Alert July 05, 2011

SEC Proposes Amendments to Broker-Dealer Financial Reporting Rule

The SEC issued a proposal to amend the broker-dealer financial reporting rule (Rule 17a‑5 under the Securities and Exchange Act of 1934 (the “1934 Act”)), including requirements for compliance and exemption reports and a related accountant’s examination report, and a new “Form Custody” to be filed by broker‑dealers.  The amendments would facilitate the ability of the PCAOB to implement oversight of independent public accountants of broker‑dealers as required by the Dodd-Frank Act, require the filing of new reports and forms to enable the SEC and designated examining authorities (“DEAs”) to more closely examine compliance with financial responsibility rules, place additional responsibilities on independent public accountants to immediately report material non-compliance with financial responsibility rules discovered during the course of audits, and require broker‑dealers that either clear transactions or carry customer accounts to consent to allowing the SEC and DEAs to have access to independent public accountants to discuss their findings with respect to annual audits of the broker-dealers and to review audit documentation.

Compliance Report.  Under the proposed amendments to Rule 17a-5, each carrying broker-dealer would be required annually to file a Compliance Report containing the following statements and information:

  • That the broker-dealer has established and maintained a system of internal control to provide the broker-dealer with reasonable assurance that any instances of material non‑compliance with Rule 15c3-1 under the 1934 Act (the Net Capital Rule), Rule 15c3-3 under the 1934 Act (the Customer Protection Rule), Rule 17a‑13 under the 1934 Act (Quarterly Security Counts) or the applicable rules of the broker-dealer’s DEA requiring account statements to be sent to customers of the broker-dealer (“Account Statement Rule” and together, the “Financial Responsibility Rules”) will be prevented on a timely basis;
  • Whether the broker-dealer was in compliance in all material respects with the Financial Responsibility Rules as of its fiscal year-end;
  • Whether the information used to assert compliance with the Financial Responsibility Rules was derived from the books and records of the broker-dealer;
  • Whether internal control over compliance with the Financial Responsibility Rules was effective during the most recent fiscal years such that there were no instances of material weakness; and
  • A description of each identified instance of material non-compliance and each identified material weakness in internal control over compliance with the specified rules.

The SEC proposes to replace the term “material inadequacies” currently used in Rule 17a-5 with “material non-compliance.”  The SEC notes that it is not proposing that broker-dealers make an assertion in the Compliance Report relating to effectiveness of internal control over financial reporting.

Examination Report.  The SEC proposes to require each carrying broker-dealer to engage an independent public accountant to examine the broker-dealer’s assertions in the Compliance Report and issue an Examination Report to be filed by the accountant with the SEC.  The examination and resulting Examination Report would replace the existing practice that results in the accountant issuing a report based on a “study.”  The proposed amendments and requirements relating to the Examination Report would result in the following fundamental changes to broker-dealer audits:

  • Broker-dealer examinations would be performed in accordance with PCAOB standards, rather than GAAS, consistent with the Dodd-Frank Act;
  • In connection with their engagement, independent public accountants would be required to provide an opinion concerning the broker-dealer’s compliance, and internal control over compliance, with key regulatory requirements; and
  • The Examination Report, as it applies to internal control over compliance, would cover the full fiscal year instead of relating to the effectiveness of controls only at year-end.

The SEC believes that one benefit of the new compliance examination and report requirements is that a broker-dealer that acts as a qualified custodian for itself when acting as an investment adviser or for its related investment advisers under Rule 206(4)-2 under the Investment Advisers Act (the “IA Custody Rule”) would be able to use the Examination Report to satisfy the reporting requirements under both Rule 17a-5 and the IA Custody Rule.

Notification by Accountants.  The proposed amendments would require that an independent public accountant notify the SEC within one business day if the accountant determines during the course of an examination that an instance of “material non-compliance” exists with respect to any of the Financial Responsibility Rules.  This would replace the current requirement that an accountant call to the attention of a broker-dealer’s chief financial officer any material inadequacy, and that the chief financial officer then notify the SEC and the broker-dealer’s DEA.

