PROPRIETARY TRADERS
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PROPRIETARY TRADING FIRMS – SPECIAL NOTE ON THREATENING REGULATORY DEVELOPMENTS . October 1, 2006 News Update. Click here.

Older writing before our significant update above (read that first).

We cover the industry looking for stories that can impact our clients

PROPRIETARY TRADING FIRMS – SPECIAL NOTE ON REGULATORY DEVELOPMENTS

This industry involves very active trading in equities and, sometimes, equity derivatives, using the firm’s capital.

There are three principal structures:
(1) all of the traders are employees of the firm and receive IRS Form W-2 (wages);
(2) all of the traders are independent contractors and receive IRS Form 1099 (usually, income for trading services) and
(3) all of the traders are members of the firm and receive a Schedule K-1 (share of partnership income).

In all cases the traders sign lengthy detailed agreements in which the trader agrees that he or she is not a “customer” of the trading firm (but, rather, an employee, independent contractor, or member, depending upon the structure used). In cases where the trader has to place funds in a type of surety account in effect, to ensure that when they trade the firm’s capital they will not act recklessly, because their account can be depleted. In some cases, the trader agrees to be liable for trading losses incurred by the firm arising from the trader’s activities, above the amount placed in the surety-type account.

We have been advised that the National Association of Securities Dealers (NASD) is investigating proprietary trading firms, on a case by case basis, regarding the proper characterization of traders as traders or “customers.” The NASD reviews were sparked by the actions of some former proprietary traders of Refco, Inc. These traders argued that they were customers of Refco, Inc., not traders, because when Refco, Inc. entered bankruptcy, they would have a better position in the bankruptcy court. In addition, as customers they could claim SIPC insurance for brokerage accounts. Given the extremely confused and slow-moving nature of the Refco proceedings, it could be a very long time, if ever, before the customer vs. trader issue at Refco is settled.

While we wait for the wheels of justice to grind on, proprietary trading firms and traders would be well-advised to review very carefully the structure of the firm, the rights and liabilities of members, and regulatory developments. It is a fact of life in this industry that proprietary trading is viewed with disfavor, even downright suspicion, in some quarters. Monitoring developments, therefore, is a must for all concerned.

News Flash: Proprietary traders' deposits in the LLC equity model of doing business are back in the news again. Click here to learn more.

Prop trading firm agreements and tax issues come in various forms and sizes. In our one-of-a-kind and in-depth prop trading section, we cover all the tax, legal and risk issues you should address – either before you join a firm (preferably) or if you are already in a firm. For example, is the SEC on the heels of prop trading firms now and are they seeking to change the way they do business – which might significantly change the deal you have now?

Prop trading offers up to five times (or more) the amount of leverage available to retail traders. That leverage is like a sword – it has an upside to greater and faster profits, but the downside is more risk, more costs and pitfalls. Before you leap to "take the money and run," become an educated consumer.

Currently, many of the prop trading firms use the "LLC model," inviting you to join the firm as an LLC member. Some firms also offer to hire you as either "independent contractors" or "employees." Other firms will allow you to trade with them as "customers," just like other retail traders. However, as a customer, you don't get additional leverage over the pattern day trader rules (which give traders 4-to-1 leverage). If the firm is a broker/dealer or a member of an exchange, you are required to have a brokerage license.

Before you leap into one of these deals, read through this section, read the fine print of the agreements and see how they stack up, and consider a consultation with one of our CPAs or attorneys about all the tax and legal issues. We won't talk you out of prop trading, but we will make sure you understand the risks vs. rewards and the legal and tax issues, and we will give you some ideas to improve both. We also can alert you to some firms that we think are trouble and steer you in the direction of the firms we think are safe.

A note of caution: WorldCo, one of the larger prop trading firms, recently went out of business. Many of their prop traders got burned (they did not get their capital back). Click here for an article about WorldCo's demise in Active Trader magazine, with many quotes from Robert Green. There are recent rumors that the SEC is looking closer at the prop trading firms and that they are forcing some changes. Now is a good time to ask questions from you firm, get better educated on the legal and tax issues, and reevaluate your situation. What better way to do this than by working with our site and professionals!

