Financial Responsibility Rules for Broker-Dealers

Federal RegisterAug 21, 2013

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-70072; File No. S7-08-07]

RIN 3235-AJ85

Financial Responsibility Rules for Broker-Dealers

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is adopting amendments to the net capital, customer protection, books and records, and notification rules for broker-dealers promulgated under the Securities Exchange Act of 1934 (“Exchange Act”). These amendments 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.

DATES:

Effective Date:

October 21, 2013.

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, Associate Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate Director, at (202) 551-5521; Randall Roy, Assistant Director, at (202) 551-5522; Raymond Lombardo, Branch Chief, at (202) 551-5755; Sheila Dombal Swartz, Special Counsel, (202) 551-5545; Carrie A. O'Brien, Special Counsel, (202) 551-5640; or Kimberly N. Chehardy, Attorney Advisor, (202) 551-5791; Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

II. Amendments

A. Amendments to the Customer Protection Rule

1. Background

2. Proprietary Accounts of Broker-Dealers

i. Definition of “PAB Account” under Rule 15c3-3(a)(16)

ii. Written Permission To Use PAB Account Securities

iii. PAB Reserve Bank Accounts

iv. Other PAB Issues Raised by Commenters

v. Amendment to Rule 15c3-1(c)(2)(iv)(E) Related to PAB Accounts

3. Banks Where Special Reserve Deposits May Be Held

4. Allocation of Customers' Fully Paid and Excess Margin Securities to Short Positions

5. Importation of Rule 15c3-2 Requirements Into Rule 15c3-3 and Treatment of Free Credit Balances

i. Importation of Rule 15c3-2

ii. Treatment of Free Credit Balances

a. Treatment of Free Credit Balances Outside of a Sweep Program

b. Treatment of Free Credit Balances in a Sweep Program

6. “Proprietary Accounts” Under the Commodity Exchange Act

7. Expansion of the Definition of “Qualified Securities” To Include Certain Money Market Funds

B. Holding Futures Positions in a Securities Portfolio Margin Account

C. Amendments With Respect to Securities Lending and Borrowing and Repurchase/Reverse Repurchase Transactions

D. Documentation of Risk Management Procedures

E. Amendments to the Net Capital Rule

1. Requirement To Deduct From Net Worth Certain Liabilities or Expenses Assumed by Third Parties

2. Requirement To Subtract From Net Worth Certain Non-Permanent Capital Contributions

3. Requirement To Deduct the Amount by Which a Fidelity Bond Deductible Exceeds SRO Limits

4. Broker-Dealer Solvency Requirement

5. Amendment to Rule Governing Orders Restricting Withdrawal of Capital From a Broker-Dealer

6. Adjusted Net Capital Requirements

i. Amendment to Appendix A of Rule 15c3-1

ii. Money Market Funds

a. Clarification

b. Proposed Haircut Reduction From 2% to 1%

c. Aggregate Debit Items Charge

F. Technical Amendments

III. Responses to Specific Requests for Comment

IV. Paperwork Reduction Act

A. Summary of the Collection of Information Requirements

B. Use of Information

C. Respondents

D. Total Annual Reporting and Recordkeeping Burden

1. Securities Lending Agreements and Disclosures

2. DEA Permission To Withdraw Capital Within One Year of Contribution

3. Written Subordination Agreements Under Rule 15c3-3

4. PAB Reserve Bank Account Recordkeeping Requirements

5. Adequate Procedures Required Under Paragraph (j)(1) of Rule 15c3-3

6. Treatment of Free Credit Balances

7. Documentation of Risk Management Procedures

8. Notice Requirements

E. Collection of Information Is Mandatory

F. Confidentiality

G. Record Retention Period

V. Economic Analysis

A. Introduction

B. Economic Baseline

C. Discussion of General Comments Received

D. Economic Analysis of the Amendments and Alternatives

1. Amendments to the Customer Protection Rule

i. Economic Analysis

a. Proprietary Accounts of Broker-Dealers

(I). Summary of Amendments

(II). Baseline and Incremental Economic Effects

(III). Alternatives

(IV). Compliance Cost Estimates

b. Banks Where Special Reserve Deposits May Be Held

(I). Summary of Amendments

(II). Baseline and Incremental Economic Effects

(III). Alternatives

(IV). Compliance Cost Estimates

c. Allocation of Customers' Fully Paid and Excess Margin Securities to Short Positions

d. Importation of Rule 15c3-2 Requirements Into Rule 15c3-3

e. Treatment of Free Credit Balances

(I). Summary of Amendments

(II). Baseline and Incremental Economic Effects

(III). Alternatives

(IV). Compliance Cost Estimates

f. “Proprietary Accounts” Under the Commodity Exchange Act

ii. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

2. Holding Futures Positions in a Securities Portfolio Margining Account

i. Economic Analysis

ii. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

3. Amendments With Respect to Securities Lending and Borrowing and Repurchase/Reverse Repurchase Transactions

i. Economic Analysis

ii. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

4. Documentation of Risk Management Procedures

i. Economic Analysis

ii. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

5. Amendments to the Net Capital Rule

i. Economic Analysis

a. Requirement To Deduct From Net Worth Certain Liabilities or Expenses Assumed By Third Parties

(I). Summary of Amendments

(II). Baseline and Incremental Economic Effects

(III). Alternatives

b. Requirement To Subtract From Net Worth Certain Non-Permanent Capital Contributions

(I). Summary of Amendments

(II). Baseline and Incremental Economic Effects

(III). Alternatives

c. Requirement To Deduct the Amount by Which a Fidelity Bond Exceeds SRO Limits

d. Broker-Dealer Solvency Requirement

e. Amendment to Rule Governing Restrictions of Withdrawals of Capital

f. Amendment to Rule 15c3-1 Appendix A

ii. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

VI. Final Regulatory Flexibility Analysis

A. General Issues Raised by Public Comments

B. Amendments to the Customer Protection Rule

1. Need for and Objectives of the Rule Amendments

2. Significant Issues Raised by Public Comment

3. Small Entities Subject to the Rules

4. Reporting, Recordkeeping, and Other Compliance Requirements

5. Agency Action To Minimize Effect on Small Entities

D. Securities Lending and Borrowing and Repurchase/Reverse Repurchase Transactions

1. Need for and Objectives of the Amendments

2. Significant Issues Raised by the Public Comments

3. Small Entities Subject to the Rule

4. Reporting, Recordkeeping, and Other Compliance Requirements

5. Agency Action To Minimize Effect on Small Entities

E. Documentation of Risk Management Procedures

1. Need for and Objectives of the Amendments

2. Significant Issues Raised by Public Comments

3. Small Entities Subject to the Rule

4. Reporting, Recordkeeping, and Other Compliance Requirements

5. Agency Action To Minimize Effect on Small Entities

F. Amendments to the Net Capital Rule

1. Need for and Objectives of the Amendments

2. Significant Issues Raised by Public Comments

3. Small Entities Subject to the Rule

4. Reporting, Recordkeeping, and Other Compliance Requirements

5. Agency Action to Minimize Effect on Small Entities

VII. Statutory Authority

I. Background

The Commission is adopting amendments to the broker-dealer net capital rule (Rule 15c3-1),

customer protection rule (Rule 15c3-3),

books and records rules (Rules 17a-3 and 17a-4), and notification rule (Rule 17a-11).

The Commission proposed these rule changes on March 9, 2007.

The Commission re-opened the public comment period on May 3, 2012.

The Commission received a total of 97 comment letters on the proposed amendments.

Sixty comment letters

were received prior to the re-opening of the comment period, and 37 were received after it. The Commission carefully considered all of the comment letters, and as discussed in detail below, modified the amendments in certain respects in light of the comments received. In addition, the Commission has determined to defer consideration of action at this time with respect to certain of the proposed amendments.

17 CFR 240.15c3-1.

17 CFR 240.15c3-3.

17 CFR 240.17a-3; 17 CFR 240.17a-4; and 17 CFR 240.17a-11.

See Amendments to Financial Responsibility Rules for Broker-Dealers,

Exchange Act Release No. 55431 (Mar. 9, 2007), 72 FR 12862 (Mar. 19, 2007) (“

Amendments to Financial Responsibility Rules”

). As part of this release, the Commission also requested comment on three additional matters: reducing the Rule 17a-11 (17 CFR 240.17a-11) early warning level for broker-dealers that carry over $10 billion in debits; harmonization of the net capital deductions required by 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 repurchase and reverse repurchase agreement transactions (17 CFR 240 240.15c3-1(c)(2)(iv)(B) and (c)(2)(iv)(F), respectively); and accounting for third-party liens on customer securities held at a broker-dealer. As discussed below in section III. of this release, the Commission received comments in response to these requests but has determined to defer consideration of actions with respect to these specific matters at this time.

Amendments to Financial Responsibility Rules for Broker-Dealers,

Exchange Act Release No. 66910 (May 3, 2012), 77 FR 27150 (May 9, 2012).

Comments on the amendments are

available at http://www.sec.gov/comments/s7-08-07/s70807.shtml. See also

letter dated April 22, 2007 from Peter G. Crane, President, Crane Data LLC (“

Crane Data Letter

”); letter dated April 22, 2007 from David Michael Bishop (“

Bishop Letter

”); letter dated April 27, 2007 from Ted Beer, Broker/Dealer Principal (“

Beer Letter

”); letter dated April 28, 2007 from Ted Beer, Broker/Dealer Principal (“

Beer 2 Letter

”); letter dated April 29, 2007 from R.A. Lowenstein, FinOps Compliance Consultant (“

Lowenstein Letter

”); letter dated April 29, 2007 from G. Kirk Ellis (“

Ellis Letter

”); letter dated May 1, 2007 from Stuart J. Kaswell and David J. Harris, Dechert LLP on behalf of Federated Investors (“

Federated Letter

”); letter dated May 2, 2007 from Daniel R. Levene, President, small NASD broker-dealer (“

Levene Letter

”); letter dated May 4, 2007 from Gerard J. Quinn, Vice President and Associate General Counsel, SIFMA (“

SIFMA Letter

”); letter dated May 7, 2007 from Michael Bell, President and CEO, Curian Clearing, LLC (“

Curian Clearing Letter

”); letter dated May 10, 2007 from Richard B. Franz II, Senior Vice-President, Treasurer and Chief Financial Officer, Raymond James & Associates (“

Raymond James Letter

”); letter dated May 16, 2007 from Steven R. Gerbel, Chicago Capital Management LP (“

Chicago Capital Letter

”); letter dated May 17, 2007 from Jeffrey L. Kiss, Principal, PackerKiss Securities, Inc. (“

PackerKiss Letter

”); letter dated May 17, 2007 from Josephine Wang, General Counsel, SIPC (“

SIPC Letter

”); letter dated May 18, 2007 from Kimberly Taylor, Managing Director and Clearing House President, Chicago Mercantile Exchange Inc. (“

CME Letter

”); letter dated May 18, 2007 from Diane V. Esheleman, Executive Vice President, JP Morgan Chase Bank, N.A. (“

JP Morgan Letter

”); letter dated May 21, 2007 from Faith Colish, Carter Ledyard Milburn LLP (“

Colish Letter

”); letter dated May 23, 2007 from Charles R. Manzoni, Jr., General Counsel, FAF Advisors, Inc. (“

FAF Advisors Letter

”); letter dated May 27, 2007 from Joyce Glenn (“

Glenn Letter

”); letter dated May 28, 2007 from William Bare (“

Bare Letter

”); letter dated May 29, 2007 from Robert Keenan, CEO, St. Bernard Financial Services, Inc. (“

St. Bernard Financial Services Letter

”); letter dated May 31, 2007 from John C. Melton, Sr., Executive Vice President, Coastal Securities (“

Coastal Letter

”); letter dated June 3, 2007 from Anonymous (“

Anonymous Letter

”); letter dated June 5, 2007 from Kelly S. McEntire, Executor, Retired State Administrator/Executor of Janus Capital Investments (“

McEntire Letter

”); letter dated June 13, 2007 from Bruce Bent, Chairman, The Reserve (“

Reserve Letter

”); letter dated June 14, 2007 from Amal El Said, Accounting and Regulatory, Abbey National (“

Abbey National Letter

”); letter dated June 14, 2007 from Frank A. Perrone, Senior Vice President, Brown Brothers Harriman & Co. (“

Brown Brothers Harriman Letter

”); letter dated June 15, 2007 from James J. Angel, Ph.D., CFA, Associate Professor of Finance, McDonough School of Business, Georgetown University (“

Angel Letter

”); letter dated June 15, 2007 from Matthew M. Hughey, Chief Financial Officer, First Clearing, LLC (“

First Clearing Letter

”); letter dated June 15, 2007 from Marshall J. Levinson, Senior Managing Director, Bear, Stearns & Co. Inc., Chair, SIFMA Capital Committee (“

SIFMA 2 Letter

”); letter dated June 15, 2007 from Christopher Williams, Director and Senior Counsel, and Barbara Brooks, Principal Financial Officer, Dresdner Kleinwort (“

Dresdner Kleinwort Letter

”); letter dated June 18, 2007 from Michael Dworkin (“

Dworkin Letter

”); letter dated June 18, 2007 from Keith Weller, Executive Director and Senior Associate General Counsel, UBS Global Asset Management (Americas) Inc. (“

UBS Letter

”); letter dated June 18, 2007 from Marcelo Riffaud, Managing Director, Legal Department, Deutsche Bank Securities Inc. (“

Deutsche Bank Securities Letter

”); letter dated June 18, 2007 from Jill Gross and Rahat Sarmast, Pace Investor Rights Project (“

Pace Letter

”); letter dated June 18, 2007 from Robert E. Putney, III, Director and Senior Counsel, BlackRock, Inc. (“

BlackRock Letter

”); letter dated June 18, 2007 from James S. Keller, Chief Regulatory, the PNC Financial Services Group, Inc. (“

PNC Letter

”); letter dated June 18, 2007 from Sarah A. Miller, General Counsel, American ABA Securities Association (“

ABASA Letter

”); letter dated June 18, 2007 from David Hirschmann, Executive Vice President, National Chamber Foundation of U.S. Chamber of Commerce (“

National Chamber Foundation Letter

”); letter dated June 18, 2007 from Michael W. Fields, Chief Fixed Income Officers, American Beacon Advisors (“

American Beacon Letter

”); letter dated June 18, 2007 from David Lonergan, Head of U.S. Cash Management, Barclays Global Investors (“

Barclays Letter

”); letter dated June 18, 2007 from Howard Spindel, Senior Managing Directors, Integrated Management Solutions (“

Integrated Management Letter

”); letter dated June 18, 2007 from Jane G. Heinrichs, Associate Counsel, Investment Company Institute (“

ICI Letter

”); letter dated June 18, 2007 from Jeffrey P. Neubert, CEO, Clearinghouse Association L.L.C. (“

Clearing House Letter

”); letter dated June 19, 2007 from James T. McHale, Associate General Counsel, E*Trade Brokerage Holdings, Inc. (“

E*Trade Letter

”); letter dated June 25, 2007 from Cliff Verron, Managing Director, Deputy Chief Financial Officers and John Ramsay, Managing Director, Deputy General Counsel, Citigroup Global Markets Inc. (“

Citigroup Letter

”); letter dated June 25, 2007 from AMEX, CBOE, ISE, OCC, and NYSE/ARCA (“

AMEX Letter

”); letter dated July 3, 2007 from Keith F. Higgins, Chair, Committee on Federal Regulation of Securities, American Bar Association (“

