Study guide
Net capital is the heart of the Series 28: roughly a third of the exam tests SEA Rule 15c3-1, the requirement that a broker-dealer maintain liquid capital at all times. This chapter builds the computation from minimum requirements through ratios, allowable assets, haircuts and the subordination rules that let a firm add regulatory capital.
Minimum Dollar Requirements by Class of Firm
Every broker-dealer must maintain net capital equal to the greater of a minimum dollar amount and a ratio-based requirement. The dollar minimums depend on the firm's business model, and the exam expects you to match firm to number. A carrying firm that holds customer funds or securities must maintain at least 250,000 dollars, the Series 27 headline figure. Introducing firms operate at two lower tiers. A firm that introduces accounts on a fully disclosed basis and receives customer securities for prompt forwarding to its clearing firm, but never holds them, has a 50,000 dollar minimum. A firm that does not receive or hold customer funds or securities at all, other than checks made payable to third parties such as the clearing firm, qualifies for the 5,000 dollar minimum. Dealers that trade for their own account generally have a 100,000 dollar minimum, and market makers compute a per-security requirement subject to caps. The firm's minimum is set by its most demanding activity: if Crescent Bay Securities, nominally a 5,000 dollar introducing firm, takes even one customer stock certificate into its possession and holds it, it has stepped into a higher requirement and likely violated its 15c3-3 exemption at the same time. Compliance is moment to moment, not month end: a firm must be able to demonstrate compliance at any point during the day, and dipping below the minimum even briefly is a deficiency requiring same-day notice under 17a-11 and suspension of business until cured. FINRA membership agreements can also impose higher minimums than the rule itself.
Aggregate Indebtedness and the Two Ratio Methods
Beyond the dollar floor, a firm must satisfy one of two ratio tests. Under the basic method, aggregate indebtedness may not exceed 1,500 percent of net capital, the 15-to-1 ratio, tightened to 800 percent, or 8-to-1, during a firm's first twelve months of business. Stated the other way, net capital must be at least one fifteenth of aggregate indebtedness. Aggregate indebtedness, AI, is the total money liabilities of the firm arising in connection with any transaction, with specific exclusions. Included are items such as accounts payable, accrued expenses, customer-related credits and most unsecured liabilities. Excluded are liabilities adequately collateralized by the firm's own assets, fixed liabilities adequately secured by fixed assets such as a mortgage on firm real estate, deferred tax liabilities, and, critically, liabilities subordinated to general creditors under a satisfactory subordination agreement approved by FINRA. That exclusion is why subordinated debt is such powerful medicine for a struggling ratio: it adds to net capital and simultaneously leaves AI. The alternative method, elected mostly by carrying firms, replaces the AI test with a requirement of two percent of aggregate debit items from the customer reserve formula, subject to a 250,000 dollar minimum, which makes it largely academic for introducing firms without reserve computations. Practice the arithmetic: if Foxglove Brokerage has AI of 120,000 dollars and net capital of 9,000 dollars, its ratio is 13.3-to-1, compliant with 15-to-1 but past the 12-to-1 early warning threshold, so notice is due even though no violation has occurred.
From Net Worth to Tentative Net Capital: Allowable Assets and Adjustments
The computation starts with GAAP net worth from the trial balance and adjusts it toward liquidity. First, add back allowable credits: properly subordinated liabilities count as capital, and deferred tax liabilities and certain discretionary liabilities may be added back. Second, deduct non-allowable assets, which are assets that cannot be quickly converted to cash. The classic list: unsecured receivables, including most receivables from affiliates and unsecured advances to employees; fixed assets such as furniture, equipment and leasehold improvements; prepaid expenses and goodwill and other intangibles; exchange memberships; and securities with no ready market. Commissions receivable from the clearing firm are generally allowable if promptly collectible, one of the few receivables an introducing firm can count. Aged fail-to-deliver contracts attract charges as they age, and aged suspense items become non-allowable. A ready market exists when there are independent bona fide offers to buy and sell so that a price reasonably related to the last sale can be determined promptly and paid; without one, the security is non-allowable in full. The result after these adjustments is tentative net capital. Suppose Alder & Finch Securities shows GAAP net worth of 90,000 dollars, but holds 20,000 dollars of furniture, a 15,000 dollar unsecured loan to a branch manager and 5,000 dollars of prepaid rent: tentative net capital is only 50,000 dollars before haircuts. This is why a firm can be solvent under GAAP yet fail the net capital rule, and why the FINOP must track asset quality, not just totals.
Haircuts and Other Charges
From tentative net capital the firm deducts haircuts, percentage charges on proprietary securities positions that cushion against market movement during liquidation. The benchmark equity haircut is 15 percent of market value on the greater of long or short positions, with a partial charge on the smaller side to the extent it exceeds 25 percent of the larger side. Undue concentration adds another charge: if a single non-exempt security position exceeds 10 percent of tentative net capital, an additional haircut, generally another 15 percent for equities, applies to the excess, discouraging firms from betting their capital on one name. Government securities enjoy small maturity-based haircuts, from a fraction of one percent on short maturities up to roughly six percent at the long end, and municipal securities have their own reduced maturity-based schedule; money market instruments carry minimal charges. Securities with no ready market take a 100 percent deduction, and open contractual commitments, such as underwriting commitments, take haircuts on the unsold portion. Two operational charges round out the computation. Under FINRA Rule 4360 every member carrying required fidelity bond coverage deducts from net worth any deductible amount elected above the permitted excess deductible. And unresolved short securities differences and aged fails generate charges on a schedule. After all deductions, the remainder is net capital, compared against the greater of the dollar minimum and the ratio requirement. Excess net capital, the amount above the requirement, is the FINOP's daily cushion and the number regulators watch when evaluating withdrawals and expansion.
