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93-30 NASD Provides SEC-Approved Clarifications and Interpretations to Recent Net Capital Rule Amendments

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Executive Summary

On November 24, 1992, the Securities and Exchange Commission (SEC) adopted significant amendments to the Net Capital Rule, Rule 15c3-1. The changes to the minimum net capital requirements will take effect in three installments beginning July 1, 1993; other changes took effect on January 1. Additional amendments to the rule, published for comment in December, are still being considered. This Notice sets forth, in question and answer format, certain guidelines for compliance with the new requirements.

Background

As announced in Notice to Members 92-72 (December 15, 1992), several amendments to the SEC's Net Capital Rule were effective January 1. One change concerning market makers is effective July 1, 1993. The net capital ceiling for a market maker will increase to $1 million as of that date. The changes to the rule's minimum net capital requirements will take effect in three steps starting July 1, 1993.

The adopted amendments increase the required minimum net capital for firms that carry customer accounts to at least $250,000 ($100,000 for those firms that operate pursuant to the paragraph (k)(2)(i) exemption of Rule 15c33); create two classes of introducing firms each with a different minimum requirement (at least $50,000 for firms that receive but do not hold customer securities for delivery to the clearing broker/dealer and $5,000 for firms that do not receive customer funds or securities); increase the minimum to at least $100,000 for dealers and underwriters that trade solely for their own accounts; increase the minimum to at least $25,000 for firms that transact a business in mutual fund shares and certain other share accounts on other than a subscription-way basis; increase the minimum requirements for market makers to at least $100,000; and maintain a $5,000 minimum category for other broker/dealers that do not handle customer funds or securities.

Other adopted amendments establish one standardized method of calculating haircuts for all firms; adopt the alternative method for computing concentration charges for all firms; reduce the impact on aggregate indebtedness for two items (mutual funds payable offset by fails to deliver and corresponding stock loan/stock borrow); and permit the use of an offset when computing the open contractual commitment haircut on underwritings.

Since publication of Notice to Members 92-72, several NASD members have raised questions concerning the new requirements. The Association is publishing the answers to certain of these questions for the benefit of all members.

Questions concerning this Notice may be directed to Samuel Luque, Associate Director, Financial Responsibility at (202) 728-8472.

Minimum Net Capital Quick Reference Guide

 

Minimum Dollar Requirements

Phase-in Periods

 

Amended to

July 1, 1993

Jan. 1, 1994

July 1, 1994

         

Mutual fund dealers subscription basis

5,000

3,300

4,100

5,000

Mutual fund dealers wire-order basis

25,000

10,000

17,500

25,000

*Introducing firms not receiving

       

funds/securities

5,000

5,000

5,000

5,000

Introducing firms receiving securities

50,000

20,000

35,000

50,000

Firms carrying customer accounts under k(2)(i) exempt/15c3-3

100,000

50,000

75,000

100,000

Dealers and market makers

100,000

50,000

75,000

100,000

*Brokers' brokers

150,000

150,000

150,000

150,000

Firms carrying customer accounts basic (AI) method

250,000

100,000

175,000

250,000

Firms electing the alternative method

250,000

150,000

200,000

250,000

**Futures commission merchants

250,000

250,000

250,000

250,000

*Other brokers or dealers

5,000

5,000

5,000

5,000

Note: Whenever a broker/dealer engages in more than one of the above activities the highest requirement for any of those activities is the dollar requirement.

Ratio requirements and other requirements for futures commission merchants and market makers may dictate requirements higher than the minimum dollar requirement.

* Denotes no change.

