Proposed Rule Change

Net Capital Computation

By Danielle Paul

On March 9, 2007 the SEC proposed amendments to the Rule 15c3-1; the Net Capital Rule.  Some of the changes to the actual rule are not additions to the rule, but place actual verbiage into the rule that would have previously been pulled from various interpretations of the text.

There are six key proposed changes to the rule.  The topics that are covered are:

• Expense Sharing Agreements
• Capital Contributions
• Excess Fidelity Bond Deductibles
• Certain insolvency events, proposed definition of insolvency, and reporting requirements.
• Notification of Withdrawal of Capital
• Haircuts for options and money market funds
• Technical Amendments

Expense sharing agreements – Under the SEC proposal, BDs who have entered into expense sharing arrangements would be required to verify that the third-party who is assuming the liabilities for the BD has resources independent from the BD to actually pay such expenses. If the BD cannot verify that sufficient resources exist, then they would be required to include the liabilities paid by the third-party when calculating their net capital. This verification can include audited financial statements, tax returns or regulatory files containing financial data.  For more information and NASD interpretive guidelines on Expense Sharing Agreements, see Notice to Members 03-63 (October 2003).

Capital Contributions - Investors, owners or members may from time to time infuse monies into the BD that are withdrawn shortly thereafter.  The SEC has emphasized that monies infused as capital contributions should not be temporary and should be treated as a liability if it can be withdrawn at the discretion on the contributor.  Under the Rule proposal, if money is infused and can be returned at the discretion of the contributor, the contribution would be placed on the books as a liability of the broker dealer.   Further, any capital contributions withdrawn within a year would be required to be treated as a liability, unless the BD has received permission in writing from its designated examining authority, since it will be presumed to have been intended to be temporary. For more information on Equity Withdrawals, see Appendix D of Rule 15c3-1.

Fidelity Bond Deductibles - All registered broker-dealers, who do business with the public and are members of SIPC, are required to have a Fidelity Bond.  The form and amounts of the bonding can vary depending on the firm's business.  However, the rules set forth a maximum deductible amount. While SRO Rules have required that excess deductibles be deducted from net capital, this requirement was not present in Rule 15c3-1. Thus firms were not required to show the impact of the deduction on their FOCUS filings. To rectify this gap, the SEC is proposing to include the deduction for the excess Fidelity Bond deductible in Rule 15c3-1.  For more information on Excess Fidelity Bond Deductible, see NYSE Rule 319 (b), and NASD Rule 3020 (b) (2), NYSE Rule 319.

Solvency Requirements - The SEC proposed to further define the term insolvency and require broker-dealers to cease conducting securities business if certain insolvency events occur.  Specifically the amendment would prevent firms that are seeking bankruptcy protection from continuing to do business.  The definition of insolvency would be defined as “a broker-dealer’s placement in a voluntary or involuntary bankruptcy or similar proceeding; the appointment of a trustee, receiver or similar official; a general assignment by the broker-dealer for the benefit of its creditors; an admission of insolvency; or the inability to make computations necessary to establish compliance with Rule 15c3-1.”  In addition to amending 15c3-1 to define insolvency, the SEC proposes amending 17a-11 to require firms that meet the definition of insolvent to immediately file notice with  the commission, its designated examining authority and, if applicable, the CFTC. 

Capital Withdrawals - As it reads now, Paragraph (e) of Rule 15c3-1 states that when a firm makes a withdrawal that would exceed 30% of the firm’s excess net capital it must notify the Commission 48 hours prior to the withdrawal and if a withdrawal is made that would exceed 20%, notice must be filed within 2 days of the withdrawal.  The rule also permits the Commission to issue orders to restrict withdrawals, loans or advances to shareholders, insiders and affiliates if based on facts and circumstances available it believes that such withdrawals, loans or advances in excess of 30% of the BD’s net capital would jeopardize that BD’s ability to repay customer claims or liabilities or would be detrimental to the financial integrity of the BD.  The March 7, 2007 proposal states that they would like to remove the 30% of excess capital limitation verbiage and make any equity withdrawal, advance, and loan subject to review.

Haircuts - The Commission is proposing to change the haircut on money market funds from 2% to 1% to better align the risk to the security.  Additionally, they will continue the relief for the option pricing model for listed options and related positions that hedge those options that was instituted in February 1997.  The Commission feels that the lower requirement better aligns the requirements in the Net Capital Rule with the risks associated with these positions and accounts. See Exchange Act Release No 38248 (February 6, 1997) for more information.

Technical changes - The last change they are proposing is to remove text that is “superfluous” or “redundant”.  Additionally, they are proposing to update or correct citations to other regulations.