United States: SEC Adopts Changes To Broker-Dealer Net Capital And Financial Responsibility Rules

The US Securities and Exchange Commission recently adopted important changes to the financial responsibility rules for securities broker-dealers, including changes to the regulatory capital and regulatory reporting rules. The new rules include important regulatory capital changes in relation to acting as agent in securities lending, assumption of broker-dealer expenses, and important new recordkeeping and reporting rules relating to compliance with risk mitigation and financial responsibility.

Introduction

Summary of the Rule Changes

On July 30, 2013, the US Securities and Exchange Commission (the "SEC") adopted changes to its financial responsibility rules for securities broker-dealers, and, in particular, adopted important changes to Rule 15c3-1, the "net capital rule."1 The net capital rule is the principal SEC rule governing regulatory capital requirements for securities broker-dealers in the United States. The rule changes also amend Rule 15c3-3, which is known as the "customer protection rule." The customer protection rule is the principal SEC rule requiring segregation of customer assets. While a number of highly technical changes are made to the customer protection rule, the most important modification to the customer protection rule involves the regulatory codification of existing SEC guidance regarding the treatment of proprietary accounts of broker-dealers that are held by other broker-dealers. Finally, the rule changes require broker-dealers carrying over $20 million in net capital to document their procedures for managing risk and maintaining liquidity.

Procedural History

The SEC first proposed the now-adopted rule changes on March 9, 2007.2 In 2012, the SEC re-opened the public comment period. The rule changes, as adopted, become effective 60 days following publication in the Federal Register. The new reporting rules are generally effective during 2014. Attached at Appendix I to this note is a chart summarizing the effective dates of the various provisions. The new Form Custody, as included in the Adopting Release, is also included as an attachment to this note. The changes to the net capital rule and customer protection rule are of necessity detailed and complex, and this summary will, similarly, necessarily be incomplete.

Overview of the Net Capital Rule and the Customer Protection Rule

Overview of the Net Capital Rule

The net capital rule, SEC Rule 15c3-1, is the principal rule by which the financial health of US broker-dealers is regulated and monitored. The net capital rule requires US broker-dealers to maintain "net capital" (i.e., capital in excess of liabilities) in specified amounts that are determined by the types of business conducted by the broker-dealer. The net capital rule is designed to ensure the ready availability of funds and securities to customers, and that a broker-dealer that is forced to liquidate will have sufficient assets to be able to return funds and securities promptly to creditors and customers.

The net capital rule is a highly detailed and technical rule that requires broker-dealers to compute net worth based on US generally accepted accounting principles ("GAAP"), as modified by the various provisions and interpretations of the rule. Broker-dealers must ensure that at all times net worth is maintained above a minimum required amount.

The net capital rule permits broker-dealers to follow either a "basic" method or an "alternative" method in order to comply with the rule. The "basic" method requires a broker-dealer to first compute its "aggregate indebtedness" and then generally limits such aggregate indebtedness to 800% of the broker-dealer's net capital in its first year of business, and 1,500% thereafter. Under the "alternative" method, a broker-dealer may not permit its net capital to be less than the greater of (a) $250,000 or (b) 2% of aggregate debit items, computed in accordance with the customer protection rule (described below). A broker-dealer must affirmatively elect to use the alternative method for computing net capital, and must notify its designated examining authority (usually FINRA) of that election.

The computation of net worth is subject to certain modifications, including for unrecognized profit and unrealized losses, marked-to-market value of securities, exclusion of subordinated debt, deduction for haircuts of securities (specified in the rule but subject to adjustment), money market instruments or options, deductions for "undue concentration" and deductions for "open contractual commitments" (a term that includes underwriting agreement commitments). In general, these modifications are very conservative (as compared to GAAP), and require deductions from net worth to account for risk activities of the broker-dealer. Rules governing the inclusion of subordinated debt in the net capital computation, the amount of outstanding debt that can be held by a broker-dealer and the withdrawal of equity capital by owners of the broker-dealer, are also part of the net capital rule.

Overview of the Customer Protection Rule

SEC Rule 15c3-3, which is commonly known as the "customer protection rule," is intended to protect customers' funds held by their broker-dealers and prohibit broker-dealers from using customer funds and securities to finance any part of their business that is unrelated to servicing securities customers. The rule requires a broker-dealer that maintains custody of customer securities and cash to comply with two primary requirements. First, the rule requires broker-dealers to maintain physical possession or control over customers' fully paid and excess margin securities. For purposes of the first requirement, physical possession or control means that the broker-dealer must hold fully paid and excess margin securities in certain specified locations and that the securities shall remain free of any liens or other security interests. One such permissible location is a US bank. A broker-dealer can establish possession and control for purposes of the customer protection rule by holding securities in non-US control locations (called "foreign control locations"); provided that the non-US custodian provides certain representations to the US broker-dealer regarding the status of the securities and the absence of liens.

Second, the broker-dealer must maintain a reserve of cash or qualified securities in an account at a bank that is at least equal in value to the net cash the broker-dealer owes to customers. The calculation of net cash set forth in the customer protection rule requires that the broker-dealer add all customer credit items (such as an amount equal to any free cash in customer securities accounts) and deduct from such credit items, any customer debit items (such as margin loans). The net amount by which customer credit items exceed customer debit items, if any, must be on deposit in the broker-dealer's customer reserve account.

Deposits in the broker-dealer's customer reserve account must take the form of cash or certain qualified securities. Generally, weekly computations of the reserve are required. As the reserve account is for the exclusive benefit of customers, funds may not be withdrawn unless an updated reserve formula calculation reflects that the reserve requirement has decreased.

Summary of the Net Capital Rule Changes

Amendments to Stock Lending Practices: Required Disclaimer of Principal Status and New Reporting Requirements

In light of certain broker-dealer failures, the SEC has shown concern that certain broker-dealers are both taking on excess leverage through stock lending, and also treating as agency transactions stock lending for which the broker-dealer holds principal risk.

The amended net capital rule therefore clarifies that broker-dealers providing securities lending and borrowing settlement services are deemed to be acting in a principal capacity for purposes of the net capital rule, and therefore subject to capital deductions in respect of such provisions. However, a broker-dealer can avoid these deductions if, as part of participation in a securities loan:

  • the broker-dealer has fully disclosed the identity of each party to the other;
  • each party has expressly agreed in writing that the obligations of the broker-dealer do not include a guarantee of performance by the other party; and
  • the parties agree that their remedies in the event of a default by the other party do not include a right of setoff against obligations, if any, of the broker-dealer. In order to identify broker-dealers that are highly leveraged as a result of stock lending activities, the SEC also adopted an amendment to reporting Rule 17a-11. This new provision requires a broker-dealer to notify the SEC if the total amount of money payable (as a principal liability) against all securities loaned or subject to a repurchase agreement, or the total contract value of all securities borrowed or subject to a reverse repurchase agreement, exceeds 2,500% of tentative net capital. Importantly, government securities (including Treasuries) are excluded from this calculation.

Assumption of Broker-dealer Liabilities by a Third Party

As amended, the net capital rule will now require a broker-dealer to take into account in its computation of regulatory net capital liabilities that are assumed by a third party, including an affiliated third party, if the broker-dealer cannot demonstrate that the third party has the resources - independent of the broker-dealer's income and assets - to pay the liabilities.3 In response to comments, the SEC noted that a broker-dealer can demonstrate the capability of the third party to meet its obligations in this regard by maintaining records "such as the third party's most recent (i.e., as of a date within the previous 12 months) audited financial statements, tax returns, or regulatory filings containing financial reports."

Deduction from Net Capital of Any Capital Contributed to a Broker-dealer by a Person that Has the Option to Withdraw It

In the Adopting Release, the SEC states that it is concerned that capital contributions to broker-dealers should not be temporary in nature. Therefore, as amended, the net capital rule will now require broker-dealers to deduct from their computation of net capital:

  • any capital contributed under an agreement that gives the contributor the right to withdraw the capital; and
  • any capital contributed to the broker-dealer that is intended to be withdrawn within one year. In addition, capital withdrawn within one year of having been contributed is now deemed to have been "intended" to be withdrawn within one year unless the broker-dealer receives written permission for the capital withdrawal from its designated examining authority.

Broker-dealer Solvency Requirement

Under the rule as amended, a broker-dealer must be "solvent." Broker-dealers that are not solvent must cease securities operations. Under the rule, a broker-dealer will not be solvent if it:

  • is placed in a voluntary or involuntary bankruptcy or similar proceeding;
  • has a trustee, receiver, or similar official appointed;
  • makes a general assignment for the benefit of its creditors;
  • makes an admission of insolvency; or
  • is unable to make computations necessary to establish compliance with the net capital rule.

Changes to the Customer Protection Rule

Changes to the Regulation of Proprietary Accounts of Introducing Brokers

Under existing SEC guidance (called the "PAIB letter"), a broker-dealer is not required to take a capital deduction for funds held with another broker-dealer (usually referred to as a "carrying" broker); provided that the carrying broker maintains cash or qualifying securities in a special, segregated account.

The amendments codify the PAIB letter, and require carrying broker-dealers to: (i) perform a separate reserve computation for proprietary accounts of other brokers (called "PAB" accounts) in addition to the customer reserve computation currently required for Rule 15c3-3 customer accounts; (ii) establish and fund a separate reserve bank account for the benefit of PAB account holders; and (iii) obtain and maintain physical possession or control of non-margin securities carried for PAB accounts. Under the rule amendments, a carrying broker may use PAB account securities for its own purposes, provided that it informs the PAB account holder that it intends to do so and provides the PAB account holder with the opportunity to object to such use. If the carrying broker complies with these requirements, the PAB account holder will not be required to deduct the value of the PAB account from its net capital under the net capital rule.

