As the pandemic rapidly spread throughout the world at the beginning of this year, financial markets fell into disarray.[1] If you are following market trends, however, you have probably seen that despite dropping to drastically low levels in February and March, stock prices have returned, and even surpassed, pre-pandemic numbers, causing speculation of a precarious financial bubble.[2] Unfortunately, not every market trend is now on the upswing, demonstrating that perhaps the pandemic cannot take the blame for all current financial developments. One such notable downward trend is the steady decline of the broker-dealer.[3]
A broker-dealer, stripped down to a simple definition, is a registered financial professional dedicated to the buying and selling of securities.[4] Over the past decade (before the pandemic), the number of registered broker-dealers, especially individuals registered only as broker-dealers and not dually registered as another professional in the industry, has continued to decrease.[5] The answer to “why” does not lie on the coattails of a global public health crisis, but may lie within the nature of the profession itself, specifically the regulatory framework shaping the broker-dealer world.[6]
Why are broker-dealers even a topic in the legal universe? Well, a broker-dealer is one of the major players in the investor protection schema created by federal securities laws.[7] While the Securities Exchange Act of 1934 (“Exchange Act”) defines a “broker” and a “dealer” differently, most regulatory rules apply to both generally.[8] The Exchange Act essentially requires broker-dealers to register with the Securities and Exchange Commission (“SEC”) by prohibiting essential business transactions until registration is complete.[9] An exception to this requirement is when a broker-dealer conducts business solely within one state; in this case, only state registration may be required.[10] Even in the limited exceptions where a broker-dealer is not required to register with the SEC, all broker-dealers involved in securities transactions are still subject to “fraud, manipulation, and insider trader prohibitions.”[11] Additionally, every SEC registered broker-dealer must also register with a Self-Regulatory Organization (“SRO”).[12] One of the biggest, and most prominent SROs is the Financial Industry Regulatory Authority (“FINRA”).[13] FINRA assists the SEC with regulating the activities of broker-dealers.[14] Essentially, broker-dealers, with limited exceptions, are subject to extensive regulation by three major regulatory authorities: the SEC, SROs, and individual state regulators.[15]
Are the many regulatory players from the SEC and FINRA to individual states the reason why registration of broker-dealers has slowly declined over the past decade? Many scholars and industry professionals have answered that question with a resounding “yes.”[16] It seems very difficult to balance requirements from multiple players; especially if those requirements tighten each year, which is often the case.[17] With so many regulations to balance, it is no wonder that the profession is dwindling.
Another data point, suggesting overwhelming regulation woes as a factor in the profession’s decline, is the comparison of broker-dealers to another player in the game: Registered Investment Advisors (“RIAs”). Unlike broker-dealers, investment advisors, in addition to state regulations, are regulated pursuant to the Investment Advisors Act.[18] Currently, the number of RIAs registered with the SEC overwhelms that of broker-dealers.[19] While broker-dealers must comply with the SEC, FINRA, and state regulators, RIAs escape FINRA’s watch and only have to comply with regulation by the SEC and individual states.[20] Of course, admittedly, RIAs and broker-dealers play different roles in the financial world.[21] While broker-dealer’s offer clients many different types of financial products including securities, securities-backed loans, and even credit cards, RIA’s mostly play a role in clearing investment transactions through third parties like banks or brokerage firms and use third-party financial institutions to safeguard client assets.[22] Essentially, RIA’s generally provide more limited financial services than a traditional broker-dealer.[23] Therefore, an investor may choose to turn to one depending on his or her specific needs.[24]
Despite the obvious differences in their roles, the disparity in the number of professionals entering each profession has likely been due to the difference in the complexity of their regulatory obligations.[25] For example, as of 2017, the SEC only conducted on-site examinations of around eight percent of RIA firms.[26] As a whole, 40 percent of RIA firms have never even been examined.[27] This is very different from the 55 percent of brokerage firms that are examined annually by the SEC or FINRA.[28] It should be noted that we may see changes in these numbers in the future, especially given the SEC’s recently released 2020 Examination Priorities Report.[29] In this report, the SEC indicated that it will focus more on regulation of RIAs during the 2020 fiscal year.[30] Perhaps as RIA numbers and their controlled funds increase, scrutiny will continue to rise.[31] Nonetheless, it remains to be seen whether RIAs will ever be regulated as much as broker-dealers, especially given the absence of a major player like FINRA working in partnership with the SEC.
Regardless of whether SEC scrutiny of RIAs will increase this year, the truth remains that broker-dealers are regulated to a greater degree given the oversight of many regulatory players.[32] Only time will tell if the numbers of broker-dealers continue to decline as more strict regulations like Regulation B-I, mentioned above, are adopted and implemented. Perhaps, if overregulation continues to influence various parts of the financial industry, as I suspect it has done with broker-dealers, a push towards deregulation may be on the horizon.
[1] Shalini Nagarajan, From the COVID-19 panic to the Dutch Tulip mania in 1637, here are 10 of the worst stock market crashes in history, Market Insider (June 9, 2020, 7:41 PM), https://markets.businessinsider.com/news/stocks/10-biggest-stock-market-crashes-covid-19-dutch-tulip-mania-2020-6-1029294125#.
[2] Id.; see also Jeff Camarda, Does S&P 500 + US Economy = Covid Stock Bubble?, Forbes (July 13, 2020, 11:39 AM), https://www.forbes.com/sites/jeffcamarda/2020/07/13/does-sp-500–us-economy–covid-stock-bubble/#61a9a38e5daa
[3] Financial Industry Regulatory Authority, 2020 FINRA Industry Snapshot Report (2020), https://www.finra.org/sites/default/files/2020-07/2020-industry-snapshot.pdf. This is the most recent FINRA report. It contains numerous charts showing the steady decline of the number of FINRA registered broker dealers. id. It is important to note that data for 2020 is not yet available so the current report does not demonstrate the pandemic’s possible influence on broker-dealer numbers.
[4] See generally Robert L.D. Colby, Lanny A. Schwartz, & Zachary J. Zweihorn, What Is a Broker-Dealer?, in Broker-Dealer Regulation 2-1 (Clifford E. Kirsch ed., 2016).
[5] See Melanie Waddell, Number of BDs Continues to Decline, Report Shows, ThinkAdvisor (Jul. 31, 2020, 11:25 AM), https://www.thinkadvisor.com/2020/07/31/number-of-bds-continues-to-decline-finra-report-shows/.
[6] Cf. id.
[7] See generally, Colby et al., supra note 4.
[8] See id. at 2–4 n.1
[9] Exchange Act § 15(a)(1); see also Colby et al., supra note 4 at 2-6.
[10] See SEC, Guide to Broker-Dealer Registration (April 2008), at pt. II.D.1, https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html#III [hereinafter Investor Publication].
[11] See Securities Act § 17(a); Exchange Act §§ 9(a), 10(b), and 15(c)(1) and (2). See also Colby et al., supra note 4, at 2-9.
[12] See Exchange Act § 15(b)(9).
[13] See Self-Regulatory Organizations, Legal Info. Inst., https://www.law.cornell.edu/wex/self_regulatory_organization (last visited Sept. 11, 2020).
[14] See Investor Publication, supra note 10, at pt. III.B
[15] See id.
[16] See, e.g., NASDAQ, Broker-Dealers vs. Registered Investment Advisors (‘RIAs’): Which is Which? (Jan. 16, 2019), https://www.nasdaq.com/articles/broker-dealers-vs-registered-investment-advisers-rias-which-which-2019-01-16 [hereinafter NASDAQ]; see also Lanny A. Schwartz et al., So, Now You Own a Broker-Dealer!, Davis Polk (2017), https://www.davispolk.com/files/2017-09-20_so_now_you_own_broker_dealer.pdf.
[17] For example, one of the newest regulations is Regulation B-I which became effective June 30, 2020. See Fred Reish, The SEC Issues New Rules for Broker-Dealers: Will They Help Investors?, Forbes (June 11, 2019), https://www.forbes.com/sites/fredreish/2019/06/11/the-sec-issues-new-rules-for-broker-dealers-will-they-help-investors/#4f61fbef7de9.
[18] See 15 U.S.C. §80b-1, et seq; See also Julian W. Wells, Joshua S. Bratspies & Jordan D. Weinreich, Registered Investment Advisors – How They Compare to Broker-Dealers, 2015 N.J.L. 17, 18 (2015).
[19] See NASDAQ, supra note 16.
[20] See id.
[21] See Wells et al., supra note 18, at 17.
[22] Id.
[23] Id.
[24] Id.
[25] For a complete breakdown of the differences between broker-dealers and investment advisors from the SEC’s perspective, see SEC, Study on Investment Advisors and Broker-Dealers (Jan. 2011), https://www.sec.gov/news/studies/2011/913studyfinal.pdf.
[26] See Wells et al., supra note 18, at 17.
[27]Id. at 18.
[28] Id.
[29] See SEC, 2020 Examination Priorities Report (2020), https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf.
[30] Id.
[31] See id.
[32] See generally, Wells et al., supra note 18.
