Small Firm Survival in an Increasingly Tougher Environment

Remarks by Howard Spindel

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Good morning. I’m here again, this time with my good friend Bob Lehman who, like me, deals constantly with issues affecting small and medium-sized broker-dealers. This year, I decided to give you more of my personal observations that are a product of over 35 years in securities industry. Actually, I spent a number of hours thinking not only about the new initiatives that now confront us but also about some of the existing rules, regulations, laws and protocols that need change. That’s a bit of a departure for me. In past years, I have been careful to report to you what has been happening and what would be going into effect in the near future. This time, I will not only do that, I will attempt to look back on where we’ve been and suggest some change that could not only make our life in the securities industry an easier one, but could also result in increased public confidence in our business. I’m sure nobody has objection to that!

Once again, I wish to remind everyone that the vast majority of brokerdealers in our industry are small firms. About 90% of them have fewer than 100 people. Yet they are subjected to most of the same rules to which larger firms are subject. And they are expected to comply with these rules without the benefit of sophisticated staff people who are conversant with every new FASB opinion or changes in rules and regulations. For the most part, the smaller firms, and even to some extent the mediumsized firms, are dominated and populated by people that are revenue producers who hopefully know and understand how to make a buck and do so in an ethical way. They do not necessarily have knowledge about every nuance of every rule and regulation but certainly know most of the rules and regulations that affect them directly.

 

Every once in a while, our regulators actually recognize the distinction between the large firms and the others. For example, in the wake of various industry scandals the regulators promulgated new rules covering research analysts and their functions. These rules solidify the so-called Chinese Wall that exists between analysts and others in firms, yet recognize that in certain small firms, it’s not feasible to have the segregation that can exist in larger firms. Similarly, the 2002 Gruttadauria case, spawned major new changes in supervisory control rules but these new rules recognize, quite clearly and emphatically, that if a member is limited in size and resources, its compliance requirements will be quite different than those of larger firms.

In light of the recent increased recognition by the regulators that indeed small firms are different and should be regulated differently than larger firms, I am going to point out later some of the rules and regulations that are in need of further change to adequately recognize the difference.

 

First, I’d like to reflect on some of what we discussed last year and provide you with an update on where we are.

Expense sharing agreements

Last year, I gave you some thoughts relating to the July 11, 2003, SEC staff letter that articulated its position regarding expense sharing agreements. That letter was embellished somewhat by NASD Notice to Members 03-63 which attempted to explain, in plain English, how NASD views compliance with the letter. Unfortunately, NASD staff has perhaps gone beyond the intentions of the SEC letter. Internally, a one page point list of requirements is in use by the various district offices, and examiners use this list as if it were some kind of a rule to be complied with. Aside from the fact that the list is not available to the general public and thus asking one to comply with it is perhaps asking too much, it is an example of what sometimes happens in our regulatory environment.

More important than compliance with 03-63 is what you should do about it. I cannot overemphasize bullet point number 1 in the SEC letter. In that item, SEC staff tells us that one way of recording the broker-dealer share of the expenses is to make an allocation on a “reasonable” basis. This is probably the most important sentence in the whole letter, i.e. if you use reasonable allocation methodology and you record the resulting expenses on the broker-dealer’s books, records and reports, most of the rest of the letter does not apply. The agreements should make clear whether the shared expenses are expected to be reimbursed by the broker-dealer or whether, instead, the broker-dealer will simply reflect a capital contribution equal to the amount of the shared expenses. Either is permissible.

 

What is not so clear from the Notice to Members is how the regulators will go about enforcing the letter. The answer to that is, zealously. How do you counteract the zeal? First of all, in spite of the fact that the letter permits you to not record certain shared expenses in the ledgers and on the face of financial statements of a broker-dealer, the conditions for doing so are so onerous that most firms are better off putting them on the books.

 

The examiners believe that they can question allocation methodology. Interestingly enough, our good friend Mike Macchiaroli – who gets involved with many different aspects of our business, including such matters as Consolidated Supervised Entities, a subject that has no direct impact on small firms but which is being discussed in the other room– has said repeatedly in various public forums that he does not expect examiners to go through a nit-picking exercise of determining whether a broker-dealer’s 25% allocation of expenses should really have been 15% or 35%. All that SEC staff seems to wish for is that there be some recognition of expenses that makes sense. My experience is that too many examiners missed Mike’s comments, or maybe they didn’t miss them but instead chose to ignore them.

