In October 2003, FINRA issued NASD Notice to Members 03-63 (the Notice to Members) in which the SEC issued guidance on the treatment of expenses and liabilities to broker-dealers utilizing expense sharing agreements pursuant to SEC Rules 15c3-1, 17a-3, and 17a-4. Since that time, expense sharing agreements have been reviewed and revised in accordance with the Notice to Members, with most member firms having had at least one or two cycle exams from the issuance of the SEC guidelines, to date. Over that period, most firms had made revisons to their intercompany expense sharing agreements, and they were now believed to be acceptable.
However, because of the current focus on securities ponzi schemes perpetrated by broker-dealers and their affiliated entities, the SEC has refocused FINRA on the review and analysis of expense sharing relationships. Recently, member firms utilizing expense-sharing agreements have undergone increased scrutiny in FINRA cycle exams, resulting in most expense sharing agreements and or the allocation process being deemed deficient by FINRA, regardless of the findings of adequacy in prior cycle exams.
There are a number of issues being addressed by the SEC in the Notice to Members. Since these issues are being targeted in current FINRA cycle exams, and year end is near, we want to bring to your attention the recent deficiencies of note, which generally included the following:
- The expense sharing agreement did not include a specific allocation of expenses that the broker-dealer paid every month, regardless of revenue (a base monthly allocation);
- The expense sharing agreement provided for waiver or debt forgiveness of the base monthly allocation;
- The expense sharing agreement did not specifically provide:
- A representation that the broker-dealer will maintain copies of each agreement pursuant to SEC Rules 17a-3 and 17a-4 and all related supporting documents;
- A statement indicating the extent to and basis for which the third party service provider is legally obligated to pay vendors for costs attributable to the activities of the broker-dealer, which are paid by such service provider;
- A statement indicating that all operating expenses paid by the third party service provider, which are not included in reports filed by the broker-dealer with FINRA or the SEC, will be recorded by the broker-dealer on a separate schedule of costs and maintained pursuant to SEC Rule 17a-4;
- A statement that the broker-dealer will notify FINRA if and when it establishes a new, or amends an existing agreement;
- A statement indicating that unpaid expenses payable by the third party service provider, that are attributable to the broker-dealer, will be included in their net capital computation, by adjustments which will reduce net capital and increase aggregate indebtedness; and
- A representation indicating that the third party service provider will provide the broker-dealer with copies of the expense allocation methodology, and copies of invoices paid by the third party service provider on behalf of the broker-dealer.
As there appears to be a shift in the acceptability of intercompany expense sharing agreements by FINRA, we would recommend that firms take prompt action to review both the terms and conditions of their expense sharing agreements for conformity with the SEC Guidelines, and the process and methodology utilized in determining the base monthly allocation utilized so that the 2010 allocations are determined prior to commencing the new fiscal year. Additionally, you need to be aware that should you materially amend the agreement, a copy of the revised agreement must be forwarded to your district office FINRA, or you will subject your firm to additional regulatory scrutiny.
We hope you have found this information helpful. Should you have any questions or concerns, please feel free to contact Daniel E. LeGaye directly at 281-367-2454, or via email, or consult with your legal counsel or third party consultant.
This legal update has been provided to you courtesy of The LeGaye Law Firm, P.C., 2203 Timberloch Drive, Suite 100, The Woodlands, Texas 77380. Visit our web site at www.legayelaw.com. The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation. Not Board Certified by Texas Board of Legal Specialization.