United States: SEC Reopens Comment Period For Proposed Amendments To Its Financial Responsibility Rules For Broker-Dealers (Financial Services Alert - May 15, 2012)

Last Updated: May 17 2012
Article by Robert M. Kurucza

Developments of Note

  • Goodwin Procter Alert: The Impact of the Massachusetts Uniform Probate Code on Trust Administration
  • SEC Reopens Comment Period for Proposed Amendments to its Financial Responsibility Rules for Broker-Dealers
  • FDIC Chairman Outlines FDIC's Strategy for Resolution of Systemically Important Financial Firm
  • FINRA Sanctions Four Firms $9.1 Million Over Sales of Leveraged and Inverse Exchange-Traded Funds

Other Items of Note

  • FRB Issues Approval of Application by Industrial and Commercial Bank of China Limited and Two Other Chinese Banks to Become Bank Holding Companies Through Acquisition of Up to 80% of The Bank of East Asia (U.S.A.) National Association
  • FinCEN Extends Comment Period on Proposed Rule Regarding Customer Due Diligence Requirements

DEVELOPMENTS OF NOTE

Goodwin Procter Alert: The Impact of the Massachusetts Uniform Probate Code on Trust Administration

Goodwin Procter's Trusts & Estate Planning Practice issued an Alert discussing how the administration of trusts is affected by the Massachusetts Uniform Probate Code (MUPC), which became fully effective on March 31, 2012 and which imposes new duties and responsibilities on trustees.

SEC Reopens Comment Period for Proposed Amendments to its Financial Responsibility Rules for Broker-Dealers

The SEC issued a release announcing that it is reopening the comment period for proposed amendments to its net capital, customer protection, books and records, and notification rules for broker-dealers under the Securities Exchange Act of 1934 (the "Exchange Act"). The proposed rule amendments were issued by the SEC on March 9, 2007 and the original comment period, as extended, closed on June 18, 2007. The SEC did not act on the proposed amendments at that time and is presently reconsidering the proposed rule amendments.

AMENDMENTS TO THE CUSTOMER PROTECTION RULE

Proprietary Accounts of Broker-Dealers. The SEC proposes to amend Rule 15c3-3 under the Exchange Act to require broker-dealers to treat accounts they carry for domestic and foreign broker-dealers in the same manner generally as "customer" accounts for the purposes of the Rule's reserve formula. These accounts would be referred to as proprietary accounts for another broker-dealer, or "PAB" accounts.

Banks Where Special Reserve Deposits May Be Held. Rule 15c3-3 would be amended to exclude cash deposits at affiliate banks for the purposes of meeting customer or PAB reserve requirements and place limitations on the amount of cash a broker-dealer could maintain in a customer or PAB special reserve bank account at one unaffiliated bank. The purpose of the proposed amendment is to address the risk involved with the requirement under Rule 15c3-3(e) that broker-dealers must deposit cash or qualified securities into the customer reserve account maintained at a bank. Since cash deposits are fungible with other deposits carried by the bank and may be freely used in the course of the bank's commercial lending activities, there is a risk that cash deposits made by a broker-dealer could be lost or inaccessible for a period if the bank experiences financial difficulties. Such an event could adversely impact the broker-dealer and its customers if the balance of the reserve deposit is concentrated at one bank in the form of cash.

Expansion of the Definition of Qualified Securities to Include Certain Money Market Funds. Another proposed amendment to Rule 15c3-3 would expand the definition of "qualified securities" to include money market funds that only invest in securities meeting the definition of qualified security, with certain safeguards, including: (a) the money market fund could not be a company affiliated with the broker-dealer; (b) the broker-dealer would be required to use a fund that agrees to redeem fund shares in cash on the next business day and the fund cannot have the ability to delay redemption beyond one-day or to require a multi-day redemption notification period; and (c) the money market fund would be required to have an amount of net assets (assets net of liabilities) that is at least ten times the value of the fund's shares held by the broker-dealer in its customer reserve account.

Allocation of Customers' Fully Paid and Excess Margin Securities to Short Positions. The SEC proposes to add a new paragraph (d)(4) to Rule 15c3-3, requiring an additional action with respect to retrieving securities from non-control positions when the broker-dealer needs to obtain possession or control over a specific issue and class of securities. The broker-dealer would be required to take prompt steps to obtain physical possession or control over securities of the same issue and class as those included on the broker-dealer's books as a proprietary short position or as a short position for another person. A broker-dealer required to obtain physical possession or control over the security would no longer be able to monetize the value of the security and use the cash for proprietary activities.

