The $585,000 Cushion: Deductions, the AI Ratio, and the 120% Line
Dunmore Securities LLC is a government securities broker-dealer that clears on a fully disclosed basis, does not hold customer funds or securities, and is not an OTC market maker. At the November 30 month-end the controller computes tentative net capital of $780,000 and proposes no deduction for three items: a $140,000 receivable from a customer for a Treasury purchase that settled 40 days ago and remains unpaid and unsecured; a $30,000 advance to its parent holding company; and $25,000 of prepaid rent for next year. Aggregate indebtedness is $8,100,000. The CFO asks whether the firm can keep trading as usual and whether anything has to be filed.
1. Compute net capital and the applicable minimum requirement. Is Dunmore in compliance with Rule 15c3-1?
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All three items are non-allowable assets and must come out of tentative net capital. The $140,000 customer receivable is unsecured and long past normal settlement, so it cannot be counted until collected. The $30,000 advance to the parent is a loan to an affiliate, also non-allowable. Prepaid rent has no realizable value to customers and is deducted.
Net capital = $780,000 - $140,000 - $30,000 - $25,000 = $585,000.
Because the firm does not carry customer accounts, does not hold customer funds and is not a market maker, its dollar minimum is $100,000 rather than the $250,000 that applies to a carrying firm. But the ratio test still governs: AI/15 = $8,100,000 / 15 = $540,000. The requirement is the greater of the dollar minimum and the ratio amount, i.e. $540,000. Net capital of $585,000 clears it by $45,000, so the firm is in compliance.
2. Assuming compliance, is any notice to regulators required? Walk through the early-warning calculation and the firm's obligations.
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Compliance is not the end of the analysis. The early-warning test compares net capital to 120% of the requirement: 1.2 x $540,000 = $648,000. At $585,000 the firm sits below that line even though it is above 100%.
Under Rule 15c3-1(e) the firm must notify the SEC by telegraph or telephone within 24 hours of the trigger (with written notice to follow) and give the same notice to its designated examining authority. It may continue to do business, but it should stop any capital withdrawal or distribution, defer discretionary compensation, and recompute net capital daily until the cushion is restored. A late notice is itself a violation, and the miss will surface in the annual audit and in the CEO's compliance report. The judgment point is that passing the minimum is not the same as being out of the warning zone.
3. Suppose the aged customer receivable had been $260,000 instead of $140,000. What changes?
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Net capital becomes $780,000 - $260,000 - $30,000 - $25,000 = $465,000, which is $75,000 below the $540,000 ratio requirement.
Now the firm is not merely in the warning zone; it fails Rule 15c3-1 outright. It must immediately stop doing a securities business, must not withdraw capital or make affiliate loans, must notify the SEC and its DEA within 24 hours, and may not resume until it is back above its requirement or the SEC directs otherwise. The customary cure is a capital injection or a properly documented satisfactory subordination agreement, combined with writing off or collecting the aged receivable. Note the sequencing trap: the firm cannot cure a ratio failure by continuing to trade its way out, because continuing to trade is itself the prohibited act.