Broker-Dealer Reports

Federal RegisterJun 27, 2011

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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.

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

rule-comments@sec.gov.

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.

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;

and (3) eliminate potentially redundant requirements for certain broker-dealers affiliated with, or dually-registered as, investment advisers.

17 CFR 240.17a-5 (“Rule 17a-5”).

Public Law 111-203 (Jul. 21, 2010).

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.

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

working papers.”

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.

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.

The supporting schedules must be comprised of a computation of required and actual net capital under

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.

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;

(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”);

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.

See

15 U.S.C 78q(a), 15 U.S.C 78q(e), and Rule 17a-5(d).

See

Rule 17a-5(d)(2).

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”).

See

Rule 17a-5(g).

See also

12 CFR part 220

et seq.

(“Regulation T”).

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.

See

Rule 17a-5(k);

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.

Proposed paragraph (d)(1)(i)(B)(1) of Rule 17a-5.

Proposed paragraph (d)(1)(i)(B)(2) of Rule 17a-5.

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.

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

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

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.

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.

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.

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;

(2) whether the information used to assert compliance with the Financial Responsibility Rules was derived from the books and records of the broker-dealer;

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.

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.

See

proposed paragraph (d)(3)(i)(B)(1) of Rule 17a-5.

See

proposed paragraph (d)(3)(i)(B)(2) of Rule 17a-5.

See

proposed paragraph (d)(3)(i)(B)(3) of Rule 17a-5.

See

proposed paragraph (d)(3)(i)(C) of Rule 17a-5.

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.

See

Rule 15c3-1(c)(2)(iv)(B).

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.

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.

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.

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.

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.

See

Rule 206(4)-2(a)(6).

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.

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.

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.

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.

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.

Rule 17a-5 presently requires that independent public accountants include any instances of material inadequacies in their reports based on the Study.

The term “material

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.

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 § 601 of the PCAOB's Interim Attestation Standards;

see PCAOB Attestation Standard § 601.

See

proposed paragraph (d)(3)(ii) of Rule 17a-5.

See

Rule 17a-5(g).

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.

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,

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.

See, e.g.,

paragraph 36 of

PCAOB Attestation Standard § 601.

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).

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.

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.

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).

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.

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.

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.

See

proposed paragraph (d)(3)(iii) of Rule 17a-5.

See

proposed paragraph (d)(3)(i)(C) of Rule 17a-5.

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.

The Commission proposes these definitions, in part, because they are based on previous Commission action.

See

proposed paragraph (d)(3)(iii) of Rule 17a-5.

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.”

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.

An event is “reasonably possible” if the chance of the future event or events occurring is more than remote, but less than likely.

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.

Id.

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-

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.

The Examination Report would be required to be prepared in accordance with PCAOB standards.

See

proposed paragraph (g)(2)(i) of Rule 17a-5.

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.

The proposed changes would not affect existing obligations of broker-dealers or their accountants with respect to financial reporting.

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.

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.

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.

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.

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.

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

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.

See

Section 982 of the Dodd-Frank Act.

See

Rule 206(4)-2(a)(6)(ii)(A).

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.

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.”

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.

See

proposed paragraph (h) of Rule 17a-5.

See

Rule 17a-5(h)(2). “Material inadequacy” is not a defined term in existing auditing literature.

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.

See

Rule 206(4)-2(a)(4)(ii).

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.

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).

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.

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.

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.

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.

Under the IA Custody Rule, only banks, certain savings associations, registered broker-dealers, registered futures commission merchants (“FCMs”),

and certain foreign financial institutions may act as qualified custodians.

See

Rule 206(4)-2(a)(1)(i)-(ii).

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.

For the complete definition of the term “qualified custodian,”

see infra

note 154.

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.

The Commission has

issued guidance identifying the control objectives that would need to be included in the scope of the examination.

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.

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.

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

differs from that of a bank, and the different entities are subject to different regulations governing their custodial functions.

See

section 4d(a) and (b) of the Commodity Exchange Act (7 U.S.C. 4d);

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).

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

109

15 U.S.C. 78ddd(d)(1)(c).

110

See

Rule 17a-5(e)(4).

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

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).

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:

• 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.

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.

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

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).

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

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).”

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

See

Rule 17a-5(f)(2)(ii).

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

123

See, e.g., SEC

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

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

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

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

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

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.

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

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.

127

See

Form X-17A-5 Schedule I, Part II, Part IIa, Part IIb, and Part III.

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

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.

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

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.

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

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

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.

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

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

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).

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.

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).

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

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

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).

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

See

Rule 15c3-3(k)(2)(i).

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.

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.

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?

• 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

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.

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.

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.

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

information in most transactions involving debt securities).

144

17 CFR 240.10b-10.

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.

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”).

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

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.

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

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).

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:

• 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.

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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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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.

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.

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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).

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.

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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).

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

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.

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If the broker-dealer

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