Net Capital Requirements

The net capital rule is a floor built from several tests that run at the same time. The greater of the ratio requirement and the highest activity minimum sets the base figure, and two amounts then sit on top of it: the consolidated subsidiary and affiliate minimums, and, where reverse repurchase agreements apply, 10 percent of the stated excesses.

How Much Net Capital Must a Firm Hold at All Times?

Every broker or dealer must at all times have and maintain net capital no less than the greater of two things: the highest minimum requirement applicable to its ratio requirement, or the highest minimum applicable to any of its activities. It must also not be insolvent, as the rule defines that term.

In lieu of the ratio requirement and the activity minimums, an over-the-counter (OTC) derivatives dealer maintains net capital under a separate paragraph written for it.

Two supplemental requirements also apply. Each broker or dealer complies with the market maker computation and the reverse repurchase add-on, to the extent either applies to its activities. Of those two, only the reverse repurchase amount is required in addition to the amounts the general requirement produces. The market maker computation is floored by that general requirement and capped at $1,000,000 unless it demands more.

The general requirement then adds a consolidation duty. In addition, a broker or dealer maintains net capital of not less than its own net capital requirement plus the sum of each broker's or dealer's subsidiary or affiliate minimum net capital requirements consolidated under the rule's consolidation appendix.

Exam Tip: Gotchas

• The ratio test and the activity minimum are not added together. The firm holds the greater of the two. The consolidation sentence is not the only addition: the reverse repurchase amount is also required in addition to the amounts the general requirement produces.
• Insolvency is a separate failure. A firm can carry ample net capital and still breach the rule by being insolvent as the rule defines it.
• The at-all-times wording rules out an average. The rule sets a level the firm must hold continuously, not a month-end or period-average figure.

What Are the Two Ratio Standards?

The rule prints two ratio standards, and a firm operates under one of them.

The aggregate indebtedness standard. No broker or dealer, other than one that elects the alternative below, may permit its aggregate indebtedness to all other persons to exceed 1,500 percent of its net capital. A different figure applies at the start of a firm's life: 800 percent of its net capital for 12 months after commencing business as a broker or dealer.

The alternative standard. A broker or dealer may elect not to be subject to the aggregate indebtedness standard. Four things follow from that election:

• The firm may not permit its net capital to be less than the greater of $250,000 or 2 percent of aggregate debit items, computed in accordance with the reserve formula the customer protection rule sets out.
• The firm must notify its Examining Authority, in writing, of the election.
• Once it has notified its Examining Authority, it continues to operate under the alternative standard unless a change is approved upon application to the Commission.
• Additional computation conditions apply to an electing firm that is not exempt from the customer protection rule.

Exam Tip: Gotchas

• The 800 percent figure is a start-up rule, not a penalty. It runs for 12 months after the firm commences business as a broker or dealer, after which the 1,500 percent ratio applies.
• The election locks. After notifying its Examining Authority the firm continues under the alternative standard unless a change is approved upon application to the Commission, so it cannot simply switch back.
• The alternative standard is itself a greater-of test. The firm takes the higher of $250,000 or 2 percent of aggregate debit items under the reserve formula.

Which Activity Minimum Applies?

Six activity minimums are printed in one paragraph, and the rule closes that list with a residual category for a firm doing none of the other five.

The figures are the smaller half of each paragraph. The rest of the text decides which row a firm sits in.

The carrying firm's two deeming rules. A firm is deemed to receive funds, or to carry customer or broker or dealer accounts and to receive funds from those persons, if in connection with its activities it receives checks, drafts, or other evidences of indebtedness made payable to itself or to persons other than the requisite registered broker or dealer carrying the account of a customer, escrow agent, issuer, underwriter, sponsor, or other distributor of securities.

A firm is deemed to hold securities for, or to carry customer or broker or dealer accounts and hold securities of, those persons if it does not promptly forward or promptly deliver all of the securities of customers or of other brokers or dealers it receives in that business.

