# Broker-Dealer Reports > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2011-15341 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** June 27, 2011 - **Citation:** 76 FR 37572 ## Text 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. 1 The first set of amendments (collectively, the “Annual Reporting Amendments”) relates to the requirement that a broker-dealer file annual financial reports with the Commission. The Annual Reporting Amendments are designed to, among other things: (1) Update the existing requirements of Rule 17a-5; (2) facilitate the ability of the PCAOB to implement oversight of independent public accountants of broker-dealers as required by the Dodd-Frank Act; 2 and (3) eliminate potentially redundant requirements for certain broker-dealers affiliated with, or dually-registered as, investment advisers. 1 17 CFR 240.17a-5 (“Rule 17a-5”). 2 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. 3 3 PCAOB Auditing Standard 3 defines “Audit documentation” as the “written record of the basis for the auditor's conclusions that provides the support for the auditor's representations, whether those representations are contained in the auditor's report or otherwise. Audit documentation also facilitates the planning, performance, and supervision of the engagement, and is the basis for the review of the quality of the work because it provides the reviewer with written documentation of the evidence supporting the auditor's significant conclusions. Among other things, audit documentation includes records of the planning and performance of the work, the procedures performed, evidence obtained, and conclusions reached by the auditor. Audit documentation also may be referred to as work papers or working papers.” The third set of amendments (collectively, the “Form Custody Amendments”) would enhance the ability of the Commission and examiners of a DEA to oversee broker-dealers' custody practices by requiring broker-dealers to file on a quarterly basis a new Form Custody. Form Custody would elicit information as to whether and how a broker-dealer maintains custody of cash and securities of customers and others. II. The Proposed Annual Reporting Amendments A. Background Sections 17(a) and (e) of the Exchange Act and Rule 17a-5 together require a broker-dealer to, among other things, file an annual report (an “Annual Audit Report”) containing audited financial statements, supporting schedules, and supplemental reports, as applicable, with the Commission and the broker-dealer's DEA. 4 The financial statements must be comprised of a statement of financial condition, a statement of income, a statement of cash flows, a statement of changes in stockholders' or partners' or sole proprietor's equity, and a statement of changes in liabilities subordinated to claims of general creditors. 5 The supporting schedules must be comprised of a computation of required and actual net capital under Exchange Act Rule 15c3-1, and, for broker-dealers that maintain custody of customer funds or securities (“carrying broker-dealers”), a computation of the customer reserve requirement and information relating to the possession or control requirements under Exchange Act Rule 15c3-3. 6 The supplemental reports include: (1) A report of an independent public accountant that is the result of a review of, among other things, the broker-dealer's accounting system, internal accounting control and procedures for safeguarding securities, and practices and procedures in complying with various Commission financial responsibility rules and Regulation T of the Board of Governors of the Federal Reserve System; 7 (2) a report of an independent public accountant provided to, among others, the Securities Investor Protection Corporation (“SIPC”) to help administer the collection of assessments from broker-dealers for purposes of establishing and maintaining its broker-dealer liquidation fund (the “SIPC Fund”); 8 and (3) for broker-dealers that compute net capital under an alternative model-based standard, a report of an independent public accountant indicating the results of the accountant's review of the internal risk management control system established and documented by the broker-dealer in accordance with Exchange Act Rule 15c3-4. 9 4 See 15 U.S.C 78q(a), 15 U.S.C 78q(e), and Rule 17a-5(d). 5 See Rule 17a-5(d)(2). 6 See Rule 17a-5(d)(3). See also 17 CFR 240.15c3-1 (“Rule 15c3-1”) and 17 CFR 240.15c3-3 (“Rule 15c3-3”). 7 See Rule 17a-5(g). See also 12 CFR part 220 et seq. (“Regulation T”). 8 See Rule 17a-5(e)(4). These reports will be collectively referred to in this release as the “SIPC Reports.” As part of the Annual Reporting Amendments, the Commission is proposing to amend how the SIPC Reports are filed; see infra Section II.C. 9 See Rule 17a-5(k); see also 17 CFR 240.15c3-4. Paragraph (g) of Rule 17a-5, entitled “Audit objectives,” describes the objectives that should be achieved by an independent public accountant in preparing a report for the broker-dealer to file with its Annual Audit Report. 10 For example, the audit is required to be performed in accordance with generally accepted auditing standards (“GAAS”). 11 In addition, paragraph (g)(1) of Rule 17a-5 requires that the audit include a “review” and appropriate tests of the broker-dealer's accounting system, internal accounting control and procedures for safeguarding securities for the period since the prior examination date. 12 The paragraph further states that the scope of the audit and review of the accounting system, internal accounting control, and procedures for safeguarding securities shall be sufficient to provide reasonable assurance that any material inadequacies existing in those items, including in the procedures for obtaining and maintaining physical possession and control of all fully paid and excess margin securities, complying with Regulation T, and making the quarterly securities examinations, counts, verifications, and comparisons and recordation of differences required by Exchange Act Rule 17a-13 would be disclosed. 13 Currently, with respect to these requirements, independent public accountants for broker-dealers issue a report describing a “study” of these practices and procedures and, if applicable, notification to the Commission of the discovery of any material inadequacies (the “Study”). The form of the report that describes the Study is specified in an AICPA publication entitled AICPA Audit & Accounting Guide: Brokers and Dealers in Securities; 14 however, the form of the report does not specify the level of assurance required to be obtained by the independent public accountant when performing the Study. 10 See Rule 17a-5(g). 11 Auditing and attestation standards for broker-dealers are currently established by the American Institute of Certified Public Accountants (the “AICPA”). 12 See Rule 17a-5(g)(1). 13 Id. See also 17 CFR 240.17a-13 (“Rule 17a-13”). The term “material inadequacy” is defined in Rule 17a-5(g)(3). 14 See the AICPA Audit & Accounting Guide: Brokers and Dealers in Securities (Jul. 2010) (the “Broker-Dealer Audit Guide”). Professional auditing standards provide for three levels of attestation engagement by an accountant. 15 Under the highest level of attestation engagement, the accountant obtains “reasonable assurance” with respect to the matter that is the subject of the accountant's attestation engagement and provides an opinion. This standard is required with respect to audits and examinations. 16 The second level of attestation engagement is a review, which results in the accountant obtaining a moderate level of assurance with respect to the matter that is the subject of the accountant's attestation engagement. The third type of attestation engagement is one in which the accountant performs agreed-upon procedures, which results in no assurance, but rather a reporting of the accountant's findings after the performance of procedures that have been agreed to by specified parties. Rule 17a-5 currently requires that a broker-dealer engage an independent public accountant to audit the broker-dealer's financial statements. Some of the supporting schedules are also subject to financial statement audit procedures. 15 Professional auditing standards include both GAAS and standards promulgated by the PCAOB. 16 This proposing release generally refers to an “audit” of a broker-dealer's financial statements and an “examination” of the broker-dealer's compliance with a particular rule or implementation of controls designed to achieve compliance with a particular rule. Rule 17a-5 also requires that a broker-dealer that is claiming an exemption from the requirements of Rule 15c3-3 file a report with the Commission. 