[Federal Register Volume 76, Number 123 (Monday, June 27, 2011)]
[Proposed Rules]
[Pages 37572-37616]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-15341]
[[Page 37571]]
Vol. 76
Monday,
No. 123
June 27, 2011
Part III
Securities and Exchange Commission
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17 CFR Parts 240 and 249
Broker-Dealer Reports; Proposed Rule
Federal Register / Vol. 76 , No. 123 / Monday, June 27, 2011 /
Proposed Rules
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 249
[Release No. 34-64676; File No. S7-23-11]
RIN 3235-AK56
Broker-Dealer Reports
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is
proposing amendments to the broker-dealer financial reporting rule
under the Securities Exchange Act of 1934 (the ``Exchange Act''). The
first set of amendments would, among other things, update the existing
requirements of Exchange Act Rule 17a-5, facilitate the ability of the
Public Company Accounting Oversight Board (the ``PCAOB'') to implement
oversight of independent public accountants of broker-dealers as
required by the Dodd-Frank Wall Street Reform and Consumer Protection
Act (the ``Dodd-Frank Act''), and eliminate potentially redundant
requirements for certain broker-dealers affiliated with, or dually-
registered as, investment advisers. The second set of amendments would
require broker-dealers that either clear transactions or carry customer
accounts to consent to allowing the Commission and designated examining
authorities (``DEAs'') to have access to independent public accountants
to discuss their findings with respect to annual audits of the broker-
dealers and to review related audit documentation. The third set of
amendments would enhance the ability of the Commission and examiners of
a DEA to oversee broker-dealers' custody practices by requiring broker-
dealers to file a new Form Custody.
DATES: Comments should be received on or before August 26, 2011.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an e-mail to [email protected]. Please include
File Number S7-23-11 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-23-11. This file number
should be included on the subject line if e-mail is used. To help the
Commission process and review your comments more efficiently, please
use only one method. The Commission will post all comments on the
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for Web site viewing and
printing in the Commission's Public Reference Room, 100 F Street, NE.,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. All comments received will be posted without change;
the Commission does not edit personal identifying information from
submissions. You should submit only information that you wish to make
publicly available.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate
Director, at (202) 551-5521; Randall W. Roy, Assistant Director, at
(202) 551-5522; and Mark M. Attar, Branch Chief, at (202) 551-5889,
Division of Trading and Markets; or John F. Offenbacher, Senior
Associate Chief Accountant, at (202) 551-5300, Office of the Chief
Accountant, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-7010.
SUPPLEMENTARY INFORMATION: The Commission is requesting public comment
on proposed amendments to Exchange Act Rule 17a-5 and proposed Form
Custody.
I. Introduction
The Commission is proposing three sets of amendments to Exchange
Act Rule 17a-5--the broker-dealer financial reporting rule.\1\ The
first set of amendments (collectively, the ``Annual Reporting
Amendments'') relates to the requirement that a broker-dealer file
annual financial reports with the Commission. The Annual Reporting
Amendments are designed to, among other things: (1) Update the existing
requirements of Rule 17a-5; (2) facilitate the ability of the PCAOB to
implement oversight of independent public accountants of broker-dealers
as required by the Dodd-Frank Act; \2\ and (3) eliminate potentially
redundant requirements for certain broker-dealers affiliated with, or
dually-registered as, investment advisers.
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\1\ 17 CFR 240.17a-5 (``Rule 17a-5'').
\2\ Public Law 111-203 (Jul. 21, 2010).
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The second set of amendments (collectively, the ``Access to Audit
Documentation Amendments'') would require broker-dealers that either
clear transactions or carry customer accounts to consent to provide the
Commission and DEAs with access to independent public accountants to
discuss their findings with respect to annual audits of broker-dealers
and to review related audit documentation.\3\
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\3\ PCAOB Auditing Standard 3 defines ``Audit documentation'' as
the ``written record of the basis for the auditor's conclusions that
provides the support for the auditor's representations, whether
those representations are contained in the auditor's report or
otherwise. Audit documentation also facilitates the planning,
performance, and supervision of the engagement, and is the basis for
the review of the quality of the work because it provides the
reviewer with written documentation of the evidence supporting the
auditor's significant conclusions. Among other things, audit
documentation includes records of the planning and performance of
the work, the procedures performed, evidence obtained, and
conclusions reached by the auditor. Audit documentation also may be
referred to as work papers or working papers.''
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The third set of amendments (collectively, the ``Form Custody
Amendments'') would enhance the ability of the Commission and examiners
of a DEA to oversee broker-dealers' custody practices by requiring
broker-dealers to file on a quarterly basis a new Form Custody. Form
Custody would elicit information as to whether and how a broker-dealer
maintains custody of cash and securities of customers and others.
II. The Proposed Annual Reporting Amendments
A. Background
Sections 17(a) and (e) of the Exchange Act and Rule 17a-5 together
require a broker-dealer to, among other things, file an annual report
(an ``Annual Audit Report'') containing audited financial statements,
supporting schedules, and supplemental reports, as applicable, with the
Commission and the broker-dealer's DEA.\4\ The financial statements
must be comprised of a statement of financial condition, a statement of
income, a statement of cash flows, a statement of changes in
stockholders' or partners' or sole proprietor's equity, and a statement
of changes in liabilities subordinated to claims of general
creditors.\5\ The supporting schedules must be comprised of a
computation of required and actual net capital under
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Exchange Act Rule 15c3-1, and, for broker-dealers that maintain custody
of customer funds or securities (``carrying broker-dealers''), a
computation of the customer reserve requirement and information
relating to the possession or control requirements under Exchange Act
Rule 15c3-3.\6\ The supplemental reports include: (1) A report of an
independent public accountant that is the result of a review of, among
other things, the broker-dealer's accounting system, internal
accounting control and procedures for safeguarding securities, and
practices and procedures in complying with various Commission financial
responsibility rules and Regulation T of the Board of Governors of the
Federal Reserve System; \7\ (2) a report of an independent public
accountant provided to, among others, the Securities Investor
Protection Corporation (``SIPC'') to help administer the collection of
assessments from broker-dealers for purposes of establishing and
maintaining its broker-dealer liquidation fund (the ``SIPC Fund''); \8\
and (3) for broker-dealers that compute net capital under an
alternative model-based standard, a report of an independent public
accountant indicating the results of the accountant's review of the
internal risk management control system established and documented by
the broker-dealer in accordance with Exchange Act Rule 15c3-4.\9\
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\4\ See 15 U.S.C 78q(a), 15 U.S.C 78q(e), and Rule 17a-5(d).
\5\ See Rule 17a-5(d)(2).
\6\ See Rule 17a-5(d)(3). See also 17 CFR 240.15c3-1 (``Rule
15c3-1'') and 17 CFR 240.15c3-3 (``Rule 15c3-3'').
\7\ See Rule 17a-5(g). See also 12 CFR part 220 et seq.
(``Regulation T'').
\8\ See Rule 17a-5(e)(4). These reports will be collectively
referred to in this release as the ``SIPC Reports.'' As part of the
Annual Reporting Amendments, the Commission is proposing to amend
how the SIPC Reports are filed; see infra Section II.C.
\9\ See Rule 17a-5(k); see also 17 CFR 240.15c3-4.
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Paragraph (g) of Rule 17a-5, entitled ``Audit objectives,''
describes the objectives that should be achieved by an independent
public accountant in preparing a report for the broker-dealer to file
with its Annual Audit Report.\10\ For example, the audit is required to
be performed in accordance with generally accepted auditing standards
(``GAAS'').\11\ In addition, paragraph (g)(1) of Rule 17a-5 requires
that the audit include a ``review'' and appropriate tests of the
broker-dealer's accounting system, internal accounting control and
procedures for safeguarding securities for the period since the prior
examination date.\12\ The paragraph further states that the scope of
the audit and review of the accounting system, internal accounting
control, and procedures for safeguarding securities shall be sufficient
to provide reasonable assurance that any material inadequacies existing
in those items, including in the procedures for obtaining and
maintaining physical possession and control of all fully paid and
excess margin securities, complying with Regulation T, and making the
quarterly securities examinations, counts, verifications, and
comparisons and recordation of differences required by Exchange Act
Rule 17a-13 would be disclosed.\13\ Currently, with respect to these
requirements, independent public accountants for broker-dealers issue a
report describing a ``study'' of these practices and procedures and, if
applicable, notification to the Commission of the discovery of any
material inadequacies (the ``Study''). The form of the report that
describes the Study is specified in an AICPA publication entitled AICPA
Audit & Accounting Guide: Brokers and Dealers in Securities; \14\
however, the form of the report does not specify the level of assurance
required to be obtained by the independent public accountant when
performing the Study.
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\10\ See Rule 17a-5(g).
\11\ Auditing and attestation standards for broker-dealers are
currently established by the American Institute of Certified Public
Accountants (the ``AICPA'').
\12\ See Rule 17a-5(g)(1).
\13\ Id. See also 17 CFR 240.17a-13 (``Rule 17a-13''). The term
``material inadequacy'' is defined in Rule 17a-5(g)(3).
\14\ See the AICPA Audit & Accounting Guide: Brokers and Dealers
in Securities (Jul. 2010) (the ``Broker-Dealer Audit Guide'').
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Professional auditing standards provide for three levels of
attestation engagement by an accountant.\15\ Under the highest level of
attestation engagement, the accountant obtains ``reasonable assurance''
with respect to the matter that is the subject of the accountant's
attestation engagement and provides an opinion. This standard is
required with respect to audits and examinations.\16\ The second level
of attestation engagement is a review, which results in the accountant
obtaining a moderate level of assurance with respect to the matter that
is the subject of the accountant's attestation engagement. The third
type of attestation engagement is one in which the accountant performs
agreed-upon procedures, which results in no assurance, but rather a
reporting of the accountant's findings after the performance of
procedures that have been agreed to by specified parties. Rule 17a-5
currently requires that a broker-dealer engage an independent public
accountant to audit the broker-dealer's financial statements. Some of
the supporting schedules are also subject to financial statement audit
procedures.
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\15\ Professional auditing standards include both GAAS and
standards promulgated by the PCAOB.
\16\ This proposing release generally refers to an ``audit'' of
a broker-dealer's financial statements and an ``examination'' of the
broker-dealer's compliance with a particular rule or implementation
of controls designed to achieve compliance with a particular rule.
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Rule 17a-5 also requires that a broker-dealer that is claiming an
exemption from the requirements of Rule 15c3-3 file a report with the
Commission.\17\ Rule 15c3-3(k) sets forth certain conditions that a
broker-dealer must meet to be exempt from the rule's requirements.
Generally, the broker-dealer would be exempt if it does not hold
customer funds or securities, or, if it does, it promptly forwards all
funds and securities received. Rule 17a-5 provides that the independent
public accountant engaged by the broker-dealer must ``ascertain that
the conditions of the exemption were being complied with as of the
examination date and that no facts came to the independent public
accountant's attention to indicate that the exemption had not been
complied with during the period since the independent public
accountant's last examination.'' \18\ This requirement has resulted in
independent public accountants providing a statement concerning whether
they have ascertained that the broker-dealer was complying with the
conditions of the exemption.\19\
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\17\ See Rule 17a-5(g)(2).
\18\ Id.
\19\ See Broker-Dealer Audit Guide, supra note 14 at Section
3.32.
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Many of the requirements currently contained in Rule 17a-5 have
existed since 1975, and, for the most part, have remained substantially
unchanged.\20\ For example, as noted above, to comply with the
requirement of paragraph (g) of Rule 17a-5 to conduct an audit and
review of the identified matters, independent public accountants
currently issue a report based on a Study. The practice of conducting
the Study is relatively unique to broker-dealer audits and, while audit
literature at one time referred to the performance of a ``study,'' the
performance of a study is no longer included in contemporary audit
standards governing the work to be performed by an independent public
accountant.
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\20\ See Broker-Dealer Reports, Exchange Act Release No. 11935
(Dec. 17, 1975), 40 FR 59706 (Dec. 30, 1975). In this release, the
Commission adopted amendments to Rule 17a-5, which included, among
other things, the adoption of the requirement for broker-dealers to
file Financial and Operational Combined Uniform Single (or
``FOCUS'') Reports.
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In addition, recent legislation and Commission rulemaking have
further prompted the need to reexamine the requirements pertaining to
the Annual Audit Report. First, Section 982 of the Dodd-Frank Act
amended the Sarbanes-Oxley Act of 2002 (the ``Sarbanes-Oxley Act'')
\21\ to provide the PCAOB with explicit authority to, among other
things, establish, subject to Commission approval, auditing and related
attestation, quality control, ethics, and independence standards to be
used by registered public accounting firms with respect to the
preparation and issuance of audit reports to be included in broker-
dealer filings with the Commission.\22\ The Dodd-Frank Act also
authorizes the PCAOB to inspect registered public accounting firms that
provide audit reports for broker-dealers and to enforce standards
relative to their audits.
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\21\ 17 U.S.C. 7202 et seq.
\22\ See Section 982 of the Dodd-Frank Act.
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Further, in December 2009, the Commission amended Rule 206(4)-2
(the ``IA Custody Rule'') under the Investment Advisers Act of 1940
(the ``Advisers Act''),\23\ which governs investment advisers' custody
practices.\24\ Among other requirements, registered investment advisers
that have custody of client funds or securities must maintain those
assets at a qualified custodian, such as a bank or broker-dealer.\25\
If an investment adviser that also is, for example, a bank, or its
related person, serves as a qualified custodian for advisory client
funds or securities, the adviser must annually obtain, or receive from
its related person, a written internal control report prepared by an
independent public accountant registered with, and subject to regular
inspection by, the PCAOB. Broker-dealers that also are registered as
investment advisers may, acting in their capacity as broker-dealers,
maintain client funds and securities as qualified custodians in
connection with advisory services provided to clients, and under the IA
Custody Rule are required to obtain internal control reports. Broker-
dealers acting as qualified custodians also may maintain advisory
assets in connection with advisory services provided by related or
affiliated investment advisers. In such instances, these broker-dealers
are also required to provide internal control reports to their related
investment advisers.
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\23\ 17 CFR 275.206(4)-2 (``Rule 206(4)-2'').
\24\ See Custody of Funds or Securities by Investment Advisers,
Advisers Act Release No. 2876 (May 20, 2009), 74 FR 25354 (May 27,
2009) (``IA Custody Proposing Release''); Advisers Act Release No.
2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010) (``IA Custody
Adopting Release'').
\25\ See Rule 206(4)-2.
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For the reasons discussed above, the Commission is proposing
amendments to Rule 17a-5. The amendments proposed by the Commission are
intended to update the broker-dealer audit requirements and provide for
an examination of compliance, and internal control over compliance,
with key regulatory requirements that would provide the Commission with
greater assurance as to a broker-dealer's compliance with the
requirements. In addition, the proposed changes are intended to
facilitate the ability of the PCAOB to set standards for, and implement
its inspection authority over, broker-dealers' independent public
accountants by providing an improved foundation for the PCAOB to
establish new broker-dealer audit standards. Moreover, the proposed
changes, as they pertain to compliance with requirements concerning the
custody of customer funds and securities, are intended to complement
and reinforce the regulatory changes effected by the IA Custody Rule.
In particular, the Commission preliminarily believes that broker-
dealers that also are registered as investment advisers and hold
advisory client funds or securities, or that hold funds or securities
for related investment advisers, would be able to use the Examination
Report described below to satisfy the internal control report
requirements under both Rule 17a-5, as it is proposed to be amended,
and the IA Custody Rule.
As discussed below, the proposed changes would provide, as to
broker-dealers subject to the requirements of Rule 15c3-3, for an
examination of compliance, and internal control over compliance, with
respect to Rule 15c3-1, Rule 15c3-3, Rule 17a-5, and rules prescribed
by DEAs requiring broker-dealers to send account statements to
customers (``Account Statement Rules''). Rule 15c3-1 requires broker-
dealers to maintain at all times a minimum amount of net liquid assets,
or ``net capital.'' Under Rule 15c3-1, broker-dealers must perform two
calculations: (1) A computation of required minimum net capital; \26\
and (2) a computation of actual net capital.\27\
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\26\ A broker-dealer's required minimum net capital is the
greater of a fixed-dollar amount prescribed in Rule 15c3-1, or an
amount computed using one of two financial ratios. The first
financial ratio generally provides that a broker-dealer shall not
permit its aggregate indebtedness to exceed 1500% of its net
capital. See Rule 15c3-1(a)(1)(i). The second financial ratio
provides that a broker-dealer shall not permit its net capital to be
less than 2% of aggregate customer debit items. See Rule 15c3-
1(a)(1)(ii). Customer debit items--computed pursuant to Exhibit A to
Rule 15c3-3, which is described below--consist of, among other
things, margin loans to customers and securities borrowed to
effectuate customer deliveries of securities on short sales.
\27\ A broker-dealer computes its actual net capital by first
calculating its net worth using United States (``U.S.'') generally
accepted accounting principles. Second, qualifying subordinated
loans are added to net worth. Third, illiquid assets such as real
estate, fixtures, furniture, goodwill, and most unsecured
receivables are subtracted from net worth. Illiquid securities also
must be deducted. Finally, the broker-dealer must reduce
(``haircut'') the market value of the liquid securities it owns by a
percentage amount. This ``haircut'' provides a cushion against
adverse market movements and other risks faced by the broker-dealer.
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Rule 15c3-3 imposes two key requirements on carrying broker-
dealers. First, each carrying broker-dealer must obtain physical
possession or control over customers' fully paid and excess margin
securities.\28\ ``Control'' means the broker-dealer must hold these
securities free of lien in one of several locations specified in the
rule (e.g., a bank or clearing agency).\29\ Under Rule 15c3-3, the
broker-dealer must make a daily determination from its books and
records (as of the preceding day) of the quantity of fully paid and
excess margin securities in its possession or control and the quantity
of fully paid and excess margin securities not in its possession or
control.\30\ If the amount in the broker-dealer's possession and
control is less than the amount indicated as being held for customers
on the broker-dealer's books and records, the broker-dealer generally
must initiate steps to retrieve customer securities from non-control
locations or otherwise obtain possession of them or place them in
control locations.\31\
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\28\ See Rule 15c3-3(b)(1).
\29\ See Rule 15c3-3(c).
\30\ See Rule 15c3-3(d).
\31\ Id.
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The second key requirement in Rule 15c3-3 is that the carrying
broker-dealer must maintain at a bank or banks cash or qualified
securities \32\ on deposit in a ``Special Reserve Bank Account for the
Exclusive Benefit of Customers'' equaling at least the net amount
computed by adding customer credit
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items (e.g., cash in securities accounts) and subtracting from that
amount customer debit items (e.g., margin loans).\33\ Rule 15c3-3 is
designed to protect customer funds and securities by generally
segregating them from the broker-dealer's proprietary business
activities. If the carrying broker-dealer fails, customer funds and
securities should be readily available for return to customers. The
rule requires carrying broker-dealers to compute the customer reserve
requirement on a weekly basis, except where customer credit balances do
not exceed $1 million (in which case the computation can be performed
monthly, although, in this case, the broker-dealer must maintain 105%
of the required deposit amount).\34\
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\32\ The term ``qualified security'' is defined in Rule 15c3-3
to include securities issued by the U.S. or guaranteed by the U.S.
with respect to principal and interest. See Rule 15c3-3(a)(6).
\33\ See Rule 15c3-3(e).
\34\ See Rule 15c3-3(e)(3).
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Rule 17a-13 requires a broker-dealer that holds securities
(proprietary, customer, or both), on a quarterly basis, to examine and
count the securities it physically holds, account for the securities
that are subject to its control or direction but are not in its
physical possession (e.g., securities held at a control location),
verify the securities, and compare the results of the count and
verification with its records. The broker-dealer must take an
operational capital charge under Rule 15c3-1 for all short securities
differences (which include securities positions reflected on the
broker-dealer's securities record that are not susceptible to either
count or confirmation) unresolved after discovery.\35\ The differences
also must be recorded on the broker-dealer's records.\36\
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\35\ See Rule 15c3-1(c)(2)(v).
\36\ See Rule 17a-3(a)(4)(vi).
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The Account Statement Rules of DEAs require member broker-dealers
to send, at least once every calendar quarter, a statement of account
containing a description of any securities positions, money balances,
or account activity to each customer whose account had a security
position, money balance, or account activity during the period since
the last such statement was sent to the customer.\37\
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\37\ For example, NASD Rule 2340 requires broker-dealers that
are members of FINRA that conduct a general securities business to
send account statements to customers at least quarterly. The current
FINRA rulebook consists of: (1) FINRA rules; (2) NASD rules; and (3)
rules incorporated from the NYSE (``Incorporated NYSE Rules'')
(together, the NASD rules and Incorporated NYSE Rules are referred
to as the ``Transitional Rulebook''). While the NASD rules generally
apply to all FINRA members, the Incorporated NYSE Rules apply only
to those members of FINRA that are also members of the NYSE. The
FINRA rules apply to all FINRA members, unless such rules have a
more limited application by their terms. For more information see
FINRA's Information Notice, Mar. 12, 2008 (Rulebook Consolidation
Process). If a broker-dealer's DEA is the Chicago Board Options
Exchange (the ``CBOE''), the broker-dealer would be subject to
CBOE's account statement rule, CBOE Rule 9.12.
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B. Proposed Audit Reports and Changes to Applicable Auditing Standards
As part of the Annual Reporting Amendments, the Commission is
proposing changes that would revise the reports that broker-dealers
file under Rule 17a-5. While the requirement that broker-dealers file a
report consisting of the audited financial statements and supporting
schedules that are currently required under Rule 17a-5 (the ``Financial
Report'') would remain unchanged, carrying broker-dealers would be
required to file a new report asserting to compliance with specified
rules and related internal controls (the ``Compliance Report''). These
broker-dealers also would be required to file a report from their
independent public accountants (the ``Examination Report'') that
addresses the assertions in the Compliance Report. Broker-dealers that
do not hold customer funds or securities would be required to file a
report asserting their exemption from the requirements of Rule 15c3-3
(the ``Exemption Report) and a report from their independent public
accountants that would be the result of a review of the broker-dealer's
assertion that it is exempt from Rule 15c3-3. Finally, the proposed
amendments would change the audit standards applicable to broker-dealer
audits and compliance examinations from GAAS to standards promulgated
by the PCAOB.
To implement these changes, the Commission proposes a number of
amendments to Rule 17a-5. The Commission proposes that paragraph (d) of
Rule 17a-5 be re-titled from ``Annual filing of audited financial
statements'' to ``Annual reports,'' because under the proposed
revisions to paragraph (d), broker-dealers would generally be required
to file a Financial Report and a Compliance Report or an Exemption
Report with the Commission.\38\ Paragraph (d)(1) of Rule 17a-5 would be
amended to set forth the general requirement for broker-dealers to file
annual financial reports with the Commission. These reports would
include: (1) A ``Financial Report'' as described in paragraph (d)(2),
which would consist of the audited financial statements and supporting
schedules that broker-dealers are currently required to file with the
Commission; \39\ (2) a Compliance Report as described in paragraph
(d)(3) unless the broker-dealer is exempt from the provisions of Rule
15c3-3,\40\ or an Exemption Report as described in paragraph (d)(4) if
the broker-dealer claims an exemption from the provisions of Rule 15c3-
3; \41\ and (3) reports prepared by the independent public accountant
pursuant to the engagement provisions in paragraph (g), unless the
broker-dealer is exempt from the requirement to either file the annual
audit report or engage an independent public accountant pursuant to
paragraphs (d)(1) and (e)(1) of Rule 17a-5.\42\ The proposed
requirements for the Compliance Report and Exemption Report are
described in greater detail below.
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\38\ Paragraph (d) of Rule 17a-5, currently titled ``Annual
filing of audited financial statements,'' is being renamed to
reflect that the Commission will now require broker-dealers to file
two reports with the Commission (i.e., a Financial Report and a
Compliance Report, or a Financial Report and an Exemption Report).
\39\ Proposed paragraph (d)(1)(i)(A) of Rule 17a-5. See also
Rule 17a-5(d)(2), which lists the requirements to be included in the
Financial Report and would continue to do so because the Commission
is not proposing any amendment to the financial statements and
supporting schedules required of the broker-dealer. The Commission
proposes a technical amendment, to rename the annual audit report to
``Financial Report,'' to reflect that proposed paragraph (d)(2)
relates to the financial audit requirements.
\40\ Proposed paragraph (d)(1)(i)(B)(1) of Rule 17a-5.
\41\ Proposed paragraph (d)(1)(i)(B)(2) of Rule 17a-5.
\42\ Proposed paragraph (d)(1)(i)(C) of Rule 17a-5.
Specifically, Rule 17a-5(d)(1)(ii) states that ``a broker or dealer
succeeding to and continuing the business of another broker or
dealer need not file a report * * * if the predecessor broker or
dealer has filed a report in compliance with [Rule 17a-5(d)] * *
*.'' Rule 17a-5(d)(1)(iii) contains an exemption for broker-dealers
from filing an annual audit report if the broker-dealer is a member
of a national securities exchange and ``has transacted a business in
securities solely with or for other members of a national securities
exchange, and has not carried any margin account, credit balance or
security for any person who is defined as a `customer' in paragraph
(c)(4) of [Rule 17a-5].'' Rule 17a-5(e)(1) provides that for certain
broker-dealers, the financial statements that must be filed pursuant
to Rule 17a-5(d) need not be audited. The exceptions in paragraphs
(e)(1)(A)-(B) of Rule 17a-5 are applicable when either: (1) The
broker-dealer's securities business has been limited to acting as
broker (agent) for an issuer in soliciting subscriptions for
securities of the issuer and the broker has promptly transmitted to
the issuer all funds and promptly delivered to the subscriber all
securities received in connection with the issuance, and the broker
has not otherwise held funds or securities for or owed money or
securities to customers; or (2) the broker-dealer's securities
business has been limited to buying and selling evidences of
indebtedness secured by mortgage, deed or trust, or other lien upon
real estate or leasehold interests, and the broker-dealer has not
carried any margin account, credit balance or security for any
securities customer.
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1. Compliance Report
Under the proposed amendments to paragraph (d) of Rule 17a-5, each
carrying broker-dealer would be required annually to file a Compliance
[[Page 37576]]
Report containing a statement and assertions concerning compliance, and
internal control over compliance, with specified rules. Specifically,
the Compliance Report would include a statement as to whether the
broker-dealer has established and maintained a system of internal
control to provide the broker-dealer with reasonable assurance \43\
that any instances of material non-compliance with Rule 15c3-1, Rule
15c3-3, Rule 17a-13, or the Account Statement Rule (collectively, the
``Financial Responsibility Rules'') will be prevented or detected on a
timely basis. The Compliance Report is intended to enhance a broker-
dealer's focus on compliance with the specified rules and provide a
foundation for the proposed ``Compliance Examination'' described below
in Section II.B.2 of this release.\44\
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\43\ Exchange Act Section 13(b)(7) defines ``reasonable
assurance'' and ``reasonable detail'' as ``such level of detail and
degree of assurance as would satisfy prudent officials in the
conduct of their own affairs.'' 15 U.S.C. 78m(b)(7). The Commission
has long held that ``reasonableness'' is not an ``absolute standard
of exactitude for corporate records.'' See Foreign Corrupt Practices
Act of 1977, Exchange Act Release No. 17500 (Jan. 29, 1981), 46 FR
11544, 11546 (Feb. 9, 1981). These concepts differ from the concept
of ``reasonable assurance'' in an audit context.
