- SEC Issues Guidance on the Recording of Expenses and Liabilities by Broker-Dealers
- December 16, 2003 | Authors: Benjamin J. Catalano; Frances M. Luke
- Law Firm: Dorsey & Whitney LLP - New York Office
It is common practice for a U.S. registered broker-dealer to enter into an expense-sharing agreement with its parent company or affiliate whereby the parent company or affiliate provides the broker-dealer with certain securities trading services and related administrative functions, as well as certain space, facilities, equipment and other services in exchange for a fee. In recent months, there has been concern expressed by the National Association of Securities Dealers, Inc. ("NASD") and the New York Stock Exchange ("NYSE") (collectively, the "SROs") that some broker-dealers may be incorrectly omitting expenses and liabilities subject to these agreements on the broker-dealer's books and records, resulting in inaccurate disclosure of the broker-dealer's performance and financial condition. The SROs are concerned that the omission may artificially inflate the broker-dealer's profitability and cause it to appear to be in full capital compliance when in some cases it may not be. In addition, since the party paying the expenses of a member broker-dealer under an expense-sharing agreement is usually not itself a registered broker-dealer, it is difficult for the SROs to access the books and records related to the member broker-dealer's operations during an exam.
To clarify the application of the financial responsibility rules 1when a parent holding company affiliate or other third party agrees to assume responsibility for payment of the broker-dealer expenses, the SROs requested guidance from the Division of Market Regulation at the Securities and Exchange Commission ("SEC"). On July 11, 2003, the SEC issued a letter setting forth a list of nine requirements for recording broker-dealer expenses and liabilities. 2These requirements became effective as of the date of the SEC's letter, however, the NASD extended the compliance period for its members to December 1, 2003. There is now an initiative by the NASD District Offices to review expense-sharing agreements already in place as part of routine exams and continuing membership applications.
The SEC's requirements are summarized as follows:
1. Pursuant to Rule 17a-3(a)(1) and (2), a broker-dealer must record each expense 3incurred relating to its business and any corresponding liability, regardless of whether the liability is joint or several with any person and regardless of whether a third party has agreed to assume the expense or liability. The record must include the value of any goods or services used in the broker-dealer's business, when a third party has furnished the goods or services or has paid or has agreed to pay the expense or liability, whether or not the recording of the expense is required by GAAP, and whether or not any liability relating to the expense is considered a liability of the broker-dealer for net capital purposes. The SEC suggests that the broker-dealer record the expenses as incurred in amounts determined according to a reasonable allocation (applied on a consistent basis) of the costs assumed by the third party. In addition, the NASD has indicated that expense agreements should list the services or products provided to the broker-dealer, with a reasonable cost assigned to each.
2. The broker-dealer may make record of expenses in accordance with Rule 17a-3(a)(1) and (2) by preparing a separate schedule of expenses. Alternatively, the broker-dealer may record those expenses on the reports it must file with the SEC or its designated examining authority ("DEA") -- either the NASD or the NYSE -- under the financial responsibility rules.
According to NASD guidance, to the extent a broker-dealer already reflects its expenses and liabilities as part of its general ledger, and maintains proper back-up documentation relative to the expense, no other documentation is necessary relative to items 1 and 2 above.
3. If a third party has agreed to assume responsibility for an expense relating to the business of the broker-dealer, and the expense is not recorded on the reports the broker-dealer files with the SEC or with its DEA under the financial responsibility rules, any corresponding liability will be considered a liability of the broker-dealer for net capital purposes unless:
- If the expense results in a payment owed to a vendor or other party, the vendor or other party has agreed in writing that the broker-dealer is not directly or indirectly liable to the vendor or other party for the expense;
- The third party has agreed in writing that the broker-dealer is not directly or indirectly liable to the third party for the expense;
- There is no other indication that the broker-dealer is directly or indirectly liable to any person for the expense;
- The liability is not a liability of the broker-dealer under GAAP; and
- The broker-dealer can demonstrate that the third party has adequate resources independent of the broker-dealer to pay the liability or expense.
Upon entering into an expense-sharing agreement and annually thereafter, as of the broker-dealer's fiscal year-end, the broker-dealer has to obtain evidence that the third party has adequate resources independent of the broker-dealer to pay the costs incurred by the broker-dealer. This may be accomplished by receiving a copy of the third party's audited financial statements. 4
4. Any withdrawal of equity capital from a broker-dealer by a third party, as defined in Rule 15c3-1(e)(4)(ii) (other than a withdrawal under paragraph (e)(4)(iii) of Rule 15c3-1 5), within three months before or within one year after the broker-dealer incurs an expense that the third party has paid or agreed to pay, will be presumed for net capital purposes to have been made to repay the third party for the expense of the broker-dealer, unless the broker-dealer's books and records reflect a liability to the third party relating to the expense.
It should be noted that broker-dealers must use an accrual basis of accounting to maintain their financial records. Capital withdrawals may not be used as a means of timing the broker-dealer's recognition of the costs incurred in its operations.
5. For purposes of determining net capital, if the broker-dealer records a capital contribution from a third party that has assumed responsibility for paying an expense of the broker-dealer, and the expense is not recorded on the reports the broker-dealer files with the SEC or with its DEA under the financial responsibility rules, the broker-dealer must demonstrate that the recording of a contribution to capital is appropriate. Among other things, the broker-dealer must demonstrate that the third party has paid the expense or has adequate resources independent of the broker-dealer to pay the expense and that the broker-dealer has no obligation, direct or indirect, to a vendor or other party to pay the expense. For net capital purposes, any equity capital withdrawn by the third party (other than a withdrawal under paragraph (e)(4)(iii)) Rule 15c3-1, within three months before or one year after the broker-dealer incurs the expense, will be deemed to have been a repayment of the expense to the third party.
If a contribution to capital is made to a broker-dealer with an understanding that the contribution can be withdrawn at the option of the contributor, the contribution may not be included in the firm's net capital computation and must be re-characterized as a liability. Any withdrawal of capital as to that contributor within a period of one year (other than a withdrawal under Rule 15c3-1 (e)(4)(iii) will be presumed to have been contemplated at the time of the contribution. 6
The fourth and fifth items above require a broker-dealer, from which capital is withdrawn, to recalculate its net capital from the date of when the expense was paid to the third party and to provide telegraphic notice as required per Exchange Act Rule 17a-11, if necessary.
6. If a third party agrees or has agreed to assume responsibility for an expense of the broker-dealer, the broker-dealer must make, keep current, and preserve the following records pursuant to Rules 17a-3 and 17a-4:
- If a vendor or other party has agreed that the broker-dealer is not liable directly or indirectly to the vendor or other party for an expense, a written agreement between the broker-dealer and the vendor or other party that clearly states that the broker-dealer has no liability, direct or indirect, to the vendor or other party; and
- A record of each expense assumed by the third party.
7. A broker-dealer must make, keep current, and preserve a written expense sharing agreement between the broker-dealer and a third party that has paid or agreed to pay an expense of the broker-dealer. The agreement must set out clearly which party is obligated to pay each expense, whether the broker-dealer has any obligation, direct or indirect, to reimburse or otherwise compensate any party for paying the expense, and the method of allocation when the broker-dealer records the expense in an amount that is determined according to an allocation made by the third party.
8. Each broker-dealer and broker-dealer applicant must be able to demonstrate to the appropriate authorities that it is in compliance with the financial responsibility rules in connection with any expense-sharing agreement. Therefore it may be required to provide these authorities with access to books and records, including those of unregistered entities, relating to the expenses covered by the agreement.
If the broker-dealer fails to provide access to such books and records, including those of a party that has agreed to assume responsibility for paying all or a portion of the applicant's costs pursuant to Membership and Registration Rule 1014(a)(7), the NASD will not permit the applicant to use an expense-sharing agreement to show that it is able to maintain sufficient excess net capital to support its intended business operations on a continuing basis. Similarly, if the broker-dealer fails to provide access to such books and records, the SRO may operate under the rebuttable presumption that the broker-dealer was not in capital compliance for the term covered by the expense-sharing agreement.
9. A broker-dealer must notify its DEA if it enters into, or has entered into, an expense sharing agreement and the broker-dealer does not record each of the expenses it incurs relating to its business on the reports it is required to file with the SEC or with its DEA under the financial responsibility rules. The notification must include the date of the agreement and the names of the parties to the agreement. The broker-dealer must provide a copy of the agreement to its DEA upon request. This notification must be made in writing to a broker-dealer's assigned NASD District Office for both existing and new expense-sharing agreements.
1 For purposes of the SEC letter, the financial responsibility rules include the net capital rule, Rule 15c3-1 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and reporting and recordkeeping requirements under Exchange Act Rules 17a-3, 17a-4, and 17a-5.
2 The SEC letter and related NASD Notice to Members can be found at: http://www.nasdr.com/pdf-text/0363ntm.pdf
3 The NASD has interpreted the word "expense" to include all costs for which a broker-dealer would derive direct or indirect benefit and/or for which a broker-dealer would be responsible if another entity had not agreed to pay for it (e.g., rent, telephone, copy services, etc...).
4 If the third party is a reporting company under the Exchange Act and is current on all financial filings required under that Act, the firm may rely on those filings to determine whether the third party has adequate resources apart from the broker-dealer.
If the third party is not a reporting company under the Exchange Act, the broker-dealer must obtain evidence pursuant to either a. or b. below, at a minimum, as well as further information as requested by NASD:
a. A signed and dated copy of a complete set of the third party's most recent audited financial statements, but in no event with an as-of date older than 12 months; or a signed and dated copy of the third party's most current required Federal income tax return as it has been filed with the Internal Revenue Service within the last 12 months.
b. If the shareholders, partners, or other owners of the third party want their abilities to infuse capital into the third party to be accepted as demonstrating adequate resources independent of the broker-dealer, they must, at a minimum, provide copies of their audited financial statements or Federal income tax returns, using the same twelve-month parameters as in a. Other additional evidence may also be required by NASD.
5Paragraph (e)(4(iii) indicates that the notice and limitation provisions on capital withdrawals do not preclude a broker-dealer from making the required tax payments or paying partners reasonable compensation and that such amounts are not included in the calculation of withdrawals, advances or loans for the purposes of these provisions.
6Though this requirement is similar to fourth item above, it applies in a situation where the broker-dealer's actual expense to a vendor or service provider was recorded on the broker-dealer's general ledger as an expense and a related liability owed to the third party and the third party forgave the liability and the broker-dealer removed the forgiven liability and credited a capital contribution from the third party. The broker-dealer may not record the capital contribution until it can show the evidence required under item 3 above that the third party paid the expense or has the financial resources to pay the expense independent of the broker-dealer, and that the broker-dealer is not obligated to repay the third party for any portion of the expense.