|March 6, 2014|
Previously published on February 24, 2014
On March 3, 2014, certain temporary exemptions from compliance with amendments to the financial responsibility requirements for U.S.-registered broker-dealers will sunset.1 As a result, firms soon will be required to comply with new amendments to the customer protection rule (Rule 15c3-3); the recordkeeping rules (Rules 17a-3 and 17a-4); and a paragraph of the broker-dealer net capital rule (Rule 15c3-1), all of which were promulgated under the Securities Exchange Act of 1934 (“SEA”).2 The amendments that were not otherwise subject to the temporary exemption became effective on October 21, 2013.3 This Legal Alert discusses the primary changes to the Customer Protection Rule and the Recordkeeping Rule that broker-dealers should address as necessary prior to March 3, 2014. If a firm has not already considered the impact of these changes, it should do so as soon as possible because the SEC and FINRA have announced that compliance with the foregoing rules will be among their exam priorities in 2014.4
The Customer Protection Rule
The purpose of Rule 15c3-3 is to protect customer funds and securities by prohibiting broker-dealers from using such funds and securities for the broker-dealer’s own account.5 If the broker-dealer fails or is liquidated, the intent behind the rule is that customer funds and securities should be easily identifiable and distributable to customers.6 To achieve this goal, “[a] carrying broker dealer [i.e. a broker-dealer that maintains custody of customer securities and cash] must maintain physical possession or control over customers’ fully paid and excess margin securities.”7 A carrying broker-dealer also must maintain cash reserve or qualified securities at least equal in value to the net cash owed.8 Rule 15c3-3(a), which is subject to the temporary exemption that ends on March 3, 2014, sets forth the formula for determining the reserve requirement. In addition, firms should be mindful of the requirement in SEA Rule 17a-5(e)(2) that a general partner or duly authorized officer of the broker-dealer, as appropriate, must certify under oath that the firm’s annually audited financial statements are true and correct to the best knowledge and belief of that person.
Firms Must Now Conduct a PAB Reserve Computation
Prior to the amendments to Rule 15c3-3, and because broker-dealers were not included in the definition of customer, a broker-dealer that carried accounts that held proprietary securities and cash of other broker-dealers (“PAB Accounts”) were not required to comply with Rule 15c3-3 for such accounts.9 The Securities Investor Protection Action of 1970 (“SIPA”), however, defines the term “customer” more broadly than Rule 15c3-3.10 According to the SEC, the definitional differences increased the risk that claims by customers and PAB account holders, both of whom were customers under SIPA, would expose the Securities Investor Protection Corporation (“SIPC”) fund to losses because PAB Accounts were not subject to the customer reserve requirement.11
To address the potential problem, the SEC has amended Rule 15c3-3 to require a broker-dealer that carries PAB Accounts to perform a PAB reserve computation.12 In particular, the amendments require:
a separate reserve computation for PAB Accounts;
a separate reserve account for the benefit of PAB Accounts; and
physical possession or control of non-margin securities carried for the PAB Accounts.13
A carrying broker-dealer, however, may use such securities in the ordinary course of its securities business if written notice is provided and the PAB account holder has been given an opportunity to object.14 The amendments also permit a carrying broker-dealer and a PAB account holder to agree to exclude the account from the PAB reserve computation, which also would exclude the PAB Account from SIPA protection if needed.15
Requirements Concerning Affiliated and Unaffiliated Banks
A carrying broker-dealer must deposit cash or qualified securities into the customer or PAB reserve account, which must be maintained at a bank, as defined in the Rule.16 The broker-dealer also must execute a written contract with the bank that prohibits the bank from lending or hypothecating securities deposited into the reserve account.17 Prior to the amendments, Rule 15c3-3 did not similarly restrict a bank from accessing cash deposits, and the SEC expressed concern that a bank could experience financial distress that could adversely affect customers and PAB accounts holders.18 To address this concern, the SEC adopted an amendment that “[e]xcludes the amount of any cash on deposit at an affiliated bank of the broker-dealer from being used to meet the reserve requirement.”19 According to the SEC, affiliated banks of broker-dealers were singled out based on the concern that broker-dealers would not apply the same objectivity in evaluating the “financial soundness” of an affiliated bank as a broker-dealer would in evaluating an unaffiliated bank.20 In addition, the amendment requires that cash deposited at an affiliated bank and at unaffiliated bank must be excluded from the minimum deposits required under the Rule when the amount of deposit at the respective bank exceeds 15% of the bank’s equity capital as reported in the bank’s regulatory filings.21