American Bar Association Letter

”); letter dated July 23, 2007 from Charles S. Morrison, Senior Vice President and Money Market Group Leader, Fidelity Management & Research Company, and John Valenti, Vice President, National Financial Securities LLC (“

Fidelity/NFS Letter

”); letter dated August 6, 2007 from Stuart Kaswell, Dechert LLP, on behalf of Federated Investors, Inc. (“

Federated 2 Letter

”); letter dated October 9, 2007 from Stuart Kaswell, Dechert LLP on behalf of Federated Investors, Inc. (“

Federated 3 Letter

”); letter dated November 16, 2007 from Marshall J. Levinson, Chair, Capital Committee, SIFMA (“

SIFMA 3 Letter

”); letter dated January 7, 2008 from Stuart J. Kaswell, Dechert LLP, on behalf of Federated Investors, Inc. (“

Federated 4 Letter

”); letter dated August 7, 2008 from Stuart J. Kaswell, Bryan Cave LLP, on behalf of Federated Investors, Inc. (“

Federated 5 Letter

”); letter dated November 10, 2008 from Lee A. Pickard, Pickard & Djinis LLP on behalf of Federated Investors (“

Federated 6 Letter

”); letter dated November 25, 2008 from Lee A. Pickard, Pickard & Djinis LLP on behalf of Federated Investors (“

Federated 7 Letter

”);

letter dated December 18, 2008 from Lee A. Pickard, Pickard & Djinis LLP on behalf of Federated Investors (“

Federated 8 Letter

”); letter dated July 28, 2009 from Richard J. McDonald, Chief Regulatory Counsel, Susquehanna International Group LLP (“

SIG Letter

”); letter dated June 8, 2010 from The Honorable Gregory W. Meeks (“

Meeks Letter

”); letter dated October 14, 2011 from The Honorable Gregory W. Meeks (“

Meeks 2 Letter

”); letter dated May 5, 2012 from Edward P. Cernocky (“

Cernocky Letter

”); letter dated May 11, 2012 from Chris Barnard (“

Barnard Letter

”); letter dated May 15, 2012 from Helen M. Saarinen (“

Saarinen Letter

”); letter dated May 18, 2012 from Laura H. Hearne (“

Hearne Letter

”); letter dated May 24, 2012 from Dick Fuld (“

Fuld Letter

”); letter dated May 30, 2012 from Bruce J. Womack (“

Womack Letter

”); letter dated June 1, 2012 from Lee A. Pickard, Pickard & Djinis LLP, on behalf of Federated Investors (“

Federated 9 Letter

”); letter dated June 4, 2012 from Michael Scillia, Director, National Investment Banking Association (“

NIBA Letter

”); letter dated June 7, 2012 from Anthony Fitzgerald (“

Fitzgerald Letter

”); letter dated June 7, 2012 from Tom Vincent, Senior V.P., Corporate Governance and Wealth Management Compliance, BOK Financial Corporation (“

BOK Letter

”); letter dated June 8, 2012 from Denise Dolphin (“

Dolphin Letter

”); letter dated June 8, 2012 from Colin W. McKechnie, Managing Director, JP Morgan Chase Bank, N. A (“

JP Morgan 2 Letter

”); letter dated June 8, 2012 from William A. Jacobson, Associate Clinical Professor, Cornell Law School, and Director, Cornell Securities Law Clinic, Ithaca, New York (“

Cornell Letter

”); letter dated June 8, 2012 from Ryan K. Bakhtiari, Aidikoff, Uhl & Bakhtiari, on behalf of the Public Investors Arbitration Bar Association (“

PIABA Letter

”); letter dated June 8, 2012 from Kenneth E. Bentsen, Jr., Executive Vice President, Public Policy and Advocacy, SIFMA (“

SIFMA 4 Letter

”); letter dated June 8, 2012 from Sarah A. Miller, Chief Executive Officer, Institute of International Bankers (“

IIB Letter

”); letter dated June 8, 2012 from James T. McHale, Global Head of Compliance, E*TRADE Financial Corporation (“

E*Trade 2 Letter

”); letter dated June 11, 2012 from Steve M. Brewer, Sr., ASG Securities, LLC, Houston, Texas (“

ASG Securities Letter

”); letter dated June 25, 2012 from Gene L. Finn (“

Finn Letter

”); letter dated June 26, 2012 from Cindy Walsh (“

Walsh Letter

”); letter dated July 12, 2012 from Michael Scillia, Director, National Investment Banking Association (“

NIBA 2 Letter

”); letter dated July 18, 2012 from Gene L. Finn (“

Finn 2 Letter

”); letter dated July 30, 2012 from David Waddell (“

Waddell Letter

”); letter dated August 6, 2012 from Gene Finn (“

Finn 3 Letter

”); letter dated August 15, 2012 from Echeal R. Sigan (“

Sigan Letter

”); letter dated August 26, 2012 from Mark Irwin (“

Irwin Letter

”); letter dated September 17, 2012 from Gene L. Finn (“

Finn 4 Letter

”); letter dated September 27, 2012 from Jeff S. Clark (“

Clark Letter

”); letter dated September 28, 2012 from Robert LaPlante, M.P.A. (“

LaPlante Letter

”); letter dated October 19, 2012 from Rick Louderbough (“

Louderbough Letter

”); letter dated October 24, 2012 from Paul L. Matecki, Senior Vice President, General Counsel, Raymond James Financial, Inc. (“

Raymond James 2 Letter

”); letter dated October 25, 2012 from Eric Gamble, Ph.D. (“

Gamble Letter

”); letter dated November 1, 2012 from Percy R. Moorman, Esq. (“

Moorman Letter

”); letter dated January 4, 2013 from Marquis Wilkins (“

Wilkins Letter

”); letter dated January 5, 2013 from Anonymous SEC Fan (“

Anonymous SEC Letter

”); letter dated January 24, 2013 from Robert Fournier (“

Fournier Letter

”); and letter dated January 28, 2013 from Scott E. Shjefte (“

Shjefte Letter

”). Comment letters and specific comments outside the scope of this rulemaking are not addressed in this release.

II. Amendments

A. Amendments to the Customer Protection Rule

1. Background

The Commission adopted Rule 15c3-3 in 1972 in response to a congressional directive to strengthen the financial responsibility requirements for broker-dealers that hold securities and cash for customers.

In particular, Rule 15c3-3 is designed “to give more specific protection to customer funds and securities, in effect forbidding brokers and dealers from using customer assets to finance any part of their businesses unrelated to servicing securities customers;

e.g.,

a firm is virtually precluded from using customer funds to buy securities for its own account.”

To meet this objective, Rule 15c3-3 requires a broker-dealer that maintains custody of customer securities and cash (a “carrying broker-dealer”) to take two primary steps to safeguard these assets. The steps are designed to protect customers

by segregating their securities and cash from the broker-dealer's proprietary business activities. If the broker-dealer fails financially, the securities and cash should be readily available to be returned to the customers. In addition, if the failed broker-dealer is liquidated in a formal proceeding under the Securities Investor Protection Act of 1970 (“SIPA”), the securities and cash would be isolated and readily identifiable as “customer property” and, consequently, available to be distributed to customers ahead of other creditors.

See Broker-dealers; Maintenance of Certain Basic Reserves,

Exchange Act Release No. 9856 (Nov. 10, 1972), 37 FR 25224 (Nov. 29, 1972).

See Net Capital Requirements for Brokers and Dealers,

Exchange Act Release No. 21651 (Jan. 11, 1985), 50 FR 2690, 2690 (Jan. 18, 1985).

See also Broker-Dealers; Maintenance of Certain Basic Reserves,

Exchange Act Release No. 9856 (Nov. 10, 1972), 37 FR 25224, 25224 (Nov. 29, 1972).

Rule 15c3-3 defines

customer

as “any person from whom or on whose behalf a broker or dealer has received or acquired or holds funds or securities for the account of that person.” The rule excludes certain categories of persons from the definition, including broker-dealers, municipal securities dealers, and government securities broker-dealers. It also excludes general partners, directors, and principal officers of the broker-dealer and any other person to the extent that the person has a claim for property or funds which by contract, agreement or understanding, or by operation of law, is part of the capital of the broker-dealer or is subordinated to the claims of creditors of the broker-dealer. 17 CFR 240.15c3-3(a)(1).

See

15 U.S.C. 78aaa

et seq.

The first step required by Rule 15c3-3 is that a carrying broker-dealer must maintain physical possession or control over customers' fully paid and excess margin securities.

Physical possession or control means the broker-dealer must hold these securities in one of several locations specified in Rule 15c3-3 and free of liens or any other interest that could be exercised by a third party to secure an obligation of the broker-dealer.

Permissible locations include a bank, as defined in section 3(a)(6) of the Exchange Act, and a clearing agency.

See

17 CFR 240.15c3-3(b) and (d). The term

fully paid securities

includes all securities carried for the account of a customer in a special cash account as defined in Regulation T promulgated by the Board of Governors of the Federal Reserve System, as well as margin equity securities within the meaning of Regulation T which are carried for the account of a customer in a general account or any special account under Regulation T during any period when section 8 of Regulation T (12 CFR 220.8) specifies that margin equity securities shall have no loan value in a general account or special convertible debt security account, and all such margin equity securities in such account if they are fully paid: provided, however, that the term

fully paid securities

shall not apply to any securities which are purchased in transactions for which the customer has not made full payment. 17 CFR 240.15c3-3(a)(3). The term

margin securities

means those securities carried for the account of a customer in a general account as defined in Regulation T, as well as securities carried in any special account other than the securities referred to in paragraph (a)(3) of Rule 15c3-3. 17 CFR 240.15c3-3(a)(4). The term

excess margin securities

means those securities referred to in paragraph (a)(4) of Rule 15c3-3 carried for the account of a customer having a market value in excess of 140 percent of the total of the debit balances in the customer's account or accounts encompassed by paragraph (a)(4) of Rule 15c3-3 which the broker-dealer identifies as not constituting margin securities. 17 CFR 240.15c3-3(a)(5). As discussed in section II.F. of this release, the Commission is adopting technical amendments to the definitions of the terms

fully paid securities

and

margin securities

under Rule 15c3-3.

See

paragraphs (a)(3) and (4) of Rule 15c3-3, as adopted.

See

17 CFR 240.15c3-3(c). Customer securities held by the carrying broker-dealer are not assets of the firm. Rather, the carrying broker-dealer holds them in a custodial capacity and the possession and control requirement is designed to ensure that the carrying broker-dealer treats them in a manner that allows for their prompt return.

Id.

The second step is that a carrying broker-dealer must maintain a reserve of cash or qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers, including cash obtained from the use of customer securities.

The account must be titled “Special Reserve Bank Account for the Exclusive

Benefit of Customers.”

The amount of net cash owed to customers is computed pursuant to a formula set forth in Exhibit A to Rule 15c3-3.

Under the customer reserve formula, the broker-dealer adds up customer credit items (

e.g.,

cash in customer securities accounts and cash obtained through the use of customer margin securities) and then subtracts from that amount customer debit items (

e.g.,

margin loans).

If credit items exceed debit items, the net amount must be on deposit in the customer reserve account in the form of cash and/or qualified securities.

A broker-dealer cannot make a withdrawal from the customer reserve account until the next computation and even then only if the computation shows that the reserve requirement has decreased.

The broker-dealer must make a deposit into the customer reserve account if the computation shows an increase in the reserve requirement.

17 CFR 240.15c3-3(e). The term

qualified security

is defined in Rule 15c3-3 to mean a security issued by the United States or a security in respect of which the principal and interest are guaranteed by the United States.

See

17 CFR 240.15c3-3(a)(6).

See

17 CFR 240.15c3-3(e)(1). The purpose of giving the account this title is to alert the bank and creditors of the broker-dealer that this account is to be used to meet the broker-dealer's obligations to customers (and not the claims of general creditors) in the event the broker-dealer must be liquidated in a formal proceeding.

17 CFR 240.15c3-3a.

Id.

17 CFR 240.15c3-3(e). Customer cash is a balance sheet item of the carrying broker-dealer (

i.e.,

the amount of cash received from a customer increases the amount of the carrying broker-dealer's assets and creates a corresponding liability to the customer). The customer reserve formula is designed to isolate these broker-dealer assets so that an amount equal to the net liabilities to customers is held as a reserve in the form of cash or qualified securities. The requirement to establish this reserve is designed to effectively prevent the carrying broker-dealer from using customer funds for proprietary business activities such as investing in securities. The goal is to put the carrying broker-dealer in a position to be able to readily meet its cash obligations to customers by requiring the firm to make deposits of cash and/or qualified securities into the customer reserve account in the amount of the net cash owed to customers.

Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers,

Exchange Act Release No. 68071 (Oct. 18, 2012), 77 FR 70213, 70277 n.671 (Nov. 23, 2012).

See

17 CFR 240.15c3-3(e). Under paragraph (e), broker-dealers are generally required to perform the customer reserve computation as of the close of business on the last business day of the week. Broker-dealers from time to time may perform a mid-week computation if it would permit them to make a withdrawal. 17 CFR 240.15c3-3(g).

In addition, the customer reserve formula permits the broker-dealer to offset customer credit items only with customer debit items.

This means the broker-dealer can use customer cash to facilitate customer transactions such as financing customer margin loans and borrowing securities to make deliveries of securities that customers have sold short.

Broker-dealer margin rules require securities customers to maintain a minimum level of equity in their securities accounts.

In addition to protecting the broker-dealer from the consequences of a customer default, this equity serves to over-collateralize the customers' obligations to the broker-dealer and thereby protect customers whose cash was used to facilitate the broker-dealer's financing of securities purchases and short sales by other customers. For example, if the broker-dealer fails, the customer debits, because they generally are over-collateralized, should be attractive assets for another broker-dealer to purchase or, if not purchased by another broker-dealer, they should be able to be liquidated to a net positive equity.

The proceeds of the debits sale or liquidation can be used to repay the customer cash used to finance the customer obligations. This cash plus the funds and/or qualified securities held in the customer reserve account should equal or exceed the total amount of customer credit items (

i.e.,

the total amount owed by the broker-dealer to its customers).

See

17 CFR 240.15c3-3a.

For example, if a broker-dealer holds $100 for customer A, the broker-dealer can use that $100 to finance a security purchase of customer B. The $100 the broker-dealer owes customer A is a credit in the formula and the $100 customer B owes the broker-dealer is a debit in the formula. Therefore, under the customer reserve formula there would be no requirement to maintain cash and/or U.S. government securities in the customer reserve account. However, if the broker-dealer did not use the $100 held in customer A's account for this purpose, there would be no offsetting debit and, consequently, the broker-dealer would need to have on deposit in the customer reserve account cash and/or qualified securities in an amount at least equal to $100.

Broker-dealers are subject to margin requirements in Regulation T promulgated by the Federal Reserve (

see

12 CFR 220.1,

et seq.

), in rules promulgated by the self-regulatory organizations (“SROs”) (

see, e.g.,

FINRA Rules 4210-4240), and with respect to security futures, in rules jointly promulgated by the Commission and the CFTC (

see

17 CFR 242.400-406).

The attractiveness of the over-collateralized debits facilitates the bulk transfer of customer accounts from a failing or failed broker-dealer to another broker-dealer.

