SEC Issues Proposal to Amend Financial Responsibility Rules for Broker-Dealers
On March 9, 2007, the SEC issued a proposal to amend numerous aspects of its financial responsibility rules for broker-dealers, including the following rules under the Securities Exchange Act of 1934: Rule 15c3-1 (the net capital rule), Rule 15c3-3 (the customer protection rule), Rules 17a-3 and 17a-4 (the books and records rules), and Rule 17a-11 (which requires brokerdealers to notify regulators regarding certain aspects of their capital compliance and recordkeeping). A number of the proposals are highly technical and, if adopted, could create operational issues for many broker-dealers. Comments will be due to the SEC 60 days after the proposal is published in the Federal Register, which will likely be sometime during the week of March 12, 2007.
As background, the customer protection rule requires a broker-dealer to take certain steps to protect the cash and securities it holds for customers. Under this rule, a broker-dealer must essentially segregate customer funds and fully paid and excess margin securities held by the firm for the accounts of customers. The customer protection rule is intended to require a broker-dealer to hold customer assets in a manner that enables their prompt return in the event of an insolvency and thereby avoid the need for a proceeding under the Securities Investor Protection Act of 1970 (SIPA). The required amount of customer funds to be segregated in a special reserve bank account is calculated pursuant to a formula set forth in Exhibit A to the customer protection rule.
Under the net capital rule, broker-dealers are required to maintain, at all times, a minimum amount of net capital. The net capital rule generally defines “net capital” as a broker-dealer’s net worth (assets minus liabilities), plus certain subordinated liabilities, less certain assets that are not readily convertible into cash (e.g., fixed assets), and less a percentage (haircut) of certain other liquid assets (e.g., securities). Broker-dealers are required to calculate net worth using generally accepted accounting principles.
You can find a complete summary of the SEC’s proposal at the end of this alert. The notable aspects of the proposal include:
- Proprietary Accounts of Broker-Dealers. Under the proposal, broker-dealers would be required to treat accounts they carry for domestic and foreign broker-dealers in the same manner generally as “customer” accounts for the purposes of the customer protection rule. This aspect of the proposal would effectively codify a 1998 no-action letter regarding proprietary accounts of introducing brokers, known as the “PAIB Letter.”
- Use of Banks for Cash Deposits. Under the proposal, broker-dealers would be required to exclude cash deposits at affiliate banks for the purposes of meeting the reserve requirements under the customer protection rule. In addition, the proposal would limit the amount of cash a broker-dealer could maintain in a special reserve bank account at one unaffiliated bank.
- Treatment of Free Credit Balances. Under the proposal, broker-dealers would be limited in their investments of free credit balances for customers to (1) investments and other transfers specifically directed by the customer and (2) free credit balance sweeps to money market funds and bank deposit accounts where certain notice and disclosure requirements are met.
- Futures Positions Held in Portfolio Margin Accounts. Under the proposal, the customer protection rule would be amended to provide the protections of Rule 15c3-3, as well as SIPC coverage, to future positions held in a portfolio margin account authorized by SRO Rules.
- Documentation of Risk Management Procedures. Under the proposal, large broker-dealers (measured by total credit items under the customer protection rule or by total capital under the net capital rule) would be required to document their implemented systems of internal risk management control.
- Capital Charges for Expenses Assumed by Third Parties and Short-Term Capital Contributions. Under the proposals, broker-dealers would be required to take a capital charge for (1) liabilities assumed by a third party where the broker-dealer cannot demonstrate that the third party has resources independent of the broker-dealer’s
income and assets to pay the liabilities, and (2) any capital that is contributed under an agreement giving the investor the option to withdraw it or that is intended to be withdrawn within a year. - Broker-Dealer Solvency. Under the proposal, broker-dealers would have to cease their securities business activities if they become insolvent or subject to any type of insolvency proceeding and would be required to notify regulators of the insolvency.
Securities Industry FYI is a service of the Broker-Dealer Practice of Morgan Lewis. If you have any questions concerning these important legal developments, please contact any of the following Morgan Lewis attorneys:
Robert C. Mendelson
Morgan, Lewis & Bockius LLP
101 Park Avenue
New York, NY 10178
Telephone: 212.309.6303
Fax: 212.309.6001
rmendelson@morganlewis.com
Mark D. Fitterman
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Ave, NW
Washington, D.C. 20004
Telephone: 202.739.5019
Fax: 202.739.3001
mfitterman@morganlewis.com
Theodore R. Lazo
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Ave, NW
Washington, D.C. 20004
Telephone: 202.739.5250
Fax: 202.739.3001
tlazo@morganlewis.com