The Benefits of the Small Business Audit Correction Act

As the table below shows, the number of broker-dealers in the U.S. declined by 29 percent between 2003 and 2017. Over the same period, the size of the economy (as measured by real, inflation-adjusted gross domestic product) grew by 29 percent.

This matters because it leads to greater concentration and less competition in the financial services industry. But it also matters because the small-broker dealers leaving the industry help entrepreneurs raise capital. These entrepreneurs are the source of a large share of the innovation, dynamism, and job creation in the economy. Large broker-dealers are, in contrast, typically uninterested in doing the small deals involved in getting a start-up off the ground.

Financial Industry Regulatory Authority Regulated Firms and Registered Representatives (2003-2016)

Source: FINRA

Registered representatives – the individuals who work for broker-dealer firms – are down only 3.6 percent over the period. So most of these people have gone to work for surviving broker-dealers, typically larger firms.

The primary reason that small firms are in decline is that the ever-increasing regulatory burden affect them disproportionately. The cost of complying with these regulations do not increase linearly with size. Regulations from the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) are the leading culprits. Many of those rules are Congressionally-mandated because of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank section 982 required that broker-dealers registered with the SEC be audited by public accounting firms registered with the Public Company Accounting Oversight Board (PCAOB). PCAOB audits are substantially more expensive that ordinary audits by certified public accountants because they require adherence to a set of standards and protocols designed for public companies the shares of which are normally traded on a stock exchange or OTC Markets.

Sen. Tom Cotton, R-Ark., and Rep. French Hill, R-Ark., have introduced the Small Business Audit Correction Act (S. 3004, H. R. 6021). A hearing on this bill was held by the Senate Banking Committee on June 26, 2018.

The bill would exempt privately-held, non-custodial broker-dealers from the requirements to use a PCAOB registered firm for their audits. These small firms are not public companies and do not generally hold customer securities or funds. They pose no risk to the financial system as a whole. It is appropriate to allow them to comply only with normal audits. They would still be subject to the full panoply of both SEC and FINRA rules governing broker-dealers.

This legislation should help slow the pace at which small broker-dealers exit the marketplace. It would benefit both those brokers and the entrepreneurs they serve. The public would benefit because entrepreneurs create jobs and bring innovative new products and services to the marketplace.