Financial requirements

Net capital requirements

Broker-dealers must meet certain financial requirements to be registered. These requirements are often summarized as net capital. You don’t need the detailed calculation here - think of net capital as a measure of the firm’s financial strength. Regulators don’t want firms that are effectively “broke” handling customer securities transactions. If something goes wrong in a customer’s account and the broker-dealer is liable, the firm needs enough financial resources to cover its obligations.

Broker-dealers also need capital available to process customer trades. We saw an example of this during the Gamestop short squeeze in early 2021, when some firms needed additional funding to keep submitting trades. If a broker-dealer runs out of funds, it may not be able to operate properly.

Broker-dealers are registered with and regulated 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. Sometimes those requirements differ.

*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 if a broker-dealer faces two different financial requirements? For example, what if the SEC requires a minimum net capital level of $35,000, while a state administrator requires $50,000? The National Securities Market Improvement Act (NSMIA) of 1996 was enacted to address this kind of conflict. NSMIA establishes that federal securities laws (and the SEC rules enforcing them) take priority over state law in this area.

As a result, even if a state’s net capital requirement is higher than the SEC’s, state administrators can’t require broker-dealers to maintain net capital above the federal minimum. This makes the SEC and the Securities Exchange Act of 1934 the controlling authority for broker-dealer net capital requirements. Because this is a state-based exam, the specific dollar amounts (for example, the exact minimum net capital) typically aren’t tested on the Series 65.

Sidenote

FOCUS reports

The Securities Exchange Act of 1934 requires broker-dealers to complete and file FOCUS reports regularly. These reports disclose firm financials to securities regulators to ensure minimum financial requirements are met. One of the more important disclosures is the firm’s net capital computation, as broker-dealers must maintain a minimum amount of net capital. Broker-dealers file FOCUS reports using FINRA’s eFOCUS system.

Surety bonds

In addition to net capital requirements, broker-dealers may be required by state administrators to post surety bonds. Federal law limits this power: under the National Securities Markets Improvement Act (NSMIA), a state can’t set a bonding requirement for a broker-dealer that differs from, or adds to, the federal requirements.

Definitions

Surety bond

A guarantee offered by a third party covering obligations and promises made by another party

Not the same as a fidelity bond, which covers the firm’s own losses, such as those from employee dishonesty, and which FINRA requires its member firms to carry.

A surety bond works like insurance if the firm fails to meet an obligation to a customer. Under the Uniform Securities Act, a customer can make a claim against the bond when the firm is liable to them under the act. For example, if an agent sells a product by promising features it doesn’t have, the bond helps ensure the customer can be reimbursed. The administrator may also require the bond to cover other losses, such as theft or misuse of customer funds.

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 customers, which requires power of attorney.
• Custody means holding customer funds on the customer’s 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 transaction requests, while customer funds and securities are held at another institution (such as a bank). We’ll discuss custody in more depth later in this material.

Definitions

Power of attorney

a legal authority provided to a third party to take action on behalf of an individual

Like insurance, broker-dealers must pay ongoing premiums and fees to maintain surety bonds. These payments go to the organizations providing the surety bond (usually insurance companies and banks).

A broker-dealer can avoid these requirements by posting the required amount in cash or securities instead. For example, assume a state administrator requires a broker-dealer 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 with the state administrator. That way, coverage is still available if 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:

• Posting a surety bond
• Posting equivalent surety bond coverage in:
  • Cash, and/or
  • Securities

The following video summarizes the key points covered in this chapter, plus some details from the previous chapter: