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85-75 Amendments to SEC Rule 15c3-3, Customer Protection Rule
TO: All NASD Members and Other Interested Persons
The Securities and Exchange Commission has amended Rule 15c3-3 under the Securities Exchange Act of 1934. These amendments, which for the most part, become effective on November 22, 1985, are designed to assure that customer funds and securities held by broker-dealers are protected against misuse or insolvency. It is anticipated that the net effect of these amendments will not materially affect most members, but could require greater deposits to be made in the Reserve Bank Account of some broker-dealers.
The salient points of the amendments to Rule 15c3-3 are set forth below, and will for purposes of the debit items in the reserve formula:
The above settlement dates should be used by brokers, dealers, and municipal securities dealers for purposes of clearing and settling transactions pursuant to the NASD's Uniform Practice Code and Municipal Securities Rulemaking Board Rule G-12 on Uniform Practice.
Questions regarding the application of these settlement dates to a particular situation may be directed to the Uniform Practice Department of the NASD at (212) 839-6256.
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capital of the broker-dealer prior to securities haircuts ("tentative net capital"), unless the member can demonstrate that the debit balance is related to credit items in the formula. The designated examining authority may grant partial or total exemption from this provision if circumstances so warrant.
The amendments become effective on November 22, 1985, except for the concentration provision under Item (3) above which becomes effective on April 1, 1986.
A copy of the SEC's release is attached. Questions concerning this notice may be directed to I. William Fishkind, Assistant Director, Financial Responsibility, at(202)728-8405.
John E. Pinto, Jr.
Senior Vice President
SECURITIES AND EXCHANGE COMMISSION
[17 CFR Part 240]
[Release No. 34-22499; File No. S7-8-84]
Customer Protection Rule
AGENCY: Securities and Exchange Commission.
ACTION: Rule Amendment.
SUMMARY: The Securities and Exchange Commission ("Commission") is adopting amendments to Rule 15c3-3 under the Securities Exchange Act of 1934 ("Act"). Under the rule, the broker-dealer is required to make a weekly computation (or in certain cases a monthly computation), as of the close of business Friday, to determine how much money it is holding which is either customer money or money obtained from use of customer securities (i.e., formula credits). From that amount the broker-dealer subtracts the amount of money it is owed by its cash or margin customers or by other broker-dealers because of customer transactions (i.e., formula debits). If the credits exceed the debits, the broker-dealer must deposit the excess by Tuesday morning in a Reserve Bank Account. If the debits exceed the credits, no deposit is necessary. This process is commonly referred to as the Reserve Formula Computation.
The amendments will, for purposes of the debit items of the Reserve Formula: 1) exclude the debit balances of household members and other persons related to broker-dealer principals or affiliated in a certain way with a broker-dealer; 2) exclude, under certain circumstances, the debit balances of accounts in which "principals" of a broker-dealer have ownership interests; and 3) exclude, under certain circumstances, the amount by which a broker-dealer's margin accounts receivable (a debit item) with a single customer exceeds twenty-five percent of the net capital of the broker-dealer prior to securities haircuts ("tentative net capital").
The amendments are designed to assure that customers' funds and securities held by broker-dealers are protected against misuse or insolvency. The net effect of the proposed amendments may be to require that greater deposits be made in the Reserve Bank Accounts of some broker-dealers.
EFFECTIVE DATE: November 22, 1985 except the concentration provision which will be effective on April 1, 1986. FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Division of Market Regulation, 450 5th Street, N.W., Washington, D.C. 20549 (202) 272-2904.
Rule 15c3-3 is designed to assure that customers' funds (as well as securtities) "held by broker-dealers are protected against broker-dealer misuse or insolvency. The rule requires, among other things, that a broker-dealer maintain with a bank or banks a "Special Reserve Bank Account for the Exclusive Benefit of Customers" ("Reserve Bank Account") and deposit in this account its reserve requirement as computed in accordance with the Formula for Determination of Reserve Requirement For Brokers and Dealers ("Reserve Formula"), Exhibit A of Rule 15c3-3. In addition, before making a withdrawal from the Reserve Bank Account, a broker-dealer must make a computation which shows that after the withdrawal there is an amount remaining in the Reserve Bank Account at least equal to that required to be on deposit.
Under the Rule, a broker-dealer is required to make a weekly computation (or in certain cases a monthly computation), as of close of business Friday, to determine how much money it is holding which is either customer money or money obtained from use of customer securities (i.e., formula credits). From that amount the brokar-dealer subtracts the amount of money it is owed by its cash or margin customers or by other broker-dealers and certain other entities because of customer transactions (i.e., formula debits). If the credits exceed the debits, the broker-dealer must deposit the excess by Tuesday morning in a Reserve Bank Account. If the debits exceed the credits, no deposit is necessary.
One of the purposes of the Reserve Formula is to ensure that customers' funds held by a broker-dealer are deployed only in areas of the broker-dealer's business related to servicing its customers (i.e., debit items in the Reserve Formula) or, to the extent that the funds are not deployed in these limited areas, that they be deposited in a Reserve Bank Account. Thus, the Reserve Bank Account includes all funds held by a broker-dealer that have as their source customer assets and which have not been utilized to finance the broker-dealer's customer related transactions. The rule makes it unlawful for a broker-dealer to accept or use customer funds to finance any part of its proprietary business activities. This prohibition applies as well to transactions of principal officers, directors, and general partners ("principals") of a broker-dealer and thereby prevents the broker-dealer from using customer funds to finance the insiders' own personal investment activities.
Recent events, particularly the financial failures of two broker-dealers, caused renewed concern in the area of misuse of customer free credit balances. Proposed revisions to Rule 15c3-3 were recommended by a Committee of the Securities Industry Association ("SIA") in response to the problem of protecting customer free credit balances. Based on these recommendations the Commission proposed remedial revisions to Rule 15c3-3 in Securities Exchange Act Release No. 20655 (February 15, 1984). In response to comments received on that proposal, the Commission modified its proposal and reproposed the amendments for public comment in Securities Exchange Act Release No. 21865 (March 26, 1985).
The Commission received fifteen comment letters on the proposed amendments. Most of the commentators supported the stated objective of the proposed amendments: to protect customers' funds held by broker-dealers from misuse or insolvency, and to ensure that those funds are used only to service bona fide customer accounts. Some of the commentators however, still believed that the costs of compliance (e.g., computer programming and financing costs) would be unduly burdensome on smaller and medium sized broker-dealers. Others believed that the mechanism of allowing the Designated Examining Authority ("DEA") to grant exceptions to the concentration provision would be unworkable absent uniform guidelines for granting exceptions. In light of the specific comments received and, with the view towards minimizing the compliance burden on broker-dealers, the Commission has determined to adopt the proposed amendments in modified form.
The Commission proposed three amendments to Rule 15c3-3. Each of these amendments is described below along with a summary of the comments received and any modifications made in adopting the amendments.
A. Household Members, Related Persons and Affiliates
As stated in its prior releases, the Commission is concerned that certain broker-dealer principals have been able to utilize the securities accounts of family members (or persons under their control) or affiliates to circumvent the prohibition against the use of customer funds held by their firms (i.e., credit items in the Reserve Formula) to finance their own securities activities. The Commission is concerned that this financing activity can lead to a reduction or total elimination of the broker-dealer's reserve deposit requirements to the possible detriment of bona fide public customers.
The Commission thus proposed to add a paragraph to Note E of the Reserve Formula which would provide that:
the debit balances in the accounts of household members and other persons related to principals of a broker-dealer or affiliated with a broker-dealer are not "customer" debit balances, and therefore should not be included in the Reserve Formula, unless it can be shown that such debit balances are directly related to formula credit items for those same persons.
The Commission proposed to define the terms "household members and other persons related to..." to include parents, mothers-in-law or fathers-in-law, husbands or wives, brothers or sisters, brothers-in-law or sisters-in-law, children or any relative to whose support the broker-dealer principal contributes directly or indirectly.
Commentators on the original proposal suggested that the proposed definition was too broad. In response to those comments, the Commission reproposed the definition and asked commentators to suggest alternative definitions. Although none of the latest round of commentators suggested alternative definitions, two of the commentators suggested establishing a de minimis threshold of $50,000 below which the debit balances of household members and other persons related to principals of a broker-dealer would not be affected by the amendment.
The Commission is not incorporating the threshold concept into the amendment it is adopting because, with respect to the debit balances of close relatives such as spouses and children, there is no basis for distinguishing those debit balances from the debit balances of principals of a broker-dealer. The Commission believes it is fair to assume that the principals may be exerting control over the accounts of close relatives, or that these will be favored accounts. In contrast, the Commission believes, that the accounts of parents, siblings and inlaws, absent some financial dependence, would not necessarily be controlled by the principals.
Based on the above, and in the interest of reducing any recordkeeping burden on broker-dealers, the Commission is adopting a narrower definition. For purposes of the Reserve Formula, the term "household members and other persons related to ..." will include only husbands or wives, children, sons-in-law or daughters-in-law and any other relative or household member to whose support the broker-dealer principal contributes directly or indirectly. The Commission recognizes that narrowing the definition might make it possible for principals to use the accounts of certain relatives. However, on balance, the Commission believes that the revised household member restriction combined with the concentration provision described below will adequately address the most egregious cases which pose the greatest threat to the public customers of broker-dealers
B. Joint Accounts, Etc.
In Securities Exchange Act Release No. 20655 the Commission proposed a revision of an earlier interpretation (issued in Securities Exchange Act Release No. 9922) regarding the definition of the term "customer" for purposes of Rule 15c3-3. In that earlier release, a joint account, custodian account, participation in a hedge fund or limited partnership, or a similar type account or arrangement by a person who would be excluded from the definition of customer (i.e., a general partner, director or principal officer of a broker-dealer) with persons includible in the definition of customer, was considered a customer's account. The proposal would have treated those accounts as non-customer accounts insofar as the debit items in the Reserve Formula were concerned, unless the broker-dealer demonstrated that the debits were directly related to formula credit items.
Based on comments that this proposal was too broad, the Commission modified its proposed note E(6) to the Reserve Formula as follows: if the non-customer has less than a five percent ownership interest in the subject account, then the entire debit balance will be included in the formula; if such percentage ownership is between five percent and fifty percent, then the portion of the debit balance attributable to the non-customer will be excluded from the formula and the remainder of the debit balance will be included in the formula, unless the broker-dealer can demonstrate that such debit balances are directly related to credit items in the formula; if such percentage ownership by a non-customer is greater than fifty percent, then the entire debit balance shall be excluded from the formula unless the broker-dealer can demonstrate that such debit balances are directly related to credit items in the formula.
The commentators were uniformly supportive of the proposal, as modified. Accordingly, the Commission is adopting the amendment in its modified form.
C. Concentration Provision
Finally, the Commission's original proposal would have provided that debit balances in margin accounts must be reduced by the amount by which a single customer's margin debit balance exceeds ten percent of the aggregate of all debit balances in customers' margin accounts included in Item 10 of the Reserve Formula.
Based on the comments received on that proposal, the Commission modified the proposed concentration provision to provide for a more flexible approach to the treatment of concentrated margin debits. The modified proposal tied the concentration charge to the broker-dealers tentative net capital rather than its overall margin debt, provided for an exception mechanism through the broker-dealers Designated Examining Authority ("DEA") and, made it clear that a concentrated debit balance may be included in the formula to the extent that it is directly related to credit items in the formula.
In general, the comments received on the modified concentration provision indicated that the changes made alleviated some of the concerns raised by the original proposal. Three of the commentators stated their general support for the provision, as modified. Some of the commentators expressed their concern that the concentration provision might have a disproportionate impact on small and medium-sized broker-dealers. Other commentators were fearful that, unless industry wide criteria were established, the DEA exception procedures would present administrative difficulties. Still other commentators were uncertain as to how to demonstrate the required relationship between debits and credits, in order to avoid the impact of the concentration charge. The last comment also applies to the "household members and other persons related to . . ." amendment.
This concentration provision effectively restricts a broker-dealer from lending a large percentage of other customers' money to any one customer except under certain conditions intended to alleviate the risks of such a concentrated position. The Commission believes that this is an appropriate limitation on the use of other customers' money and consistent with the purposes of Rule 15c3-3. The amendments have been designed to minimize any concomitant burdens. Indeed, the impact on broker-dealers is expected to be minimal. While the amendments will not absolutely prevent fraud or abuse, they will reduce the financial exposure of broker-dealers and perhaps lead to more investor confidence in broker-dealers who hold customer monies.
