Exclusions

There are a number of circumstances that allow persons to avoid registration as a broker-dealer. As you learned in previous chapters, registration requires numerous disclosures, seemingly endless paperwork, and filing fees. Financial firms can save significant money and time if they can avoid the process. Qualifying for an exclusion, which means a person does not meet the definition of a broker-dealer, legally allows firms to avoid registration.

These are the exclusions discussed in this chapter:

• General broker-dealer exclusions
• Institution rule
• Vacation (snowbird) rule
• Limited registration of Canadian broker-dealers

General broker-dealer exclusions

The Uniform Securities Act (USA) explicitly names three persons that are consistently excluded from the definition of a broker-dealer:

• Agents
• Issuers
• Banks, savings institutions, and trust companies

Agents are the natural persons (human beings) that represent (work for) broker-dealers. Essentially, agents are the employees, while broker-dealers are the employers (firms).

Issuers may raise capital (money) by selling their securities to investors, but are not considered broker-dealers unless they facilitate trading in another issuer’s securities. For example, Charles Schwab is an issuer of their own common stock, which normally would exclude them from broker-dealer registration. However, the exclusion does not apply because they facilitate trading in securities from other issuers.

Banks and savings institutions offer financial products to their own customers, but it’s always safe to assume they’re not included in the definition of a broker-dealer. The same goes for trust companies, which are organizations that help their clients manage trusts. One important note here - this exclusion does not carry over to bank holding companies. The Federal Reserve Bank of St. Louis, which is a regional division of the Federal Reserve (the US Central Bank), describes bank holding companies this way:

“Bank holding companies are corporate entities that own one or more banks”

Bank holding companies are large organizations with numerous subsidiaries, which include a bank (or multiple banks). These organizations also have subsidiaries engaged directly in the securities business. For example, Bank of America operates a banking business, but also owns the broker-dealer business Merrill Lynch. Therefore, Bank of America cannot claim the banking exclusion due to its ownership of a broker-dealer (which makes them a bank holding company).

Bottom line - banks and other savings institutions are excluded from the definition of a broker-dealer, but bank holding companies are not.

Institution rule

Firms may also be excluded from the definition of a broker-dealer if these two conditions exist:

• No place of business in the state
• Only doing business with:
  • Issuers
  • Other broker-dealers
  • Banks, savings institutions, and trust companies
  • Insurance companies
  • Investment companies (e.g. mutual funds)
  • Pension or profit-sharing trusts
  • Financial institutions
  • Institutional investors

First and foremost, a business engaged in broker-dealer activities with an office in the state (a.k.a. a place of business) is not excluded and must register. For example, Northwestern Mutual, which has a part of its business dedicated to broker-dealer activities, has its company headquarters located in Wisconsin. It doesn’t matter what type of investors the company handles; registration is required with Wisconsin’s state administrator because of the physical presence of their offices.

However, organizations can avoid registration if they have no place of business in a state and generally avoid retail investors. As we learned in the investors chapter, there are two general categories of investors: retail and institutional. If you scroll back up to the list of investors above, they’re all institutions. Don’t worry about the specifics if you’re not aware of these institutions (e.g. what’s a profit-sharing trust?). It’s important you know broker-dealers can avoid registration when engaging these investors, not specifically what those investors are.

If you think back to what we discussed in previous chapters, the regulators are most concerned with protecting retail investors. Institutional investors are sophisticated and don’t need much protection from state administrators. That’s why the USA doesn’t enforce registration requirements for broker-dealers that only transact with institutional investors. Of course, this rule only applies to broker-dealers that don’t maintain a place of business in the state, as it’s assumed retail investors may show up to the office.

Vacation (snowbird) rule

Another way a firm can avoid registration as a broker-dealer exists if the following conditions are met:

• No place of business in the state
• Only doing business with existing customers temporarily in that state (non-residents)

This is commonly referred to as the vacation rule, or the snowbird exclusion in the industry. Similar to the institution exclusion, it comes with a prerequisite of having no office or physical presence in the state. If an existing customer travels to another state the broker-dealer does not do retail business in or maintain an office, they can continue to do business with that customer without registering in the new state. The exclusion exists as long as the customer isn’t a resident of the new state, assumptively there temporarily.

