SEC Amends Financial Responsibility Rules for Broker-Dealers

Morgan Lewis
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Amendments impact many aspects of broker-dealers' back-office operations and will require changes to a number of existing practices.

On July 30, the Securities and Exchange Commission (SEC) adopted amendments to the net capital rule, the customer protection rule, the books and records rules, and the notification rules applicable to broker-dealers under the Securities Exchange Act of 1934 (Exchange Act).[1] The Financial Responsibility Rules Amendments will, among other things, affect a broker-dealer's practices with respect to (1) proprietary accounts of broker-dealers, (2) the banks at which special reserve deposits may be deposited and maintained, (3) the holding of futures positions in a securities portfolio margin account, (4) securities lending and borrowing activities, (5) the treatment of free credit balances in connection with sweep programs, and (6) certain net capital calculations.

The Amendments, which take effect on October 21, 2013, are outlined below.

Proprietary Accounts of Broker-Dealers

The SEC amended Rules 15c3-3 and 15c3-3a under the Exchange Act to require that carrying broker-dealers

  • perform a separate reserve computation for proprietary accounts of broker-dealers (PAB Accounts)[2] (in addition to the customer reserve computation currently required for Rule 15c3-3 customer accounts);
  • establish and fund a separate reserve account for the benefit of PAB Account holders; and
  • obtain and maintain physical possession or control of non-margin securities carried for PAB Accounts unless the carrying broker has provided written notice to the PAB Account holders that it will use those securities in the ordinary course of its securities business and has provided opportunity for the PAB Account holder to object to such use.

As explained by the SEC, the Amendments incorporate many of the provisions of an SEC no-action letter regarding PAB Accounts issued in 1998,[3] which the SEC has directed the staff to withdraw when the Financial Responsibility Rules Amendments become effective.

Implications

If a PAB Account holder objects to the use of non-margin securities in the carrying broker-dealer's course of business, the broker-dealer must maintain possession or control of those securities in accordance with the requirements of Rule 15c3-3 (i.e., segregation). In addition, the Amendments are unclear regarding the period of time within which a PAB Account holder must object to the use of its securities in the carrying broker-dealer's course of business. As a practical matter, however, carrying broker-dealers should provide PAB Account holders with a reasonable amount of time with which to object. Further, with the withdrawal of the PAIB Letter pending, both carrying and introducing broker-dealers should consider reviewing their current clearing agreements to determine if contractual language required to be incorporated by the PAIB Letter should be removed or revised in order to avoid potential inconsistency with the Financial Responsibility Rules Amendments. Such a review would include those carrying firms that have non-U.S. affiliates that are PAB Accounts.

Reserve Account Requirements

Reserve Accounts at Affiliated Banks

Under the new Rule 15c3-3(e)(5), when determining whether a broker-dealer maintains the requisite reserve account deposits, the broker-dealer must exclude the amount of cash deposited into an account at an affiliated bank. As explained by the SEC, broker-dealers that use affiliated banks to hold cash customer reserve accounts will need to either deposit qualified securities into the accounts or move their accounts to non-affiliated banks.

Reserve Accounts at Non-Affiliated Banks

With respect to non-affiliated banks, when determining whether a broker-dealer maintains the requisite reserve account deposits, Rule 15c3-3(e)(5) requires a broker-dealer to exclude cash deposited with a non-affiliated bank to the extent that the amount of the deposits exceeds 15% of the bank's equity capital as reported by the bank in its most recent Call Report.[4] Because U.S. branches of foreign banks generally do not file Call Reports, the Financial Responsibility Rules Amendments effectively preclude a broker-dealer from making deposits into accounts at such banks. The SEC, however, will consider requests for exemptive relief from broker-dealers that wish to hold a reserve account at a U.S. branch of a foreign bank.

Implications

With the Financial Responsibility Rules Amendments, the SEC is strongly signaling a preference for the deposit of qualified securities in a reserve account as opposed to deposits of cash. As mentioned in the Amendments, cash deposits are fungible with other deposits carried by a bank and freely used in the course of the bank's other activities. Thus, it appears as if the SEC is seeking to reduce the credit risk associated with special reserve accounts in two ways. The first is by eliminating such deposits at affiliated banks and also by limiting the ability to concentrate deposits at non-affiliated banks. While the latter would have the effect of diversifying risk among different non-affiliated banks, it also is likely to subject a broker-dealer to increased operational costs and efforts and, perhaps, reduced efficiencies. The second is by not imposing similar limitations on deposits of qualified securities because banks carrying special reserve accounts in which qualified securities are deposited may not use those securities in their other businesses as they could with cash.

In terms of U.S. branches of foreign banks, we believe that the SEC needs to evaluate a particular country's insolvency regime for its banks (and the country's historical and likely liquidation/resolution practices) so that it can be comfortable that the broker-dealer and its customers will have the ability to access cash in a reserve account in the event of a problem for the foreign bank, comparable to the access provided under U.S. law. In this respect, we believe that the SEC signaled its willingness to consider requests for exemptions in order to make such evaluations.

Closeout of Certain Broker-Dealer Short Positions

The SEC amended Rule 15c3-3 to require a broker-dealer to take prompt steps to close out short positions that allocate to customer long positions the next business day after 30 calendar days from when the deficit in the security arises. With respect to a syndicate short position established in connection with an offering, the 30-day calendar period does not begin to run until the underwriter's participation in the distribution is complete as determined under Rule 100(b) of Regulation M. Broker-dealers may apply to their designated examining authority (DEA) for extensions of time.

The SEC's amendment of Rule 15c3-3 is designed to thwart the practice by some broker-dealers of monetizing a customer's securities when a broker-dealer as principal, for example, sells short a security to its own customer. As explained by the SEC, in such a case, the broker-dealer previously was not required to have possession or control of the security even though the customer had fully paid for it.[5]

Free Credit Balances and Sweep Programs

The Financial Responsibility Rules Amendments address the transfer of customer free credit balances and the use of "Sweep Programs," a newly defined term.[6] With respect to non-Sweep Programs, a broker-dealer may transfer free credit balances in an account to another account only upon specific authorization from the customer and in accordance with the terms of the authorization.

With respect to Sweep Programs, a broker-dealer may transfer free credit balances held in a customer's securities account to a product in its Sweep Program or transfer a customer's interest between Sweep Programs if four conditions are met—one condition applies only to accounts opened on or after October 21, 2013, and three conditions apply to existing and new accounts.

Accounts Opened on or after October 21, 2013

For an account opened on or after October 21, 2013, the customer must give prior written affirmative consent to having free credit balances included in the Sweep Program after being notified (1) of the general terms and conditions of the products available through the Sweep Program and (2) that the broker-dealer may change the products available under the Sweep Program. This written consent is not required for current accounts, although changes applicable to these accounts will need to satisfy the other three conditions. Further, the rule language appears to contemplate a customer's consent will stand until otherwise revised.

Existing and New Accounts

For all existing and new accounts, a broker-dealer must satisfy the following three conditions:

  • The broker-dealer must provide the customer with the disclosures and notices regarding the Sweep Program required by each self-regulatory organization (SRO) of which the broker-dealer is a member.
  • The broker-dealer must provide notice to the customer, as part of the customer's quarterly statement of account, that the balance in the bank deposit account or shares of the money market mutual fund in which the customer has a beneficial interest can be liquidated on the customer's order and the proceeds returned to the securities account or remitted to the customer.
  • The broker-dealer must provide the customer with the following:
    • Written notice at least 30 calendar days prior to (1) making changes to the terms and conditions of the Sweep Program; (2) making changes to the terms and conditions of a product currently available through the Sweep Program; (3) changing, adding, or deleting products available through the Sweep Program; or (4) changing the customer's investment through the Sweep Program from one product to another.
    • Written notice describing the new terms and conditions of the Sweep Program, the product currently available through the Sweep Program, or the new product as well as the options available to the customer if he or she does not accept the new terms and conditions.