17 Rule 15c3-3(k) sets forth certain conditions that a broker-dealer must meet to be exempt from the rule's requirements. Generally, the broker-dealer would be exempt if it does not hold customer funds or securities, or, if it does, it promptly forwards all funds and securities received. Rule 17a-5 provides that the independent public accountant engaged by the broker-dealer must “ascertain that the conditions of the exemption were being complied with as of the examination date and that no facts came to the independent public accountant's attention to indicate that the exemption had not been complied with during the period since the independent public accountant's last examination.” 18 This requirement has resulted in independent public accountants providing a statement concerning whether they have ascertained that the broker-dealer was complying with the conditions of the exemption. 19 17 See Rule 17a-5(g)(2). 18 Id. 19 See Broker-Dealer Audit Guide, supra note 14 at Section 3.32. Many of the requirements currently contained in Rule 17a-5 have existed since 1975, and, for the most part, have remained substantially unchanged. 20 For example, as noted above, to comply with the requirement of paragraph (g) of Rule 17a-5 to conduct an audit and review of the identified matters, independent public accountants currently issue a report based on a Study. The practice of conducting the Study is relatively unique to broker-dealer audits and, while audit literature at one time referred to the performance of a “study,” the performance of a study is no longer included in contemporary audit standards governing the work to be performed by an independent public accountant. 20 See Broker-Dealer Reports, Exchange Act Release No. 11935 (Dec. 17, 1975), 40 FR 59706 (Dec. 30, 1975). In this release, the Commission adopted amendments to Rule 17a-5, which included, among other things, the adoption of the requirement for broker-dealers to file Financial and Operational Combined Uniform Single (or “FOCUS”) Reports. In addition, recent legislation and Commission rulemaking have further prompted the need to reexamine the requirements pertaining to the Annual Audit Report. First, Section 982 of the Dodd-Frank Act amended the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) 21 to provide the PCAOB with explicit authority to, among other things, establish, subject to Commission approval, auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms with respect to the preparation and issuance of audit reports to be included in broker-dealer filings with the Commission. 22 The Dodd-Frank Act also authorizes the PCAOB to inspect registered public accounting firms that provide audit reports for broker-dealers and to enforce standards relative to their audits. 21 17 U.S.C. 7202 et seq. 22 See Section 982 of the Dodd-Frank Act. Further, in December 2009, the Commission amended Rule 206(4)-2 (the “IA Custody Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”), 23 which governs investment advisers' custody practices. 24 Among other requirements, registered investment advisers that have custody of client funds or securities must maintain those assets at a qualified custodian, such as a bank or broker-dealer. 25 If an investment adviser that also is, for example, a bank, or its related person, serves as a qualified custodian for advisory client funds or securities, the adviser must annually obtain, or receive from its related person, a written internal control report prepared by an independent public accountant registered with, and subject to regular inspection by, the PCAOB. Broker-dealers that also are registered as investment advisers may, acting in their capacity as broker-dealers, maintain client funds and securities as qualified custodians in connection with advisory services provided to clients, and under the IA Custody Rule are required to obtain internal control reports. Broker-dealers acting as qualified custodians also may maintain advisory assets in connection with advisory services provided by related or affiliated investment advisers. In such instances, these broker-dealers are also required to provide internal control reports to their related investment advisers. 23 17 CFR 275.206(4)-2 (“Rule 206(4)-2”). 24 See Custody of Funds or Securities by Investment Advisers, Advisers Act Release No. 2876 (May 20, 2009), 74 FR 25354 (May 27, 2009) (“IA Custody Proposing Release”); Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010) (“IA Custody Adopting Release”). 25 See Rule 206(4)-2. For the reasons discussed above, the Commission is proposing amendments to Rule 17a-5. The amendments proposed by the Commission are intended to update the broker-dealer audit requirements and provide for an examination of compliance, and internal control over compliance, with key regulatory requirements that would provide the Commission with greater assurance as to a broker-dealer's compliance with the requirements. In addition, the proposed changes are intended to facilitate the ability of the PCAOB to set standards for, and implement its inspection authority over, broker-dealers' independent public accountants by providing an improved foundation for the PCAOB to establish new broker-dealer audit standards. Moreover, the proposed changes, as they pertain to compliance with requirements concerning the custody of customer funds and securities, are intended to complement and reinforce the regulatory changes effected by the IA Custody Rule. In particular, the Commission preliminarily believes that broker-dealers that also are registered as investment advisers and hold advisory client funds or securities, or that hold funds or securities for related investment advisers, would be able to use the Examination Report described below to satisfy the internal control report requirements under both Rule 17a-5, as it is proposed to be amended, and the IA Custody Rule. As discussed below, the proposed changes would provide, as to broker-dealers subject to the requirements of Rule 15c3-3, for an examination of compliance, and internal control over compliance, with respect to Rule 15c3-1, Rule 15c3-3, Rule 17a-5, and rules prescribed by DEAs requiring broker-dealers to send account statements to customers (“Account Statement Rules”). Rule 15c3-1 requires broker-dealers to maintain at all times a minimum amount of net liquid assets, or “net capital.” Under Rule 15c3-1, broker-dealers must perform two calculations: (1) A computation of required minimum net capital; 26 and (2) a computation of actual net capital. 27 26 A broker-dealer's required minimum net capital is the greater of a fixed-dollar amount prescribed in Rule 15c3-1, or an amount computed using one of two financial ratios. The first financial ratio generally provides that a broker-dealer shall not permit its aggregate indebtedness to exceed 1500% of its net capital. See Rule 15c3-1(a)(1)(i). The second financial ratio provides that a broker-dealer shall not permit its net capital to be less than 2% of aggregate customer debit items. See Rule 15c3-1(a)(1)(ii). Customer debit items—computed pursuant to Exhibit A to Rule 15c3-3, which is described below—consist of, among other things, margin loans to customers and securities borrowed to effectuate customer deliveries of securities on short sales. 27 A broker-dealer computes its actual net capital by first calculating its net worth using United States (“U.S.”) generally accepted accounting principles. Second, qualifying subordinated loans are added to net worth. Third, illiquid assets such as real estate, fixtures, furniture, goodwill, and most unsecured receivables are subtracted from net worth. Illiquid securities also must be deducted. Finally, the broker-dealer must reduce (“haircut”) the market value of the liquid securities it owns by a percentage amount. This “haircut” provides a cushion against adverse market movements and other risks faced by the broker-dealer. Rule 15c3-3 imposes two key requirements on carrying broker-dealers. First, each carrying broker-dealer must obtain physical possession or control over customers' fully paid and excess margin securities. 28 “Control” means the broker-dealer must hold these securities free of lien in one of several locations specified in the rule ( e.g., a bank or clearing agency). 29 Under Rule 15c3-3, the broker-dealer must make a daily determination from its books and records (as of the preceding day) of the quantity of fully paid and excess margin securities in its possession or control and the quantity of fully paid and excess margin securities not in its possession or control. 30 If the amount in the broker-dealer's possession and control is less than the amount indicated as being held for customers on the broker-dealer's books and records, the broker-dealer generally must initiate steps to retrieve customer securities from non-control locations or otherwise obtain possession of them or place them in control locations. 31 28 See Rule 15c3-3(b)(1). 