Limitations on Holding Customer or PAB Reserve Accounts at Certain Banks

In order to limit the possibility that customer or PAB funds will not be available as a result of the insolvency of the bank holding these accounts, the customer protection rule has been amended to state that customer and PAB reserve accounts may not be held at:

  • a bank affiliated with the broker dealer holding the PAB account; or
  • a bank, to the extent that the amount of cash deposited in the reserve account exceeds 15% of the bank's equity capital (based on the bank's most recently filed Call Report or Thrift Financial Report).

Further, under the customer protection rule, a broker-dealer must obtain a written agreement from the bank in which the bank agrees not to re-lend or hypothecate securities deposited into a broker-dealer reserve account. The SEC's rationale is that this "provides a measure of protection by requiring that the securities will be available to the broker-dealer if the bank falls into financial difficulty."

Recordkeeping and Notice Requirements

Documentation of Risk

Among the important changes adopted by the SEC is a change to the broker-dealer record-keeping requirements under SEC Rule 17a-3, which will require broker-dealers over a certain size to make and keep current records showing: "the credit, market, and liquidity risk management controls established and maintained by the broker-dealer to assist it in analyzing and managing the risks associated with its business activities."

This documentation requirement applies only to broker-dealers that have more than:

  • $1,000,000 in aggregate credit items as computed under the customer reserve formula of Rule 15c3-3; or
  • $20,000,000 in capital, including subordinated debt that is considered good capital in accordance with Appendix D to Rule 15c3-1.

New Forms for Broker-dealers that Hold Custody of Funds and Securities

Among the important changes adopted by the SEC are a number of new notice filings and forms that are required to be submitted by broker-dealers, and in particular by broker-dealers that hold custody of funds and securities. These forms are:

  • Compliance Report. For broker-dealers that hold custody of securities, a "Compliance Report" that states, among other things, that the broker-dealer has maintained a system of internal controls to provide the broker-dealer with reasonable assurance that any instances of non-compliance with financial responsibility rules has been prevented or detected. The Compliance Report must also assert (i) compliance with financial responsibility rules at year-end (or lack thereof); (ii) whether the information used to make the assertion noted at item (i) was derived from the books and records of the broker-dealer; and (iii) whether internal controls were effective during the immediately preceding year such that there were no material weaknesses. The broker-dealer's public accountant must participate in the preparation of certain portions of the Compliance Report.
  • Exemption Report. For broker-dealers that do not carry funds or securities, an "Exemption Report" stating the same and identifying the provisions of 15c3-3(k) giving rise to such exemption.
  • Form Custody. Form Custody, which will be required on a quarterly basis by all broker-dealer, is comprised of nine line items that are intended to "elicit information about a broker-dealer's custodial activities." A copy of Form Custody is appended to this note.

The nine required line items cover the following information:

  • whether the broker-dealer introduces customer accounts on a fully-disclosed or omnibus basis to another broker-dealer;
  • whether the broker-dealer carries securities accounts for customers or non-customers;
  • the US and non-US locations used by the broker-dealer to hold securities that it carries, and the frequency with which the broker-dealer performs a reconciliation between the information on its stock record and information about securities provided by the location;
  • the types and approximate market value of securities that are carried by the broker-dealer for the account of customers and non-customers;
  • whether the broker-dealer has recorded all securities it carries for the accounts of customers and non-customers on its stock record;
  • the process used by the broker-dealer with respect to free credit balances in cash accounts its holds for customers and in securities accounts of non-customers;
  • whether the broker-dealer carries customer accounts for another broker-dealer on a fully disclosed or omnibus basis;
  • whether the broker-dealer sends trade confirmations and account statements directly to customers and other accountholders;
  • whether the broker-dealer provides customers and other account holders with electronic access to information about the securities and cash positions in their accounts; and
  • whether the broker-dealer is also a registered investment adviser or an affiliate of a registered investment adviser, and related information regarding the custody of investment adviser client assets.

Conclusion

The changes to the net capital rule, customer protection rule, and recordkeeping and reporting rules are both surprisingly comprehensive and highly detailed. Specifically, while changes to the various computations and calculations required by the net capital rule and customer protection rule are highly detailed, and in many cases applicable only to a small number of broker-dealers, the reporting and recordkeeping requirements are both comprehensive in their requirements and broad in their application. All broker-dealers will now have significant additional reports and records to add to their compliance calendar, and accordingly broker-dealer compliance and management teams should be working to ensure that these new reports and records form part of the broker-dealer's compliance program.

Footnotes

1. See "Financial Responsibility Rules for Broker-Dealers," (SEC Release Nos. 34-70072, July 30, 2013) and "Broker-Dealer Reports," (SEC Release 34-70073, July 30, 2013) (each an "Adopting Release"). SEC releases are available on the SEC's Internet Website, www.sec.gov .

2. See "Amendments to Financial Responsibility Rules for Broker-Dealers," (SEC Release 34-55431, March 9, 2007) (the "Proposing Release").

3 This amendment is in addition to strict rules that are imposed by the SEC and FINRA relating to assumption of broker dealer liabilities. In this regard, see NASD Notice to Members 03-63 ("SEC Issues Guidance on the Recording of Expenses and Liabilities by Broker/Dealers"). NASD Notices to Members are available on FINRA's Internet Website, www.finra.org.

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