See Robert A. Green's June 2004 article in Active Trader magazine: Many traders work for proprietary trading firms, and many others are considering it. However, too many traders fail to understand the contracts they sign with a firm and wind up getting burned later. Know what to expect – and what you deserve – before you sign anything. Click here.

Is your proprietary trading firm agreement sanctioned by the SEC? A February 2000 Special Study by the SEC seems to sanction the "LLC model" for proprietary trading firms. Click here to learn more.

"Proprietary trading" vs."retail trading" – what's the difference? In both cases you are trading for your own ultimate benefit and putting your own money at risk. The principal difference is leverage – with retail trading, you are limited to 4-to-1 margin, but with prop trading you are entitled to much greater leverage (10- or 20-to-1). Leverage brings added costs and risks. Click here to learn more.

Why do you need a stock broker license for some prop trading firms but not for some others? Proprietary trading firms registered as broker dealers and members of exchanges require licenses. Prop trading firms that are not broker/dealers and not members of an exchange are customer accounts themselves and do not require licenses. Most also require smaller deposits. These firms use the LLC model, but have independent contractors and employees as well. Click here to learn more.

Are prop trading firm deals under scrutiny from the SEC? One leading firm claims they are. Is it a rumor or does it have merit? Click here to learn more about this brewing story.

Tax information for prop traders. We cover tax information and the best filing strategies for employees, independent contractors and LLC members. We cover state taxation issues, such as "Do you owe out-of-state taxes if you trade remotely from out of state?" (The answer is usually no.) We cover foreign taxation issues such as "Ddo you owe US taxes if you join a prop trading firm from aboard?" (Yes, you do.) Can you use an entity in a prop trading firm for added tax benefits, including retirement plans and health insurance premium deductions? (No.) Don't file your prop trader tax return until you read this section. No matter what your status, we can show you ways to save thousands more in tax dollars. Click here to learn more.

Agreement information for prop traders. We cover employees, independent contractors and LLC members. Don't sign any agreement until you read the fine print and this section. Click here to learn more. A consultation with our firm for as little as $65 can save you from falling into legal pitfalls and losing your capital.

Resource information for prop traders. Don't join a prop trading firm until you read the SEC's special study on the industry and our other resource information. Click here to learn more.

Do independent contractor prop traders need to be concerned with state rules for registered investment advisors? The answer may be yes, but this is widely overlooked. Click here to learn more.

Prop trading can be an excellent way to trade more capital than you have on hand, but with that added leverage there are added risks and pitfalls. Learn how to take advantages of the plusses and avoid and limit the risks and pitfalls.

If you have a question or just want to see how we can help you, please call us or e-mail us at info@greencompany.com.

If you need help evaluating a proprietary trading firm agreement and figuring out your tax matters with this firm, purchase one of the following offers: All consultations are done by phone and/or e-mail. Consultations may be split over several sessions.

We also recommend that prop traders sign up for our tax preparation services. We don't have to spend time on trade accounting since the firm handles that, so our fees are less than for retail traders. Visit our trader tax preparation page and figure your fees are the bottom of our range – approximately $600 per return (federal and state). Plus, we will find lots of ways for you to deduct non-reimbursed business expenses including home-office expenses, and that will save you thousands more. Click here to visit our trader tax preparation section and sign up for 2003 tax preparation.

News Flash

New rules that affect proprietary trading firms:

NASDR 04-33 Limited Net Capital Relief from the Reclassification of Certain Equity as Liabilities in Accordance with Statement of Financial Accounting Standards No. 150 (Notice posted on April 19, 2004). Action Required by May 10, 2004 View PDF. View Exhibit A—No-Action Letter
www.fasb.org/st/summary/stsum150.shtml: FASB Statement 150.
PHLX Memo. No. 1246.04
www.nasdr.com/2610_2004.asp#04-43

The key points in these new rules are that if a prop trading firm has "mandatory redeemable equity," that "capital" should be reclassified as a "liability." Capital should be on hand for at least 12 months.