29 See Rule 15c3-3(c). 30 See Rule 15c3-3(d). 31 Id. The second key requirement in Rule 15c3-3 is that the carrying broker-dealer must maintain at a bank or banks cash or qualified securities 32 on deposit in a “Special Reserve Bank Account for the Exclusive Benefit of Customers” equaling at least the net amount computed by adding customer credit items ( e.g., cash in securities accounts) and subtracting from that amount customer debit items ( e.g., margin loans). 33 Rule 15c3-3 is designed to protect customer funds and securities by generally segregating them from the broker-dealer's proprietary business activities. If the carrying broker-dealer fails, customer funds and securities should be readily available for return to customers. The rule requires carrying broker-dealers to compute the customer reserve requirement on a weekly basis, except where customer credit balances do not exceed $1 million (in which case the computation can be performed monthly, although, in this case, the broker-dealer must maintain 105% of the required deposit amount). 34 32 The term “qualified security” is defined in Rule 15c3-3 to include securities issued by the U.S. or guaranteed by the U.S. with respect to principal and interest. See Rule 15c3-3(a)(6). 33 See Rule 15c3-3(e). 34 See Rule 15c3-3(e)(3). Rule 17a-13 requires a broker-dealer that holds securities (proprietary, customer, or both), on a quarterly basis, to examine and count the securities it physically holds, account for the securities that are subject to its control or direction but are not in its physical possession ( e.g., securities held at a control location), verify the securities, and compare the results of the count and verification with its records. The broker-dealer must take an operational capital charge under Rule 15c3-1 for all short securities differences (which include securities positions reflected on the broker-dealer's securities record that are not susceptible to either count or confirmation) unresolved after discovery. 35 The differences also must be recorded on the broker-dealer's records. 36 35 See Rule 15c3-1(c)(2)(v). 36 See Rule 17a-3(a)(4)(vi). The Account Statement Rules of DEAs require member broker-dealers to send, at least once every calendar quarter, a statement of account containing a description of any securities positions, money balances, or account activity to each customer whose account had a security position, money balance, or account activity during the period since the last such statement was sent to the customer. 37 37 For example, NASD Rule 2340 requires broker-dealers that are members of FINRA that conduct a general securities business to send account statements to customers at least quarterly. The current FINRA rulebook consists of: (1) FINRA rules; (2) NASD rules; and (3) rules incorporated from the NYSE (“Incorporated NYSE Rules”) (together, the NASD rules and Incorporated NYSE Rules are referred to as the “Transitional Rulebook”). While the NASD rules generally apply to all FINRA members, the Incorporated NYSE Rules apply only to those members of FINRA that are also members of the NYSE. The FINRA rules apply to all FINRA members, unless such rules have a more limited application by their terms. For more information see FINRA's Information Notice, Mar. 12, 2008 (Rulebook Consolidation Process). If a broker-dealer's DEA is the Chicago Board Options Exchange (the “CBOE”), the broker-dealer would be subject to CBOE's account statement rule, CBOE Rule 9.12. B. Proposed Audit Reports and Changes to Applicable Auditing Standards As part of the Annual Reporting Amendments, the Commission is proposing changes that would revise the reports that broker-dealers file under Rule 17a-5. While the requirement that broker-dealers file a report consisting of the audited financial statements and supporting schedules that are currently required under Rule 17a-5 (the “Financial Report”) would remain unchanged, carrying broker-dealers would be required to file a new report asserting to compliance with specified rules and related internal controls (the “Compliance Report”). These broker-dealers also would be required to file a report from their independent public accountants (the “Examination Report”) that addresses the assertions in the Compliance Report. Broker-dealers that do not hold customer funds or securities would be required to file a report asserting their exemption from the requirements of Rule 15c3-3 (the “Exemption Report) and a report from their independent public accountants that would be the result of a review of the broker-dealer's assertion that it is exempt from Rule 15c3-3. Finally, the proposed amendments would change the audit standards applicable to broker-dealer audits and compliance examinations from GAAS to standards promulgated by the PCAOB. To implement these changes, the Commission proposes a number of amendments to Rule 17a-5. The Commission proposes that paragraph (d) of Rule 17a-5 be re-titled from “Annual filing of audited financial statements” to “Annual reports,” because under the proposed revisions to paragraph (d), broker-dealers would generally be required to file a Financial Report and a Compliance Report or an Exemption Report with the Commission. 38 Paragraph (d)(1) of Rule 17a-5 would be amended to set forth the general requirement for broker-dealers to file annual financial reports with the Commission. These reports would include: (1) A “Financial Report” as described in paragraph (d)(2), which would consist of the audited financial statements and supporting schedules that broker-dealers are currently required to file with the Commission; 39 (2) a Compliance Report as described in paragraph (d)(3) unless the broker-dealer is exempt from the provisions of Rule 15c3-3, 40 or an Exemption Report as described in paragraph (d)(4) if the broker-dealer claims an exemption from the provisions of Rule 15c3-3; 41 and (3) reports prepared by the independent public accountant pursuant to the engagement provisions in paragraph (g), unless the broker-dealer is exempt from the requirement to either file the annual audit report or engage an independent public accountant pursuant to paragraphs (d)(1) and (e)(1) of Rule 17a-5. 42 The proposed requirements for the Compliance Report and Exemption Report are described in greater detail below. 38 Paragraph (d) of Rule 17a-5, currently titled “Annual filing of audited financial statements,” is being renamed to reflect that the Commission will now require broker-dealers to file two reports with the Commission ( i.e., a Financial Report and a Compliance Report, or a Financial Report and an Exemption Report). 39 Proposed paragraph (d)(1)(i)(A) of Rule 17a-5. See also Rule 17a-5(d)(2), which lists the requirements to be included in the Financial Report and would continue to do so because the Commission is not proposing any amendment to the financial statements and supporting schedules required of the broker-dealer. The Commission proposes a technical amendment, to rename the annual audit report to “Financial Report,” to reflect that proposed paragraph (d)(2) relates to the financial audit requirements. 40 Proposed paragraph (d)(1)(i)(B)(1) of Rule 17a-5. 41 Proposed paragraph (d)(1)(i)(B)(2) of Rule 17a-5. 42 Proposed paragraph (d)(1)(i)(C) of Rule 17a-5. Specifically, Rule 17a-5(d)(1)(ii) states that “a broker or dealer succeeding to and continuing the business of another broker or dealer need not file a report * * * if the predecessor broker or dealer has filed a report in compliance with [Rule 17a-5(d)] * * *.” Rule 17a-5(d)(1)(iii) contains an exemption for broker-dealers from filing an annual audit report if the broker-dealer is a member of a national securities exchange and “has transacted a business in securities solely with or for other members of a national securities exchange, and has not carried any margin account, credit balance or security for any person who is defined as a `customer' in paragraph (c)(4) of [Rule 17a-5].” Rule 17a-5(e)(1) provides that for certain broker-dealers, the financial statements that must be filed pursuant to Rule 17a-5(d) need not be audited. The exceptions in paragraphs (e)(1)(A)-(B) of Rule 17a-5 are applicable when either: (1) The broker-dealer's securities business has been limited to acting as broker (agent) for an issuer in soliciting subscriptions for securities of the issuer and the broker has promptly transmitted to the issuer all funds and promptly delivered to the subscriber all securities received in connection with the issuance, and the broker has not otherwise held funds or securities for or owed money or securities to customers; or (2) the broker-dealer's securities business has been limited to buying and selling evidences of indebtedness secured by mortgage, deed or trust, or other lien upon real estate or leasehold interests, and the broker-dealer has not carried any margin account, credit balance or security for any securities customer. 