SEC Adopts Final Amendments to Broker-Dealers Rules

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday August 27, 2013 at 9:03 am
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Editor’s Note: The following post comes to us from Eric R. Fischer, partner in the Business Law Department at Goodwin Procter LLP, and is based on a Goodwin Procter Financial Services Alert by Peter W. LaVigne.

On July 30, 2013, the SEC adopted final amendments (the “Final Amendments”) to the financial responsibility rules for broker-dealers (SEC Release No. 34-70072) (the “Release”). The Final Amendments make changes to the net capital, customer protection, books and records, and notification rules for broker-dealers. The SEC first proposed the rule changes in March 2007 and re-opened the public comment period on May 3, 2012. The Final Amendments will be effective 60 days after publication in the Federal Register (about the week of October 14) (the “Effective Date”). This article summarizes the principal elements of the Final Amendments.

Rule 15c3-1—Net Capital Rule

Rule 15c3-1 under the Exchange Act (the “Net Capital Rule”) requires a broker-dealer to maintain, at all times, a minimum amount of net capital depending on the nature of its business. The capital standard in the rule is a net liquid assets test, which imposes standardized deductions (or “haircuts”) on securities, with less-liquid securities subject to deeper haircuts. The Rule also does not allow certain items to be included in net capital and requires certain other items to be included as liabilities. Amendments to the Net Capital Rule include the following:

  • A broker-dealer, in calculating net capital, will be required 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.
  • A broker-dealer will be required to treat as a liability any capital that is contributed under an agreement giving the investor the option to withdraw it, and any capital contribution that is intended to be withdrawn within one year of its contribution. The rule as amended provides that capital withdrawn within one year is deemed to have been intended to be withdrawn within a year unless the broker-dealer receives permission for the withdrawal in writing from its designated examining authority (“DEA”).
  • A broker-dealer will be required to deduct from net capital the amount specified by its DEA with respect to the requirement to maintain fidelity bond coverage. FINRA and other self-regulatory organizations (“SROs”) specify maximum permissible deductible amounts for fidelity bond coverage. Any amounts over the maximum permissible will be deducted from net capital.
  • The Net Capital Rule as amended provides that the broker-dealer must not be “insolvent.” The Final Amendments define insolvent to mean that the broker: “(i) is the subject of a 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, or liquidator or similar official for such broker or dealer or its property; (ii) has made a general assignment for the benefit of creditors; (iii) 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 (iv) is unable to make such computations as may be necessary to establish compliance with this section or with [the Customer Protection Rule].” As amended, Rule 17a-11 under the Exchange Act will require a broker-dealer meeting the definition of insolvent to provide notice immediately upon becoming insolvent to the SEC, the firm’s DEA and, if necessary, the CFTC.
  • The amendments remove a limitation on the SEC’s ability to issue an order temporarily restricting a broker-dealer from withdrawing capital or making loans or advances to stockholders, insiders and affiliates. Previously, the SEC could only issue such an order if the withdrawals, advances, or loans to be halted, when aggregated with all other withdrawals, advances, and loans on a net basis during a 30-day period, exceeded 30% of the firm’s excess net capital. This 30-day/30% limitation will no longer be applicable after the Effective Date.

Rule 15c3-3—Customer Protection Rule

Rule 15c3-3 under the Exchange Act (the “Customer Protection Rule”) is designed to protect customers of a broker-dealer by segregating their securities and cash from the broker-dealer’s proprietary business activities. If the broker-dealer fails financially, but has conducted its business in accordance with the Customer Protection Rule, the customers’ securities and cash should be readily available to be returned to them and, if the broker-dealer is liquidated in a formal proceeding under the Securities Investor Protection Act of 1970 (“SIPA”), the securities and cash will be isolated and readily identifiable as “customer property” and, consequently, available to be distributed to customers ahead of other creditors.

The word “customer” is defined in the Customer Protection Rule to exclude broker-dealers. However, as the SEC points out in the Release, the definition of “customer” in SIPA is broader than the definition in the Customer Protection Rule and does not exclude broker-dealers. Broker-dealers as customers under the SIPA definition have a right to a pro rata share of the customer property, but are not entitled to receive an advance from the fund maintained by the Securities Investor Protection Corporation (“SIPC”) for customers of failed broker-dealers.

