Broker-Dealer Reports

Federal RegisterAug 21, 2013

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 249

[Release No. 34-70073; File No. S7-23-11]

RIN 3235-AK56

Broker-Dealer Reports

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”), under the Securities Exchange Act of 1934 (“Exchange Act”), is amending certain broker-dealer annual reporting, audit, and notification requirements. The amendments include a requirement that broker-dealer audits be conducted in accordance with standards of the Public Company Accounting Oversight Board (“PCAOB”) in light of explicit oversight authority provided to the PCAOB by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) to oversee these audits. The amendments further require a broker-dealer that clears transactions or carries customer accounts to agree to allow representatives of the Commission or the broker-dealer's designated examining authority (“DEA”) to review the documentation associated with certain reports of the broker-dealer's independent public accountant and to allow the accountant to discuss the findings relating to the reports of the accountant with those representatives when requested in connection with a regulatory examination of the broker-dealer. Finally, the amendments require a broker-dealer to file a new form with its DEA that elicits information about the broker-dealer's practices with respect to the custody of securities and funds of customers and non-customers.

DATES:

This rule is effective June 1, 2014, except the amendment to § 240.17a-5(e)(5), which is effective October 21, 2013 and the amendments to § 240.17a-5(a) and (d)(6) and § 249.639, which are effective December 31, 2013.

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; Mark M. Attar, Branch Chief, at (202) 551-5889; Rose Russo Wells, Special Counsel, at (202) 551-5527; Sheila Dombal Swartz, Special Counsel, at (202) 551-5545; or Kimberly N. Chehardy, Attorney, at (202) 551-5791, Office of Financial Responsibility, Division of Trading and Markets; or Kevin Stout, Senior Associate Chief Accountant, at (202) 551-5930, Office of the Chief Accountant, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

The Commission is adopting amendments to Rule 17a-5 (17 CFR 240.17a-5) and technical and conforming amendments to Rule 17a-11 (17 CFR 240.17a-11) and is adopting Form Custody (17 CFR 249. 639) under the Exchange Act.

Contents

I. Background

A. Overview

B. Rules Governing Broker-Dealer Financial and Custodial Responsibility

1. The Broker-Dealer Net Capital Rule

2. The Broker-Dealer Customer Protection Rule

3. The Broker-Dealer Quarterly Securities Count Rule

4. The Broker-Dealer Account Statement Rules

II. Final Amendments to Broker-Dealer Reporting, Audit, Notification, and Other Requirements

A. Overview of New Requirements

B. Annual Reports To Be Filed—Paragraph (d) of Rule 17a-5

1. Requirement To File Reports—Paragraph (d)(1) of Rule 17a-5

i. Proposed Amendments

ii. Comments Received

iii. The Final Rule

2. The Financial Report—Paragraph (d)(2) of Rule 17a-5

3. The Compliance Report—Paragraph (d)(3) of Rule 17a-5

i. The Proposed Amendments

ii. Comments Received

iii. The Final Rule

4. The Exemption Report—Paragraph (d)(4) of Rule 17a-5

i. Proposed Amendments

ii. Comments Received

iii. The Final Rule

5. Time for Filing Annual Reports—Paragraph (d)(5) of Rule 17a-5

6. Filing of Annual Reports with SIPC—Paragraph (d)(6) of Rule 17a-5

i. The Proposed Amendments

ii. Comments Received

iii. The Final Rule

C. The Nature and Form of the Annual Reports

1. Exemptions From Audit Requirement—Paragraph (e)(1) of Rule 17a-5

2. Affirmation—Paragraph (e)(2) of Rule 17a-5

3. Confidentiality of Annual Reports—Paragraph (e)(3) of Rule 17a-5

4. Supplemental Report on SIPC Membership—Paragraph (e)(4) of Rule 17a-5

D. Engagement of the Accountant

1. Statutory Requirements and Commission Authority

2. Engagement of Accountant Requirements Prior to Today's Amendments

3. Amended Engagement of Accountant Requirements

i. Proposed Amendments

ii. Comments

iii. The Final Rule

E. PCAOB Registration of Independent Public Accountant—Paragraph (f)(1) of Rule 17a-5

F. Notification of Non-Compliance or Material Weakness

1. New Notification Requirements—Paragraph (h) of Rule 17a-5

i. The Proposed Amendments

ii. Comments Received

iii. The Final Rule

2. Conforming and Technical Amendments to Rule 17a-11

G. Other Amendments to Rule 17a-5

1. Information Provided to Customers—Paragraph (c) of Rule 17a-5

i. Background

ii. Availability of Independent Public Accountant's Comments on Material Inadequacies—Paragraph (c)(2) of Rule 17a-5

iii. Exemption From Mailing Financial Information to Customers—Paragraph (c)(5) of Rule 17a-5

2. Technical Amendments

i. Deletion of Paragraph (b)(6) of Rule 17a-5

ii. Deletion of Provisions Relating to the Year 2000

iii. Deletion of Paragraph (i)(5) of Rule 17a-5

iv. Amendments to Paragraph (f)(2) of Rule 17a-5

v. Further Technical Amendments

H. Coordination With Investment Advisers Act Rule 206(4)-2

1. Background

2. Rule 206(4)-2

3. Broker-Dealers Acting as Qualified Custodians Under Rule 206(4)-2

4. Proposal To Allow Report Based on Examination of Compliance Report to Satisfy Rule 206(4)-2

i. The Proposal

ii. Comments on the Proposal

5. Adoption of Proposal Relating to Rule 206(4)-2

III. Access to Accountant and Audit Documentation

IV. Form Custody

A. Background

B. Filing of Form Custody

1. Requirement to File Form Custody with FOCUS Reports

2. Requests for Exemption From Filing Form Custody

3. Attest Engagement Not Required for Form Custody

C. Form Custody

1. Item 1—Accounts Introduced on a Fully Disclosed Basis

2. Item 2—Accounts Introduced on an Omnibus Basis

3. Item 3—Carrying Broker-Dealers

i. Items 3.A and 3.B

ii. Item 3.C

a. Background

b. General Comments to Item 3.C

c. Item 3.C.i

d. Item 3.C.ii

e. Item 3.C.iii

iii. Items 3.D and 3.E

a. Items 3.D.i and 3.E.i

b. Items 3.D.ii and 3.E.ii

c. Items 3.D.iii and 3.E.iii

4. Item 4—Carrying for Other Broker-Dealers

5. Item 5—Trade Confirmations

6. Item 6—Account Statements

7. Item 7—Electronic Access to Account Information

8. Item 8—Broker-Dealers Registered as Investment Advisers

9. Item 9—Broker-Dealers Affiliated with Investment Advisers

V. Effective Dates

A. Amendments Effective 60 Days After Publication in the

Federal Register

B. Amendments Effective on December 31, 2013

C. Amendments Effective on June 1, 2014

VI. Paperwork Reduction Act

A. Summary of the Collection of Information Requirements

B. Use of Information

C. Respondents

D. Total Initial and Annual Burdens

1. Annual Reports To Be Filed

i. The Financial Report

ii. The Compliance Report

iii. The Exemption Report

iv. Additional Burden and Cost To File the Annual Reports

v. Supplemental Report on SIPC Membership

vi. Statement Regarding Independent Public Accountant

vii. External Costs of Engagement of Accountant

a. Financial Report (including Change from GAAS to PCAOB Standards)

b. Compliance Report

c. Exemption Report

d. Access to Accountant and Audit Documentation

2. Conforming and Technical Amendments to Rule 17a-11

3. Form Custody

E. Collection of Information Is Mandatory

F. Confidentiality

VII. Economic Analysis

A. Motivation for the Amendments

B. Economic Baseline

1. Broker-Dealers

2. Independent Public Accountants That Audit Broker-Dealer Reports

3. SIPC Lawsuits Against Accountants

4. Overview of Broker-Dealer Reporting, Auditing, and Notification Requirements Before Today's Amendments

i. Broker-Dealer Reporting

ii. Engagement of the Accountant

iii. Filing of Annual Reports with SIPC

iv. Notification Requirements

v. Information Provided to Customers

vi. Access to Accountants and Audit Documentation

vii. Form Custody

C. Costs and Benefits of the Rule Amendments

1. Broker-Dealer Annual Reporting Amendments

i. Changing the Broker-Dealer Audit Standard Setter From the AICPA to the PCAOB and the Standards From GAAS to PCAOB Standards

ii. Requirement To File New Reports

a. Compliance Report

b. Exemption Report

iii. Engagement of the Accountant

iv. Filing of Annual Reports With SIPC

v. Notification Requirements

a. Amendments to Rule 17a-5

b. Conforming and Technical Amendments to Rule 17a-11

vi. Information Provided to Customers

vii. Coordination With Investment Advisers Act Rule 206(4)-2

2. Access to Accountant and Audit Documentation

3. Form Custody

4. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

VIII. Final Regulatory Flexibility Analysis

A. Need for and Objectives of the Amendments and New Form

B. Significant Issues Raised by Public Comments

C. Small Entities Subject to the Rules

D. Reporting, Recordkeeping, and Other Compliance Requirements

E. Agency Action To Minimize Effect on Small Entities

IX. Statutory Authority

I. Background

A. Overview

In 2009, the Commission began reviewing rules regarding the safekeeping of investor assets in connection with several cases the Commission brought alleging fraudulent conduct by investment advisers and broker-dealers, including, among other things, misappropriation or other misuse of customer securities and funds.

As part of the rule review effort, the Commission amended Rule 206(4)-2 under the Investment Advisers Act of 1940 (“Rule 206(4)-2”), which governs the custody of client securities and funds by investment advisers.

When adopting this amendment, the Commission stated that it represented “a first step in the effort to enhance custody protections, with consideration of additional enhancements of the rules governing custody of customer assets by broker-dealers to follow.”

See, e.g., SEC

Bernard L. Madoff, et al.,

Litigation Release No. 20889 (Feb. 9, 2009);

SEC

Stanford International Bank, et al.,

Litigation Release No. 20901 (Feb. 17, 2009);

SEC

Donald Anthony Walker Young, et al.,

Litigation Release No. 21006 (Apr. 20, 2009);

SEC

Isaac I. Ovid, et al.,

Litigation Release No. 20998 (Apr. 14, 2009);

SEC

The Nutmeg Group, LLC, et al.,

Litigation Release No. 20972 (Mar. 25, 2009);

SEC

WG Trading Investors, L.P., et al.,

Litigation Release No. 20912 (Feb. 25, 2009).

See Custody of Funds or Securities of Clients by Investment Advisers,

Investment Advisers Act of 1940 (“Advisers Act”) Release No. 2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010).

See also

17 CFR 275.206(4)-2.

See Custody of Funds or Securities of Clients by Investment Advisers,

75 FR at 1456.

In June 2011, the Commission proposed rule amendments and a new form designed, among other things, to provide additional safeguards with respect to broker-dealer custody of customer securities and funds.

The proposed amendments would have amended certain annual reporting, audit, and notification requirements for broker-dealers.

The proposed amendments also would have required a broker-dealer that clears transactions or carries customer accounts (each, a “clearing broker-dealer”) to agree to allow representatives of the Commission or the broker-dealer's DEA to review the documentation associated with certain reports of the broker-dealer's independent public accountant and to allow the accountant to discuss with representatives of the Commission or DEA the accountant's findings associated with those reports when requested in connection with an examination of the broker-dealer.

Further, the proposed amendments would have required a broker-dealer to file with its DEA on a quarterly basis a new form—Form Custody—that would have elicited information as to whether, and if so how, a broker-dealer maintains custody of securities and funds of customers and others.

The Commission also proposed requiring that a broker-dealer file its annual reports with the Securities Investor Protection Corporation (“SIPC”).

See Broker-Dealer Reports,

Exchange Act Release No. 64676 (June 15, 2011), 76 FR 37572 (June 27, 2011).

Id.

at 37575-37583.

Id.

at 37583-37584.

Id.

at 37584-37592.

Id.

at 37592-37594.

The proposed amendments were designed to enhance the ability of the Commission to oversee broker-dealer custody practices and, among other things, to: (1) Increase the focus of broker-dealers that maintain custody of customer funds and securities (“carrying broker-dealers”) and their independent public accountants on compliance, and internal control over compliance, with certain financial and custodial requirements; (2) strengthen and clarify broker-dealer audit and reporting requirements in order to facilitate consistent compliance with these requirements; (3) facilitate the ability of the PCAOB to implement the explicit oversight authority over broker-dealer audits provided to the PCAOB by the Dodd-Frank Act;

(4) ensure that SIPC receives the necessary information to assess whether the liquidation fund it maintains is appropriately sized to the risks of a large broker-dealer failure; (5) enable Commission and DEA examiners to conduct risk-based examinations of carrying and clearing broker-dealers by

assisting the examiners in selecting areas of focus for their examinations; and (6) provide the Commission and the DEAs with a comprehensive overview of a broker-dealer's custody practices.

Public Law 111-203, 124 Stat. 1376, H.R. 4173 (July 21, 2010).

The proposed amendments also were designed to avoid duplicative requirements for broker-dealers that are dually-registered as investment advisers in view of the internal control report requirement that was added by the amendment to Rule 206(4)-2.

See

discussion below in section VII.A. of this release identifying further motivations for the amendments.

The Commission received 27 comment letters on the proposal.

The Commission has considered the comments and, as discussed in detail below, is adopting the amendments and the new form with modifications, in part in response to comments received. A number of commenters stated that the Commission should coordinate with the Commodity Futures Trading Commission (“CFTC”) to account for broker-dealers that also are registered as futures commission merchants (“FCMs”) in order to align the broker-dealer reporting and audit requirements with FCM reporting and audit requirements.

The Commission staff is in discussions with the CFTC staff concerning ways to align the reporting and audit requirements for dually-registered broker-dealer/FCMs with the goal of coordinating these requirements, including the requirements that the Commission is adopting today.

Comment letter of Naphtali M. Hamlet (June 22, 2011) (“

Hamlet Letter

”); comment letter of Robert R. Kelley (June 27, 2011) (“

Kelley Letter

”); comment letter of Chris Barnard (July 20, 2011) (“

Barnard Letter

”); comment letter of Suzanne Shatto (July 25, 2011) (“

Shatto Letter

”); comment letter of Suzanne H. Shatto (July 25, 2011) (“

Shatto Letter II

”); comment letter of Todd Genger (Aug. 2, 2011) (“

Genger Letter

”); comment letter of Suzanne Shatto (Aug. 14, 2011) (“

Shatto Letter III

”); comment letter of Deloitte & Touche LLP (Aug. 25, 2011) (“

Deloitte Letter

”); comment letter of the Securities Industry and Financial Markets Association (Aug. 25, 2011) (“

SIFMA Letter

”); comment letter of the Center for Audit Quality (Aug. 25, 2011) (“

CAQ Letter

”); comment letter of KPMG LLP (Aug. 25, 2011) (“

KPMG Letter

”); comment letter of PricewaterhouseCoopers, LLP (Aug. 25, 2011) (“

PWC Letter

”); comment letter of Citrin Cooperman & Co., LLP (Aug. 25, 2011) (“

Citrin Letter

”); comment letter of Grant Thornton LLP (Aug. 26, 2011) (“

Grant Thornton Letter

”); comment letter of James J. Angel (Aug. 26, 2011) (“

Angel Letter

”); comment letter of James J. Angel (Aug. 26, 2011) (“

Angel Letter II

”); comment letter of McGladrey & Pullen, LLP (Aug. 26, 2011) (“

McGladrey Letter

”); comment letter of the Certified Financial Planner Board of Standards, Inc. (Aug. 26, 2011) (“

CFP Letter

”); comment letter of Integrated Management Solutions USA LLC (Aug. 26, 2011) (“

IMS Letter

”); comment letter of the American Institute of Certified Public Accountants (Aug. 26, 2011) (“

AICPA Letter

”); comment letter of the Committee of Annuity Insurers (Aug. 26, 2011) (“

CAI Letter

”); comment letter of Ernst & Young LLP (Aug. 26, 2011) (“

E&Y Letter

”); comment letter of Van Kampen Funds Inc. and Invesco Distributors, Inc. (Aug. 26, 2011) (“

Van Kampen/Invesco Letter

”); comment letter of Suzanne H. Shatto (Sept. 13, 2011) (“

Shatto Letter IV

); comment letter N.M. Hamlet (Sept. 14, 2011) (“

Hamlet Letter II

”); comment letter of the Federal Regulation of Securities Committee, Business Law Section, American Bar Association (Sept. 15, 2011) (“

ABA Letter

”); and comment letter of the Committee of Annuity Insurers (Apr. 17, 2012) (“

CAI II Letter”

). The comment letters are available on the Commission's Web site at

http://www.sec.gov/comments/s7-23-11/s72311.shtml

. Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street NE., Washington, DC (File No. S7-23-11).

See CAQ Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; PWC Letter.

B. Rules Governing Broker-Dealer Financial and Custodial Responsibility

Rule 15c3-1,

Rule 15c3-3,

and Rule 17a-13,

under the Exchange Act and applicable DEA rules that require broker-dealers to periodically send account statements to customers (“Account Statement Rules”)

(collectively for the purposes of this release, “the financial responsibility rules”) are central to today's amendments to the broker-dealer reporting, audit, and notification requirements. In light of the significance of the financial responsibility rules to today's amendments, the following section briefly summarizes the requirements of each rule in order to provide a foundation for the later discussion of the amendments.

17 CFR 240.15c3-1 (a rule prescribing net capital requirements for broker-dealers).

17 CFR 240.15c3-3 (a rule prescribing requirements regarding the holding of customer securities and funds by broker-dealers).

17 CFR 240.17a-13 (a rule requiring broker-dealers to perform quarterly securities counts).

See, e.g.,

Rule 9.12 of the Chicago Board Options Exchange (“CBOE”); NASD Rule 2340 of the Financial Industry Regulatory Authoirty (“FINRA”).

1. The Broker-Dealer Net Capital Rule

Rule 15c3-1 requires broker-dealers to maintain a minimum level of net capital (consisting of highly liquid assets) at all times.

In computing net capital, a broker-dealer must, among other things, calculate net worth in accordance with U.S. generally accepted accounting principles (“GAAP”) and then make certain adjustments to net worth, such as deducting illiquid assets and taking other capital charges and adding qualifying subordinated loans.

The amount remaining after these deductions is defined as “tentative net capital.”

The final step in computing net capital is to deduct certain percentages (“haircuts”) from the market value of the broker-dealer's proprietary positions to account for the market risk inherent in the positions

and to create a buffer of liquidity to protect against other risks associated with the broker-dealer's business.

The broker-dealer must cease conducting a securities business if the amount of net capital maintained by the firm falls below the minimum required amount.

See

17 CFR 240.15c3-1. The rule requires that a broker-dealer perform two calculations: (1) A computation of the minimum amount of net capital the broker-dealer must maintain; and (2) a computation of the amount of net capital the broker-dealer is maintaining.

See

17 CFR 240.15c3-1(a) and (c)(2). The computation of net capital is based on the definition of the term “net capital” in paragraph (c)(2) of Rule 15c3-1.

Id.

Generally, a broker-dealer's minimum net capital requirement is the greater of a fixed-dollar amount specified in the rule and an amount determined by applying one of two financial ratios.

See

17 CFR 240.15c3-1(a).

See

17 CFR 240.15c3-1(c)(2)(i)-(xiii).

See

17 CFR 240.15c3-1(c)(15).

See

17 CFR 240.15c3-1(c)(2)(vi).

See, e.g., Uniform Net Capital Rule,

Exchange Act Release No. 13635 (June 16, 1977), 42 FR 31778 (June 23, 1977).

See

15 U.S.C. 78o(c)(3)(A).

2. The Broker-Dealer Customer Protection Rule

Rule 15c3-3 imposes two key requirements on a carrying broker-dealer: first, the broker-dealer must maintain physical possession or control over customers' fully paid and excess margin securities;

and second, the firm must maintain a reserve of funds or qualified securities

in an account at one or more banks that is at least equal in value to the amount of net funds owed to customers.

These requirements are designed to protect customers by requiring broker-dealers to segregate customers' securities and

funds from the broker-dealer's proprietary business activities. If the broker-dealer fails financially, customers' securities and funds should be readily available to be returned to customers. In addition, if the failed broker-dealer is liquidated in a proceeding under the Securities Investor Protection Act of 1970 (“SIPA”), as amended, the customers' securities and funds should be isolated and readily identifiable as “customer property” and, consequently, available to be distributed to customers ahead of other creditors.

See

17 CFR 240.15c3-3(d).

Control

means the broker-dealer must hold these securities free of lien in one of several locations specified in the rule (

e.g.,

at a bank or clearing agency).

See

17 CFR 240.15c3-3(c). 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 not in its possession or control.

See

17 CFR 240.15c3-3(d). If the amount in the broker-dealer's possession or 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.

Id.

The terms

fully paid securities, margin securities,

and

excess margin securities

are defined in Rule 15c3-3.

See

17 CFR 240.15c3-3(a)(3), (a)(4), and (a)(5), respectively.

The term

qualified security

is defined in Rule 15c3-3 to mean a security issued by the U.S. or a security in respect of which the principal and interest are guaranteed by the U.S.

See

17 CFR 240.15c3-3(a)(6).

See

17 CFR 240.15c3-3(e). The amount of the net funds owed to customers (“customer reserve requirement”) is computed by adding customer credit items (

e.g.,

cash in securities accounts) and subtracting from that amount customer debit items (

e.g.,

margin loans) pursuant to a formula in Exhibit A to Rule 15c3-3.

See

17 CFR 240.15c3-3a. Carrying broker-dealers are required 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 the broker-dealer must maintain 105% of the required deposit amount and may not exceed a specified aggregate indebtedness limit).

See

17 CFR 240.15c3-3(e)(3).

See

15 U.S.C. 78aaa

et seq.

Provisions of Rule 15c3-3 exempt a broker-dealer from the requirements of Rule 15c3-3 under certain circumstances.

Generally, a broker-dealer is exempt from Rule 15c3-3 if it does not hold customer securities or funds, or, if it does receive customer securities or funds, it promptly delivers the securities or promptly transmits the funds to appropriate persons.

See

17 CFR 240.15c3-3(k).

Id.

3. The Broker-Dealer Quarterly Securities Count Rule

Rule 17a-13 generally requires a broker-dealer that maintains custody of securities (proprietary, customer, or both), on a quarterly basis, to physically examine and count the securities it 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 locations of securities under certain circumstances, and compare the results of the count and verification with its records.

In accordance with a schedule, the broker-dealer must take an operational capital charge under Rule 15c3-1 for short securities differences (which include securities positions reflected on the broker-dealer's securities record that are not susceptible to either count or confirmation) that are unresolved after discovery.

The differences also must be recorded in the broker-dealer's books and records.

See

17 CFR 240.17a-13(b).

See

17 CFR 240.15c3-1(c)(2)(v).

See

17 CFR 240.17a-3(a)(4)(vi).

4. The Broker-Dealer Account Statement Rules

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.

The Account Statement Rules provide a key safeguard for customers by requiring that they receive information concerning securities positions and other assets held in their accounts on a regular basis, which they can use to identify discrepancies and monitor the performance of their accounts.

See, e.g.,

CBOE Rule 9.12; NASD Rule 2340.

II. Final Amendments to Broker-Dealer Reporting, Audit, Notification, and Other Requirements

A. Overview of New Requirements

The Commission is adopting amendments to the reporting, audit, and notification requirements in Rule 17a-5, and additional amendments to other provisions of the rule, including technical changes. The Commission also is adopting amendments to the notification requirements in Rule 17a-11, and certain other technical amendments to that rule.

Under the amendments to the reporting and audit requirements, broker-dealers must, among other things, file with the Commission annual reports consisting of a financial report and either a compliance report or an exemption report that are prepared by the broker-dealer, as well as certain reports that are prepared by an independent public accountant covering the financial report and the compliance report or the exemption report.

The filing of a compliance or exemption report and the related report of the independent public accountant are new requirements. The financial report must contain the same types of financial statements that were required to be filed under Rule 17a-5 prior to these amendments (a statement of financial condition, a statement of income, a statement of cash flows, and certain other financial statements).

In addition, the financial report must contain, as applicable, the supporting schedules that were required to be filed under Rule 17a-5 prior to these amendments (a computation of net capital under Rule 15c3-1, a computation of the reserve requirements under Rule 15c3-3, and information relating to the possession or control requirements under Rule 15c3-3).

See

paragraph (d) of Rule 17a-5.

See

paragraph (d)(2)(i) of Rule 17a-5. The requirements for the financial report are discussed below in more detail in section II.B.2. of this release.

See

paragraph (d)(2)(ii) of Rule 17a-5.

A broker-dealer that did not claim that it was exempt from Rule 15c3-3 throughout the most recent fiscal year must file the compliance report, and a broker-dealer that did claim it was exempt from Rule 15c3-3 throughout the most recent fiscal year (generally, a “non-carrying broker-dealer”) must file the exemption report.

Broker-dealers must make certain statements and provide certain information relating to the financial responsibility rules in these reports.

See

paragraphs (d)(1)(i)(B)(

) and (

) of Rule 17a-5.

See

paragraphs (d)(3) and (4) of Rule 17a-5. The requirements for the compliance report and the exemption report are discussed below in more detail in section II.B.3. and section II.B.4. of this release, respectively.

In addition to preparing and filing the financial report and the compliance report or exemption report, a broker-dealer must engage a PCAOB-registered independent public accountant to prepare a report based on an examination of the broker-dealer's financial report in accordance with PCAOB standards.

A carrying broker-dealer also must engage the PCAOB-registered independent public accountant to prepare a report based on an examination of certain statements in the broker-dealer's compliance report.

A non-carrying broker-dealer must engage the PCAOB-registered independent public accountant to prepare a report based on a review of certain statements in the broker-dealer's exemption report.

In each case, the examination or review must be conducted in accordance with PCAOB standards. The broker-dealer must file these reports with the Commission along with the financial report and the compliance report or exemption report prepared by the broker-dealer.

See

paragraphs (f)(1) and (g)(1) of Rule 17a-5.

See

paragraphs (f)(1) and (g)(2)(i) of Rule 17a-5.

See

paragraphs (f)(1) and (g)(2)(ii) of Rule 17a-5.

See

paragraph (d)(1)(i)(C) of Rule 17a-5. The requirements for the engagement of the independent public accountant are discussed below in more detail in section II.D.3. of this release.

The annual reports also must be filed with SIPC if the broker-dealer is a member of SIPC.

In addition, broker-dealers must generally file with SIPC a supplemental report on the status of the membership of the broker-dealer in SIPC.

The supplemental report must include a report of the independent public accountant that covers the SIPC annual general assessment reconciliation or exclusion from membership forms based on certain

procedures specified in the rule. In the future, SIPC may determine the format of this report by rule, subject to Commission approval.

See

paragraph (d)(6) of Rule 17a-5. This requirement is discussed below in more detail in section II.B.6. of this release.

See

paragraph (e)(4) of Rule 17a-5. This requirement is discussed below in more detail in section II.C.4. of this release.

Id.

Currently, Rule 17a-5 prescribes the format of the report.

See

17 CFR 240.17a-5.

Finally, the PCAOB-registered independent public accountant must immediately notify the broker-dealer if the accountant determines during the course of preparing the accountant's reports that the broker-dealer is not in compliance with the financial responsibility rules or if the accountant determines that any material weakness exists in the broker-dealer's internal control over compliance with the financial responsibility rules.

The broker-dealer, in turn, must file a notification with the Commission and its DEA under Rule 15c3-1, Rule 15c3-3, or Rule 17a-11 if the independent public accountant's notice concerns an instance of non-compliance that would trigger notification under those rules.

Under the amendments to Rule 17a-11, a broker-dealer also must file a notification with the Commission and its DEA if the broker-dealer discovers or is notified by the independent public accountant of the existence of any material weakness (as defined in the amendments) in the broker-dealer's internal control over compliance with the financial responsibility rules.

See

paragraph (h) of Rule 17a-5. As discussed below, material weakness is defined for purposes of the compliance report and, therefore, the notification of a material weakness only can occur in the context of the audit of a broker-dealer that files a compliance report.

Id.

Notifications under Rule 17a-11 also must be filed with the CFTC if the broker-dealer is registered as a FCM with the CFTC.

See

17 CFR 240.17a-11(g).

See

paragraph (e) of Rule 17a-11. These notification provisions are discussed below in more detail in section II.F. of this release.

Each of these amendments is discussed in more detail in the following sections of this release.

B. Annual Reports To Be Filed—Paragraph (d) of Rule 17a-5

Prior to today's amendments, paragraph (d) of Rule 17a-5 generally required a broker-dealer to annually file the financial statements and supporting schedules discussed below in section II.B.2. of this release and a report prepared by the broker-dealer's independent public accountant covering the financial statements and supporting schedules.

The Commission proposed amendments that would, among other things, restructure paragraph (d) and—as part of the proposed revisions to the attestation engagement provisions—add the requirement that a broker-dealer file either a compliance report or an exemption report, as applicable, and a report prepared by the broker-dealer's independent public accountant based on an examination of the compliance report or a review of the exemption report.

As discussed in sections II.B.1. through II.B.6. of this release, the Commission is adopting the proposed amendments to paragraph (d) with modifications.

See

17 CFR 240.17a-5(d)(1)(i). Certain types of broker-dealers were exempt from the requirement to file the reports or to file reports that had been audited by an independent public accountant.

See

17 CFR 240.17a-5(d)(1)(ii)-(iii).

See Broker-Dealer Reports,

76 FR at 37575-37581.

Before today's amendments, paragraph (d) of Rule 17a-5 was titled “Annual filing of audited financial statements.” In the proposing release, the Commission proposed to change the title to “Annual reports” to reflect that, under the proposed amendments to paragraph (d), broker-dealers would be required to prepare and file two reports with the Commission—a financial report and a compliance report or an exemption report.

See Broker-Dealer Reports,

76 FR at 37575. The Commission received no comments on this proposal and is adopting the new title as proposed.

See

paragraph (d) of Rule 17a-5. In addition, the Commission is making a technical amendment to paragraph (d) of Rule 17a-5 to replace the term “fiscal or calendar year” with the term “fiscal year.” The Commission is adopting this technical amendment because the term “fiscal year” includes instances in which December 31st,

i.e.,

the calendar year end, is the broker-dealer's fiscal year end.

1. Requirement To File Reports—Paragraph (d)(1) of Rule 17a-5

i. Proposed Amendments

The Commission proposed to amend paragraph (d)(1) of Rule 17a-5

to require that a broker-dealer file a financial report containing financial statements and supporting schedules and either a compliance report or an exemption report, as applicable.

The proposal provided that a broker-dealer must file a compliance report “unless the [broker-dealer] is exempt from the provisions of [Rule 15c3-3]” in which case the broker-dealer would be required to file an exemption report.

The proposed amendments also would have required a broker-dealer generally to file reports prepared by an independent public accountant covering the financial report and compliance report or exemption report, as applicable, unless the broker-dealer was exempt from the requirement to file the reports or from the requirement to engage an independent public accountant with respect to the reports.

