Applicability of Rule 3230 to a three-party clearing agreement.
August 7, 2001
VIA FACSIMILE AND FIRST CLASS MAIL
Bob E. Lehman, Esq.
Lehman & Eilen LLP
50 Charles Lindbergh Boulevard
Uniondale, NY 11553
Re: Three Party Clearing Arrangement - Foreign Introducing Broker-Dealer
Dear Mr. Lehman:
I am responding to our conversation of July 18, 2001 during which you requested a written response to your letter of November 8, 2000. As you are aware, we provided you with oral advice concerning your letter in March 2001. Your letter sought advice as to whether the rules of the National Association of Securities Dealers ("NASD") prohibit or otherwise restrict a member organization from entering into a piggyback clearing agreement (sometimes referred to herein as a "Subclearing Agreement") with a foreign broker-dealer.
Your letter stated as follows. The foreign broker-dealer ("Foreign Broker-Dealer") is located and operated exclusively outside of the United States and is not registered with the Securities and Exchange Commission ("SEC") or a member of the NASD. It is a broker-dealer organized under the laws of Bahrain, and its customers are neither citizens nor residents of the United States.
The Foreign Broker-Dealer directly and through other affiliates, offers investment products and services that are either listed or traded in various locations in the Middle East, Eastern and Western Europe and other jurisdictions considered to be offshore by either American or European investors. The Foreign Broker-Dealer provides its customers with services similar to those provided by full service domestic broker-dealers. In addition to transaction execution services, the Foreign Broker-Dealer provides investment research and related support services to its customers. Such services are incidental to the brokerage services being provided to its customers, and no special compensation is charged for such services.
The Foreign Broker-Dealer wishes to offer its customers the ability to invest in securities that are listed or traded in the United States. The Foreign Broker-Dealer will function as a full service broker as to its customer activities in those investments, and will take appropriate measures to learn sufficient information about each of its customers to determine the suitability of such investments for each customer if it recommends the subject security to its customer. A member firm (the "Introducing Firm") will provide transaction execution services, including Internet-based trading, that will enable customers to purchase or sell United States issued securities. Each customer may also give representatives of the Foreign Broker-Dealer a power of attorney to open accounts for the benefit of such customer with the Introducing Firm and the authority to place orders with the Introducing Firm, for the benefit of the customer, through the facilities of the Introducing Firm, including through the Internet. The Introducing Firm, in turn, will introduce such non-U.S. accounts to its clearing firm (the "Clearing Firm").
The Introducing Firm has entered into a fully disclosed clearing agreement with the Clearing Firm, also an NASD member. The Clearing Firm will have possession and custody of all customer accounts introduced by the Foreign Broker-Dealer to the Introducing Firm and will maintain all books and records customarily maintained by a clearing firm in accordance with Rules 17a-3 and 17a-4 under the Securities Exchange Act of 1934, as amended (the "Exchange Act").
Customers will enter into an agreement with the Foreign Broker-Dealer that will memorialize the business terms discussed above. The customer’s agreement with the Foreign Broker-Dealer will state whether a customer will place its U.S. securities transaction orders directly with the U.S. Introducing Firm, including via the Internet, or with representatives of the Foreign Broker-Dealer who will in turn effect and execute these orders for the benefit of the customer through the facilities of the Introducing Firm. The customer’s agreement with the Foreign Broker-Dealer will further require the customer to provide the Foreign Broker-Dealer and the Introducing Firm with appropriate information concerning its investment experience, its investment objectives and certain financial information and to update this information when and if such information changes. This agreement will state those commissions and other charges that will be assessed to customers and that such charges may be shared among the Foreign Broker-Dealer, the Introducing Firm, and the Clearing Firm. However, the agreement will not explicitly state how much each such party will receive of the total compensation paid by or charged to the customer’s account.
Customers will also enter into a standard customer agreement with the Introducing and Clearing Firms. This agreement will delineate the respective duties and responsibilities of these firms. Customers will send all funds, checks and securities directly to the Clearing Firm for deposit into their respective brokerage accounts. No customer funds, checks or securities will be sent to either the Foreign Broker-Dealer or the Introducing Firm. It is anticipated that the Clearing Firm will remit the compensation due to the Introducing Firm on a monthly basis which, in turn, will immediately forward the agreed upon portion thereof to the Foreign Broker-Dealer.
