On October 22, 2020, the staff of the U.S. Securities and Exchange Commission (SEC), Division of Trading and Markets (TM Staff), issued a No-Action Letter providing guidance to the Financial Industry Regulatory Authority, Inc. (FINRA). The letter addresses compliance of broker-dealers’ fully paid securities and excess margin securities1 lending programs (FPL Programs) with the SEC’s Customer Protection Rule (SEC Rule 15c3-3), in particular, SEC Rule 15c3-3(b)(3).2
In particular, FINRA brought to the attention of the TM Staff that in some FPL Programs, broker-dealers do not deliver directly to the lender/brokerage customer the collateral that the broker-dealer is required to pledge to the customer under SEC Rule 15c3-3(b)(3); rather, FINRA observed that these broker-dealers were carrying the collateral for the benefit of the customers in omnibus accounts under the control of the broker-dealer or that the collateral was being deposited into the customer’s securities account carried by the broker-dealer.
The TM Staff expressed that this type of collateral arrangement does not comport with the requirements of SEC Rule 15c3-3(b)(3) but also believed that broker-dealers should have time to remediate. Accordingly, the SEC’s Division of Trading and Markets is, through the No-Action Letter, providing a six-month “grace” period from the date of the No-Action Letter (until April 22, 2021) to allow firms to review their FPL Programs and bring their collateral arrangements into compliance with SEC Rule 15c3-3(b)(3). FPL Programs not in compliance with the rule after April 22, 2021, may be subject to an SEC and/or FINRA enforcement action.
SEC Rule 15c3-3(b)(1) generally requires a broker-dealer to maintain the physical possession or control of all fully paid securities and excess margin securities carried or received by the broker-dealer for the account of customers.3 However, there is an exemption set forth in SEC Rule 15c3-3(b)(3) that allows a broker-dealer to “use” the borrowed securities. For example, the broker-dealer could on-lend the borrowed securities to another broker-dealer or deliver the borrowed securities to settle another customer’s short sale or to close a customer’s open fail to deliver — in each case, without being deemed in violation of the broker-dealer’s possession or control requirement under SEC Rule 15c3-3(b)(1).
In this regard, SEC Rule 15c3-3(b)(3) requires that as a condition of borrowing the securities, the broker-dealer must enter into a written agreement with the customer requiring (inter alia) that the broker-dealer (i) provide collateral of a type permitted under Rule 15c3-3 that fully secures the securities loan, (ii) mark the loan to market not less than daily and provide additional collateral as necessary to maintain full collateralization of the loan, and (iii) provide a prominent notice that the provisions of the Securities Investor Protection Act of 1970 (SIPA) may not protect the lender with respect to the borrowed securities and, therefore, the collateral provided by the broker-dealer may constitute the customer’s only source of satisfaction if the broker-dealer fails to return the borrowed securities.4
In the SEC’s adopting release to a 1982 amendment to SEC Rule 15c3-3 whereby the SEC added paragraph (b)(3),5 the SEC stated that Rule 15c3-3(b)(3) “will still compel the firm to turn over the collateral physically to the lender and mark to the market”. The SEC contemplated that lenders would be sophisticated institutional entities, such as investment companies, insurance companies, and pension funds, who would not necessarily have a brokerage account carried by the broker-dealer, and who would expect to receive direct delivery of the collateral “away from” the broker-dealer. However, many FPL Programs that subsequently developed following the adoption of SEC Rule 15c3-3(b)(3), especially after the SEC’s approval of FINRA Rule 4330 in May 2014, are instead focused on borrowing securities from retail brokerage customers that are carried in the customer’s securities account at the broker-dealer. As a prudential matter, broker-dealers generally place collateral in a separate account for the benefit of the customer for safekeeping rather than deliver it directly to a retail lender customer.
As expressed in the No-Action Letter, the TM Staff takes the position that an FPL Program under which the broker-dealer does not deliver the collateral physically/directly to the lender (i.e., “away from” the broker-dealer), and the broker-dealer retains possession or control over the collateral, would be deemed in violation of the SEC’s Customer Protection Rule. The letter gives as specific examples of noncompliant collateral arrangements FPL Programs where the collateral is permitted or required to be deposited into (i) the lender’s securities account carried by the broker-dealer or (ii) an omnibus account at a bank in the name of the broker-dealer. The SEC’s concern appears to be that if the broker-dealer were to default and fail to return the borrowed securities to the customer, these structures would not allow the lender to directly access the collateral but instead would require the lender to obtain access to the collateral through the broker-dealer, which could be problematic in the event of a SIPA insolvency of the broker-dealer and which might place in the customer/lender in the unenviable position of being an unsecured, nonpriority, creditor of the broker-dealer.
What This Means for You
Broker-dealers should promptly review their FPL Programs to ensure that they do not raise any of the collateral issues described in the No-Action Letter. In addition, it would be prudent for broker-dealers to review other aspects of their FPL Programs, as the letter could signal a focus on these programs in the course of SEC and FINRA exams.
The SEC’s six-month remediation period is quite short, given that some broker-dealers may need to rebuild their operational systems, negotiate new collateral arrangements, and/or repaper agreements with lender customers. Moreover, some at the SEC have expressed the belief that FPL Programs should be brought into compliance before the April 22, 2021, deadline. In a somewhat unusual manner, two SEC Commissioners issued a joint statement opposing the TM Staff’s decision to allow broker-dealers a six-month “grace” period to remediate their FPL Programs. The statement suggests that enforcement actions might be appropriate if broker-dealers do not take remedial action “without delay.” The suggestion that broker-dealers must remediate sooner than the six-month grace period under the No-Action Letter or risk enforcement action is troublesome given that (i) there has been an absence of publicly available guidance from either the SEC or FINRA as to what constitutes acceptable collateral arrangements for these purposes and (ii) many existing FPL Programs have been subject to SEC and FINRA examination for several years.
We have extensive experience assisting broker-dealers with their FPL Programs and would be pleased to address potential implications of the No-Action Letter on your FPL Program and/or assist with any necessary remedial actions.
1 “Fully paid securities” are, generally, securities carried for a customer in a cash account as well as securities carried for the account of a customer in a margin account or any special account under Regulation T (12 C.F.R. Part 220) that have no loan value for margin purposes, and all margin equity securities in such accounts if they are fully paid. “Excess margin securities” generally means securities carried in a customer’s margin account that are supporting a margin debit balance and have a market value in excess of 140% of the customer’s adjusted margin debit balance.
2 17 C.F.R. § 240.15c3-3.
3 Pursuant to SEC Rule 15c3-3(a)(2), “securities carried for the account of a customer” includes securities received by on or behalf of a broker-dealer for the account of any customer as well as securities carried “long” by a broker-dealer for the account of any customer.
4FINRA Rule 4330(b)(2)(B) also requires broker-dealers to provide additional disclosures to customers when borrowing fully paid and excess margin securities, including the customer’s loss of voting rights with respect to the securities; the customer’s right to sell the securities and any limitations on such right; the factors that determine the compensation received by the broker-dealer and its associated persons; the factors that determine the compensation paid to the customer; the risks associated with each type of collateral pledged to the customer; that the securities may be “hard to borrow” because of short selling or may be used to satisfy delivery requirements resulting from short sales; potential tax implications; and the customer’s right to liquidate the loan if the broker-dealer becomes insolvent, pursuant to FINRA Rule 4314(b).
5 Net Capital Requirements for Brokers and Dealers, Exchange Act Release No. 18737 (May 13, 1982), 47 FR 21759 (May 20, 1982).
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