Implications

The Amendments go beyond what is currently permitted under National Association of Securities Dealers (NASD) Rule 2510 with respect to transfers between existing sweep vehicles. Currently, NASD Rule 2510, which governs the use of discretion in customer accounts, permits the bulk exchange of customers' interests between money market mutual funds used as sweep vehicles through a negative response process (negative consent). The rule currently does not extend to similar transfers between money market funds and bank deposit sweep products. Because the Amendments allow for the transfer of customers' interests between Sweep Programs (defined to include money market funds or FDIC-insured bank deposit accounts), the Financial Industry Regulatory Authority (FINRA) will have to consider whether any additional changes need to be made to its rules to address this apparent inconsistency. In addition, because the Amendments require prior written authorization for new accounts opened on or after October 21, 2013, broker-dealers should review and amend, if necessary, their account-opening documentation and agreements to include such authorization and related disclosures.

"Proprietary Accounts" Under the Commodity Exchange Act

The SEC amended the definition of "free credit balance" in Rule 15c3-3(a)(8) to clarify that funds held in a commodities account meeting the definition of a "proprietary account" under Commodity Exchange Act (CEA) regulations are not to be included as free credit balances in the customer reserve formula.[7] This amendment is most applicable to those broker-dealers that also are registered with the Commodity Futures Trading Commission (CFTC) as futures commission merchants (i.e., BD/FCMs).

As a practical matter, this amendment will affect the major self-clearing broker-dealers as most, if not all, are BD/FCMs.

Futures Positions in Securities Portfolio Margin Accounts

The SEC further amended Rules 15c3-3(a)(8) and (9) to expand the terms "free credit balance" and "other credit balances" to include funds carried in a securities account pursuant to an SRO portfolio margin rule approved by the SEC, including variation margin or initial margin, marks to market, and proceeds resulting from margin paid or released in connection with closing out, settling, or exercising futures contracts and options thereon.

The SEC also amended item 14 in Rule 15c3-3a to permit a broker-dealer to include, as a debit item, the amount of customer margin required and on deposit at a derivatives clearing organization related to futures positions carried in a portfolio margin account.

Securities Lending and Borrowing

Broker-dealers that provide securities lending and borrowing settlement services are deemed to be acting as principals for purposes of taking capital deductions under Rule 15c3-1, unless (1) the broker-dealer fully discloses the identity of each party to the other, (2) each party expressly agrees in writing that the obligations of the broker-dealer do not include a guarantee of performance by the other party, and (3) each party expressly agrees in writing that the other party's remedies in the event of default are limited as against the broker-dealer. In addition, a broker-dealer must notify the SEC whenever the total amount of money payable against all securities loaned or subject to a repurchase agreement, or the total contract value of all securities borrowed or subject to a reverse repurchase agreement, exceeds 2,500% of tentative net capital.[8]

As explained by the SEC, the amendment is designed to alert regulators to a sudden increase in a broker-dealer's stock loan and repo positions, which could indicate that the broker-dealer is taking on new risk that it may have limited experience in managing.[9]

Documentation of Risk Management Procedures

Broker-dealers with more than (1) $1 million in aggregate credit items, as computed under the customer reserve formula of Rule 15c3-3, or (2) $20 million in capital, including debt subordinated in accordance with Appendix D to Rule 15c3-1,[10] will have to make and keep current a record that documents the credit, market, and liquidity risk management controls established and maintained by the broker-dealer to assist it in analyzing and managing the risks associated with its business activities. The Amendments do not require that specific risk management controls be put in place but rather that those that currently exist be documented.

Amendments to Net Capital Rule

Expense Sharing Agreements

The Amendments require a broker-dealer, in calculating net capital, to take into account any liabilities that are assumed by a third party if the broker-dealer cannot demonstrate that the third party has the resources—independent of the broker-dealer's income and assets—to pay the liabilities.

The SEC states that this particular amendment simply codifies existing staff interpretive guidance[11] requiring broker-dealers that enter into expense-sharing arrangements with affiliates (including a parent) to demonstrate that each third party assuming liability for the payment of the broker-dealer's expenses has sufficient financial resources to meet that expense without relying on distributions/funding from the broker-dealer.[12]

This requirement also addresses a practice used by some clearing broker-dealers when one of their introducing brokers is facing the financial difficulty of taking a guaranty or assumption of liability by the introducing broker's owner, corporate parent, or affiliate. This then allows the introducing broker-dealer to take the liability off its books but does not adequately safeguard its customers since the guarantor cannot satisfy the liability without funding from the broker-dealer.

