FINRA Series 28 Introducing Broker-Dealer Financial and Operations Principal Exam Key Study Note

Securities Exchange Act of 1934 Rule 17a-5(d) mandates that every broker-dealer must file an annual audit report. This report must include a balance sheet, income statement, statement of cash flows, and a statement of changes in ownership equity. The audit must be conducted by an independent public accountant qualified under Rule 17a-5(f). Furthermore, Rule 17a-5(e) specifies the nature and form of these reports, requiring them to be prepared in accordance with generally accepted accounting principles (GAAP). The report must also include schedules detailing the computation of net capital and the reserve requirements under Rule 15c3-3. Failure to comply with these requirements can lead to regulatory sanctions and potential business curtailment, as outlined in FINRA Rule 4120.

When a broker-dealer’s net capital falls below the early warning level due to a capital withdrawal, immediate notification is required. FINRA Rule 4110 and SEA Rule 15c3-1(e)(1) necessitate that the firm notify the SEC and FINRA promptly. The notification must detail the amount of the withdrawal, the resulting net capital level, and the ratio of aggregate indebtedness to net capital. This notification should be made electronically, if possible, and followed up with written confirmation. Furthermore, the firm must provide an explanation of the circumstances surrounding the withdrawal and its impact on the firm’s financial condition. Failure to provide timely and accurate notification can result in regulatory action, including restrictions on the firm’s operations and potential disciplinary proceedings.

Assessing the regulatory and operational impact of a material transaction requires a multi-faceted approach. The FINOP must first identify all potential risks, including market, liquidity, and credit risks, as outlined in Securities Exchange Act of 1934 Rule 15c3-1. This involves analyzing the transaction’s impact on the firm’s net capital, reserve requirements, and overall financial condition. The FINOP must also evaluate the operational changes required to support the new technology, including modifications to clearance, settlement, and record-keeping processes. Furthermore, the FINOP must ensure that the transaction complies with all applicable regulations, including those related to customer protection, anti-money laundering, and data security. Financial statement disclosures, such as contingencies and off-balance sheet items, must accurately reflect the transaction’s impact.

A FINOP’s responsibilities in managing clearance, settlement, and delivery are critical for maintaining operational integrity. This includes ensuring timely and accurate processing of transactions, adherence to settlement dates as per FINRA Rules 11320, and proper handling of securities transfers under FINRA Rule 11550. The FINOP must oversee the reconciliation of trading records, monitor buy-in procedures as outlined in FINRA Rule 11810, and manage customer account transfers in accordance with FINRA Rule 11870. Furthermore, the FINOP is responsible for ensuring compliance with Securities Exchange Act of 1934 Rule 10b-10, which requires the timely confirmation of transactions to customers. Effective oversight of these functions minimizes operational risks and ensures compliance with regulatory requirements.

Undisclosed private securities transactions violate FINRA Rule 3280, which requires associated persons to provide written notice to their firm before participating in any private securities transaction. The firm has a supervisory responsibility under FINRA Rule 3110 to establish and maintain a system to detect and prevent such activities. Upon discovery, the FINOP must immediately investigate the matter, document the findings, and take corrective action, which may include disciplinary measures against the registered representative. The firm must also assess the impact of the transactions on customers and ensure that any losses are appropriately addressed. Failure to adequately supervise registered representatives and prevent private securities transactions can result in regulatory sanctions and reputational damage.

Securities Exchange Act of 1934 Rule 15c3-1(c)(2)(vii) requires a broker-dealer to deduct the full value of non-marketable securities from its net worth when calculating net capital. This deduction can significantly reduce a firm’s net capital, potentially leading to regulatory deficiencies. To mitigate this impact, the FINOP can explore strategies such as reducing the firm’s holdings of non-marketable securities, seeking a ready market for these securities, or obtaining a secured borrowing agreement that allows the securities to be treated as allowable assets. The FINOP must also ensure that the firm’s financial statements accurately reflect the value and nature of these securities, and that appropriate disclosures are made to regulators.

To qualify for an exemption under the Customer Protection Rule (SEA Rule 15c3-3(k)), a broker-dealer must meet specific criteria, such as limiting its business to certain types of transactions or maintaining a specific level of customer assets. The FINOP must meticulously document the firm’s compliance with these criteria and file the appropriate claim for exemption with the SEC and FINRA. Ongoing responsibilities include continuously monitoring the firm’s activities to ensure continued compliance with the exemption requirements. Any changes in the firm’s business operations or financial condition that could affect its eligibility for the exemption must be promptly reported to regulators. Failure to maintain compliance can result in the loss of the exemption and potential regulatory action.

FINRA Rule 4120(a) mandates regulatory notification and potential business curtailment when a member firm experiences financial or operational difficulties, such as net capital deficiencies or a failure to make and keep current books and records. This rule is triggered by events that suggest a firm’s inability to meet its obligations. Securities Exchange Act Rule 17a-11 requires notification to the SEC and designated examining authority of net capital deficiencies, books and records issues, and other specified events. The triggers for notification under Rule 17a-11 are more quantitatively defined, often involving specific thresholds of net capital deficiency or delays in books and records maintenance. Non-compliance with either rule can lead to regulatory sanctions, including fines, suspensions, and even expulsion from FINRA. Failure to comply with Rule 17a-11 can also result in SEC enforcement actions. The interplay between these rules requires firms to have robust monitoring systems to identify and report triggering events promptly, ensuring compliance with both FINRA and SEC regulations.

