Clearance and Settlement

The settlement cycle

SEC Rule 15c6-1 prohibits a broker-dealer from entering into a contract for the purchase or sale of a security that provides for payment of funds and delivery of securities later than the first business day after the trade date, unless the parties expressly agree otherwise at the time of the transaction. That is T+1, and it is the default for equities, corporate bonds, municipal bonds and most everything else a retail customer trades.

The rule by its terms excludes exempted securities, government securities, municipal securities, commercial paper, bankers' acceptances and commercial bills. Those are outside the SEC rule, but they are not outside a settlement convention — government and municipal securities settle on the next business day under market practice and, for municipals, under MSRB uniform practice rules. The practical answer for the exam is that essentially everything settles T+1; the rule's carve-outs matter because a question may ask which securities Rule 15c6-1 does not cover.

The rule also carves out contracts for limited partnership interests that are not listed or quoted, security-based swaps, and — a narrow but real exception — securities priced after 4:30pm Eastern and sold by an issuer to an underwriter in a firm commitment registered offering, which may settle on the second business day.

Settlement terms other than regular way exist and must be agreed at the time of the trade.

Cash settlement is same day. Both sides perform on the trade date, and cash trades are typically executed by an earlier deadline in the day.

Seller's option gives the seller the right to deliver on a later specified date, usually with a minimum of a few business days' notice.

When-, as- and if-issued transactions cover securities that have been authorized but not yet issued, such as a new municipal issue between award and delivery. There is no settlement date until the securities exist; confirmations state the terms and the date is set later.

Dividends, rights and the ex-date

The settlement cycle determines the ex-date, because a buyer must settle by the record date to be on the books.

Under T+1, a purchase on the record date settles the following business day and therefore misses the record. So the ex-dividend date is the same business day as the record date, and a customer must buy at least one business day before the record date to receive the dividend. The exam's older material puts the ex-date one or two business days before the record date, which reflects the previous T+2 and T+3 cycles.

The stock's price is reduced by the dividend on the ex-date, and open orders resting below the market — buy limits and sell stops — are reduced accordingly, unless marked do not reduce.

A due bill is the instrument that corrects an error of timing: if a security is delivered without a distribution that belongs to the buyer, a due bill accompanies it entitling the buyer to the distribution when it is paid. A due bill check does the same for cash.

Ex-rights works the same way for a rights distribution, and lesson 2.3's two valuation formulas — cum rights and ex rights — are applied on either side of that date.

Good delivery

Good delivery is the set of conditions a delivery must meet to satisfy the contract. In a book-entry world most of it happens invisibly, but the exam tests the rules because they still govern physical certificates and because they explain what the systems automate.

Equities are delivered in units of 100 shares or in multiples or divisors of 100 that add to the round lot. Certificates must be endorsed by the registered owner or accompanied by a stock power, and the signature must match the registration exactly and be guaranteed by a member firm or eligible institution.

A certificate registered to two persons requires the endorsement of both. A certificate registered to a deceased owner requires the appropriate legal documentation from the estate. A mutilated certificate is not good delivery unless authenticated by the transfer agent.

Bonds are delivered in $1,000 denominations or multiples up to $100,000, with coupons attached where applicable.

Book-entry delivery through the depository is the norm, and the Direct Registration System allows an investor to hold securities registered in their own name on the issuer's books without a physical certificate.

Delivery versus payment and receive versus payment — DVP and RVP — are institutional settlement instructions under which securities move only against simultaneous payment. They are also an account type, since an account set up for DVP settlement is documented differently from a retail account.

When the two sides do not agree about a trade, the party that does not recognize it sends a don't know notice — a DK — and the discrepancy is resolved through the uniform practice procedures. Reclamation is the process by which a delivery already accepted is returned because it was not good delivery.

Transferring an account

A customer moving to another firm does not sell and repurchase; the account is transferred in kind through the Automated Customer Account Transfer Service, governed by FINRA Rule 11870.

The customer signs a transfer instruction form at the receiving firm, which submits it to the carrying firm. Within one business day following the establishment of the transfer instruction, the carrying member must either validate the instruction or take exception to it — for example because the account number does not match, or because there is a lien or an unresolved debit.

Once validated, the carrying member must complete the transfer within three business days.

The carrying firm may not use the transfer as an opportunity to solicit the customer to stay, and it must transfer positions that are transferable in kind. Assets that cannot be transferred — proprietary funds not offered by the receiving firm, for instance — must be handled under the customer's instructions, which usually means liquidating or leaving them behind.

FINRA Rule 2273 requires a firm recruiting a registered representative from another firm to deliver an educational communication to that representative's former customers who are contacted about transferring, prompting them to ask about costs, tax consequences, assets that will not transfer, and any differences in products and services. It exists because an account transfer initiated by a representative's move is the one the customer has thought about least.

MSRB Rule G-26 sets the parallel requirements for municipal account transfers.