Each year FINRA releases its Report on FINRA’s Examination and Risk Monitoring Program, previously known as FINRA’s Exam Priorities. In this Oyster Stew podcast, our FINOP experts Jeff Harpel, Clark Tucker and Fred Wagstaff share their insights and thoughts on FINRA’s priorities around financial management, including net capital, liquidity risk and credit risk. 

Additional Reading

What Makes a Strong FINOP?

Net Capital Requirements – Get the Facts

FINOP Expense Sharing Agreements Best Practices

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Transcript provided by Temi transcript services

Jeff Harpel:  I’m Jeff Harper and I’m here with Fred Wagstaff and Clark Tucker. And we are all Series 27 Registered Financial and Operations Principles here at Oyster. Today we’re going to talk about the FINRA Exam Priorities for 2022. We might not talk about all of them in depth, but we might just mention some of them in passing under financial management. This year they have highlighted as priority areas, net capital, liquidity, risk management, credit, customer protection, and segregation of assets and portfolio margining. We’ll spend most of our time today talking about net capital and things we have seen there before, and they’ve talked about before, but we’ll probably spend most of our time talking about those. We’ll spend a little bit of time talking about customer protection and segregation of assets, maybe just touch upon liquidity or credit risk management, and portfolio margin we’ll save for some other time.

Let’s dive in and get started starting with net capital. They have a lot of repeat findings, and if you’ve ever listened to our blogs from other years, these are going to sound very familiar, because they are. And it’s sort of amazing to me that these things keep coming up year after year after year, but they do. FINRA has highlighted several of them, and we’ll just talk about a few. The first one is related to expense sharing agreements, and what FINRA has pointed out is that they have found common violations related to insufficient documentation regarding expense sharing agreements. That really covers the method of allocation itself and documenting that, method of payment and documenting that and the actual methodology used. How exactly is our cost being allocated?  Costs have to be allocated based on actual usage and the actual amounts of time or whatever the driver happens to be that really drives that cost. And you need to be able to logically explain that and document that. I know we talked a lot about this last year, and if I may, I’m going to pass this over to Clark who had a lot of great insights last year, if he can summarize those because it’s pretty much the same this year.

Clark Tucker:  Thanks, Jeff. I don’t know if I have any amazing insights this year. I will repeat a couple of the points you made on the extension agreements. Of course, just to summarize, expense sharing agreements are simply contracts from a parent provider company to a subsidiary or affiliate broker dealer for commonly shared costs such as personnel. That split time between two entities or real estate office space and utilities that they share, things like that. And Jeff mentioned cost drivers. These are not complicated. They should be very simple, helps with the fair and reasonable aspect of this, that they be fairly determined and reasonably determined. You know, if you have an employee who is perhaps doing accounting in the parent company, but spends 30% of his time in the subsidiary broker-dealer, you would want to properly credit charge the broker-dealer for its portion; and in this case, that driver would be time spent.

Clark Tucker:  So, you would allocate 30% of the personnel cost for that and multiply that for any other individuals that have a similar role on things like floor space, office space, rent, occupancy, utilities, telephones, equipment. That can be done very simply as, you know, a percentage of the total floor space that the broker-dealer occupies as compared to the larger entity. So, if it’s 10% of the office space, then 10% of the cost should be applied. I think where a lot of firms run into issues, as Jeff mentioned, is that they don’t clearly explain those cost drivers in the Schedule A and show an example of how to do it, how they’re going to allocate the cost. The specific numbers are probably less important than the methodology. If the methodology is fair and reasonably determined, and then the outcome of the allocations, meaning that the charges are consistently applied month after month.

Most of the time firms don’t have a problem with these agreements. They have to be properly executed, fairly determined reasonable for the business, and then consistently applied. One other add-on that I would offer here related to expense share agreements is depending on the capital needs of the broker-dealer.  Sometimes firms will settle up essentially paying the parent for its portion of costs on a monthly basis or a quarterly basis. And that’s fine if that would be what was appropriate for those two entities in that unique situation. But it’s perfectly permissible to have that become a little bit broader, say for a startup firm. It makes little sense for a startup firm to, in essence, cut a check to its parent to pay for shared expenses, and then have the parent have to turn around and hand the money back. It’s a capital edition when drafting expense agreements.

