United States

FINRA update: Financial and operational rules for broker-dealers

FINANCIAL REPORTING INSIGHTS  | 

In July 2021, FINRA released Regulatory Notice 21-27 announcing updates to the Interpretations of Financial and Operational Rules related to Securities Exchange Act (SEA) Rules 15c3-1, Net Capital Requirements for Brokers or Dealers, and 15c3-3, Customer Protection – Reserves and Custody of Securities. The updates are the result of communications provided by the staff of the SEC’s Division of Trading and Markets to FINRA. Following are highlights of the updates.

Net Capital Requirements for Brokers or Dealers

The following additions were made to the FINRA interpretations related to Rule 15c3-1:

  • Paragraph (c)(1)(i)/02 – “When a broker-dealer has a proprietary trading account carried by another broker-dealer, indebtedness in such account is considered ‘adequately collateralized’ if the broker-dealer’s equity in such account is at least equal to the haircut requirements specified in SEA Rules 15c3-1(c)(2)(vi) and (vii) on the positions in such account. If the proprietary trading account is not adequately collateralized (i.e., the equity in the account is less than the haircuts required on the positions), the excess of the haircut amount over the equity in the account, up to the amount of the indebtedness, shall be included as aggregate indebtedness. The remainder of the indebtedness may be considered adequately collateralized and may be excluded from aggregate indebtedness.” Additionally, the interpretations provide an example scenario illustrating the application of the new interpretation. Effectively, the interpretation will result in broker-dealers with a proprietary trading account with indebtedness in such account, carried by another broker-dealer, to recognize aggregate indebtedness for the portion of the account that is not adequately collateralized subject to the limit of the total indebtedness amount.
  • Paragraph (c)(2)(i)(G)/01 – The interpretation clarifies that a payment (including any reduction or forgiveness of a receivable from the broker-dealer’s parent or affiliate) in connection with a services arrangement with the parent or affiliate of the broker-dealer would not be considered a capital withdrawal for purposes of SEA Rules 15c3-1(c)(2)(i)(G) and 15c3-1(e) if all of the following conditions are met:
    • "at the time the service(s) were provided to the broker-dealer, the services arrangement was in writing and specified such service(s) with a reasonable and consistent basis for determining the cost of each service (e.g., utilizing a percentage of the broker-dealer’s net income to determine the cost to be charged by a parent or affiliate for technology services provided by a parent or affiliate, for example, may not be deemed “a reasonable basis” because the cost of obtaining such services generally does not fluctuate based on the level of a broker-dealer’s net income);
    • the service(s) provided were related to the broker-dealer’s business;
    • the parent or affiliate had the ability to provide such service(s); and
    • the parent or affiliate provided the service(s).”
  • Paragraph (c)(2)(iv)(B)/16 – “Deficits or unsecured balances in securities transactions with a Federal Reserve Bank need not be deducted in computing net capital under SEA Rule 15c3-1(c)(2)(iv)(B).”
  • Paragraph (c)(2)(iv)(C)/095 – The interpretation clarifies that certain unsecured receivables may be the result of revenue accrued in connection with the sale of products or for services where at the same time expenses (and a corresponding payable) have been accrued as a result of selling such products or providing such services. In such situations, the unsecured receivable associated with such revenues does not need to be deducted from net worth under SEA Rule 15c3-1(c)(2)(iv)(C) limited to the amount of the payable balance associated with the expenses incurred in connection with such revenue given the following conditions have been met:

1. “A written contract exists between the broker-dealer and the payee, in which:

a. The broker-dealer’s liability for the amount payable is limited solely to the proceeds of the receivable; and
b. The payee waives payment of the amount payable until the broker-dealer has received payment of the related amount receivable; and

2. If the broker-dealer is subject to the Aggregate Indebtedness Standard of paragraph (a)(1)(i) of SEA Rule 15c3-1,

a. The portion of the payable due within twelve months is included in aggregate indebtedness; and
b. The broker-dealer’s net capital requirement shall be increased by an amount equal to one percent of the portion of the payable that was not included in aggregate indebtedness.”

  • Paragraph (c)(2)(viii)(C)/033 – Generally, contractual securities commitments are subject to the haircut provisions of SEA Rule 15c3-1. The additional interpretation refines the generality to make clear that underwriting commitments in an unregistered offering may be reduced by binding contracts for sale, including bona fide presales. The interpretation defines a bona fide presale and provides an example of what evidence may support a bona fide presale.
  • Paragraph (e)/01 – The interpretation is a reiteration of the interpretation noted above for paragraph (c)(2)(i)(G)/01.