See Net Capital Requirements for Broker-Dealers; Amended Rules,

Exchange Act Release No. 18417 (Jan. 13, 1982), 47 FR 3512, 3513 (Jan. 25, 1982) (“The alternative method is founded on the concept that if the debit items in the Reserve Formula can be liquidated at or near their contract values, these assets, along with any cash required to be on deposit under the [customer protection] rule, will be sufficient to satisfy all customer-related liabilities (which are represented as credit items in the Reserve Formula”).

2. Proprietary Accounts of Broker-Dealers

A carrying broker-dealer may carry accounts that hold proprietary securities and cash of other broker-dealers (“PAB accounts”). As noted above, broker-dealers are not within the definition of

customer

for purposes of Rule 15c3-3.

Accordingly, a carrying broker-dealer that carries PAB accounts is not required to treat these accounts as customer accounts for the purposes of Rule 15c3-3. This means the carrying broker-dealer is not required to maintain possession or control of the securities of PAB account holders that are not securing margin loans to the account holders (“non-margin securities”) or include credit and debit items associated with those accounts in its customer reserve computation. The definition of

customer

in SIPA, however, is broader than the definition in Rule 15c3-3 in that the SIPA definition does not exclude broker-dealers.

Customers under SIPA (“SIPA customers”) generally are entitled to a number of protections, including the right to share

pro rata

with other SIPA customers in the customer property held by the broker-dealer and, if the customer property is insufficient to make each SIPA customer whole, the entitlement to receive an advance from the Securities Investor Protection Corporation (“SIPC”) of up to $500,000 (of which $250,000 currently can be used to cover cash claims).

Broker-dealers as SIPA customers have the right to a

pro rata

share of the customer property, but are not entitled to receive an advance from the SIPC fund.

Consequently, when a carrying broker-dealer is liquidated in a SIPA proceeding, each customer (including a SIPA customer that is a broker-dealer) has a claim on the customer property. Because the possession and control and customer reserve account provisions of Rule 15c3-3 do not apply to PAB account holders by virtue of the definition of

customer

in the rule, the carrying broker-dealer is not restricted by Rule 15c3-3 from using the securities and cash in these accounts for its own business purposes.

17 CFR 240.15c3-3(a)(1).

See

15 U.S.C. 78

lll

(2).

See

15 U.S.C. 78fff-2(c) and 15 U.S.C. 78fff-3(a), respectively. Under SIPA, customer property includes “cash and securities (except customer name securities delivered to the customer) at any time received, acquired, or held by or for the account of the debtor from or for the securities accounts of a customer, and the proceeds of any such property transferred by the debtor, including property unlawfully converted.” 15 U.S.C. 78

lll

(4). Therefore, customer property includes those securities positions that are held for customers and the cash that is owed to customers.

See

15 U.S.C. 78fff-2(c);

See also

SIFMA 4 Letter. Under Rule 15c3-1, a broker-dealer can exclude liabilities that are subordinated to the claims of creditors pursuant to a satisfactory subordination agreement, as defined in Appendix D to Rule 15c3-1, for purposes determining its net capital.

See

17 CFR 240.15c3-1(c)(2)(ii) and 17 CFR 240.15c3-1d.

See also

17 CFR 240.15c3-1(c)(i)(x). A non-conforming subordination agreement generally would not meet all the requirements of Appendix D to Rule 15c3-1, and, therefore, a broker-dealer could not exclude the liability resulting from the loan agreement in computing its net capital.

See

17 CFR 240.15c3-1(c)(2)(ii).

Another commenter stated that the Commission's desire to close the gap between Rule 15c3-3 and SIPA must be balanced against the potentially significant practical issues the Commission's proposal would raise in the case of accounts carried for affiliated entities operating in non-U.S. jurisdictions.

In a subsequent letter, this commenter stated that while it would prefer a more flexible solution that would allow broker-dealers and non-U.S. banks acting as broker-dealers (especially non-U.S. affiliates) to opt to have their accounts treated as neither customer accounts under SIPA nor PAB accounts, the commenter recognized that there is a clear need for an immediate solution that cannot be delayed until appropriate amendments to SIPA are adopted.

Consequently, the commenter withdrew its recommendation that the proprietary accounts of affiliated non-U.S. broker-dealers and affiliated non-U.S. banks be excluded from the “PAB account” definition, but continued to endorse its previous comments to achieve the goal of correcting the gap between Rule 15c3-3 and SIPA without creating undue or unintended burdens.

See SIFMA 2 Letter.

This commenter specifically raised concerns that it would be cumbersome to subject transactions between a carrying broker-dealer and its foreign affiliates to the proposed PAB requirements because of the integrated securities processing and settlement activities of these entities, which would limit the ability of the group as a whole to provide competitive services to U.S. investors.

See SIFMA 4 Letter.

Among other things, the commenter suggested that the Commission modify the proposed definition of

PAB account

to exclude any

customer

as defined in Rule 15c3-3 and also to exclude the other types of persons who are specifically excluded from the definition of

customer.

This suggestion included excluding accounts whose claims are subordinated to the claims of other creditors of the carrying broker-dealer.

Id.

The goal of the proposed amendments is to create a process that protects Rule 15c3-3 customers and PAB account holders of a failed carrying broker-dealer. The amendments are designed to provide such protection by mitigating the risk that there will be insufficient customer property to fully satisfy all customer claims in a SIPA liquidation. The entitlement of PAB account holders to a

pro rata

share of the fund of customer property places all SIPA customers at risk if the carrying firm does not establish a PAB reserve account for excess credits owed to PAB account holders.

At the same time, the Commission appreciates the need to consider both the practical issues raised by commenters and its objective to eliminate the inconsistency between Rule 15c3-3 and SIPA.

Accordingly, in response to commenters, the final rule adopted by the Commission excludes from the definition of

PAB account

in paragraph (a)(16) of Rule 15c3-3 “an account that has been subordinated to the claims of creditors of the carrying broker or dealer.”

A PAB account holder that has subordinated its claims with respect to that account to claims of creditors of the carrying broker-dealer will not be entitled to SIPA protection for that account.

Consequently, this provision will provide flexibility to carrying broker-dealers and their broker-dealer affiliates to structure their PAB account relationships in a manner that permits operational efficiencies (

i.e.,

the ability to exclude these accounts from the PAB reserve computation) while still promoting the goal of the amendments to have a consistent treatment of these accounts under Rule 15c3-3 and SIPA, and thereby protect accounts holders that are “customers” under SIPA.

If a U.S. broker-dealer, however, chooses to subordinate its claims to assets in that account to the claims of other creditors of the carrying broker-dealer, it will not be able to include those assets as allowable for its own net capital computation.

See Amendments to Financial Responsibility Rules,

72 FR at 12863.

The agreement would not need to be conforming for purposes of Exchange Act Rule 15c3-1d (Satisfactory Subordination Agreements).

See

15 U.S.C. 78

lll

(2).

See

17 CFR 240.15c3-3(a)(1) and 15 U.S.C. 78

lll

(2)(C)(ii). These accounts will be excluded from both the definition of

PAB account,

as well from the definition of

customer

under SIPA.

See Amendments to Financial Responsibility Rules,

72 FR at 12863. Consequently, these account holders will not be entitled to the protections in SIPA applicable to customers.

See

17 CFR 240.15c3-1(c)(2)(iv)(E).

Further, as was proposed, the definition of

PAB account

in the final rule excludes accounts that operate on a delivery-versus-payment or a receipt-versus-payment basis, or “DVP/RVP” basis, because these accounts generally hold securities and cash for short durations.

The provision relating to DVP/RVP accounts is being adopted substantially as proposed, though paragraph (a)(16), as adopted, has been modified by splitting the text into two sentences. As adopted, the reference to the DVP/RVP accounts provision was moved to the first sentence. The Commission is not adopting the proposed exclusions from the PAB reserve computation requirement related to accounts established by a PAB account holder that fully guarantee the obligations of, or whose accounts are fully guaranteed by, the carrying broker-dealer. Rather than create a specific exemption for such account holders, the Commission believes the better approach is to allow these accounts to enter into subordination agreements with the carrying broker-dealer, in order for these accounts to be excluded from the definition of

PAB account.

This approach simplifies the final rule, while continuing to provide a means for these account holders to be excluded from its scope. Consequently, as adopted, paragraph (a)(16) to Rule 15c3-3 defines the term

PAB account

to mean “a proprietary securities account of a broker or dealer (which includes a foreign broker or dealer, or a foreign bank acting as a broker or dealer) other than a delivery-versus-payment account or a receipt-versus-payment account.”

The definition of

PAB Account

does not include accounts that have been subordinated to the claims of a carrying broker-dealer's creditors.

See Amendments to Financial Responsibility Rules,

72 FR at 12863, n.17 (“[T]he amendment would exclude delivery-versus-payment and receipt-versus-payment accounts. These types of accounts pose little risk of reducing the estate of customer property in a SIPA liquidation since they only hold assets for short periods of time.”).

See

paragraph (a)(16) to Rule 15c3-3, as adopted.

Id.

ii. Written Permission To Use PAB Account Securities

Because PAB account holders are not customers for purposes of Rule 15c3-3, a carrying broker-dealer is not required to maintain possession or control of their non-margin securities. Consequently, it has been a long-

standing industry practice for carrying broker-dealers to use these PAB securities in their business activities. Under the final rule, a carrying broker-dealer that uses these PAB securities will need to include the market value of the securities as a credit in the formula when performing the PAB reserve computation. Thus, the amount that the carrying broker-dealer must maintain in its PAB reserve account will increase by the amount of these credits because there would be no corresponding debit item.

17 CFR 240.15c-3-3a.

Using non-margin securities of PAB account holders presents the risk that securities may increase in market value between PAB reserve computations and, therefore, the amount of the credit items in the formula may be less than the value of the securities for a short period of time. To accommodate industry practice, however, the Commission did not propose amending Rule 15c3-3 to apply the possession or control requirements to PAB accounts. The Commission proposed adding paragraph (b)(5) to Rule 15c3-3 that would have required the carrying broker-dealer to obtain written permission from a PAB account holder before it could use the PAB account holder's securities in the ordinary course of its securities business. In this way, the Commission proposed increasing the protections for PAB account holders without interfering with long-standing industry practice of carrying broker-dealers using the securities of their broker-dealer account holders. However, securities not being used by the broker-dealer must be maintained in accordance with the possession or control requirements of Rule 15c3-3.

One commenter stated that this provision should be eliminated from the proposed amendments, arguing that “[t]he proposal interferes unnecessarily in the contractual arrangements between broker-dealers, which are capable of understanding the terms of standard industry custodial relationships.”

The commenter also noted that the

PAIB Letter

did not contain any such requirement.

The Commission agrees with the commenter that broker-dealers should be able to understand the implications of granting another broker-dealer the ability to use their non-margin securities and, therefore, the final rule requires written notice rather than written permission. An appropriate level of protection for the PAB account holder may be achieved without requiring the carrying broker-dealer to maintain possession or control of securities carried for a PAB account, provided that the carrying broker-dealer gives written notice to its PAB account holders that it may use their non-margin securities.

See SIFMA 2 Letter.

Id.

The Commission has deleted the phrase “obtained the written permission of the account owner to use the securities in the ordinary course of its securities business” from paragraph (b)(5) of the final rule and replaced it with “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 holder to object.”

The Commission acknowledges that this change, as compared to the proposed rule, will shift the burden to the PAB account holder to proactively object to the carrying broker-dealer using the account holder's securities. However, the new written notice requirement increases the protections for PAB account holders from the status quo without imposing substantial burdens on existing account relationships. The revised rule is intended to provide to the PAB account holders the opportunity to negotiate different terms if they do not want their securities used, while eliminating the need for, and the costs that would result from, carrying broker-dealers reworking existing contracts.

As adopted, the Commission is modifying the final rule to add the phrase “and has provided an opportunity for the account holder to object” following the phrase “ordinary course of its securities business.”

This language was added to the final rule to impose a requirement that the carrying broker-dealer provide the PAB account holders an opportunity to object to the use of their non-margin securities after they receive the written notice from the carrying broker-dealer. The rule does not prescribe the form in which a PAB account holder must provide notice to the carrying broker-dealer of its objection. This will provide the PAB account holder with flexibility to communicate the objection in a manner the account holder determines is most effective in terms of conveying such objection to the carrying broker-dealer. If the PAB account holder objects, the carrying broker-dealer could not use the securities. Further, the PAB account holder could seek to move the account to another carrying broker-dealer or negotiate different terms with the carrying broker-dealer with regard to the use of its securities.

See

paragraph (b)(5) of Rule 15c3-3, as adopted.

Finally, the Commission has modified proposed paragraph (b)(5) to clarify in the final rule that a broker-dealer is affirmatively required to maintain possession and control of non-margin securities unless the broker-dealer has provided written notice to the PAB account holder.

As modified, paragraph (b)(5) reads: “A broker or dealer is required to obtain and thereafter maintain the physical possession or control of securities carried for a PAB account, unless the broker or 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 holder to object.”

The modifications replaced the phrase “shall not be required” with the phrase “is required” and replaced the phrase “provided that” with the word “unless.”

See

paragraph (b)(5) of Rule 15c3-3, as adopted.

iii. PAB Reserve Bank Accounts

The Commission proposed amendments to paragraph (e) of Rule 15c3-3 to require a carrying broker with PAB accounts to establish and maintain a PAB reserve account for PAB accounts, perform a separate PAB reserve computation for PAB accounts, and maintain cash or qualified securities in the PAB reserve account in an amount equal to the PAB reserve requirement.

The Commission also proposed amendments to paragraph (f) of Rule 15c3-3 to require carrying broker-dealers with PAB accounts to notify the bank about the status of the PAB reserve account and obtain an agreement and notification from the bank that the PAB reserve account will be maintained for the benefit of the PAB account holders.

The Commission is adopting these amendments to paragraphs (e) and (f) of Rule 15c3-3 substantially as proposed, with some technical modifications suggested by one commenter, including making terminology consistent throughout the paragraphs.

In addition, the Commission is adopting substantially as proposed the amendments to paragraph (g) of Rule 15c3-3 which specifies when the carrying broker-dealer can make withdrawals from a PAB reserve account.

Finally, the Commission is

adopting, as proposed, new paragraph (e)(4) to Rule 15c3-3, which allows a carrying broker-dealer to use credits related to PAB accounts to finance Rule 15c3-3 customer debits, but does not allow a carrying broker-dealer to use Rule 15c3-3 customer credits to finance PAB debits.

See

section II.A.3. of this release for a discussion of changes to paragraph (e)(5) of Rule 15c3-3 with respect to banks where customer or PAB reserve accounts may be held.

17 CFR 240.15c3-3(f).

See SIFMA 2 Letter.

17 CFR 240.15c3-3(g). In this paragraph, the Commission deleted the phrase “his Reserve Bank Accounts” and replaced it with the phrase “a Customer Reserve Bank Account and PAB Reserve Bank Account.” The Commission also deleted the phrase “each Reserve Bank Account” and replaced it with the phrase “the Customer Reserve Bank Account and PAB Reserve Bank Account.” These were the only changes made to the final rule in paragraph (g) of Rule 15c3-3.

iv. Other PAB Issues Raised by Commenters

In addition to specific comments on the proposed rule language, one commenter had other interpretive questions and comments about the proposed PAB requirements.

