Becker & Poliakoff

FINRA Issues Interpretation on Net Capital and Backstop Agreements

FINRA Issues Interpretation on Net Capital and Backstop Agreements

Becker & PoliakoffAlthough the utilization by FINRA broker-dealer members firms of “backstop” agreements is fairly common, and have been issued for years, the regulatory underpinnings for their use and the effect on net capital has never been clear.  Counsel, investment bankers, compliance officers, and FINOPS have struggled to cite a true regulatory basis for their viability to assist broker-dealers with their net capital requirements in public offerings.

“Backstop” agreements are agreements between two or more broker-dealer firms where one broker-dealer firm provides “capital” for another firm. The agreements are used in connection with underwritten public offerings. Often a lead or deal manager underwriter enters into the agreement with a member of the syndicate group. The syndicate group member and the lead want the syndicate firm to be part of the syndicate (or underwriting) group but the syndicate firm does not have enough required regulatory capital.

Under SEC rules (Securities Exchange Act (SEA) Rule 15c3-1(c)(2)(viii) (Open Contractual Commitments)),  a broker-dealer is required to have, prior to an underwritten offering of securities, a certain level of net capital representing a portion of the part of the offering which the broker-dealer firm is underwriting. For example, using rough numbers, a syndicate firm may want to underwrite $10 million of securities in a $100 million underwriting.  The rules are a little more complicated than our example, but essentially the firm would need approximately $3 million of net capital on hand.

The firm which does not have enough net capital to participate in the offering at the level it would prefer, must obtain equity capital or a subordinated loan (See FINRA Rule 4110) or some other alternative to get that required level of capital.  This would need to happen  in a short timeframe because syndicate groups for underwritten offerings often come together very quickly.

Many firms and practitioners, based on informal guidance from the SEC and FINRA, have relied on SEA /04 “Selling Group Participations” which states:

Haircuts need not be applied to best efforts selling group participations in firm commitment underwritings to the extent that the selling group member has an unconditional right evidenced by a written agreement with the underwriting participants to return any unsold securities.

There was no guidance as to what terms were required in a “written agreement” or what was meant by a “selling group member”.

The new FINRA Interpretation set out in Notice to Members 19-11 provides some assistance.  As stated in the Notice, the interpretation relates to the conditions under which an underwriting backstop agreement in a firm commitment underwriting would not give rise to an open contractual commitment charge (meaning the recipient firm does not need the net capital on hand). Under the Interpretation, in order to satisfy the requirements for a valid backstop agreement, the following terms and conditions need to be satisfied:

  1. [the backstop agreement] is executed and effective at or before the time the backstop recipient becomes obligated to the underwriting commitment;
  2. [the backstop agreement] requires the backstop provider to deduct in its net capital computation any applicable open contractual commitment charge that the backstop recipient would otherwise be required to take into account in its net capital computation; and
  3. [the backstop agreement] unequivocally requires the backstop provider to purchase any unsold securities allocated to the backstop recipient under the underwriting agreement.

Brian Daughney is a Shareholder in Becker’s Corporate Practice in New York. He represents issuers and investors in a wide range of corporate transactions as well as general corporate, securities compliance and reporting matters. Brian can be reached at