Document ID: SEC-2011-0266-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2011-03-02T05:00Z

[Federal Register Volume 76, Number 41 (Wednesday, March 2, 2011)]
[Notices]
[Pages 11542-11545]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-4690]

[[Page 11542]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-63961; File No. SR-FINRA-2010-059]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Approving Proposed Rule Change To Adopt FINRA 
Rule 4360 (Fidelity Bonds) in the Consolidated FINRA Rulebook

February 24, 2011.

I. Introduction

    On November 10, 2010, the Financial Industry Regulatory Authority, 
Inc., (``FINRA'') filed with the Securities and Exchange Commission 
(``SEC'') pursuant to Section 19(b)(1) of the Securities Exchange Act 
of 1934 (``Exchange Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed 
rule change to adopt NASD Rule 3020 (Fidelity Bonds) with certain 
changes into the consolidated FINRA rulebook as FINRA Rule 4360 
(Fidelity Bonds). The proposed rule change was published for comment in 
the Federal Register on November 26, 2010.\3\ The Commission received 
three comment letters on the proposed rule change.\4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Exchange Act Release No. 63331 (Nov. 17, 2010), 75 FR 
72850 (Nov. 26, 2010) (``Notice'').
    \4\ See Letters from Richard M. Garone, Travelers, dated Dec. 
16, 2010 (``Travelers''); Letter from Robert J. Duke, The Surety & 
Fidelity Association of America, dated Dec. 17, 2010 (``SFAA''); and 
Letter from Albert Kramer, Kramer Securities Corporation, dated Dec. 
31, 2010 (``Kramer'').
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II. Description of Proposed Rule Change

A. Summary

    FINRA is proposing to adopt NASD Rule 3020 (Fidelity Bonds) with 
certain changes into the consolidated FINRA rulebook as FINRA Rule 4360 
(Fidelity Bonds), taking into account Incorporated NYSE Rule 319 
(Fidelity Bonds) and its Interpretation. NASD Rule 3020 and NYSE Rule 
319 (and its Interpretation) generally require members to maintain 
minimum amounts of fidelity bond coverage for officers and employees, 
and that such coverage address losses incurred due to certain specified 
events. The purpose of a fidelity bond is to protect a member against 
certain types of losses, including, but not limited to, those caused by 
the malfeasance of its officers and employees, and the effect of such 
losses on the member's capital.