** Futures Commission Merchant = National Futures Association minimum.

Item

SEC Net Capital Rule

Minimum Net Capital Requirements

I. Firms That Carry Accounts:

 

A. Firms that carry customer accounts or broker or dealer accounts and receive or hold funds or securities for those persons

 

i. Basic Method

Greater of $250,000 or 6 2/3% of AI

ii. Alternative Method

Greater of $250,000 or 2% of Rule 15c3-3 Reserve Formula debits

B. Firms that carry customer accounts, receive but do not hold customer funds or securities, and operate under the paragraph (k)(2)(i) exemption of Rule 15c3-3

Greater of $100,000 or 6 2/3% of AI

II. Introducing Brokers:

 

A. Firms that introduce accounts on a fully disclosed basis to another broker or dealer and do not receive funds or securities

Greater of $5,000 or 6 2/3% of AI

B. Firms that introduce accounts on a fully disclosed basis to another broker or dealer and receive, but do not hold, customer or other broker/dealer securities and do not receive funds

Greater of $50,000 or 6 2/3% of AI

III. Dealers

 

Brokers or dealers that trade solely for their own accounts, endorse or write options, or effect more than ten transactions for their investment account in any one calendar year

Greater of $100,000 or 6 2/3% of AI

IV. Mutual Fund Brokers or Dealers

 

Brokers or dealers transacting a business in redeemable shares of registered investment companies and certain other share accounts

 

A. Wire orders

Greater of $25,000 or 6 2/3% of AI

B. Application method, and do not otherwise receive or hold funds or securities

Greater of $5,000 or 6 2/3% of AI

V. Market Makers

 

A broker or dealer engaged in activities as a market maker

Greater of $100,000 or 6 2/3% of AI or $2,500 per security for securities with a market value greater than $5 per share, and $1,000 per security for securities with a market value of $5 or less with a maximum requirement of $1 million

VI. Other Broker or Dealers

 

A. Firms that deal only in Direct Participation Programs (DPPs)

Greater of $5,000 or 6 2/3% of AI

B. Firms that do not take customer orders, hold customer funds or securities, or execute customer trades, because of the nature of their activities (e.g., mergers and acquisitions)

Greater of $5,000 or 6 2/3% of AI

VII. Alternative Method

 

Any firm may elect this method, however, they will be subject to the $250,000 minimum net capital requirement

Greater of $250,000 or 2% of Rule 15c3-3 Reserve Formula debits

VIII. Securities Haircuts

 

A. Equity securities

15% of the market value of the greater of the long or short position, plus 15% of the lesser to the extent it exceeds 25% of the greater position

B. Undue concentration

The charge for undue concentration for equities is 15%, applied to the concentrated position immediately

IX. Aggregate Indebtedness

 

A. Mutual funds payable offset to fails to deliver

85% of the amounts payable related to fails to deliver of the same quantity and issue of registered investment company shares is excluded from AI

B. Stock loan and stock borrowed

85% of stock loan payables related to stock borrowed receivables of the same class and issue is excluded from AI

X. Contractual Charges

 

A. Open contractual commitment haircut for securities designated as Nasdaq National Market® or listed on a national securities exchange

15% haircut

B. Open contractual commitment haircut for securities not designated as Nasdaq National Market or listed on a national securities exchange

30% haircut; however, for brokers or dealers with more than $250,000 in net capital, the first $150,000 of the haircut need not be deducted in the computation of net capital

XI. Secured Demand Note Collateral

 

