Permissible Use of Customers' Securities

The customer-securities-lending requirement determines whether and how a BD can lend out customer securities, including in fully-paid lending programs that have become common in retail brokerage. The rule layers customer-protection requirements on top of the customer-protection possession-or-control framework:

• The customer protection rule says fully-paid customer securities must be in good control
• The customer-securities-lending requirement says yes, but the firm can lend them out under specified conditions, with specified disclosures, with specified collateral

Margin Securities: Lending Under the Margin Agreement

A member may not lend a customer's eligible margin securities without first obtaining written customer authorization permitting the lending. A signed customer account agreement, margin agreement or loan consent can supply that authorization if it clearly and prominently permits lending to the firm or others.

• Assess the actual lending permission. A hypothecation heading or permission only to pledge securities does not itself establish permission to lend them
• A qualifying agreement can authorize ongoing loans within its scope; no separate consent is required for every covered loan
• Check that the authorization remains effective and covers the proposed eligible securities

When accounts move to another firm, examine whether valid written permission covers the acquiring firm's proposed loans under the actual agreements and transfer arrangements. The lending requirement does not itself mandate a new signature on every transferred account.

An authorization that has been effectively revoked cannot supply permission for new loans within the revoked scope. Assess any outstanding loans separately under their terms and applicable law. A missing copy of one margin agreement does not alone prove that no written customer authorization was given in any valid form.

What Lending Means in Margin Context

Margin securities can be loaned to:

• Other customers borrowing them for short sales
• Other firms that have failed to deliver against a sale
• The firm's own short positions

These are examples of delivery uses, not an exhaustive statutory list or proof that a particular transaction complies. Establish effective customer lending permission and other applicable safeguards. A pledge-only clause is insufficient.

When customer securities are used in connection with short sales, provide the applicable notice that the firm may receive lending compensation. A bare net-capital worksheet entry is not a securities delivery, although an actual transaction can separately affect financial calculations.

The margin-securities-lending requirement requires authorization; it does not prescribe a customer revenue-sharing formula or prove that every firm's margin rate compensates the customer for securities lending. Check the actual agreement and compensation terms rather than infer a mandatory per-loan payment or rate reduction.

Compensation example: An agreement expressly permits eligible margin-securities lending and provides no separate per-loan payment. That customer has no per-loan payment under the stated terms. For a fully paid borrow, disclose the factors determining compensation to the member, associated persons and customer, including whether customer compensation can change under the agreement. A fixed revenue split does not follow merely from authorization or account type.

Exam Tip: Gotchas

• Margin-lending permission alone does not satisfy fully paid borrowing requirements. Fully paid or excess margin borrowing requires the written loan agreement and other safeguards. Assess required content and procedures; these provisions do not mandate different physical documents solely because the securities categories differ.

Fully Paid / Excess Margin Securities: The Higher Bar

Borrowing fully paid or excess margin securities is permitted under heightened conditions. The customer-securities-lending requirement calls for the following safeguards, together with compliance with the customer-protection rule and applicable Exchange Act lending restrictions.

Enter the written loan agreement at or before the loan. It must contain the prominent qualified Securities Investor Protection Act (SIPA) notice. A separate schedule or schedules must state compensation and the parties' rights and liabilities; one combined term schedule can satisfy that requirement. The lender must receive a schedule of the securities actually borrowed at the time of borrowing.

The 30-Day FINRA Notice

The 30-day FINRA notice gates the member's first covered customer borrow. Giving notice one day before that borrow is insufficient. The period gives FINRA visibility into the proposed borrowing arrangements; it does not require preparation or customer enrollment to wait.

The duty belongs to the member that first engages in borrowing customers' fully paid or excess margin securities. A carrying-and-introducing relationship alone does not make both firms borrowers. In the same continuing arrangement, adding a downstream recipient of loaned shares does not itself restart that member's first-engagement clock. Evaluate other applicable obligations and any FINRA information requests separately.

Notice expiry is not universal clearance. The agreement, customer determination, disclosures, collateral and other applicable requirements must still be met. To audit the advance period, establish actual notice delivery and first-borrow dates; a calculated window-end date alone does not establish when borrowing began.

The notice rule does not itself prohibit every advance compensation arrangement. Assess actual contractual payment rights. Collecting a signed agreement during the period does not create a payment entitlement or permit a premature first borrow.

Preparation and actual borrowing have different triggers. A firm may prepare agreements, customer determinations and disclosures before or during the notice period. Meet each operative deadline, including agreement entry at or before the loan and delivery of the actual borrowed-securities schedule at borrowing; do not infer a mandatory order for every preparation task.

Establish the actual failure. Confirm whether notice was delivered and when borrowing began; an absent file copy alone does not prove FINRA was never notified. Customer enrollment alone does not establish a missed first-borrow determination or disclosure deadline. Once borrowing occurs without a required pre-borrow safeguard, meeting the other requirements or delivering the missing disclosure later does not make that completed borrow compliant. Prevent further affected borrows until compliance is established and remediate the failure.

