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Order Management System’s SEC Settlement Leaves More Questions Than Answers on What Constitutes “Broker” Activity

As part of its continued enforcement focus on broker-dealer registration, the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) recently settled an action with electronic order entry and management system Neovest, Inc. (“Neovest”) for engaging in “broker” activity and receiving “broker” compensation without being registered as a broker-dealer pursuant to Section 15(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).1 Both the settlement and the strong dissent from SEC Commissioner Hester Peirce leave market participants without meaningful guidance on what constitutes “broker” activity requiring registration.  Technology providers that perform functions that could easily be characterized as facilitating communications rather than securities transactions remain most vulnerable to subjective regulatory interpretation. 

The key issue was whether Neovest was “engaged in the business of effecting transactions in securities for the account of others.”  This is the definition of a “broker” under Section (3)(a)(4)(A) of the Exchange Act, which triggers broker-dealer registration under Section 15(b).  Although the topic has been evaluated in SEC no-action letters, federal court opinions, and a recent SEC release proposing a “finders” exception to broker-dealer registration, what constitutes “effecting” a securities transaction in many circumstances remains unclear.  Certain functions, such as sourcing investors or structuring or negotiating a transaction are clear “broker” functions.  But what about less obvious functions that result in a transaction?  Those functions cause the transaction to occur, but do they constitute “effecting” a transaction?  Unfortunately, following the Neovest settlement, market participants are forced to adopt the most conservative approach and must reasonably consider any action facilitating a securities transaction to be broker activity, particularly if success-based or transaction-based compensation is charged.  Indeed, as Commissioner Peirce highlights in her dissent, the existence of transaction-based compensation has all but swallowed the broker analysis, with the SEC staff potentially “drawing an arbitrary line between firms based simply on their compensation model.”2

Broker-Dealer Registration

Section 15(a) under the Exchange Act makes it unlawful to act as a “broker” without being registered as a broker-dealer pursuant to Section 15(b).  As indicated, the Exchange Act defines a “broker” as one “engaged in the business of effecting transactions in securities for the account of others.”There are no statutory definitions for being “engaged in the business” or “effecting transactions,” but the SEC staff has interpreted these terms broadly, considering “whether the person  participates on a regular basis in securities transactions at key points in the chain of distribution.”The SEC and courts have focused on actions indicative of “broker” conduct, including actively soliciting investors, participating in negotiations between buyer and seller, and receiving transaction-based compensation.5 While no particular factor is dispositive, regulators often focus on the last factor—receiving transaction-based compensation—because it confers a "salesman’s stake" in the transaction.  In the words of one SEC Commissioner, “[r]egistration helps to ensure that persons who have a ‘salesman’s stake’ in a securities transaction operate in a manner that is consistent with customer protection standards governing broker-dealers and their associated persons.”6 The Commissioners voting for the Neovest settlement have set transaction-based compensation as a dispositive litmus test for broker-dealer registration, but with very little legal analysis supporting this conclusion. Commissioner Peirce rightly questions, with compelling analysis, whether transaction-based compensation should have the outsized effect the Neovest order places on it. 

Legal Analysis

The facts of the Neovest case are highly relevant and, at times, cut both ways.  Neovest operates an order management and execution system through which its customers designate where an order should be routed.  Neovest itself does not make any routing decisions, but rather connects to many broker-dealers and communicates with them in connection with the routing and execution of its customers’ orders by those broker-dealers.  The broker-dealer analysis therefore turns on whether these communications constitute “effecting” a transaction.  Are they more like a communications system (similar to old-fashioned telephone lines or an Internet service provider) or does the basic act of communicating constitute “effecting” a transaction, the way a retail broker or a “high touch” sales trader might communicate to have an order executed?  While the dissent focuses on the fact that Neovest’s customers (and not Neovest) determine where an order should be routed, similar activity in other contexts clearly constitutes “broker” activity.  For example, Regulation NMS under the Exchange Act contemplates a “directed order,” defined as “an order from a customer that the customer specifically instructed the broker or dealer to route to a particular venue for execution.”7 No one could reasonably argue that a broker need not be registered as a broker-dealer to handle directed orders.  Perhaps this suggests that the Neovest order was rightly approved, but it more likely suggests that the current standard of what constitutes “effecting” a transaction has become unworkable. 

Neovest also marketed its services, which the settlement order viewed as “soliciting” customers. This view, however, suffers from circular reasoning: Neovest can only be soliciting brokerage customers if the service it provides (and therefore solicits) constitutes brokerage.  The practitioner is left right back at the beginning.  

