Customer Protection Rule
The Customer Protection Rule
Michael P. Jamroz, 57(3): 1069 (May 2002)
A broker-dealer conducting a general securities business must comply with the Financial Responsibility Rules. The two cornerstones of those rules are The Net Capital Rule and the Customer Protection Rule. Both rules are simple in purpose but extraordinarily complex in operation. The Net Capital Rule ensures that a broker-dealer will have adequate liquid assets to pay liquidation expenses. That rule was the subject of an article by the author in the May 1992 issue of The Business Lawyer. This Article is a companion piece. The Customer Protection Rule requires registered broker-dealers to safeguard the investment assets of their customers. The rule is designed to protect those customers from monetary losses and delays that can occur when that firm fails. By virtue of the requirement to audit compliance with the rule, accountants are generally familiar with it. Lawyers, on the other hand, are frequently challenged by the rule, as understanding it generally involves understanding broker-dealer accounting practices and back- office operational processes. As the rule affects every broker-dealer of any significance, lawyers at securities firms and their counsel frequently confront issues related to it in many contexts. Customer Protection Rule issues are presented when the securities firm is starting up, expanding its business, involved in an enforcement or other legal proceeding, establishing bank accounts or custodial agreements, drafting securities loan or repurchase agreements, or just doing a deal- -any time customer funds or securities are handled by the securities firm, the rule is at issue. This Article discusses the principal aspects of the Customer Protection Rule and explores how it compliments the Securities Investor Protection Act. It provides a basic understanding of the back office accounting practices and operational processes essential to understand the rule. It also examines securities industry developments that have taken place since the rule's adoption and the challenges that the SEC must face to address them.
Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms
Henry T. C. Hu and Bernard Black, 61(3):1011–1070 (May 2006)
Most American publicly held corporations have a one-share, one-vote structure, in which voting power is proportional to economic ownership. This structure gives shareholders economic incentives to exercise their voting power well and helps to legitimate managers' exercise of authority over property the managers do not own. Berle-Means' "separation of ownership and control" suggests that shareholders face large collective action problems in overseeing managers. Even so, mechanisms rooted in the shareholder vote, including proxy fights and takeover bids, constrain managers from straying too far from the goal of shareholder wealth maximization.
In the past few years, the derivatives revolution, hedge fund growth, and other capital market developments have come to threaten this familiar pattern throughout the world. Both outside investors and corporate insiders can now readily decouple economic ownership of shares from voting rights to those shares. This decoupling—which we call "the new vote buying"—is often hidden from public view and is largely untouched by current law and regulation. Hedge funds, sophisticated and largely unfettered by legal rules or conflicts of interest, have been especially aggressive in decoupling. Sometimes they hold more votes than economic ownership, a pattern we call "empty voting." That is, they may have substantial voting power while having limited, zero, or even negative economic ownership. In the extreme situation of negative economic ownership, the empty voter has an incentive to vote in ways that reduce the company's share price. Sometimes hedge funds hold more economic ownership than votes, though often with "morphable" voting rights—the de facto ability to acquire the votes if needed. We call this "hidden (morphable) ownership" because under current disclosure rules, the economic ownership and (de facto) voting ownership are often not disclosed. Corporate insiders, too, can use new vote buying techniques.
This article analyzes the new vote buying and its corporate governance implications. We propose a taxonomy of the new vote buying that unpacks its functional elements. We discuss the implications of decoupling for control contests and other forms of shareholder oversight, and the circumstances in which decoupling could be beneficial or harmful to corporate governance. We also propose a near-term disclosure-based response and sketch longer-term regulatory possibilities. Our disclosure proposal would simplify and partially integrate five existing, inconsistent share-ownership disclosure regimes, and is worth considering independent of its value with respect to decoupling. In the longer term, other responses may be needed; we briefly discuss possible strategies focused on voting rights, voting architecture, and supply and demand forces in the markets on which the new vote buying relies.
Consumer Arbitration: If the FAA "Ain't Broke," Don't Fix It
Alan S. Kaplinsky and Mark J. Levin, 63(3): 907–920 (May 2008)
During 2007, Congress showed significant interest in mandatory pre–dispute consumer arbitration agreements. Some in Congress focused on whether to prohibit them altogether. This Article argues that such legislation is unnecessary because the current system of consumer arbitration works well and needs no fix. The authors review case law and empirical studies showing that the current system of checks and balances in the area of consumer arbitration law is sufficiently protective of consumers' rights. These protections emanate from: (1) the Federal Arbitration Act ("FAA") itself, (2) the careful drafting of arbitration agreements, (3) the use of third–party arbitration administrators, and (4) the rigorous enforcement of the FAA by state and federal courts.
The Treatment of Derivatives Under the SEC’s Net Capital Rule
Michael P. Jamroz, 76(1): 183-210 (Winter 2020-2021)
Every broker or dealer conducting a general securities business registered with the Securities and Exchange Commission (Commission) must comply with SEC Rule 15c3-1, the Net Capital Rule. The Net Capital Rule is designed to ensure that broker-dealers will have adequate liquid assets to meet their obligations to investors and liabilities to other creditors. The rule is complex and specifically addresses the liquidity, market, and counterparty credit risks associated with the proprietary positions of the broker-dealer.