SEC and FINRA Issue Guidance on How to Characterize Certain Broker-Dealers Under SEC’s Customer Protection Rule

Executive Summary

The U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, Inc. (FINRA) have issued guidance in the form of Frequently Asked Questions (FAQs)¹ regarding the characterization of certain SEC-registered broker-dealers (which are members of FINRA) under the various exemption provisions set forth in Rule 15c3-3(k) under the U.S. Securities Exchange Act of 1934 (Exchange Act), the SEC’s customer protection rule. The new guidance changes the way many broker-dealers will be characterized as not being subject to the full requirements of SEC Rule 15c3-3 in their FINRA membership agreements, and impacts the way such firms will be characterized in their periodic FOCUS Report filings and their annual Exemption Report filings with respect to SEC Rule 15c3-3.

Background

Historical Approach

For many years, the SEC and FINRA have permitted a broker-dealer whose business activities do not require that it maintain minimum net capital of at least $100,000 pursuant to Rule 15c3-1(a)(2)(ii) under the Exchange Act, the SEC’s net capital rule, and whose business activities do not squarely fit into an exemption under SEC Rule 15c3-3(k) – SEC Rule 15c3-3(k)(1)², SEC Rule 15c3-3(k)(2)(i)³ or SEC Rule 15c3-3(k)(2)(ii)⁴– to, nonetheless, rely, or be categorized as relying, on the exemption in SEC Rule 15c3-3(k)(2)(i). Such a characterization was predicated on the fact that such a broker-dealer does not carry customer accounts or otherwise receive or hold customers’ funds or securities.⁵ Under SEC Rule 15c3-1(a)(2)(ii), a firm that relies on the exemption in SEC Rule 15c3-3(k)(2)(i), however, is required to maintain minimum net capital of $100,000.

FINRA (and the predecessor National Association of Securities Dealers, Inc. (NASD)) historically set forth in such a firm’s membership agreement that such a broker-dealer would be relying on the (k)(2)(i) exemption even though (i) the broker-dealer would never receive customers’ funds or securities or otherwise act on a limited “self-clearing” basis as contemplated by the terms of such exemption, and (ii) the broker-dealer would not be required to maintain minimum net capital of $100,000 as required in SEC Rule 15c3-1(a)(2)(ii) in order to rely on such exemption. This treatment was generally available to a broker-dealer that (i) does not, directly or indirectly, receive, hold or otherwise owe funds or securities for or to customers, other than money or other consideration received and promptly transmitted in compliance with SEC Rule 15c2-4(a) or (b)(2)⁶, (ii) does not carry accounts of or for customers, and (iii) does not carry “PAB accounts” (generally, proprietary accounts of other broker-dealers, including a foreign broker-dealer, or a foreign bank acting as a broker-dealer).⁷ The FAQs refer to such a broker-dealer/firm as a “Non-Covered Firm” because although such a firm may not fit squarely within any of the exemptions in SEC Rule 15c3-3(k) (that is, the firm’s activities are not “covered” by a (k) exemption), it is not a firm that should be subject to the possession or control and reserve requirements of SEC Rule 15c3-3 as a non-exempt, or “fully computing”, firm.

A Non-Covered Firm that is currently required under its FINRA membership agreement to maintain minimum net capital of less than $100,000 under SEC Rule 15c3-1 and that acts in one or more of the following categories of activities (Non-Covered Firm Activities) has historically been characterized by the SEC and FINRA for FINRA membership agreement purposes, FOCUS Report filing purposes⁸, and SEC Exemption Report purposes⁹ as “exempt” from SEC Rule 15c3-3 by reason of the (k)(2)(i) exemption: (i) a private placement broker or other placement agent that effects securities transactions on a best efforts or subscription basis (not on a firm commitment basis); (ii) a merger and acquisition advisory firm; (iii) a firm that refers securities transactions to other broker-dealers or firms; or (iv) a firm that provides technology or platform services. In each of the foregoing examples, the firm does not hold or receive customers’ funds or securities (or otherwise carry customers’ accounts).

