Borrowing From Clients

Which arrangements does FINRA's borrowing and lending rule reach?

1. A.Only loans a customer makes to a registered person, since that is the direction in which the customer's money is at risk.Wrong. A representative who becomes a customer's creditor is just as compromised as one who becomes the customer's debtor.
2. B.Both borrowing money from a customer and lending money to a customer.Correct. The conflict is identical in either direction, and a one-way rule could be defeated by reversing the flow of funds.
3. C.Only loans between registered persons and customers where interest is charged at a market rate.Wrong. The presence or absence of interest describes the terms, not whether the rule applies to the arrangement.
4. D.Only loans arranged at the branch office, since loans arranged privately are outside the firm's business.Wrong. Where the conversation happened has no bearing; the rule follows the broker-customer relationship itself.

Why: The rule is written in both directions: it restricts a registered person from borrowing money from a customer and from lending money to a customer. Covering both is essential because the conflict is the same in either direction, whether the representative owes the customer money or the customer owes the representative money, the account relationship is no longer arm's length. A one-way rule would also be trivially avoidable, since a representative could simply arrange for the money to flow the other way and call it a favour. The rule's permissions therefore apply to both directions alike, and a firm's written procedures must address each.

Embarrassed by a loss in a customer's account, a representative privately promises to reimburse the customer out of his own pocket if the position does not recover. No money has changed hands. Which rule does this implicate?

1. A.The prohibition on guaranteeing a customer against loss and sharing in an account, which the promise itself violates.Correct. The undertaking is the prohibited act, and no transfer of funds is needed to complete it.
2. B.The borrowing and lending rule, since the representative has committed his personal funds to a customer.Wrong. A contingent promise to make a customer whole is not a loan in either direction.
3. C.No rule, because a representative may use his own money as he pleases and the customer benefits.Wrong. The customer's apparent benefit is exactly the harm, since it misrepresents the risk of the position.
4. D.The outside business activity rule, because the promise creates a financial arrangement outside the firm's business.Wrong. He is not conducting a business away from the member; he is making a promise about a firm account.

Why: Guaranteeing a customer against loss, and sharing directly or indirectly in the profits or losses of a customer's account, are prohibited by their own rule and not by the borrowing and lending provisions. Sharing is permitted only where the member firm gives prior written authorisation, the customer agrees in writing, and the representative's participation is proportionate to his own financial contribution, with a narrow exception for immediate family accounts. A guarantee against loss is treated more strictly still, because it corrupts the customer's understanding of risk and disguises the true character of the investment. That no money has moved is irrelevant; the promise itself is the prohibited act.

A representative borrows from a customer with whom he has a genuine personal relationship outside the brokerage relationship. His firm's written procedures permit that category but require prior notice and pre-approval. He takes the loan first and tells compliance a week later. What is his position?

1. A.Compliant, because the personal relationship places the loan in a category the firm's procedures expressly permit.Wrong. Fitting a permitted category is necessary but not sufficient when the procedures impose their own conditions.
2. B.In violation; pre-approval is a condition of the loan, and approval sought after the fact cannot perform its function.Correct. The firm's only decision was whether the loan should happen, and that decision was taken away from it.
3. C.Compliant, provided the firm approves the arrangement retroactively and records the approval in writing.Wrong. A retroactive approval documents a completed transaction rather than authorising one in advance.
4. D.In violation, because a personal relationship can never support a loan unless it also involves a business connection.Wrong. A personal relationship outside the brokerage relationship is itself one of the recognised categories.

Why: The rule permits a loan only where it falls within a recognised category and the firm's written procedures allow it, and where those procedures require notice and pre-approval, obtaining them is a condition of the loan rather than an administrative formality. Approval sought after the money has moved cannot serve its purpose, which is to let the firm decide whether the arrangement should happen at all and on what terms. The category and the procedural condition are cumulative requirements, so satisfying one does not excuse the other. Had the firm's procedures excepted the personal-relationship category from pre-approval, the timing of his disclosure would not have created a violation.

A representative needs funds and arranges the loan from a small consulting company wholly owned and controlled by one of his customers, rather than from the customer personally. The company holds no brokerage account. How should this be analysed?

1. A.It is outside the rule, because the lender is a corporation and the rule addresses loans from customers who are individuals.Wrong. The rule follows the source of the funds, and a controlled company's funds are the controlling customer's.
2. B.It is outside the rule, since the lending company maintains no account at the member firm and so is not a customer.Wrong. Reading the rule that literally would give every customer with a company a free route around it.
3. C.It is treated as a loan from the customer, so the category, procedural, and approval requirements all apply.Correct. Substance governs, and a wholly owned company is the customer's money under a different name.
4. D.It is permitted, because a company organised to do business is by definition in the business of lending money.Wrong. A consulting company is not a lender, and that exception exists for institutions whose business is extending credit.

Why: The rule looks to the substance of who is lending, and money from a company a customer wholly owns and controls is the customer's money moving under a different name. Treating the entity as a stranger to the rule would give every representative a costless way to take a customer loan, since a customer with a company could simply lend through it. The arrangement therefore has to satisfy the same requirements as a direct personal loan: it must fall within a recognised category, the firm's written procedures must permit it, and any notice and approval those procedures require must be obtained first. Had the lender been an unaffiliated finance company in the business of lending, the analysis would change because that entity's funds are not the customer's.