One of my favorite phrases is that these will be resolved at least annually, and then set a date so that we can carry it on the broker-dealer’s records throughout the year as a growing inter-company payable – from parent it’s a growing inter-company receivable. And then, at the appropriate time that those can be settled either by cutting a check if fortune favors us, or through a waiver of that intercompany debt, which also acts as a cashless capital contribution. The parent has that option as well. Simply executing a memo just as long, as Jeff mentioned, as the documentation is there. And the trail is easy to follow when we can easily see what is being allocated, how it is being determined, that it’s being consistently applied and that we’re reevaluating periodically to make sure that the numbers and the ratios and the drivers still apply, and are still reasonable, and it’s being consistently applied. And then at the end, we are acting to resolve whatever amounts are owed one way or another in a timely manner.  Beyond that it baffles me that firms still have issues with expense agreements.

Jeff Harpel:  One of the other common violations they cited was inaccurate classification of receivables, liabilities, and revenue, particularly as it is related to revenue and expenses, using cash accounting to record revenue and expenses, as opposed to accrual accounting. So, there’s sort of two issues there. One just classifying receivables and other assets properly as allowable or not allowable.  As we all know, not allowable assets reduce our net capital, so getting that right is paramount to getting net capital correctly. One of the items they pointed to a lot were certificates of investments and certificates of deposit and firms not looking at them carefully to determine the terms under the agreement of the CD. And whether it really was allowable, readily redeemable, or not really.  It’s a good practice to look at all your receivables and have procedures in place to analyze what is allowable and what is not every month.

Don’t assume because the title of an account says it’s X that everything in there really is X. You know, sometimes mistakes are made.  Something that should have been a non-allowable asset gets mistakenly put into a liability account. You might have charges you don’t know about, so have practices in place to really look at your accounts, know what’s in them, so you can get that capital done correctly. The other piece of that has to do with revenue expenses and again, using cash basis accounting, instead of using accrual accounting. Fred, do you want to comment on that?

Fred Wagstaff:  Yeah, sure will Jeff. It’s hard to believe this one is in the FINRA notice, but it has been, or it is this year, and it has been in the past. This priority, as you said, has to do with cost-based accounting versus accrual-based accounting. And to me, bottom line is accrual-based accounting is the way that it has to be done, obviously. So that one’s pretty simple in my mind, accrual-based accounting.  Going back to the asset classification for net capital purposes, I agree with the things that you said, Jeff.  I think it’s extremely important to provide a form of an assessment of the net capital treatment of general ledger accounts every single month, and you have to look at the underlying data within the accounts.  Like you said, there could be debit balances in liability accounts that would be a charge to net capital and that sort of thing. And the other thing that you touched on has to do with CDs and investments that are within the account documents or in the cash accounts.  I’ve seen that happen as well. You really need to take a hard look at your account documents for your bank accounts and make sure that you don’t have anything that’s included in there that would be either a portion or all, non-allowable assets. So, I think that’s extremely important to do that.

Clark Tucker:  I would add one point onto what Fred and Jeff just said, and that is that a couple of years ago, in ASC 606 concerning revenue recognition policy, revenue recognition became the responsibility of all firms. And I think that has added a little bit of confusion as far as allowable, non-allowable receivables, good revenue versus deferred revenue, because what had traditionally been considered earned revenue and therefore eligible for capital was anything the firm was paid.  We received payment for an advance or a commission or something that was good. But ASC 606 kind of redefined some of that so that you advanced payments. Now the firm has the obligation to show how it earned the portion of that, that it is considering revenue. You know, another example would be, if quarterly fees were charged or managed assets in advance, the firm couldn’t recognize more than what it had earned as quarter progresses.  Historically firms would just record the revenue, take it straight to income, to equity, boosting capital in that capital and that’s a different animal these days.