 

03-63 states that “a reasonable allocation is one that attempts to equate the proportional cost of a service or product to the proportional use of or benefit derived from the service or product.” Certainly, that’s one way of looking at things. We have found that in many instances, it is far more reasonable to use incremental analysis in determining costs allocable to a broker-dealer than it is to analyze based upon some proportion of use.

 

For example, a financing arm of a major industrial company has a leasing subsidiary with a staff of 100 people. Once or twice a year, they determine to bundle up some of the leases and sell securities that are backed by the leases. They spend a few hours of time to place the securities with QIB’s. The persons who place the securities are essentially full-time employees of the leasing company and are associated with a related broker-dealer on a part-time basis only. The placement of the securities hardly takes up any of their time but must be done by a broker-dealer. These people are not even compensated directly by the broker-dealer and if the leasing company did not utilize the services of the related broker-dealer, the individuals would still be employed by the leasing company and would earn the same amount of money. The way I see it, in this example, no compensation expense needs to be allocated to the broker-dealer. In addition, the amount of space that the broker-dealer uses is miniscule. All of its records might fit into a single file folder. So it is not surprising that there’s no rent allocated to the broker-dealer. I have heard some examiners agree with me; unfortunately, some have disagreed. The strangest part about this story is that I have yet to determine the regulatory purpose for the disagreement. More on that later.

 

There are many examiners who now believe that they have a right to demand information from an affiliate that goes beyond what the SEC letter said. Item 8 of the SEC letter stated that:

 

8. Each broker-dealer and broker-dealer applicant must be able to demonstrate to the appropriate authorities that it is in compliance with the financial responsibility rules in connection with any expense-sharing agreement it has entered into, and therefore it may be required to provide these authorities with access to books and records, including those of unregistered entities, relating to the expenses (emphasis added) covered by the agreement.

 

Our friends at NASD embellished upon this requirement by suggesting in Notice to Members 03-63 that the regulators should have “appropriate access to all relevant books and records, including those of a third party with which it has an expensesharing agreement. Thus we now have examiners who believe that they should be entitled to full access to all of the books and records of affiliates. That certainly does not appear to be the intention of SEC staff. Books and records relating to shared expenses are certainly fair game. Trial balances, Balance Sheets, and Income Statements of affiliates are regularly requested by examiners but technically they shouldn’t be entitled to all of that information since the data are not necessary for them to form an opinion with respect to expense sharing.

 

Auditors are now faced with new duties as a result of the expense sharing pronouncements. Though GAAP has not changed, since net capital computations are potentially affected, auditors are now charged with the responsibility of examining for compliance with the pronouncements.

 

FAS 150

Last year we told you about FAS 150 and about the fact that literally construed, many broker-dealers would not have any capital at all come January 1, 2004, since SEC staff likes to use GAAP as the determinant of what exactly constitutes capital. Essentially what FAS 150 did was to direct that capital that is mandatorily redeemable needs to be reflected as a liability. I frankly hoped that SEC staff would have treated this type of capital as a liability for financial statement purposes but as capital for net capital purposes but we had no such luck. Indeed, I question why an approved subordinated liability may be treated the same as capital in determining net capital while a capital account that is not yet subject to redemption is treated as a liability. It would seem to me that even if the capital was subject to mandatory redemption, until it was redeemed, it would still be treated as capital under the law and would be subordinate to even the subordinated liabilities that the net capital rule treats as capital. Quite an anomaly I would say!

 

Anyway, in response to the request for relief sent to SEC staff by SIA’s capital committee, on February 19, 2004, the staff issued a no-action letter that allows these fictional liabilities to be added back for net capital purposes. For calendar year companies, the relief expires in December 2004. For fiscal year companies, the relief expires at the next fiscal year that expires after December 2004. Most companies that were potentially affected have already modified their partnership, LLC or corporate documents to eliminate the problem.

I don’t dispute whether or not FAS 150 is sensible. I only question why, considering that laws haven’t changed, that our regulators force us to modify agreements that have been in place for years and have protected whomever the rules were designed to protect for years. To add to the confusion we actually wound up with at least three different regulators providing conflicting information in regard to the same issue. NASD, in an extremely well-written Notice to Members 04-33 stated with respect to the fictional liabilities that SEC said could be added back temporarily as capital that:

 

The value of those ownership interests that would be redeemed for cash should be included in aggregate indebtedness

 

Their counterparts at the New York Stock Exchange in Information Memo 04-23 expressed the exact opposite, and I believe correct, view. I still haven’t figured out why both NASD and NYSE direct that these liabilities be reflected as secured when clearly they are unsecured. While NASD directs that the liabilities are aggregate indebtedness and NYSE tells us that they’re not, our friends at the American Stock Exchange at first issued a release indicating that the liabilities were aggregate indebtedness but unlike NASD, issued a correction 4 business days later.