\44\ The Compliance Examination is discussed below in Section
II.B.2 of this release. As is discussed in Section II.B.2, the
Commission does not propose the statement in the Compliance Report
to be included within the scope of the Compliance Examination.
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In addition, the Compliance Report would include the following
three assertions by the broker-dealer: (1) Whether the broker-dealer
was in compliance in all material respects with the Financial
Responsibility Rules as of its fiscal year-end; \45\ (2) whether the
information used to assert compliance with the Financial Responsibility
Rules was derived from the books and records of the broker-dealer; \46\
and (3) whether internal control over compliance with the Financial
Responsibility Rules was effective during the most recent fiscal year
such that there were no instances of material weakness.\47\ Further,
the Compliance Report would be required to contain a description of
each identified instance of material non-compliance and each identified
material weakness in internal control over compliance with the
specified rules.\48\
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\45\ See proposed paragraph (d)(3)(i)(B)(1) of Rule 17a-5.
\46\ See proposed paragraph (d)(3)(i)(B)(2) of Rule 17a-5.
\47\ See proposed paragraph (d)(3)(i)(B)(3) of Rule 17a-5.
\48\ See proposed paragraph (d)(3)(i)(C) of Rule 17a-5.
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Rule 17a-5(g) currently requires that the audit include a review of
compliance with and controls pertaining to Rule 15c3-1, Rule 15c3-3,
and Rule 17a-13. As described above, these rules contain important
baseline protections concerning broker-dealer capital adequacy and the
protection of customer funds and securities, and the Commission
preliminarily believes that it is important that they be addressed in
any annual report of a carrying broker-dealer. The proposed Compliance
Report would not cover Regulation T, which is currently addressed in
existing Rule 17a-5(g)(1)(iii). The Commission believes that the
inclusion of Regulation T in the scope of the Compliance Report would
not be necessary given the broker-dealer's assertion in the Compliance
Report of its compliance with Rule 15c3-1. In particular, a broker-
dealer's failure to comply with Regulation T, which governs broker-
dealers' extensions of credit on securities, could require a broker-
dealer to reduce its net capital by the amount of any deficit in
customer unsecured and partly secured accounts after calls for
margin.\49\
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\49\ See Rule 15c3-1(c)(2)(iv)(B).
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The Commission also is proposing to require that the Compliance
Report include a statement and three assertions concerning the Account
Statement Rule. The Account Statement rule provides a key safeguard for
customers by ensuring that they receive on a regular basis information
concerning securities positions and other assets held in their
accounts. Customers can use that information to identify discrepancies
and monitor the performance of their accounts. The Commission believes
that, taken together, the objectives of the Compliance Report are
consistent with the control objectives of the internal control report
required under the IA Custody Rule.\50\
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\50\ See Section II.B.4 of this release for a discussion of the
IA Custody Rule and the control objectives required under the IA
Custody Rule.
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The assertions contained in the Compliance Report would pertain to
compliance at year-end and also over the course of a fiscal quarter,
depending on the particular requirement.\51\ The proposed assertions
with respect to compliance with Rules 15c3-1 and 15c3-3 would relate to
compliance as of the broker-dealer's fiscal year-end. The assertions as
to compliance with Rule 17a-13 and the Account Statement Rule also
would be made as of the broker-dealer's fiscal year-end. However,
because these rules impose obligations on a quarterly basis (the
broker-dealer must conduct the quarterly count of securities and must
send statements to all customers at least once during each quarter, but
not necessarily on the last day of the quarter), to be able to make the
assertions in the Compliance Report, the broker-dealer would need to
determine that it had satisfied the requirements over the course of the
fiscal quarter immediately preceding the broker-dealer's fiscal year-
end. In contrast, the broker-dealer's assertions related to the
effectiveness of internal control over compliance with the Financial
Responsibility Rules would not pertain to a fixed point in time, but
instead would cover the entire fiscal year. The proposed time periods
related to internal control over compliance would be consistent with
those in the IA Custody Rule.\52\
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\51\ The broker-dealer is required to be in compliance with the
Financial Responsibility Rules at all times. The assertions made by
the broker-dealer for purposes of the Compliance Report are as of a
point in time to facilitate the independent public accountant's
attestation to the broker-dealer's assertions.
\52\ See Rule 206(4)-2(a)(6).
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The Commission preliminarily believes that broker-dealers would be
able to make assertions regarding both compliance and the effectiveness
of internal control over compliance with the Financial Responsibility
Rules. The Commission is not proposing that effectiveness of internal
control over financial reporting be included as one of the assertions
made by the broker-dealer in the Compliance Report.\53\ The Commission
preliminarily believes that the Compliance Report should focus on
oversight of custody arrangements and protection of customer assets,
and therefore, should be focused on compliance with the Financial
Responsibility Rules.
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\53\ For example, the Commission is not proposing an assessment
of internal control over financial reporting similar to the
assessment required under Section 404 of the Sarbanes-Oxley Act for
issuers.
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The proposed amendments to Rule 17a-5 would provide that a broker-
dealer could not assert compliance with the Financial Responsibility
Rules, as of its most recent fiscal year-end, if it identifies one or
more instances of material non-compliance.\54\ Instead, the broker-
dealer would need to identify and describe any instance of material
non-compliance, as of its most recent fiscal year-end, in the
Compliance Report.\55\ Rule 17a-5 presently requires that independent
public accountants include any instances of material inadequacies in
their reports based on the Study.\56\ The term ``material
[[Page 37577]]
inadequacies,'' however, is not defined in existing auditing
literature. The Commission is proposing to remove the reference to
``material inadequacies'' in Rule 17a-5 and replace it, for purposes of
reporting on the broker-dealer's compliance, with a reference to
``material non-compliance.'' Further, the Commission is proposing to
define an instance of material non-compliance, in new paragraph
(d)(3)(ii) of Rule 17a-5, as a failure by the broker-dealer to comply
with any of the requirements of the Financial Responsibility Rules in
all material respects. The Commission preliminarily believes that any
failure by the broker-dealer to perform any of the procedures
enumerated in the Financial Responsibility Rules would be an instance
of non-compliance; therefore, the broker-dealer should evaluate any
such failure to determine whether it is material.
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\54\ See proposed paragraph (d)(3)(ii) of Rule 17a-5. The
Commission notes that reporting on material non-compliance is
discussed, for example, in AT Sec. 601 of the PCAOB's Interim
Attestation Standards; see PCAOB Attestation Standard Sec. 601.
\55\ See proposed paragraph (d)(3)(ii) of Rule 17a-5.
\56\ See Rule 17a-5(g).
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When determining whether an instance of non-compliance is material,
the Commission preliminarily believes that the broker-dealer should
consider all relevant factors including but not limited to: (1) The
nature of the compliance requirements, which may or may not be
quantifiable in monetary terms; (2) the nature and frequency of non-
compliance identified; and (3) qualitative considerations.\57\ The
Commission also preliminarily believes that some deficiencies would
necessarily constitute instances of material non-compliance. For
example, failing to maintain the required minimum amount of net capital
as required under Rule 15c3-1, or failing to maintain the minimum
deposit requirement in a special reserve bank account for the exclusive
benefit of customers under Rule 15c3-3,\58\ would be instances of
material non-compliance. These two instances of material non-compliance
would not, however, represent all possible instances of material non-
compliance with respect to Rules 15c3-1 and 15c3-3.
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\57\ See, e.g., paragraph 36 of PCAOB Attestation Standard Sec.
601.
\58\ See Section 15(c)(3) of the Exchange Act, which provides
that no broker or dealer shall make use of the mails or any means or
instrumentality of interstate commerce to effect any transaction in,
or to induce or attempt to induce the purchase or sale of, any
security ``in contravention of such rules and regulations as the
Commission shall prescribe * * * to provide safeguards with respect
to the financial responsibility and related practices of the brokers
and dealers including, but not limited to the acceptable custody and
use of customers' securities and the carrying and use of customers'
deposits or credit balances.'' 15 U.S.C. 78o(c)(3)(A).
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The Commission is proposing several conforming amendments to Rule
17a-5 to incorporate the proposed use of the term ``material non-
compliance.'' The Commission proposes to amend paragraph (c)(5) of Rule
17a-5, which requires broker-dealers to send Statements of Financial
Condition to customers twice per year. Paragraph (c) of Rule 17a-5
provides that a broker-dealer can make these statements available
through its Internet Web site in lieu of sending the statements to the
customers in paper form.\59\ However, paragraph (c)(5)(vi) of Rule 17a-
5 prohibits broker-dealers from making the statements available online,
in lieu of sending statements to customers in paper form, if the
broker-dealer was required by paragraph (e) of Rule 17a-11 to give
notice of a material inadequacy. The Commission is proposing to delete
the reference to the term ``material inadequacy'' and amend paragraph
(c)(5)(vi) of Rule 17a-5 to provide that the broker-dealer may make the
customer statements available online, in lieu of sending statements to
customers in paper form, provided its financial statements receive an
unqualified opinion from the independent public accountant and neither
the broker-dealer nor the independent public accountant identifies a
material weakness or an instance of material non-compliance pursuant to
proposed new paragraph (g) of Rule 17a-5, described below.
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\59\ Rule 17a-5 requires that the statements be sent to its
customers, except if the activities of the broker-dealer are limited
to certain enumerated activities or except as provided in paragraph
(c)(5), which permits the broker-dealer to instead make the
statements available online if certain requirements are met. See
Rule 17a-5(c)(1) and (c)(5).
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The proposed amendments to Rule 17a-5 also would provide that a
broker-dealer could not assert that its internal control over
compliance with the Financial Responsibility Rules during the fiscal
year was effective if one or more material weaknesses exist with
respect to internal control over compliance.\60\ The Commission
preliminarily believes that a broker-dealer's internal control over
compliance with the Financial Responsibility Rules would not be
effective if a material weakness exists, given the meaning of the term
``material weakness'' as described below. Consequently, if one or more
material weaknesses exist, the broker-dealer would need to describe in
the Compliance Report each material weakness identified during the
fiscal year.\61\ This would provide the Commission with notice of the
nature of any weakness and allow the Commission and DEA examination
staff to ascertain how the broker-dealer addressed each weakness.
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\60\ See proposed paragraph (d)(3)(iii) of Rule 17a-5.
\61\ See proposed paragraph (d)(3)(i)(C) of Rule 17a-5.
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The Commission is proposing to define the term ``material
weakness'' in paragraph (d)(3)(iii) of Rule 17a-5 as a deficiency, or a
combination of deficiencies, in internal control over compliance with
the Financial Responsibility Rules, such that there is a reasonable
possibility that material non-compliance with those provisions will not
be prevented or detected on a timely basis. For purposes of this
paragraph, a deficiency in internal control over compliance would exist
when the design or operation of a control does not allow the broker-
dealer, in the normal course of performing its assigned functions, to
prevent or detect non-compliance with the Financial Responsibility
Rules on a timely basis.\62\ The Commission proposes these definitions,
in part, because they are based on previous Commission action.\63\
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\62\ See proposed paragraph (d)(3)(iii) of Rule 17a-5.
\63\ See Amendments to Rules Regarding Management's Report on
Internal Control Over Financial Reporting, Exchange Act Release No.
55928 (Jun. 27, 2007), 72 FR 35310 (Jun. 27, 2007). See also
Exchange Act Rule 12b-2 (17 CFR 240.12b-2) and Rule 1-02 of
Regulation S-X (17 CFR 210.1-02), which state that a ``material
weakness is a deficiency, or a combination of deficiencies, in
internal controls over financial reporting such that there is a
reasonable possibility that a material misstatement of the
registrant's annual or interim financial statements will not be
prevented or detected on a timely basis.''
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The Commission preliminarily believes that, for purposes of the
proposed definition of the term ``material weakness,'' there is a
reasonable possibility of an event occurring if it is ``probable'' or
``reasonably possible.'' An event is ``probable'' if the future event
or events are likely to occur.\64\ An event is ``reasonably possible''
if the chance of the future event or events occurring is more than
remote, but less than likely.\65\
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\64\ See Commission Guidance Regarding Management's Report on
Internal Control Over Financial Reporting Under Section 13(a) or
15(d) of the Securities Exchange Act of 1934, Securities Act of 1933
Release No. 8810 (Jun. 20, 2007), 72 FR 35324 (Jun. 27, 2007), at
note 47 and corresponding text.
\65\ Id.
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The Commission preliminarily believes that an instance of non-
compliance that the broker-dealer has determined does not constitute
material non-compliance may nonetheless be indicative of a control
deficiency that constitutes a material weakness. The broker-dealer's
evaluation of whether an instance of non-compliance is material would
be based upon the consideration of the specifically identified instance
of non-compliance; whereas the broker-
[[Page 37578]]
dealer's conclusions with respect to whether the related control
deficiency or deficiencies are material weaknesses would relate to
whether it is reasonably possible that the control deficiency or
deficiencies could result in material non-compliance. This evaluation
would require the broker-dealer to consider not only the specifically
identified instance of non-compliance but also any additional possible
effect that the control deficiency or deficiencies could have on
compliance.
The Commission generally requests comment on the proposed
amendments associated with the proposed Compliance Report. In addition,
the Commission requests comment on the following questions:
Should other rules be included in the scope of the
Compliance Report, in addition to, or as an alternative to, the
Financial Responsibility Rules? If so, which rules? Commenters should
explain their choices.
Should the proposed Compliance Report cover Regulation T?
Are the proposed assertions appropriate? Are there other
assertions that the broker-dealer should make regarding either
compliance or internal control over compliance? Why would any
additional assertions result in improved reporting to the Commission?
Would all of the proposed assertions achieve the
Commission's goals to, among other things, strengthen broker-dealers'
compliance with the Financial Responsibility Rules, and, in turn,
improve the financial and operational condition of broker-dealers and
the safeguarding of investor assets?
What additional steps would a broker-dealer likely have to
take in order to comply with the proposed requirements and make each
additional proposed assertion?
Are there any practical issues the Commission should
consider with respect to the proposal to assert compliance with the
Financial Responsibility Rules?
Is the proposed definition of the term ``material non-
compliance'' understandable in the context of broker-dealer audits?
What alternative definition could be used? Why would any alternative
definition be more appropriate?
Are the examples of material non-compliance described
above appropriate? What other examples of material non-compliance
should be specifically identified, if any? Should the Commission
include examples of material non-compliance in the text of the rule?
Is the proposed definition of the term ``material
weakness'' understandable in the context of Rule 17a-5? What
alternative definition could be used? Why would any alternative
definition be more appropriate?
Is the proposed definition of ``deficiency in internal
control over compliance'' understandable in the context of Rule 17a-5?
What alternative definition could be used? Why would any alternative
definition be more appropriate?
2. Compliance Examination and Examination Report
The Commission proposes to require each carrying broker-dealer to
engage an independent public accountant to examine the broker-dealer's
assertions in the Compliance Report (``Compliance Examination'') and
issue an Examination Report. Under the proposal, following the
Compliance Examination, carrying broker-dealers would be required to
file the resulting Examination Report of the independent public
accountant with the Commission. This Compliance Examination and
Examination Report would replace the existing practice that results in
the independent public accountant issuing a report based on a Study.
The Commission proposes to amend paragraph (g) of Rule 17a-5 and
rename it ``Engagement of independent public accountant.'' As proposed,
paragraph (g) would provide that a broker-dealer subject to the
requirement to file annual reports pursuant to paragraph (d) would need
to engage an independent public accountant to examine or review, as
applicable, the reports that are required under that provision. Each
carrying broker-dealer would be required to engage its independent
public accountant to prepare the Examination Report based on an
examination of the assertions contained in the Compliance Report
required to be filed pursuant to paragraph (d)(3) of Rule 17a-5.\66\
The Examination Report would be required to be prepared in accordance
with PCAOB standards.\67\
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\66\ See proposed paragraph (g)(2)(i) of Rule 17a-5.
\67\ Id. The Commission preliminarily believes that the
independent public accountant's examination would be conducted
pursuant to existing PCAOB Attestation Standards or other standards
established by the PCAOB for such purposes.
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The proposed changes would not affect existing obligations of
broker-dealers or their accountants with respect to financial
reporting.\68\ Further, the assertions in the Compliance Report would
not cover the effectiveness of internal control over financial
reporting. Therefore, the independent public accountant would not be
required in the Examination Report to opine on the effectiveness of the
broker-dealer's internal control over financial reporting. However, the
accountant's existing obligation to gain an understanding and perform
appropriate procedures relative to the broker-dealer's internal control
over financial reporting, as a necessary part of the independent public
accountant's financial statement audit, would remain unchanged.\69\
Further, the Examination Report would pertain solely to the assertions
in the Compliance Report and not to the broker-dealer's process for
arriving at the assertions. Because the report of the independent
public accountant required by proposed paragraph (g) of Rule 17a-5
would require the accountant to perform its own independent examination
of the related controls and procedures, the Commission preliminarily
does not believe that it is necessary for the independent public
accountant to provide an opinion with regard to the process that the
broker-dealer used to arrive at its conclusions.
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\68\ The Commission is not proposing to change existing
requirements with regard to the broker-dealer's audited financial
statements, the computation of required and actual net capital under
Rule 15c3-1, or, for carrying broker-dealers, the computation of the
customer reserve requirement under Rule 15c3-3. The computation of
net capital and the computation of the customer reserve requirement
would continue to be subject to audit procedures by the accountant.
\69\ See PCAOB Auditing Standard No. 12, Identifying and
Assessing Risks of Material Misstatements for audits of fiscal years
beginning on or after December 15, 2010.
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The Commission preliminarily intends that the proposed amendments
and requirements pertaining to the Examination Report would result in
the following fundamental changes to broker-dealer audits. First,
broker-dealer examinations would be performed in accordance with PCAOB
standards, rather than GAAS, consistent with the Dodd-Frank Act.\70\
Second, in connection with their engagement, independent public
accountants would be required to provide an opinion concerning the
broker-dealer's compliance, and internal control over compliance, with
key regulatory requirements. Further, the independent public
accountant's report, as it applies to internal control over compliance,
would cover the full fiscal year instead of relating to the
effectiveness of controls only at year-end. Compliance with the Account
Statement Rules would be included as part of the review. These changes
are intended to encourage, in connection with broker-dealer audits,
greater focus by the auditor on internal control over
[[Page 37579]]
compliance as it pertains to key regulatory requirements, including, in
particular, greater focus on broker-dealer custody practices under the
Financial Responsibility Rules. In addition, the Commission intends
that the amendments, as they pertain to custody of customer funds and
securities, will better align the broker-dealer custody requirements
with certain requirements in the IA Custody Rule.\71\
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\70\ See Section 982 of the Dodd-Frank Act.
\71\ See Rule 206(4)-2(a)(6)(ii)(A).
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The Commission generally requests comment on the proposed
amendments and, in particular, the Compliance Examination and
Examination Report provisions. In addition, the Commission requests
comment on the following questions:
Should the Compliance Examination also cover a broker-
dealer's statement in the Compliance Report as to whether the broker-
dealer has established and maintained a system of internal control to
provide the broker-dealer with reasonable assurance that any instances
of material non-compliance with the Financial Responsibility Rules will
be prevented or detected on a timely basis? If so, why? If not, why
not?
Should the independent public accountant provide an
opinion with regard to the process that the broker-dealer used to
arrive at its assertions?
3. Notification Requirements
The proposed amendments would require that the independent public
accountant notify the Commission within one business day if the
accountant determines that an instance of ``material non-compliance''
exists with respect to any of the Financial Responsibility Rules during
the course of the examination.\72\ This notice requirement would be
triggered at the time that the independent public accountant determines
that material non-compliance exists, not at the time of completion of
the examination. Alerting the Commission to a broker-dealer's material
non-compliance with the Financial Responsibility Rules on an expedited
basis could enable the Commission to react to the non-compliance more
quickly for the protection of investors and others. Currently, Rule
17a-5 requires notification in the event the independent public
accountant determines the existence of a ``material inadequacy.'' \73\
Specifically, the independent public accountant must call the material
inadequacy to the attention of the broker-dealer's chief financial
officer, who is then obligated to notify the Commission and the broker-
dealer's DEA.
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\72\ See proposed paragraph (h) of Rule 17a-5.
\73\ See Rule 17a-5(h)(2). ``Material inadequacy'' is not a
defined term in existing auditing literature.
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The Commission proposes modifying the notification requirement to
replace the term ``material inadequacy'' with ``material non-
compliance'' and to require the independent public accountant to notify
the Commission directly. Specifically, the Commission proposes to amend
paragraph (h) of Rule 17a-5 to provide that upon determining the
existence of any material non-compliance during the course of preparing
the independent public accountant's reports, the independent public
accountant must notify the Commission within one business day of the
determination by means of a facsimile transmission or electronic mail,
followed by first class mail, and must provide a copy of the
notification in the same manner to the principal office of the DEA for
the broker-dealer. The Commission preliminarily believes that this
change would provide more effective and timely notice of broker-dealer
compliance deficiencies, and, as noted above, enable the Commission to
react more quickly to protect customers and others adversely affected
by those deficiencies. It also would be consistent with current
notification requirements applicable to independent public accountants
examining investment advisers pursuant to the IA Custody Rule.\74\
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\74\ See Rule 206(4)-2(a)(4)(ii).
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The Commission is proposing a conforming amendment to paragraph (e)
of Rule 17a-11, which now requires that broker-dealers provide notice
to the Commission of the existence of any material inadequacy. The
Commission also is proposing two technical amendments to correct
certain references to Rule 17a-12 in paragraph (e) of Rule 17a-11.\75\
Further, the Commission is proposing to delete paragraph (h)(1) of Rule
17a-5, which relates to the extent and timing of broker-dealer audits,
and which would now be superseded by paragraphs (d) and (g).\76\
Finally, the Commission is proposing to delete paragraph (j) of Rule
17a-5, which currently requires the filing of an independent public
accountant's report describing any material inadequacies concurrent
with the annual audit report. This requirement likewise would be
superseded by the proposed amendments.
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\75\ Specifically, the Commission proposes to amend the
references for Rule 17a-12(f)(2) and Rule 17a-12(e)(2) to be Rule
17a-12(i)(2) and Rule 17a-12(h)(2), respectively.
\76\ As discussed above, the broker-dealer must assert that it
is in compliance in all material respects with the Financial
Responsibility Rules as of the fiscal year-end and that its internal
controls over compliance were effective throughout the fiscal year.
See proposed paragraph (d)(3) of Rule 17a-5.
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The Commission generally requests comment on the proposed
amendments and the notification provisions. In addition, the Commission
requests comment on the following questions:
Would an alternative means to notify the Commission of an
instance of material non-compliance be appropriate? If so, what
alternative and why?
4. Comparison to the IA Custody Rule
The IA Custody Rule provides that a registered investment adviser
is prohibited from having custody of client funds or securities unless
a qualified custodian maintains those funds and securities: (1) In a
separate account for each client under that client's name; or (2) in
accounts that contain only the investment adviser's clients' funds and
securities, under the investment adviser's name as agent or trustee for
the clients.\77\ Under the IA Custody Rule, only banks, certain savings
associations, registered broker-dealers, registered futures commission
merchants (``FCMs''),\78\ and certain foreign financial institutions
may act as qualified custodians.\79\
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\77\ See Rule 206(4)-2(a)(1)(i)-(ii).
\78\ FCMs are individuals, associations, partnerships,
corporations, and trusts that solicit or accept orders for the
purchase or sale of any commodity for future delivery on or subject
to the rules of any exchange and that accept payment from or extend
credit to those whose orders are accepted. See the Commodity Futures
Trading Commission Glossary available at http://www.cftc.gov.
\79\ For the complete definition of the term ``qualified
custodian,'' see infra note 154.
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In addition, when an investment adviser or its related person
maintains client funds and securities as qualified custodian in
connection with advisory services provided to clients, the adviser
annually must obtain, or receive from its related person, a written
internal control report prepared by an independent public accountant
registered with, and subject to regular inspection by, the PCAOB. This
report must be supported by the independent public accountant's
examination of the qualified custodian's custody controls.\80\ The
Commission has
[[Page 37580]]
issued guidance identifying the control objectives that would need to
be included in the scope of the examination.\81\
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\80\ The IA Custody Rule provides that the internal control
report must include an opinion of an independent public accountant
as to whether controls have been placed in operation as of a
specific date, and are suitably designed and are operating
effectively to meet control objectives relating to custodial
services, including the safeguarding of funds and securities held by
either the adviser or its related person on behalf of advisory
clients, during the year. The rule also requires that the accountant
``verify that the funds and securities are reconciled to a custodian
other than [the adviser or its] related person.'' The required
controls are not enumerated in the rule, however.
\81\ See Commission Guidance Regarding Independent Public
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the
Investment Advisers Act of 1940, Advisers Act Release No. 2969 (Dec.
30, 2009), 75 FR 1942 (Jan. 11, 2010). The Commission guidance on
the IA Custody Rule provided the following specified objectives: (1)
Documentation for the opening and modification of client accounts is
received, authenticated, and established completely, accurately, and
timely on the applicable system; (2) client transactions, including
contributions and withdrawals, are authorized and processed in a
complete, accurate, and timely manner; (3) trades are properly
authorized, settled, and recorded completely, accurately, and timely
in the client account; (4) new securities and changes to securities
are authorized and established in a complete, accurate and timely
manner; (5) securities income and corporate action transactions are
processed to client accounts in a complete, accurate, and timely
manner; (6) physical securities are safeguarded from loss or
misappropriation; (7) cash and security positions are reconciled
completely, accurately and on a timely basis between the custodian
and depositories; and (8) account statements reflecting cash and
security positions are provided to clients in a complete, accurate
and timely manner.
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The control objectives identified in the Commission's guidance on
the IA Custody Rule are more general than the specific operational
requirements in the Financial Responsibility Rules. These general
control objectives are appropriate for purposes of the IA Custody Rule,
since this approach allows the different types of qualified custodians
(banks, certain savings associations, registered broker-dealers,
registered FCMs, and certain foreign financial institutions) to
establish controls and procedures that meet the identified control
objectives in a manner that reflects differences in business models,
regulatory requirements, and other factors. For example, the manner in
which an FCM maintains custody of assets \82\ differs from that of a
bank, and the different entities are subject to different regulations
governing their custodial functions.
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\82\ See section 4d(a) and (b) of the Commodity Exchange Act (7
U.S.C. 4d); see also 17 CFR 1.20 to 1.30.
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Broker-dealers that maintain custody of customer funds and
securities are subject to specific operational requirements in the
Financial Responsibility Rules with respect to handling and accounting
for customer assets.\83\ The Commission preliminarily believes that the
operational requirements of those rules are consistent with the control
objectives outlined in the Commission's guidance on the IA Custody
Rule. Consequently, the Commission has preliminarily determined that,
if the proposed rule amendments are adopted, a broker-dealer subject to
the proposed Compliance Examination that also acts as a qualified
custodian for itself as an investment adviser or for its related
investment advisers under the IA Custody Rule would be able to use the
Examination Report to satisfy the reporting requirements under Rule
17a-5 and the IA Custody Rule's internal control report requirement.
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\83\ While Rule 15c3-1 prescribes broker-dealer net capital
requirements, it also contains provisions relating to custody. For
example, a broker-dealer must take net capital charges for short
security differences unresolved after specifically enumerated
timeframes. See Rule 15c3-1(c)(2)(v)(A).