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 43 that any instances of material non-compliance with Rule 15c3-1, Rule 15c3-3, Rule 17a-13, or the Account Statement Rule (collectively, the “Financial Responsibility Rules”) will be prevented or detected on a timely basis. The Compliance Report is intended to enhance a broker-dealer's focus on compliance with the specified rules and provide a foundation for the proposed “Compliance Examination” described below in Section II.B.2 of this release. 44 43 Exchange Act Section 13(b)(7) defines “reasonable assurance” and “reasonable detail” as “such level of detail and degree of assurance as would satisfy prudent officials in the conduct of their own affairs.” 15 U.S.C. 78m(b)(7). The Commission has long held that “reasonableness” is not an “absolute standard of exactitude for corporate records.” See Foreign Corrupt Practices Act of 1977, Exchange Act Release No. 17500 (Jan. 29, 1981), 46 FR 11544, 11546 (Feb. 9, 1981). These concepts differ from the concept of “reasonable assurance” in an audit context. 44 The Compliance Examination is discussed below in Section II.B.2 of this release. As is discussed in Section II.B.2, the Commission does not propose the statement in the Compliance Report to be included within the scope of the Compliance Examination. In addition, the Compliance Report would include the following three assertions by the broker-dealer: (1) Whether the broker-dealer was in compliance in all material respects with the Financial Responsibility Rules as of its fiscal year-end; 45 (2) whether the information used to assert compliance with the Financial Responsibility Rules was derived from the books and records of the broker-dealer; 46 and (3) whether internal control over compliance with the Financial Responsibility Rules was effective during the most recent fiscal year such that there were no instances of material weakness. 47 Further, the Compliance Report would be required to contain a description of each identified instance of material non-compliance and each identified material weakness in internal control over compliance with the specified rules. 48 45 See proposed paragraph (d)(3)(i)(B)(1) of Rule 17a-5. 46 See proposed paragraph (d)(3)(i)(B)(2) of Rule 17a-5. 47 See proposed paragraph (d)(3)(i)(B)(3) of Rule 17a-5. 48 See proposed paragraph (d)(3)(i)(C) of Rule 17a-5. Rule 17a-5(g) currently requires that the audit include a review of compliance with and controls pertaining to Rule 15c3-1, Rule 15c3-3, and Rule 17a-13. As described above, these rules contain important baseline protections concerning broker-dealer capital adequacy and the protection of customer funds and securities, and the Commission preliminarily believes that it is important that they be addressed in any annual report of a carrying broker-dealer. The proposed Compliance Report would not cover Regulation T, which is currently addressed in existing Rule 17a-5(g)(1)(iii). The Commission believes that the inclusion of Regulation T in the scope of the Compliance Report would not be necessary given the broker-dealer's assertion in the Compliance Report of its compliance with Rule 15c3-1. In particular, a broker-dealer's failure to comply with Regulation T, which governs broker-dealers' extensions of credit on securities, could require a broker-dealer to reduce its net capital by the amount of any deficit in customer unsecured and partly secured accounts after calls for margin. 49 49 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. 50 50 See Section II.B.4 of this release for a discussion of the IA Custody Rule and the control objectives required under the IA Custody Rule. The assertions contained in the Compliance Report would pertain to compliance at year-end and also over the course of a fiscal quarter, depending on the particular requirement. 51 The proposed assertions with respect to compliance with Rules 15c3-1 and 15c3-3 would relate to compliance as of the broker-dealer's fiscal year-end. The assertions as to compliance with Rule 17a-13 and the Account Statement Rule also would be made as of the broker-dealer's fiscal year-end. However, because these rules impose obligations on a quarterly basis (the broker-dealer must conduct the quarterly count of securities and must send statements to all customers at least once during each quarter, but not necessarily on the last day of the quarter), to be able to make the assertions in the Compliance Report, the broker-dealer would need to determine that it had satisfied the requirements over the course of the fiscal quarter immediately preceding the broker-dealer's fiscal year-end. In contrast, the broker-dealer's assertions related to the effectiveness of internal control over compliance with the Financial Responsibility Rules would not pertain to a fixed point in time, but instead would cover the entire fiscal year. The proposed time periods related to internal control over compliance would be consistent with those in the IA Custody Rule. 52 51 The broker-dealer is required to be in compliance with the Financial Responsibility Rules at all times. The assertions made by the broker-dealer for purposes of the Compliance Report are as of a point in time to facilitate the independent public accountant's attestation to the broker-dealer's assertions. 52 See Rule 206(4)-2(a)(6). The Commission preliminarily believes that broker-dealers would be able to make assertions regarding both compliance and the effectiveness of internal control over compliance with the Financial Responsibility Rules. The Commission is not proposing that effectiveness of internal control over financial reporting be included as one of the assertions made by the broker-dealer in the Compliance Report. 53 The Commission preliminarily believes that the Compliance Report should focus on oversight of custody arrangements and protection of customer assets, and therefore, should be focused on compliance with the Financial Responsibility Rules. 53 For example, the Commission is not proposing an assessment of internal control over financial reporting similar to the assessment required under Section 404 of the Sarbanes-Oxley Act for issuers. The proposed amendments to Rule 17a-5 would provide that a broker-dealer could not assert compliance with the Financial Responsibility Rules, as of its most recent fiscal year-end, if it identifies one or more instances of material non-compliance. 54 Instead, the broker-dealer would need to identify and describe any instance of material non-compliance, as of its most recent fiscal year-end, in the Compliance Report. 55 Rule 17a-5 presently requires that independent public accountants include any instances of material inadequacies in their reports based on the Study. 56 The term “material 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. 54 See proposed paragraph (d)(3)(ii) of Rule 17a-5. The Commission notes that reporting on material non-compliance is discussed, for example, in AT § 601 of the PCAOB's Interim Attestation Standards; see PCAOB Attestation Standard § 601. 55 See proposed paragraph (d)(3)(ii) of Rule 17a-5. 56 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. 57 The Commission also preliminarily believes that some deficiencies would necessarily constitute instances of material non-compliance. For example, failing to maintain the required minimum amount of net capital as required under Rule 15c3-1, or failing to maintain the minimum deposit requirement in a special reserve bank account for the exclusive benefit of customers under Rule 15c3-3, 58 would be instances of material non-compliance. These two instances of material non-compliance would not, however, represent all possible instances of material non-compliance with respect to Rules 15c3-1 and 15c3-3. 57 See, e.g., paragraph 36 of PCAOB Attestation Standard § 601. 58 See Section 15(c)(3) of the Exchange Act, which provides that no broker or dealer shall make use of the mails or any means or instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security “in contravention of such rules and regulations as the Commission shall prescribe * * * to provide safeguards with respect to the financial responsibility and related practices of the brokers and dealers including, but not limited to the acceptable custody and use of customers' securities and the carrying and use of customers' deposits or credit balances.” 