 

The obvious solution to the FAS 150 problem it to modify agreements. Most affected firms have probably done so already. Another solution is to adopt the multi-tier structure that we have favored for years.

 

Diverse (and strange) regulatory practices

More than ever before, our regulators are enforcing similar rules or concepts in diverse or strange ways. For example, as many of us know NASD Rule 3010 requires members to establish, maintain and enforce written supervisory procedures. In fact, examiners show up waiting to review the procedures. In a typical review, brokerdealers are criticized for having procedures that they do not follow, but worse than that they are also criticized for having procedures that are clearly not applicable. After that latter criticism is levied, the examiners review the procedures to see if they include certain items and criticize the broker-dealer for not having them even if they are clearly not applicable. For example, SEC Rule 17a-8 contains specific requirements relating to the handling of currency. I don’t know about you, but I am not aware of any small or medium-sized non-clearing broker-dealers that handle currency. One would think that having a procedure to handle currency for a broker-dealer that doesn’t handle currency makes no sense. Yet examiners regularly insist on it.

 

Here’s another strange way they sometimes enforce rules. As all of you know, every set of audited financials filed under Rule 17a-5 needs to include an oath or affirmation executed by an appropriate signatory. The rule specifies that for a corporate broker-dealer the appropriate signatory is a duly authorized officer and for a partnership, it is a general partner. Strangely, Rule 17a-5 does not seem to know about that form of organization that is used by most new broker-dealers, the LLC, and so is silent on how they should be treated. For that matter, Rule 15c3-1 is also silent on LLC’s and so is the FOCUS report.

 

This past year, NASD staff in some of the districts has been examining audited financials more closely. Occasionally, they have rejected reports that were executed by a broker-dealer’s only Financial and Operational Principal even though that person is the only person associated with the particular broker-dealer that might have a clue about the contents of the report. Even stranger is the fact that under NASD Rule 1022, a person who is not a Financial and Operations Principal is not even permitted to perform functions that are the purview of, and I might add the responsibility of, the FINOP. For example, in accordance with Rule 1022 a FINOP’s duties include among other things

 

(A) final approval and responsibility for the accuracy of financial reports submitted to any duly established securities industry regulatory body

and

(E) supervision and/or performance of the member's responsibilities under all financial responsibility rules promulgated pursuant to the provisions of the Act

 

yet some NASD staff persons believe that the FINOP is perhaps the wrong person to execute an oath or affirmation. What we really have here are two separate rules, an SEC rule and an NASD rule, both establishing that a broker-dealer should comply with financial reporting rules in a responsible manner. But with respect to small brokerdealers especially, if the rules are construed literally, there a strong potential that if the NASD examiners succeed in what I call an ill-conceived initiative, that every report oath or affirmation that is executed by a general partner or duly authorized corporate officer who is not also the Chief Financial Officer of the broker-dealer as described by Rule 1022, is in violation of that rule. Worse yet, under circumstances where a non-CFO executes an oath or affirmation, it is quite possible that that person is someone who doesn’t have the foggiest idea about whether the report is fairly presented. I ask, in the era of Sarbanes-Oxley, would you want to have a non-CFO execute such a document?

 

While regulators are busy promulgating new rules, they don’t clear up simple housekeeping issues that are necessary to keep up with the times. Here’s some obvious examples:

• Recognition of the proliferation of LLC’s
• Recognition in Rule 15c3-3 of the existence of broker-dealers that have no dealings with customers or that never deal with customer funds, e.g. trading firms or private placement boutiques
• Instead they’re busy adopting all kinds of rules that have a major impact, especially on small and medium sized firms.

 

Examples of these are:

• Trade reporting
• Best execution
• Business continuity plans
• Anti-money laundering rules
• And one of my favorites, privacy rules

 

And as these new rules come about, they tell us that we cannot off-load the burdens of many of them to other broker-dealers such as clearing brokers.