The commenter requested that the Commission clarify whether PAB account holders must obtain from their carrying broker-dealers a written agreement to perform the calculation as required by the

PAIB Letter.

Under the amendments, there is no requirement that PAB account holders obtain a written agreement from the carrying firm that it will perform the PAB reserve computation. Rule 15c3-3, as amended, requires the carrying firm to perform the PAB reserve computation. As stated above, Rule 15c3-3 prescribes the requirements for carrying firms with respect to PAB accounts, and the

PAIB Letter

is being withdrawn.

See SIMFA 2 Letter.

Id.

As discussed above in this section II.A.2., the Commission is directing the staff to withdraw the

PAIB Letter

as of the effective date of these rules.

In addition, the commenter requested the Commission to clarify that existing PAIB reserve accounts need not be re-titled to comply with the proposed amendments.

Item 4 of the

PAIB Letter

required that a carrying broker-dealer, “establish and maintain a separate `Special Reserve Account for the Exclusive Benefit of Customers' with a bank in conformity with the standards of paragraph (f) of Rule 15c3-3.” Paragraph (e)(1) of Rule 15c3-3, however, requires that a carrying broker-dealer establish and maintain a “Special Reserve Bank Account for Brokers and Dealers.” Given the small differences in nomenclature and the time and expense associated with broker-dealers re-titling these accounts, a carrying broker-dealer that has properly established PAB reserve account in the manner described in Item 4 of the

PAIB Letter

need not re-title the account and obtain a new notification from the bank.

However, all PAB reserve accounts established on or after the effective date of these amendments must title the account in accordance with paragraph (e)(1) of Rule 15c3-3.

See SIFMA 2 Letter.

See PAIB Letter.

Finally, the commenter urged the Commission to clarify whether, for purposes of Rule 15c3-1, the term

aggregate debit items

means total aggregate debit items computed in accordance with the customer reserve formula or the total aggregate debit items computed in accordance with both the customer reserve formula and the PAB reserve formula.

Aggregate debit items are used in the net capital rule to determine the minimum net capital requirement for broker-dealers that elect to use the alternative standard in computing their minimum net capital requirement. Specifically, the net capital rule requires broker-dealers using the alternative standard to maintain net capital of at least the greater of $250,000 or 2% of aggregate debit items.

Including PAB aggregate debit items in this computation would significantly increase net capital requirements for broker-dealers that use the alternative method. The intended purpose of this rule change is to address the inconsistencies between Rule 15c3-3 and SIPA—not to increase net capital requirements. Consequently, the requirements in Rules 15c3-1, 15c3-1d, and 17a-11 that refer to aggregate debit items continue to be based only on aggregate debit items computed in accordance with the customer reserve computation, and do not include aggregate debit items computed in accordance with the PAB reserve computation.

See SIFMA 2 Letter;

SIFMA 4 Letter.

17 CFR 240.15c3-1(a)(1)(ii). In addition, certain other financial responsibility rules require that a broker-dealer that computes net capital pursuant to the alternative method either report to the Commission, limit its ability to obtain, pre-pay, or repay subordinated debt, or limit its business if its net capital falls below a certain level based on a percentage of aggregate debit items (

see, e.g.,

Rules 15c3-1(e)(2)(vi), 15c3-1d(b)(6)(iii), 15c3-1d(b)(7), 15c3-1d(b)(8)(i)(A), 15c3-1d(b)(10)(ii)(B), 15c3-1d(c)(2), 15c3-1d(c)(5)(ii)(A), and 17a-11(c)(2)).

Under paragraph (e)(4) to Rule 15c3-3, a carrying broker-dealer will be permitted to use credits related to PAB accounts to finance Rule 15c3-3 customer debits. This rule, however, does not affect the use of aggregate debit items in computing a broker-dealer's net capital under the alternative standard pursuant to paragraph (a)(1)(ii) of Rule 15c3-1.

v. Amendment to Rule 15c3-1(c)(2)(iv)(E) Related to PAB Accounts

Finally, the Commission proposed an amendment to Rule 15c3-1

that would have required a broker-dealer, when calculating net capital, to deduct from net worth cash and securities held in a securities account at another broker-dealer if the other broker-dealer does not treat the account, and the assets therein, in compliance with the applicable PAB reserve account requirements of Rules 15c3-3 and 15c3-3a.

A commenter suggested modifying this proposed amendment,

arguing that “[a]lthough the Proposing Release states that the Commission `would not expect broker-dealers to audit or examine their carrying broker-dealers to determine whether the carrying broker-dealer is in compliance with [the proposed rules],' the text of the proposed amendment suggests that they in fact would have such an obligation.”

The commenter also stated that a broker-dealer should not be deemed to have violated Rule 15c3-1 merely because its carrying firm fails to properly perform requirements solely applicable to the carrying firm and that paragraph (c)(2)(iv)(E) under Rule 15c3-1 should be explicitly modified to clarify that cash and securities held in a securities account at another broker-dealer are not subject to the deduction specified in that paragraph.

17 CFR 240.15c3-1(c)(2)(iv)(E).

See Amendments to Financial Responsibility Rules,

72 FR at 12864.

See SIFMA 2 Letter.

Id.

While the Commission did not intend to impose any monitoring requirement on the PAB account holder, the Commission recognizes that the language, as proposed, could have implied such a requirement and agrees with the commenter that a broker-dealer should not be deemed to have violated Rule 15c3-1 with respect to requirements that are solely applicable to the carrying broker-dealer. To address this concern, the Commission has modified the language in paragraph (c)(2)(iv)(E) under Rule 15c3-1 to eliminate the proposed capital charge of Rule 15c3-1 that would have resulted from a failure of a carrying broker-dealer to comply with the PAB requirements in Rule 15c3-3.

More specifically, the Commission has deleted the proposed language referring to “cash and securities held in a securities account at another broker-dealer if the other broker-dealer does not treat the account, and the assets therein in compliance with paragraphs (b)(5) and (e) of § 240.15c3-3. . . .”

Instead, the Commission has adopted amendments to Rule 15c3-1 providing that a broker-dealer need not deduct cash and securities held in a securities account at a carrying broker-dealer except where the account has been subordinated to the claims of creditors of the carrying broker-dealer.

This provision is intended to prevent broker-dealers from including assets in their net capital that may not be readily available to be returned because they

would not be subject to the PAB account provisions discussed above. Accordingly, the amendments to paragraph (c)(2)(iv)(E) of Rule 15c3-1 are consistent with the exclusions from the definition of

PAB account

in paragraph (a)(16) of Rule 15c3-3.

17 CFR 240.15c3-1(c)(2)(iv)(E).

17 CFR 15c3-3(a)(16).

3. Banks Where Special Reserve Deposits May Be Held

As amended, paragraph (e) of Rule 15c3-3 requires a broker-dealer to deposit cash or qualified securities into the customer or PAB reserve account,

which must be maintained at a bank.

While cash deposits at a bank are fungible and may be used by the bank in its lending and investment activities, paragraph (f) of Rule 15c3-3 requires that a broker-dealer obtain a written contract from the bank wherein the bank agrees not to re-lend or hypothecate securities deposited into the reserve account.

This means the bank cannot use the securities in its business, which provides a measure of protection by requiring that the securities will be available to the broker-dealer if the bank falls into financial difficulty. Cash deposits, however, may be freely used in the course of the bank's commercial activities.

Therefore, to the extent a broker-dealer deposits cash in a reserve account, there is a risk the cash could become inaccessible if the bank experiences financial difficulties.

This could adversely impact the broker-dealer and its customers.

To limit these risks, the Commission proposed amendments to Rule 15c3-3 that would have: (1) Prohibited a broker-dealer from maintaining cash deposits in the reserve accounts for customers and PAB account holders if the bank was affiliated; and (2) limited the amount of cash that could be deposited in both types of reserve accounts at non-affiliated banks.

These restrictions would not have applied to securities held in the reserve accounts because, as noted above, the bank must agree not to use the securities in its business. The goal of the proposals was to limit cash reserve account deposits to reasonably safe amounts as measured against the capitalization of the broker-dealer and the bank.

The PAB reserve account and the customer reserve account are collectively referred to as the “reserve accounts” or a “reserve account.”

The term

bank

is defined in paragraph (a)(7) of Rule 15c3-3 as a “bank as defined in section 3(a)(6) of the Exchange Act and will also mean any building and loan, savings and loan or similar banking institution subject to the supervision by a Federal banking authority.”

See

paragraph (a)(7) to Rule 15c3-3, as adopted.

See

17 CFR 240.15c3-3(f).

See Amendments to Financial Responsibility Rules,

72 FR at 12864.

Id.

Specifically, as proposed, paragraph (e)(5) of 15c3-3 provided that a carrying broker-dealer would have been required to exclude the amount of cash deposited into reserve accounts at affiliated banks when determining whether it maintained the minimum amount required to be on deposit in the reserve accounts for its customers and PAB account holders. In addition, the proposed amendment would have required a carrying broker-dealer to exclude cash deposited in a reserve account at an unaffiliated bank to the extent the amount of the cash deposited exceeded: (1) 50% of the broker-dealer's excess net capital (based on the broker-dealer's most recently filed FOCUS Report);

or (2) 10% of the bank's equity capital (based on the bank's most recently filed Call Report or Thrift Financial Report).

Under Rule 17a-5, broker-dealers must file periodic reports on Form X-17a-5 (Financial and Operational Combined Uniform Single Reports) (“FOCUS Reports”).

See

17 CFR 240.17a-5(a). The FOCUS Report requires, among other financial information, a balance sheet, income statement, and net capital and customer reserve computations. Excess net capital is the amount that a broker-dealer's net capital exceeds its minimum requirement.

See Amendments to Financial Responsibility Rules,

72 FR at 12864. On July 21, 2011, supervisory responsibility for federal savings associations was transferred from the Office of Thrift Supervision (“OTS”) to the Office of the Comptroller of the Currency (“OCC”). As of the quarter ending March 31, 2012, savings associations were required to file a Call Report in lieu of a Thrift Financial Report.

See Proposed Agency Information Collection Activities; Comment Request,

76 FR 7082 (Feb. 8, 2011). The Call Report includes a line item for total bank equity capital. A report for a specific institution is

available at

https://cdr.ffiec.gov/public/

See also, FINRA, Interpretations of Financial and Operational Rules,

Interpretations 15c3-3(e)(1)/01 and/011 (establishing similar threshold restrictions on using money market deposit accounts or time deposits, respectively, to meet customer reserve account requirements), and Interpretation 15c3-3(e)(3)/051 (establishing similar threshold restrictions with respect to meeting the customer reserve requirement by depositing cash at an affiliated bank).

The Commission is adopting the amendments with modifications designed to address issues identified by commenters. Twenty-three commenters addressed the proposed amendments.

Fifteen commenters urged the Commission not to adopt the proposed prohibition on broker-dealers maintaining cash in reserve accounts at affiliated banks.

These commenters generally stated that, with regard to cash in reserve accounts, affiliated banks should be treated the same as unaffiliated banks because both groups are subject to the same financial regulation.

These commenters noted that banks are subject to safety and soundness requirements of their respective banking regulators and, therefore, the commenters argued that the proposed restriction with respect to affiliated banks is unwarranted.

See Federated Letter;

Curian Clearing Letter; Raymond James Letter;

JP Morgan Letter; Reserve Letter;

Dresdner Kleinwort Letter; SIFMA 2 Letter;

SIFMA 4 Letter; First Clearing Letter;

Clearing House Letter; ICI Letter;

Barclays Letter; ABASA Letter;

PNC Letter; BlackRock Letter;

Deutsche Bank Securities Letter; E*Trade Letter;

Citigroup Letter; American Bar Association Letter;

Fidelity/NFS Letter; BOK Letter;

JP Morgan 3 Letter; IIB Letter;

Raymond James 2 Letter.

See Federated Letter;

JP Morgan Letter; Dresdner Kleinwort Letter;

SIFMA 4 Letter; First Clearing Letter;

ICI Letter; ABASA Letter;

E*Trade Letter; Citigroup Letter;

American Bar Association Letter; Fidelity/NFS Letter;

Curian Letter; BOK Letter;

JP Morgan 2 Letter; IIB Letter.

Id.

One commenter also stated that the Commission's distinction between affiliated and unaffiliated banks was not sufficiently supported in the proposing release.

More specifically, this commenter stated that the Commission's “bare statement that a broker-dealer `may not exercise due diligence with the same degree of impartiality when assessing the soundness of an affiliate bank as it would with a non-affiliate . . .' does not suffice to justify the disparate treatment” with regard to the treatment of affiliated banks under the proposed rule.

This commenter also stated that it is just as easy to argue that broker-dealers are in a much better position to know about the soundness of an affiliated bank then to learn about the soundness of a unaffiliated bank, which may not be willing to provide complete and accurate information.

In addition, another commenter stated that the Commission cited no empirical or anecdotal evidence to support its reasons for prohibiting cash reserve deposits at an affiliated bank.

This commenter also stated that the Commission's concerns discount the operational efficiencies to be gained between an affiliated broker-dealer and its bank, including: Commonality between certain policies and procedures; greater ease in communication internally; and greater operational efficiencies leading to reduced operational risk in the transfer of funds to and from the bank.

See Dresdner Kleinwort Letter.

Id.

See Citigroup Letter.

Id.

One commenter stated that it took no issue with the proposed restriction on

affiliated banks.

100

Another commenter noted that the financial industry has seen a remarkable consolidation of the banking and securities industries, and, as a result, the number of broker dealers affiliated with banks has increased, along with the number of those broker-dealers maintaining deposits at affiliated banks.

101

This commenter stated that broker-dealers would be required to move deposits from one institution and divide that amount among several banks, resulting in credit risk to the broker-dealer, as well as an increase in operational risk.

102

Finally, the commenter observed that the Commission did not provide any specific examples of bank failures impacting affiliated broker-dealers, which led the commenter to question whether there is any realistic benefit to offset the increased risk that broker-dealers would be required to take on as a result of the proposal to place restrictions on cash deposits in reserve accounts at affiliated and unaffiliated banks.

103

100

See Raymond James Letter.

In a subsequent comment letter, this commenter stated that if this proposal is adopted, registered broker-dealers holding customer funds may be required to move their reserve accounts if those accounts are currently held at affiliated banks, which would increase costs.

See Raymond James 2 Letter.

101

See BOK Letter.

102

Id.

103

Id.

The Commission recognizes that all banks, whether or not affiliated with a broker-dealer, are subject to regulation by their respective banking regulators. The Commission's continuing concern, however, is that a carrying broker-dealer may not exercise due diligence with the same degree of impartiality and care when assessing the financial soundness of an affiliated bank as it would with an unaffiliated bank.

104

Moreover, the goal of protecting the carrying broker-dealer's customers through the Rule 15c3-3 reserve requirement may be undermined in the event a holding company becomes insolvent, with corresponding adverse consequences to both the bank and broker-dealer subsidiaries.

104

See Amendments to Financial Responsibility Rules,

72 FR at 12864.

In some cases, a broker-dealer may have access to more information about an affiliated bank in comparison to an unaffiliated bank for purposes of conducting due diligence. However, having more information would not be of benefit if the individuals making the decision on where to maintain the reserve account are not objective in their decision making. The Commission is concerned that a broker-dealer's decision to hold cash in a reserve account at an affiliated bank may be driven in part by profit or reasons based on the affiliation, regardless of any due diligence it may conduct or the overall safety and soundness of the bank.

