SECURITIES LITIGATION & REGULATION

Litigation News and Analysis Legislation Regulation Expert Commentary

VOLUME 19, ISSUE 19 / jANuARY 23, 2014

Westlaw Journal

EXPeRT ANaLYSIS

Broker-Dealer Net Capital Requirements: The Litigation Contingency Reserves Dilemma

By Glenn S. Gitomer, Esq. McCausland Keen & Buckman

The Securities and Exchange Commission imposes on securities broker-dealers net capital requirements, which are intended to protect customers and counter-parties from risk of loss arising from insufcient funds to consummate securities transactions and meet contractual requirements. The net cap requirements are codied in Securities Exchange Act Rules 15c3-1, 17 CFR 240.15c3-1, known as the Net Capital Rule, and 15c3-3, 17 CFR 240.15c3-3, known as the Customer Protection Rule. Considering the potential exposure to customers for claims arising from wrongful broker investment practices, the net capital requirements are extraordinarily modest. Under the Net Capital Rule, a broker-dealer, depending on the nature of its business, must maintain net capital between $5,000 and $250,000. Net capital is dened as the difference between GAAP equity, which nets out contractual obligations and other liabilities, plus certain allowable subordinated debt and credits, and illiquid assets, unsecured receivables, operational charges and proprietary positions haircuts. The Customer Protection Rule is designed to protect customer securities and funds in the custody of broker-dealers, and it generally does not apply to broker-dealers that use clearing rms as custodians of customer assets. Ironically, it is the broker-dealers that do not maintain custody of customer assets that leave customers least protected. While it would be wrong to generally cast aspersions on the practices of such broker-dealers, we can assume that smaller broker-dealers are more likely to hire registered representatives to deal with customer complaints or regulatory actions. Yet, they are less likely to have the resources required to impose rigorous oversight of their registered representatives activities, and they may often offer high commission products to their customers. The fact that they do not maintain custody of their customers assets does not provide protection for losses from claims arising from the sale of unsuitable securities, churning or other investment related improprieties. Neither the Net Capital Rule nor the Customer Protection Rule protects against broker-dealer nancial failure in this case. In calculating a rms net capital, we start with GAAP equity. A GAAP equity analysis determines loss reserves for pending claims or litigation. This analysis gives ample discretion to the broker-dealer to set the amount of the reserve that should be taken as an offset against assets. The Financial Standards Accounting Boards Accounting Standards Codication states in ASC 450-20 that an

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accrual should be recorded for a litigation loss contingency when the loss is probable and can be reasonably estimated. This standard provides great latitude and little concrete guidance to the broker-dealer facing pending litigation or arbitration. ASC 450-20-55-12 sets forth the factors to be considered in determining the probability of an unfavorable outcome (see box). After determining if the loss is reasonably probable, and before an accrual for a loss is required, the broker-dealer must determine if the amount of the loss can be reasonably estimated. While litigation loss contingencies that are reasonably probable should be disclosed on a nancial statement, such contingencies do not need to be accrued as a liability unless they can also be reasonably estimated. See ASC 450-20-55-13. If they can be reasonably estimated within a range, accrual need only be made at the lowest end of the range. See ASC 450-20-55-19. Under the Net Capital Rule, a broker-dealer subject to a lawsuit that could materially impact its net capital must obtain an opinion of outside counsel on the potential effect of such a suit on the rms nancial condition. See FINRA Interpretation to Rule 15c3-1(c)(2)/0110 This permits the broker-dealer to decide whether the suit could have a material impact before seeking an opinion of outside counsel. Then, if in the opinion of outside counsel, the loss is neither reasonably probable nor can be reasonably estimated, the loss would not be included in the calculation of aggregate indebtedness for net capital purposes.

Ironically, it is the brokerdealers that do not maintain custody of customer assets that leave customers least protected.

In other words, the great discretion provided to broker-dealers in determining whether to accrue for litigation claims, including customer claims, permits broker-dealers facing numerous or substantial claims to continue to operate right up to a material loss. This can occur under the radar of regulators and at great risk to the public. Investors may be misled into believing they are protected by the Customer Protection Rule, Securities Investor Protection Corp. insurance, or errors and omissions insurance. SIPC insurance only insures against cash and securities held at the troubled rm and not against customer claims of investment wrongdoing, and errors and omissions insurance is often either nonexistent or very limited. To give an example, say a broker-dealer that does not maintain custody of its customers assets has a $100,000 net cap requirement. Using a Rule 15c3-1(c) analysis, the broker-dealer disclosed net capital of $225,000 after accruing $100,000 for probable litigation losses. In the broker-dealers judgment or its counsels opinion, such an accrual was at the low end of its reasonably estimated losses. Meanwhile, the broker-dealer is facing multiple customer claims of wrongdoing. The aggregate amount of the claims is estimated to be $5 million. The rst claim to be arbitrated in the Financial Industry Regulatory Authority Dispute Resolution forum results in an award of $650,000. Pursuant to FINRA interpretation for Net Capital Rule 15c3-1(c)(1)/14, the adverse award must be immediately included in the rms aggregate indebtedness. The interpretation says: A broker-dealer that is the subject of an adverse award in an arbitration proceeding should book said award as an actual liability at the time the award is made, even though the appeal process has not been exhausted and no judgment has been rendered, because grounds for revision on appeal are very limited. In addition, the award would be included in aggregate indebtedness as there is no exclusion available under SEA Rule 15c3-1(c)(1). If we assume that one-quarter of the litigation reserve was attributable to this claim, that would leave the broker-dealer $500,000 below its net cap requirement. Moreover, if the award is not paid and a motion to vacate the award is not led within 30 days of the award, as required by Rule 12904(j) of the FINRA Dispute Resolution customer code of arbitration procedure, it will result in suspension proceedings against the defaulting broker-dealer, pursuant to Article VI, Section 3(b) of the FINRA bylaws. Even if the rm led a motion to vacate, the rm would still