To accommodate these changes, the Commission also proposed to reorganize the provisions of paragraph (d)(1) of Rule 17a-5, and to make other technical amendments.

See

17 CFR 240.17a-5(d)(1).

See Broker-Dealer Reports,

76 FR at 37575.

Id.

at 37575-37578, 37603-37604.

The proposed amendments with respect to the compliance report and exemption report set forth different requirements for carrying broker-dealers as compared with broker-dealers that do not hold customer securities and funds.

In order to provide clarity with respect to this distinction, the proposed amendments referenced Rule 15c3-3, which applies to carrying broker-dealers and contains provisions under which a broker-dealer is exempt from the requirements in the rule. The goal was to establish a clear way of determining whether a broker-dealer would need to file a compliance report or an exemption report. However, not all broker-dealers that are subject to Rule 15c3-3 regularly hold customer securities or funds. This prompted the Commission to inquire in the proposing release as to whether there are broker-dealers that would not qualify to file the proposed exemption report because they are not exempt from Rule 15c3-3, but that should be allowed to file a more limited report than the proposed compliance report based on the limited scope of their business.

Id.

at 37575-37578, 37580-37581 (discussing the compliance report and exemption report, respectively).

Id.

at 37581.

ii. Comments Received

The Commission received several comments on its proposed amendments to paragraph (d)(1) of Rule 17a-5.

Some commenters asked whether the provision that would require the broker-dealer to file an exemption report instead of a compliance report related to a period end date or to a period of time.

Further, as discussed in more detail in sections II.B.4. and II.D.3. of this release, commenters raised questions and concerns about how instances of exceptions to meeting the exemption provisions of paragraph (k) of Rule 15c3-3 would be treated under the proposed reporting requirements.

One commenter also stated that “limited purpose” carrying broker-dealers should not be required to file a compliance report, and broker-dealers with certain business model characteristics should not be required to file the compliance report.

Similarly, another commenter stated that broker-dealers engaging

exclusively in proprietary trading or investment banking may not technically be exempt from Rule 15c3-3 but nonetheless should not have to file the compliance report as they do not have “customers.”

Finally, one commenter stated that the Commission should clarify who must sign the compliance reports and exemption reports and the liability that attaches in the event of a misstatement or omission in the reports.

See, e.g., CAI Letter; CAI II Letter; CAQ Letter; Citrin Letter; Deloitte Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter.

See CAQ Letter; Deloitte Letter; Grant Thornton Letter; KPMG Letter.

See CAI Letter; SIFMA Letter.

See CAI Letter; CAI II Letter.

See McGladrey Letter.

See CAI Letter.

iii. The Final Rule

After considering these comments, the Commission is adopting the proposed amendments with certain modifications.

Under the final rule, all broker-dealers generally must prepare and file a financial report and either the compliance report or the exemption report.

A broker-dealer that did not claim an exemption from Rule 15c3-3 at any time during the most recent fiscal year or claimed an exemption for only part of the fiscal year must prepare and file the compliance report.

A broker-dealer must prepare and file the exemption report if the firm

did claim

that it was exempt from Rule 15c3-3 throughout the most recent fiscal year.

Broker-dealers also must file reports prepared by a PCAOB-registered independent public accountant covering the financial report and the compliance report or exemption report, as applicable.

See

paragraph (d)(1) of Rule 17a-5. Paragraph (d)(1)(iii) of Rule 17a-5 (now re-designated as paragraph (d)(1)(iv)) contains an exemption from filing an annual report if the broker-dealer is a member of a national securities exchange and has transacted 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.

See

paragraph (d)(1)(iv) of Rule 17a-5. The Commission also proposed to move the exemptions from having to file financial statements under paragraph (d) of Rule 17a-5 from paragraphs (d)(1)(ii) and (d)(1)(iii) of Rule 17a-5 to paragraphs (d)(1)(iii) and (d)(1)(iv), respectively. The Commission received no comments on these amendments and is adopting them as proposed.

See

paragraphs (d)(1)(iii) and (d)(1)(iv) of Rule 17a-5. For clarity, the amendments to paragraph (d)(1)(i) of Rule 17a-5 include a reference to the exemptions from the requirement for a broker-dealer to file the annual reports so that the paragraph now states “[e]xcept as provided in paragraphs (d)(1)(iii) and (d)(1)(iv) of this section, every broker or dealer registered under section 15 of the Act must file annually . . . .”

See

paragraph (d)(1)(i) of Rule 17a-5. As proposed, the final rule provided that the reports must be filed annually “on a calendar or fiscal year basis.” The final rule deletes the phrase “on a calendar or fiscal year basis” as the rule provides elsewhere that the annual reports must be filed on a fiscal year basis.

Id.

In addition, the Commission proposed to move the requirement that reports under paragraph (d) of Rule 17a-5 be as of the same fixed or determinable date each year, unless a change is approved in writing by the broker-dealer's DEA, from paragraph (d)(1)(i) of Rule 17a-5 to paragraph (d)(1)(ii). The Commission received no comments on this proposed amendment and is adopting it substantially as proposed.

See

paragraph (d)(1)(ii) of Rule 17a-5. The final rule also includes a technical modification from the proposal to require that the reports required to be filed under paragraph (d) must be as of the same “fiscal year end each year,” rather than as of the same “fixed or determinable date each year.”

See

paragraph (d)(1)(ii) of Rule 17a-5. This change, by having the rule refer to the broker-dealer's “fiscal year,” eliminates outdated language and conforms the language in paragraph (d) of Rule 17a-5 to language in paragraph (n) of Rule 17a-5.

See

17 CFR 240.17a-5(n). The final rule also adds a clarifying cross-reference to the provision in Rule 17a-5 pursuant to which a broker-dealer requests a change of its fiscal year end.

See

paragraph (d)(1)(i) of Rule 17a-5. Furthermore, the final rule requires that a copy of the written approval by the broker-dealer's DEA of a change in the broker-dealer's fiscal year be sent to the Commission's principal office in Washington, DC, in addition to the regional office of the Commission for the region in which the broker-dealer has its principal place of business.

Id.

This change is consistent with paragraph (n) of Rule 17a-5, which requires that when a broker-dealer changes its fiscal year, it must file a notice with the Commission's principal office in Washington, DC as well as the regional office of the Commission for the region in which the broker-dealer has its principal place of business.

See

17 CFR 240.17a-5(n).

See

paragraph (d)(1)(i) of Rule 17a-5. The financial report, compliance report, and exemption report are discussed below in more detail in sections II.B.2., II.B.3., and II.B.4., respectively, of this release.

See

paragraph (d)(1)(i)(B)(

) of Rule 17a-5.

See

paragraph (d)(1)(i)(B)(

) of Rule 17a-5.

See

paragraph (d)(1)(i)(C) of Rule 17a-5. The proposed requirements and final rule with respect to the attestation engagement for the independent public accountant are discussed below in section II.D. of this release.

The final rule is modified from the proposal in three key ways. First, the final rule provides that the broker-dealer must file the exemption report if it did “claim that it was exempt” from Rule 15c3-3

throughout the most recent fiscal year.

This modification from the proposal—which provided that a broker-dealer “shall” file the exemption report if the broker-dealer “is exempt from the provisions of [Rule 15c3-3]”—is designed to provide greater clarity as to whether a broker-dealer must file the exemption report (as opposed to the compliance report), particularly when the broker-dealer had exceptions to meeting the exemption provisions in paragraph (k) of Rule 15c3-3 during the fiscal year.

Specifically, if the broker-dealer claimed an exemption from Rule 15c3-3 in its

Financial and Operational Combined Uniform Single Reports

(“FOCUS Reports”) throughout the fiscal year,

it must file the exemption report even it had exceptions to the exemption provisions.

Consequently, the applicability of the exemption report under the final rule is based on an objective and easily ascertainable factor: whether the broker-dealer claimed an exemption from Rule 15c3-3 throughout the most recent fiscal year.

See

paragraph (d)(1)(i)(B)(2) of Rule 17a-5. A broker-dealer claiming an exemption from Rule 15c3-3 is required to indicate the basis for the exemption on the periodic reports it files with securities regulators.

See, e.g.,

Item 24 of Part IIa of the Financial and Operational Combined Uniform Single Report.

See

17 CFR 249.617.

As discussed below in more detail in section II.B.4. of this release, the provisions of paragraph (k) of Rule 15c3-3 prescribe “exemptions” from the requirements of Rule 15c3-3.

See

17 CFR 240.15c3-3(k)(1), (k)(2)(i), (k)(2)(ii), and (k)(3).

See CAI Letter;

SIFMA Letter.

The FOCUS Reports are: Form X-17A-5 Schedule I; Form X-17A-5 Part II; Form X-17A-5 Part IIa; Form X-17A-5 Part IIb; and Form X-17A-5 Part III.

As discussed in detail below in section II.B.4. of this release, a broker-dealer that has exceptions to meeting the exemption provisions in paragraph (k) of Rule 15c3-3 must identify them in the exemption report.

See

discussion in section II.B.4. of this release. There may be circumstances in which a broker-dealer has not held customer securities or funds during the fiscal year, but does not fit into one of the exemptive provisions listed under Item 24 of Part IIa. Even though there is not a box to check on the FOCUS Report, these broker-dealers should file an exemption report and related accountant's report.

As noted above, several commenters argued that broker-dealers that engage in limited custodial activities and, therefore, are not exempt from Rule 15c3-3, should not be required to file a compliance report.

Specifically, one of these commenters suggested that a “new” category of “limited purpose” broker-dealer with certain business model characteristics should be addressed in the rule and that this “new” category of broker-dealer should not be required to file the compliance report.

The Commission has considered these comments but has determined not to provide for a broader exception from the requirement to file a compliance report for broker-dealers with limited custodial activities. The objectives of the compliance report and related examination of the compliance report are intended, among other things, to “increase the focus of independent public accountants on the custody practices of broker-dealers” and to “help identify broker-dealers that have weak controls for safeguarding investor assets.”

Therefore, broker-dealers that hold customer assets—even if their custodial activities are limited—generally should be subject to the requirement to file the compliance report and related accountant's report.

See, e.g., CAI Letter;

CAI II Letter; McGladrey Letter.

See CAI II Letter.

See Broker-Dealer Reports,

76 FR at 37599.

Broker-dealers with extremely limited custodial activities (

e.g.,

holding customer checks made out to a third party for limited periods of

time) could seek exemptive relief under section 36 of the Exchange Act (15 U.S.C. 77mm) from the requirement to file the compliance report and report of the independent public accountant covering the compliance report.

The level of effort required by carrying broker-dealers to prepare a compliance report will depend on the nature and extent of their activities. For example, the controls of a carrying broker-dealer that engages in limited custodial activities could be less complex than the controls of a carrying broker-dealer that engages in more extensive custodial activities.

Therefore, this requirement is intended to be scalable so that a carrying broker-dealer with limited custodial activities generally should have to expend less effort to support its statements in the compliance report, particularly with respect to the statements relating to Rules 15c3-3 and 17a-13.

As discussed below in section II.D. of this release, the PCAOB has proposed attestation standards for an independent public accountant's examination of the compliance report and the review of the exemption report. The proposed examination standard provides procedural requirements for independent public accountants that are “designed to be scalable based on the broker's or dealer's size and complexity.”

See Proposed Standards for Attestation Engagements Related to Broker and Dealer Compliance or Exemption Reports Required by the U.S. Securities and Exchange Commission and Related Amendments to PCAOB Standards,

PCAOB Release No. 2011-004, PCAOB Rulemaking Docket Matter No. 035 (July 12, 2011) at 8 (“

PCAOB Proposing Release

”).

The second key modification is that the final rule provides that the requirement to file the exemption report applies if the broker-dealer did claim that it was exempt from Rule 15c3-3 “throughout the most recent fiscal year.”

Thus, a broker-dealer that did not claim an exemption from Rule 15c3-3 at any time during the most recent fiscal year or claimed an exemption for only part of the fiscal year must file the compliance report.

See

paragraphs (d)(1)(i)(B)(

)-(

) of Rule 17a-5.

There will be cases where a broker-dealer changes its business model to convert from a carrying broker-dealer to a non-carrying broker-dealer during the fiscal year. In this case, the broker-dealer could seek exemptive relief under section 36 of the Exchange Act (15 U.S.C. 78mm) from the requirement to file the compliance report and to instead file the exemption report. In analyzing such a request, the period of time the broker-dealer operated as a carrying broker-dealer would be a relevant consideration.

The third key modification is that the final rule specifies the individual who must execute the compliance reports and exemption reports.

As noted above, one commenter stated that the Commission should make clear who should sign the compliance reports and exemption reports and what liability attaches in the event of a misstatement or omission.

The commenter suggested a reasonableness standard, and stated that the Commission should make clear that the reports do not create a new private right of action.

In response to this comment, the final rule provides that the compliance report and the exemption report must be executed by the person who makes the oath or affirmation under paragraph (e)(2) of Rule 17a-5.

As discussed below in more detail in section II.C.2. of this release, paragraph (e)(2) of Rule 17a-5 requires an oath or affirmation to be attached to the financial report and provides that the oath or affirmation must be made by certain types of persons depending on the corporate form of the broker-dealer (

e.g.,

a duly authorized officer if the broker-dealer is a corporation).

The requirement to file these new reports with the Commission is not intended to establish a new private cause of action.

See

paragraphs (d)(1)(i)(B)(

)-(

) of Rule 17a-5.

See CAI Letter.

The filings discussed above constitute a “report” for purposes of 15 U.S.C. 78ff(a) and other applicable provisions of the Exchange Act. As a consequence, it would be unlawful for a broker-dealer to willfully make or cause to be made, a false or misleading statement of a material fact or omit to state a material fact in the filings.

Id.

See

paragraphs (d)(1)(i)(B)(

)-(

) of Rule 17a-5.

See

paragraph (e)(2) of Rule 17a-5.

2. The Financial Report—Paragraph (d)(2) of Rule 17a-5

Before today's amendments, paragraph (d)(2) of Rule 17a-5 required that the annual audited report of a broker-dealer contain certain financial statements in a format consistent with Form X-17A-5 Part II or Form X-17A-5 Part IIa, as applicable, including a statement of financial condition, an income statement, a statement of cash flows, a statement of changes in owners' equity, and a statement of changes in liabilities subordinated to claims of general creditors.

Paragraph (d)(3) of Rule 17a-5 required that the annual audited report contain supporting schedules, including a computation of net capital under Rule 15c3-1, a computation for determining reserve requirements under Rule 15c3-3, and information relating to the possession and control requirements of Rule 15c3-3.

Paragraph (d)(4) of Rule 17a-5 required a reconciliation between the net capital and reserve computations in the audited report and those in the most recent Form X-17A-5 Part II or Form X-17A-5 Part IIa, if there were material differences between the annual audited report and the form.

See

17 CFR 240.17a-5(d)(2). As noted above, Form X-17A-5 Part II and Form X-17A-5 Part IIa are among the FOCUS Reports that broker-dealers complete and file with the Commission or their DEA on a periodic basis.

See

17 CFR 240.17a-5(a) and 17 CFR 249.617. These two forms require broker-dealers to file monthly or quarterly financial information with the Commission or their DEA, including information about the broker-dealer's: (1) Assets and liabilities; ownership equity; net capital computation under Rule 15c3-1; minimum net capital requirement under Rule 15c3-1; income (loss); computation of the customer reserve requirement under Rule 15c3-3 in the case of Form X-17A-5 Part II; the possession and control requirements under Rule 15c3-3 in the case of Form X-17A-5 Part II; and changes in ownership equity.

