SEC Provides Additional Clarifications and Interpretations to Net Capital Rule Amendments

Executive Summary

In May 1993, the NASD published Notice to Members 93-30, which set forth, in question and answer format, certain guidelines for compliance with recent amendments to the Securities and Exchange Commission (SEC) Net Capital Rule, Rule 15c3-1. The SEC adopted the amendments, which became effective on a staggered schedule late last year. This Notice provides additional clarifications and interpretations of these new requirements.

Background

The NASD published its initial Notice concerning the amendments to the SEC's Net Capital Rule (Notice to Members 92-72) in December 1992. The Notice advised that several amendments to the rule took effect January 1 with other changes slated for July 1, 1993. As of that date, the net capital ceiling for a market maker increases to $1 million. Likewise, the changes to the minimum net capital requirements will take effect in three installments beginning July 1. The SEC is still considering additional amendments to the rule, published for comment in December.

The amendments to the minimum net capital requirements increase the dollar amounts for many categories of broker/dealers. The increases are based on the nature of the firm's business and the extent to which a broker/dealer has contact with customer funds or securities. In several instances, the new requirements are significantly higher than the previous minimums.

Other adopted amendments establish one standardized method of calculating haircuts for all firms; adopt the alternative method for computing concentration charges for all firms; reduce the impact on aggregate indebtedness for two items (mutual funds payable offset by fails to deliver and corresponding stock loan/stock borrow); and permit the use of an offset when computing the open contractual commitment haircut on underwritings.

After these changes were announced in December, the NASD began to receive questions concerning the new requirements. In May 1993, the NASD issued Notice to Members 93-30, answering certain of these questions for the benefit of all members. Since then, the NASD has received additional clarifications and interpretations from the SEC staff and is publishing them in this Notice.

Clarifications and Interpretations

Clearing Agreements

According to the SEC staff, it will deem an introducing firm to be a clearing firm (and required to comply with the clearing firm's greater minimum net capital), unless the firm has in place a clearing agreement, containing a statement that, for purposes of the Securities Investors Protection Act (SIPA) and the SEC's financial responsibility rules, customers are customers of the clearing firm, not the introducing firm. The following is an example of language that the SEC accepts for use in a clearing agreement.

"For purposes of the Securities and Exchange Commission's financial responsibility rules and the Securities Investor's Protection Act, (name of introducing firm)'s customers will be considered customers of (name of clearing firm) and not customers of (name of introducing firm). Nothing herein shall cause (name of introducing firm)'s customers to be construed or interpreted as customers of (name of clearing firm) for any other purpose, or to negate the intent of any other section of this agreement, including, but not limited to, the delineation of responsibilities as set forth elsewhere in this agreement."

This language establishes the concept that customers must look to the clearing firm, not the introducing firm, for the payment of monies and delivery of securities.

Customer Account Statements

The SEC staff has reconsidered its previously issued interpretation concerning customer account statements that a clearing firm must send directly to the customers of an introducing firm. In the previous interpretation, each account statement had to include the name and telephone number of a responsible clearing firm employee that a customer could contact with inquiries regarding the customer's account.

In reviewing this position, the SEC noted that individuals may assume different responsibilities at their firms or may leave their employment altogether. Hence, requiring broker/dealers to name a specific individual on customer account statements, which are often preprinted, may lead to confusion for customers inquiring about their accounts. For this reason, the SEC staff determined that it is sufficient for broker/dealers to include just the pertinent telephone number. The following language is acceptable to the SEC for use on customer account statements.

"(Name of clearing firm) carries your account and acts as your custodian for funds and securities deposited with us directly by you, through (name of introducing firm) or as a result of transactions we process for your account. Inquiries concerning the position and balances in your account may be directed to our Client Service Department: (telephone number). All other inquiries regarding your account or the activity therein should be directed to (name of introducing firm).

Members should note that all customer account statements, as well as all clearing agreements, must contain language that adheres to the above interpretations on or before October 1, 1993.

Piggyback Clearing Arrangements

Some members have entered into a "piggyback clearing arrangement" and have questioned whether such an arrangement affects their status as introducing firms.

Under a piggyback clearing arrangement, introducing broker/dealer "A" enters into a clearing agreement with clearing broker/dealer "B"; then, broker/ dealer "A" enters into a subagreement with one or more other broker/dealers, who introduce their business to broker/dealer "B" through broker/dealer "A." Clearing broker/dealer "B" is aware of the arrangement, but usually does not enter into a clearing agreement with these "piggybacked" firms.

The SEC staff advised that this type of arrangement has not yet been addressed with the SEC. Until it is, "piggyback" broker/dealers are introducing broker/dealers, if they have a written agreement with the middle firm (broker/dealer "A" in the example above), and broker/ dealer "A" has a properly executed agreement with the clearing firm (broker/dealer "B" in the example above).

Dealer Activities

In Notice to Members 92-72, the NASD noted that any firm effecting more than 10 transactions in a calendar year for its own investment account would have to maintain minimum net capital of at least $100,000. After reconsideration, the SEC staff has advised that a firm making a single monthly investment of $1,000 or less into an established mutual fund account for the firm may exclude these transactions as dealer activities. Therefore, these transactions do not count toward the 10-transaction limit.

Open Contractual Commitment Charge

Notice to Members 93-30 addressed application of an open contractual commitment charge to an underwriting of a new convertible debt security immediately convertible into an existing Nasdaq National Market security for the same issuer. It noted that the haircut percentage depended on whether the security has a market value of less than par, at par, or greater than par.

However, the firm commitment underwriting deduction for an issue with a market value at par or higher needs further clarification. While the normal haircut percentage for such security would be 15 percent under paragraph (c)(2)(vi)(j) of Rule 15c3-1, the open contractual commitment charge for such securities is 30 percent "unless the class and issue of the securities subject to the open contractual commitment deduction are listed for trading on a national securities exchange or are designated as Nasdaq National Market System Securities."

After discussion, the SEC staff advised that for an initial public offering of a debt security immediately convertible into equity shares that trade on the Nasdaq National Market or an exchange the contractual commitment charge would be the lesser of: