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14-05 SEC Approves Consolidated FINRA Rules 4314 (Securities Loans and Borrowings), 4330 (Customer Protection — Permissible Use of Customers' Securities) and 4340 (Callable Securities); Effective Date: May 1, 2014 *
* Deadline for Notification to FINRA of Existing Programs under Rule 4330.06: May 30, 2014
Effective Date for FINRA Rule 4330(b)(2)(B): October 28, 2014
Partial Redemption of Securities
Securities Lending and Borrowing
Referenced Rules & Notices
FINRA Rule 2111(b)
FINRA Rule 4314
FINRA Rule 4330
FINRA Rule 4340
NASD Rule 2330
NYSE Rule 296 and its interpretations
NYSE Rule 402
NYSE Rule 402.30
SEA Rule 15c3-3
SEA Rule 17a-3
SEA Rule 17a-4
The SEC approved FINRA's proposed rule change to adopt additional financial and operational rules for the consolidated FINRA Rulebook (the Consolidated Rulebook). FINRA Rules 4314, 4330 and 4340 are new consolidated rules governing securities loans and borrowings, permissible use of customers' securities and callable securities. The new rules are based in part on, and replace, provisions of the NYSE and NASD rules and include new provisions.
The text of the new rules is available at www.finra.org/notices/14-05.
Questions regarding this Notice should be directed to:
Background & Discussion
FINRA Rule 4314 (Securities Loans and Borrowings)
FINRA Rule 4314, based on NYSE Rule 296, sets forth the obligations of a firm that engages in lending and borrowing securities and establishes consistent disclosure and record keeping requirements relating to a firm's securities lending activities. The rule, among other things, requires a firm that acts as agent in a loan or borrow transaction to disclose its capacity. In cases where the firm lends securities to or borrows securities from a counterparty that is acting in an agency capacity, the firm must maintain books and records to reflect the details of the transaction with the agent and each principal(s) on whose behalf the agent is acting.
Specifically, Rule 4314(a) requires a firm that lends or borrows securities in the capacity of agent to disclose its capacity to the other party to the transaction, and prior to lending securities to or borrowing securities from a person that is not a FINRA member firm, to determine whether the other party is acting as principal or agent in the transaction. When the other party (which may or may not be a member firm) is acting as agent in the transaction, the member firm is required to maintain books and records that reflect: (1) the details of the transaction with the agent; and (2) each principal(s) on whose behalf the agent is acting and the details of each transaction therewith.
Supplementary Material .02 allows a firm to satisfy its disclosure obligation under Rule 4314(a) by, among other things, providing specific disclosure of its capacity as agent in the written agreement between the parties or in the individual confirmations of each loan and borrow transaction. Supplementary Material .03 clarifies the books and records requirements imposed by Rule 4314(a) and requires firms to create and maintain records for each security loan or borrow transaction in accordance with Securities Exchange Act (SEA) Rules 17a-3 and 17a-4. It further provides that when a firm enters into a security loan or borrow transaction with a party that is acting as agent on behalf of another principal(s), the firm must maintain a record of the transaction with the agent, including identifying the specific security and quantity loaned or borrowed, the contract value and the type and description of the security collateral provided to the agent, and the identity of each underlying principal and the amount and description of the collateral allocated to each such principal.
Rule 4314(b), based on NYSE Rule 296(a), continues to provide each firm that is a party to an agreement with another firm for the loan and borrowing of securities with the right to liquidate the transaction whenever the other party becomes subject to one of the liquidation conditions specified in the rule. Rule 4314(c) requires all firms that lend or borrow any security to or from any person that is not a FINRA member firm, including any customer, to have a written agreement, which may consist of the exchange of contract confirmations, that confers upon the member firm the contractual right to liquidate such transaction because of a liquidation condition of the kind specified in Rule 4314(b).
Supplementary Material .04 reminds firms of their obligations under Rule 4330(b) to provide written disclosures to customers regarding the risks and financial impact associated with the customer's loan(s) of securities, and requires that firms disclose in the written notice their right to liquidate the borrow transactions with customers under the conditions specified in Rule 4314(b). In addition, Supplementary Material .05 requires, for purposes of Rule 4314(c), that each firm that is subject to the provisions of SEA Rule 15c3-3 and that borrows fully paid or excess margin securities from a customer comply with the provisions of SEA Rule 15c3-3 relating to the requirements for a written agreement between the borrowing firm and the lending customer.
Rule 4330 (Customer Protection — Permissible Use of Customers' Securities)FINRA Rule 4330, based on NYSE Rule 402 and NASD Rule 2330, sets forth requirements applicable to a firm's use of customers' securities.
FINRA Rule 4330(a) requires a firm to obtain a customer's written authorization prior to lending securities that are held on margin for a customer and that are eligible to be pledged or loaned. Supplementary Material .02 permits a firm to use a single customer account agreement/margin agreement/loan consent signed by the customer as written authorization under Rule 4330(a), provided such customer account agreement/margin agreement/loan consent includes clear and prominent disclosure that the firm may lend either to itself or others any securities held by the customer in its margin account.