Other securities including equities collateralizing secured demand notes

30% haircut

Questions and Answers Relating to the Amendments to the Uniform Net Capital Rule

Question #1: Should a fully disclosed introducing firm (current $5,000 minimum requirement), that does not have a clearing agreement stating that the introduced customer accounts are the responsibility of the carrying firm, be considered self-clearing (with a $25,000 current minimum requirement) immediately?
Answer: No. By June 30, 1993, introducing firms will be required to have properly executed clearing agreements stating that introduced customer accounts are the responsibility of the carrying firm. If a proper clearing agreement is not executed, an introducing firm can no longer be considered an introducing firm. Such a firm will have a minimum net capital requirement of $250,000.
Question #2: If a customer disregards written instructions (i.e., the confirmation) to make the check payable to the clearing broker/dealer and submits a check to the introducing broker/dealer, made payable to the introducing firm, will the introducing broker/dealer's requirement increase from $5,000 to $250,000?
Answer: No. The SEC has recognized that on occasion customers will mistakenly make their checks payable to the introducing firm. However, the burden of demonstrating mistakes rests with the introducing firm. Firms must have procedures in place to demonstrate how such customer mistakes will be addressed. The confirmation should always indicate that checks are to be made payable to the clearing firm, escrow agent, or appropriate third party. Customers making such mistakes should be contacted directly, in writing, and instructed regarding the proper procedures.
Question #3: Into which net capital category does an introducing firm that receives and promptly transmits customer checks made out to third parties fall?
Answer: An introducing firm that receives and promptly transmits all customer and broker/dealer checks made payable to the appropriate third party will have a minimum requirement of $5,000, provided that the firm does not receive customer securities.
Question #4: In Notice to Members 92-72, it was noted that the adopted amendments created two classes of introducing firms. However, some firms introduce accounts on a fully disclosed basis and separately transact business in mutual fund shares through a (k)(2)(i) "Special Bank Account." Since the firm is receiving funds from customers for its mutual fund business, is the firm's minimum net capital requirement $250,000?
Answer: No. An introducing firm that processes customer monies related to its mutual fund business through a (k)(2)(i) account will be required to maintain net capital of not less than $25,000, provided that other activities of the firm do not require a higher net capital.
Question #5: If an introducing broker/dealer receives checks payable to itself, deposits the checks in a (k)(2)(i) account, and then promptly forwards the funds to its clearing broker/dealer, would the introducing broker/dealer be subject to a minimum net capital requirement of $100,000 or $250,000?
Answer: The firm would be deemed to have received customer funds if it operates in this manner and, therefore, would be subject to the $250,000 minimum net capital requirement. The SEC has informed us that a (k)(2)(i) account cannot be used by fully disclosed firms, except for mutual fund transactions.
Question #6: Can a $5,000 firm accept customers' funds and forward such funds to its clearing firm? If so, under what circumstances?
Answer: Yes. If the checks are made payable to the clearing firm and promptly forwarded.
Question #7: What would be the minimum net capital requirement for an introducing firm that trades for its own account, makes no markets, and does not participate in firm commitment underwritings?
Answer: An introducing firm that effects more than 10 transactions in its investment account during a calendar year will be required to maintain $100,000 in net capital. (Transactions in money market instruments are excluded from the 10-transaction limitation.) If 10 or fewer transactions are effected, the minimum net capital requirement would be either $5,000 or $50,000, as appropriate for introducing firms. (A transaction is either a purchase or sale.)
Question #8: Is an introducing broker/dealer, that has the ability to write checks or drafts on the clearing broker/dealer's behalf, subject to a higher net capital requirement than the $5,000 required for an introducing broker/dealer?
Answer: No. If the bank account is in the name of the clearing firm, and there is a written contract between the carrying broker/dealer and the introducing firm specifying that the introducing firm is acting as agent for the carrying broker/dealer, the introducing firm's minimum net capital requirement will be $5,000.
Question #9: What is an introducing broker/dealer's net capital requirement, if it receives checks from a mutual fund made payable to the firm with a reference to the customer's name and account number? (The checks are the customer's dividends and capital gains, which the customer wants deposited in its brokerage account and the customer has requested that the mutual fund send the checks to the broker/dealer.)