The following table summarizes the interpretations related to Rule 15c3-1 that have been revised, demonstrating the former and new interpretations (with emphasis on the revisions in bold font):

Section Former Language Updated Language What Changed?
Paragraph (a)/01 The net capital requirement is increased by one percent of accrued liabilities that are excluded from aggregate indebtedness under the provisions specified at interpretation 15c3-1(c)(2)(iv)(C)/09. The net capital requirement is increased by one percent of accrued liabilities that are excluded from aggregate indebtedness under the provisions specified in interpretation 15c3-1(c)(2)(iv)(C)/095. As discussed below, interpretation 15c3-1(c)(2)(iv)(C)/09 had been rescinded and the new interpretation associated with paragraph (c)(2)(iv)(C)/095 applies instead.
Paragraph (c)(1)/11 That portion of such accrued liabilities that are payable more than twelve months from the computation date may be excluded from aggregate indebtedness under the provisions specified at interpretation 15c3-1(c)(2)(iv)(C)/09. That portion of such accrued liabilities that are payable more than twelve months from the computation date may be excluded from aggregate indebtedness under the provisions specified at interpretation 15c3-1(c)(2)(iv)(C)/095 As discussed below, interpretation 15c3-1(c)(2)(iv)(C)/09 had been rescinded and the new interpretation associated with paragraph (c)(2)(iv)(C)/095 applies instead.
Paragraph (c)(2)(iv)(C)/091

The staff of the SEC’s Division of Market Regulation has concluded that since individual variable annuity products are registered under the Investment Company Act of 1940 (’40 Act), any concessions receivable therefrom come within the “...mutual fund concessions receivable and management fees receivable from registered investment companies...” language of SEA Rule 15c3-1(c)(2)(iv)(C). Therefore, a broker-dealer may give allowable asset treatment to concessions receivable from the sale of individual variable annuities for 30 days from the date they arise.

 

In contrast, group variable annuities are exempt from registration under the ’40 Act; therefore, concessions receivable from the sale of these products are not allowable assets under SEA Rule 15c3-1(c)(2)(iv)(C). However, the staff of the SEC’s Division of Market Regulation has no objection to member firms considering concessions receivable from the sale of group variable annuities as allowable assets if the member complies with the Concessions or Commissions Receivable and Related Concessions or Commissions Payable, Offset Permitted interpretation.

The staff of the SEC’s Division of Market Regulation has concluded that since individual variable annuity products are registered under the Investment Company Act of 1940 (’40 Act), any concessions receivable therefrom come within the “...mutual fund concessions receivable and management fees receivable from registered investment companies...” language of SEA Rule 15c3-1(c)(2)(iv)(C). Therefore, a broker-dealer may give allowable asset treatment to concessions receivable from the sale of individual variable annuities for 30 days from the date they arise.

 

In contrast, group variable annuities are exempt from registration under the ’40 Act; therefore, concessions receivable from the sale of these products are not allowable assets under SEA Rule 15c3-1(c)(2)(iv)(C). However, the staff of the SEC’s Division of Market Regulation has no objection to member firms considering concessions receivable from the sale of group variable annuities as allowable assets if the member complies with interpretation 15c3-1(c)(2)(iv)(C)/095.

As discussed below, interpretation 15c3-1(c)(2)(iv)(C)/09 had been rescinded and the new interpretation associated with paragraph (c)(2)(iv)(C)/095 applies instead. 
Paragraph (c)(2)(viii)(C)/032

Underwriting commitments may be reduced by confirmed sales. So called "indications of interest" received prior to the effective date of registration will not apply.

 

The Securities Act prohibits the making of a contract for sale until the registration has become effective.

Underwriting commitments in a registered offering may be reduced by binding contracts for sale.

 

So called "indications of interest" received prior to the effectiveness of a registration statement are not binding contracts for sale. The Securities Act prohibits the sale of a security in a registered offering until the registration statement has become effective.

The revision had been made to reemphasis that this interpretation is limited to registered offerings and to refine the conditions under which the underwriting commitments may be reduced. 

FINRA rescinded the interpretation associated with SEA Rule 15c3-1(c)(2)(iv)(C)/09 due to the fact that this interpretation had been expanded beyond commissions or concessions receivables/payables to include all unsecured receivables (and corresponding payable) that are the result of conditions described in SEA Rule 15c3-1(c)(2)(iv)(C)/095, as discussed above.

Customer Protection – Reserves and Custody of Securities

The following additions were made to the FINRA interpretations related to Rule 15c3-3:

  • Paragraph (j)(2)(ii)(B)(3)(i)(C)/01 – The interpretation clarifies that for the purpose of SEA Rule 15c3-3(j)(2)(ii)(B)(3)(i)(C), the language “changing, adding or deleting products available through the Sweep Program” includes changing, adding or deleting a money market mutual fund product or a bank in such Sweep Program, as applicable.
  • Exhibit A – Note E(5)/02 – The interpretation explains that an omnibus account in the context of Note E(5) refers to only such accounts as in compliance with section 7(f) of Regulation T and that an omnibus credit under section 7(f) may only be extended to a broker-dealer registered under section 15 of the Securities Exchange Act of 1934. As such, the exclusion of an omnibus account from the requirements of Note E(5) is not available for accounts established for non-U.S.-registered broker-dealers nor for accounts often referred to as “single consolidated margin accounts” (accounts that include assets of customers of a non-U.S.-registered broker-dealer).
  • Exhibit A – General/012 – This interpretation provides broker-dealers subject to the Alternative Standard of SEA Rule 15c3-1(a)(1)(ii) with the option of using a customer’s net account balance when computing the weekly and month-end reserve under SEA Rule 15c3-3 Exhibit A. The interpretation reemphasizes that if a broker-dealer decides to use a customer’s net account balance, the broker-dealer must consider adjustments that are required in the reserve formula computation and provides guidance as to additional interpretations to be considered.
  • Exhibit A – Item 10/10 – The interpretation establishes that a term debit may only be included in the reserve formula computation to the extent it is secured by securities of the broker-dealer carrying the account, given that such securities may be used without restrictions or limitations to obtain cash or funding while the term debit is outstanding. If however, the term debit is partially secured, the broker-dealer should refer to interpretation Exhibit A – Item 10/012.

The following table summarizes the interpretations related to Rule 15c3-3 that have been revised, demonstrating the former and new interpretations (with emphasis on the revisions in bold font):

Section

Former Language

Updated Language

What Changed?

Paragraph (a)(1)/01

Non-Customer

General partner;

 

Director or principal officer, i.e., president, executive vice president, treasurer, secretary or any person performing a similar function;

 

A broker or dealer (other than omnibus accounts);

 

A non-bank registered municipal securities dealer;

 

A bank municipal securities dealer that either does or does not transact its municipals securities business through a separately identified department or division, and either does or does not register as an undivided entity is a non-customer only with respect to its transactions effected in the capacity of a municipal securities dealer. All other transactions shall be treated as customer transactions;

 

A foreign bank which engages in the business of buying and selling securities for its own account through a broker or otherwise within the meaning of Section 3(a)(5) of the Act (i.e., dealer), provided the foreign bank must not fall within the definition of “bank” set forth in Section 3(a)(6) of the Act (see interpretation 15c3-3(a)(1)/032). If the foreign bank falls within the definition of a bank, it is to be treated as a customer;

 

The other participant(s)’ interest in a joint trading and investment account carried on the books of the reporting broker-dealer and the other participant(s)’ interest in a Joint Foreign and Domestic Arbitrage Account when such other participant(s) is a non-customer;

 

The Federal Reserve Bank in instances where securities are being borrowed from it for the purpose of cleaning up fails; and

 

The proprietary account of a foreign broker-dealer would be treated as a non-customer.

Non-Customer

General partner;

 

Director or principal officer, i.e., president, executive vice president, treasurer, secretary or any person performing a similar function;

 

A broker or dealer (other than omnibus accounts);

 

A non-bank registered municipal securities dealer;

 

A bank municipal securities dealer that either does or does not transact its municipals securities business through a separately identified department or division, and either does or does not register as an undivided entity is a non-customer only with respect to its transactions effected in the capacity of a municipal securities dealer. All other transactions shall be treated as customer transactions;

 

A foreign bank which engages in the business of buying and selling securities for its own account through a broker or otherwise within the meaning of Section 3(a)(5) of the Act (i.e., dealer), provided the foreign bank must not fall within the definition of “bank” set forth in Section 3(a)(6) of the Act (see interpretation 15c3-3(a)(1)/032). If the foreign bank falls within the definition of a bank, it is to be treated as a customer;

 

The other participant(s)’ interest in a joint trading and investment account carried on the books of the reporting broker-dealer and the other participant(s)’ interest in a Joint Foreign and Domestic Arbitrage Account when such other participant(s) is a non-customer;

 

The Federal Reserve Bank; and

 

The proprietary account of a foreign broker-dealer would be treated as a non-customer.

This revision clarifies that the Federal Reserve Bank is in all situations a non-customer for the purpose of Rule 15c3-3.
(Exhibit A - Item 10)/07 Debit balances in customers’ accounts collateralized by restricted securities may only be included in the Reserve Formula computation to the extent they are secured by securities that can be publicly sold. Accounts that are partly secured are treated under interpretation 15c3-3 (Exhibit A - Item 10)/02. Broker-dealers will bear the burden of proof in demonstrating that the restricted securities can be publicly sold. The Exchange may require a legal opinion where the value of such securities is a material amount.

Debit balances in customers’ accounts collateralized by control or restricted securities may only be included in the Reserve Formula computation to the extent they are secured by securities that can be publicly sold. Broker-dealers will bear the burden of proof in demonstrating that the control or restricted securities can be publicly sold. FINRA may require a legal opinion where the value of such securities is a material amount.

 

If an account is partially secured after the application of this interpretation, interpretation 15c3-3 (Exhibit A - Item 10)/012 (Partly Secured Accounts) should be applied to determine the includable amount of the debit balance in the Reserve Formula computation.

The revision to this interpretation expands the collateralization option to include “control” (and therefore the broker-dealer’s associated burden of proof over the controlled securities capacity to be publicly sold) and redirects the broker-dealer to the newly added interpretation in Exhibit A – Item 10/012 (discussed above) when partial securitization applies. Additionally, the revision modifies the party that may require a legal opinion when the value of such securities is material in amount (from the Exchange to FINRA).


FINRA removed the interpretation associated with SEA Rule 15c3-3 (Exhibit A – Item 11)/041 due to the fact that the Federal Reserve Bank is a non-customer in all situations as indicated in the revision discussed above for SEA Rule 15c3-3(a)(1)/01.

RSM CONTRIBUTORS


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