What a firm may do without meeting the carrying minimum. Without complying with that minimum, a broker or dealer may receive securities only if its activities conform with the introducing paragraph or the investment company shares paragraph, and may receive funds only in connection with the activities described in the investment company shares paragraph.

Which customer protection exemption triggers the $100,000. The exemption behind that minimum reaches a broker or dealer that carries no margin accounts, promptly transmits all customer funds and delivers all securities received in connection with its activities, does not otherwise hold funds or securities for, or owe money or securities to, customers, and effectuates all financial transactions between itself and its customers through one or more bank accounts, each designated as "Special Account for the Exclusive Benefit of Customers of (name of the broker or dealer)".

The exemption printed beside it is a different one, and it does not carry the $100,000 minimum. Its conditions include that an introducing broker or dealer clears all transactions with and for customers on a fully disclosed basis with a clearing broker or dealer, and promptly transmits all customer funds and securities to that clearing broker or dealer.

What "dealer" means for the $100,000 row. The term includes any broker or dealer that endorses or writes options otherwise than on a registered national securities exchange or a facility of a registered national securities association, and any broker or dealer that effects more than ten transactions in any one calendar year for its own investment account.

Two groups sit outside it. The dealer paragraph does not apply to persons engaging in the activities described in the investment company shares row, the residual row, or the municipal securities brokers' broker paragraph.

It also does not apply to persons whose underwriting activities are limited solely to acting as underwriters in best efforts or all or none underwritings that use the bank escrow route of the underwriting payments transmission rule, so long as those persons engage in no other dealer activities.

The permissions and conditions attached to three rows.

• A firm at the $50,000 introducing minimum may participate in a firm commitment underwriting without becoming subject to the dealer minimum, but may not enter into a commitment for the purchase of shares related to that underwriting.
• A firm at the $25,000 minimum must promptly transmit all funds and promptly deliver all securities received in connection with its activities, and may not otherwise hold funds or securities for, or owe money or securities to, customers.
• A firm at the $5,000 residual minimum may engage in two dealer activities without becoming subject to the dealer minimum, each cleared through another registered broker or dealer.

Those two activities are narrow. On a buy order, before executing the customer's order, the firm purchases as principal the same number of shares, or purchases shares to accumulate the number necessary to complete the order. On a sell order, before executing the customer's order, it sells as principal the same number of shares or a portion of them.

Exam Tip: Gotchas

• Two different tests produce $250,000. One is the floor under the elected alternative ratio standard; the other attaches to carrying accounts and receiving or holding customer funds or securities.
• The carrying minimum can be triggered by a check the firm never banks. Receiving a check made payable to itself, or to persons other than the requisite registered broker or dealer carrying the account of a customer, escrow agent, issuer, underwriter, sponsor, or other distributor of securities, deems the firm to have received funds.
• The dealer definition counts transactions, not profits. More than ten transactions in any one calendar year for the firm's own investment account brings a firm inside it.
• The $100,000 exempt-firm row runs off one exemption, not both. It is the no-margin-accounts exemption; the fully disclosed introducing exemption beside it does not carry that minimum.
• The introducing firm's underwriting permission has a limit inside it. A firm commitment underwriting is allowed, but a commitment for the purchase of shares related to that underwriting is not.

What Do the Prompt Handling Phrases Mean?

Three defined phrases in the activity minimums have clock definitions elsewhere in the rule, and the two definitions land at the same hour.

• A broker or dealer is deemed to promptly transmit all funds and to promptly deliver all securities where the transmission or delivery is made no later than noon of the next business day after receipt of those funds or securities. There is a proviso: prompt transmission or delivery is not required to be effected prior to the settlement date for the transaction.
• A broker or dealer is deemed to promptly forward funds or securities only when the forwarding occurs no later than noon of the next business day following receipt.

Exam Tip: Gotchas

• The proviso can push the deadline out, not in. Prompt transmission or delivery is not required before the settlement date, so a next-business-day noon answer can be wrong for a trade settling later.
• Only one of the two definitions carries that proviso. It covers prompt transmission and prompt delivery together, so two of the three phrases carry it; the prompt forwarding definition is a bare noon deadline.
• Both definitions use noon, not the close of business. Noon of the next business day is the hour in each.

How Much Net Capital Must a Market Maker Hold Per Security?

The rule defines market maker for its own purposes, and the test is not the qualified market maker definitions.

A market maker is a dealer who, with respect to a particular security, regularly publishes bona fide, competitive bid and offer quotations in a recognized interdealer quotation system, or furnishes bona fide competitive bid and offer quotations on request, and is ready, willing and able to effect transactions in reasonable quantities at its quoted prices with other brokers or dealers.

A broker or dealer engaged in activities as a market maker on that definition maintains net capital of not less than $2,500 for each security in which it makes a market. If a security in which it makes a market has a market value of $5 or less, the amount is not less than $1,000 for that security.

The count is not a snapshot. It is based on the average number of such markets made by the firm during the 30 days immediately preceding the computation date.

Two limits close the paragraph. Under no circumstances may the firm have net capital less than the rule's general requirement demands, and it is not required to maintain net capital of more than $1,000,000 under this computation unless that general requirement demands it.

Exam Tip: Gotchas

• The $1,000,000 figure is a ceiling on this computation. Once the per-security amounts reach $1,000,000, the computation demands that figure and no more, so $1,000,000 is what it requires of a large market maker. It gives way where the rule's general requirement demands more.
• The per-security amount drops on price, not on volume. A security with a market value of $5 or less carries $1,000 rather than $2,500.
• The market count is a 30-day average. It uses the average number of markets made during the 30 days immediately preceding the computation date, so opening or closing a market mid-month moves the figure only partly.
• This definition of market maker has its own shape. It is publication in a recognized interdealer quotation system or furnishing on request, combined with readiness to trade in reasonable quantities at quoted prices.

What Does the Liquidating Equity Election Require?

The rule prints a second market maker paragraph, headed for market makers, specialists and certain other dealers.

A dealer meeting the conditions below may elect to operate under it and thereby not apply, except to the extent the election itself requires, the securities haircut provisions or the rule's deduction appendix to market maker and specialist transactions, applying the liquidating equity test in their place.

The election is available to a dealer that meets four conditions:

• Does not effect transactions with other than brokers or dealers.
• Does not carry customer accounts.
• Does not effect transactions in options not listed on a registered national securities exchange or facility of a registered national securities association.
• Has its market maker or specialist transactions effected through and carried in a market maker or specialist account cleared by another broker or dealer, on the written undertaking the rule describes.

An electing dealer must at all times maintain a liquidating equity in respect of securities positions in its market maker or specialist account at least equal to one of two amounts.

The percentage amount. An amount equal to 25 percent, or 5 percent in the case of exempted securities, of the market value of the long positions, and 30 percent of the market value of the short positions.

That amount carries a proviso. For long or short positions in options, and in securities other than options that relate to a bona fide hedged position as the rule defines it, the amount instead equals the deductions the rule's deduction appendix specifies for those positions.

The approved lesser amount. Such lesser requirement as the Commission may approve, under specified terms and conditions, upon written application of the dealer and the carrying broker or dealer.

The rule also states how that equity is computed. All securities positions long or short in the account are marked to their respective current market values; the credit balance carried in the account is added, or deducted in the case of a debit balance; and the market value of positions long in the account is added, or deducted in the case of short positions.

Exam Tip: Gotchas

• The long and short percentages are different numbers. Long positions run at 25 percent, or 5 percent for exempted securities, while short positions run at 30 percent.
• A lesser requirement needs two applicants. The Commission approves it upon written application of the dealer and the carrying broker or dealer, so the dealer cannot apply alone.
• Options and hedged positions leave the percentage test. They take the deductions the rule's deduction appendix specifies instead.
• All four availability conditions must hold. No transactions with other than brokers or dealers, no customer accounts, no unlisted options, and clearance through another broker or dealer on the written undertaking the rule describes.