Staying Compliant: Withdrawals, Subordinations, Appendices C and D
Because net capital protects creditors and customers, the rule restricts taking capital out. Under 15c3-1(e), equity capital may not be withdrawn if the withdrawal would drop net capital below 120 percent of the minimum or push aggregate indebtedness above 10-to-1, and capital contributed cannot be treated as equity if it is intended to be withdrawn within a year. Advance notice to the SEC and the designated examining authority is required two business days before withdrawals that exceed 30 percent of excess net capital, and notice within two business days after withdrawals exceeding 20 percent; the SEC may restrict withdrawals it deems unsafe. Subordinated loans are the approved way to raise regulatory capital without diluting ownership. Appendix D to 15c3-1 sets the requirements for a satisfactory subordination agreement: minimum one-year term, written agreement subordinating the lender's claim to all present and future general creditors, no prepayment within the first year and then only with regulator approval and only if the firm still meets capital tests afterward, and suspended repayment if repayment would create a deficiency. A secured demand note is an Appendix D variant in which the lender contributes marketable securities as collateral for a demand note; the securities are haircut, and the note counts as capital. FINRA Rule 4110 requires prior FINRA approval of subordination agreements for them to count. Appendix C addresses consolidated computations: a firm may flow through capital from a subsidiary only under a flow-through guarantee meeting the appendix's conditions, and FINRA Rule 4150 requires prior notice and approval before a member guarantees, or flows through capital from, another entity, because a guarantee makes the member answerable for the other entity's obligations.
Key terms
- Net capital
- — A broker-dealer's net worth adjusted for non-allowable assets, subordinated debt add-backs and haircuts; the liquid capital that must exceed the required minimum at every moment.
- Minimum dollar requirement
- — The floor set by firm type: 250,000 dollars for carrying firms, 50,000 dollars for introducing firms that receive but promptly forward customer securities, and 5,000 dollars for introducing firms that never receive or hold customer funds or securities.
- Aggregate indebtedness (AI)
- — The firm's total money liabilities with specified exclusions such as adequately secured fixed liabilities and approved subordinated loans; capped at 1,500 percent of net capital under the basic method.
- Alternative method
- — The ratio election requiring net capital of at least two percent of aggregate debit items from the reserve formula, with a 250,000 dollar minimum; used mainly by carrying firms.
- Non-allowable asset
- — An asset excluded from net capital because it is not readily convertible to cash, such as fixed assets, prepaid expenses, goodwill, exchange memberships and most unsecured receivables.
- Tentative net capital
- — Net worth after adjustments and removal of non-allowable assets but before haircuts on securities positions.
- Haircut
- — A percentage deduction from the market value of proprietary positions, such as 15 percent on equities and smaller maturity-based charges on government and municipal securities.
- Undue concentration
- — An additional haircut applied when a single security position exceeds 10 percent of tentative net capital, charged on the excess portion.
- Ready market
- — A market with independent bona fide bids and offers allowing prompt sale at a determinable price; securities lacking one are deducted in full.
- Satisfactory subordination agreement (Appendix D)
- — A FINRA-approved loan agreement with a minimum one-year term that subordinates the lender to all general creditors, allowing the loan to count as capital and be excluded from AI.
- Secured demand note
- — An Appendix D arrangement in which a lender pledges marketable securities as collateral for a demand note that counts as regulatory capital after haircuts.
- Flow-through guarantee (Appendix C / FINRA 4150)
- — The mechanism allowing consolidated capital treatment of a subsidiary, requiring a qualifying guarantee and prior FINRA approval.
Exam tips
- Anchor the dollar minimums to conduct: 5,000 for never touching customer funds or securities, 50,000 for receiving but promptly forwarding securities, 250,000 for carrying. A question describing a firm holding even one customer certificate points to the higher requirement.
- Keep the ratio family straight: 15-to-1 is the basic limit, 8-to-1 applies in the first year, 12-to-1 is early warning, and 10-to-1 blocks equity withdrawals.
- When a question gives you a balance sheet, work the order: net worth, add back approved subordinated debt, subtract non-allowable assets to get tentative net capital, then subtract haircuts. Answers that haircut non-allowable assets are traps, since those assets were already removed entirely.
- Subordinated loans only count if the agreement satisfies Appendix D and FINRA approved it in advance; an informal loan from the owner's parent is just a liability, and probably aggregate indebtedness too.
- Net capital compliance is moment to moment. An intraday deficiency cured by the close is still a deficiency requiring same-day 17a-11 notice and cessation of business while deficient.