B. Description of Proposed Rule Change

1. General Provision
    NASD Rule 3020(a) generally provides that each member required to 
join the Securities Investor Protection Corporation (``SIPC'') that has 
employees and that is not a member in good standing of one of the 
enumerated national securities exchanges must maintain fidelity bond 
coverage; NYSE Rule 319(a) generally requires member organizations 
doing business with the public to carry fidelity bonds. Proposed FINRA 
Rule 4360 would require each member that is required to join SIPC to 
maintain blanket fidelity bond coverage with specified amounts of 
coverage based on the member's net capital requirement, with certain 
exceptions.\5\
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    \5\ See Notice, supra note 3, for a more detailed discussion of 
the proposed rule change.
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    NASD Rule 3020(a)(1) requires members to maintain a blanket 
fidelity bond in a form substantially similar to the standard form of 
Brokers Blanket Bond promulgated by the Surety Association of America. 
Under NYSE Rule 319(a), the Stockbrokers Partnership Bond and the 
Brokers Blanket Bond approved by the NYSE are the only bond forms that 
may be used by a member organization; NYSE approval is required for any 
variation from such forms. Proposed FINRA Rule 4360 would require 
members to maintain fidelity bond coverage that provides for per loss 
coverage without an aggregate limit of liability.
    Under proposed FINRA Rule 4360, a member's fidelity bond must 
provide against loss and have Insuring Agreements covering at least the 
following: Fidelity, on premises, in transit, forgery and alteration, 
securities and counterfeit currency. The proposed rule change modifies 
the descriptive headings for these Insuring Agreements, in part, from 
NASD Rule 3020(a)(1) and NYSE Rule 319(d) to align them with the 
headings in the current bond forms available to broker-dealers.
    Proposed FINRA Rule 4360 would also eliminate the specific coverage 
provisions in NASD Rule 3020(a)(4) and (a)(5), and NYSE Rule 
319(d)(ii)(B) and (C), and (e)(ii)(B) and (C), that permit less than 
100 percent of coverage for certain Insuring Agreements (i.e., 
fraudulent trading and securities forgery) to require that coverage for 
all Insuring Agreements be equal to 100 percent of the firm's minimum 
required bond coverage.\6\
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    \6\ Members may elect to carry additional, optional Insuring 
Agreements not required by proposed FINRA Rule 4360 for an amount 
less than 100 percent of the minimum required bond coverage.
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    As currently provided in NASD Rule 3020 and NYSE Rule 319, proposed 
FINRA Rule 4360 would require that a member's fidelity bond include a 
cancellation rider providing that the insurer will use its best efforts 
to promptly notify FINRA in the event the bond is cancelled, terminated 
or ``substantially modified.'' Also, the proposed rule change would 
adopt the definition of ``substantially modified'' in NYSE Rule 319 and 
would incorporate NYSE Rule 319.12's standard that a firm must 
immediately advise FINRA in writing if its fidelity bond is cancelled, 
terminated or substantially modified.\7\
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    \7\ NYSE Rule 319 defines the term ``substantially modified'' as 
any change in the type or amount of fidelity bonding coverage, or in 
the exclusions to which the bond is subject, or any other change in 
the bond such that it no longer complies with the requirements of 
the rule.
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    FINRA is proposing to add supplementary material to proposed FINRA 
Rule 4360 that would require members that do not qualify for a bond 
with per loss coverage without an aggregate limit of liability to 
secure alternative coverage. Specifically, a member that does not 
qualify for blanket fidelity bond coverage as required by proposed 
FINRA Rule 4360(a)(3) would be required to maintain substantially 
similar fidelity bond coverage in compliance with all other provisions 
of the proposed rule, provided that the member maintains written 
correspondence from two insurance providers stating that the member 
does not qualify for the coverage required by proposed FINRA Rule 
4360(a)(3).
2. Minimum Required Coverage
    Proposed FINRA Rule 4360 would require each member to maintain, at 
a minimum, fidelity bond coverage for any person associated with the 
member, except directors or trustees of a member who are not performing 
acts within the scope of the usual duties of an officer or employee. As 
further detailed below, the proposed rule change would eliminate the 
exemption in NASD Rule 3020 for sole stockholders and sole proprietors.
    The proposed rule change would increase the minimum required 
fidelity bond coverage for members, while continuing to base the 
coverage on a member's net capital requirement. To that end, proposed 
FINRA Rule 4360 would require a member with a net capital requirement 
that is less than $250,000 to maintain minimum coverage of the greater 
of 120 percent of the firm's required net capital under Exchange Act 
Rule 15c3-1 or $100,000. The increase to $100,000 would modify the 
present minimum requirement of $25,000.
    Under proposed FINRA Rule 4360, members with a net capital 
requirement of at least $250,000 would use a table in the rule to 
determine their minimum fidelity bond coverage requirement. The

[[Page 11543]]

