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51911Federal Register / Vol. 78, No. 162 / Wednesday, August 21, 2013 / Rules and Regulations

1 See, e.g., SEC v. Bernard L. Madoff, et al.,Litigation Release No. 20889 (Feb. 9, 2009); SEC v.Stanford International Bank, et al., LitigationRelease No. 20901 (Feb. 17, 2009); SEC v. Donald Anthony Walker Young, et al., Litigation ReleaseNo. 21006 (Apr. 20, 2009); SEC v. Isaac I. Ovid, et al., Litigation Release No. 20998 (Apr. 14, 2009);SEC v. The Nutmeg Group, LLC, et al., LitigationRelease No. 20972 (Mar. 25, 2009); SEC v. WG Trading Investors, L.P., et al., Litigation Release No.20912 (Feb. 25, 2009).

2 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 CFR275.206(4)–2.

3 See Custody of Funds or Securities of Clients by Investment Advisers, 75 FR at 1456.

4 See Broker-Dealer Reports, Exchange ActRelease No. 64676 (June 15, 2011), 76 FR 37572(June 27, 2011).

5 Id. at 37575–37583.6 Id. at 37583–37584.7 Id. at 37584–37592.8 Id. at 37592–37594.9 Public Law 111–203, 124 Stat. 1376, H.R. 4173

(July 21, 2010).

c. Items 3.D.iii and 3.E.iii4. Item 4—Carrying for Other Broker-

Dealers5. Item 5—Trade Confirmations6. Item 6—Account Statements7. Item 7—Electronic Access to Account

Information8. Item 8—Broker-Dealers Registered as

Investment Advisers9. Item 9—Broker-Dealers Affiliated with

Investment AdvisersV. Effective DatesA. Amendments Effective 60 Days After

Publication in the Federal RegisterB. Amendments Effective on December 31,

2013C. Amendments Effective on June 1, 2014

VI. Paperwork Reduction ActA. Summary of the Collection of

Information RequirementsB. Use of InformationC. RespondentsD. Total Initial and Annual Burdens1. Annual Reports To Be Filedi. The Financial Reportii. The Compliance Reportiii. The Exemption Report

iv. Additional Burden and Cost To File theAnnual Reportsv. Supplemental Report on SIPC

Membershipvi. Statement Regarding Independent

Public Accountantvii. External Costs of Engagement of

Accountanta. Financial Report (including Change from

GAAS to PCAOB Standards) b. Compliance Reportc. Exemption Reportd. Access to Accountant and Audit

Documentation2. Conforming and Technical Amendments

to Rule 17a–113. Form Custody

E. Collection of Information Is MandatoryF. ConfidentialityVII. Economic Analysis

A. Motivation for the AmendmentsB. Economic Baseline1. Broker-Dealers2. Independent Public Accountants That

Audit Broker-Dealer Reports3. SIPC Lawsuits Against Accountants4. Overview of Broker-Dealer Reporting,

Auditing, and Notification RequirementsBefore Today’s Amendments

i. Broker-Dealer Reportingii. Engagement of the Accountantiii. Filing of Annual Reports with SIPCiv. Notification Requirementsv. Information Provided to Customers

vi. Access to Accountants and AuditDocumentationvii. Form CustodyC. Costs and Benefits of the Rule

Amendments1. Broker-Dealer Annual Reporting

Amendmentsi. Changing the Broker-Dealer Audit

Standard Setter From the AICPA to thePCAOB and the Standards From GAASto PCAOB Standards

ii. Requirement To File New Reportsa. Compliance Report

b. Exemption Reportiii. Engagement of the Accountant

iv. Filing of Annual Reports With SIPCv. Notification Requirementsa. Amendments to Rule 17a–5

b. Conforming and Technical Amendmentsto Rule 17a–11

vi. Information Provided to Customersvii. Coordination With Investment

Advisers Act Rule 206(4)–22. Access to Accountant and Audit

Documentation3. Form Custody4. Consideration of Burden on

Competition, and Promotion of Efficiency, Competition, and CapitalFormation

VIII. Final Regulatory Flexibility AnalysisA. Need for and Objectives of the

Amendments and New FormB. Significant Issues Raised by Public

CommentsC. Small Entities Subject to the RulesD. Reporting, Recordkeeping, and Other

Compliance RequirementsE. Agency Action To Minimize Effect on

Small EntitiesIX. Statutory Authority

I. BackgroundA. Overview

In 2009, the Commission beganreviewing rules regarding thesafekeeping of investor assets inconnection with several cases theCommission brought alleging fraudulentconduct by investment advisers and

broker-dealers, including, among otherthings, misappropriation or othermisuse of customer securities andfunds. 1 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 governsthe custody of client securities andfunds by investment advisers. 2 Whenadopting this amendment, theCommission stated that it represented‘‘a first step in the effort to enhancecustody protections, with considerationof additional enhancements of the rulesgoverning custody of customer assets by

broker-dealers to follow.’’ 3 In June 2011, the Commission

proposed rule amendments and a newform designed, among other things, toprovide additional safeguards with

respect to broker-dealer custody of customer securities and funds. 4 Theproposed amendments would haveamended certain annual reporting,audit, and notification requirements for

broker-dealers. 5 The proposedamendments also would have requireda broker-dealer that clears transactionsor carries customer accounts (each, a‘‘clearing broker-dealer’’) to agree toallow representatives of the Commissionor the broker-dealer’s DEA to review thedocumentation associated with certainreports of the broker-dealer’sindependent public accountant and toallow the accountant to discuss withrepresentatives of the Commission orDEA the accountant’s findingsassociated with those reports whenrequested in connection with anexamination of the broker-dealer. 6 Further, the proposed amendmentswould have required a broker-dealer tofile with its DEA on a quarterly basis a

new form—Form Custody—that wouldhave elicited information as to whether,and if so how, a broker-dealer maintainscustody of securities and funds of customers and others. 7 The Commissionalso proposed requiring that a broker-dealer file its annual reports with theSecurities Investor ProtectionCorporation (‘‘SIPC’’). 8

The proposed amendments weredesigned to enhance the ability of theCommission to oversee broker-dealercustody practices and, among otherthings, to: (1) Increase the focus of

broker-dealers that maintain custody of customer funds and securities(‘‘carrying broker-dealers’’) and theirindependent public accountants oncompliance, and internal control overcompliance, with certain financial andcustodial requirements; (2) strengthenand clarify broker-dealer audit andreporting requirements in order tofacilitate consistent compliance withthese requirements; (3) facilitate theability of the PCAOB to implement theexplicit oversight authority over broker-dealer audits provided to the PCAOB bythe Dodd-Frank Act; 9 (4) ensure thatSIPC receives the necessary informationto assess whether the liquidation fund it

maintains is appropriately sized to therisks of a large broker-dealer failure; (5)enable Commission and DEA examinersto conduct risk-based examinations of carrying and clearing broker-dealers by

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51912 Federal Register / Vol. 78, No. 162 / Wednesday, August 21, 2013 / Rules and Regulations

10 The proposed amendments also were designedto avoid duplicative requirements for broker-dealersthat are dually-registered as investment advisers inview of the internal control report requirement that

was added by the amendment to Rule 206(4)–2. Seediscussion below in section VII.A. of this releaseidentifying further motivations for the amendments.

11 Comment letter of Naphtali M. Hamlet (June 22,2011) (‘‘Hamlet Letter ’’); comment letter of RobertR. Kelley (June 27, 2011) (‘‘ Kelley Letter ’’); commentletter of Chris Barnard (July 20, 2011) (‘‘ Barnard Letter ’’); comment letter of Suzanne Shatto (July 25,2011) (‘‘Shatto Letter ’’); comment letter of SuzanneH. 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 letterof Deloitte & Touche LLP (Aug. 25, 2011) (‘‘ DeloitteLetter ’’); comment letter of the Securities Industryand Financial Markets Association (Aug. 25, 2011)(‘‘SIFMA Letter ’’); comment letter of the Center forAudit 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 CitrinCooperman & Co., LLP (Aug. 25, 2011) (‘‘ CitrinLetter ’’); comment letter of Grant Thornton LLP(Aug. 26, 2011) (‘‘ Grant Thornton Letter ’’); commentletter 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 theCertified 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 theAmerican 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 letterof Van Kampen Funds Inc. and InvescoDistributors, Inc. (Aug. 26, 2011) (‘‘ Van Kampen/ Invesco Letter ’’); comment letter of Suzanne H.Shatto (Sept. 13, 2011) (‘‘ Shatto Letter IV ); commentletter 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) (‘‘ ABALetter ’’); and comment letter of the Committee of Annuity Insurers (Apr. 17, 2012) (‘‘ CAI II Letter’’ ).The comment letters are available on theCommission’s Web site at http://www.sec.gov/ comments/s7-23-11/s72311.shtml . Comments arealso available for Web site viewing and printing inthe Commission’s Public Reference Room, 100 FStreet NE., Washington, DC (File No. S7–23–11).

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

13 17 CFR 240.15c3–1 (a rule prescribing netcapital requirements for broker-dealers).

14 17 CFR 240.15c3–3 (a rule prescribingrequirements regarding the holding of customersecurities and funds by broker-dealers).

15 17 CFR 240.17a–13 (a rule requiring broker-dealers to perform quarterly securities counts).

16 See, e.g., Rule 9.12 of the Chicago Board

Options Exchange (‘‘CBOE’’); NASD Rule 2340 of the Financial Industry Regulatory Authoirty(‘‘FINRA’’).

17 See 17 CFR 240.15c3–1. The rule requires thata broker-dealer perform two calculations: (1) Acomputation of the minimum amount of net capitalthe broker-dealer must maintain; and (2) acomputation 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’’ inparagraph (c)(2) of Rule 15c3–1. Id. Generally, a

broker-dealer’s minimum net capital requirement isthe greater of a fixed-dollar amount specified in therule and an amount determined by applying one of two financial ratios. See 17 CFR 240.15c3–1(a).

18 See 17 CFR 240.15c3–1(c)(2)(i)–(xiii).

19 See 17 CFR 240.15c3–1(c)(15).20 See 17 CFR 240.15c3–1(c)(2)(vi).21 See, e.g., Uniform Net Capital Rule, Exchange

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

22 See 15 U.S.C. 78o(c)(3)(A).23 See 17 CFR 240.15c3–3(d). Control means the

broker-dealer must hold these securities free of lienin 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 dailydetermination from its books and records (as of thepreceding day) of the quantity of fully paid andexcess margin securities not in its possession orcontrol. See 17 CFR 240.15c3–3(d). If the amountin the broker-dealer’s possession or control is lessthan the amount indicated as being held forcustomers on the broker-dealer’s books and records,the broker-dealer generally must initiate steps toretrieve customer securities from non-controllocations or otherwise obtain possession of them orplace them in control locations. Id. The terms fully

paid securities, margin securities, and excessmargin securities are defined in Rule 15c3–3. See17 CFR 240.15c3–3(a)(3), (a)(4), and (a)(5),respectively.

24 The term qualified security is defined in Rule15c3–3 to mean a security issued by the U.S. or asecurity in respect of which the principal and

interest are guaranteed by the U.S. See 17 CFR240.15c3–3(a)(6).25 See 17 CFR 240.15c3–3(e). The amount of the

net funds owed to customers (‘‘customer reserverequirement’’) is computed by adding customercredit items ( e.g., cash in securities accounts) andsubtracting from that amount customer debit items(e.g., margin loans) pursuant to a formula in ExhibitA to Rule 15c3–3. See 17 CFR 240.15c3–3a.Carrying broker-dealers are required to compute thecustomer reserve requirement on a weekly basis,except where customer credit balances do notexceed $1 million (in which case the computationcan be performed monthly, although the broker-dealer must maintain 105% of the required depositamount and may not exceed a specified aggregateindebtedness limit). See 17 CFR 240.15c3–3(e)(3).

assisting the examiners in selectingareas of focus for their examinations;and (6) provide the Commission and theDEAs with a comprehensive overview of a broker-dealer’s custody practices. 10

The Commission received 27comment letters on the proposal. 11 TheCommission has considered thecomments and, as discussed in detail

below, is adopting the amendments andthe new form with modifications, inpart in response to comments received.A number of commenters stated that theCommission should coordinate with theCommodity Futures TradingCommission (‘‘CFTC’’) to account for

broker-dealers that also are registered asfutures commission merchants(‘‘FCMs’’) in order to align the broker-dealer reporting and audit requirements

with FCM reporting and auditrequirements. 12 The Commission staff isin discussions with the CFTC staff concerning ways to align the reportingand audit requirements for dually-registered broker-dealer/FCMs with thegoal of coordinating these requirements,including the requirements that theCommission is adopting today.B. Rules Governing Broker-Dealer Financial and Custodial Responsibility

Rule 15c3–1, 13 Rule 15c3–3, 14 andRule 17a–13, 15 under the Exchange Actand applicable DEA rules that require

broker-dealers to periodically sendaccount statements to customers(‘‘Account Statement Rules’’) 16 (collectively for the purposes of thisrelease, ‘‘the financial responsibilityrules’’) are central to today’samendments to the broker-dealerreporting, audit, and notificationrequirements. In light of the significanceof the financial responsibility rules totoday’s amendments, the followingsection briefly summarizes therequirements of each rule in order toprovide a foundation for the laterdiscussion of the amendments.1. The Broker-Dealer Net Capital Rule

Rule 15c3–1 requires broker-dealers tomaintain a minimum level of net capital(consisting of highly liquid assets) at alltimes. 17 In computing net capital, a

broker-dealer must, among other things,calculate net worth in accordance withU.S. generally accepted accountingprinciples (‘‘GAAP’’) and then make

certain adjustments to net worth, suchas deducting illiquid assets and takingother capital charges and addingqualifying subordinated loans. 18 Theamount remaining after thesedeductions is defined as ‘‘tentative net

capital.’’ 19 The final step in computingnet capital is to deduct certainpercentages (‘‘haircuts’’) from themarket value of the broker-dealer’sproprietary positions to account for themarket risk inherent in the positions 20 and to create a buffer of liquidity toprotect against other risks associatedwith the broker-dealer’s business. 21 The

broker-dealer must cease conducting asecurities business if the amount of netcapital maintained by the firm falls

below the minimum required amount. 22 2. The Broker-Dealer CustomerProtection Rule

Rule 15c3–3 imposes two keyrequirements on a carrying broker-dealer: first, the broker-dealer mustmaintain physical possession or controlover customers’ fully paid and excessmargin securities; 23 and second, thefirm must maintain a reserve of funds orqualified securities 24 in an account at

one or more banks that is at least equalin value to the amount of net fundsowed to customers. 25 Theserequirements are designed to protectcustomers by requiring broker-dealers tosegregate customers’ securities and


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26 See 15 U.S.C. 78aaa et seq.27 See 17 CFR 240.15c3–3(k).28 Id.29 See 17 CFR 240.17a–13(b).30 See 17 CFR 240.15c3–1(c)(2)(v).31 See 17 CFR 240.17a–3(a)(4)(vi).

32 See, e.g., CBOE Rule 9.12; NASD Rule 2340.33 See paragraph (d) of Rule 17a–5.34 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 thisrelease.

35 See paragraph (d)(2)(ii) of Rule 17a–5.

36 See paragraphs (d)(1)(i)(B)( 1) and ( 2) of Rule17a–5.

37 See paragraphs (d)(3) and (4) of Rule 17a–5.The requirements for the compliance report and theexemption report are discussed below in moredetail in section II.B.3. and section II.B.4. of this

release, respectively.38 See paragraphs (f)(1) and (g)(1) of Rule 17a–5.39 See paragraphs (f)(1) and (g)(2)(i) of Rule 17a–

5.40 See paragraphs (f)(1) and (g)(2)(ii) of Rule 17a–

5.41 See paragraph (d)(1)(i)(C) of Rule 17a–5. The

requirements for the engagement of theindependent public accountant are discussed belowin more detail in section II.D.3. of this release.

42 See paragraph (d)(6) of Rule 17a–5. Thisrequirement is discussed below in more detail insection II.B.6. of this release.

43 See paragraph (e)(4) of Rule 17a–5. Thisrequirement is discussed below in more detail insection II.C.4. of this release.

funds from the broker-dealer’sproprietary business activities. If the

broker-dealer fails financially,customers’ securities and funds should

be readily available to be returned tocustomers. In addition, if the failed

broker-dealer is liquidated in aproceeding under the Securities InvestorProtection Act of 1970 (‘‘SIPA’’), asamended, the customers’ securities andfunds should be isolated and readilyidentifiable as ‘‘customer property’’ and,consequently, available to be distributedto customers ahead of other creditors. 26

Provisions of Rule 15c3–3 exempt a broker-dealer from the requirements of Rule 15c3–3 under certaincircumstances. 27 Generally, a broker-dealer is exempt from Rule 15c3–3 if itdoes not hold customer securities orfunds, or, if it does receive customersecurities or funds, it promptly deliversthe securities or promptly transmits thefunds to appropriate persons. 28

3. The Broker-Dealer QuarterlySecurities Count Rule

Rule 17a–13 generally requires a broker-dealer that maintains custody of securities (proprietary, customer, or

both), on a quarterly basis, to physicallyexamine and count the securities itholds, account for the securities that aresubject to its control or direction but arenot in its physical possession ( e.g.,securities held at a control location),verify the locations of securities undercertain circumstances, and compare theresults of the count and verificationwith its records. 29 In accordance with aschedule, the broker-dealer must take anoperational capital charge under Rule15c3–1 for short securities differences(which include securities positionsreflected on the broker-dealer’ssecurities record that are not susceptibleto either count or confirmation) that areunresolved after discovery. 30 Thedifferences also must be recorded in the

broker-dealer’s books and records. 31

4. The Broker-Dealer Account StatementRules

The Account Statement Rules of DEAsrequire member broker-dealers to send,at least once every calendar quarter, astatement of account containing adescription of any securities positions,money balances, or account activity toeach customer whose account had asecurity position, money balance, oraccount activity during the period since

the last such statement was sent to thecustomer. 32 The Account StatementRules provide a key safeguard forcustomers by requiring that they receiveinformation concerning securitiespositions and other assets held in theiraccounts on a regular basis, which theycan use to identify discrepancies andmonitor the performance of theiraccounts.II. Final Amendments to Broker-DealerReporting, Audit, Notification, andOther Requirements

A. Overview of New RequirementsThe Commission is adopting

amendments to the reporting, audit, andnotification requirements in Rule 17a–5,and additional amendments to otherprovisions of the rule, includingtechnical changes. The Commission alsois adopting amendments to thenotification requirements in Rule 17a–11, and certain other technicalamendments to that rule.

Under the amendments to thereporting and audit requirements,

broker-dealers must, among otherthings, file with the Commission annualreports consisting of a financial reportand either a compliance report or anexemption report that are prepared bythe broker-dealer, as well as certainreports that are prepared by anindependent public accountant coveringthe financial report and the compliancereport or the exemption report. 33 Thefiling of a compliance or exemptionreport and the related report of the

independent public accountant are newrequirements. The financial report mustcontain the same types of financialstatements that were required to be filedunder Rule 17a–5 prior to theseamendments (a statement of financialcondition, a statement of income, astatement of cash flows, and certainother financial statements). 34 Inaddition, the financial report mustcontain, as applicable, the supportingschedules that were required to be filedunder Rule 17a–5 prior to theseamendments (a computation of netcapital under Rule 15c3–1, a

computation of the reserve requirementsunder Rule 15c3–3, and informationrelating to the possession or controlrequirements under Rule 15c3–3). 35

A broker-dealer that did not claimthat it was exempt from Rule 15c3–3throughout the most recent fiscal year

must file the compliance report, and a broker-dealer that did claim it wasexempt from Rule 15c3–3 throughoutthe most recent fiscal year (generally, a‘‘non-carrying broker-dealer’’) must filethe exemption report. 36 Broker-dealersmust make certain statements andprovide certain information relating tothe financial responsibility rules inthese reports. 37 In addition to preparing and filing thefinancial report and the compliancereport or exemption report, a broker-dealer must engage a PCAOB-registeredindependent public accountant toprepare a report based on anexamination of the broker-dealer’sfinancial report in accordance withPCAOB standards. 38 A carrying broker-dealer also must engage the PCAOB-registered independent publicaccountant to prepare a report based onan examination of certain statements inthe broker-dealer’s compliance report. 39

A non-carrying broker-dealer mustengage the PCAOB-registeredindependent public accountant toprepare a report based on a review of certain statements in the broker-dealer’sexemption report. 40 In each case, theexamination or review must beconducted in accordance with PCAOBstandards. The broker-dealer must filethese reports with the Commissionalong with the financial report and thecompliance report or exemption reportprepared by the broker-dealer. 41

The annual reports also must be filedwith SIPC if the broker-dealer is amember of SIPC. 42 In addition, broker-dealers must generally file with SIPC asupplemental report on the status of themembership of the broker-dealer inSIPC. 43 The supplemental report mustinclude a report of the independentpublic accountant that covers the SIPCannual general assessmentreconciliation or exclusion frommembership forms based on certain


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44 Id. Currently, Rule 17a–5 prescribes the formatof the report. See 17 CFR 240.17a–5.

45 See paragraph (h) of Rule 17a–5. As discussed below, material weakness is defined for purposes of the compliance report and, therefore, thenotification of a material weakness only can occurin the context of the audit of a broker-dealer thatfiles a compliance report.

46 Id. Notifications under Rule 17a–11 also must be filed with the CFTC if the broker-dealer isregistered as a FCM with the CFTC. See 17 CFR240.17a–11(g).

47 See paragraph (e) of Rule 17a–11. Thesenotification provisions are discussed below in moredetail in section II.F. of this release.

48 See 17 CFR 240.17a–5(d)(1)(i). Certain types of broker-dealers were exempt from the requirement tofile the reports or to file reports that had beenaudited by an independent public accountant. See17 CFR 240.17a–5(d)(1)(ii)–(iii).

49 See Broker-Dealer Reports, 76 FR at 37575–37581.

50 Before today’s amendments, paragraph (d) of Rule 17a–5 was titled ‘‘Annual filing of auditedfinancial statements.’’ In the proposing release, theCommission proposed to change the title to‘‘Annual reports’’ to reflect that, under the proposedamendments to paragraph (d), broker-dealers would

be required to prepare and file two reports with theCommission—a financial report and a compliancereport or an exemption report. See Broker-Dealer Reports, 76 FR at 37575. The Commission receivedno comments on this proposal and is adopting thenew title as proposed. See paragraph (d) of Rule17a–5. In addition, the Commission is making atechnical amendment to paragraph (d) of Rule 17a–5 to replace the term ‘‘fiscal or calendar year’’ withthe term ‘‘fiscal year.’’ The Commission is adoptingthis technical amendment because the term ‘‘fiscalyear’’ includes instances in which December 31st,i.e., the calendar year end, is the broker-dealer’sfiscal year end.

51 See 17 CFR 240.17a–5(d)(1).52 See Broker-Dealer Reports, 76 FR at 37575.53 Id.54 Id.

55 Id. at 37575–37578, 37603–37604.56 Id. at 37575–37578, 37580–37581 (discussing

the compliance report and exemption report,respectively).

57 Id. at 37581.58 See, e.g., CAI Letter; CAI II Letter; CAQ Letter;

Citrin Letter; Deloitte Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter.

59 See CAQ Letter; Deloitte Letter; Grant ThorntonLetter; KPMG Letter.

60 See CAI Letter; SIFMA Letter.61 See CAI Letter; CAI II Letter.

procedures specified in the rule. In thefuture, SIPC may determine the formatof this report by rule, subject toCommission approval. 44

Finally, the PCAOB-registeredindependent public accountant mustimmediately notify the broker-dealer if the accountant determines during thecourse of preparing the accountant’sreports that the broker-dealer is not incompliance with the financialresponsibility rules or if the accountantdetermines that any material weaknessexists in the broker-dealer’s internalcontrol over compliance with thefinancial responsibility rules. 45 The

broker-dealer, in turn, must file anotification with the Commission andits DEA under Rule 15c3–1, Rule 15c3–3, or Rule 17a–11 if the independentpublic accountant’s notice concerns aninstance of non-compliance that wouldtrigger notification under those rules. 46 Under the amendments to Rule 17a–11,

a broker-dealer also must file anotification with the Commission andits DEA if the broker-dealer discovers oris notified by the independent publicaccountant of the existence of anymaterial weakness (as defined in theamendments) in the broker-dealer’sinternal control over compliance withthe financial responsibility rules. 47

Each of these amendments isdiscussed in more detail in thefollowing 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 generallyrequired a broker-dealer to annually filethe financial statements and supportingschedules discussed below in sectionII.B.2. of this release and a reportprepared by the broker-dealer’sindependent public accountant coveringthe financial statements and supportingschedules. 48 The Commission proposedamendments that would, among otherthings, restructure paragraph (d) and—

as part of the proposed revisions to theattestation engagement provisions—addthe requirement that a broker-dealer fileeither a compliance report or anexemption report, as applicable, and areport prepared by the broker-dealer’sindependent public accountant basedon an examination of the compliancereport or a review of the exemptionreport. 49 As discussed in sections II.B.1.through II.B.6. of this release, theCommission is adopting the proposedamendments to paragraph (d) withmodifications. 50

1. Requirement To File Reports—Paragraph (d)(1) of Rule 17a–5i. Proposed Amendments

The Commission proposed to amendparagraph (d)(1) of Rule 17a–5 51 torequire that a broker-dealer file afinancial report containing financialstatements and supporting schedulesand either a compliance report or anexemption report, as applicable. 52 Theproposal provided that a broker-dealermust file a compliance report ‘‘unlessthe [broker-dealer] is exempt from theprovisions of [Rule 15c3–3]’’ in whichcase the broker-dealer would berequired to file an exemption report. 53 The proposed amendments also wouldhave required a broker-dealer generallyto file reports prepared by anindependent public accountant coveringthe financial report and compliancereport or exemption report, asapplicable, unless the broker-dealer wasexempt from the requirement to file thereports or from the requirement toengage an independent publicaccountant with respect to the reports. 54 To accommodate these changes, theCommission also proposed to reorganizethe provisions of paragraph (d)(1) of

Rule 17a–5, and to make other technicalamendments. 55

The proposed amendments withrespect to the compliance report andexemption report set forth differentrequirements for carrying broker-dealersas compared with broker-dealers that donot hold customer securities andfunds. 56 In order to provide clarity withrespect to this distinction, the proposedamendments referenced Rule 15c3–3,which applies to carrying broker-dealersand contains provisions under which a

broker-dealer is exempt from therequirements in the rule. The goal wasto establish a clear way of determiningwhether a broker-dealer would need tofile a compliance report or anexemption report. However, not all

broker-dealers that are subject to Rule15c3–3 regularly hold customersecurities or funds. This prompted theCommission to inquire in the proposingrelease as to whether there are broker-

dealers that would not qualify to file theproposed exemption report because theyare not exempt from Rule 15c3–3, butthat should be allowed to file a morelimited report than the proposedcompliance report based on the limitedscope of their business. 57

ii. Comments ReceivedThe Commission received several

comments on its proposed amendmentsto paragraph (d)(1) of Rule 17a–5. 58 Some commenters asked whether theprovision that would require the broker-dealer to file an exemption reportinstead of a compliance report related toa period end date or to a period of time. 59 Further, as discussed in moredetail in sections II.B.4. and II.D.3. of this release, commenters raisedquestions and concerns about howinstances of exceptions to meeting theexemption provisions of paragraph (k)of Rule 15c3–3 would be treated underthe proposed reporting requirements. 60 One commenter also stated that ‘‘limitedpurpose’’ carrying broker-dealers shouldnot be required to file a compliancereport, and broker-dealers with certain

business model characteristics shouldnot be required to file the compliancereport. 61 Similarly, another commenterstated that broker-dealers engaging


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62 See McGladrey Letter.63 See CAI Letter.64 See paragraph (d)(1) of Rule 17a–5. Paragraph

(d)(1)(iii) of Rule 17a–5 (now re-designated asparagraph (d)(1)(iv)) contains an exemption fromfiling an annual report if the broker-dealer is amember of a national securities exchange and hastransacted business in securities solely with or forother members of a national securities exchange,and has not carried any margin account, credit

balance or security for any person who is definedas a ‘‘customer’’ in paragraph (c)(4) of Rule 17a–5.See paragraph (d)(1)(iv) of Rule 17a–5. TheCommission also proposed to move the exemptionsfrom having to file financial statements underparagraph (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. TheCommission received no comments on theseamendments and is adopting them as proposed. Seeparagraphs (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 exemptionsfrom the requirement for a broker-dealer to file theannual 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 dealerregistered under section 15 of the Act must fileannually . . . .’’ See paragraph (d)(1)(i) of Rule 17a–5. As proposed, the final rule provided that thereports must be filed annually ‘‘on a calendar orfiscal year basis.’’ The final rule deletes the phrase‘‘on a calendar or fiscal year basis’’ as the ruleprovides elsewhere that the annual reports must befiled on a fiscal year basis. Id. In addition, theCommission proposed to move the requirement thatreports 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 Commissionreceived no comments on this proposedamendment and is adopting it substantially asproposed. See paragraph (d)(1)(ii) of Rule 17a–5.The final rule also includes a technical

modification from the proposal to require that thereports required to be filed under paragraph (d)must be as of the same ‘‘fi scal year end each year,’’rather than as of the same ‘‘fixed or determinabledate each year.’’ See paragraph (d)(1)(ii) of Rule17a–5. This change, by having the rule refer to the

broker-dealer’s ‘‘fiscal year,’’ eliminates outdatedlanguage 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 rulealso adds a clarifying cross-reference to theprovision in Rule 17a–5 pursuant to which a

broker-dealer requests a change of its fiscal yearend. 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 theCommission for the region in which the broker-dealer has its principal place of business. Id. Thischange is consistent with paragraph (n) of Rule17a–5, which requires that when a broker-dealerchanges its fiscal year, it must file a notice with theCommission’s principal office in Washington, DC aswell as the regional office of the Commission for theregion in which the broker-dealer has its principalplace of business. See 17 CFR 240.17a–5(n).

65 See paragraph (d)(1)(i) of Rule 17a–5. Thefinancial report, compliance report, and exemptionreport are discussed below in more detail insections II.B.2., II.B.3., and II.B.4., respectively, of this release.

66 See paragraph (d)(1)(i)(B)( 1) of Rule 17a–5.67 See paragraph (d)(1)(i)(B)( 2) of Rule 17a–5.68 See paragraph (d)(1)(i)(C) of Rule 17a–5. The

proposed requirements and final rule with respectto the attestation engagement for the independentpublic accountant are discussed below in sectionII.D. of this release.

69 See paragraph (d)(1)(i)(B)(2) of Rule 17a–5. A broker-dealer claiming an exemption from Rule15c3–3 is required to indicate the basis for theexemption on the periodic reports it files withsecurities regulators. See, e.g., Item 24 of Part IIa of the Financial and Operational Combined UniformSingle Report. See 17 CFR 249.617.

70 As discussed below in more detail in sectionII.B.4. of this release, the provisions of paragraph(k) of Rule 15c3–3 prescribe ‘‘exemptions’’ from therequirements of Rule 15c3–3. See 17 CFR 240.15c3–3(k)(1), (k)(2)(i), (k)(2)(ii), and (k)(3).

71 See CAI Letter; SIFMA Letter.

72 The FOCUS Reports are: Form X–17A–5Schedule 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.

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

74 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 fundsduring the fiscal year, but does not fit i nto one of the exemptive provisions listed under Item 24 of Part IIa. Even though there is not a box to checkon the FOCUS Report, these broker-dealers shouldfile an exemption report and related accountant’sreport.

75 See, e.g., CAI Letter; CAI II Letter; McGladrey Letter.

76 See CAI II Letter.77 See Broker-Dealer Reports, 76 FR at 37599.78 Broker-dealers with extremely limited

custodial activities ( e.g., holding customer checksmade out to a third party for limited periods of

Continued

exclusively in proprietary trading orinvestment banking may not technically

be exempt from Rule 15c3–3 butnonetheless should not have to file thecompliance report as they do not have‘‘customers.’’ 62 Finally, one commenterstated that the Commission shouldclarify who must sign the compliancereports and exemption reports and theliability that attaches in the event of amisstatement or omission in thereports. 63 iii. The Final Rule

After considering these comments, theCommission is adopting the proposedamendments with certainmodifications. 64 Under the final rule, all

broker-dealers generally must prepareand file a financial report and either thecompliance report or the exemptionreport. 65 A broker-dealer that did notclaim an exemption from Rule 15c3–3 atany time during the most recent fiscalyear or claimed an exemption for onlypart of the fiscal year must prepare andfile the compliance report. 66 A broker-dealer must prepare and file theexemption report if the firm did claimthat it was exempt from Rule 15c3–3throughout the most recent fiscal year. 67 Broker-dealers also must file reportsprepared by a PCAOB-registeredindependent public accountant coveringthe financial report and the compliancereport or exemption report, asapplicable. 68

The final rule is modified from theproposal in three key ways. First, thefinal rule provides that the broker-dealermust file the exemption report if it did‘‘claim that it was exempt’’ from Rule

15c3–369

throughout the most recentfiscal year. 70 This modification from theproposal—which provided that a

broker-dealer ‘‘shall’’ file the exemptionreport if the broker-dealer ‘‘is exemptfrom the provisions of [Rule 15c3–3]’’—is designed to provide greater clarity asto whether a broker-dealer must file theexemption report (as opposed to thecompliance report), particularly whenthe broker-dealer had exceptions tomeeting the exemption provisions inparagraph (k) of Rule 15c3–3 during thefiscal year. 71 Specifically, if the broker-

dealer claimed an exemption from Rule15c3–3 in its Financial and Operational Combined Uniform Single Reports(‘‘FOCUS Reports’’) throughout thefiscal year, 72 it must file the exemptionreport even it had exceptions to theexemption provisions. 73 Consequently,the applicability of the exemption reportunder the final rule is based on anobjective and easily ascertainable factor:whether the broker-dealer claimed anexemption from Rule 15c3–3 throughoutthe most recent fiscal year. 74

As noted above, several commentersargued that broker-dealers that engage inlimited custodial activities and,therefore, are not exempt from Rule15c3–3, should not be required to file acompliance report. 75 Specifically, one of these commenters suggested that a‘‘new’’ category of ‘‘limited purpose’’

broker-dealer with certain businessmodel characteristics should beaddressed in the rule and that this

‘‘new’’ category of broker-dealer shouldnot be required to file the compliancereport. 76 The Commission hasconsidered these comments but hasdetermined not to provide for a broaderexception from the requirement to file acompliance report for broker-dealerswith limited custodial activities. Theobjectives of the compliance report andrelated examination of the compliancereport are intended, among other things,to ‘‘increase the focus of independentpublic accountants on the custodypractices of broker-dealers’’ and to‘‘help identify broker-dealers that haveweak controls for safeguarding investorassets.’’ 77 Therefore, broker-dealers thathold customer assets—even if theircustodial activities are limited—generally should be subject to therequirement to file the compliancereport and related accountant’s report. 78


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time) could seek exemptive relief under section 36

of the Exchange Act (15 U.S.C. 77mm) from therequirement to file the compliance report and reportof the independent public accountant covering thecompliance report.

79 As discussed below in section II.D. of thisrelease, the PCAOB has proposed attestationstandards for an independent public accountant’sexamination of the compliance report and thereview of the exemption report. The proposedexamination standard provides proceduralrequirements for independent public accountantsthat are ‘‘designed to be scalable based on the

broker’s or dealer’s size and complexity.’’ SeeProposed Standards for Attestation EngagementsRelated to Broker and Dealer Compliance or Exemption Reports Required by the U.S. Securitiesand Exchange Commission and Related Amendments to PCAOB Standards, PCAOB ReleaseNo. 2011–004, PCAOB Rulemaking Docket Matter

No. 035 (July 12, 2011) at 8 (‘‘ PCAOB Proposing Release ’’).80 See paragraphs (d)(1)(i)(B)( 1)–(2) of Rule

17a–5.81 There will be cases where a broker-dealer

changes its business model to convert from acarrying broker-dealer to a non-carrying broker-dealer during the fiscal year. In this case, the

broker-dealer could seek exemptive relief undersection 36 of the Exchange Act (15 U.S.C. 78mm)from the requirement to file the compliance reportand to instead file the exemption report. Inanalyzing such a request, the period of time the

broker-dealer operated as a carrying broker-dealerwould be a relevant consideration.

82 See paragraphs (d)(1)(i)(B)( 1)–(2) of Rule17a–5.

83 See CAI Letter. The filings discussed aboveconstitute a ‘‘report’’ for purposes of 15 U.S.C.78ff(a) and other applicable provisions of theExchange Act. As a consequence, it would beunlawful for a broker-dealer to willfully make orcause to be made, a false or misleading statementof a material fact or omit to state a material fact inthe filings.

84 Id.85 See paragraphs (d)(1)(i)(B)( 1)–(2) of Rule 17a–

5.86 See paragraph (e)(2) of Rule 17a–5.87 See 17 CFR 240.17a–5(d)(2). As noted above,

Form X–17A–5 Part II and Form X–17A–5 Part IIaare among the FOCUS Reports that broker-dealerscomplete and file with the Commission or theirDEA 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 financialinformation with the Commission or their DEA,including information about the broker-dealer’s: (1)Assets and liabilities; ownership equity; net capitalcomputation under Rule 15c3–1; minimum netcapital requirement under Rule 15c3–1; income(loss); computation of the customer reserverequirement under Rule 15c3–3 in the case of FormX–17A–5 Part II; the possession and controlrequirements under Rule 15c3–3 in the case of Form X–17A–5 Part II; and changes in ownershipequity.

88 See 17 CFR 240.17a–5(d)(3).89 See 17 CFR 240.17a–5(d)(4).90 See Broker-Dealer Reports, 76 FR at 37575.91 See paragraph (d)(2) of Rule 17a–5. The

Commission has made plain English changes to thelanguage of the paragraph ( e.g., replacing the term‘‘shall’’ with ‘‘must’’). The Commission also,consistent with current practice, has clarified thatthe financial statements must be prepared inaccordance with U.S. GAAP to distinguish fromother accounting frameworks. See paragraph (d)(2)of Rule 17a–5. In addition, the Commission hasreplaced the words ‘‘notes to the consolidatedstatement of financial condition’’ with ‘‘notes to thefinancial statements.’’ This change in terminologyis designed to conform the language in Rule 17a–5 to current accounting practice. Under GAAP,notes to a complete set of financial statements mustcover all the financial statements, and not just oneof the statements, such as the consolidatedstatement of financial condition.


93 Id.94 Id. The independent public accountant would

not have been required to examine the proposed

The level of effort required bycarrying broker-dealers to prepare acompliance report will depend on thenature and extent of their activities. Forexample, the controls of a carrying

broker-dealer that engages in limitedcustodial activities could be lesscomplex than the controls of a carrying

broker-dealer that engages in moreextensive custodial activities. 79 Therefore, this requirement is intendedto be scalable so that a carrying broker-dealer with limited custodial activitiesgenerally should have to expend lesseffort to support its statements in thecompliance report, particularly withrespect to the statements relating toRules 15c3–3 and 17a–13.

The second key modification is thatthe final rule provides that therequirement to file the exemption reportapplies if the broker-dealer did claimthat it was exempt from Rule 15c3–3‘‘throughout the most recent fiscal

year.’’80

Thus, a broker-dealer that didnot claim an exemption from Rule15c3–3 at any time during the mostrecent fiscal year or claimed anexemption for only part of the fiscalyear must file the compliance report. 81

The third key modification is that thefinal rule specifies the individual whomust execute the compliance reportsand exemption reports. 82 As notedabove, one commenter stated that theCommission should make clear whoshould sign the compliance reports andexemption reports and what liability

attaches in the event of a misstatementor omission. 83 The commentersuggested a reasonableness standard,and stated that the Commission shouldmake clear that the reports do not createa new private right of action. 84 Inresponse to this comment, the final ruleprovides that the compliance report andthe exemption report must be executed

by the person who makes the oath oraffirmation under paragraph (e)(2) of Rule 17a–5. 85 As discussed below inmore detail in section II.C.2. of thisrelease, paragraph (e)(2) of Rule 17a–5requires an oath or affirmation to beattached to the financial report andprovides that the oath or affirmationmust be made by certain types of persons depending on the corporateform of the broker-dealer ( e.g., a dulyauthorized officer if the broker-dealer isa corporation). 86 The requirement to filethese new reports with the Commissionis not intended to establish a new

private cause of action.2. The Financial Report—Paragraph(d)(2) of Rule 17a–5

Before today’s amendments,paragraph (d)(2) of Rule 17a–5 requiredthat the annual audited report of a

broker-dealer contain certain financialstatements in a format consistent withForm X–17A–5 Part II or Form X–17A–5 Part IIa, as applicable, including astatement of financial condition, anincome statement, a statement of cashflows, a statement of changes in owners’equity, and a statement of changes inliabilities subordinated to claims of general creditors. 87 Paragraph (d)(3) of Rule 17a–5 required that the annualaudited report contain supporting

schedules, including a computation of net capital under Rule 15c3–1, acomputation for determining reserverequirements under Rule 15c3–3, andinformation relating to the possessionand control requirements of Rule 15c3–3.88 Paragraph (d)(4) of Rule 17a–5required a reconciliation between thenet capital and reserve computations inthe audited report and those in the mostrecent Form X–17A–5 Part II or Form X–17A–5 Part IIa, if there were materialdifferences between the annual auditedreport and the form. 89

The Commission proposed combiningthe provisions in paragraphs (d)(2)through (d)(4) of Rule 17a–5 in revisedparagraph (d)(2) without substantivemodification to those provisions. 90 Inaddition, the Commission proposed thatrevised paragraph (d)(2) be titled‘‘Financial report’’ to reflect that theinformation required in this reportwould be financial in nature and to

differentiate it from the proposedcompliance reports and exemptionreports. The Commission did notreceive comments concerning theamendments to paragraph (d)(2) of Rule17a–5 and is adopting themsubstantially as proposed. 91 3. The Compliance Report—Paragraph(d)(3) of Rule 17a–5i. The Proposed Amendments

As proposed, the requirements for thecontents of the compliance report wereprescribed in paragraph (d)(3) of Rule17a–5. 92 Under the proposal, a carrying

broker-dealer would need to include inthe compliance report a specificstatement, certain assertions, anddescriptions. 93 The independent publicaccountant would examine theassertions in the compliance report inpreparing the report of the accountant. 94


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114 See E&Y Letter. This commenter also statedthat a point-in-time assessment would be consistentwith the requirement for issuers subject to internalcontrol reporting under section 404 of the Sarbanes-Oxley Act. Further, for carrying broker-dealers thatare not subject to Rule 206(4)–2, this commenterstated that the incremental benefits of having theassertion pertain to the entire year rather than theyear end assessment does not justify the cost. Id.

115 See CAQ Letter; Deloitte Letter; McGladrey Letter.

116 See E&Y Letter.117 See Angel Letter; Deloitte Letter.118 See Deloitte Letter; KPMG Letter; PWC Letter.119 See CAI Letter.

120 See CAQ Letter; Deloitte Letter; E&Y Letter.121 See paragraph (d)(3) of Rule 17a–5.122 See paragraphs (d)(3)(i)(A)( 1)–(5) of Rule 17a–

5.

123 See paragraph (d)(3)(i)(A)( 1) of Rule 17a–5.124 See paragraph (d)(3)(ii) of Rule 17a–5.125 Id.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 thatthe registrant’s internal control over financialreporting is effective if there are one or morematerial weaknesses in the registrant’s internalcontrol over financial reporting.’’).

127

As noted above, the Commission has stated inother contexts that there is a reasonable possibilityof an event occurring if it is ‘‘probable’’ or‘‘reasonably possible.’’ See Amendments to RulesRegarding Management’s Report on Internal Control Over Financial Reporting, 72 FR 35310. See also 17CFR 240.12b–2; 17 CFR 210.1–02. Commissionguidance provides that an event is ‘‘probable’’ if thefuture event or events are likely to occur, and thatan event is ‘‘reasonably possible’’ if the chance of the future event or events occurring is more thanremote, but less than likely. See CommissionGuidance Regarding Management’s Report onInternal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities ExchangeAct of 1934, 72 FR at 35332 n.47 and correspondingtext.

Rule 206(4)–2 should be able to elect tomake the assertion pertain to the entirefiscal year in order to satisfy reportingrequirements under the IA CustodyRule. 114 Others stated that broker-dealers should have the opportunity toremediate any material weaknesses ininternal control that were identifiedduring the period and, if correctiveaction was taken, not be required toinclude them in the compliancereport. 115

Regarding the proposed assertion thatthe broker-dealer was in compliancewith the financial responsibility rules,one commenter stated that broker-dealers may need to interpret certainrequirements and in other cases broker-dealers may be relying on informalinterpretations obtained throughdialogue with the Commission or itsDEA.116 This commenter recommendedthat in those circumstances theCommission require broker-dealers to

formally document such interpretationsand obtain evidence of agreementsreached with the Commission or theDEA.

Some commenters stated that theCommission should provide additionalguidance about the control objectivesthat would need to be met to achieveeffective internal control overcompliance with the financialresponsibility rules. 117 Severalcommenters urged the Commission toclarify the interaction between materialweaknesses in internal control overfinancial reporting and materialweaknesses in internal control overcompliance with the financialresponsibility rules. 118 One commenterstated that the compliance report wasover-inclusive and burdensome, andsuggested that the final rule focusinstead on ‘‘issues most vital to thefinancial condition of the broker-dealerand its compliance and internal controlover compliance.’’ 119

Some commenters had questions andcomments about the proposed assertionthat information used to assertcompliance with the financialresponsibility rules was derived fromthe books and records of the broker-

dealer. Three commenters askedwhether ‘‘books and records’’ meansrecords maintained under Rule 17a–3.120

iii. The Final Rule

The Commission is adopting theproposed amendments to Rule 17a–5requiring a carrying broker-dealer toprepare and file a compliance report,with modifications, some of which arein response to comments. 121 Generally,as adopted, the broker-dealer’scompliance report will include fivespecific statements, and twodescriptions, if applicable.

Specifically, paragraph (d)(3) of Rule17a–5 requires that the compliancereport contain statements as to whether:(1) The broker-dealer has establishedand maintained Internal Control OverCompliance (which, as discussed below,is a defined term in the f inal rule); (2)the Internal Control Over Compliance of the broker-dealer was effective duringthe most recent fiscal year; (3) theInternal Control Over Compliance of the

broker-dealer was effective as of the endof the most recent fiscal year; (4) the

broker-dealer was in compliance withRule 15c3–1 and paragraph (e) of Rule15c3–3 as of the end of the most recentfiscal year; and (5) the information the

broker-dealer used to state whether itwas in compliance with Rule 15c3–1and paragraph (e) of Rule 15c3–3 wasderived from the books and records of the broker-dealer. Further, if applicable,the compliance report must contain a

description of: (1) Each identifiedmaterial weakness in the InternalControl Over Compliance during themost recent fiscal year, including thosethat were identified as of the end of thefiscal year; and (2) any instance of non-compliance with Rule 15c3–1 orparagraph (e) of Rule 15c3–3 as of theend of the most recent fiscal year.

The final rule does not use the termassertion—the assertions contained inthe proposal are now referred to asstatements. 122 The consistent use of theterm statements is designed to simplifythe structure of the rule rather than to

substantively change the nature of thematters stated in the compliance reportor which of the statements are to beexamined by the independent publicaccountant.

In the final rule, the first statement inthe compliance report is whether the

broker-dealer has established andmaintained Internal Control Over

Compliance. 123 The rule definesInternal Control Over Compliance tomean internal controls that have theobjective of providing the broker-dealerwith reasonable assurance that non-compliance with the financialresponsibility rules will be prevented ordetected on a timely basis. 124 In orderto clarify the application of the rule, theproposal has been modified so that partof the statement contained in theproposed compliance report, as to the

broker-dealer’s system of internalcontrol, has been incorporated in thedefinition of Internal Control Over Compliance in the final rule. 125 Underthe final rule, a broker-dealer cannotstate that it has established andmaintained Internal Control OverCompliance if the internal controls donot provide the broker-dealer withreasonable assurance that non-compliance with the financialresponsibility rules will be prevented ordetected on a timely basis.

The final rule also provides that a broker-dealer is not permitted toconclude that its Internal Control OverCompliance was effective if there wereone or more material weaknesses in itsInternal Control Over Compliance. 126 Amaterial weakness is defined as adeficiency, or a combination of deficiencies, in the broker-dealer’sInternal Control Over Compliance suchthat there is a reasonable possibility 127 that non-compliance with Rule 15c3–1or paragraph (e) of Rule 15c3–3 will not

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


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128 See paragraph (d)(3)(iii) of Rule 17a–5. Seealso 17 CFR 240.12b–2; 17 CFR 210.1–02(a)(4)(providing that a ‘‘[m]aterial weakness means adeficiency, or a combination of deficiencies, ininternal controls over financial reporting . . . suchthat there is a reasonable possibility that a materialmisstatement of the registrant’s annual or interimfinancial statements will not be prevented ordetected on a timely basis.’’).

129 See CAI Letter.

130 See 17 CFR 240.15c3–1(a)(6)(iv)(B), (a)(6)(v),(a)(7)(ii), (a)(7)(iii), (c)(2)(x)(B)( 1), (c)(2)(x)(F)(3)(notification requirements with respect to Rule15c3–1); 17 CFR 240.17a–11(b)–(c) (notificationrequirements with respect to Rule 15c3–1); 17 CFR240.15c3–3(i) (notification requirement in the eventof a failure to make a required deposit to the reserveaccount).

131 See Broker-Dealer Reports, 76 FR at 37577.132 See paragraphs (d)(3)(i)(A)( 1) and (d)(3)(ii) of

Rule 17a–5. As indicated above, the independentpublic accountant is not required to examine thisstatement. See paragraph (g)(2)(i) of Rule 17a–5.

133 See paragraphs (d)(3)(i)(A)( 1) and (d)(3)(ii) of Rule 17a–5.

134 See paragraph (d)(3)(i)(A)( 5) of Rule 17a–5.135 See paragraph (d)(3)(iii) of Rule 17a–5.136 Id. See also PCAOB Auditing Standard, AS

No. 5 app. A, at ¶ A3 (providing that ‘‘[a] deficiencyin internal control over financial reporting existswhen the design or operation of a control does notallow management or employees, in the normalcourse of performing their assigned functions, toprevent or detect misstatements on a timely

basis.’’).137 See paragraph (d)(3)(i)(A)( 2) of Rule 17a–5.138 See CAQ Letter; E&Y Letter; KPMG Letter;

PWC Letter.

basis. 128 A deficiency in InternalControl Over Compliance exists whenthe design or operation of a control doesnot allow the management or employeesof the broker-dealer to prevent or detecton a timely basis non-compliance withthe financial responsibility rules in thenormal course of performing theirassigned functions.

