For the most part, my broker-dealer clients are introducing firms that clear through any number of generally recognized clearing firms. Increasingly, for whatever reason, I have been asked to get involved in disputes with clearing firms surrounding terms contained in the clearing agreement.  Unfortunately, this typically turns into a big problem, as these agreements are some of the most one-sided contracts you would ever hope to see.  And there’s the rub:  my clients need their clearing relationships, so they have little choice but to knuckle under and sign agreements that are weighted heavily in favor of the clearing firm.

What are some examples? How about the clearing deposit, for starters.  Introducing firms are required to place a substantial amount of money with their clearing firms just to be able to do any business.  But, the amount of these deposits is largely up to the clearing firm to decide.  While there may be some rudimentary give-and-take on the amount during negotiations, ultimately the clearing firm simply dictates how much it needs.  Even after the agreement is signed, the clearing firm has the right to ask for more…or else.  You may recall a few years ago, shortly after Apex Clearing was formed, it asked its correspondents to increase their deposits by significant amounts.  Indeed, as reported in the Wall Street Journal, TradeKing had to obtain an injunction against Apex to delay a demanded increase in its clearing deposit from $100,000 to $13 million, claiming it would put the firm out of business.[1]  I am not picking on Apex, or suggesting it is the only clearing firm to have done this; but this dispute was made into a public matter, so I can highlight it.

And try getting that deposit back. While clearing firms are contractually obligated to return the deposit at the conclusion of the clearing relationship, some still hold on to the deposits like grim death, as they say, even when the introducing firm has moved on. To justify this, the clearing firms will point to a couple of stray customer accounts that still linger (even if they don’t trade), meaning that, as they see it, the clearing relationship is not truly over.  Or, they may insist that there is some wildly fantastic potential claim brewing, giving them the right, in their own complete discretion, to hold the deposit until they unilaterally conclude the threat is gone.  If ever.  And, moreover, this discussion hasn’t even touched on the insane termination fees that clearing firms require if an introducing firm wants out of the relationship prior to the end of the term of the agreement.

The indemnification provisions baked into clearing agreements are hideously tilted in favor of the clearing firm, even though they purport to be reciprocal. The introducing firm basically has to indemnify the clearing firm for anything that happens, intentional or otherwise, while the clearing firm is only required to indemnify the introducing firm when the clearing firm acts intentionally, or sometimes only when it is actually found, by a court or a regulatory body, to have acted improperly.  More than once, I have had the down-the-rabbit-hole experience of making a demand against a clearing firm for a loss incurred by my client, a loss plainly attributable to the clearing firm’s error, only to have the clearing firm respond by demanding indemnification from my client for whatever amount the clearing firm may have to pay my client.  Logic doesn’t get much more circular than that.

This past week, an issue arose when one of my clients attempted to assign its clearing agreement to another broker-dealer that was going to acquire my client’s customer accounts. Like most, if not all, clearing agreements, this one recited that the clearing firm had to approve the assignment.  There’s nothing necessarily wrong with that.  In fact, here, the clearing firm consented to the assignment.  The problem arose, however, because the clearing firm deemed the assignment to be effective before the customer accounts actually transferred.  As a result of that interpretation, the clearing firm concluded that my client needed a new clearing agreement, to cover the time period until the customer accounts all transferred.  And it wanted a new clearing deposit.  And new monthly minimum payments.  And a new two-year term, with no early termination provision.

In response, we argued that the assignment was not effective, because FINRA had not approved it and, therefore, the existing clearing agreement still governed, but the clearing firm remained adamant. Indeed, the clearing firm was so adamant that it restricted my client’s customers to liquidating trades only for two complete trading days while we hashed this out.

I think the rules are pretty clear. FINRA Rule 4311(b)(1) requires that a clearing firm “submit to FINRA for prior approval any agreement for the carrying of accounts, whether on an omnibus or fully disclosed basis, before such agreement may become effective. The carrying firm also shall submit to FINRA for prior approval any material changes to an approved carrying agreement before such changes may become effective.”  It seemed clear to my client and me (and the assignee broker-dealer, as well) that an assignment of the clearing agreement was, indeed, a “material change,” especially considering that the Supplemental Material to Rule 4311 defines “material changes” to include “changes to: (a) the allocation of responsibilities required by this Rule; (b) termination clauses applicable to the introducing firm; (c) any terms or provisions affecting the liability of the parties; and (d) the parties to the agreement.”  How can an assignment from one broker-dealer to another not be reasonably viewed as a change to “the parties to the agreement?”

But, here’s where the story gets even goofier.  How did we end up fixing it?  By notifying FINRA.  In conversations to which I was not privy, FINRA – and, later, the SEC – apparently said something to the clearing firm that made it recant its position, and reinstate all trading privileges to my client’s customers.  I am not sure what was conveyed, but I presume that the clearing firm was advised that absent regulatory approval of the assignment, it was not effective, so my client remained the introducing firm under its clearing agreement.

I readily acknowledge that I routinely take shots at FINRA in this blog, and have been quick to point out those circumstances where its purported devotion to “investor protection” seems particularly illusory. But, here, I have nothing but praise for FINRA.  When advised of the facts, most importantly the fact that my client’s customers were being denied access to the markets except to effect liquidating trades, FINRA acted immediately and dramatically, and caused the clearing firm to rethink its formerly intractable position.  Nothing I was saying was going to change the clearing firm’s mind about the assignment.  But, when confronted by FINRA and the SEC, well, that was another story. That is investor protection, ladies and gentlemen, and I will be the first to admit it.

If only every story had this happy ending.

[1] Zecco Trading also got an injunction against Apex, for the same reason.  Both cases were subsequently settled, so it is likely that Apex backed down on its demands, at least somewhat.