table is a modified version of the tables in NASD Rule 3020(a)(3) and 
NYSE Rule 319(e)(i). The identical NASD and NYSE requirements for 
members that have a minimum net capital requirement that exceeds $1 
million would be retained in proposed FINRA Rule 4360; however, the 
proposed rule would adopt the higher requirements in NYSE Rule 
319(e)(i) for a member with a net capital requirement of at least 
$250,000, but less than $1 million.
    Under the proposed rule, the entire amount of a member's minimum 
required coverage must be available for covered losses and may not be 
eroded by the costs an insurer may incur if it chooses to defend a 
claim. Specifically, any defense costs for covered losses must be in 
addition to a member's minimum coverage requirements. A member may 
include defense costs as part of its fidelity bond coverage, but only 
to the extent that it does not reduce a member's minimum required 
coverage under the proposed rule.
3. Deductible Provision
    Under current NASD Rule 3020(b), a deductible provision may be 
included in a member's bond of up to $5,000 or 10 percent of the 
member's minimum insurance requirement, whichever is greater. If a 
member desires to maintain coverage in excess of the minimum insurance 
requirement, then a deductible provision may be included in the bond of 
up to $5,000 or 10 percent of the amount of blanket coverage provided 
in the bond purchased, whichever is greater. The excess of any such 
deductible amount over the maximum permissible deductible amount based 
on the member's minimum required coverage must be deducted from the 
member's net worth in the calculation of the member's net capital for 
purposes of Exchange Act Rule 15c3-1. Where the member is a subsidiary 
of another member, the excess may be deducted from the parent's rather 
than the subsidiary's net worth, but only if the parent guarantees the 
subsidiary's net capital in writing.
    Under NYSE Rule 319(b), each member organization may self-insure to 
the extent of $10,000 or 10 percent of its minimum insurance 
requirement as fixed by the NYSE, whichever is greater, for each type 
of coverage required by the rule. Self-insurance in amounts exceeding 
the above maximum may be permitted by the NYSE provided the member or 
member organization certifies to the satisfaction of the NYSE that it 
is unable to obtain greater bonding coverage, and agrees to reduce its 
self-insurance so as to comply with the above stated limits as soon as 
possible, and appropriate charges to capital are made pursuant to 
Exchange Act Rule 15c3-1. This provision also contains identical 
language to the NASD rule regarding net worth deductions for 
subsidiaries.
    Proposed FINRA Rule 4360 would provide for an allowable deductible 
amount of up to 25 percent of the fidelity bond coverage purchased by a 
member. Any deductible amount elected by the firm that is greater than 
10 percent of the coverage purchased by the member \8\ would be 
deducted from the member's net worth in the calculation of its net 
capital for purposes of Exchange Act Rule 15c3-1.\9\ Like the NASD and 
NYSE rules, if the member is a subsidiary of another FINRA member, this 
amount may be deducted from the parent's rather than the subsidiary's 
net worth, but only if the parent guarantees the subsidiary's net 
capital in writing.
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    \8\ FINRA notes that a member may elect, subject to 
availability, a deductible of less than 10 percent of the coverage 
purchased.
    \9\ NASD Rule 3020 bases the deduction from net worth for an 
excess deductible on a firm's minimum required coverage, while 
proposed FINRA Rule 4360 would base such deduction from net worth on 
coverage purchased by the member.
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4. Annual Review of Coverage
    Consistent with NASD Rule 3020(c) and NYSE Rule 319.10, proposed 
FINRA Rule 4360 would require a member (including a firm that signs a 
multi-year insurance policy), annually as of the yearly anniversary 
date of the issuance of the fidelity bond, to review the adequacy of 
its fidelity bond coverage and make any required adjustments to its 
coverage, as set forth in the proposed rule. Under proposed FINRA Rule 
4360(d), a member's highest net capital requirement during the 
preceding 12-month period, based on the applicable method of computing 
net capital (dollar minimum, aggregate indebtedness or alternative 
standard), would be used as the basis for determining the member's 
minimum required fidelity bond coverage for the succeeding 12-month 
period. The ``preceding 12-month period'' includes the 12-month period 
that ends 60 days before the yearly anniversary date of a member's 
fidelity bond. This would give a firm time to determine its required 
fidelity bond coverage by the anniversary date of the bond.
    Proposed FINRA Rule 4360 would allow a member that has only been in 
business for one year and elected the aggregate indebtedness ratio for 
calculating its net capital requirement to use, solely for the purpose 
of determining the adequacy of its fidelity bond coverage for its 
second year, the 15 to 1 ratio of aggregate indebtedness to net capital 
in lieu of the 8 to 1 ratio (required for broker-dealers in their first 
year of business) to calculate its net capital requirement. 
Notwithstanding the above, such member would not be permitted to carry 
less minimum fidelity bond coverage in its second year than it carried 
in its first year.
5. Exemptions
    Based in part on NASD Rule 3020(a), proposed FINRA Rule 4360 would 
exempt from the fidelity bond requirements members in good standing 
with a national securities exchange that maintain a fidelity bond 
subject to the requirements of such exchange that are equal to or 
greater than the requirements set forth in the proposed rule. 
Additionally, consistent with NYSE Rule Interpretation 319/01, proposed 
FINRA Rule 4360 would continue to exempt from the fidelity bond 
requirements any firm that acts solely as a Designated Market Maker 
(``DMM''),\10\ floor broker or registered floor trader and does not 
conduct business with the public.
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    \10\ See Exchange Act Release No. 58845 (Oct. 24, 2008), 73 FR 
64379 (Oct. 29, 2008) (Order Approving File No. SR-NYSE-2008-46). In 
this rule filing, the role of the specialist was altered in certain 
respects and the term ``specialist'' was replaced with the term 
``Designated Market Maker.''
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    Proposed FINRA Rule 4360 would not maintain the exemption in NASD 
Rule 3020(e) for a one-person firm.\11\ Historically, a sole proprietor 
or sole stockholder member was excluded from the fidelity bond 
requirements based upon the assumption that such firms were one-person 
shops and, therefore, could not obtain coverage for their own acts. 
FINRA has determined that sole proprietors and sole stockholder firms 
can and often do acquire fidelity bond coverage, even though it is 
currently not required, since all claims (irrespective of firm size) 
are likely to be paid or denied on a facts-and-circumstances basis. 
Also, certain coverage areas of the fidelity bond benefit a one-person 
shop (e.g., those covering customer property lost in transit).
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    \11\ A one-person member (that is, a firm owned by a sole 
proprietor or stockholder that has no other associated persons, 
registered or unregistered) has no ``employees'' for purposes of 
NASD Rule 3020, and therefore such a firm currently is not subject 
to the fidelity bonding requirements. Conversely, a firm owned by a 
sole proprietor or stockholder that has other associated persons has 
``employees'' for purposes of NASD Rule 3020, and currently is, and 
will continue to be, subject to the fidelity bonding requirements.