Appropriateness Review

Before the first borrow with the customer, the member needs reasonable grounds that the securities loans are appropriate. Exercise reasonable diligence into essential customer facts, including:

• The customer's financial situation and needs, tax status and investment objectives
• Investment time horizon, liquidity needs and risk tolerance
• Other information the customer provides in connection with the loan

These factors are nonexclusive. Relevant loan risks, compensation terms and a customer's disclosed concerns can inform the determination. The requirement does not expressly name a separate test of understanding the qualified SIPA warning or a fixed income-versus-risk formula. Required written risk disclosures are a separate obligation.

Blanket retail enrollment without an appropriateness determination does not meet the requirement. Keep records evidencing compliance; the rule does not prescribe a particular questionnaire or customer-specific notes form. A signature on an agreement showing only loan terms does not establish that the determination was made.

The borrowing member remains responsible for the determination. Under a carrying agreement, it may rely on representations of the introducing member that has the customer relationship. Information from a customer's tax adviser can inform the review, but a tax-bracket observation does not transfer the member's responsibility to that adviser.

For an institutional account, a specified route permits fulfillment when the member reasonably believes the customer can independently evaluate investment risks, generally and for the particular transactions or strategies, and the customer affirmatively indicates independent judgment. Apply these factors to an agent when decisionmaking authority has been delegated. Institutional status alone does not satisfy both conditions.

Written Customer Disclosure

Additional short-sale notices also apply. Registered broker-dealers must notify customers that they may elect not to allow their fully paid securities to be used for short sales. If a broker-dealer uses a customer's securities for short sales, it must notify that customer that the firm may receive compensation from lending the securities. That compensation notice is not limited to fully paid securities. These notices are distinct from the qualified protection warning and compensation-factor disclosures below.

Customers must receive written disclosures including:

• Loss of voting rights and the right to sell loaned securities, including any limitations
• Factors determining compensation to the member, associated persons and customer, including whether customer compensation can change under the agreement
• Risks of each collateral type; possible hard-to-borrow status and use for short-sale deliveries
• Potential tax implications, including cash-in-lieu payments, and the member's specified liquidation rights

The clear and prominent protection notice must explain that SIPA may not protect the securities-loan transaction and delivered collateral may be the only source of satisfaction if the member fails to return the securities. That is a qualified warning, not a universal exclusion or a guarantee of collateral recovery. Actual claims depend on the agreement, custody arrangements and applicable law.

Daily Collateral

Collateral can be:

• Cash
• U.S. Treasury bills or notes
• An irrevocable letter of credit from a qualifying bank
• Other collateral specifically designated as permissible by SEC order

SEC collateral orders matter. Certain non-governmental debt can qualify under conditions addressing ratings, default status and currency. Limited equity collateral can qualify for specified institutional securities lenders under conditions governing the securities, custody, concentration and diversification. Check the applicable relief rather than automatically approve every corporate bond or equity position or exclude the entire category.

The agreement must provide for collateral that fully secures the loan, delivered upon execution or, for a later loan, by the close of that loan's business day. Mark the loan to market not less than daily.

Initial-loan example: The firm executes the agreement and borrows $100,000 of securities at that time. Delivering only $85,000 cash, with no other collateral, fails the full-security requirement due upon execution. The next-business-day top-up deadline for a later end-of-day shortfall does not excuse missing this initial delivery deadline.

If end-of-day loan value exceeds the collateral then held by the lender, deliver additional eligible collateral by the close of the next business day to restore at least 100% coverage. Applicable collateral orders can require additional coverage. The rule does not mandate release of collateral after every price decline; assess the agreement and continuing coverage.

Example: A customer lends 1,000 shares valued at $200 each against $200,000 cash collateral. At Monday's close, the shares are worth $210,000 and the lender still holds $200,000 collateral. The firm must deliver at least $10,000 additional eligible collateral by Tuesday's close, assuming Tuesday is a business day. A later price decline does not itself require a collateral release.

Distinguish marking from delivery. A top-up delivered by Tuesday's close after Monday's specified shortfall is not late merely because it arrives on the next business day. Missing Tuesday's close is a deadline violation. The borrowing firm supplies collateral to the customer lender; requiring collateral does not eliminate the customer's exposure to collateral risks, which must also be disclosed.

Check the relevant lender's coverage. Compare all outstanding securities loaned with collateral held by that lender. If lender A holds $95,000 cash against $100,000 of loans, collateral held by a different lender B does not cure A's shortfall when A has no rights to it. Review each lender's actual loan and collateral arrangements; a program-wide surplus alone is insufficient.

Release example: A lender holds $500,000 cash against 5,000 borrowed shares now worth $90 each, or $450,000. If the agreement permits reduction to 100% coverage and no higher requirement applies, up to $50,000 may be released. Retaining the surplus is also permitted. When collateral is noncash, a decline in the borrowed shares alone does not establish a surplus; check both current values.