See

17 CFR 240.17a-5(d)(3).

See

17 CFR 240.17a-5(d)(4).

The Commission proposed combining the provisions in paragraphs (d)(2) through (d)(4) of Rule 17a-5 in revised paragraph (d)(2) without substantive modification to those provisions.

In addition, the Commission proposed that revised paragraph (d)(2) be titled “Financial report” to reflect that the information required in this report would be financial in nature and to differentiate it from the proposed compliance reports and exemption reports. The Commission did not receive comments concerning the amendments to paragraph (d)(2) of Rule 17a-5 and is adopting them substantially as proposed.

See Broker-Dealer Reports,

76 FR at 37575.

See

paragraph (d)(2) of Rule 17a-5. The Commission has made plain English changes to the language of the paragraph (

e.g.,

replacing the term “shall” with “must”). The Commission also, consistent with current practice, has clarified that the financial statements must be prepared in accordance with U.S. GAAP to distinguish from other accounting frameworks.

See

paragraph (d)(2) of Rule 17a-5. In addition, the Commission has replaced the words “notes to the consolidated statement of financial condition” with “notes to the financial statements.” This change in terminology is designed to conform the language in Rule 17a-5 to current accounting practice. Under GAAP, notes to a complete set of financial statements must cover all the financial statements, and not just one of the statements, such as the consolidated statement of financial condition.

3. The Compliance Report—Paragraph (d)(3) of Rule 17a-5

i. The Proposed Amendments

As proposed, the requirements for the contents of the compliance report were prescribed in paragraph (d)(3) of Rule 17a-5.

Under the proposal, a carrying broker-dealer would need to include in the compliance report a specific statement, certain assertions, and descriptions.

The independent public accountant would examine the assertions in the compliance report in preparing the report of the accountant.

See Broker-Dealer Reports,

76 FR at 37575-37578.

Id.

The independent public accountant would not have been required to examine the proposed

“statement” and descriptions in the compliance report.

Specifically, as proposed, the carrying broker-dealer would be required to include in the compliance report a statement as to whether the firm 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.

In addition, the compliance report would need to include the following three assertions: (1) Whether the broker-dealer was in compliance in all material respects with the financial responsibility rules as of its fiscal year end; (2) whether the information used to assert compliance with the financial responsibility rules was derived from the books and records of the broker-dealer; and (3) whether internal control over compliance with the financial responsibility rules was effective during the most recent fiscal year such that there were no instances of material weakness.

Finally, the carrying broker-dealer would need to include in the compliance report a description of each identified instance of material non-compliance and each identified material weakness in internal control over compliance with the financial responsibility rules.

The independent public accountant would examine the assertions in preparing the report of the accountant.

The independent public accountant would not examine the statement regarding the establishment of the system of internal control.

See Broker-Dealer Reports,

76 FR at 37575-37576.

Id.

GAAS and PCAOB standards for attestation engagements provide that accountants ordinarily should obtain written assertions in an examination or review engagement.

See, e.g.,

PCAOB Interim Attestation Standard,

AT Section 101

at ¶ .09. Accordingly, the Commission proposed that the independent public accountant's report cover only the three assertions in the compliance report.

Under the proposal, the broker-dealer would not be able to assert compliance with the financial responsibility rules as of its most recent fiscal year end if it identified one or more instances of material non-compliance.

Similarly, the broker-dealer would not be able to assert that its internal control over compliance with the financial responsibility rules during the fiscal year was effective if one or more material weaknesses existed with respect to internal control over compliance.

100

See Broker-Dealer Reports,

76 FR at 37576-37577.

100

Id.

at 37577.

An instance of

material non-compliance

was proposed to be defined as a failure by the broker-dealer to comply with any of the requirements of the financial responsibility rules in all material respects.

101

When determining whether an instance of non-compliance is material, the Commission stated 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.

102

The Commission also stated that some deficiencies would necessarily be instances of material non-compliance, including failing to maintain the required minimum amount of net capital 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.

103

101

Id.

102

Id.

103

Id.

The term

material weakness

was proposed to be defined 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 the financial responsibility rules will not be prevented or detected on a timely basis.

104

The proposed definition of material weakness was modeled on the definition of material weakness in a Commission rule—Rule 1-02(a)(4) of Regulation S-X

105

—and in auditing literature governing financial reporting.

106

In the proposing release, the Commission stated that 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.

107

The Commission also stated 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.

108

The Commission further stated that an event is probable if the future event or events are likely to occur and that an event is reasonably possible if the chance of the future event or events occurring is more than remote, but less than likely.

109

104

Id.

105

See

17 CFR 210.1-02(a)(4); 17 CFR 240.12b-2.

106

See

PCAOB Auditing Standard,

AS No. 5

app. A at ¶ A7; American Institute of Certified Public Accountants (“AICPA”),

AU Section 325

at ¶ .06.

107

See Broker-Dealer Reports,

76 FR at 37577.

108

Id. See also

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 (June 20, 2007), 72 FR 35324, 35332 n.47 and corresponding text (June 27, 2007).

109

Broker-Dealer Reports,

76 FR at 37577. The Commission has stated in other contexts that there is a reasonable possibility of an event occurring if it is “probable” or “reasonably possible.”

See Amendments to Rules Regarding Management's Report on Internal Control Over Financial Reporting,

Exchange Act Release No. 55928 (June 20, 2007), 72 FR 35310 (June 27, 2007).

See also

17 CFR 240.12b-2; 17 CFR 210.1-02. Commission guidance provides that an event is “probable” if the future event or events are likely to occur, and that an event is “reasonably possible” if the chance of the future event or events occurring is more than remote, but less than likely.

See Commission Guidance Regarding Management's Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934,

72 FR at 35332 n.47 and corresponding text.

ii. Comments Received

The Commission received a number of comments on the proposed compliance report. Generally, the comments focused on the intended scope of the compliance report and the assertions to be included. Specifically, many commenters raised concerns about what would constitute “material non-compliance.”

110

Several of these commenters urged the Commission to provide guidance with additional specific examples or quantitative and qualitative factors to be considered when determining whether non-compliance was material.

111

One commenter proposed alternate definitions for material non-compliance and material weakness and provided examples of non-compliance that should not be regarded as material.

112

110

See ABA Letter;

CAI Letter; CAQ Letter;

Deloitte Letter; E&Y Letter;

Grant Thornton Letter; KPMG Letter;

McGladrey Letter; PWC Letter;

SIFMA Letter; Van Kampen/Invesco Letter.

111

See ABA Letter;

CAQ Letter; E&Y Letter;

KPMG Letter; McGladrey Letter;

PWC Letter.

112

See SIFMA Letter.

Commenters also addressed the time period covered by the assertion relating to effectiveness of internal control. In particular, some commenters stated that the proposed assertion that internal control was effective should be as of a point in time, as opposed to “during the fiscal year.”

113

One commenter stated that broker-dealers that must file the internal control report required under

Rule 206(4)-2 should be able to elect to make the assertion pertain to the entire fiscal year in order to satisfy reporting requirements under the IA Custody Rule.

114

Others stated that broker-dealers should have the opportunity to remediate any material weaknesses in internal control that were identified during the period and, if corrective action was taken, not be required to include them in the compliance report.

115

113

See Deloitte Letter;

E&Y Letter; Grant Thornton Letter;

KPMG Letter.

114

See E&Y Letter.

This commenter also stated that a point-in-time assessment would be consistent with the requirement for issuers subject to internal control reporting under section 404 of the Sarbanes-Oxley Act. Further, for carrying broker-dealers that are not subject to Rule 206(4)-2, this commenter stated that the incremental benefits of having the assertion pertain to the entire year rather than the year end assessment does not justify the cost.

Id.

115

See CAQ Letter;

Deloitte Letter; McGladrey Letter.

Regarding the proposed assertion that the broker-dealer was in compliance with the financial responsibility rules, one commenter stated that broker-dealers may need to interpret certain requirements and in other cases broker-dealers may be relying on informal interpretations obtained through dialogue with the Commission or its DEA.

116

This commenter recommended that in those circumstances the Commission require broker-dealers to formally document such interpretations and obtain evidence of agreements reached with the Commission or the DEA.

Some commenters stated that the Commission should provide additional guidance about the control objectives that would need to be met to achieve effective internal control over compliance with the financial responsibility rules.

117

Several commenters urged the Commission to clarify the interaction between material weaknesses in internal control over financial reporting and material weaknesses in internal control over compliance with the financial responsibility rules.

118

One commenter stated that the compliance report was over-inclusive and burdensome, and suggested that the final rule focus instead on “issues most vital to the financial condition of the broker-dealer and its compliance and internal control over compliance.”

119

116

See E&Y Letter.

117

See Angel Letter;

Deloitte Letter.

118

See Deloitte Letter;

KPMG Letter; PWC Letter.

119

See CAI Letter.

Some commenters had questions and comments about the proposed assertion that information used to assert compliance with the financial responsibility rules was derived from the books and records of the broker-dealer. Three commenters asked whether “books and records” means records maintained under Rule 17a-3.

120

See CAQ Letter;

Deloitte Letter; E&Y Letter.

iii. The Final Rule

The Commission is adopting the proposed amendments to Rule 17a-5 requiring a carrying broker-dealer to prepare and file a compliance report, with modifications, some of which are in response to comments.

121

Generally, as adopted, the broker-dealer's compliance report will include five specific statements, and two descriptions, if applicable.

121

See

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

Specifically, paragraph (d)(3) of Rule 17a-5 requires that the compliance report contain statements as to whether: (1) The broker-dealer has established and maintained Internal Control Over Compliance (which, as discussed below, is a defined term in the final rule); (2) the Internal Control Over Compliance of the broker-dealer was effective during the most recent fiscal year; (3) the Internal Control Over Compliance of the broker-dealer was effective as of the end of the most recent fiscal year; (4) the broker-dealer was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal year; and (5) the information the broker-dealer used to state whether it was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 was derived from the books and records of the broker-dealer. Further, if applicable, the compliance report must contain a description of: (1) Each identified material weakness in the Internal Control Over Compliance during the most recent fiscal year, including those that were identified as of the end of the fiscal year; and (2) any instance of non-compliance with Rule 15c3-1 or paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal year.

The final rule does not use the term assertion—the assertions contained in the proposal are now referred to as statements.

122

The consistent use of the term statements is designed to simplify the structure of the rule rather than to substantively change the nature of the matters stated in the compliance report or which of the statements are to be examined by the independent public accountant.

122

See

paragraphs (d)(3)(i)(A)(

)-(

) of Rule 17a-5.

In the final rule, the first statement in the compliance report is whether the broker-dealer has established and maintained Internal Control Over Compliance.

123

The rule defines

Internal Control Over Compliance

to mean internal controls that have the objective of providing the broker-dealer with reasonable assurance that non-compliance with the financial responsibility rules will be prevented or detected on a timely basis.

124

In order to clarify the application of the rule, the proposal has been modified so that part of the statement contained in the proposed compliance report, as to the broker-dealer's system of internal control, has been incorporated in the definition of

Internal Control Over Compliance

in the final rule.

125

Under the final rule, a broker-dealer cannot state that it has established and maintained Internal Control Over Compliance if the internal controls do not provide the broker-dealer with reasonable assurance that non-compliance with the financial responsibility rules will be prevented or detected on a timely basis.

123

See

paragraph (d)(3)(i)(A)(

) of Rule 17a-5.

124

See

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

125

Id.

The final rule also provides that a broker-dealer is not permitted to conclude that its Internal Control Over Compliance was effective if there were one or more material weaknesses in its Internal Control Over Compliance.

126

material weakness

is defined as a deficiency, or a combination of deficiencies, in the broker-dealer's Internal Control Over Compliance such that there is a reasonable possibility

127

that non-compliance with Rule 15c3-1 or paragraph (e) of Rule 15c3-3 will not be prevented or detected on a timely basis, or that non-compliance to a material extent with Rule 15c3-3, except for paragraph (e), Rule 17a-13 or any Account Statement Rule will not be prevented or detected on a timely

basis.

128

A deficiency in Internal Control Over Compliance exists when the design or operation of a control does not allow the management or employees of the broker-dealer to prevent or detect on a timely basis non-compliance with the financial responsibility rules in the normal course of performing their assigned functions.

126

See

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

See also

17 CFR 229.308(a)(3) (providing that “[m]anagement is not permitted to conclude that the registrant's internal control over financial reporting is effective if there are one or more material weaknesses in the registrant's internal control over financial reporting.”).

127

As noted above, the Commission has stated in other contexts that there is a reasonable possibility of an event occurring if it is “probable” or “reasonably possible.”

See Amendments to Rules Regarding Management's Report on Internal Control Over Financial Reporting,

72 FR 35310.

See also

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,

72 FR at 35332 n.47 and corresponding text.

128

See

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

See also

17 CFR 240.12b-2; 17 CFR 210.1-02(a)(4) (providing that a “[m]aterial weakness means 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 final amendments reflect several other key changes from the proposal. For example, one commenter stated that the compliance report was overinclusive and burdensome, and therefore suggested that the final rule focus on “issues most vital to the financial condition of the broker-dealer and its compliance and internal control over compliance.”

129

The final rule requires a statement as to whether the broker-dealer was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal year and, if applicable, a description of any instances of non-compliance with these rules as of the fiscal year end. This is a modification from the proposed assertion that the broker-dealer is in compliance with the financial responsibility rules in all

material

respects and proposed description of any material non-compliance with the financial responsibility rules. Thus, the final rule reflects two changes from the proposal: (1) Elimination of the concepts of “material non-compliance” and “compliance in all material respects” for the purposes of reporting in the compliance report; and (2) a narrowing of these statements and requirements from compliance with all of the financial responsibility rules to compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3. In this way, the final rule more narrowly focuses on the core requirements of the financial responsibility rules, as suggested by the commenter.

129

See CAI Letter.

The “material non-compliance” and “compliance in all material respects” concepts were designed to limit the types of instances of non-compliance that would prevent a carrying broker-dealer from stating that it was in compliance with the financial responsibility rules. In order to retain a limiting principle, the final rule focuses on provisions that trigger notification requirements when they are not complied with, namely, Rule 15c3-1 and the customer reserve requirement in paragraph (e) of Rule 15c3-3.

130

Any instance of non-compliance with these requirements as of the fiscal year end must be addressed in the compliance report. As stated in the proposing release, failing to maintain the required minimum amount of net capital under Rule 15c3-1 or failing to maintain the minimum deposit requirement in a special reserve bank account under paragraph (e) of Rule 15c3-3 would have been instances of material non-compliance under the proposed rule.

131

Accordingly, under the proposal, a broker-dealer would have been required to describe all instances of non-compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3. Under the proposal, a broker-dealer also would have been required to describe instances of material non-compliance with Rule 17a-13 and the Account Statement Rules. The final rule is narrower in that a broker-dealer is only required to describe instances of non-compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3.

130

See

17 CFR 240.15c3-1(a)(6)(iv)(B), (a)(6)(v), (a)(7)(ii), (a)(7)(iii), (c)(2)(x)(B)(

), (c)(2)(x)(F)(

) (notification requirements with respect to Rule 15c3-1); 17 CFR 240.17a-11(b)-(c) (notification requirements with respect to Rule 15c3-1); 17 CFR 240.15c3-3(i) (notification requirement in the event of a failure to make a required deposit to the reserve account).

131

See Broker-Dealer Reports,

76 FR at 37577.

Consistent with these changes, the final rule requires a statement as to whether the carrying broker-dealer has established and maintained

Internal Control Over Compliance,

which is defined as internal controls that have the objective of providing the broker-dealer with reasonable assurance that non-compliance with the financial responsibility rules will be prevented or detected on a timely basis.

