Chapter 8 - FINRA Financial/Operational Rules

Question 1

Uniform Practice Code

Answer 1

Sets standards for clearing and settlement procedures to be used by FINRA members. These standards enhance the efficiency of settlements of contracts, deliveries, ex-dividends, due bills, and marks to the market. Applies to all transactions between members, except exempt securities (as defined under SEA of 1934). Interpretations are governed by the FINRA Operations Committee.

Question 2

Electronic delivery under FINRA rules

Answer 2

Clients must acknowledge willingness to accept electronic delivery. Once acknowledged, firms can direct clients to their website to obtain information.

Question 3

Regular-way settlement under the UPC

Answer 3

A trade of corporate or municipal securities must settle on BD2. If seller wants to delivery prior to BD2, buyer has right to refuse.

Trades involving US gov’t securities settle on BD1.

Question 4

Cash contracts under UPC

Answer 4

Contracts which settle same business day. Seller must deliver same BD and buyer must pay on receipt.

Question 5

Seller’s option contract under UPC

Answer 5

Occurs when seller doesn’t intend to delivery within 2 BDs. Seller must specify delivery date (at least BD3)

Seller may then deliver earlier by sending written notice one day beforehand (so earliest notice date is BD2)

Question 6

NSCC rules under the UPC

Answer 6

Transactions between FINRA members involving OTC securities are cleared through NSCC, assuming security is qualified for NSCC clearance and both members are qualified as clearing members.

Each participant submits trade data to NSCC at end of day. NSCC attempts to match data. Next day, NSCC sends contract sheet with list of trades which compared correctly and are now ready to settle, and uncompared trades which participants must reconcile.

Question 7

Continuous net settlement under UPC

Answer 7

This process is possible when members employ a clearing agency like the NSCC and a depository like the DTC to settle trades.

For each security which a member buys and sells, positions are netted out (so firm either owes or is owed, but not both). FTD/FTR are taken into account in the netting process.

Has greatly reduced the number of open fail positions.

Question 8

Unrecognized/unmatched trades

Answer 8

Each transaction should result in a confirmation from the contra-party. If discrepancies exist between the two confirmations, the member must communicate discrepancies promptly to the counter-party. Once resolved, party in error should send a corrected confirmation within 1BD.

Question 9

DK Notice

Answer 9

DK = don’t know

If contra-party doesn’t recognize trade on a confirmation, they must promptly notify the confirming party by phone, and within 1BD send written notice

Within 4 BDs of trade, confirming broker will send a DK notice, questioning whether a trade occurred. Contra-broker must examine records.

If a member believes a transaction is clearly erroneous, it may cancel the trade upon notification and approval of FINRA.

After verification, if confirming dealer believes a trade occurred, must notify contra-party immediately by phone and within 1BD by written notice, indicating failure to confirm. Non-confirming party should establish whether trade occurred and either (if trade did occur) promptly call dealer and notify via written notice within 1BD, or (if trade didn’t occur) send written notice promptly indicating non-recognition.

Question 10

Errors in trade confirmations or trades

Answer 10

Procedures to be followed depend on nature of error and firm policies

RRs should generally bring errors to attention of supervisors

Question 11

Error account

Answer 11

All BDs are required to maintain an error account (single account for entire firm), to be used if the firm or an RR execute a trade in error

If error occurs, firm should immediately execute the original transaction and maintain record of the error

Question 12

Delivery of securities under UPC

Answer 12

Establishes requirements for deliveries, to ensure securities will be acceptable to transfer agent. Transfer agent makes final determination of whether a security is good and able to be delivered.

Question 13

Endorsements under UPC

Answer 13

A customer who sells a security is required to sign the stock certificate.

1 sign the certificate on the back and mail to the broker. Seller can send by registered mail in order to safeguard
2 send unsigned certificate in one envelope and signed stock power (Power of Substitution) in another
3 enter name of the broker on the back of the certificate, and broker will sign a power of substitution when it sends to the transfer agent.

Question 14

Assignments under UPC

Answer 14

Must be written exactly as written on the certificate and must be guaranteed (with signature) by a member of the NYSE or a bank.

If name needs to be corrected, correction must be guaranteed by NYSE member firm or bank.

Question 15

Additional documentation for stock delivery under UPC

Answer 15

If an account is registered in the name of (and security is signed by) an executor or guardian, the transfer agent will accept with no additional documentation. Will not accept signatures of someone deceased, must be signed by executor and necessary legal documents (i.e. copy of death certificate and appointment of executor, state tax waiver and affidavit of domicile).

