Increased U.S. Regulatory Focus on Fully Paid Securities Lending Programs

Fully paid securities lending programs have increasingly been a focus of examinations and enforcement investigations by both the Financial Industry Regulatory Authority (FINRA) and the SEC.¹ A keystone of the fully paid lending regulatory structure, FINRA Rule 4330 (Customer Protection — Permissible Use of Customers’ Securities), contains a number of nuances and ambiguities that, compounded by a general lack of regulatory guidance in this area, can make compliance challenging for broker-dealers offering such programs. Compliance failures can be costly, as recent enforcement actions have shown. Below, we provide a brief summary of Rule 4330 and identify certain common pitfalls for firms to avoid.

What Is Rule 4330, and When Does it Apply?

FINRA Rule 4330 is FINRA’s customer protection rule, which establishes parameters for the permissible use of customers’ securities. The rule applies to FINRA member firms that borrow fully paid or excess margin securities carried for the account of a customer. The rule also contains requirements applicable to member firms that lend securities held on margin for a customer and that are eligible to be pledged or loaned. 

Rule 4330(b) prescribes several initial requirements and ongoing obligations for firms that offer programs under which they borrow fully paid or excess margin securities from customers. A firm must notify FINRA at least 30 days before initiating a new fully paid securities lending program and provide to FINRA any information that FINRA deems necessary to evaluate the program’s compliance with applicable FINRA rules or federal securities laws or rules.² Additionally, prior to first borrowing any securities from a customer, the firm must 

• have reasonable grounds for believing (based on the exercise of reasonable diligence to ascertain the essential facts relative to the customer) that the customer’s loans of securities are appropriate for the customer
• enter into a written agreement with the customer³
• provide the customer, in writing, certain specified disclosures meant to highlight the risks inherent in fully paid lending

Rule 4330(b) further requires that the firm create and maintain, in accordance with the requirements of Rule 17a-4(a) under the Exchange Act, records evidencing the firm’s compliance with the above-described obligations to perform appropriateness determinations and provide written risk disclosures to customers. 

Rule 4330 was implemented in 2014,⁴ but has gained attention in recent years as both FINRA and the SEC have increased their focus on firms offering fully paid securities lending programs to retail customers. However, formal regulatory guidance on the rule has been limited, with no FINRA notices or other releases addressing the substance of the rule or otherwise providing interpretive guidance published since February 2014.⁵ 

Determining Whether Fully Paid Lending Is Appropriate for Customers
Rule 4330(b)(2)(A) requires that prior to first entering into any securities borrows with a customer, a member firm have reasonable grounds to believe that a customer’s loans of securities are appropriate for that customer. To make this determination, the firm must “exercise reasonable diligence to ascertain the essential facts relative to the customer,” including, but not limited to, the customer’s financial situation and needs, tax status, investment objectives, investment time horizon, liquidity needs, risk tolerance, and any other information disclosed by the customer in connection with entering into securities loans.

Determining Appropriateness for Introduced Accounts

Where a customer is being introduced to a firm’s fully paid securities lending program by an introducing broker with whom the firm has entered into a carrying agreement pursuant to Rule 4311, Supplementary Material .04 to Rule 4330 allows the firm, when making its appropriateness determination, to rely on the representations of the introducing broker that has the customer relationship with the customer. Importantly, however, Supplementary Material .04 makes clear that “[t]he member borrowing a customer’s fully paid or excess margin securities is responsible for making the determination regarding the appropriateness of such borrow from a customer required by paragraph (b)(2)(A)[.]”

Determining Appropriateness for Institutional Accounts

Where a customer enrolling in a firm’s fully paid securities lending program meets the definition of an “institutional account” under Rule 4512(c),⁶ Supplementary Material .05 to Rule 4330 permits the firm to fulfill its appropriateness determination obligation by complying with the requirements of Rule 2111(b) to determine the customer’s ability to independently evaluate investment risks and to exercise independent judgment in evaluating the firm’s recommendations.

