Recap: The Foundation of FINRA Rule 4330
In our first post, we explored the essential, customer-facing compliance duties for Fully-Paid Securities Lending (FPL) programs mandated by FINRA Rule 4330. This rule establishes the bedrock of the client relationship. We learned that before a broker-dealer can borrow a retail customer’s shares, it must perform three key functions.
First, the firm must conduct a thorough appropriateness determination to ensure that the program’s risks are suitable for the customer. Second, it must provide comprehensive, written risk disclosures, explicitly warning the customer about the loss of SIPC protection and voting rights. Finally, the firm must create and maintain diligent records proving its compliance with these obligations. While these steps are critical for customer protection, they represent only half of the broker’s compliance challenge.
The Other Half of the “Rule Stack”: SEC Rule 15c3-3
The true operational authority for FPL programs comes not from FINRA, but from the Securities and Exchange Commission (SEC). The SEC’s primary “Customer Protection Rule,” Securities Exchange Act Rule 15c3-3, generally prohibits broker-dealers from using or lending a customer’s fully-paid securities. It mandates that these assets remain segregated and in the firm’s “possession or control.”
An FPL program is only possible because of a specific exemption found in SEC Rule 15c3-3(b)(3). This provision grants the broker-dealer legal authority to borrow the customer’s securities if, and only if, the broker provides the customer with specific, qualifying collateral (consisting of cash or U.S. Treasury securities) for the full value of the loan, marked-to-market daily.
This creates a “rule stack” for compliance: FINRA Rule 4330 governs the customer relationship (the “who and how”), while SEC Rule 15c3-3 governs the assets and mechanics (the “what and where”). A broker cannot have a compliant FPL program without mastering both.
Litigation Risk: The Critical Difference Between Agent and Principal
This dual-rule framework has profound implications for a broker-dealer’s litigation risk. In recent years, high-profile lawsuits challenged the compensation structures of institutional lending programs. In those cases, plaintiffs (such as large pension funds) argued that their custodian bank, acting as an agent, breached its fiduciary duty by taking an unreasonable share of lending revenue.
FPL programs are structured in a fundamentally different way that provides a powerful legal defense. The FPL agreement, mandated by FINRA 4330, establishes a principal-to-principal relationship. The broker-dealer is not an “agent” working on the customer’s behalf; it is a direct counterparty borrowing the securities for its own account.
Because the relationship is contractual and non-fiduciary, the primary legal arguments of “self-dealing” or “breach of fiduciary duty” are neutralized. The key litigation risk shifts away from fiduciary arguments and toward contractual transparency. So long as the compensation split is clearly disclosed, as required by Rule 4330, the broker is on firmer legal ground.
Justifying the Revenue Split: Why 50/50 Revenue Is Not 50/50 Profit
A clear contract is the first line of defense, but a broker must also be prepared to justify why a significant revenue split (e.g., 50/50) is commercially reasonable and “appropriate.” Plaintiff’s attorneys may argue that a 50% share for the broker is excessive when the customer is providing 100% of the asset. This argument, however, confuses revenue with profit and ignores the significant risks and costs that the broker absorbs.
The customer’s 50% share is a nearly risk-free payout. The broker’s 50% share is gross revenue that must cover three major costs. First is counterparty default risk. The broker borrows from the retail customer and on-lends to the “street” (e.g., a hedge fund). If that street counterparty fails to return the shares, the broker is still 100% liable for returning the shares to its retail customer. The broker, not the customer, absorbs all third-party credit risk.
Second are the substantial operational costs of running the program. This includes building and maintaining the platform, managing daily (or intraday) mark-to-market collateral movements for millions of accounts, processing all substitute dividend payments, and managing the compliance and reporting for both the FINRA and SEC rules.
Third, and most significantly, the broker’s revenue share must cover the immense cost of regulatory capital. As we will explore, this cost is not operational but structural, and it is imposed by an entirely different set of regulators.
The $100 Billion Handcuffs: How Bank Capital Rules Can Make FPL Unprofitable
When a broker-dealer (especially one owned by a large bank holding company) posts cash as the collateral required by SEC Rule 15c3-3, the accounting rules (U.S. GAAP) require the transaction to be “grossed-up” on the balance sheet. This means both a new asset (the cash collateral pledged) and a new liability (the obligation to return the collateral) are added, inflating the firm’s total assets.
This balance sheet inflation is severely penalized by post-financial-crisis banking regulations, collectively known as Basel III. Specifically, the Supplemental Leverage Ratio (SLR) forces large banking organizations to hold a high level of capital against their total unweighted assets. Because the FPL loan inflates the balance sheet, it directly consumes the firm’s most expensive resource: capital.
This regulatory capital charge can be so high that it completely wipes out any potential profit from the lending spread. This has left many brokers in a seemingly impossible position: running a program that is perfectly compliant with securities law (FINRA and SEC) but economically non-viable under banking capital rules (Basel III). In our next post in this series, we will outline the elegant solution to this capital dilemma.