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The Commission generally requests comment on the comparability of
the scope of the internal control report under the IA Custody Rule and
the scope of the proposed Compliance Examination under the proposed
amendments to Rule 17a-5. In addition, the Commission requests comment
on the following question:
Should the Commission add additional elements to the scope
of the proposed Examination Report? Commenters should identify any such
elements and discuss the feasibility, benefits and costs of including
them as elements in the scope of the proposed Compliance Examination.
5. Proposed Exemption Report
As discussed above, broker-dealers claiming an exemption from Rule
15c3-3 (i.e., non-carrying broker-dealers) are required to have their
independent public accountants ``ascertain that the conditions of the
exemption were being complied with as of the examination date and that
no facts came to the [independent public accountant's] attention to
indicate that the exemption had not been complied with during the
period since [the independent public accountant's] last examination.''
\84\ The Commission proposes to amend this requirement by requiring a
non-carrying broker-dealer claiming an exemption from Rule 15c3-3 to
file a new Exemption Report.\85\ This Exemption Report would replace
the existing requirement described above.
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\84\ See Rule 17a-5(g)(2).
\85\ A non-carrying broker-dealer would file the Exemption
Report and corresponding report prepared by its independent public
accountant in lieu of the Compliance Report and Examination Report.
The Commission notes, however, that under the IA Custody Rule, a
non-carrying or ``introducing'' broker-dealer may be a ``qualified
custodian.'' In this case, in order to receive an internal control
report that would satisfy the IA Custody Rule, the non-carrying
broker-dealer would have to be separately examined by an independent
public accountant for that purpose.
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Specifically, under new paragraph (d)(4) of Rule 17a-5, the
Exemption Report would require an assertion by a broker-dealer that it
is exempt from the provisions of Rule 15c3-3 because it meets one or
more of the conditions set forth in paragraph (k) of Rule 15c3-3 with
respect to all of its business activities.\86\ In addition, the non-
carrying broker-dealer would be required to engage an independent
public accountant to review the assertion in the Exemption Report and
prepare a report based on that review and in accordance with standards
of the PCAOB.\87\ If the independent public accountant is aware of any
material modifications \88\ that should be made to the assertion
contained in the Exemption Report, the independent public accountant
would be required to disclose them in its report. The Commission
preliminarily believes that an example of a discovery that would
necessitate a material modification would be a discovery that the
broker-dealer failed to promptly forward any customer securities it
received.\89\
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\86\ See Rule 15c3-3(k), which sets forth the exemptions to Rule
15c3-3.
\87\ See proposed paragraph (g)(2)(ii) of Rule 17a-5.
\88\ See paragraph 90 of PCAOB Attestation Standard Sec. 101.
\89\ See Rule 15c3-3(k)(2)(ii), which provides that an
introducing broker-dealer is exempt from the requirements of Rule
15c3-3 if the introducing broker-dealer ``promptly transmits all
customer funds and securities to the clearing broker or dealer which
carries all of the accounts of such customers * * *''
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The Commission preliminarily believes that the independent public
accountant would be able to obtain the moderate level of assurance
contemplated by the required review \90\ through a combination of
procedures that the accountant would perform in connection with the
financial audit currently required under Rule 17a-5 \91\ and certain
inquiries and other procedures targeted specifically to the exemption
asserted by the broker-dealer.
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\90\ See paragraph 55 of PCAOB Attestation Standard Sec. 101.
\91\ See Rule 17a-5(d). As noted previously, the Commission is
not proposing to change the requirement that broker-dealers file
annual audited financial statements. Therefore, the Commission
preliminarily believes that the independent public accountant can
leverage the work related to the financial audit in the course of
undertaking its review of the broker-dealer's assertion with respect
to the claimed exemption from Rule 15c3-3.
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The Commission generally requests comment on the proposed Exemption
Report. In addition, the Commission requests comment on the following
questions:
[[Page 37581]]
Are there other types of broker-dealers that would not
qualify to file an Exemption Report, but, based on the limited scope of
their businesses, should be allowed to file a more limited report than
the Compliance Report? If so, please identify the types of broker-
dealers and indicate why they should not be required to file Compliance
Reports.
What additional processes and controls might a broker-
dealer put in place in order to comply with the new requirements
relating to the Exemption Report and to accommodate a review of the
report by an independent public accountant?
Should the Commission require that the assertion made by
the broker-dealer with respect to the exemption from Rule 15c3-3 be
examined by the accountant (i.e., the independent public accountant
issues an opinion based on obtaining reasonable assurance) as opposed
to being reviewed (i.e., the independent public accountant issues a
report based on obtaining a moderate level of assurance)? Commenters
should discuss the feasibility, benefits and costs of such a
requirement.
What additional costs and burdens would a non-carrying
broker-dealer incur under the proposal requiring an independent public
accountant to review the broker-dealer's claim that it qualifies for an
exemption from Rule 15c3-3?
6. Change in Applicable Audit Standards
The Commission is proposing to require that the audit of the
Financial Report, the examination of the Compliance Report, and the
review of the Exemption Report be performed pursuant to standards
established by the PCAOB. The Dodd-Frank Act provided authority to the
PCAOB to establish, subject to Commission approval, auditing and
related attestation, quality control, ethics, and independence
standards to be used by registered public accounting firms with respect
to the preparation and issuance of audit reports to be included in
broker-dealer filings with the Commission pursuant to Section 17(e) of
the Exchange Act.\92\ To enable the PCAOB to effectively implement the
authority provided to it by the Dodd-Frank Act, the Commission is
proposing to amend paragraph (g) of Rule 17a-5 to provide that the
independent public accountants' reports required under the rule must be
prepared in accordance with the standards of the PCAOB.\93\
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\92\ See Section II.A. of this release for a discussion of the
PCAOB's new oversight authority under the Dodd-Frank Act.
\93\ See proposed paragraph (g)(1) of Rule 17a-5.
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In September 2010, the Commission issued interpretive guidance
concerning the auditing standards that should be applied by broker-
dealer accountants with respect to the current requirements in Rule
17a-5.\94\ That guidance stated that references in Commission rules,
staff guidance, and in the federal securities laws to GAAS or to
specific standards under GAAS, as they relate to non-issuer broker-
dealers, should continue to be understood to mean auditing and
attestation standards generally accepted in the U.S., in addition to
any applicable rules of the Commission.\95\
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\94\ See Commission Guidance Regarding Auditing, Attestation,
and Related Professional Practice Standards Related to Brokers and
Dealers, Exchange Act Release No. 62991 (Sep. 24, 2010), 75 FR 60616
(Oct. 1, 2010). The Commission also noted in its guidance that it
intended to revisit this interpretation in connection with this
rulemaking.
\95\ Id. at 60617.
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Because PCAOB auditing standards differ from existing standards
governing broker-dealer audits, the proposed change to paragraph (g)
would result in a change in the procedures accountants would have to
undertake as part of their engagement for audits of broker-dealers. For
example, certain audit documentation requirements contained in PCAOB
Auditing Standard 3 (Audit Documentation) and the engagement quality
review requirement in PCAOB Auditing Standard 7 (Engagement Quality
Review) are not required by GAAS.
The Commission generally requests comment on the proposed change to
applicable auditing standards. In addition, the Commission requests
comment on the following questions:
Are there implications to the differences that were
identified that the Commission should consider? Are there other
differences that exist that would have significant implications to the
audits of broker-dealers?
Should the requirement to be audited in accordance with
PCAOB standards be phased in for non-carrying broker-dealers? Why or
why not? If so, what time-table should the Commission adopt?
7. Compliance Date and Transition Period
The Commission is proposing to make the Annual Reporting Amendments
effective for annual reports filed with the Commission for fiscal years
ending on or after December 15, 2011. The Commission is proposing this
date to include fiscal years that end on or after December 31, 2011.
The Commission preliminarily intends to implement a transition period
for carrying broker-dealers required to file Compliance Reports with
the Commission with fiscal years ending on or after December 15, 2011
but before September 15, 2012. During this transition period, a
carrying broker-dealer's assertion in its Compliance Report as to
whether internal control over compliance with the Financial
Responsibility Rules was effective would be a point-in-time assertion
as of the date of the Compliance Report, rather than covering the
broker-dealer's entire fiscal year. The Commission preliminarily
believes that the compliance date and transition period set forth above
will provide adequate time for broker-dealers to prepare the additional
required reports and for independent public accountants to plan and
perform the Compliance Examination procedures.
The Commission generally requests comment on the proposed
compliance date and transition period. In addition, the Commission
requests comment on the following questions:
Will the proposed compliance date and transition period
for the Annual Reporting Amendments provide sufficient time for broker-
dealers to prepare the additional reports and for independent public
accountants to comply with PCAOB standards? Will it provide sufficient
time to plan and perform Compliance Examination procedures? If not,
what are the impediments and what would be a more appropriate time
frame for implementation?
8. General Solicitation of Comments
The Commission generally requests comment on all aspects of these
proposed amendments. In addition, the Commission requests comment on
the following questions related to the proposal:
Certain broker-dealers conducting a limited and specific
type of business are not presently required to file an annual audit
report.\96\ Should the Commission
[[Page 37582]]
require all broker-dealers to file an annual audit of their financial
statements and supporting schedules? Should any of the proposed
amendments to Rule 17a-5 applicable to carrying firms be applied to
other specific types of broker-dealers? If so, which types of firms and
why? What impact would extension of the audit requirement or the
proposed amendments relating to non-carrying firms have on small
businesses?
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\96\ See Rule 17a-5(e)(1)(A) and (B), which provide limited
exemptions to broker-dealers from having their financial statements
and supporting statements audited by an independent public
accountant, so long as specified factors are met (e.g., if the
securities business of the broker-dealer has been limited to acting
as a broker for an issuer in soliciting subscriptions for securities
of such issuer and the broker has promptly transmitted to such
issuer all funds and promptly delivered to the subscriber all
securities received in connection therewith, and the broker has not
otherwise held funds or securities for or owed money or securities
to customers, then the broker-dealer does not have to have the
financial statements audited by an independent public accountant).
See Rule 17a-5(e)(1)(A).
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C. Proposed Amendment to the Filing of SIPC Reports
1. Existing Requirement
SIPC is a non-profit, membership corporation created under the
Securities Investor Protection Act of 1970 (``SIPA'').\97\ SIPC is
designed to protect the custodial function of a broker-dealer in the
event it fails financially. For example, SIPC can fund the liquidation
of a broker-dealer that cannot wind itself down in an orderly self-
liquidation.\98\ As part of the liquidation, SIPC can advance up to
$500,000 per customer to satisfy claims for securities and cash.\99\
However, of the $500,000, only $250,000 can be used to satisfy claims
for cash.\100\ In order to pay for these liquidations and advances,
SIPC maintains the SIPC Fund.\101\ The SIPC Fund is established and
maintained by collecting assessments from broker-dealers that are
required to be members of SIPC.\102\ Generally all broker-dealers
registered with the Commission under Section 15(b) of the Exchange Act
\103\ are required to be members of SIPC.\104\ However, broker-dealers
engaged exclusively in the distribution of mutual fund shares, the sale
of variable annuities, the insurance business, the furnishing of
investment advice to investment companies or insurance company separate
accounts, or whose principal business is conducted outside the U.S. are
not required to be members of SIPC.\105\
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\97\ 15 U.S.C. 78 et seq.
\98\ 15 U.S.C. 78eee(a)(3).
\99\ 15 U.S.C. 78fff-3(a).
\100\ 15 U.S.C. 78fff-3(d).
\101\ 15 U.S.C. 78ddd.
\102\ 15 U.S.C. 78ddd(c).
\103\ 15 U.S.C. 78o(b).
\104\ 15 U.S.C. 78ccc(a)(2).
\105\ 15 U.S.C. 78ccc(a)(2)(A)(i)-(iii).
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Under SIPA, SIPC may assess each of its member broker-dealers a fee
determined as a percentage of the firm's revenues.\106\ There are
required percentage assessments that must be made when the SIPC Fund
falls below deposited amounts or such other amount as the Commission
may determine in the public interest (``the SIPC Fund Target
Level'').\107\ SIPC can assess broker-dealers a fee based on a greater
percentage of their revenues when the SIPC Fund falls below the SIPC
Fund Target Level.\108\
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\106\ See 15 U.S.C. 78ddd(c)(2). See also SIPC Bylaws, Article
6.
\107\ Prior to the Lehman Brothers Inc. and Bernard L. Madoff
Investment Securities LLC SIPA liquidations, the SIPC Fund was
maintained at a target level of not less than $1 billion. Currently,
the SIPC Fund Target Level is $2.5 billion. See SIPC Bylaws, Article
6, Section 1(a)(1)(A) (specifying the $2.5 billion SIPC Fund Target
Level). See also Securities Investor Protection Corporation
Modernization Task Force, Adequacy of the SIPC Fund (Jun. 2010), at
5 (describing the increase in the SIPC Fund Target Level from $1
billion to $2.5 billion).
\108\ SIPC Bylaws, Article 6, Section 1(a).
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In order to assist in the collection of these assessments, SIPC has
promulgated two forms that broker-dealers must file with SIPC, as
applicable: Form SIPC-3 and Form SIPC-7. Form SIPC-3 is required when a
broker-dealer is claiming an exemption from SIPC membership (i.e., when
the broker-dealer does not have to pay an assessment). Such a broker-
dealer must file Form SIPC-3 each year certifying that the broker-
dealer remained qualified for the exemption during the prior year. Form
SIPC-7 elicits information from a broker-dealer that is a SIPC member
about the broker-dealer's sources of revenue attributable to its
securities business. Every broker-dealer that is a member of SIPC must
file this form annually.
When SIPC raises SIPC Fund assessments above the minimum assessment
provided for in Section 4(d)(1)(c) of SIPA,\109\ Rule 17a-5(e)(4)
requires a broker-dealer that files Form SIPC-3 or Form SIPC-7 to also
file with the Commission, the broker-dealer's DEA, and SIPC a
supplemental report (``Supplemental Report'') covered by an opinion of
the broker-dealer's independent public accountant that covers the
information in the respective form. Among other things, the
Supplemental Report also is required to: (1) Include a statement that
the broker-dealer qualified for an exclusion from SIPC membership under
SIPA during the prior year if exclusion from membership is claimed; and
(2) include an independent public accountant's report stating that ``in
the accountant's opinion * * * [the broker-dealer's] claim for
exclusion from membership was consistent with income reported'' or
``the assessments were determined fairly in accordance with applicable
instructions and forms'' (as applicable).\110\
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\109\ 15 U.S.C. 78ddd(d)(1)(c).
\110\ See Rule 17a-5(e)(4).
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2. Proposed Amendment
Because Forms SIPC-3 and SIPC-7 are used solely by SIPC for
purposes of levying its assessments, the Commission preliminarily
believes that Supplemental Reports relating to these forms would be
more appropriately filed with SIPC and that SIPC, rather than the
Commission, should, by rule, prescribe the form of the Supplemental
Reports. This would provide SIPC with the discretion to determine the
need for and form of a Supplemental Report and the nature and extent of
the review by an independent public accountant, if any. The Commission
would continue to have a role in establishing the requirements for a
Supplemental Report because the Commission must approve SIPC rule
proposals.
The Commission proposes to amend Rule 17a-5 to require that broker-
dealers continue to file a Supplemental Report with the Commission, the
broker-dealer's DEA, and SIPC until the Commission considers and
determines to approve any such rule adopted by SIPC. Because, for an
interim period, broker-dealers would be required to continue to file
their Supplemental Reports with the Commission, the Commission is
proposing to update the rule text to conform it to existing
professional standards and industry practices. Specifically, the
Commission is proposing to amend Rule 17a-5(e)(4) to eliminate the
ambiguity that stems from the differing auditing terms used therein by
removing all references to ``review'' and ``opinion'' where those terms
are used in Rule 17a-5(e)(4).\111\ In their place, the Commission
proposes to amend paragraph (e)(4) of Rule 17a-5 to provide that
Supplemental Reports shall include the independent public accountant's
report prepared pursuant to agreed-upon procedures based on the
performance of the procedures outlined in current paragraph (e)(4)(iii)
of Rule 17a-5, which the Commission is not proposing to change.\112\
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\111\ See Rule 17a-5(e)(4), Rule 17a-5(e)(4)(iii), and Rule 17a-
5(e)(4)(iii)(F).
\112\ See Rule 17a-5(e)(4)(iii). The Commission notes that as
part of the proposed amendments to this paragraph, the procedures
outlined in current paragraph (e)(4)(iii) of Rule 17a-5 would
remain, but would be renumbered to be included in paragraph
(e)(4)(ii)(C).
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The Commission generally requests comment on all aspects of these
proposed amendments. In addition, the Commission requests comment on
the following questions related to the proposal:
[[Page 37583]]
Should the Commission and/or a broker-dealer's DEA
continue to receive SIPC Reports relating to assessments, and, if so,
for what reasons?
Should the Commission continue to require that the broker-
dealer engage an independent public accountant to perform some level of
work with respect to the information contained in the SIPC Reports? If
so, should the Commission also specify what type of engagement the
broker-dealer must have with its independent public accountant with
respect to the information contained in the SIPC Reports? For example,
should the Commission require a broker-dealer to engage its independent
public accountant to perform a review of the information in the SIPC
Reports pursuant to PCAOB standards? Commenters should discuss the
feasibility, benefits, and costs of such requirements.
Should the Commission impose any requirements or
limitations on SIPC with respect to its ability to propose rules to
have SIPC Reports filed solely with SIPC? If so, what requirements and/
or limitations?
III. The Proposed Access to Audit Documentation Amendments
Pursuant to Section 17(b) of the Exchange Act, broker-dealers are
subject to routine inspection and examination by Commission and DEA
staff. To facilitate the examination of a broker-dealer that clears
transactions or carries customer accounts (a ``clearing broker-
dealer''), the Commission is proposing that each clearing broker-dealer
be required to consent to permitting its independent public accountant
to make available to Commission and DEA examination staff the audit
documentation associated with its annual audit reports required under
Rule 17a-5 and to discuss findings relating to the audit reports with
Commission and DEA examination staff.\113\ The Commission preliminarily
believes that it is appropriate to limit these requirements to broker-
dealers that maintain customer funds and securities or self-custody
their proprietary securities because these firms generally have more
complex business operations than other broker-dealers. Consequently,
having access to audit documentation and the independent public
accountants that audit these broker-dealers would be of greater
assistance to examiners in performing examinations of these firms, as
compared to firms with simpler business models.
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\113\ The sole obligation of the broker-dealer under this
proposed requirement would be to provide the proposed consent in the
manner discussed below. The Commission is not addressing in this
release any rights, obligations, or responsibilities of a broker-
dealer's independent public accountant with respect to its work
papers.
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The Commission is not proposing that the Commission or DEA staff
would use any audit documentation they may request, or discuss findings
related to the audit reports, for purposes of examining independent
public accountants; the PCAOB carries out that function. Rather, the
Commission preliminarily intends that any such requests would be made
exclusively in connection with conducting a regulatory examination of
the clearing broker-dealer.
The Commission preliminarily intends that examiners generally would
use any information obtained from audit documentation and discussions
with the independent public accountants to establish the scope and
focus of a pending examination of a clearing broker-dealer. The
Commission preliminarily believes that, in cases in which such
information is obtained, it would enhance and improve the efficiency
and effectiveness of Commission and DEA examinations of clearing
broker-dealers by providing examiners with access to additional
relevant information to plan their examinations. This additional
relevant information would enable representatives of the Commission and
a clearing broker-dealer's DEA to better focus and tailor their
examination efforts relating to asset verification and other matters
pertinent to customer protection. For example, where an independent
public accountant has performed extensive testing of a carrying broker-
dealer's custody of funds and securities by confirming holdings at sub-
custodians, examiners could focus their efforts on other matters that
had not been the subject of prior testing and review.
In connection with these proposals, the Commission is proposing to
amend paragraph (f)(2) of Rule 17a-5, which contains the requirement
for broker-dealers to file notices with the Commission and their DEAs
to designate their independent public accountants, to require that the
broker-dealer represent that the engagement of the independent public
accountant by the broker-dealer meets the required undertakings of
amended paragraph (g).\114\ Currently, paragraph (f)(2) of Rule 17a-5
provides that a broker-dealer required to file an annual audit report
must file a statement with the Commission and its DEA that it has
designated an independent public accountant responsible for performing
the annual audit of the broker-dealer, which is called ``Notice
pursuant to Rule 17a-5(f)(2)'' (``Notice'').\115\ Paragraph (f)(2)(iii)
of Rule 17a-5 prescribes the items that are required to be included in
the Notice: the name, address, telephone number and registration number
of the broker-dealer; the name, address and telephone number of the
accounting firm; and the audit date of the broker-dealer for the year
covered by the agreement.\116\
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\114\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
\115\ See Rule 17a-5(f)(2).
\116\ See Rule 17a-5(f)(2)(iii)(A) through (C).
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The proposed amendments to Rule 17a-5 would require: (1) That the
Notice include a statement as to whether the broker-dealer's engagement
letter with its independent public accountant is for a single year or
is of a continuing nature; \117\ (2) a representation that the
engagement of the independent public accountant by the broker-dealer
meets the required undertakings of paragraph (g); \118\ (3) in the case
of a clearing broker-dealer, a representation that the broker-dealer
agrees to allow representatives of the Commission or the DEA, if
requested for purposes of an examination of the broker-dealer, to
review the audit documentation associated with the reports of the
independent public accountant prepared pursuant to paragraph (g) of
Rule 17a-5; \119\ and (4) in the case of a clearing broker-dealer, a
representation that the broker-dealer agrees to permit the independent
public accountant to discuss with representatives of the Commission and
the DEA of the broker-dealer, if requested for purposes of an
examination of the broker-dealer, the findings associated with the
reports of the independent public accountant prepared pursuant to
paragraph (g) of Rule 17a-5.\120\ Subparagraph (f)(2)(iii) of Rule 17a-
5 would provide that a non-clearing broker-dealer is not required to
include the third and fourth representations above.\121\
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\117\ See proposed paragraph (f)(2)(ii)(D) of Rule 17a-5. The
Commission notes that FINRA currently provides its members with a
template for the Rule 17a-5(f)(2) Notice that includes a provision
as to whether the engagement is continuing in nature, which is
available at http://www.finra.org/web/groups/industry/@ip/@comp/@regis/documents/industry/p009841.pdf.
\118\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
\119\ See proposed paragraph (f)(2)(ii)(F) of Rule 17a-5.
\120\ See proposed paragraph (f)(2)(ii)(G) of Rule 17a-5.
\121\ See proposed paragraph (f)(2)(iii) of Rule 17a-5, which
would provide that a ``broker or dealer who does not carry nor clear
transactions nor carry customer accounts is not required to include
the representations in paragraph (e)(ii)(F).''
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[[Page 37584]]
The Commission also is proposing several technical changes to
paragraph (f)(2) of Rule 17a-5. Specifically, the Commission proposes
to amend the language in the preamble of paragraph (f)(2) to streamline
the paragraph and to add a reference to the requirements of the Notice.
The Commission proposes to delete paragraph (f)(2)(ii), which provides
that the agreement can be continuing in nature, because the amended
preamble to paragraph (f)(2) captures this concept.
If the Access to Audit Documentation Amendments described above
were adopted, Notices on file with the Commission at the time of the
effectiveness of the amendment would not be in compliance with the new
rules. Accordingly, broker-dealers subject to paragraph (f)(2) would
have to file new Notices if the proposals were adopted. However, if the
engagement covered by the new Notice was of a continuing nature, no
subsequent filing would be required unless the broker-dealer changed
independent public accountants.\122\
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\122\ See Rule 17a-5(f)(2)(ii).
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The Commission generally requests comment on all aspects of these
proposed amendments. In addition, the Commission requests comment on
the following questions:
Should the proposed Access to Audit Documentation
Amendments apply to all broker-dealers, or additional broker-dealers
rather than just clearing broker-dealers?
Would applying the proposed Access to Audit Documentation
Amendments to non-clearing broker-dealers provide any advantages in
terms of enhancing the examination of the broker-dealers or gaining
efficiencies?
Are there any other types of broker-dealers whose conduct
may pose risks to the investing public that should be subject to the
proposed Access to Audit Documentation Amendments?
Are there additional reasons why examiners should obtain
documentation from independent public accountants other than those
described above (i.e., to establish the scope and focus of a pending
examination of a clearing broker-dealer)? If so, please explain the
reasons and the objectives behind the reasons and how the information
could be used to achieve those objectives.
Would any limitations on the ability of examiners to have
access to audit documentation or to discuss the findings of the
independent public accountant be appropriate? If so, what are those
restrictions, why would they be appropriate, and what effect would they
have on broker-dealer examinations?
Should examiners be required to request access to the
audit documentation in writing?
Should the Commission require a broker-dealer to submit a
statement consenting to provide access to its independent public
accountant and the audit documentation (``statement of consent'') only
when it files the ``Notice pursuant to Rule 17a-5(f)(2)''?
How often should the statement of consent be filed (e.g.,
on an annual or more frequent basis)?
Are the proposed representations in the Notice sufficient
to provide effective access to the independent public accountant's
audit documentation? If not, what additional representations, or what
other measures, would be more effective?
Will the terms of engagement between clearing broker-
dealers and their independent public accountants, including
compensation terms, be affected by the proposed amendments? What
additional costs might this place on clearing broker-dealers? In this
respect, would there be a disproportionate impact on smaller clearing
broker-dealers?
What is the risk, if any, that clearing broker-dealers and
their current independent public accountants will not be able to agree
on mutually-agreeable terms in order to compensate them for additional
burdens they may incur as a result of the proposed amendments?
IV. The Proposed Form Custody Amendments
The Commission has brought numerous enforcement actions against
investment advisers and broker-dealers alleging fraudulent conduct that
includes misappropriation or other misuse of customer assets.\123\
Consequently, the Commission recently took steps to enhance oversight
of the custody function of investment advisers,\124\ and is now
proposing enhancements to the oversight of the custody function of
broker-dealers. The Commission is proposing amendments to Rule 17a-5
that are designed to provide greater information regarding the custody
function at broker-dealers and their compliance with requirements
relating to custody of customer and non-customer assets. Specifically,
the Commission is proposing a new form to be filed by broker-dealers--
Form Custody--which is designed to elicit information concerning
whether a broker-dealer maintains custody of customer and non-customer
assets, and, if so, how such assets are maintained.\125\ As discussed
below, the Commission proposes to require that a broker-dealer file
proposed Form Custody with its quarterly FOCUS Report.\126\
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\123\ See, e.g., SEC v. Donald Anthony Walker Young, et al.,
Litigation Release No. 21006 (Apr. 20, 2009) (complaint alleges
registered investment adviser and its principal misappropriated in
excess of $23 million, provided false account statements to
investors in limited partnership, and provided false custodial
statements to limited partnership's introducing broker); SEC v.
Isaac I. Ovid, et al, Litigation Release No. 20998 (Apr. 14, 2009)
(complaint alleges that defendants, including registered investment
adviser and manager of purported hedge funds, misappropriated in
excess of $12 million); SEC v. The Nutmeg Group, LLC, et al.,
Litigation Release No. 20972 (Mar. 25, 2009) (complaint alleges that
registered investment adviser misappropriated in excess of $4
million of client assets, failed to maintain client assets with a
qualified custodian, and failed to obtain a surprise examination);
SEC v. WG Trading Investors, L.P., et al., Litigation Release No.
