Regulatory Obligations and Related Considerations
Exchange Act Rule 15c3-1 (Net Capital Rule) requires that firms must at all times have and maintain net capital at specific levels to protect customers and creditors from monetary losses that can occur when firms fail. Exchange Act Rule 17a-11 requires firms to notify FINRA in the event their net capital falls below the “minimum amount required” by the Net Capital Rule.
- How does your firm review its net capital treatment of assets to confirm that they are correctly classified for net capital purposes?
- How does your firm confirm that it has correctly identified and aged all failed-to-deliver contracts, properly calculated the applicable net capital charges and correctly applied the deductions to its net capital calculation?
- For firms with expense sharing agreements, what kind of allocation methodology does your firm use and what kind of documentation does your firm maintain to substantiate its methodology for allocating specific broker-dealer costs to the firm or an affiliate?
Exam Findings and Effective Practices
- Inaccurate Classification of Receivables, Liabilities and Revenue – Incorrectly classifying receivables, liabilities and revenues, which resulted in inaccurate reporting of firms’ financial positions and, in some instances, a capital deficiency; incorrectly classifying non-allowable assets, such as large investments in certificates of deposit (CDs) because firms did not have a process to assess the net capital treatment of CDs pursuant to Exchange Act Rule 15c3-1(c)(2)(vi)(E); and not reviewing account agreements for CDs to determine whether they contained stipulations restricting withdrawals prior to maturity, including restricting their withdrawal or giving the bank discretion to permit or prohibit their withdrawal.
- Failed to Deliver and Failed to Receive Contracts (Fails) – Not having a process to correctly identify, track and age intra-month and end of the month Fails for firms’ operating an Exchange Act Rule 15a-6 chaperoning business, including:
- Inaccurate Net Capital Charge – Failing to compute and apply the correct applicable net capital charge for aged Fails;
- No Information from Clearing Firm – Failing to request or confirm receipt of timely information relating to Fails from their clearing firms;
- Gaps in Policies and Procedures – Failing to address monitoring, reporting and aging of Fails in firms’ policies and procedures;
- Incorrect Balance Sheets and FOCUS Reports – Failing to record Fails on firms’ balance sheet, and, as a result, filing incorrect FOCUS reports; and
- No Blotters – Failing to maintain blotters for Fails.
- Incorrect Capital Charges for Underwriting Commitments – Not maintaining an adequate process to assess moment-to-moment and open contractual commitment capital charges on underwriting commitments, and not understanding their role as it pertained to the underwriting (i.e., best efforts or firm commitment).
- Inaccurate Recording of Revenue and Expenses – Using cash accounting to record revenue and expenses as of the date the money changes hands, rather than accrual accounting (where firms would record revenue and expenses as of the date that revenue is earned or expenses are incurred); and making ledger entries as infrequently as once per month, as a result of which firms did not have adequate context to determine the proper accrual-based transaction date.
- Insufficient Documentation Regarding Expense-Sharing Agreements – Not delineating a method of allocation for payment; not allocating (fixed or variable) expenses proportionate to the benefit to the broker-dealer; or not maintaining sufficient documentation to substantiate firms’ methodologies for allocating specific broker-dealer costs—such as technology fees, marketing charges, retirement account administrative fees and employees’ compensation—to broker-dealers or affiliates.
- Net Capital Assessment – Performing an assessment of their net capital treatment of assets, including CDs, to confirm that they were correctly classified for net capital purposes.
- Agreement Review – Obtaining from, and verifying with, banks the withdrawal terms of any assets, with particular focus on CD products, and reviewing all of the agreement terms, focusing on whether withdrawal restrictions may affect an asset’s classification and its net capital charge for the terms of all assets, including CDs, and reviewing all of the agreement terms, focusing on whether withdrawal restrictions may affect an asset’s classification and its net capital charge.
- Training and Guidance – Developing guidance and training for Financial and Operational Principal and other relevant staff on Net Capital Rule requirements for Fails, including how to report Fails on their balance sheets, track the age of Fails and, if necessary, calculate any net capital deficit resulting from aged Fails.
- Aging Review – Performing reviews to confirm that they correctly aged Fail contract charges and correctly applied a net capital deduction, when applicable, to their net capital calculation.
- Collaboration with Clearing Firms – Clarifying WSPs to address clearing firms’ responsibilities regarding net capital requirements, including for Fails, and introducing firms engaging their clearing firms to confirm that:
- introducing firms were receiving a record of all Fails on a daily basis (or at least monthly);
- clearing firms’ reports included all of the required information; and
- introducing firms were correctly interpreting the clearing firms’ reports (especially distinctions between trade date and settlement date and those dates’ implications for aging calculations for Fails).
- Interpretations of Financial and Operational Rules
- Regulatory Notice 15-33 (Guidance on Liquidity Risk Management Practices)
- Regulatory Notice 10-57 (Funding and Liquidity Risk Management Practices)
- Notice to Members 03-63 (SEC Issues Guidance on the Recording of Expenses and Liabilities by Broker/Dealers)
- Funding and Liquidity Topic Page