Settlement Failures and Close-Out Procedures
Even with modern book-entry systems, settlement failures occur. Understanding what happens when a seller does not deliver securities or a buyer does not pay is frequently tested on the exam.
Fail to Deliver / Fail to Receive
- A fail to deliver occurs when the selling broker-dealer does not deliver securities by settlement date
- A fail to receive occurs when the buying broker-dealer does not receive securities by settlement date
- A fail does not cancel the contract; the trade remains binding
- The remedy is through buy-in or sell-out procedures, not cancellation
Exam Tip: Gotchas
- A fail to deliver does not cancel the trade. The contract is still binding, and the remedy is a buy-in or sell-out, not cancellation.
Buy-In Procedures (FINRA Rule 11810)
When a seller fails to deliver, the buyer may initiate a buy-in to obtain the securities from another source.
Timeline
| Step | Timing |
|---|---|
| Delivery was due | Settlement date (T+1) |
| Earliest buy-in execution | 3 business days after delivery was due |
| Written notice of intent | Must be delivered by 12:00 PM ET at least 2 business days before buy-in execution |
| Close-out deadline | Not later than 10 business days after delivery was due (30 business days for certain securities) |
Cost Allocation
- If the buy-in price is higher than the original contract price, the failing seller is liable for the difference
- The buyer purchases the securities at the current market price and bills the difference to the seller
- If the buy-in price is lower, the buyer simply acquires the securities more cheaply
Exam Tip: Gotchas
- The failing seller pays the difference if the buy-in price is higher. The buyer does not absorb the cost.
- Buy-in notice must be given by 12:00 PM ET at least 2 business days before execution.
Sell-Out Procedures (FINRA Rule 11820)
When a buyer fails to pay, the seller may initiate a sell-out.
- The seller may sell the securities and hold the failing buyer liable for any loss
- If the securities sell for less than the original contract price, the buyer owes the difference
- Mirror image of the buy-in process, but triggered by the buyer's failure to pay
Don't Know (DK) Notices
A DK notice is sent when one party to a trade does not recognize or agree to the terms of the transaction.
- Used during the trade comparison process
- Governed by FINRA Rule 11210 Series and NYSE Rule 135
- If a party receives a comparison and does not recognize the trade, they must send a DK notice promptly
- Unresolved DK'd trades may result in cancellation or arbitration
Common DK scenarios:
- Wrong quantity or price on the comparison
- Trade was never agreed to
- Account number mismatch
Exam Tip: Gotchas
- DK notices are about trade comparison disputes, not settlement failures. A DK means one party does not recognize the trade at all.
Extensions of Time for Payment (Regulation T)
Under Regulation T, payment in a cash account is due by settlement date (T+1), with an outside deadline of T+3 (settlement + 2 business days).
What Happens When a Customer Doesn't Pay
| Step | Action |
|---|---|
| Payment not received by T+1 | Firm may request an extension |
| Extension request | Filed with a self-regulatory organization (SRO) such as FINRA or an exchange |
| Extension denied / no payment | Firm must liquidate the position |
| After liquidation | Account is frozen for 90 days |
The 90-Day Account Freeze
- During the freeze, the customer can still trade but must deposit cash in advance of any purchase (not after)
- This is a penalty for failure to pay on time; the customer loses the ability to buy now and pay later
- Also known as a freeriding violation if the customer bought and sold a security before paying for the original purchase
Exam Tip: Gotchas
- The 90-day freeze does not prevent trading. The customer can still buy, but must deposit cash in advance before placing the order (not after).
- A freeriding violation triggers the freeze: buying and selling a security before paying for the original purchase.