The final amendments reflect severalother key changes from the proposal.For example, one commenter stated thatthe compliance report was overinclusiveand burdensome, and thereforesuggested that the final rule focus on‘‘issues most vital to the financialcondition of the broker-dealer and itscompliance and internal control overcompliance.’’ 129 The final rule requiresa statement as to whether the broker-dealer was in compliance with Rule15c3–1 and paragraph (e) of Rule 15c3–3 as of the end of the most recent fiscalyear and, if applicable, a description of

any instances of non-compliance withthese rules as of the fiscal year end. Thisis a modification from the proposedassertion that the broker-dealer is incompliance with the financialresponsibility rules in all material respects and proposed description of any material non-compliance with thefinancial responsibility rules. Thus, thefinal rule reflects two changes from theproposal: (1) Elimination of theconcepts of ‘‘material non-compliance’’and ‘‘compliance in all materialrespects’’ for the purposes of reportingin the compliance report; and (2) a

narrowing of these statements andrequirements from compliance with allof the financial responsibility rules tocompliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3. In thisway, the final rule more narrowlyfocuses on the core requirements of thefinancial responsibility rules, assuggested by the commenter.

The ‘‘material non-compliance’’ and‘‘compliance in all material respects’’concepts were designed to limit thetypes of instances of non-compliancethat would prevent a carrying broker-dealer from stating that it was incompliance with the financialresponsibility rules. In order to retain alimiting principle, the final rule focuseson provisions that trigger notificationrequirements when they are not

complied with, namely, Rule 15c3–1and the customer reserve requirement inparagraph (e) of Rule 15c3–3. 130 Anyinstance of non-compliance with theserequirements as of the fiscal year endmust be addressed in the compliancereport. As stated in the proposingrelease, failing to maintain the requiredminimum amount of net capital underRule 15c3–1 or failing to maintain theminimum deposit requirement in aspecial reserve bank account underparagraph (e) of Rule 15c3–3 wouldhave been instances of material non-compliance under the proposed rule. 131 Accordingly, under the proposal, a

broker-dealer would have been requiredto describe all instances of non-compliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3. Under theproposal, a broker-dealer also wouldhave been required to describe instancesof material non-compliance with Rule17a–13 and the Account Statement

Rules. The final rule is narrower in thata broker-dealer is only required todescribe instances of non-compliancewith Rule 15c3–1 and paragraph (e) of Rule 15c3–3.

Consistent with these changes, thefinal rule requires a statement as towhether the carrying broker-dealer hasestablished and maintained Internal Control Over Compliance, which isdefined as internal controls that havethe objective of providing the broker-dealer with reasonable assurance thatnon-compliance with the financialresponsibility rules will be prevented ordetected on a timely basis. 132 Thedefinition of Internal Control Over Compliance modifies the proposedstatement that the carrying broker-dealerhas established and maintained asystem of internal control to provide thefirm with reasonable assurance that anyinstances of material non-compliancewith the financial responsibility ruleswill be prevented or detected on atimely basis. 133 Thus, the definitioneliminates the concept of material non-compliance. Similarly, the proposedassertion as to whether the informationused to assert compliance with thefinancial responsibility rules was

derived from the books and records of the carrying broker-dealer has beenmodified to a statement as to whetherthe information used to state whetherthe carrying broker-dealer was incompliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3 wasderived from the broker-dealer’s booksand records. 134

The definition of material weaknesssimilarly has been modified from theproposal. Under the final rule, amaterial weakness would includedeficiencies in internal control relatingto ‘‘non-compliance’’ with Rule 15c3–1or 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 AccountStatement Rules. 135 This modification of the definition of material weakness is

based on the practical difficulties increating a system of control that willeliminate a reasonable possibility of the

occurrence of any instances of non-compliance with certain requirements of the financial responsibility rules. Forexample, the inadvertent failure to sendone account statement out of thousandsof such statements would not constitutenon-compliance to a material extentwith the Account Statement Rulesthough it would be an instance of non-compliance.

Further, and consistent with currentauditing standards, the definition of ‘‘deficiency in internal control’’ in thefinal rule has been modified to includethe phrase ‘‘the management oremployees of the broker or dealer’’ inplace of the phrase ‘‘the broker ordealer.’’ 136

The final rule—substantially asproposed—requires the carrying broker-dealer to state whether its InternalControl Over Compliance was effectiveduring the most recent fiscal year. 137 Some commenters suggested that a

broker-dealer that has remediated amaterial weakness be permitted toprovide an assertion about whether amaterial weakness still exists at the endof the year, instead of having to statewhether internal control was effectiveduring the most recent fiscal year. 138 In

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139 See CAQ Letter; Deloitte Letter; E&Y Letter; McGladrey Letter.

140 See paragraph (d)(3)(i)(A)( 3) of Rule 17a–5.141 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 thatthe registrant’s internal control over financialreporting is effective if there are one or morematerial weaknesses in the registrant’s internalcontrol over financial reporting.’’).

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)( 3) of Rule 17a–5.

145 See paragraph (d)(3)(i)(B) of Rule 17a–5.146 See E&Y Letter.147 See Angel Letter; Deloitte Letter.148 See Broker-Dealer Reports, 76 FR at 37580.149 Id.150 See Deloitte Letter; KPMG Letter; PWC Letter. 151 See 17 CFR 240.17a–3; 17 CFR 240.17a–4.

with the financial responsibility rules,the Commission believes it isappropriate for the broker-dealer’sstatement to address effectiveness of itsInternal Control Over Compliancethroughout the fiscal year.Consequently, the final rule requires thestatement to cover the entire fiscal yearas opposed to the date that is the endof the fiscal year as suggested bycommenters.

However, in response to commentssuggesting that the broker-dealer bepermitted to report the remediation orwhether a material weakness still existsat the end of the year, 139 the final rulealso requires the carrying broker-dealerto state whether its Internal ControlOver Compliance was effective as of theend of the most recent fiscal year. 140 Thus, if there was a material weaknessin the Internal Control Over Complianceof the broker-dealer during the year thathas been addressed such that the broker-

dealer no longer considers there to be amaterial weakness at fiscal year end, thecompliance report would reflect boththe identification of the materialweakness and that its Internal ControlOver Compliance was effective as of theend of the most recent fiscal year,thereby indicating that the materialweakness had been addressed as of thefiscal year end.

Consistent with these changes, thefinal rule provides that the carrying

broker-dealer cannot conclude that itsInternal Control Over Compliance waseffective during the most recent fiscalyear if there were one or more materialweaknesses in Internal Control OverCompliance of the broker-dealer duringthe fiscal year. 141 The final rule adds asimilar provision relating to theeffectiveness of a broker-dealer’sInternal Control Over Compliance at theend of the most recent fiscal year 142 torespond to comments 143 and to alignwith the additional statement discussedabove as to whether the broker-dealer’sInternal Control Over Compliance waseffective as of the end of the fiscalyear. 144

The final rule also retains theproposed requirement that the carrying

broker-dealer provide a description of

each identified material weakness in the broker-dealer’s Internal Control OverCompliance, but, in conformity withother modifications to the proposal, thefinal rule requires that the materialweaknesses include those identifiedduring the most recent fiscal year aswell as those that were identified as of the end of the fiscal year. 145 This changeshould not add a significant burden

because broker-dealers should knowwhether any material weaknessesidentified before year end have beenremediated.

As noted above, one commenterrecommended that the Commissionrequire broker-dealers to document oralguidance obtained through dialoguewith Commission or DEA staff. 146 Whilesuch a requirement was not proposedand is not being adopted in the finalrule, it may be appropriate and prudentfor a broker-dealer to maintaindocumentation in its books and records

of the matters discussed with theCommission or DEA staff, the broker-dealer’s own views and conclusion onthose matters, and any guidancereceived by the broker-dealer.

Also as noted above, two commentersasked the Commission to provideadditional guidance about the controlobjectives that should be met to achieveeffective internal control overcompliance with the financialresponsibility rules. 147 As stated in theproposing release, the control objectivesidentified in the Commission’s guidanceon Rule 206(4)–2 are more general thanthe specific operational requirements inthe financial responsibility rules. 148 Inparticular, broker-dealers are subject tooperational requirements with respect tohandling and accounting for customerassets. 149 Given the specificity of thefinancial responsibility rules, theCommission does not believe thatadditional guidance about the controlobjectives is necessary.

As noted above, several commenterssought assurances that the independentpublic accountant’s examination of thecompliance report would not cover theeffectiveness of internal control overfinancial reporting. 150 The final ruledoes not require that the broker-dealerinclude a statement regarding theeffectiveness of its internal control overfinancial reporting, nor does it requirethat the independent public accountantattest to the effectiveness of internalcontrol over financial reporting. The

requirement in the final rule is for the broker-dealer to state whether itsInternal Control Over Compliance waseffective during the most recent fiscalyear and at the end of the fiscal year andfor the accountant to express an opinion

based on an examination of thosestatements.

A broker-dealer’s Internal ControlOver Compliance is intended to focus,for example, on a broker-dealer’soversight of custody arrangements andprotection of customer assets. Incontrast, internal control over financialreporting is focused on the reliability of financial reporting and the preparationof financial statements in accordancewith GAAP. As stated in the proposingrelease, the Commission did notpropose that effectiveness of internalcontrol over financial reporting beincluded as one of the assertions made

by the broker-dealer in the compliancereport. The Commission intends that thecompliance report should focus onoversight of net capital, custodyarrangements, and protection of customer assets, and therefore, should

be focused on compliance with thefinancial responsibility rules.

Further, the examination of thecompliance report would pertain solelyto certain statements in the compliancereport and not to the broker-dealer’sprocess for arriving at the statements.The report of the independent publicaccountant, based on the examination of the compliance report, requires theaccountant to perform its ownindependent examination of the relatedinternal controls. Consequently, it is notnecessary for the independent publicaccountant to provide an opinion withregard to the process that the broker-dealer used to arrive at its conclusions.

As noted above, commenters soughtclarification of the meaning of ‘‘booksand records’’ as used in the compliancereport statement. The reference inparagraph (d)(3)(i)(A)( 5) of Rule 17a–5to books and records refers to the booksand records a broker-dealer is requiredto make and maintain underCommission rules ( e.g., Rule 17a–3 and

Rule 17a–4).151

4. The Exemption Report—Paragraph(d)(4) of Rule 17a–5i. Proposed Amendments

The Commission proposed that theexemption report must contain anassertion by the broker-dealer that it isexempt from Rule 15c3–3 because itmeets conditions set forth in paragraph(k) of Rule 15c3–3 and ‘‘should identify


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172 See paragraph (d)(1)(i)(B)( 2) of Rule 17a-5. A broker-dealer claiming an exemption from Rule15c3–3 is required to indicate the basis for theexemption on the periodic reports it files withsecurities 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-5.174 See paragraph (d)(4)(ii) of Rule 17a-5. The

proposed rule provided that the broker-dealer mustassert that it is exempt from the provisions of Rule15c3–3 because it meets ‘‘conditions’’ set forth inparagraph (k) and should identify the specific‘‘conditions.’’ See Broker-Dealer Reports, 76 FR at37580–37581.

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 24of Part IIa of the FOCUS Report, which is titled‘‘EXEMPTIVE PROVISION UNDER RULE 15c3–3’’and requires a broker-dealer that claims to beexempt from the requirements of Rule 15c3–3 toidentify the provision in Rule 15c3–3—paragraph(k)(1), paragraph (k)(2)(i), paragraph (k)(2)(ii), orparagraph (k)(3)—under which it is claiming to beexempt. See 17 CFR 249.617.

180

This change also is intended to make clear thatthe broker-dealer can identify the provisions of paragraph (k) of Rule 15c3–3 that the broker-dealeris relying on to claim the exemption by simplyidentifying in the exemption report thesubparagraph in paragraph (k) ( i.e., (k)(1), (k)(2)(i),(k)(2)(ii), or (k)(3)) that contains the particularconditions the broker-dealer is relying on to claimthe exemption rather than repeating the conditionsthemselves in the exemption report. For example,it would be sufficient for a broker-dealer relying onthe exemption provisions in paragraph (k)(2)(ii) of Rule 15c3–3 to identify the provisions in theexemption report under which in claimed anexemption by referring to ‘‘paragraph (k)(2)(ii) of Rule 15c3–3’’ or ‘‘17 CFR 240.15c3–3(k)(2)(ii).’’

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

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 toensure that they do not receive customer securitiesor checks made payable to themselves).

184 See AICPA Broker-Dealer Audit Guide at ¶3.35.

185 See PCAOB Proposing Release app. 2 at ¶ 10.

the most recent fiscal year. 172 Thischange is designed to remove anyambiguity as to when a broker-dealermust file the exemption report asopposed to the compliance report,particularly in situations where the

broker-dealer had exceptions to meetingthe exemption provisions in paragraph(k) of Rule 15c3–3. Consistent with thischange, the final rule requires the

broker-dealer to identify in theexemption report the provisions inparagraph (k) under which it ‘‘claimedthe exemption.’’ 173

Further, as proposed, the broker-dealer would have been required toidentify the exemption ‘‘conditions’’ inparagraph (k) of Rule 15c3–3. 174 The useof the word ‘‘provisions’’ in the finalrule is designed to eliminate a potentialambiguity as to whether the exemptionprovisions in paragraphs (k)(2) and (3)of Rule 15c3–3 applied to the exemptionreport. In particular, paragraph (k) of

Rule 15c3–3 prescribes ‘‘exemptions’’from the requirements of Rule 15c3–3.175 Paragraph (k)(1) provides that therequirements of Rule 15c3–3 do notapply to a broker-dealer that meets allof the ‘‘conditions’’ set forth in theparagraph. 176 Paragraph (k)(2) identifiestwo sets of conditions (without usingthe word ‘‘conditions’’) either of whichexempts a broker-dealer from therequirements of Rule 15c3–3. 177 Paragraph (k)(3) provides that theCommission may exempt a broker-dealer from the provisions of Rule 15c3–3, either unconditionally or on specifiedterms and conditions, if the Commissionfinds that the broker-dealer hasestablished safeguards for the protectionof funds and securities of customerscomparable with those provided for byRule 15c3–3 and that it is not necessaryin the public interest or for theprotection of investors to subject theparticular broker-dealer to theprovisions of Rule 15c3–3. 178 TheCommission intended that a broker-dealer file an exemption report if it isexempt 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 rulerefers to the ‘‘provisions’’ of paragraph(k) of Rule 15c3–3. 179 Consequently, a

broker-dealer filing the exemptionreport must identify the provisions inparagraph (k) that it relied on to claiman exemption from Rule 15c3–3. 180

The third modification designed toaddress commenters’ questions andconcerns about how to handleexceptions to meeting the exemptionprovisions in paragraph (k) of Rule15c3–3 relates to the proposed assertionthat the broker-dealer ‘‘is exempt fromthe provisions’’ of Rule 15c3–3 ‘‘becauseit meets conditions set forth in’’paragraph (k). The final rule providesthat the exemption report must containa statement that the broker-dealer metthe identified exemption provisions inparagraph (k) of Rule 15c3–3 throughoutthe most recent fiscal year without

exception or that it met the identifiedexemption provisions in paragraph (k)of Rule 15c3–3 throughout the mostrecent fiscal year except as described inthe exemption report. 181 Thismodification from requiring the broker-dealer to state an absolute ( i.e., that it isexempt from Rule 15c3–3) allows the

broker-dealer to account for instances inwhich it had exceptions to meeting theexemption provisions in paragraph (k)of Rule 15c3–3 directly in theexemption report (rather than having tofile the compliance report). Specifically,if to the broker-dealer’s best knowledgeand belief, it had no exceptions duringthe most recent fiscal year to theidentified exemption provisions inparagraph (k) of Rule 15c3–3, it muststate in the exemption report that it metthe identified exemption provisions inparagraph (k) without exception.Alternatively, a broker-dealer that had

exceptions must state that it met theidentified exemption provisions exceptas described in the exemption report.

If the broker-dealer states that it hadexceptions ( e.g., exceptions identifiedduring the year, such as through routinemonitoring of its compliance processesas part of the execution of its internalcontrols, internal or external audits, orregulatory examinations), the final rulerequires the firm to identify, to its bestknowledge and belief, each exceptionand briefly describe the nature of theexception and the approximate date(s)on which the exception existed. 182 TheCommission expects that non-carrying

broker-dealers generally trackexceptions as part of monitoringcompliance with the exemptionprovisions in paragraph (k) of Rule15c3–3. 183 Further, a non-carrying

broker-dealer’s adherence to theexemption provisions in paragraph (k)of Rule 15c3–3 generally is a focus of

Commission examiners when theyconduct financial responsibilityexaminations on this class of firm. Forexample, examiners will reviewwhether a non-carrying broker-dealerpromptly forwards checks in accordancewith provisions in paragraph (k) of Rule15c3–3. The Commission also notes thatthe 2011 AICPA Broker Dealer AuditGuide states: ‘‘In auditing the financialstatements of a broker-dealer claimingexemption from SEC Rule 15c3–3, theauditor should determine whether andto what extent the broker-dealercomplied with the specific exemptionduring the audit period as well as thequality of the broker-dealer’s controlsand procedures to ensure ongoingcompliance.’’ 184 In addition, under thePCAOB’s proposed standards, theindependent public accountant shouldinquire of individuals at the broker-dealer who have relevant knowledge of controls relevant to the broker-dealer’scompliance with the exemptionprovisions and who are responsible formonitoring compliance with theexemption provisions whether they areaware of any deficiencies in controlsover compliance or instances of non-compliance with the exemptionconditions. 185 Moreover, in theindependent public accountant’s report,‘‘[i]f the broker’s or dealer’s statement isnot fairly stated, in all material respects,


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186 Id. at ¶ 20.187 See Angel Letter.188 See Item 24 of Part IIa of the FOCUS Report.

189 See Angel Letter. The commenter did notexplain why the exemption report would result inexcessive paperwork. Id. See also discussion belowin section VI.D.1.iii. of this release for the estimatedpaperwork hour burden associated with thisrequirement.

190 See McGladery Letter. The materialinadequacy report—which applied to carrying andnon-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 toPCAOB Standards, PCAOB Release No. 2011–05,PCAOB Rulemaking Docket Matter No. 036 (July 12,2011) (‘‘PCAOB Proposed Auditing Standard for Supplemental Information’’ ).

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 Commissionas a broker-dealer, the FCM must file the report notlater than the time permitted for filing an annualaudit report under Rule 17a–5.

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–5.199 See 17 CFR 240.17a–5(d)(6).200 See Broker-Dealer Reports, 76 FR at 37592.

because of an instance or certaininstances of non-compliance with theexemption conditions, the auditor mustmodify the review report to describethose instances of non-compliance andstate that the broker or dealer is not incompliance with the specifiedexemption conditions.’’ 186

Under the final rule, a non-carrying broker-dealer must identify in theexemption report and describe eachexception during the most recent fiscalyear in meeting the identifiedexemption provisions in paragraph (k)of Rule 15c3–3. The description mustinclude the approximate date(s) onwhich the exception existed. Withoutsuch reporting, the Commission and the

broker-dealer’s DEA would have noinformation to assess the nature, extent,and significance of the exceptions.

As noted above, one commenter askedwhether the exemption report should bereplaced with a box to check on theFOCUS Report, as the amount of paperwork involved for small firms‘‘seems rather excessive.’’ 187 TheCommission does not believe this is anappropriate alternative. First, asindicated above, a broker-dealerclaiming an exemption from Rule 15c3–3 already is required to indicate the

basis for the exemption on its FOCUSReport. 188 Second, the exemption reportrequires the broker-dealer to makecertain statements that the independentpublic accountant must review. Thus,the exemption report will provide astandardized statement across all

broker-dealers claiming an exemptionfrom Rule 15c3–3 for the independentpublic accountant to review. Third, theexemption report will provide theCommission and the broker-dealer’sDEA with more information thancurrently is reported by non-carrying

broker-dealers in the FOCUS Report.Specifically, it requires the broker-dealer to, among other things, stateeither that it met the identifiedexemption provisions in paragraph (k)throughout the most recent fiscal yearwithout exception or that it met theidentified exemption provisionsthroughout the most recent fiscal year

except as described in the report. Thiswill provide the Commission and the broker-dealer’s DEA with information asto whether a broker-dealer is meetingthe exemption provisions of paragraph(k) of Rule 15c3–3 (not simply that the

broker-dealer is claiming the exemptionas is reported in the FOCUS Report).Fourth, requiring that the exemptionreport be filed with the Commission

should increase broker-dealers’ focus onthe statements being made, facilitatingconsistent compliance with theexemption provisions in Rule 15c3–3,and therefore, providing betterprotection of customer assets. Fifth, therequirement to prepare and file theexemption report should not result inexcessive paperwork, as stated by onecommenter. 189 As noted above, one commenterpointed out that the exemption reportrelates solely to Rule 15c3–3 and askedhow the adequacy of a non-carrying

broker-dealer’s internal controls overcompliance with Rule 15c3–1 would beassessed. 190 Under the finalamendments, a broker-dealer’s financialreport will continue to include asupporting schedule containing a netcapital computation under Rule 15c3–1,which will be covered by theindependent public accountant’sexamination of the financial report.

Moreover, the PCAOB has proposedstandards for auditing supplementalinformation accompanying auditedfinancial statements. 191 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 requiredthat the annual audit report be filed notmore than 60 days after the date of thefinancial statements. 192 TheCommission proposed amendingparagraph (d)(5) to replace the termannual audit report with annual reports .193 This change was designed toreflect the fact that, under the proposal,

broker-dealers must file a financialreport, a compliance report orexemption report, and reports prepared

by an independent public accountantcovering these reports. While theCommission did not receive commentson this proposed change, onecommenter stated that the existingrequirement in Rule 17a–5 that theannual audit report be filed 60 daysafter the date of the financial statements

should be lengthened to 90 days. 194 Insupport of this recommendation, thecommenter cited CFTC Rule 1.10, whichallows an FCM up to 90 days to fileannual audit reports. 195

The Commission is adopting, withmodifications, the proposed amendmentto paragraph (d)(5) of Rule 17a–5. 196 The modifications add the term‘‘calendar’’ to make explicit that thetime for filing the annual reports is 60calendar days after the fiscal year end(as opposed to business days). Themodifications replace the words ‘‘dateof the financial statements’’ with thewords ‘‘end of the fiscal year of the

broker or dealer’’ to provide consistencyin the language of Rule 17a–5. 197 Thefinal rule does not change the time limitfor filing the annual reports to 90 daysafter the end of the fiscal year. The 60-day time frame is a long standingrequirement and it provides theCommission and other regulators with

relatively current information to, amongother things, monitor the financialcondition of broker-dealers. Further,

broker-dealers may seek an extension of time to file the annual reports from theirDEAs. 198

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 providedthat the ‘‘annual audit report’’ must befiled at the regional office of theCommission for the region in which the

broker-dealer has its principal place of business, the Commission’s principaloffice in Washington, DC, and theprincipal office of the DEA of the

broker-dealer. 199 Copies were requiredto be provided to all self-regulatoryorganizations (‘‘SROs’’) of which the

broker-dealer is a member.

i. The Proposed AmendmentsThe Commission proposed two

amendments to this provision. First, theCommission proposed that an SRO thatis not a broker-dealer’s DEA could byrule waive the requirement that broker-dealers file annual reports with it

because many SROs do not believe thatit is necessary to receive copies of broker-dealer annual reports if they arenot the broker-dealer’s DEA. 200 The


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217 See McGladrey Letter.218 Several commenters argue that requiring the

annual report to be filed with SIPC wouldcontradict limitations the Supreme Court hasimposed on SIPC’s authority to bring claims againstaccountants. The decisions cited by thesecommenters, however, do not speak to the preciseissue the amended rule is intended, among otherthings, to address—the New York Court of Appeals’decision held that SIPC could not state a cause of action for either fraudulent or negligentmisrepresentation against an auditing firm becauseit was not a recipient of the annual audit report. SeeSIPC v. BDO Seidman, LLP, 746 NE.2d 1042 (N.Y.2001); aff’d, 245 F.3d 174 (2d Cir. 2001). Rather, inHolmes v. Securities Investor Protection

Corporation, the Supreme Court found that thestatutory provision relied on by SIPC, 15 U.S.C.78eee(d), did not, either alone or with the RacketeerInfluenced and Corrupt Organizations Act, conferstanding. 503 U.S. 258, 275 (1992). And, in ToucheRoss & Co. v. Redington, the Supreme Courtdetermined that customers of securities brokeragefirms do not have an implied cause of action fordamages under section 17(a) of the Exchange Actagainst accountants who audit the financial reportsfiled by such firms; thus, SIPC could not assert thisimplied cause of action on behalf of thesecustomers. 442 U.S. 560, 567 (1979). As alreadynoted, the Commission does not intend by thisamendment to take a position on the circumstancesunder which SIPC may have a viable cause of actionagainst an independent public accountant.

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 itsinception through 2001, SIPC initiated 299proceedings under SIPA.

222 See Redington v. Touche Ross & Co., 592 F.2d617 (2d Cir. 1978); In re Bell & Beckwith, 77 B.R.606 (Bkrtcy. N.D. Ohio, 1987); Mishkin v. Peat,Marwick, Mitchell & Co., 658 F.Supp. 271 (S.D.N.Y.1987); SIPC v. BDO Seidman, LLP, 49 F.Supp.2d644 (S.D.N.Y. 1999); In re Donahue Securities Inc.,2004 WL 3152763 (Bkrtcy S.D. Ohio, 2004); In reSIPC v. R.D. Kushnir & Co, 274 B.R. 768 (Bkrtcy.N.D. Ill., 2002); In re Sunpoint Securities, Inc., 377B.R. 513 (Bkrtcy. E.D. Tex., 2007); Compliant at 5–6, Gilbert v. Ohab, Bkrtcy. M.D. Fl. (May 2010) (No.6:08-ap-00145–KSJ); Complaint at 2, Shively v.Mortland, Bkrtcy. D. Co. (Feb. 2004) (No. 03–BK–1102–HRT).

223 See 17 CFR 240.17a–5(e)(1)(i).224 Id.225 See Broker-Dealer Reports, 76 FR at 37593–

37594. The proposed and final amendments toparagraph (f) of Rule 17a–5 are discussed below insection 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 ordealer who files a report which is not covered byan accountant’s opinion shall include in the oathor affirmation required by paragraph (e)(2) of thissection a statement of the facts and circumstancesrelied upon as a basis for exemption from therequirement that financial statements and schedulesfiled pursuant to paragraph (d) of this section becovered by the opinion of an accountant.’’ See 17CFR 240.17a–5(e)(1)(ii). The Commission did notpropose amendments to this subparagraph.However, to be consistent with today’samendments, the Commission is making t echnical

Continued

15c3–3 customer reserve requirementsof broker-dealers, and also include, forcarrying broker-dealers, a compliancereport containing information about the

broker-dealer’s compliance with, andcontrols over compliance with, the

broker-dealer financial responsibilityrules. The annual reports also generallyinclude the independent publicaccountant’s reports covering thefinancial report and compliance reportor exemption report, as applicable,prepared by the broker-dealer. Thisinformation will assist SIPC inmonitoring the financial strength of

broker-dealers and, therefore, inassessing the adequacy of the SIPCFund. 217

In addition, by receiving the annualreports, SIPC may be able to overcomea legal hurdle to pursuing claims againsta broker-dealer’s accountant where theaccountant’s failure to adhere toprofessional standards in auditing a

broker-dealer caused a loss to the SIPCFund. Although this amendment isintended to remove one potential legalhurdle to SIPC actions againstaccountants, the other elements of anyrelevant cause of action would beunaffected. The Commission does notintend by this amendment to take aposition on the circumstances underwhich SIPC may have a viable cause of action against an independent publicaccountant. 218

Several commenters stated that theCommission did not address thepotential costs and benefits of requiring

broker-dealers to file copies of theirannual reports with SIPC, including

potential accounting litigation costs. 219 As discussed below in section VII. of this release, the Commission recognizesthat there may be increased litigationcosts (or reserves for potential litigationcosts) as a result of the amendment andthat to the extent that there are suchcosts, some of them may be passed onto broker-dealers in the form of increased audit fees. But, while thisamendment may facilitate the ability of SIPC to bring actions againstaccountants for malpractice or materialmisrepresentation under state law byremoving one potential legal hurdle tosuch actions, it will not necessarilyresult in a significant increase in suchactions. Generally, SIPC initiates a smallnumber of proceedings each year, andmost of these proceedings have notinvolved a claim against a broker-dealer’s accountant. Specifically, SIPCwas established in 1971. In the period

from 1971–2011, SIPC initiated 324proceedings under SIPA to liquidate afailed broker-dealer. 220 This results inan average of approximately 8 SIPAproceedings per year, though 109 of the324 proceedings were initiated in theperiod from 1971–1974, which was theimmediate aftermath of the financialcrisis of 1968–1970. 221 According toSIPC staff, SIPC has brought 9 lawsuitsagainst accountants since 1971, which isone lawsuit for every 36 SIPAproceedings. 222 Accordingly, thelikelihood of a lawsuit against anaccountant is small and the Commission

anticipates that the overall costs relatedto litigation as a result of the filingrequirement should not be significant.The Commission believes that any suchcosts are justified by the benefits of enhanced customer protection and theassociated ability of SIPC to betterassess the financial condition of broker-

dealers and the adequacy of the SIPCFund.C. The Nature and Form of the Annual Reports

1. Exemptions From AuditRequirement—Paragraph (e)(1) of Rule17a–5

Prior to today’s amendments,paragraph (e)(1)(i) of Rule 17a–5provided, among other things, that theaudit of the broker-dealer’s financialstatements needed to be performed byan accountant that is independent asdefined in paragraph (f) of Rule 17a–5.223 Paragraph (e)(1)(i) also containedprovisions under which certain broker-dealers were not required to engage anaccountant to audit their financialstatements. 224

The Commission proposed amendingparagraph (e)(1)(i) of Rule 17a–5 toremove the words ‘‘An audit shall beconducted by a public accountant whoshall be in fact independent as definedin paragraph (f)(3) of this section herein,and he shall give an opinion coveringthe statements filed pursuant toparagraph (d).’’ This amendment wouldconsolidate the requirements withrespect to the qualifications of theaccountant in paragraph (f) of Rule 17a–5, and paragraph (e)(1)(i) of Rule 17a–5 would address only exemptions fromthe requirement to engage anindependent public accountant to auditthe annual reports prepared by the

broker-dealer. 225 The Commissionreceived no comments on this proposal,

and is adopting it with modifications.226

The modifications: (1) Modernizecertain terms in the rule in a mannerconsistent with the Commission’s‘‘plain English’’ initiative; and (2) cite tothe reports required under ‘‘Rule 17a–5(d)(1)(i)(C)’’ to provide a more precisecross reference than the former citationto reports required under ‘‘Rule 17a–5(d).’’ 227


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amendments to paragraph (e)(1)(ii) of Rule 17a–5 sothat it now provides that ‘‘[a] broker or dealer thatfiles annual reports under paragraph (d) of thissection that are not covered by reports prepared byan independent public accountant must include inthe oath or affirmation required by paragraph (e)(2)of this section a statement of the f acts andcircumstances relied upon as a basis for exemptionfrom the requirement that the annual reports filedunder paragraph (d) of this section be covered byreports prepared by an independent publicaccountant.’’ See paragraph (e)(1)(ii) of Rule 17a–5.

228 See 17 CFR 240.17a–5(e)(2).229 See Broker-Dealer Reports, 76 FR at 37603.230 See IMS Letter.231 See paragraph (e)(2) of Rule 17a–5.232 See IMS Letter.

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’sWeb site. These reports may be accessed via theSearch for Company Filings link under Filings & Forms on the Commission’s home page.

236 The Commission staff has previously postedguidance on the Commission Web site on how torequest confidential treatment for the financialstatements other than the statement of financialcondition. See http://www.sec.gov/divisions/ marketreg/bdnotices.htm .


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 leasttwo potentially pertinent exemptions under whichthe Commission has authority to withhold certaininformation. FOIA Exemption 4 provides anexemption for ‘‘trade secrets and commercial orfinancial information obtained from a person andprivileged or confidential.’’ 5 U.S.C. 552(b)(4). FOIAExemption 8 provides an exemption for matters thatare ‘‘contained in or related to examination,operating, or condition reports prepared by, on

behalf of, or for the use of an agency responsiblefor the regulation or supervision of financialinstitutions.’’ 5 U.S.C. 552(b)(8). However, asdiscussed below, under paragraph (c)(2)(iv) of Rule17a–5, if there are material weaknesses, theaccountant’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 (whichis not being amended today) requires a broker-dealer to furnish to its customers annually a balancesheet with appropriate notes prepared inaccordance with GAAP and which must be auditedif the broker-dealer is required to file auditedfinancial statements with the Commission. See 17CFR 240.17a–5(c)(2)(i).

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.

2. Affirmation—Paragraph (e)(2) of Rule17a–5

Prior to today’s amendments,paragraph (e)(2) of Rule 17a–5 providedthat an oath or affirmation must beattached to the annual audit report that,to the best knowledge and belief of theperson making the oath or affirmation,the financial statements and schedulesare true and correct and, among otherthings, that the oath or affirmation must

be made by the proprietor if a soleproprietorship, by a general partner, if apartnership, or by a duly authorizedofficer, if a corporation. 228 TheCommission proposed amending thefirst sentence of paragraph (e)(2) of Rule17a–5 by adding the word ‘‘financial’’

before the word ‘‘report.’’ 229 TheCommission is adopting thisamendment as proposed.

One commenter stated that currentlyparagraph (e)(2) of Rule 17a–5 does notspecifically cover limited liabilitycompanies, and its reference topartnerships assumes that a generalpartner is a natural person. 230 Thecommenter argued that it should beupdated to conform to generallyaccepted business laws.

In response to this comment, theCommission is adopting amendments toparagraph (e)(2) of Rule 17a–5 thatmodify the proposed amendments. 231 Inparticular, the Commission is addingthat if the broker-dealer is a limitedliability company or limited liabilitypartnership, the oath or affirmationmust be made by the chief executive

officer, chief financial officer, manager,managing member, or any of thosemembers vested with managementauthority for the limited liabilitycompany or limited liabilitypartnership. 232 3. Confidentiality of Annual Reports—Paragraph (e)(3) of Rule 17a–5

Prior to today’s amendments,paragraph (e)(3) of Rule 17a–5 providedthat the financial statements filed underparagraph (d) are public, except that if the Statement of Financial Condition is

bound separately from the balance of the annual audited financial statementsfiled under paragraph (d)(1), the balanceof the annual audited financialstatements will be deemedconfidential. 233 As noted in theproposing release, the wording of thisprovision has led to confusion. 234 Inparticular, Commission staff hasreceived inquiries on how broker-dealers can indicate that they arerequesting confidential treatment for theportion of the financial statementsintended to be kept confidential to theextent permitted by law and, onoccasion, financial statements broker-dealers intended to be confidential areinadvertently made public. 235 Thiscould happen, for example, if a broker-dealer fails to bind the balance sheetseparately from the other portion of thefinancial statements when it files thefinancial statements with theCommission. 236

Consequently, the Commissionproposed amending paragraph (e)(3) of Rule 17a–5 to provide that the annualreports filed pursuant to paragraph (d)are public, except that if the Statementof Financial Condition is boundseparately from the annual report filedpursuant to ‘‘paragraph (d)(2) of Rule17a–5,’’ and each page of the balance of the annual report is stamped‘‘confidential,’’ the balance of theannual report shall be deemedconfidential. 237 The proposed rule textinadvertently referenced only thefinancial report. It was intended that thefinancial report, compliance report,exemption report, and relatedaccountant reports would be treated thesame under paragraph (e)(3) of Rule17a–5. Consequently, the Commission ismodifying the proposed amendment.Specifically, paragraph (e)(3) of Rule17a–5, as adopted, provides that if theStatement of Financial Condition is

bound separately from the balance of the ‘‘annual reports filed underparagraph (d) of this section,’’ and eachpage of the balance of the annual reportsis stamped ‘‘confidential,’’ then the

balance of the annual reports will be

deemed confidential to the extentpermitted by law. 238 Consequently, if the compliance reports and exemptionreports and the related reports of theindependent public accountant aresubmitted in accordance with theprocedures specified in paragraph (e)(3)of Rule 17a–5, these reports will bedeemed confidential to the extentpermitted by law. 239 Prior to today’s amendments,paragraph (e)(3) of Rule 17a–5 alsoprovided that the broker-dealer’sreports, including the confidentialportions, will be available, for example,for official use by any official oremployee of the U.S. and an official oremployee of any national securitiesexchange and registered nationalsecurities association of which the

broker-dealer is a member and ‘‘by anyother person to whom the Commissionauthorizes disclosure of suchinformation as being in the public

interest.’’240

The Commission proposedamending this list of permittedrecipients to include the PCAOB. 241 TheCommission did not receive commentson this proposal and is adopting itessentially as proposed with a minorwording edit for clarity. 242 4. Supplemental Report on SIPCMembership—Paragraph (e)(4) of Rule17a–5

As discussed above in section II.B.6.of this release, SIPC maintains the SIPCFund to be used in liquidations of

broker-dealers under SIPA. The SIPCFund is established and maintainedthrough assessments on broker-dealersthat are required to be members of


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243 Broker-dealers engaged exclusively in the

distribution of mutual fund shares, the sale of variable annuities, the insurance business, thefurnishing of investment advice to investmentcompanies or insurance company separateaccounts, or whose principal business is conductedoutside the U.S. are not required to be members of SIPC. See 15 U.S.C. 78ccc(a)(2)(A)(i)–(iii).

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).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.251 See Broker-Dealer Reports, 76 FR at 37582.252 Id.253 Id.254 Id.255 Id.

256 Id.257 See Broker-Dealer Reports, 76 FR at 37582.

The Commission proposed one modification to theprocedures listed in former paragraph (e)(4)(iii);namely, amending the procedure described inparagraph (e)(4)(iii)(F), which is now renumbered(e)(4)(ii)(6), to change the reference from ‘‘FormSIPC–7’’ to ‘‘Form SIPC–3’’ because the reference toForm SIPC–7 is inaccurate. Id.

258 See CAI Letter; McGladrey Letter.259 See CAI Letter.260 See McGladrey Letter.261 See paragraph (e)(4) of Rule 17a–5.262 See 17 CFR 200.83. Information about how to

request confidential treatment of informationsubmitted 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 5U.S.C. 552 et seq. (Freedom of Information Act—‘‘FOIA’’). FOIA provides at least two pertinentexemptions under which the Commission hasauthority to withhold certain information. FOIAExemption 4 provides an exemption for ‘‘tradesecrets and commercial or financial informationobtained from a person and privileged orconfidential.’’ 5 U.S.C. 552(b)(4). FOIA Exemption8 provides an exemption for matters that are‘‘contained in or related to examination, operating,or condition reports prepared by, on behalf of, orfor the use of an agency responsible for theregulation or supervision of financial institutions.’’5 U.S.C. 552(b)(8).

SIPC. 243 In order to assist in thecollection of assessments from member

broker-dealers, SIPC has promulgatedtwo forms that broker-dealers must filewith SIPC, as applicable: Form SIPC–3and Form SIPC–7. Form SIPC–3 isrequired when a broker-dealer isclaiming an exemption from SIPCmembership ( i.e., when the broker-dealer does not have to pay anassessment). In this case, the broker-dealer must file Form SIPC–3 each yearcertifying that the broker-dealerremained qualified for the exemptionduring the prior year. Form SIPC–7elicits information from a broker-dealerthat is a SIPC member about the broker-dealer’s sources of revenue attributableto its securities business. Every broker-dealer that is a member of SIPC mustfile this form annually.

Prior to today’s amendments,paragraph (e)(4) of Rule 17a–5 providedthat a broker-dealer must file with its

annual report a supplemental report onthe status of the membership of the broker-dealer in SIPC, which wasrequired to be ‘‘covered by an opinionof the independent public accountant’’if the annual report of the broker-dealerwas required to be audited. 244 Amongother things, the supplemental reportneeded to cover the SIPC annual generalassessment reconciliation or exclusionfrom membership forms ( i.e., FormSIPC–7 or Form SIPC–3). 245 Paragraph(e)(4)(iii) of Rule 17a–5 used the terms‘‘review’’ and ‘‘opinion’’ in describingthe accountant’s report that must cover

the supplement report.246

In addition, itrequired that the review by theaccountant include certain minimumprocedures. 247

Under this provision, thesupplemental report did not need to befiled if the SIPC Fund assessments werethe minimum assessment provided forunder SIPA. 248 Between 1996 and 2009,the annual assessment for SIPCmembers remained at the $150minimum assessment level provided forunder SIPA. 249 In 2009, SIPC raised theassessment above the minimum, which

triggered the requirement in paragraph(e)(4) of Rule 17a–5 to file asupplemental report with theCommission, the broker-dealer’s DEA,and SIPC. 250

The Commission stated in theproposing release that, because FormsSIPC–3 and SIPC–7 are used solely bySIPC for purposes of levying itsassessments, the supplemental reportrequired pursuant to paragraph (e)(4) of Rule 17a–5 relating to these formswould be more appropriately filedexclusively with SIPC and that SIPC(rather than the Commission) shouldprescribe by rule the form of thesupplemental report. 251 TheCommission stated that it wouldcontinue to have a role in establishingthe requirements for a supplementalreport because the Commission mustapprove SIPC rules. 252

For these reasons, the Commissionproposed to amend paragraph (e)(4) of

Rule 17a–5 to require that broker-dealers file with SIPC a report on theSIPC annual general assessmentreconciliation or exclusion frommembership forms that contains suchinformation and is in such format asdetermined by SIPC by rule andapproved by the Commission. 253 However, because there would be aninterim period before a rule determined

by SIPC became effective, theCommission proposed amendments toparagraph (e)(4) under which broker-dealers would continue to file asupplemental report with theCommission, the broker-dealer’s DEA,and SIPC until SIPC adopts a rulepursuant to paragraph (e)(4)(i) of Rule17a–5 and the rule is approved by theCommission. 254 Consequently, a broker-dealer would be required to file theSIPC supplemental reports with SIPCusing the existing formats for the reportsuntil the earlier of the Commissionapproving a rule adopted by SIPC or twoyears. If after two years, a rulepromulgated by SIPC has not beenapproved by the Commission, broker-dealers would no longer be required tofile these reports.

Further, to facilitate this change, theCommission proposed to update therule text to conform it to existingprofessional standards and industrypractices. 255 Specifically, theCommission proposed amendingparagraph (e)(4) of Rule 17a–5 toeliminate the ambiguity that stems from

the differing auditing terms used in thatrule by removing all references to‘‘review’’ and ‘‘opinion.’’ 256 In theirplace, the Commission proposed thatthe supplemental report include anindependent public accountant’s report

based on the performance of theprocedures listed in paragraph (e)(4)(iii)of Rule 17a–5, which the Commissiondid not propose to change. 257

The Commission received twocomments relating to the proposedamendments to paragraph (e)(4) of Rule17a–5, both of which supported theproposed change. 258 One commenterindicated that the proposed amendmentwould decrease the burden on broker-dealers associated with filing thesupplemental report with theCommission and the broker-dealer’sDEA.259 In addition, the othercommenter indicated that until thesupplemental reports are filedexclusively with SIPC, they should besubject to confidential treatment. 260

The Commission is adopting theamendments to paragraph (e)(4) of Rule17a–5 as proposed. 261 With respect tothe comment about the Commissionkeeping the supplemental reportconfidential, a broker-dealer can requestconfidential treatment for the report. 262 If such a request is made, theCommission anticipates that it willaccord the supplemental reportconfidential treatment to the extentpermitted by law. 263


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278 Id.279 See Public Company Accounting Oversight

Board; Order Approving Proposed Temporary Rule for an Interim Program of Inspection Related toAudits of Brokers and Dealers, Exchange ActRelease No. 65163 (Aug. 18, 2011), 76 FR 52996(Aug. 24, 2011).

280 See Public Company Accounting Oversight Board; Order Approving Proposed Board Funding Rules for Allocation of the Board’s Accounting Support Fee Among Issuers, Brokers, and Dealers,and Other Amendments to the Board’s Funding Rules, Exchange Act Release No. 65162 (Aug. 18,2011), 76 FR 52997 (Aug. 24, 2011).

281 See PCAOB Proposing Release at 5.282 See PCAOB Proposed Auditing Standard for

Supplemental Information.283 Id. at 3.

284 See Proposed Amendments to Conform theBoard’s Rules and Forms to the Dodd-Frank Act and Make Certain Updates and Clarifications,PCAOB Release No. 2012–002, PCAOB RulemakingDocket Matter No. 039 (Feb. 28, 2012).

285 See 17 CFR 240.17a–5(d).286 See 17 CFR 240.17a–5(g). An engagement to

perform an audit (or examination) of financialstatements is designed to provide reasonableassurance about whether the financial statementsare free of material misstatement. See, e.g., PCAOBInterim Auditing Standard, AU Section 110 at ¶ .02.The term audit is defined in section 110(1) of theSarbanes-Oxley Act, as amended by the Dodd-FrankAct, to mean ‘‘an examination of the financialstatements, reports, documents, procedures,controls, or notices of an issuer, broker, or dealer

by an independent public accountant in accordancewith the rules of the [PCAOB] or the Commission,for the purpose of expressing an opinion on thefinancial statements or providing an audit report.’’

287 See 17 CFR 240.17a–5(j). Prior to today’s

amendments, paragraph (g)(3) of Rule 17a–5describes a material inadequacy in a broker-dealer’saccounting system, internal accounting controls,procedures for safeguarding securities, andpractices and procedures to include any conditionwhich has contributed substantially to or, if appropriate corrective action is not taken, couldreasonably be expected to: (1) Inhibit a broker-dealer from promptly completing securitiestransactions or promptly discharging itsresponsibilities to customers, other broker-dealersor creditors; (2) result in material financial loss; (3)result in material misstatements of the broker-dealer’s financial statements; or (4) result inviolations of the Commission’s recordkeeping orfinancial responsibility rules to an extent that couldreasonably be expected to result in the conditions

described in (1) through (3) above. See 17 CFR240.17a–5(g)(3). In addition to the materialinadequacy report, a broker-dealer was required tofile during certain periods a supplemental reportcovered by an opinion of the independent publicaccountant on the status of the broker-dealer’smembership in SIPC. See 17 CFR 240.17a–5(e)(4).The Commission is amending this requirement asdiscussed above in section II.C.4. of this release.Further, a broker-dealer that computes net capitalunder the alternative model-based standard in

Appendix E to Rule 15c3–1 (17 CFR 240.15c3–1e)is required to file a supplemental report of anindependent public accountant indicating theresults of the accountant’s review of the internalrisk management control system established anddocumented by the broker-dealer in accordancewith Rule 15c3–4 (17 CFR 240.15c3–4). See 17 CFR240.17a–5(k). The Commission is not amending thisrequirement today.

288 See 17 CFR 240.17a–5(g)(1).289 See 17 CFR 240.17a–5(g)(1)(i).290 See 17 CFR 240.17a–5(g)(1)(ii).291 See 17 CFR 240.17a–5(g)(1)(iii). See also 12

CFR 220 et seq. (Regulation T).292 See 17 CFR 240.17a–5(g)(1)(iv).293 See 17 CFR 240.17a–5(g)(1).

guidance also stated that theCommission intended to revisit theinterpretation in connection with arulemaking project to update the auditand related attestation requirementsunder the federal securities laws for

broker-dealers. 278 As discussed below,the Commission is now adoptingamendments to Rule 17a–5 to requirethat audits and attestations of broker-dealer reports filed under Rule 17a–5 bemade in accordance with standards of the PCAOB—the rule as amended doesnot contain references to GAAS.