Answer: A firm that receives checks from a mutual fund made payable to itself, resulting from dividends or capital gains in a customer's account, will have a net capital requirement of $250,000. The fact that the customer requested this transaction would not alter this requirement.
Question #10: Does the required clearing agreement for introducing firms (i.e., the agreement must state that customers are the customers of the clearing firm for purposes of the Securities Investors Protection Act, that account statements must be sent directly to customers, etc.) apply to a $5,000 introducing firm as well as to a $50,000 introducing firm?
Answer: Yes. All fully disclosed introducing firms will be required to execute clearing agreements that contain the appropriate language as outlined in Notice to Members 9272 (see page 517). The language required by the Rule to be included in all clearing agreements is intended to establish the concept that the customers must look to the clearing firm for the payment of monies and delivery of securities.
Question #11: If a firm (i) conducts a general securities business on a fully disclosed basis, receives no customer securities, and all customer checks are made payable, and promptly forwarded, to the clearing firm, and (ii) deposits customer checks made payable to itself for mutual fund transactions (only) into a (k)(2)(i) "Special Bank Account" and promptly transmits the firm's own check to the mutual fund issuer, what would be the broker/dealer's net capital requirement?
Answer: Based on its mutual fund wire-order business, the firm's net capital requirement would be $25,000, and the firm would claim the (k)(2)(i) exemption from the Customer Protection Rule.
Question #12: If a sole mutual fund dealer (current $2,500 minimum requirement) receives checks made payable to the fund, what will its new capital requirement be?
Answer: A firm that operates pursuant to 15c3-1(a)(2)(v), acting only on a subscription-order basis with respect to the purchase and sale of open-end mutual fund shares and insurance company separate accounts, and receives checks made payable to the appropriate third party, will have a minimum net capital requirement of $5,000.
Question #13: What is the net capital requirement for a firm that acts as the underwriter for a mutual fund?
Answer: A broker/dealer that engages solely in mutual fund transactions will be required to maintain a minimum net capital of $5,000, provided that all trades are done on a subscription basis directly with the fund. The requirement for a firm that conducts a similar business but on a wire-order basis will be $25,000.
Question #14: What is the minimum net capital requirement for a firm that holds mutual fund securities in street name on behalf of customers?
Answer: The requirement is $250,000, the same as for any firm that holds securities on behalf of its customers, regardless of whether the securities are mutual fund shares, equities, or debentures.
Question #15: Does the $1,000 per security requirement for market makers go into effect on July 1, 1993, the same time that the $1 million ceiling goes into effect?
Answer: No. The requirement to maintain net capital of not less than $1,000 per security with a market value of $5 or less for those securities in which they make a market became effective on January 1, 1993. The current $100,000 ceiling requirement will be increased to $1 million effective July 1, 1993.
Question #16: Does a broker/dealer calculating net capital under the alternative standard require SEC approval if it wishes to change to the aggregate indebtedness standard?
Answer: Yes. Also, any firm that wishes to compute net capital under the alternative standard after January 1, 1993, must file the appropriate notification with its Designated Examining Authority. If the firm wishes to change from the alternative standard, it must obtain prior approval from the SEC before the change can be made.
Question #17: What is the contractual charge for initial public offerings and secondary offerings listed on the Nasdaq National Market or an exchange?
Answer: For all securities being underwritten in an initial public offering, the percentage deduction applied as the open contractual commitment charge is 30 percent, even if the issue immediately begins trading in the secondary market on the Nasdaq National Market or an exchange. If the underwriting is a secondary offering of an issue already trading on the Nasdaq National Market or an exchange, the percentage is 15 percent.
Question #18: What is the open contractual commitment charge for a firm commitment underwriting of a new convertible debt security that is immediately convertible into an existing Nasdaq National Market security for the same issuer?
Answer: The open contractual commitment charge for a convertible debt security is calculated by multiplying the dollar amount of the commitment by the appropriate percentage as determined by Rule 15c3-1 (c)(2)(vi)(G). If the security has a market value at par or higher, the percentage deduction is determined by Rule 15c3-1(c)(2)(vi)(J). If the security has a market value less than par, the percentage deduction is determined by Rule 15c3-1(c)(2)(vi)(F).
