Broker-Dealer Regulation Under the Securities Exchange Act of 1934: The Case of Independent Contracting

Saturday, January 1st, 1994 at 12:00 am by Alexander C. Dill
Alexander C. Dill, Broker-Dealer Regulation Under the Securities Exchange Act of 1934: The Case of Independent Contracting, 1994 Colum. Bus. L. Rev. 189

This article propounds a theory of Exchange Act regulation. It is argued that the registered broker-dealer firm has become the key element in the regulatory framework of investor protection; within the self-regulatory system and under Commission oversight, it bears the principal burden of implementing Congressional and Commission policy. The article explicates this thesis through a case study of independent contracting, a business practice which contradicts the legal and economic underpinnings of the Exchange Act. In presenting this theory of regulation, the article uses a historical and economic analysis to explain the emergence of the broker-dealer firm as the primary instrument of investor protection.

Part II describes the conventional broker-dealer firm and independent contracting in the securities brokerage industry, and then summarizes the tax and labor law benefits that arise from independent contractor status. Part III summarizes the historical development of Exchange Act regulation and its underlying principles. Part IV summarizes and analyzes the Commission’s and the Division’s current positions on independent contracting, as reflected in interpretive and no-action letters, enforcement decisions, and the Hollinger decision. Part IV also discusses the significance of Hollinger for investor protection.

Part V presents an economic theory of Exchange Act regulation that supplements the foregoing legal and historical analysis. Ronald Coase’s work on ‘social‘ cost and his theory of the ‘firm‘ are useful in explaining the emerging regulatory role of the broker-dealer firm and the inconsistency of permitting independent contracting. The ‘Coase theorem‘ maintains that parties would allocate property rights efficiently in the absence of transaction costs and thus produce goods and services at their true ‘social‘ cost – i.e., without imposing externalities on the public. Coase also asserts that business firms are formed in order to reduce transaction costs through controlling the means of production. This theory may be combined with Coase’s theory of ‘social‘ cost and extended to the regulatory context, using the Exchange Act as an example.

I maintain that both Congress and the Commission, through an evolutionary process, have come to view the broker-dealer ‘firm‘ implicitly as the most efficient means of internalizing the relatively high (social) transaction costs of securities trades. In addition, courts increasingly have recognized enterprise liability as an efficient risk-shifting means of investor protection. In effect, the brokerage ‘firm‘ is no longer merely a profit-making enterprise for reducing private transaction costs. Evidence for this thesis lies in the historical development of Exchange Act regulation. However, because they are not regulated as broker- dealer ‘firms,‘ yet in essence act like them, independent contractors do not internalize social cost and consequently produce an inefficiency. To achieve economic (social wealth-maximizing) efficiency – i.e., to equate both the independent contractor’s and its firm’s private and social costs – independent contractors should either become ‘employees‘ under tax and labor law or register with the Commission as broker-dealers. Only such a policy change would remain true to the legal and policy requirements of section 15 of the Exchange Act, and the central regulatory role played by the broker-dealer firm.

I conclude that the Commission should squarely confront the detrimental impact of independent contracting on the Exchange Act scheme of investor protection and endeavor to prohibit it, despite the cost of interfering with an otherwise legitimate business arrangement. Only Commission rulemaking or legislative action would effectively achieve this objective.

Author Information

Branch Chief, Office of Trading Practices, Division of Market Regulation, Securities and Exchange Commission