Free Credit Balance

A customer of Pellingham Rowe Securities sells a large position and leaves the $180,000 of proceeds sitting uninvested in her cash account for several months. She later complains that she had forgotten the money was there and that the firm never told her she could have it. What obligation does a broker-dealer have with respect to uninvested customer cash of this kind?

1. A.None. Cash the customer chooses to leave uninvested is her own responsibility to monitor.The firm has an affirmative, recurring notice obligation with respect to free credit balances.
2. B.It must send a written notice at least quarterly stating the free credit balance and that the funds are payable on demand.Correct. Quarterly written notice of the balance and of its availability on demand is required.
3. C.It must automatically sweep the balance into a money market fund within five business days.A sweep may be offered as a service but is not required. What is required is the periodic notice.
4. D.It must segregate the cash in a special customer account and may not use it in its business.Free credit balances are not segregated, and the required notice says so expressly.

Why: Uninvested customer cash held by a broker-dealer is a FREE CREDIT BALANCE, which means it is money the firm owes the customer and which the customer may demand at any time. A broker-dealer must give each customer holding such a balance a written notice, not less often than quarterly, stating the amount of the free credit balance and making clear that the funds are not segregated, that the firm may use them in its business, and that they are payable to the customer on demand. The requirement exists precisely for the situation described: cash left idle is easy for a customer to forget, and the periodic notice ensures she is reminded that the money is hers and available.

Marisol's brokerage account at Denbigh Securities holds uninvested cash awaiting reinvestment. With respect to that free credit balance, the firm must give her a written notice, at least quarterly, stating that:

1. A.The funds are segregated from the firm's assets and may not be used by the firm for any purpose.Free credit balances are not segregated. The firm may use them in its business subject to the reserve requirements.
2. B.The funds are not segregated, may be used by the firm in its business, and are payable to her on demand.Correct. Those three statements are exactly what the quarterly free credit balance notice must convey.
3. C.The funds are automatically swept into a money market fund unless she objects within ten business days.A sweep arrangement is a separate contractual feature and is not what the required notice states.
4. D.The funds are insured by the Federal Deposit Insurance Corporation up to the standard deposit limit.Cash in a brokerage account is not FDIC insured. SIPC provides limited protection if the firm fails.

Why: A carrying firm must notify customers at least quarterly about free credit balances. The notice must state that the funds are not segregated, that the firm may use them in its business, and that the customer has the right to receive the funds on demand. That combination is what makes the arrangement transparent to the customer.

Idle cash in a retail customer's account at Thistlewood Brokerage moves automatically each evening into the money market vehicle the customer elected at account opening. In cashiering terms, what is this?

1. A.A residual credit, because the cash accrued to the account after the trading day closed.Wrong. Residual credits arise on an account that has already been transferred away, not on the daily balance of a live account.
2. B.A journal to a third party, because the money market vehicle is a separate legal entity.Wrong. Journals are made on a specific instruction between accounts on the firm's books, not run nightly by the system.
3. C.A reinvestment, because a distribution is being used to acquire additional shares.Wrong. Nothing has been distributed here; the cash is simply sitting idle and being put somewhere it earns.
4. D.A sweep, because free credit balances move to the elected vehicle under a standing election.Correct. An idle balance plus a standing election is what distinguishes this from every other cash movement in the department.

Why: A sweep is the automatic, standing-instruction movement of free credit balances out of the brokerage account into a money market fund or bank deposit vehicle the customer elected, and back again when cash is needed to settle a purchase. It is driven by the balance, not by an event on any particular security. Reinvestment is the different mechanic of applying a dividend or capital gain distribution to buy more of the paying security. If the customer had elected no sweep vehicle, the cash would simply sit in the account as a free credit balance.

Ardmore Securities holds fully paid common stock belonging to cash account customers. Under the SEC's customer protection rule, what must the firm do with those securities?

1. A.Pledge them to a bank as collateral for the firm's own borrowingOnly margin securities may be repledged, and even then only up to a percentage of the customer's debit balance. Fully paid securities may not be pledged at all.
2. B.Maintain possession or control of them at a good control location, free of lienThis is the core requirement of the customer protection rule for fully paid and excess margin securities.
3. C.Lend them to short sellers, provided the proceeds are credited to the firm's reserve accountLending fully paid customer securities requires a separate written agreement with the customer; it is not authorized by depositing proceeds anywhere.
4. D.Transfer them into street name so they can be included in the firm's net capital computationCustomer property is never an asset of the firm, and street name registration does not convert it into one.

Why: Rule 15c3-3 requires a broker-dealer to promptly obtain and thereafter maintain physical possession or control of all fully paid and excess margin securities carried for customers. Control means holding them at a good control location such as a clearing agency or a qualified bank, free of any lien or claim. These securities are the customers' property and may not be pledged or lent to finance the firm's business.