Short-Term Capital Contributions

The Financial Responsibility Rules Amendments will require broker-dealers to treat as a liability (1) any capital that is contributed under an agreement that gives the investor the option to withdraw it and (2) any capital contribution that is intended to be withdrawn within one year of its contribution. Capital that is withdrawn within one year of contribution is deemed to have been intended to be withdrawn within one year unless the broker-dealer receives permission in writing for the withdrawal from its DEA.

Fidelity Bonding Requirements

Under current SRO rules, most broker-dealers are required to comply with mandatory fidelity bonding requirements. These rules typically allow broker-dealers to have a deductible provision included in the bond up to a certain amount. Broker-dealers that maintain deductible amounts over these limits are often required by SRO rules to deduct this excess amount from their net worth when calculating net capital under Rule 15c3-1. However, Rule 15c3-1 does not specifically reference the SRO deductible requirements as a charge to net worth. To address this inconsistency, the Financial Responsibility Rules Amendments will require a broker-dealer to deduct from its net worth the amount specified by the broker-dealer's DEA relating to its fidelity bond coverage.[13]

Broker-Dealer Solvency Requirements

Under the Amendments, a broker-dealer must cease conducting a securities business if the broker-dealer is "insolvent." This is in addition to the prohibition in section 15(c)(3) of the Exchange Act on conducting business if a broker-dealer's level of capital falls below required levels. A broker-dealer is "insolvent" if the broker-dealer

  • is the subject of any bankruptcy, equity receivership proceeding, or any other proceeding to reorganize, conserve, or liquidate such broker or dealer or its property or is applying for the appointment or election of a receiver, trustee, liquidator, or similar official for such broker or dealer or its property;
  • has made a general assignment for the benefit of creditors;
  • is insolvent within the meaning of section 101 of title 11 of the U.S. Code or is unable to meet its obligations as they mature and has made an admission to such effect in writing or in any court or before any agency of the United States or any state; or
  • is unable to make such computations as may be necessary to establish compliance with section 15(c)(3) or with Rule 15c3-3.

Temporary Restrictions on Capital Withdrawals

Under the Financial Responsibility Rules Amendments, the SEC may restrict, for up to 20 business days, any withdrawal by a broker-dealer of equity capital, unsecured loan, or advance to a stockholder, partner, sole proprietor, member, employee, or affiliate as the SEC deems necessary or appropriate in the public interest when the withdrawal may be detrimental to the financial integrity of the broker-dealer. A more limited and similar provision currently allows the SEC to impose such a restriction on withdrawals only when the withdrawals, when aggregated with other withdrawals during a 30-day calendar period, would exceed 30% of a firm's excess net capital.

Conclusion

Given the sweeping nature of the Financial Responsibility Rules Amendments and the short amount of time remaining until the effective date of the Amendments, broker-dealers should promptly evaluate their current back-office operations to determine the types of contractual agreements, technology systems, and capitalization revisions that will be necessary for compliance by October 21, 2013, the effective date for the Amendments. More specifically, broker-dealers should review the banks with which they currently maintain reserve accounts to determine whether they can continue to maintain those reserve accounts, either funded by cash deposits or securities, under the Amendments. Broker-dealers also should review their clearing agreements, PAB Account agreements, and PAB Account practices to determine what revisions, if any, should be made to contractual provisions, disclosure notifications, and related compliance policies to ensure that their business operations are minimally disrupted. With respect to Sweep Programs, broker-dealers should consider whether their existing compliance policies and operations require modifications to provide a framework for notifying customers about future changes to the program consistent with the Amendments. Broker-dealers may also need to review Rule 15c3-3 compliance systems to accommodate changes in reserve formula computations and segregation practices. Finally, broker-dealers should determine whether the Financial Responsibility Rules Amendments relating to a broker-dealer's net capital—including expense-sharing arrangements, short-term capital contributions, fidelity bonding requirements, and limitations on withdrawal of capital—will necessitate modifications of those contractual arrangements.

[1]. 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].