New Approach

Under the new FAQs, a Non-Covered Firm that engages in Non-Covered Firm Activities is no longer eligible to be characterized as exempt under SEC Rule 15c3-3(k)(2)(i), or under any other (k) exemption. Rather, such a firm is deemed, in effect, not to be subject to the various SEC Rule 15c3-3 requirements and is eligible to file an annual Exemption Report (in contrast to a Compliance Report) with the SEC and FINRA (the New Approach). But, again, under the New Approach, such a firm can no longer be characterized as exempt under (k)(2)(i) (or any other (k) exemption) in (i) the firm’s FINRA membership agreement, (ii) the firm’s periodic FOCUS Report filing, and/or (iii) the firm’s annual Exemption Report. It does not appear that the Non-Covered Firm Activities are necessarily intended to be the exclusive or sole activities that a Non-Covered Firm could engage in under the New Approach. That is, a firm may be able to engage in other activities and still be characterized as a Non-Covered Firm under the FAQs and the New Approach, although such a firm may need to discuss the scope of those activities with FINRA or the SEC as being eligible under the New Approach. For the purposes of this Client Alert, we will focus on a Non-Covered Firm engaging in Non-Covered Firm Activities, but the discussion below should apply to a Non-Covered Firm that engages in any qualifying activities under the New Approach.

Although a Non-Covered Firm engaging in Non-Covered Firm Activities is no longer eligible to claim an exemption under SEC Rule 15c3-3(k)(1) or (k)(2) with respect to such Non-Covered Firm Activities, but is nonetheless deemed to be subject to SEC Rule 15c3-3, a Non-Covered Firm will/does not become subject to SEC Rule 15c3-3(d) (daily determination of possession or control of customers’ securities) or SEC Rule 15c3-3(e) (reserve requirements, including the maintenance of a reserve bank account or an EBOC account). That is, the firm is effectively treated as subject to, but exempt under, SEC Rule 15c3-3 the way that such a firm has historically been operating.¹⁰

Accordingly, as a substantive/practical matter, the FAQs do not change/impact regulatory requirements applicable to a Non-Covered Firm that engages in Non-Covered Firm Activities under SEC Rule 15c3-3; rather, the FAQs just affect the firm’s characterization in its FINRA membership agreement and in certain regulatory reporting requirements.

Impact to FINRA Membership Agreement

Pursuant to the FINRA FAQs, a Non-Covered Firm engaging in Non-Covered Firm Activities would be required to amend its FINRA membership agreement via a membership agreement change request (MAC Request) through the FINRA Firm Gateway to reflect that the firm is no longer deemed to be acting under the (k)(2)(i) (or any other (k)) exemption under SEC Rule 15c3-3 with respect to such Non-Covered Firm Activities but is nonetheless not subject to the various requirements of SEC Rule 15c3-3. This is a fairly straightforward process and should not trigger the need for a more formal Continuing Membership Application (a CMA) under FINRA Rule 1017(a)(5), provided that no material changes to the firm’s approved business activities, as set forth in the membership agreement, have occurred or are contemplated. FINRA states in its FAQs that there is no fee required for a MAC Request on the grounds that an applicable firm would not be changing its business solely through such request. In addition, a Non-Covered Firm engaging in Non-Covered Firm Activities should not need to seek approval under FINRA Rule 1020 to “change” its status of operation under SEC Rule 15c3-3 because, again, the firm would not be substantively changing its activities/conduct or method of doing business under SEC Rule 15c3-3.¹¹

In the MAC Request, the firm should state that with respect to its conduct of Non-Covered Firm Activities (or other eligible activities – see above and further below), which the firm should specify/describe, although it is no longer eligible to claim an exemption under SEC Rule 15c3-3(k), it is not required to comply with the requirements of SEC Rule 15c3-3 by reason of the SEC’s guidance set forth in footnote 74 to SEC Release No. 34-70073 (July 30, 2013). The FAQs, as described herein, are essentially an implementation of the footnote 74 requirements/guidance.

