On July 30, 2013, the SEC issued a release (the “Release”) adopting final amendments to the reporting, audit and notification provisions contained in certain investor protection and financial responsibility rules for broker-dealers, which, among other things, require that broker-dealers file new annual reports with the SEC and file new Form Custody with each broker-dealer’s designated examining authority (“DEA”) on a quarterly basis (the “Reporting and Audit Amendments”). Concurrently with the adoption of the Reporting and Audit Amendments, the SEC also adopted amendments to the net capital, customer protection, books and records, and related notification rules for broker-dealers (the “Financial Responsibility Amendments”). The Financial Responsibility Amendments were discussed in the August 13, 2013 Financial Services Alert.
This article summarizes the principal elements of the Reporting and Audit Amendments, which amend Rule 17a-5 under the Securities Exchange Act of 1934 (the “Exchange Act”), make technical and conforming amendments to Rule 17a-11 under the Exchange Act, and adopt new Form Custody. This article refers to Rule 15c3-1 under the Exchange Act (the “Net Capital Rule”), Rule 15c3-3 under the Exchange Act (the “Customer Protection Rule”), and Rule 17a-13 under the Exchange Act (the “Quarterly Securities Account Rule”), in addition to applicable rules of a broker-dealer’s DEA that require the broker-dealer to periodically send account statements to customers, collectively as the “Financial Responsibility Rules.”
Final Rule Amendments
The Reporting and Audit Amendments require broker-dealers to file a new annual report, file new Form Custody on a quarterly basis, and engage a PCAOB-registered independent public accountant (an “Independent Accountant”) to examine certain reports in accordance with standards promulgated by the PCAOB.
New Reporting Requirements
Under the provisions of Rule 17a-5 under the Exchange Act as they existed prior to the Reporting and Audit Amendments, broker-dealers were required to annually file certain reports with the SEC regarding their financial condition, including a statement of financial condition, a statement of income, a statement of cash flows, and certain other financial statements (collectively a “Financial Report”). Under the Reporting and Audit Amendments, broker‑dealers will also be required to file either a “Compliance Report” or an “Exemption Report” in connection with the filing of their Financial Report. A broker-dealer that does not claim that it was exempt from the Customer Protection Rule throughout its most recent fiscal year (a “carrying broker-dealer”) will be required to file a Compliance Report, and a broker-dealer claiming it was exempt from the Customer Protection Rule throughout its most recent fiscal year (a “non-carrying broker-dealer”) will be required to file an Exemption Report. In general, the Customer Protection Rule requires that broker-dealers maintain physical possession or control over certain of its customers’ securities and segregate customers’ securities and funds from the broker-dealer’s proprietary business activities, in an amount that is at least equal to the amount of net funds owed to customers. A broker-dealer is exempt from the requirements of the Customer Protection Rule under certain circumstances, one of which is that it does not hold customer securities or funds.
All broker-dealers generally will be required to prepare and file a Financial Report and either a Compliance Report or an Exemption Report.
Compliance Report. A carrying broker-dealer (i.e., a broker-dealer that has custody of customer funds or securities) will be required to file a Compliance Report with the SEC to verify that it is adhering to broker-dealer capital requirements, protecting customer assets that it holds, and periodically sending account statements to customers. The Reporting and Audit Amendments require that the Compliance Report contain statements as to whether:
- the broker-dealer has established and maintained Internal Control Over Compliance (as defined in the amended Rule 17a-5);
- the broker-dealer’s Internal Control Over Compliance was effective during and as of the end of its most recent fiscal year;
- the broker-dealer was in compliance with applicable provisions of the Net Capital Rule and the Customer Protection Rule as of the end of its most recent fiscal year; and
- the information the broker-dealer used to state whether it was in compliance with applicable provisions of the Net Capital Rule and the Customer Protection Rule was derived from the books and records of the broker-dealer.
In addition, a Compliance Report must also contain, if applicable, a description of:
- each identified material weakness in the Internal Control Over Compliance during the broker-dealer’s most recent fiscal year, including those that were identified as of the end of such fiscal year; and
- any instance of non-compliance with applicable provisions of the Net Capital Rule and the Customer Protection Rule as of the end of the most recent fiscal year.
The Reporting and Audit Amendments define 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.
In adopting the Reporting and Audit Amendments, the SEC also provided guidance with respect to various aspects of the Compliance Report requirements. For example, the Reporting and Audit Amendments provide that 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. In addition, the Reporting and Audit Amendments provide 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.
A material weakness is defined by the Reporting and Audit Amendments as a deficiency, or a combination of deficiencies, in the broker-dealer’s Internal Control Over Compliance such that there is a reasonable possibility that non-compliance with certain provisions of the Net Capital Rule or the Customer Protection Rule will not be prevented or detected on a timely basis, or that non-compliance to a material extent with the Financial Responsibility Rules will not be prevented or detected on a timely basis.