[2]. New Rule 15c3-3(a)(16) defines the term "PAB Account" to include certain entities that are not deemed "customers" under Rule 15c3-3. Such entities include all introducing broker-dealers, as well as foreign brokers-dealers or foreign banks acting as broker-dealers, unless the entity has (a) solely established one or more delivery versus payment (DVP)/receive versus payment (RVP) accounts with the carrying broker-dealer or (b) subordinated its claims to assets to the claims of other creditors of the carrying broker-dealer.

[3]. See Letter from Michael A. Macchiaroli, Assoc. Dir., Div. of Mkt. Regulation, Sec. & Exch. Comm'n, to Raymond J. Hennessy, Vice President, N.Y. Stock Exch., Inc., and Thomas Cassella, Vice President, Nat'l Ass'n of Sec. Dealers Regulation, Inc. (Nov. 3, 1998), available here [hereinafter PAIB Letter]. This no-action letter applied to proprietary accounts of introducing broker-dealers.

[4]. Call Reports are available at the Federal Financial Institutions Examination Council's website here.

[5]. Financial Responsibility Rules Amendments, supra note 1, at 51,835.

[6]. Rule 15c3-3(a)(17) defines a "sweep account" to mean "a service provided by a broker or dealer where it offers to its customer the option to automatically transfer free credit balances in the securities account of the customer to either a money market mutual fund product as described in § 270.2a-7 of this chapter or an account at a bank whose deposits are insured by the Federal Deposit Insurance Corporation [(FDIC)]."

[7]. Under CEA Rule 1.3(y), a "proprietary account" is defined to include persons who have an ownership interest in a futures commission merchant.

[8]. For purposes of this leverage threshold, however, transactions involving government securities, as defined in section 3(a)(42) of the Exchange Act, are excluded from the calculation.

[9]. Financial Responsibility Rules Amendments, supra note 1, at 51,487.

[10]. The SEC also added new Rule 17a-4(e)(9) to require a broker-dealer to retain the documented risk management controls or procedures until three years after the broker-dealer terminates the use of the system of controls or procedures documented therein.

[11]. See Letter from Michael A. Macchiaroli, Assoc. Dir., Div. of Mkt. Regulation, Sec. & Exch. Comm'n, to Elaine Michitsch, Member Firm Operations, N.Y. Stock Exch., Inc., and Susan DeMando, Dir., Fin. Operations, Nat'l Ass'n of Sec. Dealers Regulation, Inc. (July 11, 2003), available here [hereinafter Third-Party Expense Letter]; see also FINRA, Notice to Members 03-63, Expense-Sharing Agreements (Oct. 2003), available here (discussing the issuance of the Third-Party Expense Letter). The SEC also states that it is not directing the staff to withdraw the Third-Party Expense Letter because it contains additional staff guidance not incorporated into the Amendments that will continue to be relevant to compliance with this modification to Rule 15c3-1, including recordkeeping obligations for expense-sharing agreements.

[12]. The SEC further states that a broker-dealer can demonstrate the adequacy of the third party's financial resources by providing its most recent audited financial statements, tax return, or regulatory filings containing financial reports. Financial Responsibility Rules Amendments, supra note 1, at 51,851.

[13]. See e.g., FINRA Rule 4360; Chicago Board Options Exchange Rule 9.22; NASDAQ OMX PHLX Rule 705.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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Access/Correct/Update/Delete Personal Information

For non-EU/Swiss residents, if you would like to know what personal information we have about you, you can send an e-mail to privacy@jdsupra.com. We will be in contact with you (by mail or otherwise) to verify your identity and provide you the information you request. We will respond within 30 days to your request for access to your personal information. In some cases, we may not be able to remove your personal information, in which case we will let you know if we are unable to do so and why. If you would like to correct or update your personal information, you can manage your profile and subscriptions through our Privacy Center under the "My Account" dashboard. If you would like to delete your account or remove your information from our Website and Services, send an e-mail to privacy@jdsupra.com.

Changes in Our Privacy Policy

We reserve the right to change this Privacy Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our Privacy Policy will become effective upon posting of the revised policy on the Website. By continuing to use our Website and Services following such changes, you will be deemed to have agreed to such changes.

