers: Claiming Dual Exemption & Maintaining a Special Account
Broker-dealers’ calendar year-end audits are officially underway, and the March 2, 2020, annual report filing deadline is fast approaching. For management of introducing broker-dealers that file an exemption report because they claimed an exemption from the customer protection rule throughout the fiscal year, this is a good time for a refreshed understanding of Securities Exchange Act Rule 15c3-3(k) and assessment of adherence to the claimed exemption provisions. In November 2018, the SEC updated its list of frequently asked questions (FAQ) concerning the July 30, 2013, amendments to the broker-dealer financial reporting rule. The FAQ document should be a useful resource for all broker-dealer auditors and sheds light on two areas in practice where the rules have been inconsistently applied: (1) identification of the proper exemption for broker-dealers with multiple lines of business and (2) the need for a broker-dealer claiming the (k)(2)(i) exemption to maintain a special account for the exclusive benefit of customers.
A Refresher on the Exemption Report
Securities Exchange Act Rule 17a-5(d)(2) specifies a broker-dealer that claims it’s exempt from Section 240.15c3-3 throughout the most recent fiscal year must file an exemption report. The exemption report must (1) identify the provisions in §240.15c3-3(k) under which the broker or dealer claimed an exemption from §240.15c3-3, (2) state that the exemption provision(s) identified was met throughout the most recent fiscal year without exception, or that the exemption provision(s) was met with exception, and (3) if applicable, identify each exception during the most recent fiscal year and briefly describe the nature of each exception and approximate date(s) on which the exception existed.
Exemptions from Securities Exchange Act Rule 15c3-3 include:
- (k)(1) – This exemption is restrictive and reserved for a broker-dealer that only does direct-way mutual fund or variable annuity business. A broker-dealer is prohibited from claiming the (k)(1) exemption if it conducts any other line of business activity.
- (k)(2)(i) – Commonly used as a catch-all for broker-dealers whose business activities don’t otherwise qualify for another exemption. To qualify, a broker-dealer must carry no margin accounts, promptly transmit all customer funds and deliver all securities received in connection with its activities as a broker-dealer. Further, a broker-dealer claiming this exemption doesn’t otherwise hold funds or securities for, or owe money or securities to, customers and effectuates all financial transactions between the broker or dealer and its customers through one or more bank accounts, each to be designated as “Special Account for the Exclusive Benefit of Customers of (name of the broker or dealer).”
- (k)(2)(ii) – This exemption is for a broker-dealer that does all business through a clearing agent on a fully disclosed basis. Broker-dealers that maintain business lines other than this shouldn’t rely on this exemption solely and must claim a dual exemption with the (k)(2)(i) exemption.
- (k)(3) – This exemption may be granted upon written application by a broker-dealer if the SEC (1) finds the broker-dealer has established safeguards for protecting customers’ funds and securities that are comparable to those provided by the financial responsibility rules and (2) determines that it’s not necessary in the public interest or for the protection of investors to subject the particular broker-dealer to Rule 15c3-3’s provisions. The SEC has never granted such an exemption.
Can Broker-Dealers Claim Dual Exemptions?
Some broker-dealers maintain a single line of business, and the related exemption is simple to identify. For instance, a broker-dealer that effects all of its business through a clearing broker-dealer on a fully disclosed basis would claim an exemption under (k)(2)(ii). Likewise, a broker-dealer that operates solely in an M&A capacity would most likely claim an exemption under (k)(2)(i).
However, in many instances, introducing broker-dealers provide a diverse set of products and services that don’t fit the definition of a single exemption. Consider the example of a broker-dealer that effects most of its business through a clearing broker-dealer on a fully disclosed basis, but the remainder of its business is composed of M&A advisory services and the direct or application-way sale of variable annuity insurance products. Often, broker-dealers in this situation will claim the exemption that best describes their primary business line (in this case, business effected through a clearing agent). While that particular exemption might be the most relevant, it doesn’t address all pertinent business streams.
Question 12 in the SEC’s FAQ addresses this specific issue:
Non-carrying broker-dealers may have multiple business activities with customers. A non-carrying broker-dealer may introduce some customer transactions to a carrying broker-dealer on a fully disclosed basis in conformance with paragraph (k)(2)(ii) of Rule 15c3-3 and at the same time effect customer transactions in securities such as mutual funds or insurance products in conformance with paragraph (k)(2)(i) of Rule 15c3-3. In such cases, should the broker-dealer identify both paragraphs (k)(2)(i) and (k)(2)(ii) of Rule 15c3-3 as the exemptions under which it claims exemption from Rule 15c3-3 in its exemption report? Should all exceptions under both paragraphs be identified in the exemption report?
The broker-dealer’s exemption report should fully reflect the nature of all of its business activities. It is common for both of the exemption provisions in paragraph (k)(2) of Rule 15c3-3 to apply to the business activities of an introducing broker dealer. In such cases, the broker dealer should reflect both exemption provisions supporting its claim of exemption in the exemption report, and should also identify any applicable exceptions under each.
Based on this guidance, a broker-dealer that effects a portion of its business through a clearing broker-dealer and has any other business lines should claim exemptions under both (k)(2)(i) and (k)(2)(ii). The (k)(1) exemption can’t be part of dual exemption as it is for broker-dealers whose activities are limited only to the direct-way mutual fund or variable annuity business.
There’s been a divergence in practice on this issue, and given the SEC’s recent clarification, there could be a greater level of regulatory scrutiny on the claiming of proper exemptions moving forward. As evidence, the PCAOB specifically cited this matter in its Small Business and Broker-Dealer Audit Forum in September 2019.
When Is a Special Account Necessary?
Another area of confusion under the exemption provisions is when a broker-dealer must maintain a special account for its customers. Question 9 of the SEC’s FAQ document addresses this issue:
Must a broker-dealer that makes a claim of exemption from Rule 15c3-3 under paragraph (k)(2)(i) establish a “Special Account for the Exclusive Benefit of Customers?”
Absent specific instruction from its DEA or the Commission, such a broker-dealer is not required to maintain a “Special Account for the Exclusive Benefit of Customers” if due to the nature of its business activities the broker-dealer would not ever be in possession of customer funds or securities. If customer funds or securities were received, however, and not promptly transmitted to such an account, the receipt of the funds or securities would be considered an exception that management would be required to describe in its exemption report.
Essentially, if a broker-dealer has any potential to receive customer funds (regardless of whether it actually does), it should establish a special account. The account must be maintained for the benefit of customers and can’t be subject to any lien, creditor, etc. If a broker-dealer doesn’t have a special account but subsequently determines it’s necessary, e.g., it receives a check, the issue can be corrected and listed as an exception in the exemption report.
There have been differences in practice concerning the application of the exemption provisions. While the SEC FAQ guidance provides clarity on several issues including those outlined above, each broker-dealer has a unique set of circumstances, and the rules can be difficult to navigate. Management of introducing broker-dealers should revisit this guidance to assess whether year-end exemption reports are accurate and consider reaching out to its FINRA representative for additional clarity if necessary. For more information, reach out to your BKD Trusted Advisor™ or use the Contact Us form below.