Since the Commission proposed theseamendments, the PCAOB has taken anumber of actions to implement theexplicit authority over broker-dealeraudits provided to it by the Dodd-FrankAct. For example, on August 18, 2011,the Commission approved two PCAOBrule changes: a temporary PCAOB rulethat established an interim program of inspection of audits of broker-dealers, 279

and a PCAOB rule change providingthat funds to cover the PCAOB’s annual budget be allocated among issuers, brokers, and dealers. 280 In addition, asdiscussed below, subsequent to theCommission’s proposal to amend Rule17a–5, the PCAOB proposed attestationstandards to establish requirements forexamining broker-dealer compliancereports and reviewing broker-dealerexemption reports ‘‘to align itsattestation standards more closely withthe auditor’s responsibilities under [theproposed amendments to Rule 17a–5].’’ 281 The PCAOB concurrentlyproposed an auditing standard forsupplemental informationaccompanying audited financialstatements that would supersede thecurrent standard. 282 The auditingstandard would apply to supportingschedules broker-dealers must fileunder Rule 17a–5, including schedulesregarding the computation of net capitaland the customer reserve requirementand information related to the broker-dealer’s possession or control of customer assets. 283 The PCAOB alsoproposed amendments ‘‘to tailor certain

of its rules to the audits and[independent public accountants] of

broker-dealers.’’ 284 2. Engagement of AccountantRequirements Prior to Today’sAmendments

Rule 17a–5 requires that a broker-dealer prepare and file certain financial

statements and supporting schedules inaddition to the balance sheet andincome statement required undersection 17(e)(1)(A) of the ExchangeAct. 285 Before today’s amendments, thefinancial statements and supportingschedules were generally required to beaudited in accordance with GAAS by anindependent public accountantregistered with the PCAOB. 286

In addition to filing a report of theindependent public accountant coveringthe financial statements and supportingschedules, paragraph (j) of Rule 17a–5required the broker-dealer to file withthe annual audit a supplemental reportprepared by the accountant (‘‘materialinadequacy report’’) that either: (1)Indicated that the accountant did notfind any material inadequacies; or (2)described any material inadequacies ininternal control the accountant foundduring the course of the audit of thefinancial statements and supportingschedules and any corrective actiontaken or proposed by the broker-dealer. 287

For purposes of preparing the materialinadequacy report, paragraph (g)(1) of Rule 17a–5 required that the auditinclude a ‘‘review’’ of the broker-dealer’s accounting system, internalaccounting control, and procedures forsafeguarding securities. 288 Further, theaccountant was required to review thepractices and procedures of the broker-dealer in: (1) Making the periodiccomputations of aggregate indebtednessand net capital under paragraph (a)(11)of Exchange Act Rule 17a–3 and thereserve required by paragraph (e) of Rule 15c3–3; 289 (2) making thequarterly securities examinations,counts, verifications, and comparisonsand the recordation of differencesrequired by Rule 17a–13; 290 (3)complying with the requirement forprompt payment for securities underRegulation T of the Board of Governorsof the Federal Reserve System(‘‘Regulation T’’); 291 and (4) obtaining

and maintaining physical possession orcontrol of all fully paid and excessmargin securities of customers asrequired by Rule 15c3–3. 292 The scopeof the independent public accountant’sprocedures was required to be sufficientto provide ‘‘reasonable assurance’’ thatany material inadequacies existing atthe date of the examination in the

broker-dealer’s accounting system,internal accounting control, andprocedures for safeguarding securities aswell as in the practices and proceduresdescribed in items (1) through (4) abovewould be disclosed. 293

The AICPA Broker-Dealer Audit Guide provided that the materialinadequacy report should address whatthe independent public accountantconcluded in its ‘‘study’’ of theadequacy of the broker-dealer’s


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294 The material inadequacy report is addressedin the AICPA’s Audit & Accounting Guide: Brokersand Dealers in Securities (Sept. 1, 2011 ed.)(‘‘AICPA Broker-Dealer Audit Guide’’ ), whichprovides that the report should: (1) Address whatauditors concluded in their study of the adequacyof the broker-dealer’s practices and procedures incomplying with the Commission’s financialresponsibility rules in relation to the definition of a material inadequacy in Rule 17a–5; and (2)disclose material weaknesses in internal controlover financial reporting (including procedures forsafeguarding securities) that are revealed throughauditing procedures designed and conducted for thepurpose of expressing an opinion on the financialstatements. See AICPA Broker-Dealer Audit Guideat ¶ 3.77. The AICPA Broker-Dealer Audit Guidefurther provides that if conditions believed to bematerial weaknesses are found to exist or haveexisted during the year, the report should disclosethe nature of the weaknesses and the correctiveaction taken or proposed to be taken by the broker-dealer. See AICPA Broker-Dealer Audit Guide at ¶3.80. The AICPA Broker-Dealer Audit Guide alsoprovides sample reports ‘‘on internal controlrequired by SEC Rule 17a–5(g)(1).’’ See AICPABroker-Dealer Audit Guide apps. C, D, and F.

295 See 17 CFR 240.17a–5(g)(2).296 See 17 CFR 240.17a–5(i).297 See 17 CFR 240.17a–5(i)(1).

298 See 17 CFR 240.17a–5(i)(2).299 Id.300 See 17 CFR 240.17a–5(i)(3).301 See 17 CFR 240.17a–5(i)(4).302 See 17 CFR 240.17a–5(i)(5).303 See Broker-Dealer Reports, 76 FR at 37578–

37579. In addition, the Commission proposedchanging the title of paragraph (g) from Audit objectives to Engagement of the independent public accountant. Id. at 37606.

304 Id. at 37578–37579.

305 Id.306

An attest engagement designed to provide ahigh level of assurance is referred to as an‘‘examination.’’ See, e.g., PCAOB InterimAttestation Standard, AT Section 101 at ¶ .54. Forthis type of engagement, the accountant’sconclusion will be expressed in the form of anopinion. For example, the accountant’s conclusion

based on an examination of an assertion could statethat in the accountant’s opinion, [the assertion] isfairly stated in all material respects. See, e.g.,PCAOB Interim Attestation Standard, AT Section101 at ¶ .84. The proposed rule provided that theexamination and related report would apply to the

broker-dealer’s ‘‘assertions’’ in the compliancereport (and therefore would not apply to other itemsin the proposed compliance report; namely, astatement as to whether the broker-dealer hasestablished a system of internal control and adescription of instances of material non-

compliance, and material weaknesses overcompliance with, the financial responsibility rules).307 An attest engagement designed to provide a

moderate level of assurance is referred to as a‘‘review.’’ See, e.g., PCAOB Interim AttestationStandard, AT Section 101 at ¶¶ .55, .89. For thistype of engagement, the accountant’s conclusionwill be expressed, not in the form of an opinion,

but in the form of ‘‘negative assurance.’’ See, e.g.,PCAOB Interim Attestation Standard, AT Section101 at ¶ .68. For example, the accountant’sconclusion based on a review of an assertion couldstate that no information came to the accountant’sattention that indicates that the assertion is notfairly stated in all material respects. See, e.g.,PCAOB Interim Attestation Standard, AT Section101 at ¶ .88.

practices and procedures in complyingwith the financial responsibility rules inrelation to the definition of materialinadequacy as stated in paragraph (g)(3)of Rule 17a–5. 294 The issuance of astudy is relatively unique to broker-dealer audits, however, and whileauditing standards at one time referredto the performance of a study, currentauditing standards no longer containsuch references.

Additional engagement of accountantrequirements prior to today’samendments were set forth inparagraphs (g) and (i) of Rule 17a–5.Paragraph (g)(2) of Rule 17a–5 providedthat, if the broker-dealer was exemptfrom Rule 15c3–3, the independentpublic accountant must ascertain thatthe conditions of the exemption were

being complied with as of theexamination date and that no facts cameto the independent public accountant’sattention to indicate that the exemption

had not been complied with during theperiod since the last examination. 295 Paragraph (i) of Rule 17a–5, before

today’s amendments, was titled,‘‘Accountant’s reports—generalprovisions.’’ 296 Paragraph (i)(1) of Rule17a–5 provided that the accountant’sreport must be dated, signed manually,indicate the city and state where issued,and identify the financial statementsand schedules covered by the report. 297 Paragraph (i)(2) of Rule 17a–5 providedthat the accountant’s report must statewhether the audit was made inaccordance with generally acceptedauditing standards; state whether theaccountant reviewed the proceduresfollowed for safeguarding securities; anddesignate any auditing procedures

deemed necessary by the accountantunder the circumstances of theparticular case which have beenomitted, and the reason for theiromission. 298 Further, the rule providedthat ‘‘[n]othing in this section shall beconstrued to imply authority for theomission of any procedure whichindependent accountants wouldordinarily employ in the course of anaudit made for the purpose of expressing the opinions required under[Rule 17a–5].’’ 299

Prior to today’s amendments,paragraph (i)(3) of Rule 17a–5 providedthat the accountant’s report must stateclearly the opinion of the accountant: (i)with respect to the financial statementsand schedules covered by the report andthe accounting principles and practices;and (ii) as to the consistency of theapplication of the accounting principles,or as to any changes in such principlesthat have a material effect on the

financial statements.300

Paragraph (i)(4)provided that any matters to which theaccountant took exception must beclearly identified, the exceptionspecifically and clearly stated, and, tothe extent practicable, the effect of eachsuch exception on the related financialstatements given. 301 Paragraph (i)(5) of Rule 17a–5 provided that the termsaudit (or examination ), accountant’sreport, and certified have the meaningsgiven in Rule 1–02 of Regulation S–X(17 CFR 210.1–02). 302 3. Amended Engagement of AccountantRequirements

i. Proposed AmendmentsThe Commission proposed to

substantially amend paragraph (g) andremove paragraph (j) of Rule 17a–5, inpart, to update the engagement of theaccountant requirements to addressoutdated or inconsistent terminology inthe rule. 303 The proposed amendmentsto paragraph (g) and removal of paragraph (j) of Rule 17a–5 would haveeliminated the requirement for theaccountant to prepare and the broker-dealer to file a material inadequacyreport. 304 In its place, the independentpublic accountant would have beenrequired to prepare, and the broker-dealer would have been required to file,in addition to a report covering the

financial report, a report covering eitherthe broker-dealer’s compliance report orexemption report, as applicable. 305 Specifically, the Commission proposedto amend paragraph (g) of Rule 17a–5 to

be titled ‘‘Engagement of independentpublic accountant’’ and to require a

broker-dealer required to file annualreports under paragraph (d) of Rule 17a–5 to engage an independent publicaccountant, unless the broker-dealer issubject to the exclusions in paragraphs(d)(1) and (e)(1)(i) of Rule 17a–5. Theindependent public accountant, as partof the engagement, would have beenrequired to undertake to: (1) Prepare areport based on an examination of the

broker-dealer’s financial report inaccordance with standards of thePCAOB; and (2) prepare a report basedon an ‘‘examination’’ of the assertions of the broker-dealer in the compliancereport in accordance with standards of

the PCAOB306

or to prepare a report based on a ‘‘review’’ of the broker-dealer’s exemption report in accordancewith standards of the PCAOB. 307 Thisprovision would have retained therequirement that the financialstatements and supporting schedules beaudited by the independent publicaccountant, so that the accountantwould have continued to be required toobtain ‘‘reasonable assurance’’ aboutwhether they were free of materialmisstatement, but would have changed


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308 See Broker-Dealer Reports, 76 FR at 37606. Asstated above, an engagement to perform an audit of financial statements is designed to provide‘‘reasonable assurance’’ about whether the financialstatements are free of material misstatement. See,e.g., PCAOB Interim Attestation Standard, AT Section 101 at ¶ .54.

309 See PCAOB Proposing Release at 5.310 Id.311 See, e.g., ABA Letter; AICPA Letter; Citrin

Letter; E&Y Letter; Van Kampen/Invesco Letter.312 See Citrin Letter. The Commission also

received many comments seeking additional time totransition to the final rules. Those comments arediscussed below in section V. of this release.

313 See AICPA Letter.314 See Broker-Dealer Reports, 76 FR at 37575.315 See ABA Letter.

316 Id.317 Id. As stated below, AICPA guidance will no

longer be applicable once standards of the PCAOBapply to broker-dealer annual reports.

318 See Grant Thornton Letter.319 See E&Y Letter.320 Id.321 See Citrin Letter.322 See Angel Letter.323 See Deloitte Letter; KPMG Letter; PWC Letter.

the audit standards from GAAS tostandards of the PCAOB. 308

The Commission proposed makingconforming amendments to paragraph(i) of Rule 17a–5, substituting the words‘‘examinations’’ and ‘‘reviews’’ for theword ‘‘audits,’’ substituting the words‘‘standards of the PCAOB’’ for‘‘generally accepted auditingstandards,’’ substituting ‘‘annualreports’’ for ‘‘financial statements,’’ andchanging the title to ‘‘Reports prepared

by the independent public accountant.’’The Commission also proposed deletingparagraph (i)(5) of Rule 17a–5, whichprovided that the terms ‘‘audit,’’‘‘examination,’’ ‘‘accountant’s report,’’and ‘‘certified’’ have the meanings givenin Rule 1–02 of Regulation S–X. Asproposed, paragraph (i)(1) of Rule 17a–5 would have provided that theindependent public accountant’s reportsmust: be dated; be signed manually;indicate the city and state where issued;

and identify without detailedenumeration the items covered by thereports. Paragraph (i)(2) of Rule 17a–5would have provided that theaccountant’s report must state whetherthe examination or review was made inaccordance with standards of thePCAOB and must designate anyexamination, and, if applicable, reviewprocedures deemed necessary by theindependent public accountant underthe circumstances of the particular casethat have been omitted, and the reasonfor their omission. Further, the rulewould have provided that ‘‘[n]othing inthis section shall be construed to implyauthority for the omission of anyprocedure that independent publicaccountants would ordinarily employ inthe course of an examination or reviewmade for the purpose of expressing theopinions or statement required under[Rule 17a–5].’’ Paragraph (i)(3) of Rule17a–5 would have provided that theindependent public accountant’s reportsmust state clearly the opinion of theindependent public accountant: (i) withrespect to the financial report and theaccounting principles and practicesreflected therein and the compliancereport; and (ii) with respect to the

financial report, as to the consistency of the application of the accountingprinciples, or as to any changes in suchprinciples that have a material effect onthe financial statements. Paragraph (i)(4)of Rule 17a–5 would have provided thatany matters to which the independent

public accountant takes exception must be clearly identified, the exceptionthereto specifically and clearly stated,and, to the extent practicable, the effectof each such exception on any relateditems contained in the annual reports.

As stated above, after the Commissionproposed the amendments to Rule 17a–5, the PCAOB issued proposedstandards that ‘‘would establishrequirements for examining theassertions in a broker’s or dealer’scompliance report and reviewing a

broker’s or dealer’s assertion in theexemption report.’’ 309 The PCAOBstated that the proposed standards were‘‘tailored to the requirements’’ in Rule17a–5 as proposed to be amended by theCommission. 310

ii. CommentsThe Commission received several

comments regarding the proposedrevisions to the independent accountant

engagement requirements in Rule 17a–5. 311 One commenter stated that GAASshould be used for audits of non-carrying broker-dealers; or, in thealternative, that the Commission shoulddelay the effective date for therequirement that the audit be conductedin accordance with PCAOB standardsfor smaller broker-dealers until one yearafter the approval of theamendments. 312 A second commenterstated that PCAOB standards shouldapply only for broker-dealers‘‘permanently subject to PCAOBinspection’’ and that the Commissionshould not require that audits of broker-dealers be performed in accordancewith PCAOB standards for non-issuer

broker-dealers until the PCAOBdetermines which non-issuer broker-dealers will be subject to its permanentinspection program. 313

One commenter noted that theproposing release states that broker-dealers will be required to file a report

by the accountant that ‘‘addresses’’ theassertions in the compliance report, 314 and stated that the Commission shouldprovide more guidance on what anaccountant must address, as ‘‘nowherein the Release or in the proposed rulesis there guidance as to what ‘addresses’means or entails.’’ 315 This commenterfurther stated that the Commission

‘‘presumably’’ will rely on PCAOBrules, and suggested that final rulesregarding the accountant’s obligationswith respect to its examination of thecompliance report should be deferreduntil after a comment period of at least60 days after the PCAOB rules arefinalized or the Commission amends itsproposal to include specifics as to what‘‘address’’ means and what type of review is required by the accountant. 316 The commenter also stated that therequirement should not be effectiveunless the AICPA Broker-Dealer Audit Guide is revised and updated. 317 Onecommenter asked what was expected of the auditor with respect to the booksand records assertion and stated that aseparate opinion on this assertion mayentail more detailed procedures as tothe source of the information. 318

Another commenter stated that areview engagement should not beemployed for the exemption report

because inquiry and observation wouldnot provide sufficient evidenceregarding a broker-dealer’s assertion thatit is exempt from the requirements of Rule 15c3–3 and stated that, under thePCAOB’s interim attestation standards,an auditor should not accept anengagement to perform a ‘‘review’’ levelof service related to an entity’scompliance with specified requirementsor an assertion with regard to thatcompliance. 319 As an alternative, thiscommenter suggested an ‘‘agreed-uponprocedures’’ approach addressing theresults of procedures specified by theCommission or the performance of anexamination engagement if suitablecriteria were developed. 320 Anothercommenter stated that the benefit of receiving an audit report covering theexemption report would not justify thecost. 321 Similarly, a commenter statedthat the exemption report should bereplaced with a box to check on theFOCUS Report as the auditor attestationprovided no added benefit. 322

Several commenters urged theCommission to clarify the interaction

between material weaknesses in internalcontrol over financial reporting andmaterial weaknesses in internal control

over compliance with the financialresponsibility rules. 323 One commenterstated that due to the reliance placed onthe financial books and records to


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324 See Van Kampen/Invesco Letter.325 Id.326 Id.327 See SIFMA letter.328 See CAI Letter.

329 As discussed above in section II.B.3. of thisrelease, the final rule does not use the termassertion—the assertions contained in the proposalare now referred to as statements. These changes arenot intended to be substantive. Paragraph (g) of Rule 17a–5 specifies that the accountant prepare areport based on an examination of certainstatements enumerated in the rule. Similar to theproposal, the statements subject to the examination

do not include a statement as to whether the broker-dealer has established a system of internal controlor a description of instances of non-compliancewith certain financial responsibility rules.

330 See AICPA Letter; Citrin Letter.331 See Public Law 111–203 §982. For example,

section 982(a) of the Dodd-Frank Act added section110 to the Sarbanes-Oxley Act, which containsdefinitions of terms such as audit, audit report, and

professional standards. These definitions apply toaudits, audit reports, and professional standardswith respect to audits of broker-dealers as well asaudits of issuers. In addition, section 982(b) of theDodd-Frank Act amended section 101 of theSarbanes-Oxley Act to substitute the words‘‘issuers, brokers, and dealers’’ for the word‘‘issuers.’’

332 See Custody of Funds or Securities of Clientsby Investment Advisers, 75 FR at 1460.

333 See Temporary Rule for an Interim Program of Inspection Related to Audits of Brokers and Dealers, PCAOB Release No. 2011–001, PCAOBRulemaking Docket Matter No. 32, 1 (June 14,2011).

334 See PCAOB Proposed Auditing Standard for Supplemental Information.

335 Id. at 2–3.336 See PCAOB Proposing Release at 5.337 See AICPA Letter.

calculate net capital, it will not befeasible to attest to the effectiveness of internal control over the financialresponsibility rules without alsoattesting to internal control overfinancial reporting. 324 The commenterstated that, accordingly, it is necessaryto include internal control overfinancial reporting within the scope of the rule. The commenter stated itsunderstanding that accountants expectto include internal control overfinancial reporting in their attestationscope over the financial responsibilityrules, and that the process will includedocumenting all existing processes andengaging internal audit to validate theeffectiveness of the proceduresimplemented through proceduralwalkthroughs and control testing tovalidate management’s assertions. 325 This commenter also stated its belief that independent public accountantswill need ‘‘to include an attestation of

the additional in scope processes withinthe scope of their audit work in order tocomply with PCAOB requirements.’’ 326

As noted above in section II.B.4.ii. of this release, with respect to theindependent public accountant’s reviewof the exemption reports, onecommenter stated that, for example, a

bank or clerical error that results in a broker-dealer that operates under anexemption to Rule 15c3–3 finding itself in possession of customer assetsovernight once during the fiscal yearshould not ‘‘warrant the ‘materialmodification’ of a broker-dealer’sExemption Report.’’ 327 Anothercommenter noted that ‘‘to consider asingle instance of a broker-dealer failingto promptly forward a customer’ssecurities as an instance that wouldnecessitate a material modificationcreates an unworkable standard.’’ 328 iii. The Final Rule

The Commission is adoptingamendments to the engagement of theaccountant requirements in Rule 17a–5substantially as proposed, except forrevisions, as discussed in detail below,to clarify the rule’s requirements and tomake technical changes. Paragraph (g) of Rule 17a–5 as adopted provides that theindependent public accountant engaged

by the broker-dealer to provide reportson the financial report and either thecompliance report or exemption reportmust, as part of the engagementundertake to: (1) Prepare a report basedon an examination of the broker-dealer’s

financial report in accordance withstandards of the PCAOB; and (2) preparea report based on an examination of certain enumerated statements of the

broker-dealer in the compliancereport 329 in accordance with standardsof the PCAOB or prepare a report basedon a review of the statements in the

broker-dealer’s exemption report inaccordance with standards of thePCAOB. Additionally, as proposed, theamendments delete paragraph (j) of Rule17a–5, which, as explained above,required that the broker-dealer file withthe annual audit report a materialinadequacy report, as well as provisionsin paragraph (g) of Rule 17a–5 requiringthat the audit be conducted inaccordance with GAAS and addressingthe accountant’s review for materialinadequacies.

Various commenters suggested thatGAAS instead of PCAOB standardsshould apply for engagements of

accountants with respect to certain broker-dealer reports, such as reports of non-carrying broker-dealers. 330 TheCommission believes that requiringGAAS for audits of broker-dealers thatare exempt from Rule 15c3–3 would not

be consistent with the provisions of theDodd-Frank Act that provide thePCAOB with explicit authority toestablish standards with regard to auditsof broker-dealer reports filed with theCommission. 331 These provisions enablethe PCAOB to exercise its standard-setting authority over audits of broker-dealers registered with the Commission.The change from GAAS to PCAOBauditing standards will facilitate theCommission’s regulatory oversightauthority because the Commission hasdirect oversight authority over thePCAOB, including the ability to approveor disapprove the PCAOB’s rules andstandards. The Commission also has

greater confidence in the quality of audits conducted by an independentpublic accountant registered with, andsubject to regular inspection by, thePCAOB. 332 Further, as the PCAOBdevelops and implements an inspectionprogram of broker-dealer audits ascontemplated by the Dodd-Frank Act,that program will include inspection of,among other things, ‘‘registered publicaccounting firms’ current compliancewith laws, rules, and standards inperforming audits of brokers anddealers.’’ 333 The requirement that all

broker-dealer independent publicaccountants comply with the standardsestablished by the PCAOB shouldfacilitate the development andimplementation of its permanentinspection program, as contemplated bythe Dodd-Frank Act.

As noted above, the PCAOB hasproposed an auditing standard forsupplemental information

accompanying audited financialstatements, including the supportingschedules broker-dealers must file aspart of the financial report. 334 ThePCAOB stated that a primary factor thatled it to reexamine its requirementsregarding supplemental information wasthe Commission’s proposal to amendthe reporting requirements of Rule 17a–5.335 In addition, as noted above, thePCAOB has proposed specificattestation standards for examiningcompliance reports and reviewingexemption reports. The PCAOB’sproposing release noted that the

proposed standards ‘‘are tailored to therequirements in SEC Proposed Rule17a–5.’’ 336 The proposed standards, if adopted, would establish a single and

broker-dealer-specific approach toexamining compliance reports andreviewing exemption reports. Thisshould provide greater clarity as toprocedures an independent publicaccountant should use in examining acompliance report and reviewing anexemption report.

With respect to comments suggestingthat PCAOB standards should applyonly to auditors of broker-dealers‘‘permanently subject to PCAOBinspection,’’ 337 the PCAOB has notexempted the audits by independent


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366 See PCAOB Interim Attestation Standard, AT Section 201 at ¶ .03.

367 See E&Y Letter.368 See Citrin Letter.369 See Angel Letter.370 See 17 CFR 240.17a–5(g)(2).

371 See CAI Letter; SIFMA letter.372 See PCAOB Interim Attestation Standard, AT

Section 101 at ¶ .90. See also PCAOB Proposing Release app. 2 at ¶ 11 (‘‘The auditor shouldevaluate the identified instances of non-compliancewith the exemption conditions to determine

whether the instances of non-compliance,individually or in combination, cause the broker’sor dealer’s assertion not to be fairly stated, in allmaterial respects. If the broker’s or dealer’sassertion is not fairly stated, in all material respects,the auditor should: (a) Modify the review report. . . and (b) evaluate the effect of the matter on theaudit of the financial statements and supplementalinformation.’’).

373 See PCAOB Interim Attestation Standard, AT Section 101 at ¶ .67 (stating that in expressing itsconclusion, an independent public accounting‘‘should consider an omission or a misstatement to

be material if the omission or misstatement—individually or when aggregated with others—issuch that a reasonable person would be influenced

by the omission or misstatement.’’). 374 Id. at ¶¶ .68, .88.

engaged by a client to issue a report of findings based on specific proceduresperformed on subject matter that thespecified parties believe areappropriate. 366 Additionally, in an‘‘agreed-upon procedures’’ engagement,the independent public accountant doesnot perform an examination or a review,and does not provide an opinion ornegative assurance. Thus, no conclusionwould be rendered as to the broker-dealer’s statement that it met certainexemption provisions in Rule 15c3–3.

In addition to the commenteradvocating an ‘‘agreed-uponprocedures’’ standard, 367 a secondcommenter stated that the cost ‘‘wouldnot justify the need’’ for an audit reportcovering the exemption report 368 and athird commenter stated that theexemption report should be replacedwith a box to check on the FOCUSReport as the auditor attestation

provided no added benefit.369

Inresponse to all these comments, theCommission notes that previously Rule17a–5 required that if a broker-dealer isexempt from Rule 15c3–3, theindependent public accountant isrequired to ascertain whether theconditions of the exemption were beingcomplied with and that no facts came tothe accountant’s attention to indicatethat the exemption had not beencomplied with. 370 Consequently, therule previously required theindependent public accountant to reacha conclusion with respect to a broker-

dealer’s claimed exemption from Rule15c3–3. The Commission believes thatthe rule should continue to require aconclusion from the independent publicaccountant on the broker-dealer’sclaimed exemption from Rule 15c3–3

because of the importance of safeguarding customer securities andcash. Consequently, the Commissiondoes not believe that it would beappropriate to use a lower standard ( i.e.,the agreed-upon procedures standard) orto have no requirement for theindependent public accountant toperform any work with respect to the

exemption report. Moreover, becausethe independent public accountant waspreviously required to render aconclusion with respect to the broker-dealer’s claimed exemption from Rule15c3–3, the exemption report reviewshould not result in significant

incremental cost over the existingrequirement.

As noted above, two commentersraised concerns that minor exceptions tomeeting the exemption provisions of paragraph (k) of Rule 15c3–3 couldresult in the independent publicaccountant becoming aware of materialmodifications that should be made tothe statement in the exemptionreport. 371 Under PCAOB standards forattestation engagements, theindependent public accountant’s reviewreport on a statement in an exemptionreport would be required to include astatement about whether the accountantis aware of any material modificationsthat should be made to the statement inthe exemption report in order for it to

be fairly stated in all materialrespects. 372 As discussed above insection II.B.4.iii. of this release, theexemption report requirements have

been modified from the proposal so that

a broker-dealer must either state that itmet the identified exemption provisionsin paragraph (k) throughout the mostrecent fiscal year without exception orthat it met the identified exemptionprovisions throughout the most recentfiscal year except as described in thereport. Consequently, a broker-dealerthat had exceptions will state that factin the exemption report and describethe exceptions. Under PCAOBstandards, if the statement is fairlystated in all material respects, includingdescriptions of any exceptions, the

broker-dealer’s independent publicaccountant would not need to state thatthe accountant is aware of any materialmodifications that should be made tothe statement. 373

The Commission did not receivecomments regarding the proposedamendments to paragraph (i) of Rule17a–5. However, the final rule has beenrevised from the proposal for clarity andconsistency with the other amendments

to Rule 17a–5. The title of the rule has been modified from the proposal to adda citation for clarity. As adopted, thetitle is, ‘‘Reports of the independentpublic accountant required underparagraph (d)(1)(i)(C) of [Rule 17a–5].’’As adopted, paragraph (i)(1) of Rule17a–5 provides, as proposed, that theindependent public accountant’s reportsmust: Be dated; be signed manually;indicate the city and state where issued;and identify without detailedenumeration the items covered by thereports.

Paragraph (i)(2) of Rule 17a–5, asadopted, is also consistent with theproposal except that the word‘‘Identify’’ is substituted for the word‘‘Designate’’ for clarity and the phrase‘‘opinions or conclusions’’ is substitutedfor the phrase ‘‘opinions or statement’’

because as explained above, consistentwith auditing standards, a reviewengagement will not result in an

opinion, but in the accountant’sconclusion in the form of ‘‘negativeassurance’’—for example, a conclusionthat no information came to theaccountant’s attention that indicatesthat a statement is not fairly stated in allmaterial respects. 374 The rule thereforeprovides that the independent publicaccountant’s reports must: (i) Statewhether the examinations or review, asapplicable, were made in accordancewith standards of the PCAOB; (ii)identify any examination and, if applicable, review procedures deemednecessary by the independent public

accountant under the circumstances of the particular case that have beenomitted and the reason for theiromission. The rule also provides that:‘‘[n]othing in this section may beconstrued to imply authority for theomission of any procedure thatindependent public accountants wouldordinarily employ in the course of anexamination or review made for thepurpose of expressing the opinions orconclusions required under [Rule 17a–5].’’

Paragraph (i)(3) of Rule 17a–5, asadopted, is re-organized for clarity.Specific reference has been added tothose statements in the compliancereport that the accountant mustexamine, consistent with otheramendments to Rule 17a–5 ( e.g., theamendments to paragraph (g)(2)(i) of Rule 17a–5 regarding the engagement of the accountant to prepare a report basedon the examination of specifiedstatements in the compliance report). Inaddition, a subparagraph is added toinclude a reference to the exemption


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375 As proposed, paragraph (i)(3) did not containa reference to the exemption report. See Broker-Dealer Reports, 76 FR at 37607. The final rulemakes clear that the auditor’s conclusion must beincluded in the independent public accountant’sreport covering the exemption report.

376 As noted above, the accountant’s conclusion

in an examination engagement will be expressed inthe form of an opinion. For example, theaccountant’s conclusion based on an examination of an assertion could state that in the accountant’sopinion, the assertion is fairly stated in all materialrespects. See, e.g., PCAOB Interim AttestationStandard, AT Section 101 at ¶ .84. The accountant’sconclusion in a review engagement will beexpressed, not in the form of an opinion, but in theform of ‘‘negative assurance.’’ See, e.g., PCAOBInterim Attestation Standard, AT Section 101 at ¶.68. For example, the accountant’s conclusion basedon a review of an assertion could state that noinformation came to the accountant’s attention thatindicates that the assertion is not fairly stated in allmaterial respects. See, e.g., PCAOB InterimAttestation Standard, AT Section 101 at ¶ .88.

377 See 17 CFR 240.17a–5(f)(1).378 See 17 CFR 240.17a–5(f)(3).379 See Broker-Dealer Reports, 76 FR at 37593–

37594.380 Id.

381 Id.382 See paragraph (f)(1) of Rule 17a–5. The

Commission has revised paragraph (f)(1) of Rule17a–5 from the proposal to: Change the title from‘‘Qualification of accountants’’ to ‘‘Qualifications of independent public accountant;’’ and deleting thewords ‘‘in addition.’’

383 See 17 CFR 210.2–01.384 See Strengthening the Commission’s

Requirements Regarding Auditor Independence,Exchange Act Release No. 47265 (Jan. 28, 2003), 68FR 6006 (Feb. 5, 2003). See also Auditor Independence: SEC Review of Auditor Independence Rules, NASD Notice to Members 02–19 (Mar. 2002).

385 See 17 CFR 210.2–01(b).386 See 17 CFR 210.2–01, Preliminary Note 2.

report. 375 The rule provides that theindependent public accountant’s reportsmust state clearly: (i) The opinion of theindependent public accountant withrespect to the financial report requiredunder paragraph (d)(1)(i)(A) of Rule17a–5 and the accounting principlesand practices reflected in that report; (ii)the opinion of the independent publicaccountant with respect to the financialreport required under paragraph(d)(1)(i)(A) of Rule 17a–5, as to theconsistency of the application of theaccounting principles, or as to anychanges in those principles, that have amaterial effect on the financialstatements; and (iii) either (A) theopinion of the independent publicaccountant with respect to thestatements required under paragraphs(d)(3)(i)(A)(2), (3), (4), and ( 5) of Rule17a–5 in the compliance report requiredunder paragraph (d)(1)(i)(B)( 1) of Rule17a–5, or (B) the conclusion of the

independent public accountant withrespect to the statements required underparagraphs (d)(4)(i), (ii), and (iii) of Rule17a–5. The specific references to thecompliance report and exemption reportin paragraph (i)(3) are intended toprovide a complete description of whatmust be contained in the report of theindependent public accountant undercurrent attestation standards, whichrequire a conclusion in the case of anexamination to be expressed in the formof an opinion and a conclusion in thecase of a review that is not expressed inthe form of an opinion, but in the formof ‘‘negative assurance.’’ 376

Paragraph (i)(4) of Rule 17a–5 has been modified from the proposal to adda reference to paragraph (d) to make itmore clear that the annual reportsreferenced in the paragraph are thefinancial report, compliance report, andexemption report prescribed inparagraph (d). In addition—in the

interest of using ‘‘plain English’’ in theCommission’s rules—the word ‘‘must’’has been substituted for the word‘‘shall’’ and the word ‘‘thereto’’ has beeneliminated. The rule as adoptedtherefore provides that ‘‘[a]ny matters towhich the independent publicaccountant takes exception must beclearly identified, the exceptions must

be specifically and clearly stated, and,to the extent practicable, the effect of each such exception on any relateditems contained in the annual reportsrequired under paragraph (d) of [Rule17a–5] must be given.’’

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

Prior to today’s amendments,paragraph (f)(1) of Rule 17a–5 was titled‘‘Qualification of accountants’’ andprovided that: ‘‘The Commission willnot recognize any person as a certified

public accountant who is not dulyregistered and in good standing as suchunder the laws of his place of residenceor principal office.’’ 377 Paragraph (f)(3)of Rule 17a–5 provided that theaccountant ‘‘shall be independent inaccordance with the provisions of § 210.2–01 (b) and (c) of this chapter’’and, paragraph (e)(1)(i) of Rule 17a–5provided that the accountant ‘‘shall bein fact independent as defined inparagraph (f)(3) of this section.’’ 378

As discussed above, section17(e)(1)(A) of the Exchange Act, asamended by the Dodd-Frank Act,requires registered broker-dealers toannually file financial statements withthe Commission certified by ‘‘anindependent public accounting firm, or

by a registered public accounting firm if the firm is required to be registeredunder the Sarbanes-Oxley Act of 2002.’’Accordingly, the Commission proposedamending paragraph (f)(1) to providethat: ‘‘The independent publicaccountant must be qualified andindependent in accordance with§ 210.2–01 of this chapter and, inaddition, the independent publicaccountant must be registered with thePublic Company Accounting OversightBoard if required by the Sarbanes-OxleyAct of 2002.’’ 379 The Commissionfurther proposed deleting theaccountant independence language inparagraph (e)(1)(i) of Rule 17a–5. 380 Inaddition, the Commission proposeddeleting paragraph (f)(3) and re-designating paragraph (f)(4) as

paragraph (f)(3). 381 These proposedamendments to paragraph (f) of Rule17a–5 would consolidate the provisionsof paragraphs (e)(1)(i), (f)(1), and (f)(3) of Rule 17a–5 into paragraph (f)(1) andmake Rule 17a–5 consistent with otherCommission requirements governing thequalifications of accountants. TheCommission received no comments onthese proposals and is adopting themsubstantially as proposed. 382

Although the underlyingindependence requirements have notchanged, broker-dealers and theirindependent public accountants arereminded that they must comply withthe independence requirements of Rule2–01 of Regulation S–X. 383 As a resultof the Sarbanes-Oxley Act of 2002, Rule2–01 of Regulation S–X wasstrengthened, including increasedrestrictions on the provision of certainnon-audit services to an audit client. 384

Under the Commission’s rules, anaccountant will not be recognized asindependent with respect to an auditclient if the accountant is not, or areasonable investor with knowledge of all relevant facts and circumstanceswould conclude that the accountant isnot, capable of exercising objective andimpartial judgment on all issuesencompassed within the accountant’sengagement. In determining whether anaccountant is independent, theCommission will consider all relevantcircumstances, including allrelationships between the accountantand the audit client, and not just thoserelating to reports filed with theCommission. 385 The standard ispredicated largely on whether arelationship or the provision of aservice: (1) Creates a mutual orconflicting interest between theaccountant and the audit client; (2)places the accountant in the position of auditing his or her own work; (3) resultsin the accountant acting as managementor an employee of the audit client; or (4)places the accountant in a position of

being an advocate for the audit client. 386 Further, Rule 2–01 of Regulation S–X

sets forth a non-exclusive specification


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387 See 17 CFR 210.2–01(c).388 See 17 CFR 210.2–01(c)(4)(i).389 See 15 U.S.C. 78j–1.390 See 17 CFR 210.2–01(c)(7).391 See 17 CFR 210.2–01(c)(2).392 See 17 CFR 240.17a–11.393 See 17 CFR 240.17a–11(b)(1).

394 See, e.g., 17 CFR 240.15c3–1(a)(6)(iv)(B); 17CFR 240.15c3–1(a)(6)(v); 17 CFR 240.15c3–1(a)(7)(ii); 17 CFR 240.15c3–1(c)(2)(x)(C)( 1); 17 CFR240.15c3–1(e); 17 CFR 240.15c3–1d(c)(2); 17 CFR240.15c3–3(i).

395 See 17 CFR 240.15c3–3(i).396 See 17 CFR 240.17a–5(h)(2).397 Id.398 Id.


400 Id. at 37579.401 Id.402 Id.403 Id.404 Id. Rule 206(4)–2 provides, in pertinent part,

that upon finding any ‘‘material discrepancies’’during the ‘‘surprise’’ examination of an investmentadviser to verify client funds and securities, theindependent public accountant must notify theCommission within one business day. 17 CFR275.206(4)–2(a)(4)(ii).

405 See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter; SIFMALetter; Van Kampen/Invesco Letter.

406 See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter; VanKampen/Invesco Letter.

of circumstances that are inconsistentwith the general standard. For example,the accountant is prohibited fromproviding the following non-auditservices, among others, to an auditclient: 387

• Bookkeeping or other servicesrelated to the accounting records orfinancial statements of the audit client;

• Financial information systemsdesign and implementation; and• Management functions or human

resources.With respect to bookkeeping or other

services related to the accountingrecords or financial statements of theaudit client, Rule 2–01(c)(4)(i) of Regulation S–X specifies that theseservices include: (1) Maintaining orpreparing the audit client’s accountingrecords; (2) preparing financialstatements that are filed with theCommission or the information thatforms the basis of financial statementsfiled with the Commission; or (3)preparing or originating source dataunderlying the audit client’s financialstatements. 388

Not all of the independencerequirements in Rule 2–01 of RegulationS–X that are applicable to audits of issuers are applicable to engagementsunder Rule 17a–5. Specifically, auditorsof broker-dealers are not subject to thepartner rotation requirements or thecompensation requirements of theCommission’s independence rules

because the statute mandating thoserequirements is limited to issuers. 389 Additionally, auditors of broker-dealers

are not subject to the audit committeepre-approval requirements 390 or thecooling-off period requirements foremployment 391 because thoserequirements only reference issuers.F. Notification of Non-Compliance or Material Weakness

As discussed in detail below, theCommission is amending thenotification provisions in Rule 17a–5and amending Rule 17a–11 to align thatrule with the amendments to Rule 17a–5. Under Rule 17a–11, a broker-dealermust provide notice to the Commissionand its DEA in certain circumstances. 392 For example, paragraph (b)(1) of Rule17a–11 requires a broker-dealer to givenotice if its net capital declines belowthe minimum amount required underRule 15c3–1. 393 Rule 15c3–1 and Rule15c3–3 also require broker-dealers to

provide notification in certaincircumstances. 394 For example,paragraph (i) of Rule 15c3–3 requires acarrying broker-dealer to immediatelynotify the Commission and its DEA if itfails to make a deposit into its customerreserve account as required byparagraph (e) of Rule 15c3–3. 395

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

Prior to today’s amendments,paragraph (h)(2) of Rule 17a–5 providedthat if, during the course of the audit orinterim work, the independent publicaccountant determined that any‘‘material inadequacies’’ existed, thenthe independent public accountant wasrequired to inform the chief financialofficer (‘‘CFO’’) of the broker-dealer,who, in turn, was required to give noticeto the Commission and the broker-dealer’s DEA within 24 hours inaccordance with the provisions of Rule17a–11. 396 The rule also provided thatthe broker-dealer must furnish theindependent public accountant with thenotice, and if the independent publicaccountant failed to receive the noticewithin the 24 hour period, or if theaccountant disagreed with anystatements contained in the notice, theindependent public accountant wasrequired to inform the Commission andthe DEA within the next 24 hours. 397 Inthat event, the independent publicaccountant was required to describe anymaterial inadequacies found to exist or,if the broker or dealer filed a notice, the

independent public accountant wasrequired to detail the aspects of the broker-dealer’s notice with which theindependent public accountant did notagree. 398

i. The Proposed Amendments

The proposed amendments to Rule17a–5 would have replaced referencesto material inadequacies, including thematerial inadequacy report, with arequirement applicable to carrying

broker-dealers to identify an instance of ‘‘material non-compliance’’ with thefinancial responsibility rules and any

material weakness in internal controlover compliance with the financialresponsibility rules in the compliancereport and the requirement to engage anindependent public accountant to

examine the compliance report. 399 Consistent with those proposedchanges, the Commission proposedamending the notification provisions of paragraph (h)(2) of Rule 17a–5 toreplace the term ‘‘material inadequacy’’with the term ‘‘material non-compliance,’’ which would result in arequirement to notify the Commissionupon the discovery by the accountantduring the course of preparing a report

based on an examination of thecompliance report of an instance of material non-compliance as that termwas proposed to be defined under theamendments. 400

The Commission also proposedamending provisions regarding thenotification process. 401 Under theproposal, the accountant would have

been required to notify the Commissionand the broker-dealer’s DEA directly. 402 In the proposing release, theCommission stated that it preliminarily

believed these changes would providemore effective and timely notice of

broker-dealer compliance deficienciesand enable the Commission to reactmore quickly to protect customers andothers adversely affected by thosedeficiencies. 403 The amendments alsowould have been consistent with thenotification requirement in Rule 206(4)–2 that is triggered in the context of a‘‘surprise’’ examination of aninvestment adviser. 404

ii. Comments Received

The Commission received numerouscomments in response to thisproposal. 405 Most of these commentersobjected to the proposed notificationprocess. 406 Among the reasons givenwere that it would be inappropriate torequire the accountant to notify theCommission and the DEA directly,

because, among other things, the broker-dealer is principally responsible forcompliance with the securities laws,


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407 See Deloitte Letter.408 See KPMG Letter. See also PCAOB Interim

Attestation Standard, AT Section 101 at ¶ .13.409 See PWC Letter. See also PCAOB Interim

Attestation Standard, AT Section 101 at ¶¶ .11–.13.410 See E&Y Letter.411 See, e.g., ABA Letter; E&Y Letter; McGladrey

Letter.412 See Van Kampen/Invesco Letter.413 See KPMG Letter.414 See ABA Letter.415 See paragraph (h) of Rule 17a–5.416 As the proposal noted, the proposed

amendment to require the independent publicaccountant to notify the Commission directly of material non-compliance would have beenconsistent with the surprise examinationnotification requirement in Rule 206(4)–2 under theAdvisers Act. A surprise examination of aninvestment adviser by an independent publicaccountant generally verifies that client funds andsecurities of which the investment adviser hascustody are held by a qualified custodian, such asa bank or broker-dealer. The accountant’s surpriseexamination report opines on the adviser’scompliance with the custody rule requirement that

client funds and securities are maintained by aqualified custodian and also opines on the adviser’scompliance with certain recordkeeping obligations

between surprise examinations. The difference innature and scope of custodial and other activities

between broker-dealers and advisers results insignificantly broader examination requirements for

broker-dealers. Broker-dealers are required toundergo an annual examination by an independentpublic accountant of their financial statements andcertain supporting schedules: A computation of netcapital under Rule 15c3–1, a computation fordetermining reserve requirements under Rule 15c3–

3, and information relating to the possession andcontrol requirements of Rule 15c3–3. Moreover,under today’s amendments, the independent publicaccountant must examine the compliance report of

broker-dealers that maintain custody of customerfunds or securities. The differences in the overallnature of an examination also supports continuingto maintain today’s model under which a broker-dealer has the primary notification obligation ( e.g.,unlike in the case of a surprise examination of aninvestment adviser, a broker-dealer would already

be making its own assessment and preparing itsown report in the case of a compliance reportexamination). Further, the Dodd-Frank Actprovided the PCAOB with explicit authority to,among other things, establish (subject toCommission approval) auditing and relatedattestation, quality control, ethics, andindependence standards for registered public

accounting firms with respect to their preparationof audit reports to be included in broker-dealerfilings with the Commission, and the authority toconduct and require an inspection program of registered public accounting firms that audit broker-dealers. The PCAOB oversight of broker-dealerexaminations provides additional regulatoryoversight with respect to the examination of the

broker-dealer further supporting the retention of theprimary obligation with the broker-dealer toprovide notice to the Commission and the broker-dealer’s DEA.

417 Id. Under the current provisions of paragraph(h) of Rule 17a–5 (which are being amended), theindependent public accountant ‘‘shall call it to theattention’’ of the CFO of the broker-dealer anymaterial inadequacies. See 17 CFR 240.17a–5(h)(2).In the final rule, the independent public accountantis required to ‘‘immediately notify’’ the CFO of the

‘‘nature’’ of any non-compliance with the financialresponsibility rules or material weakness. Thischange from the current notification requirement isdesigned to make the rule more clear as ‘‘shall callit to the attention’’ does not specify when thenotification must be given. Further, as proposed,the independent public accountant would have

been required to provide the Commission withnotice of any material non-compliance within one

business day of determining that the material non-compliance exists. See Broker-Dealer Reports, 76 FRat 37606. Under the final rule, the independentpublic accountant provides notice to the broker-dealer’s CFO of any non-compliance with thefinancial responsibility rules or material weaknessand the CFO, in turn, is required to provide theCommission and other securities regulators with

notice if the non-compliance requires notice underRule 15c3–1, Rule 15c3–3, or Rule 17a–11 or in thecase of a material weakness. Consequently, becausethere is an intermediate step before the Commissionreceives notice, it is important that the independentpublic accountant notify the CFO immediately sothat the Commission and other securities regulatorsreceive timely notice.

418 See Broker-Dealer Reports, 76 FR at 37606.

including timely notification; 407 thatPCAOB standards provide that ‘‘thepractitioner should not take on the roleof the responsible party;’’ 408 and thatPCAOB attestation standards (whichwere referenced in the proposingrelease) clearly provide thatmanagement is responsible for thesubject matter to which it is asserting,and not the accountant. 409 In addition,one commenter stated that alignment of notification procedures (that is, torequire the accountant to notify theCommission directly) between Rule17a–5 and Rule 206(4)–2 is notnecessary, given the other auditing andreporting responsibilities in place orproposed. 410 In addition to suggestionsthat the notification process that existedprior to today’s amendments should not

be changed, 411 one commenter statedthat the rule should requiresimultaneous notice by the accountantto the Commission and to the firm’s

management.412

In addition, one commenter askedwhether the notification provisionsapply to a review of the exemptionreport. 413 Another commenter statedthat a report of non-compliance alsowill trigger a Rule 17a–11 notice, whichwould be duplicative and createconfusion. 414 iii. The Final Rule

In part in response to commentsreceived, and to achieve consistencywith other revisions to the proposedrule amendments described above, thenotification provisions in the final rulehave been modified from the proposedamendments. 415 First, the Commissionis persuaded by comments received thatthe primary obligation to notify theCommission should remain with the

broker-dealer. 416 Therefore, the

notification process in place beforetoday’s amendments generally has beenretained.

Second, the final rule amendmentsrequire that, if the independent publicaccountant determines that the broker-dealer ‘‘is not in compliance with’’ anyof the financial responsibility rulesduring the course of preparing theaccountant’s reports, the independentpublic accountant must immediatelynotify the broker-dealer’s CFO of thenature of the non-compliance. 417 As

proposed, the independent publicaccountant would have been required toprovide notification if the accountantdetermined that any ‘‘material non-compliance’’ existed. As discussedabove in section II.D.3. of this release,the final rule does not include adefinition of the term material non-compliance, as in the proposal. Thus,the independent public accountant will

be required to provide notification tothe broker-dealer of all instances of non-compliance with the financialresponsibility rules as opposed to theproposal, which required theindependent public accountant to reportto the Commission and the DEA onlyinstances of material non-compliance.While this may increase the number of times the independent publicaccountant must provide notification of non-compliance with the financialresponsibility rules, the independentpublic accountant will not have to

analyze whether an instance of non-compliance is ‘‘material non-compliance’’ under the proposeddefinition.

If the independent public accountantprovides notice to the broker-dealer of an instance of non-compliance with thefinancial responsibility rules, the

broker-dealer must provide notice to theCommission and its DEA in accordancewith the notification provisions of Rule15c3–1, Rule 15c3–3, or Rule 17a–11,

but only if the notice provided by theindependent public accountantconcerns an instance of non-compliance

that requires the broker-dealer toprovide notification under those rules.The proposal would have required theaccountant to notify the Commission‘‘upon determining that any materialnon-compliance exists.’’ 418 Rule 15c3–1, Rule 15c3–3, and Rule 17a–11 specifyinstances of non-compliance thatrequire notification by the broker-dealer,and paragraph (h) of Rule 17a–5, asamended, refers to the notificationprovisions in those rules.

The broker-dealer must provide acopy of the notification to theaccountant within one business day

and, if the accountant does not receivethe notice or the accountant does notagree with any statements in the notice,the accountant must provide a report tothe Commission and the broker-dealer’s


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419 See paragraph (h) of Rule 17a–5.420 Id.421 Id.422 Paragraph (b)(1) of Rule 17a–11 provides,

among other things, that every broker-dealer whosenet capital declines below the minimum amountrequired pursuant to Rule 15c3–1 shall give noticeof such deficiency that same day in accordancewith paragraph (g) of Rule 17a–11 and that thenotice shall specify the broker-dealer’s net capitalrequirement and its current amount of net capital.See 17 CFR 240.17a–11(b)(1). Paragraph (g) of Rule17a–11 provides, among other things, that thenotice shall be given or transmitted to the principaloffice of the Commission in Washington, DC, theregional office of the Commission for the region inwhich the broker-dealer has its principal place of

business, the DEA of which such broker-dealer isa member, and the CFTC if the broker-dealer isregistered as a futures commission merchant with

such Commission, and that the notice shall be givenor transmitted by telegraphic notice or facsimiletransmission. See 17 CFR 240.17a–11(g). Paragraph(i) of Rule 15c3–3 provides that if a broker-dealershall fail to make a reserve bank account or specialaccount deposit, as required by Rule 15c3–3, the

broker-dealer shall by telegram immediately notifythe Commission and the regulatory authority for the

broker-dealer, which examines such broker-dealeras to financial responsibility and shall promptlythereafter confirm such notification in writing. See17 CFR 240.15c3–3(i). The Commission staff isconsidering ways to modernize the process bywhich broker-dealers file these and other noticeswith the Commission.

423 See note to paragraph (h) of Rule 17a–5, asadopted.

424 See paragraph (h) of Rule 17a–5.425 See paragraph (e) of Rule 17a–11.426 See paragraph (h) of Rule 17a–5.

427 See paragraph (h) of Rule 17a–5; 17 CFR240.17a–11(g).

428 See paragraph (h) of Rule 17a–5.429 Id.430 Id.431 One change from the current rule (which is

being amended) is to provide that required actions be completed within ‘‘one business day’’ asopposed to within a ‘‘24 hour period.’’ This changeis designed to account for non-business days duringwhich certain actions may not be feasiblycompleted.