Contacting JD Supra

If you have any questions about this Privacy Policy, the practices of this site, your dealings with our Website or Services, or if you would like to change any of the information you have provided to us, please contact us at: privacy@jdsupra.com.

JD Supra Cookie Guide

As with many websites, JD Supra's website (located at www.jdsupra.com) (our "Website") and our services (such as our email article digests)(our "Services") use a standard technology called a "cookie" and other similar technologies (such as, pixels and web beacons), which are small data files that are transferred to your computer when you use our Website and Services. These technologies automatically identify your browser whenever you interact with our Website and Services.

How We Use Cookies and Other Tracking Technologies

We use cookies and other tracking technologies to:

  1. Improve the user experience on our Website and Services;
  2. Store the authorization token that users receive when they login to the private areas of our Website. This token is specific to a user's login session and requires a valid username and password to obtain. It is required to access the user's profile information, subscriptions, and analytics;
  3. Track anonymous site usage; and
  4. Permit connectivity with social media networks to permit content sharing.

There are different types of cookies and other technologies used our Website, notably:

  • "Session cookies" - These cookies only last as long as your online session, and disappear from your computer or device when you close your browser (like Internet Explorer, Google Chrome or Safari).
  • "Persistent cookies" - These cookies stay on your computer or device after your browser has been closed and last for a time specified in the cookie. We use persistent cookies when we need to know who you are for more than one browsing session. For example, we use them to remember your preferences for the next time you visit.
  • "Web Beacons/Pixels" - Some of our web pages and emails may also contain small electronic images known as web beacons, clear GIFs or single-pixel GIFs. These images are placed on a web page or email and typically work in conjunction with cookies to collect data. We use these images to identify our users and user behavior, such as counting the number of users who have visited a web page or acted upon one of our email digests.

JD Supra Cookies. We place our own cookies on your computer to track certain information about you while you are using our Website and Services. For example, we place a session cookie on your computer each time you visit our Website. We use these cookies to allow you to log-in to your subscriber account. In addition, through these cookies we are able to collect information about how you use the Website, including what browser you may be using, your IP address, and the URL address you came from upon visiting our Website and the URL you next visit (even if those URLs are not on our Website). We also utilize email web beacons to monitor whether our emails are being delivered and read. We also use these tools to help deliver reader analytics to our authors to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

Analytics/Performance Cookies. JD Supra also uses the following analytic tools to help us analyze the performance of our Website and Services as well as how visitors use our Website and Services:

  • HubSpot - For more information about HubSpot cookies, please visit legal.hubspot.com/privacy-policy.
  • New Relic - For more information on New Relic cookies, please visit www.newrelic.com/privacy.
  • Google Analytics - For more information on Google Analytics cookies, visit www.google.com/policies. To opt-out of being tracked by Google Analytics across all websites visit http://tools.google.com/dlpage/gaoptout. This will allow you to download and install a Google Analytics cookie-free web browser.

Facebook, Twitter and other Social Network Cookies. Our content pages allow you to share content appearing on our Website and Services to your social media accounts through the "Like," "Tweet," or similar buttons displayed on such pages. To accomplish this Service, we embed code that such third party social networks provide and that we do not control. These buttons know that you are logged in to your social network account and therefore such social networks could also know that you are viewing the JD Supra Website.

Controlling and Deleting Cookies

If you would like to change how a browser uses cookies, including blocking or deleting cookies from the JD Supra Website and Services you can do so by changing the settings in your web browser. To control cookies, most browsers allow you to either accept or reject all cookies, only accept certain types of cookies, or prompt you every time a site wishes to save a cookie. It's also easy to delete cookies that are already saved on your device by a browser.

The processes for controlling and deleting cookies vary depending on which browser you use. To find out how to do so with a particular browser, you can use your browser's "Help" function or alternatively, you can visit http://www.aboutcookies.org which explains, step-by-step, how to control and delete cookies in most browsers.

Updates to This Policy

We may update this cookie policy and our Privacy Policy from time-to-time, particularly as technology changes. You can always check this page for the latest version. We may also notify you of changes to our privacy policy by email.

Contacting JD Supra

If you have any questions about how we use cookies and other tracking technologies, please contact us at: privacy@jdsupra.com.

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This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.