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be out of compliance with its net cap requirement, because of the requirement that the award be immediately accrued as a liability. This is not simply a hypothetical example. It is representative of what is leaving many customers, who have been seriously aggrieved by broker-dealer abuses, without a meaningful remedy, notwithstanding the Net Capital Requirement and Customer Protection Rule. In June 2000 the U.S. General Accounting Ofce submitted to Congress a report titled Securities Arbitration: Actions Needed to Address Problem of Unpaid Awards. This report said: GAOs survey of investors who received awards in 1998 found that a number of brokerdealers that had left the securities industry often did not pay arbitration awards rendered against them. GAOs survey found that 49 percent of the awards rendered in 1998 were not paid at all and an additional 12 percent were only partially paid. While more recent FINRA Dispute Resolution statistics are not as extreme, in 2011 it was estimated that $51 million, or about 11 percent, of customer awards, went unpaid. This represents a substantial improvement from the 2000 GAO ndings. It evidences, however, the continuing problem presented by the failure of thinly capitalized broker-dealers that face mounting customer claims without any independent review of the effect these claims have on their viability and need to raise additional capital. Failing to make a proper provision for litigation contingencies in considering whether a brokerdealer has complied with its net cap requirement is illustrated by the case of McGinn, Smith & Co. In April 2010 the SEC led an emergency enforcement action against McGinn Smith and its principals in SEC v. McGinn, Smith & Co. et al., No. 10-cv-00457, enforcement action led (N.D.N.Y. Apr. 20, 2010), in which a receiver was appointed. The SEC alleged in its complaint that McGinn, Smith and afliated entities raised about $120 million from investors by selling unregistered debt offerings with misrepresentations that these investments would generate sufcient income to support promised interest rates and return of principal. The SEC alleged that McGinn Smiths principals knew that it would never be possible to repay investors their principal or promised quarterly interest payments. The SEC further alleged that principals Timothy McGinn and David Smith instead misused offering proceeds to support their nancially troubled or bankrupt entities and for their own personal activities, such as procuring strippers for a sexually themed cruise. On Aug. 7, 2013, in a related criminal action, McGinn and Smith were sentenced to 15 and 10 years in prison, respectively. In 2008, three substantial customer claim arbitrations alleging fraudulent activity were led with FINRA Dispute Resolution against McGinn Smith: One led Nov. 18, 2008, sought $400,000 and resulted in an award of $455,000 on Feb. 1, 2010. The second, led Dec. 10, 2008, sought more than $8 million and resulted in an award of almost $2 million Apr. 6, 2010. The third, led Dec. 31, 2008, sought $2.5 million and resulted in an award of $805,110 on Dec. 31, 2009. McGinn Smiths last annual audited report, Form X-17A-5 for the year 2008, led with the SEC on Feb. 9, 2009, indicated that McGinn Smith had a $100,000 net capital requirement and had net capital of $127,577 as of Dec. 31, 2008. For 2008, McGinn Smith took no reserves for litigation contingencies, notwithstanding the fact that claims in the aggregate amount of $10.979 million were pending against it, which ultimately resulted in aggregate awards in excess of $3.183 million. In note 6 of its 2008 audited nancial statement, McGinn Smiths auditor said:

The public needs to be protected from this abuse by regulatory scrutiny of the reasonableness of litigation contingency reserves.

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In the normal course of business, customer complaints may arise. Some of these complaints may lead to civil actions. At this time the company is not currently aware of any pending litigation that would have a material effect on the nancial position of the rm. Accordingly, no provisions for losses, if any, are included in the nancial statements. However, no assurances can be given as to the outcome of these proceedings. The nancial statement noted that in 2008 there were related party transactions exceeding $1 million and employee compensation and benets, exclusive of commissions, of $6.385 million. This indicated that the principals were drawing substantial prots out of the companys operations, while leaving its customers inadequate accruals to address their claims. Although McGinn Smith led a motion to vacate the Dec. 31, 2009, $805,100 award, at that point McGinn Smith should have immediately recognized the award as a liability. It did not, which put the company out of compliance with its net cap requirement. It was not until March 1, 2010, however, that McGinn Smith was suspended by FINRA for failing to pay assessed hearing session fees. A broker-dealers calculation of net capital takes factors into consideration apart from GAAP accounting. Permitting broker-dealers to default to the broad discretion of GAAP accounting to the establishment of litigation contingency reserves enables truly undercapitalized brokerdealers to continue to operate and draw substantial prots through compensation to their principals at the risk of their customers. The public needs to be protected from this abuse by regulatory scrutiny of the reasonableness of litigation contingency reserves taken by thinly capitalized broker-dealers facing substantial or multiple customer claims or other litigation.

Investors may be misled into believing they are protected by the Customer Protection Rule, SIPC insurance, or errors and omissions insurance.

Glenn S. Gitomer is a shareholder and chair of the securities litigation group at McCausland Keen & Buckman, based in Radnor, Pa. His practice focuses on securities litigation and arbitration, securities industry employment disputes, and representing parties in federal, state and SRO regulatory investigations. He can be reached at ggitomer@ mkbattorneys.com.

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