A Critical Article on Prop Firms

I always hear what's good about them..... but never what's bad. Aren't these just
shops that allow you more leverage, yet your money is at risk? Why not just trade
futures if all I want is leverage? Here is an article I found on the web
(www.daytradingstocks.com):

Proprietary trading firms offer traders attractive jobs to trade their firms' capital.
Often times, when you look at the substance of the agreement, traders are really
risking their own capital. Often times, when you look at the substance of the
agreement, traders are really risking their own capital (" deposits" or "LLC firm
capital"), although with much greater leverage (margin) than would otherwise be
allowable by securities law. Traders need to know the potential tax & securities law
consequences from some of these proprietary trading firm agreements. Read below
to learn about proprietary trading firm agreements for independent contractors and
LLC entities.

Many active traders wish they had more capital to trade with, figuring the old adage
applies - "it takes money to make money." These traders are attracted to the deals
offered by some "proprietary trading firms" to trade the firms capital rather than
their own capital. Now a 2nd adage comes into play - "trade others peoples money."
Some of these proprietary trading firm deals sound " too good to be true." Well, now
it's time for a 3rd adage - "if its too good to be true, it generally is not true."

When you look behind the form and see the underlying substance, you realize that
you are really risking your money, not the firms ("so you are not trading other
peoples money"). Yes, you are using the firms capital to trade with much higher
leverage than would otherwise be allowed by securities law if you opened your own
trading account with a direct-access brokerage firm, but be careful, excess leverage
is a dangerous game.

There are some reputable proprietary trading firms offering true jobs to traders who
do not risk any of their own money. These firms usually pay out 50% of a trader's
gains as a bonus on a Form W-2 for "salary."

However, there are some less reputable brokerage firms marketing their firms as
"proprietary trading firms" offering phony "jobs" to traders to risk their own capital
and not the firms capital. These firms usually pay out 80% to 100% of the trader's
gains either on a Form K-1 for an LLC or a Form 1099-Misc. for "compensation" to
independent contractors (which is really a draw).

Here is what to look for in spotting one of these phony deals with a proprietary
trading firm.

Some smaller, less reputable securities brokerage firms specializing in day traders
market a portion of their Web site or business as a "proprietary trading firm" seeking
to "employ" traders to trade "the firms capital." These firms will have a button on
their Web site for "Trade for the Firm" or "Careers." On those Web pages, the firm
explains the merits of their "proprietary trading firm" program. Their marketing line
is that the firm will "employ" and "train" you to trade the firms capital and that you
will keep most of trading gains for yourself. The firm will provide you with a desk on
their trading floor, along side other "professional traders."

The firm generally requires a "good faith deposit" from you, if you are to be an
"independent contractor" or a "capital contribution", if you are joining the firm LLC as
an LLC member. The minimum amount is generally $25,000 (which happens to be
the same amount the SEC requires as minimum capital for day trading). The firm
explains that this "deposit" or "capital account" will not be used for trading and will
kept aside in your name for you to take back at a later date.

The firm then sets-up a "sub-trading account" for you to trade, funding it with the
firm's capital. This account has actual firm funds or "notional funds" (paper funds like
margin). The sub-trading account has your name on it and only you have "power of
attorney" to trade this account. The firm uses many policies, software and risk
management methods to control your trading and potential losses in this account.

Now comes the fine print. When you look closely at your "independent contractor
agreement" or "LLC Operating Agreement", you may notice that you are technically
responsible for 100% of all losses in connection with your trading within the firm.
These losses include all your trading expenses. You may see that the firm has the
right by agreement to offset your sub-trading account losses with your deposit or
capital account. This is how the firm can transfer the losses from the firm back to
you. The firm manages your trading to make sure you don't lose more than your
deposit, thereby effectively limiting their risk to zero in most cases. This is their
business plan and their challenge in working with you in these types of
arrangements.

Some of these firms have stopped using the "independent contractor" agreements
and are now using the LLC (Limited Liability Company) business model. We believe
these firms have restructured how they are doing business for two reasons. First,
pressure from the SEC to have these traders be registered and trading in a firm as
official members of the firm.

Second, the traders had tax problems due to their "independent contractor" tax
status. These independent contractors told they had to pay self-employment taxes,
which a trader in securities is exempt from paying (our firm figured out how they did
not have to pay self-employment taxes). These independent contractors were also
reporting compensation, which is more appropriately reported as trading gains and
losses (our firm figured out ways to report losses rather than compensation, saving
our clients lots of money). These firms think that using an LLC Form K-1 will do away
with these types of tax problems. Actually, the K-1 reporting does not solve the tax
problems. Read more below.

In the LLC business model, you have two accounts within the firm. Your "capital
account" which keeps aside your LLC member capital contribution (usually $25,000
minimum) to the LLC firm. Second, your "sub-trading account", funded with the
firms money for you to trade. At the end of each month, the firm "settles" the "subtrading
account" with your "capital account", in effect transferring the net trading
gain or loss in the sub-trading account into your capital account. After this
settlement, your sub-trading account is zero and your capital account reflects 100%
of your gains or losses to date.

Before the firm settles your sub-trading account to your capital account, they first
charge your sub-trading account with all your expenses including but not limited to
margin interest expense, training, facilities charges for your desk space, phone,
support and everything else you incur. You now realize that you are really paying for
all these expenses out of your trading gains.

After all expenses are charged, the firm then takes it's agreed share of your gains
(generally 20% to zero, as it varies from firm to firm). If you have a net loss in your
sub-trading account, the firm does not get any profit share. Don't worry about the
firm, they already made lots of money on you from commissions (part of your
trading gains and losses) on your leveraged trading and all those expenses, many of
which were provided at a large mark-up from their affiliates.

After all these charges, if you have income in your sub-trading account, it is
transferred to your capital account, and you may withdraw that excess capital.

If you have losses in your sub-trading account, it is transferred to your capital
account and you are required to bring your capital account back to the minimum
required amount. So in effect, you are forced to pay for your losses right away or
you will be terminated from the LLC. Some firms may allow you to continue until
your capital account reaches zero.

At year- end, the LLC sends you a Form K-1 (tax information document) reporting
"your share of the LLC gains and losses." In reality, the firm prepares your K-1 not
based on any sharing of the LLC firm results but rather your actual net results on
your sub-trading account. Here is where a new tax problem arises. The IRS only
allows an LLC to report as a partnership if the LLC members are true partners,
sharing in the firm's results. In this business model there is not true sharing and the
IRS can seek to disallow the partnership tax reporting.

We also believe the SEC may come back to visit some of these LLCs and realize that
the LLC members are not really members but "trading in securities" using this
scheme to use much greater leverage than would otherwise be allowable by
securities regulation.

Due to these tax and SEC risks, we suggest that if you consider joining one of these
firms, you join as an entity rather than as an individual.

 

somebody already put that article on here about a month ago...so you should find the thread and read those responses...but thanks for your contribution.

 

could you find that article, down to the exact url and copy/post that address.

the home page for the url means that we may/might/might not find that article