Securities and Exchange Commission- Settlement Rule Change

 Settlement Rule Change

Effective on September 5, 2017, the Securities and Exchange Commission (SEC) amended the Securities Exchange Act of 1934 to shorten the standard settlement cycle for most broker-dealer transactions from three business days after the trade date (T+3) to two business days after the trade date (T+2). The amended rule applies the T+2 settlement cycle to the same securities transactions that are currently covered by the T+3 settlement cycle. These include transactions for stocks, corporate bonds, municipal securities, exchange-traded funds, and limited partnerships. Ultimately, the changing of the settlement rule (SEC Rule 15c6-1) to T+2 effects both SEC and SRO rules (including FINRA and the MSRB). However, settlement rule change does not impact transactions involving U.S. Treasury securities or options, since these trades will continue to settle on the next business day.

For exam purposes, this amendment will impact a number of different settlement-related provisions. The content below will provide students with both a summary and various examples of questions to illustrate how the change of regular-way settlement will impact regulatory exams. View the video below to learn more about the T+2 Settlement Update and what this could mean for you.

 

Concept: Impact:
Regular-Way Settlement Secondary market transactions involving corporate and municipal securities will now settle two business days after the trade date.
Accrued Interest For trades involving corporate and municipal bonds, accrued interest is calculated from the last coupon date and then up to, but not including, the settlement date. The settlement date is now two business days after the trade date.
Ex-Dividend Date For stocks, the ex-dividend date is now one business day prior to the record date.
Equity Option Exercise If an equity option is exercised, the settlement date for the resulting stock transactions is now two business days after the exercise date.
Regulation T Payment Date According to Regulation T, transactions that are executed in either cash or margin accounts must be paid for within two business days of settlement. This now means that payment is due within four business days of the trade date
(i.e., T+4 or S+2).If customer payment is not made by T+4, the broker-dealer may execute a close-out (sell the securities) on the day after payment was due (T+5).
Regulation SHO – Rule 204 This rule requires a broker-dealer that sells an equity security to either deliver the security by settlement date (T + 2) OR immediately purchase or borrow the security by no later than the beginning of trading on the next settlement day (T+3).

Exceptions:

§ Long Sales and Bona Fide Market Making Activities – If the fail was a result of a long sale or a broker-dealer’s bona fide market making activities, the close-out requirement is three settlement days following the settlement date (T +5).

(Bona fide market making includes a registered market maker, an options market maker, and other market makers that are obligated to quote OTC equities.)

In both of these situations, the broker-dealer is granted two extra settlement (business) days

 

SEC Rule 15c3-3 (The Customer Protection Rule) If a broker-dealer executes a sell order for a customer and if, for some reason, it has not obtained possession of the securities from the customer within 10 business days after the settlement date, the broker-dealer must immediately close out the transaction by purchasing the security.

§ Under T+3 this had meant 13 business days from the trade date. However, now with T+2 settlement, this changes to 12 business days from the trade date.

FINRA Rule 2341 (Investment Company Securities) Prompt Payment for Investment Company Shares

According to this rule, member firms (including underwriters) that engage in direct retail transactions for investment company shares are required to transmit the payments they receive from customers for the shares (which the members sold to customers) to the payees (i.e., underwriters, investment companies, or their designated agents) by the later of:

A. The end of the second business day (previously three business days) following a receipt of a customer’s order to purchase the shares or

B. The end of one business day following the receipt of a customer’s payment for the shares.

 

Here some sample new test questions…

Regular-Way Settlement 

Which of the following securities use a regular-way settlement of T + 2?

  1. Convertible bonds
    B. Mutual fund shares
    C. U.S. Treasury bills
    D. Equity options

Answer: (A) Corporate and municipal securities transactions settle on a regular-way basis, which is two business days after the trade date (T + 2). Mutual fund shares typically settle on the same day as the trade, while Treasury securities and option contracts settle on the business day after the trade (T + 1). Keep in mind that if an equity option is ultimately exercised, it involves the purchase and sale of a corporate security and, therefore, the stock transaction settles T + 2.

In a municipal bond transaction, “T + 2” indicates that:

  1. The bond trades with a 2-point premium
    B. The bond trades with an additional takedown of 2 points
    C. The transaction will settle on a regular-way basis, which is two business days after the trade date
    D. Two bonds will be delivered on the settlement date

Answer: (C) In a municipal bond transaction, T + 2 indicates that the bonds will settle on a regular-way basis, which is two business days after the trade date.

Accrued Interest

On Monday, June 15, an investor purchases $20,000 of 6% ABC Corporation bonds for regular-way settlement. The bonds have a maturity date of November 1, 2028. How many days of accrued interest will the buyer owe the seller of the bond?

