What Is a Good Faith Violation in Trading?

A good faith violation in trading is a rule infraction primarily occurring within cash brokerage accounts. This often misunderstood trading rule can lead to significant restrictions for investors. Understanding this concept is important for anyone engaging in securities transactions, as it directly impacts how and when funds can be used for trading.

Defining a Good Faith Violation

A good faith violation occurs when an investor purchases a security with funds that have not yet fully settled and then sells that security before the initial purchase funds officially clear. It involves using money that is expected to settle, rather than fully available cash. This scenario typically arises in cash accounts, where investors are required to pay for all security purchases in full by their settlement date.

The term “good faith” refers to the expectation that an investor will ensure sufficient settled funds are in their account to cover a purchase by its settlement date. When a security bought with unsettled funds is sold before those funds settle, it indicates that a good faith effort to deposit additional cash may not have been made.

This practice is addressed by regulatory bodies such as the Financial Industry Regulatory Authority (FINRA) and the Federal Reserve Board’s Regulation T. Settled funds are cash that has fully cleared from a deposit or from the sale of a security, making it available for immediate use or withdrawal.

Situations Leading to Violations

Good faith violations commonly arise from misunderstandings of trade settlement periods, particularly the recent change for most U.S. stocks. Until recently, most stock transactions settled on a T+2 basis, meaning two business days after the trade date. However, as of May 28, 2024, the U.S. stock market transitioned to a T+1 settlement cycle, which means most stock transactions now settle one business day after the trade date. This change aims to reduce risk and provide quicker access to funds.

One common scenario is “free riding.” This occurs when an investor buys a security without having sufficient settled cash, perhaps relying on a recent deposit that hasn’t cleared, and then sells that security before the initial payment settles. For example, if an investor deposits funds on Monday and immediately buys stock, then sells that stock on Tuesday before the Monday deposit has cleared, a violation occurs.

Another typical situation involves using unsettled proceeds from a prior sale. An investor might sell Stock A on Monday, generating proceeds that will settle on Tuesday (under T+1). If the investor then uses these unsettled proceeds to buy Stock B on Monday and subsequently sells Stock B on the same day or early Tuesday, before the proceeds from Stock A have settled, a good faith violation is triggered.

Impact of a Violation

When a good faith violation occurs, brokerage firms typically issue warnings. Repeated violations can lead to more significant consequences. If an investor incurs three good faith violations within a rolling 12-month period, their cash account will face a restriction for 90 days.

During this 90-day restriction, the account holder can only purchase securities if they have fully settled cash available in their account before placing a trade. This means the investor cannot use unsettled funds or the proceeds from new sales to cover purchases until those funds have completely settled. While the account remains active, the ability to trade with unsettled funds is temporarily removed, forcing a more cautious approach to transactions.

Avoiding Violations

Preventing good faith violations involves understanding the settlement process for securities transactions. Always ensure that funds are fully settled before using them to purchase new securities, especially if there is an intention to sell those newly purchased securities quickly.

Investors should closely monitor settlement dates for both deposits and sales within their brokerage accounts. Since most stock trades now settle on a T+1 basis, waiting at least one business day after a sale for the proceeds to settle before making new purchases that might be sold quickly is a practical approach. Understanding the specific rules and notifications provided by your brokerage regarding unsettled funds can also help. For investors who frequently trade, a margin account could be an alternative, though it introduces different risks.