Key. SEC Financial Responsibility Rules

1 Appendix 11 Key. SEC Financial Responsibility RulesThe SEC Net CapitalRule(Rule15c3-1)BackgroundThe Securities and Exchange Commission's(SEC)1uniform net capital rule(15c3-1) and customer protection rule (15c3-3) form the foundation of thesecurities industry's Financial Responsibility framework.' The net capitalrule focuses on liquidity and is designed to protect securities customers,counterparties, and creditors by requiring that broker-dealers havesufficient liquid resources on hand at all times to satisfy claims 15c3-3, or the customer protection rule, which complements rule15c3-1, is designed to ensure that customer property (securities and funds)in the custody of broker-dealers is adequately safeguarded.

2 By law, both ofthese Rules apply to the activities of registered broker-dealers, but not tounregistered the net capital rule (Rule 15c3-1) in 1975 to establish uniformnet capitalstandardsfor brokers anddealers'registered withSECunderSection 15(b) of the Securities Exchange Act of 1934 (Exchange Act). Withfew exceptions, all broker-dealers registered withSECmust comply withthis liquidity standard.' The primary purpose of this rule is to ensure that'SEC is the federal agency responsible for administering the Federal Securities Laws. One objective ofthe Federal Securities Laws is to protect investors.

3 'Otherfinancial Responsibility Rules include the records maintenance and preservation Rules (17a-3 and17a-4); the Financial reporting rule (17a-5); the early warning or "telegraphic" notice rule (17a-11); thequarterly security counts rule (17a-13); the hypothecation Rules (8c-1 and 15c2-1); the initial marginrequirements of the Board of Governors of the Federal Reserve System (12 Section (b));and the maintenance margin Rules of the self-regulatory organizations ( , New York Stock Exchangerule 431).Note: SEC and Commodity Futures Trading Commission(CFTC)officials stated that the futuresindustry capital adequacy and customer assets protection requirements (CFTC Rules , , respectively) generally mirror the requirements in SEC Rules 15c3-1 and 15c3-3.

4 'A broker is anypersonthat engages in the business of effecting transactions in securities for theaccount of others, but does not include a bank. A dealer is any person that engages in the business ofbuying and selling securities for his own account, through a broker or otherwise, but does not includea bank, or any person insofar as he buys or sells securities for his own account, either individually orin some fiduciary capacity, but not as part of a regular business. Broker-dealers combine the functionsof brokers and dealers.'The sole market maker (a dealer that makes bids and offers at which he/shewilltrade) and solespecialist (a member:designated by an exchange to be the sole market maker for a particular stock) onthe options floor are exempted from the SEC net capital rule; and floor brokers on an exchange, undercertain circumstances are exempted from the rule.

5 Also, SEC may exempt certainbroker-dealersfromthe rule upon a determination that it is "not necessary in the public interest or for the protection ofinvestors" to subject the particular broker-dealer to the rule. See Rule15c3-1(b).Page 130 GAO/GGD-98-153 Risk-Based CaptialAppendix 11 Key SECF inancial Responsibility Rulesregistered broker-dealers maintain atalltimessufficientliquidassets5to(1) promptly satisfy their liabilities-the claims of customers, creditors,and other broker-dealers; and (2) to provide a cushion of liquid assets inexcess of liabilities to cover potential market, credit, and other risks ifthey should be required to liquidate.

6 The rule achieves its purpose byprescribing a liquidity test that requires a broker-dealer to maintain thegreater of a specified minimum dollar amount or specified percentage ofnet capital in relation to either aggregate indebtedness (generally allliabilities of the broker-dealer) or customer-related receivables (moneyowed to the broker-dealer by customers) as computed by the reserverequirements of Rule 15c3-3. The net capital rule thus enhancesinvestor/customer&confidencein thefinancialintegrity of broker-dealersand the net capital rule applies only to theregistered broker-dealer and does not apply to the broker-dealer's holdingcompany or unregulated subsidiaries oraffiliates.

7 'To comply withSEC'snet capitalrule,broker-dealers must perform twocomputations: one computation determines the broker-dealer's net capital (liquid capital ), and another computation determines the broker-dealer'sappropriate minimum net capital requirement (base capital requirement).Net capital is defined as Generally Accepted AccountingPrinciples(GAAP)equity plus qualified subordinated liabilities$ and credits lessnonallowableassets,9certain operational charges ( ,fail-to-deliver),lob1 Jiquidassets are assets that can be converted easily into cash with relatively little loss of must have at all times at least $1 of liquid assets for each $1 of liabilities (except forsubordinated liabilities that are treated as part of thebroker-dealer'scapital)

8 In addition to theminimumrequirementsof the net capital rule in case they fail the net capital test orvoluntarilyceaseoperations. Once liquidation is decided upon, a broker-dealer's operations are generally liquidated inan orderly manner within a short time frame without the use of a formal bankruptcy proceeding.'Generally,a customer is defined as any person from whom or on whose behalf a broker or dealer hasreceived or acquired or holds funds or securities for the account of such person.'Anexception to thisprincipleiswhere the registered broker-dealer guarantees or assumesresponsibility for the liabilities of the related unregistered entity.

9 In such a situation, thebroker-dealeris required to consolidate into a single computation the assets and liabilities of both itself and theguaranteed entity. See Rule15c3-1(a)and Appendix C to the rule.'fobe counted as capital in the net capital computation, the subordinated liabilities, among otherthings: (1) must have an initial term of 1 year or more; (2) must be subordinated to the claims of allpresent and future creditors, including customers; (3) may not be repaid if the repayment wouldreduce regulatory net capital below certain required amounts; and (4) must be approved for inclusionas net capital by the broker-dealer's self-regulatory organization (SRO).

10 9 Nonallowableassets are considered illiquid assets (assets that cannot be immediately or quicklyconverted into cash) by the net capital rule. Such assets decrease a broker-dealer's net capital , becausethey are deducted from GAAP equity in the net capital computation.' A fail-to-deliver is a situation in which the sellingbroker-dealerdoes not receive securities from theclient in time to make delivery with the buying GAO/GGD-98-153 Risk-Based CaptialFigureIht:SEC Net capital FormulationTotal capital DeductionsGAAP equity plus allowable subordinated debtand creditsNet capitalLiquid capital available to 11 Key SEC Financial Responsibility Rules4indprescribed percentages of the market value(otherwiseknown ashaircuts)" of securities and commodities that constitute thebroker-dealer's trading and investment positions.