Net Capital Deficiency, Customer Subscription Money in the Operating Account, and a Pending Distribution
At Friday's close, Northgate Securities reports net capital of $262,000 against a minimum requirement of $250,000. Included in the calculation is a $150,000 subordinated loan from a shareholder that matures in seven months; the controller booked it at face value. Earlier in the week, Northgate received $480,000 in customer checks for a DPP offering it is selling as a selected dealer and deposited them into its general operating account, intending to wire them to the escrow agent on Monday; on Friday the firm used $95,000 of that balance to cover payroll and rent. The controller says the firm is 'still above the minimum,' so no notices are required, and the CFO wants to pay a $60,000 shareholder distribution next month.
1. Recompute net capital. What is the firm's actual position, and what must happen today?
Read the worked answer
The subordinated loan does not count.
A satisfactory subordination agreement is includable in net capital only while it has at least one year remaining to maturity. With seven months left, the $150,000 must be excluded (or, in the period before that cutoff, amortized out as maturity approaches). The controller booked it at face value, which overstates capital by $150,000.
Recomputation: $262,000 − $150,000 = $112,000 against a $250,000 requirement. That is a deficiency of $138,000, not a comfortable cushion and certainly not an early-warning scenario - the firm is below the minimum.
What happens today:
- The firm must give immediate notice (within 24 hours) to its principal regulator, with the required copy to FINRA, that it is not maintaining minimum net capital.
- It may not continue to transact a securities business while deficient absent relief; it must raise capital or curtail activity immediately, and it should engage counsel before the next trade date.
- The pending FOCUS filing must reflect the corrected computation. Filing the uncorrected numbers compounds the problem.
- The controller's 'no notices required' conclusion is the single most dangerous sentence in the file; a good-faith arithmetic error is defensible, an undocumented decision not to notify is not.
2. Analyze the treatment of the $480,000 in customer subscription checks and the $95,000 used for payroll and rent.
Read the worked answer
This is worse than the capital problem.
- Subscription funds for a DPP are customer funds until they are deposited with the escrow agent and applied as the offering documents require. They are not working capital.
- Depositing them into the firm's general operating account commingled customer money with firm money. Even a Friday-to-Monday hold creates a possession-or-control and reserve problem: the firm must be able to demonstrate it held customer funds properly and excluded them from its own use.
- Using $95,000 for payroll and rent is a misuse of customer funds, full stop. It does not become acceptable because the firm intended to replace the money.
- Required remediation: restore the full $480,000 to the escrow agent or a properly designated account immediately, funded with firm money; identify and correct any reserve computation for the period; document the timeline hour by hour.
- Escalate to senior management, counsel, and the board or audit committee. Expect a self-reporting analysis: voluntary disclosure of a customer-funds misuse is treated very differently from having it discovered in an examination.
- The selected-dealer role is part of the analysis: the firm's WSPs must specify who may touch subscription checks and require same-day transmittal to the escrow agent with dual control.
Order of operations: restore the money, then compute, then report. Restitution before disclosure is not concealment; delay in restitution is.
3. The CFO wants to pay a $60,000 shareholder distribution next month. What is the answer, and what early-warning threshold should the firm have been monitoring?
Read the worked answer
The answer is no, and the question itself shows the firm was not monitoring the right number.
- The early-warning threshold is 120% of the minimum requirement: $250,000 × 1.20 = $300,000. At $262,000 as originally reported, the firm was already below that threshold and should have been treating the situation as urgent well before Friday.
- Capital withdrawals are restricted: a firm may not withdraw equity capital, including by dividend or distribution, if the withdrawal would leave net capital below 120% of its requirement (and never below 100%). With corrected net capital of $112,000, the firm fails both tests by a wide margin.
- Paying $60,000 to shareholders while deficient would be a separate and deliberate violation - a distribution to insiders funded while customer money is missing from escrow is the fact pattern regulators describe in fraud terms.
The supervisory lesson: the firm's net capital monitoring must run off the correct computation, with the subordinated-loan maturity schedule as an input, and must produce an escalation when the ratio approaches 120% - not when it crosses 100%. A monthly capital review that ignores loan amortization is a control that produces false comfort, and here it produced three simultaneous problems: a deficiency, a misuse of customer funds, and a proposed distribution that would have made both worse.