Firm Settles FINRA Charges for Customer Protection Rule Violations
Commentary by Glen Barrentine
A firm settled FINRA charges for inaccurately calculating the required customer reserve, which resulted in the broker-dealer's failure to maintain a sufficient reserve balance and related accurate books and records.
According to the AWC, the firm omitted the short market values of securities in its customers' cash and margin accounts, along with the required withholding taxes, when making its weekly customer reserve calculation. FINRA said that during the relevant period, the firm improperly calculated its customer reserve formula on 32 occasions and failed to make sufficient deposits into its reserve account.
FINRA said that the firm's reliance on incomplete data when calculating the customer reserve resulted in (i) inaccurate books and records and (ii) the filing of eight inaccurate FOCUS reports.
FINRA found that the firm violated SEA Sections 15(c) ("Registration and regulation of brokers and dealers") and 17(a) ("Records and reports"); and SEA Rules 15c3-3 ("Customer protection-reserves and custody of securities"), 17a-3 ("Records to be made by certain exchange members, brokers and dealers"), 17a-4 ("Records to be preserved by certain exchange members, brokers and dealers") and SEA 17a-5 ("Reports to be made by certain brokers and dealers"). FINRA found that the broker-dealer also violated FINRA Rules 2010 ("Standards of Commercial Honor and Principles of Trade") and 4511 ("Books, Records and Reports - General Requirements").
To settle the charges, the firm agreed to (i) a censure and (ii) pay a $50,000 fine.
Commentary
Firms that carry customer accounts are required under the Customer Protection Rule to maintain a "Special Reserve Bank Account for the Exclusive Benefit of Customers" and to deposit therein, on a weekly basis, the funds required by the reserve calculation.
This requirement is intended to ensure that, in the event a broker-dealer is liquidated by the Securities Investor Protection Corporation ("SIPC"), the broker-dealer will have sufficient assets on hand to satisfy its customer obligations. For this reason, both the SEC and FINRA treat the rule, and the reserve calculation in particular, as one of the more important requirements with which broker-dealers must comply.
Unfortunately, however, the reserve calculation can be complicated and, as shown by the AWC, a miscalculation will result in a cascade of related violations.
In the matter at hand, the miscalculation stemmed from the firm "mistakenly relying on a data source for its computation" that failed to include the short market value of customer securities. While not entirely clear from the AWC, it seems likely that the data source was a new or revised report. Alternatively, it is possible that the report was not new or revised but that the firm had not previously carried customer short positions.
In the event the data source was new to the reserve calculation, obviously, the firm should have been more careful in vetting the new data source to ensure that it included all values necessary to the reserve calculation. In the event the firm had recently changed its business model to allow customer short positions, this change should have been vetted to identify any possible impact on the firm's reserve calculation and whether it was properly accounted for in the data feeds used by the firm for this purpose.
Interestingly, the firm prepared a "Corrective Action Statement," which was attached to the AWC. This Statement references several steps that the firm took to enhance its controls "for changing functions in the applicable reserve formula." These include:
- Documentation of "proposed changes to the formula or the firm's reserve calculation spreadsheet" and "mandatory review of the proposed changes" by the firm's president and CCO.
Because it is likely that neither the firm's president or CCO will have sufficient understanding of the reserve formula calculation, it would appear that this approval step is only intended to ensure that the change documentation is actually undertaken.
- "Implementing weekly meetings between the firm's FINOP" and his or her designees "to review and verify the reserve calculation" and, specifically, to "discuss any material changes" in the reserve calculation.
This would seem to be a good practice in that, presumably, it forces the FINOP to understand the source of unexpected or material changes in the calculation from week to week, which should help identify changes as a result of data errors from, for example, a new report.
- Elevating any observed material changes to the firm's president and CCO.
Again, it would appear that this step is largely intended to ensure that the FINOP has identified a reasonable explanation to the account for the material change.