Regulation T Free-Riding Violation: Causes and 90-Day Account Restriction
In a cash brokerage account with zero unsettled funds, an investor purchases $20,000 of stock on Monday morning. On Tuesday afternoon, before depositing funds to pay for the purchase, the investor sells the entire position for $22,000 and attempts to use the sales proceeds to pay for Monday's purchase. What regulatory violation has occurred, and what penalty is imposed under Federal Reserve Regulation T?
Selling securities in a cash account before paying for them is 'free-riding'. Regulation T mandates freezing the account for 90 days (cash upfront required).
Complete Analysis & Legal Rationale
Under Federal Reserve Regulation T, securities purchased in a cash account must be paid for in full before they are sold. Selling a security prior to paying for it and attempting to use the sales proceeds to cover the original purchase is an unlawful practice known as 'free-riding.' When free-riding occurs, the broker-dealer must freeze the customer's account for 90 days. During this 90-day freeze, the customer may still trade, but cash sufficient to cover the trade must be on deposit in the account PRIOR to order entry.
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
Cash accounts require full payment before sale; day-trading without settling violates Regulation T.
Free-riding triggers a mandatory 90-day cash-upfront account restriction under Regulation T.
Churning is excessive trading by a broker with control over an account to generate commissions, unrelated to customer free-riding.
Profits are not seized by SIPC (SIPC protects against broker-dealer bankruptcy, not trade discipline).
Official Standard: Establishes payment deadlines and mandates a 90-day account freeze when securities are sold prior to settlement payment.