The bad parts of Pro Trading firms

Discussion in 'Prop Firms' started by newbie, Oct 29, 2001.

  1. newbie


    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 a t risk? Why not just trade futures if all I want is leverage? Here is an article I found on the web:

    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.
    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 "sub-trading 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.
  2. Such a well thought out, informed, insightful overview of the "cons" of prop shops.....and all from a "newbie"!
  3. newbie


    I wish I could take credit-but you'll notice I copied the article from a web site as stated in my first posts first paragraph, after doing a search on google.
  4. lescor


    That article pretty much sums up the agreement with ECHOtrade that I just signed. But what's the point of the article? Who would go into this business without knowing all that stuff already? The agreement clearly spells out what you are getting into and what your costs are going to be.

    Trading professionally is a business, and any business is going to have overhead. These firms are not charities and are also in it to make a profit, and they make their profits from their traders- big surprise!

    I've decided to trade with a pro firm for several reasons, and leverage is not even in the top three. Besides, if you blow up because of overleveraged positions, you don't know how to manage risk properly and are probably in over your head as a pro.

    And the idea that the SEC is going to come down on these firms for allowing people to exceed the regulated margin requirments is silly. The structure of the firm and the requirement to be liscenced by the NASD relieves you from these regulations.
  5. How come nobody will address the LLC tax issue?
    Don and Gene must why don't they answer the post? Do they not want us to know?
    Lescor, I know you've only been with Echo for a short time, but I assume you'd look into something that could possibly take half your hard earned cash.

    Put is this way, the reason I ask is that I plan on opening an account with an LLC...and I want to open it at a place where people know what's going on...everybody keeps saying I've got this technology and that technology...what I want is someone who says..."look, I can show you how to keep more of the cash you earn"

    Gotta get back to "The Bus", he's kickin' major butt tonight.
  6. jem


    uptiki you have pulled me out of my shell. I practiced law, I am a full time trader and I have an interest in a small llc where we back some traders and some of our traders bring in their own money. I have read the IRS site and I have consulted with accountants on this issue. (I was told by a big time accounting firm in Chicago that I do not know what I am talking about and that ever trader has to pay self employment taxes, arrogant idiots). I have spoken with the lawyer for the accountant guy from florida who is in the trader magazines and publicized this issue.

    Although I have an opinion on this issue, you would never get me to give it to you unless I had paid my malpractice insurance (I have not because I do not practice) and you paid me good money for an opinion letter (the reward for the taking the risk of a malpractice suit). I have one trader in my office who was a tax preparer and his wife is an accountant. We spent a long time on the issue. He was audited. He passed. But what about the next trader.

    There is a great deal of misinformation about this issue. And the people who tell you that it is no sweat are just not telling you the truth because different auditors are going to have varying degrees of understanding in this matter. You take an honest position on your taxes and you better be able to back it up with the law the code the regs and the facts. Now I welcom people to give you the info and maybe even an opinion but I doubt you could get someone in a "sueable" position to give you an opinion that might really satisfy you. In fact as an attorney if I had an LLC as a client I would advise them to not have an opinion on this issue. After all what if the IRS disagrees with them.
  7. Jem-
    Thanks for your honest response. I guess that's why I have yet to hear from any other LLC heads about trader taxes.
  8. Fletch


    I'm not sure you are taking into account the marked-to-market accounting. I think it's pretty clear that the income is ordinary income for LLCs that elect MTM accounting. I'm sure someone else could provide the exact IRS code relating to that.

  9. This is an interesting topic, but I am not a tax expert. The way Lieber & Weissman Sec., L.L.C. is set up, you are taxed as ordinary income and each L.L.C.. member gets a K-1 L.L.C. partnership tax form at the end of the year. Lieber & Weissman ,
    L.L.C. is audited yearly according to PHLX and SEC guidelines.

    I would advise all prospective L.L.C. trading members to read their
    L.L.C. members agreement and seek the advice of a qualified CPA
    who understands L.L.C./Partnership tax accounting practices. You
    may ask other traders who they use or go to the following sites
    tax professionals who might help:

    Green & Co., Robert Green CPA

    Mann & Company CPA’s P.C.

    I would also advise traders to keep haircuts & confirms for three
    years. If your broker sends you e-mail reports and you can put them in an excel spreadsheet format, this may be a big help to your tax professional.

    Gene Weissman
    Lieber & Weissman Sec., L.L.C.
  10. jem


    Fletch, just to let you know I am a marked to market trader and even though the LLC makes this election for me I also sent in a letter to the IRS making the election. However, I do not want to go into the issues on a public forum like this. Sorry.
    #10     Oct 30, 2001