Safekeeping and Commingling Prohibitions

This section covers a core obligation for securities professionals: keeping client assets separate and safe.

What Does the Commingling Prohibition Cover?

Commingling is unlawful when actual handling violates the separation or lien rule that applies to the assets. It is not a universal ban on every collective holding. The applicable duties differ by firm and asset status:

• An investment adviser with custody must use a qualified custodian. The custodian may use a separate account under each client's name, or an account containing only the adviser's clients' funds and securities under the adviser's name as agent or trustee, or under the name of a pooled investment vehicle the adviser manages
• Account structure is only one safeguard. The adviser must also give the client written notice of the custodian and how the assets are maintained, and must meet the rule's account-statement and other custody requirements
• Under the NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents, it is a prohibited practice for a broker-dealer to fail to segregate customers' free securities or securities held in safekeeping, and for an agent to act as a custodian for a customer's money or securities
• When a broker-dealer hypothecates customer securities, SEC hypothecation rules bar arrangements that permit commingling them with another customer's securities without each customer's written consent, or with securities of a person who is not a bona fide customer (including the firm) under a lien for a loan to the firm
• Under the hypothecation rules, customer and other securities represented by certificates held by a clearing corporation or custodian bank in a qualifying central-handling system are not commingled merely because positions are aggregated through book entries
• Fully paid customer certificates placed with proprietary inventory and pledged together under a lien for a firm loan violate the possession-or-control and lien rules because of their asset status and use, not merely because they are physical certificates
• Customer cash works differently at a broker-dealer: SEC rules let the firm use customer credits only for the specified purposes listed as debits in the SEC reserve formula, and to the extent credits exceed debits, at least the net amount must sit in a special reserve bank account for the exclusive benefit of customers

What Are the Safekeeping Obligations?

Broker-dealers that hold customer securities have duties that turn on the securities' status and use:

• Under NASAA's policy, customers' free securities and securities held in safekeeping must be segregated
• Federal law requires the firm to obtain and maintain physical possession or control of fully paid and excess-margin securities
• Control locations the rule recognizes include qualifying clearing corporations and central-handling systems, qualifying banks, omnibus accounts with another broker-dealer, and the firm's own offices. The rule does not require a separate account structure for every street-name customer security
• Customer free credit balances (uninvested cash) are payable to the customer on demand. A firm that accepts or uses them must tell each such customer, at least every three months, the amount due and that it is payable on demand

What Counts as Misuse of Customer Funds?

Several rules limit how a firm or individual may use customer property:

• FINRA prohibits any member or associated person from making improper use of a customer's securities or funds
• Conversion, as FINRA's sanction guidelines describe it, generally is an intentional and unauthorized taking of, or exercise of ownership over, property by one who neither owns the property nor is entitled to possess it. That description contains no exception for a later repayment
• A broker-dealer must not convert, invest, or transfer a customer's credit balances to another account or institution except as the SEC customer protection rule permits, such as on the customer's specific order, authorization, or draft, or through a qualifying sweep program
• Under the NASAA policy, an agent engaging in the practice of lending or borrowing money or securities from a customer is a prohibited practice. The policy states no exception, so customer authorization does not cure it
• A broker-dealer that has no lien on a customer's securities may hypothecate them only if it secures the customer's properly executed written consent promptly after the initial transaction, except as SEC rules permit. That consent does not override the separate federal ban on combining customer securities with the firm's securities under a lien for a loan to the firm
• An investment adviser has narrow, defined exceptions instead of an absolute ban:
  • The adviser may borrow from a client only if the client is a broker-dealer, an affiliate of the adviser, or a financial institution engaged in the business of loaning funds
  • The adviser may lend money to a client only if the adviser itself is a financial institution engaged in the business of loaning funds, or the client is an affiliate of the adviser
• Misuse may also create exposure under the Uniform Securities Act (USA) antifraud provisions when the facts establish a fraudulent scheme, a material misstatement or omission, or a practice operating as fraud or deceit. No registration exemption shields conduct that independently satisfies that standard

Exam Tip: Gotchas

• Commingling and conversion are different violations. Commingling violates an applicable separation or lien restriction without requiring a taking. Conversion generally is an intentional, unauthorized taking or exercise of ownership. A genuine borrowing arrangement is a separate prohibited-practices analysis.
• The borrowing/lending exceptions belong to investment advisers, not agents. NASAA's agent rule states no exception for borrowing from or lending to a customer.
• Do not confuse an agent's absolute borrowing ban with a broker-dealer's hypothecation of customer securities. Customer consent can satisfy NASAA's no-lien condition, but it does not permit customer securities to be combined with proprietary securities under a lien securing a firm loan.

What Should You Check on Exam Day?

• Commingling means violating the applicable separation or lien rule, not every collective holding. Qualifying central book-entry aggregation alone is not commingling.
• Conversion generally is an intentional, unauthorized taking of customer property or exercise of ownership over it, and its definition has no exception for a later repayment.
• Broker-dealers segregate customers' free or safekeeping securities and maintain possession or control of fully paid and excess-margin securities. Customer cash follows the SEC reserve formula.
• NASAA's agent rule states no exception for borrowing or lending with a customer. A broker-dealer needs an existing lien or written consent under NASAA, but cannot combine customer and proprietary securities under a firm-loan lien.
• Misuse creates antifraud exposure when it also satisfies the USA's fraud-or-deceit standard; no exemption shields conduct that does.