15 U.S.C. 78o(c)(3)(A). The Commission is proposing several conforming amendments to Rule 17a-5 to incorporate the proposed use of the term “material non-compliance.” The Commission proposes to amend paragraph (c)(5) of Rule 17a-5, which requires broker-dealers to send Statements of Financial Condition to customers twice per year. Paragraph (c) of Rule 17a-5 provides that a broker-dealer can make these statements available through its Internet Web site in lieu of sending the statements to the customers in paper form. 59 However, paragraph (c)(5)(vi) of Rule 17a-5 prohibits broker-dealers from making the statements available online, in lieu of sending statements to customers in paper form, if the broker-dealer was required by paragraph (e) of Rule 17a-11 to give notice of a material inadequacy. The Commission is proposing to delete the reference to the term “material inadequacy” and amend paragraph (c)(5)(vi) of Rule 17a-5 to provide that the broker-dealer may make the customer statements available online, in lieu of sending statements to customers in paper form, provided its financial statements receive an unqualified opinion from the independent public accountant and neither the broker-dealer nor the independent public accountant identifies a material weakness or an instance of material non-compliance pursuant to proposed new paragraph (g) of Rule 17a-5, described below. 59 Rule 17a-5 requires that the statements be sent to its customers, except if the activities of the broker-dealer are limited to certain enumerated activities or except as provided in paragraph (c)(5), which permits the broker-dealer to instead make the statements available online if certain requirements are met. See Rule 17a-5(c)(1) and (c)(5). The proposed amendments to Rule 17a-5 also would provide that a broker-dealer could not assert that its internal control over compliance with the Financial Responsibility Rules during the fiscal year was effective if one or more material weaknesses exist with respect to internal control over compliance. 60 The Commission preliminarily believes that a broker-dealer's internal control over compliance with the Financial Responsibility Rules would not be effective if a material weakness exists, given the meaning of the term “material weakness” as described below. Consequently, if one or more material weaknesses exist, the broker-dealer would need to describe in the Compliance Report each material weakness identified during the fiscal year. 61 This would provide the Commission with notice of the nature of any weakness and allow the Commission and DEA examination staff to ascertain how the broker-dealer addressed each weakness. 60 See proposed paragraph (d)(3)(iii) of Rule 17a-5. 61 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. 62 The Commission proposes these definitions, in part, because they are based on previous Commission action. 63 62 See proposed paragraph (d)(3)(iii) of Rule 17a-5. 63 See Amendments to Rules Regarding Management's Report on Internal Control Over Financial Reporting, Exchange Act Release No. 55928 (Jun. 27, 2007), 72 FR 35310 (Jun. 27, 2007). See also Exchange Act Rule 12b-2 (17 CFR 240.12b-2) and Rule 1-02 of Regulation S-X (17 CFR 210.1-02), which state that a “material weakness is a deficiency, or a combination of deficiencies, in internal controls over financial reporting such that there is a reasonable possibility that a material misstatement of the registrant's annual or interim financial statements will not be prevented or detected on a timely basis.” The Commission preliminarily believes that, for purposes of the proposed definition of the term “material weakness,” there is a reasonable possibility of an event occurring if it is “probable” or “reasonably possible.” An event is “probable” if the future event or events are likely to occur. 64 An event is “reasonably possible” if the chance of the future event or events occurring is more than remote, but less than likely. 65 64 See Commission Guidance Regarding Management's Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, Securities Act of 1933 Release No. 8810 (Jun. 20, 2007), 72 FR 35324 (Jun. 27, 2007), at note 47 and corresponding text. 65 Id. 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. 66 The Examination Report would be required to be prepared in accordance with PCAOB standards. 67 66 See proposed paragraph (g)(2)(i) of Rule 17a-5. 67 Id. The Commission preliminarily believes that the independent public accountant's examination would be conducted pursuant to existing PCAOB Attestation Standards or other standards established by the PCAOB for such purposes. The proposed changes would not affect existing obligations of broker-dealers or their accountants with respect to financial reporting. 68 Further, the assertions in the Compliance Report would not cover the effectiveness of internal control over financial reporting. Therefore, the independent public accountant would not be required in the Examination Report to opine on the effectiveness of the broker-dealer's internal control over financial reporting. However, the accountant's existing obligation to gain an understanding and perform appropriate procedures relative to the broker-dealer's internal control over financial reporting, as a necessary part of the independent public accountant's financial statement audit, would remain unchanged. 69 Further, the Examination Report would pertain solely to the assertions in the Compliance Report and not to the broker-dealer's process for arriving at the assertions. Because the report of the independent public accountant required by proposed paragraph (g) of Rule 17a-5 would require the accountant to perform its own independent examination of the related controls and procedures, the Commission preliminarily does not believe that it is necessary for the independent public accountant to provide an opinion with regard to the process that the broker-dealer used to arrive at its conclusions. 68 The Commission is not proposing to change existing requirements with regard to the broker-dealer's audited financial statements, the computation of required and actual net capital under Rule 15c3-1, or, for carrying broker-dealers, the computation of the customer reserve requirement under Rule 15c3-3. The computation of net capital and the computation of the customer reserve requirement would continue to be subject to audit procedures by the accountant. 69 See PCAOB Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatements for audits of fiscal years beginning on or after December 15, 2010. The Commission preliminarily intends that the proposed amendments and requirements pertaining to the Examination Report would result in the following fundamental changes to broker-dealer audits. First, broker-dealer examinations would be performed in accordance with PCAOB standards, rather than GAAS, consistent with the Dodd-Frank Act. 70 Second, in connection with their engagement, independent public accountants would be required to provide an opinion concerning the broker-dealer's compliance, and internal control over compliance, with key regulatory requirements. Further, the independent public accountant's report, as it applies to internal control over compliance, would cover the full fiscal year instead of relating to the effectiveness of controls only at year-end. Compliance with the Account Statement Rules would be included as part of the review. These changes are intended to encourage, in connection with broker-dealer audits, greater focus by the auditor on internal control over compliance as it pertains to key regulatory requirements, including, in particular, greater focus on broker-dealer custody practices under the Financial Responsibility Rules. In addition, the Commission intends that the amendments, as they pertain to custody of customer funds and securities, will better align the broker-dealer custody requirements with certain requirements in the IA Custody Rule. 71 70 See Section 982 of the Dodd-Frank Act. 71 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. 72 This notice requirement would be triggered at the time that the independent public accountant determines that material non-compliance exists, not at the time of completion of the examination. Alerting the Commission to a broker-dealer's material non-compliance with the Financial Responsibility Rules on an expedited basis could enable the Commission to react to the non-compliance more quickly for the protection of investors and others. Currently, Rule 17a-5 requires notification in the event the independent public accountant determines the existence of a “material inadequacy.” 73 Specifically, the independent public accountant must call the material inadequacy to the attention of the broker-dealer's chief financial officer, who is then obligated to notify the Commission and the broker-dealer's DEA. 72 See proposed paragraph (h) of Rule 17a-5. 