Chapter 6 - Computation of Net Capital Flashcards
After calculating AI and determining its minimum required net capital, the next step is to…
Calculate net capital to ensure its at or above the minimum
Net capital is computed by…
Starting with net worth (equity) and making certain deductions based on liquidity of the BD’s assets
Net worth =
Capital stock + retained earnings
Fair value measurement
Based on observable inputs based on currently available market data (like market prices) when possible, independent of entity performing the valuation. Unobservable inputs are used in the absence of observable data and are based on the best information available.
Fair value hierarchy
Level 1 = Contemporaneous market prices in an active market at the time of valuation, not adjusted for liquidity factors
Level 2 = Less active market in which quotes must be obtained from multiple sources to obtain a consensus view; liquidity or other risk adjustments may be made
Level 3 = Unobservable inputs, necessitating a valuation model that uses assumptions about the value a market participant would place; liquidity or other risk adjustments may be made
Net capital computation
Total assets – total liabilities = total equity (net worth)
Net worth +/- adjustments = tentative net capital
TNC – haircuts on firm inventory = net capital
Additions to net worth in the net capital calculation
- Satisfactory subordination agreements (SLA is full loan amount; SDN is face value less haircut)
- Additional capital required on reverse repurchase agreements
Satisfactory subordination agreement criteria
- Agreement is in writing, is for a specific amount, and must acknowledge that the proceeds will be used in the BD’s business and are subject to business risks
- Lender must agree to subordinate their claim for repayment to claims of all other creditors
- Minimum duration of 1 year
- Agreement is filed with SEC 10 days prior to effective date and with FINRA at least 30 days prior to effective date
The minimum duration of a subordinated loan is normally one year. Subordinated loans may be considered to be part of a broker-dealer’s capital if they are qualified. If a broker-dealer wishes to consider the proceeds of a subordinated loan to be part of its equity as well as part of its capital, then the lender must be a partner or stockholder, the agreement may not provide for accelerated maturity, and the minimum duration must be three years.
Rules on prepayments with subordinated debt
If period >1 year, prepayment provision may be included but no prepayments can be made in the first year.
No prepayments allowed at all if it would cause AI:NC ratio to exceed 10:1 or cause NC to fall below 120% of minimum dollar amount.
Impacts to net capital of SLA vs SDN
SLA – capital is increased by the full amount of the loan
SDN – capital is increased by face amount of the note. Face amount is limited by the value of the securities backing the note, i.e. market value of securities less a haircut (generally 30%)
Temporary subordination agreements
No more than 45 days duration. BDs are limited to no more than 3 in any 12-month period. Usually permitted for underwriting purposes only.
Not available if:
- Firm was required to file a notice to the SEC under 17a-11
- Its AI/NC ratio exceeds 10:1, or
- NC <120% of minimum
Temporary subordination agreements may not be used to raise permanent capital in order to comply with the provisions of Rule 15c3-1
Revolving subordination agreement
Requires written approval from DEA.
Revolving subordination agreement provides for repayment within less than one year of any/all of loan amount.
Must take capital charge for full amount of loan commitment regardless of amount actually outstanding. Capital charge lasts from effective date of agreement to maturity.
Problems with SDN collateral
If the value of SDN collateral securities, less haircuts, falls below value of the SDN, BD must immediately notify the lender and DEA. Lender must deposit promptly additional cash/securities. If the lender fails to deposit, BD must promptly sell securities pledged as collateral in order to bring collateral value after haircuts (including full value of cash) to a sufficient amount.
Alternatively, BD can reduce the principal amount of the note to a level sufficiently collateralized. Can’t reduce principal more than 15% and may only be done with DEA approval. Approval will not be given if the reduction would cause AI:NC ratio to exceed 10:1 or net capital to drop below 120% of minimum $ requirement.
Reverse repurchase agreement
BD is lending (by buying securities) and agreeing to sell back at a later date
2 special requirements relating to additional capital + haircuts
Repurchase agreement
BD sells securities and agrees to repurchase them at a specified price at a later date. Difference between sale price and repurchase price is interest.
Reverse repurchase agreements net capital impacts
BD is required to maintain additional net capital based on the type of security being reverse repurchased. Additional capital is 10% of:
- Excess market value of US Treasuries, notes and bonds over 105% of contract price (including accrued interest)
- Excess market value of US agency or mortgage related securities over 110% of contract price (including accrued interest)
- Excess market value of other securities over 120% of contract price (including accrued interest)
Deductions from net worth in the net capital calculation
- Haircuts to securities positions
- Fixed assets (for real estate, deduct carrying value – mortgage)
- Prepaid items
- Exchange memberships/seat (or receivables from sale)
- Goodwill
- Insurance claims not expected to be valid (according to counsel) and not covered by valid insurance, if after 7 business days after the loss
- For sole proprietors, personal liabilities in excess of personal assets
- Unsecured advances and loans
- Portion of receivables which are unsecured
- PFOF receivable
- Margin account deficits (collateral value < debit balance): if maintenance margin call has been outstanding for 5 or less business days, can deduct margin call from deficit. If >5 days, deduct full deficit.
- Cash account deficit if >1 exception has been granted
- Collateral deficit on SDN (including 30% haircut)
- Reverse repurchase agreement deficit (deduct deficit)
- Repurchase agreement deficit (if deficit, deduct typical haircut percentages)
- Commissions receivable, dividends/interest receivable, floor brokerage receivable, mutual fund concessions receivable, or mgmt. fees receivable if >30 days aged
- Non-municipal good faith deposits if >11 days aged from settlement of underwriting
- Municipal good faith deposits (or any other receivable from muni underwriting) if >60 days
- Short securities differences according to schedule (7,14,21,28 BDs after discovery)
- Long difference which has been sold
- Non-marketable securities (100% value deducted), including unregistered stock or partner’s interest in LP
- Contractual commitment on listed securities: 15% haircut on market value, plus unrealized loss, less unrealized gain, less selling concession (if net capital is >$250k, can add back up to $150k of this deduction)
- Contractual commitment on unlisted securities: 30% haircut, less selling concession (discount for BD) (if net capital is >$250k, can add back up to $150k of this deduction)
- Aged FTD (5+ business days): 15% haircut to market value, plus unrealized loss, less unrealized gain
- Aged municipal FTD (21+ business days): same rules as above
- Fidelity bonds - deductible less 10% of policy
Non-allowable asset
Fully deducted from net capital
Short securities differences haircuts from net capital
Deduction for market value of short securities differences according to this schedule:
7 business days after discovery = 25%
14 days = 50%
21 days = 75%
28 days = 100%
Non-marketable securities
No ready market = recognized, established securities market in which there are independent bids/offers. Price reasonably related to last sales price or current bid/offer can be determined almost instantly. Ready market is assumed if bank/DEA accept security as collateral.