Treatment of Free Credit Balances. The SEC proposes to add a new paragraph (j) to Rule 15c3-3, which would make it unlawful for a broker-dealer to convert, invest or otherwise transfer free credit balances, except under three circumstances set forth in proposed paragraphs (j)(2)(i)-(iii). The first circumstance would permit a broker-dealer to convert, invest, or otherwise transfer the free credit balances to any type of investment or other product, or to a different account with the broker-dealer or at another institution, or otherwise dispose of the free credit balances, but only upon a specific order, authorization, or draft from the customer, and only under the terms and conditions specified by the customer in the order, authorization or draft. The second circumstance would permit a broker-dealer to have the ability to change the sweep option of a new customer from a money market fund to a bank deposit account (and vice versa), provided specific conditions are met. The third circumstance would apply to existing customers as of the effective date of the proposed rule and would permit a broker-dealer to have the option to change an existing customer's sweep option from a money market fund to a bank deposit account (and vice versa), provided certain required conditions are met.

HOLDING FUTURES POSITIONS IN A SECURITIES PORTFOLIO MARGIN ACCOUNT

The SEC proposes to amend the definition of "free credit balances" in paragraph (a)(8) of Rule 15c3-3 to include funds resulting from margin deposits and daily marks to market related to, and proceeds from the liquidation of, futures on stock indices and options thereon carried in a securities account pursuant to a portfolio margining rule of an SRO. Under the proposed amendment, a broker-dealer holding such funds would be required to treat them as "credit items" for purposes of the customer reserve computation.

The proposed amendment would also amend Rule 15c3-3a Item 14 to permit the broker-dealer to include as a debit item the amount of customer margin required on deposit at a futures clearing organization related to futures positions carried in a securities account pursuant to an SRO portfolio margin rule.

AMENDMENTS WITH RESPECT TO SECURITIES LENDING AND BORROWING AND REPURCHASE/REVERSE REPURCHASE TRANSACTIONS

Subparagraph (c)(2)(iv)(B) to Rule 15c3-1 under the Exchange Act would be amended to clarify that broker-dealers providing securities lending and borrowing settlement services are assumed, for purposes of the rule, to be acting as principals and are subject to applicable capital deductions.

The proposed amendment would also add a new paragraph (c)(5) to Rule 17a-11 under the Exchange Act, which would require broker-dealers to notify the SEC whenever the total amount of money payable against all securities loaned or subject to a repurchase agreement, or the total contract value of all securities borrowed or subject to a reverse repurchase agreement, exceeds 2,500 percent of tentative net capital; provided that, for purposes of this leverage threshold, transactions involving "government securities" as defined in Section 3(a)(42) of the Exchange Act, are excluded from the calculation.

DOCUMENTATION OF RISK MANAGEMENT PROCEDURES

The SEC proposes to add a new paragraph (a)(23) to Rule 17a-3 under the Exchange Act, which would require certain large broker-dealers to document any implemented internal risk management control designed to assist in analyzing and managing the risks (e.g., market, credit, liquidity, operational) arising from the business activities it engages in, including, for example, securities lending and repo transactions, OTC derivative transactions, proprietary trading and margin lending. The requirement would apply to broker-dealers that have more than (a) $1,000,000 in aggregate credit items as computed under the customer reserve formula of Rule 15c3-3, or (b) $20,000,000 in total capital including debt subordinated in accordance with Appendix D to Rule 15c3-1.

The proposed amendment would also add a new paragraph (e)(9) to Rule 17a-4 under the Exchange Act, which would require a broker-dealer to maintain records of the documentation described above for three years after the date the broker-dealer ceases to use the system controls.

AMENDMENTS TO THE NET CAPITAL RULE

Requirement to Subtract From Net Worth Certain Liabilities or Expenses Assumed By Third Parties and Non-Permanent Capital Contributions. The proposal would add a new paragraph (c)(2)(i)(F) to Rule 15c3-1 under the Exchange Act, which would require 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. To evidence a third-party's financial capacity, the broker-dealer could maintain as a record the third party's most recent and current (i.e., as of a date within the previous twelve months) audited financial statements, tax return or regulatory filing containing financial reports.

The proposed amendment would also add a new paragraph (c)(2)(i)(G) to Rule 15c3-1, which would require a broker-dealer to treat as a liability (a) any capital that is contributed under an agreement giving the investor the option to withdraw it or (b) any capital contribution that is intended to be withdrawn within a year unless the broker-dealer receives permission in writing from its designated examining authority. This amendment is designed to codify the SEC's position that a capital contribution should be treated as a liability if it is made with the understanding that the contribution can be withdrawn at the option of the investor.

Requirement to Deduct the Amount by Which a Fidelity Bond Deductible Exceeds SRO Limits. A proposed amendment would add a new paragraph (c)(2)(xiv) to Rule 15c3-1, which would require a broker-dealer to deduct, with regard to fidelity bonding requirements prescribed by a broker-dealer's examining authority, the excess of any deductible amount over the maximum deductible amount permitted.

