Chapter 4 - The Customer Protection Rule

Question 1

SEC Rule 15c3-3 (Customer Protection Rule)

Answer 1

Ensures the safekeeping of customer securities and funds

Question 2

15c3-3 definition of a customer

Answer 2

Any person for whom the BD has received, acquired, or holds funds or securities

Also includes another BD that maintains an omnibus account for the accounts of customers of the BD

Does not include another BD, municipal securities dealer, a partner, officer or director of the BD, or a subordinated lender

Question 3

15c3-3 requires that…

Answer 3

A BD promptly obtain and maintain physical possession or control of all fully paid and excess margin securities that belong to its customers

Question 4

Control of securities

Answer 4

Securities are under the direct control of the BD

Question 5

Good control location

Answer 5

15c3-3 defines several locations as good control locations. These include:
- Clearing corporation, national securities association or custodian bank (NSCC or DTC) (BD must maintain records of ownership)
- Omnibus account at another BD (BD with physical possession must maintain the securities free of liens)
- Transfer agent (if in transfer >40 days, BD must obtain written statement that the transfer agent acknowledges transfer instructions and possession)
- Foreign depository, clearing agency or custodian bank that the SEC has deemed satisfactory
- Bank with option of delivery with no fee (bank must acknowledge in writing that the securities are free of liens) (securities held by bank as collateral for loan are not in control of BD)
- Offices of the BD (or in transit between offices)
- Other locations as the SEC finds adequate upon application by the BD

Question 6

Frequency of control determination

Answer 6

Daily as of close of the previous business day

Must determine quantity of fully paid and excess securities that are in its possession and control (and those that aren’t)

BD must take action to promptly obtain possession and control of these securities by moving them from non-control locations to control locations

Question 7

Non-control locations and appropriate BD actions

Answer 7

• Loaned to another BD: BD must issue return instructions by no later than the following business day and must physical possession/control within five business days of the issuance of instructions (if collateral for a loan, this is two business days)
• Fails to receive >30 calendar days: BD must take action through a buy-in or otherwise, no later than following business day
• Security dividend receivable, stock split receivable, or similar distribution receivable >45 calendar days: BD must take action through a buy-in or otherwise, no later than following business day

Question 8

Short security differences

Answer 8

If the BD discovers a short security difference, it has 45 calendar days to buy in the security difference that hasn’t been resolved within the 45-day period

Question 9

Customer Sell Orders (possession issues)

Answer 9

If a BD executes a sell order for a customer and doesn’t obtain possession of securities from the customer within 10 business days, the BD must close out the transaction by buying in the securities

If BD believes customer is acting in good faith, BD may apply for an extension with its DEA

Question 10

Special Reserve account for the exclusive benefit of customers

Answer 10

Required at BDs

Must be separate from BD’s other bank accounts

Must contain cash or qualified securities set aside for the exclusive benefit of customers

Amounts in the account may not be used by the BD for any purpose; solely a reserve account

Question 11

Qualified securities

Answer 11

Security that’s issued by the US or a security whose interest and principal are guaranteed by the US. Only qualified securities may be deposited in the reserve account.

Question 12

Reserve Formula Computation

Answer 12

Customer credits minus customer debits

(If debits>credits, no reserve account is necessary)

Ex. $300k credits - $250k debits = $50k must be on deposit

Note that no netting of amounts (short security differences vs long security differences, amounts in transit, etc.) is permitted

Question 13

Customer credits

Answer 13

Amounts owed to customers by the firm

Ex. cash dividends or interest received by the customer, proceeds from short selling, cash deposits

Question 14

Customer debits

Answer 14

Amounts owed to the firm by customers

Ex. margin loans, customers’ owed amounts for transactions

Question 15

Frequency of reserve account calculation

Answer 15

Weekly, as of close of the last business day of the week, to determine amount of cash/qualified securities that must be on deposit in the reserve account

Question 16

When is the deadline for the required deposit into the reserve account?

Answer 16

No later than one hour after opening of banking business on the second business day following determination (Tuesday in a normal week)

If BD fails to deposit, must notify the SEC immediately (and follow up with written notice) and notify their DEA

Question 17

Alternative method of reserve calculation

Answer 17

Allowed to do reserve calculation monthly if ratio of aggregate indebtedness to net capital doesn’t exceed 8:1 and don’t carry customer free credits exceeding $1m

BD must maintain deposit of 105% of amount otherwise required

If for any calculation, AI ratio exceeds 8:1, must do weekly until there are four consecutive calculations with ratio below 8:1

Question 18

Regarding the reserve account, a BD must obtain written notification from the bank that…

Answer 18

The reserve account is for the exclusive benefit of customers and that cash and qualified securities in the account may not be used as collateral for a loan to the BD and is not subject to any lien or claim

Question 19

Which BDs are exempt from the Customer Protection Rule?