432 See KPMG Letter.433 See paragraph (h) of Rule 17a–5.

DEA within one business day. 419 Thereport from the accountant must, if the

broker-dealer failed to file a notification,describe any instances of non-compliance that required the broker-dealer to provide a notification. 420 If the

broker-dealer filed a notification but theindependent public accountant does notagree with the statements in the notice,the report from the accountant mustdetail the aspects of the notification of the broker-dealer with which theaccountant does not agree. 421 Thisnotification process is generally thesame as that in place before today’samendments.

While the final rule incorporates theexisting notification process, theCommission wants to emphasize theimportance of broker-dealers providingnotification to the Commission andother securities regulators of non-compliance with Rule 15c3–1 asrequired by Rule 17a–11 and non-

compliance with paragraph (e) of Rule15c3–3 as required by paragraph (i) of Rule 15c3–3. 422 Consequently, theCommission is adding a note toparagraph (h) of Rule 17a–5 calling theattention of the broker-dealer andindependent public accountant to thesenotification requirements. 423 Further, animportant element of this process is the

back-up provided by the independentpublic accountant in terms of theobligation under the rule to provide theCommission and DEA with notificationof the instance of non-compliance if the

accountant does not receive a copy of the broker-dealer’s notification or theaccountant does not agree with thestatements in the notification.Therefore, of necessity, the independentpublic accountant would have to havemeasures in place to determine whether,and if so when, the accountant receiveda copy of the notification required to beprovided by the broker-dealer to theCommission or the broker-dealer’s DEA.An independent public accountantcould decide not to rely solely on thereceipt of a copy of the notice from the

broker dealer and take other steps tocheck whether the broker-dealerprovided notice to the Commission andthe DEA, such as obtaining a copy of afacsimile transmission from the broker-dealer to the Commission and DEA.

Third, the proposal has been modifiedto add that, if the accountant determinesin connection with the audit of acarrying broker-dealer’s annual reports

that any material weakness (as definedin paragraph (d)(3)(iii) of Rule 17a–5)exists, the independent publicaccountant must immediately notify the

broker-dealer’s CFO of the nature of thematerial weakness. 424 As discussedabove, before today’s amendments,paragraph (h)(2) of Rule 17a–5 requiredthe accountant to notify the broker-dealer’s CFO if the accountantdetermined that any ‘‘materialinadequacies’’ existed. However, asexplained above in section II.B.3. of thisrelease, the final rules do not containthe concept of material inadequacy.Also, as the term material weakness isdefined with respect to the compliancereport, this notification requirementonly applies to carrying broker-dealers,whereas the requirement to providenotification of a material inadequacyapplied to carrying and non-carrying

broker-dealers.As discussed in more detail below in

section II.F.2. of this release, theCommission is amending Rule 17a–11to provide that a broker-dealer mustprovide notification to the Commissionand its DEA if the broker-dealerdiscovers, or is notified by itsindependent public accountant, of the

existence of a material weakness.425

Paragraph (h) of Rule 17a–5, as statedabove, requires that the independentpublic accountant notify the broker-dealer if the accountant determines thata material weakness exists. 426 The rulealso requires the broker-dealer toprovide notice in accordance with theprovisions of Rule 17a–11, which,among other things, require the broker-

dealer to provide notice to theCommission and its DEA in accordancewith paragraph (g) of Rule 17a–11within 24 hours and transmit a reportwithin 48 hours of the notice statingwhat the broker-dealer has done or isdoing to correct the situation. 427 Paragraph (h) of Rule 17a–5 requires the

broker-dealer to provide the accountantwith a copy of the notice it sends to theCommission within one business dayand, if the accountant does not receivethe notice or the accountant does notagree with the statements in the notice,the accountant must provide a report tothe Commission and the broker-dealer’sDEA within one business day. 428 Thereport from the accountant must, if the

broker-dealer failed to file a notification,describe any material weakness. 429 If the broker-dealer filed a notification andthe accountant does not agree with thestatements in the notification, the reportfrom the accountant must detail the

aspects of the notification of the broker-dealer with which the accountant doesnot agree. 430 Again, this notificationprocess is generally the same as the onein place before today’s amendments. 431 In response to the comment that the ruleshould require simultaneous notice bythe accountant to the Commission andto the firm’s management, thenotification procedures adopted todayrequire that the accountant notifymanagement of the broker-dealer andalso ensure that the Commissionreceives timely notice.

As stated above, one commenterasked whether the notificationprovisions apply to a review of anexemption report. 432 The notificationprovisions in paragraph (h) of Rule 17a–5 with respect to non-compliance withthe financial responsibility rules applyregardless of whether the independentpublic accountant is engaged to preparea report based on examination of a

broker-dealer’s compliance report or areview of a broker-dealer’s exemptionreport. 433 An independent publicaccountant may determine that a broker-dealer is not in compliance with arequirement in the financialresponsibility rules ( e.g., not in

compliance with Rule 15c3–1) during


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434 See ABA Letter.435 See 17 CFR 240.17a–11(e).436 See Broker-Dealer Reports, 76 FR at 37579.

Rule 17a–12 contains reporting requirements forover-the-counter (‘‘OTC’’) derivatives dealers. See17 CFR 240.17a–12. The rule is similar to Rule 17a–5. Compare 17 CFR 240.17a–12, with 17 CFR240.17a–5. For example, paragraph (h)(2) of Rule17a–12 describes material inadequacies andparagraph (i)(2) of Rule 17a–12 provides that if theaccountant determines that any materialinadequacy exists, the accountant must call it to theattention of the CFO of the OTC derivatives dealer,who must inform the Commission. See 17 CFR240.17a–12(h)(2) and (i). The Commission did notpropose amending Rule 17a–12. Consequently, Rule17a–12 retains the concept of material inadequacy.

437 See Deloitte Letter.438 See paragraph (e) of Rule 17a–11. As stated

above, this provision only applies to broker-dealersthat file compliance reports, as the tern materialweakness is defined with respect to the compliancereport.

439 See 17 CFR 240.17a–5(c).440 17 CFR 240.17a–5(c)(2).441 17 CFR 240.17a–5(c)(3).442 See 17 CFR 240.17a–5(c)(5). See also Broker-

Dealer Exemption from Sending Certain Financial Information to Customers, Exchange Act ReleaseNo. 48282 (Aug. 1, 2003), 68 FR 46446 (Aug. 6,2003).

443 These practices and procedures include, forexample, periodic net capital computations underRule 15c3–1 and periodic counts of securities underRule 17a–13.

the course of an audit engagement of anon-carrying broker-dealer that files anexemption report either as part of theexamination of the broker-dealer’sfinancial statements or the review of certain statements the broker-dealer’sexemption report. In this case, theindependent public accountant wouldneed to immediately notify the CFO of the broker-dealer of the nature of thenon-compliance. The notificationprovisions with respect to an instance of material weakness only apply to broker-dealers that file a compliance report

because material weakness is definedfor purposes of the compliance report.

The rule as amended does not requirethe accountant to notify the Commissiondirectly when the accountantdetermines that a non-compliance withthe financial responsibility rules exists,which eliminates the concern of acommenter that a report of non-compliance by the accountant, as

proposed, would also trigger a Rule17a–11 notice, which would beduplicative and create confusion. 434 Asadopted, the responsibility to providenotification rests with the broker-dealerin the first instance.

2. Conforming and TechnicalAmendments to Rule 17a–11

Before today’s amendments,paragraph (e) of Rule 17a–11 providedthat whenever a broker-dealerdiscovered, or was notified by anindependent public accountant,pursuant to paragraph (h)(2) of Rule17a–5 or paragraph (f)(2) of Rule 17a–12of the existence of any materialinadequacy as defined in paragraph (g)of Rule 17a–5 or paragraph (e)(2) of Rule17a–12, the broker-dealer was requiredto give notice to the Commission within24 hours of the discovery or notificationand transmit a report to the Commissionwithin 48 hours of the notice statingwhat the broker-dealer has done or wasdoing to correct the situation. 435 TheCommission proposed amendingparagraph (e) of Rule 17a–11 to deletethe references to Rule 17a–5 and tocorrect the references to Rule 17a–12. 436

One commenter stated that thecurrent notification process underparagraph (h)(2) of Rule 17a–5 andparagraph (e) of Rule 17a–11 satisfiesthe objective of notifying theCommission in a timely manner andthat the commenter was concerned thatthe proposal could undermine theeffectiveness of the notification processin part because it would require noticeto the Commission only when theaccountant determines that there is adeficiency, and not when it isindependently discovered by the broker-dealer. 437

The Commission agrees with thecommenter that notification should beprovided to the Commission when adeficiency in internal control isdiscovered by the broker-dealer, inaddition to when it is notified by itsaccountant of the existence of anymaterial weakness. Therefore, the finalrule retains references to Rule 17a–5 inparagraph (e) of Rule 17a–11. TheCommission is conforming paragraph (e)of Rule 17a–11 to today’s amendmentsto Rule 17a–5 to substitute the termmaterial weakness as defined inparagraph (d)(3)(iii) of Rule 17a–5 forthe term material inadequacy withrespect to Rule 17a–5 and to replace thereference to paragraph (h)(2) of Rule17a–5 with a reference to paragraph (h)of Rule 17a–5. Specifically, the finalrule provides that whenever a broker-dealer discovers, or is notified by itsaccountant under paragraph (h) of Rule17a–5 of the existence of any material

weakness, the broker-dealer must: (1)Give notice of the material weaknesswithin 24 hours of the discovery ornotification; and (2) transmit a reportwithin 48 hours of the notice statingwhat the broker or dealer has done oris doing to correct the situation. 438 Therule retains a reference to materialinadequacy as defined in paragraph(h)(2) of Rule 17a–12, but theamendments correct citations to thatrule.

G. Other Amendments to Rule 17a–5

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

Paragraph (c) of Rule 17a–5 generallyrequires a broker-dealer that carriescustomer accounts to send its balancesheet with appropriate notes and certainother financial information to each of its

customers twice a year. 439 TheCommission did not propose to amendthis requirement. Accordingly, a broker-dealer that carries customer accountsmust continue to send its customers: (1)An audited balance sheet withfootnotes, including a footnotespecifying the amount of the broker-dealer’s net capital and required netcapital, under paragraph (c)(2) of Rule17a–5; 440 and (2) an unaudited balancesheet dated six months after the date of the audited balance sheet withfootnotes, including a footnote regardingthe amount of the broker-dealer’s netcapital and required net capital, underparagraph (c)(3) of Rule 17a–5. 441 Theinformation required by paragraphs(c)(2) and (c)(3) of Rule 17a–5 musteither be mailed to customers, or, if the

broker-dealer meets certain conditionsunder paragraph (c)(5) of Rule 17a–5,the broker-dealer can semi-annuallysend its customers summaryinformation regarding its net capital, aslong as it also provides customers witha toll-free number to call for a free copyof its balance sheet with appropriatenotes, makes its balance sheet withappropriate notes available to customerson its Web site, and meets otherspecified requirements. 442

ii. Availability of Independent PublicAccountant’s Comments on MaterialInadequacies—Paragraph (c)(2) of Rule17a–5

Prior to today’s amendments,paragraph (c)(2)(iii) of Rule 17a–5provided that if, in conjunction with a

broker-dealer’s most recent audit report,the broker-dealer’s independent publicaccountant commented on any materialinadequacies in the broker-dealer’sinternal controls, its accounting system,or certain of its practices andprocedures 443 under paragraphs (g) and(h) of Rule 17a–5, and paragraph (e) of Rule 17a–11, the broker-dealer’s auditedstatements sent to customers wererequired to include a statement that acopy of the auditor’s comments wereavailable for inspection at theCommission’s principal office inWashington, DC, and the regional officeof the Commission in which the broker-


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444 See 17 CFR 240.17a–5(c)(2)(iii).445 See Broker-Dealer Reports, 76 FR at 37579.446 This proposal would have been codified in

paragraph (c)(2)(iv) of Rule 17a–5 as a result of paragraph (c)(2)(iii) being removed and paragraph(c)(2)(iv) being redesignated as paragraph (c)(iii).See Broker-Dealer Reports, 76 FR at 37603.

447 See ABA Letter; CAI Letter; Deloitte Letter.448 Id.449 See ABA Letter.450 See paragraph (c)(2)(iv) of Rule 17a–5.

451 Id.452 Paragraph (c)(2)(iv) of Rule 17a–5, as adopted,

includes both the principal office of theCommission in Washington, DC and the regionaloffice of the Commission for the region in which a

broker-dealer has its principal place of business aslocations where the accountant’s reports areavailable. Including the applicable regional office of the Commission as a location where these noticesare available will make them more accessible tocustomers and is consistent with the previoustreatment of material inadequacy reports.

453 17 CFR 240.17a–5(c)(5).454 See Broker-Dealer Reports, 76 FR at 37577.455 See ABA Letter; CAI Letter; SIFMA Letter.456 See ABA Letter.457 See CAI Letter. This commenter stated that as

FINRA has proposed that broker-dealers sendcustomer account statements monthly instead of quarterly, broker-dealers are already potentiallyfacing ‘‘extremely high’’ costs of sendinginformation to customers. FINRA withdrew itsproposals to send customer account statementsmonthly instead of quarterly on July 30, 2012. SeeProposed Rule Change to Adopt FINRA Rule 2231(Customer Account Statements) in the Consolidated FINRA Rulebook, File No. SR–2009–028, (July 30,2012), available at http://www.finra.org/web/ groups/industry/@ip/@reg/@rulfil/documents/ rulefilings/p143262.pdf (withdrawal of proposedrule change).

dealer had its principal place of business. 444

As discussed above in sections II.D.3.and II.F. of this release, the Commissionproposed deleting references to, and thedefinition of, the term materialinadequacy in Rule 17a–5, andproposed amending paragraph (h) of Rule 17a–5 to require a broker-dealer’sindependent public accountant to notifythe Commission and the broker-dealer’sDEA if the accountant determined thatany material non-compliance existed atthe broker-dealer during the course of preparing its reports. 445 Consequently,the Commission proposed replacingparagraph (c)(2)(iii) of Rule 17a–5,which contained the term materialinadequacies, with a requirement that, if a broker-dealer’s accountant providednotice to the Commission of an instanceof material non-compliance, thefinancial information sent to customersunder paragraph (c)(2) of Rule 17a–5

must include a statement that a copy of the accountant’s notice was available forcustomers’ inspection at the principaloffice of the Commission inWashington, DC. 446 Under thisproposal, notices to the Commissionregarding an accountant’s determinationthat one or more instances of materialnon-compliance existed at a broker-dealer would be publicly available.

Three commenters responded to theproposed amendments to paragraph(c)(2) of Rule 17a–5. 447 Thesecommenters each stated that theCommission should accord confidentialtreatment to accountants’ notices to theCommission regarding determinationsof material non-compliance. 448 Onecommenter stated that due to thetechnical nature of the financialresponsibility rules, there was a risk thatnotices of material non-compliancecould be misinterpreted by the mediaand others. 449

The Commission is revising itsproposal to amend paragraph (c)(2) of Rule 17a–5 to be consistent with thenew notification provisions inparagraph (h) described above relatingto the identification by a broker-dealer’saccountant of a material weaknessrather than an instance of material non-compliance. 450 Specifically, if, inconnection with the most recent annual

reports, the report of the independentpublic accountant covering the broker-dealer’s compliance report identifies amaterial weakness, the broker-dealermust include a statement that one ormore material weaknesses have beenidentified and that a copy of the reportof the independent public accountant iscurrently available for the customer’sinspection at the principal office of theCommission in Washington, DC, and theregional office of the Commission forthe region in which the broker-dealerhas its principal place of business. 451

In response to commenters’ concernsabout making the report of material non-compliance available to the public, thereport that now will be made publiclyavailable is a report that identifies theexistence of a material weakness—not areport of material non-compliance. Inaddition, making the report of theindependent public accountant coveringthe compliance report publicly available

if it identifies the existence of a materialweakness is consistent with theprevious treatment of a report of amaterial inadequacy. Providingcustomers notice of an accountant’sfinding that goes directly to thefinancial and operational condition of their broker-dealer and making thereport containing the finding publiclyavailable will make available tocustomers information that facilitatestheir ability to make more informeddecisions in selecting broker-dealersthrough which they prefer to conduct

business. For these reasons, the finalrule does not accord confidentialtreatment to a report of an independentpublic accountant covering thecompliance report if it identifies amaterial weakness as some commenterssuggested should be the case withrespect to the proposed—but notadopted—report of material non-compliance. Consequently, anindependent public accountant’s reportcovering the compliance report will bemade available for the customer’sinspection at the principal office of theCommission in Washington, DC, and theregional office of the Commission forthe region in which the broker-dealer

has its principal place of business if thereport identifies the existence of amaterial weakness. 452

iii. Exemption From Mailing FinancialInformation to Customers—Paragraph(c)(5) of Rule 17a–5

Before today’s amendments,paragraph (c)(5) of Rule 17a–5 provideda conditional exemption from therequirement that a broker-dealer sendpaper copies of financial information to

customers if the broker-dealer mailed tocustomers a financial disclosurestatement with summary informationand an Internet link to its balance sheetand other information on the broker-dealer’s Web site. 453 One of theconditions of the exemption, containedin paragraph (c)(5)(vi) of Rule 17a–5,was that the broker-dealer was notrequired by paragraph (e) of Rule 17a–11 to give notice of a materialinadequacy during the prior year. TheCommission proposed revising thecondition in paragraph (c)(5)(vi) of Rule17a–5 to provide that the broker-dealer’sfinancial statements must receive anunqualified opinion from theindependent public accountant andneither the broker-dealer, underproposed paragraph (d) of Rule 17a–5,nor the independent public accountant,under proposed paragraph (g) of Rule17a–5, identified a material weakness oran instance of material non-compliance. 454

The Commission received severalcomments on the proposal. 455 Onecommenter stated that broker-dealersshould be able to deliver the financialinformation available to customers viaits Web site regardless of whether aninstance of material non-compliance ormaterial weakness was identified. 456 Another commenter stated that the ruleshould not require a 100% rate of compliance with the financialresponsibility rules to qualify for theexemption. 457 A third commenter statedthat the proposed amendment should beeliminated, or replaced with therequirement that broker-dealers includea notice of the material weakness ornon-compliance on customer account


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458 See SIFMA Letter.459 See Broker-Dealer Reports, 76 FR at 37593. As

discussed above in section II.B.6. of this release, theCommission is amending paragraph (d)(6) of Rule17a–5 to require that a copy of a broker-dealer’sannual report must be filed with SIPC. Specifically,the Commission is amending paragraph (d)(6) toprovide that a broker-dealer’s annual reports ‘‘must

be filed at the regional office of the Commission forthe region in which the broker or dealer has itsprincipal place of business, the Commission’sprincipal office in Washington, DC, the principaloffice of the designated examining authority for the

broker or dealer, and with the Securities InvestorProtection Corporation (‘SIPC’) if the broker ordealer is a member of SIPC. Copies of the reportsmust be provided to all self-regulatory organizationsof which the broker or dealer is a member, unlessthe self-regulatory organization by rule waives thisrequirement.’’

460 See Reports to be Made by Certain Brokers and Dealers, Exchange Act Release No. 40608 (Oct. 28,1998), 63 FR 59208 (Nov. 3, 1998).

461 See Broker-Dealer Reports, 76 FR at 37593.462 Id. at 37594.463 See 17 CFR 240.17a–5(f)(2).

464 See 17 CFR 240.17a–5(f)(2)(iii)(A)–(C).465 See Broker-Dealer Reports, 76 FR at 37583–

37584, 37605–37606.

statements for a year following itsidentification. 458

In response to comments received, theCommission has decided not to adoptthe proposed condition in paragraph(c)(5)(vi) of Rule 17a–5 for qualifying forthe conditional exemption. Requiringpaper delivery of financial informationto customers when a broker-dealer’sfinancial statements do not receive anunqualified opinion from itsindependent public accountant, orwhen the broker-dealer fails to complywith certain regulatory requirements,will not necessarily result in a moreeffective means of communication tocustomers and runs counter to thedominant trend toward electroniccommunications between financialentities and their customers. Further, asdiscussed above, if a broker-dealer or itsindependent public accountant providesnotice to the Commission of a materialweakness in the broker-dealer’s Internal

Control Over Compliance, paragraph(c)(2)(iv) of Rule 17a–5 as adoptedrequires the broker-dealer to includewith the semi-annual financialdisclosure statement it sends itscustomers a statement that theindependent public accountantidentified a material weakness and thata copy of the report of the independentpublic accountant is available for thecustomers’ inspection.2. Technical Amendmentsi. Deletion of Paragraph (b)(6) of Rule17a–5

Before today’s amendments,paragraph (b)(6) of Rule 17a–5 providedthat ‘‘a copy of [a broker-dealers] annualaudit report shall be filed at the regionaloffice of the Commission for the regionin which the broker or dealer has itsprincipal place of business and theprincipal office of the designatedexamining authority for said broker ordealer. Two copies of said report shall

be filed at the Commission’s principaloffice in Washington, DC. Copies thereof shall be provided to all self-regulatoryorganizations of which said broker ordealer is a member.’’ The Commissionproposed to delete this paragraph

because the same provisions are inparagraph (d)(6) of Rule 17a–5. 459 The

Commission received no comments onthis proposal and is deleting paragraph(b)(6) of Rule 17a–5 as proposed.ii. Deletion of Provisions Relating to theYear 2000

Before today’s amendments,paragraph (e)(5) of Rule 17a–5 required

broker-dealers to file Form BD–Y2K.

Form BD–Y2K elicited information withrespect to a broker-dealer’s readiness forthe year 2000 and any potentialproblems that could arise with theadvent of the new millennium. 460 FormBD–Y2K was required to be filed inApril 1999 and only then. In theproposing release, the Commissionproposed to delete paragraph (e)(5) of Rule 17a–5 in its entirety because theprovisions of that paragraph are nowmoot. 461 The Commission received nocomments on this proposal and isdeleting paragraph (e)(5) of Rule 17a–5as proposed.

iii. Deletion of Paragraph (i)(5) of Rule17a–5In the proposing release, the

Commission proposed to deleteparagraph (i)(5) of Rule 17a–5, which,

before today’s amendments, providedthat ‘‘the terms audit (or examination ),accountant’s report, and certified shallhave the meanings given in § 210.1–02of this chapter.’’ 462 The Commissionreceived no comments on this proposaland is deleting paragraph (i)(5) of Rule17a–5 as proposed.iv. Amendments to Paragraph (f)(2) of

Rule 17a–5Before today’s amendments,paragraph (f)(2) of Rule 17a–5 providedthat a broker-dealer that was required tofile an annual audit report must file astatement with the Commission and itsDEA that it has designated anindependent public accountantresponsible for performing the annualaudit of the broker-dealer, which wascalled ‘‘Notice pursuant to Rule 17a–5(f)(2)’’.463 Paragraph (f)(2)(iii) of Rule17a–5 prescribed the items that wererequired to be included in the notice:the name, address, telephone number

and registration number of the broker-dealer; the name, address and telephone

number of the accounting firm; and theaudit date of the broker-dealer for theyear covered by the agreement. 464

In addition to the proposedamendments discussed below in sectionIII. of this release, the Commissionproposed certain technical amendmentsto paragraph (f)(2) of Rule 17a–5. 465 First, the Commission proposedamending the language in paragraph(f)(2)(i) of Rule 17a–5 to streamline theparagraph and to add a reference toproposed paragraph (f)(2)(ii) of Rule17a–5, which would have prescribed theinformation a broker-dealer would have

been required to include in its noticedesignating its accountant. In addition,the Commission proposed to amendparagraph (f)(2)(i) of Rule 17a–5 torequire that a broker-dealer include astatement in its notice as to whether theengagement with its independent publicaccountant was for a single year or wasof a continuing nature. This statement

was previously required by paragraph(f)(2)(ii) of Rule 17a–5, which theCommission proposed to delete as partof its revisions to that paragraph. TheCommission did not receive anycomments on these proposed changesand is adopting them as proposed. TheCommission also proposed to retain theannual December 10 filing deadline forthe statements provided pursuant toparagraph (f)(2), but also added thelanguage ‘‘(or 30 calendar days after theeffective date of its registration as a

broker or dealer, if earlier).’’ TheCommission did not receive anycomments on this amendment and isadopting it as proposed. In addition, thefinal rule adds a conforming change tothe date of the statement designating theindependent public accountant. Underthe proposal, the statement must bedated ‘‘no later than December 1.’’Under the final rules, the statementmust be dated ‘‘no later than December1 (or 20 calendar days after the effectivedate of its registration as a broker ordealer, if earlier)’’ to make the timingconsistent with the filing deadlinesdescribed above.

As discussed in the proposing release,notices pursuant to paragraph (f)(2) of

Rule 17a–5 currently on file with theCommission do not contain therepresentations that are required by theamendments to paragraph (f)(2) that theCommission is adopting today.Accordingly, broker-dealers subject toparagraph (f)(2) of Rule 17a–5 ( i.e., all

broker-dealers that are required to fileaudited annual reports) must file a new‘‘statement regarding the independent


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478 Compare the control objectives described inCommission Guidance Regarding Independent Public Accountant Engagements Performed Pursuant to Rule 206(4)–2 Under the Investment Advisers Act of 1940, 75 FR at 1494, with therequirements in 17 CFR 240.15c3–1, 17 CFR240.15c3–3, 17 CFR 240.17a–13, and the DEAAccount Statement Rules.

479 See Broker-Dealer Reports, 76 FR at 37580.480 The Commission staff has estimated that

approximately 18% of FINRA-registered broker-dealers also are registered as investment adviserswith the Commission or with a state. SeeCommission staff, Study on Investment Advisersand Broker-Dealers, as required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011).

481 See 17 CFR 275.206(4)–2(a)(6). Based on datacollected from the Investment Adviser RegistrationDepository as of August 2012, close to 200investment advisers reported on Form ADV thatclient assets were being held at a qualifiedcustodian that was related to the adviser.

482 While Rule 15c3–1 prescribes broker-dealernet capital requirements, it also contains provisionsrelating to custody. For example, a broker-dealermust take net capital charges for short securitydifferences unresolved after specificallyenumerated timeframes. See 17 CFR 240.15c3–1(c)(2)(v)(A).

483 See Broker-Dealer Reports, 76 FR at 37579–37580; Commission Guidance Regarding Independent Public Accountant EngagementsPerformed Pursuant to Rule 206(4)–2 Under theInvestment Advisers Act of 1940, 75 FR at 1493–1494.


485 See CFP Letter.486 See CAI Letter; Deloitte Letter.

487 See Deloitte Letter.488 See CAQ Letter; PWC Letter. Paragraph (a)(4)

of Rule 206(4)–2 requires, among other things, thatclient funds and securities of which an investmentadviser has custody must be verified by actualexamination at least once during each calendar year

by an independent public accountant, pursuant toa written agreement between the investment adviserand the accountant, at a time that is chosen by theaccountant without prior notice or announcementto the investment adviser and that is irregular fromyear to year. See 17 CFR 275.206(4)–2.

489 See CAQ Letter; PWC Letter.490 See PWC Letter.491 See 17 CFR 240.17a–5(d)(3) and (g)(2)(i).

financial responsibility rules. 478 Thisapproach allows different types of qualified custodians (banks, certainsavings associations, broker-dealers,FCMs, and certain foreign financialinstitutions) to establish controls andprocedures that meet the identifiedcontrol objectives in a manner thatreflects differences in business models,regulatory requirements, and otherfactors. 479

3. Broker-Dealers Acting as QualifiedCustodians Under Rule 206(4)–2

Broker-dealers that also are registeredas investment advisers may, acting intheir capacity as broker-dealers,maintain client securities and funds asqualified custodians in connection withadvisory services provided to clients. 480 As a result of being the adviser andqualified custodian to its clients, underRule 206(4)–2 these broker-dealers mustobtain an internal control report relatingto the custody of those assets from anindependent public accountant that isregistered with, and subject to regularinspection by, the PCAOB. In addition,

broker-dealers acting as qualifiedcustodians also may maintain advisoryclient assets in connection withadvisory services provided by related oraffiliated investment advisers. Rule206(4)–2 requires such a broker-dealerto provide an internal control report toits related investment adviser. 481

4. Proposal to Allow Report Based onExamination of Compliance Report to

Satisfy Rule 206(4)–2i. The Proposal

Broker-dealers that maintain custodyof customer funds and securities aresubject to specific operationalrequirements in the financialresponsibility rules with respect tohandling and accounting for customer

assets. 482 The operational requirementsof the financial responsibility rules areconsistent with the control objectivesoutlined in the Commission’s guidanceon Rule 206(4)–2. 483 As a result of theproposed amendments to Rule 17a–5,the Commission stated in the proposingrelease that a broker-dealer subject to anexamination by an independent publicaccountant of its compliance report thatalso acts as a qualified custodian foritself as an investment adviser or for itsrelated investment advisers under Rule206(4)–2 would be able to use theindependent public accountant’s reportresulting from the examination to satisfythe internal control report requirementunder Rule 206(4)–2. 484 ii. Comments on the Proposal

The Commission received severalcomments regarding the proposal thatthe independent public accountant’sreport based on an examination of thecompliance report would satisfy theinternal control report under Rule206(4)–2. One commenter stated that itis ‘‘critically important’’ that there be asingle independent public accountantengagement of the custody function at

both the broker-dealer and investmentadviser operations of any duallyregistered entity (or of affiliated broker-dealers and investment advisers) andthat this engagement use a single,consistent standard for evaluatingcustody at both the broker-dealer andinvestment adviser operations. 485 Twocommenters noted that there are non-carrying broker-dealers that act asqualified custodians under the AdvisersAct and that these broker-dealers wouldnot be subject to the proposedcompliance report requirements and,consequently, would not be able to usethe report of the independent publicaccountant covering the compliancereport to satisfy the internal controlreport requirement in Rule 206(4)–2

because the broker-dealers would befiling exemption reports instead of compliance reports. 486 One commentercharacterized this as an area of redundancy that could be eliminated by

allowing an accountant’s review of anon-carrying broker-dealer’s transmittalprocedures to be ‘‘recognized by theInvestment Adviser regulatory regimepromulgated by the Commission.’’ 487

In addition, two commenters askedfor clarification regarding theinteraction of the proposed compliancereport requirements with therequirement in Rule 206(4)–2 thatinvestment advisers undergo an annualsurprise examination by an independentaccountant to verify customer funds andsecurities held in custody. 488 Specifically, both asked that theCommission clarify whether theindependent public accountantperforming the surprise examinationwould be able to place reliance on theproposed compliance report and relatedcompliance examination to determinethe nature and extent of the proceduresfor the surprise examination. 489 One of the commenters also asked that, if the

Commission clarifies that theindependent public accountantperforming the surprise examination isexpected to rely on the proposedcompliance report requirements, whatfactors should the independent publicaccountant consider, given that thereport based on an examination of thecompliance report would not berequired to be completed until 60 daysafter the fiscal year end while thesurprise examination may occur at anytime. 490 5. Adoption of Proposal Relating to Rule206(4)–2

As discussed above, under today’samendments, a carrying broker-dealermust prepare, and file with theCommission and its DEA, a compliancereport on, among other things, itsInternal Control Over Compliance, andmust file with the compliance report areport prepared by its independentpublic accountant based on anexamination of the compliancereport. 491 As a result of the amendmentsto Rule 17a–5, the Commission hasdetermined that the independent publicaccountant’s report based on anexamination of the compliance report


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492 See Commission Guidance Regarding Independent Public Accountant EngagementsPerformed Pursuant to Rule 206(4)–2 Under theInvestment Advisers Act of 1940, 75 FR at 1494;Broker-Dealer Reports, 76 FR at 37579–37580. Asdiscussed above in section II.D.3. of this release, theindependent public accountant must examine the

compliance report in accordance with attestationstandards promulgated by the PCAOB.Consequently, the PCAOB’s attestation standardsare integral to the Commission’s determination thatthe independent public accountant’s report basedon an examination of the compliance reportsatisfies the internal control report requirementunder Rule 206(4)–2. The Commission could revisitthis determination if the PCAOB’s attestationstandards do not support the determination.

493 See paragraphs (d)(3)(i)(A)( 1) and (d)(3)(ii) of Rule 17a–5.

494 See 17 CFR 240.17a–13. As discussed above insection II.D.3. of this release, the PCAOB proposedattestation standards related to the compliancereport. The PCAOB’s proposed attestation standardsinclude a requirement that the independent publicaccountant must perform procedures to obtainevidence about the existence of customer funds or

securities held for customers, e.g., confirmation of customer security positions directly withdepositories and clearing organizations. See PCAOBProposing Release app. 1, at ¶ 26. This procedurewould be consistent with the tests of the qualifiedcustodian’s reconciliation that the Commissionspecified in the guidance on Rule 206(4)–2. SeeCommission Guidance Regarding Independent Public Accountant Engagements Performed Pursuant to Rule 206(4)–2 Under the Investment Advisers Act of 1940, 75 FR 1494.

495 See, e.g., CBOE Rule 9.12; NASD Rule 2340.See also Commission Guidance Regarding Independent Public Accountant EngagementsPerformed Pursuant to Rule 206(4)–2 Under theInvestment Advisers Act of 1940, Advisers ActRelease No. 2969 (Dec. 30, 2009), 75 FR 1494 (Jan.

11, 2010), which describes as a control objective forqualified custodians (including broker-dealerqualified custodians) that account statementsreflecting cash and security positions are providedto clients in a complete, accurate and timelymanner.

496 See supra notes 299, 300.497 See PCAOB Interim Attestation Standard, AT

Section 601. AT Section 601 requires anindependent public accountant ‘‘to obtain anunderstanding of internal control over compliancesufficient to plan the engagement and to assesscontrol risk for compliance with specifiedrequirements. In planning the examination, suchknowledge should be used to identify types of potential non-compliance, to consider factors thataffect the risk of material noncompliance, and todesign appropriate tests of compliance.’’ Id. at ¶ .45.

498 Id.

499 See Commission Guidance Regarding Independent Public Accountant EngagementsPerformed Pursuant to Rule 206(4)–2 Under theInvestment Advisers Act of 1940, Advisers ActRelease No. 2969 (Dec. 30, 2009), 75 FR 1492 (Jan.11, 2010).

500 For the purpose of this release, a ‘‘clearing broker-dealer’’ is a broker-dealer that clearstransactions or carries customer accounts.


502 Id.503 For example, where an independent public

accountant has performed extensive testing of acarrying broker-dealer’s custody of funds andsecurities by confirming holdings at custodians andsub-custodians, examiners could focus their effortson other matters that had not been the subject of prior testing and review.


will satisfy the internal control reportrequirement under Rule 206(4)–2

because the operational requirements of the financial responsibility rules areconsistent with the control objectivesoutlined in the Commission’s guidanceon Rule 206(4)–2. 492 For example, to beable to include a statement that the

broker-dealer has established andmaintained Internal Control OverCompliance (which is defined asinternal controls that have the objectiveof providing the broker-dealer withreasonable assurance that non-compliance with the financialresponsibility rules will be prevented ordetected on a timely basis), 493 a broker-dealer’s internal control overcompliance with Rule 17a–13 will resultin controls over the safeguarding of securities from loss or misappropriationand the completeness, accuracy, andtimeliness of the securitiesreconciliation process. 494 To make a

similar statement with respect to theAccount Statement Rules, a broker-dealer would of necessity have internalcontrols over compliance with theAccount Statement Rules designed toensure that customers receive complete,accurate, and timely informationconcerning securities positions andother assets held in their accounts. 495 A

statement that the broker-dealer hasestablished and maintained InternalControl Over Compliance would coverthese and other internal controls overcompliance with the financialresponsibility rules and would beexamined by the independent publicaccountant during the examination of the compliance report.

As commenters noted, broker-dealersthat are not carrying broker-dealers arenot subject to the compliance reportrequirements and, therefore, those

broker-dealers must comply with theinternal control report requirement inRule 206(4)–2 if they are subject to thatrequirement. The exemption report isnot redundant of the internal controlreport requirement in Rule 206(4)–2

because, among other things, the scopeof the required statements included in a

broker-dealer’s exemption report isdifferent than the scope of the internalcontrol report requirement in Rule206(4)–2. 496

As noted above, commenters alsoasked whether the accountant would beable to place reliance on the proposedcompliance report and relatedexamination of the compliance report todetermine the nature and extent of theprocedures for the surprise examination.PCAOB attestation standards require anindependent public accountant ‘‘toobtain an understanding of internalcontrol over compliance sufficient toplan the engagement and to assesscontrol risk for compliance withspecified requirements.’’ 497 TheCommission agrees that theindependent public accountant’sunderstanding of internal controlsrelated to custody at the broker-dealeracting as a qualified custodian, as wellas other facts and circumstances, mayaffect the nature and extent of procedures performed for the annualsurprise examination. 498 TheCommission has provided interpretiveguidance on the relationship betweenthe annual surprise examination and the

internal control report for engagementsperformed pursuant to Rule 206(4)–2. 499 III. Access to Accountant and AuditDocumentation

The Commission proposed amendingparagraph (f)(2) of Rule 17a–5 to requirethat each clearing broker-dealer 500 include a representation in its statement

regarding its independent publicaccountant that the broker-dealer agreesto allow Commission and DEAexamination staff to review the auditdocumentation associated with itsannual audit reports required underRule 17a–5 and to allow its independentpublic accountant to discuss findingsrelating to the audit reports withCommission and DEA examination staff if requested for the purposes of anexamination of the broker-dealer. 501 This proposed requirement wasintended to facilitate examinations of clearing broker-dealers by Commission

and DEA examination staff.502

Access toinformation obtained from auditdocumentation and discussions with aclearing broker-dealer’s independentpublic accountant would enhance theefficiency and effectiveness of Commission and DEA examinations byproviding examiners with access toadditional relevant information to plantheir examinations. 503

The Commission proposed to limitthis requirement to clearing broker-dealers, which generally have morecomplex business operations than non-carrying firms. 504 Thus, access toaccountants and audit documentationwas considered of substantially greatervalue when preparing for regulatoryexaminations of these types of broker-dealers, as compared to firms with morelimited business models.

To facilitate Commission and DEAexamination staff access to a clearing

broker-dealer’s independent publicaccountant and the accountant’s auditdocumentation, the Commissionproposed amending paragraph (f)(2) of


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505 Id.506 Id.507 See CAI Letter; CAQ Letter; CFP Letter;

Deloitte Letter; E&Y Letter; KPMG Letter; PWC Letter; SIFMA Letter.

508 See CAQ Letter; Deloitte Letter; E&Y Letter; KPMG Letter.

509 See CAI Letter; KPMG Letter; PWC Letter; SIFMA Letter.

510 See Deloitte Letter; E&Y Letter; KPMG Letter.511 See E&Y Letter; PWC Letter.512 See CAI Letter.

513 See CFP Letter.514 PCAOB Auditing Standard 3 defines ‘‘Audit

documentation ’’ as the ‘‘written record of the basisfor the auditor’s conclusions that provides thesupport for the auditor’s representations, whetherthose representations are contained in the auditor’sreport or otherwise. Audit documentation alsofacilitates the planning, performance, andsupervision of the engagement, and is the basis forthe review of the quality of the work because itprovides the reviewer with written documentationof the evidence supporting the auditor’s significantconclusions. Among other things, auditdocumentation includes records of the planningand performance of the work, the proceduresperformed, evidence obtained, and conclusionsreached by the auditor. Audit documentation alsomay be referred to as work papers or working

papers. ’’515 See CAQ Letter; KPMG Letter.516 See KPMG Letter. See also Deloitte Letter,

which suggests that Commission and DEAexaminers first provide notice to the broker-dealer,in writing, of plans to request access to the broker-

dealer’s audit documentation and then make awritten request to the accountant. Although, inpractice, Commission and DEA examiners mayprovide advance or simultaneous notice to a broker-dealer of requests to access audit documentationfrom the broker-dealer’s accountant, theCommission is not adopting a requirement thatexaminers so notify broker-dealers of such requests.This additional notification would likely delay anexaminer’s ability to gain access to the broker-dealer’s audit documentation and is not necessarygiven the broker-dealer’s prior consent. In addition,a broker-dealer can request that its accountantprovide notice when examiners request auditdocumentation, and, expects that, in practice,accountants will provide such notice. See also E&Y Letter.

517 17 CFR 200.83. Generally, persons who submitinformation to the Commission may request that theCommission accord confidential treatment to theinformation for any reason permitted by federallaw.

518 The Commission believes that this auditdocumentation likely would fall under exemptions(b)(8) and/or (b)(4) of FOIA. See 5 U.S.C. 522(b)(8);5 U.S.C. 522(b)(4).

519 See E&Y Letter; PWC Letter.520 See PWC Letter.521 See E&Y Letter.522 See Broker-Dealer Reports, 76 FR at 37583.523 Id.524 Id.

Rule 17a–5 to require that a clearing broker-dealer’s notice designating itsindependent public accountant include,among other things, representations: (1)That the broker-dealer agrees to allowrepresentatives of the Commission orthe broker-dealer’s DEA, if requested forpurposes of an examination of the

broker-dealer, to review thedocumentation associated with thereports of its independent publicaccountant prepared pursuant toparagraph (g) of Rule 17a–5; and (2) thatthe broker-dealer agrees to permit itsindependent public accountant todiscuss with representatives of theCommission and the DEA, if requestedfor the purposes of an examination of the broker-dealer, the findingsassociated with the reports of theaccountant prepared pursuant toparagraph (g) of Rule 17a–5. 505 Proposed paragraph (f)(2)(iii) of Rule17a–5 provided that a broker-dealer that

does not clear transactions or carrycustomer accounts would not berequired to include theserepresentations in its notice. 506

Eight commenters addressed theproposed changes to paragraph (f)(2) of Rule 17a–5. 507 Generally, commentersrequested that the Commission do oneor more of the following: (1) Clarify thetype of documentation that theCommission and DEA examiners wouldseek to access 508 ; (2) grant confidentialtreatment to documentation obtained bythe Commission under thisprovision 509 ; (3) clarify the process bywhich Commission and DEA examinerswould seek access to a broker-dealer’sindependent public accountant and itsaudit documentation 510 ; and (4) limitthe use of information anddocumentation obtained from a broker-dealer’s independent publicaccountant. 511 In addition, onecommenter raised general concerns thatproviding Commission and DEAexaminers with access to a broker-dealer’s auditor and auditdocumentation will discouragecommunications between broker-dealersand their auditors and may requireauditors to produce documentationprotected by attorney-client and/oraccountant-client privilege. 512 Finally,

one commenter asserted that it isreasonable for securities regulators to beable to validate any concerns promptlywith a broker-dealer’s accountant. 513

In response to requests for clarity asto the types of audit documentation thatCommission and DEA examiners wouldseek to access under the proposal, theCommission revised proposedparagraph (f)(2)(ii)(F) of Rule 17a–5 toclarify that ‘‘audit documentation’’ hasthe meaning established by PCAOBstandards. 514 This revision, which wasspecifically suggested by twocommenters, 515 is not intended to alteran independent public accountant’sobligations with respect to auditdocumentation; rather, it is intended toclarify the types of audit documentationthat the Commission and DEAexaminers may ask to review inconnection with a broker-dealerexamination.

In response to questions regarding theprocess by which Commission and DEAexaminers might seek to access auditdocumentation, the Commission agreeswith a commenter that suggested thatthese requests be in writing because thatwill provide independent publicaccountants with a record of requests forinformation and specify thedocumentation the Commission or DEAexamination staff would like toaccess. 516 Therefore, the Commission

has modified the rule from the proposalto provide that a request to a broker-dealer’s independent public accountantfor the accountant to discuss auditfindings or for access to auditdocumentation be made in writing.

Independent public accountants canseek to protect information obtained byexaminers from being disclosed toFreedom of Information Act (‘‘FOIA’’)requestors by specifically requestingconfidential treatment of auditdocumentation following the processdescribed in Rule 83 of theCommission’s Rules on Information andRequests. 517 The Commissionanticipates that it will accordconfidential treatment to suchdocuments to the extent permitted bylaw. 518

Two commenters requested that theCommission clarify the intended use of information and documents obtainedfrom an independent publicaccountant. 519 One recommended thatthe Commission clarify that theinformation obtained from theindependent public accountant not beused for any purpose other than inconnection with a regulatoryexamination of the broker-dealer. 520 Theother suggested that the rule text statethat the requests for information should

be solely for the purposes of conductinga regulatory examination of the clearing

broker-dealer. 521 The Commission doesnot believe that it is necessary to modifythe proposed rule text in response tothese comments. The Commissionstated that it did not propose thatexaminers would use the requestedinformation for the purpose of inspecting independent publicaccountants. 522 As the Commissionstated in the proposing release, thepurpose of this access requirement is toenhance and improve the efficiency andeffectiveness of Commission and DEAexaminations of broker-dealers. 523 ThePCAOB is responsible for inspections of independent public accountants thataudit broker-dealers. 524 In response tothese comments, the Commissionreiterates its intention, as stated in theproposing release, that any requests for


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525 Id.526 See SIFMA Letter.527 Id.528 See CAI Letter.

529 Id.530 Id.


532 Id.533 See Angel Letter; Barnard Letter; CAI Letter;

CFP Letter; E&Y Letter; IMS Letter; KPMG Letter; Shatto Letter; SIFMA Letter.

534 See CAI Letter; E&Y Letter; KPMG Letter; Shatto Letter; SIFMA Letter.

535 See Angel Letter; CFP Letter; SIFMA Letter.536 See IMS Letter. This commenter, however, did

not provide any suggestion for reducing the costsassociated with Form Custody. See section VII.

below for an economic analysis of the costs and benefits relating to Form Custody.

audit documentation under thisprovision would be made exclusively inconnection with conducting a regulatoryexamination of a broker-dealer. 525

One commenter stated thatCommission and DEA examiners should

be limited to inspecting auditdocumentation relating to a broker-dealer in the offices of the broker-dealer’s independent public accountantand that the broker-dealer should bepermitted to be present duringconversations between Commission orDEA staff and the accountant. 526 TheCommission has considered thesecomments and decided not to modifythe proposal in response to thesecomments. However, Commission andDEA examiners may exercise discretionin determining whether to review auditdocumentation in the offices of the

broker-dealer’s accountant and whetherto permit the broker-dealer to be presentduring conversations with the

accountant. This commenter alsorequested that the Commission establisha process by which broker-dealers canobject to overly broad or unduly

burdensome requests. 527 The rule willnot be modified in response to thiscomment and the Commissionrecommends that any concernsregarding the scope of auditdocumentation requests be directed tothe examiner from whom the requestwas received. The examiner willconsider the concerns and determinewhether and how to limit the scope of the audit documentation request, if appropriate. The independent publicaccountant also can express concerns tosenior examination staff if the scope of the audit documentation requestremains a concern after discussionswith the examiner.

Another commenter stated that theCommission must be responsible forreturning all audit work papers that itreceives for purposes of an examinationof the broker-dealer to either the broker-dealer or its accountant. 528 The purposeof requesting access to auditdocumentation is to assist examiners inconducting a regulatory examination of the clearing broker-dealer. Upon

completion of the examination, if theCommission and DEA, and any officesand divisions thereof, no longer needthe audit documentation, theCommission and DEA will, upon therequest of the independent publicaccountant and in the absence of unusual circumstances, return auditdocumentation to the independent

public accountant or the broker-dealerwithin a reasonable time after theexamination is complete.

One commenter stated that, if adopted, this requirement willdiscourage or ‘‘chill’’ communications

between a broker-dealer and its auditor because ‘‘the broker-dealer knows thatregardless of the nature of an auditingissue and how it was discovered . . . itcannot freely seek advice from, ordiscuss the issue openly with[] theauditor[] without fear of the auditormisunderstanding the broker-dealer’sresponse or simply drawing aconclusion that a broker-dealer’squestions indicate the broker-dealer’slack of knowledge or admission of anissue.’’ 529 Presumably, this ‘‘chillingeffect’’ would result from a broker-dealer’s desire to avoid the creation of audit documentation memorializingmisunderstandings andmiscommunications, which, whenaccessed by Commission and DEAexaminers, could result in regulatoryscrutiny. The Commission is notpersuaded by this comment; while it ispossible for miscommunications tooccur between representatives of a

broker-dealer and its auditor, potentialmisunderstandings ormiscommunications should not limitthe ability of the Commission or a DEAto have access to audit documentationor a broker-dealer’s independent publicaccountant. Further, to the extent amisunderstanding ormiscommunication between a broker-

dealer and its accountant is reflected inthe accountant’s audit documentationrelating to the broker-dealer, the broker-dealer could clarify the nature of themisunderstanding ormiscommunication to examiners andexplain how it was rectified if suchclarification and rectification is notalready described in subsequent auditdocumentation.

The same commenter also assertedthat the requirement that broker-dealersallow regulators to access auditdocumentation may, in effect, requireauditors to produce documentation

protected by attorney-client privilege oraccountant-client privilege. 530 The rulelanguage providing Commission andDEA examiners with access to a broker-dealer’s auditor and auditdocumentation is not designed to affectthe circumstances in which privilegecan be asserted. Any claims of privilegecan be addressed on a case-by-case basis

by appropriate Commission and DEAstaff as those claims arise.

IV. Form Custody

A. Background Proposed Form Custody was

comprised of nine line items (each, an‘‘Item’’) designed to elicit informationabout a broker-dealer’s custodialactivities. 531 As is discussed below,several Items on the proposed form

contained multiple questions, and somerequired the completion of charts andthe disclosure of custody-relatedinformation specific to the broker-dealercompleting the form. 532

The Commission received ninecomment letters on proposed FormCustody. 533 While commentersgenerally supported the proposed form,the Commission received severalcomments on the timing of, exemptionsfrom, and the compliance date for filingthe form and whether a broker-dealeralso would be required to file anaccountant’s attestation covering theform. 534 In addition, severalcommenters suggested that theCommission make certain revisions tothe form and address certain technicalinterpretative questions. 535 Onecommenter, who agreed ‘‘in concept’’that Form Custody is appropriate forcustodial broker-dealers, also stated thatthe aggregate cost estimate of theproposed form was ‘‘staggering.’’ 536

The Commission is adopting therequirement that broker-dealers fileForm Custody with their DEAs, subjectto modifications that, in part, respond toissues raised by commenters. Adescription of the comments on the

proposed process for filing FormCustody is set forth below in sectionIV.B. of this release, together with adiscussion of the final rule amendmentsthat the Commission is adopting today.A description of the comments on theproposed form is set forth below insection IV.C. of this release, togetherwith a discussion of the final form theCommission is adopting today.B. Filing of Form Custody

1. Requirement to File Form Custodywith FOCUS Reports

Under paragraph (a) of Rule 17a–5, a

broker-dealer is required to file periodic


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537 See 17 CFR 240.17a–5(a); 17 CFR 249.617.FOCUS Reports are one of the primary means of monitoring the financial and operational conditionof broker-dealers and enforcing the broker-dealerfinancial responsibility rules. The completed formsalso are used to determine which firms are engagedin various securities-related activities and howeconomic events and government policies mightaffect various segments of the securities industry.The FOCUS Report was designed to eliminateoverlapping regulatory reports required by variousSROs and the Commission and to reduce reporting

burdens as much as possible. FOCUS Reports andForm Custody are deemed confidential underparagraph (a)(3) of Rule 17a–5.

538 See Broker-Dealer Reports, 76 FR at 37592. Forpurposes of Form Custody, the term ‘‘customer’’means a person that is a ‘‘customer’’ for purposesof Rule 15c3–3(a), and a ‘‘non-customer’’ means aperson other than a ‘‘customer’’ as that term isdefined in Rule 15c3–3(a). See 17 CFR 240.15c3–3(a); FINRA, Interpretations of Financial and Operational Rules, Rule 15c3–3(a)(1)/01, availableat http://www.finra.org/Industry/Regulation/ Guidance/FOR/ .

539 See Broker-Dealer Reports, 76 FR at 37592.540 Id.541 See Form X–17A–5 Schedule I, Part II, Part IIa,

Part IIb, and Part III.542 See Broker-Dealer Reports, 76 FR at 37585.

543 Id.544 Id. at 37592.545 See Shatto Letter.546 See paragraph (a)(5) of Rule 17a–5.547 Id. Consistent with the proposal, a broker-

dealer must file Form Custody with its DEA at thesame time that the broker-dealer files its FOCUSReport with its DEA. However, since the final rulechanges the date for the filing of the year endFOCUS Report to ‘‘within 17 business days after theend of the fiscal year where that date is not the endof a calendar quarter,’’ the deadline for the year endfiling of Form Custody is correspondingly changedto ‘‘within 17 business days after the end of thefiscal year of the broker or dealer where that dateis not the end of a calendar quarter.’’

548 See CAI Letter.549 Id.550 15 U.S.C. 78mm.

FOCUS Reports with the Commissionand the broker-dealer’s DEA. 537 In theproposing release, the Commissionproposed adding paragraph (a)(5) toRule 17a–5 to require the filing of FormCustody, which was designed to elicitinformation concerning whether a

broker-dealer maintained custody of customer and non-customer assets, and,if so, how such assets weremaintained. 538 Under this proposedamendment, a broker-dealer would berequired to file Form Custody with itsDEA at the same time it filed its periodicFOCUS Report with its DEA underparagraph (a) of Rule 17a–5. 539 TheDEA, in turn, would be required tomaintain the information obtainedthrough the filing of Form Custody andto transmit such information to theCommission at such time as it transmitsFOCUS Report data to the Commissionunder paragraph (a)(4) of Rule 17a–5. 540

A broker-dealer’s FOCUS Report

provides the Commission and a broker-dealer’s DEA with information relatingto the broker-dealer’s financial andoperational condition but does notsolicit detailed information on how a

broker-dealer maintains custody of assets. 541 Proposed Form Custody wasintended to provide additionalinformation about a broker-dealer’scustodial activities and to make it easierfor examiners to identify risks andpossible violations of laws andregulations concerning the broker-dealer’s custody of assets. 542 If, uponreviewing Form Custody, regulatoryauthorities were to become aware of inconsistencies or other red flags ininformation contained on the form, theycould initiate a more focused and

detailed analysis of the broker-dealer’scustodial activities. Such an analysiscould, in turn, identify potential abusesrelated to customer assets. Moreover,proposed Form Custody was intended toexpedite the examination of a broker-dealer’s custodial activities and reduceexamination costs, as examiners wouldno longer need to request basic custody-related information already disclosed onthe form. 543

The Commission proposed that a broker-dealer file Form Custody with itsDEA within 17 business days after theend of each calendar quarter and within17 business days after the date selectedfor the broker-dealer’s annual reportwhere that date was other than the endof a calendar quarter. 544 TheCommission received one commentregarding proposed paragraph (a)(5) of Rule 17a–5, which supported theCommission’s proposal as to when a

broker-dealer should be required to file

Form Custody.545

The Commission is adoptingparagraph (a)(5) of Rule 17a–5substantially as proposed. As to when a

broker-dealer must file its Form Custodywith its DEA, the Commission isadopting its proposal that a broker-dealer file Form Custody with its DEAwithin 17 business days after the end of each calendar quarter. 546 However, foryear end filings of Form Custody by a

broker-dealer that has selected a fiscalyear end date that is not the end of acalendar year, the Commission hasmodified its proposal to provide that a

broker-dealer also must file FormCustody with its DEA within 17 business days after the end of the broker-dealer’s fiscal year. 547

The Commission did not receive anycomments relating to when DEAs arerequired to transmit Form Custodyinformation to the Commission and isadopting this requirement as proposed.

2. Requests for Exemption From FilingForm Custody

One commenter recommended thatthe Commission include a provision inRule 17a–5 that would enable the

Commission to exempt broker-dealersfrom the requirement to file FormCustody if the Commission determinedthat receiving the form for a particularfirm, or type of firm, would serve nouseful purpose. 548 For example, thecommenter stated that no usefulpurpose would be served by receivingForm Custody from a firm that has nocustomer or non-customer accounts. 549 The Commission intends for all

broker-dealers to file Form Custodywithout exception. The Commission isconcerned about circumstances where

broker-dealers falsely represent toregulators and others that they do nothandle funds or securities or issue tradeconfirmations or account statements.One of the purposes of Form Custody isto assist Commission and DEAexaminers in identifying potentialmisrepresentations relating to broker-dealers’ custody of assets. ThroughForm Custody, examiners will be in a

position to better understand a broker-dealer’s custody profile and identifycustody-related violations andmisconduct. For example, if a broker-dealer represents on Form Custody thatit does not issue account statements, butan examiner receives an accountstatement issued by the broker-dealer(e.g., in connection with a customercomplaint or in the course of anexamination of the broker-dealer), theexaminer will be able to react morequickly to the misrepresentation.Further, the requirements to file theform will promote greater focus andattention to custody practices byrequiring that broker-dealers makespecific representations in this regard.

In addition, although the Commissiondoes not currently contemplate anycircumstance in which it would exempta broker-dealer from having to file FormCustody, if the Commissionsubsequently determines that it isappropriate to exempt a broker-dealer,or type of broker-dealer, from suchrequirements, the Commission can actunder existing authority. In particular,under section 36 of the Exchange Act,the Commission, by rule, regulation, ororder, may exempt any person, or any

class or classes of persons, from any ruleunder the Exchange Act to the extentthat such exemption is necessary orappropriate in the public interest and isconsistent with the protection of investors. 550

Nonetheless, the Commissionunderstands that a number of Items onForm Custody may not apply to certaintypes of broker-dealers ( e.g., broker-


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551 See General Instruction A to Form Custody.552 See KPMG Letter. See also Broker-Dealer

Reports, 76 FR at 37592.553 See KPMG Letter.554 Id.

555 See Broker-Dealer Reports, 76 FR at 37585.See AICPA Broker-Dealer Audit Guide glossary(defining the term fully disclosed basis as a‘‘situation in which a nonclearing broker introducesa customer to a clearing broker and the customer’sname and statement are carried by, and disclosedto, that clearing broker.’’).

556 See Broker-Dealer Reports, 76 FR at 37585.557 Id.558 See, e.g., FINRA Rule 4311.


560 Id. at 37586.561 See AICPA Broker-Dealer Audit Guide at ¶¶

5.144–5.145.

dealers that do not carry customer, non-customer, or proprietary securitiesaccounts) and has modified the form’sinstructions to make clear that questionson the form that cannot be answered

because the broker-dealer does notengage in a particular activity do notneed to be answered. 551

3. Attest Engagement Not Required forForm Custody

In response to a question posed by theCommission in the proposing release,one commenter stated that theCommission should not require a

broker-dealer to engage a PCAOB-registered independent publicaccountant to audit Form Custody. 552 This commenter stated that an audit of Form Custody is not necessary since theintent of the form is to gather custody-related information, which in somecases may not be derived from the

broker-dealer’s books and records. 553 This commenter also does not believethat the benefits of performing an auditof the information included on FormCustody would outweigh the costs orthat an audit is necessary for theCommission to achieve its principalobjective of using the information in theexamination of a broker-dealer’s custodyactivities. 554

The Commission did not propose torequire that a broker-dealer engage anindependent public accountant toreview Form Custody, and agrees thatsuch a requirement should not beimposed. Accordingly, under today’samendments, broker-dealers are notrequired to enter into an attestationengagement with an independent publicaccountant for purposes of reviewingForm Custody.

C. Form Custody

As is discussed above, proposed FormCustody was comprised of nine Itemsdesigned to elicit information about a

broker-dealer’s custodial activities. Setforth below is a description of each of the Items.

1. Item 1—Accounts Introduced on aFully Disclosed Basis

Item 1 consists of two subparts. Item1.A, as proposed, would have elicitedinformation concerning whether the

broker-dealer introduced customeraccounts to another broker-dealer on afully disclosed basis by requiring the

broker-dealer to check the appropriate

‘‘Yes’’ or ‘‘No’’ box. 555 Item 1.B of FormCustody would require broker-dealersthat check ‘‘Yes’’ on Item 1.A to identifyeach broker-dealer to which customeraccounts are introduced on a fullydisclosed basis. 556 The Commission didnot receive any comments on Item 1.Aor 1.B and is adopting this Item asproposed.

As is discussed in the proposingrelease, many broker-dealers enter intoagreements (‘‘carrying agreements’’)with another broker-dealer in which thetwo firms allocate certainresponsibilities with respect to thehandling of accounts. 557 These carryingagreements are governed by applicableSRO rules, which require a broker-dealer entering into a carryingagreement to allocate certainresponsibilities associated withintroduced accounts. 558

Typically, under a carryingagreement, one broker-dealer

(‘‘introducing broker-dealer’’) agrees toact as the customer’s accountrepresentative ( e.g., by providing thecustomer with account openingdocuments, ascertaining the customer’sinvestment objectives, and makinginvestment recommendations). Thecarrying broker-dealer typically agreesto receive and hold the customer’s cashand securities, clear transactions, makeand retain records relating to thetransactions and the receipt and holdingof assets, and extend credit to thecustomer in connection with thecustomer’s securities transactions.

Item 1.A, as adopted, elicitsinformation concerning whether the

broker-dealer introduces customeraccounts to another broker-dealer on afully disclosed basis, rather than askingwhether the broker-dealer is an‘‘introducing broker-dealer.’’ TheCommission is presenting the questionin this manner because some broker-dealers operate as carrying broker-dealers ( i.e., they hold cash andsecurities) for one group of customers

but also introduce the accounts of asecond group of customers on a fullydisclosed basis to another broker-dealer.For example, a broker-dealer may incurthe capital expense and cost of acting asa carrying broker-dealer for certainproducts ( e.g., equities) but not for otherproducts ( e.g., options). In this case, the

firm operates as a hybrid introducing/carrying broker-dealer by introducing ona fully disclosed basis to a carrying

broker-dealer those customers that tradesecurities for which the broker-dealer isnot prepared to provide a full range of services. Broker-dealers also mayintroduce customer accounts on anomnibus basis, as is discussed below insection IV.C.2. of this release.

If the broker-dealer answers Item 1.A by checking the ‘‘Yes’’ box, the broker-dealer will be required under Item 1.Bto identify each broker-dealer to whichcustomer accounts are introduced on afully disclosed basis. The carrying

broker-dealer in such an arrangementmaintains the cash and securities of theintroduced customers and is thereforeobligated to return cash and securities tothe introduced customers. Commissionand DEA examiners could use theidentification information provided by a

broker-dealer in response to Item 1.B to

confirm the existence of an introducing/carrying relationship.

2. Item 2—Accounts Introduced on anOmnibus Basis

Item 2 of Form Custody consists of two subparts. Item 2.A, as proposed,would have elicited informationconcerning whether the broker-dealerintroduced customer accounts toanother broker-dealer on an omnibus

basis by requiring the broker-dealer tocheck the appropriate ‘‘Yes’’ or ‘‘No’’

box. 559 Item 2.B, as proposed, wouldrequire a broker-dealer that checks‘‘Yes’’ in response to Item 2.A toidentify each broker-dealer to whichcustomer accounts are introduced on anomnibus basis. 560 The Commission didnot receive any comments on Items 2.Aor 2.B and is adopting this Item asproposed.

An omnibus account is an accountcarried and cleared by another broker-dealer that contains accounts of undisclosed customers on acommingled basis and that are carriedindividually on the books of the broker-dealer introducing the accounts. 561 Disclosure of this information isimportant because when a broker-dealerintroduces customer accounts to another

broker-dealer on an omnibus basis, theintroducing broker-dealer (in addition tothe broker-dealer carrying the omnibusaccount) is considered to be a carrying

broker-dealer with respect to thoseaccounts under the Commission’s

broker-dealer financial responsibility


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562 See Net Capital Rule, Exchange Act ReleaseNo. 31511 (Nov. 24, 1992), 57 FR 56973, 56978 n.16(Dec. 2, 1992).

563 Id.564 See Broker-Dealer Reports, 76 FR at 37586.565 Id. at 37586–37589.566 See CFP Letter; SIFMA Letter.567 See Broker-Dealer Reports, 76 FR at 37586.568 Id.

569 See 17 CFR 240.15c3–3(a)(1).570 See Broker-Dealer Reports, 76 FR at 37586–

37587.571 See CFP Letter.572 Id.

573 See SIFMA Letter.574 See 17 CFR 240.15c3–3(c).

rules. 562 Thus, in these arrangements,the broker-dealer introducing theomnibus account is obligated to returncash and securities in the account tocustomers. 563

If the broker-dealer checks the ‘‘Yes’’ box in Item 2.A, it will be required toidentify in Item 2.B each broker-dealerto which accounts are introduced on anomnibus basis. Commission and DEAexaminers could use this information toconfirm whether the cash and securitiesintroduced to the carrying broker-dealerare in fact being held in an omnibusaccount at the carrying broker-dealerand that the books and records of the

broker-dealer that introduced thecustomer accounts to the carrying

broker-dealer reflect the correct amountsof customer cash and securities held inthe omnibus account.

3. Item 3—Carrying Broker-DealersItem 3 of Form Custody, as proposed,

would have elicited informationconcerning how a carrying broker-dealerheld cash and securities. 564 ProposedItem 3 was comprised of five subparts,as described below. 565 Two commentersspecifically addressed this Item, inparticular regarding subparts 3.C., 3.D,and 3.E, which also are discussed

below. 566

i. Items 3.A and 3.BThe first question of Item 3 of

proposed Form Custody—Item 3.A—would have elicited informationconcerning whether the broker-dealer

carried securities accounts forcustomers by requiring the broker-dealerto check the appropriate ‘‘Yes’’ or ‘‘No’’

box. 567 The General Instructions toForm Custody specify that the term‘‘customer’’ as used in the Form meansa ‘‘customer’’ as defined in Rule 15c3–3.

The next question of Item 3—Item3.B—would have elicited informationconcerning whether the broker-dealercarried securities accounts for personsthat are not ‘‘customers’’ under thedefinition in Rule 15c3–3. 568 Forexample, under Rule 15c3–3, personsthat are not ‘‘customers’’ include anaccountholder that is a general partner,director, or principal officer of thecarrying broker-dealer, andaccountholders that are themselves

broker-dealers. 569 The Commission didnot receive any comments on Item 3.Aor 3.B and is adopting these questionsas proposed.ii. Item 3.Ca. Background

Item 3.C, as proposed, would haverequired the broker-dealer to identify inthree charts the types of locations whereit held securities and the frequency withwhich it performed reconciliations

between the information on its stockrecord and information on the records of those locations. 570 Each of these charts,which are set forth in Items 3.C.ithrough 3.C.iii, is discussed in moredetail below.

b. General Comments to Item 3.COne commenter suggested that it

would be helpful to require the broker-dealer to disclose the identities of specific entities at which it custodies

securities.571

This commenter statedthat such disclosure would allowregulators to identify potentialdiscrepancies more easily, as well aschanges in custody relationships thatmay warrant further investigations. 572

The Commission has considered thissuggestion and determined thatproviding the identities of a broker-dealer’s custodians instead of the typesof locations would significantly increasethe burden on broker-dealers inpreparing the form, which is intended to

be a starting point for Commission andDEA examiners in assessing a broker-dealer’s compliance with its custodyrequirements. Large broker-dealers oftenmaintain custody of customers’securities in many locations, which cantotal in the hundreds, particularly if the

broker-dealer carries a large number of uncertificated investments forcustomers, such as alternativeinvestments. Requiring broker-dealers todisclose this level of detail on FormCustody could significantly increase thecosts of preparing the form for a numberof broker-dealers. Although theCommission acknowledges thatrequiring the additional information thecommenter suggested would enhancethe ability of regulators to identifydiscrepancies, the Commission believesthat the information on Form Custodyprovides sufficient information to allowexaminers to determine whether it isappropriate to seek additionalinformation from a particular broker-dealer. To the extent a Commission or

DEA examiner believes that it isappropriate to obtain this informationfrom a particular broker-dealer, theexaminer could do so in a documentrequest to that firm, a method that theCommission expects would be lesscostly than requiring this informationfrom all broker-dealers on FormCustody. Accordingly, the Commissionhas determined not to require that

broker-dealers identify on the form thespecific identities of all of theircustodians.

Another commenter to Item 3.Crequested that the Commission clarifythe distinction between ‘‘locationswhere the broker-dealer holds securitiesdirectly in the name of the broker-dealer’’ and ‘‘locations where the

broker-dealer holds securities onlythrough an intermediary.’’ 573 In makingthis distinction, the Commissionintended to distinguish betweenlocations that are aware of the identityof the broker-dealer and act directlyupon the broker-dealer’s instructionsand locations that are not aware of theidentity of the broker-dealer or that willnot act on instructions directly from the

broker-dealer. In the latter scenario, thelocation holding securities for the

broker-dealer would act only oninstructions relating to the broker-dealer’s securities from the broker-dealer’s intermediary. The Commissionhas modified the instructions to Item3.C of Form Custody to reflect thisclarification.

c. Item 3.C.iThe first chart in Item 3.C—set forth

in Item 3.C.i—identifies the mostcommon locations where broker-dealershold securities. Many of the locationsidentified on the first chart, anddescribed below, are locations deemedto be satisfactory control locationsunder paragraph (c) of Rule 15c3–3. 574 The Commission did not receive anycomments on Item 3.C.i of proposedForm Custody and is adopting it asproposed.

The first location identified in thechart is the broker-dealer’s vault.Broker-dealers primarily hold securitiesin fungible bulk at other institutions. Insome cases, however, broker-dealersmay physically hold securitiescertificates ( e.g., in the case of restrictedsecurities).

The second location identified in thechart is another U.S. registered broker-dealer. For example, a broker-dealermay hold customers’ foreign securitiesat another U.S. broker-dealer, or may


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575 See Broker-Dealer Reports, 76 FR at 37587.576 Id. at 37587–37589.577 This definition is similar to the definition of

the term free credit balance in Rule 15c3–3, exceptthat the definition in the rule is limited to liabilitiesto customers whereas the definition in the Formcontemplates liabilities to customers and non-customers. See 17 CFR 240.15c3–3(a)(8).


579 Id.580 Id. at 37587.581 Id.

hold securities in an omnibus account atanother broker-dealer.

The third and fourth locationsidentified in the chart are theDepository Trust Company and theOptions Clearing Corporation. These arethe two most common securitiesclearing and depository organizationsfor equities and options in the U.S. and,consequently, are identified by namerather than by type of location.

The fifth location identified in thechart is a U.S. bank. Broker-dealers mayhave arrangements with U.S. banks toreceive and hold securities for theaccounts of the broker-dealer’scustomers and non-customers, as wellas for the broker-dealer’s own account.Obtaining information about a broker-dealer’s relationships with U.S. bankscould enable examiners to test andconfirm the accuracy of the broker-dealer’s representations on FormCustody ( i.e., that a U.S. bank holdssecurities for the broker-dealer), and, inaddition, facilitate the collection of information regarding the relationship

between the broker-dealer and the bank.For instance, customer fully paid andexcess margin securities must be in thepossession or control of the broker-dealer and therefore cannot be pledgedas collateral for a loan to the broker-dealer, among other things, andcustomer margin securities may not becommingled with proprietary securitiesthat are pledged as collateral for a bankloan. Form Custody could, for example,lead examiners to seek accountstatements and documentationgoverning the broker-dealer’srelationship with the U.S. bank toensure customer fully paid and excessmargin securities are not pledged ascollateral for a loan to the broker-dealer.

The sixth location identified in thechart is the transfer agent of an open-end investment management companyregistered under the InvestmentCompany Act of 1940 ( i.e., a mutualfund). Generally, mutual funds issuesecurities only in book-entry form. Thismeans that the ownership of securitiesis not reflected on a certificate that can

be transferred but rather through a

journal entry on the books of the issuermaintained by the issuer’s transferagent. A broker-dealer that holds mutualfunds for customers generally holdsthem in the broker-dealer’s name on the

books of the mutual fund.d. Item 3.C.ii

The second chart in Item 3.C—setforth in Item 3.C.ii—is intended tocapture all other types of U.S. locationswhere a broker-dealer may holdsecurities that are not specified in thechart included in Item 3.C.i. This

category would include, for example,securities held in book-entry form bythe issuer of the securities or the issuer’stransfer agent. A broker-dealer thatholds securities at such locations mustlist the types of locations in the spacesprovided in the chart and indicate thefrequency with which the broker-dealerperforms asset reconciliations withthose locations. The Commission didnot receive any comments on Item 3.C.iiof proposed Form Custody and isadopting it as proposed.

e. Item 3.C.iii

The third chart in Item 3.C—set forthin Item 3.C.iii—pertains to foreignlocations where the broker-dealermaintains securities. Under theproposal, the Commission did not listcategories of foreign locations becauseterminology used to identify certainlocations may differ by jurisdiction. 575 For example, in some foreignjurisdictions, banks may operate asecurities business, making it difficult toclassify whether securities are held at a

bank or a broker-dealer. A broker-dealerthat holds securities in a foreignlocation must list the types of foreignlocations where it maintains securitiesin the spaces provided in the chart andindicate the frequency with whichreconciliations are performed with thelocation. The Commission did notreceive any comments on Item 3.C.iii of proposed Form Custody and is adoptingit as proposed.

iii. Items 3.D and 3.E

Items 3.D and 3.E of proposed FormCustody each contained three identicalsubparts (discussed in more detail

below) designed to elicit informationabout the types and amounts of securities and cash the broker-dealerheld, whether those securities wererecorded on the broker-dealer’s stockrecord and, if not, why they were notrecorded, and where the broker-dealerheld free credit balances. 576 The GeneralInstructions to proposed Form Custodydefined ‘‘free credit balances’’ asliabilities of a broker-dealer to

customers or non-customers which aresubject to immediate cash payment tocustomers or non-customers on demand,whether resulting from sales of securities, dividends, interest, deposits,or otherwise. 577

The difference between proposed Item3.D and proposed Item 3.E is that theformer would have elicited informationwith respect to securities and free credit

balances held for the accounts of customers, whereas the latter wouldhave elicited information with respectto securities and free credit balancesheld for the accounts of persons who arenot customers. 578 Accordingly, theproposed form asked two sets of identical questions to elicit informationabout each category of accountholder—customer and non-customer. 579

a. Items 3.D.i and 3.E.iItems 3.D.i and 3.E.i of proposed

Form Custody would have elicitedinformation about the types and dollaramounts of the securities the broker-dealer carried for the accounts of customers and non-customers,respectively. 580 Specifically, for eachItem, the broker-dealer would have been

required to complete information on achart to the extent applicable. 581 Theproposed charts were comprised of twelve rows, with each row representinga category of security. These categoriesincluded: (1) U.S. Equity Securities; (2)Foreign Equity Securities; (3) U.S.Listed Options; (4) Foreign ListedOptions; (5) Domestic Corporate Debt;(6) Foreign Corporate Debt; (7) U.S.Public Finance Debt; (8) Foreign PublicFinance Debt; (9) U.S. Government Debt;(10) Foreign Sovereign Debt; (11) U.S.Structured Debt; and (12) ForeignStructured Debt. A thirteenth row wasincluded in each chart to identify anysecurities not specifically listed in thefirst twelve rows. The types of securitieswere categorized this way because thevarious categories ordinarily areassociated with certain types of locations. Thus, as examiners review theform, they could assess whether thetypes of securities held by the broker-dealer were maintained at locationsgenerally known to hold such securities.If a broker-dealer’s completed formindicated that some types of securitieswere held at a location atypical for suchsecurities, the examiner could refine thefocus of the examination to evaluatewhether customer assets were properlysafeguarded. The Commission isadopting these requirements, withmodifications, as discussed below.

One commenter requested that theCommission clarify whether alternativeinvestments, mutual funds, andexchange traded funds fall within the


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582 See SIFMA Letter.583 See Broker-Dealer Reports, 76 FR at 37587.

584 Id.585 Id.586 See SIFMA Letter.587 Id.588 See Broker-Dealer Reports, 76 FR at 37587.589 Id.

590 See 17 CFR 240.17a–3(a)(5).591 See Broker-Dealer Reports, 76 FR at 37588.

scope of ‘‘Other’’ securities within thethirteenth row of Items 3.D.i and3.E.i. 582 The Commission hasconsidered this comment anddetermined that those investments areother types of securities that should bepart of Items 3.D.i and 3.E.i, but that itwould be useful to separately identifyeach of these categories of securities inItems 3.D.i and 3.E.i, rather than groupthem together in the ‘‘Other’’ category.By identifying these types of investments separately on FormCustody, Commission and DEAexaminers will have a betterunderstanding of a broker-dealer’s

business activities and a more refinedunderstanding of the types of securitiesheld by the broker-dealer. Thisinformation, in turn, could facilitatemore focused examinations byCommission and DEA examiners.Accordingly, Items 3.D.i and 3.E.i of Form Custody, as adopted, will contain

six additional rows to account for bothdomestic and foreign alternativeinvestments (referred to on the form as‘‘private funds’’), mutual funds, andexchange traded funds. TheCommission is referring to the term‘‘private funds’’ on the form, rather thanthe term ‘‘alternative investments,’’ forpurposes of clarity; while both terms areoften used interchangeably in practice,the term ‘‘private fund’’ is a regulatoryterm defined in other contexts of thesecurities laws ( e.g., on Form ADV),whereas the term ‘‘alternativeinvestments’’ is not. For purposes of Form Custody, the term ‘‘private fund’’is given the same meaning as is used bythe Commission on Form ADV—that is,an investment company as defined insection 3 of the Investment CompanyAct of 1940 but for section 3(c)(1) or3(c)(7) of that Act. Items 3.D.i and 3.E.iof Form Custody and the relatedInstructions to those Items, as adopted,reflect these changes.

The charts in Items 3.D.i and 3.E.i, asproposed, would have each had eightcolumns. The first column contained

boxes for each category of securityspecified in the Item (and identified inthe second column), as discussed

above.583

The broker-dealer would have been required to check the box in eachchart for every applicable category of security it holds for the accounts of customers and non-customers,respectively. The second column wouldhave identified the category of security.The third through eighth columnsrepresented ranges of dollar values: (1)Up to $50 million; (2) greater than $50million up to $100 million; (3) greater

than $100 million up to $500 million;(4) greater than $500 million up to $1

billion; (5) greater than $1 billion up to$5 billion; and (6) greater than $5

billion. In each chart, the broker-dealerwould have been required to check the

box in the column reflecting theapproximate dollar value for everycategory of security that the broker-dealer carried for the accounts of customers and non-customers,respectively. 584

The Commission proposed identifyingdollar ranges for the values of thesecurities, as opposed to actual values,to ease compliance burdens. 585 Theintent was to elicit information aboutthe relative dollar value of securities the

broker-dealer held for customers andnon-customers in each category of security. Values would be reported as of the date specified in the broker-dealer’saccompanying quarterly FOCUS Report.

One commenter noted that the chartsset forth in Items 3.D.i and 3.E.i of proposed Form Custody did not include

boxes to check to reflect theapproximate dollar values for thecategories of securities the broker-dealercarried for the accounts of customersand non-customers. 586 This commenterrequested guidance on whether broker-dealers would be required to populatethe chart with checkmarks or moreprecise estimates of market value. 587 The Commission intended to include

boxes to check to reflect approximatedollar values in the charts set forth inItems 3.D.i and 3.E.i of proposed FormCustody, and the form, as adopted,includes these boxes.

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

Items 3.D.ii and 3.E.ii of proposedForm Custody would have elicitedinformation concerning whether the

broker-dealer had recorded all thesecurities it carried for the accounts of customers and non-customers,respectively, on its stock record byrequiring the broker-dealer to check theappropriate ‘‘Yes’’ or ‘‘No’’ box. 588 If the

broker-dealer checked ‘‘No,’’ it wouldhave been required to explain in the

space provided why it had not recordedsuch securities on its stock record andindicate the type of securities andapproximate U.S. dollar market value of such unrecorded securities. 589 TheCommission did not receive anycomments on Items 3.D.ii and 3.E.ii of

proposed Form Custody and is adoptingthese Items as proposed.

The Commission anticipates that a broker-dealer ordinarily would answer‘‘Yes’’ in response to Items 3.D.ii and3.E.ii because the stock record—which a

broker-dealer is required to createpursuant to Rule 17a–3 590 —is a recordof custody of securities. A long positionin the stock record indicates ownershipof the security or a right to thepossession of the security. Thus, the‘‘long side’’ of the stock record indicatesthe person to whom the broker-dealerowes the securities. Common examplesof ‘‘long side’’ positions are securitiesreceived from customers ( e.g., fully paidor excess margin securities), securitiesowned by the firm ( i.e., securities heldin the broker-dealer’s inventory for itsown account), securities borrowed, andfails-to-deliver ( i.e., securities sold to orthrough another broker-dealer but notdelivered).

A short position in the stock recordindicates either the location of thesecurities or the responsibility of otherparties to deliver the securities to the

broker-dealer. Every security owned orheld by the broker-dealer must beaccounted for by its location. Sincesecurities are fungible, the short side of the stock record does not in factdesignate where particular securities arelocated. Rather, it indicates the totalamount of securities, on a security-by-security basis, held at each location,which could include, for example,securities depositories. Common short-

side stock record locations also include banks ( e.g., when a broker-dealerpledges securities to a bank as collateralfor a loan), stock loan counterparties(e.g., when a broker-dealer lendssecurities to another firm as part of asecurities lending transaction), andcounterparties failing to deliversecurities to the broker-dealer ( e.g.,when the broker-dealer has purchasedsecurities that have not yet beenreceived from the counterparty).

The Commission’s goals in asking thisquestion were twofold. First, thequestion would elicit the disclosure of

the unusual circumstance in which a broker-dealer carries securities for theaccount of a customer or non-customer

but does not reflect them on its stockrecord. 591 The Commission and othersecurities regulators could use thisinformation to assess whether the

broker-dealer is properly accounting forsecurities. Second, this question couldprompt a broker-dealer to identify, andself-correct, circumstances in which it


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592 Id.593 Id.594 See Rule 15c3–3(e) and Rule 15c3–3a.

595 See Amendments to Financial Responsibility Rules for Broker-Dealers, Exchange Act Release No.55431 (Mar. 9, 2007), 72 FR 12862 (Mar. 19, 2007);Amendments to Financial Responsibility Rules for Broker-Dealers (Reopening of Comment Period),Exchange Act Release No. 34–66910 (May 3, 2012),77 FR 27150 (May 9, 2012). See also letter fromMichael A. Macchiaroli, Associate Director,Division of Market Regulation, Commission, toRaymond J. Hennessy, Vice President, New YorkStock Exchange (‘‘NYSE’’), and Thomas Cassella,Vice President, NASD Regulation, Inc. (Nov. 10,1998).

596 See 17 CFR240.15c3–3(k)(2)(i).597 See Amendments to Financial Responsibility

Rules for Broker-Dealers, Exchange Act Release No.55431 (Mar. 9, 2007), 72 FR 12862 (Mar. 19, 2007)at 12866.

598 See Broker-Dealer Reports, 76 FR at 37589.599 Id.600 Id.601 See Custody of Funds or Securities of Clients

by Investment Advisers, 75 FR at 1462.602 Form BD is the uniform application for broker-

dealer registration with the Commission. Form BDstates that a person is presumed to control acompany if, among other things, that person hasdirectly or indirectly the right to vote 25% or more

Continued

did not include securities on its stockrecord as required by Rule 17a-3. 592 c. Items 3.D.iii and 3.E.iii

Items 3.D.iii and 3.E.iii of proposedForm Custody would have elicitedinformation as to how the broker-dealertreated free credit balances in securitiesaccounts of customers and non-

customers, respectively.593

Theinformation would have been elicitedthrough a chart the broker-dealer would

be required to complete. The chart inItem 3.D.iii of proposed Form Custodyhad five rows with each rowrepresenting a different process fortreating free credit balances. The chartwould have disclosed whether freecredit balances were: (1) Included in acomputation under Rule 15c3–3(e); (2)held in a bank account under Rule15c3–3(k)(2)(i); (3) swept to a U.S. bank;(4) swept to a U.S. money market fund;and/or (5) ‘‘other,’’ with a space todescribe such other treatment. Theoptions were not intended to bemutually exclusive in that a broker-dealer may treat free credit balances inseveral different ways ( e.g., a broker-dealer may be instructed by certaincustomers to sweep their free credit

balances to a bank, and by othercustomers to sweep their free credit

balances to a U.S. money market fund).The Commission did not receive anycomments on Items 3.D.iii and 3.E.iii of proposed Form Custody and is adoptingthese Items as proposed.

A broker-dealer will be required tocheck the box in the first column of thechart for every process that applies tothe broker-dealer’s treatment of freecredit balances in customer and non-customer accounts, respectively. Thefirst process identified on each chart isthat the broker-dealer treats customerand non-customer free credit balancesin accordance with the customer reservecomputation required under paragraph(e) of Rule 15c3–3. Paragraph (e) of Rule15c3–3 requires a broker-dealer tomaintain a special reserve bank accountfor the exclusive benefit of its customersand maintain deposits in that account(to the extent a deposit is required) in

amounts computed in accordance withExhibit A to Rule 15c3–3. 594 Rule 15c3–3 requires that a broker-dealer complywith these reserve account provisionsonly with respect to customer-relatedcredit balances. The Commission has,however, proposed amendments to Rule15c3–3 that would require a broker-dealer to maintain a reserve account andperform a reserve computation for non-

customer accountholders that aredomestic and foreign broker-dealers. 595

The second process identified on thechart is that the broker-dealer handlesfree credit balances by placing funds ina ‘‘bank account under Rule 15c3–3(k)(2)(i).’’ Paragraph (k)(2)(i) of Rule15c3–3 prescribes a process by which a

broker-dealer can qualify for anexemption from the requirements of Rule 15c3–3. Specifically, theexemption applies to a broker-dealerthat does not carry margin accounts,promptly transmits all customer fundsand delivers all securities received inconnection with its activities, does nototherwise hold funds or securities for,or owe money or securities to,customers and effectuates all financialtransactions between the broker-dealerand its customers through one or more

bank accounts that are each designatedas a ‘‘Special Account for the ExclusiveBenefit of Customers of (the name of

broker or dealer).’’596

The third process identified in thechart—‘‘swept to a U.S. bank’’—isincluded because some broker-dealersengage in ‘‘bank sweep programs.’’Rather than hold customer funds insecurities accounts, some broker-dealersrequire or offer the option to transferfree credit balances in securitiesaccounts to a specific money marketfund or interest bearing bank account(‘‘Sweep Programs’’). The customerearns dividends on the money marketfund or interest on the bank accountuntil such time as the customer choosesto liquidate the position in order to usethe cash, for example, to purchasesecurities. 597 Customers must make arequest to the broker-dealer for thereturn of funds swept from theirsecurities accounts to the bank.

The fourth option identified in thechart is that the broker-dealer sweepsfree credit balances into a money marketfund as part of a Sweep Program. Inmost cases when a broker-dealer sweepsfree credit balances into a money marketfund, the broker-dealer purchases sharesin the money market fund, which are

registered in the name of the broker-dealer. The money market fundunderstands that these shares are notproprietary positions of the broker-dealer, and any interest earned on theshares from the money market fund arepayable to the customers.

Finally, the fifth option in the chartcovers any other process that is notdescribed in the other options.4. Item 4—Carrying for Other Broker-Dealers

Item 4 of proposed Form Custodywould have required a broker-dealer todisclose whether it acted as a carrying

broker-dealer for other broker-dealers. 598 There were two sets of questions in Item 4—Item 4.A.i, ii, andiii and Item 4.B.i, ii, and iii. The first setof questions would have elicitedinformation from a broker-dealer as towhether it carried transactions for other

broker-dealers on a fully disclosed

basis.599

The second set of questionswould have elicited information from a broker-dealer as to whether it carriedtransactions for other broker-dealers onan omnibus basis. 600 The Commissiondid not receive any comments to Item 4of proposed Form Custody and isadopting this Item as proposed.

Items 4.A.i and 4.B.i require a broker-dealer to indicate by checking theappropriate ‘‘Yes’’ or ‘‘No’’ box whetherit carries customer accounts for another

broker-dealer on a fully disclosed basisand on an omnibus basis, respectively.Items 4.A.ii and 4.B.ii require a broker-dealer, if applicable, to indicate thenumber of broker-dealers with which ithas an arrangement to carry accounts ona fully disclosed basis and on anomnibus basis, respectively. Items4.A.iii and 4.B.iii require a broker-dealer, if applicable, to identify anyaffiliated broker-dealers that introduceaccounts to the broker-dealer on a fullydisclosed basis and on an omnibus

basis, respectively.As the Commission has noted, related

person custody arrangements canpresent higher risks to ‘‘advisoryclients’’ than maintaining assets with anindependent custodian. 601 Consistentwith the definition of the term in othercontexts applicable to broker-dealers,including Form BD, 602 the General


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of a class of a voting security or has the power tosell or direct the sale of 25% or more of a class of voting securities, or, in the case of a partnership,the right to receive upon dissolution, or hascontributed, 25% or more of the firm’s capital.

603 This definition of the term affiliate is the sameas the definition in Form BD, including thespecification that ownership of 25% or more of thecommon stock is deemed prima facie evidence of control.

604 Form Custody does not require a broker-dealerto identify unaffiliated broker-dealers for which itcarries accounts, though, as discussed above, itwould need to indicate that it carries accounts forsuch broker-dealers. The Commission believes that

this approach provides the Commission and DEAexaminers with access to useful informationinvolving a broker-dealer’s custody practices whilealleviating potential time and cost burdensassociated with completing Form Custody giventhat some broker-dealers carry accounts forhundreds of unaffiliated broker-dealers. TheCommission notes that information about these

broker-dealers would be part of the books andrecords of the carrying broker-dealer. Therefore, anaffirmative answer to Item 4 could prompt theCommission and DEA examiners to requestinformation about the identities of the unaffiliated

broker-dealers. See Broker-Dealer Reports, 76 FR at37589 n.143.


606 17 CFR 240.10b–10.607 Id.608 See 17 CFR 240.17a–3(a)(1), which requires

the broker-dealer to make ‘‘[b]lotters (or otherrecords of original entry) containing an itemizeddaily record of all purchases and sales of securities,all receipts and deliveries of securities (includingcertificate numbers), all receipts and disbursementsof cash and all other debits and credits. Suchrecords shall show the account for which each suchtransaction was effected, the name and amount of

securities, the unit and aggregate purchase or saleprice (if any), the trade date, and the name or otherdesignation of the person from whom purchased orreceived or to whom sold or delivered.’’

609 Although broker-dealers may allocate thefunction of sending confirmations to other broker-dealers or to service providers, the allocating

broker-dealer retains the responsibility for sendingconfirmations. See New York Stock Exchange, Inc.; Order Approving Proposed Rule Change, ExchangeAct Release No. 18497 (Feb. 19, 1982), 47 FR 8284(Feb. 25, 1982) at n.2 (providing ‘‘no contractualarrangement for the allocation of functions betweenan introducing and carrying organization canoperate to relieve either organization from theirrespective responsibilities under the federalsecurities laws and applicable SRO rules’’).

610 See SIFMA Letter.611 See Broker-Dealer Reports, 76 FR at 37590–

37591.612 See SIFMA Letter.613 See, e.g., NASD Rule 2340.614 See NASD Rule 2340. NASD Rule 2340

defines a general securities member as any memberthat conducts a general securities business and isrequired to calculate its net capital pursuant to Rule15c3–1. NASD Rule 2340(d)(2). Additionally, NASDRule 2340 defines account activity broadly so that

Instructions for Form Custody definethe term ‘‘affiliate’’ as any person whodirectly or indirectly controls the

broker-dealer or any person who isdirectly or indirectly controlled by orunder common control with the broker-dealer. The definition also specifies thatownership of 25% or more of thecommon stock of the broker-dealerintroducing accounts to the broker-dealer submitting the Form Custody isdeemed prima facie evidence of control;this provision also is consistent with thedefinition used in Form BD. 603

Item 4 in Form Custody elicitsinformation about broker-dealers’custodial responsibilities with respect toaccounts held for the benefit of other

broker-dealers, and requires broker-dealers to identify such broker-dealersthat are affiliates of the broker-dealer. 604 The Commission believes that thisinformation will provide theCommission with an enhanced

understanding of, and useful andreadily available information relating to,the scope of broker-dealer introducing/carrying relationships and activities,and the custodial practices of broker-dealers involved in such relationships.5. Item 5—Trade Confirmations

Item 5 of Form Custody, as proposed,would have required broker-dealers todisclose whether they send transactionconfirmations to customers and otheraccountholders by checking theappropriate ‘‘Yes’’ or ‘‘No’’ box. 605 Confirmations are important safeguardsthat enable customers to monitortransactions that occur in theirsecurities accounts. Timely

confirmations alert customers of unauthorized transactions and providecustomers with an opportunity to objectto the transactions. The Commissionreceived one comment on Item 5 of proposed Form Custody. As discussed

below, the Commission is modifying theinstructions to Item 5 in response to thiscomment and is otherwise adoptingItem 5 as proposed.Exchange Act Rule 10b–10 specifiesthe information a broker-dealer mustdisclose to customers on a tradeconfirmation at or before completion of a securities transaction. 606 Generally,Rule 10b–10 requires a confirmation toinclude, among other things: (1) Thedate and time of the transaction and theidentity, price, and number of shares orunits (or principal amount) of suchsecurity purchased or sold by suchcustomer; (2) the broker-dealer’scapacity (agent or principal) and itscompensation; (3) the source and

amount of any third party remunerationit has received or will receive; and (4)other information, both general ( e.g.,that the broker-dealer is not a SIPCmember, if such is the case) andtransaction-specific ( e.g., certain yieldinformation in most transactionsinvolving debt securities). 607

The information contained on a tradeconfirmation should reconcile withcustomer statements and the broker-dealer’s journal entries. 608 In thisregard, there is a link between tradeconfirmations sent by a broker-dealerand the broker-dealer’s recordspertaining to custody of customerassets. 609 How a broker-dealer answersItem 5 could assist examiners infocusing their inspections. For example,if the form indicates that a third partyis responsible for sending trade

confirmations, the examiners canconfirm with that third party that it isin fact sending confirmations.

With respect to Item 5.A, onecommenter requested clarification as towhether a broker-dealer should indicatethat it sends trade confirmationsdirectly to customers (by checking‘‘yes’’) where it employs a vendor to doso. 610 The Commission has consideredthis comment and determined that a

broker-dealer should affirmativelyrespond to Item 5 of Form Custody, asadopted, by checking the ‘‘yes’’ box onthe form if it employs a vendor to sendtrade confirmations to customers on its

behalf because, in such an arrangement,the broker-dealer is ultimatelyresponsible for complying with its tradeconfirmation obligations, not thevendor. The Commission has modifiedthe instructions to Item 5 to reflect thisclarification.

6. Item 6—Account StatementsItem 6 of proposed Form Custody

would have required broker-dealers todisclose whether they send accountstatements directly to customers andother accountholders by checking theappropriate ‘‘Yes’’ or ‘‘No’’ box. 611 TheCommission received one comment onItem 6 of proposed Form Custody. 612 Asis discussed below, the Commission ismodifying the instructions to Item 6 inresponse to this comment and isotherwise adopting Item 6 as proposed.

Account statements generally are sentto customers and other accountholderson a monthly or quarterly basis andtypically set forth the assets held in theinvestor’s securities account as of aspecific date and the transactions thatoccurred in the account during therelevant period. SROs imposerequirements on broker-dealers withrespect to the statements they must sendto their customers. 613 For example,FINRA generally requires any memberthat conducts a general securities

business and also carries customeraccounts or holds customer funds orsecurities, at least once each calendarquarter, to send an account statement toeach customer whose account had asecurity position, money balance, oraccount activity since the last statementwas sent. 614 The account statement


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clients’ assets in customer accounts segregated fromits proprietary assets. See 17 CFR 275.206(4)–2(d)(6). A qualified custodian must maintain clientfunds and securities: (1) In a separate account foreach client under that client’s name; or (2) inaccounts that contain only the clients’ funds andsecurities, under the investment adviser’s name asagent or trustee for the clients. See 17 CFR275.206(4)–2(a)(1).

626 See Broker-Dealer Reports, 76 FR at 37591.627 Id.628 Id.629 See, e.g., Custody of Funds or Securities of

Clients by Investment Advisers, 75 FR at 1465.630 See Broker-Dealer Reports, 76 FR at 37591.

631 If the broker-dealer acts as custodian for aninvestment adviser client’s securities, and does notrecord those securities on its stock record, the

broker-dealer would need to explain why thosesecurities were not recorded on its stock record inresponse to the question in Item 3.D.ii of FormCustody.

632 See Angel Letter.633 Column 2 of Item 8.C of Form Custody, as

proposed, would have required a broker-dealer/investment adviser to identify the SEC File No. orCRD No. of each custodian where assets of investment adviser clients were held. However, notall custodians of investment adviser client assetshave an SEC File No. or CRD No. Accordingly, theinstructions applicable to Column 2 of Item 8.C, asadopted, have been modified to provide that a

broker-dealer needs to identify custodians in thecolumn by SEC File No. or CRD No., ‘‘if applicable.’’ Thus, a broker-dealer can leaveColumn 2 of Item 8.C blank if assets of itsinvestment adviser clients are held at a custodianthat does not have an SEC File No. or CRD No.


635 Id.636 See supra note 603 and corresponding text

which specifies the same ownership percentage onForm BD.

In the first column, the broker-dealerwould have been required to disclosethe name of the custodian, and in thesecond column, the broker-dealer wouldhave been required to identify thecustodian by either SEC file number orCRD number, as applicable. 626

The third and fourth columns of the

chart would have elicited informationabout the scope of the broker-dealer/investment adviser’s authority over theaccounts held at the custodian byrequiring the broker-dealer/investmentadviser to check the appropriate ‘‘Yes’’or ‘‘No’’ box. 627 Specifically, in the thirdcolumn, the broker-dealer/investmentadviser would have been required toindicate whether it had the authority toeffect transactions in the advisory clientaccounts at the custodian. In the fourthcolumn, the broker-dealer/investmentadviser would have been required toindicate whether it had the authority towithdraw funds and securities fromthose accounts.

In the fifth column, the broker-dealer/investment adviser would have beenrequired to indicate whether thecustodian sends account statementsdirectly to the broker-dealer’sinvestment adviser clients. 628 TheCommission recently adoptedamendments to Rule 206(4)–2 to requirethat investment advisers have areasonable basis, after due inquiry, for

believing that qualified custodians of advisory client assets send accountstatements to the investment advisers’

clients. As stated in the release adoptingthat requirement, the Commission believes that the direct delivery of account statements by qualifiedcustodians provides greater assurance of the integrity of account statementsreceived by clients. 629

In the sixth column, the broker-dealer/investment adviser would have

been required to indicate whetherinvestment adviser client assets wererecorded on the broker-dealer’s stockrecord. 630 If the broker-dealer was actingas custodian for such assets, theCommission anticipates that those

assets would be recorded on the broker-dealer’s stock record. 631

The Commission received onecomment in response to Item 8 of FormCustody, as proposed. 632 Thiscommenter stated that the informationsought in Item 8 was largely redundantwith information collected frominvestment advisers on Form ADV. TheCommission is aware that some overlapexists between the information collectedfrom investment advisers on Form ADVand the information that would becollected from broker-dealers dually-registered as investment advisers inItem 8 of proposed Form Custody.However, these two forms also containa significant amount of non-overlappingmaterial, reflecting their differentpurposes and uses. Form Custody isintended to be a single source of readily-available information to assistCommission and DEA examiners inpreparing for and performing focusedcustody exams, and it is particularlyimportant that such information bereadily available in the case of dually-registered firms. Accordingly, theCommission is adopting Item 8 of FormCustody substantially as proposed. 633

9. Item 9—Broker-Dealers AffiliatedWith Investment Advisers

Item 9 of Form Custody consists of two subparts. Item 9.A, as proposed,would have elicited informationconcerning whether the broker-dealerwas an affiliate of an investmentadviser. 634 Item 9.B.i, as proposed,would have elicited information from a broker-dealer that checks ‘‘Yes’’ inresponse to Item 9.A to identify whetherit has custody of client assets of theadviser, and, if Item 9.B.i is checked‘‘Yes,’’ to indicate the approximate U.S.dollar market value of the adviser clientassets of which the broker-dealer has

custody. 635 The Commission did notreceive any comments to Item 9 of proposed Form Custody and is adoptingthis Item as proposed. The additionalinformation obtained from a broker-dealer in response to Item 9 will provideSEC and DEA examiners with a betterunderstanding of a broker-dealer’scustody profile and, in particular,custodial relationships with investmentadviser affiliates.