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[[Page 11544]]

III. Summary of Comments

    The Commission received three comment letters in response to the 
proposed rule change addressing different aspects of the proposal.\12\ 
FINRA submitted a response to these comment letters.\13\
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    \12\ See supra note 4.
    \13\ See Letter from Erika L. Lazar, Counsel, FINRA, to 
Elizabeth M. Murphy, Secretary, Commission, dated February 23, 2010 
(``FINRA Letter'').
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A. Elimination of the Exemption in NASD Rule 3020 for Sole Proprietors 
and Sole Stockholders

    All three commenters oppose the proposed elimination of the 
exemption from the fidelity bond requirements in NASD Rule 3020 for 
sole proprietors and sole stockholders.\14\ One commenter believes that 
it is irresponsible to require one-person shops to maintain a fidelity 
bond that would provide little, if any, true coverage and that a one-
person shop should be allowed to decide if they want to self-insure in 
other areas that would not invoke the alter-ego concept.\15\ Another 
commenter requests that the proposed rule change not be approved 
without an exemption for sole proprietors and sole stockholders and 
notes that maintaining a fidelity bond will be a great financial burden 
for small firms.\16\ The third commenter agrees with the premise that 
sole proprietors and sole stockholders may rely on certain Insuring 
Agreements in a fidelity bond.\17\ However, two commenters, including 
the third commenter referenced above, are concerned that Insuring 
Agreement A--Fidelity as required by the proposed rule, is not 
available in the market for a sole proprietor or sole stockholder 
because the sole owner is considered an alter-ego of the company and 
dishonesty of a sole owner cannot be underwritten prudently.\18\ One 
commenter suggests language that would exclude sole proprietors and 
sole stockholders from Insuring Agreement A--Fidelity coverage and 
believes that the rule filing does not accurately describe Insuring 
Agreement A--Fidelity because it uses the term ``malfeasance.''\19\
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    \14\ See Kramer, SFAA and Travelers.
    \15\ See Travelers.
    \16\ See Kramer.
    \17\ See SFAA.
    \18\ See SFAA and Travelers.
    \19\ See SFAA.
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    In its response to comments, FINRA notes that a one-person member 
has no ``employees'' for purposes of the rule, and therefore such a 
firm currently is not subject to the fidelity bonding requirements.\20\ 
However, a firm owned by a sole proprietor or stockholder that has 
other associated persons has ``employees'' for purposes of current NASD 
Rule 3020, and currently is, and will continue to be, subject to 
fidelity bonding requirements.\21\ FINRA further disputes the claim 
that sole proprietors and sole stockholder firms cannot obtain fidelity 
bond coverage. Specifically, FINRA has determined that sole proprietors 
and sole stockholder firms can and do acquire fidelity bond coverage, 
even though it is not currently required under the NASD rule.\22\
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    \20\ See FINRA Letter.
    \21\ Id.
    \22\ See Notice, supra note 3; see also FINRA Letter.
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    FINRA further provides that Insuring Agreements B through F in the 
proposed rule are all premised on losses suffered by the insured based 
on the acts of another person; such persons do not have to be an 
``employee'' of the firm and therefore sole proprietor and sole 
stockholder firms can obtain fidelity coverage through these 
agreements.\23\ FINRA notes that the term ``employee'' currently is 
defined in the Securities Dealer Blanket Bond to include, among others, 
an officer or other employee of the insured, while employed in, at or 
by any of the insured's offices or premises, an attorney retained by 
the insured while performing legal services for the insured and any 
natural person performing acts coming with the scope of the usual 
duties of an officer or employee of the insured, including any persons 
provided by an employment contractor. FINRA believes that while a sole 
proprietor or sole stockholder may not have other associated persons or 
registered persons, it may have ``employees'' for purposes of a 
fidelity bond and therefore may benefit from Fidelity coverage.\24\ 
FINRA believes that requiring all SIPC member firms, regardless of 
size, to maintain fidelity bond coverage promotes investor protection 
objectives and protects firms from unforeseen losses.
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    \23\ See FINRA Letter.
    \24\ Id.
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    With respect to the comment that the rule filing inaccurately 
describes Insuring Agreement A--Fidelity by using the term 
``malfeasance,'' FINRA responds that the term ``malfeasance'' was used 
as part of a description of the purpose of the fidelity bond in general 
and does not aim to impose additional requirements beyond what is 
covered by the proposed rule.\25\
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    \25\ Id.
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B. Requirement for Per Loss Coverage Without an Aggregate Limit of 
Liability