20912 (Feb. 25, 2009) (complaint alleges that registered broker-
dealer and affiliated registered adviser orchestrated fraudulent
investment scheme, including misappropriating as much as $554
million of the $667 million invested by clients and sending clients
misleading account information); SEC v. Stanford International Bank,
et al., Litigation Release No. 20901 (Feb. 17, 2009) (complaint
alleges that affiliated bank, broker-dealer, and advisers colluded
with each other in carrying out an $8 billion fraud); SEC v. Bernard
L. Madoff, et al., Litigation Release No. 20889 (Feb. 9, 2009)
(complaint alleges that Madoff and Bernard L. Madoff Investment
Securities LLC--a registered investment adviser and registered
broker-dealer--committed a $50 billion fraud).
\124\ See, e.g., Custody of Funds or Securities by Investment
Advisers, Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456
(Jan. 11, 2010).
\125\ For purposes of Form Custody, the term ``customer'' means
a person that is a ``customer'' for purposes of Rule 15c3-3(a), and
a ``non-customer'' means a person other than a ``customer'' as that
term is defined in Rule 15c3-3(a). See Rule 15c3-3(a) and FINRA's
Interpretations of Financial and Operational Rules, Rule 15c3-3,
Rule 15c3-3(a)(1)/01, available on FINRA's Internet Web site at
http://www.finra.org/Industry/Regulation/Guidance/FOR/.
\126\ See Rule 17a-5(a). FOCUS Reports, filed with the
Commission and SROs by broker-dealers, are one of the primary means
of monitoring the financial and operational condition of broker-
dealers and enforcing the broker-dealer financial responsibility
rules. The completed forms are also used to determine which firms
are engaged in various securities-related activities, and how
economic events and government policies might affect various
segments of the securities industry. The FOCUS Report was designed
to eliminate overlapping regulatory reports required by various SROs
and the Commission and to reduce reporting burdens as much as
possible. See supra note 20. The Commission notes that FOCUS Reports
are, and proposed Form Custody would be, deemed to be confidential
pursuant to paragraph (a)(3) of Rule 17a-5.
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Currently, a broker-dealer's FOCUS Report provides the Commission
and other regulators (e.g., a broker-dealer's DEA) with information
relating to the broker-dealer's financial and operational
condition.\127\ A broker-dealer's FOCUS Report does not, however,
solicit
[[Page 37585]]
detailed information on how a broker-dealer maintains custody of
assets. The proposed new form is intended to provide additional
information about a broker-dealer's custodial activities. The
Commission preliminarily believes that proposed Form Custody could make
it easier for examiners to determine whether broker-dealers are in
compliance with laws and regulations concerning the custody of assets.
If, upon reviewing Form Custody, regulatory authorities became aware of
inconsistencies or other red flags in information contained in the
form, they could initiate a more detailed and focused analysis of the
broker-dealer's custodial activities. Such an analysis may, in turn,
identify potential abuses related to customer assets. Moreover,
proposed Form Custody could expedite the examination of a broker-
dealer's custodial activities and reduce examination costs, as
examiners would no longer need to request basic custody-related
information already disclosed on the form.
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\127\ See Form X-17A-5 Schedule I, Part II, Part IIa, Part IIb,
and Part III.
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The Commission is proposing that broker-dealers file Form Custody
with their quarterly FOCUS Reports. The Commission preliminarily
believes that Form Custody would help provide applicable regulators
with current information about a broker-dealer's custodial activities
and, as described below, would promote compliance with applicable laws
and rules. The Commission is proposing that Form Custody be filed on a
quarterly basis to ensure that the information disclosed on the form is
current and to enable examiners to identify significant recent changes
in a broker-dealer's custody practices. For example, examiners could
more promptly investigate instances in which a broker-dealer frequently
changes the locations where customer securities are held. While a
broker-dealer may have valid and lawful reasons for changes in the
custody arrangements for its customers' securities, such actions also
could suggest improper activity and could cause examiners to make
further inquiries.
Proposed Form Custody is comprised of nine line items (each, an
``Item'') that elicit information about a broker-dealer's custodial
activities. Several Items contain multiple questions, and a few Items
require completion of charts and disclosure of custody-related
information specific to the broker-dealer completing the form. Each
Item and its subparts are discussed below.
A. Item 1--Accounts Introduced on a Fully Disclosed Basis
Item 1.A of Form Custody would elicit information concerning
whether the broker-dealer introduces customer accounts to another
broker-dealer on a fully disclosed basis by requiring the broker-dealer
to check the appropriate ``Yes'' or ``No'' box. Many broker-dealers
enter into agreements (``carrying agreements'') with another broker-
dealer in which the two firms allocate certain responsibilities with
respect to the handling of accounts.\128\ These carrying agreements are
governed by applicable self-regulatory organization (``SRO'') rules,
which require broker-dealers entering into a carrying agreement to
allocate certain responsibilities associated with introduced
accounts.\129\
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\128\ To be consistent with the definition of the term
``customer'' in Rule 15c3-3, the Commission proposes to define the
term ``customer'' in the General Instructions to Form Custody the
same. See Rule 15c3-3(a)(1).
\129\ See, e.g., NYSE Rule 382, NASD Rule 3230, and FINRA Rule
4311.
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Typically, under a carrying agreement, one broker-dealer (the
``introducing broker-dealer'') agrees to act as the customer's account
representative (e.g., by providing the customer with account opening
documents, ascertaining the customer's investment objectives, and
making investment recommendations). The carrying broker-dealer
typically agrees to receive and hold the customer's cash and
securities, clear transactions, make and retain records relating to the
transactions and the receipt and holding of assets, and extend credit
to the customer in connection with the customer's securities
transactions.
Proposed Item 1.A would elicit information concerning whether the
broker-dealer introduces customer accounts to another broker-dealer on
a fully disclosed basis, rather than asking whether the broker-dealer
is an ``introducing broker-dealer.'' The Commission is proposing the
question in this manner because some broker-dealers operate as carrying
broker-dealers (i.e., they hold cash and securities) for one group of
customers but also introduce the accounts of a second group of
customers on a fully disclosed basis to another broker-dealer. For
example, a broker-dealer may incur the capital expense and cost of
acting as a carrying broker-dealer for certain products (e.g.,
equities) but not for other products (e.g., options). In this case, the
firm operates as a hybrid introducing/carrying broker-dealer by
introducing on a fully disclosed basis to a carrying broker-dealer
those customers that trade securities the broker-dealer is not equipped
to maintain. Broker-dealers also may introduce customer accounts on an
omnibus basis, as is discussed in detail in Section IV.B. of this
release.
If the broker-dealer answers Item 1.A by checking the ``Yes'' box,
the broker-dealer would be required under Item 1.B to identify each
broker-dealer to which customer accounts are introduced. As discussed
above, the carrying broker-dealer in such an arrangement maintains the
cash and securities of the introduced customers. Consequently, Item 1.B
would elicit the identity of each broker-dealer obligated to return
cash and securities to the introduced customers. Commission and DEA
examiners could use this information to confirm the existence of an
introducing/carrying relationship and to confirm that the carrying
broker-dealer acknowledges its obligation to return the cash and
securities belonging to the introduced customers.\130\
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\130\ See Letter from Richard G. Ketchum, Director, Division of
Market Regulation, Commission, to David Marcus, New York Stock
Exchange (Jan. 14, 1985), which states that the customers of
introducing broker-dealers are presumed to be customers of the
clearing broker-dealer for purposes of the Commission's financial
responsibility rules and SIPA.
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The Commission generally requests comment on all aspects of
proposed Item 1. In addition, the Commission requests comment on the
following questions relating to proposed Items 1.A and 1.B:
Should the Commission require additional information about
accounts introduced to carrying broker-dealers on a fully disclosed
basis? If so, what type of information?
Should the Commission require the broker-dealer to
disclose the number of accounts it introduces on a fully disclosed
basis?
Should the Commission require the broker-dealer to
disclose the approximate dollar amount of assets held in fully
disclosed accounts at the carrying broker-dealer?
Should the Commission solicit information as to whether a
broker-dealer other than the carrying broker-dealer clears transactions
that are ultimately maintained by the carrying broker-dealer on a fully
disclosed basis?
Should the Commission require the broker-dealer to
identify whether it relies on the carrying broker-dealer or another
third party to maintain books and records relating to introduced
accounts?
B. Item 2--Accounts Introduced on an Omnibus Basis
Item 2.A would elicit information concerning whether the broker-
dealer
[[Page 37586]]
introduces customer accounts to another broker-dealer on an omnibus
basis by requiring the broker-dealer to check the appropriate ``Yes''
or ``No'' box. An omnibus account is an account carried and cleared by
another broker-dealer that contains accounts of undisclosed customers
on a commingled basis and that are carried individually on the books of
the broker-dealer introducing the accounts.\131\ Disclosure of this
information is important because a broker-dealer that introduces
customer accounts to another broker-dealer on an omnibus basis is
considered to be a carrying broker-dealer with respect to those
accounts under the Commission's broker-dealer financial responsibility
rules.\132\ Thus, in these arrangements, the broker-dealer introducing
the omnibus account to a carrying broker-dealer is obligated to return
cash and securities in the account to customers.\133\
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\131\ See Broker-Dealer Audit Guide, supra note 14.
\132\ See Net Capital Rule, Exchange Act Release No. 31511 (Nov.
24, 1992); 57 FR 56973 (Dec. 2, 1992), n. 16.
\133\ Id.
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If the broker-dealer checks the ``Yes'' box in Item 2.A, it would
be required to identify in Item 2.B each broker-dealer to which
accounts are introduced on an omnibus basis. Commission and DEA
examiners could use this information to confirm whether the cash and
securities introduced to the carrying broker-dealer are in fact being
held in an omnibus account at the carrying broker-dealer.
The Commission generally requests comment on all aspects of
proposed Item 2. In addition, the Commission requests comment on the
following questions relating to proposed Items 2.A and 2.B:
Should the Commission require additional information about
accounts introduced to carrying broker-dealers on an omnibus basis? For
example, should the Commission require a broker-dealer to provide
information about the specific types of products or customers
introduced to a carrying broker-dealer on an omnibus basis? What other
information about accounts introduced to carrying- broker-dealers on an
omnibus basis should the Commission require to be disclosed? Why?
Should the Commission require a broker-dealer to disclose
the number of omnibus accounts it introduces to other broker-dealers?
If yes, please explain why. If no, please explain why not.
Should the Commission require a broker-dealer to disclose
the approximate dollar amount of assets held in omnibus accounts at the
carrying broker-dealer? If yes, please explain why. If no, please
explain why not.
Should the Commission solicit information as to whether a
broker-dealer other than the carrying broker-dealer clears transactions
where the securities are ultimately maintained by the carrying broker-
dealer on an omnibus basis? If yes, please explain why. If no, please
explain why not.
C. Item 3--Carrying Broker-Dealers
1. Items 3.A and 3.B
Item 3 elicits information concerning how a carrying broker-dealer
holds cash and securities. Item 3 is comprised of five subparts. The
first question--Item 3.A--elicits information concerning whether the
broker-dealer carries securities accounts for customers by requiring
the broker-dealer to check the appropriate ``Yes'' or ``No'' box. As
noted above, the proposed General Instructions to Form Custody would
specify that the term ``customer'' as used in the Form means a
``customer'' as defined in Rule 15c3-3. The next question--Item 3.B--
elicits information concerning whether the broker-dealer carries
securities accounts for persons that are not ``customers'' under the
definition in Rule 15c3-3. For example, under Rule 15c3-3, persons that
are not ``customers'' include an accountholder that is a general
partner, director, or principal officer of the carrying broker-dealer
and accountholders that are themselves broker-dealers.
2. Item 3.C
Item 3.C requires the broker-dealer to identify in three charts the
types of locations where it holds securities and the frequency with
which it performs reconciliations between the information on its stock
record and information on the records of those locations. The proposed
instructions to Item 3.C provide that the broker-dealer must identify
the types of locations where it holds securities. The broker-dealer
would be required to identify locations that are used at any one time
for maintaining customer, non-customer, and proprietary securities. The
proposed instructions also require the broker-dealer to specify the
locations where the broker-dealer holds securities directly in the name
of the broker-dealer (i.e., the broker-dealer should not identify a
type of location if the broker-dealer only holds securities at the
location through an intermediary). For example, when a broker-dealer is
not a member of a securities clearing organization but, instead,
accesses the securities processing facilities of the organization by
holding securities at an entity that is a member of the organization
(e.g., a U.S. bank), the broker-dealer would be required to identify
the category of location for which the broker-dealer has a direct
custodial relationship (i.e., the U.S. bank), but not the securities
clearing organization.
The first chart--set forth in Item 3.C.i--identifies the most
common locations where broker-dealers hold securities. Many of the
locations identified on the first chart, and described below, are
locations deemed to be satisfactory control locations under paragraph
(c) of Rule 15c3-3.
The first location identified in the chart is the broker-dealer's
vault. As noted above, broker-dealers primarily hold securities in
fungible bulk at other institutions. In some cases, however, broker-
dealers may physically hold securities certificates (e.g., in the case
of restricted securities).
The second location identified in the chart is another U.S.
registered broker-dealer. For example, a broker-dealer may hold
customers' foreign securities at another U.S. broker-dealer, or may
hold securities in an omnibus account at another broker-dealer.
The third and fourth potential locations identified in the chart
are the Depository Trust Company (``DTC'') and the Options Clearing
Corporation. These are two of the predominant securities clearing
organizations in the U.S. and, consequently, are identified by name
rather than type.
The fifth potential location identified in the chart is a U.S.
bank. Broker-dealers may have arrangements with U.S. banks to receive
and hold securities for the accounts of the broker-dealer's customers
and non-customers, as well as for the broker-dealer's own account.
Obtaining information about a broker-dealer's relationships with U.S.
banks could enable examiners to test and confirm the accuracy of the
broker-dealer's representations on proposed Form Custody (i.e., that a
U.S. bank holds securities for the broker-dealer), and in addition
facilitate the collection of information regarding the relationship
between the broker-dealer and the bank. For instance, customer fully
paid and excess margin securities cannot be pledged as collateral for a
loan to the broker-dealer, and customer margin securities may not be
commingled with proprietary securities that are pledged as collateral
for a bank loan. Form Custody could, for example, lead examiners to
seek account statements and documentation governing the broker-dealer's
relationship with the U.S. bank to ensure customer fully paid and
excess
[[Page 37587]]
margin securities are not pledged as collateral.
The sixth potential location identified in the chart is the
transfer agent of an open-end investment management company registered
under the Investment Company Act of 1940 (i.e., a mutual fund).
Generally, mutual funds issue securities only in book entry form. This
means that the ownership of securities is not reflected on a
certificate that can be transferred but rather through a journal entry
on the books of the issuer maintained by the issuer's transfer agent. A
broker-dealer that holds mutual funds for customers would hold them in
the broker-dealer's name on the books of the mutual fund.
The second chart--set forth in Item 3.C.ii--is intended to capture
all other types of U.S. locations where a broker-dealer may hold
securities that are not specified in the chart included in Item 3.C.i.
This could include securities held in book-entry form by the issuer of
the securities or the issuer's transfer agent. A broker-dealer that
holds securities in such locations would be required to list the types
of locations in the spaces provided in the chart and indicate the
frequency with which the broker-dealer performs asset reconciliations
with those locations.
The third chart--set forth in Item 3.C.iii--pertains to foreign
locations where the broker-dealer maintains securities. The Commission
is not proposing to list categories of foreign locations because
terminology used to identify certain locations may differ by
jurisdiction. For example, in some foreign jurisdictions, banks may
operate a securities business, making it difficult to classify whether
securities are held at a bank or a broker-dealer. A broker-dealer that
holds securities in a foreign location would be required to list the
types of foreign locations where it maintains securities in the spaces
provided in the chart and indicate the frequency with which
reconciliations are performed with the location.
3. Items 3.D and 3.E
Items 3.D and 3.E of proposed Form Custody each have three
identical subparts that elicit information about the types and amounts
of securities and cash the broker-dealer holds, whether those
securities are recorded on the broker-dealer's stock record and, if
not, why they are not recorded, and where the broker-dealer holds free
credit balances. The General Instructions to proposed Form Custody
would define ``free credit balances'' as liabilities of a broker-dealer
to customers or non-customers which are subject to immediate cash
payment to customers or non-customers on demand, whether resulting from
sales of securities, dividends, interest, deposits, or otherwise.\134\
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\134\ This definition is similar to the definition of the term
``free credit balance'' in Rule 15c3-3, except that the definition
in the rule is limited to liabilities to ``customers'' whereas the
definition in the proposed Form contemplates liabilities to
customers and non-customers. See Rule 15c3-3(a)(8).
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The difference between Item 3.D and Item 3.E is that the former
would elicit information with respect to securities and free credit
balances held for the accounts of customers, whereas the latter would
elicit information with respect to securities and free credit balances
held for the accounts of persons that are not customers.\135\
Accordingly, the form would ask two sets of identical questions to
elicit information about each category of accountholder--customer and
non-customer.
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\135\ As discussed above, the term ``customer'' on proposed Form
Custody would mean a ``customer'' as defined in Rule 15c3-3(a)(1).
Broker-dealers may carry securities accounts for ``customers'' as
defined in Rule 15c3-3 and for persons that are not customers (such
as insiders and other broker-dealers).
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Proposed Items 3.D.i and 3.E.i would elicit information about the
types and dollar amounts of the securities the broker-dealer carries
for the accounts of customers and non-customers, respectively.
Specifically, for each Item, the broker-dealer would be required to
complete information on a chart to the extent applicable. The charts
have twelve rows, with each row representing a category of security.
The categories are: (1) U.S. Equity Securities; (2) Foreign Equity
Securities; (3) U.S. Listed Options; (4) Foreign Listed Options; (5)
Domestic Corporate Debt; (6) Foreign Corporate Debt; (7) U.S. Public
Finance Debt; (8) Foreign Public Finance Debt; (9) U.S. Government
Debt; (10) Foreign Sovereign Debt; (11) U.S. Structured Debt; and (12)
Foreign Structured Debt. A thirteenth row is included in each chart to
identify any securities not specifically listed in the first twelve
rows. The types of securities are categorized this way because the
various categories ordinarily are associated with certain types of
locations. Thus, as examiners review the form, they could assess
whether the types of securities held by the broker-dealer are
maintained at locations generally known to hold such securities. If the
form indicates that some types of securities are held at a location
that is atypical for such securities, the examiner can refine the focus
of the examination to ensure customer assets are properly safeguarded.
The charts in Items 3.D.i and 3.E.i each have eight columns. The
first column contains boxes for each category of security specified in
the Item. The broker-dealer would be required to check the box in each
chart for every applicable category of security it holds for the
accounts of customers and non-customers, respectively. The second
column identifies the category of security. The third through eighth
columns represent ranges of dollar values: (1) Up to $50 million; (2)
greater than $50 million up to $100 million; (3) greater than $100
million up to $500 million; (4) greater than $500 million up to $1
billion; (5) greater than $1 billion up to $5 billion; and (6) greater
than $5 billion. The broker-dealer would be required to check the box
in each chart reflecting the approximate dollar value for every
category of security the broker-dealer carries for the accounts of
customers and non-customers, respectively.
The Commission is proposing dollar ranges for the values of the
securities, as opposed to actual values, to ease compliance burdens.
The intent is to elicit information about the relative dollar value of
securities the broker-dealer holds for customers and non-customers in
each category of security. Values would be reported as of the date
specified in the broker-dealer's accompanying quarterly FOCUS Report.
Proposed Items 3.D.ii and 3.E.ii would elicit information
concerning whether the broker-dealer has recorded all the securities it
carries for the accounts of customers and non-customers, respectively,
on its stock record by requiring the broker-dealer to check the
appropriate ``Yes'' or ``No'' box. If the broker-dealer checks ``No,''
it would be required to explain in the space provided why it has not
recorded such securities on its stock record and indicate the type of
securities and approximate U.S. dollar market value of such unrecorded
securities.
The Commission anticipates that a broker-dealer would answer
``Yes'' in response to Items 3.D.ii and 3.E.ii because the stock
record--which a broker-dealer is required to create pursuant to Rule
17a-3--is a record of custody and movements of securities. A long
position in the stock record indicates ownership of the security or a
right to the possession of the security. Thus, the ``long side'' of the
stock record indicates the person to whom the broker-dealer owes the
securities. Common examples of ``long side'' positions are securities
received from customers (e.g., fully paid or excess margin securities),
securities owned by the firm (i.e., securities held in the
[[Page 37588]]
broker-dealer's inventory for its own account), securities borrowed,
and fails-to-deliver (i.e., securities sold to or through another
broker-dealer but not delivered).
A short position in the stock record indicates either the location
of the securities or the responsibility of other parties to deliver the
securities to the broker-dealer. Every security owned or held by the
broker-dealer must be accounted for by its location. Since securities
are fungible, the short side of the stock record does not in fact
designate where particular securities are located. Rather, it indicates
the total amount of securities, on a security-by-security basis, held
at each location, which could include, for example, securities
depositories. Common short-side stock record locations also include
banks (e.g., when a broker-dealer pledges securities to a bank as
collateral for a loan), stock loan counterparties (e.g., when a broker-
dealer lends securities to another firm as part of a securities lending
transaction), and counterparties failing to deliver securities to the
broker-dealer (e.g., when the broker-dealer has purchased securities
that have not yet been received from the counterparty).
The Commission's goals in proposing this question are twofold.
First, the question could elicit the disclosure of the unusual
circumstance in which a broker-dealer carries securities for the
account of a customer or non-customer but does not reflect them on its
stock record. The Commission and other securities regulators could use
this information to assess whether the broker-dealer is properly
accounting for securities. Second, this question could prompt a broker-
dealer to identify, and self-correct, circumstances in which it did not
include securities on its stock record as required by Rule 17a-3.
Proposed Items 3.D.iii and 3.E.iii would elicit information as to
how the broker-dealer treats free credit balances in securities
accounts of customers and non-customers, respectively. The information
is elicited through a chart the broker-dealer would be required to
complete. The chart in Item 3.D.iii has five rows with each row
representing a different process for treating free credit balances. The
treatment options (referred to as ``processes'' on the form) would be
that free credit balances are: (1) Included in a computation under Rule
15c3-3(e); (2) held in a bank account under Rule 15c3-3(k)(2)(i); (3)
swept to a U.S. bank; (4) swept to a U.S. money market fund; and (5)
``other,'' with a space to describe such other treatment. The options
are not intended to be mutually exclusive in that a broker-dealer may
treat free credit balances in several different ways (e.g., a broker-
dealer may be instructed by certain customers to sweep their free
credit balances to a bank, and by other customers to sweep their free
credit balances to a U.S. money market fund).
A broker-dealer would be required to check the box in the first
column of the chart for every process that applies to the broker-
dealer's treatment of free credit balances in customer and non-customer
accounts, respectively. The first process identified on each chart is
that the broker-dealer treats customer and non-customer free credit
balances in accordance with the customer reserve computation required
under Rule 15c3-3(e). Rule 15c3-3(e) requires a broker-dealer to
maintain a special reserve bank account for the exclusive benefit of
its customers and maintain deposits in that account (to the extent a
deposit is required) in amounts computed in accordance with Exhibit A
to Rule 15c3-3.\136\ Rule 15c3-3 requires a broker-dealer to comply
with these reserve account provisions only with respect to customer-
related credit balances. The Commission has, however, proposed
amendments to Rule 15c3-3 that would require a broker-dealer to
maintain a reserve account and perform a reserve computation for non-
customer accountholders that are domestic and foreign broker-
dealers.\137\
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\136\ See Rule 15c3-3(e) and Rule 15c3-3a.
\137\ See Amendments to Financial Responsibility Rules for
Broker-Dealers, Exchange Act Release No. 55431 (Mar. 9, 2007), 72 FR
12862 (Mar. 19, 2007). See also Letter from Michael A. Macchiaroli,
Associate Director, Division of Market Regulation, Commission, to
Raymond J. Hennessy, Vice President, NYSE, and Thomas Cassella, Vice
President, NASD Regulation, Inc. (Nov. 10, 1998).
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The second process identified on the chart is that the broker-
dealer handles free credit balances by placing funds in a ``bank
account under Rule 15c3-3(k)(2)(i).'' Rule 15c3-3(k)(2)(i) prescribes a
process by which a broker-dealer can qualify for an exemption from the
requirements of Rule 15c3-3. Specifically, the exemption applies to a
broker-dealer that does not carry margin accounts, promptly transmits
all customer funds and delivers all securities received in connection
with its activities, does not otherwise hold funds or securities for,
or owe money or securities to, customers and effectuates all financial
transactions between the broker-dealer and its customers through one or
more bank accounts that are each designated as a ``Special Account for
the Exclusive Benefit of Customers of (the name of broker or dealer).''
\138\
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\138\ See Rule 15c3-3(k)(2)(i).
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The third process identified in the chart--``swept to a U.S.
bank''--is included because some broker-dealers engage in ``Bank Sweep
Programs.'' Rather than hold customer funds in securities accounts,
some broker-dealers require or offer the option to transfer free credit
balances in securities accounts to a specific money market fund or
interest bearing bank account (``Sweep Programs''). The customer earns
dividends on the money market fund or interest on the bank account
until such time as the customer chooses to liquidate the position in
order to use the cash, for example, to purchase securities.\139\
Customers must make a request to the broker-dealer for the return of
funds swept from their securities accounts to the bank.
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\139\ See Amendments to Financial Responsibility Rules for
Broker-Dealers, Exchange Act Release No. 55431 (Mar. 9, 2007), 72 FR
12862 (Mar. 19, 2007) at 12866.
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The fourth option identified in the chart is that the broker-dealer
sweeps free credit balances into a money market fund as part of a Sweep
Program. In most cases when a broker-dealer sweeps free credit balances
into a money market fund, the broker-dealer purchases shares in the
money market fund, which is registered in the name of the broker-
dealer. The money market fund understands that these shares are not
proprietary positions of the broker-dealer, and any interest earned on
the shares from the money market fund are payable to the customers.
Finally, the fifth option in the chart would cover any other
process that is not described in the other options.
The Commission generally requests comment on all aspects of
proposed Item 3. In addition, the Commission requests comment on the
following questions relating to proposed Item 3:
Should the Commission identify additional U.S. locations
in Item 3.C.i relating to where broker-dealers maintain custody of
securities held in the U.S.?
Should the Commission include separate charts to identify
locations where customer, non-customer, and proprietary securities are
held?
Should the charts in Item 3.C solicit information from
broker-dealers other than the location where securities are held and
reconciliation frequency?
Should the broker-dealer be required to identify only the
types of locations in Items 3.C.i, ii and iii where un-hypothecated
securities are located? For example, should the broker-dealer not be
required to identify locations where securities are hypothecated in
transactions such as stock loans, bank loans and repurchase agreements?
[[Page 37589]]
Should the Commission identify additional categories of
securities in the charts specified under Item 3.D and 3.E? For example,
are the securities listed on those charts sufficiently comprehensive to
cover most, if not all, types of securities carried by broker-dealers?
Should the Commission require the broker-dealer to provide
the identities of all custodians, as opposed to, or in addition to,
describing the types of custodians?
Should the Commission use different dollar ranges in the
charts specified in Items 3.D.i and 3.E.i? If so, what ranges?
