FINRA Proposes for Member Comment Consolidated Rules for Membership Application Proceedings and Securities Lending Transactions

January 08, 2010

As part of the ongoing process of consolidating NASD and NYSE rules into a single FINRA rulebook, FINRA has issued Notice 10-01, which proposes for comment consolidated rules to address the new and continuing membership application process.1 FINRA also has issued Notice 10-03, which proposes for comment consolidated rules addressing member obligations in connection with securities lending transactions.2

I. New Member Applications and Change in Ownership/Business Applications

Rather than provide a detailed analysis of the proposed membership application rules, the following discussion focuses on proposed changes and additions that may be of particular interest to persons applying for FINRA membership and member firms seeking to change their business activities and/or ownership and control structures.

A. New Member Applications

1. Additional Information/Disclosure Requirements

Generally, the proposed rules for the new membership application will reflect the current NASD new member application process, with new requirements to provide extensive additional organizational, control and ownership information about the applicant, its affiliates and its relationship with its affiliates. FINRA states that it seeks the additional information to ensure that it has access to all of the relevant aspects of an applicant’s business that are within the scope of FINRA’s statutory authority. 

In particular, FINRA proposes, among other things, to amend its new member application rules to require increased information about the applicant’s affiliate relationships in the form of organizational charts and summary information about each affiliate’s principal activity and the legal relationship between the affiliate and the application. In addition, the applicant would be required to provide detailed and comprehensive summaries of its business relationship with each affiliate.3

2. Amended Decisional Process

The standards for determining the disposition of an application are in proposed FINRA Rule 1130. Although the proposed new rule incorporates most of current NASD Rule 1014, the new rule would add a new standard that requires an applicant to fully disclose and document all of its funding sources and that would permit FINRA to determine that the sources are not objectionable. The proposed rule would clarify that FINRA staff may impose higher minimum capital requirements on an applicant in situations where the applicant is entering into contractual commitments regarding investment advisory business. The proposed rule also would permit FINRA staff to consider information about affiliates, including investigations, and settled and pending state, federal or self-regulatory actions, against the affiliate(s), in determining whether the applicant meets the standard required to comply with federal securities laws and regulations and FINRA rules.4 

The proposed new rule would appear to give FINRA staff the tools to reach deeply into an applicant and its affiliates’ activities and finances prior to approval of the applicant to become a member firm.

B. Continuing Membership Application

FINRA proposes to incorporate NASD Rule 1017, the rule requiring a member to file a application for approval of certain changes to its ownership, control or business operations, into new FINRA Rule 1160. The proposed changes reflected in new FINRA Rule 1160 would result in amendment to both the process and the information required in a continuing membership application. 

The proposed new rule would extend to 45 days from 30 days the time frame within which FINRA staff must make a final decision on a CMA following the final filing of any information or documents required for a decision. The proposed rule would require that FINRA staff state in the final decision whether there are restrictions imposed to address specific financial, operational, supervisory, disciplinary, investor protection or other regulatory concerns based on decision standards in proposed FINRA Rule 1130. FINRA also proposes to prohibit a change in ownership or control pending final FINRA action until no earlier than 30 days after the submission of a complete application and to mandate that any interim restrictions imposed by FINRA would remain in effect for the applicant and all successors to the applicant’s ownership or control, unless removed by final action of FINRA or stayed, upon appeal, by the NAC, the FINRA Board or the SEC.

C. New Written Notice Requirement — FINRA Rule 1170

FINRA also is proposing a new written notice requirement. This new requirement would be in addition to the formal continuing membership approval process. FINRA is proposing this new notice requirement because it believes certain business changes may impact a firm’s supervisory and compliance infrastructure and/or finances but not raise to the level of a continuing membership application. FINRA believes this new notice filing requirement will permit FINRA to identify possible regulatory issues raised by the business change.

The new rule requires a member firm to provide FINRA with 30 days prior written notice of any disclosable event listed in the rule. Disclosable events include: 

  • investments and divestitures of 10 percent or more of ownership by any one person or control group,
  • changes or loss of key personnel, 
  • changes in a member’s service bureaus, clearance activities, or method of bookkeeping or recordkeeping, or of utilization of outside service providers, 
  • expansion of business requiring capital infusions in excess of 25 percent of the member’s net capital or requiring additional licenses, 
  • addition of products or services that would be new,
  • listing of the firm on facilities or media designed to solicit offers or inquiry regarding purchase of the member in part or the transfer of some or all of the member’s assets, and 
  • the discovery of conditions that the member reasonably believes could lead to capital, liquidity or operational problems, or the impairment of recordkeeping, clearance or control functions.

Based on the notice filing, FINRA staff may require the member firm to file a formal continuing membership application.

The proposed changes to the new member and membership continuation processes indicate that FINRA is taking a more "hands-on" approach to launch of new broker-dealers and changes in control or operations at existing broker-dealers. FINRA has already centralized the new member process (which formerly occurred in each regional office) in its New York office, and in the past year, our experience has been that both new member applications and continuation applications are subject to more intensive and time-consuming review than ever before. Comments on the proposed rule changes are due by March 5, 2010.

II. Securities Lending Rules

FINRA is requesting comment on three proposed FINRA rules addressing securities lending transactions, permissible use of customers’ securities, and possession and control of callable securities. In particular, proposed FINRA Rule 4314 addresses disclosure and related recordkeeping requirements applicable to securities lending transactions. Proposed FINRA Rule 4330 sets forth the requirements applicable to a member firm's borrowing or lending of a customer’s margin securities. Proposed FINRA Rule 4340 addresses the obligations applicable to any callable securities a member firm has in its possession or control.

