Customer Protection Rules
Customer protection is a cornerstone of securities regulation. FINRA and SEC rules establish extensive requirements to safeguard customer assets and ensure fair treatment.
SEC Rule 15c3-3: Customer Protection Rule
SEC Rule 15c3-3 is the primary rule safeguarding customer securities and cash.
Two Key Requirements
| Requirement | Purpose |
|---|---|
| Possession or Control | Firm must maintain custody of customer securities |
| Reserve Requirement | Customer cash kept separate from firm assets |
Possession and Control
Broker-dealers must:
- Promptly obtain customer securities
- Maintain physical possession OR control
- Keep securities at approved locations
- Calculate daily what they owe customers
Approved Control Locations
- Clearing corporations (DTC)
- Banks
- Other broker-dealers (under specific agreements)
Reserve Requirement
Firms must:
- Keep customer cash separate from proprietary funds
- Cannot use customer cash for firm operations
- Deposit required reserves in special bank accounts
- Calculate reserve requirements weekly
Key Protection: Customer assets cannot be used to fund the broker-dealer's business activities.
Suitability Obligation (FINRA Rule 2111)
Suitability requires that recommendations be appropriate for the specific customer.
Three Components of Suitability
| Component | Requirement |
|---|---|
| Reasonable-Basis | Product suitable for at least some investors |
| Customer-Specific | Product suitable for this particular customer |
| Quantitative | Trading frequency not excessive |
Customer Profile Factors
Suitability analysis must consider:
| Factor | Importance |
|---|---|
| Age | Risk tolerance changes with life stage |
| Financial situation | Ability to absorb losses |
| Investment objectives | Growth, income, preservation |
| Risk tolerance | Willingness to accept volatility |
| Time horizon | When funds will be needed |
| Liquidity needs | Access to cash requirements |
| Tax status | Tax implications of investments |
| Investment experience | Sophistication level |
Reasonable-Basis Suitability
The firm must:
- Understand the product being recommended
- Perform due diligence on investments
- Ensure product is suitable for some investors
Customer-Specific Suitability
The recommendation must be:
- Appropriate for this customer's profile
- Consistent with stated objectives
- Within customer's risk tolerance
Quantitative Suitability
When broker controls the account:
- Trading cannot be excessive
- Costs must not overwhelm returns
- Pattern must make sense for objectives
Know Your Customer (FINRA Rule 2090)
Know Your Customer (KYC) requires firms to understand essential facts about each customer.
Essential Facts Include
| Category | Information |
|---|---|
| Identity | Name, address, date of birth, SSN |
| Financial | Income, net worth, liquid assets |
| Investment | Experience, objectives, risk tolerance |
| Employment | Occupation, employer |
When KYC Is Required
- Account opening
- Before making recommendations
- When circumstances change
- Periodic updates
Best Execution (FINRA Rule 5310)
Best execution requires firms to seek the most favorable terms for customer orders.
Best Execution Obligations
| Obligation | Description |
|---|---|
| Regular Review | Evaluate execution quality periodically |
| Consider All Factors | Price, speed, likelihood of execution |
| Use Diligence | Make reasonable efforts to find best prices |
| Document Decisions | Maintain records of execution decisions |
Factors in Best Execution
- Price improvement opportunities
- Speed of execution
- Order size
- Trading characteristics of the security
- Market conditions
Regulation Best Interest (Reg BI)
Regulation Best Interest (SEC Rule) requires broker-dealers to act in the customer's best interest.
Four Core Obligations
| Obligation | Requirement |
|---|---|
| Disclosure | Provide Form CRS and material facts |
| Care | Exercise reasonable care in recommendations |
| Conflict of Interest | Mitigate or eliminate conflicts |
| Compliance | Establish policies to achieve compliance |
Care Obligation
Broker-dealers must:
- Understand risks and rewards
- Consider customer's investment profile
- Consider alternatives
- Not place firm interests ahead of customer
Conflict of Interest Mitigation
Firms must:
- Identify conflicts
- Disclose conflicts
- Mitigate or eliminate conflicts
- Prohibit conflicts that cannot be mitigated
Form CRS (Customer Relationship Summary)
Form CRS is a required disclosure document.
Required Information
| Section | Content |
|---|---|
| Introduction | Type of firm (broker-dealer or RIA) |
| Services | What services are offered |
| Fees and Costs | How firm is compensated |
| Conflicts | Key conflicts of interest |
| Standards of Conduct | Legal standard that applies |
| Disciplinary History | Where to find disciplinary records |
Delivery Requirements
Form CRS must be provided:
- At or before account opening
- At or before new service recommendation
- Upon customer request
- Within 30 days of material changes
Customer Account Statements
Statement Requirements
| Requirement | Standard |
|---|---|
| Frequency | At least quarterly |
| Active Accounts | Monthly if transactions occur |
| Content | Positions, transactions, values |
Required Disclosures
- Account positions
- Transaction history
- Fees and charges
- Market value of securities
- Account changes
Confirmations (FINRA Rule 2232)
Trade confirmations must be sent promptly after each transaction.
Required Information
| Information | Purpose |
|---|---|
| Security description | What was traded |
| Transaction type | Buy, sell, long, short |
| Price and quantity | Terms of trade |
| Commission/markup | Costs to customer |
| Settlement date | When payment/delivery due |
| Firm role | Agent or principal |
Timing
- At or before settlement
- Typically same day or next business day
Customer Complaints
Handling Requirements
| Requirement | Action |
|---|---|
| Written complaints | Must be maintained for 4 years |
| Investigation | Prompt review required |
| Response | Customer should receive acknowledgment |
| Reporting | Serious complaints reported to FINRA |
FINRA BrokerCheck
Customers can research:
- Broker employment history
- Qualifications and licenses
- Disciplinary actions
- Customer complaints
Privacy and Confidentiality
Regulation S-P
Firms must:
- Provide privacy notices
- Explain information sharing practices
- Allow opt-out of certain sharing
- Safeguard customer information
Information Security
| Requirement | Purpose |
|---|---|
| Safeguard policies | Protect customer data |
| Access controls | Limit who can view information |
| Disposal procedures | Securely destroy records |
Key Takeaways
- Rule 15c3-3 protects customer assets from firm insolvency
- Suitability has three components: reasonable-basis, customer-specific, quantitative
- KYC requires understanding essential customer facts
- Best execution seeks most favorable terms for orders
- Reg BI requires acting in customer's best interest
- Form CRS discloses key relationship information
- Confirmations and statements keep customers informed
- Privacy rules protect customer information
Test Your Knowledge
Under SEC Rule 15c3-3, broker-dealers are required to:
A
B
C
D
Test Your Knowledge
FINRA Rule 2111 (Suitability) requires broker-dealers to consider all of the following EXCEPT:
A
B
C
D
Test Your Knowledge
Under Regulation Best Interest (Reg BI), broker-dealers must:
A
B
C
D
Up Next
4.1 Registration
Chapter 4: Overview of Regulatory Framework
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