132

The definition of

Internal Control Over Compliance

modifies the proposed statement that the carrying broker-dealer has established and maintained a system of internal control to provide the firm with reasonable assurance that any instances of material non-compliance with the financial responsibility rules will be prevented or detected on a timely basis.

133

Thus, the definition eliminates the concept of material non-compliance. Similarly, the proposed assertion as to whether the information used to assert compliance with the financial responsibility rules was derived from the books and records of the carrying broker-dealer has been modified to a statement as to whether the information used to state whether the carrying broker-dealer was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 was derived from the broker-dealer's books and records.

134

132

See

paragraphs (d)(3)(i)(A)(

) and (d)(3)(ii) of Rule 17a-5. As indicated above, the independent public accountant is not required to examine this statement.

See

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

133

See

paragraphs (d)(3)(i)(A)(

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

134

See

paragraph (d)(3)(i)(A)(

) of Rule 17a-5.

The definition of

material weakness

similarly has been modified from the proposal. Under the final rule, a

material weakness

would include deficiencies in internal control relating to “non-compliance” with Rule 15c3-1 or paragraph (e) of Rule 15c3-3, and “non-compliance to a material extent” with Rule 15c3-3, except for paragraph (e), Rule 17a-13, and the Account Statement Rules.

135

This modification of the definition of

material weakness

is based on the practical difficulties in creating a system of control that will eliminate a reasonable possibility of the occurrence of any instances of non-compliance with certain requirements of the financial responsibility rules. For example, the inadvertent failure to send one account statement out of thousands of such statements would not constitute non-compliance to a material extent with the Account Statement Rules though it would be an instance of non-compliance.

135

See

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

Further, and consistent with current auditing standards, the definition of “deficiency in internal control” in the final rule has been modified to include the phrase “the management or employees of the broker or dealer” in place of the phrase “the broker or dealer.”

136

Id. See also

PCAOB Auditing Standard,

AS No. 5

app. A, at ¶ A3 (providing that “[a] deficiency in internal control over financial reporting exists when the design or operation of a control does not allow

management or employees,

in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.”).

The final rule—substantially as proposed—requires the carrying broker-dealer to state whether its Internal Control Over Compliance was effective during the most recent fiscal year.

137

Some commenters suggested that a broker-dealer that has remediated a material weakness be permitted to provide an assertion about whether a material weakness still exists at the end of the year, instead of having to state whether internal control was effective during the most recent fiscal year.

138

In light of the importance of a broker-dealer being in continual compliance

with the financial responsibility rules, the Commission believes it is appropriate for the broker-dealer's statement to address effectiveness of its Internal Control Over Compliance throughout the fiscal year. Consequently, the final rule requires the statement to cover the entire fiscal year as opposed to the date that is the end of the fiscal year as suggested by commenters.

137

See

paragraph (d)(3)(i)(A)(

) of Rule 17a-5.

138

See CAQ Letter;

E&Y Letter; KPMG Letter;

PWC Letter.

However, in response to comments suggesting that the broker-dealer be permitted to report the remediation or whether a material weakness still exists at the end of the year,

139

the final rule also requires the carrying broker-dealer to state whether its Internal Control Over Compliance was effective as of the end of the most recent fiscal year.

140

Thus, if there was a material weakness in the Internal Control Over Compliance of the broker-dealer during the year that has been addressed such that the broker-dealer no longer considers there to be a material weakness at fiscal year end, the compliance report would reflect both the identification of the material weakness and that its Internal Control Over Compliance was effective as of the end of the most recent fiscal year, thereby indicating that the material weakness had been addressed as of the fiscal year end.

139

See CAQ Letter;

Deloitte Letter; E&Y Letter;

McGladrey Letter.

140

See

paragraph (d)(3)(i)(A)(

) of Rule 17a-5.

Consistent with these changes, the final rule provides that the carrying broker-dealer cannot conclude that its Internal Control Over Compliance was effective during the most recent fiscal year if there were one or more material weaknesses in Internal Control Over Compliance of the broker-dealer during the fiscal year.

141

The final rule adds a similar provision relating to the effectiveness of a broker-dealer's Internal Control Over Compliance at the end of the most recent fiscal year

142

to respond to comments

143

and to align with the additional statement discussed above as to whether the broker-dealer's Internal Control Over Compliance was effective as of the end of the fiscal year.

144

141

See

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

See also

142

See

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

143

See CAQ Letter;

Deloitte Letter; E&Y Letter;

McGladrey Letter.

144

See

paragraph (d)(3)(i)(A)(

) of Rule 17a-5.

The final rule also retains the proposed requirement that the carrying broker-dealer provide a description of each identified material weakness in the broker-dealer's Internal Control Over Compliance, but, in conformity with other modifications to the proposal, the final rule requires that the material weaknesses include those identified during the most recent fiscal year as well as those that were identified as of the end of the fiscal year.

145

This change should not add a significant burden because broker-dealers should know whether any material weaknesses identified before year end have been remediated.

145

See

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

As noted above, one commenter recommended that the Commission require broker-dealers to document oral guidance obtained through dialogue with Commission or DEA staff.

146

While such a requirement was not proposed and is not being adopted in the final rule, it may be appropriate and prudent for a broker-dealer to maintain documentation in its books and records of the matters discussed with the Commission or DEA staff, the broker-dealer's own views and conclusion on those matters, and any guidance received by the broker-dealer.

146

See E&Y Letter.

Also as noted above, two commenters asked the Commission to provide additional guidance about the control objectives that should be met to achieve effective internal control over compliance with the financial responsibility rules.

147

As stated in the proposing release, the control objectives identified in the Commission's guidance on Rule 206(4)-2 are more general than the specific operational requirements in the financial responsibility rules.

148

In particular, broker-dealers are subject to operational requirements with respect to handling and accounting for customer assets.

149

Given the specificity of the financial responsibility rules, the Commission does not believe that additional guidance about the control objectives is necessary.

147

See Angel Letter;

Deloitte Letter.

148

See Broker-Dealer Reports,

76 FR at 37580.

149

Id.

As noted above, several commenters sought assurances that the independent public accountant's examination of the compliance report would not cover the effectiveness of internal control over financial reporting.

150

The final rule does not require that the broker-dealer include a statement regarding the effectiveness of its internal control over financial reporting, nor does it require that the independent public accountant attest to the effectiveness of internal control over financial reporting. The requirement in the final rule is for the broker-dealer to state whether its Internal Control Over Compliance was effective during the most recent fiscal year and at the end of the fiscal year and for the accountant to express an opinion based on an examination of those statements.

150

See Deloitte Letter;

KPMG Letter; PWC Letter.

A broker-dealer's Internal Control Over Compliance is intended to focus, for example, on a broker-dealer's oversight of custody arrangements and protection of customer assets. In contrast, internal control over financial reporting is focused on the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. As stated in the proposing release, the Commission did not propose that effectiveness of internal control over financial reporting be included as one of the assertions made by the broker-dealer in the compliance report. The Commission intends that the compliance report should focus on oversight of net capital, custody arrangements, and protection of customer assets, and therefore, should be focused on compliance with the financial responsibility rules.

Further, the examination of the compliance report would pertain solely to certain statements in the compliance report and not to the broker-dealer's process for arriving at the statements. The report of the independent public accountant, based on the examination of the compliance report, requires the accountant to perform its own independent examination of the related internal controls. Consequently, it is not 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.

As noted above, commenters sought clarification of the meaning of “books and records” as used in the compliance report statement. The reference in paragraph (d)(3)(i)(A)(

) of Rule 17a-5 to books and records refers to the books and records a broker-dealer is required to make and maintain under Commission rules (

e.g.,

Rule 17a-3 and Rule 17a-4).

151

See

17 CFR 240.17a-3; 17 CFR 240.17a-4.

4. The Exemption Report—Paragraph (d)(4) of Rule 17a-5

i. Proposed Amendments

The Commission proposed that the exemption report must contain an assertion by the broker-dealer that it is exempt from Rule 15c3-3 because it meets conditions set forth in paragraph (k) of Rule 15c3-3 and “should identify

the specific conditions.”

152

As discussed below in section II.D.3. of this release, under the proposal, the independent public accountant, as part of the engagement, would have been required to prepare a report based on a review of the exemption report in accordance with PCAOB standards.

153

152

See Broker-Dealer Reports,

76 FR at 37580-37581.

153

Id.

at 37578-37579. PCAOB standards for attestation engagements provide that accountants ordinarily should obtain written assertions in an examination or review engagement.

ii. Comments Received

The Commission received several comments regarding the exemption report.

154

Some commenters stated that the Commission should clarify whether the assertion would cover the entire fiscal year or be as of a fixed date.

155

One commenter stated that the assertion should be as of a fixed date.

156

With respect to the independent public accountant's review of the exemption report, one commenter provided the example of a bank or clerical error that results in a broker-dealer that operates under an exemption to Rule 15c3-3 finding itself in possession of customer assets overnight once during the fiscal year.

157

This commenter stated that such a situation should not “warrant the `material modification' of a broker-dealer's Exemption Report.”

158

Similarly, another commenter noted that “to consider a single instance of a broker-dealer failing to promptly forward a customer's securities as an instance that would necessitate a material modification creates an unworkable standard.”

159

154

See CAQ Letter;

Deloitte Letter; Grant Thornton Letter;

KPMG Letter.

Some of the comments relating to the exemption report and the response to the comments are discussed above in section II.B.1. of this release.

155

See CAQ Letter;

Deloitte Letter; Grant Thornton Letter;

KPMG Letter.

156

See KPMG Letter.

157

See SIFMA Letter.

158

Id.

159

See CAI Letter.

One commenter stated that the exemption report relates only to Rule 15c3-3 and asked how the Commission intended to assess, for a firm that claims an exemption from Rule 15c3-3, compliance with Rule 15c3-1 and the adequacy of the firm's internal control over compliance with that rule.

160

Another commenter asked whether the exemption report should be replaced with a box to check on the FOCUS Report, as the amount of paperwork involved for small firms “seems rather excessive.”

161

160

See McGladrey Letter.

161

See Angel Letter.

iii. The Final Rule

The Commission is adopting, with modifications discussed below, the requirements regarding the exemption report.

162

The modifications are designed to address commenters' concerns that the proposed exemption report assertion would create an unworkable standard given the possibility that a broker-dealer might have instances of exceptions to meeting the exemption provisions in paragraph (k) of Rule 15c3-3 and that the proposed requirements with respect to the exemption report did not explicitly provide how exceptions should be treated. In response to these concerns, the final rule provides that exemption reports must contain the following statements made to the best knowledge and belief of the broker-dealer: (1) A statement that identifies the provisions in paragraph (k) of Rule 15c3-3 under which the broker-dealer claimed an exemption from Rule 15c3-3; (2) a statement the broker-dealer met the identified exemption provisions in paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year without exception or that it met the identified exemption provisions in paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year except as described in the exemption report; and (3) if applicable, a statement that identifies each exception during the most recent fiscal year in meeting the identified provisions in paragraph (k) of Rule 15c3-3 and that briefly describes the nature of each exception and the approximate date(s) on which the exception existed.

163

162

See

paragraph (d)(4) of Rule 17a-5.

163

Id.

In response to comments seeking clarity as to whether the assertion in the exemption report should cover a fixed date or the fiscal year,

164

the final rule explicitly provides that the statement and certain information in the exemption report must cover the most recent fiscal year.

165

This corresponds to the provisions of paragraph (d)(1)(i)(B) of Rule 17a-5 governing when a broker-dealer must file the exemption report instead of the compliance report. In particular, a broker-dealer that claimed an exemption from Rule 15c3-3 throughout the most recent fiscal year must file the exemption report.

166

164

See CAQ Letter;

Deloitte Letter; Grant Thornton Letter;

KPMG Letter.

165

See

paragraph (d)(4)(ii) of Rule 17a-5.

166

See

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

In addition, as proposed, the exemption report was required to contain an assertion that the broker-dealer “is exempt from the provisions” of Rule 15c3-3 “because it meets conditions set forth in” paragraph (k) of Rule 15c3-3 and “should identify the specific conditions.”

167

Thus, the exemption report would have required the broker-dealer to state definitively that “it is exempt” from Rule 15c3-3 because it “meets the conditions set forth in” in paragraph (k).

168

As noted above, commenters raised questions and concerns about how certain exceptions would be handled under the proposed exemption report requirements. The final rule addresses these comments in a number of ways.

167

See Broker-Dealer Reports,

76 FR at 37604.

168

Id.

First, it provides that the statements in the exemption report must be made to the “best knowledge and belief of the broker or dealer.”

169

This modification is designed to address situations where the broker-dealer is unaware of an instance or instances in which it had an exception to meeting the exemption provisions in paragraph (k) of Rule 15c3-3 during the most recent fiscal year. As discussed below, the broker-dealer must state in the report that it met the exemption provisions throughout the year without exceptions or with exceptions that must be identified.

170

169

See

paragraph (d)(4) of Rule 17a-5.

170

As discussed above in section II.B.3. of this release, a carrying broker-dealer must state in the compliance report whether it was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal year.

See

paragraph (d)(3)(i)(A)(

) of Rule 17a-5. In response to comments and in light of the nature of the statements required in the exemption report, the Commission added the best knowledge and belief standard to the exemption report requirement.

Second, the final rule provides that the broker-dealer first must identify in the exemption report the “provisions” in paragraph (k) of Rule 15c3-3 under which it “claimed” an exemption from Rule 15c3-3.

171

As discussed above in section II.B.1. of this release, the final rule has been modified to provide that a broker-dealer must file the exemption report if it did “claim that it was exempt” from Rule 15c3-3 throughout

the most recent fiscal year.

172

This change is designed to remove any ambiguity as to when a broker-dealer must file the exemption report as opposed to the compliance report, particularly in situations where the broker-dealer had exceptions to meeting the exemption provisions in paragraph (k) of Rule 15c3-3. Consistent with this change, the final rule requires the broker-dealer to identify in the exemption report the provisions in paragraph (k) under which it “claimed the exemption.”

173

171

See

paragraph (d)(4)(i) of Rule 17a-5. As proposed, paragraph (d)(4) of Rule 17a-5 provided that the exemption report “shall contain a statement by the broker or dealer that it is exempt from the provisions of [Rule 15c3-3] because it meets the conditions set forth in [paragraph (k) of Rule 15c3-3] and

should

identify the specific conditions.”

See Broker-Dealer Reports,

76 FR 37604 (emphasis added). The Commission intended that the broker-dealer be required to identify the provisions of paragraph (k) of Rule 15c3-3 under which the broker-dealer was claiming the exemption. To make clear that this requirement and the other requirements of the exemption report are mandatory, the final rule uses the word “must” in relation to each element of the exemption report.

See

paragraph (d)(4) of Rule 17a-5.

172

See

paragraph (d)(1)(i)(B)(

) of Rule 17a-5. A broker-dealer claiming an exemption from Rule 15c3-3 is required to indicate the basis for the exemption on the periodic reports it files with securities regulators.

See, e.g.,

Item 24 of Part IIa of the FOCUS Reports.

See

17 CFR 249.617.

173

See

paragraph (d)(4)(i) of Rule 17a-5.

Further, as proposed, the broker-dealer would have been required to identify the exemption “conditions” in paragraph (k) of Rule 15c3-3.

174

The use of the word “provisions” in the final rule is designed to eliminate a potential ambiguity as to whether the exemption provisions in paragraphs (k)(2) and (3) of Rule 15c3-3 applied to the exemption report. In particular, paragraph (k) of Rule 15c3-3 prescribes “exemptions” from the requirements of Rule 15c3-3.

175

Paragraph (k)(1) provides that the requirements of Rule 15c3-3 do not apply to a broker-dealer that meets all of the “conditions” set forth in the paragraph.