Broker-Dealer Solvency Requirement. Another proposed amendment to Rule 15c3-1 would require a broker-dealer to cease its securities business activities if certain insolvency events occur.

The proposal would also amend paragraph (b)(1) of Rule 17a-11 to require a broker-dealer meeting the definition of "insolvent" to provide immediate notice to the SEC, the firm's designated examining authority and, if applicable, the CFTC.

Amendment to Rule Governing Orders Restricting Withdrawal of Capital From a Broker-Dealer. Paragraph (e) of Rule 15c3-1 permits the SEC to restrict, for up to 20 business days, any withdrawals by the broker-dealer of equity or unsecured loans exceeding 30% of the firm's excess net capital if the SEC believes such withdrawal would be detrimental to the financial integrity of the firm. That paragraph would be amended to delete the 30% limitation.

Adjusted Net Capital Requirements. A proposed amendment to paragraph (b)(1)(iv) of Appendix A of Rule 15c3-1 would permit broker-dealers to employ theoretical option pricing models to calculate haircuts for listed options and related positions that hedge those options. The SEC previously, in 1997, adopted a temporary amendment to Appendix A that, by virtue of decreasing the range of pricing inputs to the model, effectively reduced the haircuts applied by the carrying firm with respect to non-clearing option specialist and market maker accounts. The proposed amendment would make permanent this previously granted relief.

Another amendment would reduce the "haircut" broker-dealers apply under Rule 15c3-1 for money market funds from 2% to 1%.

FURTHER REQUESTS FOR COMMENT

The SEC has also requested comment on the following related matters that have not yet been proposed as rule amendments:

Early Warning Levels. The Capital Committee of the Securities Industry Association proposes lowering the Rule 17a-11 early warning level for broker-dealers carrying over $10 billion in debits and recommends a tiered approach in which the early warning level would be calculated by adding: (5% of the first $10 billion in debits) + (4% of the next $5 billion) + (3% of the next $5 billion) + (2.5% of all remaining debits). The SEC requests comment on this proposal and notes that FINRA and other self-regulatory organizations would need to alter their early warning levels to make such a proposed amendment effective.

Harmonize Securities Lending and Repo Capital Charges. The SEC is considering harmonizing the net capital deductions required under paragraph (c)(2)(iv)(B) of Rule 15c3-1 for securities lending and borrowing transactions with the deductions required under paragraph (c)(2)(iv)(F) for securities repo transactions because the two transactions are economically similar. The SEC describes the changes it would make to eliminate the current mismatch and seeks comment on whether the changes are feasible.

Accounting for Third-Party Liens on Customer Securities Held at a Broker-Dealer. The SEC is considering changing how third-party liens against customer fully paid securities carried by a broker-dealer are treated under the financial responsibility rules, including Rule 15c3-1, Rule 17a-3 and Rule 17a-4, and seeks comment on whether, for example, the broker-dealer should be required to (1) include the amount of the customer's obligation to the third party as a credit item in the reserve formula, (2) move the securities subject to the lien into a separate pledge account in the name of the pledgee, or (3) record on its books and records and disclose to the customer the existence of the lien, identity of the pledgee, obligation of the customer, and amount of securities subject to the lien.

PUBLIC COMMENT REQUESTED

The reopened public comment period ends on June 8, 2012.

FDIC Chairman Outlines FDIC's Strategy for Resolution of Systemically Important Financial Firm

As the next step in developing the FDIC's implementation of its authority under the Dodd-Frank Act to resolve systemically important financial institutions ("SIFIs"), FDIC acting chairman Martin Gruenberg outlined the major components of its resolution strategy in a May 10, 2012 speech to the Federal Reserve Bank of Chicago Bank Structure Conference. The FDIC would place the SIFI's parent bank holding company into receivership and revoke its charter, while allowing its subsidiaries to continue operations with government-provided liquidity, should the Treasury Department and several federal agencies agree that a SIFI presents a risk of systemic consequences. Additionally, the FDIC would transfer most of the troubled SIFI's assets and some liabilities into a bridge company, which would undergo a swap of debt for equity, similar to a Chapter 11 restructuring under the bankruptcy statutes. The recapitalized company would eventually emerge as a new, private entity.

