What Is a Good Faith Violation? How to Avoid One
Navigate the rules of trading to avoid good faith violations and maintain smooth account operations.
A good faith violation occurs in a cash brokerage account when an investor buys and then sells securities without fully paying for the initial purchase with settled funds.
Understanding Good Faith Violations
Settled funds refer to cash that is fully available in an account, either from a new deposit or from the proceeds of a previous security sale that have completed their settlement period. This distinction is important because while funds from a sale may appear immediately in an account, they are not immediately “settled” for the purpose of new purchases and subsequent sales.
These rules primarily apply to cash accounts, which differ from margin accounts where investors can borrow funds from their brokerage to make purchases. The framework for these regulations stems from broader financial industry guidelines, including those established by the Financial Industry Regulatory Authority (FINRA), such as FINRA Rule 4210, and provisions within the Securities Exchange Act of 1934, specifically Section 7. These regulations serve to maintain orderly markets and ensure that investors trade with appropriate funding.
How a Good Faith Violation Occurs
A good faith violation typically occurs due to the settlement period for securities transactions. Most stock trades in the U.S. settle on a T+1 basis, meaning trade date plus one business day. This period is the time it takes for the ownership of securities to officially transfer to the buyer and for the cash payment to officially transfer to the seller.
Consider an example: an investor sells Stock A on Monday, generating proceeds. While these proceeds may be immediately visible and available for new purchases, they will not officially settle until Tuesday (T+1). If the investor then uses these unsettled funds on Monday to buy Stock B, and subsequently sells Stock B before the proceeds from Stock A have settled on Tuesday, a good faith violation occurs. This is because the sale of Stock B was made using funds that had not yet cleared the settlement process for the original purchase.
The violation happens when the security bought with unsettled funds is liquidated before those funds become settled. This sequence demonstrates a lack of “good faith” in ensuring the initial purchase was adequately covered by finalized funds. Such scenarios are common in cash accounts where investors may not fully account for the settlement timeline when engaging in rapid buying and selling.
Consequences of a Good Faith Violation
Incurring a good faith violation can lead to specific restrictions on an investor’s cash account. A common consequence is a “cash account restriction” or “90-day freeze.” If an investor receives three good faith violations within a 12-month rolling period, their brokerage firm will typically restrict the account for 90 calendar days.
During this restriction, the investor will only be able to purchase securities if they have sufficient settled cash in their account before placing a trade. This means they cannot use unsettled funds or the proceeds from a new sale until those funds have fully settled. The purpose of this restriction is to prevent further violations and encourage compliance with settlement rules. More severe restrictions, including an account being limited to “sell only” for a period, can occur if an investor accumulates a higher number of violations, such as four or five within the 12-month period.
Avoiding Good Faith Violations
Preventing good faith violations involves careful management of settled and unsettled funds within a cash brokerage account. The most direct way to avoid a violation is to ensure that all new purchases are made with fully settled cash. This means waiting for the proceeds from any security sales to complete their T+1 settlement period before using those funds for another purchase.
Investors should regularly monitor their account balances and settlement dates, which are typically available through their brokerage’s online platform. If active trading is desired, some investors consider a margin account, which allows for borrowing funds from the brokerage. While margin accounts do not incur good faith violations, they come with their own set of risks, including the potential for significant losses and interest charges, and require careful consideration. If there is any uncertainty regarding fund status or settlement, consulting with the brokerage firm directly can provide clarity and help prevent inadvertent violations.