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83-74 Proposed Amendments to Article III, Section 19 of the Rules of Fair Practice, "Customers' Securities or Funds"

I M P O R T A N T

MAIL VOTE

Officers * Partners * Proprietors

TO: All NASD Members

Last Voting Date Is January 30, 1984

Enclosed herewith are proposed amendments to Article III, Section 19 of the Rules of Fair Practice and the Explanation thereto. These amendments have been approved by the Association's Board of Governors for submission to the membership for a vote. If approved, they must then be filed with, and approved by, the Securities and Exchange Commission.

BACKGROUND OF THE PROPOSED AMENDMENTS

As an ongoing responsibility, the standing committees of the Board of Governors review and, if necessary, recommend revisions to the Association's rules and regulations. In this regard, the Capital and Margin Committee has proposed certain revisions to Article III, Section 19 of the Rules of Fair Practice, "Customers' Securities or Funds." The changes proposed by the Committee are more technical rather than substantive in nature and reflect similar actions by other self-regulatory organizations.

The revisions are intended to eliminate regulation which has been rendered obsolete by a member's obligation to comply with certain requirements of SEC Rule 15c3-3, the "Customer Protection Rule," which governs the protection of customers' funds and securities. The current provisions contained in Section 19 with respect to the lending of customers' securities under a "fair and reasonable" standard are now either addressed or superseded through the possession and control requirements of Rule 15c3-3.

The proposed revisions will also eliminate the necessity for receiving, processing and retaining certain duplicative paperwork. Specifically, the amendments will eliminate the requirement of obtaining written lending authorizations separate and apart from the standard margin agreements. This will permit members to use only one margin/loan consent agreement requiring only one signature from a customer rather than two as is currently required. As previously noted, these changes eliminating the "two signature" requirement have already been adopted by recent amendments to New York Stock Exchange Rule 402 and AMEX Rule 449.

In light of the foregoing considerations, the Board determined that this proposal should be circulated to the membership for approval.

DISCUSSION OF THE PROPOSED RULE AMENDMENTS

One of the proposed amendments to Section 19 includes the addition of a new section, entitled "General Provisions." This section places an affirmative obligation on a member to adhere to the provisions of SEC Rule 15c3-3 with respect to possession and control requirements and the maintenance of cash reserves.

A second proposed change concerns the section regarding a member's authorization to lend customers' securities. In this paragraph, the rule currently requires a member to obtain a lending authorization separate from, and in addition to, a margin account agreement before it may lend customers' securities. Federal securities laws relating to the lending of securities do not require such separate authorizations. In light of this, and in consideration of the other regulatory safeguards that have evolved over the years, the requirement for separate authorizations appears unnecessary. Therefore, the proposed revisions eliminate the two-agreement requirement entirely.

In a third proposed change, paragraph (c) of the current rule would be deleted. This paragraph requires that a member obtain from a customer a specific authorization designating the particular securities to be loaned should they be fully paid or excess margin securities. The proposal eliminates this requirement in favor of relying on the safeguards embodied in Rule 15c3-3(b)(3) with respect to the lending of fully paid and excess margin securities.

Finally, the Explanation of the Board of Governors, which follows the rule, has been revised in accordance with the provisions discussed above.

* * *

The text of the proposed rule is attached and merits your immediate attention. Please mark the ballot according to your convictions and return it in the enclosed stamped envelope to "The Corporation Trust Company." Ballots must be postmarked no later than January 30, 1984.

The Board of Governors believes the proposed amendments are necessary and appropriate and recommends that members vote their approval.

Questions concerning this notice may be directed to James M. Cangiano, Associate Director, Department of Policy Research, at (202) 728-8273, or to your District Director.

Sincerely,

Gordon S. Macklin
President

Attachments

TEXT OF PROPOSED REVISIONS

Customers' Securities or Funds

Sec. 19.

Improper Use

(a) No member or person associated with a member shall make improper use of a customers' securities or funds.

General Provisions

(b) Every member in the conduct of its business shall adhere to the provisions of Rule 15c3-3 promulgated under the Securities Exchange Act of 1934 with respect to obtaining possession and control of securities, and the maintenance" of appropriate cash reserves. For the purposes of this Section, the definitions contained in Rule 15c3-3 shall apply.