Our Robert Green called and spoke with the author of PHLX Memo No. 1246.04. The author told Green that as of June 21, 2004 (the day we spoke), PHLX had not yet identified any of the 18 prop trading firms on PHLX that are adversely impacted by FASB 150.

If you are a proprietary trader in a prop trading firm and gave the firm a deposit when you joined the firm, it would be a good idea to review your agreements with the firm. LLC members should review their LLC Operating Agreements and look for language that could be construed as mandatory redeemable equity. Ask your firm's management about these new rules and if they will affect the firm in general or your trading leverage. Most firms probably won't have a problem. Those that do may be able to cure it by modifying the agreements. Other firms may need to invest more capital to replace capital that is reclassified to liabilities.

As a member of a prop trading firm, you are affected by what happens to your firm, so find out.

If you need help, sign up for a 60-minute consultation with one of our attorneys. They will review your prop trading firm agreement and/or other documents, speak with your firm if necessary and consult you on the best way to proceed. Sign up here.

Is your proprietary trading firm agreement sanctioned by the SEC? A February 2000 Special Study by the SEC seems to sanction the "LLC model" for proprietary trading firms.

Here is an excerpt from: "Special Study: Report of Examinations of Day-Trading Broker-Dealers" by the SEC, dated February, 2000. See further details and our observations about that report on our Resource page.

Excerpt: "Day-trading firms are typically organized in one of two ways: as traditional corporate entities or limited liability companies or partnerships ("LLC"). These organizational differences separate day-trading firms into two specific operating models with fundamentally different characteristics.

Most day-trading firms are organized as traditional customer-based corporate entities and are members of the NASD. Customer-based firms are required to comply with federal securities laws and regulations that are designed to further customer protection. Firms that conduct a retail customer business must comply with NASD membership requirements; customer reserve requirements; the Federal Reserve Board's initial margin and SRO maintenance margin requirements; and SRO suitability rules. The Staff estimates that there are more than 100 day-trading firms organized as retail brokerage firms. (GTT Note: we cover tax and other matters for "retail customer traders" in our traders section.)

The second model is the LLC partnership structure in which a firm operates a proprietary business. These firms represent that they do not have customers, but "members" who become part owners of the firm. Day traders at these firms, as part owners, contribute capital to the firm and in turn, trade the firm's capital. Most of these firms are members of the PHLX (Philadelphia Stock Exchange). There are approximately 13 day-trading firms that are members of the PHLX. To become a member of a day-trading firm structured as an LLC, individuals are required to sign operating agreements that designate the member's ownership rights including: profit sharing arrangements, restrictions on withdrawals, provisions limiting losses, and other provisions common to partnership agreements. Because these firms are exempt from registering with the NASD, they are not subject to the NASD Conduct Rules.

Prior to a change in its rules, the PHLX allowed members of proprietary firms to trade proprietary accounts without being licensed representatives. Thus, proprietary day-trading firms were able to advertise day trading to the general public and accept members that were not licensed. The PHLX recently amended PHLX Rule 604 to require individuals trading off the floor of the exchange to pass the Series 7 licensing examination." (Many of these prop trading firms also require a series 55 and 63 license).

Notice the SEC writes about the LLC model and seems to sanction it. Most prop trading firms continue to use this model as of 2004.

A few of these firms use the LLC model exclusively, while others also hire employees and independent contractor prop traders.

We cover all of these types of prop trading firm arrangements in this section. Before you sign any agreements to join any prop trading firm, we strongly suggest you read all the information in this prop trading section and consider a consultation with one of our CPAs or attorneys. Look before you leap and read the fine print!

"Proprietary trading" vs. "retail trading" – what's the difference? In both cases, you are trading for your own ultimate benefit and putting your own money at risk. The principal difference is leverage; with retail trading you are limited to 4-to-1 margin, but with prop trading you are entitled to much higher leverage (10- to 20-to-1 or more). Leverage brings added costs and risks.