Certificates in the name of a company must be signed exactly how name appears (except & and Co.) Person signing must be designated by BOD to sign on behalf of the corporation. Therefore, transfer agent will require papers showing such designation (i.e. corporate resolution). Some companies will file a copy of their resolution with all transfer agents in advance (to avoid submitting each time)

Question 16

Units of delivery under UPC

Answer 16

Certificates must be in certain units in order to be acceptable for broker-to-broker delivery. Buying broker may refuse delivery if in units other than allowed multiples.

Question 17

Units of delivery – stock transactions

Answer 17

Multiples of 100 shares, or in smaller units totalling 100 shares.

Example – for transaction involving 500 shares, one certificate for 500 shares or 5 certificates for 100 shares are both good. 2 certificates for 250 shares is bad.

10 certificates for 50 shares each is good; 5 certificates for 60 shares + 1 for 200 shares is bad (because not possible to take 60 share certificates and make 100 share units).

For an odd lot, any number of units/certificates may be delivered.

A buying broker is required to accept partial delivery if delivery conforms to requirements, but not required to accept such that it leaves an odd lot remaining.

Question 18

Units of delivery – bond transactions

Answer 18

Bearer bonds - $1,000 denominations or denominations of $100, or multiples aggregating to $1,000.

Registered bonds - $1,000 units or multiples thereof, or amounts of $100 or multiples aggregating to $1000.

Unit investment trust – single trust unit

CDs – identical to bonds

Drafts that accompany the shipment of securities must be accepted only during normal business hours (buying BD has option to accept early)

Question 19

Ex-dividend

Answer 19

Stock is trading without its dividend. Begins to trade ex-dividend 1BD before record date. Person who purchases stock on or after ex-dividend date will not receive the dividend since the trade will settle after the record date.

Question 20

Due bill

Answer 20

In the event a trade occurs in time for buyer to receive dividend, but seller fails to deliver by record date, a due bill will accompany the security when it’s delivered (i.e. dividend is due to the buyer).

Question 21

Bond interest under the UPC

Answer 21

Other than bonds trading flat (i.e. without accrued interest), buyer of the bond will pay seller any accrued interest (from last payment date to day before settlement)

Question 22

Interest calculations on US govt bonds vs corporate/muni

Answer 22

US govt bonds – computed on basis of actual days

Corp/muni – 30-day months

Question 23

Reclamation under UPC

Answer 23

Reclamation = right to return (or demand return of) security which has been previously delivered and accepted

Requires use of the Uniform Reclamation Form

Reclamation can occur because:
- wrong security
- required due bill not attached
- missing or incorrect signature
- transfer agent refuses to accept delivery for any reason
- mutilated security is delivered without authentication by the trustee, registrar, issuer, or transfer agent,
- bond is delivered without all coupons
- security called for redemption prior to delivery (unless entire issue is called or was traded specifically as a called security)

Question 24

Close-out procedures under UPC

Answer 24

Can either result in a buy-in or sell-out

Buy-in: Selling broker has failed to make proper delivery. Buying broker will then purchase in the open market, charging the selling broker the difference between contract price and buy-in price. May not be executed sooner than BD3 following settlement date. Buy-in broker must send buy-in notice to selling broker no later than noon 2 BDs before execution. Selling broker can notify buying broker that securities are in transit or with transfer agent and provide certificate numbers; buying broker then must defer buy-in by 7 days.

Sell-out: If selling broker makes good delivery and buying broker refuses to accept, selling broker can sell on open market immediately without notice. It can charge buying broker for any loss.

FINRA members which buy in or sell out must notify the other member on the date of such action.

Question 25

Marks to the market under UPC

Answer 25

Mark to the market = member firm is partially unsecured (due to change in market price) on an open contract with another member firm

MTTM is sent when a broker either wants increase in collateral deposit (if market price increases) or contra-broker wants return of part of deposit (if market price declines). Member firm receiving demand must comply promptly (no specific timeframe in the rule)

Question 26

Other Stock Loan issues under UPC

Answer 26

Lending member firms have right to demand return of loan at any time

Lender of stock retains all rights other than voting rights

Question 27

When-issued securities under UPC

Answer 27

“When, as, and if issued” and “when, as, and if delivered” = transactions involving securities not yet available for delivery

When issued, FINRA Operations Committee will determine whether the final issuance is essentially the same as originally announced and will determine settlement date. If they determine it’s substantially different, transactions are canceled. If committee doesn’t declare settlement date, will be 1BD following date of notification of intention of delivery. If syndicate, settlement will be on date that syndicate contract settles (max 90 days)

Settlement is the date agreed upon by the parties. Confirmations must be sent one business day following the trade date but need not contain a settlement date

Question 28

Clearly erroneous transactions under UPC

Answer 28

Clearly erroneous = obvious error in any term (price, # shares, or security name).

