Joint Statement on No-Action Relief for Non-Compliance with the Customer Protection Rule

Last night, a no-action letter was issued relating to apparent non-compliance by certain broker-dealers with Rule 15c3-3,[1] which is aptly named the “Customer Protection Rule.”[2] In short, certain broker-dealers’ failure to comply with the Customer Protection Rule puts retail customer funds and securities at risk, and the no-action letter purports to allow this misconduct to continue for up to six additional months.[3] The letter clearly states that these practices are not consistent with the requirements of the Customer Protection Rule.  On that point we agree, and it is critical that registrants heed that message.

No-action relief, however, is not the appropriate method to communicate the message in these circumstances. No-action relief is a mechanism that allows registrants to obtain certain assurances when their conduct may touch upon a gray area of regulation, or even may be technically proscribed, but does not raise the policy concerns underlying a particular rule. It is designed to give market participants comfort in continuing a particular course of conduct in areas where clarity is lacking, or participants face potentially conflicting requirements.[4]  It should not provide a grace period for compliance with clear violations of law -- especially violations that put investor funds directly at risk.  Here, the potential harm to customers arising from the conduct goes to the very heart of the Customer Protection Rule and should be remediated without delay. 

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The Commission has become aware that certain broker-dealers are operating programs in which they borrow securities from their retail customers without complying with the specific requirements designed to protect those customers in the event of the broker-dealer’s failure.[5] In particular, rather than transferring actual physical possession of collateral to customers, some broker-dealers are seeking to minimize their costs by depositing the required collateral into accounts at the broker-dealer or in omnibus accounts at a bank in the name of the broker-dealer.[6] In the event of a broker-dealer’s failure, the firm’s control over the collateral means that it may not be readily accessible by the customer.[7] More importantly, the provisions of the Securities Investor Protection Act (“SIPA”), which are designed to protect customers in the event of a failure, may not apply to the collateral in these circumstances.[8]

Whether these arrangements violate Rule 15c3-3 is not a close call. When a broker or dealer borrows a customer’s securities, Rule 15c3-3(b)(3) requires that the broker or dealer deliver collateral which fully secures the loan of securities.[9] In the Adopting Release for this provision, the Commission stated that it “[r]equires the physical possession of the collateral be transferred to the lender or to his appointed agent.”[10] Likewise, the Commission stated that the rule will “compel the firm to turn over the collateral physically to the lender.”[11] The Commission’s focus on physical delivery of collateral in these transactions was meant to prevent the very risk presented by broker-dealers’ current practices.

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We appreciate the focus on addressing compliance with the Customer Protection Rule and informing registrants of the need for remediation.  We also appreciate and consistently rely upon the depth of experience and expertise of the staff with respect to broker-dealer compliance.  However, this is not about declining to defer to the judgment of the staff, because there is no question regarding the violation of the Customer Protection Rule.  We would, of course, give serious weight to the staff’s views regarding any particular broker-dealer’s conduct and how best to handle it.  But the question here is whether an extended, across-the-board grace period for such violations should be granted, and that decision falls within the discretion of the full Commission. 

In the midst of a historically volatile year for the nation’s markets, acquiescing to the continuation of this conduct for up to six months presents an unacceptable risk to investors. This does not mean that enforcement actions are the only, or even the best, option.  It may well be appropriate to decline to take action against those who promptly and in good faith remediate. The Commission’s longstanding position on this issue could have been re-emphasized in a Risk Alert reminding registrants of the importance of adhering to the Customer Protection Rule and ensuring that retail investor funds receive the full protections afforded under SIPA.