Apex Clearing Corporation (Apex), is a Dallas, Texas-based provider of correspondent clearing services for introducing broker-dealer clients. Since 2019, the firm has offered a fully-paid securities lending program (FPLP) to its clients.
In its news release accompanying the enforcement action, FINRA describes this lending practice as one where “a broker-dealer borrows a customer’s fully-paid or excess margin securities and typically lends them to a third party in exchange for a daily borrowing fee.”
Once a customer has decided to enrol in an FPLP, “the clearing firm determines which securities to borrow, when, and on what terms.” And a daily borrowing fee that the clearing firm collects “is generally shared among the clearing firm, the introducing broker-dealer and the customer who owns the borrowed security.”
The lending practice is governed by FINRA Rule 4330 (Customer Protection – Permissible Use of Customers’ Securities) which stipulates that before a borrowing relationship is established the firm must:
- have reasonable grounds for believing that the loaning of securities is appropriate for the customer; and
- provide the customer, in writing, with notice of potentially reduced protections disclosures regarding the customer’s rights the risks and financial impact.
According to FINRA, the firm failed to meet any of these requirements because it:
- lacked reasonable grounds to think the program was appropriate for participating customers;
- distributed documents that misrepresented that customers would receive compensation when in fact no compensation was offered; and
- failed to provide certain customers with required written disclosures.
Issue 1: Is it appropriate for participating customers?
The lack of reasonable grounds for believing the program was appropriate for participating customers can be traced to Apex’s agreement with the broker-dealers in question.
The broker-dealer clients who chose to participate in the FPLP program agreed to:
- set the criteria determining which introduced customers were eligible to participate in the FPLP;
- determine which customers could participate in the FPLP; and
- determine what compensation would be shared with customers when their securities were borrowed.
The four broker-dealers in question were all fined and censured by FINRA in December 2023:
In each case, FINRA found that the broker-dealers automatically enrolled customers in the FPLP at account opening. So, although the firms agreed to determine which of their customers could participate in the FPLP offered by Apex, they “did not take reasonable steps to make appropriateness determinations.”
And the FPLP may in fact have been inappropriate for some customers who “received cash payments in lieu of dividends and thus were potentially subject to adverse tax consequences,” which is also referenced in the Apex decision.
Apex, in turn, “had no procedures or system to assess whether participation in the FPLP was appropriate for retail customers or to comply with the mandated disclosures.
Its written supervisory procedures only “referenced the mechanics of the securities lending process” and simply stated that it was the broker-dealer who was responsible for determining customer suitability for the program.
Issue 2: Misrepresentation about compensation
The Master Securities Lending Agreement (MSLA) and Risk Disclosure Document supplied by Apex to its broker-dealer clients for onward distribution to customers indicated that the customer would receive compensation for loans of securities made under the FPLP.
These statements were inaccurate for the customers who did not receive a fee.
Some versions of the MSLA also indicated that customers participating in the FPLP would be compensated via reduced management fees charged by the broker-dealer.
FINRA deemed such statements misleading because “none of the relevant introducing broker-dealers charged management fees to any customer,” irrespective of whether they participated in or opted out of the FPLP.
Issue 3: Failure to provide written disclosures
The failure to provide written disclosures was connected specifically to a 2021 change to the MSLA by Apex.
Originally, the Risk Disclosure Document was intrinsic to the MSLA. This Risk Disclosure Document contained the requisite information on potentially reduced investor protections as well as disclosures on customer rights, risks and financial impact.
Apex “electronically tracked that customers received the document to evidence Apex’s compliance” with the rules.
The changes made to the MSLA meant that the it no longer included the Risk Disclosure Document, which was instead available electronically on the Apex website.
Only some broker-dealers continued to separately provide or make available the Risk Disclosure Document to customers. It is not clear from the AWC whether Apex continued to track the receipt of this document by customers, but it can be inferred that this practice ceased following its carving out from the MSLA.
FINRA held that by not bundling the Risk Disclosure Document with the MSLA Apex failed to provide in writing the mandated information and disclosures.
In total more than five million customers introduced to Apex by the four broker-dealer clients were ultimately enrolled in the program and the securities of 17% of these were actually borrowed by Apex.
Commenting on the rationale for a censure and fine against the Apex, Bill St. Louis, FINRA Executive Vice President and Head of Enforcement, said: “In addition to obtaining restitution for harmed investors from the introducing firms, we must hold accountable the clearing firm that designed, facilitated and benefitted from this program.”
As part of the settlement, Apex must implement corrective measures within 180 days, with a senior management official certifying the entity’s compliance.
GRIP Comment
Thomas: Initially, I was a little bit confused by the rationale put forward in one part of the AWC for the first failing by Apex.
This seemed to me to conflate the lack of reasonable grounds for believing an FPLP is appropriate for a customer with the non-receipt by the customer of a loan fee: “From January 2019 through June 2023, Apex did not have reasonable grounds to believe that fully-paid securities lending was appropriate for certain customers enrolled in its FPLP. This is because, during that period, certain of Apex’s introducing broker-dealers enrolled customers into the Apex FPLP and those customers did not receive a loan fee for lending their shares in connection with the FPLP. However, those customers were exposed to the risks and financial consequences of the FPLP.”
The confusion may well be my own, but FINRA Rule 4330 certainly makes no reference to the receipt of a loan fee as a condition for having reasonable grounds to believe that a loan of securities is appropriate for the customer in question.
My interpretation of this is that it is the broker-dealers that failed to make the appropriateness determinations as required and Apex is being penalized for this failing because it does not seem to have had in place any checks to confirm that such determinations had in actuality been made.
Another way that FINRA could be looking at this, though, is from the perspective of the inequity of the arrangement where customers did not receive any fees for lending their shares, but were still “exposed to the risks and financial consequences” of the arrangement. In his comments, St. Louis emphasized this point when he said that “[i]t is unreasonable to expect a customer to take on risks and the potential financial consequences of securities lending with no financial upside.”
Irrespective of how you decide to construe this language, it is an interesting wrinkle to a thought-provoking case and regulatory issue.
Julie: Apex distributed misleading documents to more than five million retail investors, inaccurately stating that customers would receive a loan fee.
In reality, FINRA notes that some customers received no compensation, while those whose shares were borrowed over a dividend date actually incurred tax consequences due to payments classified as cash-in-lieu of dividends. These negative impacts and misleading statements point to a breakdown in its disclosure oversight in its securities lending program in violation of FINRA Rule 4330, which mandates proper disclosure about the risks and financial implications of securities lending.
There was a clear violation of Rules 3110 (supervision) and 2010 (industry standards of commercial honor) due to the absence of clear, written supervisory procedures to ensure the lending program would supply adequate disclosure and that brokers would evaluate the appropriateness of products for customers.