Answer 19

BDs which:
- k(1) firms - restrict their activities to the sale of mutual funds and promptly (by noon of following business day) transmit all funds and deliver all securities when received
- k(2)(i) firms – carry no margin accounts, promptly transmit funds and deliver securities, and don’t otherwise hold funds or securities for customers
- k(2)(ii) firms – clear their trades through another firm on a fully disclosed basis

Question 20

What if an exempt (from 15c3-3) firm wants to become non-exempt?

Answer 20

If an exempt firm intends to become non-exempt (or switch its exemption between the statutes), must obtain FINRA written approval before doing so. FINRA will base its approval on experience and qualifications of the BD, procedures for safeguarding customer assets, and financial/operational condition

Question 21

Credits in the reserve requirement computation

Answer 21

1. Free credit balances and other credit balances in customers’ accounts (customer money being held by a BD)
2. Money borrowed (payable) from a bank using customers’ securities as collateral
3. Collateral received (payable) against customers’ securities loaned (not the firm’s)
4. Fail to receive on customer securities (payable)
5. Credit balance in firm account attributable to principal sales to customers (i.e. firm sold stock short to a customer from its own account)
6. Market value of stock dividends, stock splits, and similar distributions receivable outstanding over 30 calendar days (BD may be required to buy in after 45 days)
7. Market value of short security count differences over 30 calendar days old (BD must buy in the difference if unresolved after 45 calendar days)
8. Market value of short securities and credits (not to be offset by longs/debits) in all suspense accounts over 30 calendar days
9. Market value of securities that are in transfer in excess of 40 calendar days and that have not been confirmed to be in transfer by the transfer agent/issuer

Question 22

Debits in the reserve requirement computation

Answer 22

1. Debit balances in customers’ cash and margin accounts, excluding unsecured accounts and accounts doubtful of collection (take a 1% haircut on this item) (does not include balance sheet cash)
2. Securities borrowed to execute short sales by customers (or by the firm to make delivery on FTDs)
3. FTDs for customers (not the firm) less than 30 calendar days
4. Margin required and on deposit with the OCC for all option contracts written or purchased in customer accounts
5. Margin required and on deposit with a clearing agency registered with the SEC, or a derivatives clearing organization registered with the CFTC and related to security futures products or futures contracts/options carried in a securities account pursuant to an SRO portfolio margining rule

Required deposit = Credits – debits (x 105% if computed monthly)

Question 23

Standard vs alternative method of calculating net capital

Answer 23

Standard method = ratio of aggregate indebtedness to net capital
Alternative method = based on required capital on assets, specifically on aggregate debit items in the reserve formula

If a firm intends to switch from standard to alternative method, must notify its DEA (FINRA). If switching from alternative to standard, must have SEC approval.

Question 24

Adjustments to customer debit balances in the reserve formula

Answer 24

Amount of debit balances is subject to a 1% haircut

Depending on circumstances, also might need these adjustments:
1. Security concentration adjustment – if a specific security accounts for over 15% of all securities collateralizing margin accounts, must exclude amount in excess of 15%
2. Customer concentration adjustment – if one customer’s debit balance exceeds 25% of the BD’s tentative net capital by over $50k, must adjust. Related accounts (common control or cross-guarantee) are considered one. BD can avoid this adjustment if it can demonstrate that the debit balance is directly related to credit items in the reserve formula.

Question 25

PABs

Answer 25

Proprietary accounts of BDs, i.e. proprietary securities account of a BD other than a COD/DVP account, also excludes accounts subordinated to claims of creditors.

Question 26

Issues around proprietary accounts of BDs (PAB)

Answer 26

Common practice for an introducing BD to place its proprietary account with its clearing firm and include the assets of that account as allowable assets when computing net capital

Under 15c3-3, clearing BDs are not required to maintain possession/control of the proprietary assets (since a BD is not a customer) or include them as customer credits in their reserve computation, i.e. not required to segregate proprietary account. This could result in an introducing BD having assets not readily available (because the clearing firm has used the funds). In such cases, these assets must be considered non-allowable when calculating net capital, which could reduce net capital.

SEC guidance on PABs is now codified in 15c3-3

Question 27

PAB rules

Answer 27

Similar to reserve requirement rules

1. A BD must maintain a special reserve account of brokers and dealers (PAB reserve account) separate from customer reserve account. Carrying BD must notify the bank that the PAB account will be maintained for the exclusive benefit of PAB account holders.
2. A BD must maintain possession/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 course of business and provided an opportunity for the account holder to object.
3. PAB reserve computation is done on same schedule as customer reserve
4. Calculation mirrors customer reserve. If credits>debits, net amount must be held in reserve
5. Excess debits in customer reserve calculation can be used to reduce PAB credits, but not vice versa
6. Account consists of cash and qualified securities
7. May withdraw excess but must keep record of computation
8. If BD fails to make the deposit on time, must notify SEC by telegram immediately and then written, and notify DEA

Question 28

Timing of PAB reserve calculation

Answer 28

If BD doesn’t carry accounts of customers or conducts proprietary trading business, monthly rather than weekly.