And I think that’s an area of focus where firms really should spend a little bit of time. Just because a retainer has been received or an asset-based fee has been received, does not necessarily mean that the firm can count that yet. The firm should work with its accountants and make sure that it is classifying between actual revenue and equity or deferred revenue (which is, of course, a liability as long as it has not been earned), and that the firm has a clear methodology to be able to demonstrate that what is being recorded as revenue, and therefore adding to net capital, has been earned.

Jeff Harpel:  Now, let me add one thing, and I think Clark has come across this problem too, which is almost the reverse. A couple of times I’ve seen people or firms, particularly if they use QuickBooks, or something like that, who will send out a bill and QuickBooks will record that as a receivable and gets courted as deferred revenue. So we have an asset and a liability, but we haven’t actually gotten the money yet, so they send out a bill say the 30th of the month, we have a receivable or potentially a prepaid and a liability. And if you think about it, that really is illogical. You can’t have a prepaid item if you haven’t made the payment yet, and you can’t really have deferred revenue, if you haven’t received the cash yet. So, you have to be careful and look for those kinds of situations also because you might be taking a charge on a prepaid or receivable that truly isn’t just yet.

So that’s somewhat unique. And it seems to be a mechanical problem, usually associated with QuickBooks. That’s where I’ve seen it, where fictitious either nine, allowable assets or liabilities that would otherwise be included in aggregate and debt in this get created little tidbit, something to be on the lookout for.  Couple other things that FINRA mentioned in that capital consideration, they talk a little bit about underwriting commitments and the fact that people are not keeping good records to actually know what their underwriting commitments are.  Too many times a firm will say, well, where am I, at the end of the day? And sort of forget about the fact that net capital is a moment-to-moment calculation. So, you need to know where you stand at any point in time, particularly as it relates to underwriting commitments.  You need to know what your underwritings are going to be, how much, when they are going to become effective.

You can accurately figure out your underwriting commitment changes it. It’s been a problem with some firms in the past and FINRA has pointed it out again. So keep good records. That’s the bottom line. One of the other things they’ve pointed out are failed to deliver and failed to receive charges, being inaccurately calculated. You know, you need to know how old your fails are. And I’ve seen too many times that firms will miscount the days when determining aging. It’s very simple to put in a formula and inadvertently forget the first day or the last day. If the aging is supposed to be five days, they end up with six, or if it’s supposed to be four days, they end up with five or 30, they end up with 31 or, or the opposite. They think their formula is calculated 30 days and it’s 29. Make sure were when you’re calculating aging for dates that you do it accurately.

Fred Wagstaff:  Jeff, I’ll just jump in here on the underwriting commitments. You know, one thing that I’ve noticed in practice that works really well, going to documentation, is to have a form that you fill out every time that you have an underwriting commitment. And that form is something that you could hand over to any regulator that shows that you documented it.  It shows your moment in time capital computation, and then you overlay that into your actual net capital computation with your other items. So that to me works in practice very well. And then on the fails side, Jeff, I agree with everything that you said, I think once you get a system in place for calculating the fails, like you said, you can make some very common administrative or clerical mistakes in the calculation, make sure that the folks that are actually preparing that understands it and understands the rule so that you do get that right.

Jeff Harpel:  Key point there, make sure the people doing it understand the rule. Many times they think they understand it. That just sort of moves us on a little bit to some of the things FINRA points out as effective practices. And one of them, that you just mentioned, Fred, that they pointed out last year and the year before and the year before is training and guidance. Making sure your financial people, your FINOPs, anybody supporting the FINOPs, are properly trained, that they really know the rules inside and out. Not just that they know them today, but they have a method and a means to keep up, to track changes.  Things that are going on in the industry that might have been true yesterday, might not be true tomorrow, and you need that sort of constant training and updating of your knowledge.

Fred Wagstaff:  I agree with that, Jeff. And I think one of the key things, and I’ve seen this in practice as well, that in my private industry experience, you have two different worlds. You have the financial world, and you have the operations world and net capital and in the reserve calculation. And as a result of that, operations folks don’t typically talk accounting speak. And to me, there’s a lot of training and interaction that needs to take place between the two groups to make sure, as we’ve said, that you understand the rule, that you’re adhering to the rule, and you are staying abreast of any changes in the rules that you need to put in place.

