IAR Securities
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CNLG CONOLOG CORP 1 POS AM: Post-effective amendment to an S-Type filing Mar 7, 2000
11:38 AM
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oag.state.ny.us
FRANCHISE OFFICES OF BROKER-DEALERS
The NASD, unlike the State of New York, requires that each branch office of a broker-dealer be registered, and that a registered representative be named as the branch manager. If a branch manager possessing additional NASDR qualifications as a supervisor is present in the office at all times, the office is designated an "Office of Supervisory Jurisdiction" ("OSJ").(37)
Recently, in the micro-cap fraud market, it appears that OSJs are increasingly becoming "franchise offices." In a typical situation, the broker-dealer is the franchisor, and the branch manager, or their closely held corporation, is the franchisee. In one case that came to light, the franchisee is a salesperson and not the branch manager. If the closely held corporation is partly owned by an unregistered person, then commissions are being paid to someone who is not officially known to or regulated by any securities regulator.
Typically, the franchisee rents office space, rents or buys the office furniture and equipment, and pays the utilities. The franchisor (broker-dealer) registers everyone in the branch office as its agents, but the office, in fact, operates completely independent of the main office. The franchise agreement typically provides that 15% or 20% of the commissions earned by the branch office will be retained by the broker-dealer, 50% will be paid to the salesperson, and the remaining 30% or 35% of gross commissions will be paid to the franchisee. After paying the rent, utilities, overrides to supervisors and recruiters, and any other overhead expenses, the franchisee keeps the balance as profits.
The real problem with this type of set up is that franchise offices can change their affiliation from one broker-dealer to another with no more effort than it takes to get the individual sales agents reregistered with the new firm. The lease of the office and the telephone accounts are all in the name of the branch manager or the franchisee corporation, and customers can continue to reach the same agents at the same address and phone number. The Melville office of Investors Associates, Inc. ("IAI"), for example, left en masse in April 1997 and became a branch office of H.J. Meyers ("HJM") within a matter of days. The office left HJM in early June 1997 and became affiliated with Ash & Company, Inc. later that month, all without changing its address or phone numbers, or losing its customers. The Melville office is now becoming affiliated with IAR Securities Corp. On occasion, the branch creates the perception of continuity by using the franchisee corporation's name on letterheads, envelopes, or Federal Express airbills, and suggesting that the unregistered franchisee corporation is the "introducing broker," and that the trades are "cleared" by the licensed broker-dealer.
If an unscrupulous person were to start a new broker-dealer and apply for an NASD broker-dealer license, or purchase an existing firm, the NASD would conduct an inquiry into the background of the owner and the source of the capital used to start or buy the firm. There is, however, no such inquiry in the case of a franchise office moving from one firm to another. In numerous situations therefore, regulators have no information about who is truly running the operation. Furthermore, the net capital requirements imposed on a broker-dealer do not apply to its branches, even if a franchise branch is the only branch of the firm that is making a market in a particular security.
The problems associated with franchise offices, as opposed to branch offices set up and maintained by the brokerage firm itself, are evident in the testimony given at the public hearings. Alan Mandel, former Compliance Director of Greenway Capital Corp. ("Greenway")(38), gave the following description of his trip to Atlanta to audit a branch office in response to an April 1997 subpoena issued by the Attorney General of the State of New York, which demanded, in part, production of any scripts in use in any office:
On my trip ... to the Atlanta office, the branch manager there chose to leave the firm rather than be subjected to my audit .... It was a shared office environment. There were many offices within the plant and a common secretary, and I was prevented from going into the office under threat of trespass.
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I was told that ... the branch manager was paying the rent for the space. It was a franchise not a branch office.(39)
Although the branch office contained records of Greenway, Greenway's own Compliance Director was denied access to the records on the grounds that the branch manager no longer worked for Greenway (he had resigned upon learning of the planned audit), and that he held the lease on the office.
Daren O'Connor, an investigator for the New Jersey Bureau of Securities, who has conducted numerous unannounced audits, testified:
[O]ne of the biggest issues we see today is the franchise branch offices. These offices are almost always, in essence, a separate broker dealer.
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In essence, they are renting the license of the home office and they avoid net capital, they avoid a lot of the registration issues, ... and disclosure they would have to make.
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They're often set up with corporate entities that enter into the franchise agreement.
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It is definitely a back door that's open for people that are unsavory in the securities business. It is not disclosed in any of the books and records who the officers are in these corporations, who is getting payments from these corporations and partnerships, whatever you want to call them.(40)
[New Jersey takes the view that] these franchise branches are separate broker dealers. Even though they are using the name of the home office, we charge that whatever entity, partnership is running that office is in essence a broker dealer ....
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[I]n almost every instance each branch office has its own trading accounts as opposed to a main trading account for broker dealers in the normal situation. Certain firms will let the branch office itself go out and make markets in the securities.(41)
In an attempt to deal with the issues raised by franchise offices, the State of Connecticut is bringing an administrative action against a firm that has a franchise branch office, alleging that (1) the firm failed to supervise the individuals within that branch because the firm did not conduct any audits of the branch, and (2) the branch operated as a separate broker-dealer without meeting the state's licensing standards.
Among the other problems discovered at franchise offices is the ability of the branch to bring in consultants that are statutorily disqualified. As part of a Connecticut audit, examiners looked at the cash disbursements journal and saw money being disbursed to a marketing firm. Upon further investigation it was discovered that the marketing firm was owned by the father of the principal that they were examining.(42)
Ralph Lambiase, Director of the Connecticut Division of Securities, questioned the entire franchising system, stating, "[n]ow, why do you franchise? Because if you franchise, you don't need the capital to set up as a broker-dealer, and if you're not a broker-dealer, then you don't get any scrutiny from the state for licensing purposes."(43)
As a result of the New York Attorney General's investigation of micro-cap firms, and testimony presented at the Public Hearings, the Attorney General has determined that certain agreements between a broker-dealer and a person or entity operating a branch office are "franchises" within the meaning of General Business Law Article 33, § 681 (3).(44)
The broker-dealer granting the franchise (i.e., the "franchisor") must therefore file an application on Form NYF-1 and register an "offering prospectus"(45) with the Attorney General's Department of Law, and comply with the other disclosure and record-keeping requirements of GBL § 683 and the corresponding regulations of 13 NYCRR Part 200.
The Attorney General has also determined that any firm, association, corporation or other entity that operates a branch office as a franchisee, or receives or has an interest in the commissions or other proceeds of the operations of any securities broker, dealer, principal or salesperson, is a non-NASD "broker" within the meaning of GBL Article 23-A, § 359-e (b), and must file N.Y. Form M-1 and otherwise comply with the registration requirements of GBL § 359-e.
The Attorney General's interpretation of GBL Articles 33 and 23-A as requiring registration of branch office franchisors and franchisees will provide access to books, records and other information about the financing and the otherwise invisible persons behind these branch offices that seem to have an existence totally independent of the NASD broker-dealer with which they are affiliated at the moment. That information will be available upon request to the investing public, and should prove extremely useful for developing civil or criminal prosecutions if it appears that unregistered or barred persons are controlling the branch offices.
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