With regard to establishing industry guidelines for granting requests for exceptions from the concentration provision, the Commission is delaying the effective date of this amendment until April 1, 1986. The DEAs, with the aid of the Commission's staff, will be able to formulate objective criteria for granting exceptions during this time period. Such criteria will enable the DEAs to review the exception requests expeditiously and should provide guidance to broker-dealers in seeking an exception. In addition, the amendment adopted by the Commission will make it clear that during any review period, the concentrated debit may be included in the reserve formula computation for five business days after a request for DEA exception is made.
With regard to demonstrating the relationship between particular debit balances with credit items in the formula, broker-dealers are free to choose any method of allocating debits and credits. The Commission believes that many broker-dealers will use the allocation systems that they use in making other determinations required by Rule 15c3-3. However, broker-dealers are not limited to such systems. In fact, because the principal objective of the amendments is to ensure that customer free credit balances are not being misused by principals of a broker-dealer, it would be sufficient for a broker-dealer to demonstrate the requisite relationship indirectly by showing that it did not carry any customer free credit balances.
In sum, the Commission believes that establishing objective criteria for granting exceptions, allowing concentrated debit balances to be included in the formula during any review period and, allowing broker-dealers flexibility in demonstrating that a particular debit balance is related to a formula credit item will ensure that the amendments will not be unduly burdensome on broker-dealers. At the same time, the Commission believes the amendments it is adopting are necessary and appropriate in the public interest to ensure that customer funds and securities are not placed at undue risk because of fraudulent practices by broker-dealers or large extensions of credit to individual accounts financed with free credit balances.
III. SUMMARY OF FINAL REGULATORY FLEXIBILITY ANALYSIS
The Commission has prepared a Final Regulatory Flexibility Analysis in accordance with 5 U.S.C. §604 regarding the amendments to Rule 15c3-3. The Analysis notes that the amendments are necessary in order to ensure that broker-dealers do not circumvent the prohibition against broker-dealer principals using customer funds to finance their own personal/proprietary investment activities and toward unnecessary concentrations in broker-dealers margin lending. The analysis states that the Commission did not receive any comments concerning the Initial Regulatory Flexibility Analysis. The Analysis points out that in response to commentators concern about the costs involved in compliance with the amendments to Rule 15c3-3, the Commission modified the amendments to lessen any compliance burden.
A copy of the Final Regulatory Flexibility Analysis may be obtained by contacting Julio Mojica, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, (202) 272-2372.
IV. STATUTORY BASIS
Pursuant to the Securities Exchange Act of 1934 and particularly Sections 15(c)(3), 17 and 23(a) thereof, 15 U.S.C. §§78o(c)(3), 78q and 78w(a), the Commission is adoptting amendments to §240.15c3-3 in Part 240 of Chapter II of Title 17 of the Code of Federal Regulations in the manner set forth below.
Lists of Subjects in 17 CFR Part 240
Reporting and recordkeeping requirements, Securities.
V. TEXT OF THE PROPOSED AMENDMENTS
In accordance with the foregoing, 17 CFR Part 240 is amended as follows:
PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934
Authority: Sec. 23, 98 Stat. 901, as amended, 15 U.S.C. 78W * * *.
§240.15c3-3 also issued under Sees. 15(c)(2), 15(c)(3) and 17(a), 48 Stat. 895, 897, as amended; 15 U.S.C 78o(c), 78q(a) * * *.
§240.15c3-3a also issued under Sees. 15(c)(2), 15(c)(3) and 17(a), 48 Stat. 895, 897, as amended; 15 U.S.C., 78o(c), 78q(a) * * *.
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NOTE E. * * *
If the registered national securities exchange or the registered national securities association having responsibility for examining the broker or dealer ("designated examining authority") is satisfied, after taking into account the circumstances of the concentrated account including the quality, diversity, and marketability of the collateral securing the debit balances of margin accounts subject to this provision, that the concentration of debit balances is appropriate, then such designated examining authority may grant a partial or plenary exception from this provision.
The debit balance may be included in the reserve formula computation for five business days from the day the request is made.
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By the Commission.
Dated: October 3, 1985.