Financial requirements

Net capital requirements

Broker-dealers must meet certain financial requirements to be registered. One of the key requirements is net capital. You don’t need the detailed calculation here - think of net capital as a measure of the firm’s financial strength and ability to meet its obligations.

Regulators don’t want financially unstable (“broke”) firms 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 that liability. Broker-dealers also need sufficient capital simply to process customer trades (as we saw during the Gamestop short squeeze in early 2021). 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 federal law governing broker-dealers) 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 addresses this issue by giving priority to federal law. In other words, when federal and state requirements conflict, federal law controls.

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 final authority on a broker-dealer’s net capital requirements. Since this is a state-based exam, the specific dollar amounts are typically not tested on the Series 66.

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 makes investment decisions on the customer’s behalf, which requires power of attorney.
• Custody means holding customer funds or securities on the customer’s behalf. If you keep an account at 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.

Definitions

Power of attorney

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

Like insurance, surety bonds typically involve ongoing premiums and fees. These payments go to the organizations that provide the bond (often insurance companies or banks).

A broker-dealer can avoid paying premiums by meeting the requirement with 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 deposit $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 can’t require a specific method for meeting the surety bond requirement. 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: