A Small Entity Compliance Guide¹

Introduction

As described below, the Commission has amended the net capital, customer protection, books and records, and notification rules for broker-dealers.  The amendments to the broker-dealer financial responsibility rules are designed to address several areas of concern regarding the financial responsibility requirements for broker-dealers.  The amendments also update certain financial responsibility requirements and make certain technical amendments.

What Are Broker-Dealer Financial Responsibility Rules and How Do They Protect Customers?

Broker-dealers must meet certain financial responsibility requirements under the Securities Exchange Act of 1934.  These requirements help to protect customers from the consequences of the financial failure of a broker-dealer by requiring the safeguarding of customer securities and funds held by the broker-dealer.

These requirements include:

• Net Capital Rule (Rule 15c3-1) – Requires a broker-dealer to maintain more than a dollar of highly liquid assets for each dollar of liabilities.  If the broker-dealer fails, this rule helps to ensure that the broker-dealer has sufficient liquid assets to pay all liabilities to customers.
• Customer Protection Rule (Rule 15c3-3) – Broker-dealers sometime use their own funds to conduct trades and other transactions.  Rule 15c3-3 essentially requires a broker-dealer that maintains custody of customer securities and cash to segregate such securities and cash from the broker-dealer’s proprietary activities.  By segregating customer securities and cash from a firm’s proprietary business activities, the rule increases the likelihood that customer assets will be readily available to be returned to customers if a broker-dealer fails.
• Books and Records Rules (Exchange Act Rules 17a-3 and 17a-4) – Require a broker-dealer to make and maintain certain business records to assist the firm in accounting for its activities, and assist securities regulators in examining for compliance with the securities laws. 
• Notification Rule (Exchange Act Rule 17a-11) – Requires a broker-dealer to give notice to the SEC and other securities regulators when certain events occur, such as the firm’s net capital falling below its required minimum.

These requirements are designed to protect customer assets held at broker-dealers.  However, if a broker-dealer violates these requirements by, for example, misappropriating these assets, the securities and cash may not be available to be returned to customers.

In a situation where a broker-dealer misappropriates funds or converts securities from its customer, the Securities Investor Protection Corporation (“SIPC”) may initiate a liquidation proceeding to determine whether SIPC will pay the customers for any shortfalls in their accounts up to $500,000 per customer (of which $250,000 can be used to make up a cash shortfall.) (More information about the terms of SIPC coverage can be found at www.sipc.org.)

Amendments to Financial Responsibility Rules

Customer Protection Rule (Exchange Act Rule 15c-3-3)

• Proprietary Accounts of Broker-Dealers (“PAB Accounts”).  This amendment closes a “gap” between the definition of “customer” in Rule 15c3-3 (which does not include broker-dealers) and the definition of “customer” under the Securities Investor Protection Act of 1970 (which includes broker-dealers) (“SIPA”), by requiring carrying broker-dealers to maintain a new segregated reserve account for account holders that are broker-dealers.  The amendment also requires carrying broker-dealers to obtain and maintain possession and control of securities carried for a PAB account, unless the carrying broker-dealer has provided written notice to the account holder that the securities may be used in the ordinary course of its securities business, and has provided an opportunity for the account owner to object.
   
• Banks Where Special Reserve Deposits May Be Held.  These amendments place restrictions on cash bank deposits for purposes of the requirement to maintain a customer or PAB reserve account under Rule 15c3-3.  The rule is amended to exclude cash deposits held in a PAB or customer reserve account at affiliated banks and limit cash held at non-affiliated banks to an amount no greater than 15% of the bank’s equity capital, as reported by the bank in its most recent Call Report.
   
• Treatment of Free Credit Balances.  These amendments establish customer disclosure, notice, and affirmative consent requirements (for new accounts) for programs where customer cash in a securities account is “swept” to a money market fund as described in Rule 2a-7 under the Investment Company Act of 1940 or an account at a bank whose deposits are FDIC-insured.  Outside the context of a sweep program, the amendments also permit a broker-dealer to invest or transfer to another account or institution, free credit balances in a customer’s account only upon a specific order, authorization, or draft from the customer.
   
• Deletion of Rule 15c3-2. This amendment deletes Rule 15c3-2 (customers’ free credit balances) and imports certain requirements in that rule into Rule 15c3-3, including requirements that broker-dealers inform customers of the amounts due to them and that such amounts are payable on demand.
   
• Allocation of Customers’ Fully Paid and Excess Margin Securities to Short Positions.  This amendment requires broker-dealers to obtain physical possession or control of customer fully paid and excess margin securities that allocate to a broker-dealer or non-customer short position, after the short position has been aged more than 30 calendar days.
   
• Proprietary Accounts under the Commodity Exchange Act (“CEA”).  These amendments to the definition of “free credit balances” and “other credit balances” under Rule 15c3-3 clarify that funds held in a commodity account meeting the definition of a “proprietary account” under CEA regulations are not included as “free credit balances” or “other credit balances” in the Rule 15c3-3 reserve formula.
   
