3.11 Customer Protection

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

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

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:

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

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

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

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

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

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

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

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

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