176

Paragraph (k)(2) identifies two sets of conditions (without using the word “conditions”) either of which exempts a broker-dealer from the requirements of Rule 15c3-3.

177

Paragraph (k)(3) provides that the Commission may exempt a broker-dealer from the provisions of Rule 15c3-3, either unconditionally or on specified terms and conditions, if the Commission finds that the broker-dealer has established safeguards for the protection of funds and securities of customers comparable with those provided for by Rule 15c3-3 and that it is not necessary in the public interest or for the protection of investors to subject the particular broker-dealer to the provisions of Rule 15c3-3.

178

The Commission intended that a broker-dealer file an exemption report if it is exempt from Rule 15c3-3 under the provisions in either paragraph (k)(1), (k)(2)(i), (k)(2)(ii), or (k)(3) of Rule 15c3-3. To make this clear, the final rule refers to the “provisions” of paragraph (k) of Rule 15c3-3.

179

Consequently, a broker-dealer filing the exemption report must identify the provisions in paragraph (k) that it relied on to claim an exemption from Rule 15c3-3.

180

174

See

paragraph (d)(4)(ii) of Rule 17a-5. The proposed rule provided that the broker-dealer must assert that it is exempt from the provisions of Rule 15c3-3 because it meets “conditions” set forth in paragraph (k)

and

should identify the specific “conditions.”

See Broker-Dealer Reports,

76 FR at 37580-37581.

175

See

17 CFR 240.15c3-3(k)(1), (k)(2)(i), (k)(2)(ii), and (k)(3).

176

See

17 CFR 240.15c3-3(k)(1)(i)-(iv).

177

See

17 CFR 240.15c3-3(k)(2)(i)-(ii).

178

See

17 CFR 240.15c3-3(k)(3).

179

This modification is consistent with Item 24 of Part IIa of the FOCUS Report, which is titled “EXEMPTIVE PROVISION UNDER RULE 15c3-3” and requires a broker-dealer that claims to be exempt from the requirements of Rule 15c3-3 to identify the provision in Rule 15c3-3—paragraph (k)(1), paragraph (k)(2)(i), paragraph (k)(2)(ii), or paragraph (k)(3)—under which it is claiming to be exempt.

See

17 CFR 249.617.

180

This change also is intended to make clear that the broker-dealer can identify the provisions of paragraph (k) of Rule 15c3-3 that the broker-dealer is relying on to claim the exemption by simply identifying in the exemption report the subparagraph in paragraph (k) (

i.e.,

(k)(1), (k)(2)(i), (k)(2)(ii), or (k)(3)) that contains the particular conditions the broker-dealer is relying on to claim the exemption rather than repeating the conditions themselves in the exemption report. For example, it would be sufficient for a broker-dealer relying on the exemption provisions in paragraph (k)(2)(ii) of Rule 15c3-3 to identify the provisions in the exemption report under which in claimed an exemption by referring to “paragraph (k)(2)(ii) of Rule 15c3-3” or “17 CFR 240.15c3-3(k)(2)(ii).”

The third modification designed to address commenters' questions and concerns about how to handle exceptions to meeting the exemption provisions in paragraph (k) of Rule 15c3-3 relates to the proposed assertion that the broker-dealer “is exempt from the provisions” of Rule 15c3-3 “because it meets conditions set forth in” paragraph (k). The final rule provides that the exemption report must contain a statement that the broker-dealer met the identified exemption provisions in paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year without exception or that it met the identified exemption provisions in paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year except as described in the exemption report.

181

This modification from requiring the broker-dealer to state an absolute (

i.e.,

that it is exempt from Rule 15c3-3) allows the broker-dealer to account for instances in which it had exceptions to meeting the exemption provisions in paragraph (k) of Rule 15c3-3 directly in the exemption report (rather than having to file the compliance report). Specifically, if to the broker-dealer's best knowledge and belief, it had no exceptions during the most recent fiscal year to the identified exemption provisions in paragraph (k) of Rule 15c3-3, it must state in the exemption report that it met the identified exemption provisions in paragraph (k) without exception. Alternatively, a broker-dealer that had exceptions must state that it met the identified exemption provisions except as described in the exemption report.

181

See

paragraph (d)(4)(ii) of Rule 17a-5.

If the broker-dealer states that it had exceptions (

e.g.,

exceptions identified during the year, such as through routine monitoring of its compliance processes as part of the execution of its internal controls, internal or external audits, or regulatory examinations), the final rule requires the firm to identify, to its best knowledge and belief, each exception and briefly describe the nature of the exception and the approximate date(s) on which the exception existed.

182

The Commission expects that non-carrying broker-dealers generally track exceptions as part of monitoring compliance with the exemption provisions in paragraph (k) of Rule 15c3-3.

183

Further, a non-carrying broker-dealer's adherence to the exemption provisions in paragraph (k) of Rule 15c3-3 generally is a focus of Commission examiners when they conduct financial responsibility examinations on this class of firm. For example, examiners will review whether a non-carrying broker-dealer promptly forwards checks in accordance with provisions in paragraph (k) of Rule 15c3-3. The Commission also notes that the 2011 AICPA Broker Dealer Audit Guide states: “In auditing the financial statements of a broker-dealer claiming exemption from SEC Rule 15c3-3, the auditor should determine whether and to what extent the broker-dealer complied with the specific exemption during the audit period as well as the quality of the broker-dealer's controls and procedures to ensure ongoing compliance.”

184

In addition, under the PCAOB's proposed standards, the independent public accountant should inquire of individuals at the broker-dealer who have relevant knowledge of controls relevant to the broker-dealer's compliance with the exemption provisions and who are responsible for monitoring compliance with the exemption provisions whether they are aware of any deficiencies in controls over compliance or instances of non-compliance with the exemption conditions.

185

Moreover, in the independent public accountant's report, “[i]f the broker's or dealer's statement is not fairly stated, in all material respects,

because of an instance or certain instances of non-compliance with the exemption conditions, the auditor must modify the review report to describe those instances of non-compliance and state that the broker or dealer is not in compliance with the specified exemption conditions.”

186

182

See

paragraph (d)(4)(iii) of Rule 15c3-3.

183

See, e.g., Net Capital Rule,

Exchange Act Release No. 31511 (Nov. 24, 1992), 57 FR 56973 (Dec. 2, 1992), at 56981 n.25 (stating that non-carrying broker-dealers must develop procedures to ensure that they do not receive customer securities or checks made payable to themselves).

184

See AICPA Broker-Dealer Audit Guide

at ¶ 3.35.

185

See PCAOB Proposing Release

app. 2 at ¶ 10.

186

Id.

at ¶ 20.

Under the final rule, a non-carrying broker-dealer must identify in the exemption report and describe each exception during the most recent fiscal year in meeting the identified exemption provisions in paragraph (k) of Rule 15c3-3. The description must include the approximate date(s) on which the exception existed. Without such reporting, the Commission and the broker-dealer's DEA would have no information to assess the nature, extent, and significance of the exceptions.

As noted above, one commenter asked whether the exemption report should be replaced with a box to check on the FOCUS Report, as the amount of paperwork involved for small firms “seems rather excessive.”

187

The Commission does not believe this is an appropriate alternative. First, as indicated above, a broker-dealer claiming an exemption from Rule 15c3-3 already is required to indicate the basis for the exemption on its FOCUS Report.

188

Second, the exemption report requires the broker-dealer to make certain statements that the independent public accountant must review. Thus, the exemption report will provide a standardized statement across all broker-dealers claiming an exemption from Rule 15c3-3 for the independent public accountant to review. Third, the exemption report will provide the Commission and the broker-dealer's DEA with more information than currently is reported by non-carrying broker-dealers in the FOCUS Report. Specifically, it requires the broker-dealer to, among other things, state either that it met the identified exemption provisions in paragraph (k) throughout the most recent fiscal year without exception or that it met the identified exemption provisions throughout the most recent fiscal year except as described in the report. This will provide the Commission and the broker-dealer's DEA with information as to whether a broker-dealer is meeting the exemption provisions of paragraph (k) of Rule 15c3-3 (not simply that the broker-dealer is claiming the exemption as is reported in the FOCUS Report). Fourth, requiring that the exemption report be filed with the Commission should increase broker-dealers' focus on the statements being made, facilitating consistent compliance with the exemption provisions in Rule 15c3-3, and therefore, providing better protection of customer assets. Fifth, the requirement to prepare and file the exemption report should not result in excessive paperwork, as stated by one commenter.

189

187

See Angel Letter.

188

See

Item 24 of Part IIa of the FOCUS Report.

189

See Angel Letter.

The commenter did not explain why the exemption report would result in excessive paperwork.

Id. See also

discussion below in section VI.D.1.iii. of this release for the estimated paperwork hour burden associated with this requirement.

As noted above, one commenter pointed out that the exemption report relates solely to Rule 15c3-3 and asked how the adequacy of a non-carrying broker-dealer's internal controls over compliance with Rule 15c3-1 would be assessed.

190

Under the final amendments, a broker-dealer's financial report will continue to include a supporting schedule containing a net capital computation under Rule 15c3-1, which will be covered by the independent public accountant's examination of the financial report. Moreover, the PCAOB has proposed standards for auditing supplemental information accompanying audited financial statements.

191

190

See McGladery Letter.

The material inadequacy report—which applied to carrying and non-carrying broker-dealers—covered Rule 15c3-1.

See

17 CFR 240.17a-5(g).

191

See Proposed Auditing Standard, Auditing Supplemental Information Accompanying Audited Financial Statements and Related Amendments to PCAOB Standards,

PCAOB Release No. 2011-05, PCAOB Rulemaking Docket Matter No. 036 (July 12, 2011) (“

PCAOB Proposed Auditing Standard for Supplemental Information”

5. Time for Filing Annual Reports—Paragraph (d)(5) of Rule 17a-5

Prior to today's amendments, paragraph (d)(5) of Rule 17a-5 required that the annual audit report be filed not more than 60 days after the date of the financial statements.

192

The Commission proposed amending paragraph (d)(5) to replace the term

annual audit report

with

annual reports

193

This change was designed to reflect the fact that, under the proposal, broker-dealers must file a financial report, a compliance report or exemption report, and reports prepared by an independent public accountant covering these reports. While the Commission did not receive comments on this proposed change, one commenter stated that the existing requirement in Rule 17a-5 that the annual audit report be filed 60 days after the date of the financial statements should be lengthened to 90 days.

194

In support of this recommendation, the commenter cited CFTC Rule 1.10, which allows an FCM up to 90 days to file annual audit reports.

195

192

See

17 CFR 240.17a-5(d)(5).

193

See Broker-Dealer Reports,

76 FR at 37604.

194

See IMS Letter.

195

See

17 CFR 1.10(b)(ii). Rule 1.10 also provides that if the FCM is registered with the Commission as a broker-dealer, the FCM must file the report not later than the time permitted for filing an annual audit report under Rule 17a-5.

The Commission is adopting, with modifications, the proposed amendment to paragraph (d)(5) of Rule 17a-5.

196

The modifications add the term “calendar” to make explicit that the time for filing the annual reports is 60 calendar days after the fiscal year end (as opposed to business days). The modifications replace the words “date of the financial statements” with the words “end of the fiscal year of the broker or dealer” to provide consistency in the language of Rule 17a-5.

197

The final rule does not change the time limit for filing the annual reports to 90 days after the end of the fiscal year. The 60-day time frame is a long standing requirement and it provides the Commission and other regulators with relatively current information to, among other things, monitor the financial condition of broker-dealers. Further, broker-dealers may seek an extension of time to file the annual reports from their DEAs.

198

196

See

paragraph (d)(5) of Rule 17a-5.

197

Id. See also

paragraph (n) of Rule 17a-5.

198

See

paragraph (m) of Rule 17a-5.

6. Filing of Annual Reports With SIPC—Paragraph (d)(6) of Rule 17a-5

Prior to today's amendments, paragraph (d)(6) of Rule 17a-5 provided that the “annual audit report” must be filed at the regional office of the Commission for the region in which the broker-dealer has its principal place of business, the Commission's principal office in Washington, DC, and the principal office of the DEA of the broker-dealer.

199

Copies were required to be provided to all self-regulatory organizations (“SROs”) of which the broker-dealer is a member.

199

See

17 CFR 240.17a-5(d)(6).

i. The Proposed Amendments

The Commission proposed two amendments to this provision. First, the Commission proposed that an SRO that is not a broker-dealer's DEA could by rule waive the requirement that broker-dealers file annual reports with it because many SROs do not believe that it is necessary to receive copies of broker-dealer annual reports if they are not the broker-dealer's DEA.

200

The

Commission received no comments on this proposal and is adopting it as proposed.

201

200

See Broker-Dealer Reports,

76 FR at 37592.

201

See

paragraph (d)(6) of Rule 17a-5.

Second, the Commission proposed amending this provision to require a broker-dealer to file its annual reports with SIPC.

202

SIPC, a nonprofit, nongovernmental membership corporation established by SIPA, is responsible for providing financial protection to customers of failed broker-dealers. SIPA also provided for the establishment of a fund (“SIPC Fund”) to pay for SIPC's operations and activities. SIPC uses the fund to make advances to satisfy customer claims for securities and cash that cannot be readily returned to the customer. SIPA limits the amount of the advance to $500,000 per customer, of which $250,000 can be used to satisfy the cash portion of a customer's claim. The SIPC Fund also covers the administrative expenses of liquidation proceedings for failed broker-dealers when the general estate of the failed firm is insufficient; these include costs incurred by a trustee, trustee's counsel, and other advisors. SIPC finances the SIPC Fund through annual assessments, set by SIPC, on all member firms, plus interest generated from its permitted investments. Generally, all broker-dealers registered with the Commission under section 15(b) of the Exchange Act

203

are required to be members of SIPC.

204

Before today's amendments, broker-dealers were required to file only limited information with SIPC. Specifically: (1) Information elicited on Form SIPC-6, the “General Assessment Payment Form;” (2) information elicited on Form SIPC-7, the “Annual General Assessment Reconciliation;” and (3) for periods in which the SIPC assessment is not a minimum assessment, a comparison by the independent public accountant of the amounts reflected in the annual report the broker-dealer filed with the Commission with amounts reported on Form SIPC-7.

202

See Broker-Dealer Reports,

76 FR at 37592.

203

See

15 U.S.C. 78o(b).

204

See

15 U.S.C. 78ccc(a)(2). 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.

See

15 U.S.C. 78ccc(a)(2)(A)(i)-(iii).

The Commission explained in the proposing release that the proposed requirement for broker-dealers to file their annual reports with SIPC could allow SIPC to better monitor industry trends and enhance its knowledge of particular firms.

205

The Commission also explained that the requirement that broker-dealers file copies of their annual reports with SIPC was designed to address cases where the SIPC Fund has been used to pay the administrative expenses of the liquidation of a failed broker-dealer and SIPC sought to recover the money advanced when the estate had insufficient assets.

206

In some of these cases, SIPC has sought to recover money damages from the broker-dealer's auditing firm based on an alleged failure to comply with auditing standards. At least one court, however, has held under New York law that SIPC could not maintain such a claim because it was not a recipient of the annual audit filing and could not have relied on it.

207

205

See Broker-Dealer Reports,

76 FR at 37592.

206

Id. See also

SIPC,

2010 Annual Report,

at 18,

available at http://www.sipc.org/pdf/2010%20Annual%20Report.pdf

207

See SIPC

BDO Seidman, LLP,

746 NE.2d 1042 (N.Y. 2001).

ii. Comments Received

The Commission received seven comments on the proposal that broker-dealers be required to file their annual reports with SIPC.

208

Six commenters generally opposed the requirement.