73 See Rule 17a-5(h)(2). “Material inadequacy” is not a defined term in existing auditing literature. The Commission proposes modifying the notification requirement to replace the term “material inadequacy” with “material non-compliance” and to require the independent public accountant to notify the Commission directly. Specifically, the Commission proposes to amend paragraph (h) of Rule 17a-5 to provide that upon determining the existence of any material non-compliance during the course of preparing the independent public accountant's reports, the independent public accountant must notify the Commission within one business day of the determination by means of a facsimile transmission or electronic mail, followed by first class mail, and must provide a copy of the notification in the same manner to the principal office of the DEA for the broker-dealer. The Commission preliminarily believes that this change would provide more effective and timely notice of broker-dealer compliance deficiencies, and, as noted above, enable the Commission to react more quickly to protect customers and others adversely affected by those deficiencies. It also would be consistent with current notification requirements applicable to independent public accountants examining investment advisers pursuant to the IA Custody Rule. 74 74 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. 75 Further, the Commission is proposing to delete paragraph (h)(1) of Rule 17a-5, which relates to the extent and timing of broker-dealer audits, and which would now be superseded by paragraphs (d) and (g). 76 Finally, the Commission is proposing to delete paragraph (j) of Rule 17a-5, which currently requires the filing of an independent public accountant's report describing any material inadequacies concurrent with the annual audit report. This requirement likewise would be superseded by the proposed amendments. 75 Specifically, the Commission proposes to amend the references for Rule 17a-12(f)(2) and Rule 17a-12(e)(2) to be Rule 17a-12(i)(2) and Rule 17a-12(h)(2), respectively. 76 As discussed above, the broker-dealer must assert that it is in compliance in all material respects with the Financial Responsibility Rules as of the fiscal year-end and that its internal controls over compliance were effective throughout the fiscal year. See proposed paragraph (d)(3) of Rule 17a-5. The Commission generally requests comment on the proposed amendments and the notification provisions. In addition, the Commission requests comment on the following questions: • Would an alternative means to notify the Commission of an instance of material non-compliance be appropriate? If so, what alternative and why? 4. Comparison to the IA Custody Rule The IA Custody Rule provides that a registered investment adviser is prohibited from having custody of client funds or securities unless a qualified custodian maintains those funds and securities: (1) In a separate account for each client under that client's name; or (2) in accounts that contain only the investment adviser's clients' funds and securities, under the investment adviser's name as agent or trustee for the clients. 77 Under the IA Custody Rule, only banks, certain savings associations, registered broker-dealers, registered futures commission merchants (“FCMs”), 78 and certain foreign financial institutions may act as qualified custodians. 79 77 See Rule 206(4)-2(a)(1)(i)-(ii). 78 FCMs are individuals, associations, partnerships, corporations, and trusts that solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any exchange and that accept payment from or extend credit to those whose orders are accepted. See the Commodity Futures Trading Commission Glossary available at http://www.cftc.gov. 79 For the complete definition of the term “qualified custodian,” see infra note 154. In addition, when an investment adviser or its related person maintains client funds and securities as qualified custodian in connection with advisory services provided to clients, the adviser annually must obtain, or receive from its related person, a written internal control report prepared by an independent public accountant registered with, and subject to regular inspection by, the PCAOB. This report must be supported by the independent public accountant's examination of the qualified custodian's custody controls. 80 The Commission has issued guidance identifying the control objectives that would need to be included in the scope of the examination. 81 80 The IA Custody Rule provides that the internal control report must include an opinion of an independent public accountant as to whether controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held by either the adviser or its related person on behalf of advisory clients, during the year. The rule also requires that the accountant “verify that the funds and securities are reconciled to a custodian other than [the adviser or its] related person.” The required controls are not enumerated in the rule, however. 81 See Commission Guidance Regarding Independent Public Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment Advisers Act of 1940, Advisers Act Release No. 2969 (Dec. 30, 2009), 75 FR 1942 (Jan. 11, 2010). The Commission guidance on the IA Custody Rule provided the following specified objectives: (1) Documentation for the opening and modification of client accounts is received, authenticated, and established completely, accurately, and timely on the applicable system; (2) client transactions, including contributions and withdrawals, are authorized and processed in a complete, accurate, and timely manner; (3) trades are properly authorized, settled, and recorded completely, accurately, and timely in the client account; (4) new securities and changes to securities are authorized and established in a complete, accurate and timely manner; (5) securities income and corporate action transactions are processed to client accounts in a complete, accurate, and timely manner; (6) physical securities are safeguarded from loss or misappropriation; (7) cash and security positions are reconciled completely, accurately and on a timely basis between the custodian and depositories; and (8) account statements reflecting cash and security positions are provided to clients in a complete, accurate and timely manner. The control objectives identified in the Commission's guidance on the IA Custody Rule are more general than the specific operational requirements in the Financial Responsibility Rules. These general control objectives are appropriate for purposes of the IA Custody Rule, since this approach allows the different types of qualified custodians (banks, certain savings associations, registered broker-dealers, registered FCMs, and certain foreign financial institutions) to establish controls and procedures that meet the identified control objectives in a manner that reflects differences in business models, regulatory requirements, and other factors. For example, the manner in which an FCM maintains custody of assets 82 differs from that of a bank, and the different entities are subject to different regulations governing their custodial functions. 82 See section 4d(a) and (b) of the Commodity Exchange Act (7 U.S.C. 4d); see also 17 CFR 1.20 to 1.30. Broker-dealers that maintain custody of customer funds and securities are subject to specific operational requirements in the Financial Responsibility Rules with respect to handling and accounting for customer assets. 83 The Commission preliminarily believes that the operational requirements of those rules are consistent with the control objectives outlined in the Commission's guidance on the IA Custody Rule. Consequently, the Commission has preliminarily determined that, if the proposed rule amendments are adopted, a broker-dealer subject to the proposed Compliance Examination that also acts as a qualified custodian for itself as an investment adviser or for its related investment advisers under the IA Custody Rule would be able to use the Examination Report to satisfy the reporting requirements under Rule 17a-5 and the IA Custody Rule's internal control report requirement. 83 While Rule 15c3-1 prescribes broker-dealer net capital requirements, it also contains provisions relating to custody. For example, a broker-dealer must take net capital charges for short security differences unresolved after specifically enumerated timeframes. See Rule 15c3-1(c)(2)(v)(A). The Commission generally requests comment on the comparability of the scope of the internal control report under the IA Custody Rule and the scope of the proposed Compliance Examination under the proposed amendments to Rule 17a-5. In addition, the Commission requests comment on the following question: • Should the Commission add additional elements to the scope of the proposed Examination Report? Commenters should identify any such elements and discuss the feasibility, benefits and costs of including them as elements in the scope of the proposed Compliance Examination. 