Wednesday, February 10, 2010

Holy Hypothecation Mishap, Batman!

You could easily see a Series 7 question like this one at the testing center:

Broker-dealers may lawfully hypothecate which of the following?
A. customers' fully paid securities
B. customers' excess margin securities
C. customers' securities held in safekeeping
D. customers' securities upon which the firm holds a proper lien

EXPLANATION: one of my pet peeves with all these license exams is that it eventually becomes a guessing game rather than an opportunity to teach new hires some very important information. This question here appears to mean absolutely nothing, but, in fact, a failure to understand its meaning can cost you a big fine by FINRA and a suspension or revocation of your license. A broker-dealer called a "clearing member" or a "custodial broker-dealer" routinely holds customer assets on its books. When I cut a check to my SIMPLE IRA each month, TD Ameritrade puts it on their books--do they wrap up $875 with my name on it? No--like a bank, they play with my cash and merely put it down as what is owed to me. Similarly, I've never seen any of the stock certificates that I've purchased because my broker-dealer holds them in street name, on my behalf. In other words, I put a lot of trust in my broker-dealer. I assume they're good for that cash balance in my account and that all of those shares of stock are actually still under their control/possession. If FINRA found out that a broker-dealer was going around pledging customer assets as collateral for a loan to the firm, that could be a problem. It would be similar to having your neighbor take out a home equity loan but actually pledge your house as collateral. Wouldn't that be awkward if your neighbor couldn't pay off the loan, and the bank foreclosed on your house. To prevent that, FINRA, the SEC, and the state regulators will only allow broker-dealers to pledge customer securities required to secure the margin loan in a margin account. Fully paid securities belong to customers, even if the firm holds them in street name or in the customer's name in "safekeeping." When the customer signs the margin agreement, including the hypothecation agreement, then the firm can pledge the customer's securities as collateral. But if a firm accidentally pledges securities it has no business pledging, bad things can happen. Just a few weeks ago, we saw an instance where a principal got in trouble for hypothecating securities the firm had no right to hypothecate. To read about it yourself, go to, click on "industry professionals" then under Enforcement click on "disciplinary actions" then find the January 2010 summary. On page 11, you'll see that a principal accidentally hypothecated customer securities worth about $106 million dollars, earning him a suspension and a small fine. You'll also see that it takes about 10 clicks to find anything on the FINRA website, but that's another matter.

Oh yeah, and the answer to the question is . . . D.

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