United States

Financial responsibility rules for broker-dealers


The Securities and Exchange Commission (SEC) is amending rules for broker-dealers regarding customer protection, net capital, books and records, and notification requirements. The SEC release stated that these amendments to the broker-dealer financial responsibility rules are designed to better protect a broker-dealer’s customers, and enhance the SEC’s ability to monitor and prevent unsound business practices. The rule amendments were approved by a unanimous Commission vote.

There are no real surprises in these amendments. Effectively, they finalize rules which were proposed in 2007, as well as codifying interpretations and industry practices that were not previously included in the SEC rules.

Customer protection rules

PAB accounts (proprietary securities and cash of other broker-dealers)

The amendments formally define a PAB account as “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 account or a receipt-versus-payment account.” This definition of PAB account does not include accounts that have been subordinated to the claims of creditors of a carrying broker-dealer.

As adopted, the SEC’s amendments to Rules 15c3-3 and 15c3-3a require carrying broker-dealers to:

  • Perform a separate reserve computation for PAB accounts (in addition to the customer reserve computation currently required for Rule 15c3-3 customer accounts)
  • Establish and fund a separate reserve account for the benefit of PAB account holders
  • Obtain and maintain physical possession or control of nonmargin 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

Accordingly, this final rule eliminates the need for a PAIB letter between broker-dealers. In addition, a broker-dealer does not need to deduct 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.

It is important to note that the carrying broker-dealer that uses PAB securities will need to include the market value of those securities as a credit in the reserve formula. In addition, carrying broker-dealers are advised to provide written notice to the PAB account holder that it plans on using securities in the normal course of its securities business. Otherwise, such securities are subject to physical possession or control provisions.

A carrying broker-dealer with PAB accounts must notify its bank about the status of the PAB reserve account, and obtain an agreement and notification from the bank that the PAB reserve account will be maintained for the benefit of the PAB account holders. A carrying broker-dealer that has properly established a PAB reserve account in the manner described in Item 4 of the PAIB letter need not re-title the account and obtain a new notification from the bank.

The revised rule allows a carrying broker-dealer to use credits related to PAB accounts to finance Rule 15c3-3 customer debits, but does not allow a carrying broker-dealer to use Rule 15c3-3 customer credits to finance PAB debits.

So as to not increase the net capital requirements of carrying broker-dealers, the requirements in SEC Rules 15c3-1, 15c3- 1d and 17a-11 that refer to aggregate debit items continue to be based only on aggregate debit items computed in accordance with the customer reserve computation. They do not include aggregate debit items computed in accordance with the PAB reserve computation.

Banks where special reserve deposits may be held

Cash deposited with an affiliated bank, or cash deposited with an unaffiliated bank to the extent that the amount of the deposit exceeds 15 percent of the bank’s equity capital, as reported by the bank in its most recent regulatory financial filings, must be excluded from the reserve formula.

Allocation of customers’ fully paid and excess margin securities to short positions

Broker-dealers must promptly obtain physical possession or control over securities of the same issue and class as those included on the broker’s or dealer’s books or records that allocate to a short position of the broker or dealer, or a short position for another person for more than 30 calendar days. This new rule extended the time frame from 10 to 30 business days, and set the aging process to start when the control deficit arises, not when the short position is established.

Free credit balances

The SEC has deleted Rule 15c3-2, and added revised rules to Rule 15c3-3 (j). These rules prohibit broker-dealers from converting, investing or transferring customer credit balances to another account or institution, except as follows:

  • For activities not involving a sweep program, 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. These instructions can allow for repetitive transactions.
  • For activities involving a sweep program (defined as a service provided by a broker or dealer where it offers to its customers the option to automatically transfer free credit balances in the securities account of the customer to either an approved money market mutual fund product or an account at a bank whose deposits are insured by the Federal Deposit Insurance Corporation):
    • For an account opened on or after the effective date of the rule, the customer must give prior written affirmative consent to having free credit balances in the customer’s securities account included in the Sweep Program after being notified: (1) of the general terms and conditions of the products available through the sweep program; and (2) that the broker or dealer may change the products available under the sweep program.
    • For all new or existing accounts, the following three conditions apply:
      • The broker-dealer provides the customer with the disclosures and notices regarding the sweep program required by each SRO of which the broker-dealer is a member
      • The broker-dealer provides notice to the customer, as part of the customer’s quarterly statement of account, that the balance in the bank deposit account or shares of the money market mutual fund in which the customer has a beneficial interest, can be liquidated on the customer’s order, and the proceeds returned to the securities account or remitted to the customer
      • The broker-dealer provides the customer with written notice at least 30 calendar days before: (1) making changes to the terms and conditions of the sweep program; (2) making changes to the terms and conditions of a product currently available through the sweep program; (3) changing, adding or deleting products available through the sweep program; or (4) changing the customer’s investment through the sweep program from one product to another; and the notice describes 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 or product.

A broker or dealer is permitted 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 a sweep program.

Proprietary accounts (as defined by the regulations under the Commodity Exchange Act) are not to be included as free credit balances in the customer reserve formula.

Holding futures positions in a securities portfolio margin account

Often, there are futures positions in a securities account that is margined on a portfolio basis. The SEC has expanded the terms “free credit balances” and “other credit balances” to include “funds carried in a securities account pursuant to a self-regulatory organization portfolio margin rule approved by the Commission . . . including variation margin or initial margin, marks to market, and proceeds resulting from margin paid or released in connection with closing out, settling or exercising futures contracts and options thereon.”

To offset the impact of this change on the customer reserve formula, the SEC now permits a broker-dealer to include as a debit item the amount of customer margin required and on deposit at a derivatives clearing organization related to futures positions carried in a portfolio margin account.