Should the Commission require broker-dealers to provide
specific dollar amounts, rather than indicating ranges, in Items 3.D.i
and 3.E.i?
Should the Commission require broker-dealers to identify
in Items 3.D.iii and 3.E.iii the specific locations where free credit
balances are held (e.g., the names of banks and money market funds)?
D. Item 4--Carrying for Other Broker-Dealers
Item 4 of proposed Form Custody requires a broker-dealer to
disclose whether it acts as a carrying broker-dealer for other broker-
dealers. There are two sets of questions in Item 4--Item 4.A.i, ii, and
iii and Item 4.B.i, ii, and iii. The first set of questions would
elicit information from a broker-dealer as to whether it carries
transactions for other broker-dealers on a fully disclosed basis. The
second set of questions would elicit information from a broker-dealer
as to whether it carries transactions for other broker-dealers on an
omnibus basis.
Proposed Items 4.A.i and 4.B.i require a broker-dealer to indicate
by checking the appropriate ``Yes'' or ``No'' box whether it carries
customer accounts for another broker-dealer on a fully disclosed basis
and on an omnibus basis, respectively. Items 4.A.ii and 4.B.ii require
a broker-dealer, if applicable, to indicate the number of broker-
dealers with which it has an arrangement to carry accounts on a fully
disclosed basis and on an omnibus basis, respectively. Items 4.A.iii
and 4.B.iii require a broker-dealer, if applicable, to identify any
affiliated broker-dealers that introduce accounts to the broker-dealer
on a fully disclosed basis and on an omnibus basis, respectively.
The Commission has stated that related person custody arrangements
can present higher risks to ``advisory clients'' than maintaining
assets with an independent custodian,\140\ and the Commission believes
the same to be true for broker-dealer clients. Consistent with the
definition of the term in other contexts applicable to broker-dealers,
including Form BD,\141\ the General Instructions for proposed Form
Custody would define the term ``affiliate'' as any person who directly
or indirectly controls the broker-dealer or any person who is directly
or indirectly controlled by or under common control with the broker-
dealer. The definition also would specify that ownership of 25% or more
of the common stock of the broker-dealer introducing accounts to the
broker-dealer submitting the Form Custody is deemed prima facie
evidence of control; this definition is consistent with the definition
used in Form BD.\142\
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\140\ See Custody of Funds or Securities by Investment Advisers,
Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456 at 1462
(Jan. 11, 2010).
\141\ Form BD is the uniform application for broker-dealer
registration with the Commission. Form BD states that a person is
presumed to control a company if, among other things, that person
has directly or indirectly the right to vote 25% or more of a class
of a voting security or has the power to sell or direct the sale of
25% or more of a class of voting securities, or, in the case of a
partnership, the right to receive upon dissolution, or has
contributed, 25% or more of the firm's capital.
\142\ This definition of the term ``affiliate'' is the same as
the definition in Form BD, including the specification that
ownership of 25% or more of the common stock is deemed prima facie
evidence of control.
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Item 4 in proposed Form Custody would elicit information about
broker-dealers' custodial responsibilities with respect to accounts
held for the benefit of other broker-dealers, and would require broker-
dealers to identify such broker-dealers that are affiliates of the
broker-dealer.\143\ The Commission believes that this information will
be useful for examination purposes and will provide the Commission with
an enhanced understanding of, and useful and readily available
information relating to, the scope of broker-dealer introducing/
carrying relationships and activities, and the custodial practices of
broker-dealers involved in such relationships.
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\143\ Form Custody would not require a broker-dealer to identify
unaffiliated broker-dealers for which it carries accounts, though,
as discussed above, it would need to indicate that it carries
accounts for such broker-dealers. The Commission preliminarily
believes that this approach provides the Commission and DEA
examiners with access to useful information involving a broker-
dealer's custody practices while alleviating potential time and cost
burdens associated with completing proposed Form Custody given that
some broker-dealers carry accounts for hundreds of unaffiliated
broker-dealers. The Commission notes that information about these
broker-dealers would be part of the books and records of the
carrying broker-dealer. Therefore, an affirmative answer to Item 4
could prompt the Commission and DEA examiners to request information
about the identities of the unaffiliated broker-dealers.
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The Commission generally requests comment on all aspects of
proposed Item 4. In addition, the Commission requests comment on the
following questions relating to proposed Item 4:
The Commission is proposing to require that broker-dealers
carrying accounts of other broker-dealers specify on proposed Form
Custody the identities of only affiliated broker-dealers that introduce
accounts to the carrying broker-dealer. Should the Commission require
that broker-dealers carrying accounts of other, unaffiliated, broker-
dealers specify on proposed Form Custody the identities of all broker-
dealers that introduce accounts to the carrying broker-dealer?
For purposes of defining the term ``affiliate'' in Item 4,
should the Commission use the Form BD definition of the term
``affiliate''? Is there a more appropriate definition? If so, which
definition? For example, should ownership by a carrying broker-dealer
of 10% or more of the common stock of the introducing broker-dealer
qualify such entities as affiliates?
E. Item 5--Trade Confirmations
Item 5 of proposed Form Custody would require broker-dealers to
disclose whether they send transaction confirmations to customers and
other accountholders by checking the appropriate ``Yes'' or ``No'' box.
Confirmations are important safeguards that enable customers to monitor
transactions that occur in their securities accounts. Timely
confirmations would alert customers of unauthorized transactions and
would provide customers with an opportunity to object to the
transactions.
Exchange Act Rule 10b-10 specifies the information a broker-dealer
must disclose to customers on a trade confirmation at or before
completion of a securities transaction.\144\ Generally, Rule 10b-10
requires a confirmation to include, among other things: (1) The date
and time of the transaction and the identity, price, and number of
shares or units (or principal amount) of such security purchased or
sold by such customer; (2) the broker-dealer's capacity (agent or
principal) and its compensation; (3) the source and amount of any third
party remuneration it has received or will receive; and (4) other
information, both general (e.g., that the broker-dealer is not a SIPC
member, if such is the case) and transaction-specific (e.g., certain
yield
[[Page 37590]]
information in most transactions involving debt securities).
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\144\ 17 CFR 240.10b-10.
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The information contained on a trade confirmation should reconcile
with customer statements and the broker-dealer's journal entries.\145\
In this regard, there is a direct link between trade confirmations sent
by a broker-dealer and the broker-dealer's custody of customer
assets.\146\ How a broker-dealer answers Item 5 of proposed Form
Custody could assist examiners in focusing their inspection. For
example, if a broker-dealer claims that a third-party is responsible
for sending trade confirmations, the examiners can confirm with that
third-party that it is sending them on behalf of the broker-dealer.
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\145\ See 17 CFR 240.17a-3(a)(1), which requires the broker-
dealer to make ``blotters'' ``(or other records of original entry)
containing an itemized daily record of all purchases and sales of
securities, all receipts and deliveries of securities (including
certificate numbers), all receipts and disbursements of cash and all
other debits and credits. Such records shall show the account for
which each such transaction was effected, the name and amount of
securities, the unit and aggregate purchase or sale price (if any),
the trade date, and the name or other designation of the person from
whom purchased or received or to whom sold or delivered.''
\146\ Although broker-dealers may allocate the function of
sending confirmations to other broker-dealers or to service
providers, the broker-dealer retains the responsibility for sending
confirmations. See New York Stock Exchange, Inc.; Order Approving
Proposed Rule Change, Exchange Act Release No. 18497 (Feb. 19,
1982), 47 FR 8284 (Feb. 25, 1982) at note 2 (``* * * no contractual
arrangement for the allocation of functions between an introducing
and carrying organization can operate to relieve either organization
from their respective responsibilities under the federal securities
laws and applicable SRO rules'').
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The Commission generally requests comment on all aspects of
proposed Item 5. In addition, the Commission requests comment on the
following questions relating to proposed Item 5:
If the broker-dealer answers ``No'' to Item 5.A, what
information in addition to the identity of the broker-dealer that sends
the confirmations would be useful to elicit in the form? For example,
if the broker-dealer is a party to a carrying agreement pursuant to
which a carrying broker-dealer agrees to issue trade confirmations for
the broker-dealer, should the Commission require the broker-dealer to
identify the date the agreement was made with the carrying broker-
dealer and/or which SRO approved the carrying agreement?
If the broker-dealer answers ``Yes'' to Item 5.A, and the
broker-dealer has hired a third party service provider to prepare and
send trade confirmations on the broker-dealer's behalf, should the
broker-dealer be required to disclose the name of the third party
service provider?
Is there any additional information related to trade
confirmations that the Commission should request in Item 5?
F. Item 6--Account Statements
Item 6 of proposed Form Custody would require broker-dealers to
disclose whether they send account statements directly to customers and
other accountholders by checking the appropriate ``Yes'' or ``No'' box.
Account statements generally are sent to customers and other
accountholders on a monthly or quarterly basis and typically set forth
the assets held in the investor's securities account as of a specific
date and the transactions that occurred in the account during the
relevant period. SROs impose requirements on broker-dealers with
respect to the statements they must send to their customers.\147\ For
example, FINRA generally requires any member that conducts a general
securities business and also carries customer accounts or holds
customer funds or securities, at least once each calendar quarter, to
send an account statement to each customer whose account had a security
position, money balance, or account activity since the last statement
was sent.\148\ The account statement must contain a description of any
securities positions, money balances, or account activity in the
account. In addition, the account statement must include a statement
that advises the customer to report promptly any inaccuracy or
discrepancy in that person's account to the brokerage firm.\149\ The
statement also is required to advise the customer that any oral
communications made to the broker-dealer regarding inaccuracies or
discrepancies should be re-confirmed in writing to further protect the
customer's rights, including rights under SIPA.\150\
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\147\ See NASD Rule 2340 (Customer Account Statements) and NYSE
Rule 409 (Statements of Accounts to Customers).
\148\ See NASD Rule 2340, which defines a ``general securities
member'' as any member that conducts a general securities business
and is required to calculate its net capital pursuant to Rule 15c3-
1. Additionally, NASD Rule 2340 defines ``account activity'' broadly
so that it includes, but is not limited to, purchases, sales,
interest credits or debits, charges or credits, dividend payments,
transfer activity, securities receipts or deliveries and/or journal
entries relating to securities or funds in the possession or control
of the member. See also Exchange Act Release No. 54411 (Sept. 7,
2006), 71 FR 54105 (Sept. 13, 2006) (order granting approval of a
proposed rule change relating to Rule 2340 concerning customer
account statements).
\149\ If the customer's account is serviced by both an
introducing broker-dealer and a clearing broker-dealer, the
statement must inform customers that such reports must be made to
both firms. See NASD Rule 2340(a).
\150\ Id.
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Like trade confirmations, account statements are important investor
safeguards to monitor transactions that occur in an investor's
securities account. As noted above, an introducing broker-dealer and
clearing broker-dealer that are parties to a carrying agreement may
allocate the sending of account statements to the clearing broker-
dealer.\151\ If the allocation has been made to a broker-dealer other
than the broker-dealer completing Form Custody, this would be disclosed
on the Form in Item 6.B. Item 6.C would elicit whether the broker-
dealer sends account statements to anyone other than the beneficial
owner of the account.\152\
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\151\ As with trade confirmations, broker-dealers can allocate
the function but not the responsibility; see supra note 146.
\152\ Generally, the beneficial owner of an account represents
the person entitled to the economic benefits of ownership. With
respect to securities, the term beneficial owner is defined in Rule
13d-3 under the Exchange Act (17 CFR 240.13d-3).
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The Commission is proposing to require broker-dealers to answer the
questions in Item 6 to enhance its understanding of a broker-dealer's
relationship with customers, particularly in the context of the broker-
dealer's custodial responsibilities. The Commission notes that broker-
dealers do not currently disclose to the Commission whether they send
account statements directly to customers. Collecting this information
on proposed Form Custody would provide examiners with additional
background information that could be used to refine the focus of their
inspections. Further, the Commission anticipates that examiners would
make further inquiries to the extent the Form reveals answers that are
inconsistent with industry practice.
A review of Item 6 also may facilitate an examiner's preparation
for an inspection. For example, if a broker-dealer indicates on Form
Custody that it holds customer accounts and sends account statements to
customers, the examiner could prepare a more targeted document request
to the broker-dealer. In this regard, an examiner could request
customer account statements from the broker-dealer, as well as
statements from the custodian(s) of the broker-dealer's customer
assets, which would be disclosed in response to Item 3.C. of Form
Custody. Examiners could then review and reconcile these documents to
verify whether customer assets are held at the custodian(s) identified
by the broker-dealer.
The Commission generally requests comment on all aspects of
proposed Item 6. In addition, the Commission requests comment on the
following questions relating to proposed Item 6:
[[Page 37591]]
If the broker-dealer answers ``No'' to Item 6.A, what
information in addition to the identity of the broker-dealer that sends
the account statements would be useful to elicit in the form?
If a broker-dealer sends account statements to persons
other than the beneficial owner of the account, should the Commission
require the broker-dealer to explain why those persons receive account
statements from the broker-dealer?
G. Item 7--Electronic Access To Account Information
Item 7 of proposed Form Custody would require broker-dealers to
indicate whether they provide customers and other accountholders with
electronic access to information about the securities and cash
positions in their accounts by checking the appropriate ``Yes'' or
``No'' box. Electronic access to account information can provide
investors with an efficient means of monitoring transactions that occur
in their securities accounts. This inquiry would inform the Commission
as to how readily customers are able to access and review their account
information.
The Commission preliminarily believes that electronic access to
account information is beneficial to customers, who can more easily
monitor the performance of their accounts and perhaps more quickly
identify any discrepancies or inaccuracies. The Commission proposes to
include this item in proposed Form Custody because it would help to
inform examiners as to how readily customers can access and review
account information.
The Commission generally requests comment on all aspects of Item 7
to Form Custody. In addition, the Commission requests comment on the
following questions related to Item 7:
If a broker-dealer checks ``Yes'' in response to Item 7,
should the Commission require additional disclosure on Form Custody
relating to the types of electronic access the broker-dealer provides
to customers and other accountholders?
If a broker-dealer checks ``Yes'' in response to Item 7,
should the Commission require broker-dealers to indicate on Form
Custody if customers that elect to receive certain account-related
communications (e.g., trade confirmations) electronically also are sent
copies of those documents via mail or whether they are limited to
accessing those documents electronically?
H. Item 8--Broker-Dealers Registered as Investment Advisers
Item 8 of proposed Form Custody would elicit information, if
applicable, about whether and how the broker-dealer operates as an
investment adviser. The first question in proposed Item 8.A would
require the broker-dealer to indicate whether it is registered as an
investment adviser with the Commission under the Advisers Act or with
one or more states pursuant to the laws of a state.\153\ If the broker-
dealer indicates that it is registered with the Commission under the
Advisers Act or pursuant to state law (or both), then it would be
required to respond to the remaining questions under proposed Item 8.
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\153\ Section 203A of the Advisers Act prohibits certain
investment advisers from registering with the Commission, based on
the advisers' assets under management, among other factors.
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Proposed Item 8.B. would require the broker-dealer to disclose the
number of clients it has as an investment adviser. This would provide
the Commission with information about the scale of the broker-dealer's
investment adviser activities.
Proposed Items 8.C would require the broker-dealer to complete a
chart, which would consist of six columns, in which the broker-dealer
would provide information about the custodians where the assets of the
investment adviser clients are held.\154\
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\154\ Under the IA Custody Rule, it is a ``fraudulent,
deceptive, or manipulative act, practice or course of business'' for
an investment adviser registered or required to be registered under
Section 203 of the Advisers Act to have custody of client funds or
securities unless, among other things, a qualified custodian
maintains those funds or securities. See Rule 206(4)-2. The
Commission defines a qualified custodian as: (1) A bank as defined
in Section 202(a)(2) of the Advisers Act or savings association as
defined in Section 3(b)(1) of the Federal Deposit Insurance Act (12
U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit
Insurance Corporation under the Federal Deposit Insurance Act (2
U.S.C. 1811); (2) a broker-dealer registered under Section 15(b)(1)
of the Exchange Act holding the client assets in customer accounts;
(3) an FCM registered under Section 4f(a) of the Commodity Exchange
Act (7 U.S.C. 6f(a)), holding the client assets in customer
accounts, but only with respect to clients' funds and security
futures, or other securities incidental to transactions in contracts
for the purchase or sale of a commodity for future delivery and
options thereon; and (4) a foreign financial institution that
customarily holds financial assets for its customers, provided that
the foreign financial institution keeps the advisory clients' assets
in customer accounts segregated from its proprietary assets. See
Rule 206(4)-2(d)(6). The Commission requires that the qualified
custodian maintain client funds and securities: (1) In a separate
account for each client under that client's name; or (2) in accounts
that contain only the clients' funds and securities, under the
investment adviser's name as agent or trustee for the clients. See
Rule 206(4)-2(a)(1).
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In the first column, the broker-dealer would be required to
disclose the name of the custodian, and in the second column, the
broker-dealer would be required to identify the custodian by either SEC
file number or CRD number, as applicable.
The third and fourth columns of the chart would elicit information
about the scope of the broker-dealer/investment adviser's authority
over the accounts held at the custodian by requiring the broker-dealer/
investment adviser to check the appropriate ``Yes'' or ``No'' box.
Specifically, in the third column, the broker-dealer/investment adviser
would indicate whether it has the authority to effect transactions in
the advisory client accounts at the custodian. In the fourth column,
the broker-dealer/investment adviser would indicate whether it has the
authority to withdraw funds and securities out of the accounts at the
custodian.
In the fifth column, the broker-dealer/investment adviser would
indicate whether the custodian sends account statements directly to the
investment adviser clients. The Commission recently adopted amendments
to the IA Custody Rule to require that investment advisers have a
reasonable basis, after due inquiry, for believing that qualified
custodians of advisory client assets send account statements to the
investment advisers' clients. As stated in the release adopting that
requirement, the Commission believes that the direct delivery of
account statements by qualified custodians will provide greater
assurance of the integrity of account statements received by
clients.\155\
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\155\ See, e.g., Custody of Funds or Securities by Investment
Advisers, Advisers Act Release No. 2876 (May 20, 2009), 74 FR 25354
(May 27, 2009) (proposing release); Advisers Act Release No. 2968
(Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010) (adopting release).
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In the sixth column, the broker-dealer/investment adviser would
indicate whether investment adviser client assets are recorded on the
broker-dealer's stock record. If the broker-dealer is acting as
custodian for such assets, the Commission anticipates that those assets
would be recorded on the stock record.
The information solicited in Item 8 differs from the information
that would be elicited in Item 3, because Item 3 requires a broker-
dealer to provide detailed information about its custodial functions.
In contrast, the goal of the information elicited in Item 8 is to
assist the Commission and DEA examiners in developing a profile of the
firm with respect to its functions as an investment adviser, and not as
a custodian.
The Commission generally requests comment on all aspects of
proposed Item 8. In addition, the Commission requests comment on the
following questions:
Should the Commission request additional information from
dually-registered broker-dealer/investment
[[Page 37592]]
advisers in the chart located in Item 8.C? If so, what information
should the Commission request?
Should the Commission require broker-dealer/investment
advisers to disclose the type of client assets held by custodians
(e.g., fixed income securities or equity securities, etc.)?
Should the Commission amend the charts in Item 8 to
require broker-dealer/investment advisers to disclose the dollar amount
of assets held at the custodian in ranges?
I. Item 9--Broker-Dealers Affiliated with Investment Advisers
Item 9 of Form Custody would elicit information concerning whether
the broker-dealer is an affiliate of an investment adviser. For these
purposes, an affiliate is any person who directly or indirectly
controls the broker-dealer or any person who is directly or indirectly
controlled by or under common control with the broker-dealer. Ownership
of 25% or more of the common stock of the investment adviser is deemed
prima facie evidence of control.\156\ If the broker-dealer is such an
affiliate, Item 9 would also elicit information concerning whether the
broker-dealer has custody of client assets of an affiliated investment
advisor and, if so, the approximate U.S. dollar market value of the
assets.
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\156\ See supra note 141 and corresponding text which specifies
the same ownership percentage on Form BD.
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The Commission generally requests comment on all aspects of
proposed Item 9. In addition, the Commission requests comment on the
following question related to Item 9:
Should the Commission define affiliate differently? Should
the Commission use a different percentage of ownership for prima facie
evidence of control?
J. Proposed Text Amendments To Require the Filing of Form Custody
The Commission is proposing to add a new paragraph (a)(5) to Rule
17a-5 to implement the Form Custody filing requirement. Specifically,
proposed paragraph (a)(5) would provide that ``[e]very broker or dealer
subject to this paragraph (a) shall file Form Custody with its
designated examining authority within 17 business days after the end of
each calendar quarter and within 17 business days after the date
selected for the annual reports where said date is other than the end
of a calendar quarter. The designated examining authority shall
maintain the information obtained through the filing of the Form
Custody and transmit such information to the Commission.'' \157\ The
proposed language, including filing proposed Form Custody within 17
business days after the end of each calendar quarter, is the same as
the existing requirements under Rule 17a-5 pertaining to the time frame
for broker-dealers to file their FOCUS Reports,\158\ and the
maintenance of the FOCUS Reports filed with the DEAs.\159\
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\157\ See proposed paragraph (a)(5) of Rule 17a-5. The
Commission proposes to amend the numbering of the remaining
subparagraphs--for example, current paragraph (a)(5) of Rule 17a-5
would be renumbered as paragraph (a)(6) and current paragraph (a)(6)
would be renumbered as paragraph (a)(7).
\158\ See Rule 17a-5(a)(2)(ii).
\159\ See Rule 17a-5(a)(4).
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The Commission generally requests comment on all aspects of
proposed new paragraph (a)(5) of Rule 17a-5. In addition, the
Commission requests comment on the following question related to
proposed new paragraph (a)(5):
Should the Commission require the proposed Form Custody be
filed on a different schedule? If so, what schedule?
K. General Solicitation of Comments on Form Custody
In addition to the questions above with respect to the specific
Items of Form Custody, the Commission requests comment more generally
on the overall approach of the proposal. In addition, the Commission
requests comment on the following questions:
Should the Commission require that the broker-dealer
engage an independent public accountant with respect to Form Custody?
If so, what level of engagement should be required? For example, should
the Form Custody be audited by the independent public accountant?
V. Additional Amendments to Rule 17a-5
In addition to the proposed amendments discussed above and their
corresponding technical amendments, the Commission proposes several
``clean up'' amendments to Rule 17a-5 that would modernize the rule and
delete unnecessary or outdated provisions.
A. Requirement To File Annual Reports
The Commission proposes to amend paragraph (d)(6) of Rule 17a-5 to
provide that copies of the annual reports shall be provided to all SROs
of which the broker-dealer is a member ``unless the self-regulatory
organization by rule waives this requirement.'' The Commission proposes
this addition because in some cases SROs do not believe it is necessary
to receive copies of broker-dealer annual reports, particularly when
they are not the broker-dealer's DEA.
The Commission also proposes to amend paragraph (d)(6) of Rule 17a-
5 to require broker-dealers to file copies of their annual reports with
SIPC. As discussed above, SIPC may be required to fund the liquidation
of a broker-dealer that cannot wind itself down in an orderly fashion.
As part of the liquidation process, SIPC may be required to advance up
to $500,000 per customer to satisfy claims for cash and securities of
which $250,000 can be used to satisfy claims for cash.\160\ In order to
pay for these liquidations and advances, SIPC maintains the SIPC Fund.
This SIPC Fund is established and maintained by collecting assessments
from broker-dealers that are required to be members of SIPC.\161\
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\160\ 15 U.S.C. 78fff-3(a), (d).
\161\ 15 U.S.C. 78ddd.
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In some cases where SIPC has used the SIPC Fund to liquidate failed
broker-dealers and make advances to customers, SIPC has not been able
to recover the money advanced because the estate of the failed broker-
dealer had insufficient assets.\162\ SIPC has sought to recover money
damages from auditing firms, but at least one court has held under New
York law that SIPC could not maintain a claim because it was not a
recipient of the annual audit filing and could not have relied on
it.\163\ Therefore, if SIPC had received a copy of the annual reports
as contemplated under this proposed amendment, SIPC could have brought
a claim against the auditing firm. In addition, the filing of annual
reports with SIPC could allow it to better monitor industry trends and
enhance its knowledge of particular firms.
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\162\ The most recent example of a SIPA liquidation in which
SIPC does not expect to recover money advanced to a trustee is the
liquidation of Bernard L. Madoff Investment Securities LLC. SIPC
2010 Annual Report, p.18, available at http://www.sipc.org/pdf/2010%20Annual%20Report.pdf.
\163\ See SIPC v. BDO Seidman, LLP, 746 N.E.2d 1042 (N.Y. 2001).
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The Commission generally requests comment on all aspects of these
proposed amendments. In addition, the Commission requests comment on
the following question related to the proposal:
Rather than filing the annual reports directly with SIPC,
should the Commission propose that the broker-dealers make the reports
available to SIPC upon request? If so, why? If no, why not?
B. Confidentiality of Annual Reports
The Commission also proposes to update the method in which broker-
[[Page 37593]]
dealers request that their annual reports be filed with the Commission
on a confidential basis. Currently, under paragraph (e)(3) of Rule 17a-
5, in order for a broker-dealer to receive confidential treatment for
the financial statements it files with the Commission, other than the
Statement of Financial Condition, the broker-dealer must bind the
Statement of Financial Condition separately from the remaining
financial statements and denote the Statement of Financial Condition as
``Public'' and the separate document as ``Confidential.''\164\ The
wording of this provision has led to confusion, resulting in inquiries
to the Commission staff on how broker-dealers can receive confidential
treatment for financial statements filed with the Commission under
paragraph (e)(3) of Rule 17a-5, and, on occasion, broker-dealers
inadvertently making publicly available financial statements intended
to be confidential. The Commission proposes that broker-dealers
continue to bind separately the Statement of Financial Condition from
the remaining pages of the annual reports. In order to provide better
clarity as to which part of the annual report is public and which part
should be kept confidential, the Commission proposes to require that
the broker-dealer stamp each page of the separately bound confidential
portion of its annual reports as ``Confidential.''
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\164\ The Commission's Web site provides guidance that the
public and non-public portions of the financial statements must be
clearly segregated and the Facing Page must be appropriately marked.
For example, the Facing Page attached to the Statement of Financial
Condition should not be marked ``Confidential.'' Further, if the
Statement of Financial Condition is not bound separately or placed
in a separate package, then, in accordance with Rule 17a-5(e)(3),
none of the statements will be accorded confidential treatment. See
``Broker-Dealer Notices and Reports'' at http://www.sec.gov/divisions/marketreg/bdnotices.htm.
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Paragraph (e)(3) of Rule 17a-5 currently provides that the annual
reports, including the confidential portions, shall be available, for
example, for official use by any official or employee of the U.S., and
national securities exchanges and registered national securities
associations of which the person filing is a member. The Commission
proposes to amend paragraph (e)(3) of Rule 17a-5 to include the PCAOB
as a permitted recipient. The Commission further proposes to amend
paragraph (e)(3) of Rule 17a-5 by updating references to the revised
rule and reflecting the proposed Annual Audit Reports.
The Commission generally requests comment on all aspects of this
proposed amendment. In addition, the Commission requests comment on the
following question related to the proposal:
Would this proposed amendment be the simplest method to
request confidentiality treatment, or is there a better alternative?