In retail trading, you are fully on your own as your own "sole proprietor," or in a business-entity trading business. Your retail brokerage firm provides you with a platform and gives you direct-access and low-cost brokerage services. As a retail "customer account," you are subject to the pattern day trader rules, which limit your leverage to 4-to-1. Failing that qualification, you are limited to 2-to-1 margin, just like standard investors.

That limitation of margin is perceived as a problem for some traders, who seek greater leverage opportunities. Prop trading firms arrange for you to trade the firm's capital, not your own, so they are not bound by the SEC customer rules. Therefore, prop trading firms can offer you opportunities to trade with much greater margin.

Greater leverage allows for larger positions to generate larger profits, but the ugly flip side is that it generates larger costs and risks. Excess and reckless use of leverage is one of the primary reasons why traders fail. Most prop trading firms use leverage as a carrot. Because a prop trading firm is partially responsible for any losses over your deposit amount, they control risk carefully by not allowing overnight positions. This means you are required to "day trade," which increases commissions dramatically, and the prop trading firm profits from commissions.

Why do you need a stock broker license for some prop trading firms but not for some others? Proprietary trading firms registered as broker/dealers and members of exchanges require licenses, including series 7 (and sometimes 55 and 63). Most also require significant deposits, whether you join the firm as an LLC member, independent contractor or employee.

If you don't have a brokerage license or less capital to place on deposit, and you still seek margin greater than 4-to-1, you may be interested in joining a smaller boutique prop trading firm that is not a broker/dealer and not a member of an exchange. These smaller firms are treated as "customer accounts" of other prop trading firms or direct-access brokers. While these firms are limited to 4-to-1 margin on a firm-wide level (under the pattern day trader rules), these firms are able to grant you additional margin as a trader within the firm; depending on how much firm capital is used or provided by other traders within the firm.

Are prop trading firm deals under scrutiny from the SEC? One leading firm claims they are. Is it a rumor or does it have merit?

Join in the discussion on our message board. Click here.

Many traders seek greater leverage than 4-to-1, and they are attracted to prop trading firm offers to trade the firm's capital with 20-to-1 leverage or more (because prop trading firms are not bound by the SEC "customer rules"). However, some prop trading firms may be going out of their way to craft deals that they think satisfy the SEC but possibly may not in the future.

Congress, the Federal Reserve, the SEC and the NASD are collectively charged with writing the margin laws and policing the improper use of leverage in the markets. Traders hunt for excess leverage opportunities and clever ways around the rules, which sometimes leads to abuse.

For examples, some hedge funds are currently registering as broker/dealers to get around the pattern day trader rules. The SEC has indicated it is reviewing this practice and may rule against it soon.

One leading prop trading firm told us they petitioned the SEC to act against competing prop trading firms "for violating Reg T margin rules."

This firm claims other prop trading firms have prop trading arrangements that "look, smell and act" like "customer accounts." Therefore these prop traders should be treated as "customers" and only allowed 4-to-1 leverage.

This firm highlights the following factors as contributing to their argument: Some deals have 100- or 99-percent payouts (profit sharing on the sub-trading accounts by the prop traders); the traders put up deposits just like customers do; and the traders are responsible for all losses just like customers (in fact some "indemnify" the firm for all losses).

This firm told us the SEC declined their requests to issue any new SEC rulings or guidance on this matter. The firm claims the SEC told them the SEC would address these alleged infractions of Reg T in their ongoing audit process of prop trading firm broker/dealers. We plan to contact the SEC to confirm this story and we will report our findings soon (if it's a true story or a smear campaign by this other firm – it could be either and it's too early to tell).

This firm also told us that one other leading firm was recently audited by the SEC and the SEC told them to stop using the above described type of deals (with 100- or 99-percent payouts, deposits and loss indemnification). We spoke with another CEO of a leading prop trading firm we do business with and he confirmed this story and that it was true – that he heard it himself from the CEO of the prop trading firm being audited. We called many of our prop trading clients at that firm and none of them told us they heard any news about this.