In addition, in response to the comments regarding affiliated banks, the Commission notes that substantial numbers of banks have failed or required government assistance in recent years.

105

While a particular bank failure may not have materially impacted an affiliated broker-dealer to date,

106

the risk remains that the financial difficulty of an entity that is part of a holding company structure may adversely impact other affiliated entities, including affiliated broker-dealers and banks.

107

Therefore, the final rule retains the prohibition on maintaining customer reserve cash deposits at an affiliated bank.

108

105

According to the FDIC, the number of FDIC-insured institutions that failed in the U.S. over the last four years are: (1) 140 in 2009; (2) 157 in 2010; (3) 92 in 2011; and (4) 51 in 2012. A complete list of failed banks since October 1, 2000, is

available at

www.fdic.gov/bank/individual/failed/banklist.html

106

See BOK Letter;

Dresdner Kleinwort Letter.

107

See, e.g., Lehman Brothers Inc.—Trustee's Preliminary Investigation Report and Recommendations

(Case No. 08-01420 (JMP) SIPA),

available at

http://bankrupt.com/misc/sipareport0904.pdf

108

Id.

This prohibition does not apply to securities on deposit at an affiliated bank, but only cash deposits because, as noted above, the latter are fungible with other deposits carried by the bank and may be freely used in the course of the bank's commercial activities.

109

Consequently, to the extent that operational or other efficiencies can be achieved through the use of an affiliated bank, the carrying broker-dealer can use qualified securities held at an affiliated bank to meet its reserve deposit requirements.

110

The ability to use qualified securities alleviates concerns that a broker-dealer would be required to take deposits from one institution and divide that amount among several banks, resulting in credit risk to the broker-dealer, as well as an increase in operational risk.

111

109

See

Federal Reserve, Division of Banking Supervision and Regulation,

Commercial Bank Examination Manual, Section 3000.1, Deposit Accounts

(stating that deposits are the primary funding source for most banks and that banks use deposits in a variety of ways, primarily to fund loans and investments),

available at

http://www.federalreserve.gov/boarddocs/supmanual/cbem/3000.pdf

See also

OCC Banking Circular (BC-196), Securities Lending (May 7, 1985) (stating securities should be lent only pursuant to a written agreement between the lender institution and the owner of the securities specifically authorizing the institution to offer the securities for loan),

available at

http://www.occ.gov/static/news-issuances/bulletins/pre-1994/banking-circulars/bc-1985-196.pdf

110

See Citigroup Letter.

111

See BOK Letter.

Based on FOCUS Report data, as of December 31, 2011, 79% of the total customer reserve requirement across all carrying broker-dealers was met using qualified securities.

In summary, while the Commission acknowledges concerns raised by commenters, the Commission continues to believe that it is appropriate to exclude cash deposited in affiliated banks from the calculation to determine whether a broker-dealer has met its reserve account requirements. Therefore, the final rule excludes the amount of any cash on deposit in an affiliated bank of the broker-dealer from being used to meet the reserve requirements.

112

Broker-dealers that use affiliated banks for holding cash customer reserve accounts will need to either deposit qualified securities into the accounts or move their accounts to non-affiliated banks.

112

See

paragraph (e)(5) of Rule 15c3-3, as adopted.

As for the limits on the amounts of cash that could be deposited in one unaffiliated bank, some commenters argued that the proposed thresholds were too restrictive. One commenter urged the Commission to reconsider the proposed limits, noting that the proposed amendment will impose significant costs on broker-dealers and potentially adversely impact the broker-dealers' customers.

113

Several commenters suggested that the Commission allow cash reserve deposits without the percentage restrictions at unaffiliated banks that are well-capitalized or for which the broker-dealer has performed due diligence.

114

One commenter suggested that the Commission consider higher percentages for cash deposits at large money-center banks.

115

This commenter stated that this would strike a better balance between the Commission's concerns regarding the safety of cash deposits and the costs imposed on broker-dealers arising from having to use qualified securities (as opposed to cash) to meet deposit requirements or having to maintain reserve accounts at multiple banks.

116

This commenter also stated that the percentage thresholds would negatively impact smaller broker-dealers because they would exceed the 50% of excess net capital threshold at lower deposit levels.

117

Two

commenters noted that the proposed 10% bank equity capital limitation appears to be derived from a 1988 NYSE staff interpretation, which stated that customer reserve accounts may be maintained in money market deposit accounts if the total of such deposits in any one bank does not exceed 50% of the broker-dealer's excess net capital or 10% of the bank's equity capital.

118

These commenters pointed out that significant changes have taken place with respect to federal bank regulatory agency oversight of the safety and soundness of banks since 1988, including the imposition of prompt corrective action provisions.

119

These commenters stated that the concerns that gave rise to the 1988 interpretation have been mitigated by current statutes and regulations requiring prompt corrective action in the event that a bank's capital position deteriorates.

120

113

See Raymond James 2 Letter.

114

See Raymond James Letter;

JP Morgan Letter; Clearing House Letter;

ABASA Letter; PNC Letter;

Deutsche Bank Securities Letter; E*Trade Letter;

JP Morgan 2 Letter.

115

See SIFMA 2 Letter;

SIFMA 4 Letter.

116

See SIFMA 2 Letter.

117

Id.

118

See PNC Letter;

ABASA Letter.

119

See PNC Letter;

ABASA Letter.

120

Id.

As stated above, substantial numbers of banks have failed or required government assistance in recent years.

121

Consequently, the rule, as adopted, establishes requirements designed to avoid the situation where a carrying broker-dealer's cash deposits constitute a substantial portion of the bank's deposits. At the same time, the proposal has been modified to mitigate concerns raised by commenters that broker-dealers would have to maintain reserve accounts at multiple banks. First, the Commission has eliminated the provision that would have excluded the amount of a cash deposit that exceeds 50% of the broker-dealer's excess net capital. As noted by comments, this provision likely would have disproportionately impacted small and mid-size broker-dealers when they deposited cash into large commercial banks since they would exceed the excess net capital threshold well before exceeding the bank equity capital threshold.

122

Also, based on staff experience monitoring larger broker-dealers, firms that maintain large amounts of cash in their customer reserve accounts generally use more than one non-affiliated bank to maintain these accounts.

121

See

www.fdic.gov/bank/individual/failed/banklist.html

122

See SIFMA 2 Letter;

JP Morgan 2 Letter.

The bank equity capital threshold is the more important metric since it relates directly to the financial strength of the bank, which is the entity holding the account. Thus, this metric more directly addresses the risk at issue: The potential impairment of the bank's ability to quickly return the customer reserve deposit to the broker-dealer.

Second, with respect to the bank equity capital threshold, in response to comments, the Commission has increased the threshold from 10% to 15% of the bank's equity capital. The increase of the threshold to 15% is designed to address concerns raised by commenters that the proposed percentage tests were unduly restrictive in certain respects and should be modified, particularly with respect to large broker-dealers with large deposit requirements. Consequently, the increase from 10% to 15% is designed to mitigate commenters' concerns that the 10% threshold would require broker-dealers to spread out cash deposits over a number of banks, while still providing adequate protection against the risk that arises when a bank's deposit base is overly reliant on a single depositor.

The elimination of the 50% of excess net capital threshold and increase in the bank capital threshold from 10% to 15% is intended to address concerns raised by commenters that they would have to substantially alter their current cash deposit practices in light of the goal of the rule to promote the broker-dealer's ability to have quick access to the deposit.

As proposed, the equity capital threshold would have been based on equity capital “as reported by the bank in its most recent Call Report or Thrift Financial Report.” Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”),

123

the supervision of savings associations was transferred from the OTS to the OCC (for federal savings associations) and the FDIC (for state savings associations).

124

Also, beginning in the period ending March 31, 2012, savings associations began to file a Call Report in lieu of a Thrift Financial Report, thereby ending the use of the Thrift Financial Report.

125

Therefore, due to the passage of the Dodd-Frank Act and the elimination of the Thrift Financial Report, as well as to provide more flexibility with regard to any successor reports that may be required to be filed by a bank, the Commission is modifying the phrase “Call Report or Thrift Financial Report” to read “Call Report or any successor form the bank is required to file by its appropriate Federal banking agency (as defined by section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813))”.

123

Public Law 111-203, 124 Stat. 1376 (2010).

124

Id.

at §§ 300-378.

See also List of OTS Regulations to be Enforced by the OCC and the FDIC Pursuant to the Dodd-Frank Act,

OCC, FDIC, (June 14, 2011), 76 FR 39246 (July 6, 2011). Supervision of savings and loan holding companies and their subsidiaries (other than depository institutions) was transferred from the OTS to the Federal Reserve.

125

See Proposed Agency Information Collection Activities; Comment Request,

76 FR 7082 (Feb. 8, 2011).

Two commenters expressed concern about the use of a Call Report to determine a bank's “equity capital” under the rule.

126

These commenters noted that there is no equity capital line item in the Call Reports of U.S. branches of foreign banks due to these branches not being separately incorporated legal entities.

127

Therefore, the proposed Call Report provision potentially excluded U.S. branches of foreign banks from holding reserve accounts. The commenters stated that for foreign banks, the equity capital can be found in other forms, such as Form FR Y-7, Form FR Y-70, Form 6-K, and Form F-20, among other financial statements filed with U.S. regulators.

128

One commenter suggested the Commission revise the proposed provision to read: “The amount of the deposit exceeds 10% of the bank's equity capital (as reported by the bank in its most recent Call Report or Thrift Financial Report if such report includes a line item for `equity capital').”

129

Alternatively, these commenters suggested that in lieu of a Call Report a U.S. branch of a foreign bank could periodically obtain a certificate from the bank stating its equity capital (or stating that its equity capital exceeds a specified level).

130

126

See IIB Letter; SIFMA 4 Letter.

127

Id.

128

Id.

129

See IIB Letter.

130

See IIB Letter; SIFMA 4 Letter.

The Commission recognizes that the U.S. branches of some foreign banks may meet the definition of

bank

under section (3)(a)(6) of the Exchange Act and, therefore, also under paragraph (a)(7) of Rule 15c3-3.

131

However, the

Commission is retaining the requirement that the bank's equity be determined using its most recent Call Report because U.S. branches of foreign banks generally are not FDIC-insured.

132

Consequently, deposits at these institutions would not receive the protections of FDIC insurance in the event of a bank failure. FDIC insurance provides additional protections to cash deposited in a reserve account at a bank in the event of a bank failure that would not be available at an uninsured bank.

133

The Commission, however, will consider requests for exemptive relief from broker-dealers that wish to hold a reserve account at a U.S. branch of a foreign bank.

131

The term

bank

as defined in section 3(a)(6) of the Exchange Act is limited to banks directly regulated by U.S. state or federal bank regulators. The determination whether any particular financial institution meets the requirements of section 3(a)(6) is the responsibility of the financial institution and its counsel.

See

15 U.S.C. 78c(a)(6);

cf. Securities Issued Or Guaranteed By United States Branches Or Agencies of Foreign Banks; Interpretive Release,

Securities Act Release No. 6661 (Sept. 23, 1986), 51 FR 34460 (Sept. 29, 1986) (determination as to whether branch or agency of foreign bank falls within the definition of

bank

under section 3(a)(2) of Securities Act of 1933, 15 U.S.C. 77c(a)(2), is responsibility of issuers and their counsel). However, section 4(d) of the International Banking Act, 12 U.S.C. 3102(d), expressly prohibits agencies of foreign banks established under federal law from receiving deposits or exercising fiduciary powers, criteria necessary for qualification as a bank under section 3(a)(6)(C) of the Exchange Act.

See

12 U.S.C. 3102(d);

see also Conference of State Bank Supervisors

Conover,

715 F.2d 604 (D.C. Cir. 1983), cert. denied, 466 U.S. 927 (1984) (stating that

federally-chartered agencies of foreign banks are prohibited from receiving deposits from foreign, as well as domestic, sources).

132

The FDIC protects depositors' funds in the event of the financial failure of their bank or savings institution. FDIC deposit insurance covers the balance of each depositor's account, dollar-for-dollar, up to the insurance limit, including principal and any accrued interest through the date of the insured bank's closing. No depositor has suffered a loss of insured deposits since the FDIC was created in 1933.

See

FDIC, When a Bank Fails—Facts for Depositors, Creditors, and Borrowers,

available at

http://fdic.gov/consumers/banking/facts/index.html

See also

Federal Reserve, Structure and Share Data for U.S. Offices of Foreign Banks,

available at

http://www.federalreserve.gov/releases/iba/

133

Id.

Therefore, the availability of FDIC insurance could also be a contributing factor to mitigating the risk that an impairment of the reserve deposit at an unaffiliated bank will have a material negative impact on the broker-dealer's ability to meet its obligations to customers and PAB account holders.

See Amendments to Financial Responsibility Rules,

72 FR at 12864.

For these reasons, the Commission is adopting the final rule to exclude, when determining whether a broker-dealer maintains the minimum deposits required under paragraph (e) of Rule 15c3-3, cash deposited with an affiliated bank as well as cash deposited with an unaffiliated bank “to the extent that the amount of the deposit exceeds 15% of the bank's equity capital as reported by the bank in its most recent Call Report or any successor form the bank is required to file by its appropriate Federal banking agency (as defined by section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)).”

134

As discussed above, the Commission is deleting from the final rule the provision that would have excluded the amount of cash on deposit that exceeds 50% of the broker-dealer's excess net capital.

134

See

paragraph (e)(5) of Rule 15c3-3, as adopted.

4. Allocation of Customers' Fully Paid and Excess Margin Securities to Short Positions

Paragraph (d) of Rule 15c3-3 currently sets forth steps a broker-dealer must take to retrieve securities from non-control locations if there is a shortfall in the fully paid or excess margin securities it is required to hold for its customers. The actions prescribed in the rule do not include a requirement that the broker-dealer obtain possession or control of a fully paid or excess margin security that is reflected on the broker-dealer's stock record as a long position of a customer that allocates to a broker-dealer or non-customer short position. In the simplest case, this occurs when the carrying broker-dealer as principal sells short a security to its own customer. Currently, in such a case, the broker-dealer is not required to have possession or control of the security even though its customer has paid for the security in full. Rather, the broker-dealer must include the mark-to-market value of the security as a credit item in the reserve formula. The broker-dealer can use the cash paid by the customer to purchase the security to make any increased deposit requirement caused by the credit item.

135

As the Commission stated in the proposing release, this permits the broker-dealer, in effect, to partially monetize the customer's security.

136

This result is contrary to the customer protection goals of Rule 15c3-3, which seek to ensure that broker-dealers do not use customer assets for proprietary purposes.

137

135

In effect, the broker-dealer has monetized the customer's security and has to purchase or borrow it, at a future date, to return the customer's fully paid securities.

136

See Amendments to Financial Responsibility Rules,

72 FR at 12865.

137

See, e.g., Customer Protection Rule,

Exchange Act Release No. 22499 (Oct. 3, 1985), 50 FR 41337 (Oct. 10, 1985).

To address these concerns, the Commission proposed an amendment to Rule 15c3-3 that would have required a broker-dealer to obtain physical possession or control of customer fully paid and excess margin securities that allocate to a broker-dealer short position.