Jeff Harpel:  So some other things they talk about as effective practices is reviewing agreements, making sure they’re understood, be they expense sharing agreements or agreements with banks related to CDs. One problem I have occasionally seen is there might be agreement with a bank. A company, a firm opens a bank account, and maybe they have a lending agreement also with the same bank, and the bank requires some sort of compensating balance to be maintained.  That compensating balance becomes a non-allowable asset. It’s not cash you can actually use, and that is easily missed if you’re not looking at those interrelationships between the bank, blending activities and your deposit accounts. So, another one I’ve seen happen.

Fred Wagstaff:  And Jeff, one thing I’ve seen that has happened on bank accounts, as well, is if you have banking relationships where the bank through an agreement that the client, which would be the broker-dealer, would sign that allows the funds to be swept into like a money market account or a portion of it gets swept to a money market account. You’ve got to be real careful with that too, because when it gets swept into a money market account, that’s a security. That’s not cash subject to a security haircut. So you’ve got to be real careful, and that’s why it’s extremely important to look at these agreements for the banks and make sure that you really understand, what you have there. Is it truly unrestricted cash or is it something other than that, that restricts you from getting access to the cash like you would in an unrestricted cash account?

Jeff Harpel:  Yeah, I’ve seen another situation too, where some banks have money market accounts, where money is swept into a money market account, which is still a bank account. It’s still allowable and not subject to the haircut. But I saw one situation where the treasury staff, trying to be incredibly efficient and make as much money as possible, said to themselves, well, if I sweep it into this particular bank account, I’ll learn X more basin points. The problem was that particular branch of that particular bank that could pay that higher yield was in the Cayman Islands. And we know bank accounts in the Cayman Islands are not allowed, so by rule, they are a hundred percent not allowable assets.  Needless to say, that resulted in a notice of a capital deficiency. But again, that goes back to be careful, make sure your staff knows what is or isn’t allowed because in this case, the treasury folks thought they were doing an outstanding job, but they didn’t ask the question that they should have asked and created a big problem.

So it’s partly training, making sure they know and partly, as I said, when in doubt, ask the question before you do it.  That was an easily avoided problem. We had to unwind the whole thing, but it was an easily avoided problem if someone had just asked ahead of time.  It was also a lesson learned. So that particular firm updated its procedures to include the FINOP in the stream of approvals before they do anything like that.  It created a problem, but it also created improvements in the control environment.  Lessons were learned, but I’ve seen that happen. One of the effective practices that FINRA points out, and again, they pointed this out in the past, is to just perform an assessment of your entire balance sheet regularly to determine what’s allowable, and what’s not. And of, as I mentioned earlier, you know, what was yesterday doesn’t mean it is today and what is hidden in a particular account or something could be hidden in a particular account.

You can’t always rely on the titles used on accounts. You need to really know. So periodically, someone other than the person reconciling the accounts needs to look at the accounts and make sure everything is treated properly.

Just touching on some of the other items that are in FINRA’s priorities for 2022, they do talk a considerable amount about liquidity risk management. We’re not going to spend a lot of time on that, but liquidity is important, especially if you are a clearing firm. And just because you have liquidity in place today, and it works, you need to always have that plan in your back pocket for “What if this happens? What if the other thing happens?” And we’re seeing situations in our world today, Russia invading Ukraine, where things can change very quickly and you need to be prepared. And FINRA is looking at those liquidity plans. So make sure, just make sure you have got a liquidity contingency plan. It should cover things like governance of liquidity management, how liquidity is monitored, how often it’s monitored, evaluating the quality of all your funding sources and alternate funding sources. And as I said, any assumptions about what if this happens, what if that happens, then the market doesn’t look today like it did before. And what are your early learning and escalation procedures, all of those things should be an in your contingency plan.

Fred Wagstaff:  Jeff, the one thing that I would add here, and I don’t think you mentioned this, is stress testing. That’s an important element of the liquidity risk management plan. FINRA takes a hard look at it.