For example, let’s assume ABC Brokerage Firm has its headquarters in Idaho. The majority of the company’s business is in the state, and the business is properly registered as a broker-dealer with the Idaho state administrator. One of their customers, who is an Idaho resident, travels to Texas for a two-week vacation. ABC Brokerage Firm can continue to do securities transactions with that customer while they’re on vacation without registering in Texas. This exclusion prevents unnecessary registration requirements for firms with traveling customers.

Generally speaking, vacation is considered 30 days or fewer in the new state. A broker-dealer could be required to register should their customer go on vacation for longer than a month. However, it’s possible you encounter a valid situation where the customer stays longer than 30 days and the broker-dealer still obtains the exception.

While the snowbird rule largely focuses on customers on vacation, the rules and regulations technically reference ‘non-residents.’ If a customer goes to another state for an education or work-related program and maintains residency in the original state, the exclusion will still apply regardless of the timeframe. For example, let’s assume a customer goes to another state for a master’s program or a work-related assignment for several months. They can continue to do business with their broker-dealer without the firm registering in the new state as long as the customer retains residency in the original state.

Limited registration of Canadian broker-dealers

When the USA was originally written, representatives from Canada were a part of the lawmaking process. That’s why there’s specific mention of Canadian persons in the law. While they don’t avoid registration completely, the process a Canadian broker-dealer goes through to legally do business in a US state is less intense than the normal American registration process.

Canada has its own registration system for financial firms, which you don’t need to know much about. You can safely assume Canada’s registration process is similar to the American process. If a broker-dealer is located in Canada, is properly registered in Canada, and maintains no offices in any given US state, they can apply for limited US registration.

This would only be a concern if the broker-dealer wanted to do securities transactions with a customer located in a US state. For example, what if a Canadian customer of a Canadian broker-dealer travels or moves to a US state? Can they continue to do business together? The USA provides a form of limited registration status to Canadian broker-dealers in certain circumstances (discussed below).

Limited registration requires Canadian broker-dealers to maintain effective registration with the appropriate self-regulatory organization (SRO) or stock exchange in Canada and continue to maintain “good standing” with their regulators. Additionally, the following requirements must be met:

• Must file an application with the appropriate Canadian jurisdiction (regulator)
• Filing of consent to service of process
• Submission of books and records (if requested by state administrator)

If these conditions are met, Canadian broker-dealers can do securities transactions in a US state in one of two circumstances.

First, a Canadian broker-dealer can gain limited registration status if they’re doing business with a person from Canada that is temporarily in a US state, assuming there was a pre-existing relationship with that person. For example, let’s assume a Toronto-based broker-dealer has a relationship with Leon, a Canadian customer. Leon travels to California for the winter season to avoid cold weather. The broker-dealer can gain limited registration status and continue to do business with Leon as long as he’s there temporarily. ‘Temporarily’ is defined as less than 183 days (yes, this is a weirdly specific number), or basically 6 months.

The second circumstance relates to Canadian persons with full-time residence in a US state. This rule only applies if the broker-dealer is doing securities transactions exclusively in a Registered Retirement Savings Plan (RRSP), which is basically Canada’s version of an Individual Retirement Plan (IRA). Let’s assume the same example as before, but this time Leon moves from Toronto and is now a full-time resident of California. The Canadian broker-dealer can utilize limited registration status and continue to do business with Leon even though he’s not temporarily in California. However, the securities transactions are limited to those done in Leon’s RRSP.

If Canadian broker-dealers plan on claiming limited registration status in the United States for prolonged periods of time, they must renew their applications just like American broker-dealers. If you recall from the disclosures and fees chapter, registration for American persons lasts until the end of each calendar year (December 31st), requiring renewal prior to the end of the year to avoid a registration lapse. The rule is essentially the same for Canadian broker-dealers, except the cutoff is December 1st. In order to avoid a registration lapse, Canadian broker-dealers should renew by the end of November.

The following video summarizes the key points covered in this chapter: