Two Errors in the Net Capital Computation
Calder Capital is a small introducing broker-dealer with no customer funds or securities. Its financial principal computed net capital of $285,000 at March month-end and reported aggregate indebtedness of $900,000. While preparing the FOCUS filing, the newly hired CCO notices two problems: $40,000 of the allowable assets is a receivable from an affiliated operating company that is not a broker-dealer and has no fixed payment schedule; and a $500,000 position in below-investment-grade corporate bonds is carried at full market value with no haircut applied. The firm's minimum net capital requirement is $250,000. The FOCUS report for March is due in six business days, and the CEO asks whether the firm can simply correct the numbers in that filing.
1. Recompute net capital. Is there a deficiency, and what notification obligations are triggered and when?
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Recomputation.
- Start: $285,000.
- Remove the $40,000 affiliate receivable. A claim on a non-broker-dealer affiliate with no defined payment schedule is not an allowable asset.
- Apply the haircut: below-investment-grade debt carries a 15% haircut, so $500,000 x 15% = $75,000 must be deducted.
- Adjusted net capital: $285,000 - $40,000 - $75,000 = $170,000.
Requirement. The greater of $250,000 or 6-2/3% of aggregate indebtedness ($900,000 x 6.667% = $60,000), so $250,000. The firm is short $80,000, and it is also below the 120% early-warning level of $300,000.
Consequences. (1) Under SEA Rule 17a-11(a), a net capital deficiency requires immediate notice to the SEC and to FINRA as designated examining authority, followed by written notice within 24 hours. (2) Under Rule 15c3-1, a firm below its minimum must cease conducting a securities business other than closing out existing transactions. (3) The obligation is triggered by discovery, not by the FOCUS due date. Waiting six days to disclose is itself a violation, and filing a knowingly corrected-but-unexplained FOCUS without notice compounds it. Notify today, then file accurately with an explanation of the correction.
2. What may the firm do, and not do, between discovering the shortfall and filing its FOCUS report?
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May do:
- Liquidate or reduce positions to shrink haircuts and free capital.
- Execute and fund a capital infusion or a properly documented subordinated loan, but only count it once the agreement is approved and the cash is actually received.
- Continue closing out existing customer transactions and paying obligations.
- Prepare the 17a-11 notice and a written timeline of who knew what and when.
May not do:
- Open new customer accounts, execute new purchase recommendations, or accept new business.
- Book a promised capital infusion or an unsigned subordination agreement as an asset.
- File the FOCUS with the original numbers, or with corrected numbers and no accompanying explanation.
- Treat the affiliate receivable as allowable because the affiliate is profitable, or net the bond position against a hedge that does not exist in the firm's records.
Also consider: the errors originate with the financial principal's computation, which raises a question about accounting controls and whether Rule 17a-11(c) notice (material inadequacy in the system of internal accounting controls) is also required. Document the cure before the next computation date, because a firm that cures and re-breaches is treated far more harshly than one that cures and stays cured.
3. If the firm cures the shortfall with a subordinated loan from the CEO's brother-in-law, what conditions must be met before it counts as net capital?
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A subordinated loan is net capital only if each of the following holds:
- Written agreement on the required form, filed with and approved by FINRA before it may be counted. An executed-but-unapproved agreement does not fix the deficiency.
- Minimum one-year term, with no accelerated repayment right except the narrow permitted events (death, dissolution, or the firm's own liquidation). A demand feature or a lender's optional rollover destroys the net capital credit.
- Cash actually received. A promissory note from a related party is not cash.
- Eligible lender and arm's-length terms. A family loan is not prohibited, but the relationship must be disclosed and the terms must be no more favorable to the lender than an arm's-length loan; a loan that can be called if the CEO is terminated is not subordinated capital.
Practical judgment: a related-party loan is a workable bridge but a poor permanent capital structure. Flag it to the CEO as a short-term cure, require full documentation of the relationship in the firm's records, and continue looking for a durable source of capital, since examiners will scrutinize whether the loan is genuinely at risk.