The guidance addresses expense arrangements, buy-in procedures, free credit balances, sweep programs, and bulk transfers, among other things.
On March 6, the staff of the Securities and Exchange Commission (SEC) issued long-awaited guidance in the form of frequently asked questions (FAQs) on the financial responsibility rule amendments adopted on July 30, 2013. The FAQs provide guidance on (1) the effective dates of the Financial Responsibility Rules Amendments; (2) amendments to Rule 15c3-1 (the Net Capital Rule); (3) amendments to Rule 15c3-3 (the Customer Protection Rule), including (i) the allocation of customers’ fully paid and excess margin securities to short positions, (ii) proprietary accounts of broker-dealers, (iii) the treatment of free credit balances outside a sweep program, (iv) certain sweep program questions, and (v) questions regarding the bulk transfer of customer accounts; and (4) amendments to Rule 17a-11.
The FAQs clarify the following effective dates:
Amendments to the Net Capital Rule—Rule 15c3-1
Third-Party Expense-Sharing Arrangements
The FAQs clarify, for purposes of Rule 15c3-1(c)(2)(i)(F), that the guidelines set forth in a July 11, 2003 letter (Third-Party Expense Letter) still apply to third-party expense-sharing arrangements. The Third-Party Expense Letter sets forth nine points concerning the application of the financial responsibility rules when a third party—such as a parent holding company or an affiliate of a broker-dealer—agrees to assume responsibility for the payment of the broker-dealer’s expenses. The staff clarifies that these nine points are still relevant staff guidance, even though they contain a condition that has been codified into Rule 15c3-1. The staff indicates that a broker-dealer for which the Financial Industry Regulatory Authority (FINRA) is the designated examining authority must demonstrate to FINRA that the third party has adequate resources independent of the broker-dealer as set forth in the National Association of Securities Dealers (NASD) (n/k/a FINRA) Notice to Members 03-63 (Expense-Sharing Agreements).
Amendments to the Customer Protection Rule—Rule 15c3-3
Banks Where Special Reserve Deposits May Be Held
For purposes of Rule 15c3-3(e)(5)—which requires a broker-dealer to exclude the total amount of any cash deposited with an affiliated bank when determining whether the broker-dealer maintains the minimum reserve account deposits under Rule 15c3-3—broker-dealers should refer to the term “affiliated person” in Rule 15c3-3(a)(13) when determining whether a bank is an affiliate.
Allocation of Customers’ Fully Paid and Excess Margin Securities to Short Positions
Rule 15c3-3(d)(4) requires a broker-dealer to take prompt steps to obtain physical possession or control of a customer’s fully paid and excess margin securities of the same issue and same class as those included on the broker-dealer’s books and records that allocate to a short position for more than 30 calendar days. The FAQs explain the following:
Proprietary Accounts of Broker-Dealers (PAB Accounts)
Rule 15c3-3(b)(5) states that “[a] broker or dealer is required to obtain and thereafter maintain the physical possession or control of securities carried for a PAB account, unless the broker or dealer has provided written notice to the account holder that the securities may be used in the ordinary course of its securities business, and has provided an opportunity for the account holder to object.” The FAQs explain the following:
Treatment of Sweep Credit Balances Outside of Sweep Program
Rule 15c3-3(j)(2)(i)—non-sweep programs—allows a broker-dealer to invest or transfer free credit balances in a customer’s account to another account or institution only upon a specific order, authorization, or draft from the customer and only as specified by the customer in said order, authorization, or draft. The FAQs state the following:
Sweep Program Questions
Rule 15c3-3(j)(2)(ii)—sweep programs—establishes customer disclosure, notice, and affirmative consent requirements for programs where a customer’s free credit balances in a securities account are “swept” into a money market mutual fund or an account at a bank whose deposits are insured by the Federal Deposit Insurance Corporation. The FAQs clarify the following:
Bulk Transfer Questions
In connection with bulk transfers, the FAQs clarify the following:
Amendments to Rule 17a-11
Rule 17a-11(c)(5) establishes new notification requirements for when a broker-dealer’s repurchase and securities lending activities exceed a certain threshold. In lieu of the notification requirement, the final rule provides that a broker-dealer may report monthly its stock loan and repurchase activity to its designated examining authority (DEA) in a form acceptable to its DEA. The FAQs clarify that Rule 17a-11(c)(5) covers only cash (cash-for-collateral) transactions and does not include non-cash (collateral-to-collateral) transactions.
The FAQs clarify certain interpretive questions raised by broker-dealers throughout the rulemaking process. In other instances, the FAQs may have inadvertently injected further interpretive issues. The FAQs also, in some instances, highlight the need for firms to evaluate their current processes and procedures to fit within such clarifying positions conveyed by the SEC staff.
Buy-in procedures. The FAQs relating to buy-in procedures provide helpful guidance regarding the calculation of the 30-calendar-day period under Rule 15c3-3(d)(4) and a broker-dealer’s option to borrow securities to cure any deficit. However, broker-dealers should be wary of regulators’ review of potential sham transactions designed to reset certain calculation periods. Broker-dealers should ensure that any buy-in or borrow effected by the broker-dealer to obtain possession or control under the Customer Protection Rule is legitimate and could not be construed as designed to improperly reset the 30-day period. Further, broker-dealers should be aware that, in the event of a trading halt by the SEC, FINRA, or an applicable exchange or a Depository Trust Company “chill,” “freeze,” or “global lock,” an extension of the 30-calendar-day period may be available upon request pursuant to amended Rule 15c3-3(n). We expect the SEC and FINRA to update the Interpretations of Financial and Operational Rules guidance available on FINRA’s website to reflect this. In addition, while not discussed in the FAQs, buying in securities, whether to comply with Rule 15c3-3 or otherwise, may be a taxable event and could subject a customer to unforeseen capital gains. Broker-dealers should consider this when determining whether to buy in or borrow securities to comply with Rule 15c3-3(d)(4).
Free credit balance transfers. In connection with free credit balance transfers, broker-dealers that elect to follow the guidance provided in the FAQs will have to develop policies and procedures to ensure that customers’ oral communications relating to the transfer of free credit balances are properly documented. Broker-dealers should consider (i) employing similar procedures to those currently used to document a customer’s direction to transfer assets into a money market fund in order to help alleviate the burden of implementing entirely new policies and procedures or (ii) using an order ticket to reflect the transaction that is created contemporaneously with the customer’s instruction.
Sweep programs and bulk transfers. The FAQs relating to sweep programs and bulk transfers generally provide that broker-dealers that are FINRA members may continue to rely on certain FINRA rules and guidance relating to the Customer Protection Rule. Broker-dealers should continue to monitor FINRA rules relating to both the Net Capital and Customer Protection Rules as FINRA may update its rules and related guidance to reflect the Financial Responsibility Rules Amendments. However, while the FAQs indicate that NTM 02-57 and Rule 2510(d) (2) still apply, the SEC added the notion that the receiving firm in the case of a bulk transfer should reinvest customers’ free credit balances in a “substantially similar product in its Sweep Program to the extent practicable.” This statement appears to be tailored more narrowly than the plain text of the rule amendments, which should allow for changes between money market funds and FDIC-insured bank deposit accounts within a sweep program.
In addition, the FAQs note that carrying firms may rely on an introducing broker’s representations regarding a customer’s “written” consent to include the customer’s free credit balances in a sweep program. However, as discussed in no-action guidance issued by the SEC on February 26, 2014, broker-dealers may rely on a customer’s verbal consent to have his or her free credit balances included in a sweep program until March 3, 2015, provided that, among other things, the customer’s written consent is obtained no later than 90 calendar days after account opening. Carrying broker-dealers should consider whether any such introducing broker’s representation—at least during the relevant no-action period—includes that the introducing broker properly documented the verbal consent and obtained the subsequent written consent in the prescribed time period.
We will continue to monitor the issuance of any additional guidance in this area, whether issued by the SEC or FINRA.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
. See Financial Responsibility Rules for Broker-Dealers, Release No. 34-70072, 78 Fed. Reg. 51,824 (Aug. 21, 2013), available here [hereinafter Financial Responsibility Rules Amendments or Amendments]. For more information on the Financial Responsibility Rules Amendments, see our August 27, 2013 LawFlash, “SEC Amends Financial Responsibility Rules for Broker-Dealers,” available here. The Financial Responsibility Rules Amendments were originally scheduled to take effect on October 21, 2013. However, on October 17, 2013, the SEC issued an order providing a temporary exemption for broker-dealers from certain of the Financial Responsibility Rules Amendments until March 3, 2014. For more information on the order, see our October 18, 2013 LawFlash, “Temporary Exemption from Certain SEC Financial Responsibility Rules Amendments,” available here.
. Rule 15c3-3(a)(13) defines an “affiliated person” as “[a]ny person who directly or indirectly controls a broker or dealer or any person who is directly or indirectly controlled by or under common control with the broker or dealer. Ownership of 10% or more of the common stock of the relevant entity will be deemed prima facie control of that entity for purposes of [paragraph (a)(13)].”
. The FAQs caution, however, that any broker-dealer relying on such an oral communication will bear the burden of demonstrating compliance with the rule.
. View the no-action letter here. For more information on this no-action letter, as well as certain no-action guidance concerning the use of certain nonaffiliated U.S. branches of foreign banks, see our February 28, 2014 LawFlash “SEC Issues Relief from Certain Financial Responsibility Rule Requirements,” available here.