Increased Scrutiny of “Auto-Enrollment” of Customers Into Fully Paid Lending Programs

In its published examination priorities, FINRA has cautioned firms on the practice of “auto-enrollment,” stating its expectation that firms enrolling retail customers in their fully paid securities lending programs should have a process to “determine whether the program is appropriate for the customer.”⁷ “Auto-enrollment” has also been a subject of recent FINRA enforcement actions, in which FINRA indicated that the practice of enrolling all new customers in a fully paid lending program when they open a new account infers that the required appropriateness determination is not being performed (for additional information, see our Sidley Update, “FINRA Settlements Focus on Disclosure and Appropriateness in Retail Customer Fully Paid Lending Arrangements” (available here)). 

Sharing Revenue From Fully Paid Lending With Customers

Regulatory scrutiny of compensation arrangements with customers has also increased. While FINRA Rule 4330 does not prescribe the type or amount of compensation that must be paid to customers, FINRA has stated in its examination priorities that firms should “accurately disclose the portion of fees generated on loaned shares” that will be received by customers.⁸ Furthermore, FINRA has made clear in recent enforcement actions that customers must be compensated for their loans of securities. The SEC’s most recent examination priorities indicate that it, too, will be focused on revenue sharing arrangements under fully paid lending programs, with areas of review including “structure, marketing, fees, and potential conflicts associated with offerings by broker-dealers to retail customers[.]”⁹ 

Provision of Written, Program-Specific Risk Disclosures to Customers

FINRA Rule 4330(b)(2)(B) requires firms to provide certain disclosures, highlighting the potential risks inherent in fully paid lending, to a customer in writing prior to first borrowing any fully paid or excess margin securities from the customer. Specifically, firms must provide customers with a clear and prominent notice that the protections of the Securities Investor Protection Act of 1970 may not protect the customer with respect to its loans of securities. The firm also must disclose to the customer its rights related to the loaned securities as well as the risks and financial impact of such loans, including but not limited to the factors that determine the compensation to be paid to both the customer and the firm; the customer’s loss of voting rights; that the securities may be “hard-to-borrow” because of short selling or be used to satisfy delivery requirements resulting from short sales; and potential tax implications.¹⁰ Importantly, FINRA has stated that the risk disclosures provided by the firm to its customers should be “specific to [the] member’s individual fully paid or excess margin securities lending activities” and so different or additional disclosures may be required depending on the particular structure of a firm’s program.¹¹

Accuracy of Statements in Program Agreements, Associated Documents, and Marketing Materials

FINRA Rule 2210(d) requires that the content of a member firm’s communications with customers be based on principles of fair dealing and good faith, be fair and balanced, and provide a sound basis for evaluating the services offered and that the firm not make statements that are false, exaggerated, unwarranted, promissory, or misleading. FINRA’s recent examination priorities and enforcement activity highlight the regulator’s expectation that agreements, associated documents, and marketing materials used by a firm in connection with its fully paid securities lending program should regularly be reviewed for accuracy and updated as appropriate to reflect the program’s specific terms, conditions, and risks. In particular, FINRA has indicated that where a “firm distributes or makes available communications that promote or recommend...fully paid securities lending programs[,]” its communications (which include the aforementioned agreements, documents, and marketing materials) should “accurately and clearly disclose the terms and conditions of the program, including the portion of fees customers would receive.”¹²

Recordkeeping Requirements

Rule 4330(b)(3) requires that a member firm offering a fully paid securities lending program to customers create and maintain records evidencing the firm’s compliance with the requirements set forth in Rule 4330(b)(2), including the firm’s appropriateness determinations for customers enrolled in its program and its provision of the required risk disclosures to such customers. Such records must be maintained in accordance with the requirements of Rule 17a-4(a) under the Exchange Act.

Supervisory Systems and Written Supervisory Procedures

FINRA Rule 3110(a) requires that a member firm establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations and with applicable FINRA rules. FINRA Rule 3110(b) further requires that the firm establish, maintain, and enforce written procedures to supervise the types of business in which it engages and the activities of its associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations and with applicable FINRA rules. Through its recent examination priorities and enforcement activity, FINRA has indicated that firms should have supervisory systems and written supervisory procedures (WSPs) reasonably designed to achieve compliance with the requirements set forth in Rule 4330 and that such WSPs should be regularly reviewed and updated.