• Treatment of Futures Held in Securities Portfolio Margin Account.  These amendments include futures carried in a portfolio margin securities account in a broker-dealer’s  reserve calculation.  They complement Dodd-Frank Act changes to SIPA which extended SIPA protection to persons who hold futures positions in a portfolio margining account carried as a securities account.

Net Capital Rule (Exchange Act Rule 15c3-1)

• Requirement to Deduct From Net Worth Certain Liabilities or Expenses Assumed By Third Parties.  This amendment requires a broker-dealer to adjust its net worth when calculating net capital by including any liabilities that are assumed by a third-party if the broker-dealer cannot demonstrate that the third-party has the resources, independent of the broker-dealer’s income and assets, to pay the liabilities.
   
• Requirement to Subtract From Net Worth Certain Non-Permanent Capital Contributions.  This amendment requires a broker-dealer to treat as a liability any capital that is contributed under an agreement giving the investor the option to withdraw it.  The rule also requires that a broker-dealer treat as a liability any capital contribution that is withdrawn within a year of its contribution unless the broker-dealer receives permission in writing from its designated examining authority (“DEA”).
   
• Broker-Dealer Solvency Issues.  This amendment requires that a broker-dealer cease conducting a securities business if certain insolvency events occur.
   
• Requirement to Deduct the Amount by Which a Fidelity Bond Deductible Exceeds Self-Regulatory Organization (“SRO”) Limits.  This amendment requires broker-dealers to deduct from net capital, with regard to fidelity bonding requirements prescribed by a broker-dealer’s DEA, the excess of any deductible amount over the amount permitted by SRO rules.
   
• Amendment to Rule Governing Orders Restricting Withdrawal of Capital from a Broker-Dealer.  This amendment permits the Commission to temporality restrict, by order, all withdrawals, advances, and loans by a broker-dealer.  Previously, Commission rules restricted withdrawals, advances, and loans in excess of 30% of a broker-dealer’s excess net capital, which was difficult to administer in practice due to the inherent unreliability of a troubled broker-dealer’s books and records.
   
• Amendments with Respect to Securities Lending and Borrowing and Repurchase/Reverse Repurchase Transactions.  This amendment clarifies that broker-dealers providing securities lending and borrowing settlement services are deemed, for purposes of Rule 15c3-1, to be acting as principals and are subject to applicable capital deductions.  Under the amendment, these deductions could be avoided if a broker-dealer takes certain steps to disclaim principal liability.
   
• Adjusted Net Capital Requirements.  The amendment to Appendix A to Rule 15c3-1 will make permanent a temporary amendment which decreased the range of pricing inputs to the approved option pricing models.  The amendments to Rule 15c3-1 also clarify that a money market fund, for the purposes of paragraph (c)(2)(vi)(D)(1) of Rule 15c3-1, is a fund described in Rule 2a-7 under the Investment Company Act of 1940.

Books and Records Rules (Exchange Rules 17a-3 and 17a-4)

These amendments require certain broker-dealers to document their credit, market, and liquidity risk management controls.  The amendments will apply only to broker-dealers that have more than $1,000,000 in aggregate credit items as computed under the customer reserve formula of Rule 15c3-3, or $20,000,000 in capital including debt subordinated in accordance with Appendix D to Rule 15c3-1.  The final rule does not specify the type of controls a broker-dealer must establish.  It simply requires the documentation of the procedures the broker-dealer has established.

Notification Rule (Exchange Act Rule 17a-11)

The amendments to Rule 17a-11 establish new notification requirements for when a broker-dealer’s repurchase and securities lending activities exceed a certain threshold.  In lieu of the notification requirement, the final rule provides that a broker-dealer may report monthly its stock loan and repurchase activity to its DEA, in a form acceptable to its DEA.  The amendments also require an “insolvent” broker-dealer under Rule 15c3-1 to notify regulatory authorities.

Effective Date

These final rule amendments are effective October 21, 2013.  On October 17, 2013, the Commission issued an exemptive order temporarily extending the compliance date for certain of the new amendments until March 3, 2014.

Other Resources

The adopting release for these amendments can be found on the Commission’s website at http://www.sec.gov/rules/final/2013/34-70072.pdf. The proposing release can be found on the Commission’s website at http://www.sec.gov/rules/proposed/2007/34-55431.pdf.  The exemptive order can be found on the Commission’s website at http://www.sec.gov/rules/exorders/2013/34-70701.pdf.

Contacting the Commission

The Commission’s Division of Trading and Markets is available to assist small entities with questions regarding these amendments.  Questions may be directed to the Division of Trading and Markets by email at tradingandmarkets@sec.gov or by telephone at (202) 551-5777.

¹ This guide was prepared by the staff of the U.S. Securities and Exchange Commission (“Commission”) as a “small entity compliance guide” under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended.  The guide summarizes and explains rules adopted by the Commission, but is not a substitute for any rule itself.  Only the rule itself can provide complete and definitive information regarding its requirements.