Refer to table of thresholds in book (exchange listed - 10% price difference for $0-$25, 5% for $25-50, OTC - 10% for $5-75)

In usual circumstances and to maintain a fair and orderly market, FINRA may choose to use alternative reference prices based on certain factors including whether stock was subject to stock split, IPO, halted trading, etc.

Question 29

Procedures for reviewing erroneous transactions

Answer 29

Firm must submit written complaint within 30 minutes of execution (60 min for outlier transaction)

A FINRA officer or Nasdaq official has the authority to declare a transaction null and void, generally within 30 min of notification but in all cases by 3pm next trading day

Question 30

Outlier transaction

Answer 30

Transaction in Nasdaq market where execution price is more than 3 times the current numerical guidelines.

Question 31

Appeal process for erroneous transactions

Answer 31

Can appeal to the Market Operations Review Committee (MORC) or UPC (Uniform Practice Committee). Appeal must be in writing and must be received within 30 min after notification of decision

Exchange listed securities – appeal decision will be made as soon as feasible but generally on the same trading day (if appeal is made after 3pm, next trading day)
OTC securities - as soon as feasible but no later than 2 trading days after execution under review

Question 32

Carrying/clearing agreements

Answer 32

Agreement between introducing firm and carrying/clearing firm

At a minimum, clearing agreement should include:
- Opening and approving accounts
- Acceptance of orders
- Transmission of orders for execution
- Execution of orders
- Extension of credit
- Receipt and delivery of funds and securities
- Preparation and transmission of confirmations
- Maintenance of books and records
- Monitoring of accounts

If clearing firm is responsible for recordkeeping and providing confirmations/statements, introducing firm must provide all info about customer accounts (i.e. fully disclosed). When fully disclosed, carrying firm must take responsibility for safeguarding customer assets.

Question 33

Additional rules on carrying/clearing agreements under UPC

Answer 33

Must submit any new agreements for FINRA for review/approval (for introducing firms, review only)

If fully disclosed basis, each new customer must be notified, in writing at the time the account is opened, of the existence of the clearing agreement

Clearing firm must provide a list of reports to the introducing firm to assist the introducing firm in monitoring its activities/accounts. By July 1 of each year, clearing firm must also notify the introducing firms CEO and CCO in writing of reports offered to, requested by, and supplied to the introducing firm (with a copy of this notice sent to FINRA as well)

If clearing firm receives complaint from customer, must promptly forward to introducing firm and primary SRO, and provide acknowledgment to customer.

Question 34

Expense sharing agreements under UPC

Answer 34

BD must make record of expenses incurred. Also required if third party has agreed to pay expenses. A BD must notify its DEA of any expense sharing agreement if it doesn’t record expenses in the reports that it files with the SEC/DEA.

If a third party agrees to take expenses, any corresponding liability will not be considered a liability of the firm for net capital purposes if:
- Agreed in writing the firm is not liable for expense
- Not a liability under GAAP
- Vendor has agreed in writing that firm isn’t directly or indirectly liable
- No other indication the firm is liable
- BD can demonstrate third party is able to pay

Expense sharing agreements should attempt reasonable allocation of expenses, i.e. one which attempts to equate proportional cost of service to proportional benefit derived

Question 35

Proxy statements

Answer 35

Document issued by SEC issuer when it’s seeking votes from shareholders. When shares are held in street name by a BD, proxies are delivered to BD, which must forward to beneficial owners of securities. Firms are entitled to reimbursement from the issuer for costs of delivering proxies (sliding scale = more accounts, less payment)

Question 36

FINRA financial responsibility rules

Answer 36

Although most financial responsibility rules are set by the SEC, FINRA does have some as well.

Within 6 months of a firm’s registration with the SEC, FINRA must conduct an inspection to determine compliance with rules (can delay to 2nd 6-month period if BD has not begun operations). FINRA also may apply more stringent net capital and early reporting requirements than SEC rules.

Question 37

FINRA required net capital notifications

Answer 37

Firm is required to notify FINRA promptly (within 24 hours) if:
- Net capital <150% of minimum dollar requirement (more stringent than 17a-11)
- AI is >10x net capital (more stringent than 17a-11)
- If using alternative method: net capital <5% of ADI
- Scheduled capital withdrawals in next 6 months will cause any of the above

Doesn’t apply to introducing BDs.