This is a brewing story and we have not yet confirmed the facts. Is it a smear campaign by a firm that may be on the block to be sold (and may be trying to goose its valuation) or is it true and might some of the prop trading deals be under scrutiny to change?

If that change comes, can prop trading firms satisfy the SEC by simply reducing their payout percentages, taking lower or no deposits, or have loss recoup provisions short of indemnification? At this stage, we highly doubt that the SEC will put prop trading firms out of business overnight. Instead, the more likely outcome will be some tweaking of how business is done now.

We are working on a full story here and will break the story on our message boards soon. If you have any facts or stories to help us, please contact Robert A. Green, CPA & CEO at rgreen@greencompany.com or call (212) 579-2945.

Do independent contractor prop traders need to be concerned with state rules for registered investment advisors? The answer may be yes, but this is widely overlooked.

A prop trader is engaged by a prop trading firm as an independent contractor and paid "non-employee" compensation for their money-management advice. How is this any different from what a money manager does, and shouldn't the registered investment advisor rules apply?

The SEC and states have rules for "registered investment advisors" (RIAs). We cover them in depth in our hedge fund section.

California rules for investment advisors require registration if you have even just one money-management client that pays for your advice.

This begs an important question: There are many prop trading firms organized or with branch offices in California. These California-based prop trading firms engage individuals who are residents of the state to be independent contractor traders for their firm. Should that independent contractor prop traders register with the state as an RIA?

What about all California prop trader independent contractors trading with any prop trading firm around the country? It may not matter if the prop trading firm is organized in California or has a branch office or presence in the state. For California RIA purposes, it really only matters where the investment advisor lives and works. There are thousands of prop traders who live in California, so is this a new problem?

These are good questions and we don't see anyone addressing them on the Internet or within these firms.

Here is a preliminary answer from one of our attorneys: Your question can only arise under California law if the prop trader firm is neither a broker/dealer nor an investment adviser. I am unable to find a definitive answer to your question in cases where the prop trader firm is neither of those two classes. The conservative course would be to register with California as an investment adviser.

The California Corporations Code at Sec. 25202 requires registration of an investment adviser in California if it has at least one "client" that is a California resident within the preceding 12-month period, barring an exception (e.g., a federal registered investment adviser (RIA), with fewer than six California clients, which would require at least $25 million in assets under management). "Client" is defined under California rules by reference to the federal RIA rules, which in SEC Regs. Sec. 275.203(b)(3)-1 provide that "A limited partnership is a client of any general partner or other person acting as investment adviser to the partnership." An investment adviser in defined in the federal statute, Sec. 80b-2, as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities." A person with discretionary authority would be an investment adviser through advising others in the purchase and sale of securities by entering such trades directly. The reference in the statute to "general partner" could be interpreted to mean that the investment adviser must be a principal, and not the employee or consultant to a principal, but such a reading would hardly dispose of the question.

Even if the trading activity itself does not give rise to being an investment adviser, I can envision some cases where the prop trader is an investment adviser, because he or she is not merely a trader for his or her own account, but giving advice to the prop trading firm, for compensation. In that case, the California rules would require registration, unless the firm is a federal RIA with less than six California clients. Under California law, a client that is a broker/dealer or itself an investment adviser is not counted as a client.

The views expressed are intended to be conservative, which is reasonable in view of the state of California law, which is both expansive in its approach and ambiguous when it comes to many details. The definition of "investment adviser" is certainly broad enough to take in a more high-end prop trader who not only trades his or her own sub-account, but also gives advice on trading, and in the W-2 or 1099 model is clearly receiving "compensation." The prop trader would have to argue that he or she is being "compensated" only for their own trading, and not for giving advice. If the prop trader circulates e-mails about hot stocks, etc., that would constitute giving "investment advice."

While it is always very helpful to have appropriate language in the agreements, the California regulators, or the SEC, NASD – whichever regulator is involved – would not be bound by that language. In any event, the summary of the California law that I provided gives a safe harbor – where the prop trading firm is a broker/dealer or is itself an investment adviser. Once you leave the safe harbor, you are on your own.