138

Specifically, the proposed amendment would have added a fifth step to take when a deficit arose in the amount of securities the broker-dealer was required to maintain in possession or control; namely that for “[s]ecurities included on [the broker-dealer's] books or records as a proprietary short position or as a short position for another person, excluding positions covered by paragraph (m) of this section, for more than 10 business days (or more than 30 calendar days if the broker or dealer is a market maker in the securities), [. . .] the broker or dealer shall, not later than the business day following the day on which the determination is made, take prompt steps to obtain physical possession or control of such securities.”

139

138

See Amendments to Financial Responsibility Rules,

72 FR at 12865.

139

Id.

at 12895.

Eleven commenters addressed this proposed amendment.

140

Three commenters urged the Commission to disallow naked short selling of securities and one argued that the Commission should force short sellers to pre-borrow.

141

Three commenters generally opposed the proposed rule. They argued that the credit item added to the reserve formula computation when a customer's fully paid or excess margin security allocates to a short position provides the customer with adequate protection.

142

Two of these commenters requested that the 30 calendar days allowed for a broker-dealer acting as a market maker to obtain possession or control over securities allocating to a short position be expanded to include all situations where a broker-dealer must act pursuant to the rule (

i.e.,

not be limited to market maker positions).

143

These commenters argued that it would be difficult to distinguish between market maker and non-market maker positions in complying with the proposed rule. Another commenter requested that the Commission reevaluate the proposed amendment because of its potential effects on investment and hedging strategies in addition to the heavy

burden it will impose on short sales.

144

One commenter supported the amendments noting that it had “come to believe . . . that the Commission's proposal is consistent with the direction of the Commission's other short sale regulations. . . .”

145

140

See Glenn Letter; Bare Letter; Anonymous Letter; SIFMA 2 Letter; First Clearing Letter; Hearne Letter; Deutsche Bank Securities Letter; Citigroup Letter; AMEX Letter; SIFMA 4 Letter; Federated 6 Letter; Raymond James 2 Letter.

141

See Glenn Letter;

Bare Letter; Anonymous Letter;

Hearne Letter.

The Commission has taken a number of measures to strengthen investor protections against potentially abusive “naked” short selling, including adopting rules requiring that fails to deliver resulting from short sales immediately be closed-out and expressly targeting fraud in short selling transactions.

See Amendments to Regulation SHO,

Exchange Act Release No. 60388 (July 27, 2009), 74 FR 38266 (July 31, 2009); “

Naked

”

Short Selling Antifraud Rule,

Exchange Act Release No. 58774 (Oct. 14, 2008), 73 FR 61666 (Oct. 17, 2008). In addition, the Commission adopted a short sale-related price test that, if triggered, imposes a restriction on the prices at which securities may be sold short.

See Amendments to Regulation SHO,

Exchange Act Release No. 61595 (Feb. 26, 2010), 75 FR 11232 (Mar. 10, 2010).

142

See First Clearing Letter;

Deutsche Bank Securities Letter; Citigroup Letter.

143

See Citigroup Letter;

Deutsche Bank Securities Letter.

144

See Raymond James 2 Letter.

145

See SIFMA 4 Letter.

SIFMA originally opposed the proposed amendments.

See SIFMA 2 Letter.

As discussed above in section II.A.2.ii. of this release, the Commission has determined that a credit item is sufficient to protect PAB account holders if the carrying broker-dealer provides them with notice that it may be using their non-margin securities, as well as the opportunity to object to such use. The use of the non-margin securities of PAB account holders is a long-standing industry practice. In contrast, customers under Rule 15c3-3, which include the carrying broker-dealer's retail customers, have an expectation that the fully paid and excess margin securities reflected on their account statements are, in fact, in the possession or control of the carrying broker-dealer. However, as described above, this expectation may be frustrated where the securities are allocated to a short position carried by the broker-dealer, as the securities are not in the possession or control of the broker-dealer.

This gap in the existing rule, in effect, permits the broker-dealer to partially monetize the customer's security. Also, under some circumstances (

e.g.,

a change in the market value of the securities), the amount the broker-dealer may have on deposit in the customer reserve account as a consequence of the credit item may be less than the value of the securities. Consequently, if the broker-dealer fails, sufficient funds may not be readily available to purchase the securities to return them to customers. The use of customer securities in this manner is contrary to the customer protection goals of Rule 15c3-3 and the expectations of a broker-dealer's customers.

146

For these reasons, the Commission is adopting the amendment.

147

The Commission agrees, however, that the proposed distinction based upon a broker-dealer's market maker status could present operational challenges and, consequently, the final rule has been modified to allow a uniform period of 30 calendar days before the possession and control requirement is triggered.

146

See supra

notes 12 and 18, and accompanying text.

147

Current paragraph (d)(4) of Rule 15c3-3 is being re-designated paragraph (d)(5), as proposed.

Specifically, as adopted, paragraph (d)(4) of Rule 15c3-3 requires a broker-dealer to take prompt steps to obtain physical possession or control over securities of the same issue and class as those included “on the broker's or dealer's books or records that allocate to a short position of the broker or dealer or a short position for another person, excluding positions covered by paragraph (m) of this section, for more than 30 calendar days. . . .”

148

The Commission does not believe that lengthening the time from 10

business

days to 30

calendar

days for non-market maker positions will significantly diminish the protections provided by the new rule.

149

Therefore, the Commission is adopting a uniform 30 calendar day time period in the final rule.

148

See Amendments to Financial Responsibility Rules,

72 FR at 12865-12866. The amendment will not apply to securities that are sold long for a customer but not obtained from the customer within ten days after the settlement date. This circumstance is addressed by paragraph (m) of Rule 15c3-3, which requires the broker-dealer to close the transaction by purchasing securities of like kind and quantity. 17 CFR 240.15c3-3(m).

149

For example, the rule currently has a thirty calendar day time period for securities failed to receive and a forty-five calendar day time period for securities receivable as a result of corporate actions (

e.g.,

stock splits) before the broker-dealer must take prompt steps to obtain possession or control of such securities.

See

17 CFR 240.15c3-3(d)(2)-(3).

Three commenters requested that the Commission clarify that the aging process begins when the Rule 15c3-3 possession and control deficit arises and not when the short transaction is executed.

150

The proposed amendment was designed to require that the aging process commence at the time a deficit in securities allocating to a short position arises. One commenter

151

also requested that the Commission modify the proposed amendment to specifically exclude an underwriter's short position created in connection with a distribution of securities until after the later of the completion of such underwriter's participation in the distribution (as defined in Rule 100 of Regulation M)

152

or the delivery date for securities acquired in the exercise of any overallotment option (or “Green Shoe”).

153

The Commission agrees with the commenter that there should be consistency between the final rule and Regulation M.

154

Consequently, the Commission has added a sentence to the final rule to clarify that the 30 calendar day period with respect to a syndicate short position established in connection with an offering does not begin to run until the underwriter's participation in the distribution is complete as determined pursuant to Rule 100(b) of Regulation M.

155

Finally, the Commission is adopting the revision to paragraph (n) as proposed to permit broker-dealers to apply to their designated examining authority (“DEA”) for extensions of time related to paragraph (d)(4).

156

150

See Deutsche Bank Securities Letter;

Citigroup Letter; SIFMA 2 Letter.

151

See SIFMA 2 Letter.

The commenter stated: “Regulation M embodies a carefully crafted scheme for the regulation of secondary market transactions by underwriters and other distribution participants, including the regulation of `syndicate covering transactions,' which should not be disrupted by proposed paragraph (d)(4).”

Id.

In addition, SIFMA commented that where an underwriter sells short to a customer in anticipation of obtaining the securities through the exercise of an overallotment option, paragraph (d)(4) should not require the premature exercise of the overallotment option or the use of secondary market purchases instead of the overallotment option.

Id.

152

17 CFR 242.100 through 242.105. More specifically, Rule 100 of Regulation M provides: “For purposes of regulation M . . . the following definitions shall apply: . . .

Completion of participation in a distribution.

. . . A person shall be deemed to have completed its participation in a distribution as follows: . . . (2) [a]n underwriter, when such person's participation has been distributed, including all other securities of the same class that are acquired in connection with the distribution, and any stabilization arrangements and trading restrictions in connection with the distribution have been terminated; Provided, however, that an underwriter's participation will not be deemed to have been completed if a syndicate overallotment option is exercised in an amount that exceeds the net syndicate short position at the time of such exercise. . . .” 17 CFR 242.100(b).

153

A green shoe or overallotment option is a provision contained in an underwriting agreement that gives the underwriting syndicate the right to purchase additional shares from the issuer or selling security holders (in addition to those initially underwritten by the syndicate) for the purpose of covering any overallotments that are made on behalf of the syndicate in connection with an offering of securities.

154

Rule 100 of Regulation M also provides that an underwriter's participation will not be deemed to have been completed if a syndicate overallotment option is exercised in an amount that exceeds the net syndicate short position at the time of exercise. 17 CFR 242.100(b).

155

17 CFR 242.100(b).

156

SROs generally have procedures in place for broker-dealers to apply for extensions of time under paragraph (n) of Rule 15c3-3.

See, e.g.,

FINRA Rule 4230.

5. Importation of Rule 15c3-2 Requirements Into Rule 15c3-3 and Treatment of Free Credit Balances

i. Importation of Rule 15c3-2

Rule 15c3-2 requires a broker-dealer holding free credit balances to provide its

customers

(defined as any person other than a broker-dealer) at least once every three months with a statement of the amount due the customer and a notice that: (1) the funds are not being segregated, but rather are being used in the broker-dealer's business; and (2) the funds are payable on demand. The rule was adopted in 1964, before the

adoption of Rule 15c3-3 in 1972.

157

Since the adoption of Rule 15c3-3, broker-dealers have been limited in their use of customer free credit balances. The Commission proposed importing requirements in Rule 15c3-2

158

into Rule 15c3-3 and eliminating Rule 15c3-2 as a separate rule in the Code of Federal Regulations.

159

The Commission received two comments supporting the proposal.

160

157

See Customers' Free Credit Balances,

Exchange Act Release No. 7266 (Mar. 12, 1964), 29 FR 7239 (June 3, 1964).

158

17 CFR 240.15c3-2.

159

See Amendments to Financial Responsibility Rules,

72 FR at 12867.

160

See SIFMA 2 Letter;

SIFMA 4 Letter.

The Commission is adopting the amendments substantially as proposed—deleting Rule 15c3-2 and adding paragraph (j)(1) to Rule 15c3-3. The Commission believes it is appropriate to eliminate Rule 15c3-2 as a separate rule because it is largely irrelevant in light of the requirements in Rule 15c3-3. Further, the provisions in Rule 15c3-2 that the Commission wishes to retain are being re-codified in Rule 15c3-3. These provisions include the requirement that broker-dealers inform customers of the amounts due to them and that such amounts are payable on demand.

161

Consequently, the Commission is amending Rule 15c3-3 to add new paragraph (j)(1), which provides that “[a] broker or dealer must not accept or use any free credit balance carried for the account of any customer of the broker or dealer unless such broker or dealer has established adequate procedures pursuant to which each customer for whom a free credit balance is carried will be given or sent, together with or as part of the customer's statement of account, whenever sent but not less frequently than once every three months, a written statement informing the customer of the amount due to the customer by the broker or dealer on the date of the statement, and that the funds are payable on demand of the customer.”

162

161

Rule 15c3-2 contains an exemption for broker-dealers that also are banking institutions supervised by a Federal authority. This exemption will not be imported into Rule 15c3-3 because there are no broker-dealers left that fit within the exemption. Further, the definition of

customer

for purposes of the imported 15c3-2 requirements will be the definition of

customer

in Rule 15c3-3, which is somewhat narrower than the definition in Rule 15c3-2.

162

See

paragraph (j)(1) of Rule 15c3-3, as adopted. The Commission also modified the phrase “[i]t shall be unlawful for a broker or dealer to” to the phrase “[a] broker or dealer must not” in order to avoid using the term “unlawful.” Any violation of the rules and regulations promulgated under the Exchange Act is unlawful and therefore it is unnecessary to use this phrase in the final rule.

ii. Treatment of Free Credit Balances

Free credit balances are funds payable by a broker-dealer to its customers on demand.

163

They may result from cash deposited by the customer to purchase securities, proceeds from the sale of securities or other assets held in the customer's account, or earnings from dividends and interest on securities and other assets held in the customer's account. Broker-dealers may, among other things, pay interest to customers on their free credit balances or offer to routinely transfer (“sweep”) them to a money market fund or bank account. On occasion, broker-dealers have changed the product to which a customer's free credit balances are swept—in recent years, most frequently from a money market fund to an interest bearing bank account. Because of differences in these two types of products, including the type of protection afforded the customer in the event of insolvency, there may be investment consequences to the customer when changing from one product to the other. The money market shares—as securities—would receive up to $500,000 in SIPA protection in the event the broker-dealer failed. The bank deposits—as cash—would receive up to $250,000 in protection from the FDIC in the event the bank failed. On the other hand, the money market fund shares may incur market losses; whereas, the full amount of the bank deposit would be guaranteed up to the FDIC's $250,000 limit. There also may be differences in the amount of interest earned from the two products. In short, there may be consequences to moving a customer's free credit balances from one product to another, and, accordingly, customers should have a sufficient opportunity to make an informed decision.

164

163

See

17 CFR 240.15c3-3(a)(8).

164

See Amendments to Financial Responsibility Rules,

72 FR at 12866.

The Commission proposed amendments to Rule 15c3-3 that would have established conditions required to be met in order for a broker-dealer to use or transfer free credit balances in a customer's securities account.

165

More specifically, as initially proposed, the amendments would have structured the new rule to make it unlawful for a broker-dealer to convert, invest, or otherwise transfer to another account or institution free credit balances held in a customer's account except as provided in the proposed rule.

166

The proposed rule then prescribed three conditions to address three different scenarios involving the use or transfer of customer free credit balances. The first scenario involved the use or transfer of free credit balances outside the context of a routine sweep to a money market fund or bank. As discussed below, proposed paragraph (j)(2)(i) would have prohibited the use or transfer of free credit balances in this scenario unless the customer had specifically ordered or authorized the transaction. The second and third scenarios involved the use or transfer of free credit balances in the context of a program to routinely sweep them to a money market fund or bank account (a “sweep program”). As discussed below, proposed paragraph (j)(2)(ii) would have addressed sweep program requirements for accounts opened after the effective date of the rule (“new accounts”) and proposed paragraph (j)(2)(iii) would have addressed sweep program requirements for accounts existing as of the effective date of the rule (existing accounts). The Commission is adopting new paragraph (j)(2) to Rule 15c3-3 with substantial modifications from the proposed rule in response to comments and to clarify certain portions of the rule.

167

165

Id.

at 12866-12867.

166

Id.

at 12866.

167

In 2005, the NYSE addressed the issue of disclosure in a sweep program context by issuing an information memo to its members discussing, among other things, the disclosure responsibilities of a broker-dealer offering a sweep program to its customers.

See

Information Memo 05-11 (Feb. 15, 2005). The memo stated that broker-dealers should disclose material differences in interest rates between the different sweep products and, with respect to the bank sweep program, further disclose the terms and conditions, risks and features, conflicts of interest, current interest rates, manner by which future interest rates will be determined, and the nature and extent of FDIC and SIPC protection.

