Expense Sharing Agreements: Know the Fundamentals

Expense Sharing Agreements: Know the Fundamentals

Expense Sharing Agreements are one of the most important regulatory concepts in the broker dealer and investment advisory world. These expense sharing agreements determine everything from a broker dealer making the appropriate records reflecting 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 to documenting any withdrawal of equity capital, as defined in paragraph (e)(4)(ii) of Exchange Act Rule 15c3-1, from a broker dealer by a third party.

The problem is that while expense sharing agreements are dense, it’s also fundamental to broker dealer operations and compliance when applicable at the firm level. Here’s a quick refresher on the fundamentals of expense sharing agreements to help you successfully navigate capital compliance.

What Is an Expense Sharing Agreement?

Based on FINRA’s Notice, Fact Patterns 1 and 2:

 1.  An expense agreement provides that the broker dealer will pay a certain monthly fee to an affiliated company “in consideration of the mutual covenants and agreements to be kept and performed on the part of the parties.”

 2. An expense agreement states that the broker dealer will pay its parent$25,000 per month for “management services and other administrative services "that the parent provides. The written agreement does not further define the services. The broker dealer does not record any expenses such as rent, utilities, telephone, etc., and management says that all such expenses are included in the $25,000 per month fee.

 Analysis: In the computations of net capital, each broker dealer in Fact Patterns 1 and 2 must reduce net worth by its actual expenses as if there were no expense agreement. An expense agreement must enumerate the services or products being provided to the broker dealer, with a reasonable cost assigned to each.

Fact Pattern 3:

 3. An expense agreement specifies that the broker dealer will pay its holding company $1,000 per month for rent and $500 per month for utilities and telephone services. The broker dealer occupies two floors of a three-story building, while the holding company and another affiliate occupy the third floor; the holding company pays $25,000 per month to rent the building and pays $15,000 per month for telephones and utilities. Management states that the rent and utilities fees specified in the expense agreement are consistent with the business goals and objectives of both firms, and therefore have been allocated on a reasonable basis.

 Analysis: The expenses do not appear to be allocated on a reasonable basis. In its computation of net capital, the broker/dealer must reduce net worth by expenses allocated on a reasonable basis.

Essential Expense Sharing Agreement

There are three essential components of expense sharing agreements: record keeping, net capital and withdrawals of capital.

1. Books and Records. A broker dealer which has its expenses or liabilities paid by a third party and does not record those expenses in its financial reports filed must enter into a written expense sharing agreement with that third party, notify its designated examining authority (“DEA”) of the existence, date and names of the parties to that agreement and provide a copy to the DEA upon request. In addition, a broker dealer must maintain records of all expenses relating to its business. Under SEC Rules17(a)(1) and (2), a broker dealer must record all such expenses, regardless of whether the liability is joint or several or a third party has agreed to pay the expense.

 2. Net Capital. Expenses of a broker dealer for which a third party agrees to assume responsibility, and which are not recorded on the broker dealer's reports to the SEC and its DEA will be considered a liability for net capital purposes unless certain requirements are met.

 3. Withdrawals of Capital. 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 recorded on the reports the broker dealer is required to file with the Securities and Exchange Commission or with its DEA under the financial responsibility rules, the broker dealer must be able to demonstrate that the recording of a contribution to capital is appropriate. Among other things, the broker dealer must be able to demonstrate that the third party has paid the expense or has adequate resources independent of the broker dealer to pay the expense and that the broker dealer has no obligation, director indirect, to a vendor or other party to pay the expense. For net capital purposes, any equity capital withdrawn by the third party, other than a withdrawal described in paragraph (e)(4)(iii) of Exchange Act Rule 15c3-1, within three months before or one year after the broker dealer incurs the expense, will be deemed to have been a repayment of the expense to the third party. For net capital purposes, if a contribution to capital is made to a broker dealer with an understanding that the contribution can be withdrawn at the option of the contributor, the contribute on may not be included in the firm’s net capital computation and must be re-characterized as a liability. Any withdrawal of capital as to that contributor within a period of one year, other than a withdrawal described in paragraph(e)(4)(iii) of Exchange Act Rule 15c3-1, shall be presumed to have been contemplated at the time of the contribution.

Expense Sharing Agreement Is Critical to Broker Dealer Compliance Business Practices  

Expense Sharing Agreements are a fundamental element of the treatment of broker dealer expenses and liabilities. Understanding what makes an Expense Sharing Agreement valid and the consequences of violating an agreement can help keep your broker dealer on track and prevent regulatory and legal conflicts and exceptions.

Implementing appropriate expense sharing agreements can be complicated, especially if your broker dealer or investment adviser manages many agreements. RegComp Financial can help you stay on top of different elements of expense sharing agreements and ensure that you don’t accidentally breach agreements or violate any of FINRA’s requirements.

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