A carrying broker-dealer that carries accounts holding proprietary securities and cash of other broker-dealers (so-called “PAB accounts”) was not, under the prior rule, required to segregate cash and securities in PAB accounts as required for customer accounts, creating a risk that, if the carrying broker-dealer failed, there would not be sufficient customer property to make whole all SIPA customers, including broker-dealers with PAB accounts. Certain amendments to the Customer Protection Rule are intended to correct the disparity in treatment of PAB accounts and the accounts of other customers.

The Final Amendments incorporate many of the provisions of a November 3, 1998 no-action letter issued to the NYSE and NASD (the “PAIB Letter”), which permitted a broker-dealer not to take a net capital deduction under the Net Capital Rule for cash held in a securities account at another broker-dealer, provided the other broker-dealer agreed to perform a reserve computation for PAB accounts, establish a separate reserve account, and maintain cash or qualified securities in the reserve account equal to the computed reserve requirement. Because many of the provisions of the PAIB Letter are incorporated into the Final Amendments, the SEC staff is withdrawing the PAIB Letter on the Effective Date.

Definition of PAB Account. The Final Amendments define the term “PAB account” to mean “a proprietary securities account of a broker or dealer (which includes a foreign broker or dealer, or a foreign bank acting as a broker or dealer) other than a delivery-versus-payment or a receipt-versus-payment account.” The definition goes on to state that the term PAB account “does not include an account that has been subordinated to the claims of creditors of the carrying broker or dealer.” Accounts subordinated to the claims of creditors of the carrying broker-dealer are excluded because they would not share pro-rata with other customers in customer property in the event of a failure of the carrying broker-dealer. This exception allows carrying broker-dealers and the broker-dealers for whom they open accounts the flexibility to enter into business arrangements in which the carrying broker-dealer can use the funds and securities in a broker-dealer’s proprietary account. In addition, delivery-versus-payment (“DVP”) and receipt-versus-payment (“RVP”) accounts are excluded because funds and securities are not held in those accounts but are custodied outside of the carrying broker-dealer.

Treatment of PAB Accounts. The amendments to the Customer Protection Rule and to Rule15c3-3a require carrying broker-dealers to:

  • Perform a separate reserve computation for PAB accounts (in addition to the customer reserve computation currently required for The Customer Protection Rule 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.

The Final Amendments require that a carrying broker that is maintaining PAB accounts establish a special reserve account for the PAB accounts, perform a separate reserve computation for the PAB accounts and maintain cash or qualified securities in the PAB reserve account in an amount equal to the PAB reserve requirement.

The new bank account that carrying broker-dealers must establish for PAB accounts must be called the “Special Reserve Bank Account for Brokers and Dealers.” However, since the PAIB Letter required carrying brokers to establish a special account with a slightly different name, the SEC is not requiring carrying brokers to rename special accounts already established prior to the Effective Date.

Other Amendments Relating to PAB Accounts. The amendments make the following additional changes relating to PAB accounts:

  • A carrying broker-dealer with PAB accounts must notify its bank about the status of the PAB account and obtain an agreement and notification from the bank that the PAB reserve account will be maintained for the benefit of PAB account holders.
  • Paragraph (g) of the Customer Protection Rule has been amended to specify when a carrying broker-dealer can make withdrawals from a PAB reserve account.
  • A new paragraph (e)(4), added to the Customer Protection Rule, allows a carrying broker-dealer to use credits related to PAB accounts to finance customer debits under the Customer Protection Rule, but does not allow a carrying broker-dealer to use customer credits under the Customer Protection Rule to finance PAB debits.
  • The Net Capital Rule has been amended to provide that a broker-dealer need not deduct from capital 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.

Banks Where Special Reserve Deposits May Be Held. The amended Customer Protection Rule contains two new provisions governing banks at which reserve accounts are held. First, cash on deposit in a bank affiliated with the broker-dealer may not be used to meet the reserve requirements. However, this prohibition does not apply to securities held at an affiliated bank. If a broker-dealer wishes to hold cash in a reserve account at an affiliated bank, it may do so by depositing qualified securities – securities issued or guaranteed by the United States – that may be held as cash.