  1. 16
    B. 46
    C. 48
    D. 227

Answer: (B) Since the bonds mature on November 1, it can be surmised that the semiannual interest payments are made on November 1 and May 1. Since the bonds were purchased in June, accrued interest is calculated from the last interest payment date (May 1) up to, but not including, the settlement date. Since the trade date was Monday, June 15, the settlement date is Wednesday, June 17 (two business days after the trade date). Since this is a corporate bond, accrued interest is calculated using a 30-day month and a 360-day year. The number of accrued days is 30 days for May and 16 days for June for a total of 46 days. The process for determining accrued interest for Treasury securities does not change since their settlement date remains the next business day after the trade (T + 1).

Ex-Dividend Date

An investor owns 100 shares of XYZ common stock. A dividend is declared on May 28 and will be paid to owners of record on Tuesday, June 15. When is the ex-dividend date for the stock?

  1. Thursday, June 10
    B. Friday, June 11
    C. Tuesday, June 15
    D. Monday, June 14

Answer: (D) The ex-dividend date is the first date on which a purchaser of stock is not entitled to a dividend that has been declared. This date is one full business day before the record date. In this example, since the record date is Tuesday, June 15, the ex-dividend date is Monday, June 14.

A company declares a dividend which is payable on June 5 to stockholders of record on May 20. If an investor purchases the stock on Tuesday, May 19 for regular-way settlement, he:

  1. Is entitled to the dividend
    B. Is not entitled to the dividend since the stock is already selling ex-dividend
    C. Is entitled to a due bill
    D. Cannot settle the trade until June 5

Answer: (B) To be entitled to a dividend, a purchaser’s transaction must settle on or before the record date. For stocks, the ex-dividend date is one business day before the record date. The investor who purchased the stock on Tuesday, May 19 will not become the owner of the stock until Thursday, May 21 since the settlement of a stock transaction occurs two business days after the trade date. This investor is not entitled to the dividend since he needed to be the owner of record by Wednesday, May 20.

Equity Option Exercise

If the Options Clearing Corporation assigns an exercise notice on Monday, May 2 for an equity call option, on what day will the called stock trade settle?

  1. Wednesday, May 4
    B. Thursday, May 5
    C. Monday, May 2
    D. Friday, May 6

Answer: (A) If an equity option contract is exercised, the settlement of the stock transaction between the brokers is two business days after the date of exercise.

Regulation T Payment Date

A customer purchases 100 shares of MNO at $24 per share in a cash account. Which TWO of the following statements are TRUE regarding this transaction?

  1. The settlement date is two business days after the trade.
    II. The settlement date is three business days after the trade date.
    III. The Regulation T payment date is four business days after the trade date.
    IV. The Regulation T payment date is five business days after the trade date
  2. I and III
    B. I and IV
    C. II and III
    D. II and IV

Answer: (A) Stock transactions settle on the second business day after the trade date between the two firms that are involved in the trade. According to Regulation T, customers must pay for their transactions being executed in either cash or margin accounts by the second business day following regular-way settlement. Since regular-way settlement for stock transactions is two business days after the trade date, customers have four days to pay for their purchases. The payment date may be expressed as either two business days after settlement (S + 2) or four business days after a regular-way trade (T + 4).

According to Regulation T, when an investor purchases an option contract, the transaction must be paid for within:

  1. One business day
    B. Two business days
    C. Three business days
    D. Four business days

Answer: (D)  Although option transactions have a unique settlement date, which is the business day following the trade date (T + 1), they fall under the Regulation T payment rule that applies to corporate securities. According to Regulation T, corporate securities must be paid for within two business days of the regular-way settlement date. Since regular-way settlement is two business days after the trade date, option purchasers are given a total of four business days after the trade date to pay for the purchase.

Regulation SHO – Rule 204

A broker-dealer has a fail-to-deliver position as a result of bona fide market-making activities and not being able to deliver stock by the settlement date. Under SEC Regulation SHO, the firm must:

  1. Purchase or borrow the security immediately
    B. Purchase or borrow the security within three settlement days
    C. Purchase or borrow the security within 13 settlement days
    D. Purchase or borrow the security within 35 settlement days

Answer: (B) In order to further reduce the number of fail-to-deliver positions, the SEC adopted Rule 204 to Regulation SHO. This rule requires a broker-dealer that sells an equity security to either deliver the security by settlement date (T + 2), or immediately purchase or borrow the security by no later than the beginning of trading on the next settlement day (T + 3). In Regulation SHO, the term settlement day has the same meaning as business day. If the fail was the result of bona fide market-making activities by the broker-dealer, the close-out requirement is three settlement days following the settlement date (T + 5).

SEC Rule 15c3-3 – The Customer Protection Rule

When a customer sells securities through a broker-dealer, a mandatory buy-in is required if the broker-dealer does not receive securities from the customer by the:

  1. Tenth business day following the trade date
    B. Tenth business day preceding the settlement date
    C. Tenth calendar day following the settlement date
    D. Tenth business day after the settlement date

Answer: (D) Rule 15c3-3 requires a broker-dealer to obtain possession of securities within a reasonable time. If a customer enters a sell order for securities and, for some reason, fails to deliver the securities within 10 business days of the settlement date (T+ 12), the broker-dealer must buy-in the customer. Under exceptional circumstances, the broker-dealer may apply to FINRA for an extension.

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