FINRA Files Proposed Rule Changes Relating to Securities Borrowing/Lending and Rehypothecation (with Lofchie Comment)

FINRA has filed a proposed rule change to adopt financial and operational rules relating to securities loans and borrowings, and permissible uses of customers' securities. The changes to the rules would be as follows:

• The proposed rules would require a written agreement as to any securities loan between a FINRA member and non-member (and would create, if necessary a deemed agreement between two FINRA members);
• Would impose various record keeping requirements in connection with securities loans where the FINRA member is acting as agent (bearing in mind that there are already at least informal requirements that apply where a broker-dealer is borrowing from an agent);
• Impose certain disclosure and consent obligations where broker-dealers intend to rehypothecate customers "margin securities"; i.e., those securities not required to be segregated;
• Impose various compliance and customer protection obligations on programs to borrow fully-paid securities from customers; and (on a fairly separate note)
• Require that customers be given preference over the firm AND its employees when there is a favorable call of debt securities.

Lofchie Comment: FINRA's rule proposals should be read in conjunction with the recent SEC rule changes relating to Rules 15c3-1 (the net capital rule) and Rule 15c3-3 (the customer protection rule). See SEC Amends Capital and Custody Rules for Broker-Dealers (with Lofchie Comment). Many of FINRA's rule proposals are non-objectionable. For example, if a broker-dealer is engaged in borrowing/lending transactions as agent, rather than as principal, that should obviously be clear to its counterparties and on its own books and records. The required procedures relevant to fully-paid borrow programs, despite all of the other requirements imposed on firms, are achievable. One of the least productive rule proposals could be one of the most burdensome and expensive. Broker-dealers that rehypothecate customer securities are required to have in place an agreement that warns the customer that their securities may be rehypothecated. Although existing agreements that provide a customer consent to rehypothecation are grandfathered, the grandfathering is subject to the condition that the existing agreement must refer to the rehypothecation of customer "margin securities" and not just "securities." This condition serves no purpose, and could result in firms having to repaper thousands of agreements. What makes any repapering requirement even more wasteful is that customers whose securities are rehypothecated are treated exactly the same in bankruptcy as those whose securities are segregated; that is, customers receive no real benefit from refusing to allow the rehypothecation of their margin securities. Firms should certainly comment on this aspect of the proposal. An interesting aspect of the FINRA proposal is the requirement that customer securities be preferenced over broker-dealer employee securities when there is a favorable call of debt. This was a pre-existing NYSE requirement. It is hard to tell what the legal basis is for disfavoring employee accounts in this manner which seems neither fair nor justified. From a policy standpoint, it provides at least some small incentive for employees to hold their assets in an account away from their employer, which could make it more difficult for the employer to monitor insider trading.

See: FINRA Filing Announcement; Text of Proposed Rule Changes.