Authorization to lend - Pledging or lending related to indebtedness

(b)
(c) No member shall lend, either to himself or to others, securities carried for the account of any customer, which are eligible to be pledged or loaned unless such member shall first have obtained from the customer a separate written authorization permitting the lending of securities thus carried by such member. And, regardless of any agreement between a member and a customer authorizing the member to lend or pledge such securities, no member shall lend or pledge more of such securities than is fair and reasonable in view of the indebtedness of the customer, except such lending as may be specifically authorized under subsection (c).

Separate lending authorization designating securities

(c) No member shall lend securities carried for the account of any customer which have been fully paid for or which are in excess of the amount which may be loaned in view of the indebtedness of the customer, unless such member shall first have obtained from such customer a separate written authorization designating the particular securities to be loaned.

Segregation and identification of securities

(d) No member shall hold securities carried for the account of any customer which have been fully paid for or which are in excess of the amount which may be pledge in view of the indebtedness of the customer, excess margin securities unless such securities are segregated and identified by a method which clearly indicates the interest of such customer in those securities.

Prohibition against guarantees

(e) No member or person associated with a member shall guarantee a customer against loss in any securities account of such customer carried by the member or in any securities transaction effected by the member with or for such customer.

Sharing in accounts; extent permissible

(f) No member or person associated with a member shall share directly or indirectly in the profits or losses in any account of a customer carried by the member or any other member, unless such member or person associated with a member obtains prior written authorization from the member carrying the account; and, a member or person associated with a member shall share in the profits or losses in any account of such customer only in direct proportion to the financial contributions made to such account by either the member or person associated with a member. Exempt from the direct proportionate share limitation are accounts of the immediate family of such member or person associated with a member. For purposes of this section, the term "immediate family" shall include parents, mother-in-law or father-in-law, husband or wife, children or any relative to whose support the member or person associated with a member otherwise contributes directly or indirectly.

o o o Explanation of the Board of Governors

Explanation of Certain Paragraphs Paragraph (d) Section 19 of Article III of the Rules of Fair Practice

Paragraph (b)

The first part of this paragraph requires a member to obtain a lending authorization in addition to a margin account agreement before lending a customer's securities. The particular securities to be lent need not be designated so long as the member does not lend more securities than are "fair and reasonable."

The second part of this paragraph limits the amount of a customer's securities which may be lent or pledged under a general agreement with the customer. With respect to lending, the "fair and reasonable" standard means that a member may lend a customer's securities only in an amount which is reasonably related to the customer's debit balance, unless the additional written authorization required under paragraph (c) is obtained from the customer.

With respect to pledging a customer's securities, the "fair and reasonable" standard refers to the amount of the customer's securities which a member would be required to deposit as collateral in order to borrow an amount approximating the customer's debit balance; the amount of collateral so required usually depends on the type and equality of securities in question, as well as the policies of the lending institution.

Paragraph (c)

This paragraph requires a member to obtain a specific authorization designating the particular securities in order to lend a customer's fully paid securities or those in excess of an amount which is reasonably related to the customer's debit balance.

Paragraph (d)

This paragraph requires members to segregate and identify by customers both fully paid and securities held in margin accounts which are in excess of the amount which may be pledged under the "fair and reasonable" standards in paragraph (b). These are commonly referred to as excess margin securities. although not mentioned as such in the section.

With regard to a customer's account which contains only stocks, it is general practice for firms to segregate that portion of the stocks having a market value in excess of 140% of the debit balance therein. When a customer's account contains bonds, the basis upon which the member is borrowing or can borrow on such bonds should be taken into consideration in determining the amount of securities to be segregated.

Following are three general types of segregation of customer's securities currently in use by many firms:

1. Physical segregation of securities by issue, with a separate list showing ownership of the securities by each customer. The listing, on cards or other records, should reflect all changes in ownership interest. This method is for securities in street name (not in individual customers' names), but the proportionate interests of the individual customers are indicated by the records.
2. Physical segregation of securities by issue, affixing to each certificate a tab or other identification showing the name of the beneficial owner of the certificate. This may be used for shares in street name or in the customer's name.
3. Specific segregation of all certificates of each customer in separate envelopes or folders, identified by customer, or by clipping the certificates together and identifying the customer by tab or other notation affixed to the segregated certificates.

In all the above methods, the records should note the dates when the securities are segregated. When such securities are not in the actual custody of the member, for instance, when they are in the physical possession of a correspondent firm, their location and the means by which they may be identified as belonging to each customer should be indicated on the books of the member carrying the customers' accounts.

For purposes of Section 19, a customer's securities subordinated under a "satisfactory subordination," as defined in Rule 15c3-1 of the Securities and Exchange Commission, are not deemed to be securities carried for the account of a customer.


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