A recent enforcement case highlighted the stark difference between the custody requirements of a broker-dealer and an investment adviser. Merrill Lynch was smacked with over $400 million in disgorgement and penalties for putting customer assets at risk.
Private fund managers and investment advisers are well aware of the limits on the custody. The purpose is to keep customer assets safe in the event the investment adviser goes out of business or its malfeasance.
On the broker-dealer side it’s the Customer Protection Rule under Section 15(c)(3) of the Securities Exchange Act and Rule 15c3-3 thereunder. The Customer Protection Rule is designed to protect clients in the event of a broker-dealer failure from a delay in returning a customer’s securities or a shortfall in which customers are not made whole. Rule 15c3-3(e) requires a broker-dealer to maintain a reserve of funds or qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers.
Fortunately, Lehman Brothers was in compliance with the rule in the fall of 2008 so its customers were made whole.
Merrill Lynch was not in compliance with the rule at times between 2009 and 2015. By violating the rule, the firm was able to finance its own trading activities by keeping fewer reserves for customer cash. The SEC dismissed some options trade that it deemed to lack economic substance allowing the firm to artificially reduce the amount of customer cash required in the firm’s reserve accounts.
“The rules concerning the safety of customer cash and securities are fundamental protections for investors and impose lines that simply can never be crossed,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement. “Merrill Lynch violated these rules, including during the heart of the financial crisis, and the significant relief imposed today reflects the severity of its failures.”
Merrill Lynch did not lose any customer cash. But the cash was at risk if the firm failed. It was at risk because the firm failed to follow the rules for protecting that cash.
Both the Customer Protection Rule for broker-dealers and the Custody Rule for investment advisers are complex. Most of that complexity is at the edges to deal with specific situations. One should not get lost in following the the reason behind the rules: protecting the clients’ funds and assets.
Sources:
- Merrill Lynch to Pay $415 Million for Misusing Customer Cash and Putting Customer Securities at Risk
- SEC order – Merrill Lynch
- SEC order – William Tirrell
- Customer Protection Rule Initiative
- Huge Customer Protection Rule Fine Brings Back Memories by ERNEST BADWAY
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