Jeff Harpel:  Another item FINRA mentions is customer protection and segregation of assets. I want to focus really on one thing in particular, which tends to impact smaller firms, introducing firms in particular. They’re talking about check forwarding procedures. If you are an introducing firm, if you want to maintain your exemption from rule 50 C33 and not have to do reserve computations every week, there’s certain guidelines or requirements around check forwarding. If you get a check in made out to your clearing firm, it’s got to be out to them by noon the next day. So, you need to make sure that you’ve got policies and procedures that guarantee that those procedures will be followed. Those checks will get out the door. You also need to know what happens if you inadvertently get a check written to the firm in the firm’s name? You know, what do you do?

What do you do? If you get a customer check written to some third party, what do you do? And all these things need to be recorded. You need some sort of blotter to record all these items and their disposition. You’ve got to be able to prove that you complied with all the requirements of the exemptions. So you need to keep very good records of all the checks in or out, checks written to the firm, their disposition. And it’s the only real way to make sure you’re going to be safe. No one wants to do a reserve calculation every week, if you don’t have to.

Fred Wagstaff:  Jeff, one thing I would like to add is that from what some of the things that FINRA has put in there, that one of the biggest risks that a firm has in the 15c3-3 world, this covers whether you’re a claim firm or not, I think, is concerning the limited training and staff turnover. I think that’s a real thing if you don’t have good training, and that goes hand in hand with any kind of poor internal department coordination that could result in a real problem in the reserve calculation or in check forwarding, et cetera.

Clark Tucker:  Well, that makes sense because in the absence of the occasional bad actor, I think most customer funds issues or protection of assets comes down to a training issue, or someone assumed something that was incorrect, or didn’t know how to do something, and didn’t think to ask about it.  And most of that, if not all of that, can be eliminated with the right training upfront if customer facing employees know what to do with checks, which ones to immediately return to a customer for whatever reason or how to properly forward, and not just assume that an extra day is okay.  That training eliminates problems and you can document properly and move on and make money.

Jeff Harpel:  The last item, just to touch upon, is credit risk management, and again, this is very important. If you are a clearing firm, particularly where you have a lot of receivables, a lot of customer receivables. , being able to have those risk measurements in place to tell you what might happen if this happens, what might happen if that happens because market disruptions do happen for smaller firms.  If you’re a reducing firm or a special purpose firm, you might not worry too much about credit risk management, but if you clear or carry customer accounts, it’s a big deal.

Fred Wagstaff:  I was going to say Jeff, for clearing firms it’s a requirement under the books and records rules to have that control framework in place, where they have to maintain a control process to identify and aggregate and manage and supervise the entire credit risk profile. And they should review the accuracy of the process to calculate the credit risk and they should also evaluate the underlying collateral that they have in the event of market conditions that could cause exposures and effects on that capital.

Jeff Harpel:  Similar to what we said with liquidity risk management, you need a structure in place. You need a credit committee, you need governance over credit – Who is going to look at it? How you’re going to monitor it? What red flags and early warning reports do you get? What contingency plans do you have if this happens, or if that happens, or the other thing happens?

 Thank you, Clark, and Fred for participating today. Again, we are all FINOP consultants, here at Oyster. We’re here to help.

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About The Podcast Speakers
Photo of Jeff Harpel

Jeff Harpel

Jeff Harpel has over 30 years of expertise in accounting, finance, and auditing in the securities industry. Jeff’s FINOP and operations experience includes a comprehensive understanding of securities financial and operations requirements, dealing with regulatory examiners and a thorough command of internal controls, financial systems, and merger conversion activities.

Photo of Fred Wagstaff

Fred Wagstaff

Fred is an accomplished financial CFO and FINOP with extensive experience in the full-service broker-dealer, clearing, and registered investment advisory industry. Fred’s experience includes merger and acquisition financial responsibilities, financial and operational responsibilities including financial statement preparation, net capital computations, regulatory filings, incentive compensation development, commission payout systems and financial/accounting optimization and strategy.

Photo of Clark Tucker

Clark Tucker

Clark Tucker is a senior FINOP executive with more than 25 years of experience in the banking and securities industries. Clark’s Series 27 license and his broker dealer financial and operations expertise ensures our clients receive the high-quality outsourced FINOP support they need.

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