For purposes of Item 9, an affiliate isany person who directly or indirectlycontrols the broker-dealer or any personwho is directly or indirectly controlled

by or under common control with the broker-dealer. Ownership of 25% ormore of the common stock of theinvestment adviser is deemed prima

facie evidence of control. 636

V. Effective Dates

As discussed below, the Commissionhas established December 31, 2013 asthe effective date for the requirement tofile Form Custody and the requirementto file annual reports with SIPC. TheCommission is delaying the effectivedate for the requirements relating to

broker-dealer annual reports to June 1,2014. These delayed effective dates areintended to provide time for broker-dealers, broker-dealer independentpublic accountants, and broker-dealerDEAs to prepare for the changes thatwill result from these new requirements.The amendments relating to broker-

dealer annual reports and the otheramendments to Rule 17a–5 (includingthe technical amendments) affectnumerous paragraphs in that rule andtwo paragraphs in Rule 17a–11. Giventhe complexity and practical difficultyof having certain provisions becomeeffective before others, the amendmentsto Rule 17a–5 and the amendments toRule 17a–11 will become effective on

June 1, 2014, regardless of whether theyrelate to the annual report requirements,except that there will be differenteffective dates for the amendments toparagraph (a) of Rule 17a–5 (which

includes the filing requirement for FormCustody), Form Custody, the deletion of paragraph (e)(5) of Rule 17a–5 (whichsets forth the requirement to file FormBD–Y2K), and the requirement to fileannual reports with SIPC. The effectivedates for the remaining paragraphs of Rule 17a–5 and Rule 17a–11 arediscussed further below.


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637 See paragraph (a)(5) of Rule 17a–5.638 See E&Y Letter; SIFMA Letter.

639 See Broker-Dealer Reports, 76 FR at 37581.During the transition period, the statement in thecompliance report as to whether internal controlwas effective would have been a point-in-timestatement as of the date of the report, rather thancovering the entire fiscal year.

640 See, e.g., ABA Letter; AICPA Letter; CAQ Letter; Citrin Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter; SIFMA Letter; Shatto Letter; CAI Letter; Van Kampen/Invesco Letter.

641 See Shatto Letter.642 See, e.g., CAQ Letter; Deloitte Letter; Grant

Thornton Letter; KPMG Letter; McGladrey Letter.643 See ABA Letter.644 See Van Kampen/Invesco Letter.

645 See E&Y Letter.646 See CAI Letter.647 See SIFMA Letter.648 Id.

A. Amendments Effective 60 Days After Publication in the Federal Register

Before today’s amendments,paragraph (e)(5) of Rule 17a–5 requireda broker-dealer to file Form BD–Y2K,which elicits information with respectto a broker-dealer’s readiness for theyear 2000 and any potential problemsthat could arise with the advent of thenew millennium. The Commission isdeleting this paragraph from Rule 17a–5 as the requirement is no longerapplicable. The amendment deletingparagraph (e)(5) of Rule 17a–5 will beeffective 60 days after this release ispublished in the Federal Register .B. Amendments Effective on December 31, 2013

The amendments to paragraph (a) of Rule 17a–5 and the rule establishingForm Custody (17 CFR 249.639) areeffective on December 31, 2013. Theamendments to paragraph (a) include

the requirement for a broker-dealer tofile Form Custody with its DEA. 637 Consequently, broker-dealers subject tothis filing requirement must begin filingForm Custody with their DEAs 17

business days after the calendar quarteror fiscal year, as applicable, endedDecember 31, 2013.

Two commenters requested that theCommission provide broker-dealerswith sufficient time to develop, test, andimplement the systems that they willuse to comply with the Form Custodyfiling requirements. 638 The Commissionunderstands that broker-dealers willneed to allocate personnel and systemsresources to comply with the FormCustody filing requirements,particularly for a broker-dealer’s initialfiling. DEAs also will need to beprepared to receive the forms that arefiled by broker-dealers. EstablishingDecember 31, 2013 as the effective dateof the Form Custody requirements isdesigned to accommodate the effortsthat need to be undertaken by both

broker-dealers and DEAs in connectionwith the filing and receipt of FormCustody.

Additionally, the amendment toparagraph (d)(6) of Rule 17a–5 is

effective on December 31, 2013. Broker-dealer annual reports must be filed withSIPC for fiscal years ending on or afterDecember 31, 2013.C. Amendments Effective on June 1,2014

The amendments to paragraphs (b),(c), (d)(1), (d)(2), (d)(3), (d)(4), (d)(5),(e)(1), (e)(2), (e)(3), (e)(4), (f), (g), (h), (i),(k), (l), (m) and (n) and the deletion of

paragraph (j) of Rule 17a–5 and theamendments to Rule 17a–11 areeffective on June 1, 2014. Consequently,all of the amendments to Rule 17a–5 notdiscussed above in sections V.A. andV.B. of this release and the amendmentsto Rule 17a–11 are effective on that date.This includes the amendments relatingto the annual report requirements, withthe exception of the requirement to fileannual reports with SIPC, which iseffective on December 31, 2013. In 2014,therefore, the annual reportrequirements will apply to all broker-dealers subject to these requirementsthat have a fiscal year ending on or after

June 1, 2014.The Commission proposed that the

amendments would apply for fiscalyears ending on or after December 15,2011, with a first-year transition periodfor carrying broker-dealers required tofile compliance reports with fiscal yearsending on or after December 15, 2011

but before September 15, 2012.639

TheCommission received 14 commentsconcerning the compliance date of theamendments. 640 Most commentersrecommended that the Commissiondelay the compliance date. Onecommenter, however, stated that broker-dealers should start working oncompliance immediately. 641 Severalstated that the compliance date of theamendments should be aligned with theeffective date of the proposed PCAOBstandards for engagements related tocompliance reports and exemptionreports. 642 One commenter suggestedthat the Commission postpone theassertion requirements until the rule has

been in effect for one year. 643 Anothercommenter stated that the rules should

be effective for fiscal years ending on or before December 15, 2012 ‘‘to allowsufficient time to complete robustdocumentation and testing of theprocesses related to the FinancialResponsibility Rules and the FinancialStatements.’’ 644 Similarly, anothercommenter stated that the effective dateshould be deferred to fiscal years endingon or before December 15, 2012 ‘‘to give

broker-dealers and their auditors time to

adequately address the final rules,’’ andthat the effective date should be alignedwith the effective date of PCAOBstandards. 645 Another commenter statedthat the rule amendments should applyonly to annual reports filed on or afterDecember 15, 2012, and thatimplementation of the proposal must bepostponed until after the PCAOBestablishes auditing and attestationstandards and broker-dealers have hadample time to plan and budget for thenew standards. 646 Finally, a commenterstated that broker-dealers should berequired to file the first compliancereport or exemption report no earlierthan one quarter after the adoption of the final rule amendments and to reportidentified instances of material non-compliance or material weaknesses inannual reports filed no earlier than fivequarters after the adoption of the finalrule amendments, with a transitionperiod as proposed of no less than five

quarters after the adoption of the finalrule amendments. 647 This commenteralso suggested that the Commissionrequire the filing of the first FormCustody no earlier than three quartersafter the effective date of the finalrule. 648

The amendments, among other things,establish important new safeguards withrespect to broker-dealer custody of customer funds and securities.However, the Commission recognizesthat broker-dealers and other affectedparties may need additional time toprepare to comply with the newrequirements.

Amendments to provisions regarding broker-dealer annual reports and theengagement of an independent publicaccountant in paragraphs (d)(1), (d)(2),(d)(3), (d)(4), (d)(5), (e)(1), (e)(2), (e)(3),(e)(4), (g), and (i) of Rule 17a–5 and thedeletion of paragraph (j) of Rule 17a–5generally will apply for broker-dealerswith fiscal years ending on or after June1, 2014. In particular, broker-dealersmust file compliance reports orexemption reports, as applicable, and

broker-dealers must file reports of independent public accountantscovering compliance reports or

exemption reports in accordance withRule 17a–5 as amended, for fiscal yearsending on or after June 1, 2014, with notransition period. Similarly, PCAOBstandards, rather than GAAS, apply toexaminations of financial reports forfiscal years ending on or after June 1,2014. For broker-dealers with fiscalyears that end before June 1, 2014,


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649 See Citrin Letter.650 See ABA Letter.651 44 U.S.C. 3501 et seq.652 See Broker-Dealer Reports, 76 FR at 37594–

37598.

653 See discussion above in sections II.B.1., II.B.2.,II.B.3., and II.B.4. of this release.

654 See discussion above in section II.B.2. of thisrelease.

applicable reports must be filed inaccordance with the provisions of Rule17a–5 as they existed before today’samendments.

Amendments to the customerstatement provisions of paragraph (c) of Rule 17a–5 apply for fiscal years endingon or after June 1, 2014, and in theinterim broker-dealers must complywith those provisions as they existed before today’s amendments.

Paragraph (f)(2) of Rule 17a–5 requiresa broker-dealer to file a statementregarding its independent publicaccountant on December 10 of eachyear. As a result of today’s amendments,all broker-dealers that are required byRule 17a–5 to engage an independentpublic accountant must file a newstatement by December 10, 2013 thatcontains the information andrepresentations required underparagraph (f)(2) of Rule 17a–5 asamended. For example, after today’samendments, the statement mustinclude a representation that theaccountant has undertaken theengagement of the accountantprovisions of paragraph (g) of Rule 17a–5 as amended. The statement also mustinclude, if applicable, representationsregarding access to the broker-dealer’sindependent public accountant and theaudit documentation of the independentpublic accountant.

The amendments to the notificationprovisions in paragraph (h) of Rule 17a–5 and amendments to Rule 17a–11 areeffective on June 1, 2014. In the interim,these provisions as they existed beforetoday’s amendments continue to apply.Finally, the amendments toparagraphs (b), (c), (d)(1), (d)(2), (d)(3),(d)(4), (d)(5), (e)(1), (e)(2), (e)(3), (e)(4),(f), (g), (h), (i), (k), (l), (m), and (n) of Rule 17a–5 and the amendments to Rule17a–11 not discussed above, includingtechnical amendments, are effective on

June 1, 2014.With respect to the annual report

requirements, the June 1, 2014 effectivedate should provide sufficient time forthe PCAOB to finalize, and for theCommission to consider, proposedstandards applicable to broker-dealer

examinations and reviews and for broker-dealers and their accountants to become familiar with, and be preparedto comply with, those standards. TheCommission has chosen a specificeffective date, instead of aligning thatdate with the date of adoption of therule amendments or the date that theCommission approves PCAOB standardsapplicable to broker-dealerexaminations and reviews, as suggested

by commenters, to provide certaintyregarding the date by which broker-dealers and their accountants must

comply with the new requirements.Certain commenters referenced AICPAguidance with respect to broker-dealeraudits. However, this guidance will nolonger be applicable for fiscal yearsending on or after June 1, 2014, whenstandards of the PCAOB begin to apply.

One commenter suggested that theeffective date for non-carrying andsmaller broker-dealers to comply withamendments to the annual reportingrequirements should be one year afterthe adoption of the amendments. 649 TheCommission notes that most smaller

broker-dealers are non-carrying firmsand, therefore, will be required to filethe exemption report and a report of theindependent public accountant basedon a review of the exemption report. Asdiscussed in sections VI. and VII. of thisrelease, the hour burdens and costs of the exemption report requirements will

be substantially less than the hour burdens and costs of the compliance

report requirements. Consequently, theCommission does not believe theeffective date should be extendedfurther for smaller broker-dealers.

As stated above, another commentersuggested that the Commissionpostpone the assertion requirementsuntil the rule has been in effect for oneyear. 650 The Commission recognizesthat all broker-dealers subject to theserequirements and their independentpublic accountants will need time toprepare to comply with therequirements. The effective date theCommission is establishing shouldprovide sufficient time for small or non-carrying firms, as well as larger carryingfirms, to prepare for compliance withthe new requirements.VI. Paperwork Reduction Act

Certain provisions of the final ruleamendments contain ‘‘collection of information’’ requirements within themeaning of the Paperwork ReductionAct of 1995 (‘‘PRA’’). 651 TheCommission solicited comment on theestimated burden associated with thecollection of information requirementsin the proposed amendments. 652 TheCommission submitted the proposedcollection of information requirementsto the Office of Management and Budget(‘‘OMB’’) for review in accordance with44 U.S.C. 3507 and 5 CFR 1320.11.

The titles and OMB control numbersfor the collections of information are:

(1) Rule 17a–5, Reports to be made bycertain brokers and dealers (OMBControl Number 3235–0123);

(2) Rule 17a–11, Notificationprovisions for brokers and dealers (OMBControl Number 3235–0085); and

(3) Form Custody (OMB ControlNumber 3235–0691).

An agency may not conduct orsponsor, and a person is not required torespond to, a collection of informationrequirement unless it displays acurrently valid OMB control number. Asdiscussed above, the Commissionreceived 27 comment letters on theproposed rulemaking. Some of thesecomments relate directly or indirectly tothe PRA. These comments are addressed

below. Finally, some initial burdenestimates have been adjusted, asdiscussed below, to reflect updatedinformation used to make the estimates.

A. Summary of the Collection of Information Requirements

As discussed in greater detail above insections II., III., and IV. of this release,

the Commission is adoptingamendments to Rules 17a–5 and 17a–11and is adopting new Form Custody for

broker-dealers to file with their DEA.Under the amendments to Rule 17a–

5, broker-dealers must, among otherthings, file with the Commission annualreports consisting of a financial reportand one of two new reports—either acompliance report or an exemptionreport that are prepared by the broker-dealer, and generally must also filereports prepared by an independentpublic accountant registered with thePCAOB covering those reports inaccordance with PCAOB standards. 653 The financial report must contain thesame types of financial statements thatwere required to be filed under Rule17a–5 prior to these amendments (astatement of financial condition, astatement of income, a statement of cashflows, and certain other financialstatements). 654 In addition, the financialreport must contain, as applicable, thesupporting schedules that were requiredto be filed under Rule 17a–5 prior tothese amendments (a computation of netcapital under Rule 15c3–1, acomputation of the reserve requirementsunder Rule 15c3–3, and informationrelating to the possession or controlrequirements under Rule 15c3–3).

A broker-dealer that does not claim anexemption from Rule 15c3–3 throughthe most recent fiscal year—generally acarrying broker-dealer—must file thecompliance report, and a broker-dealerthat claimed an exemption from Rule15c3–3 throughout the most recent


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655 See discussion above in section II.D.3. of thisrelease.

656 See paragraphs (f)(1) and (g)(2)(i) of Rule 17a–5.


658 See discussion above in section II.C.4. of thisrelease.

659 See discussion above in section II.F. of thisrelease.

660 See discussion above in section III. of thisrelease.

661 See discussion above in section IV. of thisrelease. 662 See Broker-Dealer Reports, 76 FR at 37595.

fiscal year must file the exemptionreport. In the compliance report andexemption report, a broker-dealer mustmake certain statements and providecertain information relating to thefinancial responsibility rules.

In addition to preparing and filing thefinancial report and the compliancereport or exemption report, a broker-dealer must engage a PCAOB-registeredindependent public accountant toprepare a report based on anexamination of the broker-dealer’sfinancial report in accordance withPCAOB standards. 655 A broker-dealerthat files a compliance report also mustengage the PCAOB-registeredindependent public accountant toprepare a report based on anexamination of certain statements in thecompliance report. 656 A broker-dealerthat files an exemption report mustengage the PCAOB-registeredindependent public accountant to

prepare a report based on a review of certain statements in the broker-dealer’sexemption report. In each case, theexamination or review must beconducted in accordance with PCAOBstandards. A broker-dealer must filethese reports of the independent publicaccountant with the Commission alongwith the financial report and thecompliance report or exemption reportprepared by the broker-dealer.

The amendments add a requirementthat the annual reports also be filed withSIPC if the broker-dealer is a member of SIPC. 657 In addition, broker-dealersmust generally file with SIPC asupplemental report on the status of themembership of the broker-dealer inSIPC. 658 The supplemental report mustinclude a report of the independentpublic accountant based on certainprocedures specified in the rule inaccordance with PCAOB standards. Inthe future, SIPC may determine theformat of this report by rule, subject toCommission approval.

Under the amendments, the PCAOB-registered independent publicaccountant must immediately notify the

broker-dealer if the accountantdetermines during the course of

preparing the accountant’s reports thatthe broker-dealer was not in complianceat any time during the fiscal year withthe financial responsibility rules or if the accountant determines that anymaterial weakness existed in the broker-

dealer’s Internal Control OverCompliance during the fiscal year. 659 The broker-dealer, in turn, must file anotification with the Commission andits DEA under Rule 15c3–1, Rule 15c3–3, or Rule 17a–11 if the accountant’snotice concerns an instance of non-compliance that would triggernotification under those rules. Underamendments to Rule 17a–11, a broker-dealer also must file a notification withthe Commission and its DEA if theaccountant’s notice concerns (or if the

broker-dealer discovers) a materialweakness in the broker-dealer’s InternalControl Over Compliance.

The amendments also require a broker-dealer that clears transactions orcarries customer accounts to agree toallow representatives of the Commissionor the broker-dealer’s DEA to review thedocumentation associated with thereports of the broker-dealer’sindependent public accountant and to

allow the accountant to discuss itsfindings with the representatives, if requested in writing for purposes of anexamination of the broker-dealer. 660

Finally, the amendments require broker-dealers to file a new FormCustody, which elicits informationconcerning the custody practices of the

broker-dealer. 661 Form Custody must befiled with the DEA each quarter. TheDEA must transmit the informationobtained from Form Custody to theCommission at the same time that ittransmits FOCUS Report data to theCommission under paragraph (a)(4) of Rule 17a–5.

The burdens associated with thecollection of information requirementsin the amendments are discussed below.B. Use of Information

The proposed amendments relating tothe reports to be filed by the broker-dealer are designed to enhance theability of the Commission to oversee

broker-dealer custody practices and,among other things, to: (1) Increase thefocus of carrying broker-dealers andtheir independent public accountantson compliance, and internal controlover compliance, with the financialresponsibility rules; (2) facilitate theability of the PCAOB to implement theexplicit oversight authority of broker-dealer audits provided to the PCAOB bythe Dodd-Frank Act; and (3) withrespect to broker-dealers that are dually-registered as investment advisers, satisfythe internal control report requirement

that was added by the amendment toRule 206(4)–2 noted above with theaccountant’s report based on anexamination of the compliance report.Securities regulators will use thesereports to monitor the financialcondition of broker-dealers. In addition,the components of the reports that aremade public may be used by investorsto review the financial condition of

broker-dealers with which they haveaccounts or obtain other securitiesrelated services. SIPC can use theannual reports to monitor the financialstrength of broker-dealers and to assessthe adequacy of the SIPC Fund.

The amendment requiring a broker-dealer that clears transactions or carriescustomer accounts to allow Commissionand DEA examination staff to review theaudit documentation associated with itsannual audit reports required underRule 17a–5 and to allow its independentpublic accountant to discuss findingsrelating to the audit reports withCommission and DEA examination staff is intended to facilitate examinations of clearing broker-dealers by Commissionand DEA examination staff. Commissionand DEA examiners will use theinformation obtained from auditdocumentation and discussions with the

broker-dealer’s independent publicaccountant to plan their examinations.

Finally, Commission and DEAexaminers will use Form Custody tounderstand a broker-dealer’s custodyprofile and identify custody-relatedviolations and misconduct. For

example, if a broker-dealer representson Form Custody that it does not issueaccount statements, but an examinerdiscovers that an account statement has

been issued by the broker-dealer ( e.g., inconnection with a customer complaintor in the course of an examination of the

broker-dealer), the examiner will be ableto react more quickly to themisrepresentation. Further, therequirement to prepare and file the formshould motivate broker-dealers to focusmore attention on their custodypractices.

C. Respondents

The Commission estimated in theproposal that there were 5,063registered broker-dealers that would beaffected by the proposed amendmentsand that, of these, 305 were carrying

broker-dealers, 528 were carrying orclearing broker-dealers, and 4,752 were

broker-dealers that claimed exemptionsfrom Rule 15c3–3. 662 The Commissiondid not receive comments regardingthese estimates, but the Commission has


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663 The updated estimates are based on FOCUSReport data as of year end 2011. As discussedabove, FOCUS Reports are deemed confidentialpursuant to paragraph (a)(3) of Rule 17a–5.

664 As discussed below, the total one-time burdenrelates to the requirement to draft and file a revisedstatement regarding the independent publicaccountant under Rule 17a–5(f)(2). The Commissionestimated a total one-time burden of 10,214 hoursin the proposing release for the statement regardingthe independent public accountant and for SIPCforms. See Broker-Dealer Reports, 76 FR at 37595.

665 As discussed below, the total annual hour burden relates to the compliance report (17,520hours), the exemption report (30,919 hours), thefiling of annual reports with SIPC (2,246 hours),and Form Custody (226,032 hours). TheCommission estimated a total annual burden of 287,325 hours in the proposing release. See Broker-Dealer Reports, 76 at FR 37595.

666 See Broker-Dealer Reports, 76 FR at 37596.667 See SIFMA Letter.668 Id.669 See Van Kampen/Invesco Letter. 670 Id.

updated the estimates to reflect morerecent information. 663

As of December 31, 2011, 4,709 broker-dealers filed FOCUS Reportswith the Commission. Of these, 4,417

broker-dealers claimed exemptions fromRule 15c3–3. Consequently, theCommission estimates that there areapproximately 292 carrying broker-dealers (4,709 ¥ 4,417 = 292). Based onFOCUS Report data, the Commissionfurther estimates that there areapproximately 513 carrying or clearing

broker-dealers. According to SIPC, as of March 31, 2012, 217 broker-dealersclaimed exemptions from SIPCmembership. Therefore, theCommission estimates that 4,492 (4,709¥ 217 = 4,492) broker-dealers aremembers of SIPC.

D. Total Initial and Annual Burdens

As discussed in detail below, theCommission estimates that the totalPRA burden resulting from theamendments to Rules 17a–5 and 17a–11and new Form Custody include aninitial, one-time burden of approximately 13,522 hours 664 and anannual burden of approximately276,717 hours. 665 There is significantvariance between the largest broker-dealers and the smallest broker-dealers.Consequently, the estimates described

below are averages across all types of broker-dealers expected to be affected by the amendments.

1. Annual Reports To Be Filed

i. The Financial ReportThe Commission’s amendments to

Rule 17a–5 retain the currentrequirement that broker-dealersannually file financial statements andsupporting schedules that must beaudited by a PCAOB-registeredaccountant. As a result, theCommission’s estimate of the hour

burden for broker-dealers to prepare andfile the financial report has not changed

as a result of the amendments to Rule17a–5.ii. The Compliance Report

Under the amendments, a carrying broker-dealer must prepare and file withthe Commission a new compliancereport each year. The compliance reportmust contain statements as to whether:

(1) The broker-dealer has establishedand maintained Internal Control OverCompliance; (2) the Internal ControlOver Compliance of the broker-dealerwas effective during the most recentfiscal year; (3) the Internal Control OverCompliance of the broker-dealer waseffective as of the end of the most recentfiscal year; (4) the broker-dealer was incompliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3 as of theend of the most recent fiscal year; and(5) the information the broker-dealerused to state whether it was incompliance with Rule 15c3–1 and

paragraph (e) of Rule 15c3–3 wasderived from the books and records of the broker-dealer. In addition, if applicable, the compliance report mustcontain a description of: (1) Eachidentified material weakness in the

broker-dealer’s Internal Control OverCompliance during the most recentfiscal year, including those that wereidentified as of the end of the fiscalyear; and (2) any instance of non-compliance with Rule 15c3–1 orparagraph (e) of Rule 15c3–3 as of theend of the most recent fiscal year.

The Commission estimated that, onaverage, carrying broker-dealers wouldspend approximately 60 hours each yearto prepare the compliance report, asproposed. 666

One commenter stated that theproposal did not ‘‘address the additionalcosts broker-dealers would incur inpreparing Compliance Reports.’’ 667 Thecommenter, however, did not commentdirectly on the estimated hour burden orprovide specific examples of costs, inaddition to the hour burdens, that

broker-dealers would bear. 668 Anothercommenter also stated that the proposedestimate of 60 hours ‘‘is not an accurateestimate of the time burden to complete

the Compliance Report’’ and that the burdens in the proposing release areunderstated. 669 The commenter statedthat completing the compliance reportwill require extensive collaboration

between management, internal auditand the independent public accountantsresulting in added hours to perform thevalidation and evidence gathering of the

existing processes necessary to make theassertions in the proposed compliancereport. 670 The commenter, however, didnot provide a different estimate of thenumber of hours it would take tocomplete the compliance report.

In response to these comments, theCommission notes that the final rulemodifies the proposal in ways that maymodestly reduce the time burden. Forexample, the final rule requires astatement as to whether the broker-dealer was in compliance with Rule15c3–1 and paragraph (e) of Rule 15c3–3 as of the end of the most recent fiscalyear and, if applicable, a description of any instances of non-compliance withthese rules as of the fiscal year end,rather than the proposed assertion thatthe broker-dealer is in compliance withthe financial responsibility rules in allmaterial respects and proposeddescription of any material non-compliance with the financial

responsibility rules. This reflects twochanges from the proposal: (1)Elimination of the concepts of ‘‘materialnon-compliance’’ and ‘‘compliance inall material respects’’ with Rule 15c3–1and 15c3–3 for the purposes of reportingin the compliance report; and (2) anarrowing of these statements anddescription requirements fromcompliance with all of the financialresponsibility rules to compliance withRule 15c3–1 and paragraph (e) of Rule15c3–3.

As modified, the final rule no longerrequires the broker-dealer to evaluatewhether an instance of non-compliancewith the financial responsibility ruleswas material, a component of theproposal that generated significantcomment. In addition, the broker-dealeronly needs to report instances of non-compliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3. In thisregard, broker-dealers currently arerequired to include supportingschedules to their financial statementscontaining a computation of net capitaland the reserve requirement underparagraph (e) of Rule 15c3–3.Consequently, the work required underthis pre-existing requirement should

provide the broker-dealer with theinformation it needs to make thestatement as to whether it is incompliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3 as of thefiscal year end.

Given these modifications, thestatements in the compliance reportconcerning the broker-dealer’s InternalControl Over Compliance likely will beresponsible for the bulk of the hour

burden associated with preparing the


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671 60 hours × 292 carrying broker-dealers =17,520 hours. See the discussion below regardingthe external costs associated with obtaining theaccountant’s report on the compliance report.

672 See discussion above in sections II.B.1. andII.B.4. of this release.

673 See Broker-Dealer Reports, 76 FR at 37596.674 7 hours × 4,417 non-carrying broker-dealers =

30,919 hours. See the discussion below regarding

the external costs associated with obtaining theaccountant’s report on the exemption report.


676 The Commission does not expect thecompliance report, exemption report, and relatedreports of the independent public accountant toincrease the mailing costs of the annual reports

because these additional reports in the aggregateshould not significantly increase the size andweight of the package of annual reports.

677 See Broker-Dealer Reports, 76 FR at 37596.678 As discussed in subsection C. above,

according to SIPC, as of March 31, 2012, 217 broker-dealers claimed exemptions from SIPCmembership. The Commission therefore estimatesthat 4,492 (4,709 ¥ 217 = 4,492) broker-dealers aremembers of SIPC.

679 1 ⁄ 2 hour × 4,492 broker-dealers = 2,246 hours.680 The number of pages of an annual report, and

consequently the associated postage costs, likelywill vary significantly based on the size of the

broker-dealer and the types of business in which itengages.

compliance report. For example, the broker-dealer will need to evaluatewhether its Internal Control OverCompliance with the financialresponsibility rules was effective duringthe most recent fiscal year.

The Commission believes that themodifications to the final rule discussedabove may modestly reduce the hour

burden of the final rule as compared tothe hour burden that would haveresulted from the proposed rule;namely, because a broker-dealer will notneed to evaluate whether instances of non-compliance with the financialresponsibility rules are material andwill only need to report instances of non-compliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3. In light of the comments suggesting that theproposing release underestimated the

burden, the Commission is not reducingthe hour burden estimate for the rule toreflect the potential reduction in hour

burden associated with the requirement.Thus, to the extent the proposing releaseunderestimated the burden associatedwith making the statements in thecompliance report about the broker-dealer’s Internal Control OverCompliance, the amount of the burdenreduction realized through themodifications discussed above is nowattributed to the burden associated withthe statements about Internal ControlOver Compliance.

For these reasons, the Commission isretaining the rule’s overall hour burdenestimate without revision. TheCommission, however, is updating thenumber of carrying broker-dealers toreflect more recently available data fromthe broker-dealer FOCUS Reports. TheCommission now estimates that thereare 292 carrying broker-dealers.Consequently, the Commissionestimates that the total annual reporting

burden to prepare and file thecompliance report is approximately17,520 hours per year for all carrying

broker-dealers. 671 iii. The Exemption Report

Under the amendments, a non-carrying broker-dealer must file theexemption report. 672 In the exemptionreport, the broker-dealer must provideto its best knowledge and belief: (1) Astatement that identifies the provisionsin paragraph (k) of Rule 15c3–3 underwhich the broker-dealer claimed anexemption from Rule 15c3–3; (2) astatement that the broker-dealer met the

identified exemption provisions inparagraph (k) throughout the mostrecent fiscal year without exception orthat it met the identified exemptionprovisions in paragraph (k) throughoutthe most recent fiscal year except asdescribed in the exemption report; and(3) if applicable, a statement thatidentifies each exception during themost recent fiscal year in meeting theidentified provisions in paragraph (k)and that briefly describes the nature of each exception and the approximatedate(s) on which the exception existed.

The Commission estimated that itwould take a non-carrying broker-dealerapproximately five hours to prepare andfile the proposed exemption report. 673 The Commission did not receive anycomments on this hour estimate. Asdiscussed above in section II.B.4. of thisrelease, the Commission is adopting,with modifications, the requirementsregarding the exemption report. These

provisions generally clarified the scopeand application of the report. However,one modification provides that if the

broker-dealer states that it met theidentified exemption provisions inparagraph (k) of Rule 15c3–3 throughoutthe most recent fiscal year except asdescribed in the report, the broker-dealer must identify each exceptionduring the most recent fiscal year inmeeting the identified provisions inparagraph (k) of Rule 15c3–3 and that

briefly describes the nature of eachexception and the approximate date(s)on which the exception existed. TheCommission expects that non-carrying

broker-dealers generally trackexceptions as part of monitoringcompliance with the exemptionprovisions in paragraph (k) of Rule15c3–3. The requirement to identify anddescribe exceptions would create anincremental burden over the rule asproposed. Based on staff experiencewith the application of Rule 17a–5, theCommission estimates that theadditional work associated withdescribing exceptions in the exemptionreport would take two hours. Therefore,the Commission is revising the hourestimate associated with the exemptionreport to seven hours.The Commission now estimates thatthere are approximately 4,417 non-carrying broker-dealers that must fileexemption reports. Therefore, theCommission estimates that the annualreporting burden for all non-carrying

broker-dealers to prepare and file theexemption report is approximately30,919 hours per year. 674

iv. Additional Burden and Cost To Filethe Annual Reports

The filing requirements for the annualreports are being amended. 675 Inparticular, Rule 17a–5 previouslyprovided that a broker-dealer must filetwo copies of its annual reports with theCommission’s principal office in

Washington, DC. The final rule nolonger requires that two copies be filed,so that, in accordance with paragraph(d)(6) of Rule 17a–5, broker-dealersmust file only one copy of the annualreports with the Commission’s principaloffice. This change could reduce slightlythe hour burden and cost associatedwith filing the annual reports with theCommission. 676

Amendments to paragraph (d)(6) of Rule 17a–5 require that a broker-dealeralso file a copy of its annual reportswith SIPC. The Commission estimatedthat it would take 30 minutes to prepare

an additional copy of the annual reportsand mail it to SIPC as required by theproposed amendments. 677 TheCommission did not receive commentsregarding this estimate. In addition, theclarification to the final rule that only

broker-dealers that are members of SIPCmust file a copy of their annual reportswith SIPC will not affect the final PRAhour burden estimate. Therefore, theCommission is retaining this estimatewithout revision. The Commission nowestimates that 4,492 broker-dealers aremembers of SIPC. 678 Therefore, theCommission estimates that the annualindustry-wide reporting burdenassociated with this amendment isapproximately 2,246 hours per year. 679

There would be postage costsassociated with sending a copy of theannual reports to SIPC that areestimated to be, on average, 680 approximately $12.05 per broker-dealer


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681 Based on Commission staff experience withannual report filings of broker-dealers under Rule17a–5, the Commission staff estimates thatapproximately 50% of broker-dealers file theirannual reports using an overnight mail deliveryservice. These broker-dealers would consequentlyincur higher postage costs than broker-dealerswhich choose to mail their annual reports usingfirst class mail or delivery methods other thanovernight mail. Therefore, postage costs will varydepending on the size of the annual report andmethod of delivery. The Commission estimates thatthe cost to mail the additional reports would be, onaverage, $12.05 per broker-dealer. As of October2012, the $12.05 rate is an average rate of the costof an Express Mail Flat Rate Envelope of $18.95 anda Priority Mail Flat Rate Envelope of $5.15, basedon costs obtained on the Web site of the U.S. PostalService at: www.usps.gov . ($18.95 + $5.15) =$24.10/2 = $12.05.

682 4,492 broker-dealers × $12.05 = $54,128.683 (75 approvals × 10 minutes)/60 = 12.5 hours.684 75 approvals × $0.45 (current price of a letter

sent first class) = $33.75.

685 See discussion above in section II.C.4. of thisrelease.

686 See Broker-Dealer Reports, 76 FR at 37597.687 15 U.S.C. 78ccc(e)(2). The statute generally

requires that the Board of Directors of SIPC file wi ththe Commission a copy of any proposed rule changeaccompanied by a concise general statement of the

basis and purpose of such proposed rule change. Inaddition, the statute states that ‘‘the Commissionshall, upon the filing of any proposed rule change,publish notice thereof, together with the terms of substance of such proposed rule change or adescription of the subjects and issues involved’’ and

that the ‘‘Commission shall give interested personsan opportunity to submit written data, views, andarguments with respect to such proposed rulechange.’’ 15 U.S.C. 78ccc(e)(2)(A).


689 See Rule 17a–5(f)(2)(ii). 17 CFR 240.17a–5(f)(2)(ii).

690 See Rule 17a–5(f)(2)(ii)(F) and (G).691 See Broker-Dealer Reports, 76 FR at 37596.

per year. 681 Thus, the Commissionestimates that the total annual postagecosts associated with sending a copy of the annual reports to SIPC would beapproximately $54,128 per year for all

broker-dealers that are SIPCmembers. 682

Finally, the Commission notes thatparagraph (d)(1)(ii) of Rule 17a–5 of thefinal rule was amended to require thata copy of a DEA’s written approval tochange a broker-dealer’s fiscal year endmust be sent to the Commission’sprincipal office in Washington DC, inaddition to the regional office of theCommission for the region in which the

broker-dealer has its principal place of business. Based on the number of copiesof approvals received by theCommission and staff experience in theapplication of Rule 17a–5, theCommission estimates thatapproximately 75 broker-dealers willreceive approval each year to change

their fiscal year end. The Commissionestimates that it would take 10 minutesto copy and send an additional copy of the approval to the Commission’sprincipal office in Washington, DC for atotal industry-wide annual hour burdenof approximately 12.5 hours, 683 and atotal industry-wide cost of approximately $33.75 per year to mailthe approval. 684 v. Supplemental Report on SIPCMembership

Prior to today’s amendments,paragraph (e)(4) of Rule 17a–5 providedthat a broker-dealer must file with itsannual report a supplemental report onthe status of the membership of the

broker-dealer in SIPC, which wasrequired to be ‘‘covered by an opinionof the independent public accountant’’if the annual report of the broker-dealerwas required to be audited. TheCommission is adopting amendments to

paragraph (e)(4) of Rule 17a–5 toprovide that broker-dealers must filewith SIPC—but no longer with theCommission after an interim period if SIPC adopts a rule under paragraph(e)(4)(i) that is approved by theCommission—a report of anindependent public accountantdesigned to help administer thecollection of assessments from broker-dealers for purposes of establishing andmaintaining SIPC’s broker-dealerliquidation fund. 685 The Commission isadopting the proposed amendments toparagraph (e)(4) of Rule 17a–5substantially as proposed. Onemodification is that, as adopted, thefinal rule provides that the accountantmust perform the procedures specifiedin the rule in accordance with PCAOBstandards. SIPC may determine theformat of this report by rule, subject toCommission approval.

Because broker-dealers are currently

required to file these reports with boththe Commission and SIPC, the final ruleamendment does not result in anychange to the Commission’s currentestimate of the hour burden for broker-dealers to comply with this requirementunder the current PRA collection forRule 17a–5. Although broker-dealerswill file the supplemental report onSIPC membership only with SIPC if aSIPC rule change to implement thisamendment is approved by theCommission, as noted in the currentPRA collection, the variation in the sizeand complexity of broker-dealers subjectto Rule 17a–5 makes it difficult tocalculate the burden of the informationcollection of Rule 17a–5. Therefore, theCommission will determine whether itis appropriate to revise the PRAestimate for Rule 17a–5 after any SIPCrule filing is approved or after the endof the two-year sunset provision.

In the proposing release theCommission estimated, however, thatSIPC would incur a one-time burdenassociated with filing a rule change withthe Commission to implement thisproposed amendment of approximately100 hours. 686 The process andrequirements for SIPC to file rule

changes with the Commission, however,is set out in SIPA. 687 Any burden on

SIPC to file a rule change with theCommission would be associated withthe requirements under SIPA. Therefore,the Commission is deleting theproposed one-time 100 hours from thefinal rule amendments.vi. Statement Regarding IndependentPublic Accountant

The Commission is amendingparagraph (f)(2) of Rule 17a–5 to revisethe statement regarding identification of a broker-dealer’s independent publicaccountant that broker-dealers must fileeach year with the Commission andtheir DEA (except that if the engagementis of a continuing nature, no furtherfiling is required). 688 The revisedstatement contains additionalinformation that includes arepresentation that the independentpublic accountant has undertaken toprovide a report regarding the broker-dealer’s financial reports and a report

regarding the broker-dealer’scompliance report or exemption report,as applicable. 689 In addition, thestatement provided by a clearing orcarrying broker-dealer must includerepresentations regarding the access toits accountant requirements describedabove. 690 Therefore, all broker-dealerswill generally be required to file a newstatement regarding their independentpublic accountant. The Commissionestimated that the one-time hour burdenassociated with amending its existingstatement and filing the new statementwith the Commission, in order tocomply with the proposed amendments,would be an average of approximatelytwo hours on a one-time basis for each

broker-dealer, as the statement can becontinuing in nature. 691

The Commission is revising thisestimate for clearing and carrying

broker-dealers, as these broker-dealerswill likely need to renegotiate theiragreements with their independentpublic accountants. The Commissionestimates, based on staff experience,that it will take a carrying or clearing

broker-dealer approximately ten hourson a one-time basis to renegotiate itsagreement with its accountant, amendits statement regarding its accountant,and file the new statement with theCommission. The Commission estimatesthat the one-time burden for all carrying


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692 10 hours × 513 carrying or clearing broker-dealers = 5,130 hours.

693 2 hours × 4,196 non-carrying and non-clearing broker-dealers = 8,392 hours.

694 4,709 broker-dealers × $0.45 cost for first classpostage × 3 mailings = $6,357.15.

695 See discussion above in section II.D.3. of thisrelease.

696 Id.

697 In the proposing release, these costs wereincluded in the Economic Analysis. TheCommission is also including these costs in thePRA amendments to more accurately reflectexternal costs incurred by broker-dealers as a resultof the PRA hour burdens imposed by the final ruleamendments, and in response to comments.

698 See, e.g., McGladrey Letter; SIFMA Letter.699 See ABA Letter.700 See CAI Letter.

701 See section VII. of this release (discussing benefits and costs of changing from GAAS toPCAOB auditing standards).

702 See Broker-Dealer Reports, 76 FR at 37599.703 See ABA Letter.704 Id.705 Id.706 See Van Kampen/Invesco Letter.

or clearing broker-dealers isapproximately 5,130 hours 692 and theone-time burden for all broker-dealersthat neither carry customer accounts norclear transactions is approximately8,392 hours, 693 for a total industry-widereporting burden of approximately13,522 hours on a one-time basis.

Finally, the Commission believesthere will be postage costs associatedwith sending the amended statementregarding the accountant, which must

be sent to the Commission’s principaloffice in Washington, DC, the regionaloffice of the Commission for the regionin which the broker-dealer’s principalplace of business is located, and to itsDEA. The Commission estimates thateach mailing will cost approximately$0.45, for a total cost of approximately$6,357 for all broker-dealers on a one-time basis. 694 vii. External Costs of Engagement of Accountant

The amendments to Rule 17a–5 retainthe current requirement that broker-dealers annually file with theCommission a financial report and areport prepared by a PCAOB-registeredaccountant based on an audit of thefinancial report. 695 However, thefinancial report must be audited inaccordance with standards of thePCAOB, instead of in accordance withGAAS, as previously required. Theamendments also require a broker-dealer to file with the Commissioneither a compliance report or anexemption report and to obtain anindependent accountant’s report basedon an examination or review of thosereports, respectively. 696

Broker-dealers incur annual externalcosts associated with the PRA burden interms of hiring outside auditors andaccountants to comply with therequirements of Rule 17a–5. Anyexternal costs of accountants’ reportsincluded in the PRA collection of information for these final ruleamendments are averages across all

broker-dealers. The external PRA costsincurred by a broker-dealer to complywith the final rule amendments will

generally depend on its size and thecomplexity of its business activities.Because the size and complexity of

broker-dealers varies significantly, theCommission provides estimates of the

average external cost per broker-dealeracross all broker-dealers. 697

The Commission received variouscomments regarding the costs of theproposed requirements and engagementof the accountant provisions. Morespecifically, the Commission receivedcomments addressing: (1) The costs of the change from GAAS to PCAOBstandards for the financial report; (2) thecosts of the examination of the newcompliance report; and (3) the costs of the review of the new exemption report.The comments received with respect tothese three areas and the Commission’sresponses are addressed in detail ineach subsection below.

a. Financial Report (Including ChangeFrom GAAS to PCAOB Standards)

Two commenters stated that theCommission did not address the costsassociated with the change from GAASto PCAOB standards. 698 These costs

would affect the external costs of broker-dealers under the PRA burden tothe extent the change in standardscaused an increase in externalaccounting fees incurred by broker-dealers. One commenter also stated thatthe Commission may need to considerthe PCAOB’s proposed rules before itcan make a reasonable estimate, andthat transition to PCAOB standards mayrequire substantial revisions to auditprograms. 699 Another commenter statedthat the economic analysis was‘‘inconclusive’’ because the PCAOB hasnot yet established auditing andattestation standards for broker-dealers. 700 In response to this comment,the Commission estimates the costs of its rules using the best informationavailable to it at the time.

Based on information currentlyavailable, including the proposedPCAOB standards, the Commission doesnot expect that the move to PCAOBstandards for audits of broker-dealerfinancial reports will result insignificant one-time implementationcosts or recurring annual costs. Theproposed PCAOB standards for audits of financial reports (financial statementsand supporting schedules) generallyincorporate concepts and requirementscontained within GAAS, therebyminimizing the potential costs to

broker-dealer auditors of this change. As

such, the Commission is not includingany additional external PRA costsrelated to the change from GAAS toPCAOB auditing standards. 701 However,in response to the comment, theCommission will examine the effect of any final PCAOB standards on theexternal costs associated with thiscollection of information in subsequentextensions of this collection of information and make any necessarycost adjustments.

b. Compliance ReportThe Commission estimated that the

incremental external cost to a carrying broker-dealer of obtaining theindependent public accountant’s report

based on an examination of theproposed compliance report would bean average incremental cost of approximately $150,000 per carrying

broker-dealer per year. 702 TheCommission is including these externalcosts in this collection of information.

One commenter stated that theCommission underestimated the cost of examining the compliance report. 703 This commenter believed that theauditing costs associated with thecompliance examinations wereunderestimated given that the proposingrelease contemplated a move fromGAAS to PCAOB auditing standards. 704 This commenter stated that thetransition may require substantialrevisions to independent publicaccountant audit programs, includingimplementation of new auditingtechniques and processes and theassociated training programs and notedthat the proposed PCAOB standardswere not released until after thepublication of the proposing release. 705 Another commenter stated thatcompleting both the compliance reportsand exemption reports ‘‘will requireextensive collaboration betweenmanagement, internal audit, and theindependent public accountants’’ andthat due to the ‘‘significant increase inhours,’’ the proposed amendments have‘‘the potential to double the total currentaudit fees and have a material impact’’on firms. 706 These commenters did not

quantify their cost estimates in terms of dollars; nor did they provide data tosupport their conclusions.

As explained above in section II.D. of this release, before today’s amendments,Rule 17a–5 required a broker-dealer to


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711 In the proposing release, the Commissionestimated that a broker-dealer’s accountant wouldspend approximately 5 hours per year speakingwith Commission or DEA staff and providing themwith audit documentation.

712 In the proposing release, the Commissionmultiplied 528 clearing and carrying broker-dealers× 5 hours × $250/hour = $660,000.

713 513 clearing and carrying broker-dealers ×$1,250 in increased costs per clearing broker-dealer= $641,250.


715 See paragraph (e) of Rule 17a–11. Thisprovision retains references to material inadequacywith respect to Rule 17a–12.

716 See Broker-Dealer Reports, 76 FR at 37597.717 See Angel Letter.

718 See IMS Letter. The cost of $69,179,670 wasreflected in the Economic Analysis in the proposingrelease. See Broker-Dealer Reports, 76 FR at 37601.This cost was calculated as an internal cost of theestimated PRA hours and is the total cost dividedamong 5,057 firms. Id. at 37601 n.215. This internalcost would amount to an average of $13,680 per

broker-dealer.

there are approximately 4,417 non-carrying broker-dealers. TheCommission therefore estimates that thetotal industry-wide external annualreporting cost of this requirement isapproximately $13,251,000 per year(4,417 non-carrying broker-dealers ×$3,000 = $13,251,000).

d. Access to Accountant and AuditDocumentationThe amendments to Rule 17a–5

require that carrying or clearing broker-dealers agree to allow Commission andDEA staff, if requested in writing forpurposes of an examination of the

broker-dealer, to review the work papersof the independent public accountantand to allow the accountant to discussits findings with the examiners.

In the proposing release, theCommission estimated that a carrying orclearing broker-dealer’s accountantwould charge the broker-dealer for timeits personnel spend speaking with theCommission or the broker-dealer’s DEAand providing them with auditdocumentation. 711 Thus, theCommission estimated that theadditional cost of accountant timeassociated with this amendment to allclearing and carrying broker-dealerswould be approximately $660,000annually. 712 As the Commission nowestimates that the number of carrying orclearing broker-dealers is 513, the newestimate is approximately $641,250. 713 2. Conforming and TechnicalAmendments to Rule 17a–11

The Commission proposed technicalamendments to Rule 17a–5 andproposed amending paragraph (e) of Rule 17a–11 to eliminate a reference toRule 17a–5. 714 The Commission statedthat these changes should not result inan additional hour burden for the Rule17a–11 collection of information. Asdiscussed above in section II.F.2. of thisrelease, in response to a comment,paragraph (e) of Rule 17a–11, asadopted, retains a reference to Rule 17a–5. In addition, the Commission isadopting conforming amendments tosubstitute the term material weakness asdefined in paragraph (d)(3)(iii) of Rule17a–5 for the term material inadequacywith respect to Rule 17a–5. Specifically,

the final rule provides that whenever a broker-dealer discovers, or is notified byits accountant under paragraph (h) of Rule 17a–5 of the existence of anymaterial weakness, the broker-dealermust: (1) Give notice of the materialweakness within 24 hours of thediscovery or notification; and (2)transmit a report within 48 hours of thenotice stating what the broker-dealer hasdone or is doing to correct thesituation. 715

The Commission does not expect anychange in the number of notices filedper year as a result of the finalamendments because the materialinadequacy notification requirement is

being replaced by a material weaknessnotification requirement. Therefore, thefinal amendments to Rule 17a–11should not result in a change in thecurrent PRA burden for Rule 17a–11.However, the Commission will take intoaccount any changes in the number of

notices associated with this collection of information in subsequent extensions of this collection of information and makeany necessary adjustments, asappropriate.

3. Form CustodyAs described more fully above, the

amendments require that all broker-dealers registered with the Commissionfile Form Custody quarterly with theirDEA. The Commission estimated thatthe hour burden associated withcompleting and filing proposed FormCustody would be approximately 12hours per quarter, or 48 hours per year,on average, for each broker-dealer. 716

In section IV. of this release, inadopting the final amendments to FormCustody, the Commission received onecomment in response to Item 8 of FormCustody, as proposed, noting that theinformation sought in Item 8 was largelythe same as information collected frominvestment advisers on Form ADV. 717 As stated above in section IV. of thisrelease, the Commission is aware thatsome overlap exists between theinformation collected from investmentadvisers on Form ADV and theinformation that would be collectedfrom broker-dealers dually-registered asinvestment advisers in Item 8 of proposed Form Custody. However, thesetwo forms also contain a significantamount of non-overlapping material,reflecting their different purposes anduses. Form Custody is intended to be asingle source of readily-available

information to assist Commission andDEA examiners in preparing for andperforming focused custody exams, andit is particularly important that suchinformation be readily available in thecase of dually-registered firms.Consequently, the Commission believesthat the PRA burden for Form Custodyis reasonable in light of its intendedpurpose, as discussed above in sectionIV. of this release. Additionally, thecommenter did not indicatedisagreement with the hour burdenestimate as proposed. Therefore, theCommission is retaining the hour

burden estimate without revision.The Commission now estimates that

there are approximately 4,709 broker-dealers that must file Form Custody.The Commission therefore estimatesthat the total annual burden associatedwith completing and filing FormCustody for all 4,709 broker-dealers isapproximately 226,032 hours per year(4,709 broker-dealer times 4 responsesper year times 12 hours = 226,032hours).

One commenter stated that theestimated costs to the industry of $69,179,670 is ‘‘staggering,’’ and thatsuch costs would likely indirectly bepassed on to customers. 718 Thecommenter did not disagree with thePRA estimate in the proposing release;rather, the commenter focused on size of the total estimated costs. TheCommission recognizes that therequirement to file Form Custody will

increase compliance costs for broker-dealers and, consequently, the PRAestimates reflect these costs. The PRAhour burden estimates (and associatedinternal burden costs), however, areaverages across all broker-dealers. Thecosts incurred by a broker-dealer tocomply with the requirement to fileForm Custody will depend on its sizeand the complexity of its businessactivities. Because the size andcomplexity of broker-dealers variessignificantly, the Commission providesestimates of the average cost per broker-dealer across all broker-dealers.