This alert will focus on the proposed securities lending rules.5

A. Securities Lending Transactions — Rule 4314

1. Capacity Disclosure and Recordkeeping

Proposed Rule 4314 builds upon NYSE Rule 296 and the 2006 industry initiative to adopt voluntary securities lending disclosure and recordkeeping requirements (the Agency Lending Disclosure Initiative).6 In particular, Rule 4314 would require member firms engaged in agency lending transactions to disclose their capacity to their counterparty and to maintain certain books and records specified in the rule.

2. Liquidation Rights and Written Agreement

In addition, the proposed rule would incorporate elements of NYSE Rule 296 by providing that each member firm that is a party to a securities lending agreement with another member firm shall have the right to liquidate such transaction whenever the other party to such transaction becomes subject to certain liquidation events listed in the rule. Proposed Rule 4314 also would expand upon NYSE Rule 296 by requiring all member firms to have written agreements governing any securities lending transaction with another non-member firm, including customers (current NYSE Rule 296 only requires a written agreement if the transaction is with a non-NYSE firm).

The proposed rule would include various Supplementary Materials that would define the types of transactions subject to the rule, the manner by which a member firm can meet its disclosure obligations under the rule, and clarifies the rule’s books and records requirements.

B. Permissible Use of Customer Securities — Rule 4330

NYSE Rule 402 sets forth the requirements applicable to a member firm’s use of customers’ securities. Subject to certain changes, FINRA proposes to adopt NYSE Rule 402 as FINRA Rule 4330 and eliminate NASD Rule 2330(b)-(d) and NASD IM-2330.

1. Written Authorization

Proposed FINRA Rule 4330 continues to require a member firm to obtain a customer’s written authorization prior to lending the customer’s eligible margin securities. The proposed rule continues to permit a member firm to meet the written authorization requirement by using a single customer-signed margin agreement, provided that it contains the following disclosure language in bold face immediately above the signature line: “BY SIGNING THIS AGREEMENT I ACKNOWLEDGE THAT MY SECURITIES MAY BE LOANED TO YOU OR LOANED OUT TO OTHERS.”7

2. Use of Fully Paid/Excess Margin Securities

a. FINRA Notice

FINRA is proposing new requirements applicable to the borrowing and lending of customers’ fully paid or excess margin securities. Under the new rule, a member firm must notify FINRA at least 30 days prior to engaging in such activities. After receiving such a notice, FINRA may request various related information, including the written agreement authorizing such arrangements, the types of customers, the accounts used and the collateral involved in the transactions.

b. Customer Disclosure — SIPA Protection

The new rule would require customer notice that the provisions of SIPA may not protect the customer with respect to the lending/borrowing of fully paid/excess margin securities and that the collateral delivered to the customer may be the only source of satisfaction of the member firm’s obligation in the event the member firm or its counterparties do not return the securities. In addition, the new rule would require that a customer be provided with information regarding risks associated with the securities lending transaction — such as potential loss of SIPC protection, a loss of voting rights, the type and sufficiency of collateral, any limits on the use of the collateral, the economics of the transaction including any potential tax implications, and the member's right to liquidate the transaction. The broker-dealer would be required to maintain books and records evidencing their compliance with these notice requirements.

c. Suitability Determinations

The new rule would for the first time require that a member firm determine whether the borrowing/lending of customer fully paid/excess margin securities is suitable for the customer. Apparently this requirement would apply even if the member firm did not recommend the transaction to the customer, and on its face this requirement appears to apply not only to retail customers but also to institutional customers. FINRA's Notice does not suggest any standards for making this suitability determination. 

The Notice suggests that FINRA has concerns about the growth of stock loan programs involving fully paid and excess margin securities, and the adequacy of broker-dealer disclosures concerning those programs. Comments on the proposed rule changes are due by March 8, 2010.

For additional information concerning this alert, please contact the following lawyers:

David Boch, Partner, Broker-Dealer Group, 617.951.8485

Amy N. Kroll, Partner, Broker-Dealer , 202.373.6118

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

1 A copy of the proposed rule may be found at

2 A copy of the proposed rule may be found at

3 In addition, FINRA proposes to adopt new FINRA Rule 1111 that will replace NASD Rule 1011 “Definitions.” In Rule 1111 FINRA would define “affiliate” and “control,” would move the definition of “material change in business operations” to the new rule establishing standards for filing a continuing membership application, and would supplement the events defined as “sales practice events” to include “statutory disqualification” in order to include in sales practice events certain misconduct, such as convictions of misdemeanor tax evasion, not captured by the current definition.

4 FINRA also proposes to change slightly the filing process, the timing of the steps in the application process and the cost of filing.

5 Proposed FINRA Rule 4340 would replace NYSE Rule 402.30 concerning callable securities; it would adopt a more principles-based approach to allocating partial calls, but includes complicated provisions concerning when the accounts of the firm or its employees can (or must) be included in partial calls.

6 The NASD previously had endorsed the Agency Lending Disclosure Initiative as a best practice in Notice to Members 05-45.

7 It is unclear how this requirement interacts with NASD Rule 3110(f), which requires a different bold-face disclosure which also must be displayed immediately above the signature block in any agreement containing a pre-dispute arbitration clause.

This article was originally published by Bingham McCutchen LLP.