NASD Regulation staff granted an exemption from paragraph (c)(1) of Rule 3020 where member demonstrated that it did not pursue the business proposal that would have required it to maintain higher net capital and a corresponding level of fidelity bond coverage.
October 18, 2001
Mr. William E. Floria
House of Securities Company
12 West Church Street
Frederick, MD 21701
Re: Exemption Request from Fidelity Bonding Requirements
Dear Mr. Floria:
This is in response to your September 6, 2001 letter, in which you request that House of Securities Company (the “Firm”) be exempt from the annual review and adjustment requirements of NASD Rule 3020(c)(1) because of a substantial change in the Firm’s business. As explained below, the staff of NASD Regulation, Inc.’s Office of General Counsel (the “staff”) grants your request for an exemption, effective as of the date of this letter.
Based on your letter and our subsequent telephone conversations on September 6, 2001, I understand the facts to be as follows. Before 1999, the Firm engaged in business that required it to maintain a net capital of only $25,000. In 1999, however, the National Securities Clearing Corporation (“NSCC”) required the Firm to increase its minimum net capital from $25,000 to $250,000 in anticipation of a business arrangement whereby the Firm would engage in transactions through NSCC. Consequently, the Firm increased its net capital to $250,000 and obtained a $300,000 fidelity bond policy to correspond to its new net capital level. In April 2001, the Firm requested that the NASD reduce the Firm’s required net capital back to $25,000 because its proposed business plan with the NSCC did not come to fruition. The NASD granted the Firm’s request in May 2001, but the Firm continued to maintain fidelity bond coverage of $300,000. You have asked the staff to exempt the Firm from Rule 3020(c)(1), which requires the Firm to maintain a $300,000 fidelity bond, so that the Firm may adjust its fidelity bond to correspond to its current net capital requirement of $25,000.
NASD Rule 3020 provides that each member that is required to join the Securities Investor Protection Corporation (“SIPC”) and that has employees must maintain a blanket fidelity bond, unless the member is covered by the fidelity bond requirement of a national securities exchange. The Rule applies to all members regardless of the type of business they conduct. The purpose of the fidelity bond is to protect the member against certain types of losses, including losses caused by the malfeasance of its officers and employees, and the effect of such losses on the member’s capital. The amount of required fidelity bond coverage is based on the member’s net capital requirements under the Securities Exchange Act of 1934 (“Exchange Act”).
Paragraph (c)(1) of Rule 3020 provides that a member must review the adequacy of its fidelity bond coverage on an annual basis, as of the anniversary date of the issuance of the original bond, and maintain an amount of fidelity bond coverage for the next 12 months that correlates to its highest net capital requirement for the previous 12 months. Paragraph (c)(4) of Rule 3020 permits NASD Regulation staff, where good cause is shown, to exempt members from the requirements under paragraph (c)(1) of the Rule.
As discussed in NASD Notice to Members 98-67 (August 1998), in considering an application for exemption from paragraph (c) of Rule 3020, NASD Regulation applies a “good cause” standard that requires a member to demonstrate that a modification from the bonding requirement is justified by the level of loss exposure that may be expected from the member. In addition, NASD Regulation will apply this authority only when it is clear that an exemption will not have any unintended impact on the insurance pool, and the modified coverage will adequately protect the member against potential losses. NASD Regulation also will include conditions in any exemption to ensure that any subsequent increase in capital requirements is accompanied by a corresponding increase in coverage.
Pursuant to Rule 3020(c)(1), the Firm must maintain minimum fidelity bond coverage of $300,000 because its highest net capital for the 12-month period preceding the anniversary date of the bond was $250,000, unless it receives an exemption from this requirement. According to your representations, the Firm did not ever implement the business proposal that required it to increase its net capital to $250,000. Thus, in the preceding 12 months, the Firm did not engage in any business activities that required a net capital of $250,000.
Based on the facts and representations contained in your letter and discussed in our telephone conversations, the staff grants the Firm’s request for an exemption from Rule 3020(c) so that the Firm may use its net capital of $25,000 (which went into effect in May 2001), instead of its highest net capital for the 12 months preceding the anniversary date of its bond, in its upcoming annual review of its fidelity bond coverage. The staff believes that granting the Firm this exemption is consistent with the standards discussed in NASD Notice to Members 98-67. Among other things, the level of loss exposure that may be expected from the Firm has not changed because the Firm did not engage in the new business activities, the anticipation of which caused the Firm to increase its net capital. The staff also believes that the adjusted fidelity bond coverage will continue to protect the Firm against potential losses based on its actual business activities. In addition, the staff does not believe that granting the Firm an exemption from Rule 3020(c) under the circumstances described herein will have a negative effect on the insurance pool.
We note that in its letter dated September 6, 2001, the Firm requested that the staff grant the Firm an exemption from Rule 3020(c) effective as of June 2001. The staff, however, is not willing to grant retroactive exemptive relief to the Firm, and the exemption described in this letter is effective as of the date of this letter.
In addition, the Firm should be aware that the net capital requirement is self-operative. Specifically, the Firm is required to increase its net capital requirement in accordance with the net capital provisions of the Exchange Act whenever it engages in any activity that would warrant such an adjustment. Moreover, the Firm should be aware that it is obligated to increase its corresponding fidelity bond coverage in the event there is an increase in its required net capital.
If you have any questions on this matter, please do not hesitate to contact me at (202) 728-8902.
Very truly yours,
|cc:||Cathleen Shine, Senior Vice President and Director
NASD Regulation, Inc., District 10