209

One commenter indicated that it is appropriate for broker-dealers to file their annual reports with SIPC if SIPC uses the reports to reconcile the annual reports with the Form SIPC-7 or otherwise places reliance on them.

210

Three of the commenters stated that the Commission failed to adequately articulate the policy considerations driving the proposed change and also failed to discuss the possible costs of increased litigation risk to accountants.

211

Some of the commenters argued that this change would contradict limitations on SIPC's authority to bring claims against accountants under SIPA and the securities laws imposed by the U.S. Supreme Court.

212

208

See CAQ Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter

209

See CAQ Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; PWC Letter

210

See McGladrey Letter.

Form SIPC-7 is discussed in more detail below in section II.C.4. of this release.

211

See CAQ Letter; Deloitte Letter; KPMG Letter

212

See CAQ Letter; Deloitte Letter; E&Y Letter; KPMG Letter; PWC Letter

After the proposal, a task force established by SIPC to undertake a comprehensive review of SIPA and SIPC's operations and policies and to propose reforms to modernize SIPA and SIPC recommended to the SIPC Board that SIPC members be required to file audit reports with SIPC concurrently with their filing with the SEC, a position consistent with the proposal. In a report presented to the SIPC Board of Directors in February 2012,

213

the task force stated that including SIPC as a designated recipient of the audit report “would further the goal of investor protection by providing another layer of review of the report by an organization directly affected by its contents.”

214

In addition, the task force stated that “including SIPC as a recipient would help to address the persistent concern that any signs of `financial weakness, as by non-compliance with net capital requirements or otherwise, [be] watched very carefully and followed up' in order to augment the financial responsibility requirements SIPA was intended to enhance, and to provide greater investor protection.”

215

213

See Report and Recommendations of the SIPC Modernization Task Force

(Feb. 2012),

available at http://www.sipc.org/pdf/Final%Report%202012.pdf

. The Task Force was comprised of volunteers, and included investor advocates, regulatory specialists, and academic experts, including the trustee for the liquidation of Lehman Brothers Inc. and MF Global Inc.

214

See Report and Recommendations of the SIPC Modernization Task Force,

at 19.

215

Id.

(quoting the SEC,

Study of Unsafe and Unsound Practices of Broker-Dealers,

H.R. Doc. No. 92-231, at 152 (1971)).

iii. The Final Rule

The Commission is adopting the amendment requiring broker-dealers to file their annual reports with SIPC substantially as proposed.

216

SIPC plays an important role in the securities markets and the SIPC Fund can help reduce losses to investors from the failure of their broker-dealer. SIPC has a legitimate interest in receiving the annual reports of its broker-dealer members to assist it with its maintenance of the SIPC Fund and to monitor trends in the broker-dealer industry. SIPC presently obtains revenue information from broker-dealers, through Form SIPC-7, to determine how best to structure broker-dealer assessments to maintain the SIPC Fund at an appropriate level. However, the information collected in the form is limited and may not assist SIPC in assessing whether the SIPC Fund is appropriately sized to the risks of a large broker-dealer failure. The annual audited reports contain much more detailed information about the assets, liabilities, income, net capital, and Rule

15c3-3 customer reserve requirements of broker-dealers, and also include, for carrying broker-dealers, a compliance report containing information about the broker-dealer's compliance with, and controls over compliance with, the broker-dealer financial responsibility rules. The annual reports also generally include the independent public accountant's reports covering the financial report and compliance report or exemption report, as applicable, prepared by the broker-dealer. This information will assist SIPC in monitoring the financial strength of broker-dealers and, therefore, in assessing the adequacy of the SIPC Fund.

217

216

See

paragraph (d)(6) of Rule 17a-5. The Commission clarified that the broker-dealer must file the annual reports with SIPC only “if the broker or dealer is a member of SIPC.” The Commission believes that SIPC has an interest in receiving annual reports only from broker-dealers that are SIPC members, because only these broker-dealers may pose a risk to the SIPC Fund.

217

See McGladrey Letter.

In addition, by receiving the annual reports, SIPC may be able to overcome a legal hurdle to pursuing claims against a broker-dealer's accountant where the accountant's failure to adhere to professional standards in auditing a broker-dealer caused a loss to the SIPC Fund. Although this amendment is intended to remove one potential legal hurdle to SIPC actions against accountants, the other elements of any relevant cause of action would be unaffected. The Commission does not intend by this amendment to take a position on the circumstances under which SIPC may have a viable cause of action against an independent public accountant.

218

Several commenters argue that requiring the annual report to be filed with SIPC would contradict limitations the Supreme Court has imposed on SIPC's authority to bring claims against accountants. The decisions cited by these commenters, however, do not speak to the precise issue the amended rule is intended, among other things, to address—the New York Court of Appeals' decision held that SIPC could not state a cause of action for either fraudulent or negligent misrepresentation against an auditing firm because it was not a recipient of the annual audit report.

See SIPC

BDO Seidman, LLP,

746 NE.2d 1042 (N.Y. 2001); aff'd, 245 F.3d 174 (2d Cir. 2001). Rather, in

Holmes

Securities Investor Protection Corporation,

the Supreme Court found that the statutory provision relied on by SIPC, 15 U.S.C. 78eee(d), did not, either alone or with the Racketeer Influenced and Corrupt Organizations Act, confer standing. 503 U.S. 258, 275 (1992). And, in

Touche Ross & Co.

Redington,

the Supreme Court determined that customers of securities brokerage firms do not have an implied cause of action for damages under section 17(a) of the Exchange Act against accountants who audit the financial reports filed by such firms; thus, SIPC could not assert this implied cause of action on behalf of these customers. 442 U.S. 560, 567 (1979). As already noted, the Commission does not intend by this amendment to take a position on the circumstances under which SIPC may have a viable cause of action against an independent public accountant.

Several commenters stated that the Commission did not address the potential costs and benefits of requiring broker-dealers to file copies of their annual reports with SIPC, including potential accounting litigation costs.

219

As discussed below in section VII. of this release, the Commission recognizes that there may be increased litigation costs (or reserves for potential litigation costs) as a result of the amendment and that to the extent that there are such costs, some of them may be passed on to broker-dealers in the form of increased audit fees. But, while this amendment may facilitate the ability of SIPC to bring actions against accountants for malpractice or material misrepresentation under state law by removing one potential legal hurdle to such actions, it will not necessarily result in a significant increase in such actions. Generally, SIPC initiates a small number of proceedings each year, and most of these proceedings have not involved a claim against a broker-dealer's accountant. Specifically, SIPC was established in 1971. In the period from 1971-2011, SIPC initiated 324 proceedings under SIPA to liquidate a failed broker-dealer.

220

This results in an average of approximately 8 SIPA proceedings per year, though 109 of the 324 proceedings were initiated in the period from 1971-1974, which was the immediate aftermath of the financial crisis of 1968-1970.

221

According to SIPC staff, SIPC has brought 9 lawsuits against accountants since 1971, which is one lawsuit for every 36 SIPA proceedings.

222

Accordingly, the likelihood of a lawsuit against an accountant is small and the Commission anticipates that the overall costs related to litigation as a result of the filing requirement should not be significant. The Commission believes that any such costs are justified by the benefits of enhanced customer protection and the associated ability of SIPC to better assess the financial condition of broker-dealers and the adequacy of the SIPC Fund.

219

See, e.g., CAQ Letter;

Deloitte Letter; KPMG Letter.

220

See

SIPC,

Annual Report 2011,

at 6.

221

Id. See also

Commission,

Study of Unsafe and Unsound Practices of Brokers and Dealers: Report and Recommendations of the Securities and Exchange Commission

(December 1971) (discussing the financial crisis of 1968-1970). Since its inception through 2001, SIPC initiated 299 proceedings under SIPA.

222

See Redington

Touche Ross & Co.,

592 F.2d 617 (2d Cir. 1978);

In re Bell & Beckwith,

77 B.R. 606 (Bkrtcy. N.D. Ohio, 1987);

Mishkin

Peat, Marwick, Mitchell & Co.,

658 F.Supp. 271 (S.D.N.Y. 1987);

SIPC

BDO Seidman, LLP,

49 F.Supp.2d 644 (S.D.N.Y. 1999);

In re Donahue Securities Inc.,

2004 WL 3152763 (Bkrtcy S.D. Ohio, 2004);

In re SIPC

R.D. Kushnir & Co,

274 B.R. 768 (Bkrtcy. N.D. Ill., 2002);

In re Sunpoint Securities, Inc.,

377 B.R. 513 (Bkrtcy. E.D. Tex., 2007); Compliant at 5-6,

Gilbert

Ohab,

Bkrtcy. M.D. Fl. (May 2010) (No. 6:08-ap-00145-KSJ); Complaint at 2,

Shively

Mortland,

Bkrtcy. D. Co. (Feb. 2004) (No. 03-BK-1102-HRT).

C. The Nature and Form of the Annual Reports

1. Exemptions From Audit Requirement—Paragraph (e)(1) of Rule 17a-5

Prior to today's amendments, paragraph (e)(1)(i) of Rule 17a-5 provided, among other things, that the audit of the broker-dealer's financial statements needed to be performed by an accountant that is independent as defined in paragraph (f) of Rule 17a-5.

223

Paragraph (e)(1)(i) also contained provisions under which certain broker-dealers were not required to engage an accountant to audit their financial statements.

224

223

See

17 CFR 240.17a-5(e)(1)(i).

224

Id.

The Commission proposed amending paragraph (e)(1)(i) of Rule 17a-5 to remove the words “An audit shall be conducted by a public accountant who shall be in fact independent as defined in paragraph (f)(3) of this section herein, and he shall give an opinion covering the statements filed pursuant to paragraph (d).” This amendment would consolidate the requirements with respect to the qualifications of the accountant in paragraph (f) of Rule 17a-5, and paragraph (e)(1)(i) of Rule 17a-5 would address only exemptions from the requirement to engage an independent public accountant to audit the annual reports prepared by the broker-dealer.

225

The Commission received no comments on this proposal, and is adopting it with modifications.

226

The modifications: (1) Modernize certain terms in the rule in a manner consistent with the Commission's “plain English” initiative; and (2) cite to the reports required under “Rule 17a-5(d)(1)(i)(C)” to provide a more precise cross reference than the former citation to reports required under “Rule 17a-5(d).”

227

225

See Broker-Dealer Reports,

76 FR at 37593-37594. The proposed and final amendments to paragraph (f) of Rule 17a-5 are discussed below in section II.E. of this release.

226

See

paragraph (e)(1)(i) of Rule 17a-5.

227

Id.

Prior to today's amendments, paragraph (e)(1)(ii) of Rule 17a-5 provided that “[a] broker or dealer who files a report which is not covered by an accountant's opinion shall include in the oath or affirmation required by paragraph (e)(2) of this section a statement of the facts and circumstances relied upon as a basis for exemption from the requirement that financial statements and schedules filed pursuant to paragraph (d) of this section be covered by the opinion of an accountant.”

See

17 CFR 240.17a-5(e)(1)(ii). The Commission did not propose amendments to this subparagraph. However, to be consistent with today's amendments, the Commission is making technical

amendments to paragraph (e)(1)(ii) of Rule 17a-5 so that it now provides that “[a] broker or dealer that files annual reports under paragraph (d) of this section that are not covered by reports prepared by an independent public accountant must include in the oath or affirmation required by paragraph (e)(2) of this section a statement of the facts and circumstances relied upon as a basis for exemption from the requirement that the annual reports filed under paragraph (d) of this section be covered by reports prepared by an independent public accountant.”

See

paragraph (e)(1)(ii) of Rule 17a-5.

2. Affirmation—Paragraph (e)(2) of Rule 17a-5

Prior to today's amendments, paragraph (e)(2) of Rule 17a-5 provided that an oath or affirmation must be attached to the annual audit report that, to the best knowledge and belief of the person making the oath or affirmation, the financial statements and schedules are true and correct and, among other things, that the oath or affirmation must be made by the proprietor if a sole proprietorship, by a general partner, if a partnership, or by a duly authorized officer, if a corporation.

228

The Commission proposed amending the first sentence of paragraph (e)(2) of Rule 17a-5 by adding the word “financial” before the word “report.”

229

The Commission is adopting this amendment as proposed.

228

See

17 CFR 240.17a-5(e)(2).

229

See Broker-Dealer Reports,

76 FR at 37603.

One commenter stated that currently paragraph (e)(2) of Rule 17a-5 does not specifically cover limited liability companies, and its reference to partnerships assumes that a general partner is a natural person.

230

The commenter argued that it should be updated to conform to generally accepted business laws.

230

See IMS Letter.

In response to this comment, the Commission is adopting amendments to paragraph (e)(2) of Rule 17a-5 that modify the proposed amendments.

231

In particular, the Commission is adding that if the broker-dealer is a limited liability company or limited liability partnership, the oath or affirmation must be made by the chief executive officer, chief financial officer, manager, managing member, or any of those members vested with management authority for the limited liability company or limited liability partnership.

232

231

See

paragraph (e)(2) of Rule 17a-5.

232

See IMS Letter.

3. Confidentiality of Annual Reports—Paragraph (e)(3) of Rule 17a-5

Prior to today's amendments, paragraph (e)(3) of Rule 17a-5 provided that the financial statements filed under paragraph (d) are public, except that if the Statement of Financial Condition is bound separately from the balance of the annual audited financial statements filed under paragraph (d)(1), the balance of the annual audited financial statements will be deemed confidential.

233

As noted in the proposing release, the wording of this provision has led to confusion.

234

In particular, Commission staff has received inquiries on how broker-dealers can indicate that they are requesting confidential treatment for the portion of the financial statements intended to be kept confidential to the extent permitted by law and, on occasion, financial statements broker-dealers intended to be confidential are inadvertently made public.

235

This could happen, for example, if a broker-dealer fails to bind the balance sheet separately from the other portion of the financial statements when it files the financial statements with the Commission.

236

233

See

17 CFR 240.17a-5(e)(3).

234

See Broker-Dealer Reports,

76 FR at 37592-37593.

235

The public portions of broker-dealer annual audited reports are available on the Commission's Web site. These reports may be accessed via the

Search for Company Filings

link under

Filings & Forms

on the Commission's home page.

236

The Commission staff has previously posted guidance on the Commission Web site on how to request confidential treatment for the financial statements other than the statement of financial condition.

See http://www.sec.gov/divisions/marketreg/bdnotices.htm

Consequently, the Commission proposed amending paragraph (e)(3) of Rule 17a-5 to provide that the annual reports filed pursuant to paragraph (d) are public, except that if the Statement of Financial Condition is bound separately from the annual report filed pursuant to “paragraph (d)(2) of Rule 17a-5,” and each page of the balance of the annual report is stamped “confidential,” the balance of the annual report shall be deemed confidential.

237

The proposed rule text inadvertently referenced only the financial report. It was intended that the financial report, compliance report, exemption report, and related accountant reports would be treated the same under paragraph (e)(3) of Rule 17a-5. Consequently, the Commission is modifying the proposed amendment. Specifically, paragraph (e)(3) of Rule 17a-5, as adopted, provides that if the Statement of Financial Condition is bound separately from the balance of the “annual reports filed under paragraph (d) of this section,” and each page of the balance of the annual reports is stamped “confidential,” then the balance of the annual reports will be deemed confidential to the extent permitted by law.

238

Consequently, if the compliance reports and exemption reports and the related reports of the independent public accountant are submitted in accordance with the procedures specified in paragraph (e)(3) of Rule 17a-5, these reports will be deemed confidential to the extent permitted by law.

239

237

See Broker-Dealer Reports,

76 FR at 37592-37593.

238

See

paragraph (e)(3) of Rule 17a-5.

239

See

5 U.S.C. 552

et seq.