What Do Reverse Repurchase Agreements Add?

This requirement is additive rather than a greater-of test. A broker or dealer maintains net capital in addition to the amounts the rule's general requirement produces, in an amount equal to 10 percent of three excess amounts, each measured against contract prices including accrued interest, with any one party:

Exam Tip: Gotchas

• This add-on is one of two amounts the rule adds rather than compares. It sits on top of the general requirement, as the consolidated minimums of subsidiaries and affiliates do.
• The percentages rise as credit quality falls. Treasury obligations are measured against 105 percent, agency and mortgage related securities against 110 percent, and everything else against 120 percent.
• Only the excess is captured, and then only a tenth of it. The firm holds 10 percent of the amount by which market value exceeds the stated percentage of contract prices with that party.

Who Is Exempt From the Rule?

Three exemptions close the structure, and one of them is written for a floor broker.

The options specialist exemption. The provisions of the rule do not apply to a specialist that meets all four of these conditions:

• Its securities business, except for an occasional non-specialist related securities transaction for its own account, is limited to acting as an options market maker on a national securities exchange.
• It is a member in good standing of, and subject to the capital requirements of, a national securities exchange.
• It does not transact a business in securities with anyone other than a broker or dealer registered with the Commission under the broker-dealer registration statute or the government securities broker and dealer registration statute, or a member of a national securities exchange.
• It is not a clearing member of The Options Clearing Corporation, and its securities transactions are effected through and carried in an account cleared by another registered broker or dealer.

The floor broker election. A member in good standing of a national securities exchange who acts as a floor broker, and whose activities do not require compliance with other provisions of the rule, may elect to comply with a financial responsibility standard in lieu of the other provisions.

That standard has two ways to satisfy it. The value of the member's exchange membership, based on the lesser of the most recent sale price or the current bid price for an exchange membership, is not less than $15,000. Alternatively, an amount equal to the excess of $15,000 over the value of the exchange membership is held by an independent agent in escrow.

A proviso conditions the election. The rules of that exchange must require the proceeds from the sale of the member's exchange membership, and the amount held in escrow, to be subject to the prior claims of the exchange and its clearing corporation, and those arising directly from the closing out of contracts entered into on the floor of those exchanges.

The Commission exemption. The Commission may, upon written application, exempt a broker or dealer from the rule, either unconditionally or on specified terms and conditions.

Exam Tip: Gotchas

• The floor broker election is available only to a narrow firm. It requires a member in good standing whose activities do not require compliance with other provisions of the rule.
• The membership value test takes the lesser price. It uses the lesser of the most recent sale price or the current bid price for an exchange membership, measured against $15,000.
• Escrow covers only the shortfall. The amount held by an independent agent equals the excess of $15,000 over the value of the membership, not the whole $15,000.
• The specialist exemption fails if any one condition fails. All four must hold, including that the firm is not a clearing member of The Options Clearing Corporation.

What Should You Check on Exam Day?

• Take the greater of the ratio requirement and the highest activity minimum, then check whether the market maker computation or the reverse repurchase add-on also applies.
• Separate the two $250,000 tests: the elected alternative ratio standard, and the carrying firm that receives or holds customer funds or securities.
• Confirm the market maker figure is $2,500 per security, $1,000 where market value is $5 or less, on a 30-day average, and that $1,000,000 is a ceiling.
• Read prompt transmission, delivery and forwarding as noon of the next business day, and check the settlement-date proviso before answering.
• For an exemption, run every condition. The specialist exemption needs all four; the floor broker election needs good standing, the activity limit, the membership or escrow value, and exchange rules subjecting the proceeds and escrow to prior claims.