Cross-Lien Agreements with Clearing Entities

TO: All NASD Members and Other Interested Persons

In a recent letter to the NASD (see the enclosure), the Securities and Exchange Commission's Division of Market Regulation expressed concern that certain brokers and dealers may have entered into agreements with their clearing entities that violate the provisions of the Commission's hypothecation rules (8c-l and 15c2-l). These rules are designed, among other things, to prevent brokers or dealers from commingling customers' and firm securities to collateralize the same loan.

The relevant portions of these rules prohibit "the direct or indirect hypothecation by a broker or dealer, or his arranging for or permitting, directly or indirectly, the continued hypothecation of any securities carried for the account of any customer under circumstances...that will permit such securities to be commingled with securities carried for the account of any person other than a bona fide customer of such broker or dealer under a lien for a loan made to such broker or dealer...."

Members that do business with clearing banks or other entities frequently maintain two separate borrowings with the same lender, one for the firm and the other for customers. A customer loan is used to finance the extension of credit to its customers by the broker-dealer with customers' securities pledged under said loan. A firm bank loan is collateralized by firm securities used to finance firm activities.

However, some broker-dealers apparently have entered into clearing agreements that give the clearing organization recourse to all securities and other property within that clearing firm's possession or control. This "cross-lien" language makes customers' securities susceptible to the clearing entity if the broker-dealer defaults on the firm loan. This constitutes a violation of the hypothecation rules.

Consequently, where a broker-dealer has several loans that are collateralized by customers' securities and firm inventory with a single lender, the lender may not have a lien on customers' securities for any loan except other loans also made against securities carried for the account of customers of the same broker-dealer. Members should review existing agreements with their clearing entities and take immediate steps to amend them where appropriate.

When a "cross-lien" agreement does exist between customers' and firm securities that are utilized as collateral for loans between broker-dealers and their clearing banks or other entities, the Reserve Formula Computation under SEC Rule 15c3-3 is impacted. In those instances, Item 2 of the Reserve Formula must include in the credits the lesser of the total amount of all monies borrowed (including any other borrowing from the same entity not collateralized by securities) or the market value of customer collateral, provided however, that if the market value of the collateral in the customer loan is insufficient to adequately collateralize said loan, the dollar amount of the loan should be used.

Questions concerning this notice should be directed to your local NASD District Office or to I. William Fishkind, Assistant Director, Financial Responsibility, at (202) 728-8405.

Sincerely,

John E. Pinto, Jr.
Senior Vice President
Compliance

Enclosure