Prior to filing a MAC Request, a Non-Covered Firm engaging in Non-Covered Firm Activities should notify its assigned FINRA Risk Monitoring Analyst (formerly known as a FINRA Coordinator) that such firm will be seeking to amend its FINRA membership agreement in accordance with the foregoing. If a firm also operates under the (k)(2)(ii) exemption for other aspects of its business (see also the discussion below), it may need to alert/notify its clearing firm of the foregoing under the firm’s clearing agreement. Firms may also want to notify their outside auditors to provide advance notice that the firm’s Exemption Report and FOCUS Report filings will change for 2020 and to preview those proposed changes in light of the FAQs (see also the further discussion below regarding changes to Exemption Report and FOCUS Report filings under the New Approach).

Correspondent Firms

Although not obligated to do so, clearing firms may consider notifying their correspondents that such correspondents may be impacted by the new FAQs, and it would be incumbent upon the correspondents to update their FINRA membership agreements and Exemption Reports/FOCUS Reports accordingly, as described above.

Mixed Business Firms

For a firm that engages in “mixed” business activities, that is, both Non-Covered Firm Activities for certain parts of its business and other activities (Covered Firm Activities) that fit within a (k) exemption for other parts of its business (i.e., (k)(2)(i) and/or (k)(2)(ii), but not (k)(1)), such a firm will continue to be exempt under the applicable (k) exemption with respect to its Covered Firm Activities; the new FAQs would apply only to the firm’s Non-Covered Firm Activities. Thus, the FAQs do not change the characterization of the firm’s Covered Firm Activities under SEC Rule 15c3-3, including for purposes of filing an Exemption Report and periodic FOCUS Reports or the need to amend/revise the firm’s FINRA membership agreement.¹²

Impact to Exemption Report

With respect to a Non-Covered Firm’s Exemption Report, the FAQs state that under the New Approach, a Non-Covered Firm that does not claim an exemption under paragraph (k) of SEC Rule 15c3-3 with respect to Non-Covered Firm Activities should include in its Exemption Report a description of those business activities and a statement that during the reporting period for the Exemption Report the firm (i) did not directly or indirectly receive, hold, or otherwise owe funds or securities for or to customers, other than money or other consideration received and promptly transmitted in compliance with paragraph (a) or (b)(2) of SEC Rule 15c2-4, (ii) did not carry accounts of or for customers, and (iii) did not carry PAB accounts (as defined in SEC Rule 15c3-3). The firm’s reporting with respect to Covered Firm Activities, however, would not change. It is not clear if for a Non-Covered Firm’s current fiscal year, it would need to state in its next annual Exemption Report that it was exempt under a (k) exemption for part of the year (until the firm changed its FINRA membership agreement) and conducted activities under the footnote 74 guidance for the remaining portion of the year. That should be a discussion with the firm’s outside auditor.

Impact to FOCUS Report

With respect to a Non-Covered Firm’s FOCUS Report, the FAQs state that a Non-Covered Firm should not indicate in its FOCUS Report that it is claiming an exemption from SEC Rule 15c3-3 with respect to its Non-Covered Firm Activities; that is, Items 4550, 4560, 4570 and 4580 of the FOCUS Report, Part II or Part IIA, under “Exemptive Provision under Rule 15c3-3”, should be left blank with respect to such activities. However, the firm may enter a memo to Item 4560 that states: “The firm has no possession or control obligations under SEA Rule 15c3-3(b) or reserve deposit obligations under SEA Rule 15c3-3(e) because its business is limited to [list activities].” The firm’s reporting with respect to its Covered Firm Activities, however, would not change. Presumably, a Non-Covered Firm would change its reporting with respect to SEC Rule 15c3-3 for its next FOCUS Report immediately following the firm’s change to its FINRA membership agreement. 

Some Observations

SEC Rule 15c3-3 was adopted in 1972 to protect customers’ funds (cash) and securities received or held by a registered broker-dealer. SEC Rule 15c3-3 was intended to coordinate with the Securities Investor Protection Act of 1970, which, among other things, established SIPC as well as an insurance fund to be administered and maintained by SIPC to protect against a shortfall in customers’ “net equity” claims with respect to an insolvent firm. The primary objective of SEC Rule 15c3-3 is to prevent a registered broker-dealer from using customers’ assets to finance the broker-dealer’s business, except, in certain cases, with respect to serving customers’ securities activities effected by the broker-dealer.

