Beware of Small Independent Broker/Dealers

There are a number of factors that clients should take into consideration when dealing with any broker/dealer. However, this post is designed to point out two of these factors that are more important when dealing with a small broker/dealer, usually called an “independent broker/dealer.” Please keep in mind that this post is not designed to be complete in all material respects. Thus, this post should not be relied upon as providing legal or investment advice. If you have any questions about the information contained herein, you should contact an experienced professional.

In dealing with small independent broker/dealers, the bottom line is if you loose money with one of these companies and you file an arbitration claim against the firm and win, is the firm going to have enough money to pay you or will it just go out of business.

Since March of 2010 through the date of this post, there have been approximately 18 small independent broker/dealers that have ceased operations. Many of these closings were caused by arbitration awards entered against the firms that the firms were unable to satisfy. These awards caused the firms to fall below their required net capital requirement. This is important in that it is usually from net capital surplus that these awards are paid.

What is Net Capital?

Brokerage firms are required to follow certain rules that are designed to minimize the chances of financial failure and, more importantly, to protect customer assets if they do fail. For example, the SEC’s Rule 15c3-1-the “Net Capital Rule”-requires brokerage firms to maintain certain levels of their own liquid assets. The minimum net capital a firm must have on hand depends on its size and business. The statutory minimum amounts of net capital range from as low as $5,000 to over $1,000,000.

Consequently, the first thing that you should consider when establishing a relationship with a firm is what is their net capital requirement, for if the firm falls below its net capital requirement, it will be forced to shut down its business. This type of situation has been a hot topic recently because of the number of firms that have been forced to close as a result of large arbitration awards entered against them for selling illiquid limited partnerships. If you have lost money with a brokerage firm that has a low net capital requirement, the faster you take action to recover your investment losses, the greater your probability of collecting.

What Type of Products does the Firm Deal In?

Is the firm that you are contemplating dealing with a “full” service firm or a boutique style firm? Does it deal with products that fall within your investment parameters, including risk tolerance? In other words, does the firm deal in high risk or little known products, which history has demonstrated do not always fare that well.