As proposed, the first sentence of paragraph (j)(2) of the rule would have established the prohibition with respect to the treatment of free credit balances by providing that “[i]t shall be unlawful for a broker or dealer to convert, invest, or otherwise transfer to another account or institution, free credit balances held in a customer's account except as provided in paragraphs (j)(2)(i), (ii) and (iii).”

168

The Commission received one comment in response to the proposed text of this first sentence.

169

The commenter expressed concern that the proposed text in the first sentence of paragraph (j)(2) could be construed broadly, in effect, to prohibit a broker-dealer from using, investing, or transferring cash deposits that are not swept to other investments or products (and are included as credits in the reserve formula) in the normal course of the broker-dealer's business, as is currently permitted by Rule 15c3-3. The commenter suggested that the text be

revised to clarify the scope of the proposed rule by prohibiting a broker-dealer from deducting a free credit balance from the customer's account at the broker-dealer and transferring it to another institution and investing it in another instrument on behalf of the customer, except as permitted under paragraph (j)(2).

170

168

See Amendments to Financial Responsibility Rules,

72 FR at 12896.

169

See SIFMA 2 Letter.

170

Id.

In response to the comment, as a preliminary matter, cash balances in customer securities accounts must be included as credits in the customer reserve formula. Further, the net amount of the credits over debits must be deposited in a customer reserve account in the form of cash or qualified securities. However, cash credit items that are net of debit items can be used by the broker-dealer for the limited purpose of facilitating transactions of its customers.

171

The commenter suggested that proposed paragraph (j)(2) of Rule 15c3-3 could be interpreted to impose new limits on a broker-dealer's ability to use cash that is an asset on the firm's balance sheet. In response to this concern, the Commission notes that the prohibition in the first sentence of proposed paragraph (j)(2) of Rule 15c3-3 is intended to place conditions only on the broker-dealer's ability to convert the cash asset of the customer (

i.e.,

a receivable from the broker-dealer) into a different type of asset (

e.g.,

a security or an obligation of another institution outside the context of a sweep program) or to transfer the customer's cash asset to another account.

171

See

17 CFR 240.15c3-3(e)(2) (“It shall be unlawful for any broker or dealer to accept or use any of the amounts under items comprising Total Credits under the formula referred to in paragraph (e)(1) of this section except for the specified purposes indicated under items comprising Total Debits under the formula, and, to the extent Total Credits exceed Total Debits, at least the net amount thereof shall be maintained in the Reserve Bank Account pursuant to paragraph (e)(1) of this section.”).

The Commission is adopting paragraph (j)(2) of Rule 15c3-3 with certain technical modifications.

172

As adopted paragraph (j)(2) reads: “A broker or dealer must not convert, invest, or transfer to another account or institution, credit balances held in a customer's account except as provided in paragraphs (j)(2)(i) and (ii) of this section.”

173

172

Specifically, the Commission is replacing the phrase “[i]t shall be unlawful for a broker or dealer to” with the phrase “[a] broker or dealer must not” because—as noted above—any violation of the rules and regulations promulgated under the Exchange Act is unlawful and therefore it is unnecessary to use this phrase in the final rule. The Commission also is replacing the phrase “free credit balance” with the phrase “credit balances” to clarify that this provision covers both free credit balances and other credit balances.

See

17 CFR 240.15c3-3(a)(8)-(9) (defining

free credit balances

and

other credit balances

). The Commission is deleting the word “otherwise” because it would be redundant. Finally, the rule text does not include a reference to paragraph (j)(2)(iii), as proposed, because this paragraph was deleted from the final rule text.

173

See

paragraph (j)(2) of Rule 15c3-3, as adopted.

a. Treatment of Free Credit Balances Outside of a Sweep Program

As proposed, paragraph (j)(2)(i) of Rule 15c3-3 would have permitted a broker-dealer to convert, invest or otherwise transfer to another account or institution free credit balances held in a customer's account only upon a specific order, authorization, or draft from the customer, and only in the manner, and under the terms and conditions, specified in the order, authorization, or draft.

174

This catchall provision would have applied to any use or transfer of customer free credit balances outside the context of a sweep program.

174

See Amendments to Financial Responsibility Rules,

72 FR at 12866.

The Commission proposed paragraph (j)(2)(i) in order to comprehensively cover the range of possibilities with respect to the disposition of free credit balances in a customer account other than pursuant to a sweep program. The Commission received two comments recommending that proposed paragraph (j)(2)(i) be clarified to permit a broker-dealer to obtain a one-time consent to ongoing transfers of any free credit balances to a customer to another account, entity or product (outside of a sweep program).

175

The commenters noted that customers, for example, may prefer that free credit balances be regularly transferred to a linked account in their name at another broker-dealer or bank that is not part of a sweep program, and that this clarification would enable a broker-dealer to efficiently handle such customer requests by eliminating the need to obtain individual “specific orders” for repeated transfers that are substantially identical.

176

The Commission agrees with the commenters that a customer may consent to ongoing routine transfers from the customer's account outside of a sweep program without obtaining the customer's specific consent for each individual transfer, provided the customer has consented to the ongoing transfers under paragraph (j)(2)(i) of Rule 15c3-3. This scenario would already be covered by the proposed rule, and, therefore, the Commission is adopting paragraph (j)(2)(i) substantially as proposed, with certain technical modifications.

177

As adopted, paragraph (j)(2)(i) of Rule 15c3-3 reads: “A broker or dealer is permitted 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, and only in the manner, and under the terms and conditions, specified in the order, authorization, or draft.”

178

175

See SIFMA 2 Letter;

E*Trade 2 Letter.

176

Id.

177

See

paragraph (j)(2)(i) of Rule 15c3-3, as adopted. The technical changes delete the words “convert” and “otherwise” from the final rule because a broker-dealer would be prohibited from “converting” a customer's free credit balances and, therefore, it is not necessary to include the word in the final rule. The word “otherwise” is redundant.

178

Id.

Finally, one commenter stated that both regulators and firms need the flexibility to remove funds from a reserve account to cover extraordinary requests for payment of customer free credit balances.

179

However, the commenter noted that “in light of recent market events, we withdraw our earlier proposal to allow such withdrawals under specified conditions and instead recommend that such withdrawals be permitted only by approval of Commission staff or a broker-dealer's [DEA].”

180

Broker-dealers currently may make withdrawals under paragraph (g) of Rule 15c3-3.

181

In light of the risks that could arise to customer funds, the Commission does not believe it would be appropriate at this time to expand a firm's ability to make additional withdrawals from its reserve account.

179

See SIFMA 4 Letter.

180

Id.

In its June 15, 2007 comment letter, SIFMA urged “the Commission to consider allowing a broker-dealer to remove funds from a reserve account to cover a large same-day request for payment of a free credit balance, as long as the free credit balance was included in the latest Rule 15c3-3 reserve computation and the broker-dealer begins a new reserve computation as of that date.”

See SIFMA 2 Letter.

181

17 CFR 240.15c3-3(g).

b. Treatment of Free Credit Balances in a Sweep Program

The second and third set of conditions in the proposed rules addressed using or transferring free credit balances in the context of a sweep program.

182

In particular, the Commission proposed four conditions with respect to using or transferring free credit balances in a sweep program. A broker-dealer would have been required to meet: (1) all four conditions with respect to free credit balances in new accounts;

183

and (2) the second, third, and fourth conditions with respect to

free credit balances in existing accounts.

184

The four conditions were:

182

See Amendments to Financial Responsibility Rules,

72 FR at 12866.

183

See

paragraph (j)(2)(ii)(A)-(D) of Rule 15c3-3, as adopted.

184

See

paragraph (j)(2)(iii)(A)-(C) of Rule 15c3-3, as adopted.

1. The customer has previously affirmatively consented to such treatment of the free credit balances after being notified of the different general types of money market mutual fund and bank account products in which the broker or dealer may transfer the free credit balances and the applicable terms and conditions that would apply if the broker or dealer changes the product or type of product in which free credit balances are transferred;

2. The broker or dealer provides the customer on an ongoing basis with all disclosures and notices regarding the investment and deposit of free credit balances as required by the self-regulatory organizations for which the broker or dealer is a member;

3. The broker or dealer provides notice to the customer as part of the customer's quarterly statement of account that the money market mutual funds or bank deposits to which the free credit balances have been transferred can be liquidated on the customer's demand and held as free credit balances; and

4. The broker or dealer provides the customer with at least 30 calendar days notice before the free credit balances would begin being transferred to a different product, different product type, or into the same product but under materially different terms and conditions. The notice must describe the new money market fund, bank deposit type, or terms and conditions, and how the customer can notify the broker or dealer if the customer chooses not to have the free credit balances transferred to the new product or product type, or under the new terms and conditions.

Commenters generally agreed with the fundamental principle embodied in the proposal—that customer free credit balances should not be transferred from an obligation of the broker-dealer to an obligation of another entity without the customer's authorization.

185

Other commenters supported the proposed disclosures but suggested additional disclosures be made to customers, including clarification with respect to other protections available to the customer.

186

Two commenters stated that the practice of sweep programs should be banned entirely or that the Commission should adopt a “harder stance” and require more than just disclosure.

187

One commenter responded to the Commission's request for comment as to the cost burdens that would result if the first condition (set forth in proposed paragraph (j)(2)(ii)(A)) to obtain a new customer's prior agreement were to be applied to existing customers. The commenter stated that such costs would be substantial because broker-dealers would be required to amend their agreements with all existing customers.

188

One commenter stated that the amendments in the proposing release did not adequately address situations in which broker-dealers change customer account elections without first obtaining customer authorization.

189

185

See SIFMA 2 Letter;

First Clearing Letter; Pace Letter.

186

See SIPC Letter.

187

See Ellis Letter;

Dworkin Letter.

One commenter stated that broker-dealers profit from “excessive” fees charged to clients who opt out of the sweep programs.

See Ellis Letter.

The second commenter suggested that the broker-dealer's “customer has been effectively denied the opportunity to opt out of bank account sweeps by [the broker-dealer] preventing him or her from utilizing any other vehicle to park his or her free credit balances. . . .”

See Dworkin Letter.

The commenter noted that by opting out of the sweep, the customer is “confined to a situation where the free credit balance cannot earn any kind of return at all[.]”

Id.

188

See SIFMA 2 Letter.

189

See Waddell Letter.

In adopting the final rule, the Commission has made some modifications to the language in the proposed rule in response to commenters and to clarify its application. For clarification and in response to comments, the Commission has defined the term

Sweep Program

in paragraph (a)(17) of Rule 15c3-3 to identify the types of transactions and products to which the new provisions apply.

Commenters raised concerns about limitations on the types of products broker-dealers could use for sweep arrangements under the proposed amendments. Three commenters suggested that the Commission should not limit the types of products broker-dealers can use for sweep arrangements to money market funds and bank deposit products.

190

See SIFMA 2 Letter;

First Clearing Letter; Raymond James 2 Letter.

Sweep programs provide a mechanism for excess cash in a customer's securities account to be held in a manner that allows the customer to earn interest on the funds but retain the flexibility to quickly access that cash to purchase securities or withdraw it.

191

In effect, transferring this excess cash to a bank account or money market fund is an alternative to retaining a credit balance in the customer's securities account. The final rule is designed to accommodate this alternative by providing broker-dealers with flexibility in the operation of sweep programs. The Commission believes it is appropriate to confine this flexibility to products that approximate the holding of a customer's excess cash in a securities account. The Commission does not view sweep accounts as a mechanism for investing customers' excess cash without their specific consent in longer term or more volatile assets. For these reasons, the Commission does not believe it would be appropriate to expand the products covered by the final rule beyond money market funds as described in Rule 2a-7 under the Investment Company Act of 1940 or an account at an insured bank as described in paragraph (a)(17) of Rule 15c3-3.

191

See Ellis Letter;

Dworkin Letter.

Consequently, paragraph (a)(17) of Rule 15c3-3, as adopted, states “[t]he term

Sweep Program

means a service provided by a broker or dealer where it offers to its customers the option to automatically transfer free credit balances in the securities account of the customer to either a money market mutual fund product as described in [Rule 2a-7] or an account at a bank whose deposits are insured by the Federal Deposit Insurance Corporation.”

192

The Commission intended that the definition of

Sweep Program

provide that the bank to which free credits are swept be insured by the FDIC.

193

The revised text of the rule makes this explicit. Finally, under this definition, a one-time or other special transfer of a customer's free credit balances would not qualify as a Sweep Program.

192

See

paragraph (a)(17) of Rule 15c3-3, as adopted.

193

See Amendments to Financial Responsibility Rules,

72 FR at 12866 (“[T]he bank deposit would be guaranteed up to the FDIC's $100,000 limit.”). FDIC insurance covers all deposit accounts, including checking and savings accounts, money market deposit accounts and certificates of deposit. The standard insurance amount is currently $250,000 per depositor, per insured bank, for each account ownership category. 12 CFR 330.1(o).

Three commenters raised the issue of bulk transfers.

194

They argued that the rule should allow broker-dealers to process bulk transfers of customer assets between, for instance, one money market fund and another money market fund or a bank deposit product and a money market fund. These commenters identify a potential ambiguity in the rule as proposed; namely, how transfers from one Sweep Program product to another Sweep Program product are to be handled under the rule if they do not involve passing funds through the

customer's securities account. To address this issue, paragraph (j)(2)(ii) of Rule 15c3-3 is being modified from the proposal to clarify that the conditions for operating a Sweep Program (which are set forth in paragraphs (j)(2)(ii)(A) and (B)) will apply to: (1) The transfer of free credit balances from a customer's securities account to a product in a Sweep Program; and (2) the transfer of a customer's interest in one Sweep Program product to another Sweep Program product. This will address both bulk transfers

195

of customer positions from one product (

e.g.,

a money market fund) to another (

e.g.,

a bank deposit product) and transfers of individual customer positions from one product to another.

194

See SIFMA 2 Letter;

First Clearing Letter; E*Trade 2 Letter.

195

See also

NASD Rule 2510 (Discretionary Accounts) (providing an exception from the NASD rule for “bulk exchanges at net asset value of money market mutual funds . . . utilizing negative response letters provided: (A) The bulk exchange is limited to situations involving mergers and acquisitions of funds, changes of clearing members and exchanges of funds used in sweep accounts; (B) The negative response letter contains a tabular comparison of the nature and amount of the fees charged by each fund; (C) The negative response letter contains a comparative description of the investment objectives of each fund and a prospectus of the fund to be purchased; and (D) The negative response feature will not be activated until at least 30 days after the date on which the letter was mailed.”).

The Commission is modifying paragraph (j)(2)(ii) of Rule 15c3-3 from the proposal to delete the phrase “to either a money market mutual fund as described in § 270.2a-7 of this chapter or an interest bearing account at a bank without a specific order, authorization or draft for each such transfer, provided” and instead to use the term

Sweep Program

as defined in paragraph (a)(17) of the final rule. The Commission also replaced the phrase “the account of a customer” with the phrase “a customer's securities account” to clarify that paragraph (j)(2)(ii) and its required conditions apply to the transfer of free credit balances in connection with a customer's securities account, in addition to the bulk transfers described above.

196

As adopted, paragraph (j)(2)(ii) to Rule 15c3-3 reads, in pertinent part: “[a] broker or dealer is permitted to transfer free credit balances held in a customer's securities account to a product in its Sweep Program or to transfer a customer's interest in one product in a Sweep Program to another product in a Sweep Program,

provided

” the conditions set forth in paragraphs (j)(2)(ii)(A) and (B) are met.