Exemption Report. A non-carrying broker-dealer (i.e., a broker-dealer that does not have custody of customer assets) will be required to file an Exemption Report with the SEC citing its exemption from requirements of the Customer Protection Rule applicable to carrying broker‑dealers. The Exemption Report must contain the following statements, made to the best knowledge and belief of the broker-dealer:
- a statement that identifies the provisions in paragraph (k) of the Customer Protection Rule under which the broker-dealer claimed an exemption from such rule;
- a statement that the broker-dealer met the identified exemption provisions throughout its most recent fiscal year without exception or except as identified in the Exemption Report; and
- if applicable, a statement that identifies each exception during its most recent fiscal year in meeting the identified provisions of paragraph (k) of the Customer Protection Rule that briefly describes the nature of each exception and the approximate date(s) on which the exception existed.
Filing of the Reports with Securities Investor Protection Corporation. To the extent that a broker-dealer is a member of the Securities Investor Protection Corporation (“SIPC”), the Reporting and Audit Amendments will require the broker-dealer to concurrently file its Financial Report and Compliance Report or Exemption Report with SIPC.
Engagement of Accountant
A broker-dealer also must engage an Independent Accountant to prepare a report based on a review of certain statements in the broker-dealer’s Exemption or Compliance Report.
The Reporting and Audit Amendments provide that the Independent Accountant must, as part of the engagement and in accordance with standards promulgated by the PCAOB, undertake to: (i) prepare a report based on an examination of the broker-dealer’s Financial Report and (ii) prepare a report based on an examination of certain enumerated statements of the broker-dealer in the Compliance Report or the Exemption Report, as applicable. The Release provides that an Independent Accountant’s report based on an examination of a broker-dealer’s Compliance Report will satisfy the internal control requirement that applies under Rule 206(4)-2 pursuant to the Investment Advisers Act of 1940 with regard to a broker-dealer acting as qualified custodian under certain circumstances.
Other Audit-Related Changes
The Reporting and Audit Amendments also make certain other changes to the manner in which audits of broker-dealer financial statements are conducted, including:
- effective as of December 31, 2013 audits of broker-dealer financial statements and schedules must be conducted in accordance with standards promulgated by the PCAOB;
- carrying broker-dealers and broker-dealers that clear transactions must allow representatives of the SEC or the broker-dealer’s DEA to review certain audit-related documentation and reports; and
- the Independent Accountant must be permitted to discuss the findings of such reports with representatives of the SEC or DEA when requested in connection with a regulatory examination of the broker-dealer.
The Reporting and Audit Amendments also provide that the Independent Accountant must immediately notify the broker-dealer’s Chief Financial Officer (“CFO”) if certain determinations are made during the course of preparing the Independent Accountant’s reports required by amended Rule 17a-5 under the Exchange Act. Specifically, the Independent Accountant will be required to notify the CFO if it determines that the broker-dealer is not in compliance with any of the Financial Responsibility Rules, regardless of whether a compliance failure is material or immaterial. In addition, the Independent Accountant must notify the broker-dealer’s CFO if, during the course of preparing a report based on an examination of a Compliance Report, the accountant determines or becomes aware that any material weakness (as described above) exists in the broker-dealer’s Internal Control Over Compliance.
The SEC clarified in the Release that the examination of the Compliance Report pertains only to certain statements contained in the Compliance Report and not to the broker-dealer’s process for arriving at the statements. Accordingly, the report based on the examination of the Compliance Report requires the Independent Accountant to perform its own independent examination of the related internal controls. It is not necessary for the accountant to provide an opinion with regard to the process for arriving at the statements and conclusions.
In certain circumstances, as required under applicable rules under the Exchange Act, a broker‑dealer must provide notice to the SEC and its DEA of any instances of non-compliance or material weakness noted above, within the time period prescribed in such rules.
The Reporting and Audit Amendments require a broker-dealer to file with its DEA new Form Custody following each calendar quarter and any fiscal year that does not coincide with a calendar quarter. Form Custody includes items designed to elicit information about whether and how the broker-dealer maintains custody of its customers’ securities and cash, such as:
- Whether the broker-dealer introduces customers to another broker-dealer on a fully disclosed basis;
- Whether the broker-dealer introduces customer accounts to another broker-dealer on an omnibus basis;
- Whether the broker-dealer carries securities accounts for customers;
- Whether the broker-dealer carries securities accounts for non-customers;
- If the broker-dealer carries securities accounts, the locations where the securities are held; and
- Separately for customer and non-customer accounts, the approximate market value of various types of securities held by the broker-dealer.
Form Custody also contains questions for carrying broker-dealers for other broker-dealers, including questions about how responsibility for providing trade confirmations and customer account statements is managed between the carrying broker-dealer and the other broker-dealer.
Broker-dealers will be required to file Form Custody within 17 business days after the end of each calendar quarter and, in certain cases, each fiscal year.
Compliance and Effective Dates
The Reporting and Audit Amendments will be effective 60 days after publication in the Federal Register which is expected to be on August 21, 2013. The new reporting requirements contained in the Reporting and Audit Amendments will apply to fiscal years ending on or after June 1, 2014 and will be due 60 calendar days after the end of each fiscal year. The requirement to annually file the Financial Report and the Compliance Report or Exemption Report with SIPC, however, is effective as of December 31, 2013. The requirements with respect to filing of Form Custody will become effective on December 31, 2013.