For these reasons, the Commission believes the internal costs related to thePRA for this hour burden are reasonableand, therefore, the Commission is notadjusting the final cost estimate, exceptto reflect updated data with respect to


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719 Id.720 See paragraph (e)(3) of Rule 17a–5.721 See 17 CFR 240.17a–5(c)(2)(i).722 See 17 CFR 200.83. Information regarding

requests for confidential treatment of informationsubmitted to the Commission is available at http://www.sec.gov/foia/howfo2.htm#privacy .

723 See, e.g., 15 U.S.C. 78x (governing the publicavailability of information obtained by theCommission); 5 U.S.C. 552 et seq.

724 15 U.S.C. 78c(f).725 15 U.S.C. 78w(a)(2).726 See Broker-Dealer Reports, 76 FR at 37598. An

economic analysis was included in the proposingrelease. Id. at 37598–37601.

727 Id. at 37598.728 Id.729 See ABA Letter; AICPA Letter; Angel Letter;

CAI Letter; Citrin Letter; IMS Letter; KPMG Letter; McGladrey Letter; SIFMA Letter; Van Kampen/ Invesco Letter.

730 See IMS Letter.

731 For example, one commenter stated that theCommission’s estimate of the costs of thecompliance report have ‘‘the potential to double thetotal current audit fees and have a material impact’’on firms. See Van Kampen/Invesco Letter. Thecommenter, however, did not provide a quantified

baseline estimate of current audit fees incurred by broker-dealers with which to compare theCommission’s estimate of the incremental cost thatthe compliance report amendments will have onaudit fees.

the number of broker-dealers andcompensation. 719

E. Collection of Information IsMandatory

The collection of informationobligations imposed by the ruleamendments are mandatory for broker-dealers that are registered with theCommission.F. Confidentiality

The Commission expects to receiveconfidential information in connectionwith the proposed collections of information. Paragraph (e)(3) of Rule17a–5, as amended, provides that

broker-dealer annual reports filed withthe Commission are not confidential,except that if the Statement of FinancialCondition is bound separately from the

balance of the annual reports, and eachpage of the balance of the annual reportsis stamped ‘‘confidential,’’ then the

balance of the annual reports shall bedeemed confidential to the extentpermitted by law. 720 However, underparagraph (c)(2)(iv) of Rule 17a–5, if there are material weaknesses, theaccountant’s report on the compliancereport must be made available forcustomers’ inspection and,consequently, it would not be deemedconfidential. In addition, paragraph(c)(2)(i) of Rule 17a–5 requires a broker-dealer to furnish to its customersannually a balance sheet withappropriate notes prepared inaccordance with GAAP and which must

be audited if the broker-dealer isrequired to file audited financialstatements with the Commission. 721 With respect to the other informationcollected under the amendments, a

broker-dealer can request theconfidential treatment of theinformation. 722 If such a confidentialtreatment request is made, theCommission anticipates that it will keepthe information confidential to theextent permitted by law. 723

VII. Economic AnalysisThe Commission is sensitive to the

costs and benefits of its rules. Whenengaging in rulemaking that requires theCommission to consider or determinewhether an action is necessary orappropriate in the public interest,

section 3(f) of the Exchange Act requiresthat the Commission consider, inaddition to the protection of investors,whether the action will promoteefficiency, competition, and capitalformation. 724 In addition, section23(a)(2) of the Exchange Act requiresthat the Commission consider the effectson competition of any rules theCommission adopts under the ExchangeAct, and prohibits the Commission fromadopting any rule that would impose a

burden on competition not necessary orappropriate in furtherance of thepurposes of the Exchange Act. 725

In the proposing release, theCommission solicited comment on thecosts and benefits of the proposedamendments and new form, includingwhether estimates of the costs and

benefits were accurate andcomprehensive. 726 The Commissionfurther encouraged commenters to

provide specific data and analysis insupport of their views. 727 TheCommission also requested comment onwhether the proposed amendmentswould place a burden on competition,and promote efficiency, competition,and capital formation. 728

The Commission received 27comment letters on the proposedamendments. A number of commentersaddressed the Commission’s estimatesof the cost and benefits of the proposedamendments. 729 Generally, thesecommenters stated that theCommission’s cost and benefit estimatesfailed to include all of the costsassociated with the proposedamendments and that the costs that theCommission did include in its analysiswere underestimated. For example, onecommenter stated that the proposedamendments ‘‘place unnecessaryregulatory burdens and costs onindustry, in general, and smaller firms,in particular’’ and that ‘‘broker-dealerscompete against investment adviserswho are not burdened by the sameregulatory requirements,’’ including therequirements in the proposedamendments. 730 While commentersstated that the Commissionunderestimated costs, they did not

provide alternative quantified estimatesof the costs. 731

As discussed throughout this release,in part in response to comments, theCommission has modified the proposedrules to reduce compliance burdenswhere consistent with investorprotection. In addition, as discussed

below, where commenters identifiedcosts the Commission did not consider,the Commission has revised itseconomic analysis of the final rules totake these costs into account.

In adopting the rule amendments andnew form, the Commission has beenmindful of the associated costs and

benefits. The costs and benefits that theCommission has considered in adoptingthese amendments and new form arediscussed below. The discussionfocuses on the Commission’s reasons foradopting these amendments and newform, the affected parties, and the costsand benefits of the amendments andnew form compared to the baseline,described below, and to alternativecourses of action.

Many of the benefits and costsdiscussed below are difficult toquantify, in particular when discussingincreases in investor confidence andimprovements in investor protection.For example, the extent to which theincreased ability of the Commission andDEAs to oversee compliance with thefinancial responsibility rules will helplimit future violations of the rules isunknown. Similarly, it is unknown howmuch increasing the focus of broker-

dealers on the financial responsibilityrules will result in enhancedcompliance with those rules. Moreover,limited public data exists to study thecosts of broker-dealer audits. Therefore,much of the discussion is qualitative innature but, where possible, theCommission attempted to quantify thecosts.

A. Motivation for the AmendmentsThe rule amendments and new form

being adopted today are designed toprovide additional safeguards withrespect to broker-dealer custody of customer securities and funds. Themotivation for these amendments,which are discussed throughout thisrelease, are summarized below.


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732 See, e.g., SEC v. Donald Anthony Walker Young, et al., Litigation Release No. 21006 (Apr. 20,2009); SEC v. Isaac I. Ovid, et al., Litigation ReleaseNo. 20998 (Apr. 14, 2009); SEC v. The Nutmeg Group, LLC, et al., Litigation Release No. 20972(Mar. 25, 2009); SEC v. WG Trading Investors, L.P.,et al., Litigation Release No. 20912 (Feb. 25, 2009);SEC v. Stanford International Bank, et al.,Litigation Release No. 20901 (Feb. 17, 2009); SEC v. Bernard L. Madoff, et al., Litigation Release No.20889 (Feb. 9, 2009). The Commission also has

brought an enforcement action against anaccountant that purported to audit f inancialstatements and disclosures of one of these broker-dealers. See SEC v. David G. Friehling, C.P.A., et al.,Litigation Release No. 20959 (Mar. 18, 2009).

733 See PCAOB Inspection Report at p. ii.734 Id.

735 See discussion in section II.D.3. of this release.736 Section 107(a) of the Sarbanes-Oxley Act

provides that the Commission ‘‘shall have oversightand enforcement authority over the [PCAOB] asprovided by the [Sarbanes-Oxley Act].’’ Section107(b) of the Sarbanes-Oxley act provides that ‘‘[n]orule of the [PCAOB] shall become effective withoutprior approval of the Commission’’ other thancertain initial or transitional standards. Section107(c) of the Sarbanes-Oxley Act provides forCommission review of disciplinary action taken bythe PCAOB. Section 107(d) of the Sarbanes-OxleyAct provides that the Commission may censure andimpose other sanctions on the PCAOB in certaincircumstances.

737 Rule 15c3–1, the Commission’s net capitalrule, specifies that a broker-dealer shall be deemedto carry customer or broker-dealer accounts ‘‘if, inconnection with its activities as a broker or dealer,it receives checks, drafts, or other evidences of indebtedness made payable to itself or personsother than the requisite registered broker or dealercarrying the account of a customer, escrow agent,issuer, underwriter, sponsor, or other distributor of

Continued

First, as mentioned above in sectionI.A. of this release, over the last severalyears, the Commission has broughtseveral cases alleging fraudulentconduct by investment advisers and

broker-dealers, including among otherthings, alleged misappropriation orother misuse of customer securities andfunds. 732 These cases highlight the needfor enhancements to the rules governing

broker-dealer custody of customerassets. Such enhancements include bothincreased focus on compliance andinternal compliance controls by broker-dealers and their auditors, as well asmeasures to increase the ability of theCommission and broker-dealer DEAs tooversee broker-dealer custody practices

by requiring broker-dealers to providemore information about these practices.

Second, as discussed above in sectionII.D. of this release, certain provisions of Rule 17a–5 before today’s amendmentswere inconsistent with current audit

practices, standards, and terminology,which have evolved since theseprovisions were adopted. Thisinconsistency has resulted in disparateaudit practices and inconsistentcompliance with the rule. As discussedabove in section II.D.3.iii. of this release,the PCAOB has published a reportcontaining observations frominspections of portions of 23 broker-dealer audits conducted by tenaccounting firms. 733 According to thereport, PCAOB inspections staff identified deficiencies in all of theaudits inspected. 734 The deficienciesnoted in the report provide support forthe need to strengthen and clarify

broker-dealer audit and reportingrequirements in order to facilitateconsistent compliance with theserequirements.

Third, as discussed in section II.D. of this release, prior to today’samendments, Rule 17a–5 required that

broker-dealer audits be conducted inaccordance with GAAS, which areestablished by the Auditing StandardsBoard of the AICPA. The amendments—

by requiring that the audits be

conducted in accordance with PCAOBstandards—recognize the PCAOB’sexplicit oversight authority over broker-dealer audits as provided by the Dodd-Frank Act, including the authority toestablish (subject to Commissionapproval) and enforce auditing andrelated attestation, quality control,ethics, and independence standards. 735 In addition, the Commission has directoversight authority over the PCAOB,including the authority to approve ordisapprove the PCAOB’s rules andstandards. 736 Consequently, requiringthat broker-dealer audits be conductedin accordance with standards theCommission has approved will betterensure alignment between broker-dealeraudits and the regulatory policyobjectives reflected in the Commission’sfinancial responsibility rules.

Fourth, as discussed in section II.B.6.of this release, because broker-dealershave not been required to file with SIPC

their annual audited financialstatements, SIPC has received limitedinformation regarding the financialcondition of its broker-dealer members.SIPC can use this information, amongother things, to assess whether the SIPCFund is appropriately sized to the risksof a large broker-dealer failure. Inaddition, at least one court, the NewYork Court of Appeals, has held that incases where SIPC is required to fund theliquidation of a broker-dealer, SIPCcould not maintain a claim against theauditor of the broker-dealer based on analleged failure to comply with auditing

standards because SIPC did not receivethe audited financial statements andtherefore could not have relied uponthem.

Fifth, as discussed in section III. of this release, the audit work performed

by independent public accountants withrespect to audits of carrying andclearing broker-dealers can provideuseful information to Commission andDEA examiners in terms of planning thescope and focus of the examination of the broker-dealer. ProvidingCommission and DEA examiners withaccess to the independent publicaccountant that audited the broker-

dealer and audit documentation relatedto the audit will allow the examiners togain an understanding of the work theaccountant did in auditing the broker-dealer and any areas of concernhighlighted by the auditor. This willenable the examiners to conduct risk-

based examinations of carrying andclearing broker-dealers and assist theexaminers in determining areas of focusfor their examinations. Furthermore, theamendments will make it clear to theindependent public accountant that the

broker-dealer has agreed that theaccountant can provide this informationand, consequently, eliminateuncertainty as to whether the broker-dealer consents to the disclosure of theinformation.

Sixth, as discussed in section IV. of this release, because broker-dealers werenot required to provide comprehensiveor consolidated information about theircustody practices to the Commission or

their DEA, the Commission and the broker-dealer’s DEA had a fragmentedand incomplete picture of whether a

broker-dealer maintained custody of customer and non-customer assets, andif so, how such assets were maintained.This hindered the ability of theCommission and DEAs to efficientlyplan, prioritize, and performexaminations.B. Economic Baseline

The regulatory changes adopted todayamend requirements that apply to

broker-dealers registered with theCommission and independent publicaccountants that audit or attest to broker-dealer annual reports. Thediscussion below includes approximatenumbers of broker-dealers andaccountants that would be affected bytoday’s amendments and a descriptionof the economic baseline against whichthe costs and benefits, as well as theimpact on efficiency, competition, andcapital formation, of today’samendments and new form aremeasured.1. Broker-Dealers

The broker-dealers registered with theCommission vary significantly in termsof their size, business activities, and thecomplexity of their operations. Forexample, carrying broker-dealers holdcustomer securities and funds. 737


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securities’’ or ‘‘if it does not promptly forward orpromptly deliver all of the securities of customersor of other brokers or dealers received by the firmin connection with its activities as a broker ordealer.’’ 17 CFR 240.15c3–11(a)(2)(i). Further, Rule15c3–3, the Commission’s customer protection rulegoverning reserves and custody of securities,defines the term ‘‘securities carried for the accountof a customer’’ to mean ‘‘securities received by oron behalf of a broker or dealer for the account of any customer and securities carried long by a brokeror dealer for the account of any customer,’’ as wellas securities sold to, or bought for, a customer bya broker-dealer. 17 CFR 240.15c3–3(a)(2).

738 See Definitions of Terms and ExemptionsRelating to the ‘‘Broker’’ Exceptions for Banks, FinalRule, Exchange Act Release No. 56501 (Sept. 24,2007), 72 FR 56514, 56541 n.269 (Oct. 3, 2007).

739 Id. at ¶ 1.15; see also Exchange Act ReleaseNo. 31511 (Nov. 24, 1992), 57 FR 56973 (Dec. 2,1992) (describing role of introducing broker-dealers).

740 Exchange Act Release No. 31511 (Nov. 24,1992), 57 FR 56973 (Dec. 2, 1992).

741 See, e.g., FINRA Rule 4311 (CarryingAgreements). This FINRA rule governs therequirements applicable to FINRA members whenentering into agreements for the carrying of anycustomer accounts in which securities transactionscan be effected. Historically, the purpose of thisrule has been to ensure that certain functions andresponsibilities are clearly allocated to either theintroducing or carrying firm, consistent with therequirements of the SRO’s and Commission’sfinancial responsibility and other rules andregulations, as applicable. See also Notice of Filing of Amendment No. 1 and Order Granting Accelerated Approval of a Proposed Rule ChangeAdopting, as Modified by Amendment No. 1, RulesGoverning Guarantees, Carrying Agreements,Security Counts and Supervision of General Ledger Accounts in the Consolidated FINRA Rulebook,Exchange Act Release 34–63999 (Mar. 7, 2011), 76FR 12380 (Mar. 7, 2011).

742 See Books and Records Requirement for Brokers and Dealers Under the Securities ExchangeAct of 1934, Exchange Act Release 34–44992 (Nov.2, 2001) (‘‘[T]he Commission recognizes that forsome types of transactions, such as purchases of mutual funds or variable annuities, the customermay simply fill out an application or a subscriptionagreement that the broker-dealer then forwardsdirectly to the issuer.’’).

743 See American Bar Association, Report and Recommendations of the Task Force on PrivatePlacement Broker-Dealers 23–24 (2005); see alsoExchange Act Release No. 31511 (Nov. 24, 1992),57 FR 56973 (Dec. 2, 1992).

744 The information in this chart is based onFOCUS Report data filed by broker-dealers in 2011.

745 Not all broker-dealers registered with theCommission are SIPC members. According to SIPC,as of March 31, 2012, 217 broker-dealers claimedexemptions from SIPC membership. TheCommission therefore estimates that 4,492 (4,709 ¥217 = 4,492) broker-dealers are members of SIPC.

Clearing broker-dealers cleartransactions as members of securityexchanges and the Depository Trust &Clearing Corporation and the OptionsClearing Corporation. 738 Many clearing

broker-dealers are carrying broker-dealers, but some clearing broker-dealers clear only their own transactionsand do not hold customer securities andcash.As stated in section I.B.1. above, a

broker-dealer that claims an exemptionfrom Rule 15c3–3 is generally referredto as ‘‘non-carrying broker-dealer.’’ Non-carrying broker-dealers include‘‘introducing brokers.’’ 739 These non-carrying broker-dealers accept customerorders and introduce their customers toa carrying broker-dealer that will holdthe customers’ securities and cash alongwith the securities and cash of customers of other introducing broker-dealers and those of direct customers of the carrying broker-dealer. The carrying

broker-dealer generally receives andexecutes the orders of the introducing

broker-dealer’s customers. 740 Carrying broker-dealers also prepare tradeconfirmations, settle trades, andorganize book entries of thesecurities. 741 Introducing broker-dealersalso may use carrying broker-dealers toclear the firm’s proprietary trades andcarry the firm’s securities. Anothergroup of non-carrying broker-dealerseffects transactions in securities such asmutual funds on a subscription-way

basis, where customers purchase thesecurities by providing the fundsdirectly to the issuer. 742 Finally, somenon-carrying broker-dealers act asfinders by referring prospectivepurchasers of securities to issuers. 743

The broker-dealer industry is theprimary industry affected by the ruleamendments and the new form. In somecases, the amendments impose differentrequirements on different types of

broker-dealers. For example, carrying broker-dealers must file the compliance

report and an independent publicaccountant’s report covering the

compliance report, while non-carrying broker-dealers must file the exemptionreport and an independent publicaccountant’s report covering theexemption report. Only carrying andclearing broker-dealers must agree toallow Commission and DEA examinersto review the audit documentation of their independent public accountantsand to allow accountants to discusstheir findings with the examiners. All

broker-dealers must file Form Custody, but many of the line items on the formapply only to carrying broker-dealers.

To establish a baseline forcompetition among broker-dealers, theCommission looks at the status of the

broker-dealer industry detailed below.In terms of size, the following tablesillustrate the variance among broker-dealers with respect to total capital. Theinformation in the table is based onFOCUS Report data for calendar year2011.

BROKER -DEALER CAPITAL AT CALENDAR YEAR END 2011 744 [$ millions]

Capital Number of firms Aggregate totalcapital

Less than $500,000 ..................................................................................................................................... 2,506 $347Greater than or equal to $500,000 and less than $5 million ...................................................................... 1,320 2,212Greater than or equal to $5 million and less than $50 million .................................................................... 608 10,520Greater than or equal to $50 million and less than $100 million ................................................................ 80 5,672Greater than or equal to $100 million and less than $500 million .............................................................. 125 26,655Greater than or equal to $500 million and less than $1 billion ................................................................... 28 19,248Greater than or equal to $1 billion and less than $5 billion ........................................................................ 27 61,284Greater than or equal to $5 billion and less than $10 billion ... .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. . 6 41,175

Greater than or equal to $10 billion ............................................................................................................ 9 175,585

Total ...................................................................................................................................................... 4,709 342,698

According to FOCUS Report data, asof December 31, 2011, there wereapproximately 4,709 broker-dealersregistered with the Commission. 745 Nine

broker-dealers dominate the broker-dealer industry, holding over half of allcapital held by broker-dealers. Of the4,709 registered broker-dealers, 4,417

firms claimed exemptions from Rule15c3–3 on their FOCUS Reports.Accordingly, the Commission estimatesthat there are approximately 292


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746 Per FINRA’s Web site, there were 4,456 FINRAmember firms at year end 2011. See http:// www.finra.org/Newsroom/Statistics/.

747 See Commission staff, Study on Investment Advisers and Broker-Dealers, as required by Section913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011).

748 This data is based on audited reports filed by broker-dealers in 2011 and FOCUS Report data.

749 See AICPA, Improving the Clarity of Auditing Standards, available at http://www.aicpa.org/ InterestAreas/FRC/AuditAttest/Pages/ ImprovingClarityASBStandards.aspx . The AICPAannounced the clarification and convergenceproject in July 2008. See http://www.aicpa.org/ InterestAreas/FRC/AuditAttest/ DownloadableDocuments/Clarity/Archive/ASB _Clarity _ %20and _ Convergence _ (8.5x11).pdf .

750 See SIPC, Annual Report 2011, at 6.751 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) (discussingthe financial crisis of 1968–1970). Since itsinception through 2001, SIPC initiated 299proceedings under SIPA.


753 See, e.g., AICPA Broker-Dealer Audit Guideapp. H (sample representation letter).

754 According to GAAS, auditors ‘‘shouldconsider obtaining a representation letter’’ in anexamination or review engagement, and ‘‘specificwritten representations will depend on thecircumstances of the engagement and the nature of the subject matter and the criteria.’’ See AICPA, AT Section 101 at ¶ .60. Further, while the AICPABroker-Dealer Audit Guide contains a samplerepresentation letter, publications such as thisguide ‘‘are not auditing standards’’ but are‘‘recommendations on the application of the[auditing standards] in specific circumstances,including engagements for entities in specializedindustries.’’ See AICPA, AU Section 150, at ¶ .05.

755 See below discussion in section VII.C.1.i. of this release.

756

Prior to today’s amendments, paragraph (g)(3)of Rule 17a–5 describes a ‘‘material inadequacy’’ ina broker-dealer’s accounting system, internalaccounting controls, procedures for safeguardingsecurities, and practices and procedures to include‘‘any condition which has contributed substantiallyto or, if appropriate corrective action is not t aken,could reasonably be expected to: (i) inhibit a brokeror dealer from promptly completing securitiestransactions or promptly discharging hisresponsibilities to customers, other brokers ordealers or creditors; (ii) result in material financialloss; (iii) result in material misstatements in the

broker’s or dealer’s financial statements; or (iv)result in violations of the Commission’srecordkeeping or financial responsibility rules to an

Continued

carrying broker-dealers (4,709 ¥ 4,417 =292). Further, based on FOCUS Reportdata, the Commission also estimates thatthere are approximately 513 broker-dealers that are clearing or carryingfirms. The Commission staff hasestimated that approximately 18% of

broker-dealers registered with FINRA 746 also are registered as investmentadvisers with the Commission or with astate. 747

2. Independent Public Accountants ThatAudit Broker-Dealer Reports

Independent public accountants thataudit broker-dealer reports also will beimpacted by the rule amendments.Based on the audit reports filed by

broker-dealers in 2011, approximately900 accounting firms audited broker-dealer reports that were filed with theCommission. However, six largeaccounting firms dominate the marketperforming audits for approximately

20% of all broker-dealers registeredwith the Commission, and those broker-dealers audited by the six largeaccounting firms had total capital thatwas more than 90% of the total capitalof all broker-dealers registered with theCommission. 748 These statisticshighlight the current baseline forcompetition under which theaccountants are operating.

Prior to today’s amendments, theAICPA established the auditing andattestation standards to be followed bythe independent public accountants of

broker-dealers ( i.e., GAAS). The

AICPA’s auditing standards are revisedand updated from time to time. Forexample, the AICPA recently revisedGAAS (including audit standards thatapply to audits of broker-dealerfinancial statements), and the revisedstandards were generally effective forfiscal years that ended on or afterDecember 31, 2012. 749 Consequently,the independent public accountants of

broker-dealers have from time to timehad to familiarize themselves withupdates and revisions to GAAS.

3. SIPC Lawsuits Against AccountantsSIPC was established in 1971. In the

period from 1971 to 2011, SIPC initiated324 proceedings under SIPA to liquidatea failed broker-dealer. 750 This results inan average of approximately 8 SIPAproceedings per year, though 109 of the324 proceedings were initiated in theperiod from 1971 to 1974, which wasthe immediate aftermath of the financialcrisis of 1968–1970. 751 According toSIPC staff, SIPC has brought 9 lawsuitsagainst accountants since 1971, which isone lawsuit for every 36 SIPAproceedings. 752 The SIPC staff reportsthat two of these lawsuits were broughtafter the 2001 New York decisiondiscussed in section II.B.6.iii. of thisrelease and three lawsuits were broughtin liquidation proceedings that wereactive at or about the same time as the2001 New York decision. The suitsinitiated around the time of the 2001decision and thereafter were brought injurisdictions other than New York.4. Overview of Broker-Dealer Reporting,Auditing, and NotificationRequirements Before Today’sAmendmentsi. Broker-Dealer Reporting

Before today’s amendments, Rule17a–5 generally required broker-dealersto prepare and file a financial reportwith the Commission and the broker-dealer’s DEA, as well as a report of aPCAOB-registered independent publicaccountant covering the financial report.Brokers-dealers also were required to

file concurrently with the auditedfinancial report a material inadequacyreport prepared by the independentpublic accountant.

With regard to the materialinadequacy report, broker-dealersgenerally made representations to theirindependent public accountants abouttheir compliance with certain financialresponsibility rules in a representationletter. 753 However, broker-dealers didnot file reports with the Commission ortheir DEA containing suchrepresentations. GAAS does notprescribe specific or standardizedrepresentations to be made by a broker-dealer to its accountant with regard toan attestation engagement performed

under Rule 17a–5. 754 Therefore, broker-dealers’ representations to theirindependent public accountant relatingto compliance with certain financialresponsibility rules varied depending onwhat was required by the terms of theindividual engagements.ii. Engagement of the Accountant

As noted above, prior to today’samendments, broker-dealers generallywere required to file with theCommission: (1) A report of anindependent public accountant basedon an audit of the broker-dealer’sfinancial statements and supportingschedules; and (2) a materialinadequacy report prepared by theaccountant, based on, among otherthings, a review of a broker-dealer’saccounting system, internal accountingcontrol, and procedures for safeguardingsecurities. The accountant was requiredto be registered with the PCAOB.However, Rule 17a–5 required that theaudit be performed in accordance withGAAS, which are issued by the AICPA.Consequently, the standard setting bodyfor broker-dealer audits has been theAICPA (rather than the PCAOB)notwithstanding the requirement that

broker-dealers be audited by a PCAOB-registered independent publicaccountant. 755

With regard to the independent publicaccountant’s preparation of the materialinadequacy report, Rule 17a–5 requiredthat the scope of the accountant’sreview be sufficient to provide‘‘reasonable assurance’’ that anymaterial inadequacies 756 existing at the


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758 See Public Law 111–203 § 982.759 See Proposed Auditing Standard, Auditing

Supplemental Information Accompanying Audited Financial Statements and Related Amendments toPCAOB Standards, PCAOB Release No. 2011–05,PCAOB Rulemaking Docket Matter No. 036, 3 (July12, 2011) (‘‘ PCAOB Proposed Auditing Standard for Supplemental Information’’ ). As discussed above,the PCAOB has also proposed standards forattestation engagements related to broker-dealercompliance or exemption reports. See PCAOBProposing Release.

760 See PCAOB Proposed Auditing Standard for Supplemental Information at 2–3.

761 Id. at 2 (‘‘The proposed standard would benefit investors and other users of financialstatements by updating and enhancing the requiredaudit procedures when the auditor of the financialstatements is engaged to audit and report onwhether supplemental information accompanyingthe financial statements is fairly stated, in all

material respects, in relation to the financialstatements as a whole.’’).

762 Id. at 4–5.763 Section 107 of the Sarbanes-Oxley Act states

that no rule of the PCAOB ‘‘shall become effectivewithout prior approval of the Commission inaccordance with this section, other than asprovided in section 103(a)(3)(B) with respect toinitial or transitional standards.’’ See Public Law107–204 §107. This section also states that theCommission ‘‘shall approve a proposed rule, if itfinds that the rule is consistent with therequirements of this Act and the securities laws, oris necessary or appropriate in the public interest orfor the protection of investors’’, and generallyprovides that the proposed rule procedures followthe same rule filing procedure for SROs undersection 19(b) of the Exchange Act. Id.

764 See Custody of Funds or Securities of Clientsby Investment Advisers, 75 FR at 1456.

765 See Citrin Letter.

modifications made to the proposedamendments and form, and reasonablealternatives, where applicable.

The costs incurred by a broker-dealerto comply with the rule amendmentsand new form generally will depend onits size and the complexity of its

business activities. Because the size andcomplexity of broker-dealers varysignificantly as indicated in theeconomic baseline, their costs couldvary significantly. In some cases, theCommission is providing estimates of the average cost per broker-dealer acrossall broker-dealers, taking intoconsideration the variance in the size of

broker-dealers and the complexity of their business activities.

1. Broker-Dealer Annual ReportingAmendmentsi. Changing the Broker-Dealer AuditStandard Setter From the AICPA to thePCAOB and the Standards From GAAS

to PCAOB StandardsToday’s amendments require that

audits of broker-dealer financialstatements and schedules be conductedin accordance with the standards of thePCAOB, thereby replacing the AICPA asthe standard setter. The amendmentsalso require that broker-dealers file oneof two new reports—either a compliancereport or an exemption report—and areport of an independent publicaccountant based on an examination of the compliance report or a review of theexemption report. This sectiondiscusses the costs and benefits of the

change from the AICPA to the PCAOBas the standard setter for broker-dealeraudits and the corresponding changefrom GAAS to PCAOB standards withrespect to the audit of the financialstatements and schedules. The costs and

benefits of requiring the use of PCAOBstandards with respect to examinationsand reviews of the new compliancereport and exemption report arediscussed separately below in sectionVII.C.1.iii. of this economic analysisregarding the engagement of theaccountant.

The change from the AICPA to the

PCAOB as standard setter for broker-dealer audits and the correspondingchange from GAAS to PCAOB auditingstandards for audits of broker-dealerfinancial reports and supportingschedules provides several benefits. Byrequiring that these audits be conductedin accordance with PCAOB standards,the amendments align Rule 17a–5 withstatutory provisions. As discussedabove, the Sarbanes-Oxley Act amendedthe Exchange Act to require that certain

broker-dealer financial reports filedwith the Commission be audited by an

accounting firm registered with thePCAOB. The Dodd-Frank Act, enactedin July 2010, amended the Sarbanes-Oxley Act to provide the PCAOB withexplicit authority to, among otherthings, establish (subject to Commissionapproval) auditing and relatedattestation, quality control, ethics, andindependence standards for registeredpublic accounting firms with respect totheir preparation of audit reports to beincluded in broker-dealer filings withthe Commission, and the authority toconduct an inspection program of registered public accounting firms thataudit broker-dealers. 758 However, Rule17a–5 provided that broker-dealeraudits be performed in accordance withGAAS; namely, auditing standardsissued by the AICPA.

After today’s amendments, thePCAOB will be the standard setter fortwo types of entities: issuers that arepublic companies and broker-dealers.

Given this mandate, the PCAOB canfocus on establishing standards tailoredto these types of entities. For example,with respect to the audit of the financialreport, the PCAOB has proposed astandard for auditing supplementalinformation accompanying auditedfinancial statements filed with theCommission, including supportingschedules broker-dealers must file withthe Commission and the broker-dealer’sDEA, such as schedules regarding thecomputation of net capital and thecustomer reserve requirement andinformation related to the broker-

dealer’s possession or control of customer securities. 759 In addition, thePCAOB included the Commission’sproposal to amend Rule 17a–5 as one of the factors that led the PCAOB to‘‘reexamine its requirements regardingsupplemental information.’’ 760 Consequently, the PCAOB has proposeda standard that would be used for thesupplemental reports to the broker-dealer’s financial report. 761 The PCAOB

stated that ‘‘[t]he proposed standardenhances existing PCAOB standards by:(1) [R]equiring the auditor to performcertain audit procedures to test andevaluate the supplemental information,and (2) [e]stablishing requirements thatpromote enhanced coordination

between the work performed on thesupplemental information with workperformed on the financial statementaudit and other engagements, such as acompliance attestation engagement for

brokers and dealers.’’ 762 The change to the PCAOB as the audit

standard setter for broker-dealers shouldfacilitate the development of thePCAOB’s permanent inspection programas contemplated by the Dodd-Frank Act,

because audits of broker-dealers will beinspected by the PCAOB in accordancewith its own standards, and not those of another standard setter, and because of feedback that can be obtained throughthe inspections process regarding gaps

and areas that may need improvement.Further, the Commission has directoversight authority over the PCAOB,including the ability to approve ordisapprove the PCAOB’s rules. 763 Thismay help to increase investorconfidence in the independent publicaccountants that audit broker-dealers. Inaddition, as previously stated, theCommission has greater confidence inthe quality of audits conducted by anindependent public accountantregistered with, and subject to regularinspection by, the PCAOB. 764

As an alternative approach, onecommenter argued that GAAS shouldapply for audits of non-carrying broker-dealers. 765 Another commenter statedthat PCAOB standards should applyonly for broker-dealers ‘‘permanentlysubject to PCAOB inspection,’’ and thatthe Commission should not require thataudits of broker-dealers be performed inaccordance with PCAOB standards fornon-issuer broker-dealers until thePCAOB determines which non-issuer


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766 See AICPA Letter.

767 See, e.g., McGladrey Letter; SIFMA Letter.768 See ABA Letter.769 See PCAOB Auditing Standards (AS) and

Interim Auditing Standards (AU) (2013), availableat www.pcaobus.org/standards/auditing .

770 Id.771 See PCAOB Auditing Standard No. 1 (AS No.

1). At least one of these audit standards would notapply to audits of broker-dealer financial reports.See PCAOB Auditing Standard No. 5, ‘‘An Audit of Internal Control Over Financial Reporting that isIntegrated with an Audit of Financial Statements.’’

772 As discussed in section V. of this release, theCommission has delayed the compliance date forthis requirement to provide sufficient time for

broker-dealers and their accountants to prepare tocomply with the new requirement.

773 See discussion above in sections II.B.1., II.B.3.,and II.B.4. of this release.

774 See paragraphs (f)(1) and (g)(2)(i) of Rule 17a–5.

775 See discussion above in sections II.B.1., II.B.3.,and II.D.3. of this release.

broker-dealers will be subject to itspermanent inspection program. 766

The Commission has determined thatall audits of broker-dealer financialstatements and supporting schedulesshould be performed in accordance withPCAOB standards for several reasons.First, allowing the use of more than oneauditing standard would introduceinconsistencies in audits of broker-dealer financial reports. Second,allowing the use of non-PCAOBauditing standards for certain broker-dealer audits would reduce the benefitsdiscussed above of requiring that allaudits of broker-dealer financial reports

be conducted in accordance withPCAOB standards. Third, as discussedin more detail below, the switch fromGAAS to PCAOB standards should notresult in significant incremental costs.

Independent public accountants thataudit issuers are already familiar withPCAOB audit standards, which shouldease any transition to PCAOB standardsfor their audits of broker-dealers.Although the retention of two standardscould reduce the incremental costs of switching from GAAS to PCAOBstandards for some independent publicaccountants that do not audit issuers, itwould not reduce the incremental costsfor all such independent publicaccountants. For example, arequirement that the financialstatements of one class of broker-dealer

be audited in accordance with GAASand the financial statements of anotherclass of broker-dealer be audited inaccordance with PCAOB standardswould avoid the incremental costs onlyfor independent public accountants thatlimit their audit engagements to theformer class of broker-dealer. Theseindependent public accountants wouldnot need to stay current with PCAOBstandards and adopt their procedures tothose standards. However, independentpublic accountants that were engaged toaudit broker-dealers in both classeswould need to stay current with bothsets of standards and adopt theirprocedures to both sets of standards,which could increase their incrementalcosts. Further, the PCAOB may

determine, subject to Commissionapproval, to adopt specific auditingstandards for certain types of broker-dealers (for example, carrying and non-carrying broker-dealers). This coulddecrease costs for certain broker-dealeraudits.

The Commission received severalcomments on the costs of its proposal toreplace GAAS with PCAOB standardswith respect to audits of broker-dealerfinancial reports. Several commenters

stated that the Commission did notaddress the costs associated with thechange from GAAS to PCAOBstandards. 767 One commenter alsostated that the transition to PCAOBstandards from GAAS may requiresubstantial revisions to broker-dealeraudit programs. 768

Current PCAOB standards for auditsof financial information generallyincorporate concepts and requirementscontained within GAAS, therebyminimizing the potential costs of thischange to independent publicaccountants that audit broker-dealers.For example, in April 2003, the PCAOBadopted interim auditing standardsconsisting of GAAS then in existence, tothe extent not superseded or amended

by the PCAOB. 769 The PCAOB’s Website lists 50 such standards, including,for example, a standard relating toauditing accounting estimates (AU 342)and a standard relating to auditing fair

value measurements and disclosures(AU 328). 770 The PCAOB has adopted,and the Commission has approved, 16PCAOB auditing standards, beginningwith a standard relating to references inaudit reports to PCAOB standards. 771

While some independent publicaccountants of broker-dealers may incurone-time implementation costs toupdate their broker-dealer auditprograms to reflect PCAOB standards,the costs should not be significant. Asstated above, most of the PCAOB’scurrent standards for audits of financialreports incorporate concepts andrequirements contained within GAAS.Thus, the independent publicaccountants of broker-dealers alreadyshould be familiar with many of thePCAOB’s standards. In addition, asdiscussed in the economic baseline, theAICPA from time-to-time updates andrevises its standards. On such anoccurrence, an independent publicaccountant would need to take steps to

become familiar with the updates andrevisions and change its broker-dealeraudit program accordingly. This needfor continuing education presumablyalready is priced into the audit feesindependent public accountants charge

broker-dealers.In contrast to the views expressed bysome commenters, the Commission does

not expect that a requirement that anaudit of financial statements andsupporting schedules be conducted inaccordance with standards of thePCAOB instead of with GAAS willresult in substantial changes for broker-dealer audit programs and therefore theCommission does not anticipate thatthis change will result in significantcosts to broker-dealers in the form of increased audit fees. 772 ii. Requirement To File New Reports

Under the amendments, a broker-dealer will need to file one of two newreports: a compliance report or anexemption report. 773 A carrying broker-dealer ( i.e., one that does not claim anexemption from Rule 15c3–3) must filethe compliance report, and a broker-dealer that claimed an exemption fromRule 15c3–3 throughout the most recentfiscal year must file the exemptionreport. In the reports, a broker-dealermust make certain statements andprovide certain information relating tothe financial responsibility rules. Inaddition to preparing and filing thecompliance report, a carrying broker-dealer must engage the PCAOB-registered independent publicaccountant to prepare a report based onan examination of certain statements inthe broker-dealer’s compliancereport. 774 A broker-dealer that claimedan exemption from Rule 15c3–3throughout the most recently endedfiscal year must engage the PCAOB-registered independent publicaccountant to prepare a report based ona review of certain statements in the

broker-dealer’s exemption report. Ineach case, the examination or reviewmust be conducted in accordance withPCAOB standards.a. Compliance Report

Under the amendments, a carrying broker-dealer must prepare and file withthe Commission a new compliancereport each year, along with a reportprepared by a PCAOB-registeredindependent public accountant basedon an examination of certain statementsmade in the compliance report inaccordance with PCAOB standards. 775 The compliance report must containstatements as to whether: (1) The

broker-dealer has established and


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776 See, e.g., 15 U.S.C. 78ff(a).777 See E&Y Letter.

778 See Broker-Dealer Reports, 76 FR 37596.779 See SIFMA Letter.780 See Van Kampen/Invesco Letter.781 See ABA Letter; CAI Letter; CAQ Letter;

Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter; SIFMALetter; Van Kampen/Invesco Letter.

782 See ABA Letter; CAQ Letter; E&Y Letter; KPMG Letter; McGladrey Letter; PWC Letter.

783 See SIFMA Letter.

maintained Internal Control OverCompliance; (2) the Internal ControlOver Compliance of the broker-dealerwas effective during the most recentfiscal year; (3) the Internal Control OverCompliance of the broker-dealer waseffective as of the end of the most recentfiscal year; (4) the broker-dealer was incompliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3 as of theend of the most recent fiscal year; and(5) the information the broker-dealerused to state whether it was incompliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3 wasderived from the books and records of the broker-dealer. In addition, if applicable, the compliance report mustcontain a description of: (1) Eachidentified material weakness in theInternal Control Over Complianceduring the most recent fiscal year,including those that were identified asof the end of the fiscal year; and (2) any

instance of non-compliance with Rule15c3–1 or paragraph (e) of Rule 15c3–3 as of the end of the most recent fiscalyear.

The compliance report requirementsprovide a number of benefits. Forexample, specifying and standardizingthe statements required in thecompliance report should promoteconsistent compliance with Rule 17a–5and should ensure that the Commissionreceives information relating to aspectsof a carrying broker-dealer’s compliancewith the financial responsibility rulesthat are of particular concern. Although,as discussed above in section II.D.3. of this release, current auditing standardsrequire that independent publicaccountants obtain writtenrepresentations from management aspart of the audits of financial statementsand attestation engagements, GAASonly provide examples of managementrepresentations and do not mandate thatspecific management representations bemade. By clearly specifying andstandardizing the statements, thecompliance report should increaseconsistency with respect to the mattersexamined by the independent publicaccountants as part of the examination

of the compliance report.The specification and standardizationof the statements also should facilitateCommission and DEA oversight of

broker-dealer compliance with thefinancial responsibility rules to the

benefit of broker-dealer customers, byhelping the Commission and DEAs tomore quickly identify broker-dealerswith potential problems. Moreover, asadopted, the final rule requires a broker-dealer’s compliance report to includeinformation regarding whether the

broker-dealer’s internal control was

effective as of the end of the fiscal year,in addition to information regardingwhether there were material weaknessesin the Internal Control Over Complianceduring the fiscal year. This will providethe Commission and the DEA withinformation on whether the broker-dealer has taken action by the end of thefiscal year to cure any materialweaknesses in the Internal Control OverCompliance that existed during thefiscal year.

Requiring the compliance report to befiled with the Commission and the

broker-dealer’s DEA also shouldincrease broker-dealers’ focus onensuring the accuracy of the statements

being made and enhance compliancewith the financial responsibility rulesgiven the penalties for false filings. Forexample, filers are subject to penaltiesfor willfully making false statements inany application, report, or documentfiled with the Commission. 776

One commenter stated thatincremental benefits of having theassertion in the compliance report withrespect to internal controls pertain tothe whole year rather than the fiscalyear end does not justify the costs. 777 Inresponse, the Commission notes thatkey requirements in the financialresponsibility rules must be compliedwith on an on-going basis throughoutthe year. Therefore, it is critical to haveinternal controls over compliance withthese rules that are effective throughoutthe year rather than just at fiscal yearend. Therefore, the Commission

believes that there are benefits to havinga carrying broker-dealer state that itsInternal Control Over Compliance waseffective throughout the year.

Broker-dealers will incur costsassociated with preparing thecompliance report. The level of effortrequired by carrying broker-dealers toprepare a compliance report willdepend on the nature of the activities of the broker-dealer. For example, thecontrols necessary for a carrying broker-dealer that engages in limited custodialactivities generally should be lesscomplex than the controls necessary for

a carrying broker-dealer that engages inmore extensive custodial activities.Therefore, a carrying broker-dealer withlimited custodial activities should haveto expend less effort to make itsstatements in the compliance reportrelating to the effectiveness of itsInternal Control Over Compliance. Tothe extent that the amount of custodialactivity is related to the size of a broker-dealer, the cost of preparing the

compliance report should be lower forsmaller carrying broker-dealers.

The Commission estimated in theproposing release that, on average,carrying broker-dealers would spendapproximately 60 hours each year toprepare the proposed compliancereport. 778 One commenter stated thatthe proposal did not ‘‘address theadditional costs broker-dealers wouldincur in preparing ComplianceReports.’’ 779 However, the commenterdid not comment on the estimated hour

burden or provide specific data andanalysis on the additional costs that

broker-dealers would incur in preparingcompliance reports. Another commenterstated that the proposed estimate of 60hours ‘‘is not an accurate estimate of thetime burden to complete theCompliance Report’’ and that the

burdens in the proposing release areunderstated. 780 This commenter,however, did not provide a quantified

alternative estimate of the costs orspecific data to support its statement.The Commission is retaining the 60-

hour estimate for the reasons discussed below. The final rules contain twochanges from the proposal that couldresult in lower costs than if the ruleshad been adopted as proposed: (1)Elimination of the concepts of ‘‘materialnon-compliance’’ and ‘‘compliance inall material respects’’ with Rule 15c3–1and 15c3–3 for the purposes of reportingin the compliance report; and (2) anarrowing of these statements anddescription requirements fromcompliance with all of the financialresponsibility rules to compliance withRule 15c3–1 and paragraph (e) of Rule15c3–3.

As previously discussed, manycommenters raised concerns about howfirms would determine whether aninstance of non-compliance constitutesmaterial non-compliance. 781 Commenters urged the Commission toprovide guidance with additionalspecific examples or quantitative andqualitative factors to be consideredwhen determining whether non-compliance was material, 782 orproposing alternate definitions or

examples of non-compliance thatshould not be regarded as material. 783 Under the rules as adopted, broker-dealers will not be required to conduct


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784 See 17 CFR 240.15c3–1(a)(6)(iv)(B), (a)(6)(v),(a)(7)(ii), (a)(7)(iii), (c)(2)(x)(B)( 1), (c)(2)(x)(F)(3); 17CFR 240.17a –11(b)–(c); 17 CFR 240.15c3–3(i).

785 See Broker-Dealer Reports, 76 FR at 37577.786 See 17 CFR 240.17a–5(d)(3)(i)(B).

787 See discussion above in section VI.D.1.ii. of this release. 60 hours × 292 carrying broker-dealers= 17,520 hours per year.

788 For purposes of this economic analysis, salarydata is from the Securities Industry and FinancialMarkets Association (‘‘SIFMA’’) Report on

Management and Professional Earnings in theSecurities Industry 2011 (‘‘SIFMA Report onManagement and Professional Earnings in theSecurities Industry’’), which provides base salaryand bonus information for middle-management andprofessional positions within the securitiesindustry. The salary costs derived from the reportand referenced in this cost benefit section aremodified to account for an 1800-hour work year andmultiplied by 5.35 to account for bonuses, firm size,employee benefits, and overhead.

789 See discussion above in section VI.D.1.ii. of this release. Based on staff experience, theCommission believes that a carrying broker-dealerlikely would have a Compliance Manager gatherinformation necessary to validate the statements to

be provided and that it would take the ComplianceManager approximately 45 hours to perform thistask. In addition, the Commission believes that a

carrying broker-dealer likely would have a Chief Compliance Officer review the information andmake the attestation and that it would take theChief Compliance Officer approximately 15 hoursper year to perform this task. According to theSIFMA Report on Management and ProfessionalEarnings in the Securities Industry, as modified byCommission staff to account for an 1,800-hourwork-year and multiplied by 5.35 to account for

bonuses, firm size, employee benefits and overhead,the hourly cost of a Compliance Manager isapproximately $279/hour, and the hourly cost of aChief Compliance Officer is approximately $433/hour. 292 carrying broker-dealers × 45 hours × $279= $3,666,060. 292 carrying broker-dealers × 15hours × $433 = $1,896,540. $3,666,060 + $1,896,540= $5,562,600 per year.

a separate evaluation of materialitywhen determining instances of non-compliance that must be reported. Thisshould reduce the likelihood thatinconsistent approaches be taken bothamong broker-dealers and between

broker-dealers and their independentpublic accountants.

The ‘‘material non-compliance’’ and‘‘compliance in all material respects’’concepts were designed to limit thetypes of instances of non-compliancethat would need to be identified in thereport. To retain a limiting principle,the final rule focuses on provisions thattrigger notification requirements whenthey are not complied with, namely,Rule 15c3–1 and the customer reserverequirement in paragraph (e) of Rule15c3–3. 784 Any instances of non-compliance with these requirements asof the fiscal year end must be describedin the compliance report. As stated inthe proposing release, failing to

maintain the required minimum amountof net capital under Rule 15c3–1 orfailing to maintain the minimumdeposit requirement in a special reserve

bank account under Rule 15c3–3 wouldhave been instances of material non-compliance under the proposed rule. 785 Accordingly, under the proposal, a

broker-dealer would have been requiredto describe all instances of non-compliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3. Under theproposal, a broker-dealer also wouldhave been required to describe instancesof material non-compliance with Rule

17a–13 and the Account StatementRules. The final rule is narrower in thata broker-dealer only is required todescribe instances of non-compliancewith Rule 15c3–1 and paragraph (e) of Rule 15c3–3. While the final rulesincrease costs relative to the baseline,they should result in modestly lowercosts to broker-dealers relative to theproposal.

The final rule also retains theproposed requirement that the carrying

broker-dealer provide a description of each identified material weakness in theinternal control of the broker-dealerover compliance with the financialresponsibility rules, but, in conformitywith other modifications to theproposal, the final rule specifies that thematerial weaknesses include thoseidentified during the most recent fiscalyear as well as those that wereidentified as of the end of the fiscalyear. 786 The Commission believes that

the modifications to the final rulediscussed above may modestly reducethe hour burden of the final rule ascompared to the hour burden thatwould have resulted from the proposedrule; namely, because a broker-dealerwill not need to evaluate whetherinstances of non-compliance with thefinancial responsibility rules arematerial and will only need to reportinstances of non-compliance with Rule15c3–1 and paragraph (e) of Rule 15c3–3. While these modifications will resultin additional costs to broker-dealersover the baseline, they are not expectedto increase costs over those estimatedfor the proposed rule. This is becausethe proposed statement as to whetherthe broker-dealer’s Internal Control OverCompliance was effective during themost recent fiscal year, and the relatedstatement about material weakness,would also cover the fiscal year end. As

noted above, the modification to requiretwo statements (one covering the fiscalyear and one covering the fiscal yearend) was prompted by commentersuggestions that broker-dealers bepermitted to report the remediation of amaterial weakness, or whether amaterial weakness still exists, at the endof the fiscal year. These changes willprovide information to the Commissionand DEAs as to whether materialweaknesses during the year have beenremediated as of the fiscal year end.They also afford the broker-dealer theopportunity to state in the report that amaterial weakness has been remediated,if applicable.

