The letter should be beneficial for registered investment companies and unregistered “hedge” funds, in each case, that trade on margin extended to them by an SEC-registered broker-dealer, such as a U.S. prime broker (a “carrying firm”), where the same or affiliated managers manage multiple investment funds. Prior to the issuance of the no-action letter, carrying firms may have been required to aggregate the margin debit balances of all funds with the same or affiliated managers for purposes of SEC Rule 15c3-3, which made it more likely that the carrying broker (prime brokerage) would hit the debit “ceiling” in the rule and have to “cut off” or limit margin financing across all/each of such funds. The letter should also be beneficial to carrying firms by providing clarification on how to apply Note E(5) to these types of fund-customers.
As such, the no-action letter allows investment funds, that meet certain criteria as discussed herein, and that have the same or common managers to be evaluated separately for these purposes.
Brokerage customers that maintain margin accounts at a carrying firm, such as a prime broker, are, generally, subject to limits on the amount of margin/financing that such customers are eligible to receive from the carrying firm under applicable margin regulations, in particular, Regulation T and Rule 4210 of the Financial Industry Regulatory Authority, Inc. (FINRA)1. In addition, a customer with a large margin indebtedness or loan from its carrying firm (resulting in a large “debit” balance in the customer’s margin account at the carrying firm) could, in effect, be subject to a separate limitation on the ultimate amount of the customer’s margin indebtedness as a result of a limit imposed on the carrying firm under Rule 15c3-3, Appendix A, Note E(5) as promulgated by the SEC under the U.S. Securities Exchange Act of 1934, as described herein. SEC Rule 15c3-3 is the SEC’s “customer protection” rule that, generally, requires carrying firms to safeguard customers’ securities and funds/cash held by such firms on behalf of, or for the account of, its customers.
Under the SEC’s “customer reserve formula” set forth in SEC Rule 15c3-3, Appendix A, carrying firms are required to do periodic computations (daily, weekly or monthly, depending on the firm) of “credits” (which includes customer “free credit” balances that are subject to immediate cash payment upon the demand of a customer) and “debits” (which includes margin financing/indebtedness extended, or loaned, by the carrying firm to its customers with respect to the purchase of (long) securities positions by such customers). Under SEC Rule 15c3-3, a broker-dealer may only use credit balances in the reserve formula to finance/fund debit balances (or otherwise is required to deposit net credit balances into a special reserve bank account of the carrying firm). In this regard, a carrying firm can use customers’ free credit balances (item 1 in the customer reserve formula) to finance customers’ debit (margin) balances (item 10 in the customer reserve formula). However, under Note E(5) to Appendix A, carrying firms are capped at the amount of customer free credit balances that it may use to finance any particular customer’s margin (item 10) debit balance, as discussed below.
Note E(5) was adopted in October 19852 and limits the amount of debit balance that a broker-dealer can recognize in item 10 of the customer (and, also, the PAB3) reserve formula with respect to (i) a single customer’s account (other than an omnibus account), (ii) guaranteed accounts, (iii) accounts under “common control”, and (iv) other “related accounts.” As noted above, a debit balance for these purposes means the aggregate/outstanding margin balance of a customer extended/loaned by the carrying firm to the customer to allow the customer to purchase (long) securities.4
The primary purpose of Note E(5) is to protect customers’ free credit balances (cash balances available for immediate withdrawal by the customer) carried by a broker-dealer against fraudulent debits as well as the credit risk arising from margin debits of a large customer. The request letter to the SEC noted the belief that the SEC did not, when it adopted Note E(5) in 1985, contemplate that investment funds, with different beneficial ownership, but that have a common manager or have affiliated managers under common control – either public or private funds - would be subject to Note E(5).5
Pursuant to the customer (and PAB) reserve formula of Exhibit A to SEC Rule 15c3-3, a broker-dealer enters the amount of debit balances in customers’ cash and margin securities accounts on item 10 thereof. However, Note E(5) to item 10 generally requires the broker-dealer to reduce debit balances in margin accounts (other than omnibus accounts) by the amount by which any single customer's debit balance exceeds 25% (to the extent such amount is greater than $50,000) of the broker-dealer's tentative net capital6 (the “Note E(5) Reduction”). Note E(5) further provides that related accounts (e.g., accounts under common control) will be deemed to be a single customer’s account for the purposes of Note E(5).
Carrying firms, such as prime brokers, have historically found it difficult to determine when the item 10 debit balances of investment funds – such as hedge funds and registered investment companies, in each case, that have the same, or an affiliated, investment manager who directs the trading activities for the applicable fund - are required, or not required, to be aggregated/combined for the purposes of the Note E(5) Reduction. As such, carrying firms may, conservatively, have elected to aggregate such debit balances thereby resulting in investment funds, within a single investment family/group that trade separately from one another, to run up against the debit “limit” or “ceiling” imposed on broker-dealers under Note E(5). As a result, carrying firms that are subject to the Note E(5) Reduction may have limited the amount of margin financing that such broker-dealer would extend to any one of such “concentrated” investment fund-customers (and, thus, potentially limited the degree of trading by such investment fund-customers) separately from loan limits under applicable margin regulations.7
The SEC’s Industry Relief:
On January 8, 2020, the Staff of the SEC issued a “no-action” letter to the Securities Industry and Financial Markets Association regarding the treatment of certain investment funds under Note E(5) to SEC Rule 15c3-3, Appendix A8. This relief is industry guidance that applies to all carrying firms and is effective immediately.