As noted, pursuant to SEC Rule 15c3-1(a)(2)(ii), a registered broker-dealer that proposes to act under the exemption in SEC Rule 15c3-3(k)(2)(i) must maintain minimum net capital of $100,000. As also noted, for many years, the SEC and FINRA have permitted firms that did not come within another (k) exemption to be characterized as exempt under (k)(2)(i) — even though the firm was only required to maintain minimum net capital of less than $100,000, such as a private placement broker that is only required to maintain minimum net capital of $5,000 pursuant to SEC Rule 15c3-1(a)(2)(vi) and which firm does not receive or hold customers’ funds or securities and does not carry customers’ accounts.

However, in the past year or so, and as an aftermath of the SEC’s adoption of its so-called “Broker-Dealer Reports” release in 2013¹³, FINRA has come to the view that because a Non-Covered Firm that engages in Non-Covered Firm Activities is not required to maintain minimum net capital of $100,000 in accordance with SEC Rule 15c3-1(a)(2)(ii), and such a firm does not fit within the activities specified in SEC Rule 15c3-3(k)(2)(i) (or any other (k) exemption), then such a firm is ineligible to rely on, or be characterized as relying on, the exemption in SEC Rule 15c3-3(k)(2)(i) (or any other (k) exemption). As such, FINRA has been suggesting more recently in connection with New Member Applications and CMAs that Non-Covered Firms need to more accurately characterize how they operate under SEC Rule 15c3-3, including in their FINRA membership agreements, Exemption Reports and FOCUS Reports. The FAQs are the result of FINRA’s initiative in this regard.

Pursuant to an existing FAQ from the SEC (from 2018), the SEC stated that a registered broker-dealer which is exempt under the (k)(2)(i) exemption is not required to establish an EBOC account if “due to the nature of its business activities the broker-dealer would not ever be in possession of customer funds or securities.”¹⁴ Because a (k)(2)(i)-exempt firm is permitted to receive/hold customers’ funds and/or securities for a limited period of time (subject to the “prompt transmission” thereof, as described above), this FAQ might suggest that as long as the broker-dealer — with respect to Non-Covered Firm Activities — elects to maintain minimum net capital of $100,000 in accordance with SEC Rule 15c3-1(a)(2)(ii) and as reflected in its FINRA membership agreement, the firm should be eligible to operate under the exemption in SEC Rule 15c3-3(k)(2)(i).¹⁵ Notwithstanding the foregoing, however, we understand that this is not the intent of the FAQs and a firm cannot “elect” to increase its minimum net capital requirement in its FINRA membership agreement — without a change in activity (which would likely trigger a CMA with FINRA) that would bring it within the scope of permissible activities under (k)(2)(i) — solely to maintain its exempt status under (k)(2)(i).¹⁶

¹ See the SEC’s Division of Trading and Markets’ Frequently Asked Questions Concerning the Amendments to Certain Broker-Dealer Financial Responsibility Rules and Frequently Asked Questions Concerning the July 30, 2013 Amendments to the Broker-Dealer Financial Reporting Rule and FINRA’s Frequently Asked Questions About Exemption Reporting Under SEA Rule 15c3-3(k) for Purposes of FOCUS Reporting and Updating of Membership Agreements and eFOCUS Frequently Asked Questions.

² SEC Rule 15c3-3(k)(1) provides an exemption from the requirements of SEC Rule 15c3-3 in respect of transactions of customers in (a) redeemable securities issued by a registered investment company under the U.S. Investment Company Act of 1940, (b) interests or participations in an insurance company separate account, or (c) the solicitation of share accounts for a saving and loan association insured by an instrumentality of the United States, and where, in each case, the broker-dealer promptly transmits all funds and delivers all securities received in connection with its activities as a broker-dealer, and does not otherwise hold funds or securities for, or owe money or securities to, customers. The term “promptly transmits” for these purposes means by noon of the next business day after receipt or by noon of the next business day following the settlement date, whichever is later.