C. Removing Obsolete Provisions
The Commission proposes to delete paragraph (e)(5) of Rule 17a-5 in
its entirety because the provisions are now moot. Paragraph (e)(5) of
Rule 17a-5 discusses the requirement for broker-dealers to file Form
BD-Y2K. Form BD-Y2K elicited information with respect to the broker-
dealer's readiness for the year 2000 and any potential problems that
could arise with the advent of the new millennium.\165\ Form BD-Y2K was
required to be filed in April of 1999 and only then.
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\165\ See Reports to be Made by Certain Brokers and Dealers,
Exchange Act Release No. 40608 (Oct. 28, 1998), 63 FR 59208 (Nov.
3,1998).
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D. Classification of Qualified Accountant
The Commission proposes to amend paragraph (f)(1) of Rule 17a-5,
which determines how the Commission classifies a qualified independent
public accountant, by adding a sentence to the paragraph stating that
the ``accountant must be registered with the Public Company Accounting
Oversight Board if required by the Sarbanes-Oxley Act of 2002.'' This
is a technical, non-substantive amendment because broker-dealer
accountants are already required to be registered with the PCAOB.
E. Technical Amendments
The Commission proposes to delete paragraph (b)(6) of Rule 17a-5,
which currently provides that a ``copy of the annual audit report shall
be filed at the regional office of the Commission for the region in
which the broker or dealer has its principal place of business and the
principal office of the designated examining authority for said broker
or dealer. Two copies of said report shall be filed at the Commission's
principal office in Washington, DC. Copies thereof shall be provided to
all self-regulatory organizations of which said broker or dealer is a
member.'' The Commission proposes to delete this paragraph because it
is redundant to the requirement in paragraph (d)(6) of the rule.\166\
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\166\ As previously discussed, the Commission proposes to amend
paragraph (d)(6) of Rule 17a-5 to require that a copy of the annual
report be filed with SIPC. Specifically, the Commission proposes
that paragraph (d)(6) provide that the annual reports shall ``be
filed at the regional office of the Commission for the region in
which the broker or dealer has its principal place of business, the
Commission's principal office in Washington, DC, and the principal
office of the designated examining authority for said broker or
dealer and with the Securities Investor Protection Corporation.
Copies thereof shall be provided to all self-regulatory
organizations of which said broker or dealer is a member, unless the
self-regulatory organization by rule waives this requirement.''
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For consistency purposes, the Commission proposes to delete
references to ``balance sheet'' and replace them with references to
``Statement of Financial Condition.'' \167\
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\167\ See, e.g., Rule 17a-5(c)(2)(i).
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The Commission also proposes technical amendments to paragraph
(e)(1)(i) of Rule 17a-5. Paragraph (e)(1)(i) provides the exemption for
broker-dealers that are not required to engage an independent public
accountant to audit their financial statements. The technical
amendments that the Commission is proposing include updating references
and clarifying the existing language.\168\ The Commission also proposes
technical amendments to paragraph (e)(1)(ii) of Rule 17a-5, which
requires a broker-dealer to include an oath or affirmation related to
the claimed exemption from the annual audit requirement. Specifically,
the Commission proposes to update references and other non-substantive
changes to the text of the paragraph.
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\168\ See, e.g., proposed Rule 17a-5(e)(1).
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Further, the Commission is proposing to amend paragraph
(e)(4)(iii)(F) of Rule 17a-5 to correct an inaccurate reference to a
form filed in connection with the SIPC Reports. Currently, paragraph
(e)(4)(iii)(F) refers to the ``Certificate of Exclusion from
Membership'' as Form SIPC-7. The proposed amendments would change the
reference in proposed paragraph (e)(4)(iii)(F) from Form SIPC-7 to Form
SIPC-3 in proposed paragraph (e)(4)(ii)(C).
In addition, the Commission is proposing to amend paragraphs (f)(1)
and (f)(3) of Rule 17a-5. Currently, paragraph (f)(1) of Rule 17a-5
contains the ``Qualification of accountants.'' Specifically, paragraph
(f)(1) states that the ``Commission will not recognize any person as a
certified public accountant who is not duly registered and in good
standing as such under the laws of his place of residence or principal
office. The Commission will not recognize any person as a public
accountant who is not in good standing and entitled to practice as such
under the laws of his place of residence or principal office.'' \169\
Paragraph (f)(3) of Rule 17a-5 contains the requirement for
independence: ``[a]n accountant shall be independent in accordance with
the provisions of Sec. 210.2-01(b) and (c) of
[[Page 37594]]
this chapter.'' The Commission proposes to delete paragraph (f)(3) and
amend (f)(1) to state that ``the independent public accountant must be
qualified and independent in accordance with Sec. 210.2-01 of this
chapter. In addition, the accountant must be registered with the Public
Company Accounting Oversight Board if required by the Sarbanes-Oxley
Act of 2002.'' The Commission is proposing this technical amendment to
update the definition of an independent public accountant to be
consistent with other Commission rules. Furthermore, by citing to Sec.
210.2-01 in its entirety, rather than the provisions of (b) and (c),
the text of (f)(1) becomes unnecessary. The Commission is also
proposing a conforming amendment to paragraph (f)(4), which contains a
notice provision concerning the replacement of the broker-dealer's
independent public accountant. Paragraph (f)(4) would be renumbered as
(f)(3).
---------------------------------------------------------------------------
\169\ See Rule 17a-5(f)(1).
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The Commission is proposing to delete paragraph (i)(5) of Rule 17a-
5, which provides that the terms ``audit,'' ``accountant's report,''
and ``certified'' ``shall have the meanings given in Sec. 210.1-02 of
this chapter.'' The Commission is proposing to delete this paragraph
because the terms are defined under existing auditing standards
promulgated by the PCAOB.
The Commission is proposing additional technical amendments
throughout Rule 17a-5, including changes to consistently use the
defined term ``independent public accountant'' \170\ and to make the
rule gender neutral.\171\
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\170\ See, e.g., proposed paragraph (f)(4) of Rule 17a-5.
\171\ Id.
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The Commission generally requests comment on all aspects
of the amendments proposed in this Section V.
VI. Paperwork Reduction Act
The proposed amendments to Rule 17a-5 contain a ``collection of
information'' within the meaning of the Paperwork Reduction Act of 1995
(``PRA''). The Commission is submitting the proposed amendments and the
proposed new collection to the Office of Management and Budget
(``OMB'') for review in accordance with the PRA. An agency may not
conduct or sponsor, and a person is not required to comply with, a
collection of information unless it displays a currently valid control
number. The titles for the collections of information are:
(1) Rule 17a-5, Reports to be made by certain brokers and dealers
(OMB Control Number 3235-0123);
(2) Rule 17a-11, Notification provisions for brokers and dealers
(OMB Control Number 3235-0085); and
(3) Form Custody (a proposed new collection of information).
A. Collections of Information Under the Proposed Rule Amendments
As discussed above, the Commission is proposing three sets of
amendments to Rule 17a-5. The first set of proposed amendments, the
Annual Reporting Amendments, would: (1) Update the existing
requirements of the rule; (2) facilitate the PCAOB with its inspection
and oversight authority over broker-dealer independent public
accountants; and (3) enable a broker-dealer to use a single report to
satisfy the proposed requirements under Rule 17a-5 and the IA Custody
Rule's internal control report requirement.
The second set of proposed amendments, the Access to Audit
Documentation Amendments, applies only to clearing broker-dealers. The
Access to Audit Documentation Amendments are designed to facilitate the
communication between a clearing broker-dealer's independent public
accountant and representatives of Commission and the DEA. Additionally,
the Access to Audit Documentation Amendments are designed to enable
representatives of the Commission and the DEA of the clearing broker-
dealer, in the scope of their examination of the firm, to have access
to the audit documentation related to the examination of the broker-
dealer.
The third set of proposed amendments, the Form Custody Amendments,
would enhance the information received by the Commission and DEAs with
respect to the custody practices of broker-dealers by requiring broker-
dealers to file on a quarterly basis a new Form Custody. Proposed Form
Custody would elicit information as to whether and how a broker-dealer
maintains custody of cash and securities of customers and others.
Each set of proposed amendments has a corresponding paperwork
burden, which is addressed below.
B. Proposed Use of Information
As discussed above, the Commission is proposing three sets of
amendments to Rule 17a-5. The first set of proposed amendments, the
Annual Reporting Amendments, would require a broker-dealer to either
file a Compliance Report or an Exemption Report as part of its annual
audit requirements under Rule 17a-5. The Compliance Report would be
filed by a carrying broker-dealer and contain assertions by the broker-
dealer with respect to the Financial Responsibility Rules. The
Exemption Report would be filed by a broker-dealer that claims an
exemption from Rule 15c3-3 because it does not operate as a carrying
broker-dealer and would contain an assertion as to the basis for the
claimed exemption. In addition, the broker-dealer would be required to
engage an independent public accountant to provide a report addressing
the accuracy of the assertions in either the Compliance Report or
Exemption Report, as applicable.
The Commission preliminarily believes that the information gathered
from the proposed Annual Reporting Amendments would assist the PCAOB in
establishing an effective oversight and inspection program over the
independent public accountants of broker-dealers, and it would enable
broker-dealers that are jointly registered as investment advisers to
use a single report to satisfy the proposed requirements under Rule
17a-5 and the IA Custody Rule's internal control report requirement.
The second set of proposed amendments, the Access to Audit
Documentation Amendments, would provide the Commission and DEA
examiners with access to clearing broker-dealer independent public
accountants to discuss the independent public accountants' findings
with respect to broker-dealer annual audit reports and to review audit
documentation associated with those reports. Specifically, the
amendments would require a representation from the clearing broker-
dealer that it agrees to permit its independent public accountant to
discuss with representatives of the Commission the findings with
respect to annual audit reports of broker-dealers and review the
related audit documentation. These proposed amendments would provide
another tool to Commission and DEA examiners of broker-dealers by
providing access to additional relevant information.
The third set of proposed amendments, the Form Custody Amendments,
would establish a new Form Custody that the broker-dealer would need to
include when filing its quarterly FOCUS Reports. Form Custody would
elicit information as to whether and how a broker-dealer maintains
custody of cash and securities of customers and others. The Commission
preliminarily believes that proposed Form Custody would provide more
detailed information about a broker-dealer's custodial activities.
Moreover, proposed Form Custody could assist in expediting the
[[Page 37595]]
Commission's or DEA's examination of a broker-dealer's custodial
activities as examiners would no longer need to request basic custody-
related information already disclosed on the form.
C. Respondents
The applicability of the proposed amendments discussed in this
release depends on how a broker-dealer conducts its business. There are
5,063 broker-dealers registered with the Commission as of year-end
2009. Of the 5,063 registered broker-dealers, 305 broker-dealers are
carrying broker-dealers--i.e., broker-dealers that maintain custody of
customer funds and/or securities and are required to comply with the
customer protection provisions of Rule 15c3-3. The type of report a
broker-dealer would be required to file under the proposed Annual
Reporting Amendments would be based on whether a broker-dealer is a
carrying broker-dealer subject to Rule 15c3-3, or is exempt from Rule
15c3-3. Carrying broker-dealers would be required to file Compliance
Reports under the proposed Annual Reporting Amendments. Broker-dealers
exempt from Rule 15c3-3 would be required to file Exemption Reports.
There are 4,752 broker-dealers that claim exemptions to Rule 15c3-3.
\172\ The Commission estimates 305 carrying broker-dealer respondents
would file the proposed Compliance Report and 4,752 non-carrying
broker-dealer respondents would file the proposed Exemption Report
under the Annual Reporting Amendments.\173\
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\172\ These numbers are based on FOCUS Report data as of year-
end 2009. See supra note 126 for a description of the FOCUS Report.
As discussed in note 126, FOCUS Reports are deemed to be
confidential pursuant to paragraph (a)(3) of Rule 17a-5.
\173\ There are 4,752 broker-dealers that claim an exemption to
Rule 15c3-3.
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The Access to Audit Documentation Amendments would apply to
clearing broker-dealers, which, as defined above, includes broker-
dealers that clear transactions or carry customer accounts. There are
528 clearing broker-dealers based on year-end 2009 FOCUS Report data,
and, accordingly, the Commission estimates that there would be 528
broker-dealer respondents with respect to the Access to Audit
Documentation Amendments.\174\
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\174\ The clearing broker-dealers would be required to respond
to the paperwork burdens associated with the Access to Audit
Documentation Amendments, and 528 broker-dealers represent the
number of Part II FOCUS filers.
---------------------------------------------------------------------------
The Commission estimates that there would be approximately 5,057
broker-dealer respondents with respect to the Form Custody
Amendments.\175\
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\175\ Carrying broker-dealers and non-carrying broker-dealers
would be required to file Form Custody; 305 + 4,752 = 5,057.
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Additionally, the Commission estimates that there could be
approximately 550 independent public accountants affected by the
amendments. This number represents the number of independent public
accountants registered with the PCAOB that are engaged to perform
broker-dealer audits.
The Commission generally requests comment on all aspects of these
estimates. In addition, the Commission requests specific comment on the
following items related to these estimates:
Should the Commission use different estimates for the
number of respondents for the Annual Reporting Amendments? If so, what
estimates should the Commission use and why? What are the sources of
these estimates?
Should the Commission use different estimates for the
number of broker-dealer respondents for the Access to Audit
Documentation Amendments? If so, what estimates should the Commission
use and why? What are the sources of these estimates?
Should the Commission use a different estimate of the
number of independent public accountants that would be affected by the
amendments? If so, what estimate should the Commission use and why?
What is the source of this estimate?
Commenters should provide specific data and analysis to support any
comments they submit with respect to these estimates with respect to
the number of respondents.
D. Total Annual Recordkeeping and Reporting Burden
As discussed below, the Commission estimates the total
recordkeeping burden resulting from the proposed Rule 17a-5 amendments
would be approximately 287,325 hours on an annual basis \176\ and
10,214 hours on a one-time basis.\177\ The Commission notes that, given
the significant variance between the largest broker-dealer and the
smallest broker-dealer, the total annual and one-time hour burden
estimates described below are averages across all types of broker-
dealers expected to be affected by the proposed amendments.
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\176\ The total annual hour burden is estimated to be 287,325
hours (18,300 hours for the Compliance Report + 23,760 hours for the
Exemption Report + 2,529 hours for copies of the Annual Reports to
be filed with SIPC + 242,736 hours for Form Custody).
\177\ The total one-time burden is estimated to be 10,114 hours
for the revised Notice Designating Accountant (required for the
proposed Access to Audit Documentation Amendments) + 100 hours for
SIPC forms to be filed with respect to the SIPC proposal.
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1. Annual Reporting Amendments
a. Financial Reports Filed With the Commission
Currently, broker-dealers are required to file their annual audit
report, which, as discussed previously, the Commission proposes to
rename as the broker-dealer's ``Financial report'' in Rule 17a-5. The
Commission is not proposing any substantive changes to the financial
audit; therefore the Commission believes the hour burden for broker-
dealers with respect to financial reports would remain the same.\178\
As is discussed in Section V.E. of this release, the Commission is
proposing to delete paragraph (b)(6) of Rule 17a-5, which currently
provides that two copies of a broker-dealer's annual audit report be
filed at the Commission's principal office in Washington, DC, because
it is redundant with paragraph (d)(6) of Rule 17a-5, which requires
that only one copy of a broker-dealer's annual audit report be filed at
the Commission's principal office in Washington, DC. By deleting
paragraph (b)(6) of Rule 17a-5, only one copy of the annual audit
report would need to be filed with the Commission, rather than two,
which will result in a slight reduction in broker-dealers' hour burden
in providing related papers to the Commission.\179\
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\178\ The Commission notes that the financial audit would be
subject to standards promulgated by the PCAOB; however, this would
not change the Commission's prescribed reporting burden associated
with the financial audit.
\179\ As is discussed above in Section V.A. of this release,
broker-dealers would be required to file a copy of their annual
audit reports with SIPC under proposed paragraph (d)(6) of Rule 17a-
5, which would impose an annual hour burden on broker-dealers. This
burden is discussed below in Section VI.D.1.d of this release.
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The Commission requests comment on all aspects of these proposed
burden estimates. Commenters should provide specific data and analysis
to support any comments they submit with respect to these burden
estimates, if possible.
b. Compliance Report and Examination Report
The Commission proposes to require carrying broker-dealers to file
two new reports: (1) The proposed Compliance Report, which is prepared
by the carrying broker-dealer; and (2) the Examination Report, which is
prepared by the broker-dealer's independent public accountant as a
result of its examination of the Compliance
[[Page 37596]]
Report.\180\ Included in the Compliance Report would be a statement
that the carrying broker-dealer is responsible for establishing and
maintaining a system of internal control to provide the broker-dealer's
management with reasonable assurance that there are no instances of
material non-compliance with the Financial Responsibility Rules and
three assertions. The three assertions would be whether the broker-
dealer: (1) Was in compliance with Financial Responsibility Rules as of
its most recent fiscal year-end; (2) used information derived, in all
periods during the fiscal year, from the broker-dealer's books and
records; and (3) had a system of internal control over compliance with
these rules that was effective during the most recent fiscal year such
that there were no instances of material weakness.
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\180\ The Compliance Report and Examination Report are discussed
in Section II.B.2 of this release.
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The Commission preliminarily believes that broker-dealers would
validate, gather, and review records to enable them to make the
assertions in the proposed Compliance Report. The Commission estimates,
on average, that broker-dealers would spend an additional 60 hours to
perform the validation and evidence gathering.\181\ For all carrying
broker-dealers, we estimate the annual hour burden to be 18,300
hours.\182\
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\181\ The Commission's preliminary estimate of 60 hours is an
average based on the varying sizes of carrying broker-dealers and is
based on staff experience.
\182\ 60 hours x 305 carrying broker-dealers = 18,300. See infra
Economic Analysis Section for a discussion of the external cost
estimates associated with the independent public accountant
preparing the Examination Report based on an examination of the
Compliance Report.
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The Commission requests comment on all aspects of these proposed
burden estimates. Commenters should provide specific data and analysis
to support any comments they submit with respect to these burden
estimates, if possible.
c. Exemption Report
For a non-carrying broker-dealer claiming an exemption from Rule
15c3-3, the proposed Exemption Report would require the broker-dealer
to assert that it is exempt from Rule 15c3-3 and identify the provision
of the rule that it is relying on to qualify for the exemption. The
non-carrying broker-dealer would be required to include this assertion
in its Exemption Report to be filed with the Commission. The Commission
does not anticipate that this requirement will result in a significant
hourly burden because the broker-dealer has been operating under the
claimed exemption and is aware of what exemption it will claim on the
Exemption Report. Therefore, the hour burden associated with this
proposed amendment should be administrative and encompass the drafting
and filing of the report. Based on staff experience with broker-dealers
filing similar types of reports, the Commission estimates it should
take a non-carrying broker-dealer five hours to prepare the Exemption
Report and file the Exemption Report and copy of the associated
independent public accountant's report with the Commission and
applicable securities regulators. Thus, we estimate the annual hour
burden for broker-dealers required to file the Exemption Report and
associated independent public accountant's report would be 23,760
hours.\183\
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\183\ 5 hours x 4,752 non-carrying broker-dealers = 23,760
hours. See infra Economic Analysis Section for a discussion of the
external costs associated with engaging an independent public
accountant to prepare its report based on the review of the broker-
dealer's Exemption Report.
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The Commission requests comment on all aspects of these proposed
burden estimates. Commenters should provide specific data and analysis
to support any comments they submit with respect to these burden
estimates, if possible.
d. Copies of Annual Reports Filed With SIPC
The Commission is proposing that copies of broker-dealer annual
reports (including the Financial Report and either the Compliance
Report and corresponding independent public accountant's report based
on the Compliance Examination, or the Exemption Report and
corresponding independent public accountant's report based on the
review of the Exemption Report) be filed with SIPC. The Commission
estimates that broker-dealers would incur an administrative cost
associated with the additional filing. The Commission estimates that it
would take 30 minutes to prepare the additional copies and mail them to
SIPC. Therefore, the Commission estimates that there is an annual hour
burden of 2,529 with respect to this requirement.\184\
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\184\ 1/2 hour x 5,057 broker-dealers = 2,528.50 hours, which is
rounded up to 2,529 hours.
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The Commission requests comment on all aspects of these proposed
burden estimates. Commenters should provide specific data and analysis
to support any comments they submit with respect to these burden
estimates, if possible.
e. Notice of Designated Accountant
The Commission proposes amending Rule 17a-5(f)(2) and the Notice of
Designated Accountant. As discussed above, the Commission proposes to
require broker-dealers to state in their Notice that they have engaged
an independent public accountant pursuant to proposed paragraph (g) of
Rule 17a-5. Broker-dealers are currently required to file a Notice with
the Commission designating the independent public accountant who will
be conducting the broker-dealer's annual audit.
The Commission proposes to require that broker-dealers file a
revised Notice designating their independent public accountant and
containing the proposed new provisions in subparagraphs (D) through (G)
to Rule 17a-5(f)(2)(ii), as applicable. As previously discussed,
proposed new subparagraph (D) requires the broker-dealer to indicate
whether the engagement is for a single year or not. Proposed
subparagraph (E) requires the broker-dealer to make a representation
that the engagement of the independent public accountant by the broker
or dealer meets the required undertakings of paragraph (g).\185\ Each
clearing broker-dealer is required to make the following
representations: (1) That it agrees to allow representatives of the
Commission or its DEA, if requested for purposes of an examination of
the broker-dealer, to review the audit documentation associated with
the reports of the independent public accountant prepared pursuant to
paragraph (g) of Rule 17a-5; \186\ and (2) to permit the independent
public accountant to discuss with representatives of the Commission and
the DEA of the broker-dealer, if requested for purposes of an
examination of the broker-dealer, the findings associated with the
reports of the independent public accountant prepared pursuant to
paragraph (g) of Rule 17a-5.\187\
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\185\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
\186\ See proposed paragraph (f)(2)(ii)(F) of Rule 17a-5.
\187\ See proposed paragraph (f)(2)(ii)(G) of Rule 17a-5.
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The Commission notes that broker-dealers have previous versions of
the Notice containing the current required information that could be
used and revised to include the proposed new information. Therefore,
the Commission estimates that it would take a broker-dealer
approximately two hours to amend its existing Notice and file its new
Notice pursuant to the proposed amendments. This estimate includes the
time it would take a compliance officer and potentially other personnel
to review the revised Notice to ensure that it complies with the
proposed
[[Page 37597]]
requirements. The Commission notes that the Notice can be continuing in
nature and therefore the designation of an independent public
accountant can apply to successive audits. Thus, the Commission
estimates that the filing of the proposed new Notice would result in a
one-time burden for broker-dealers. The Commission further estimates
that this would be a one-time hour burden associated with revising and
filing the new Notice, which would total 10,114 hours for all broker-
dealers.\188\
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\188\ 2 hours x 5,057 broker-dealers = 10,114.
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The Commission requests comment on all aspects of these proposed
burden estimates. If possible, commenters should provide specific data
and analysis to support any comments they submit with respect to these
burden estimates.
f. SIPC Forms
As previously discussed, the Commission proposes to amend Rule 17a-
5 to provide that broker-dealers continue to file their required SIPC
Forms with the Commission and SIPC unless the Commission takes final
action to approve any proposed rule change SIPC may file for Commission
consideration to require the filing of the forms solely with SIPC.
Because broker-dealers are currently required to file the forms with
both the Commission and SIPC, the Commission does not believe there is
any change in the hour burden for broker-dealers to comply with this
requirement.
However, the Commission notes that SIPC would have to file a
proposed and final rule with the Commission, to, as discussed above,
require broker-dealers to file the SIPC Forms with SIPC. Based on staff
experience with filings related to SRO rule changes, the Commission
estimates that it would take, conservatively, 100 hours for SIPC to
prepare the filings necessary to require broker-dealers to file the
SIPC Forms solely with SIPC. Therefore, the one-time hour burden
associated with this requirement is 100 hours. Additionally, the
Commission notes that subsequent to the adoption of SIPC's rule, that
broker-dealers would benefit from only having to file the reports with
one entity.
The Commission requests comment on all aspects of these proposed
burden estimates. Commenters should provide specific data and analysis
to support any comments they submit with respect to these burden
estimates, if possible.
2. Access to Audit Documentation Amendment
The Commission proposes to amend Rule 17a-5 to require broker-
dealers to consent to allow representatives of the Commission and DEA
to speak with, and review the audit documentation of, their independent
public accountants, if requested in connection with a regulatory
examination. As previously discussed, the rule proposal would require
broker-dealers to amend and file a new Notice. As described above, the
Commission calculated the hour burden associated with amending the
Notice with respect to the proposed Annual Reporting. The Commission
believes the estimated hour burden includes, if applicable, the needed
representations associated with the Access to Audit Documentation.
The Commission requests comment on all aspects of these proposed
burden estimates. Commenters should provide specific data and analysis
to support any comments they submit with respect to these burden
estimates, if possible.
3. Proposed Form Custody
The Commission is proposing a new form--Form Custody--that is
designed to elicit information about whether and how a broker-dealer
maintains custody of customer assets and handles customer cash. As
discussed below, a broker-dealer would be required to file Form Custody
quarterly and with its annual audit reports. The goal is to create a
report that provides information about the custodial activities of
broker-dealers that can serve as a starting point for securities
regulators to undertake more in depth reviews as they deem appropriate.
As discussed above, the proposed form is comprised of nine line
items that elicit information about the broker-dealer's custodial
responsibilities and operations. Some of the items contain multiple
questions and also require the completion of charts or the disclosure
of additional data points in designated spaces on the form.
The Commission preliminarily believes that the hour burden
associated with the FOCUS Report provides an appropriate baseline for
estimating the hour burden associated with the proposed Form Custody
because the FOCUS Report is a broker-dealer report that requires the
broker-dealer to provide financial and operational information.\189\
Specifically, the Commission believes that the information the broker-
dealer uses to compute the required computation related to Rule 15c3-3
in the FOCUS Report can be used in answering the questions contained in
the proposed Form Custody. Thus, the Commission bases this estimate on
the current hour burden estimate for broker-dealers to complete their
FOCUS Reports, and that on average, each broker-dealer would require 12
hours to complete Form Custody.\190\ This results in an estimated
annual burden of 242,736 hours.\191\
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\189\ See supra note 126.
\190\ The Commission notes that the current PRA hour burden
estimate for the FOCUS Report filing is 12 hours. See SEC File No.
270-155, 75 FR 8759 (Feb. 25, 2010).
\191\ 5,057 x 4 = 20,228 annual responses x 12 hours = 242,736.
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The Commission requests comment on all aspects of these proposed
burden estimates. Commenters should provide specific data and analysis
to support any comments they submit with respect to these burden
estimates, if possible.
4. Technical Amendments to Rule 17a-5 and to Rule 17a-11
The Commission believes that the proposed technical amendments to
Rule 17a-5 (e.g., making the rule gender-neutral) \192\ would not
impose any additional time burden on broker-dealers. Additionally, the
Commission's proposed conforming amendment to paragraph (e) of Rule
17a-11 (eliminating a reference to current paragraph (h) of Rule 17a-5
and correcting references) is also technical in nature and should not
result in an additional hour burden.
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\192\ See supra discussion in Section V. E. for specified
technical amendments.