Securities Exchange Act Rule 15c3-3(k) provides exemptions from the full requirements of the Customer Protection Rule for certain broker-dealers. These exemptions, such as (k)(2)(i) and (k)(2)(ii), allow firms that limit their business activities to avoid maintaining a special reserve bank account for the exclusive benefit of customers. An introducing broker-dealer claiming a (k)(2)(i) exemption typically forwards all customer funds and securities promptly to a clearing firm, while a (k)(2)(ii) firm clears all transactions through a clearing broker on a fully disclosed basis. Claiming an exemption significantly impacts operational and compliance requirements. The introducing broker-dealer must meticulously adhere to the conditions of the exemption, ensuring prompt transmission of funds and securities or maintaining a fully disclosed clearing arrangement. Failure to comply with the exemption’s conditions nullifies the exemption, subjecting the firm to the full requirements of Rule 15c3-3, including the reserve formula calculation and maintenance of a special reserve bank account. This necessitates robust monitoring and control procedures to ensure ongoing compliance with the chosen exemption.

Securities Exchange Act Rule 17a-5(d) mandates that every broker-dealer file an annual audited financial statement with the SEC. This requirement applies regardless of whether the broker-dealer is a member of a self-regulatory organization (SRO) or not. The audited report must be filed within 60 days after the date of the broker-dealer’s fiscal year end, subject to potential extensions granted under Rule 17a-5(m). Rule 17a-5(e) specifies the content and form of the audited report. It must include a balance sheet, income statement, statement of cash flows, and statement of changes in ownership equity. The report must be prepared in accordance with generally accepted accounting principles (GAAP) and audited in accordance with generally accepted auditing standards (GAAS) by an independent public accountant. Furthermore, the report must include a supplemental schedule of the broker-dealer’s computation of net capital and computation for determination of reserve requirements pursuant to Rule 15c3-3. The independent public accountant must also provide an opinion on the financial statements and the supplemental schedules.

FINRA Rule 4510 establishes the general requirement for member firms to make and preserve books and records in compliance with Securities Exchange Act Rules 17a-3 and 17a-4. These rules collectively ensure that broker-dealers maintain accurate and complete records of their business activities, enabling regulators to oversee their operations and protect investors. Securities Exchange Act Rule 17a-3 specifies the records that a broker-dealer must create, including records of original entry (e.g., blotters), customer account information, order tickets, confirmations, and trial balances. Rule 17a-4 outlines the retention periods for these records, ranging from three to six years, depending on the type of record. Examples include retaining blotters and other records of original entry for six years, and customer account records for six years after the account is closed. FINRA Rule 4510 reinforces these requirements, emphasizing the importance of accurate and accessible recordkeeping for regulatory oversight and investor protection. The rationale behind these rules is to provide a clear audit trail of all transactions and activities, allowing regulators to detect and prevent fraud, manipulation, and other violations of securities laws.

FINRA Rule 11810 outlines the “buy-in” procedures that a broker-dealer must follow when another broker-dealer fails to deliver securities as required under a contract. A buy-in is essentially a procedure where the purchasing broker-dealer purchases the securities in the open market and charges the selling broker-dealer for any losses incurred. A buy-in notice must be issued promptly after the settlement date if the securities are not delivered. The buy-in notice must specify the securities, quantity, settlement date, and the intention to execute a buy-in. The selling broker-dealer then has a prescribed timeframe (typically determined by industry standards and the type of security) to deliver the securities. If the selling broker-dealer fails to deliver within this timeframe, the purchasing broker-dealer must execute the buy-in “for the account and risk” of the selling broker-dealer. This means that any losses incurred in the buy-in process, including the difference between the original contract price and the buy-in price, are the responsibility of the selling broker-dealer. Failure to execute a buy-in within the prescribed timeframe can result in regulatory sanctions and potential liability for any losses that could have been avoided had the buy-in been executed promptly.

Securities Exchange Act Rule 17a-5(h) outlines the notification requirements when a broker-dealer discovers a material weakness in its internal control structure related to compliance with financial responsibility rules. Upon discovery of such a weakness, the broker-dealer must immediately notify the SEC and its designated examining authority (DEA). The notification must be in writing and must describe the nature of the material weakness, the steps the firm is taking to address the weakness, and the anticipated timeline for remediation. The notification should also include any potential impact the weakness may have on the firm’s ability to comply with net capital, customer protection, and other financial responsibility rules. The firm must also provide updates to the SEC and DEA as remediation efforts progress. Failure to comply with these notification requirements can result in significant consequences, including regulatory sanctions such as fines, censures, suspensions, and even revocation of registration. Additionally, the firm may be subject to enforcement actions by the SEC for violating Rule 17a-5(h).

FINRA Rule 4160 requires broker-dealers to establish and maintain procedures for the verification of their assets. The primary goal of this rule is to ensure that a firm’s assets are accurately recorded and safeguarded, thereby protecting customer funds and securities and maintaining the firm’s financial integrity. To comply with Rule 4160, a firm must implement procedures for the periodic verification of all assets, including cash, securities, and receivables. These procedures should include physical counts of securities, reconciliation of bank accounts, and confirmation of balances with counterparties. The frequency of verification should be determined based on the nature and risk profile of the assets, but must occur at least annually. The firm must also maintain records of all verification procedures performed, including any discrepancies identified and the corrective actions taken. Failure to adequately verify assets can result in inaccurate financial reporting, potential losses of customer funds or securities, and regulatory sanctions. FINRA may impose fines, censures, suspensions, or other disciplinary actions for violations of Rule 4160.