(Freedom of Information Act—“FOIA”). FOIA provides at least two potentially pertinent exemptions under which the Commission has authority to withhold certain information. FOIA Exemption 4 provides an exemption for “trade secrets and commercial or financial information obtained from a person and privileged or confidential.” 5 U.S.C. 552(b)(4). FOIA Exemption 8 provides an exemption for matters that are “contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions.” 5 U.S.C. 552(b)(8). However, as discussed below, under paragraph (c)(2)(iv) of Rule 17a-5, if there are material weaknesses, the accountant's report on the compliance report must be made available for customers' inspection and, consequently, it would not be deemed confidential. In addition, paragraph (c)(2)(i) of Rule 17a-5 (which is not being amended today) requires a broker-dealer to furnish to its customers annually a balance sheet with appropriate notes prepared in accordance with GAAP and which must be audited if the broker-dealer is required to file audited financial statements with the Commission.

See

17 CFR 240.17a-5(c)(2)(i).

Prior to today's amendments, paragraph (e)(3) of Rule 17a-5 also provided that the broker-dealer's reports, including the confidential portions, will be available, for example, for official use by any official or employee of the U.S. and an official or employee of any national securities exchange and registered national securities association of which the broker-dealer is a member and “by any other person to whom the Commission authorizes disclosure of such information as being in the public interest.”

240

The Commission proposed amending this list of permitted recipients to include the PCAOB.

241

The Commission did not receive comments on this proposal and is adopting it essentially as proposed with a minor wording edit for clarity.

242

240

See

17 CFR 240.17a-5(e)(3).

241

See Broker-Dealer Reports,

76 FR at 37592-37593.

242

See

paragraph (e)(3) of Rule 17a-5.

4. Supplemental Report on SIPC Membership—Paragraph (e)(4) of Rule 17a-5

As discussed above in section II.B.6. of this release, SIPC maintains the SIPC Fund to be used in liquidations of broker-dealers under SIPA. The SIPC Fund is established and maintained through assessments on broker-dealers that are required to be members of

SIPC.

243

In order to assist in the collection of assessments from member broker-dealers, 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). In this case, the 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.

243

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.

See

15 U.S.C. 78ccc(a)(2)(A)(i)-(iii).

Prior to today's amendments, paragraph (e)(4) of Rule 17a-5 provided that a broker-dealer must file with its annual report a supplemental report on the status of the membership of the broker-dealer in SIPC, which was required to be “covered by an opinion of the independent public accountant” if the annual report of the broker-dealer was required to be audited.

244

Among other things, the supplemental report needed to cover the SIPC annual general assessment reconciliation or exclusion from membership forms (

i.e.,

Form SIPC-7 or Form SIPC-3).

245

Paragraph (e)(4)(iii) of Rule 17a-5 used the terms “review” and “opinion” in describing the accountant's report that must cover the supplement report.

246

In addition, it required that the review by the accountant include certain minimum procedures.

247

244

See

17 CFR 240.17a-5(e)(4).

245

Id.

246

See

17 CFR 240.17a-5(e)(4)(iii).

247

See

17 CFR 240.17a-5(e)(4)(iii)(A)-(F).

Under this provision, the supplemental report did not need to be filed if the SIPC Fund assessments were the minimum assessment provided for under SIPA.

248

Between 1996 and 2009, the annual assessment for SIPC members remained at the $150 minimum assessment level provided for under SIPA.

249

In 2009, SIPC raised the assessment above the minimum, which triggered the requirement in paragraph (e)(4) of Rule 17a-5 to file a supplemental report with the Commission, the broker-dealer's DEA, and SIPC.

250

248

See

17 CFR 240.17a-5(e)(4); 15 U.S.C. 78ddd(d)(1)(c).

249

See

SIPC,

SIPC to Reinstitute Assessments of Member Firms' Operating Revenues

(Mar. 2, 2009) (news release).

250

Id.

The Commission stated in the proposing release that, because Forms SIPC-3 and SIPC-7 are used solely by SIPC for purposes of levying its assessments, the supplemental report required pursuant to paragraph (e)(4) of Rule 17a-5 relating to these forms would be more appropriately filed exclusively with SIPC and that SIPC (rather than the Commission) should prescribe by rule the form of the supplemental report.

251

The Commission stated that it would continue to have a role in establishing the requirements for a supplemental report because the Commission must approve SIPC rules.

252

251

See Broker-Dealer Reports,

76 FR at 37582.

252

Id.

For these reasons, the Commission proposed to amend paragraph (e)(4) of Rule 17a-5 to require that broker-dealers file with SIPC a report on the SIPC annual general assessment reconciliation or exclusion from membership forms that contains such information and is in such format as determined by SIPC by rule and approved by the Commission.

253

However, because there would be an interim period before a rule determined by SIPC became effective, the Commission proposed amendments to paragraph (e)(4) under which broker-dealers would continue to file a supplemental report with the Commission, the broker-dealer's DEA, and SIPC until SIPC adopts a rule pursuant to paragraph (e)(4)(i) of Rule 17a-5 and the rule is approved by the Commission.

254

Consequently, a broker-dealer would be required to file the SIPC supplemental reports with SIPC using the existing formats for the reports until the earlier of the Commission approving a rule adopted by SIPC or two years. If after two years, a rule promulgated by SIPC has not been approved by the Commission, broker-dealers would no longer be required to file these reports.

253

Id.

254

Id.

Further, to facilitate this change, the Commission proposed to update the rule text to conform it to existing professional standards and industry practices.

255

Specifically, the Commission proposed amending paragraph (e)(4) of Rule 17a-5 to eliminate the ambiguity that stems from the differing auditing terms used in that rule by removing all references to “review” and “opinion.”

256

In their place, the Commission proposed that the supplemental report include an independent public accountant's report based on the performance of the procedures listed in paragraph (e)(4)(iii) of Rule 17a-5, which the Commission did not propose to change.

257

255

Id.

256

Id.

257

See Broker-Dealer Reports,

76 FR at 37582. The Commission proposed one modification to the procedures listed in former paragraph (e)(4)(iii); namely, amending the procedure described in paragraph (e)(4)(iii)(F), which is now renumbered (e)(4)(ii)(6), to change the reference from “Form SIPC-7” to “Form SIPC-3” because the reference to Form SIPC-7 is inaccurate.

Id.

The Commission received two comments relating to the proposed amendments to paragraph (e)(4) of Rule 17a-5, both of which supported the proposed change.

258

One commenter indicated that the proposed amendment would decrease the burden on broker-dealers associated with filing the supplemental report with the Commission and the broker-dealer's DEA.

259

In addition, the other commenter indicated that until the supplemental reports are filed exclusively with SIPC, they should be subject to confidential treatment.

260

258

See CAI Letter;

McGladrey Letter.

259

See CAI Letter.

260

See McGladrey Letter.

The Commission is adopting the amendments to paragraph (e)(4) of Rule 17a-5 as proposed.

261

With respect to the comment about the Commission keeping the supplemental report confidential, a broker-dealer can request confidential treatment for the report.

262

If such a request is made, the Commission anticipates that it will accord the supplemental report confidential treatment to the extent permitted by law.

263

261

See

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

262

See

17 CFR 200.83. Information about how to request confidential treatment of information submitted to the Commission is

available at

http://www.sec.gov/foia/howfo2.htm#privacy

263

See, e.g.,

Exchange Act section 24, 15 U.S.C. 78x (governing the public availability of information obtained by the Commission) and 5 U.S.C. 552

et seq.

(Freedom of Information Act—“FOIA”). FOIA provides at least two pertinent exemptions under which the Commission has authority to withhold certain information. FOIA Exemption 4 provides an exemption for “trade secrets and commercial or financial information obtained from a person and privileged or confidential.” 5 U.S.C. 552(b)(4). FOIA Exemption 8 provides an exemption for matters that are “contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions.” 5 U.S.C. 552(b)(8).

D. Engagement of the Accountant

As part of today's amendments to the broker-dealer annual reporting requirements in Rule 17a-5, the Commission is amending certain requirements relating to a broker-dealer's engagement of an independent public accountant. Specifically, the Commission is requiring that a broker-dealer engage an independent public accountant to prepare reports based on an examination of the broker-dealer's financial report and either an examination of certain statements in the broker-dealer's compliance report or a review of certain statements in the broker-dealer's exemption report. The examinations and reviews must be made in accordance with the standards of the PCAOB, consistent with the explicit authority granted to the PCAOB by the Dodd-Frank Act to establish (subject to Commission approval) auditing and attestation standards with respect to broker-dealer audits.

264

Among other things, the amendments replace provisions that required the filing of a “material inadequacy” report and are intended to update terminology in the rule to make the rule's requirements clear and to provide for a more consistent approach to engaging broker-dealer independent public accountants.

264

See

Public Law 111-203 § 982.

This section addresses statutory requirements for broker-dealer annual reports and the Commission's authority with regard to these reports, describes the engagement of accountant requirements in Rule 17a-5 prior to today's amendments, summarizes the Commission's proposed amendments and comments received, and discusses the final rule amendments.

1. Statutory Requirements and Commission Authority

Section 17(e)(1)(A) of the Exchange Act requires a broker-dealer to file annually with the Commission a “certified” balance sheet and income statement as well as “such other financial statements (which shall, as the Commission specifies, be certified) and information concerning its financial condition as the Commission, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of investors.”

265

Section 17(e)(2) of the Exchange Act provides the Commission with authority, by rule, to prescribe the form and content of the financial statements and the accounting principles and standards used in their preparation as it deems necessary or appropriate in the public interest or for the protection of investors.

266

In addition, section 17(a) of the Exchange Act more generally requires registered broker-dealers to make and disseminate such reports as the Commission, by rule, may prescribe as necessary or appropriate in the public interest, for the protection of investors.

267

The Commission adopted Rule 17a-5, in part, under these provisions.

268

265

See

15 U.S.C. 78q(e)(1)(A).

266

See

15 U.S.C. 78q(e)(2).

267

See

15 U.S.C. 78q(a).

268

See Broker-Dealer Reports,

Exchange Act Release No. 11935 (Dec. 17, 1975), 40 FR 59706 (Dec. 30, 1975).

Prior to the enactment of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”),

269

section 17(e)(1)(A) required that the annual financial statements a broker-dealer must file with the Commission be certified by “an independent public accountant.” The Sarbanes-Oxley Act established the PCAOB

270

and amended section 17(e)(1)(A) by replacing the words “certified by an independent public accountant” with the words “certified by a registered public accounting firm.”

271

Title I of the Sarbanes-Oxley Act prescribed specific PCAOB registration, standards-setting, inspection, investigation, disciplinary, foreign application, oversight, and funding programs in connection with audits of issuers.

272

However, as originally enacted, the Sarbanes-Oxley Act did not expressly prescribe similar programs in connection with audits of broker-dealers that are not issuers.

269

Public Law 107-204, 116 Stat. 745 (2002).

270

Public Law 107-204 § 101.

271

See

Public Law 107-204 § 205(c)(2). The term

Registered Public Accounting Firm

is defined in section 2(a)(12) as “a public accounting firm registered with the [PCAOB] in accordance with this Act.”

See

Public Law 107-204 § 2(a)(12).

272

Section 2(a)(7) of the Sarbanes-Oxley Act defines the term

issuer

as “an issuer as defined in section 3 of the [Exchange Act], the securities of which are registered under section 12 of [the Exchange Act], or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933…, and that it has not withdrawn” (U.S.C. citations omitted).

See

Public Law 107-204 § 2(a)(7).

The Dodd-Frank Act, enacted in July 2010, amended the Sarbanes-Oxley Act 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 for registered public accounting firms with respect to their preparation of audit reports to be included in broker-dealer filings with the Commission, and the authority to conduct and require an inspection program of registered public accounting firms that audit broker-dealers.

273

The Dodd-Frank Act addressed inspection authority by adding section 104(a)(2)(A) to the Sarbanes-Oxley Act, which provides that the PCAOB “may, by rule, conduct and require a program of inspection* * *of registered public accounting firms that provide one or more audit reports for a broker or dealer” and that the PCAOB, in establishing a program for inspection, “may allow for differentiation among classes of brokers or dealers, as appropriate.”

274

273

See

Public Law 111-203 § 982.

274

See

Public Law 111-203 § 982(e)(1).

The Dodd-Frank Act also added section 104(a)(2)(D) to the Sarbanes-Oxley Act, which provides that a public accounting firm is not required to register with the PCAOB if the public accounting firm is exempt from an inspection program established by the PCAOB.

275

The Dodd-Frank Act made a conforming amendment to section 17(e)(1)(A) of the Exchange Act to replace the words “certified by a registered public accounting firm” with the words “certified by an independent public accounting firm, or by a registered public accounting firm if the firm is required to be registered under the Sarbanes-Oxley Act of 2002.”

276

275

Id.

276

See

Public Law 111-203 § 982(e)(2). As discussed below, today's amendments to the qualifications of the independent public accountant provisions require, consistent with amended section 17(e)(1)(A), that the accountant be qualified, independent, and registered with the PCAOB “if required by the Sarbanes-Oxley Act of 2002.”

See

paragraph (f)(1) of Rule 17a-5.

Before today's amendments, paragraph (g)(1) of Rule 17a-5 required that audits of broker-dealer reports filed with the Commission under Rule 17a-5 be made in accordance with generally accepted auditing standards (“GAAS”), which are established by the Auditing Standards Board of the American Institute of Certified Public Accountants (“AICPA”). In light of the authority granted to the PCAOB by the Dodd-Frank Act to establish standards governing audit reports to be included in broker-dealer filings with the Commission, the Commission issued transitional interpretive guidance to clarify 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 brokers or dealers, should continue to be understood to mean auditing standards generally accepted in the U.S., in addition to any applicable rules of the Commission.

277

The

guidance also stated that the Commission intended to revisit the interpretation in connection with a rulemaking project to update the audit and related attestation requirements under the federal securities laws for broker-dealers.

278

As discussed below, the Commission is now adopting amendments to Rule 17a-5 to require that audits and attestations of broker-dealer reports filed under Rule 17a-5 be made in accordance with standards of the PCAOB—the rule as amended does not contain references to GAAS.

277

See Commission Guidance Regarding Auditing, Attestation, and Related Professional Practice Standards Related to Brokers and Dealers,

Exchange Act Release No. 62991 (Sept. 24, 2010), 75 FR 60616, 60617 (Oct. 1, 2010).

278

Id.

Since the Commission proposed these amendments, the PCAOB has taken a number of actions to implement the explicit authority over broker-dealer audits provided to it by the Dodd-Frank Act. For example, on August 18, 2011, the Commission approved two PCAOB rule changes: a temporary PCAOB rule that established an interim program of inspection of audits of broker-dealers,

279

and a PCAOB rule change providing that funds to cover the PCAOB's annual budget be allocated among issuers, brokers, and dealers.

280

In addition, as discussed below, subsequent to the Commission's proposal to amend Rule 17a-5, the PCAOB proposed attestation standards to establish requirements for examining broker-dealer compliance reports and reviewing broker-dealer exemption reports “to align its attestation standards more closely with the auditor's responsibilities under [the proposed amendments to Rule 17a-5].”

281

The PCAOB concurrently proposed an auditing standard for supplemental information accompanying audited financial statements that would supersede the current standard.

282

The auditing standard would apply to supporting schedules broker-dealers must file under Rule 17a-5, including schedules regarding the computation of net capital and the customer reserve requirement and information related to the broker-dealer's possession or control of customer assets.

283

The PCAOB also proposed amendments “to tailor certain of its rules to the audits and [independent public accountants] of broker-dealers.”

284

279

See Public Company Accounting Oversight Board; Order Approving Proposed

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