The process outlined by the FDIC acting chairman is part of the agency's effort to develop the "orderly liquidation authority" it was granted by the Dodd-Frank Act, and to convince the financial industry that SIFIs neither have an unlimited public backstop, nor will they cause destabilizing disruptions when under financial strain. Additionally, the FDIC has established the Office of Complex Financial Institutions to monitor risk and coordinate with foreign regulators. It has also issued final rules governing the priority of claims under the orderly liquidation authority and requiring SIFIs to submit "living wills" to the FDIC periodically (discussed in the September 20, 2011 Financial Services Alert). Finally, the FDIC has worked through the Financial Stability Board to develop a statement of "Key Attributes of Effective Resolution Regimes for Financial Institutions" and has engaged with foreign financial regulators on a bilateral basis to plan for joint resolution efforts addressing the cross-border operations of SIFIs and the global nature of systemic risk.

FINRA Sanctions Four Firms $9.1 Million Over Sales of Leveraged and Inverse Exchange-Traded Funds

On May 1, 2012, FINRA announced that it had sanctioned four member firms a total of 9.1 million, including fines of $7.3 million and restitution of $1.8 million, for selling leveraged and inverse exchange-traded funds ("ETFs") without reasonable supervision and without a reasonable basis for recommending the securities. Each firm entered into an Acceptance, Waiver and Consent ("AWC") resolving the FINRA investigation. In settling the matters, the firms neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

Background. ETFs typically invest in a portfolio of securities that track an underlying benchmark or index. Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs seek to deliver performance that is the opposite of the performance of the index or benchmark they track (e.g., by using short positions in derivatives to profit from a falling market). In FINRA Regulatory Notice 09-31, published in June 2009, FINRA explained that most leveraged and inverse ETFs reset daily, meaning that they are designed to achieve their stated objectives on a daily basis. Firms are required to perform a customer-specific suitability review before recommending securities to customers and, in the view of FINRA, inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.

Findings. FINRA found that from January 2008 through June 2009, the firms did not have adequate supervisory systems in place to monitor the sale of leveraged and inverse ETFs, and failed to conduct adequate due diligence regarding the risks and features of the ETFs.

As a result, the firms did not have a reasonable basis to recommend the ETFs to their retail customers. FINRA also found that the firms' registered representatives made unsuitable recommendations of leveraged and inverse ETFs to some customers with conservative investment objectives or risk profiles. According to FINRA, each of the firms sold billions of dollars of leveraged and inverse ETFs to customers, some of whom held them for extended periods when the markets were volatile.

FINRA'S findings covered sales during the period ending June 2009, when it first cautioned members in Regulatory Notice 09-31 with respect to leveraged and inverse ETFs. The penalties levied by FINRA reflect a determination that the firms should have known that the investments were unsuitable for some retail customers even in the absence of notice by FINRA. FINRA has more recently advised member firms about the obligation to provide heightened supervision with respect to complex products generally, in Regulatory Notice 12-03.

OTHER ITEMS OF NOTE

FRB Issues Approval of Application by Industrial and Commercial Bank of China Limited and Two Other Chinese Banks to Become Bank Holding Companies Through Acquisition of Up to 80% of The Bank of East Asia (U.S.A.) National Association

The FRB issued an approval order (the "Order") of the application of Industrial and Commercial Bank of China Limited ("ICBC"), China Investment Corporation and Central Huijin Investment Ltd., all of Beijing, China, to become U.S. bank holding companies by acquiring up to 80% of the voting stock of The Bank of East Asia (U.S.A.) National Association, of New York City, which engages in retail and commercial banking in the U.S. through the operation of 13 branches in New York and California. ICBC is the largest bank in China, and the government of China owns approximately 70% of ICBC. In the Order (and as bases for its approval), the FRB concluded, among other things, that ICBC's Chinese home regulatory supervisors subjected ICBC "to comprehensive supervision on a consolidated basis..." and that ICBC's anti-money laundering compliance ("AML") efforts and Chinese laws and regulations addressing AML issues, as well as supervision of AML compliance by Chinese regulatory agencies, are consistent with the FRB's approval of the application. Prior to the FRB's issuance of the Order, the FRB's approvals of applications by Chinese banks had been limited to approvals of applications to establish a branch in the U.S. where the FRB was not required to make a determination that China subjected the applicant bank to comprehensive supervision on a consolidated basis.

FinCEN Extends Comment Period on Proposed Rule Regarding Customer Due Diligence Requirements

The Financial Crimes Enforcement Network ("FinCEN") extended the comment period from May 4, 2012 to June 11, 2012 on FinCEN's advanced notice of proposed rulemaking (the "ANPR") proposing to strengthen existing customer due diligence requirements and to require expressly that covered financial institutions (including banks, brokers or dealers in securities, mutual funds, futures commissions merchants and introducing brokers in commodities) identify, with limited exceptions, beneficial owners of their account holders. See the March 6, 2012 Financial Services Alert for a discussion of the ANPR

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2012 Goodwin Procter LLP. All rights reserved.

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