³ SEC Rule 15c3-3(k)(2)(i) provides an exemption from the requirements of SEC Rule 15c3-3 in respect of securities transactions of customers where the broker-dealer carries no margin accounts, promptly transmits all customers funds and delivers all securities received in connection with its activities as a broker-dealer, but does not otherwise hold funds or securities for, or owe money or securities to, customers and effectuates all financial transactions between such broker-dealer and its customers through one or more accounts at a U.S. bank (or U.S. branch or agency of a foreign bank), each to be designated as “Special Account for the Exclusive Benefit of Customers” of the broker-dealer (generally referred to as an “EBOC” account). The term “promptly transmits” for these purposes means by noon of the next business day after receipt or by noon of the next business day following the settlement date, whichever is later.

⁴ SEC Rule 15c3-3(k)(2)(ii) provides an exemption from the requirements of SEC Rule 15c3-3 in respect of securities transactions of customers that are introduced by the broker-dealer to another broker-dealer who clears and settles such transactions on a fully disclosed basis (for the account of such customers), and who promptly transmits all customer funds and securities to the clearing broker-dealer.  The term “promptly transmits” for these purposes means by noon of the next business day after receipt.

⁵ Pursuant to SEC Rule 15c3-3(k)(3), the SEC may, “upon written application by a broker or dealer”, exempt such broker or dealer from the provisions of SEC Rule 15c3-3, either unconditionally or on specified terms and conditions. The SEC has not historically used this provision to grant or provide exemption under SEC Rule 15c3-3.

⁶ SEC Rule 15c2-4 applies to broker-dealers that participate in best efforts offerings of securities (that is, otherwise, than on a firm commitment basis, including with respect to private placements/offerings). SEC Rule 15c2-4(a) generally requires that any money or other consideration received by the broker-dealer in connection with such an offering be promptly transmitted to the persons entitled thereto. In an offering that is made on a contingency basis (e.g., an “all-or-none” or “part-or-none” offering), pursuant to SEC Rule 15c2-4(b)(2), such funds must generally be held by an independent/unaffiliated bank escrow agent, pending the discharge of the contingency and the consummation of the applicable closing of the sale of the securities in question.

⁷ See Section II.4 of the former NASD Guide to Rule Interpretations – Net Capital Rule from November 1993. Such interpretation contemplates that a broker-dealer that maintains minimum net capital of $5,000 pursuant to SEC Rule 15c3-1(a)(2)(vi) (and, thus, does not carry customer accounts or otherwise receive or hold customers’ funds or securities) would rely on the (k)(2)(i) exemption.

⁸ Pursuant to SEC Rule 17a-5(a)(3), these types of firms are generally required to file quarterly FOCUS Reports (Form IIA) with FINRA containing certain unaudited financial information, and which also requires the firm to identify the exemption(s) that it relies on under SEC Rule 15c3-3(k).

⁹ Pursuant to SEC Rule 17a-5(d)(1)(i)(B)(2) and (d)(6), if a broker-dealer claims it was exempt from SEC Rule 15c3-3 throughout the most recent fiscal year, the broker-dealer is required to file an annual “Exemption Report” with the SEC and FINRA, among other regulators, that must be reviewed by the firm’s outside auditor in accordance with standards of the Public Company Accounting Oversight Board (PCAOB). Pursuant to SEC Rule 17a-5(d)(1)(i)(B)(1) and (d)(6), a firm that is not eligible to file an Exemption Report must, instead, file a “Compliance Report” that must be examined by the firm’s outside auditor in accordance with standards of the PCAOB. See also SEC Rule 17a-5(g).

¹⁰ Arguably, a Non-Covered Firm that engages in Non-Covered Firm Activities is not subject to, or within the scope of, SEC Rule 15c3-3, but that is not the way the SEC and FINRA are viewing the change with respect to Non-Covered Firms.

