Recent Changes to Branch and Small Office Requirements:Getting Out in the Neighborhood

The structure of the regulation of the securities industry continues to change to accommodate changes in customer demand and technological capabilities of the industry. As discussed in detail below, the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE) and the North American Securities Administrators Association (NASAA) have proposed, and the Securities and Exchange Commission (SEC) has approved, a new and uniform definition of “branch office” (the “Uniform Definition”) and the transition to a centralized, CRD-based branch office application system, using a new Form BR. The new Form BR will allow member organizations to submit a single filing to simultaneously fulfill the branch office registration/approval requirements of the NASD, the NYSE and most states. And, in a more recent development, the SEC has approved the NYSE’s proposed Interpretation of its Rule 342 (concerning supervision and control of offices) to permit waiver of the otherwise normally required level of supervisory qualifications of resident branch office managers for “limited purposes offices” which have more than three registered representatives (RRs).

Changes in Customer Demand Conflicting with Regulation

Branch Offices. The securities brokerage industry has realized there are would-be investors who do not want to come to big offices, but who do want face to face meetings with brokers rather than trade online. So for some time the industry has “gone out into the neighborhoods”, opening smaller offices (often offices with one and two representatives). This movement was somewhat hampered by the intense regulation of the industry and particularly the definition of “branch office.” Indeed, the SEC, NASD, MSRB and NYSE and many state regulators had defined “branch office” differently.

Prior to the Uniform Definition becoming effective, there was no uniform definition among regulators of “branch office” (each of which must meet significant supervisory requirements.) For example, the NASD defined a branch office as “any location identified by any means to the public or customers as a location at which the member conducts an investment banking or securities business” (with four narrow exceptions.) NYSE Rule 342.10 defined a branch office as “any location where [as few as] one or more associated persons of a member…regularly conduct” transactions in securities (apparently with no exceptions. Both of these definitions could, for example, require that branch office onsite supervisory capability be present for a registered representative (RR) to conduct business temporarily from his home by telephone, or another location used primarily for non-securities business, but from which three or four securities transactions might be effected in a year.

“Limited Purpose” Offices. And, until recently, NYSE Rule 342 required that any “office” with three or more RRs must have – onsite – a resident branch office manager who is “qualified”, i.e. has passed one of the Series 9 or 10 (general sales supervisor), options/general or Series 24 (general securities principal) examinations – a significant expense for any small broker-dealer.

And changes demanded by customers in the structure of financial services, of which securities brokerage is only a part, have pressured securities brokerage firms to change their structures in ways that now “bump up against” legal regulations, including this on-site supervisory requirement. In particular, many customers want to deal with one office near their homes for all of their securities, insurance and commercial banking (and possibly other financial) services. In meeting this demand, many small broker-dealers seek to increase the number of their small multi-functional offices offering such combined services. In creating these offices, such firms frequently limit the securities activities of such offices, and the training of the RRs therein, to, for example, mutual funds and variable contracts products. And, frequently, in order to provide all of securities, banking and insurance services, such an office requires more than three RRs. However, notwithstanding the limited nature of the securities services provided, there was until recently no exception or exemption of such four-RR-plus offices from the requirement of on-site “qualified” branch office manager supervision and control.

The concerns and reasons for the regulation of “branch offices” and “limited purpose” offices are simply assurance of adequate supervision. But technological advances in the recent (and not so recent) past have produced increasingly sophisticated supervisory abilities enabling members to more effectively supervise the activities of their associated persons in off-site locations remote from the supervisor. And although as usual the law has trailed technology, in these two areas the regulatory community is catching up to technology. But the blessings are mixed.

Regulation is Catching Up – with Some Pain

Branch Offices. On September 9, 2005 the SEC approved amendments to NASD Rule 3010 and NYSE Rule 342 which would provide a uniform industry definition (the “Uniform Definition”) of the term “branch office”. The amendments were the result of a proposal made jointly to the SEC by the NASD, NYSE and NASAA in December, 2003. They became effective with the NYSE on October 6, 2005, and will be effective within the NASD on March 1, 2006.

