
[Federal Register Volume 75, Number 227 (Friday, November 26, 2010)]
[Notices]
[Pages 72850-72855]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-29727]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-63331; File No. SR-FINRA-2010-059]


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

November 17, 2010.
    Pursuant to Section 19(b)(1) \1\ of the Securities Exchange Act of 
1934 (``Act'' or ``Exchange Act'') \2\ and Rule 19b-4 thereunder,\3\ 
notice is hereby given that on November 10, 2010, Financial Industry 
Regulatory Authority, Inc. (``FINRA'') (f/k/a National Association of 
Securities Dealers, Inc. (``NASD'')) filed with the Securities and 
Exchange Commission (``SEC'' or ``Commission'') the proposed rule 
change as described in Items I, II, and III below, which Items have 
been prepared by FINRA. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 15 U.S.C. 78a.
    \3\ 17 CFR 240.19b-4.
---------------------------------------------------------------------------

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    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.
    The text of the proposed rule change is available on FINRA's Web 
site at http://www.finra.org, at the principal

[[Page 72851]]

office of FINRA and at the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. FINRA has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    As part of the process of developing a new consolidated rulebook 
(``Consolidated FINRA Rulebook''),\4\ FINRA is proposing to adopt NASD 
Rule 3020 as FINRA Rule 4360 (Fidelity Bonds), taking into account NYSE 
Rule 319 (and its Interpretation).\5\ Proposed FINRA Rule 4360 would 
update and clarify the fidelity bond requirements and better reflect 
current industry practices. Unless otherwise noted below, the 
provisions in NASD Rule 3020 would transfer, subject only to non-
substantive changes, as part of proposed FINRA Rule 4360.
---------------------------------------------------------------------------

    \4\ The current FINRA rulebook consists of: (1) FINRA Rules; (2) 
NASD Rules; and (3) rules incorporated from NYSE (``Incorporated 
NYSE Rules'') (together, the NASD Rules and Incorporated NYSE Rules 
are referred to as the ``Transitional Rulebook''). While the NASD 
Rules generally apply to all FINRA members, the Incorporated NYSE 
Rules apply only to those members of FINRA that are also members of 
the NYSE (``Dual Members''). The FINRA Rules apply to all FINRA 
members, unless such rules have a more limited application by their 
terms. For more information about the rulebook consolidation 
process, see Information Notice, March 12, 2008 (Rulebook 
Consolidation Process).
    \5\ For convenience, the Incorporated NYSE Rules are referred to 
as the NYSE Rules.
---------------------------------------------------------------------------

    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.
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. Like NASD Rule 
3020, 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.
    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. Members may apply for 
this level of coverage with any product that meets these requirements, 
including the Securities Dealer Blanket Bond (``SDBB'') or a properly 
endorsed Financial Institution Form 14 Bond (``Form 14'').\6\
---------------------------------------------------------------------------

    \6\ Since 1982, firms electing to acquire coverage through the 
FINRA-sponsored Insurance Program (``Sponsored Program'') have been 
provided with the SDBB. It is the ``default'' insurance for FINRA 
members in that when a firm completes the application for the 
Sponsored Program, they are applying for the SDBB.
---------------------------------------------------------------------------

    Most fidelity bonds contain a definition of the term ``loss'' (or 
``single loss''), for purposes of the bond, which generally includes 
all covered losses resulting from any one act or a series of related 
acts. A payment by an insurer for covered losses attributed to a 
``single loss'' does not reduce a member's coverage amount for losses 
attributed to other, separate acts. A fidelity bond with an aggregate 
limit of liability caps a member's coverage during the bond period at a 
certain amount if a loss (or losses) meets this aggregate threshold. 
FINRA believes that per loss coverage without an aggregate limit of 
liability provides firms with the most beneficial coverage since the 
bond amount cannot be exhausted by one or more covered losses, so it 
will be available for future losses during the bond period.
    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. FINRA 
has been advised by insurance industry representatives that the 
proposed rule change does not substantively change what is required to 
be covered by the bond.\7\
---------------------------------------------------------------------------

