Most FINRA broker-dealers operate pursuant to an exemption from SEC Rule 15c3-3 (the Customer Protection Rule). This rule requires that broker-dealers choosing to receive or hold customer funds must compute the Reserve Formula on at least a monthly basis and lock up the amount calculated by the formula in a Special Reserve Account for the Exclusive Benefit of Customers. Broker-Dealers choosing to operate in this manner are subject to at $250,000 minimum net capital requirement and they must maintain $300,000 in net capital to avoid being in “early warning” with FINRA in their financial monitoring.
Many broker-dealers elect to operate pursuant to an exemption from SEC Rule 15c3-3, thus requiring a lower net capital requirement – perhaps as low as $5,000. In fact, most operate pursuant to the (k)(2)(ii) exemption to the rule which applies to firms that clear all transactions on a fully-disclosed basis through a clearing firm. These firms are not permitted to receive or hold customer funds. And compliance with these requirements is now subject to annual verification by an independent public accountant pursuant to SEC Rule 17a-5. Click here for more details on that requirement.
SEC views “receipt” of customer funds to mean the receipt of cash or checks made payable to the introducing broker-dealer. So introducing brokers who want to avail themselves of the (k)(2)(ii) exemption must ask customers to make checks payable to the clearing firm (and obviously must not accept cash). So that takes care of the receipt of funds aspect. However, there is another requirement to qualify for the exemption. And that is that a broker-dealer may not hold customer funds. The SEC has stated that even if checks are made payable to the clearing firm (or a product sponsor), they must be “promptly forwarded” by the introducing broker in order to qualify for the exemption. That means no checks sitting in desk drawers. In fact the SEC has stated that it defines “promptly forwarded” to mean forwarded by noon the next business day.
Many broker-dealers operate through a branch office system. As such, brokers in the branches accept checks from customers and are required to forward these checks. There is an exemption for checks related to variable annuity purchases while those transactions are being reviewed by a principal. In those cases, the checks must be forwarded within 7 days after the firm receives the paperwork in good order for the transaction. Otherwise, checks must be sent out the very next day. There are many operational approaches to facilitating compliance with this exemption.
Unfortunately, many broker-dealers run into problems in this area. And when this happens, FINRA may require the broker-dealer to operate at a higher level of net capital ($250,000). Non-compliance with the exemption to the Customer Protection Rule is preventable through the development of good operational processes and effective supervisory systems.
If you have questions about financial or operational issues, Mitch Atkins, FINRA’s former South Region Director has extensive experience in this area. Call Mitch Atkins, Principal at FirstMark Regulatory Solutions, at 561-948-6511.
UPDATE: This article was written in December of 2014. However, on June 19, 2015, FINRA published Regulatory Notice 15-23 which outlines guidance related to and SEC no-action letter that for the first time has granted relief from the requirement to transmit checks by noon the next business day for securities sold on a subscription basis. Clearly this includes mutual funds and variable annuities, but the jury seems to be out on whether it applies to non-traded REITS, BDCs and other products. The author has made inquiry of FINRA on this point and is awaiting further information.