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E. Collection of Information Is Mandatory
The collection of information obligations imposed by the proposed
rule amendments and the proposed new rule would be mandatory for
broker-dealers that are registered with the Commission.
F. Confidentiality
The Commission notes that a broker-dealer can seek confidential
treatment for information filed with the Commission under existing laws
and rules governing confidential treatment.\193\ The Commission will
accord this information confidential treatment to the extent permitted
by law.\194\
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\193\ 15 U.S.C. 78o-7(k). A broker-dealer can request that the
Commission keep this information confidential. See Section 24 of the
Exchange Act (15 U.S.C. 78x), 17 CFR 240.24b-2, 17 CFR 200.80 and 17
CFR 200.83.
\194\ To the extent that the Commission receives confidential
information pursuant to this collection of information, such
information would be kept confidential, subject to the provisions of
the Freedom of Information Act. 5 U.S.C. 552.
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[[Page 37598]]
G. Request for Comment
Pursuant to 44 U.S.C. 3306(c)(2)(B), the Commission requests
comment on the proposed collections of information in order to: (1)
Evaluate whether the proposed collections of information are necessary
for the proper performance of the functions of the Commission,
including whether the information would have practical utility; (2)
evaluate the accuracy of the Commission's estimates of the burden of
the proposed collections of information; (3) determine whether there
are ways to enhance the quality, utility, and clarity of the
information to be collected; (4) evaluate whether there are ways to
minimize the burden of the collection of information on those who
respond, including through the use of automated collection techniques
or other forms of information technology; and (5) evaluate whether the
proposed rule amendments would have any effects on any other collection
of information not previously identified in this section.
Persons who desire to submit comments on the collection of
information requirements should direct their comments to the OMB,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090, and refer to File No. S7-23-11. OMB is
required to make a decision concerning the collections of information
between 30 and 60 days after publication of this document in the
Federal Register; therefore, comments to OMB are best assured of having
full effect if OMB receives them within 30 days of this publication.
Requests for the materials submitted to OMB by the Commission with
regard to these collections of information should be in writing, refer
to File No. S7-23-11, and be submitted to the Securities and Exchange
Commission, Office of Investor Education and Advocacy, 100 F Street,
NE., Washington, DC 20549.
VII. Economic Analysis
The Commission recognizes that there are costs associated with the
adoption of the proposed amendments to Rule 17a-5 and proposed Form
Custody that are separate from the hour burdens discussed in the
Paperwork Reduction Act. Thus, the Commission has identified certain
costs and benefits of the proposed rule amendments and requests comment
on all aspects of this cost-benefit analysis, including identification
and assessment of any costs and benefits not discussed in the
analysis.\195\ The Commission preliminarily believes that potential
costs incurred by a broker-dealer to comply with the proposed rule
amendments would depend on its size and the complexity of its business
activities. The size and complexity of broker-dealers vary
significantly. Therefore, their costs could vary significantly. The
Commission is providing estimates on the average cost per broker-dealer
taking into consideration the variance in size and complexity of the
business activities of broker-dealers. Any costs incurred would also
vary depending on whether the broker-dealers carry customer accounts or
not. For these reasons, the cost estimates represent the average cost
across all broker-dealers.
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\195\ For the purposes of this cost/benefit analysis, the
Commission is using salary data from the Securities Industry and
Financial Markets Association (``SIFMA'') Report on Management and
Professional Earnings in the Securities Industry 2009, which
provides base salary and bonus information for middle-management and
professional positions within the securities industry. The salary
costs derived from the report and referenced in this cost benefit
section are modified to account for an 1800-hour work year and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead. Hereinafter, references to data derived from
the report as modified in the manner described above will be cited
as SIFMA's Management & Professional Earnings in the Securities
Industry 2009.
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The Commission seeks comment and data on the benefits identified.
The Commission also seeks comment on the accuracy of its cost estimates
in each section of this cost-benefit analysis, and requests those
commenters to provide data, including identification of statistics
relied on by commenters to reach conclusions on cost estimates.
Finally, the Commission seeks estimates and views regarding these costs
and benefits for particular types of market participants (e.g., broker-
dealers, customers of broker-dealers and independent public
accountants), as well as any other costs or benefits that may result
from these proposed rule amendments and the new proposed Form.
Under Section 3(f) of the Exchange Act,\196\ the Commission shall,
when engaging in rulemaking that requires the Commission to consider or
determine whether an action is necessary or appropriate in the public
interest, consider, in addition to the protection of investors, whether
the action will promote efficiency, competition, and capital formation.
Section 23(a)(2) of the Exchange Act \197\ requires the Commission to
consider the anticompetitive effects of any rules the Commission adopts
under the Exchange Act. Section 23(a)(2) prohibits the Commission from
adopting any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act. The Commission has considered the effects of each of the proposed
amendments in this release on competition, efficiency and capital
formation. The Commission's preliminary view, as discussed in greater
detail with respect to each proposed amendment below, is that the
proposed rule amendments may promote efficiency, competition, and
capital formation and any burden on competition is justified by the
benefits.
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\196\ 15 U.S.C. 78c(f).
\197\ 15 U.S.C. 78w(a)(2).
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In considering the effect of the proposed amendments on capital
formation, the Commission notes that broker-dealers that lack
appropriate custody procedures or internal controls may expose
investors to unnecessary risks. For example, if losses are incurred by
investors as a result of a broker-dealer's failure to properly
safeguard customer assets, investors may lose confidence in broker-
dealers, which, in turn, could negatively impact the ability of
companies to raise capital through securities issuances underwritten by
broker-dealers. A perceived lack of such procedures should be expected
to reduce investors' willingness to invest through broker-dealers, and
measures, such as these proposed amendments, should thereby enhance
capital formation by strengthening the operational controls of broker-
dealers with respect to safeguarding customer assets. At the same time,
the Commission acknowledges that additional requirements designed to
safeguard investor assets could impose a burden on competition by
raising compliance costs for broker-dealers.
The Commission generally requests comment on all aspects of this
analysis of the burden on competition and promotion of efficiency,
competition, and capital formation. Commenters should provide specific
data and analysis to support their views.
A. Annual Reporting Amendments
1. Benefits
The Commission preliminarily believes that the Annual Reporting
Amendments will have a number of benefits. First, the Annual Reporting
Amendments would update the existing requirements of Rule 17a-5, which
is
[[Page 37599]]
used by the Commission to monitor the financial condition of broker-
dealers. This will align the text of Rule 17a-5 with current auditing
literature. Second, the amendments would facilitate PCAOB inspection
and oversight authority over broker-dealer independent public
accountants by providing an improved foundation for the PCAOB to
establish new broker-dealer audit standards. Third, the Commission
preliminarily believes that the Annual Reporting Amendments proposed in
this release, if adopted, would create an efficient process for broker-
dealers by enabling them to satisfy the proposed requirements under
Rule 17a-5 and the IA Custody Rule's internal control report
requirement.
Additionally, the Commission preliminarily believes that the
proposed Annual Reporting Amendments would strengthen and improve
compliance with the Financial Responsibility Rules because it would
increase the focus of independent public accountants on the custody
practices of broker-dealers. This could help identify broker-dealers
that have weak controls for safeguarding investor assets.
The Commission preliminarily believes that the proposed Annual
Reporting Amendments, by updating the existing requirements of Rule
17a-5 and requiring reports prepared by independent public accountants
that make custody a greater focus of the audit, would strengthen
broker-dealer compliance with the Financial Responsibility Rules and,
in turn, improve the financial and operational condition of broker-
dealers and the safeguarding of investor assets. These improvements
could enhance investor trust in the financial markets and thereby
potentially have a positive impact on capital formation.
Additionally, the Commission preliminarily believes that the
proposed Annual Reporting amendments create regulatory efficiencies for
broker-dealers that are also registered as investment advisers because
the proposals would potentially eliminate regulatory redundancy by
enabling entities subject to the IA Custody Audit Rule and the
Compliance Examination to submit a single report with the Commission.
2. Costs
As discussed above, the Commission estimates that there are 305
carrying broker-dealers that would be subject to the Compliance
Examination and Report based on data included in FOCUS Reports. The
Commission recognizes that the proposed amendments associated with the
Compliance Examination would create additional costs incurred by the
broker-dealers related to their annual audits. As stated previously,
the proposed requirements with respect to the Compliance Examination
are based on existing requirements in Rule 17a-5. The Commission is
also proposing new requirements for the Compliance Examination that are
not currently in Rule 17a-5.\198\
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\198\ See supra discussion in Section II.B.2; the proposed
Compliance Examination would result in the following four changes to
existing audit work: (1) Use of PCAOB standards; (2) revised
reporting requirements for the examination of the broker-dealer's
assertions regarding compliance and internal controls over
compliance (i.e., expression of an opinion); (3) period of time of
reporting on internal controls over compliance (i.e., controls over
compliance effective through the year instead of only at year-end);
and (4) including the Account Statement Rule as part of the
examination.
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The Commission preliminarily believes that the costs associated
with the Compliance Examination would be incremental to the current
annual audit costs, because the proposed amendments are based on
existing requirements. Consequently, the Commission preliminarily
believes that the independent public accountants would be able to build
upon existing work to satisfy the new requirements. For example, as
discussed above, under existing requirements, the independent public
accountant, among other things, must review the accounting system,
internal accounting control and procedures for safeguarding securities,
including appropriate tests therefore for the period since the prior
examination date.\199\ The Commission preliminarily estimates that the
additional costs incurred by carrying broker-dealers associated with
paying their independent public accountants would average $150,000 per
firm, per year. The Commission derived this cost estimate from its
estimates of the costs associated with the IA Custody Rule.
---------------------------------------------------------------------------
\199\ See Section II.A. of this release.
---------------------------------------------------------------------------
The Commission estimated that the IA Custody Rule would impose
costs of $250,000 per investment adviser.\200\ The Commission noted
that the cost to prepare an internal control report relating to custody
would vary based on the size and services offered by a qualified
custodian, but that the average cost for an internal control report was
approximately $250,000.\201\ The Commission notes that the IA Custody
Rule imposed new requirements on investment advisers, and was not based
on existing obligations. The Commission preliminarily believes that the
costs associated with the Compliance Examination would be incremental
to broker-dealers because of the existing work done by the independent
public accountants. The Commission preliminarily estimates that the
additional costs associated with the Compliance Examination and
Examination Report to be, on average, $150,000 per year per broker-
dealer. As noted above, the Commission derived this cost estimate from
its estimates of the costs associated with the IA Custody Rule.
---------------------------------------------------------------------------
\200\ See IA Custody Adopting Release at 1478.
\201\ See IA Custody Adopting Release at note 291 and
corresponding text at 1479.
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Therefore the Commission estimates an annual cost associated with
this proposal to be $45,750,000 per year.\202\
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\202\ $150,000 x 305 broker-dealers = $45,750,000.
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The Commission estimates that 4,752 non-carrying broker-dealers
would be required to file the proposed Exemption Report. As discussed
above, this number is based on the number of non-carrying broker-
dealers that claim exemptions from Rule 15c3-3.\203\ These non-carrying
broker-dealers would be required to have an independent public
accountant review the claimed assertion (exemption) and prepare a
corresponding report that also would be filed with the Commission. The
Commission preliminarily believes that an independent public
accountant's review of the exemption assertion would add an incremental
cost to that incurred by the annual financial audit. As discussed
above, independent public accountants engaged by broker-dealers must
``ascertain that the conditions of the exemption were being complied
with as of the examination date and that no facts came to [the
independent public accountant's] attention to indicate that the
exemption had not been complied with during the period since [the
independent public accountant's] last examination.'' \204\ The
Commission therefore estimates that the submission of the Exemption
Report and any additional work done by the independent public
accountant to conduct the review would result in an incremental
increase to the current audit cost of the non-carrying broker-dealer.
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\203\ These numbers are based on FOCUS Report data as of year-
end 2009. See supra notes 172-173.
\204\ See Rule 17a-5(g)(2). As noted previously, the independent
public accountants currently satisfy this requirement by including a
statement in the study providing that they have ascertained that the
broker-dealer was complying with the conditions of the exemption;
see Broker Dealer Audit Guide supra note 14 at Section 3.32.
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The cost for paying the independent public accountant to perform a
financial audit of a non-carrying broker-dealer varies depending on the
size and amount of net revenues. The Commission's preliminary estimates
of
[[Page 37600]]
these costs as set forth below are based on staff experience, including
communications with broker-dealers, broker-dealer auditors, and auditor
industry groups. The Commission preliminarily estimates that the cost
for an annual audit for a non-carrying broker-dealer with net revenue
of less than $1 million to be $15,000. The Commission preliminarily
estimates the average cost for an audit of a non-carrying broker-dealer
with net revenue of $1 million to $10 million to be $20,000. The
Commission preliminarily estimates the average cost of an audit of a
non-carrying broker-dealer with net revenue greater than $10 million
and less than $100 million to be $60,000. Finally, the Commission
preliminarily estimates the average cost of an audit of a non-carrying
broker-dealer with net revenue greater than $100 million to be
$300,000. Therefore, the Commission preliminarily estimates the average
cost for the financial audit for non-carrying broker-dealers is
approximately $30,000.\205\ As noted, the Commission believes that the
cost of the proposed review would be incremental to costs currently
incurred for the financial audit. The Commission estimates that, on
average, the additional average cost would be approximately $3,000 for
each non-carrying broker-dealer.\206\ Therefore, the total annual cost
for all non-carrying broker-dealers required to submit Exemption
Reports is estimated to be $14,256,000.\207\
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\205\ The average is derived from applying the number of broker-
dealers with the given net revenue ranges and multiplying it by the
estimated audit costs; for example there are over 2,000 non-carrying
broker-dealers with net revenues under $1 million; however there are
over 1500 firms with net revenue between $1 million and $10 million
and so forth. The Commission preliminarily estimates the average
audit cost to be $30,000.
\206\ Based on staff experience the Commission believes that the
incremental work done to conduct the review represents 10% of the
current work done. Therefore the Commission estimates an average
additional cost of around $3,000 (10% * $30,000).
\207\ $3,000 x 4,752 = $14,256,000.
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The Commission preliminarily believes that the proposed amendments
may impose a burden on competition for smaller broker-dealers to the
extent that they impose relatively fixed costs, which would represent a
higher percentage of net income for smaller broker-dealers. However,
the Commission preliminary believes that the incremental costs
resulting from the proposed amendments would not impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
B. Access to Audit Documentation Amendments
1. Benefits
The Commission preliminarily believes that the proposed Access to
Audit Documentation Amendments would have a number of benefits. These
proposed rules would make it easier for the Commission and DEAs to
access information about a clearing broker-dealer's independent public
accountant's work and the steps taken by the independent public
accountant to audit the broker-dealer's financial statements. In turn,
this information would enable the Commission and DEA examiners to more
efficiently deploy examination resources.\208\ The Commission
preliminarily believes that examiners reviewing the audit documentation
may tailor the scope of their examinations by identifying areas where
extensive audit work was performed by the independent public accountant
and focusing their examinations on other areas. Enabling Commission and
DEA examination staff to conduct more focused examinations of broker-
dealers could, in turn, provide investors with greater protection, as
examination resources could be allocated more strategically for their
benefit.
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\208\ As discussed previously, the Commission preliminarily
believes that where an independent public accountant has performed
extensive testing of a carrying broker-dealer's custody of
securities and cash by confirming holdings at subcustodians,
examiners could focus their efforts on matters that had not been the
subject of prior testing and review.
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2. Costs
The Commission notes that clearing broker-dealers would incur
additional costs from the proposed Access to Audit Documentation
Amendments by permitting representatives of the Commission and its DEA
to discuss with the independent public accountants the findings in
their audit reports and to review the audit documentation associated
with the audit reports. While the Commission does not anticipate that
its representatives would need to discuss findings and review audit
documentation with respect to each clearing broker-dealer annually, the
Commission's estimate is nevertheless based on the total number of
clearing broker-dealers. Further, the Commission assumes that
independent public accountants would charge their clearing broker-
dealer clients for any time spent with the Commission and DEA
representatives discussing the findings associated with the annual
audit reports and providing access to the documentation associated with
the annual audit reports. The Commission estimates clearing broker-
dealers would incur an additional $660,000 per year in annual
costs.\209\
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\209\ Based on industry sources, the Commission estimates that
the hourly cost of an independent public accountant to be $250. With
an additional 5 hours per year, the annual hour burden would be
2,640 (528 clearing broker-dealers x 5 hours) for a yearly cost
estimate of $660,000 (2,640 hours x $250 per hour).
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The Commission preliminarily believes that the proposed amendments
may impose a burden on competition for smaller broker-dealers to the
extent that they impose relatively fixed costs, which would represent a
higher percentage of net income for smaller broker-dealers. However,
the Commission preliminarily believes that the incremental costs
resulting from the proposed amendments would not impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act, given the investor protection objectives of the
proposed amendments.
C. Proposed Form Custody and Related Requirements
1. Benefits
The Commission frequently brings enforcement actions against
investment advisers and broker-dealers alleging fraudulent conduct,
including misappropriation or other misuse of investor assets.\210\ The
Commission also has brought an enforcement action against the
accountant responsible for auditing one of these broker-dealers.\211\
In order to enhance protection, the Commission has taken steps to
enhance oversight of the custody function of investment advisers \212\
and preliminarily believes that the proposal to adopt Form Custody will
provide information related to custodial practices of broker-dealers
that, in turn, will better protect investors who entrust funds and
securities to broker-dealers. Proposed Form Custody would be filed with
a broker-dealer's quarterly FOCUS Reports and would elicit information
about whether and how the broker-dealer maintains custody of assets.
This form would consolidate information about the broker-dealer's
custodial responsibility and relationships with other custodians in one
report so that the Commission and other securities regulators can have
a more comprehensive understanding of the broker-dealer's custody
practices and arrangements. Further, the Commission
[[Page 37601]]
believes that the additional information made available on the proposed
form would aid in the examination of broker-dealers, because the
examination staff could use the form as another tool for purposes of
prioritizing and planning examinations.
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\210\ See supra note 123.
\211\ SEC v. David G. Friehling, C.P.A., et al., Litigation
Release No. 20959 (Mar. 18, 2009).
\212\ See supra note 124.
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The Commission believes that the proposed Form Custody amendments
also could enhance investor confidence. By establishing a discipline
under which broker-dealers are required to report to the Commission
greater detail as to their custodial functions, investor perception as
to the safety of their funds and securities at broker-dealers could
improve. This, in turn, could increase the willingness of investors to
provide capital for investment through broker-dealers.
2. Costs
The proposed form is comprised of nine line items that elicit
information about the broker-dealer's custodial responsibilities and
operations. Some of the Items contain multiple questions and also
elicit information by requiring charts to be filled out or additional
information to be provided in spaces provided.\213\
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\213\ See supra Section IV for discussion of each proposed item
of Form Custody.
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The cost of compliance will vary given the variation in the size
and complexity of the businesses of the brokers and dealers subject to
Rule 17a-5. The Commission estimates that, on average, each report
would require approximately 12 hours for a broker-dealer to
complete.\214\ As noted above, the Commission proposes to require that
firms file proposed Form Custody on a quarterly basis. Therefore, the
Commission estimates that there would be 20,228 annual responses \215\
and therefore a total annual hour burden of 242,736 hours.\216\ Thus,
the Commission anticipates that the annual cost to the industry will be
$69,179,760.\217\
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\214\ See supra note 190; the Commission's current hour burden
associated with a broker-dealer filing a FOCUS Report is 12 hours.
\215\ 5,057 firms x 4 times a year = 20,228 total responses.
\216\ 20,228 total responses x 12 hours per Form Custody =
242,736.
\217\ The Commission anticipates that one or more Financial
Reporting Managers, at an average cost of $285 per hour, would be
responsible for completion of Form Custody. This $285 per hour
figure for a Financial Reporting Manager is based upon information
obtained from SIFMA's Management & Professional Earnings in the
Securities Industry 2009 publication, modified by Commission staff
to account for an 1800-hour work-year and multiplied by 5.35 to
account for bonuses, firm size, employee benefits and overhead.
Thus, the annual cost burden is estimated to be $69,179,760 (242,736
total hours x $285 per hour).
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The Commission preliminarily believes that the proposed amendments
could have a burden on competition because they could increase
compliance costs for broker-dealers. However, the Commission
preliminarily believes that this proposed amendment would not have a
disproportionate effect on smaller broker-dealers. The Commission
expects that smaller firms in completing proposed Form Custody will
incur fewer associated costs because the information required to be
disclosed is less. For example, broker-dealers that introduce customers
on a fully disclosed basis and do not have custody of customer funds or
assets would leave much of the Form blank.
C. Request for Comment on Economic Analysis
The Commission seeks estimates of the costs and benefits identified
in this Economic Analysis Section, as well as any costs and benefits
not already discussed, which may result from the adoption of the
proposed amendments and form.
The Commission also requests comment on the potential costs and
benefits of alternatives suggested by commenters. The Commission
specifically requests comments with respect to the following:
With respect to the costs estimates for the proposed
Compliance Examination and corresponding Examination Report, is the
cost associated with the IA Custody Rule comparable? Is the
Commission's estimated cost for the proposed Compliance Examination and
Examination Report conservative or too low?
With respect to the costs estimates for the proposed
Compliance Examination, do commenters believe that there could be some
cost savings because some respondents would no longer have to engage an
independent public accountant to perform the internal control
examination required by the IA Custody Rule? If so, how much savings
could be generated?
With respect to the cost estimates for the proposed
Exemption Report and review by the independent public accountant, would
the amount of additional work for the review by the independent public
accountant be greater than estimated by the Commission?
Are there any additional costs associated with the
proposed Access to Audit Documentation Amendments that are not
currently contemplated in the Economic Analysis section? Will
independent public accountants allocate the costs associated with the
proposed Access to Audit Documentation Amendments to broker-dealers?
With respect to the cost estimates for proposed Form
Custody, do commenters believe that broker-dealers will need more than
the estimated 12 hours to complete the form? If so, why? Also, please
provide an alternative estimate.
Are there any additional economic effects related to
efficiency, capital formation or competition that the Commission has
not identified?
The Commission generally requests comment on the competitive or
anticompetitive effects as well as efficiency and capital formation
effects, of the proposed amendments and form on any market participants
if the proposals are adopted. Commenters should provide analysis and
empirical data to support their views on the costs and benefits
associated with the proposed amendments and form.
VIII. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \218\ the Commission must advise OMB
whether a proposed regulation constitutes a major rule. Under SBREFA, a
rule is ``major'' if it has resulted in, or is likely to result in:
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\218\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
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An annual effect on the economy of $100 million or more;
A major increase in costs or prices for consumers or
individual industries; or
A significant adverse effect on competition, investment,
or innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. The Commission requests
comment on the potential impact of the proposed rule amendments on the
economy on an annual basis. Commenters are requested to provide
empirical data and other factual support for their view to the extent
possible.
IX. Initial Regulatory Flexibility Analysis
The Commission has prepared the following Initial Regulatory
Flexibility Analysis (``IRFA''), in accordance with the provisions of
the Regulatory Flexibility Act,\219\ regarding the proposed rule
amendments to Rule 17a-5 under the Exchange Act.
---------------------------------------------------------------------------
\219\ 5 U.S.C. 603.
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A. Reasons for the Proposed Action
The proposed Annual Reporting Amendments are designed to, among
other things: (1) Update the existing requirements of Rule 17a-5; (2)
facilitate
[[Page 37602]]
the ability of the PCAOB to implement oversight of independent public
accountants of broker-dealers as required by the Dodd-Frank Act; and
(3) eliminate potentially redundant requirements for certain broker-
dealers affiliated with, or dually-registered as, investment advisers.
The Commission preliminarily believes the Access to Audit
Documentation Amendments would enhance Commission and DEA examinations
of broker-dealers by providing examiners with access to additional
relevant information, which could improve the efficiency and
effectiveness of the examination process. The Commission preliminarily
believes that Commission and DEA examiners could use the Access to
Audit Documentation Amendments to develop the scope for their
examinations of clearing broker-dealers.
Currently, limited information is elicited about the scope of the
broker-dealer's custodial function and the manner in which it handles
assets of customers and other persons. The Commission, therefore, is
proposing Form Custody, which it preliminarily believes would be useful
because it provides information about the custodial activities of the
broker-dealer that can serve as a starting point for examiners to
undertake more in-depth reviews as they deem appropriate.
B. Objectives
The objectives of the proposed Form Custody Amendments are to
enhance the Commission's oversight of broker-dealers, especially with
respect to broker-dealers' custody of assets. As stated previously, the
Commission preliminarily believes that proposed Form Custody would
provide useful information that is currently not routinely made
available to the Commission. In addition, the proposed Access to Audit
Documentation Amendments would assist the examination of broker-
dealers. Another objective of the proposed Annual Reporting Amendments
is, among other things, to update the existing provisions of Rule 17a-5
to align the text of the rule with current auditing literature.
C. Legal Basis
Pursuant to the Exchange Act \220\ and, particularly, Sections
15(c), 17(a), 17(E) and 23 of the Exchange Act, the Commission is
proposing amendments to Rule 17a-5 and new Form Custody.\221\
---------------------------------------------------------------------------
\220\ 15 U.S.C. 78a et seq.
\221\ 15 U.S.C. 78o.
---------------------------------------------------------------------------
D. Small Entities Subject to the Rule
Paragraph (a) of Rule 0-10 provides that for purposes of the
Regulatory Flexibility Act, a small entity ``[w]hen used with reference
to a broker or dealer, the Commission has defined the term ``small
entity'' to mean a broker or dealer (``small broker-dealer'' that: (1)
Had total capital (net worth plus subordinated liabilities of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements, were prepared pursuant to Rule 17a-5(d) or, if
not required to file such statements, a broker or dealer that had total
capital (net worth plus subordinated debt) of less than $500,000 on the
last business day of the preceding fiscal year (or in the time that it
has been in business if shorter); and (2) is not affiliated with any
person (other than a natural person) that is not a small business or
small organization as defined in this release.'' \222\ Currently, based
on FOCUS Report data, there are 871 broker-dealers that are classified
as ``small'' entities for purposes of the Regulatory Flexibility
Act.\223\
---------------------------------------------------------------------------
\222\ 17 CFR 240.0-10(c).
\223\ See 17 CFR 240.0-10(a).
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E. Reporting, Recordkeeping, and Other Compliance Requirements
The Commission proposes three amendments to Rule 17a-5: The (1)
Annual Reporting Amendments; (2) Access to Audit Documentation
Amendments; and (3) Form Custody Amendments.
The Commission preliminarily believes that the potential impact of
the proposals on small broker-dealers would be substantially less than
on larger firms. With respect to the Annual Reporting Amendments, small
broker-dealers would be subject to the Exemption Report, and not the
proposed Compliance Report and Examination.\224\ Therefore, small
broker-dealers would engage their independent public accountant to
review their Exemption Reports and would be subject to the additional
costs associated with that review. Additionally, these firms could be
required to pay additional fees to their independent public accountant,
should the Commission or DEA examiners decide to interview them.
---------------------------------------------------------------------------
\224\ There are no broker-dealers that are carrying firms that
satisfy the definition of a ``small'' broker-dealer.
---------------------------------------------------------------------------
F. Duplicative, Overlapping, or Conflicting Federal Rules
The Commission believes that there are no federal rules that
duplicate, overlap, or conflict with the proposed rule amendments.
