On Monday, March 19, the SEC proposed amendments to the customer protection rule (Rule 15c3-3) and the net capital rule (Rule 15c3-1) – some big, some small. This special alert addresses the two most significant proposals.

I. Treatment of Free Credit Balances

The SEC’s proposal would clarify the obligations and authority of broker-dealers with respect to the way they handle customers’ free credit balances (funds payable by the broker-dealer to the customer on demand). The new rule would clarify that broker-dealers cannot convert, invest or otherwise transfer free credit balances except in three circumstances.

A. With the consent of the customer

Broker-dealers would be permitted to transfer free credit balances to any type of investment or other product, or to a different account within the broker-dealer or at another institution, or otherwise dispose of free credit balances, as long as the broker-dealer has received a specific order, authorization or draft from the customer. Any transfer or disposition would have to comply with the terms and conditions the customer specified in the order, authorization or draft.

B. Changing a new customer’s sweep option from a money market fund to a bank deposit account (or vice versa)

Broker-dealers would be permitted to change the sweep option of a new customer from a money market fund to a bank deposit account (and vice versa) if the following conditions are met:

1. The customer agrees prior to the change (for example, in the account opening agreement) that the broker-dealer can switch the sweep option between those two types of products;

2. The broker-dealer provides the customer with all notices and disclosure regarding the investment and deposit of free credit balances required by the broker-dealer’s SRO;

3. The broker-dealer provides the customer with notice in the customer’s quarterly statement that the money market fund or bank deposit account can be liquidated on the customer’s demand and converted back into a free credit balance held in his or her securities account; and

4. The broker-dealer provides the customer with notice at least 30 calendar days before changing the product, the product type, or the terms and conditions under which the free credit balances are swept. This notice would need to describe the change and provide an opt-out to the customer.

C. Changing an existing customer’s sweep option from a money market fund to a bank deposit account (and vice versa)

Broker-dealers would be permitted to change the sweep option of an existing customer from a money market fund to a bank deposit account (and vice versa) if the following conditions are met:

1. The broker-dealer provides the customer with all notices and disclosure regarding the investment and deposit of free credit balances required by the broker-dealer’s SRO;

2. The broker-dealer provides the customer with notice in the customer’s quarterly statement that the money market fund or bank deposit account can be liquidated on the customer’s demand and converted back into a free credit balance held in his or her securities account; and

3. The broker-dealer provides the customer with notice at least 30 calendar days before changing the product, the product type or the terms and conditions under which the free credit balances are swept. This notice would need to describe the change and provide an opt-out to the customer.

The proposal would not require the broker-dealer to obtain an existing customer’s previous agreement to permit the broker-dealer to switch its sweep option between money market fund products and bank deposit account products. Accordingly, the broker-dealer would not have to amend each existing customer account agreement.

II. Treatment of expense sharing agreements and temporary capital contributions in net capital calculations

A. Expense sharing agreements

The SEC is proposing to amend the net capital rule to require a broker-dealer to include any liabilities that are assumed by a third party when calculating net capital, if the broker-dealer cannot demonstrate that the third party has the resources, independent of the broker-dealer’s income and assets, to pay the liabilities.

Sufficient evidence of adequate resources would include the third party’s most recent and current audited financial statements, tax return or regulatory filing containing financial reports. The broker-dealer would not be required to file this information with the SEC, but would need to retain it as a record.

B. Short-term capital contributions

The proposed amendments would require a broker-dealer to treat as a liability any capital that is:

1. contributed under an agreement giving the investor the option to withdraw it; and

2. intended to be withdrawn within a year, unless the broker-dealer received permission from its designated examining authority not to treat it as a liability.

A withdrawal made within one year of the contribution would be presumed to have been intended to be withdrawn within a year and subject to the deduction.

The requirements would not apply to withdrawals used to make tax payments or to pay reasonable compensation to partners.

The SEC also proposed many other changes to the customer protection and net capital rules. These include:

• treating accounts carried for domestic and foreign broker-dealers the same as customer accounts for purposes of the reserve formula in Rule 15c3-3

• excluding cash deposits at affiliated banks for purposes of meeting reserve requirements

• limiting the amount of cash a broker-dealer could maintain in a special reserve bank account of any one unaffiliated bank

• including certain money market funds in the definition of “qualified securities” for purposes of meeting customer reserve deposit requirements

• requiring broker-dealers to take prompt steps to obtain physical possession or control over securities of the same issue and class as those included on the broker-dealers’ books as a proprietary short position or as a short position for another person

• applying a 1 percent reduction (instead of the current 3 percent reduction) of debit balances in customers’ cash and margin accounts for broker-dealers using the alternative standard of computing net capital

• clarifying that funds held in a commodity account meeting the definition of “proprietary account” under CEA regulations are not to be included as free credit balances in the customer reserve formula

• including funds resulting from margin deposits and daily marks to market related to, and proceeds from the liquidation of, stock index futures and related options carried in a securities account pursuant to an SRO portfolio margining rule in the definition of free credit balances

• improving regulatory oversight of securities lending and repurchase transactions.