 

Certain old rules should be eliminated. Examples are the “Use it or Lose it” rules. As applied to broker-dealers, inactive ones lose their license. But many firms seem inactive, e.g. private placement firms. I have yet to determine why NASD should care about whether a broker-dealer is inactive.

 

As applied to registered personnel, if a registration isn’t used for 2 years, it is lost.

 

I have a much better solution, why not force a continuing education
refresher session on someone whose license became stale?

 

Culture of regulation

That brings me to another subject, the culture of regulation. Over the past few years, we have been hearing, especially from regulators, about the culture of compliance, basically implying that, in general, broker-dealers do not wish to make an effort to comply with rules. I believe that this is far from the truth. In fact, the problem with compliance with rules, regulations and laws especially for small broker-dealers, is that there are just too many of these being promulgated and it is the culture of regulation that is out of control. The attitudes of many of the examiners is that every rule is important, that once promulgated, practically every rule must be complied with, and that there’s hardly any rule that needs to be modified, abrogated or rescinded. On the other hand, there are some senior regulatory folks who at least pay lip service to the idea that they are looking at the rules carefully to see how they may be tweaked a bit.

 

On November 4, 2004, Robert R. Glauber, the Chairman and CEO of NASD, in a speech in Boca Raton, stated that

Another way we can try to make self-compliance easier is to be mindful of the burdens that our increased regulation and enforcement activities inflict on the industry. While we must meet our mandate as an effective regulator, we should seek to do our regulatory job without needless intrusion or burden. We should seek to set clear and appropriate rules and then enforce them rigorously and consistently.

 

And we should, as we have over the last several years, regularly review our existing rules with the intent of simplifying them and, where appropriate, eliminating those that are out-of-date.

 

I am particularly concerned that some of the most senior regulators have proudly put us all on notice that lately they have been promulgating more rules than they have promulgated in the recent past. And worse than the rules themselves, is how they are enforced, at times.

 

For example, have you ever tried to register a new broker-dealer or ask for regulatory approval for a new line of business? The process is often arduous and torturous. By the time approvals arrive, the business opportunities relating to the application have often disappeared into thin air.

 

In yet another example, along the same lines at last year’s conference, Lori Richards, a lady for whom I have great respect, told us that SEC staff

 

discovered computational errors of one sort or another in fully a quarter of our broker-dealer examinations. In 26% of our broker-dealer examinations, we discovered that the firm's required books and records were inaccurate because of computational errors. In 16% of our examinations, we discovered that computational errors had an impact on the net capital calculation. Whether we focus exclusively on net capital, or on the larger issue of the overall accuracy of the firm's books and records, these percentages are far too high.

 

At the time, I posed a question to her as to how material these computational errors were. I suspect that I was thinking like an accountant. If a man flying by in an airplane at 30,000 feet wouldn’t notice it, it’s probably not worth considering. Lori’s response at the time was something to the effect that computational errors would just simply not be tolerated. When we began our break-out session last year, I asked the audience, how many of them were from firms that at one time or another had a computational error in their books and records or net capital computations. Almost everyone raised his or her hands. Those that didn’t were either from regulatory bodies or were probably lying. Since Lori said that they found errors in only 26% of the examinations, I suspect that SEC examiners might have missed 74% of the errors. The point is that there are some minor transgressions that because they do not threaten the regulatory scheme should be tolerated by regulators, lest they forget that we too are human beings who make mistakes once in a while.

 

Do we need regulation? Of course, we do, because having it instills public confidence in our business. And discipline for major offenses should be meted out swiftly and severely.

 

On the other hand, I believe that there need to be major changes in the culture of regulation.

 

Do you remember when the speed limit was 55 miles per hour and everyone was traveling safely at 65? The obvious solution to that conundrum was not greater enforcement. We solved the problem by increasing the speed limit to 65 or by simply not enforcing against those who were only a little bit over the limit while driving with the flow of traffic. Why not do the same thing in the securities industry?

 

Actually, we have, particularly for the giant firms. In the other break-out session, conference participants are delving into the nuances of Consolidated Supervised Entities. To a great extent, many of the concepts in that environment, Value at Risk, what I call roll-your-own haircuts, are the product of an earlier initiative, that was mislabeled by many as BD-Light. I say mislabeled because to qualify as a BD-Light broker-dealer, a firm needed $100,000,000 in capital. Firms with that kind of capital are BD-Heavy, not BD-Light. Maybe they were thinking of a new kind of beer, with apologies to my friends at Anheuser Busch.

