This time of year, it is common practice for broker-dealers (“BDs”) to take a close look at their financials as they gear up for another annual audit and also review any expense-sharing agreements (“ESA”) they have in place.
We are in the last seconds of the game, team, and its time to make sure those ESAs are going to clear the goal post.
Financial Responsibility and Reporting Recap
Under the financial responsibility rules, BDs are required to prepare certain financial statements in accordance with generally accepted accounting principles (“GAAP”). A BD must maintain various books and records relating to its business, including records “reflecting all assets and liabilities, income and expense and capital accounts.”
Covering Your Blind Side – Ensure your ESA Complies with SEC Rules and FINRA Guidance
The SEC’s Division of Market Regulation has indicated that a BD is required to record each expense incurred relating to its business and any corresponding liability, regardless of whether a third party (which may include a parent, holding company, or affiliate) has agreed to assume the expense or liability. This requires that a BD record each expense it has incurred (even if that expense is a shared expense), including the value of any goods or services used in its business, when a third party has furnished the goods or services or has paid, or has agreed to pay, the expense or liability.
How do you go about recording an expense that is shared or otherwise paid for by a parent or an affiliate? Create a “reasonable” expense allocation and memorialize the method of allocation in the ESA. Identify which party is responsible for paying for the shared costs (such as rent, technology and IT services, administrative or clerical support, etc.). Thereafter, make sure the BD records the expense on its books in an amount that is determined according to the written allocation schedule.
FINRA clarified in Regulatory Notice 03-63 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.”
The ESA should indicate that all expenses incurred by the BD, and not included in the allocation and covered by the ESA, will be paid directly by the BD. The ESA should also contain provisions and representations that the third party (counterparty to the ESA), has adequate resources independent of the broker-dealer to pay the costs incurred by the broker-dealer. To demonstrate this and ensure compliance with this condition, the ESA should contain provisions requiring the third party to provide a complete set of financials to the BD annually.
The BD should maintain copies of any invoices paid by the third party on behalf of the BD, as well as a record of any expense assumed by the third party.
Lastly, the ESA should have a provision that the BD will notify FINRA in writing if a new ESA is entered into or an existing ESA is amended.
Key Summary Points: A BD must review and update as necessary its written ESA. The ESA must set out clearly which party is obligated to pay each expense, whether the broker-dealer has any obligation, direct or indirect, to reimburse or otherwise compensate any party for paying the expense, and, when the BD records the expense in an amount that is determined according to an allocation made by the third party, the method of allocation.
Financial Responsibility rules and net capital requirements and can often times seem weighty and complex, so setting up compliant ESAs and implementing strong financial controls can help minimize your risk of being sacked.
If you need assistance reviewing your ESA, or with financial reporting issues or other net capital issues, please contact us today at 800-800-3204 or visit us online at www.ncsregcomp.com.
 As described in this article, the financial responsibility rules include the net capital rule, Rule, 15c3-1 under the Securities Exchange Act of 1934 (“Exchange Act”), and reporting and recordkeeping requirements under Exchange Act Rules 17a-3, 17a-4, and 17a-5.