Improper Use of Customer Securities or Funds

Securities professionals have access to customer money and securities. Strict rules govern how they handle these assets and what financial relationships they can have with customers.

Borrowing From Customers

• A person associated with a firm in any registered capacity is generally prohibited from borrowing money from or lending money to a customer of that person
• A customer here includes anyone who has, or in the previous six months had, a securities account assigned to the registered person at any firm
• This rule prevents exploitation of the trust relationship between a broker and their customer

Five Exceptions (Firm Procedures Must Allow Them)

• Firm procedures first: any exception works only if the member firm has written procedures allowing borrowing or lending between its registered persons and customers
• Same firm, personal relationship, business relationship: the rep must notify the firm in writing and get its written approval before entering into the arrangement, and again before modifying or extending it
• Immediate family and financial institution: the firm's written procedures may waive notice and approval; for a financial institution, only if the loan is on the terms it generally offers the public
• The rule also covers indirect arrangements, which raise the same conflicts as a direct loan:
  • A rep asks a customer to lend to or borrow from a person related to the rep, such as the rep's family member or outside business
  • A rep has the customer's family member or business lend to or borrow from the rep
• An indirect arrangement is not consistent with the rule unless the firm's written procedures allow it, an exception applies, and the firm's notice and approval conditions are met

Exam Tip: Gotchas

• The borrowing prohibition works both ways. A broker cannot borrow from OR lend to a customer.
• It reaches registered persons and their own customers. A customer includes anyone whose securities account is, or in the previous six months was, assigned to the registered person at any firm.
• Only the personal-relationship exception requires the relationship to predate the account. The close personal relationship must have been formed BEFORE the broker-customer relationship began, so a friendship that develops after opening the account does not qualify. The business-relationship exception asks whether the relationship is bona fide and outside the broker-customer relationship; when it began is one factor in that judgment.

Sharing in Customer Accounts

Associated persons may NOT share in the profits or losses of a customer account unless ALL of the following conditions are met:

1. The customer provides written authorization
2. The associated person's employer firm provides written authorization
3. Sharing is proportionate to each party's financial contribution to the account

• Exception: Sharing can be disproportionate if the account belongs to an immediate family member
• Example: A broker contributes 30% of the capital but receives 50% of the profits. This is only allowed if the customer is an immediate family member.

Think of it this way: If you and a customer both put money into an account, you can only take out profits matching your share. Put in 30%, take out 30% of the gains. The only time you can take a bigger cut is if the customer is family.

Exam Tip: Gotchas

• Both the customer AND the firm must give written authorization. If only one approves, it is still a violation.
• Proportionate sharing is the default rule. Disproportionate sharing is only allowed for immediate family members.

Guarantees Against Loss

• No firm or associated person may guarantee a customer against loss on any securities transaction or in any securities account
• No condition cures it. Customer consent, firm approval, an escrow account, or money set aside to cover the promise does not make a guarantee permissible
• Example: during a public offering, a firm tells customers it will buy their shares back at no less than the price they paid. That buy-back promise is a guarantee against loss, so it is prohibited
• Using such a promise to sell the offering is also treated as a manipulative and fraudulent practice: FINRA's antifraud rule bars a firm from inducing the purchase of any security by a manipulative, deceptive, or other fraudulent device
• Issuer guarantees generally fall outside the ban: this covers a guarantee that the issuer extends to all holders of a security as part of that security
• After the fact, only the firm may reimburse. A member firm may decide, after a loss has occurred, to reimburse a customer for transaction losses, and it must report the payment as a settlement where it can reasonably be read as one. An associated person may not, because such a payment could conceal individual misconduct

Exam Tip: Gotchas

• A guarantee against loss has no "permitted if" version. Borrowing and account sharing are prohibited unless conditions are met; a guarantee is prohibited outright, so an answer that allows it with escrow, a reserve fund, or customer consent is wrong.
• A permitted sharing arrangement does not license a guarantee. Even a properly authorized profit-sharing account remains subject to the ban on guarantees.
• A rep cannot cover a customer's loss personally. Only the firm, deciding after the loss, may reimburse it.

Custody of Customer Assets

• Firms must segregate customer assets from firm assets (customer money and securities must be kept separate from the firm's own)
• Firms cannot use customer securities as collateral for the firm's own loans (except as permitted under margin rules)
• Misuse of customer funds or securities is one of the most serious violations in the industry

Exam Tip: Gotchas

• Segregation is the key word. Customer assets must be kept separate from firm assets at all times. Using customer securities for the firm's own purposes is a serious violation.

What Should You Check on Exam Day?

• Can you name the five exceptions that let an associated person borrow from or lend to a customer?
• Do you know why a written approval requirement applies even to a pre-existing personal relationship?
• Can you explain the conditions for sharing in a customer account, including when the sharing may be disproportionate?
• Do you know what "segregation" means for customer securities and funds?
• Can you explain why a promise to buy back a customer's shares at no less than cost is prohibited, and who may reimburse a loss after the fact?