5. Proposed Exemption Report As discussed above, broker-dealers claiming an exemption from Rule 15c3-3 ( i.e., non-carrying broker-dealers) are required to have their independent public accountants “ascertain that the conditions of the exemption were being complied with as of the examination date and that no facts came to the [independent public accountant's] attention to indicate that the exemption had not been complied with during the period since [the independent public accountant's] last examination.” 84 The Commission proposes to amend this requirement by requiring a non-carrying broker-dealer claiming an exemption from Rule 15c3-3 to file a new Exemption Report. 85 This Exemption Report would replace the existing requirement described above. 84 See Rule 17a-5(g)(2). 85 A non-carrying broker-dealer would file the Exemption Report and corresponding report prepared by its independent public accountant in lieu of the Compliance Report and Examination Report. The Commission notes, however, that under the IA Custody Rule, a non-carrying or “introducing” broker-dealer may be a “qualified custodian.” In this case, in order to receive an internal control report that would satisfy the IA Custody Rule, the non-carrying broker-dealer would have to be separately examined by an independent public accountant for that purpose. Specifically, under new paragraph (d)(4) of Rule 17a-5, the Exemption Report would require an assertion by a broker-dealer that it is exempt from the provisions of Rule 15c3-3 because it meets one or more of the conditions set forth in paragraph (k) of Rule 15c3-3 with respect to all of its business activities. 86 In addition, the non-carrying broker-dealer would be required to engage an independent public accountant to review the assertion in the Exemption Report and prepare a report based on that review and in accordance with standards of the PCAOB. 87 If the independent public accountant is aware of any material modifications 88 that should be made to the assertion contained in the Exemption Report, the independent public accountant would be required to disclose them in its report. The Commission preliminarily believes that an example of a discovery that would necessitate a material modification would be a discovery that the broker-dealer failed to promptly forward any customer securities it received. 89 86 See Rule 15c3-3(k), which sets forth the exemptions to Rule 15c3-3. 87 See proposed paragraph (g)(2)(ii) of Rule 17a-5. 88 See paragraph 90 of PCAOB Attestation Standard § 101. 89 See Rule 15c3-3(k)(2)(ii), which provides that an introducing broker-dealer is exempt from the requirements of Rule 15c3-3 if the introducing broker-dealer “promptly transmits all customer funds and securities to the clearing broker or dealer which carries all of the accounts of such customers * * *” The Commission preliminarily believes that the independent public accountant would be able to obtain the moderate level of assurance contemplated by the required review 90 through a combination of procedures that the accountant would perform in connection with the financial audit currently required under Rule 17a-5 91 and certain inquiries and other procedures targeted specifically to the exemption asserted by the broker-dealer. 90 See paragraph 55 of PCAOB Attestation Standard § 101. 91 See Rule 17a-5(d). As noted previously, the Commission is not proposing to change the requirement that broker-dealers file annual audited financial statements. Therefore, the Commission preliminarily believes that the independent public accountant can leverage the work related to the financial audit in the course of undertaking its review of the broker-dealer's assertion with respect to the claimed exemption from Rule 15c3-3. The Commission generally requests comment on the proposed Exemption Report. In addition, the Commission requests comment on the following questions: • Are there other types of broker-dealers that would not qualify to file an Exemption Report, but, based on the limited scope of their businesses, should be allowed to file a more limited report than the Compliance Report? If so, please identify the types of broker-dealers and indicate why they should not be required to file Compliance Reports. • What additional processes and controls might a broker-dealer put in place in order to comply with the new requirements relating to the Exemption Report and to accommodate a review of the report by an independent public accountant? • Should the Commission require that the assertion made by the broker-dealer with respect to the exemption from Rule 15c3-3 be examined by the accountant ( i.e., the independent public accountant issues an opinion based on obtaining reasonable assurance) as opposed to being reviewed ( i.e., the independent public accountant issues a report based on obtaining a moderate level of assurance)? Commenters should discuss the feasibility, benefits and costs of such a requirement. • What additional costs and burdens would a non-carrying broker-dealer incur under the proposal requiring an independent public accountant to review the broker-dealer's claim that it qualifies for an exemption from Rule 15c3-3? 6. Change in Applicable Audit Standards The Commission is proposing to require that the audit of the Financial Report, the examination of the Compliance Report, and the review of the Exemption Report be performed pursuant to standards established by the PCAOB. The Dodd-Frank Act provided authority to the PCAOB to establish, subject to Commission approval, auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms with respect to the preparation and issuance of audit reports to be included in broker-dealer filings with the Commission pursuant to Section 17(e) of the Exchange Act. 92 To enable the PCAOB to effectively implement the authority provided to it by the Dodd-Frank Act, the Commission is proposing to amend paragraph (g) of Rule 17a-5 to provide that the independent public accountants' reports required under the rule must be prepared in accordance with the standards of the PCAOB. 93 92 See Section II.A. of this release for a discussion of the PCAOB's new oversight authority under the Dodd-Frank Act. 93 See proposed paragraph (g)(1) of Rule 17a-5. In September 2010, the Commission issued interpretive guidance concerning the auditing standards that should be applied by broker-dealer accountants with respect to the current requirements in Rule 17a-5. 94 That guidance stated that references in Commission rules, staff guidance, and in the federal securities laws to GAAS or to specific standards under GAAS, as they relate to non-issuer broker-dealers, should continue to be understood to mean auditing and attestation standards generally accepted in the U.S., in addition to any applicable rules of the Commission. 95 94 See Commission Guidance Regarding Auditing, Attestation, and Related Professional Practice Standards Related to Brokers and Dealers, Exchange Act Release No. 62991 (Sep. 24, 2010), 75 FR 60616 (Oct. 1, 2010). The Commission also noted in its guidance that it intended to revisit this interpretation in connection with this rulemaking. 95 Id. at 60617. Because PCAOB auditing standards differ from existing standards governing broker-dealer audits, the proposed change to paragraph (g) would result in a change in the procedures accountants would have to undertake as part of their engagement for audits of broker-dealers. For example, certain audit documentation requirements contained in PCAOB Auditing Standard 3 ( Audit Documentation ) and the engagement quality review requirement in PCAOB Auditing Standard 7 ( Engagement Quality Review ) are not required by GAAS. The Commission generally requests comment on the proposed change to applicable auditing standards. In addition, the Commission requests comment on the following questions: • Are there implications to the differences that were identified that the Commission should consider? Are there other differences that exist that would have significant implications to the audits of broker-dealers? • Should the requirement to be audited in accordance with PCAOB standards be phased in for non-carrying broker-dealers? Why or why not? If so, what time-table should the Commission adopt? 