Regulatory Obligations and Related Considerations
Exchange Act Rule 15c3-1 (Net Capital Rule) requires that member firms must at all times have and maintain net capital at no less than the levels specified pursuant to the rule to protect customers and creditors from monetary losses that can occur when firms fail. Exchange Act Rule 17a-11 requires member firms to notify FINRA in the event their net capital falls below the minimum amount required by the Net Capital Rule.
If member firms have an affiliate paying any of their expenses, Notice to Members 03-63 (SEC Issues Guidance on the Recording of Expenses and Liabilities by Broker/Dealers) provides guidance for establishing an expense-sharing agreement that meets the standards set forth in Exchange Act Rule 17a-3;1 firms with office leases should apply the guidance in Regulatory Notice 19-08 (Guidance on FOCUS Reporting for Operating Leases) for reporting lease assets and lease liabilities on their FOCUS reports. Additionally, member firms must align their revenue recognition practices with the requirements of the Financial Accounting Standards Board’s Topic 606 (Revenue from Contracts with Customers).
- 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 your firm or an affiliate?
- How does your firm assess the potential impact to net capital for new, complex or atypical transactions? Does your firm involve regulatory reporting staff in the process to assess these types of transactions?
Findings and Effective Practices
- Incorrect Capital Charges for Underwriting Commitments: Not maintaining an adequate process to assess moment-to-moment net capital and open contractual commitment capital charges on underwriting commitments; not establishing and maintaining WSPs for calculating and applying open contractual commitment charges; failing to maintain an accurate record or log of underwritings in which the firm is involved; and not understanding the firm’s role in the underwriting (i.e., best efforts or firm commitment).
- Inaccurate Net Capital Deductions and Concentration Charges: Not maintaining an accurate process to accurately determine allowability and valuation of non-marketable securities (marketplace blockage); and not having an adequate process to conduct an internal credit analysis or an independent creditworthiness analysis of corporate and nonconvertible debt securities.
- Inadequate WSPs: Not maintaining adequate WSPs for calculating and applying haircuts for non-marketable inventory and conducting internal credit analysis or conducting an independent creditworthiness analysis of the firm’s holdings of corporate and nonconvertible debt securities.
- 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, resulting in firms not having adequate context to determine the proper accrual-based transaction date.
- Net Capital Assessment: Performing an assessment of net capital treatment of assets, to confirm that they were correctly classified for net capital purposes.
- Moment-to-Moment and Net Capital Compliance for Underwriting Commitments: Establishing and maintaining current WSPs for:
- calculating and applying open contractual commitment charges, as well as focusing on the product and proper haircut percentage;
- ensuring the firm’s role is clear within the agreement as it relates to its role in the underwriting (i.e., best efforts or firm commitment); and
- establishing a process to track open contractual commitments for which the firm is involved.
- Net Capital Deductions: Establishing a process to determine creditworthiness of inventory products; and maintaining WSPs for calculating and applying net capital deductions and haircuts for non-marketable inventory.
- Funding and Liquidity Topic Page
- Interpretations to the SEC’s Financial and Operational Rules
- Regulatory Notice 21-27 (FINRA Announces Update of the Interpretations of Financial and Operation Rules)
- Regulatory Notice 19-08 (Guidance on FOCUS Reporting for Operating Leases)
- 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)
1 Firms are reminded that any affiliate obligated to pay firm expenses must have the independent financial means to satisfy those obligations.