SEC Issues New Interpretation on Expense Sharing

It is common practice for broker-dealers to enter into expense sharing agreements with their parent companies or affiliates whereby the parent company or affiliate performs administrative functions, as well as providing space, facilities, equipment and other services in exchange for service fees. Where the parent is a foreign unregistered broker-dealer, the dealer may also provide correspondent trading and settlement services in foreign markets. In recent months, there has been concern expressed by the NASD and the NYSE that some broker-dealers may be incorrectly omitting expenses and liabilities subject to these agreements on the broker-dealer's books and records, resulting in inaccurate disclosure of the broker-dealer's performance and financial condition. The SROs are concerned that the omission may artificially inflate the broker-dealer's profitability and cause it to appear to be in full capital compliance when in some cases it may not be after giving effect to the actual value of necessary expenses. In addition, since the party paying the expenses of a member broker-dealer under an expense sharing agreement is usually not itself a registered broker-dealer, the SROs do not readily have access to the books and records related to the member broker-dealer's operations during an exam.

Q. How has the SEC addressed these concerns?

A. On July 11, 2003, the SEC issued a letter with nine requirements for recording broker-dealer expenses and liabilities.' These requirements became effective as of the date of the SEC's letter; however, the NASD extended the compliance period for its members to December 1, 2003.

Q. What are the key requirements?

1. A broker-dealer must record each expense incurred relating to its business and any corresponding liability, regardless of whether the liability is joint or several with any person and regardless of whether a third party has agreed to assume the expense or liability. The record must include the value of any goods or services used in the broker-dealer's business, when a third party has furnished the goods or services or has paid or has agreed to pay the expense or liability, whether or not the recording of the expense is required by GAAP, and whether or not any liability relating to the expense is considered a liability of the broker-dealer for net capital purposes.

2. The broker-dealer may record expenses by preparing a separate schedule of expenses. Alternatively, the broker-dealer may reflect those expenses on its FOCUS Report.

According to NASD guidance, to the extent a broker-dealer already reflects its expenses and liabilities as part of its general ledger, and maintains proper backup documentation relative to the expense, no other documentation is necessary under items 1 and 2,above.

3. If a third party has agreed to assume responsibility for an expense relating to the business of the broker-dealer, and the expense is not reflected on its FOCUS Report, any corresponding liability will be considered a liability of the broker-dealer for net capital purposes unless:

If the expense results in a payment owed to a vendor or other party, the vendor or other party has agreed in writing that the broker-dealer is not directly or indirectly liable to the vendor or other party for the expense;

• The third party has agreed in writing that the broker-dealer is not directly or indirectly liable to the third party for the expense;
• There is no other indication that the broker-dealer is directly or indirectly liable to any person for the expense;
• The liability is not a liability of the broker-dealer under GAAP; andThe broker-dealer can demonstrate that the third party has adequate resources independent of the broker-dealer to pay the liability or expense.

Upon entering into an expense sharing agreement and annually thereafter, as of the broker-dealer's fiscal year-end, the broker-dealer has to obtain evidence that the third party has adequate resources independent of the broker-dealer to pay the costs incurred by the broker-dealer. This may be accomplished by receiving a copy of the third party's audited financial statements.

4. Any withdrawal of equity capital from a broker-dealer by a third party within three months before or within one year after the broker-dealer incurs an expense that the third party has paid or agreed to pay, will be presumed for net capital purposes to have been made to repay the third party for the expense of the broker-dealer, unless the broker-dealer's books and records reflect a liability to the third party relating to the expense.

5. For purposes of determining net capital, if the broker-dealer records a capital contribution from a third party that has assumed responsibility for paying an expense of the broker-dealer, and the expense is not reflected on its FOCUS Report, the broker-dealer must demonstrate that the recording of a capital contribution was appropriate.

6. If a third party agrees or has agreed to assume responsibility for an expense of the broker-dealer, the broker-dealer must make, keep current, and preserve the following records:

• If a vendor or other party has agreed that the broker-dealer is not liable directly or indirectly to the vendor or other party for an expense, a written agreement between the broker-dealer and the vendor or other party that clearly states that the broker-dealer has no liability, direct or indirect, to the vendor or other party; and
• A record of each expense assumed by the third party.

7. Broker-dealers must make, keep current, and preserve written expense sharing agreements between the broker-dealer and a third party that has paid or agreed to pay an expense of a broker-dealer. The agreement 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 the method of allocation when the broker-dealer records the expense in an amount that is determined according to an allocation made by the third party.

8. Each broker-dealer must be able to demonstrate that it is in compliance with the financial responsibility rules in connection with any expense sharing agreement. Therefore it may be required to provide these authorities with access to books and records, including those of unregistered entities, relating to the expenses covered by the agreement.

If the broker-dealer fails to provide access to such books and records, the SRO may assert a rebuttable presumption that the broker-dealer was not in capital compliance for the term covered by the expense sharing agreement.

9. A broker-dealer must notify its DEA if it enters into, or has entered into, an expense sharing agreement and the broker-dealer does not record each of the expenses it incurs relating to its business on the reports it is required to file with the SEC or with its DEA under the financial responsibility rules. The notification must include the date of the agreement and the names of the parties to the agreement. The broker-dealer must provide a copy of the agreement to its DEA upon request.

Q. The interpretation is concerned with countering an appearance that a broker-dealer has greater profitability than a true depiction of expenses would support. Does it also apply to expense sharing arrangements used to pay out earnings to the parent company even if the subsidiary remains in full capital compliance?

A. Yes. The interpretation applies in this case as well even though the perceived problem motivating the interpretation is not present. Firms that have been taking out revenue in this manner on the basis that the parent is bearing most of the expenses will need to consider whether such fees continue to be justifiable for tax and other purposes or whether the subsidiary should instead pay dividends to its parent for amounts in excess of the justifiable value of the services provided. Such payments would, of course, be subject to the SEC's capital withdrawal rules.

Q. Are existing expense sharing arrangements grandfathered?

A. No. Existing agreements or arrangements have to be amended or codified and notice given to the firm's DEA. There is now an initiative by NASD District Offices to review expense sharing agreements already in place as part of routine exams and continuing membership applications.

©2004 Dorsey & Whitney LLP. This Broker-Dealer and Investment Adviser News is intended for general information purposes only and should not be construed as legal advice or legal opinions on any specific facts or circumstances. An attorney-client relationship is not created or continued by sending and receiving this Broker-Dealer and Investment Adviser News. Members of the Dorsey & Whitney LLP Broker-Dealer Group will be pleased to provide further information regarding the matters discussed in this Broker-Dealer and Investment Adviser News.