Treasury collateral is not a deposit insured by the Federal Deposit Insurance Corporation (FDIC). Actual qualifying cash collateral at an insured bank may separately have deposit insurance under applicable ownership and recordkeeping conditions. That protects an eligible deposit when the bank fails; it does not insure the loaned shares or guarantee recovery when a broker-dealer fails.

Exam Tip: Gotchas

• The agreement's content and safeguards determine compliance. A qualifying signed agreement can supply eligible margin-lending authorization. Fully paid borrowing also requires its written loan agreement, notice, customer determination, disclosures and collateral safeguards. A combined document does not eliminate any requirement, and a margin-only consent does not establish the fully paid safeguards.
• The SIPA warning is qualified. SIPA may not protect the loan, and collateral may be the only recourse. Customer consent does not establish a universal exclusion or guarantee recovery.
• Give FINRA notice at least 30 days before the member's first fully paid or excess margin customer borrow. The clock runs from notice to FINRA to that first covered borrow, not from the customer's signature or a program title.

Disclosure Mandate: Substance Over Form

Give a clear and prominent qualified SIPA warning and the other required written disclosures. The explicit clear-and-prominent requirement applies to the protection warning. The disclosure package must:

• Give the clear and prominent qualified SIPA warning
• Explain the rights, risks and financial impact listed above
• Address collateral risks and sale limitations
• Describe applicable compensation and liquidation terms

Also provide the applicable short-sale election and possible lending-compensation notices described above. A general disclosure that shares may be used for short sales does not itself explain the customer's election regarding fully paid securities.

The customer-securities-lending requirement permits written disclosures to be electronic and requires records evidencing compliance. It does not expressly require a separate signed warning.

The customer-protection rule nevertheless requires the written loan agreement itself to contain the prominent qualified SIPA notice. A single document can meet both obligations when it contains the required agreement terms and disclosures. A standalone warning does not cure a loan agreement that omits its required notice.

Recall terms come from the agreement and applicable law. Disclose the customer's right to sell loaned securities and any limitations. Do not infer an unrestricted termination right from that disclosure requirement. If an agreement expressly permits recall to regain voting rights, check the return timing before the voting record date; a request alone does not establish voting eligibility.

Equal payments can have different tax treatment. For a U.S. individual in a taxable account, identified substitute dividend payments reported on Form 1099-MISC are other income, not qualified dividends. Check the agreement's payment terms and the customer's actual tax situation. Joining a lending program does not establish that every customer receives a payment or has the same tax consequences.

Exam Tip: Gotchas

• The protection notice must be CLEAR and PROMINENT. A signature does not cure an obscured warning. Conversely, absence of a separate signed disclosure document alone does not prove a violation; examine the actual written disclosure and required agreement.

How the Customer-Securities-Lending Requirement Connects to Custody and Pledging Safeguards

Key rules governing customer-securities custody, pledging and lending include:

1. Customer protection rule (possession or control): Fully paid customer securities must be in good control locations
2. Hypothecation rules: Assess aggregate borrowing limits, required customer consent and restrictions on common liens, including the rules' specific clearing exceptions
3. The customer-securities-lending requirement (lending): Eligible margin securities require prior written customer lending authorization. Fully paid or excess margin borrowing carries the additional loan-agreement, advance-notice, customer-determination, disclosure and collateral safeguards, together with the applicable short-sale notices

These requirements address customer-securities custody, pledging and lending. Customer funds, reserve accounts and free credit balances have additional protections. A firm that satisfies customer-protection possession-or-control but lends fully-paid securities without the customer-securities-lending disclosures has a separate violation regardless of how clean its customer-protection position is.

A fully paid loan that meets the specified written-agreement, schedule and collateral conditions can qualify for the possession-or-control exception. That does not remove the independent customer-securities-lending obligations, including disclosures before the first borrow. Pledge permission also does not establish eligible margin-lending permission; assess the actual authorization for each kind of use.

Assess duties and evidence, not team names. Shared teams, procedures and records can address multiple obligations. The loan agreement and collateral conditions can support the custody exception as well as lending compliance. Combining functions does not permit omission of required customer determinations or disclosures. Inventory and control-location records alone do not prove those pre-borrow obligations; examine actual compliance evidence before inferring a failure.

The requirements attach to the actual activities. Eligible margin lending requires prior written permission even without a formal fully paid program. Fully paid or excess margin borrowing carries its additional safeguards even if the member does not call the arrangement a program.

What Should You Check on Exam Day?

• Can you identify valid written permission for eligible margin lending from its actual content rather than a clause name?
• Can you distinguish margin permission from the fully paid loan agreement, advance notice, customer determination, disclosures and continuing collateral safeguards?
• Can you identify the notice about electing against short-sale use of fully paid securities and the compensation notice triggered when customer securities are used for short sales?
• Can you state the qualified SIPA warning without turning it into a universal exclusion?
• Can you distinguish daily marking from the next-business-day deadline for additional collateral after a shortfall?