What is a Good Faith Violation?
A good faith violation occurs in a cash brokerage account when an investor purchases a security with cash that has not yet officially settled, and then sells that security before the proceeds from the initial purchase have settled. Essentially, it means you've used money that isn't yet fully "yours" (or cleared in your account) to make a new trade, and then tried to liquidate that new position before the first transaction's funds were finalized.Understanding Settlement Periods
To grasp good faith violations, it's crucial to understand how trades settle. In the United States, most stock and bond transactions adhere to a **T+2 settlement period**. This means that when you buy or sell a security, the actual transfer of ownership and funds isn't immediate. It takes two business days (Trading Day + 2 Business Days) for the transaction to be finalized. For example, if you sell a stock on Monday (T), the cash from that sale will not be available in your account as "settled funds" until Wednesday (T+2).This concept is vital because a good faith violation stems from not waiting for these funds to settle. Your brokerage account typically differentiates between "cash available for trading" (which might include unsettled funds) and "cash available for withdrawal" or "settled cash."
How a Good Faith Violation Happens
The violation unfolds in a specific sequence:- You sell a security. The proceeds from this sale are not immediately settled cash.
- You use those unsettled proceeds to buy a new security. This is permitted as "good faith" that the initial sale will settle.
- You then sell the newly purchased security before the proceeds from your original sale have settled. This is where the violation occurs. You've effectively sold something (the second security) that was bought with funds that hadn't yet been fully cleared and received from your first sale.
Example Scenario:
Let's illustrate with a timeline:
- Monday (Day 1): You own Stock A and sell it for $5,000. These funds are "unsettled" and will clear on Wednesday (T+2).
- Monday (Day 1) or Tuesday (Day 2): Believing you have $5,000, you use these unsettled funds to buy Stock B.
- Tuesday (Day 2): Before the $5,000 from Stock A has settled (which happens on Wednesday), you sell Stock B.
This sequence constitutes a good faith violation because you sold Stock B using proceeds from Stock A that had not yet fully settled. The brokerage firm extended you "good faith" that your initial sale would complete, but by selling the subsequent purchase prematurely, you broke that good faith.
Consequences of a Good Faith Violation
Brokerage firms are required to enforce rules around good faith violations to comply with regulations. Repeated good faith violations can lead to:- Account Restrictions: Your account might be restricted to trading only with fully settled funds. This means you would have to wait until funds are settled before placing a new trade.
- Cash Account Freezes: In severe or repeated cases, your brokerage account could be frozen for a period, typically 90 days. During this time, you may only be able to place buy orders if you have enough settled cash in your account before placing the order.
- Suspension of Trading Privileges: For persistent violations, your ability to trade might be temporarily or permanently suspended.
How to Avoid Good Faith Violations
Avoiding these violations is straightforward if you understand the settlement cycle and manage your cash appropriately:- Wait for Funds to Settle: The simplest solution is to wait for your sale proceeds to fully settle (T+2) before using that cash to buy new securities.
- Use Fully Settled Cash: Always ensure you have enough fully settled cash in your account before initiating a new purchase. This cash could be from prior settled sales or recent deposits that have cleared.
- Maintain Sufficient Cash Balance: Keeping a cash reserve in your brokerage account can prevent situations where you rely on unsettled funds for new trades.
- Understand Your Brokerage Statements: Pay close attention to the "cash available for trading" versus "cash available for withdrawal" figures on your account statements.
- Contact Your Broker: If you're unsure about the settlement status of funds or specific trades, contact your brokerage firm for clarification. They can provide precise settlement dates.
- Be Mindful of Short-Term Trading: If you frequently buy and sell securities within a few days, you are at a higher risk of committing this type of violation.
Understanding and adhering to settlement periods is crucial for smooth and compliant trading, especially in a cash brokerage account. For more information on trade settlement, you can refer to resources from regulatory bodies like FINRA, which explain what T+2 settlement means.