Question #19: What is the new net capital requirement for a direct participation program firm that does not have a (k)(2)(i) account and does not "receive" customer funds?
Answer: A firm, which limits its activities to selling direct participation programs or other similar securities and uses an escrow account pursuant to SEC Rule 15c2-4, will be in the $5,000 minimum net capital category and will not be required to have a (k)(2)(i) account.
Question #20: Is a sole government securities firm going to be subject to any changes in liquid capital requirements?
Answer: No. At this time, the adopted amendments to the Net Capital Rule will not change the liquid capital requirements for a sole government securities firm.
Question #21: Should an NASD-designated member firm increase its fidelity bond in six-month intervals as the minimum net capital requirements increase, or may the firm wait until it is time to renew the bond?
Answer: Article III, Section 32, requires a member firm to review annually the adequacy of its fidelity bond coverage. This review is required annually at the anniversary date of the issuance of the bond.
Question #22: Will a new member be subject to the new minimum requirements immediately, or will it be subject to the temporary phase-in minimums allowed existing members?
Answer: A new member would be required to comply with the minimum net capital requirements in effect at the time the firm becomes a member of the NASD, including the temporary phase-in minimums.
Question #23: May a firm that conducts a business in private debt and equity offerings, where there is no clearing relationship, but the firm promptly forwards all checks made out to the issuer, operate with a $5,000 minimum net capital requirement?
Answer: Yes. The $5,000 minimum net capital requirement is appropriate for this type of firm. However, if the offering involves any contingencies, the firm must comply with the provisions of SEC Rule 15c2-4. This firm may also operate as an introducing broker.
Question #24: May a firm elect to accelerate the effectiveness of its minimum net capital requirement and report this final minimum requirement amount as its current requirement amount on the July 1, 1993, FOCUS Report?
Answer: No. A firm must follow the SEC's temporary phase-in minimums for reporting its net capital requirement.
Question #25: If a firm falls in more than one category for determining minimum net capital requirements, which requirement would apply (e.g., a market maker that is also an introducing broker/dealer)?
Answer: A firm that engages in more than one type of business will be required to maintain a minimum net capital equal to the highest requirement for any business conducted. In the example given, the requirement would be the highest minimum associated with the firm's market-making activities. Additionally, firms should be aware of the ratio requirements if computing net capital under the aggregate indebtedness method or the alternative method.
Question #26: What does "statutory underwriter" mean?
Answer: A statutory underwriter is any broker/dealer that is contractually committed to an issuer for the purchase of its securities.
Question #27: What is the minimum net capital requirement for an introducing firm participating in a firm-commitment underwriting, but not as an underwriter?
Answer: An introducing firm may participate in a firm-commitment offering as a selling group member only, not committed to the issuer, and operate under the $50,000 minimum net capital requirement.
Question #28: Did the haircuts for equity securities change on January 1, 1993?
Answer: Yes. All firms, whether they compute net capital under the basic method or the alternative method, now compute equity haircuts the same, that is, 15 percent of the market value of the greater of the long or short position and, if the lesser position exceeds 25 percent of the greater position, an additional 15 percent is taken on the excess amount. This treatment applies to all securities in paragraph (c)(2)(vi)(J) "All Other Securities." For those equity securities that are included in paragraph (c)(2)(vi)(K)(ii) the haircut remains 40 percent.
Question #29: Did the method for determining undue concentration deductions change on January 1, 1993?
Answer: Yes. All firms, whether they compute net capital under the basic method or the alternative method must compute undue concentration deductions pursuant to paragraph (c)(2)(vi)(M). For equities and debt securities, the deduction must be applied immediately, except for securities underwritten (for which the deduction is not applied until after 11 business days).
Question #30: Is there any relief given to the aggregate indebtedness charge of 6 2/3 percent for firms that conduct a mutual fund business?
Answer: Yes. If a broker/dealer has a payable to a mutual fund that is related to a fail-to-deliver receivable of the same quantity, 85 percent of that liability would be excluded from aggregate indebtedness. Additionally, similar aggregate indebtedness relief will be afforded stock loan payables that are offset by stock borrowed receivables of the same quantity and issue.

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