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SEC Amends Financial Responsibility Rules For Broker-Dealers

The SEC has issued a series of amendments to its financial responsibility rules for broker-dealers, primarily the Customer Protection Rule (15c3-3) and the Net Capital Rule (15c3-1).  Many of these amendments were first proposed in 2007 and have been exposed to extensive public comment.  Some of the changes simply codify interpretations that have been in force for years. They will become effective on October 21, 2013.

Customer Protection Rule (15c3-3): 

Proprietary Accounts of Broker-Dealers (PAB) (formerly known as Proprietary Accounts of Introducing Brokers (PAIB)):

  • 15c-3-3 has been amended to require that carrying broker-dealers:
    • Perform a separate reserve computation for PAB accounts on a weekly basis.
    • Establish a separate reserve account for the benefit of PAB account holders and maintain cash and qualified securities in the account sufficient to cover the calculated reserve requirement.
    • Obtain and maintain physical possession or control of PAB non-margin securities unless:
      • the carrying firm has provided written notice to the PAB account holder that it will use the non-margin securities in the ordinary course of its securities business and 
      • The PAB account holder has had an opportunity to object to such use.
  • Foreign broker-dealers, and foreign banks acting as broker-dealers, are included in the definition of PAB. This is a change from the original PAIB letter issued by the SEC in 1998.
  • Guaranteed subsidiaries, guarantors of the carrying firm, accounts subordinated to the claims of general creditors of the carrying firm, and DVP/RVP accounts are excluded from the definition.
  • The rule specifies when withdrawals can be made from the PAB account, and permits the carrying broker-dealer to utilize PAB credits to finance regular 15c3-3 customer debits.
  • Written agreement by the carrying firm to include the other broker-dealers’ accounts in the PAIB reserve computation is no longer required 

Deposits to Satisfy 15c3-3 Deposit Requirements: 

  • The rule continues to prohibit the use of an affiliated bank for cash deposits to satisfy reserve requirements, but does permit the deposit of qualified securities with an affiliated bank. 
  • The rule requires that cash deposited with an unaffiliated bank not exceed 15% of that bank’s equity capital. 

Possession or Control:  

  • The amendments require that a carrying broker-dealer take prompt steps to reduce to possession or control customers’ fully paid or excess margin securities that allocate to a proprietary short position for more than 30 calendar days.   This replaces the former rule which prescribed that the broker-dealer include the market value of the position as a credit in the 15c3-3 formula.

Sweeps: 

  • The amendments include numerous notification provisions that must be complied with before a broker-dealer can sweep a customer’s cash to another institution or change the products available in a sweep program or the customer’s investment from one product to another.

Net Capital Rule (15c3-1): 

Broker-Dealer Accounts Maintained at Another Broker-Dealer (PAB):  

  • Because of the changes to rule 15c3-3 described above, a broker-dealer that maintains an account at a carrying broker-dealer does not need to take a charge for cash or securities held in that account so long as the account is not subordinated to the claims of general creditors of the carrying firm.

Securities Lending/Borrowing
Repurchase/Reverse Repurchase Transactions:
 

The net capital rule has historically prescribed charges against net capital for securities lending or borrowing positions and repurchase or reverse repurchase positions under certain conditions where the broker-dealer has acted as a principal to the transaction.  It is not always clear as to whether the broker-dealer is acting as a principal, and therefore subject to the charges, or is acting as agent and thus exempt from the charges.  In addition, the SEC is concerned about broker-dealers that rapidly expand their balance sheets with securities lending or repurchase transactions, and therefore greatly increase the risk to themselves and to their counterparties.

  • Under the amendments, broker-dealers providing “securities lending and borrowing settlement services” are assumed to be acting as principal and subject to the charges appropriate for these activities.
  • However, the broker-dealer can avoid the charges by:
    • fully disclosing to each party the identity of the other party to the transaction.
    • each party expressly agreeing in writing that the broker-dealer is not a guarantor to the transactions.
    • each party acknowledging that in the event of default by a counterparty, the remedies do not include a right of set off against the broker-dealer.

Requirement to Deduct from Net Worth Certain Liabilities or Expenses Assumed by Third Parties:  

  • The Amendments codify parts of the “Third Party Expense Letter” (from the SEC to the NYSE and NASD, 2003).  Under the Amendments, the broker-dealer must take a net capital charge for any liabilities assumed by a third party unless it can demonstrate that the third party has the resources, independent of the broker-dealer, to satisfy the liability.
  • The other provisions of the Third Party Expense Letter remain in effect.

Requirement to Subtract from Net Worth Certain Non-Permanent Capital Contributions:  

  • Consistent with the SEC’s longstanding position on the permanence of capital, the Amendments codify the provisions of the “Temporary Capital Letter” (from the SEC to the NYSE and the NASD, 2000).  The Amendments mandate that: 
    • The broker-dealer treat as a liability any capital that is contributed under an agreement that gives the investor the option to withdraw it.
    • The broker-dealer should also treat as a liability any capital contribution that is intended to be withdrawn within one year of the date of its contribution.
    • If capital is withdrawn without permission from the broker-dealer’s Designated Examining Authority (DEA) within one year of contribution, it will be treated as having been “intended to be withdrawn” at the time of contribution, and therefore would not have been considered as capital at any time.  (This would cause prior regulatory filings to need to be amended.)

Solvency Requirement:  

  • The Amendment requires that a broker-dealer cease conducting a securities business if the broker-dealer is deemed to be “insolvent,” as defined.  Insolvency would include:
    • Being placed in voluntary or involuntary bankruptcy.
    • The appointment of a trustee, receiver, or similar person. 
    • A general assignment for the benefit of creditors.
    • An admission of insolvency.
    • The inability to make computations necessary to establish compliance with the net capital rule.

Restrictions on Capital Withdrawals:

Prior to the Amendments, the net capital rule contained a provision that permitted the Commission to restrict withdrawals of capital from a broker-dealer to the extent that the total of such withdrawals, loans and advances over a 30-calendar-day period would exceed 30% of the firm’s excess net capital. 

  • The Amendments eliminate the 30% threshold, and provide that the Commission can restrict withdrawals of capital from a broker-dealer “under such terms and conditions as the Commission deems necessary or appropriate in the public interest or consistent with the protection of investors.”

Notification Provisions (Rule 17a-11):

Securities Lending/Borrowing
Repurchase/Reverse Repurchase transactions:
 
 

  • A broker-dealer must now notify the Commission whenever the total of securities lending and repurchase agreement contracts, or the total of all securities borrowed and reverse-repurchase agreement contacts, exceed 2500% of the  broker-dealers tentative net capital.  For purposes of this calculation, contracts in government securities are disregarded.    The notice can be waived if the broker-dealer reports its activities in this regard to its DEA in a form acceptable to the DEA.

Solvency Requirement: 

  • Rule 17a-11 has been amended to require that a broker-dealer that meets the definition of being insolvent must notify the Commission, the firm’s DEA, and, if applicable, the CFTC.

Books and Records (Rule 17a-3): 

Risk Management Procedures: 

The Amendments do not require any new risk management procedures.  Rather, they add a requirement that broker-dealers that have more than $1 million in aggregate credit items in their 15c3-3 formula calculation or have more than $20 million in capital, including subordinated debt, “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.”

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