7. Compliance Date and Transition Period The Commission is proposing to make the Annual Reporting Amendments effective for annual reports filed with the Commission for fiscal years ending on or after December 15, 2011. The Commission is proposing this date to include fiscal years that end on or after December 31, 2011. The Commission preliminarily intends to implement a transition period for carrying broker-dealers required to file Compliance Reports with the Commission with fiscal years ending on or after December 15, 2011 but before September 15, 2012. During this transition period, a carrying broker-dealer's assertion in its Compliance Report as to whether internal control over compliance with the Financial Responsibility Rules was effective would be a point-in-time assertion as of the date of the Compliance Report, rather than covering the broker-dealer's entire fiscal year. The Commission preliminarily believes that the compliance date and transition period set forth above will provide adequate time for broker-dealers to prepare the additional required reports and for independent public accountants to plan and perform the Compliance Examination procedures. The Commission generally requests comment on the proposed compliance date and transition period. In addition, the Commission requests comment on the following questions: • Will the proposed compliance date and transition period for the Annual Reporting Amendments provide sufficient time for broker-dealers to prepare the additional reports and for independent public accountants to comply with PCAOB standards? Will it provide sufficient time to plan and perform Compliance Examination procedures? If not, what are the impediments and what would be a more appropriate time frame for implementation? 8. General Solicitation of Comments The Commission generally requests comment on all aspects of these proposed amendments. In addition, the Commission requests comment on the following questions related to the proposal: • Certain broker-dealers conducting a limited and specific type of business are not presently required to file an annual audit report. 96 Should the Commission require all broker-dealers to file an annual audit of their financial statements and supporting schedules? Should any of the proposed amendments to Rule 17a-5 applicable to carrying firms be applied to other specific types of broker-dealers? If so, which types of firms and why? What impact would extension of the audit requirement or the proposed amendments relating to non-carrying firms have on small businesses? 96 See Rule 17a-5(e)(1)(A) and (B), which provide limited exemptions to broker-dealers from having their financial statements and supporting statements audited by an independent public accountant, so long as specified factors are met ( e.g., if the securities business of the broker-dealer has been limited to acting as a broker for an issuer in soliciting subscriptions for securities of such issuer and the broker has promptly transmitted to such issuer all funds and promptly delivered to the subscriber all securities received in connection therewith, and the broker has not otherwise held funds or securities for or owed money or securities to customers, then the broker-dealer does not have to have the financial statements audited by an independent public accountant). See Rule 17a-5(e)(1)(A). C. Proposed Amendment to the Filing of SIPC Reports 1. Existing Requirement SIPC is a non-profit, membership corporation created under the Securities Investor Protection Act of 1970 (“SIPA”). 97 SIPC is designed to protect the custodial function of a broker-dealer in the event it fails financially. For example, SIPC can fund the liquidation of a broker-dealer that cannot wind itself down in an orderly self-liquidation. 98 As part of the liquidation, SIPC can advance up to $500,000 per customer to satisfy claims for securities and cash. 99 However, of the $500,000, only $250,000 can be used to satisfy claims for cash. 100 In order to pay for these liquidations and advances, SIPC maintains the SIPC Fund. 101 The SIPC Fund is established and maintained by collecting assessments from broker-dealers that are required to be members of SIPC. 102 Generally all broker-dealers registered with the Commission under Section 15(b) of the Exchange Act 103 are required to be members of SIPC. 104 However, broker-dealers engaged exclusively in the distribution of mutual fund shares, the sale of variable annuities, the insurance business, the furnishing of investment advice to investment companies or insurance company separate accounts, or whose principal business is conducted outside the U.S. are not required to be members of SIPC. 105 97 15 U.S.C. 78 et seq. 98 15 U.S.C. 78eee(a)(3). 99 15 U.S.C. 78fff-3(a). 100 15 U.S.C. 78fff-3(d). 101 15 U.S.C. 78ddd. 102 15 U.S.C. 78ddd(c). 103 15 U.S.C. 78o(b). 104 15 U.S.C. 78ccc(a)(2). 105 15 U.S.C. 78ccc(a)(2)(A)(i)-(iii). Under SIPA, SIPC may assess each of its member broker-dealers a fee determined as a percentage of the firm's revenues. 106 There are required percentage assessments that must be made when the SIPC Fund falls below deposited amounts or such other amount as the Commission may determine in the public interest (“the SIPC Fund Target Level”). 107 SIPC can assess broker-dealers a fee based on a greater percentage of their revenues when the SIPC Fund falls below the SIPC Fund Target Level. 108 106 See 15 U.S.C. 78ddd(c)(2). See also SIPC Bylaws, Article 6. 107 Prior to the Lehman Brothers Inc. and Bernard L. Madoff Investment Securities LLC SIPA liquidations, the SIPC Fund was maintained at a target level of not less than $1 billion. Currently, the SIPC Fund Target Level is $2.5 billion. See SIPC Bylaws, Article 6, Section 1(a)(1)(A) (specifying the $2.5 billion SIPC Fund Target Level). See also Securities Investor Protection Corporation Modernization Task Force, Adequacy of the SIPC Fund (Jun. 2010), at 5 (describing the increase in the SIPC Fund Target Level from $1 billion to $2.5 billion). 108 SIPC Bylaws, Article 6, Section 1(a). 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. 122 122 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 v. Donald Anthony Walker Young, et al., Litigation Release No. 21006 (Apr. 20, 2009) (complaint alleges registered investment adviser and its principal misappropriated in excess of $23 million, provided false account statements to investors in limited partnership, and provided false custodial statements to limited partnership's introducing broker); SEC v. Isaac I. Ovid, et al, Litigation Release No. 20998 (Apr. 14, 2009) (complaint alleges that defendants, including registered investment adviser and manager of purported hedge funds, misappropriated in excess of $12 million); SEC v. The Nutmeg Group, LLC, et al., Litigation Release No. 20972 (Mar. 25, 2009) (complaint alleges that registered investment adviser misappropriated in excess of $4 million of client assets, failed to maintain client assets with a qualified custodian, and failed to obtain a surprise examination); SEC v. WG Trading Investors, L.P., et al., Litigation Release No. 20912 (Feb. 25, 2009) (complaint alleges that registered broker-dealer and affiliated registered adviser orchestrated fraudulent investment scheme, including misappropriating as much as $554 million of the $667 million invested by clients and sending clients misleading account information); SEC v. Stanford International Bank, et al., Litigation Release No. 20901 (Feb. 17, 2009) (complaint alleges that affiliated bank, broker-dealer, and advisers colluded with each other in carrying out an $8 billion fraud); SEC v. Bernard L. Madoff, et al., Litigation Release No. 20889 (Feb. 9, 2009) (complaint alleges that Madoff and Bernard L. Madoff Investment Securities LLC—a registered investment adviser and registered broker-dealer—committed a $50 billion fraud). 124 See, e.g., Custody of Funds or Securities by Investment Advisers, Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010). 125 For purposes of Form Custody, the term “customer” means a person that is a “customer” for purposes of Rule 15c3-3(a), and a “non-customer” means a person other than a “customer” as that term is defined in Rule 15c3-3(a). See Rule 15c3-3(a) and FINRA's Interpretations of Financial and Operational Rules, Rule 15c3-3, Rule 15c3-3(a)(1)/01, available on FINRA's Internet Web site at http://www.finra.org/Industry/Regulation/Guidance/FOR/. 126 See Rule 17a-5(a). FOCUS Reports, filed with the Commission and SROs by broker-dealers, are one of the primary means of monitoring the financial and operational condition of broker-dealers and enforcing the broker-dealer financial responsibility rules. The completed forms are also used to determine which firms are engaged in various securities-related activities, and how economic events and government policies might affect various segments of the securities industry. The FOCUS Report was designed to eliminate overlapping regulatory reports required by various SROs and the Commission and to reduce reporting burdens as much as possible. See supra note 20. The Commission notes that FOCUS Reports are, and proposed Form Custody would be, deemed to be confidential pursuant to paragraph (a)(3) of Rule 17a-5. 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. 130 130 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. 134 134 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 twelv [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2011-15341. Public record. Not legal advice.