Changes to the Treatment of Fully Paid and Excess Margin Securities
The SEC also expressed concern that a broker-dealer could allocate customers’ fully paid and excess margin securities to its own short positions.22 According to the SEC, possible changes in the market value of the securities could leave a broker-dealer with insufficient funds to purchase the securities and return them to the customer in the event that the broker-dealer fails.23 Pursuant to the amendments, a broker-dealer must now take prompt steps to obtain physical possession or control over securities when the same issue and class of securities are allocated to a short position of the broker or dealer for more than 30 calendar days.24 According to the SEC, the aging process begins when a deficit in securities allocating to a short position arises.25
Free Credit Balances
The SEC deleted Rule 15c3-2 and incorporated certain components of the former rule into 15c3-3 such that broker-dealers are still required to inform customers that there are free credit balance amounts due to them and that such amounts are payable on demand.26 Free credit balances can be cash deposited by a customer, proceeds from the sale of securities or earnings from dividends and interest on securities.27 Broker-dealers may pay interest to customers on free credit balances; “sweep” them into a money market fund or bank account; or transfer the free credit balances to a customer’s account outside of the broker-dealer. In addition, and provided that certain disclosures and written notices are provided, a broker-dealer may transfer credit balances within the context of a sweep program (as defined in the Rule).28
Amendments to the Recordkeeping Rules
The SEC now requires under Rule 17a-3 that broker-dealers document the controls that are established to manage market, credit, and liquidity risk.29 The SEC further stated that it is not mandating specific controls, polices or procedures in this area.30 Furthermore, the amendment applies only to broker-dealers that have at least $1 million in aggregate credit items as determined under the customer reserve formula of Rule 15c3-3 or $20 million in capital, including subordinated debt.31 Pursuant to the changes to Rule 17a-4, broker-dealers must retain the foregoing records until three years after termination of the use of the risk management controls documented therein in order to create an audit trail of such documentation.32
Broker-dealers should take the time now to ensure that they can demonstrate compliance with the new amendments to the financial responsibility rules, especially in light of the SEC and FINRA’s 2014 exam priorities in this area.
1 Order Providing Broker-Dealers a Temporary Exemption from the Requirements of Certain New Amendments to the Financial Responsibility Rules for Broker-Dealers under the Securities Exchange Act of 1934, Exchange Act Rel. No. 70701 (Oct. 17, 2013) (the “Order”), available at http://www.sec.gov/rules/exorders/2013/34-70701.pdf. The SEC initially adopted amendments to the financial responsibility rules on July 30, 2013. Financial Responsibility Rules for Broker Dealers (Exchange Act Rel. No. 70072) (July 30, 2013) (the “Final Rule”), available at http://www.sec.gov/rules/final/2013/34-70072.pdf.
2 Paragraph (c)(2)(iv)(E)(2) of Rule 15c3-1, in particular, “[p]rovides that a broker-dealer need not deduct cash and securities held in a securities account at a carrying broker-dealer except where the account has been subordinated to the claims of creditors of the carrying broker-dealer.” Order at 3 n.9 (citations omitted).
3 The Order did not exempt compliance with the following: Rule 15c3-3(j)(1); the new requirements in Rule 15c3-1 (other than the requirement in paragraph (c)(2)(iv)(E)(2)); and the new requirements in Rule 17a-11 (the notification rule). Order at 3.
4 SEC’s Examination Priorities for 2014 (Jan. 9, 2014), available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf; FINRA’s 2014 Regulatory and Examination Priorities Letter (Jan. 2, 2014), available at http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p419710.pdf.
5 Final Rule at 8.
6 Id. at 9.
7 Id. (fully paid and excess margin securities must be held in specified locations and without any encumbrances).
8 Id. at 10.
9 Id. at 12 -13.
10 Id. at 13.
11 Final Rule at 14.
13 Id. at 15. The Commission also noted that the amendments in this area were meant to incorporate many of the provisions of the no-action letter issued in 1998 by the Commission staff, known as the “PAIB Letter,” which will be withdrawn as of the effective date of the Rule amendments. Id.
15 Id. at 19 - 20. The amendments also exclude DVP and RVP accounts from the definition of PAB Accounts because DVP and RVP accounts generally hold securities and cash for short periods. Final Rule at 20 (footnote omitted).
16 Id. at 29.
18 Id. at 30.
19 Id. at 35.
20 Id. at 33.
21 Final Rule at 41.
22 Id. at 42.
23 Id. at 44-45.
24 Id. at 45.
25 Id. at 46.
26 Id. at 48.
27 Final Rule at 49.
28 Id. at 55 -56.
29 Id. at 89.
30 Id. at 92.