FINRA’s Notice To Prop Traders

June 22, 2010 | By: Robert A. Green, CPA

Are FINRA, the SEC and others about to pounce on day prop trading firms? 

In April, FINRA’s released its Regulatory Notice 10-18, which includes guidance on master and sub-account arrangements. This document has prompted much debate since its release. 

Over the past decade, regulators prodded the prop-trading industry to move away from engaging prop traders as independent contractors. Instead, prop traders were asked to join the firms as LLC members.

A person trading a firm’s capital should either be an employee (as in Wall Street banks and brokerage houses) or an owner of the firm. Regulators tried to clean up the low-hanging fruit, preferring licensed brokers to join prop trading firms organized as broker dealers. Many are “non-customer” broker dealers meaning they don’t any business with retail customer accounts. Customers can have up to 4:1 margin as pattern day traders per Reg T margin rules. Prop traders are only limited within the firm, so many can have 10:1 or greater leverage, making prop trading quite attractive.

One major bone of contention is the issue of deposits. Employee prop traders rarely pay deposits on Wall Street, and only pay them occasionally in prop trading firms. Independent contractor and LLC member prop traders usually are requested to pay deposits. The deposit size has a direct (although somewhat hidden) connection to how much leverage they are afforded by the firm and how much their share of trading profits will be (60 to 100 percent depending on deposit size).

In prop trading firms, these deposits are rarely treated as LLC member capital contributions, and they’re connected to a sub-account’s trading performance and used to cover sub-account trading losses. When traders leave a firm, most agreements demand they pay back losses in excess of their deposit accounts.

Another concern is the issue of “special allocations” of sub-account trading profits. Special allocations seem to push the envelope of what the IRS allows in partnership returns. The Wall Street employee prop trader may have a sub-account to trade and track performance, and then receive a bonus based on performance — perhaps 50 percent compensation (the Wall Street model), whereas many prop traders automatically receive 99 or 100 percent of the trading profits. We understand FINRA may regard the latter payouts as indicative of a beneficial owner — perhaps a disguised customer account. Some firms may need to change to 80/20 splits to keep muster.

While some prop trading firms offer the employee-model option with 60/40 or 50/50 payouts, some still rely on the LLC or contractor model, paying out more than 80 percent. Firms seem to make money on services, or rebates. In my opinion, rebates are a form of collecting commissions, and if this is the case, the broker should be registered as a commission broker dealer.

The IRS allows special allocations in partnership returns, which an LLC files. Special allocations stand up to IRS scrutiny if they follow the money. It’s odd to me that prop traders who are Class C or D members, yet don’t share in firm-wide profits and losses and even their own losses, can still receive 99 or 100 percent of their LLC class profits on their own sub-trading account. Traders eat what they kill.

The FINRA notice seems bent on identifying “beneficial owners” hidden in prop trading firm master and sub-account relationships. Beneficial owner is a legal term where specific property rights (“use and title”) in equity belong to a person even though legal title of the property belongs to another person. This often relates where the legal title owner has implied trustee duties to the beneficial owner.

Over this past decade on this story, many have used the term “disguised customer accounts.” Are FINRA and the SEC looking to force retail traders back into a customer account peg instead of a prop trading firm peg? If so, those traders would be forced back into regular retail compliance including 4:1 pattern day trader rules and more.

The FINRA notice list asks clearing firms to spot these red flags and then take action. Many clearing firms may not be able to see these red flags, because prop trading firms structure things in a somewhat deceptive manner. For example, if a prop trading firm has a large brokerage account and many domestic and foreign traders, those details (including trader names) may be hidden from the clearing broker. Sub-accounts may be labeled with non-identifying (by legal name) information like just account numbers.

Here, I’ve included the the FINRA Notice 10-18 list in bold, and my comments thereafter. The notice states a firm will be on inquiry notice if:

1. Sub-accounts are separately documented and/or receive separate reports from the firm.Firms document exact sub-account activity in reports often given to each prop trader.

2. Firm addresses the sub-accounts separately in terms of transaction, tax or other reporting.Firms summarize these reports into year-end tax reporting, including either 1099-Misc, Schedule K-1 or W-2.

3. Services provided to the sub-accounts engender separate surveillance and supervision risk management. Firms often oversee each trader and compare their risk, gains and losses to deposit amounts, offset losses against deposits, and request deposit replenishment. This isn’t always seen by clearing firms.

4. Firm has financial arrangements or transactions with the sub-accounts, or separate account terms, that reasonably raise questions about beneficial owners. Traders receiving 99 or 100 percent payouts on trading gains seem like beneficial owners. If the firm was truly an owner too, wouldn’t it receive a bigger share of the trading gains? Arrangements vary by sub-account and trader.

5. Sub-accounts incur charges for commissions, clearance and similar expenses. Yes. Firms charge traders for various services including education, tools, desk charges, commissions (in some cases), rebates and other services.

6. Firm has evidence of financial transactions or transfers of assets or cash balances that would reasonably evidence separate beneficial-ownership of the sub-accounts. In my view, that refers to traders making deposits, although they are rarely credited to sub-accounts. Most firms are somewhat cute about keeping the deposits off to the side and not transferring them into the sub-accounts.

7. The firm is aware of or has access to a master account or like agreement that evidences that the sub-accounts have different beneficial owners. The firm’s LLC agreement, listing Class C and D prop traders is this type of document, in my view.

8. The firm has evidence that a party maintaining a master/sub account arrangement has interposed sub-accounts that have or are intended to have the effect of hiding the beneficial-ownership interest. If the sub-accounts have account numbers without names of the traders, that could be deemed a form of hiding, I presume.

9. The number of sub-accounts maintained is so numerous as to reasonably raise questions about beneficial ownership. Many prop trading firms have numerous sub-accounts, so this is a concern too.

10. Items 3, 4, 5, 6, 8 and 9 would not apply in the case of a registered IBD or a bona fide IA arrangement described in the Notice. In my opinion, a prop trading firm organized as a non-customer broker dealer (BD) can’t claim it’s an IBD per this notice, as IBDs have customer accounts. FINRA is telling clearing firms they can rely on the customer IB to have handled compliance on its customers. Even if the broker dealer is registered as a customer BD, the prop traders in question aren’t treated by those firms as customers, so I don’t believe the firms can avail themselves of these exceptions in connection with application of this FINRA regulatory notice. I believe these prop trading firms can’t claim IA status either, as the traders are active and not passive investors, and the firms generally aren’t registered investment advisors.

FINRA is asking clearing firms for help here and they may not see these red flags. Although, if they have huge accounts with these firms, compliance forces them to understand their client and know what’s happening behind the scenes. To claim ignorance is probably not acceptable either.

If FINRA and/or the SEC examines these prop trading firms, they can easily see these red-flag items. What action will they take from there? Can prop trading firms restructure their business models to share more with their traders, so the traders aren’t deemed beneficial owners? Will that please the regulators? Does FINRA equate beneficial owners with “should be” customer accounts? It will be interesting to see how the IRS will react, too. 

Prop trading firms in the grips of the regulators may consult their lawyers for protection. They may disclose their pertinent information and not tell traders everything they should learn on their own. Attorneys representing prop trading firms are expected to handle their clients’ needs by law and not necessarily serve the public’s interest. It’s always a good idea to consult your own attorney, and not necessarily the attorney representing your prop trading firm.

We help many prop traders on their tax planning and preparation and consult with them on big picture items too. In the past, many traders decided to continue prop trading because the leverage and access was attractive and they took payouts to retain as little money as possible at risk in the firms. Keep your eyes and ears open on this story. 

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