Exemption Report.  A non-carrying broker-dealer claiming an exemption from Rule 15c3‑3 would be required to file an annual Exemption Report containing an assertion by the broker-dealer that it is exempt from the provisions of Rule 15c3-3 because it meets one or more of the conditions set forth in paragraph (k) of that rule with respect to all of its business activities.  The non-carrying broker-dealer would also be required to engage an independent public accountant to review the assertion in the Exemption Report and prepare a report based on that review and in accordance with standards of the PCAOB.  If the independent public accountant is aware of any material modifications that should be made to the assertion contained in the Exemption Report, the accountant would be required to disclose them in its report.

Change in Applicable Audit Standards.  The SEC is proposing to require that the audit of the Financial Report (currently required), the examination of the Compliance Report and the review of the Exemption Report be performed pursuant to standards established by the PCAOB.  This is being done pursuant to the authority provided by the Dodd-Frank Act to the PCAOB, subject to SEC approval, to establish auditing and related attestation, quality control, ethics and independence standards to be used by registered public accounting firms with respect to the preparation and issuance of audit reports to be included in broker-dealer filings with the SEC.

Filing SIPC Reports with the SIPC.  The SEC proposes to shift the responsibility for creating and revising reports required under SIPA and would require that the reports be filed with the SIPC. 

Access to Audit Documentation.  To facilitate the examination of a broker-dealer that clears transactions or carries customer accounts (a “clearing broker-dealer”), the SEC is proposing that each clearing broker-dealer be required to consent to permitting its independent public accountant to make available to the SEC and DEA examination staff the audit documentation associated with its annual audit reports required under Rule 17a-5 and to discuss findings related to the audit reports with the SEC and DEA examination staff.  The current notice pursuant to Rule 17a-5(f)(2) would be amended to require that the notice filed by each clearing broker-dealer include a representation that the broker-dealer agrees to allow representatives of the SEC and DEA to review the audit documentation associated with the accountant’s reports, and to permit the accountant to discuss with those representatives the findings associated with the reports.

Form Custody.  The SEC is proposing a new form to be filed by broker-dealers – Form Custody – which is designed to elicit information concerning whether a broker‑dealer maintains custody of customer and non-customer assets and, if so, how such assets are maintained. Form Custody would be required to be filed with the broker‑dealer’s quarterly FOCUS Report.  Information required to be provided on Form Custody would include the following:

  • Whether the broker-dealer introduces customer accounts to another broker‑dealer on a fully-disclosed basis and the names of each such broker‑dealer;
  • Whether the broker-dealer introduces customer accounts to another broker‑dealer on an omnibus basis and the names of each such broker‑dealer;
  • How and where the broker-dealer holds cash and securities;
  • Whether the broker-dealer carries customer accounts for another broker‑dealer on a fully disclosed or omnibus basis, and information about the reporting broker-dealer’s custodial responsibilities with respect to accounts held for the benefit of other broker‑dealers;
  • Whether the broker-dealer sends transaction confirmations to customers and other accountholders;
  • Whether the broker-dealer sends account statements directly to customers and other accountholders;
  • Whether the broker-dealer provides customers and other accountholders with electronic access to information about the securities and cash positions in their accounts;
  • Whether the broker-dealer operates as an investment adviser and, if so, information relating to its custody arrangements for customers; and
  • Whether the broker-dealer is an affiliate of an investment adviser and, if so, information concerning whether the broker-dealer has custody of client assets of an affiliated investment adviser and the approximate dollar market value of the assets.

Technical Changes; Comment Period. The SEC has also proposed clean-up and technical amendments to Rule 17a-5, including the removal of a now-obsolete provision relating to year 2000 (Y2K) preparations.  Comments on the proposal are due no later than August 26, 2011.