Pursuant to the no-action letter, the SEC has provided needed clarity to the application of the Note E(5) Reduction that should be beneficial to investment funds with common or affiliated investment managers that trade on margin provided by their carrying firms as well as to carrying firms in achieving compliance with their requirements under Note E(5).
In this regard, the SEC Staff will not recommend enforcement action to the Commission if a broker-dealer, for the purposes of the Note E(5) Reduction, does not treat the account(s) of a “Publicly-offered RIC”9 as being under common control with the account(s) of one or more investment companies or investment funds notwithstanding that the entities share a common investment manager or have affiliated investment managers.
In addition, the SEC Staff will not recommend enforcement action to the SEC if a broker-dealer, for the purposes of the Note E(5) Reduction, does not treat the account(s) of a “Private Investment Fund”10 or a “Privately-offered RIC”11 as being under common control with the account(s) of one or more investment companies or investment funds notwithstanding that the entities share a common investment manager or have affiliated investment managers if any of the following conditions is met:
- The aggregate amount of debit balances in the account(s) of the Private Investment Fund or Privately-offered RIC does not exceed a “de minimis” balance (set at 2.5% of the broker-dealer’s tentative net capital)12; or
- The Private Investment Fund or Privately-offered RIC is not narrowly held13, or;
- If narrowly held, the Private Investment Fund or Privately-offered RIC does not have ownership in common14 with any other Private Investment Fund or Privately-offered RIC that shares a common investment manager or has affiliated investment managers.15
1 Although with portfolio margining under FINRA Rule 4210(g), an eligible/qualifying customer, which could encompass certain investment funds, can qualify for greater leverage than otherwise permitted under a “strategy-based” margining arrangement under Regulation T.
2 See SEC Release No. 34-22499 (October 3, 1985).
3 SEC Rule 15c3-3, Appendix A, also applies to “PAB accounts”, which are, generally, proprietary accounts of U.S. and foreign broker-dealers as well as foreign banks acting as a broker-dealer.
4 Separately, for the purposes of the possession and control requirements of a carrying firm under SEC Rule 15c3-3(b) and (c), the carrying firm must compute an “adjusted” margin debit balance of its customers (such adjusted balance being net of credit balances in the customer’s account (other than short sale proceeds)).
5 See, for example, footnote 8 to the Commission’s proposed release relating to, among other things, Note E(5) – SEC Release No. 34-20655 – where the Commission stated that for purposes of establishing control under Note E(5), “ownership of 10% or more of the common stock of the relevant entity will be deemed to be sufficient.” The latter suggests that the Commission was contemplating control of a non-fund corporate entity, and not an investment fund.
6 Pursuant to SEC Rule 15c3-1(c)(15), the SEC’s net capital rule applicable to carrying firms, “tentative net capital” generally means a broker-dealer’s net capital after deduction of non-allowable assets, such as unsecured receivables, but before deduction of proprietary “haircuts” on securities and other assets/positions of the broker-dealer.
7 The Note E(5) Reduction does not prohibit a carrying firm from extending margin indebtedness to a “concentrated” customer in excess of the margin debit cap/ceiling thereunder; rather, the rule just limits the ability of the carrying firm to finance such margin indebtedness using/with its customers’ free credit balances (by imposing a cap/ceiling on the amount of the item 10 debit balance that the carrying firm may include in the customer reserve formula under SEC Rule 15c3-3, Appendix A. The carrying firm, however, would not be restricted under Note E(5) in providing the additional financing to such customer using/with the firm’s own funds.
8 See https://www.sec.gov/divisions/marketreg/mr-noaction/2020/sifma-010820-15c3.pdf
9 A “Publicly-offered RIC” means an investment company that is registered under the U.S. Investment Company Act of 1940 (“1940 Act”) and that issues publicly-offered shares/interests (registered under the U.S. Securities Act of 1933 (the “1933 Act”)).
10 A “Private Investment Fund” means an investment fund that is not registered under the 1940 Act because it is excluded from the definition of “investment company” by reason of Section 3(c)(1) or Section 3(c)(7) of the 1940 Act.
11 A “Privately-offered RIC” means an investment company that is registered under the 1940 Act and whose shares/interests are privately offered without registration under the 1933 Act (in reliance on the exemption from registration under the 1933 Act set forth in Section 4(a)(2) of the 1933 Act and, generally, also SEC Rule 506 of Regulation D there-under).
12 2.5% of tentative net capital is equal to 10% of the 25% of the tentative net capital threshold in the Note E(5) Reduction.
13 Under the SEC’s no-action letter, a Private Investment Fund or a Privately-offered RIC will not be deemed to be “narrowly held” if the broker-dealer has determined within the last 12 months that the fund or company has at least ten investors and no single investor has more than a 10% ownership interest in the Private Investment Fund or the Privately-offered RIC.
14 For purposes of the SEC’s no-action letter, ownership in common will be deemed to occur whenever a Private Investment Fund or Private Investment Company shares at least one investor in common with another Private Investment Fund or Private Investment Company.
15 The SEC’s no-action position addresses only the question of “common control,” and does not address other types of “related accounts,” such as accounts subject to “cross guarantees,” as those terms are used in Note E(5) to item 10. Moreover, the no-action position does not address the circumstance in which a single account, even an account of a Publicly-offered RIC or of a Private Investment Fund or Privately-offered RIC that is not narrowly held, exceeds the tentative net capital limit described in Note E(5) to item 10. In that circumstance, Note E(5) to item 10 requires the broker-dealer to reduce the debit balance in the single margin account by the amount by which it exceeds 25% of the broker-dealer’s tentative net capital.
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.