A Refresher on Broker-Dealer Expense Sharing Agreements
May 07, 2018
By Garth Puchert
Like many securities firms, broker-dealers incur various costs, such as real estate, technology, and back-office expenses, while running their businesses. These expenses are often borne by third parties, typically the broker-dealer’s parent company or other affiliate. The Securities and Exchange Commission (“SEC” or the “Commission”) and Financial Industry Regulatory Authority (“FINRA”) expect broker-dealers to execute and implement expense sharing agreements with such third parties, and meet related net capital requirements.
All broker-dealers should be aware of these requirements, as auditors and regulators have increased their scrutiny on even the smallest expenses impacting financial statements. Both the SEC and FINRA have outlined the relevant expectations of broker-dealers.
In October 2003, FINRA (then the NASD) issued guidance on expense-sharing agreements for its member firms in Notice to Members (“NTM”) 03-63. The main driver behind NTM 03-63 was a concern by regulators that broker-dealers were not properly recording expenses and liabilities on their financial statements, a concern that remains today. Pursuant to Rule 17a-3(a)(1) and (a)(2) of the Securities Exchange Act of 1934, NTM 03-63 requires a broker-dealer to make a “record reflecting each expense incurred relating to its business and any corresponding liability, regardless of whether a third party has agreed to assume the expense or liability.” NTM 03-63 also states that such expenses or liabilities assumed by third parties must be maintained in the broker-dealer’s records, regardless of the accounting treatment or impact to the firm’s net capital.
NTM 03-63 outlines some basic principles when drafting expense sharing agreements:
- Allocations of recorded expenses to third parties must be reasonable, and applied on a consistent basis, and broker-dealers must be prepared to provide evidence of the reasonableness of the allocation to FINRA.
- Expenses should include those which the broker-dealer receives a direct or indirect benefit for and/or the broker-dealer would be responsible for paying if the third party did not assume the expense.
- Expenses typically covered in these agreements include but are not limited to: rent, communications, compensation of registered personnel, technology costs, and back office services (e.g., compliance, legal, operations).
- Arbitration awards against a broker-dealer may not be satisfied by a third party.
Net Capital Implications
With respect to net capital issues, NTM 03-63 states that expenses and liabilities assumed by third parties must be liabilities for the broker-dealer for purposes of net capital unless:
- The third party has agreed in writing that the broker-dealer is not responsible for the expense or liability (for vendor payments, the vendor agrees that the broker-dealer is not responsible).
- No evidence indicates that the broker-dealer is responsible for the expense or liability.
- The broker-dealer does not incur the liability under GAAP.
- The broker-dealer can evidence that the third party maintains resources, independent of the broker-dealer, to pay the expenses.
Regarding the last issue, the SEC amended its broker-dealer net capital and financial responsibility rules in 2013 to address the assumption of broker-dealer liabilities and expenses by third parties. Specifically, the Commission’s amendments to Rule 15c3-1 of the Exchange Act included the requirement for “a broker-dealer to adjust its net worth when calculating net capital by including any liabilities that are assumed by a third-party if the broker-dealer cannot demonstrate that the third-party has the resources, independent of the broker-dealer’s income and assets, to pay the liabilities.”1 The Commission’s primary concern stemmed from instances where the third parties lacked sufficient resources, independent of the broker-dealer, to assume such liabilities or expenses thereby misrepresenting the broker-dealer’s true financial condition.2 In adopting this rule, the SEC advised broker-dealers to maintain records demonstrating the third party’s ability to cover liabilities and expenses in expense-sharing agreements. Such evidence may include the third party’s most recent audited financial statements, tax returns or regulatory filings.
What Should Broker-Dealers Do?
The FINRA and SEC guidance and rules provide a clear path for broker-dealers to follow in executing and implementing expense-sharing agreements with any third parties. Some basic steps to take in preparing for audits or regulatory exams include:
- Execute the expense sharing agreement between the broker-dealer and the third party assuming broker-dealer expenses.
- Itemize the list of expenses assumed by the third party.
- Prepare supporting documentation for each expense, regardless of the amount or materiality.
- Clearly document the rationale and methodology for expenses allocated to third parties, and demonstrate the consistency and reasonableness of the allocation percentage.
- Prepare evidence of the third party’s ability to assume liabilities and expenses for the broker-dealer.
- Periodically review (at least annually) the expense sharing agreements, allocation methodologies, and expenses or liabilities within the scope of the agreements, and update as needed based on business, operational, or regulatory changes.
- Perform periodic testing of the effectiveness and implementation of the expense sharing agreements, and remediate as needed.
- Continuously confirm that the broker-dealer is meeting related net capital requirements.
1 See, https://www.sec.gov/info/smallbus/secg/bd-financial-resp-secg.htm, Amendments to Financial Responsibility Rules for Broker-Dealers, A Small Entity Compliance Guide, modified October 21, 2013.
2 See, https://www.sec.gov/rules/final/2013/34-70072.pdf, 17 CFR 240, Financial Responsibility Rules for Broker-Dealers, effective date October 21, 2013.
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