¹¹ A MAC Request is not to be confused with either a CMA or a more informal “materiality consultation.” A MAC Request generally requires a description of the nature of the change requested for the firm’s existing membership agreement and any relevant supporting documentation (if any). The request, which must be submitted in writing through the FINRA Firm Gateway, must clearly identify the change requested and should also state why the firm believes the change requested does not warrant the filing of a CMA. Again, FINRA has stated in its FAQs that it will not charge a fee to update the firm’s membership agreement to accurately reflect its SEC Rule 15c3-3 exemption, provided that the firm does not also contemplate changes to the firm’s business.

¹²  In this regard, we understand that a firm with mixed business activities would be permitted to engage in Covered Firm Activities under a (k)(2)(i) and/or (k)(2)(ii) exemption, as applicable, and, also, engage in Non-Covered Firm Activities (or potentially other activities – see above) under the New Approach set forth in the FAQs. However, we understand that the regulators take the position that a firm cannot engage in Covered Firm Activities under a (k)(1) exemption and also engage in Non-Covered Firm Activities under the New Approach (or operate under the (k)(1) exemption and also engage in Covered Firm Activities under another (k) exemption – (k)(2)(i) or (k)(2)(ii)) on the grounds that the (k)(1) exemption is intended to cover the entire scope of business activities engaged in by a firm in light of the fact that firms that engage solely in (k)(1) activities are not required to be members of the Securities Investor Protection Corporation (SIPC) and are fully exempt from the SEC’s risk assessment rules under SEC Rule 17h-1T and SEC Rule 17h-2T. The latter is not necessarily the case for firms that engage in Non-Covered Firm Activities described in the FAQs or that engage in Covered Firm Activities described in another (k) exemption. As such, the (k)(1) exemption is viewed as available only to firms that engage, solely, in Covered Firm Activities described in the (k)(1) exemption.

¹³ See SEC Release No. 34-70073 (July 30, 2013) where, as noted, the SEC set forth a process in footnote 74 of such release to address how a Non-Covered Firm could be able to file an Exemption Report rather than a Compliance Report. See also related footnote 78 to such release.

¹⁴ See the SEC’s Division of Trading and Markets’ Frequently Asked Questions Concerning the July 30, 2013 Amendments to the Broker-Dealer Financial Reporting Rule.

¹⁵ See, for example, the FINRA Guide to Financial and Operational Rules at SEC Rule 15c3-1(a)(2)(ii)/01 whereby a firm that is exempt under the (k)(2)(i) exemption (and thus does not carry customer accounts or otherwise owe funds or securities to customers) is permitted to elect to operate at the higher minimum net capital level of $250,000 under the alternative standard of net capital in SEC Rule 15c3-1(a)(1)(ii) even though the firm could conduct its business under the lower $100,000 minimum net capital level pursuant to SEC Rule 15c3-1(a)(2)(ii).

¹⁶ We understand that the intent of the aforesaid FAQ under the (k)(2)(i) exemption, that a firm need not maintain an EBOC account, is to address certain SEC letters/guidance that a firm may operate under the (k)(2)(i) exemption without an EBOC account where it receives a customer’s funds for a purchase of securities from the customer against the simultaneous or concurrent delivery of those securities by the firm to the customer and, thus, does not ever become subject to the “promptly transmit” requirement of the (k)(2)(i) exemption.  

¹⁷ The SEC, for example, has issued guidance that a firm operating under the (k)(2)(ii) exemption, may, under certain circumstances and in connection with a new account opening review and approval, transmit a customer’s check received by the firm, but payable to the firm’s clearing firm, to the clearing firm within seven business days after receipt instead of by noon of the next business day after receipt (the normal “promptly transmit” requirement) as required under the (k)(2)(ii) exemption and SEC Rule 15c3-1. See SEC letter to MML Investors Services, LLC (publicly available July 19, 2016). It is not clear if FINRA or the SEC would require a firm that relies on the aforesaid SEC guidance, and thus does not, technically, promptly transmit the customer’s check, to, now, follow the New Approach instead of continuing to claim the (k)(2)(ii) exemption.