Democratic members of the Securities and Exchange Commission have objected to agency staff providing leeway to broker-dealers that have not properly established customer protections when borrowing securities from them.
In a no-action letter last Thursday to the Financial Industry Regulatory Authority Inc., Elizabeth Baird, deputy director of the SEC Division of Trading and Markets, said some brokers are violating the customer protection rule, which requires them to deliver collateral to customers from whom they are borrowing fully paid and excess margin securities.
These brokers did not physically turn over the collateral — such as cash, Treasury bills or notes, or an irrevocable letter of credit from a bank — to their customers. Instead, the collateral was deposited in the lender’s securities account at the broker-dealer or in a bank account in the name of the broker-dealer.
The customer protection rule requires that brokers safeguard customer securities and cash so that there is not a delay -- or a shortfall -- in returning them if the brokerage fails.
The SEC no-action letter gives the brokerages who are violating the rule until April 22 to come into compliance.
Democratic SEC members Allison Herren Lee and Caroline Crenshaw said the no-action letter was misguided because it provided cover to continue inappropriate behavior for another six months.
Lee and Crenshaw said the broker-dealers are “seeking to minimize their costs” by depositing the required collateral into brokerage accounts or at the broker’s bank. Because they're maintaining control over the collateral, customers may not be able to access it.
“Whether these arrangements violate [the customer protection rule] is not a close call,” Lee and Crenshaw wrote in a statement Friday. “In the midst of a historically volatile year for the nation’s markets, acquiescing to the continuation of this conduct for up to six months presents an unacceptable risk to investors.”
They said no-action relief can be provided when conduct “may touch upon a gray area of regulation.”
But the circumstances surrounding the brokers’ securities lending were crystal clear -- they are breaking the rule, Lee and Crenshaw said.
A no-action letter “should not provide a grace period for compliance with clear violations of law -- especially violations that put investor funds directly at risk,” Lee and Crenshaw wrote. “Here, the potential harm to customers arising from the conduct goes to the very heart of the Customer Protection Rule and should be remediated without delay.”
It is unusual for SEC members to step in on a no-action letter, which are issued by agency staff. In this case, the commission needs to weigh in, Lee and Crenshaw said.
“[T]he question here is whether an extended, across-the-board grace period for such violations should be granted, and that decision falls within the discretion of the full Commission,” they wrote.
The SEC staff seemed to be backing off in an instance where retail customer protection is at stake, said Kurt Wolfe, a securities regulatory attorney at Troutman Pepper. The agency has been emphasizing that area in enforcement.
“It’s a little bit puzzling to me,” Wolfe said. “This is their playbook in a great many actions over the last couple years.”
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