Second, the broker-dealer also must exclude from the amount of cash in a special reserve account cash deposited with a non-affiliated bank to the extent the amount of the deposit exceeds 15% of the bank’s equity capital as reported by the bank in its most recent Call Report or any successor form the bank is required to file by its appropriate Federal banking agency. The SEC stated that it recognizes that while a U.S. branch of a foreign bank may meet the definition of “bank” under Section 3(a)(6) of the Exchange Act, it is not FDIC-insured and does not file Call Reports, and thus would not qualify as a bank at which cash may be held in reserve accounts. The SEC further stated that it would consider requests for exemptive relief from broker-dealers wishing to hold a reserve account at a U.S. branch of a foreign bank.

Free Credit Balances—Sweep Accounts. Amended paragraph (j)(2)(i) of the Customer Protection Rule will permit ongoing routine transfers from the customer’s account outside of a sweep program with a one-time consent. Specifically, the amended Customer Protection Rule provides: “A broker or dealer is permitted to invest or transfer to another account or institution, free credit balances in a customer’s account only upon a specific order, authorization, or draft from the customer, and only in the manner, and under the terms and conditions, specified in the order, authorization, or draft.”

The Final Amendments define the term “Sweep Program” to mean a service provided by a broker-dealer where it offers to its customers the option to automatically transfer free credit balances in the securities account of the customer to either a money market mutual fund or an account at a bank whose deposits are insured by the FDIC. Amended paragraph (j)(2)(ii) of the Customer Protection Rule permits a broker-dealer to transfer free credit balances held in a customer’s securities account to a product in its Sweep Program or to transfer a customer’s interest in one product in a Sweep Program to another product in its Sweep Program provided certain conditions are met, including:

  • The broker-dealer provides the customer with the disclosures and notices required by the Rule and by each SRO of which the broker-dealer is a member.
  • The broker-dealer provides the customer with written notice at least 30 calendar days before (A) making changes to the terms and conditions of the Sweep Program, (B) making changes to the terms and conditions of the product currently available through the Sweep Program, (C) changing, adding or deleting products available through the Sweep Program, or (D) changing the customer’s investment through the Sweep Program from one product to another. The notice must describe the new terms and conditions of the Sweep Program or product or the new product, and the options available to the customer if the customer does not accept the new terms and conditions.
  • For an account opened on or after the effective date of the amendments, the customer gives prior written affirmative consent to having free credit balances in the customer’s securities account included in the Sweep Program after being notified of the general terms and conditions of the products available through the Sweep Program and that the broker-dealer may change the products available under the Sweep Program.

Other Changes. The final rule amendments make additional changes, including the following:

  • Funds held in a commodities account meeting the definition of a “proprietary account” under CFTC regulations at a broker-dealer also registered with the CFTC are not to be included as free credit balances in the customer reserve formula.
  • A new paragraph (d)(4) has been added to the Customer Protection Rule (apparently causing existing paragraph (d)(4) to become (d)(5)) requiring a broker-dealer to take prompt steps to obtain physical possession or control over securities of the same issue and class as those included on the books and records of the broker-dealer that allocate to a short position of the broker-dealer or a short position for another person, excluding positions covered by paragraph (m) of the of the Customer Protection Rule, for more than 30 calendar days.
  • Provisions of Rule 15c3-2 under the Exchange Act concerning treatment of free credit balances not already covered by the Customer Protection Rule have been moved to the Customer Protection Rule and Rule 15c3-2 will be removed on the Effective Date.

Proposals Not Adopted. Some rule changes proposed in 2007 were not adopted, including a proposal to expand the definition of “qualified securities” in the Customer Protection Rule to include certain money market funds, and a proposal to modify the haircut for money market funds in the Net Capital Rule from 2% to 1%. The SEC is deferring consideration of those proposals until after any final action it may take on proposed changes to the regulatory scheme for money market funds under the Investment Company Act of 1940. (See the June 11, 2013 Financial Services Alert for a discussion of the SEC’s proposed amendments to its money market fund requirements.)

 

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