G. Significant Alternatives
Pursuant to Section 3(a) of the Regulatory Flexibility Act,\225\
the Commission must consider certain types of alternatives, including:
(1) The establishment of differing compliance or reporting requirements
or timetables that take into account the resources available to small
entities; (2) the clarification, consolidation, or simplification of
compliance and reporting requirements under the rule for small
entities; (3) the use of performance rather than design standards; and
(4) an exemption from coverage of the rule, or any part of the rule,
for small entities.
---------------------------------------------------------------------------
\225\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------
The Commission considered whether it is necessary or appropriate to
establish different compliance or reporting requirements or timetables;
or clarify, consolidate, or simplify compliance and reporting
requirements under the rule for small entities. Because the proposed
rule amendments would enhance the Commission's oversight, the
Commission preliminarily believes that small entities should be covered
by the rule. The Commission also preliminarily believes that it would
not be necessary to establish different compliance requirements for
small broker-dealers, in that, as discussed previously, the proposed
amendments are based in large part on existing compliance requirements
in Rule 17a-5. Similarly, the Commission does not believe it would be
necessary to establish different compliance requirements for small
broker-dealers with respect to Form Custody. The information that would
be elicited on the form is designed to allow examiners to obtain an
understanding of the custody practices of all types of broker-dealers.
Therefore, the Commission preliminarily believes that having
inconsistent requirements could undermine the objectives of the
proposed requirement.
H. Request for Comments
The Commission encourages written comments on matters discussed in
this IRFA. In particular, the Commission seeks comment on the number of
small entities that would be affected by the proposed rule amendments
and whether the effect on small entities would be economically
significant. Commenters are asked to describe the nature of any effect
and to provide empirical data to support their views.
[[Page 37603]]
X. Statutory Authority and Text of the Proposed Amendments
The Commission is proposing amendments to Rule 17a-5 under the
Exchange Act pursuant to the authority conferred by the Exchange Act,
including Sections 15, 17, 23(a) and 36.\226\
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\226\ 15 U.S.C. 78o, 78q, 78w(a) and 78mm.
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List of Subjects in 17 CFR Parts 240 and 249
Brokers, Confidential business information, Fraud, Reporting and
recordkeeping requirements, Securities.
Text of the Proposed Amendments
For the reasons set out in the preamble, the Commission proposes to
amend Title 17, Chapter II, of the Code of Federal Regulations as
follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The authority citation for part 240 continues to read, in part,
as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i,
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4, 78p, 78q,
78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37,
80b-3, 80b-4, 80b-11, and 7201 et seq., 18 U.S.C. 1350, and 12
U.S.C. 5221(e)(3), unless otherwise noted.
* * * * *
2. Section 240.17a-5 is amended by:
a. In paragraph (a)(2)(ii), in the first sentence, removing the
phrase ``annual audit of financial statements where said date is other
than a calendar quarter'' and adding in its place ``annual reports
where said date is other than the end of a calendar quarter.'';
b. In paragraph (a)(2)(iii), removing the phrase ``the annual audit
of financial statements where said date is other than the end of the
calendar quarter.'' and adding in its place ``the annual reports where
said date is other than the end of a calendar quarter.'';
c. In paragraph (a)(2)(iv), adding the phrase ``(``designated
examining authority'')'' after the phrase ``section 17(d) of the Act'';
d. Redesignating paragraphs (a)(5) and (a)(6) as paragraphs (a)(6)
and (a)(7);
e. In newly redesignated paragraph (a)(6)(ii)(A), removing the
phrase ``(a)(5)(i)'' and adding in its place ``(a)(6)(i)'';
f. Adding new paragraph (a)(5);
g. In paragraph (b)(4), removing the word ``he'' and adding in its
place the phrase ``the broker or dealer''.
h. Removing paragraph (b)(6);
i. In paragraph (c)(1)(i), removing the phrase ``his customers''
and adding in its place the phrase ``customers of the introducing
broker or dealer'';
j. In paragraph (c)(1)(iii), removing the phrase ``in the manner
contemplated by the $2,500 minimum net capital requirement of Sec.
240.15c3-1'' and adding in its place ``and otherwise qualified to
maintain net capital of no less than what is required pursuant to Sec.
240.15c3-1(a)(2)(iv)'';
k. In paragraph (c)(2), in the first sentence, removing the phrase
``audited financial statements'' and adding in its place ``financial
report'';
l. In paragraph (c)(2)(i) removing the phrase ``balance sheet with
appropriate notes prepared in accordance with'' and adding in its place
``Statement of Financial Condition with appropriate notes prepared in
accordance with U.S.'';
m. Removing paragraph (c)(2)(iii);
n. Redesignating paragraph (c)(2)(iv) as (c)(2)(iii);
o. In newly redesignated paragraph (c)(2)(iii), removing the phrase
``annual audit report'' and adding in its place ``financial report'';
p. Adding new paragraph (c)(2)(iv);
q. In paragraph (c)(4) removing the word ``'customer''' and adding
in its place the word ``customer'';
r. In paragraphs (c)(5)(ii)(A) and (c)(5)(iii), removing the phrase
``Web site'' and adding in its place ``website'';
s. In paragraph (c)(5)(vi), removing the phrase ``was not required
by paragraph (e) of Sec. 240.17a-11 to give notice and transmit a
report to the Commission'' and replacing it with ``received an
unqualified financial statement audit report pursuant to paragraph (g)
of this section and neither the broker or dealer, pursuant to paragraph
(d) of this section, or the independent public accountant, pursuant to
paragraph (g) of this section, identified a material weakness or
instance of material non-compliance'';
t. Revising paragraph (d);
u. In paragraph (e) introductory text, removing the phrase
``financial statements'' and adding in its place ``annual reports'';
v. Revising paragraph (e)(1);
w. In paragraph (e)(2), in the first sentence, adding the word
``financial'' before ``report'';
x. Revising paragraphs (e)(3) and (e)(4);
y. Removing paragraph (e)(5);
z. Revising paragraphs (f), (g), (h), and (i); and
aa. Removing and reserving paragraph (j).
The revisions and additions read as follows:
Sec. 240.17a-5 Reports to be made by certain brokers and dealers.
(a) * * *
(5) Every broker or dealer subject to this paragraph (a) shall file
Form Custody (Sec. 249.1900 of this chapter) with its designated
examining authority within 17 business days after the end of each
calendar quarter and within 17 business days after the date selected
for the annual reports where said date is other than the end of a
calendar quarter. The designated examining authority shall maintain the
information obtained through the filing of Form Custody and transmit
such information to the Commission, at such time as it transmits the
applicable part of Form X-17A-5 (Sec. 249.617 of this chapter) as
required in paragraph (a)(4) of this section.
* * * * *
(c) * * *
(2) * * *
(iv) If in connection with the most recent annual report the
independent public accountant provided notice to the Commission
pursuant to paragraph (h) of this section, there shall be a statement
by the broker or dealer that a copy of such notice is currently
available for the customer's inspection at the principal office of the
Commission in Washington, DC.
* * * * *
(d) Annual reports. (1)(i) Every broker or dealer registered
pursuant to section 15 of the Act shall file annually, on a calendar or
fiscal year basis:
(A) A financial report as described in paragraph (d)(2) of this
section;
(B)(1) A compliance report as described in paragraph (d)(3) of this
section unless the broker or dealer is exempt from the provisions of
Sec. 240.15c3-3; or
(2) An exemption report described in paragraph (d)(4) of this
section if the broker or dealer is exempt from the provisions of Sec.
240.15c3-3; and
(C) For each report filed pursuant to this paragraph (d), a report
prepared by an independent public accountant pursuant to the engagement
provisions set forth in paragraph (g)(1) of this section, except as
provided in paragraphs (d)(1) and (e)(1) of this section.
(ii) The reports required to be filed under this paragraph (d)
shall be as of the same fixed or determinable date each year, unless a
change is approved in writing by the designated examining authority for
the broker or dealer. A copy of such written approval should be sent to
the regional office of the Commission for the region in which the
broker or dealer has its principal place of business.
[[Page 37604]]
(iii) A broker or dealer succeeding to and continuing the business
of another broker or dealer need not file the reports under this
paragraph (d) as of a date in the fiscal or calendar year in which the
succession occurs if the predecessor broker or dealer has filed a
report in compliance with this paragraph (d) as of a date in such
fiscal or calendar year.
(iv) A broker or dealer that is a member of a national securities
exchange and has transacted a business in securities solely with or for
other members of a national securities exchange, and has not carried
any margin account, credit balance or security for any person who is
defined as a customer in paragraph (c)(4) of this section, shall not be
required to file the reports under this paragraph.
(2) Financial report. The financial report shall contain:
(i) A Statement of Financial Condition (in a format and on a basis
that is consistent with the total reported on the Statement of
Financial Condition contained in Form X-17A-5 (Sec. 249.617 of this
chapter) Part II or IIA), a Statement of Income, a Statement of Cash
Flows, a Statement of Changes in Stockholders' or Partners' or Sole
Proprietor's Equity, and Statement of Changes in Liabilities
Subordinated to Claims of General Creditors. Such statements shall be
in a format that is consistent with such statements as contained in
Form X-17A-5 Part II or Part IIA. If the Statement of Financial
Condition filed in accordance with instructions to Form X-17A-5, Part
II or Part IIA, is not consolidated, a summary of financial data,
including the assets, liabilities, and net worth or stockholders'
equity, for subsidiaries not consolidated in the Part II or Part IIA
Statement of Financial Condition as filed by the broker or dealer
should be included in the notes to the consolidated statement of
financial condition reported on by the independent public accountant.
(ii) Supporting schedules shall include, from Part II or Part IIA
of Form X-17A-5 (Sec. 249.617 of this chapter) a Computation of Net
Capital Under Sec. 240.15c3-1, a Computation for Determination of the
Reserve Requirements under Exhibit A of Sec. 240.15c3-3 and
Information Relating to the Possession or Control Requirements Under
Sec. 240.15c3-3 and shall be filed with said report.
(iii) If either the Computation of Net Capital under Sec.
240.15c3-1 or the Computation for Determination of the Reserve
Requirements Under Exhibit A of Sec. 240.15c3-3 in the financial
report is materially different from the corresponding computation in
the most recent Part II or Part IIA of Form X-17A-5 (Sec. 249.617 of
this chapter) filed by the broker or dealer pursuant to paragraph (a)
of this section, then the broker or dealer shall include in the
financial report a reconciliation, including appropriate explanations,
between the computation in the financial report and the computation in
the most recent Part II or Part IIA of Form X-17A-5 filed by the broker
or dealer. If no material differences exist, a statement so indicating
shall be included in the financial report.
(3) Compliance report. (i) The compliance report shall contain:
(A) A statement as to whether the broker or dealer has established
and maintained a system of internal control to provide the broker or
dealer with reasonable assurance that any instances of material non-
compliance with Sec. Sec. 240.15c3-1, 240.15c3-3, and 240.17a-13, and
any rule of the designated examining authority of the broker or dealer
that requires account statements to be sent to the customers of the
broker or dealer (``Account Statement Rule'') will be prevented or
detected on a timely basis;
(B) Assertions by the broker or dealer that include:
(1) Whether it was in compliance in all material respects with
Sec. Sec. 240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account
Statement Rule as of the fiscal year-end;
(2) Whether the information used to assert compliance with
Sec. Sec. 240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account
Statement Rule was derived from the books and records of the broker or
dealer; and
(3) Whether the internal control over compliance with Sec. Sec.
240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account Statement Rule
was effective during the most recent fiscal year such that there were
no instances of material weakness; and
(C) A description of each identified instance of material non-
compliance and each identified material weakness in internal control
over compliance with Sec. Sec. 240.15c3-1, 240.15c3-3, and 240.17a-13,
and the Account Statement Rule.
(ii) The broker or dealer is not permitted to conclude that it is
in compliance with Sec. Sec. 240.15c3-1, 240.15c3-3, and 240.17a-13
and the Account Statement Rule if it identifies one or more instances
of material non-compliance. For purposes of this paragraph material
non-compliance would be a failure by the broker or dealer to comply
with the requirements of Sec. Sec. 240.15c3-1, 240.15c3-3, and
240.17a-13 or the Account Statement Rule in all material respects.
(iii) The broker or dealer is not permitted to conclude that the
internal control over compliance with Sec. Sec. 240.15c3-1, 240.15c3-
3, and 240.17a-13, and the Account Statement Rule were effective if
there were one or more instances of material weakness in the internal
control over compliance. For purposes of this paragraph, an instance of
material weakness is defined as a deficiency, or a combination of
deficiencies, in internal control over compliance with Sec. Sec.
240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account Statement Rule,
such that there is a reasonable possibility that material non-
compliance with Sec. Sec. 240.15c3-1, 240.15c3-3, and 240.17a-13, or
the Account Statement Rule will not be prevented or detected on a
timely basis. For purposes of this paragraph a deficiency in internal
control over compliance exists when the design or operation of a
control does not allow the broker or dealer, in the normal course of
performing their assigned functions, to prevent or detect non-
compliance with Sec. Sec. 240.15c3-1, 240.15c3-3, and 240.17a-13, or
the Account Statement Rule on a timely basis.
(4) Exemption report. The exemption report shall contain an
assertion by the broker or dealer that it is exempt from the provisions
of Sec. 240.15c3-3 because it meets conditions set forth in Sec.
240.15c3-3(k) and should identify the specific conditions.
(5) The annual reports shall be filed not more than sixty (60) days
after the date of the financial statements.
(6) The annual reports shall be filed at the regional office of the
Commission for the region in which the broker or dealer has its
principal place of business, the Commission's principal office in
Washington, DC, and the principal office of the designated examining
authority for said broker or dealer and with the Securities Investor
Protection Corporation. Copies thereof shall be provided to all self-
regulatory organizations of which said broker or dealer is a member,
unless the self-regulatory organization by rule waives this
requirement.
(e) * * *
(1)(i) The broker or dealer need not engage an independent public
accountant to provide the reports required pursuant to paragraph (d) of
this section if, since the date of the registration of the broker or
dealer pursuant to Section 15 of the Act (15 U.S.C. 78o) or of the
previous annual reports filed pursuant to paragraph (d) of this
section:
[[Page 37605]]
(A) The securities business of such broker or dealer has been
limited to acting as broker (agent) for the issuer in soliciting
subscriptions for securities of such issuer, said broker has promptly
transmitted to such issuer all funds and promptly delivered to the
subscriber all securities received in connection therewith, and said
broker has not otherwise held funds or securities for or owed money or
securities to customers; or
(B) Its securities business has been limited to buying and selling
evidences of indebtedness secured by mortgage, deed or trust, or other
lien upon real estate or leasehold interests, and said broker or dealer
has not carried any margin account, credit balance or security for any
securities customer.
* * * * *
(3) The annual reports filed pursuant to paragraph (d) of this
section shall be public, except that, if the Statement of Financial
Condition in a format that is consistent with Form X-17A-5 (Sec.
249.617 of this chapter), Part II or Part IIA, is bound separately from
the balance of the annual report filed pursuant to paragraph (d)(2) of
this section, and each page of the balance of the annual report is
stamped confidential, then the balance of the annual report shall be
deemed confidential. However, the annual reports, including the
confidential portions, shall be available for official use by any
official or employee of the U.S. or any State, by national securities
exchanges and registered national securities associations of which the
person filing such a report is a member, by the PCAOB and by any other
person to whom the Commission authorizes disclosure of such information
as being in the public interest. Nothing contained in this paragraph
shall be deemed to be in derogation of the rules of any registered
national securities association or national securities exchange that
give to customers of a member broker or dealer the right, upon request
to such member broker or dealer, to obtain information relative to its
financial condition.
(4)(i) The broker or dealer shall file with the Securities Investor
Protection Corporation (``SIPC'') a report on the SIPC annual general
assessment reconciliation or exclusion from membership forms that
contains such information and is in such format as determined by SIPC
by rule and approved by the Commission.
(ii) Until the earlier of two years after the date paragraph
(e)(4)(i) of this section is effective or SIPC adopts a rule pursuant
to paragraph (e)(4)(i) of this section and the rule is approved by the
Commission, the broker or dealer shall file a supplemental report on
the status of the membership of the broker or dealer in SIPC if,
pursuant to paragraph (d)(1)(i)(C) of this section, the broker or
dealer is required to file reports prepared by an independent public
accountant. The supplemental report shall include the independent
public accountant's report on applying agreed-upon procedures based on
the performance of the procedures outlined in paragraph (e)(4)(ii)(C).
The supplemental report shall cover the SIPC annual general assessment
reconciliation or exclusion from membership forms not previously
reported on under this paragraph (e)(4) that were required to be filed
on or prior to the date of the reports required by paragraph (d) of
this section: Provided, that the broker or dealer need not file the
supplemental report on the SIPC annual general assessment
reconciliation or exclusion from membership form for any period during
which the SIPC assessment is a specified dollar value as provided for
in section 4(d)(1)(c) of the Securities Investor Protection Act of
1970, as amended. The supplemental report shall be filed with the
regional office of the Commission for the region in which the broker or
dealer has its principal place of business, the Commission's principal
office in Washington, DC, the principal office of the designated
examining authority for the broker or dealer, and the principal office
of SIPC. The supplemental report shall include the following:
(A) A schedule of assessment payments showing any overpayments
applied and overpayments carried forward including: Payment dates,
amounts, and name of SIPC collection agent to whom mailed, or
(B) If exclusion from membership was claimed, a statement that the
broker or dealer qualified for exclusion from membership under the
Securities Investor Protection Act of 1970, and
(C) An accountant's report. The accountant shall be engaged to
perform the following procedures:
(1) Comparison of listed assessment payments with respective cash
disbursements record entries;
(2) For all or any portion of a fiscal year ending, comparison of
amounts reflected in the annual report as required by paragraph (d) of
this section, with amounts reported in the Annual General Assessment
Reconciliation (Form SIPC-7);
(3) Comparison of adjustments reported in Form SIPC-7 with
supporting schedules and working papers supporting adjustments;
(4) Proof of the arithmetical accuracy of the calculations
reflected in Form SIPC-7 and in the schedules and working papers
supporting adjustments; and
(5) Comparison of the amount of any overpayment applied with the
Form SIPC-7 on which it was computed; or
(6) If exclusion from membership is claimed, a comparison of the
income or loss reported in the financial report required by paragraph
(d) of this section to the Certification of Exclusion from Membership
(Form SIPC-3).
(f)(1) Qualification of accountants. The independent public
accountant must be qualified and independent in accordance with Sec.
210.2-01 of this chapter and, in addition, the independent public
accountant must be registered with the Public Company Accounting
Oversight Board if required by the Sarbanes-Oxley Act of 2002.
(2) Designation of accountant. (i) Every broker or dealer that is
required by paragraph (d) of this section to file annual reports shall
file no later than December 10 of each year (or 30 calendar days after
the effective date of its registration as a broker or dealer, if
earlier) a statement as prescribed in paragraph (f)(2)(ii) of this
section designating an independent public accountant with the
Commission's principal office in Washington, DC, the regional office of
the Commission for the region in which its principal place of business
is located, and the principal office of the designated examining
authority for the broker or dealer. The statement must be dated no
later than December 1. If the engagement of the independent public
accountant is of a continuing nature, providing for successive
engagements, no further filing is required. If the engagement is for a
single year, or if the most recent engagement has been terminated or
amended, a new statement must be filed by the required date.
(ii) The statement must be headed ``Notice pursuant to Rule 17a-
5(f)(2)'' and must contain the following information and
representations:
(A) Name, address, telephone number, and registration number of the
broker or dealer;
(B) Name, address, and telephone number of the independent public
accountant;
(C) The date of the annual reports of the broker or dealer covered
by the engagement;
(D) Whether the engagement is for a single year or is of a
continuing nature;
(E) A representation that the engagement of the independent public
[[Page 37606]]
accountant by the broker or dealer meets the required undertakings of
paragraph (g) of this section; and
(F) A representation that the broker or dealer agrees to allow
representatives of the Commission or its designating examining
authority, if requested for purposes of an examination of the broker or
dealer, to review the documentation associated with the reports of the
independent public accountant prepared pursuant to paragraph (g) of
this section.
(G) A representation that the broker or dealer agrees to permit the
independent public accountant to discuss with representatives of the
Commission and its designated examining authority, if requested for
purposes of an examination of the broker or dealer, the findings
associated with the reports of the independent public accountant
prepared pursuant to paragraph (g) of this section.
(iii) A broker or dealer that does not carry nor clear transactions
nor carry customer accounts is not required to include the
representations in paragraphs (e)(2)(ii)(F) and (e)(2)(ii)(G) of this
section.
(iv) Any broker or dealer that is exempted from the requirement to
file an annual audited report of financial statements shall
nevertheless file the notice specified herein indicating the date as of
which the unaudited report will be prepared.
(v) Notwithstanding the date of filing specified in paragraph
(f)(2)(i) of this section, every broker or dealer shall file the notice
provided for in paragraph (f)(2) of this section within 30 days
following the effective date of registration as a broker or dealer.
(3) Replacement of accountant. A broker or dealer must file a
notice that must be received by the Commission's principal office in
Washington, DC, the regional office of the Commission for the region in
which its principal place of business is located, and the principal
office of the designated examining authority for such broker or dealer,
not more than 15 business days after:
(i) The broker or dealer has notified the independent public
accountant whose reports covered the most recent annual reports filed
under paragraph (d) of this section that the independent public
accountant's services will not be utilized in future engagements; or
(ii) The broker or dealer has notified an independent public
accountant who was engaged to provide reports covering the annual
reports to be filed under paragraph (d) of this section that the
engagement has been terminated; or
(iii) An independent public accountant has notified the broker or
dealer that the independent public accountant would not continue under
an engagement to provide reports covering the annual reports to be
filed under paragraph (d) of this section; or
(iv) A new independent public accountant has been engaged to
provide reports covering the annual reports to be filed under paragraph
(d) of this section without any notice of termination having been given
to or by the previously engaged independent public accountant.
(v) Such notice must provide:
(A) The date of notification of the termination of the engagement
or of the engagement of the new independent public accountant as
applicable; and
(B) The details of any issues arising during the 24 months (or the
period of the engagement, if less) preceding such termination or new
engagement relating to any matter of accounting principles or
practices, financial statement disclosure, auditing scope or procedure,
or compliance with applicable rules of the Commission, which issues, if
not resolved to the satisfaction of the former independent public
accountant, would have caused the independent public accountant to make
reference to them in the report of the independent public accountant.
The issues required to be reported include both those resolved to the
former independent public accountant's satisfaction and those not
resolved to the former accountant's satisfaction. Issues contemplated
by this section are those that occur at the decisionmaking level--i.e.,
between principal financial officers of the broker or dealer and
personnel of the accounting firm responsible for rendering its report.
The notice must also state whether the accountant's report covering the
annual reports filed under paragraph (d) of this section for any of the
past two years contained an adverse opinion or a disclaimer of opinion
or was qualified as to uncertainties, audit scope, or accounting
principles, and must describe the nature of each such adverse opinion,
disclaimer of opinion, or qualification. The broker or dealer must also
request the former independent public accountant to furnish the broker
or dealer with a letter addressed to the Commission stating whether the
independent public accountant agrees with the statements contained in
the notice of the broker or dealer and, if not, stating the respects in
which independent public accountant does not agree. The broker or
dealer must file three copies of the notice and the accountant's
letter, one copy of which must be manually signed by the sole
proprietor, or a general partner or a duly authorized corporate
officer, as appropriate, and by the independent public accountant,
respectively.
(g) Engagement of independent public accountant. Every broker or
dealer required to file the annual reports pursuant to paragraph (d) of
this section shall engage an independent public accountant, unless the
broker or dealer is subject to the exclusions in paragraphs (d)(1) and
(e)(1)(i) of this section. The independent public accountant as part of
the engagement must undertake the following, as applicable:
(1) To prepare an independent public accountant's report based on
an examination of the financial report required to be filed by the
broker or dealer under paragraph (d)(2) of this section in accordance
with standards of the Public Company Accounting Oversight Board; and
(2)(i) To prepare an independent public accountant's report based
on an examination of the compliance report required to be filed by the
broker or dealer under paragraph (d)(3) of this section in accordance
with standards of the Public Company Accounting Oversight Board. This
examination and the related report would apply to the assertions of the
broker or dealer required under paragraph (d)(3) of this section; or
(ii) To prepare an independent public accountant's report based on
a review of the exemption report required to be filed by the broker or
dealer under paragraph (d)(4) of this section in accordance with
standards of the Public Company Accounting Oversight Board.
(h) Notification of material non-compliance. Upon determining any
material non-compliance exists during the course of preparing the
independent public accountant's reports, the independent public
accountant must notify the Commission within one business day of the
determination by means of a facsimile transmission or electronic mail,
followed by first class mail, directed to the attention of the Director
of the Office of Compliance Inspections and Examinations and provide a
copy of such notification in the same manner to the principal office of
the designated examining authority for the broker or dealer within one
business day of the finding.
(i) Reports prepared by the independent public accountant.
(1) Technical requirements. The independent public accountant's
reports shall:
(i) Be dated;
(ii) Be signed manually;
(iii) Indicate the city and state where issued; and
[[Page 37607]]
(iv) Identify without detailed enumeration the items covered by the
reports.
(2) Representations as to the examinations and review. The
accountant's report shall:
(i) State whether the examination or review was made in accordance
with standards of the Public Company Accounting Oversight Board;
(ii) Designate any examination and, if applicable, review
procedures deemed necessary by the independent public accountant under
the circumstances of the particular case that have been omitted, and
the reason for their omission.
(iii) Nothing in this section shall be construed to imply authority
for the omission of any procedure that independent public accountants
would ordinarily employ in the course of an examination or review made
for the purpose of expressing the opinions or statement required under
this section.
(3) Opinion to be expressed. The independent public accountant's
reports shall state clearly the opinion of the independent public
accountant:
(i) With respect to the financial report and the accounting
principles and practices reflected therein and the compliance report;
and
(ii) With respect to the financial report, as to the consistency of
the application of the accounting principles, or as to any changes in
such principles that have a material effect on the financial
statements.
(4) Exceptions. Any matters to which the independent public
accountant takes exception shall be clearly identified, the exception
thereto specifically and clearly stated, and, to the extent
practicable, the effect of each such exception on any related items
contained in the annual reports.
3. Section 240.17a-11 is amended by revising paragraph (e)
introductory text to read as follows:
Sec. 240.17a-11 Notification provision for brokers and dealers.
* * * * *
(e) Whenever any broker or dealer discovers, or is notified by an
independent public accountant pursuant to Sec. 240.17a-12(i)(2), of
the existence of any material inadequacy as defined in Sec. 240.17a-
12(h)(2), the broker or dealer shall:
* * * * *
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
4. The authority citation for Part 249 continues to read, in part,
as follows:
Authority: 15 U.S.C. 78a et seq. and 7201 et seq.; and 18 U.S.C.
1350, unless otherwise noted.
* * * * *
Note: The text of Form Custody does not, and this amendment
will not, appear in the Code of Federal Regulations.
5. Add Subpart T and Form Custody (referenced in Sec. 249.1900) to
Part 249 to read as follows:
Subpart T--Form for Broker-Dealers
Sec. 249.1900 Form Custody
BILLING CODE 8011-01-P
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By the Commission.
Dated: June 15, 2011.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-15341 Filed 6-24-11; 8:45 am]
BILLING CODE 8011-01-C