SEC gives broker-dealers violating the customer protection rule six months to come into compliance - 29 October 2020

No-action letter draws criticism from Commissioners Lee and Crenshaw who believe the six-month grace period presents an unacceptable risk to investors.

In an unusual move, Commissioners Allison Herren Lee and Caroline Crenshaw have issued a statement in opposition to a no-action position taken by the staff of the SEC’s Division of Trading and Markets. The no-action relief addresses programs through which broker-dealers borrow fully paid and excess margin securities from their customers (FPL programs), some of which do not comply with the requirements of 1934 Act Rule 15c3-3. The staff agreed to give brokers until April 22, 2021 to adjust or wind down the non-compliant FPL programs.

Lee and Crenshaw said that the clear violations of the customer protection rule should not be allowed to continue for another six months. In their view, violations such as the ones in question that put investor funds directly at risk should be remediated without delay.

Staff’s position. In its letter to the Financial Industry Regulatory Authority, the staff acknowledged that some of the FPL programs do not comply with the requirements of the broker-dealer customer protection rule. The rule requires a broker-dealer borrowing fully paid or excess margin securities from a customer to enter into a written agreement with the customer that, among other things, specifies that the broker-dealer must undertake to:

  • provide the lender collateral that fully secures the loan consisting of cash, U.S. Treasury bills or notes, an irrevocable letter of credit issued by a bank, or such other collateral as the Commission designates as permissible;
  • mark the loan to market not less than daily and provide additional collateral as necessary to fully collateralize the loan, and
  • notify the lender that the provisions of the Securities Investor Protection Act may not protect the lender and that, therefore, the collateral delivered to the lender may constitute the only source of satisfaction of the broker-dealer’s obligation to return the securities.

In the adopting release, the Commission stated that the rule will "compel the firm to turn over the collateral physically to the lender." FINRA informed the staff that some broker-dealers operating FPL programs have not turned over the collateral physically to the lender and therefore retain control over the collateral that is used to secure their borrowings of fully paid and excess margin securities.

In some instances, the collateral may be deposited into the lender’s securities account at the broker-dealer or an omnibus account at a bank in the name of the broker-dealer. During the term of the loan, the collateral must be accessed through the broker-dealer and the broker-dealer has the operational ability to transfer or liquidate the collateral. The written agreement underlying the program gives the broker-dealer control over the collateral.

Staff conditions. The staff advised FINRA that it will not recommend Commission action in accordance with the requirement in Rule 15c3-3(b)(3) that a broker-dealer provide collateral that fully secures the loan, provided the broker-dealer is operating a FPL program that was in existence prior to the date of the staff’s letter. The staff believes that it is appropriate to provide a limited amount of time for broker-dealers to come into compliance with Rule 15c3-3 to allow them to adjust or wind down the programs in an orderly manner.

The staff’s position is subject to the further condition that the broker-dealer operating the FPL program must remain in compliance with all other aspects of Rule 15c3-3(b)(3). In addition, the broker-dealer must come into compliance with paragraph (b)(3) of Rule 15c3-3 as soon as practicable but no later than April 22, 2021.

Commissioner opposition. In their statement in opposition to the no-action position, Lee and Crenshaw stated that no-action relief is not the appropriate method to be used in this situation. No-action relief is a mechanism that allows registrants to obtain certain assurances when their conduct may touch upon a gray area of regulation, they noted, or even may be technically proscribed, but does not raise the policy concerns underlying a particular rule.

They added that no-action letters are designed to provide comfort to market participants in continuing a particular course of conduct where clarity is lacking, or participants face potentially conflicting requirements. No-action advice should not be used to provide a grace period for compliance with clear violations of the law, they said.

Lee and Crenshaw emphasized that it not a close call whether some broker-dealers’ actions under the FPL programs violate Rule 15c3-3. Rather than transferring actual physical possession of collateral to customers, they noted, some broker-dealers are depositing the required collateral into accounts at the broker-dealer or in omnibus accounts at a bank in the name of the broker-dealer. The rule requires that the broker or dealer turn over the collateral which fully secures the loan of securities to the lender, they said.

Lee and Crenshaw acknowledged the depth of experience and expertise of the staff, but stated that this matter is not about declining to defer to the judgment of the staff because there is no question regarding the violation of the rule. The question at issue is whether an extended, across-the-board grace period for the named violations should be granted, they noted, and that decision falls within the discretion of the full Commission.

Enforcement action is not the only, or even the best, option in this instance, Lee and Crenshaw stated. Instead, it may be appropriate to decline to take action against those who promptly and in good faith remediate, they concluded.

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