The SEC Division of Trading and Markets (the "Division") issued a warning letter, in the form of "no-action relief," to broker-dealers operating programs in which they borrow fully paid margin securities from their customers ("fully paid lending programs" or "FPL programs"). The letter states that some of the FPL programs violate broker-dealer customer protection rule Rule 15c3-3 ("Customer protection-reserves and custody of securities").
As described in the letter, Rule 15c3-3 requires broker-dealers to provide collateral to securities lenders in such a way that "compel[s] the firm to turn over the collateral physically to the lender." The Division staff explained that some broker-dealers operating FPL programs have deposited the collateral into a lender's securities account at the broker-dealer or into an omnibus account in the name of the broker-dealer, meaning the securities lender cannot access the collateral without the broker-dealer and the broker-dealer has operational ability over the collateral.
The Division advised that it will not recommend action if the broker-dealer (i) is operating an FPL program that predates the no-action letter and (ii) remains compliant with all other aspects of paragraph (b)(3) of Rule 15c3-3, but may take action if the firm has not come into compliance by changing its collateral delivery procedures by April 22, 2021.
Following the issuance of the letter, SEC Commissioners Allison Herren Lee and Caroline A. Crenshaw issued a joint statement asserting that (i) it was inappropriate for the SEC to deal with this issue through no-action relief, rather than through action by the SEC, and (ii) the arrangements had put securities lenders at risk in the event of a failure of the broker-dealers. Ms. Lee and Ms. Crenshaw also referred to the 1982 release in which the relevant provision of Rule 15c3-3 had been adopted. See Net Capital Requirements for Brokers and Dealers, 47 FR 21759 (May 20, 1982). That release states that the SEC "[r]equires the physical possession of the collateral be transferred to the lender or to his appointed agent." Ms. Lee and Ms. Crenshaw assert that the relevant arrangement may put retail customers at risk in the event of the failure of a broker-dealer, if the Securities Investor Protection Corporation ("SIPC") were to determine that it had the power to take the collateral for the benefit of other creditors of the broker-dealer.
The policy behind the Rule 15c3-3 requirement that collateral be delivered away from the broker-dealer, rather than be put into the customer's account at the broker-dealer, is long-standing (as the dissenting Commissioners say, it dates from 1982), but the need for the specific requirement has always been somewhat unclear. On the one hand, a securities lender who holds collateral is obviously protected in the event of the bankruptcy of the broker-dealer. That said, if the collateral were to be put into a customer's account protected by Rule 15c3-3, SIPC would have to strain to reach the result that such collateral did not constitute customer property, and there is no policy reason as to why SIPC should strain to reach that result. Likewise, if the collateral were delivered out to a bank, which acted as the customer's agent, as provided for in the language quoted by the Commissioners, and the collateral was properly pledged to the securities lenders, then those lenders should be protected in the broker-dealer's bankruptcy. The Commissioners, in footnote 8, observe that collateral held at a bank in the name of the broker-dealer may be seized by SIPC but, without knowing if the counterparty held a perfected security interest in the collateral, the observation may not be on point.
"Although custody is not an exciting subject, there is a good argument that SEA Rule 15c3-3 is the single most important rule in broker-dealer regulation [emphasis in the original] as it is the principal rule that is intended to protect customers in the event of a failure of a broker-dealer carrying the asset in their accounts. See the Custody chapter of Lofchie's Guide to Broker-Dealer Regulation. The significance of the rule is exemplified by the insolvency of Lehman Brothers, Inc. ("LBI"), in which billions of dollars of customer assets were put at risk by the firm's insolvency. That said, the law may not be so clear as the Commissioners suggest. First, if a broker-dealer delivers collateral to a customer, is the customer then not permitted to retransfer the collateral back to the broker-dealer to be held in the customer's account? Second, if the collateral is delivered out to a bank that is acting as agent for the customer, are the requirements of the 1982 release satisfied?
The Commissioners say that these arrangements were put into place to save money for broker-dealers. That is true, in the sense that the FPL programs described reduce transaction costs, which benefit customers as well as broker-dealers. There is simply no way in the world that retail customers could afford to hire a bank custodian to act solely for them as their collateral agent. They do not lend enough shares to generate revenue where this would ever be realistic. So the only way that retail lenders can earn revenue by lending their securities is if a procedure can be established by which they are enabled to act in some aggregated fashion. Requiring retail customers to have an independent securities collateral custodian is not, as a practical matter, very different from prohibiting these customers from lending their securities at all. If the Commissioners are of a mind to permit retail investors to lend their securities, then the SEC will have to agree (perhaps with SIPC) on an economically workable procedure.
As to the issue of whether the staff should be limited in their authority to issue no-action letters, the need for the primacy of the Commission over the staff is also a view that has been expressed by Commissioner Hester M. Peirce, among others. There is a better approach. The staff should have more authority to take liberalizing action, subject of course to the ability of the Commission subsequently to override such action. It is impractical for the Commissioners to make all necessary judgments as to the SEC's vast jurisdiction. Getting relief from any regulatory body is typically a very slow process, as it is. To the extent that the staff is further limited in its authority, the process is further slowed.
- SEC No-Action Letter: Broker-Dealers Borrowing Fully Paid and Excess Margin Securities from Customers
- SEC Joint Statement, Allison Herren Lee and Caroline A. Crenshaw: No-Action Relief for Non-Compliance with the Customer Protection Rule
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