Net Capital Traps for Brokers or Dealers

Every broker or dealer (“BD”) is required to maintain a specified level of net working capital, as defined in Securities Exchange Act Rule 15c3-1. The dollar threshold is the greater of the regulatory minimum, which ranges from $5,000 to $1.5 million, or a specified percentage (generally 6-2/3) of the BD’s total liabilities (referred to as aggregate indebtedness). For example, a $5,000 BD with total liabilities of $600,000 would have a required minimum net capital of $40,000. If that same BD had total liabilities of $60,000, its required minimum net capital would be $5,000.

A BD must be in compliance with the net capital requirements in order to conduct business and could be subject to fines or sanctions if found to be operating without sufficient net capital. Generally, the first thing a regulator will request from a BD is a current computation of its compliance with the net capital rules. This highlights the first “trap:” compliance with the net capital rules is a continuous requirement – it is not sufficient for a BD to be in compliance at the end of the year, the end of the month or the end of the day. They must be in compliance before, during and after any transactions, and they must be able to prove it. The BD must either have so much excess capital that any one specific transaction would not cause them to fall below the requirements; or they must have an accounting system and controls in place to ensure that the information is captured and evaluated simultaneously with transactions. BDs that act as underwriters to initial public offerings are particularly at risk because of the potentially large obligation taken on temporarily just prior to the actual sale of securities to investors.

Another common “trap” occurs when a BD guarantees the liabilities of another entity. Many BDs are setup as “special purpose” entities, established solely to engage in the type of activity for which it was formed, and as affiliates or subsidiaries of larger entities. When the parent or affiliate is obtaining financing for something, whether it be a line of credit related to another line of business or even a mortgage on a property, it is not uncommon for financial institutions to request cross guarantees of the debt from subsidiaries and affiliates. Rule 15c3-1 is clear that guarantees are generally included as a component of aggregate indebtedness, so by simply signing a guarantee of a $1.5 million line of credit, the BD just increased its minimum net capital requirement by $100,000. This “trap” emphasizes the importance of having a sound control environment where communication between management, owners and compliance officers is frequent and a strict policy of not entering into any contracts without reviewing with compliance personnel.

A third “trap” relates to significant lawsuits as contingent liabilities. This, often overlooked, rule states that a BD that is the subject of a lawsuit that could have a material impact on its net capital must obtain an opinion from outside legal counsel regarding the potential impact of the lawsuit on the firm’s financial condition. If this is not done, the item must be considered a contingent liability and included as a component of aggregate indebtedness.

The final “trap” is temporary capital contributions are not “good” capital. When obtaining capital from investors, BDs need to be clear that the underlying agreements support the treatment of the capital contribution as permanent. Provisions that permit the investor to withdraw the funds at a later date at their option are indicative of the contribution being temporary. Likewise, any withdrawal of a capital contribution within one year of the contribution date is treated as if the original intent was for the contribution to be withdrawn and should be excluded from net capital, unless the BD obtains prior written approval from its designated examining authority.

These are just a few of the many “traps” that brokers and dealers subject to the net capital rules should be aware of. The experts in WS+B’s Broker Dealer Team are well versed in the intricacies of the net capital rules and are able to review a firm’s net capital computations for compliance with those rules and make recommendations for structuring improvements to avoid these traps.

– Brian Wallace


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