Financial Responsibility - Series 24

The Net Capital Rule (Rule 15c3-1)

SEC Rule 15c3-1, commonly known as the Net Capital Rule, is the cornerstone of broker-dealer financial responsibility. It requires every registered broker-dealer to maintain a minimum level of liquid assets (net capital) at all times. The rule is designed to ensure that if a broker-dealer fails or becomes insolvent, it will have sufficient liquid assets to satisfy its obligations to customers and other creditors in an orderly wind-down. As a General Securities Principal, you must understand the conceptual framework of the net capital rule, the minimum requirements applicable to your firm, and the consequences of non-compliance.

The net capital rule is fundamentally a liquidity requirement, not a solvency or net worth requirement. A firm can have substantial total assets but still violate the net capital rule if those assets are illiquid (cannot be quickly converted to cash). The rule accomplishes this by requiring broker-dealers to value their assets conservatively, applying "haircuts" (deductions) to the market value of securities positions to account for the risk that those securities might decline in value before they can be sold.

Net Capital: A broker-dealer's liquid assets minus its liabilities, with additional deductions (haircuts) applied to securities positions. Net capital represents the firm's cushion of liquid assets available to protect customers and creditors. The formula conceptually is: Net Capital = Net Worth + Subordinated Debt - Non-Allowable Assets - Haircuts on Securities.

Minimum Net Capital Requirements

The minimum net capital required depends on the nature of the broker-dealer's business. The rule provides two alternative computation methods and sets different minimums based on business activities:

Basic method (aggregate indebtedness standard): Net capital must be at least the greater of $250,000 or 6-2/3% of aggregate indebtedness (total money owed by the BD to all parties)
Alternative method (net capital ratio): Net capital must be at least the greater of $250,000 or 2% of aggregate debit items (customer receivables)
$5,000 minimum: For introducing broker-dealers that do not hold customer funds or securities and operate under a fully disclosed clearing arrangement
$50,000 minimum: For broker-dealers that receive customer securities but do not hold customer funds
$100,000 minimum: For broker-dealers that hold customer funds on a limited basis
$250,000 minimum: For general securities broker-dealers (most common requirement for carrying firms)

For the Series 24 exam, focus on understanding the concept of net capital rather than memorizing specific haircut percentages (which are tested more heavily on the Series 27). Know the minimum dollar requirements, the two computation methods, the early warning thresholds, and the consequences of a net capital violation.

Customer Protection Rule (Rule 15c3-3)

SEC Rule 15c3-3, the Customer Protection Rule, requires carrying broker-dealers to safeguard customer assets. The rule has two main components: physical possession or control of customer securities, and the reserve formula computation that ensures customer cash is segregated and protected.

Possession or Control

Under the possession or control requirement, a carrying broker-dealer must promptly obtain and maintain possession or control of all fully paid and excess margin securities carried for customer accounts. "Control" means the securities must be in a location where the firm can obtain them promptly (within a reasonable time). Securities must not be pledged, hypothecated, or used for the firm's own purposes unless specifically permitted by regulation.

The Reserve Formula

The reserve formula requires carrying broker-dealers to compute a "reserve" amount weekly (by the close of business on the second business day following the computation date). The reserve represents the amount of cash or qualified securities the firm must deposit in a Special Reserve Bank Account for the Exclusive Benefit of Customers. This account is off-limits for the firm's own use and ensures that customer funds are protected even if the firm fails.

Rule	Primary Purpose	Applies To	Key Requirement
Rule 15c3-1 (Net Capital)	Ensure firm liquidity	All broker-dealers	Maintain minimum net capital at all times
Rule 15c3-3 (Customer Protection)	Safeguard customer assets	Carrying broker-dealers	Segregate customer funds, maintain possession/control of securities

Financial Reporting Requirements

Broker-dealers are subject to extensive financial reporting requirements. The primary vehicle for financial reporting is the FOCUS Report (Financial and Operational Combined Uniform Single Report), which is filed with FINRA and the SEC. FOCUS reports provide regulators with detailed information about the firm's financial condition, including its balance sheet, income statement, net capital computation, and customer reserve formula.

Types of FOCUS Reports

FOCUS Part I: A simplified monthly or quarterly report filed by introducing broker-dealers that do not carry customer accounts. Contains basic financial information including a trial balance and net capital computation.
FOCUS Part II: A more comprehensive report filed by carrying broker-dealers on a monthly or quarterly basis. Includes detailed financial statements, net capital computation, customer reserve formula, and supplemental schedules.
FOCUS Part IIA: The most detailed report, filed by firms that carry customer accounts. Includes all Part II information plus additional schedules related to customer protection and segregation.

Filing Deadlines

FOCUS reports are due 17 business days after the reporting period ends for most firms. Some firms file monthly (carrying firms and firms with significant financial complexity), while others file quarterly. Late filing is a violation that triggers immediate regulatory attention and can result in fines, enhanced reporting requirements, or restrictions on business activity.

Early Warning Notifications

The SEC and FINRA impose early warning thresholds that are set above the absolute minimum net capital requirement. When a firm's net capital falls below the early warning level, it must immediately notify the SEC and its designated examining authority (typically FINRA). The early warning thresholds are:

Basic method: Net capital falls below 120% of the minimum required (i.e., aggregate indebtedness ratio exceeds 1,200%)
Alternative method: Net capital falls below 5% of aggregate debit items (vs. the 2% minimum)

A net capital violation is among the most serious violations a broker-dealer can commit. It can trigger immediate restrictions on business activity, mandatory customer notifications, expedited reporting requirements, and potentially a forced wind-down. Principals must monitor the firm's net capital position daily and have procedures in place to prevent violations before they occur.

Books and Records Requirements

SEC Rules 17a-3 and 17a-4 impose comprehensive recordkeeping requirements on broker-dealers. These rules specify which records must be created (Rule 17a-3) and how long they must be retained (Rule 17a-4). Proper recordkeeping is essential for regulatory oversight, customer protection, and dispute resolution.

Key Records and Retention Periods

Trade blotters and journals: Records of all purchases, sales, receipts, and deliveries of securities; must be retained for at least 6 years
General ledger: Must be retained for at least 6 years
Customer account records: Must be retained for at least 6 years after the account is closed
Customer account statements: Retained for 6 years
Communications (correspondence, emails): Must be retained for at least 3 years (first 2 years in an easily accessible location)
Written supervisory procedures: Current WSPs plus prior versions for 3 years after replacement
Customer complaints: Retained for at least 4 years
Form BD and amendments: Retained for the life of the firm plus 3 years

The general rule of thumb: most financial records must be retained for 6 years, communications for 3 years, and complaints for 4 years. Records must be maintained in a format that allows them to be produced promptly upon request by regulators. Electronic storage is permitted if it meets specific requirements for immutability and accessibility.

Check Your Understanding

Test your knowledge of financial responsibility. Select the best answer for each question.

1. The Net Capital Rule (Rule 15c3-1) is primarily designed to ensure:

2. Under the Customer Protection Rule, the Special Reserve Bank Account is for the:

3. FOCUS reports are generally due within how many business days after the reporting period?

4. Under the basic method, the early warning threshold for net capital is triggered when:

5. Customer communications (emails, letters) must be retained for at least: