SEC Proposes Amendments to Rule 15b9-1 to Require FINRA Membership for Proprietary Trading Firms

The SEC has released for comment proposed amendments to Rule 15b9-1 in an effort to increase regulatory oversight over proprietary trading firms, and particularly, high-frequency trading firms.  The amendment would require virtually all proprietary trading firms that engage in off-exchange transactions to join FINRA if they are not already members.  The amendment is an effort by the SEC to close the gap on a regulatory exemption which permitted many proprietary trading firms to avoid having to become FINRA members, and thus will make such proprietary trading firms’ off-exchange trades subject to FINRA oversight. 

Rule 15b9-1 (which has not been substantially amended since 1983) currently exempts a broker-dealer from FINRA membership if it is a member of a national securities exchange, carries no customer accounts, and has annual gross income of no more than $1,000 that is derived from securities transactions effected otherwise than on the exchange of which such broker-dealer is a member.  Rule 15b9-1 currently allows income derived from transactions for the broker-dealer’s own account with, or through, another broker-dealer to not count toward the $1,000, thus permitting proprietary trading firms to avoid FINRA membership even though many of their trades may be off-exchange.  Rule 15b9-1 was originally intended to permit broker-dealers who may be exchange members a way to occasionally earn commissions on trades introduced to other broker-dealers for off-exchange trades or to permit such exchange members a way to hedge trades entered into on their exchanges.  The proposed amendments will limit the Rule’s exemption solely to hedging transactions.

As a result of the rule change, the SEC estimates that approximately 125 broker-dealers will be required to become FINRA members.  Many off-exchange transactions are made on Alternative Trading Systems (ATSs), including dark pools and electronic communications networks (ECNs).  In its proposal, the SEC notes that in 2014, orders from broker-dealers who are not FINRA members accounted for 45% to 49% of the 230 billion orders placed on ATSs.  As a basis for the rule change, the SEC explained that although many proprietary trading firms are already exchange members and such firms have exchanges as their designated self-regulatory organization, an exchange typically only has oversight over, or is focused on, trading which occurs on the exchange, and not its members’ off-exchange transactions.  Comments to the proposal are due within 60 days from publication in the Federal Release.

SEC Enforcement Actions Result in Countersuits Alleging Administrative Proceedings Are Unconstitutional

A Judge in the Northern District of Georgia recently agreed to preliminarily enjoin SEC administrative proceedings accepting arguments from plaintiff, Charles Hill, that the SEC’s administrative proceedings are unconstitutional.  Similar to other claims recently filed, Hill argued that Administrative Law Judges (ALJs) are “inferior officers” of the SEC and their appointments violate the appointments clause because the ALJs are not appointed by the President, courts or the Commission.  While similar claims have been made by other respondents, Hills’ is the first to be accepted by a District Court Judge resulting in a preliminary injunction against the SEC continued proceedings. 

In a similar matter, the SEC earlier this year filed an administrative enforcement action against affiliated Patriarch Partner firms, SEC registered investment advisers, alleging fraud and breach of fiduciary duties as a result of improper valuations of loan assets in collateralized loan obligation (CLO) funds and the misreporting of such valuations to investors in quarterly reports. In response to the SEC’s enforcement action, the respondents filed a complaint for declaratory and injunctive relief in federal court.  The basis of the federal court complaint is not respondents’ dispute with the allegations in the underlying merits of the SEC action, but rather the choice of forum.  Similar to Hill, Patriarch Partners also asserted that the enforcement action should have been filed in federal court before a federal judge instead of as an SEC administrative proceeding before an SEC ALJ. Patriarch Partners further argued that SEC ALJs’ appointments are unconstitutional and have no legal authority under Article II of the Constitution.  In support of their argument, Patriarch Partners also noted that after a five year investigation, the formal document initiating the SEC enforcement action, the Order Instituting Proceedings (OIP), requires that an evidentiary hearing take place within 60 days of the issuance of the OIP and that an initial decision be issued by the ALJ within 300 days thereafter.  Furthermore, Patriarch Partners noted that the SEC proceedings do not permit them to file a counterclaim, provide for limited discovery (after dozens of witnesses were interviewed by the SEC during the investigation) and provide for limited appeal rights to the full Commission followed by a Court of Appeals.

A quick fix to these challenges may be for SEC Commissioners to appoint ALJs, instead of them being hired through the SEC’s hiring process.  Nonetheless, it is expected that the SEC will appeal the District Court’s decision in the Hill matter.