    One commenter notes that the proposed rule change, which would 
require members to maintain fidelity bond coverage that provides for 
per loss coverage without an aggregate limit of liability, will 
significantly modify the Financial Institutional Form 14 Bond (``Form 
14'') by creating a competitive disadvantage to underwriters that do 
not offer this type of coverage.\26\ The commenter further stated that 
only two underwriting firms offer this type of coverage and therefore 
the proposed rule change would increase costs to members.\27\
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    \26\ See Travelers. Furthermore, Travelers argues that this 
proposed change would remove the industry standard aggregate limit 
of liability.
    \27\ Id.
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    FINRA argues that a member's fidelity bond coverage should not 
include an aggregate limit of liability to prevent a member's coverage 
from being eroded by covered losses within the bond period.\28\ FINRA 
further states that it was advised by industry representatives that 
Form 14 could be revised to provide this type of coverage and that it 
could be offered by a firm that offers the current Form 14.\29\
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    \28\ See FINRA Letter.
    \29\ Id.
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C. Proposed Changes to the Deductible Provision

    One commenter opposes provision (c) in proposed FINRA Rule 4360 
that would require a deduction from net capital in the case of certain 
deductible levels.\30\ This commenter supported the increased maximum 
permissible deductible of 25% of the coverage purchased by a member, 
but believes that the net capital deduction that the broker-dealer 
would be required to take for any deductible greater than 10% of their 
fidelity bond limit could provide a strong disincentive for any firm to 
consider a higher deductible. The commenter believes that this could 
lead to higher premium costs for members.\31\
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    \30\ See Travelers.
    \31\ Id.
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    In response, FINRA notes the difference between the deduction 
linked to the current NASD rule and what is proposed. Specifically, the 
proposed rule eliminates the current concept of an ``excess 
deductible'' linked to a member's required minimum bond requirement and 
instead proposed Rule 4360 would only be subject to a deduction from 
net capital in the amount of any deductible over 10% of the coverage 
purchased by the member. Therefore, FINRA does not believe that the 
proposed deductible provision will result in a higher premium costs 
than the current rule. Rather, FINRA argues that the option for a 
deductible of up to 25% of the coverage purchased and any

[[Page 11545]]

deductible amount elected by the member that is greater than 10% of the 
coverage purchased must be deduced from the member's net worth in the 
calculation of its net capital for purposes of Exchange Act Rule 15c3-
1.

IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities 
association.\32\ In particular, the Commission believes the proposal is 
consistent with the requirements of Section 15A(b)(6) of the Act,\33\ 
which requires, among other things, that the Association's rules be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, and, in general, to 
protect investors and the public interest. The Commission believes that 
FINRA adequately addressed the comments raised in response to the 
notice of this proposed rule change.
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    \32\ In approving this rule proposal, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \33\ 15 U.S.C. 78o-3(b)(6).
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    The Commission believes that FINRA's proposed Rule 4360 (Fidelity 
Bond) will update and clarify the requirements governing fidelity bonds 
for adoption in the Consolidated FINRA Rulebook. The Commission 
believes that the proposed requirements of FINRA Rule 4360, including, 
but not limited to, requiring each member that is required to join SIPC 
to maintain blanket fidelity bond coverage, increasing the minimum 
requirement fidelity bond coverage and maintaining a fidelity bond that 
provides for per loss coverage without an aggregate limit of liability 
promotes investor protection by protecting firms from unforeseen 
losses.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\34\ that the proposed rule change (SR-FINRA-2010-059) is approved.
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    \34\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\35\
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    \35\ 17 CFR 200.30-3(a)(12).
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Cathy H. Ahn,
Deputy Secretary.
[FR Doc. 2011-4690 Filed 3-1-11; 8:45 am]
BILLING CODE 8011-01-P