    \7\ For example, previous versions of the SDBB and Form 14 
included a separate Insuring Agreement for misplacement; however, in 
the current versions of the bonds, this coverage is included in both 
``on premises'' and ``in transit'' coverage.
---------------------------------------------------------------------------

    In addition, proposed FINRA Rule 4360 would 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. 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.
    Like NASD Rule 3020(a)(1)(H) and NYSE Rule 319.12, 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.\8\
---------------------------------------------------------------------------

    \8\ 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.
---------------------------------------------------------------------------

    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

[[Page 72852]]

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). The member 
would be required to retain such correspondence for the period 
specified by Exchange Act Rule 17a-4(b)(4). FINRA has been advised by 
insurance industry representatives that the proposed alternative 
coverage requirement is necessary for firms that, for example, have had 
a covered loss paid by an insurer within the past five years or firms 
that may present certain risk factors that would prevent an insurer 
from offering per loss coverage without an aggregate limit of 
liability.
Minimum Required Coverage
    NASD Rule 3020 requires fidelity bond coverage for officers and 
employees of a member. Under NASD Rule 3020(e), the term ``employee'' 
or ``employees'' means any person or persons associated with a member 
firm (as defined in Article I, paragraph (rr) of the FINRA By-Laws) 
except: (1) Sole proprietors, (2) sole stockholders and (3) directors 
or trustees of a member who are not performing acts coming within the 
scope of the usual duties of an officer or employee. Under NYSE Rule 
319(a), any member organization doing business with the public must 
maintain fidelity bond coverage for general partners or officers and 
its employees.\9\
---------------------------------------------------------------------------

    \9\ Under NYSE Rule Interpretation 319/02 (Additional 
Coverages), the required coverage of the Brokers Blanket Bond must 
apply, through rider or otherwise, as applicable to: all domestic 
and foreign guaranteed and non-guaranteed affiliates, subsidiaries 
and branches; bearer instruments if the member organization handles 
such securities; limited partners of a member firm if they are also 
employees; and the partners, officers and employees or person acting 
in a similar capacity of electronic data processing agencies in 
their activities on behalf of the member organizations.
---------------------------------------------------------------------------

    Proposed FINRA Rule 4360, similar to NASD Rule 3020 and NYSE Rule 
319, 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. FINRA believes this increase is 
warranted since the NASD and NYSE fidelity bond rules have not been 
materially modified since their adoption--over 30 years ago--and 
$25,000 in 1974 (the year the NASD rule was adopted) is equal to 
approximately $110,000 today (adjusted for inflation). Although members 
may experience a slight increase in costs for their premiums under the 
proposed rule change, FINRA believes that the proposed amendments to 
the fidelity bond minimum requirements are necessary to provide 
meaningful and practical coverage for losses covered by the bond.
    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 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.\10\
---------------------------------------------------------------------------

    \10\ For example, NASD Rule 3020 requires a small clearing and 
carrying firm (i.e., one subject to a $250,000 net capital 
requirement) to obtain $300,000 in coverage. The same firm, had it 
been designated to NYSE, would have needed $600,000 in coverage. 
FINRA believes the increased coverage requirements are appropriate 
given the larger number/amount of claims that can be satisfied at 
these levels.
---------------------------------------------------------------------------

    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.
Deductible Provision
    Under 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 \11\ would be 
deducted from the member's net worth in the calculation of its net 
capital for purposes of Exchange Act Rule 15c3-1.\12\ Like the NASD and 
NYSE rules, if

[[Page 72853]]

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.
---------------------------------------------------------------------------

    \11\ FINRA notes that a member may elect, subject to 
availability, a deductible of less than 10 percent of the coverage 
purchased.
    \12\ 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.
---------------------------------------------------------------------------

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.
    Similar to NASD Rule 3020(c)(2), 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.
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.\13\ 
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''),\14\ floor broker or registered floor trader and does not 
conduct business with the public.
----------------------------------------------------------