 

Seriously, though, we should be learning from the experience. Prior to the promulgation of BD-Light, much of the business in derivatives was conducted in more hospitable environments such as London. That should teach us that we need to constantly review rules to see if they make any sense currently. In that respect, Robert Glauber is absolutely correct! I hope that his staff read his remarks.

 

In light of some of the developments during the past year that have affected small and medium-sized broker-dealers I have thought long and hard about which rule or rules might be eliminated with respect to these firms. Though the list of such anachronistic rules is somewhat long, I finally figured out the one rule that is on the top of my list. You will be surprised to hear what I have to say since many of you know that I earn my living from regulatory confusion and turmoil. Anyway, I cannot hold you in suspense any longer. The rule from which most small and medium-sized brokerdealers should be exempted is the rule that has caused many, if not most, of us a great deal of grief, the net capital rule.

 

No, this is not the first time that this possibility was ever mentioned. Actually, about 30 years ago, when Rule 15c3-3 was adopted, the regulators were so delighted that customer assets were somewhat segregated from proprietary assets that they indicated that perhaps Rule 15c3-3 would replace Rule 15c3-1. Of course, that never happened but perhaps it should have. Here’s why.

 

First of all, we should recognize that the net capital rule’s applicability does not really offer much protection to anyone with whom the typical small brokerdealer has dealings. Here’s an example, let’s say there’s a so-called nickel BD that privately places $10,000,000 of stock with institutional investors. The BD does not hold the funds of the investors as either they remit directly to the issuer or the funds are placed in escrow. Does $5,000 of net capital protect the investors of $10,000,000? Of course not! They don’t rely on the capital of the broker-dealer. They do not maintain an account with the BD. They don’t receive statements of account from the BD. They don’t even receive financial statements from the BD. There’s a rumor that the regulators might propose an increase to the $5,000 minimum. Let’s assume that they increase the minimum to $100,000. That doesn’t change the protection of the general public very much, does it?

 

The same would hold true for a trading firm that has its account carried by a large broker-dealer. That large broker-dealer carries the account of the trading firm as a customer. The carrying firm is quite satisfied with the margin it collects; it doesn’t need the protection of the applicability of the net capital rule to its correspondent.

 

In fact, there already are many broker-dealers that are exempt from the net capital rule. Options market makers have been exempt for years. Has public confidence in our options markets been affected as a result? Of course not! Similarly, floor brokers have effectively been exempt also.

 

What benefits would accrue with the elimination of the net capital rule for certain small and medium-sized broker-dealers whose business is limited? First of all, we would not be examined about intercompany expense sharing, we would not be nagged about how we planned to maintain enough capital, nobody would care about whether we had mandatorily redeemable capital, we could withdraw unnecessary capital with no impediments, and we would be free at last of an anachronistic rule that makes little sense since for most small and medium-sized firms it doesn’t really promote industry integrity or public confidence. We would eliminate many regulatory violations. We would not need nearly as many regulatory examiners. Regulatory fees might actually be reduced. Don’t bank on that last one!

 

For those who believe that it is vital for broker-dealers to have some sort of demonstration of fiscal responsibility, I believe that alternative standards can be developed which are likely to be less expensive than what we have today. For example, as an alternative to the net capital rule, why not have a broker-dealer purchase a bond issued by a bona fide insurance company. The coverage amount on the bond could probably be much higher than the net capital requirements today and could serve to indemnify those who rely upon our regulatory scheme such as public customers. For those rare instances where a non-clearing firm became the subject of a SIPC proceeding, the bond coverage might even indemnify SIPC. Obviously, this is all a conceptual framework that would need to be developed.

 

Indeed, as a result of the elimination I propose, my income from consulting on this issue might be reduced. I am not concerned about that. First of all, I’m versatile and I can reinvent myself and do much more than net capital consulting. Second, this is all a dream. Unfortunately, our regulators are so entrenched as a result of the net capital rule that it would be years before any such change will occur. For the sake of the industry that I have been part of for over 35 years, I challenge the regulators to take action to do the right thing. Since Mike Macchiaroli is not listening, I think I’ll send him a copy of my remarks. Now that the name BD-Light has been used to refer to giant-sized firms, maybe the new proposal should be called BD-EZ. Or maybe it should just be called BD-HS to remember the guy who proposed it.

 

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