Rule 4330(b) establishes new requirements to address the borrowing and lending of customers' fully paid or excess margin securities. Specifically, Rule 4330(b)(1) requires a firm that borrows fully paid or excess margin securities carried for the account of any customer to:
The notifications required under Rule 4330(b) for new programs and Supplementary Material .06 for pre-existing programs must be provided by a firm to its Regulatory Coordinator in writing, either in hard copy or electronically. The written notification must include the following:
FINRA Rule 4330(b)(2) requires a firm to make an appropriateness determination prior to first entering into a securities borrow with a customer and to provide specified written disclosures to customers with respect to the customer's securities loan transactions. Rule 4330(b)(2)(A) requires a firm to have reasonable grounds for believing that the customer's loan(s) of securities are appropriate for the customer. In making this determination, the firm must exercise reasonable diligence to ascertain the essential facts relative to the customer, including, but not limited to:
Supplementary Material .05 (Appropriateness Determination for Institutional Customers) provides that a firm may fulfill the obligation set forth in Rule 4330(b)(2)(A) for an institutional account, as defined in Rule 4512(c), by complying with the requirements of Rule 2111(b). FINRA reminds firms that they also are required to comply with FINRA Rule 2111 (Suitability) when recommending a securities lending program, individual transactions within such program, or an investment strategy that includes a securities lending program to a customer.4
Rule 4330(b)(2)(B) further requires a firm to provide the customer with disclosures regarding the customer's rights with respect to the loaned securities, and the risks and financial impact associated with the customer's loan(s) of securities. These disclosures include, but are not limited to:
Rule 4340 (Callable Securities)
FINRA Rule 4340, based in part on NYSE Rule 402.30 (Securities Callable in Part), requires a firm that has in its possession or control bonds or preferred stocks that are callable in part, whether specifically set aside or otherwise, to identify such securities and establish an impartial lottery system by which it will allocate among its customers the securities to be redeemed or selected as called in the event of a partial redemption or call. The rule applies to any security that by its terms may be called or redeemed prior to maturity.
The rule allows a firm to establish and make available on its website procedures by which it will allocate among its customers, on a fair and impartial basis, the securities to be redeemed or selected as called in the event of a partial redemption or call. In addition, the rule requires the firm to provide written notice (which may be electronic) to new customers at the opening of an account, and to all customers at least once every calendar year, of the manner in which they may access the allocation procedures on the firm's website and that, upon a customer's request, the firm will provide hard copies of the allocation procedures to the customer.
In addition, Rule 4340(b) and (c) set forth allocation restrictions firms must follow in the event of a favorable or unfavorable redemption of callable securities. Where a redemption of callable securities is made on terms favorable to the called parties, a firm must not allocate the securities to any account in which it or its associated persons have an interest until all other customers' positions in such securities have been satisfied.5 Similarly, where the redemption of callable securities is made on terms unfavorable to the called parties, the rule provides that a firm cannot exclude its positions or those of its associated persons, including the accounts of clerical and ministerial associated persons, from the pool of securities eligible to be called.
Supplementary Material .02 (Allocations of Partial Redemptions or Calls) provides that a firm's allocation procedures may include the use of an impartial lottery system, acting on a pro-rata basis, or such other means as will achieve a fair and impartial allocation of the partially redeemed or called securities. Supplementary Material .03 (Accounts of an Introducing Member and its Associated Persons) provides that where an introducing firm is a party to a carrying agreement with another firm that is conducting an allocation pursuant to the rule, any accounts in which the introducing firm or its associated persons have an interest shall be subject to the provisions regarding participation in favorable and unfavorable calls or redemptions. In addition, the introducing firm must identify such accounts to the firm conducting the allocation.
1 See Securities Exchange Act Release No. 70958 (November 27, 2013) (Order Approving Proposed Rule Change; File No. SR-FINRA-2013-035); 78 FR 72951 (December 4, 2013).
2 The current FINRA rulebook consists of (1) FINRA Rules; (2) NASD Rules; and (3) rules incorporated from NYSE (Incorporated NYSE Rules) (together, the NASD Rules and Incorporated NYSE Rules are referred to as the "Transitional Rulebook"). While the NASD Rules generally apply to all FINRA members, the Incorporated NYSE Rules apply only to those members of FINRA that are also members of the NYSE (Dual Members). The FINRA Rules apply to all FINRA members, unless such rules have a more limited application by their terms. For more information about the rulebook consolidation process, see Information Notice March 12, 2008 (Rulebook Consolidation Process).
3 Effective May 1, 2014, NASD Rule 2330, NASD IM-2330, Incorporated NYSE Rule 296, including Supplementary Material .10 and .20, Incorporated NYSE Rule 402, including Supplementary Material .30, and NYSE Rule Interpretations 296(b)/01 and 402(b)/01 will be eliminated from the Transitional Rulebook.
4 FINRA previously has provided guiding principles that firms and registered representatives could consider when determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. See, e.g., Regulatory Notice 12-25 (discussing the term "recommendation" and citing various resources that explain the guiding principles that firms could use when analyzing whether a communication constitutes a recommendation); Regulatory Notice 11-02 (discussing FINRA's guiding principles); Regulatory Notice 10-06, at Endnotes 3-4 (providing guidance on recommendations made on blogs and social networking websites); Notice to Members 01-23 (announcing the guiding principles and providing examples of communications that likely do and do not constitute recommendations); Michael F. Siegel, Exchange Act Rel. No. 58737, 2008 SEC LEXIS 2459, at *21-27 (Oct. 6, 2008) (applying the guiding principles to the facts of the case to find a recommendation), aff'd in relevant part, 592 F.3d 147 (D.C. Cir.), cert. denied, 130 S.Ct. 3333 (2010).
5 Supplementary Material .01 (Definition of Associated Person; Clerical and Ministerial Functions) to FINRA Rule 4340 clarifies that the term "associated person" as used in the rule has the same meaning as provided in SEA Section 3(a)(18), which expressly excludes, for certain purposes, any persons associated with the member whose functions are solely clerical or ministerial (referred to as "clerical and ministerial associated persons").