Net Capital Requirements

The net-capital rule is the SEC's primary financial-responsibility rule. Every other rule in this unit (customer protection, FOCUS reporting, early-warning notification, the FINRA expansion-restriction trigger, the fidelity-bond requirement, SIPC funding) sits on top of the net-capital framework. The rule's purpose is to ensure the firm has sufficient liquid assets to wind down its business without leaving customers or counterparties exposed.

Purpose: A Liquid-Asset Floor for Wind-Down

The Net Capital Rule is built around a single question: if the firm had to stop trading tomorrow, would it be able to satisfy customer claims, counterparty obligations, and orderly liquidation costs from its own assets?

• The rule requires the firm to maintain sufficient liquid assets at all times
• "Sufficient" is measured against either an aggregate-indebtedness ratio or an aggregate-debit-items ratio, plus a dollar minimum based on firm category
• A firm that falls below the required floor must cease securities business until the deficiency is cured

Think of it this way: The Net Capital Rule treats every BD as if it were always one customer complaint away from a wind-down. The rule does not ask whether the firm is profitable; it asks whether the firm has enough cash-like assets to cover obligations and close the books. A firm with $50 million of revenue and $40 million of furniture, fixtures, and goodwill can fail the rule because none of those assets satisfy customer claims in liquidation.

Two Computation Methods

Each broker-dealer elects one of two methods, filed with the firm's Designated Examining Authority (DEA) (which is FINRA for most BDs):

The Basic Method is also called the "15:1 ratio" rule: net capital must be at least 1/15 of aggregate indebtedness, so AI cannot exceed 15 times net capital. A firm with $1 million of net capital under the Basic Method can support up to $15 million of aggregate indebtedness.

The Alternative Method substitutes an asset-side ratio (debit items from the customer reserve formula) for the liability-side ratio (aggregate indebtedness). Large firms prefer it because their AI grows faster than their debit items, so the AI ratio would constrain growth long before the debit ratio would.

Exam Tip: Gotchas

• The Basic Method is not "the simple method." It is a ratio test on aggregate indebtedness. The Alternative Method is a ratio test on debit items. Both methods are computed from the same underlying balance sheet, but the floor test differs.
• Election is filed with the DEA, not the SEC. The DEA is FINRA for most BDs. A firm that switches methods without notifying its DEA has a separate procedural violation independent of whether either method is satisfied.

Minimum Dollar Net Capital by Firm Category

Beyond the ratio floor, every firm must satisfy a dollar minimum based on what it does:

Two layered minimums for hybrid-licensed firms:

• Futures Commission Merchants (FCMs) that are also broker-dealers: at least the greater of the BD requirement or 4% of segregated funds under the Commodity Exchange Act
• A firm that meets multiple categories must satisfy the highest applicable floor

Real-world example: A firm that introduces customer accounts but also makes markets in 50 OTC equities cannot use the $50,000 introducing-firm floor. It must satisfy the market-maker floor (greater of $2,500 per security, capped, or $100,000). The firm's required net capital is the greater of all applicable floors.

Exam Tip: Gotchas

• The $5,000 floor is for introducing firms that do NOT receive customer funds or securities. Firms that receive funds (even if they immediately forward them to the carrying firm) face the $50,000 floor. The exam often frames this around "promptly transmits" language; receiving the funds at any point triggers $50,000.
• The $1,000,000 prime-broker floor is steep. A firm acting as a prime broker for hedge funds must hold a million dollars of net capital before any customer protections layer on top. This is why most BDs do not offer prime brokerage.

Net Capital Computation: From Net Worth to Net Capital

Net capital is computed by stepping the firm's net worth through a series of regulatory adjustments:

1. Start with the firm's net worth (GAAP equity)
2. Add allowable subordinated liabilities (per the SEC's Satisfactory Subordination Agreements framework)
3. Subtract non-allowable assets (e.g., furniture, prepaid expenses, unsecured receivables, certain affiliate receivables, goodwill)
4. Apply haircuts to securities positions (percentage deductions reflecting market risk)
5. The result is tentative net capital, then net capital

Non-Allowable Assets

Assets that cannot be readily converted to cash to satisfy customer claims are subtracted in full:

• Furniture, fixtures, equipment
• Prepaid expenses
• Unsecured receivables (including aged receivables)
• Certain affiliate receivables (depending on terms)
• Goodwill and intangibles

Haircuts

Securities positions take percentage deductions that reflect the position's market risk. Different security types take different haircuts:

• U.S. government securities: small haircuts (often 0% to 6% depending on maturity)
• Investment-grade corporate bonds: moderate haircuts
• Equities: larger haircuts (commonly 15% for marginable equities)
• Non-marginable / illiquid securities: much larger haircuts, sometimes 100%

The haircut math gives a more conservative valuation than mark-to-market because the rule assumes the firm may have to liquidate quickly under stress.

Exam Tip: Gotchas

• Furniture and prepaid expenses are non-allowable. A firm with $1 million in cash and $500,000 in office furniture has $1 million of allowable assets, not $1.5 million. Common exam trap: treating the firm's full balance sheet as net capital input.
• Haircuts are deducted, not added. A 15% haircut on a $1 million equity position produces $850,000 of net-capital value, not $1.15 million.

Subordinated Loan Agreements

A loan to the broker-dealer counts as regulatory capital only if the agreement satisfies the SEC's Satisfactory Subordination Agreements framework. This is how a firm raises the equity-equivalent capital it needs without diluting ownership.

Subordinated loan requirements:

• The agreement must be subordinated to all general creditors (lender stands behind everyone else in liquidation)
• Required subordination period: at least 1 year
• DEA approval required before the funds can be added to net capital
• Repayment is prohibited if it would cause a net capital deficiency

Think of it this way: A subordinated loan is the regulatory equivalent of equity capital with a return of capital date. The lender accepts that the firm's customers and unsubordinated creditors get paid first. In exchange, the firm gets to count the loan as regulatory capital. The DEA's pre-approval prevents firms from booking sham subordinated loans (e.g., a parent company loan that is actually callable on demand).

Exam Tip: Gotchas

• Subordinated-loan approval must precede the capital credit. A firm that books a "loan" as net capital before the DEA approves it has overstated net capital, a net-capital violation regardless of whether the cash actually arrives.
• The 2%-of-debits Alternative Method lets large carrying firms avoid the 15:1 aggregate-indebtedness ceiling of the Basic Method. The trade-off is daily reserve-formula discipline. Most large clearing firms use the Alternative Method; small introducing firms use the Basic Method with the $50,000 or $5,000 dollar minimum.

What "Below Minimum" Means

A firm whose net capital falls below its required floor (whichever ratio applies, plus the dollar minimum) is "below minimum" and faces three consequences in escalating order:

• Must cease securities business until the deficiency is cured (the substantive consequence)
• Must file a same-day notification under the SEC early-warning notification regime (covered later in this unit)
• Becomes subject to FINRA business-expansion restrictions and possible curtailment under the FINRA early-warning notification framework

The substantive consequence of ceasing securities business is the rule's teeth. A BD with no net capital cannot legally take customer orders, hold customer funds, or run principal trades. The firm must either inject capital, reduce inventory and customer receivables, or wind down.