SEC Approves FINRA Rule Proposals Regarding Securities Loans and Allocations of Securities Calls (with Lofchie Comment)

The SEC approved FINRA Rule 4314 ("Securities Loans and Borrowings"), Rule 4330 ("Customer Protection – Permissible Use of Customers' Securities"), and Rule 4340 ("Callable Securities"). FINRA Rules 4314 and 4330 are derived in part from NYSE Rule 296 ("Liquidation of Securities Loans and Borrowings") and NYSE Rule 402 ("Customer Protection - Reserves and Custody of Securities").

Newly adopted FINRA Rule 4314 is intended to provide clarity as to whether a party is acting as principal or agent when entering into an agreement to loan or borrow securities, by requiring it to disclose its capacity as an agent in the transaction.

FINRA Rule 4330 prohibits a member from lending, either to itself or others, securities that are held on margin for a customer and that are eligible to be pledged or loaned unless the firm first obtains a written authorization from the customer permitting the lending of the customer's securities. More significantly, the rule adds new disclosure requirements and establishes the need for members to conduct appropriateness determinations before engaging in the borrowing customers' fully paid and excess margin securities. Certain of the suitability requirements do not apply if the customer from whom the securities are borrowed is an "institutional account" as defined inFINRA Rule 4512(c). Firms that have in place any current program to borrow fully paid securities from customers are required to notify FINRA of such program within 30 days of Rule 4340 becoming effective.

FINRA Rule 4340 (based on NYSE Rule 402.30) clarifies the procedure used by a FINRA member when a security is called or redeemed prior to maturity. The rule allows a member to establish procedures other than a lottery system (which had been the only system permitted by the prior rule) by which it will allocate among its customers, on a fair and impartial basis, the securities to be redeemed or selected as called in the event of a partial redemption or call. Where the redemption is on terms that are "favorable to the called parties," the broker-dealer is prohibiting from allocating the securities to its accounts or any of the accounts of its "associated persons" (as defined in Section 3(a)(18) of the Exchange Act).

Lofchie Comment: Rule 4314, as to the disclosure of agency status, should not be problematic. The requirements in this rule are likely consistent with the way in which members are currently conducting their securities lending business. The rule was likely adopted in reaction to an attempt by some firms to escape liability in the MJK Clearing broker-dealer bankruptcy by asserting that they were only acting as agents and were not responsible for any losses.The disclosure requirement in Rule 4330 was amended to eliminate the required placement of a legend in the customer margin agreement. As originally proposed, the FINRA Rule would have effectively required the redocumentation of new customer agreements solely for the purpose of adding this legend, a potentially enormous expense. Fortunately, this problem with the rule has been fixed. Nonetheless, in new margin agreements, firms should consider additional highlighting of the required disclosures.The suitability requirements in Rule 4330 are potentially more problematic. For starters, the scope of the securities borrowing transactions that fit within the rule is not entirely clear. Beyond that, firms will likely have to institute significant new compliance programs under the rule.New Rule 4340 (as to callable securities) will require two types of compliance procedures: (i) to determine which accounts are considered those of "associated persons" who must be excluded from favorable calls; and (ii) to determine on an ongoing basis which calls are favorable. Leaving aside the compliance issue, and turning to the policy issue, there does not seem to me to be any justification for excluded the accounts of associated persons from favorable calls; i.e., so long as the allocation procedure is truly random, why should not employees of a broker-dealer (or the broker-dealer itself) participate alongside other customers in the allocation? After all, the employees' property rights in the relevant securiteis are equivalent to the property rights of the firm's customers. Further, it is not obvious to me how one would decide whether a call is "favorable" or not; presumably, the issuer of securities only calls for reasons that are in its favor, and not in the favor of bond holders.

See: Text of Rule Changes.