If performing monthly and required to deposit additional cash/securities, must perform weekly for 4 weeks without having to deposit additional

Question 29

Banks where special deposits may be held

Answer 29

A BD is prohibited from maintaining cash deposits in a PAB reserve account if the bank is affiliated and is limited on cash at non-affiliated banks to 15% of bank’s equity capital as reported in the bank’s most recent call report. Securities are exempt from these limitations

Question 30

Rules regarding customer free credit balances (statements)

Answer 30

15c3-3 requires a BD to advise its customers quarterly (in practice monthly – see below) regarding their free credit balances, must be written notice and include funds payable on customer’s demand. Must also state that these funds are not segregated and may be used in course of business.

Separately, BDs are required to send monthly statements and 15c3-3 requires free credit balance to be disclosed in each statement

BD is exempt from these rules if it segregates customer free credit balances in such a way that prevents use by BD (separate bank account clearly designated as agency/trust account). BD must maintain detailed records of the account.

Question 31

Rules regarding free credit balances sweep

Answer 31

15c3-3 permits ongoing routine transfers of free credit balances into a sweep account (interest bearing such as MMF or bank account) with a one-time consent

Question 32

Sweep program

Answer 32

Service offered by BDs in which it offers customers the option to automatically transfer free credit balances in securities accounts to either a MMF or bank account

15c3-3 requires:
- BD provides required disclosures and notices
- BD provides written notice 30 days in advance of any changes to T&C, changing products available through sweep program or changing investment from one product to another

Question 33

Customer Margin Balance Form

Answer 33

Under FINRA Rule 4521, firms that carry customer margin accounts are required to report on this form the total of all debit balances in margin accounts and all free credit balances in all cash and margin accounts on a settlement date basis as of the last business day of the month

Question 34

How should BDs handle payments received in underwriting?

Answer 34

SEC Rule 15c2-4 requires that payments received in connection with underwritings (not conducted as firm commitments) should be promptly deposited (noon of next business day) with an escrow agent and promptly transmitted to the issuer once the contingency is met. If the contingency is not met, funds are returned to investors by the escrow agent.

Contingencies in Rule 5121 are minimum of 10/1 AI:NC ratio and net capital <120% minimum.

Question 35

Securities counts

Answer 35

SEC Rule 17a-13 requires a BD to do a physical examination/count of securities in its possession (including any subject to repurchase/reverse repurchase agreements) at least quarterly. AKA quarterly box count. BD must account for all securities in transfer, in transit, pledged/loaned, FTR/FTD, or otherwise subject to the BD’s control but not possession. BD must verify status of all securities where such control/possession issue has existed more than 30 days.

BD must record any unresolved security differences on its books and records by no later than 7 business days after the count.

Intervals between counts must be between 2 and 4 months

Count must be supervised by persons whose regular duties do not include responsibility for car of the securities

Question 36

SIPA

Answer 36

Securities Investors Protection Act

Establishes procedures for the protection of customers’ funds/securities in the event a BD becomes insolvent

BDs are required to be a member of SIPC

Question 37

SIPC

Answer 37

Securities investors Protection Corporation

Question 38

Responsibilities of FINRA members regarding SIPC

Answer 38

When customer opens a new account, BD is required to provide written notification that the customer may obtain information about SIPC by contacting them and provide the SIPC website/phone. Information also must be provided annually. Must provide information on how to obtain SIPC brochure.

Where an introducing and clearing firm service an account, only one firm needs to complete this.

Written notice of the availability of SIPC info is required annually as well.

Question 39

SIPC coverage

Answer 39

$500k per customer (even if joint account), no more than $250k of which can be cash. Cash/margin accounts are combined for purposes of calculating. A joint account is considered a separate customer.

Protection is not extended to BDs or other non-customers

Question 40

SIPC procedures

Answer 40

If a BD fails, a trustee is appointed by a federal court to distribute funds/securities to customers. The trustee is required to notify the BD’s customers of the insolvency and to handle the orderly liquidation of the BD.

Securities which can be directly tied to a customer will be distributed to that customer. Securities in possession of the BD will be distributed to customers.

Customers with claims over the SIPC limits will rank with other general creditors for the balance of their claim.

Question 41

What’s not covered by SIPC?

Answer 41

1. BDs or other non-customers
2. Commodities/futures (street name securities only)
3. Market value of margin accounts (equity only)

Question 42

Rules regarding notification of SIPC membership

Answer 42

Can be placed on firm letterhead, etc. as long as SIPC name is not more prominent than member firm name. BDs may only use the SIPC logo with the attestation that the firm is a member, may not imply SIPC is equivalent to FDIC or protects against investment losses.