The new Uniform Definition of a “branch office” is “any location where one or more associated persons of a member regularly conducts the business of effecting any transactions in, or inducing or attempting to induce the purchase or sale of any security, or any location held out as such.” Perhaps more important than this basic definition, however, are the seven exceptions to the Uniform Definition. Excluded from the definition (and the requirements) of “branch office” are: (1) a back office; (2) an RR’s primary residence, provided certain other conditions are satisfied; (3) a non-residence location used for less than thirty (30) days per year for securities business; (4) a location of convenience used occasionally and only by appointment; (5) a location used primarily for non-securities business [e.g. sale of insurance or bank products] from which less than twenty-five (25) securities transactions are effected in any calendar year; (6) the floor of an exchange; and (7) a temporary location used as part of a business continuity plan.

As noted above, prior to the adoption of the Uniform Definition the SEC, NYSE, NASD and state securities regulators all defined the term “branch office” differently thereby a requiring members to comply with differing requirements in each jurisdiction in which they conduct securities business. This required tracking numerous definitions, filing multiple forms to register, meeting differing deadlines and continuingly monitoring each jurisdiction for changes in its rules or procedures.

For example, in addition to the above NYSE definition, the state of Illinois defines “branch office” as “any office, residence or other place or location in this state where the business of a registered dealer is being conducted… and where the business of a dealer is conducted by a principal, salesperson or sales persons for such registered dealer.” (No exception is made for residence of a RR used occasionally to make business telephone calls and other similar logical exceptions are made in Illinois, and in many other state definitions.) (Illinois reportedly will not renew its branch office notice requirement; the Missouri Securities Commission has no registration or notice requirement.)

Similarly, the term “branch office” was previously defined by the NYSE as “any location other than the main office from which the business of a member . . . is conducted.” Accordingly, locations such as a RR’s primary residence, purely administrative offices, and locations utilized only temporarily or intermittently (“offices of convenience”) were required to be registered as branch offices if any securities sales activities were undertaken there.

And, a “branch office” under NASD rules must pay an annual registration fee and have a branch manager on-site. And, under prior definitions, even small, temporary or residential locations were required to meet branch office requirements even if used primarily for non-securities activities (such as for insurance and commercial banking purposes) with few securities sales annually.

In addition to introducing uniformity into the “branch office” definition, the new definition – primarily through its exceptions – gives small broker-dealers added flexibility. That is, the Uniform Definition exempts from branch office registration and on-site supervisory presence non-residence locations used less than thirty (30) business days per calendar year and “offices of convenience”. Importantly, the Uniform Definition also exempts from branch office registration and other requirements any location used primarily in non-securities activities (e.g. insurance) provided the RR effects no more than twenty-five (25) securities transaction per calendar year.

Of course the locations which under the Uniform Definition may be excluded from the definition of a branch office are subject to significant restrictions, including that such locations may not be held out to the public as branch offices, neither customer funds nor securities may be handled there, the RR’s communications to the public to and from such locations must be subject to the firm’s supervision by being placed through the firm’s systems, all orders must be entered through the actual designated branch office or main office and written supervisory procedures for such locations must be maintained by the member. NASD Interpretation IM-3010-1, promulgated with the new rule, emphasizes the existing requirement that members supervise all locations, including non-traditional offices not excluded from the definitions of “branch office”. The interpretation, to this writer, implies that regulatory oversight of such remote locations will be especially careful.

Registration on new Form BR. Concurrently with the development of the Uniform Definition, the NYSE, NASD and NASAA developed and proposed to the SEC the adoption of Form BR. Form BR would enable members to submit branch office application information to the NYSE, NASD, other SROs and states by electronically filing a single Form BR through the central registration depository (CRD). (Members currently furnish “branch location” information on Schedule E of Form BD, the Uniform Application for Broker Dealer Registration, and on various different state branch office registration forms.) Form BR may simplify filing requirements, but it is not necessarily simple. It is thirteen pages long (as compared with Schedule E, one page in length) and is accompanied by ten pages of instruction.