Supporting the old adage that “bad facts make bad law,” Neovest ultimately may have been undone by its conduct in the marketplace, rather than by any objective legal analysis of whether its actions constituted “engaged in the business of effecting transactions in securities.”  Neovest had been acquired by a global banking organization in 2005.  After the acquisition, Neovest maintained its infrastructure and technology in an unregistered affiliate, but billed for its services from the “Neovest Division” of the broker-dealer subsidiary of the banking organization.  This “split decision” exposes inconsistent analysis.  On the one hand, Neovest must have taken the view that broker-dealer registration was not required, as it conducted its post-acquisition business in an unregistered entity.8 On the other hand, Neovest or its new parent must have questioned this approach, as it took affirmative steps to create a new “division” of its broker-dealer and bill for Neovest’s services from the broker-dealer entity.  This suggests that either Neovest or its banking parent identified transaction-based compensation as an issue and determined that a broker-dealer was required to conduct (or at least bill for) Neovest’s services.  But Neovest again acted inconsistent with that decision.  Rather than retain the compensation in the division of the regulated entity charging it, the Neovest division subsequently transferred the compensation to the unregistered Neovest entity.9

Ultimately, the SEC staff and the Commissioners voting to accept the settlement appear swayed by the existence of transaction-based compensation, paid by the brokers to which Neovest routed orders at its customers’ direction.  Unfortunately, the settlement order is extremely short on legal analysis, and the reader is left only to infer what the legal rationale for the violation must have been.  The most logical inference is that the SEC views any order handling or order routing, coupled with transaction-based compensation, to be “broker” activity, even if such handling consists solely of communicating, without additional judgment or discretion, at its clients’ direction.  The consequence of such inference  is the broadest possible reading of “effecting”, that one is “effecting” a transaction by taking any action to cause the transaction to occur.  Technology providers, which provide any number of services that bring about a securities transaction, are on notice that with this broad reading, the form of compensation charged could trigger the broker registration requirement.  The consequences for not registering are significant.  Beyond an SEC enforcement action and penalty, the Exchange Act provides a right of rescission to parties to a securities contract the performance of which involves the violation of any provision of the Exchange Act, including the broker-dealer registration provisions.10 Thus, unregistered brokers operate at significant peril.

Conclusion

The Neovest order sets transaction-based compensation as the litmus test for broker-dealer registration while Commissioner Peirce’s dissent critically and appropriately questions whether registration should turn so sharply on the form of compensation.  Perhaps a better analysis would have been to focus not on the form of the compensation, but the economics of the compensation.  If the amount charged, regardless of form, is consistent with what a broker charges for effecting a transaction, that suggests that the service actually provided is execution, requiring broker-dealer registration.  But if the amount charged, again regardless of form, is consistent with what a technology or ancillary service provider or service bureau would charge, it suggests that the fee is for that ancillary or technology service and not for “broker” conduct, such as effecting a securities transaction.  Unfortunately, the Neovest order did not adopt this approach. 

In her dissent, Commissioner Peirce noted that “the public would have benefitted from the Commission’s careful consideration” of what constitutes broker activity, either through a Report pursuant to Section 21(a)(1) under the Exchange Act or through other Commission action.11 Indeed, this is a missed opportunity, likely resulting in continued fact-driven no-action guidance from the SEC staff, rather than definitive legal guidance and analysis from the Commission.   

  1. See In the Matter of Neovest, Inc., Release No. 34-92285 (June 29, 2021).

  2. Statement Regarding Neovest, Inc., Commissioner Hester M. Peirce (June 29, 2021), at 3.

  3. See Exchange Act Section 3(a)(4)(A).

  4. See Release No. 34-90112 (Oct. 7, 2020).

  5. SEC v. Hansen, 1984 U.S. Dist. LEXIS 17835, at *26 (S.D.N.Y. Apr. 6, 1984). See also Division of Trading and Markets, U.S. Securities and Exchange Commission, SEC Guide to Broker-Dealer Registration (Apr. 2008).

  6. See Statement of Commissioner Allison Herren Lee, Oct. 7, 2020 at n.9 (collecting no-action letters requiring registration based upon “salesman’s stake” rationale).

  7. Regulation NMS, Rule 600(a)(27).

  8. Prior to the acquisition, Neovest was registered as a broker-dealer. This is another distracting fact, as it speaks only to prior practice but not whether transmitting messages for orders and executions without more requires broker-dealer registration.

  9. Under FINRA rules, broker-dealers are directly prohibited from sharing transaction-based compensation with non-broker-dealers. See FINRA Rule 2060. This violation was not charged in the Neovest order, and the broker-dealer subsidiary was not a party to that order, perhaps because the SEC can enforce violations of FINRA rules only through civil injunctive action and not via Commission order.

  10. See Exchange Act Section 29(b).

  11. Statement Regarding Neovest, Inc., supra note 2, at 4.

© 2021 Vedder PriceNational Law Review, Volume XI, Number 193
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About this Author

Shareholder

Wayne M. Aaron is a Shareholder at Vedder Price and a member of the firm’s Investment Services group and Corporate practice area in the New York office.

An experienced securities regulatory lawyer, Mr. Aaron represents financial services firms, management, and other personnel in regulatory and governmental investigations and internal investigations. His varied practice spans financial services advisory matters, broker-dealer regulation and enforcement, government and regulatory investigations, and FinTech.

Mr. Aaron...

212-407-7640
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