In addition to the services performed by the Foreign Broker-Dealer described above, the parties also contemplate that the Foreign Broker-Dealer will deal directly with its customers concerning any problems, questions or issues as to entering or processing orders, or otherwise relating to customer accounts. Support staff of the Foreign Broker-Dealer, including those trained in addressing technology problems, will attempt to address issues, problems and questions, if any, brought to their attention by the Foreign Broker-Dealer’s customers. These support staff may, in turn, contact the support staff of the Introducing Firm to address any matters they are unable to handle for the customers by themselves.
Request For Interpretation
Your letter sought advice as to whether such an agreement would be governed by NASD Rule 3230 and would not, in view of the respective duties and responsibilities of each party to the Subclearing Agreement, be considered an arrangement governed by NASD Rule 1060. Your letter also discussed the applicability of NASD Rule 2420 to the arrangement described therein.
NASD Rule 1060(b)
Persons associated with a member who are engaged in the investment banking or securities business for a member are designated as representatives and must be registered as such with the Association, pursuant to NASD Rule 1031. NASD Rule 1060 provides exemptions from that requirement. NASD Rule 1060(b) states that members and persons associated with members may pay to nonregistered foreign persons transaction-related compensation based upon the business of customers they direct to member firms, if certain conditions are met. This rule provides members with assurance that they may pay foreign finders under the circumstances described in the rule and not have to register those foreign finders as associated persons. NASD Rule 1060(b) was intended to provide this assurance in situations where the sole involvement of the foreign person receiving the transaction-related compensation is the initial referral of non-U.S. customers to the member.1
The staff believes the exemption provided by NASD Rule 1060(b) would not be applicable or available under the circumstances described in your letter because the involvement of the Foreign Broker-Dealer, under the facts you describe, would not be limited to the initial referral of non-U.S. customers to the Introducing Firm.
You should be aware, however, that the employees or staff of the Foreign Broker-Dealer in this arrangement would be considered associated persons of the Introducing Firm if those persons are engaged in the investment banking or securities business, and control or are controlled by the Introducing Firm.2 Absent additional facts, the staff is unable to express an opinion concerning whether the Foreign Broker-Dealer’s employees or staff would be acting as associated persons of the Introducing Firm under the circumstances your letter described. To the extent such employees or staff are acting as associated persons of the Introducing Firm, among other things, they must be registered in the appropriate registration category under the NASD Rule 1030 Series.
NASD Rule 2420
Your letter indicated that the arrangement described above is exempt from the prohibitions of Rule 2420(a). NASD Rule 2420(a) has been interpreted to prohibit, among other things, payments of securities commissions to non-member broker-dealers, and applies to non-members that are not registered as broker-dealers under the Exchange Act, but are required to be so registered. The activities described in your letter raise the question of whether the Foreign Broker-Dealer would be required to register as a broker-dealer under the Exchange Act. You may wish to consult with the SEC’s Division of Market Regulation, Office of Chief Counsel, which regularly considers whether a particular entity is required to be registered as a broker-dealer. Generally, NASD Regulation does not consider it appropriate to conclude that a particular transaction-related payment by a member to a non-member would not violate Rule 2420 unless the non-member entity has obtained a no-action letter from the SEC staff indicating that the entity is not required to register as a broker-dealer.
NASD Rule 3230
NASD Rule 3230 governs clearing agreements entered into by members. The rule requires, among other things, that all clearing agreements entered into by a member, except where any party to the agreement is also subject to a comparable rule of a national securities exchange, specify the respective functions and responsibilities of each party to the agreement. The rule also imposes upon the clearing firm and the introducing firm certain responsibilities with respect to customer complaints. The staff believes that the clearing arrangement between the Introducing Firm and the Clearing Firm is subject to, and must conform to, the requirements of NASD Rule 3230.3
I hope that this letter is responsive to your request. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Directors of NASD Regulation, Inc. This letter responds only to the issues you have raised based on the facts as you have described them in your letter, and does not address any other rule or interpretation of the NASD, or all the possible regulatory and legal issues involved.
Sarah J. Williams
Assistant General Counsel
|cc:||Daniel M. Sibears, Senior Vice President
NASD Regulation, Inc., Member Regulation
1 See Notice to Members 95-37 (May 1995) announcing SEC approval of Part VI of Schedule C of NASD By-Laws, which was subsequently converted to NASD Rule 1060.
2 SeeArticle I, Section (ee) of the NASD By-Laws (defining “associated person of a member”).
3 See also Letter from Elliot Curzon, NASD Regulation, Inc. (July 23, 1999) (available on the NASD Regulation Web Site) discussing the applicability of Rule 3230(a) to secondary or sub-clearing arrangements with foreign securities firms.