The Form BR eliminates duplicative forms and questions and reconciles inconsistencies among existing branch office filings with various SROs and states. To some extent, it also uses the same terms presently used in existing uniform forms. The Form BR was developed on the premise that firms would file it through the Web CRD, which will also benefit regulators. The system cross-checks between the Form BR and present and proposed Forms U4 and U5 will provide regulators greater assurances of the accuracy of information they receive concerning the locations from which RRs conduct business. Also regulators will be able to generate reports through CRD-based information reported on the Form BR in conjunction with other information reported in the CRD system.

Now that the Form BR has been implemented, firms will be required to file it for each branch office in place of the existing NYSE branch office application, i.e., Schedule E of Form BD, and forms required by participating states. Firms will also be required to link registered individuals with the branch offices responsible for their supervision.

The Uniform Definition is Particularly Tough on “Limited Purpose” Brokers

The combination of the Uniform Definition and the new Form BR has its detractors. A majority of the commenters to the NASD concerning the new definition expressed concerns about a perceived negative effect upon limited purpose broker-dealers, most frequently affiliated with life insurance and investment companies and banks. Such broker-dealers perform a much narrower range of services, frequently handling only variable contracts and mutual funds, and are licensed only therefore. They have generally structured their operations based upon the current definitions and will be presented with significant administrative and other costs complying with the Uniform Definition. Other commenters objected to the requirements concerning meeting with customers at a RR’s primary residence, and suggested that the new Uniform Definition simply state that RRs shall not “regularly meet with customers at their residence.” The NASD rather lightly dismissed this objection, stating that “there are certain fundamental costs associated with regulating any branch office, regardless of size or activity.”

The NYSE has Adopted a New Interpretation Concerning “Limited Purpose” Broker-Dealers

But, recognizing that technology teamed with properly structured regulations of its members may significantly enhance the flexibility of the industry, the NYSE has proposed a new “Interpretation” of its Rule 342 which may significantly assist such limited-purpose brokers, and the SEC has approved it.

As noted above, except for “small offices”, all NYSE member branch offices were required to have an onsite qualified manager, and under its Rule 342.15 “small offices” were restricted to three RRs or less. The SEC on November 29, 2005 approved the NYSE’s proposal to permit member organizations to seek a waiver of the qualified supervisory branch office manager requirement for “Limited Purpose Offices” which have more than three RRs. The Limited Purpose Office is a new category of offices with RRs that conduct only limited business activities, or that have limited registration qualifications (e.g. Series 6 – mutual funds and variable contract products representatives or Series 52 — municipal securities representatives) or may not offer a full range of products. The proposed interpretation sets forth a process by which members may seek a waiver of the NYSE’s onsite branch office manager requirement on a case-by-case basis following prescribed criteria as set forth in the Interpretation.

The Exchange noted that it believes that more flexibility and discretion is needed to determine whether an onsite qualified branch office manager is required for limited purpose offices with more than three RRs. The interpretation would achieve that and would give added flexibility to members that acquire new offices through mergers, acquisition or regulatory changes, or who wish to structure their offerings with fewer than the full range of securities products (thus not requiring fully qualified supervision) sold in offices of more than three RRs. Under the Interpretation, members seeking a waiver would be required to provide a written plan of supervision and control acceptable to the NYSE, and of course all such Limited Purposes Offices would still be required to be under the close supervision of a main office or other designated branch office. The NYSE noted when it proposed the Interpretation that it in fact allocated supervisory requirements based on the risks actually involved by the specific activities which would actually take place, rather than based upon the simple fact of there being more than three RRs at a location. (In its proposal the NYSE analogized this to the functional approach of the Gramm-Leach-Bliley Act, which used a similar actual risk-based approach, discontinuing the total exemption of any “bank” from the definition of and restrictions upon broker-dealers, and required such banks to be registered as broker-dealers when they were actually performing the functions of broker-dealers. See St. Louis Broker-Dealer, July, 2003.)

Conclusion. The combination of the new Uniform Definition of “branch office”, the CRD-based Form BR and the NYSE Interpretation allowing waiver of the requirement of full supervisory capacity for Limited Purpose Offices of more than three RRs will significantly assist broker-dealers in placing their offices – and their RRs – out in the neighborhood, close to their clients. However, at least in the short run, these amendments, particularly the first two, may cause significant added expense and administrative requirements on small broker-dealers who have tailored their operations to the prior definitions of “branch office.”

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