3.11 Customer Protection
Key Takeaways
SEC Rule 15c3-3 (Customer Protection Rule) requires broker-dealers to maintain possession or control of customer securities and keep customer cash in separate reserve accounts
FINRA Rule 2111 (Suitability) has three components: reasonable-basis suitability, customer-specific suitability, and quantitative suitability
Regulation Best Interest (Reg BI) requires broker-dealers to act in the customer's best interest with four core obligations: disclosure, care, conflict mitigation, and compliance
Form CRS (Customer Relationship Summary) must be provided at or before account opening and discloses services, fees, conflicts, and standards of conduct
Best execution (FINRA Rule 5310) requires firms to seek the most favorable terms for customer orders considering price, speed, and likelihood of execution
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. Since June 30, 2020, Rule 2111 does not apply to recommendations covered by Regulation Best Interest, which governs recommendations to retail customers.
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
A series of recommended transactions must not be excessive when taken together, even if each one is suitable on its own. Since June 30, 2020, this applies whether or not the broker controls the account (FINRA removed the control element; Regulatory Notice 20-18):
- Trading cannot be excessive in light of the customer's investment profile
- Turnover rate, cost-equity ratio and in-and-out trading can show excessive activity
- 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
Under SEC Rule 15c3-3, broker-dealers are required to:
Trade only in securities approved by the SEC
Keep customer securities and cash separate from the firms proprietary assets
Guarantee customer accounts against losses
Provide investment advice to all customers
FINRA Rule 2111 (Suitability) requires broker-dealers to consider all of the following EXCEPT:
The customers investment objectives
The customers risk tolerance
The brokers compensation structure
The customers financial situation
Under Regulation Best Interest (Reg BI), broker-dealers must:
Guarantee the best possible returns for customers
Act in the best interest of the customer when making recommendations
Only recommend proprietary products
Charge the lowest fees in the industry
Sections you finish are checked off in the contents.