197

196

The final rule also deletes the phrase “opened on or after the effective date of this paragraph” from paragraph (j)(2)(ii) and moves it to paragraph (j)(2)(ii)(A), as described below.

197

See

paragraph (j)(2)(ii) of Rule 15c3-3, as adopted.

As adopted, paragraphs (j)(2)(ii)(A) and (B) establish four conditions that must be met to lawfully transfer a customer's free credit balances to a product in a Sweep Program or to transfer a customer's interest directly from one product in a Sweep Program to another product in a Sweep Program. The first condition—set forth in paragraph (j)(2)(ii)(A)—applies only with respect to accounts opened on or after the effective date of the rule. This addresses the burden that would have been associated with having broker-dealers re-document existing accounts. The remaining three conditions—set forth in paragraph (j)(2)(ii)(B)(

) through (

)—apply to both existing and new accounts.

Paragraph (j)(2)(ii)(A), as adopted, provides that for an account opened on or after the effective date of the rule, the customer must give prior written affirmative consent to having free credit balances in the customer's securities account included in the Sweep Program after being notified: (1) Of the general terms and conditions of the products available through the Sweep Program; and (2) that the broker or dealer may change the products available under the Sweep Program.

198

See

paragraph (j)(2)(ii)(A) of Rule 15c3-3, as adopted.

As stated above, the Commission has modified paragraph (j)(2)(ii)(A) in the final rule to read “the customer gives prior written affirmative consent to having free credit balances in the customer's securities account included in the Sweep Program after being notified. . . .”

199

The Commission modified this paragraph to incorporate the term

Sweep Program

as defined in paragraph (a)(17) of the rule and the reference to the “customer's securities account” to make this paragraph consistent with other modifications to paragraph (j)(2) of the final rule. Additionally, the Commission modified this paragraph to clarify that the customer's consent must be written, consistent with the discussion in the proposing release, which noted customer consent could be given in an account opening agreement.

200

199

Id.

The proposed rule stated the “customer has previously affirmatively consented to such treatment of the free credit balances after being notified of . . . .” In addition, as noted above, the phrase “accounts opened on or after the effective date of this paragraph” was deleted from proposed paragraph (j)(2)(ii) and moved to paragraph (j)(2)(ii)(A), with the reference to specific paragraph (j)(2)(ii) inserted after the word “paragraph.” Moving this phrase to paragraph (j)(2)(ii)(A) simplifies the final rule by eliminating the necessity of codifying two largely overlapping sets of conditions, with three of the conditions being repeated in both paragraphs. The effect of this change is to make the first condition only applicable to new accounts and the remaining conditions (paragraph (j)(2)(ii)(B)(

) through (

)) applicable to both new and existing accounts. The word “accounts” also has been replaced with the phrase “an account.”

200

See Amendments to Financial Responsibility Rules,

72 FR at 12866 (“[T]he customer would need to agree prior to the change (

e.g.,

in the account opening agreement) that the broker-dealer could switch the sweep option between those two types of products.”).

The Commission received one comment stating that the text of proposed paragraph (j)(2)(ii)(A) that would have required the disclosure of “applicable terms and conditions that will apply if the broker or dealer changes the product or type of product” could be read to require highly specific disclosure about product terms and conditions that may only be established or modified in the future and, therefore, are unknown at the time the customer opens an account with the broker-dealer.

201

In addition, the commenter stated that under proposed paragraph (j)(2)(ii)(D), a broker-dealer would already be required to describe any changes to the terms and conditions it makes contemporaneously with such changes. Given this type of notice, the commenter stated that there is no need for the type of generalized (and therefore less effective) disclosure that would have been required by paragraph (j)(2)(ii)(A). The Commission agrees with the commenter and, therefore, has deleted the phrase “transfer the free credit balances and the applicable terms and conditions that will apply if the broker or dealer changes the product or type of product in which the free credit balances are transferred. . . .” In its place, the Commission is adopting language in paragraph (j)(2)(ii)(A)(

) of Rule 15c3-3 under which the broker-dealer must notify the customer that the broker or dealer may change the products available under the Sweep Program.

202

201

See SIFMA 2 Letter.

202

See

paragraph (j)(2)(ii)(A)(

) of Rule 15c3-3, as adopted.

Paragraph (j)(2)(ii)(B), as adopted, prescribes the following three conditions to sweeping the customer's free credit balances in a new or existing account:

• The broker-dealer provides the customer with the disclosures and notices regarding the Sweep Program required by each SRO of which the broker-dealer is a member;

203

See

paragraph (j)(2)(ii)(B) of Rule 15c3-3, as adopted.

• The broker-dealer provides notice to the customer, as part of the customer's quarterly statement of account, that the balance in the bank deposit account or shares of the money market mutual fund in which the customer has a beneficial interest can be liquidated on the customer's order and the proceeds

returned to the securities account or remitted to the customer;

204

and

204

Id.

• The broker-dealer provides the customer with written notice at least 30 calendar days before: (1) Making changes to the terms and conditions of the Sweep Program; (2) making changes to the terms and conditions of a product currently available through the Sweep Program; (3) changing, adding or deleting products available through the Sweep Program; or (4) changing the customer's investment through the Sweep Program from one product to another; and the notice describes the new terms and conditions of the Sweep Program or product or the new product, and the options available to the customer if the customer does not accept the new terms and conditions or product.

205

Id.

As proposed, paragraph (j)(2)(ii)(B) of Rule 15c3-3 would have required that the broker-dealer provide these disclosures and notices “on an ongoing basis.” Three commenters stated that there are no current SRO requirements that broker-dealers make disclosures concerning sweep arrangements on an “ongoing basis” and that the Commission should clarify the source and meaning of this requirement.

206

The Commission has deleted the phrase “ongoing basis” from the final rule. As adopted, the Commission has also modified the text in paragraph (j)(2)(ii)(B), now paragraph (j)(2)(ii)(B)(

), to delete the phrase “investment and deposit of free credit balances as” and inserted the phrase “Sweep Program” to incorporate the definition in paragraph (a)(17). Finally, the Commission has modified the phrase “the self-regulatory organizations” to read “each self-regulatory organization of” to clarify that the broker-dealer must provide the notices and disclosures required by each SRO of which it is a member (including an SRO that is not its DEA).

207

206

See SIFMA 2 Letter;

First Clearing Letter; Raymond James 2 Letter.

207

See

17 CFR 240.17d-1.

As adopted, paragraph (j)(2)(ii)(B)(

) states that the broker-dealer must provide information on a quarterly basis with respect to the customer's balance in an account or fund “in which the customer has a beneficial interest.”

208

The rule text has been modified to account for the fact that customers can have a beneficial interest in accounts in their name and in omnibus accounts in the name of a custodian in which the assets of multiple customers are commingled.

208

See

paragraph (j)(2)(ii)(B)(

) of Rule 15c3-3, as adopted. More specifically, the Commission modified the phrase “that the money market mutual funds or bank deposits to which the free credit balances have been transferred” to read “that the balance in the bank deposit account or shares of the money market mutual fund in which the customer has a beneficial interest. . . .”

The Commission also modified language in paragraph (j)(2)(ii)(B)(

) of Rule 15c3-3 to replace the phrase “on the customer's demand” with the phrase “on the customer's order” to address concerns by two commenters that the former phrase could lead customers to believe that they will receive immediate re-payment of those funds, or they could revert to holding those funds as free credit balances at the broker-dealer.

209

These commenters pointed out that the disclosed terms of most sweep programs allow the money market fund or bank up to seven days to meet requests for withdrawals. Further, there are some broker-dealers that do not allow customers to maintain free credit balances in securities accounts. In response to these comments, the Commission has deleted the phrase “demand and held as free credit balances” and replaced it with the phrase “and the proceeds returned to the securities account or remitted to the customer.” This language is designed to account for broker-dealers that do not offer customers the option of having their funds held as free credit balances. In such cases, the broker-dealer would remit the funds withdrawn from the bank or derived from redeeming money market shares directly to the customer (

e.g.,

by transferring them to the customer's bank account).

209

See SIFMA 2 Letter.

Proposed paragraphs (j)(2)(ii)(D) and (iii)(C)—now paragraph (j)(2)(ii)(B)(

)—would have required the broker-dealer to provide the customer with notice at least thirty days before the broker-dealer begins transferring the customer's free credit balances to a different product or product type, or into the same product but under materially different terms and conditions.

210

As adopted, paragraph (j)(2)(ii)(B)(

) will require broker-dealers to provide customers written notice at least 30 calendar days before the broker-dealer: (1) Makes changes to the terms and conditions of the Sweep Program; (2) makes changes to the terms and conditions of a product currently available through the Sweep Program; (3) changes, adds, or deletes products available through the Sweep Program; or (4) changes the customer's investment through the Sweep Program from one product to another.

211

This modification to the final rule is in response to commenters' requests that the Commission provide clarity with respect to when the thirty day notice requirement would be triggered.

212

In response to comments, the final rule is designed to make clear that the triggering event for the thirty day notice is not exclusively related to the transfer of the customer's free credit balances, but rather changes relating to the terms and conditions of the Sweep Program, as well as, the products available through the Sweep Program. This greater specificity should enhance the protections under the final rule by providing greater certainty that the customer will have time to evaluate available options before a change to the Sweep Program is put into effect.

210

See Amendments to Financial Responsibility Rules,

72 FR at 12896.

211

A broker-dealer could request exemptive relief from the rule in unusual or emergency cases where it may be impractical or contrary to investor protection for a broker-dealer to first provide customers 30 days' written notice under the rule before taking one of these actions.

See, e.g.,

paragraph (k)(3) to Rule 15c3-3.

212

See SIFMA 2 Letter;

First Clearing Letter; Cornell Letter;

E*Trade Letter.

In addition, paragraphs (j)(2)(ii)(B)(

)(

)-(

) of Rule 15c3-3 require the broker-dealer to provide the customer with written notice at least 30 calendar days before: (1) Making changes to the terms and conditions of the Sweep Program; (2) making changes to the terms and conditions of a product currently available through the Sweep Program; (3) changing, adding or deleting products available through the Sweep Program; or (4) changing the customer's investment through the Sweep Program from one product to another.

213

Collectively, these provisions provide more specificity about the types of disclosures and notices required under the final rule than under the proposal. Further, the final rule includes the word “written” before the word “notice” to make explicit that a written notice is required.

213

See paragraph (j)(2)(ii)(B)(

)(

) of Rule 15c3-3, as adopted. The requirements set forth in final paragraph (j)(2)(ii)(B)(

)(

) were proposed as paragraphs (j)(2)(ii)(D) and (iii)(C).

As adopted, paragraph (j)(2)(ii)(B)(

)(

) requires that “[t]he notice must describe the new terms and conditions of the Sweep Program or product or the new product, and the options available to the customer if the customer does not accept the new terms and conditions or product.”

214

The Commission modified the final rule in response to a comment regarding the text of proposed paragraphs (j)(2)(ii)(D) and (iii)(C).

215

The commenter stated that, as drafted, proposed paragraphs (j)(2)(ii)(D) and (iii)(C) would have required a broker-dealer to disclose

“how the customer can notify the [broker-dealer] if the customer chooses not to have the free credit balances transferred to the new product or product type, or under new terms and conditions.”

216

The commenter stated that these paragraphs appear to assume that the customer will have the option of continuing to have free credit balances treated as they were prior to the change to the sweep arrangement.

217

The commenter pointed out that, in fact, the broker-dealer may elect not to continue offering the prior sweep options and not to offer another sweep product.

218

To account for this possibility, the Commission has revised the text in paragraph (j)(2)(ii)(B)(

)(

)

219

to require the broker-dealer to provide the customer with a notice that contains a description of the options available to the customer if the customer does not wish to accept the new terms and conditions or product.

220

This is intended to give customers sufficient opportunity to make an informed decision in connection with a Sweep Program.

214

See

paragraph (j)(2)(ii)(

)(

) of Rule 15c3-3, as adopted. The final rule codifies this text in a separate paragraph in order to emphasize the specific items the notice must contain.

215

See SIFMA 2 Letter.

216

Id.

217

Id.

218

Id.

219

More specifically, paragraph (j)(2)(ii)(B)(

)(

) provides that “the notice must describe the new terms and conditions of the Sweep Program or product or the new product, and the options available to the customer if the customer does not accept the new terms and conditions or product.” A customer that does not accept the new terms and conditions or product would need to change how free credit balances are treated by, for example, selecting investments outside the Sweep Program or having the balances transferred to an account at another financial institution.

220

See Dworkin Letter.

6. “Proprietary Accounts” Under the Commodity Exchange Act

Some broker-dealers also are registered as futures commission merchants under the Commodity Exchange Act (“CEA”). These firms carry both securities and commodities accounts for customers. The definition of

free credit balances

in paragraph (a)(8) of Rule 15c3-3 does not include funds carried in commodities accounts that are segregated in accordance with the requirements of the CEA.

221

However, regulations promulgated under the CEA exclude certain types of accounts (“proprietary accounts”) from the CEA's segregation requirements.

222

This exclusion from the segregation requirements under the CEA has raised a question as to whether a broker-dealer must treat payables to customers in proprietary commodities accounts as “free credit balances” when performing a customer reserve computation.

223

221

17 CFR 240.15c3-3(a)(8).

222

Rule 1.20 requires a futures commission merchant to segregate customer funds.

See

17 CFR 1.20. Rule 1.3(k) defines the term

customer

for this purpose.

See

17 CFR 1.3(k). The definition of

customer

excludes persons who own or hold a

proprietary account

as that term is defined in Rule 1.3(y).

See

17 CFR 1.3(y). Generally, the definition of

proprietary account

refers to persons who have an ownership interest in the futures commission merchant.

Id.

223

See Part 241-Interpretive Releases Relating to the Securities Exchange Act of 1934 and General Rules and Regulations Thereunder,

Exchange Act Release No. 9922 (Jan. 2, 1973), 38 FR 1737 (Jan. 18, 1973) (interpreting the credit balance used in Item 1 of the Rule 15c3-3a formula “to include the net balance due to customers in non-regulated commodities accounts reduced by any deposits of cash or securities with any clearing organization or clearing broker in connection with the open contracts in such accounts”).

In response to this question, the Commission notes that the objective of the customer reserve requirement in Rule 15c3-3 is to require broker-dealers to hold sufficient funds or qualified securities to facilitate the prompt return of customer property to customers either before or during a liquidation proceeding if the firm fails.

224

Under SIPA, customer property generally does not include funds held in a commodities account.

225

Therefore, funds held in a proprietary commodities account generally would not constitute customer property and persons having claims to those funds would not be customers under SIPA.

226

Moreover, the regulations under the CEA similarly provide the persons having claims to funds in proprietary commodities accounts are not customers for purposes of those regulations.

227

For these reasons, the Commission proposed a specific amendment to the definition of the term

free credit balances

in paragraph (a)(8) of Rule 15c3-3 that would have clarified that funds held in a commodities account meeting the definition of a

proprietary account

under CEA regulations are not to be included as free credit balances in the customer reserve formula.

228

As discussed below, the Commission is adopting the amendment substantially as proposed.

224

See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers,

Exchange Act Release No. 68071 (Oct. 18, 2012), 77 FR 70214, 70274 (Nov. 23, 2012) (describing rationale and requirements of Rule 15c3-3 segregation requirements).

See als

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