If any of the above apply for 15 consecutive BDs, firm may not expand its business (increase in RRs, new branches, new lines of business, exceeding average commitments in market making, becoming a market maker in a new security, etc)

Question 38

FINRA reduction of business requirements

Answer 38

If a firm has <125% of minimum dollar requirement or AI is >12x net capital for 15 consecutive BDs, firm must reduce its business.

For alternative method, reduction is required if net capital <4% of ADI.

Reduction is also required if scheduled capital withdrawals in next 6 months will cause any of the above

FINRA may disallow expansion or require reduction at its discretion (compliance failures, inability to settle transactions promptly, etc.)

Question 39

Reduction of business for FINRA purposes

Answer 39

Reducing or eliminating parts of the business. May include returning all free credit balances to customers, restricting orders to unsolicited only, delivering all fully paid securities to account holders, decreasing or changing inventory, closing branches, no new accounts, restrict executive salary payments, discontinue unsecured loans, etc.

Question 40

FINRA hearings

Answer 40

Any FINRA requirements/restrictions are effectively immediately, but a timely request for a hearing will delay for 10 BDs.

Question 41

Disclosure of financial condition under FINRA rules

Answer 41

Required to make available on customer request (or written request from other member firm party to an open transaction) a copy of most recent balance sheet.

Question 42

Integrity of F/S under FINRA rules

Answer 42

FINRA can require an audit of F/S if concerns arise over accuracy/integrity of member’s F/S

Question 43

FINRA rules on customers securities and funds

Answer 43

• Firms are prohibited from making improper use of customers’ securities/funds
• Required to have written authorization from customer to loan securities
• Fully paid and excess margin securities belonging to customers must be segregated and must clearly indicate the customer’s interest
• Firms may not guarantee a customer against loss in any transactions effected by the firm
• Firms may not participate in profit/loss in a customer’s account, unless proportional to the amount the firm has contributed to the account (except immediate family members and customers with either net worth of $1m or $500k in account and compensation agreement is in writing)

Question 44

Withdrawal of equity capital under FINRA rules

Answer 44

Equity capital cannot be withdrawn for a period of one year after contribution without FINRA written permission. Withdrawals = deduction from net worth. Members may withdraw profits earned.

Withdrawals are not allowed if it causes net capital to fall below 5% of ADI.

For carrying firms/market makers, withdrawals are prohibited if net capital <120% of minimum or AI:NC > 10:1

If BD has excess NC, required to obtain FINRA written permission to withdraw capital/pay dividend/provide unsecured advance in amount >10% excess net capital.

Question 45

Deficits in introduced accounts – FINRA rules

Answer 45

A clearing agreement may allow introducing firm to take on liability for deficits in accounts. In this situation, deficits must be deducted from net capital of both carrying and introducing BD.

Question 46

Fidelity bonds – FINRA rules

Answer 46

Members required to join SIPC must maintain a blanket fidelity bond who covers officers and employees against loss for fidelity, forgery/alteration, securities loss, counterfeit currency.

Minimum coverage:
If NC < $250k: Greater of 120% of required net capital or $100k.
If NC > $250k: table of required coverage (see book) (minimum of $600k for $250-300k; maximum of $5m for firms whose net capital requirement exceeds $12m)

Must review coverage annually on anniversary date of bond issuance. Amount of coverage is based on highest net capital for preceding 12 months.

For firms in business <1 year and use AI method, may use a ratio of 15:1 to calculate amount of fidelity bond.

Must notify FINRA immediately if any bond is canceled/terminated/substantially modified.

Question 47

Exemptions from fidelity bond requirement

Answer 47

• Any firm that maintains a fidelity bond required by a national securities exchange
• Any firm whose business is solely to act as floor broker, floor trader, or market maker and doesn’t conduct business with the general public

Question 48

FTR/FTD – FINRA rules

Answer 48

Member firms must not sell a security for their own account or purchase a security as broker for customers (except exempt securities) if the member firm has a fail to deliver that’s 60 days or older involving domestic or Canadian securities, and American Depositary Receipts, or a fail to deliver that’s 90 days or older involving foreign securities. May request an exception from FINRA in writing.

Question 49

Fidelity bond maximum permitted deductible

Answer 49

25%

Question 50

Stock power

Answer 50

AKA power of substitution. Allows signature for stock certificate.