Securities lending, borrowing and repurchase/reverse repurchase transactions

Broker-dealers providing securities lending and borrowing settlement services are deemed, for purposes of the rule, to be acting as principal, and are subject to applicable capital deductions as follows:

  • For a loan, the amount that the market value of a securities loan exceeds the value of collateral obtained
  • For repurchase transactions, the amount that the market value of the securities is less than the resale price
  • For reverse repurchase transactions, the amount of the market value of the securities is greater than the repurchase price, to the extent the excess is greater than certain percentages

The capital charges noted above can be avoided if a broker-dealer takes certain steps to disclaim principal liability. In particular, the final rule provides that:

“a broker or dealer that participates in a loan of securities by one party to another party will be deemed a principal for the purpose of the deductions required under this section, [i.e., deductions from net worth] unless the broker or dealer has fully disclosed the identity of each party to the other and each party has expressly agreed in writing that the obligations of the broker or dealer do not include a guarantee of performance by the other party and that such party’s remedies in the event of a default by the other party do not include a right of setoff against obligations, if any, of the broker or dealer.”

The SEC is also adding new paragraph (c)(5) to Rule 17a-11 to help identify broker-dealers with highly leveraged non-government securities lending and borrowing and repurchase operations. This new provision requires a broker-dealer to notify the SEC whenever the total amount of money payable against all securities loaned or subject to a repurchase agreement, or the total contract value of all securities borrowed or subject to a reverse repurchase agreement, exceeds 2,500 percent of tentative net capital; provided that, for purposes of this leverage threshold, transactions involving government securities, as defined in section 3(a)(42) of the Exchange Act, are excluded. The amendment is designed to alert regulators to a sudden increase in a broker-dealer’s stock loan and repo positions, which could indicate that the broker-dealer is taking on new risk that it may have limited experience in managing. This notification requirement can be satisfied through the filing of monthly FOCUS report with the appropriate designated examining authority.

Documentation of risk management procedures

Broker-dealers are now required to make and keep current a record documenting the credit, market and liquidity risk management controls established and maintained by the broker-dealer to assist it in analyzing and managing the risks associated with its business activities. This documentation requirement applies only to broker-dealers that have more than:

  • $1 million in aggregate credit items as computed under the customer reserve formula of Rule 15c3-3, or
  • $20 million in capital, including debt subordinated in accordance with Appendix D to Rule 15c3-1.

The SEC is not requiring that such procedures be changed, just adequately documented.

Amendments to the net capital rule

Requirement to deduct from net worth certain liabilities or expenses assumed by third parties

An expense of the broker-dealer assumed by a third party will be considered a liability for net capital purposes, unless the broker-dealer can demonstrate that the third party has adequate resources independent of the broker-dealer to pay the liability or expense.

The SEC is concerned that holding companies or affiliates may not have the financial resources, other than those of the broker-dealers to assume those liabilities.

Broker-dealers can continue to rely on the guidance in the Third Party Expense Letter.

Requirement to subtract from net worth certain non permanent capital contributions

The SEC has emphasized that capital contributions should not be temporary or subject to withdrawal at the option of the investor. Accordingly, the final rule requires a broker-dealer to subtract from net worth any contribution of capital to the broker or dealer that is:

  • Under an agreement that provides the investor with the option to withdraw the capital, or
  • Intended to be withdrawn within a period of one year of contribution.

Any withdrawal of capital made within one year of its contribution is deemed to have been intended to be withdrawn within a period of one year, unless the withdrawal has been approved in writing by the Examining Authority for the broker or dealer.

Fidelity bond capital charge

The SEC essentially adopted a long-standing Self Regulatory Organization (SRO) fidelity bond rule that now requires a deduction from net capital equal to the amount specified by rule of the examining authority for the broker-dealer, with respect to a requirement to maintain fidelity bond coverage. Most SROs' rules require a deduction equal to the amount the deductible exceeds certain amounts. For example, FINRA Rule 4360 provides for an allowable deductible amount of up to 25 percent of the fidelity bond coverage purchased by a broker-dealer. Any deductible amount greater than 10 percent of the coverage must be deducted from net capital.

Broker-dealer solvency requirement

The SEC amended rules requiring a broker-dealer to cease conducting a securities business if certain insolvency events occur. The significant change expands the definition of such insolvency events to include the inability to make computations necessary to establish compliance with financial responsibility (including Rules 15c3-1 and 15c3-3) or hypothecation rules.

Adjusted net capital requirements

The SEC made permanent a temporary amendment in 1997 allowing the use of theoretical option pricing models to calculate haircuts for listed options and related positions that hedge those options.

The SEC tightened the definition of a money market fund as a fund described under Rule 2a-7 of the Investment Company Act of 1940.

The SEC amended the definition of fully paid securities to “all securities carried for the account of a customer in a cash account as defined in Regulation T, as well as securities carried for the account of a customer in a margin account …and all margin equity securities in such account if they are fully paid.”

Items that have been deferred

Whether it is because of recent market conditions or a lack of urgency as assessed by the SEC, the following proposed rule amendments have been deferred:

  • Reducing the early warning level for broker-dealers that carry over $10 billion in debits
  • Harmonizing net capital deductions for securities borrow/loan transactions and repurchase/reverse repurchase transactions
  • Accounting for third-party liens on customer securities
  • Consideration as to whether swap accounts which are under the customer protection rules of the Commodity Exchange Act should be explicitly excluded from 15c3-3 considerations (similar to proprietary trading accounts of FCMs)
  • Expanding the definition of qualified securities to include shares of an unaffiliated money market fund
  • Potentially reducing the haircut that broker-dealers apply for money market funds from 2 percent to 1 percent.

Potentially eliminating the reductions to aggregate debit items in the customer reserve formula


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Paul Nockels
Brokerage and Trading Practice Leader