Broker-dealers must meet certain financial requirements to be registered. Those financial requirements can be boiled down to net capital. Don’t worry about the specifics, but it’s basically the company’s value. The regulators don’t want “broke” companies performing securities transactions with customers. What if something went wrong in a customer’s account and the broker-dealer was liable? Broker-dealers must also have a certain amount of capital on hand just to submit their customers’ trades (as we learned with the Gamestop short squeeze in early 2021). If the broker-dealer runs out of funds, it will not be able to function properly.
Broker-dealers are registered with and are subject to regulation by both the Securities and Exchange Commission (SEC)* and the state administrators. Both the Securities Exchange Act of 1934 (the SEC-enforced law governing broker-dealers at the federal level) and the Uniform Securities Act (USA) include specific financial requirements for broker-dealers. And sometimes, there are differences.
*Broker-dealers that operate in one state only are not subject to SEC registration or regulation. In order to be subject to federal laws, interstate commerce (doing business in more than one state) is required.
So, what happens when a broker-dealer has two different financial requirements to comply with? For example, what if the SEC enforces a minimum net capital level of $35,000, while a state administrator enforces a minimum net capital of $50,000? The National Securities Market Improvement Act (NSMIA) of 1996 was written and signed into law to solve this problem. This law elevates the SEC and the federal laws it enforces as being superior over the state administrators and the USA. This is fairly normal in government - federal laws usually trump state laws.
Even if a state’s net capital requirement is higher than the SEC’s, state administrators cannot force broker-dealers to maintain higher net capital requirements than what’s required at the federal level. This effectively makes the SEC and the Securities Exchange Act of 1934 the ultimate judge of a broker-dealer’s financial requirements. Given this is a state-based exam, the specifics (e.g. the amount of required net capital) are typically not tested on the Series 63.
In addition to net capital requirements, broker-dealers may be required by state administrators to post surety bonds.
A surety bond is basically insurance in the event of a broken obligation or promise to a customer. Generally speaking, they cover losses in the event of theft, misuse of customer funds, and unfulfilled commitments. If an agent embezzles funds from a customer account, accidentally sells a security when the customer requested a purchase, or promises features on investment products that don’t exist, a surety bond is there to ensure customers are reimbursed if necessary.
Broker-dealers that exercise discretion or maintain custody of customer funds may be required to post a surety bond (depending on the state). Discretion means the broker-dealer is making investment decisions on behalf of their customers, which requires power of attorney. Custody relates to holding customer funds on their behalf. If you maintain an account with the brokerage firm that executes your trades, that broker-dealer maintains custody of your assets. Some broker-dealers only execute their customers’ transaction requests, but their funds and securities are held at another institution (like a bank). We’ll discuss custody in further depth later in this material.
Like insurance, broker-dealers must pay ongoing premiums and fees to maintain surety bonds. These payments are made to organizations offering surety bonds (usually insurance companies and banks).
A broker-dealer can avoid these requirements by posting the requirement instead in cash or securities. For example, Washington’s state administrator requires broker-dealers to post a $100,000 surety bond. Instead of paying ongoing premiums, the broker-dealer could post $100,000 of cash or securities as collateral to the state administrator. That way, there’s still coverage in case an issue arises. The state administrator cannot force any specific method to meet surety bond requirements. All of the following are eligible means to complying:
The following video summarizes the key points covered in this chapter, plus some details from the previous chapter:
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