SEC Proposes Financial Reporting Amendments for Broker-Dealers and Adoption of New Form Custody

June 27, 2011

On June 15, 2011, the U.S. Securities and Exchange Commission proposed amendments to the broker-dealer financial reporting rules that would require broker-dealers to file a new Form Custody on a quarterly basis, amend the broker-dealer annual financial reporting rule, and require broker-dealers to provide the Commission and their respective designated examining authorities (“DEAs”) access to their independent public accountants’ audit documentation (“Proposals”).1

Proposed Form Custody

In light of the Commission’s recent enforcement actions and rulemaking regarding custody of assets by investment advisers, the Commission is proposing that broker-dealers file a new “Form Custody” with their quarterly FOCUS Reports.2 The proposed Form Custody is intended to provide the Commission with more information regarding “the custody function at broker-dealers and their compliance with requirements relating to custody of customer and non-customer assets.”3 The Commission believes that the proposed Form Custody would assist them in identifying non-compliance with the custody rules and alerting them to potential red flags.

The proposed Form Custody would solicit information from broker-dealers in nine areas related to the custody of assets. A broker-dealer would need to disclose information about activities related to the broker-dealer’s:

  • Introduction of customer accounts to other broker-dealers on a fully disclosed basis and identity of the other broker-dealers;
  • Introduction of customer accounts to other broker-dealers on an omnibus basis and identity of the other broker-dealers;
  • Carrying of securities accounts for customers or persons who are not “customers,”4 where it custodies securities for itself and others, the frequency of reconciliations between its stock records and records of the custody locations, certain information regarding the carried securities and cash, and where it holds free credit balances5 for both customers and non-customers;
  • Acting as a carrying broker for other broker-dealers on a fully disclosed or omnibus basis, the number of broker-dealers for which it acts in that capacity, and any affiliated broker-dealers that introduce accounts to the broker-dealer on a fully disclosed or omnibus basis;
  • Sending of trade confirmations directly to customers and other account holders;
  • Sending of account statements directly to customers and other account holders;
  • Provision of electronic access to information about the securities and cash positions in customer and other accountholders’ accounts;
  • Registration as an investment adviser with the Commission or state(s), the number of its investment advisory clients, and certain custodial information about the investment adviser’s assets; and
  • Affiliation with investment advisers, whether it has custody of the affiliated investment adviser’s assets and the approximate market value of the assets.

Proposed Annual Financial Reporting Amendments

Broker-dealers are required to file with the Commission and their DEA an annual audit report pursuant to Rule 17a-5 under the Securities Exchange Act of 1934 (“Exchange Act”). Prior to adoption of The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Public Company Accounting Oversight Board’s (“PCAOB”) authority under the Sarbanes-Oxley Act of 2002 was limited to audits of public companies and thus, there was a gap in the standards with respect to the audits of broker-dealers that were not affiliated with a public company. The Dodd-Frank Act granted the PCAOB “explicit authority to, among other things, establish, subject to Commission approval, auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms with respect to the preparation and issuance of audit reports to be included in broker-dealer filings with the Commission.”6 To implement this authority, the Commission is proposing amendments to Rule 17a-5 under the Exchange Act that would require broker-dealers to file with the Commission new annual reports, including a compliance report (“Compliance Report”) and an examination report from the broker-dealer’s independent public accountant (“Examination Report”), or an exemption report if the broker-dealer does not hold customer funds or securities (“non-carrying broker-dealer”) (“Exemption Report”). Firms would also need to file certain new reports prepared by their independent public accountants.

Under the Commission’s proposal, broker-dealers that maintain custody of customer funds or securities would be required to file an annual Compliance Report with the Commission stating “whether the broker-dealer has established and maintained a system of internal controls to provide the broker-dealer with reasonable assurance that any instances of material non-compliance with Rule 15c3-1, Rule 15c3-3, Rule 17a-13, or [the DEA rules regarding sending account statements to customers] (collectively, the “Financial Responsibility Rules”) will be prevented or detected on a timely basis.”7 The Compliance Report would also require a broker-dealer to make three additional representations: “whether [it] 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; and 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.”8 The proposed Compliance Report would also require firms to “identify and describe any instance[s] of material non-compliance” and describe any material weaknesses in “internal control over compliance with the [Financial Responsibility Rules].”9 The definition of “material weakness” is broad and it appears that discrepancies in net capital calculations or valuations of assets could be deemed a “material weakness” even if the miscalculation did not create a deficiency. The broad definition of material weakness could lead to increased costs for broker-dealers.

The Commission is also proposing that firms engage independent public accountants to examine the Compliance Report of each broker-dealer that maintains custody of customer funds or securities (“Compliance Examination”) and then issue an Examination Report. The Commission noted that they expect the proposed amendments to fundamentally change broker-dealer audits. Among other proposed changes, the broker-dealer examination would be prepared in accordance with PCAOB standards.10 In the Examination Report, the independent public accountant would not “opine on the effectiveness of the broker-dealer’s internal control over financial reporting,” or the “broker-dealer’s process for arriving at the assertions [in the Compliance Report].”11 The accountant, however, would be required to provide an opinion concerning the broker-dealer’s compliance, and internal control over compliance, with regulatory requirements relating to the Financial Responsibility Rules.

Broker-dealers would be able to use their Examination Report to satisfy the internal control requirements of Rule 206(4)-2 under the Investment Advisers Act of 1940, as applicable. Independent public accountants would also be required to “notify the Commission within one business day if the accountant determines that an instance of ‘material non-compliance’ exists with respect to any of the Financial Responsibility Rules during the course of the examination.”12

Non-carrying broker-dealers currently have their independent public accountants file an exemption report with the Commission stating that the broker-dealer met the conditions of the Exchange Act Rule 15c3-3 exemption for the specified period. The Commission is proposing that a non-carrying broker-dealer that relies on an exemption from Exchange Act Rule 15c3-3, file a new Exemption Report stating that it is exempt from the requirements of Rule 15c3-3 and that it meets one or more of the conditions outlined in Rule 15c3-3(k). The non-carrying broker-dealer would also need 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.”13 The independent public accountant would be required to disclose in the Exemption Report any material modifications that should be made.

In connection with the Commission’s proposal that the audit and review of the new annual reports be performed pursuant to standards established by the PCAOB as opposed to generally accepted auditing standards (“GAAS”), the Commission requested comments on the implications of the differences between the PCAOB and GAAS standards. The Commission requested comment as well on whether the requirement to audit in accordance with PCAOB standards should be phased-in for non-carrying broker-dealers.14 The Commission proposes to make the Annual Financial Reporting Amendments effective for annual reports filed for fiscal years ending on or after December 15, 2011, with a transition period for carrying broker-dealers with fiscal years ending on or after December 15, 2011, but before September 15, 2012.

The Commission also proposed that brokers-dealers claiming an exemption from the Securities Investor Protection Corporation (“SIPC”) Fund assessments (i.e., broker-dealers filing Form SIPC-3 or Form SIPC-7) file with SIPC, rather than the Commission, supplemental reports covering an opinion of the broker-dealer’s accountant regarding qualification for exclusion. Under the proposal, SIPC also would be responsible for prescribing the form of the supplemental reports. The Commission reasoned that these changes would provide SIPC the discretion to determine the requirements of a supplemental report and the scope of the review by an independent public accountant.15 The Commission would retain involvement because the Commission must approve any SIPC rule proposals.  

Proposed Access to Audit Documentation Amendments

One of the more far-reaching proposals of the Commission is to require that each clearing broker-dealer consent to permitting its independent public accountant to make available to examiners the audit documentation associated with its annual reports required under Rule 17a-5 and to discuss with examiners the findings relating to the audit reports.16 The proposed requirements would be limited to broker-dealers that “maintain customer funds and securities or self-custody their proprietary securities because these firms generally have more complex business operations than other broker-dealers.”17 The expectation of the Commission is that such information would assist examiners in defining the scope and focus of pending examinations of firms. 

The Commission’s proposal would require amendments to the notice provisions of Rule 17a-5(f)(2), which currently require broker-dealers to file notices designating their independent public accountants. The proposed amendments to Rule 17a-5 would require: (1) a statement as to whether the engagement of the independent public accountant is for more than one year; (2) a representation that the engagement of the accountant meets the required undertakings of paragraph (g); (3) a representation by the broker-dealer that it agrees to allow representatives of the Commission or the DEA to review the audit documentation; and (4) a representation by the broker-dealer that it agrees to permit the accountant to discuss with representatives of the Commission and the DEA the findings associated with the reports of the independent public accountant.18


The Proposals will be expensive for self-clearing broker-dealers to implement, and are likely to encourage some broker-dealers to review whether it would be more cost-effective to move to an introducing broker business model. The Commission has solicited comment on all of the Proposals and comments must be submitted by August 26, 2011.  Broker-dealers should consider the impact, and in particular, the cost, of the Proposals, and whether they want to submit comments to the Commission on the Proposals.

For additional information concerning this alert, please contact the following lawyers:

Elizabeth A. Marino, Counsel, Broker-Dealer, 617.951.8398

Amy Kroll, Partner, Broker-Dealer Group, 202.373.6118

David Boch, Partner, Broker-Dealer Group, 617.951.8485

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

1 See Securities Exchange Act Release No. 64676 (June 15, 2011) 76 FR 37572 (June 27, 2011) (“Proposing Release”).
2 See Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010).
3 See Proposing Release at 37584.
4 Pursuant to Exchange Act Rule 15c3-3, the following persons are not considered “customers”: “accountholders that [are] general partner[s], director[s], or principal officer[s] of the carrying broker-dealer and accountholders that are themselves broker-dealers.” See Proposing Release at 37586.
5 The Proposal defines “free credit balances” as “any liabilities of a broker-dealer to customers or non-customers that are subject to immediate cash payment to customers or non-customers on demand, whether resulting from sales of securities, dividends, interest, deposits or otherwise, excluding, however, funds in commodity accounts that are segregated in accordance with the Commodity Exchange Act or in a similar manner.” See General Instructions to Proposed Form Custody at A.8.
6 See Proposing Release at 574. See also Section 982 of the Dodd-Frank Act.
7 See Proposing Release at 576. The Commission has proposed defining “material non-compliance” as “a failure by the broker-dealer to comply with any of the requirements of the [Financial Responsibility Rules] in all material respects.” See proposed Exchange Act Rule 17a-5(d)(3)(ii).
8 See Proposing Release at 576. The Commission has proposed defining “material weakness” as “a deficiency, or a combination of deficiencies, in internal control over compliance with the [Financial Responsibility Rules], such that there is a reasonable possibility that material non-compliance with those provisions will not be prevented or detected on a timely basis. For purposes of this paragraph a deficiency in internal control over compliance exists when the design or operation of a control does not allow the broker or dealer, in the normal course of performing their assigned functions, to prevent or detect non-compliance with the [Financial Responsibility Rules] on a timely basis.” See proposed Exchange Act Rule 17a-5(d)(3)(iii).
9 See Proposing Release at 37576.
10 Pursuant to Exchange Act Rule 17a-5(g), broker-dealers must submit a independent public accountant’s report in which the independent public accountant “issue[s] a report describing a ‘study’ of [certain] practices and procedures and, if applicable, notification to the Commission of the discovery of any material inadequacies.” See Proposing Release at 37573. The proposed Compliance Examination and Examination Report would replace the “study” requirement discussed above.
11 See Proposing Release at 37578.
12 See Proposing Release at 37579.
13 See Proposing Release at 37580.
14 See Proposing Release at 37581.  
15 See Proposing Release at 37582.  
16 A “clearing broker-dealer” is a broker-dealer that clears transactions or carries customer accounts. Proposing Release at 37583.  
17 Proposing Release at 37583.  
18 See Proposing Release at 37583. 

This article was originally published by Bingham McCutchen LLP.