Brokerage Perspective on Freeriding vs. Good Faith Funding Violations

Today I will discuss freeriding and good faith funding violations.

I contacted TD Ameritrade (TDA) about the specific example described at the end of my last post and they said it would not be an issue. I would receive an e-mail over the weekend telling me the shares had been assigned and that I need to take immediate action to cover the position. I am clear provided I do this near the open on Monday morning. If I delay, then TDA has the right to apply discretion on a case-by-case basis. In so doing, they will make every effort to do what’s best for my account value and the brokerage.

Before I explain the brokerage perspective, I want to reference the SEC website with regard to “freeriding.” According to the SEC website, I am allowed to use unsettled funds to make a subsequent transaction in a cash account but I must wait until the initial funds settle before offsetting the subsequent transaction. Failure to do so is called freeriding. Covering the short with $191,000 of unsettled funds (recall that the account previously contained $100,000) is okay but continuing to trade with those funds before the $291,000 settles is not.

Freeriding is a violation of the Federal Reserve Board’s Regulation T, and brokers/dealers must suspend or restrict cash accounts for 90 days as a penalty. This shouldn’t be an issue with margin accounts because the funds may be borrowed until settlement clears. If a cash account is restricted, then securities may only be purchased using settled funds. Equity (option) transactions are settled two (one) business day after the transaction date.

TD Ameritrade makes a distinction between freeriding and a good faith violation. Here is an example of the latter:

• On Monday, I hold ABC stock.
• On Tuesday I sell ABC stock, which will settle on Thursday (two business days later).
• On Wednesday morning, I buy XYZ stock.
• On Wednesday afternoon, I sell XYZ stock for a profit.

My Wednesday morning purchase was done on good faith that the sale of ABC would settle thereby making the funds available. I am in violation because I did not wait for the ABC settlement before selling XYZ stock, which means I never fully paid for XYZ. For this, I would receive an e-mail explaining the violation. If I am in violation three times within 12 months, then my account will be restricted to using only settled funds for 90 days.

TDA regards freeriding as a situation where funds are never in the account. An example of this could involve a failed incoming ACH transfer. While ACH transactions may take up to two business days to settle, TDA makes the funds available immediately for marginable stock above $5 on a listed exchange (not options). Suppose that on the day I open a new account with a $25,000 ACH transfer, I buy $25,000 of QRS stock and sell later that afternoon for a 100% profit. If the $25,000 deposit never goes through, then I have committed a freeriding violation and profits will be seized.

In speaking with TDA, my confusion between freeriding and a good faith violation may be explained by limited margin they grant to retirement accounts. Margin is pledging securities as collateral for a brokerage loan. Accounts given tax-deferred (traditional IRA) or tax-exempt (Roth IRA) status are prohibited from accepting such loans and may lose their favorable tax status for doing so. The limited margin applied here is the ability to use unsettled funds for subsequent trades—not to provide leverage, but rather to prevent trip-ups resulting from specific, temporal oversights.