What This Means to You

Recent regulatory examinations and enforcement activity indicate that fully paid securities lending is an area of focus for both FINRA and the SEC. Firms offering fully paid lending to customers may face increased scrutiny in examinations and enforcement investigations and significant penalties for noncompliance. It is not anticipated that the regulatory interest in fully paid lending programs will wane under the new presidential administration, and indeed there may be an increased focus on protection of retail investors as well as on securities lending activities that may contribute to greater short-selling activity. Broker-dealers that offer such programs should review their supervisory systems and WSPs for compliance with Rule 4330 and other applicable laws, rules, and regulations. Broker-dealers that introduce customers to such programs should also review their supervisory systems and WSPs for compliance with applicable laws, rules, and regulations. Assistance from legal counsel who are leaders in this area, such as the Sidley lawyers referenced below, can be essential to successfully navigating the complexities of Rule 4330 and avoiding missteps.

² FINRA Rule 4330(b)(1)(C) and Supplementary Material .03.

³ FINRA Rule 4330(b)(1)(A) requires a member firm to comply with all requirements of Rule 15c3-3 under the Exchange Act (Rule 15c3-3), which includes the requirement under Rule 15c3-3(b)(3) to enter into a written agreement with the customer containing certain prescribed terms and disclosures.

⁴ See SEC, Order Approving Proposed Rule Change To Adopt FINRA Rules 4314 (Securities Loans and Borrowings), 4330 (Customer Protection-Permissible Use of Customers’ Securities) and 4340 (Callable Securities) in the Consolidated FINRA Rulebook, as Modified by Partial Amendments No. 1 and No. 2, Release No. 34-70958, 78 FR 72951 (Dec. 4, 2013).

⁵ See FINRA, Regulatory Notice 14-05, SEC Approves Consolidated FINRA Rules 4314 (Securities Loans and Borrowings), 4330 (Customer Protection — Permissible Use of Customers’ Securities) and 4340 (Callable Securities) (Feb. 3, 2014) (available here).

⁶ Under FINRA Rule 4512(c), “institutional account” means the account of “(1) a bank, savings and loan association, insurance company or registered investment company; (2) an investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act or with a state securities commission (or any agency or office performing like functions); or (3) any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.”

⁷ 2023 Report on FINRA’s Examination and Risk Monitoring Program, at 67.

⁸ Id.

⁹ SEC, Division of Examinations, Fiscal Year 2025 Examination Priorities at 9 (emphasis added).

¹⁰ Rule 4330(b)(2)(B)(ii) requires that the customer be provided in writing (which may be electronic) “disclosures regarding the customer’s rights with respect to the loaned securities, and the risks and financial impact associated with the customer's loan(s) of securities, including, but not limited to: a. loss of voting rights; b. the customer’s right to sell the loaned securities and any limitations on the customer’s ability to do so, if applicable; c. the factors that determine the amount of compensation received by the member and its associated persons in connection with the use of the securities borrowed from the customer; d. the factors that determine the amount of compensation (e.g., interest rate) to be paid to the customer and whether or not such compensation can be changed by the member under the terms of the borrow agreement; e. the risks associated with each type of collateral provided to the customer; f. that the securities may be ‘hard-to-borrow’ because of short-selling or may be used to satisfy delivery requirements resulting from short sales; g. potential tax implications, including payments deemed cash-in-lieu of dividend paid on securities while on loan; and h. the member’s right to liquidate the transaction because of a condition of the kind specified in Rule 4314(b).” Additionally, Rule 4330(b)(1)(B) requires the member firm to comply with Section 15(e) of the Exchange Act, which sets forth additional disclosures to be provided to the customer regarding the use of the customer’s loaned securities in connection with short sales.

¹¹ See Notice of Filing of a Proposed Rule Change to Adopt FINRA Rules 4314 (Securities Loans and Borrowings), 4330 (Customer Protection — Permissible Use of Customers’ Securities) and 4340 (Callable Securities) in the Consolidated FINRA Rulebook, Release No. 34–70272, 78 FR 54350, 54358 (Sept. 3, 2013).

¹² 2023 Report on FINRA’s Examination and Risk Monitoring Program, at 40.