The changes discussed above, in somecases, may result in a modest reductionin burden relative to the proposal.However, while some commenterssuggested that the proposing releaseunderestimated the burden, theCommission is not changing its estimateof the time required for a broker-dealerto prepare the compliance report. TheCommission notes that, whilecommenters questioned the estimate,they did not provide data that would

enable the Commission to revise itsestimate.The Commission, however, is

updating its estimates of the number of broker-dealers that would be required tofile the compliance report, which affectsthe cost estimates. The Commissionnow estimates that there areapproximately 292 carrying broker-dealers. Therefore, the Commissionestimates that the time required for all292 carrying broker-dealers to preparethe report is approximately 17,520

hours per year. 787 Further, theCommission estimates that the totalcost 788 associated with this requirementis approximately $5.6 million peryear. 789

b. Exemption ReportBroker-dealers that claim an

exemption from Rule 15c3–3 are

required to file an exemption report anda report of the independent publicaccountant based on a review of theexemption report. The exemption reportmust contain the following statementsmade to the best knowledge and belief of the broker-dealer: (1) A statement thatidentifies the provisions in paragraph(k) of Rule 15c3–3 under which the

broker-dealer claimed an exemptionfrom Rule 15c3–3; (2) a statement the

broker-dealer met the identifiedexemption provisions in paragraph (k)of Rule 15c3–3 throughout the mostrecent fiscal year without exception orthat it met the identified exemptionprovisions in paragraph (k) of Rule15c3–3 throughout the most recentfiscal year except as described in theexemption report; and (3) if applicable,a statement that identifies eachexception during the most recent fiscalyear in meeting the identifiedprovisions in paragraph (k) of Rule15c3–3 and that briefly describes the


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790 See Angel Letter.791 See Item 24 of Part IIa of the FOCUS Report.

792 See Broker-Dealer Reports, 76 FR at 37596.793 See discussion above in section VI.D.1.iii. of

this release.794

See discussion above in section VI.D.1.iii. of this release. 7 hours × 4,417 non-carrying broker-dealers = 30,919 hours per year. See the discussion

below regarding the external costs associated withobtaining the accountant’s report on the exemptionreport.

795 See discussion above in section VI.D.1.iii. of this release. Based on staff experience, a non-carrying broker-dealer likely would have aCompliance Manager gather information necessaryto validate the information to be provided in theexemption report, and it would take theCompliance Manager approximately six hours toperform this task. In addition, a non-carrying

broker-dealer likely would have a Chief ComplianceOfficer review the information and make theattestation, and it would take the Chief Compliance

Officer approximately one hour to perform this task.According to the SIFMA Report on Managementand Professional Earnings in the SecuritiesIndustry, as modified by Commission staff toaccount for an 1,800-hour work-year and multiplied

by 5.35 to account for bonuses, firm size, employee benefits and overhead, the hourly cost of aCompliance Manager is approximately $279/hour,and the hourly cost of a Chief Compliance Officeris approximately $433/hour. 4,417 non-carrying

broker-dealers × 6 hours × $279 = $7,394,058 peryear. 4,417 non-carrying broker-dealers × 1 hour ×$433 = $1,912,561 per year. $7,394,058 +$1,912,561 = $9,306,619 per year.

nature of each exception and theapproximate date(s) on which theexception existed.

The preparation of exemption reports by broker-dealers that claim anexemption from Rule 15c3–3 throughoutthe most recent fiscal year, as well asreviews of certain statements in theexemption reports by independentpublic accountants, should strengthenand facilitate consistent compliancewith the Commission’s financialresponsibility rules, for many of thesame reasons identified above withrespect to the compliance report.Among other things, these reportsshould enhance compliance with theexemption provisions in Rule 15c3–3,thereby providing better protection of customer assets. This increased focus isenhanced further by requiring the directfiling of the exemption report with theCommission and the broker-dealer’sDEA because of the potential penalties

for false statements. In addition, theCommission and the broker-dealer’sDEA will benefit from the informationprovided in the exemption report inconducting their supervisory oversightof the broker-dealer.

The Commission considered analternative suggested by one commenterto replace the exemption report with a

box to check on the FOCUS Report. 790 After careful consideration of thisalternative, the Commission determinedthat it is not an appropriate alternativeto the exemption report. As discussedabove in section II.B.4.iii. of this release,a broker-dealer claiming an exemptionfrom Rule 15c3–3 already is required toindicate the basis for the exemption onits FOCUS Report. 791 Second, theexemption report requires the broker-dealer to make certain statements thatthe independent public accountant mustreview. Thus, the exemption report willprovide a standardized statement acrossall broker-dealers claiming anexemption from Rule 15c3–3 for theindependent public accountant toreview. Third, the exemption report willprovide the Commission and the broker-dealer’s DEA with more informationthan currently is reported by non-

carrying broker-dealer’s in the FOCUSReport. Specifically, it requires the broker-dealer to, among other things,state either that it met the identifiedexemption provisions in paragraph (k)throughout the most recent fiscal yearwithout exception or that it met theidentified exemption provisionsthroughout the most recent fiscal yearexcept as described in the report. Thiswill provide the Commission and the

broker-dealer’s DEA with information asto whether a broker-dealer is meetingthe exemption provisions of paragraph(k) of Rule 15c3–3 (not simply that the

broker-dealer is claiming the exemptionas is reported in the FOCUS Report).The Commission expects that non-carrying broker-dealers generally trackexceptions as part of monitoringcompliance with the exemptionprovisions in paragraph (k) of Rule15c3–3. Fourth, requiring that theexemption report be filed with theCommission should increase broker-dealers’ focus on the statements beingmade, facilitating consistent compliancewith the exemption provisions in Rule15c3–3, and therefore, providing betterprotection of customer assets. Further,employing a ‘‘check the box’’ alternativewould not substantially reducecompliance costs because the broker-dealer would need to take steps toascertain that it has a valid basis for

claiming the exemption, whether or notthese steps result in an exemptionreport or ‘‘check the box.’’

The Commission estimated that itwould take a non-carrying broker-dealerapproximately five hours to prepare andfile the proposed exemption report. 792 The Commission did not receivecomments specifically addressing thisestimate. However, because the rule wasmodified from the proposal to alsorequire the identification of exceptionsto the exemption provisions, theCommission is increasing the estimateto seven hours. 793 The Commission nowestimates that there are approximately4,417 non-carrying broker-dealers thatmust file exemption reports. Therefore,the Commission estimates that theannual reporting burden for all non-carrying broker-dealers to prepare andfile the exemption report isapproximately 30,919 hours per year. 794 The Commission estimates that the totalindustry-wide cost to prepare theexemption report is approximately $9.3million per year. 795

iii. Engagement of the Accountant

As discussed above, the amendmentsto Rule 17a–5 eliminate the requirementthat the broker-dealer’s independentpublic accountant prepare, and the

broker-dealer file with the Commissionand its DEA concurrently with itsannual audited financial statements, amaterial inadequacy report, based on,among other things, a review of a

broker-dealer’s accounting system,internal accounting control, andprocedures for safeguarding securities.The amendments replace thisrequirement with a requirement, amongother things, that the broker-dealer filewith its annual reports a report prepared

by an accountant covering either the broker-dealer’s compliance report orexemption report, as applicable. Theaccountant engaged by the broker-dealermust, as part of the engagement,undertake to prepare its reports basedon an examination of certain statementsin the compliance report or a review of certain statements in the exemptionreport, as applicable, in accordance withPCAOB standards.

With regard to the independent publicaccountant’s preparation of the materialinadequacy report, Rule 17a–5 requiredthat the scope of the accountant’sreview be sufficient to provide‘‘reasonable assurance’’ that anymaterial inadequacies existing at thedate of examination would be disclosed.If the broker-dealer was exempt from

Rule 15c3–3, Rule 17a–5 provided thatthe accountant must ascertain that theconditions of the exemption were beingcomplied with as of the examinationdate and that no facts came to theaccountant’s attention to indicate thatthe conditions of the exemption had not

been complied with since the lastexamination. As discussed above,AICPA guidance provided that thematerial inadequacy report shouldaddress what the independent publicaccountant concluded in its ‘‘study’’ of the adequacy of the broker-dealer’spractices and procedures in complyingwith the financial responsibility rules in


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796 See AICPA Broker-Dealer Audit Guide at¶ 3.77.

797 See PCAOB Inspection Report at iii.798 Id.

799 As stated above, a review engagement isdesigned to provide a moderate level of assurance,and the accountant’s conclusion could state, forexample, that no information came to theaccountant’s attention that indicates that theexemption report is not fairly stated in all materialrespects.

800 See PCAOB Proposing Release at 5.

801 See Broker-Dealer Reports, 76 FR at 37599.See also discussion above in section VI.D.1.vii.b. of this release.

802 See Broker-Dealer Reports, 76 FR at 37600.The Commission estimated that the average cost of an audit of a non-carrying broker-dealer’s financialreport was approximately $30,000 per year, basedon a weighted average of estimates of that cost for

broker-dealers with varying levels of net income.The Commission further estimated that theadditional cost for a review of the exemption reportwould be an average of approximately $3,000 pernon-carrying broker-dealer per year. Id. See alsodiscussion above in section VI.D.1.vii.c. of thisrelease.

relation to the definition of materialinadequacy as stated in Rule 17a–5. 796

However, in the PCAOB’s first reporton the progress of its interim inspectionprogram of broker-dealer audits, thePCAOB stated that as to 21 of the 23audits inspected, the accountant ‘‘failedto perform sufficient audit procedures toobtain reasonable assurance that anymaterial inadequacies found to existsince the date of the last examination. . . would have been disclosed in theaccountant’s supplement report.’’ 797 Further, for all of the 14 audits of

broker-dealers that claimed anexemption from Rule 15c3–3, thePCAOB stated that the accountant ‘‘didnot perform sufficient procedures toascertain that the broker or dealercomplied with the conditions of theexemption.’’ 798 The deficiencies notedin the PCAOB’s report on the progressof the interim inspection programprovide further support for the

amendments that the Commission isadopting today to establish thefoundation for the PCAOB’sdevelopment of standards that aretailored to Rule 17a–5, and to strengthenand facilitate consistent compliancewith broker-dealer audit and reportingrequirements.

Generally, the engagement of accountant amendments should resultin higher levels of compliance with theCommission’s financial responsibilityrules by increasing the focus of carrying

broker-dealers and their independentpublic accountants on specificstatements made in the compliancereport relating to the broker-dealer’scompliance, and internal control overcompliance, with the financialresponsibility rules and increasing thefocus of non-carrying broker-dealers andtheir independent public accountantson whether the broker-dealer meets theexemption provisions in paragraph (k)of Rule 15c3–3. These amendments alsoclarify the scope and the standards thatapply to broker-dealer audits andconform language in the rule withterminology in existing audit literature,which should reduce inconsistencies in

broker-dealer compliance with Rule17a–5. The replacement of the materialinadequacy report with the report basedon an examination of the compliancereport or review of the exemption reportfacilitates the Commission’s objective toprovide clear and consistentterminology focused separately oncompliance with the financialresponsibility rules and internal control

over compliance with the financialresponsibility rules.

With regard to the examination of thecompliance report, the amendments areintended to encourage greater focus bythe independent public accountant onInternal Control Over Compliance,including, in particular, broker-dealercustody practices. By specifying thestatements that must be made by a broker-dealer to the Commission, andhence, examined by the auditor, thecompliance report should provideclarity and facilitate consistentcompliance with Rule 17a–5 byindependent public accountants.Additionally, the focus of independentpublic accountants on internal controlover the custody practices of broker-dealers should better identify broker-dealers that have weak internal controlsfor safeguarding investor securities andcash. Similarly, with regard to thereview of the exemption report, the

amendments encourage greater focus bythe accountant on whether the broker-dealer has appropriately claimed anexemption from Rule 15c3–3 by, amongother things, reviewing whether the

broker-dealer’s statements in theexemption report as to meeting theexemption provisions without or withexceptions, and, if applicable,identifying exceptions to meeting thoseprovisions, were fairly stated. 799 Asstated above, the terminology in Rule17a–5 with regard to the materialinadequacy report was outdated andinconsistent with current auditpractices.

The PCAOB stated that its proposedattestation standards for examiningcompliance reports and reviewingexemption reports were ‘‘tailored’’ tothe proposed amendments to Rule 17a–5. 800 These standards, if adopted, areexpected to establish a single and

broker-dealer-specific approach toexamining compliance reports andreviewing exemption reports and areexpected to enable the accountant toscale the engagement based on the

broker-dealer’s size and complexity.Based on its estimates of the costs

associated with the cost of an internal

control report under Rule 206(4)–2, theCommission estimated that the externalcost to a carrying broker-dealer of obtaining the independent publicaccountant’s report based on anexamination of the proposed

compliance report would be an averageincremental cost of approximately$150,000 per carrying broker-dealer peryear. 801 Based on staff experience,including communications with broker-dealers, broker-dealer independentpublic accountants, and independentpublic accountant industry groups, theCommission estimated that the externalcost to a non-carrying broker-dealer of obtaining the independent publicaccountant’s report based on a review of the proposed exemption report wouldcost an average of approximately $3,000per non-carrying broker-dealer peryear. 802 Before today’s amendments,independent public accountants of

broker-dealers were required to preparea material inadequacy report. As thatreport is no longer required, the costsassociated with engaging theindependent public accountant toprepare a material inadequacy reporthave been eliminated and replaced by

the costs associated with engaging theindependent public accountant toprepare a report covering thecompliance report or the exemptionreport. Therefore, the incremental costof today’s amendments related to theengagement of the independent publicaccountant is the amount that the costexceeds the cost of engaging theindependent public accountant toprepare the material inadequacy report.However, the Commission has notpreviously estimated the average cost of preparing the material inadequacyreport. Consequently, the Commission is

retaining the cost estimates set forth inthe proposing release, while recognizingthat costs could be lower as a result of cost savings attributable to theelimination of the material inadequacyreport requirements.

The Commission received variouscomments regarding the engagement of accountant provisions as they relate toexamining or reviewing the proposedcompliance reports and exemptionreports, respectively. One commenterstated that the Commissionunderestimated the cost of examiningthe compliance report and that theCommission may need to consider the


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803 See ABA Letter.804 See Van Kampen/Invesco Letter.805 See CAI Letter.806 See PCAOB Proposing Release at 5. An

examination engagement is designed to provide ahigh level of assurance. See, e.g., PCAOB InterimAttestation Standard, AT Section 101 at ¶.54. Inthis case, the accountant’s conclusion will beexpressed in the form of an opinion. For example,the accountant’s conclusion based on anexamination of an assertion could state that in theaccountant’s opinion, [the assertion] is fairly statedin all material respects. See, e.g., PCAOB InterimAttestation Standard, AT Section 101 at ¶.84.

807 See 17 CFR 240.17a–5(g)(2).808 See PCAOB Proposing Release at 8.809 Id. at 9.

810 See discussion above in section VI.D.1.vii.b. of this release.

811 See discussion above in section VI.D.1.vii.c. of this release.

812 See E&Y Letter.813 See PCAOB Interim Attestation Standard, AT

Section 201 at ¶.03.814 See Citrin Letter.

PCAOB’s proposed rules before it canreasonably estimate this cost. 803 Another commenter stated that theproposed amendments have ‘‘thepotential to double the total currentaudit fees and have a material impact’’on firms. 804 A third commenter statedthat the economic analysis was‘‘inconclusive’’ because the PCAOB hasnot yet established auditing andattestation standards for broker-dealers. 805 The commenters, however,did not provide quantified alternativecost estimates.

The Commission acknowledges thatthe total costs associated with theserequirements will depend on the finalPCAOB standards for attestationengagements to examine compliancereports or review exemption reports.However, as the PCAOB’s proposedstandards were tailored to the proposedamendments, nothing in those standardscauses the Commission to change its

estimates of the costs associated withthese requirements, or to question thatthe benefits will justify the costs.

Before today’s amendments, Rule17a–5 required the independent publicaccountant to, among other things,review the accounting system, internalaccounting control, and procedures forsafeguarding securities of the broker-dealer, including appropriate tests, forthe period since the prior examinationdate. The scope of the independentpublic accountant’s review was requiredto be sufficient to provide reasonableassurance that any materialinadequacies existing at the date of theauditor examination would bedisclosed. Similarly, an examination of a compliance report performed underthe PCAOB’s attestation standard forexamination engagements would requirethat the auditor obtain reasonableassurance to express an opinion onwhether the broker-dealer’s statementsin the compliance report are fairlystated, in all material respects. 806

Moreover, before today’samendments, if a broker-dealer wasexempt from Rule15c3–3, Rule 17a–5required the independent publicaccountant to ‘‘ascertain that the

conditions of the exemption were being

complied with as of the examinationdate and that no facts came to [theindependent public accountant’s]attention to indicate that the exemptionhad not been complied with during theperiod since [the independent publicaccountant’s] last examination.’’ 807 ThePCAOB’s proposed review standard forthe exemption report would require thatthe independent public accountantmake inquiries and perform otherprocedures that are commensurate withthe auditor’s responsibility to obtainmoderate assurance that the broker-dealer meets the identified conditionsfor an exemption from Rule 15c3–3. 808 These procedures would includeevaluating relevant evidence obtainedfrom the audit of the financialstatements and supporting schedulesand are designed to enable the auditorto scale the review engagement based onthe broker-dealer’s size andcomplexity. 809

The compliance report as adoptedincludes an additional statement(relative to the proposal) as to whetherthe broker-dealer’s Internal Control OverCompliance was effective as of the endof the most recent fiscal year. Therefore,costs of compliance with the final rulesmay be higher than costs of compliancewith the proposed rules to the extentInternal Control Over Compliance haschanged near or as of the fiscal year end.However, this increased cost is notexpected to be significant, since theprocedures needed to opine on thesematters as of the fiscal year end shouldnot be materially different from theprocedures employed to opine as to theeffectiveness of internal control over thecourse of the fiscal year.

As proposed, the broker-dealer wouldhave been required to assert whether itwas in compliance, in all materialrespects, with all of the financialresponsibility rules as of its fiscal yearend. As adopted, the broker-dealer mustassert whether it is in compliance withRule 15c3–1 and paragraph (e) of Rule15c3–3 ( i.e., a narrower range of rulecompliance than proposed). Thismodification of the broker-dealer’sassertion could result in lower costs for

accountants’ reports on the compliancereport as compared to the proposal asthe scope of the matters to be covered

by accountants’ examinations will benarrower.

Although these modifications couldmodestly lower costs associated withthe accountant’s report covering thecompliance report as compared to theproposal, the Commission is not

changing its estimate of costs associatedwith accountants’ reports coveringcompliance reports and exemptionreports. Based on updated data, theCommission now estimates that thereare approximately 292 carrying broker-dealers. The Commission thereforeestimates that the industry-wide annualaverage incremental external reportingcost of accountants’ reports based onexaminations of compliance reports isapproximately $44 million per year($150,000 times 292 carrying broker-dealers = $43,800,000). 810 Based onupdated data, the Commission nowestimates that there are approximately4,417 non-carrying broker-dealers. TheCommission therefore estimates that thetotal industry-wide annual reportingcost of accountant’s reports based onreviews of exemption reports isapproximately $13.3 million per year(4,417 non-carrying broker-dealers times$3,000 = $13,251,000). 811 TheCommission therefore estimates that thetotal industry-wide incremental externalannual reporting cost to broker-dealersassociated with the accountants’ reportscovering the compliance report andexemption report is approximately$57.3 million per year.

Finally, one commenter suggestedthat the Commission use an ‘‘agreed-upon procedures’’ engagement for theexemption report. 812 This alternativewas considered. The final rule,however, requires a review engagementas proposed. Under an ‘‘agreed-uponprocedures’’ engagement, theindependent public accountant isengaged by a client to issue a report of findings based on specific proceduresperformed on subject matter that thespecified parties believe areappropriate. 813 Additionally, in an‘‘agreed-upon procedures’’ engagement,the independent public accountant doesnot perform an examination or a review,and does not provide an opinion ornegative assurance. Thus, no conclusionwould be rendered as to the broker-dealer’s statements in the exemptionreport.

Another commenter stated that the benefit of receiving an audit reportcovering the exemption report wouldnot justify the cost 814 and, similarly, asecond commenter did not see a benefitfrom the auditor attestation of the


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815 See Angel Letter.816 See 17 CFR 240.17a–5(g)(2).

817 See SIPC v. BDO Seidman, LLP, 746 NE.2d1042 (N.Y. 2001); aff’d, 245 F.3d 174 (2d Cir. 2001).


819 Based on staff experience, a broker-dealerlikely would have a Financial Reporting Managerprepare an additional copy of its annual report andmail it to SIPC. According to the SIFMA Report onManagement and Professional Earnings in theSecurities Industry, as modified by Commissionstaff to account for an 1,800-hour work-year andmultiplied by 5.35 to account for bonuses, firm size,employee benefits and overhead, the hourly cost of a Financial Reporting Manager is approximately$309/hour. 4,492 SIPC-member broker-dealers × 1 ⁄ 2 hour × $309 = $694,014.

820 The number of pages of an annual report, andconsequently the associated postage costs, likelywill vary significantly based on the size of the

broker-dealer and the types of business in which itengages.

821 Based on Commission staff experience withannual report filings of broker-dealers under Rule17a–5, the Commission staff estimates thatapproximately 50% of broker-dealers file theirannual reports using an overnight mail deliveryservice. These broker-dealers would consequentlyincur higher postage costs than broker-dealerswhich choose to mail their annual reports usingfirst class mail or delivery methods other thanovernight mail. Therefore, postages costs will varydepending on the size of the annual report andmethod of delivery. The Commission estimates thatthe cost to mail the additional reports would be, onaverage, $12.05 per broker-dealer. As of October2012, the $12.05 rate is an average rate of the costof an Express Mail Flat Rate Envelope of $18.95 anda Priority Mail Flat Rate Envelope of $5.15, basedon costs obtained on the Web site of the U.S. PostalService, available at www.usps.gov . ($18.95 +$5.15) = $24.10/2 = $12.05.

822 4,492 broker-dealers × $12.05 = $54,128.823 See, e.g., CAQ Letter; Deloitte Letter; KPMG

Letter.

exemption report. 815 As noted above, before today’s amendments, if a broker-dealer was exempt from Rule15c3–3,Rule 17a–5 required the independentpublic accountant to ‘‘ascertain that theconditions of the exemption were beingcomplied with as of the examinationdate and that no facts came to [theindependent public accountant’s]attention to indicate that the exemptionhad not been complied with during theperiod since [the independent publicaccountant’s] last examination.’’ 816 Consequently, the current rule requiresthe independent public accountant toreach a conclusion with respect to a

broker-dealer’s claimed exemption fromRule 15c3–3.

The Commission believes the ruleshould continue to require a conclusionfrom the independent public accountanton the broker-dealer’s claimedexemption from Rule 15c3–3 because of the importance of safeguarding

customer securities and cash. While theCommission anticipates there will becosts related to the audit of theexemption report, the Commission doesnot believe it would be appropriate touse a lower standard ( i.e., the agreed-upon procedures standard) or have norequirement for the independent publicaccountant to perform any work withrespect to the exemption report.iv. Filing of Annual Reports With SIPC

The amendments to Rule 17a–5require broker-dealers that are SIPCmembers to file their annual reportswith SIPC. SIPC plays an important rolein the securities markets by serving asa backstop to protect customers of afailed broker-dealer that cannotpromptly return customer securities andfunds. In this capacity, SIPC has alegitimate interest in receiving theannual reports of its broker-dealermembers to assist it with itsmaintenance of the SIPC Fund and tomonitor trends in the broker-dealerindustry. For example, SIPC presentlyobtains revenue information from

broker-dealers, through Form SIPC–7, todetermine how best to structure broker-dealer assessments to maintain the SIPC

Fund at an appropriate level. However,the information collected in the form islimited and may not assist SIPC inassessing whether the SIPC Fund isappropriately sized to the risks of a large

broker-dealer failure. The annual reportscontain much more detailed informationabout the assets, liabilities, income, netcapital, and Rule 15c3–3 customerreserve requirements of broker-dealers,and also include, for carrying broker-

dealers, a compliance report containinginformation about the broker-dealer’scompliance with, and controls overcompliance with, the broker-dealerfinancial responsibility rules. Theannual reports also generally includethe independent public accountant’sreports covering the financial report andcompliance report or exemption report,as applicable, prepared by the broker-dealer. This information also will assistSIPC in monitoring the financialstrength of broker-dealers and, therefore,in assessing the adequacy of the SIPCFund.

In addition, by receiving the annualreports, SIPC may be able to overcomea potential legal hurdle to pursuingclaims against a broker-dealer’saccountant where the accountant’sfailure to adhere to professionalstandards in auditing a broker-dealercauses a loss to the SIPC Fund. Asdiscussed in section II.B.6. of this

release, SIPC has sought to recovermoney damages from the broker-dealer’sindependent public accountant basedon an alleged failure to comply withauditing standards, but at least onecourt has held under New York law thatSIPC could not maintain a claim

because it was not a recipient of theannual audit filing and could not haverelied on it. 817

SIPC’s improved ability to maintainthe SIPC Fund will benefit investors.First, if the SIPC Fund is appropriatelysized, customers of a failed broker-dealer in a SIPA liquidation should beable to recover their assets more quicklythrough advances from the fund than if the fund is not adequate. Also, to theextent the amendments overcome apotential legal hurdle to pursuingclaims against a broker-dealer’saccountant, the ability to recoverdamages from the broker-dealer’saccountant in the context of a SIPAliquidation proceeding could increasethe size of the estate of a failed broker-dealer. Increasing the size of the estatecould benefit customers with claimsthat cannot be fully satisfied throughdistributions of customer property held

by the failed broker-dealer and the SIPCadvances.The new requirement that broker-dealers that are members of SIPC filetheir annual reports with SIPC willincrease these broker-dealers’compliance costs. 818 In the proposingrelease, the Commission estimated thatit would take broker-dealersapproximately 30 minutes to prepareand file the annual reports with SIPC,

and commenters did not disagree withthis estimate. Thus, the Commissionestimates that the annual industry-widereporting burden associated with thisamendment is approximately 2,246hours per year ( 1 ⁄ 2 hour times 4,492SIPC members = 2,246 hours) and thatthe total annual cost is approximately$694,000. 819 There would be postagecosts associated with sending a copy of the annual report to SIPC that areestimated to be, on average, 820 approximately $12.05 per broker-dealerper year. 821 Thus, the Commissionestimates that the total annual postagecosts associated with sending a copy of the annual report to SIPC would beapproximately $54,128 per year for all

broker-dealers that are SIPCmembers. 822

While they did not provide estimatesof potential litigation costs, severalcommenters stated that the Commissiondid not address the potential costs and

benefits of requiring broker-dealers tofile copies of their annual reports withSIPC, including potential litigation costsfor independent public accountants. 823 The Commission recognizes that theremay be increased litigation costs (orreserves for potential litigation costs) foraccountants as a result of theamendment and that to the extent thatthere are such costs, some of them may

be passed on to broker-dealers in the


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824 See SIPC v. BDO Seidman, LLP, 746 NE.2d1042 (N.Y. 2001); aff’d, 245 F.3d 174 (2d Cir. 2001).

825 See 17 CFR 240.17a–5(h)(2).826 See 17 CFR 240.17a–11.

827 See 17 CFR 240.17a–11(b)(1).828 See, e.g., 17 CFR 240.15c3–1(a)(6)(iv)(B); 17

CFR 240.15c3–1(a)(6)(v); 17 CFR 240.15c3–1(a)(7)(ii); 17 CFR 240.15c3–1(c)(2)(x)(C)( 1); 17 CFR240.15c3–1(e); 17 CFR 240.15c3–1d(c)(2); 17 CFR240.15c3–3(i).

829 See 17 CFR 240.15c3–3(i).830 See ABA Letter; CAI Letter; CAQ Letter;

Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter; SIFMALetter; Van Kampen/Invesco Letter.

831 See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter; VanKampen/Invesco Letter.

832 See Deloitte Letter.833 See KPMG Letter. See also PCAOB Interim

Attestation Standard, AT Section 101 at ¶13.834 See PWC Letter. See also PCAOB Interim

Attestation Standard, AT Section 101 at ¶¶11–13.835 See, e.g., ABA Letter; E&Y Letter; McGladrey

Letter.836 See Van Kampen/Invesco Letter.837 See KPMG Letter.838 See ABA Letter.839 Under Rule 17a–11, a broker-dealer must

provide notice to the Commission and its DEA incertain circumstances. For example, paragraph(b)(1) of Rule 17a–11 requires a broker-dealer togive notice if its net capital declines below the

minimum amount required under Rule 15c3–1. Inaddition, Rule 15c3–1 and Rule 15c3–3 require broker-dealers to provide notifications in certaincircumstances. For example, paragraph (a)(6)(iv) of Rule 15c3–1 requires a broker-dealer that operatesas a specialist or market-maker and that operatesunder the provisions of paragraph (a)(6) of Rule15c3–1 to obtain certain representations from the

broker-dealer that carries its market maker orspecialist account. The representations include thatthe broker-dealer carrying the account will providea notification under Rule 17a–11 if the marketmaker or specialist fails to deposit the requiredamount of equity into the account within therequired time frame as prescribed in paragraph(a)(6) of Rule 15c3–1. In addition, under paragraph

Continued

form of increased fees charged by broker-dealers’ independent publicaccountants. However, commenters didnot provide estimates of potentiallitigation costs, and Commission staff were unable to find readily-availablepublic information from which toestimate specific costs of possiblelitigation. To the extent that SIPC does

bring an individual lawsuit as a directresult of this amendment ( e.g., a suit

brought in New York), there would becosts in terms of legal fees. Based onstaff experience, depending on thecomplexity, scope, and length of thelitigation, the costs to defend anindividual case could be quite signficantgiven the hourly fees charged by outsidecounsel. However, the Commission doesnot believe these costs would besignificant in the aggregate. As indicatedin the economic baseline, SIPC initiatesa small number of proceedings eachyear, and most of these proceedings

have not involved litigation by SIPCagainst the firm’s independent publicaccountant. Moreover, SIPC continuedto bring lawsuits against broker-dealeraccountants after the 2001 New Yorkdecision in jurisdictions other than NewYork. 824 Consequently, while theamendment removes one potential legalhurdle to such suits, it may notsignificantly increase the frequencywith which SIPC brings such lawsuits.Moreover, the other elements of anyrelevant cause of action would beunaffected. Accordingly, theCommission continues to believe that

the requirement to file copies of theannual reports with SIPC is appropriate.v. Notification Requirements

As discussed above in section II.F. of this release, the Commission isamending the notification provisions inRule 17a–5 and is making conformingamendments to Rule 17a–11. Prior totoday’s amendments, paragraph (h)(2) of Rule 17a–5 provided that if, during thecourse of the audit or interim work, theindependent public accountantdetermined that any ‘‘materialinadequacies’’ existed, the independentpublic accountant was required toinform the CFO of the broker-dealer,who, in turn, was required to give noticeto the Commission and the broker-dealer’s DEA within 24 hours inaccordance with the provisions of Rule17a–11. 825

Under Rule 17a–11, a broker-dealermust provide notice to the Commissionand its DEA in certain circumstances. 826

For example, paragraph (b)(1) of Rule17a–11 requires a broker-dealer to givenotice if its net capital declines belowthe minimum amount required underRule 15c3–1. 827 Before today’samendments, Rule 17a–11 required thatwhenever a broker-dealer discovered, orwas notified by an independent publicaccountant of the existence of anymaterial inadequacy, the broker-dealermust give notice to the Commission andtransmit a report to the Commissionstating what the broker or dealer hasdone or is doing to correct the situation.Rule 15c3–1 and Rule 15c3–3 alsorequire broker-dealers to providenotification in certain circumstances. 828 For example, paragraph (i) of Rule15c3–3 requires a carrying broker-dealerto immediately notify the Commissionand its DEA if it fails to make a depositinto its customer reserve account asrequired by paragraph (e) of Rule 15c3–3.829

a. Amendments to Rule 17a–5

The Commission proposed amendingthe notification provisions in Rule 17a–5 to replace the term ‘‘materialinadequacy’’ with the term ‘‘materialnon-compliance.’’ The term ‘‘materialnon-compliance’’ was defined in thecontext of the compliance report, whichwas required to be prepared and filed bycarrying broker-dealers. This provisionwould therefore have applied to broker-dealers that filed compliance reportswith the Commission. The Commissionalso proposed amending the notification

process. Under the proposed newprocess, the accountant would berequired to notify the Commission andthe broker-dealer’s DEA directly.

The Commission received numerouscomments in response to thisproposal. 830 Most of these commentersobjected to the proposed notificationprocess. 831 Among the reasons givenwere that it would be inappropriate torequire the accountant to notify theCommission and the DEA directly,

because, among other things, the broker-dealer is principally responsible forcompliance with the securities laws,

including timely notification; 832 thatPCAOB standards provide that ‘‘thepractitioner should not take on the roleof the responsible party’’ 833 ; and thatPCAOB attestation standards (whichwere referenced in the proposingrelease) clearly provide thatmanagement is responsible for thesubject matter to which it is asserting,and not the accountant. 834 In addition tosuggestions that the notification processthat existed prior to today’samendments should not be changed, 835 one commenter stated that the ruleshould require simultaneous notice bythe accountant to the Commission andto the firm’s management. 836 Inaddition, one commenter asked whetherthe notification provisions apply to areview of the exemption report. 837 Another commenter stated that non-compliance also will trigger a Rule 17a–11 notice, which would be duplicativeand create confusion. 838

The final rule requires that if theaccountant determines that there areany instances of non-compliance (asopposed to an instance of material non-compliance, as proposed) with thefinancial responsibility rules during thecourse of preparing the accountant’sreports, the accountant mustimmediately notify the CFO of the

broker-dealer of the nature of the non-compliance. If the accountant providesnotice of an instance of non-compliance,the broker-dealer must notify theCommission and its DEA, but only if required to do so by existing provisionsof Rule 15c3–1, Rule 15c3–3, or Rule17a–11 that require such notification. 839


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(i) of Rule 15c3–3, a carrying broker-dealer mustimmediately notify the Commission and its DEA if it fails to make a deposit i nto its customer reserveaccount as required by paragraph (e) of Rule15c3–3. 840 See PCAOB Inspection Report, at ii.

Consequently, the final rule requiresthat any instance of non-complianceidentified by the accountant will triggera notification by the broker-dealer to theCommission and the firm’s DEA to thesame extent that notification is requiredif discovered by the broker-dealer otherthan in connection with its annualaudit. Therefore, under the final rule, if the accountant determines that aninstance of non-compliance with thefinancial responsibility rules exists, theaccountant is not required to make adetermination of whether that instanceof non-compliance is material. Thismodification likely will result in a lower

burden relative to the proposal on theindependent public accountant as theaccountant will not need to analyzewhether an instance of non-complianceis material to determine whether thenotification requirement has beentriggered. On the other hand, theindependent public accountant will

need to provide notice to the broker-dealer of all instances of non-compliance rather than only instancesof material non-compliance. Therefore,the modification will result in morerequired notifications from theindependent public accountant to the

broker-dealer.Under the final rule, the independent

public accountant also will be requiredto provide notice to the broker-dealer if the accountant determines that anymaterial weaknesses exist. As in theproposal, material weakness is definedwith regard to the compliance reportand therefore applies only to broker-dealers that file compliance reports. Inthat report, a carrying broker-dealermust state whether its internal controlswere effective during the fiscal year aswell as at the end of the fiscal year.Internal controls are not effective if there are one or more materialweaknesses in the controls. The broker-dealer also is required to describe anyidentified material weaknesses. Theindependent public accountant mustundertake to prepare a report based onan examination of certain statements inthe compliance report, including thestatements as to whether the carrying

broker-dealer’s internal controls wereeffective.As stated above, before today’s

amendments, Rule 17a–5 required theaccountant to notify the broker-dealer if the accountant determined that anymaterial inadequacies existed. Theconcept of material inadequacygenerally applied to all broker-dealers

and, therefore, the notificationrequirement applied with respect toindependent public accountantengagements for non-carrying as well ascarrying broker-dealers under Rule 17a–5. This requirement, however, may nothave produced the intended benefits.

As discussed in section II.D.3. above,PCAOB inspection staff found that in 21of 23 broker-dealer audits inspected, theaccountant ‘‘failed to perform sufficientaudit procedures to obtain reasonableassurance that any materialinadequacies found to exist since thedate of the last examination . . . wouldhave been disclosed in the accountant’ssupplemental report.’’ 840 Materialinadequacies which were expected to bereported by the accountant included anycondition which contributedsubstantially to or, if appropriatecorrective action was not taken, couldreasonably be expected to: (1) Inhibit a

broker-dealer from promptly completing

securities transactions or promptlydischarging its responsibilities tocustomers, other broker-dealers, orcreditors; (2) result in material financialloss; (3) result in material misstatementsof the broker-dealer’s financialstatements; or (4) result in violations of the Commission’s recordkeeping orfinancial responsibility rules to anextent that could reasonably beexpected to result in the conditionsdescribed in (1) through (3) above. Thedefinition of material weakness is morespecific: a material weakness includes adeficiency in internal control such thatthere is a reasonable possibility thatnon-compliance with Rule 15c3–1 andparagraph (e) of Rule 15c3–3 will not beprevented or detected on a timely basisor that non-compliance to a materialextent with Rule 15c3–3, exceptparagraph (e), Rule 17a–13, or theAccount Statement Rules will not beprevented or detected on a timely basis.

As discussed above, today’samendments generally replace the termmaterial inadequacy and separate it intotwo components—a compliancecomponent (non-compliance with thefinancial responsibility rules) and, forcarrying broker-dealers, an internal

control component (material weaknessin Internal Control Over Compliance).The change is consistent with one of theobjectives of the amendments: toprovide clear and consistentterminology focused separately oncompliance with key financialresponsibility rules and internal controlover compliance with the financialresponsibility rules. The amendednotification provisions in Rule 17a–5reflect this change in terminology.

The Commission proposed amendingthe notification process so that theaccountant would be required to notifythe Commission and the broker-dealer’sDEA directly. However, the Commissionis not adopting this alternative becauseit agrees with the comments, discussedabove, that the notification process inplace before today’s amendmentsshould be retained.As stated above, Rule 17a–5 beforetoday’s amendments required theaccountant to notify the broker-dealer,and the broker-dealer to notify theCommission, if the accountantdetermined during the course of theaudit or interim work that a materialinadequacy existed. This requirementgenerally applied to all broker-dealeraudits. The notification provisions inthemselves did not direct theaccountant to perform specificprocedures with respect to the audit—those requirements were contained in

other provisions of Rule 17a–5. Thenotification provisions in Rule 17a–5were intended to require notification if,during the course of the audit, theaccountant became aware of anymaterial inadequacies. As amended, thenotification provisions in Rule 17a–5likewise do not in themselves requirethe accountant to perform specificprocedures with respect to theexamination of the financial report or anexamination of a compliance report orreview of an exemption report. Instead,the notification provisions are triggeredwhen the accountant becomes aware,during the course of preparing thereports of the accountant required underRule 17a–5, that the broker-dealer is notin compliance with the financialresponsibility rules or, during thecourse of preparing a report based on anexamination of a compliance report, thata material weakness exists. Thesenotification requirements are designedto put the broker-dealer in a position tocorrect controls, processes, and systemsthat have caused or potentially couldcause the firm to not comply with thefinancial responsibility rules. Asdiscussed throughout this release, thefinancial responsibility rules serve an

important investor protection function by requiring broker-dealers to maintainprudent levels of net capital and takesteps to safeguard customer securitiesand cash.

The requirement to notify the broker-dealer when the independent publicaccountant determines that the broker-dealer is not in compliance with thefinancial responsibility rules or that anymaterial weaknesses exist is notexpected to increase costs for broker-dealers when compared to the baselinerequirement to provide the broker-


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841 The final rule retains a reference to materialinadequacy as defined in paragraph (h)(2) of Rule17a–12, but amendments correct citations to thatrule.

842 See paragraph (e) of Rule 17a–11. The ruleretains provisions referencing the term material inadequacy as defined in Rule 17a–12.

843 See Deloitte Letter.844 These practices and procedures include, for

example, periodic net capital computations underRule 15c3–1 and periodic counts of securities underRule 17a–13.

845 See 17 CFR 240.17a–5(c)(2)(iii).846 See paragraph (c)(2)(iv) of Rule 17a–5.

dealer with notice when theindependent public accountantdetermines that a material inadequacyexists. As discussed above, the noticerequirements under today’samendments do not require theindependent public accountant toperform specific procedures. Instead,they are triggered when the independentpublic accountant determines that anynon-compliance or material weaknessexists during the course of performingprocedures to examine the financialreport and to examine the compliancereport or review the exemption report,as applicable. To the extent theobligation to provide the broker-dealerwith notice is factored into the feecharged by the accountant, theCommission notes that before today’samendments the independent publicaccountant was required to give noticeof a material inadequacy. Thisnotification requirement has beeneliminated and, therefore, to the extentit was factored into the fee, that cost has

been eliminated. The Commission doesnot believe that the component of theindependent public accountants’ feeassociated with the new notificationrequirements would be materiallydifferent than the component of the feeassociated with the material inadequacynotification requirements. Therefore, theCommission believes theserequirements would not result inincreased compliance costs relative tothe requirements in place before today’samendments.

b. Conforming and TechnicalAmendments to Rule 17a–11

As discussed above in section II.F.2.,prior to today’s amendments, paragraph(e) of Rule 17a–11 required thatwhenever a broker-dealer discovered, orwas notified by an independent publicaccountant, pursuant to paragraph (h)(2)of Rule 17a–5 or paragraph (f)(2) of Rule17a–12, of the existence of any materialinadequacy, the broker-dealer wasrequired to give notice to theCommission and transmit a report to the

Commission stating what the broker-dealer has done or is doing to correctthe situation.

The Commission is adoptingconforming amendments to paragraph(e) of Rule 17a–11 to substitute a noticeof the existence of any materialweakness as defined in paragraph(d)(3)(iii) of Rule 17a–5 for a notice of the existence of any materialinadequacy and to replace a reference toparagraph (h)(2) of Rule 17a–5 with areference to paragraph (h) of Rule 17a–

5.841 Specifically, the final rule providesthat whenever a broker-dealer discovers,or is notified by its accountant underparagraph (h) of Rule 17a–5 of theexistence of any material weakness, the

broker-dealer must: (1) Give notice of the material weakness within 24 hoursof the discovery or notification; and (2)transmit a report within 48 hours of thenotice stating what the broker-dealer hasdone or is doing to correct thesituation. 842

The notification requirements, amongother things, alert the Commission andthe DEA of the need to increase theirmonitoring of a broker-dealer and toobtain additional information whenappropriate in order to address anyconcerns the Commission or the DEAmay have as a result of the notification.A notification of a material weaknesswill alert the Commission and the

broker-dealer’s DEA to the existence of a condition that could impact the

broker-dealer’s ability to remain incompliance with the financialresponsibility rules, which serve animportant investor protection function

by requiring broker-dealers to maintainprudent levels of net capital and takesteps to safeguard customer securitiesand cash. Once alerted, the Commissionand the DEA can respond to thesituation through, for example,heightened monitoring of the broker-dealer to assess whether it has correctedthe problem and whether it is properlysafeguarding customer securities andcash.

The Commission believes theseamendments will not result in increasedcompliance costs to broker-dealers.Material weakness is defined withregard to the compliance report andtherefore applies only to broker-dealersthat file compliance reports ( i.e.,carrying broker-dealers). In contrast, theconcept of material inadequacygenerally applied to all broker-dealersand, therefore, the notificationrequirement applied with respect toindependent public accountantengagements under Rule 17a–5 for non-carrying as well as carrying broker-dealers. As discussed above in section

VII.B.1. of this release, the Commissionestimates that there are approximately4,709 broker-dealers registered with theCommission and that of those firms,approximately 292 are carrying broker-dealers. Consequently, before today’samendments, the notification

requirements with respect to materialinadequacy applied to approximately4,709 broker-dealers, whereas aftertoday’s amendments the notificationrequirement with respect to materialweakness will apply to approximately292 broker-dealers.

The Commission proposed amendingparagraph (e) of Rule 17a–11 to deletethe references to Rule 17a–5. However,the Commission is not adopting thisalternative because it agrees with acommenter that notification should beprovided to the Commission when adeficiency in internal control isdiscovered by the broker-dealer. 843 vi. Information Provided to Customers

Prior to today’s amendments,paragraph (c)(2)(iii) of Rule 17a–5provided that if, in conjunction with a

broker-dealer’s most recent audit report,the broker-dealer’s independent publicaccountant commented on any materialinadequacies in the broker-dealer’sinternal controls, its accounting system,or certain of its practices andprocedures 844 under paragraphs (g) and(h) of Rule 17a–5, and paragraph (e) of Rule 17a–11, the broker-dealer’s auditedstatements sent to customers wererequired to include a statement that acopy of the auditor’s comments wereavailable for inspection at theCommission’s principal office inWashington, DC, and the regional officeof the Commission in which the broker-dealer had its principal place of

business. 845 The Commission is revising its

proposal with respect to amendingparagraph (c)(2) of Rule 17a–5 to beconsistent with the new notificationprovisions in paragraph (h) describedabove relating to the identification by a

broker-dealer’s accountant of a materialweakness rather than an instance of material non-compliance. 846 Specifically, if, in connection with themost recent annual reports, the report of the independent public accountant onthe broker-dealer’s compliance reportidentifies a material weakness, the

broker-dealer must include a statementthat one or more material weaknesseshave been identified and that a copy of the report of the independent publicaccountant is currently available for thecustomer’s inspection at the principaloffice of the Commission inWashington, DC, and the regional officeof the Commission for the region in


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847 Id.848 See ABA Letter.

849 See CAI Letter. This commenter stated thatFINRA has proposed that broker-dealers sendcustomer account statements monthly instead of quarterly, broker-dealers are already potentiallyfacing ‘‘extremely high’’ costs of sendinginformation to customers. FINRA withdrew itsproposals to send customer account statementsmonthly instead of quarterly on July 30, 2012. SeeSR–FINRA–2009–028, Proposed Rule Change toAdopt FINRA Rule 2231 (Customer Account Statements) in the Consolidated FINRA Rulebook,Withdrawal of Proposed Rule Change (July 30,2012), available at http://www.finra.org/web/ groups/industry/@ip/@reg/@rulfil/documents/ rulefilings/p143262.pdf.

850 See SIFMA Letter.851 See 17 CFR 240.17a–5(c)(5)(ii), (iv), and (v).

852 As discussed previously, where anindependent public accountant has performedextensive testing of a carrying broker-dealer’scustody of securities and cash by confirmingholdings at subcustodians, examiners could focustheir efforts on matters that had not been the subjectof prior testing and review.


854 See 17 CFR 240. 17a–5(f)(2)(ii).855 See 17 CFR 17a–5(f)(2)(ii)(F)–(G).

which the broker-dealer has itsprincipal place of business. 847

The Commission does not believethese amendments will result inincremental costs to broker-dealers overthe baseline. Material weakness isdefined with regard to the compliancereport and therefore applies only to

broker-dealers that file compliancereports ( i.e., carrying broker-dealers). Incontrast, the concept of materialinadequacy generally applied to all

broker-dealers and, therefore, thecustomer notification requirementapplied with respect to independentpublic accountant engagements underRule 17a–5 for non-carrying as well ascarrying broker-dealers. As discussedabove in section VII.B.1. of this release,the Commission estimates that there areapproximately 4,709 broker-dealersregistered with the Commission and thatof those firms, approximately 292 arecarrying broker-dealers. Consequently,

before today’s amendments, thenotification requirements with respectto material inadequacy applied toapproximately 4,709 broker-dealers,whereas after today’s amendments thenotification requirement with respect tomaterial weakness will apply toapproximately 292 broker-dealers.

Rule 17a–5 also provides aconditional exemption from therequirement to send paper copies of financial information to customers if the

broker-dealer mails a financialdisclosure statement with summaryinformation and an Internet link to the

balance sheet and other information onthe broker-dealer’s Web site. Beforetoday’s amendments, one of theconditions of the exemption was thatthe broker-dealer was not requiredduring the prior year to give notice of a material inadequacy. The Commissionproposed revising this condition forusing Web site disclosure to providethat the broker-dealer’s financialstatements must receive an unqualifiedopinion from the accountant and thatneither the broker-dealer nor theaccountant identified a materialweakness or an instance of materialnon-compliance.

One commenter stated that a broker-dealer should be able to deliver thefinancial information available tocustomers via its Web site regardless of whether an instance of material non-compliance or material weakness wasidentified. 848 Another commenter statedthat the rule should not require a 100%rate of compliance with the financialresponsibility rules to qualify for the

exemption. 849 A third commenter statedthat the proposed amendment should beeliminated, or replaced with therequirement that broker-dealers includea notice of the material weakness ornon-compliance on customer accountstatements for a year following itsidentification. 850

The Commission has decided not toadopt the proposed condition forqualifying for the conditionalexemption. The decision not to adoptshould result in lower costs than wouldhave been incurred had the Commissionadopted the proposal withoutmodification. Using the Internet todisclose information should be lesscostly and more efficient for the broker-dealer than mailing paper copies to allcustomers. It also will benefitcustomers, since they will be able toaccess relevant broker-dealerinformation more efficiently through theInternet (alternatively, customers can

request a paper copy by phone at nocost to the customer). 851 vii. Coordination With InvestmentAdvisers Act Rule 206(4)–2

Advisers Act Rule 206(4)–2 providesthat when a registered investmentadviser or its related person maintainsclient funds and securities as a qualifiedcustodian in connection with advisoryservices provided to clients, the adviserannually must obtain, or receive from itsrelated person, a written internal controlreport prepared by an independentpublic accountant registered with, andsubject to regular inspection by, thePCAOB. This report must be supported by the accountant’s examination of thequalified custodian’s custody controls.Under the amendments, a broker-dealerthat also acts as a qualified custodian foritself as an investment adviser or for itsrelated investment advisers may use thereport of the independent publicaccountant based on an examination of its compliance report to meet thereporting obligations under Rule 206(4)–2. Therefore, such a broker-dealer willnot be required to obtain an internalcontrol report under Rule 206(4)–2 in

addition to a report covering thecompliance report from its independentpublic accountant. It also will result inefficiencies as a single audit will be ableto address two audit requirements.2. Access to Accountant and AuditDocumentation

The amendments to Rule 17a–5

require that carrying or clearing broker-dealers agree to allow Commission andDEA staff, if requested in writing forpurposes of an examination of the

broker-dealer, to review the work papersof the independent public accountantand to allow the accountant to discussthe its findings with the examiners.

This requirement will enable theCommission and DEAs to moreefficiently deploy examinationresources. 852 Examiners reviewing theaccountant’s work papers will be able totailor the scope of their examinations byidentifying areas where extensive auditwork was performed by the independentpublic accountant and focusing theirexaminations on other areas, allowingfor more efficient oversight of broker-dealers by the Commission and DEAexamination staff. Enabling Commissionand DEA examination staff to conductmore focused and efficient examinationsof broker-dealers could, in turn, allowfor examination resources to beallocated more strategically.

The Commission is amendingparagraph (f)(2) of Rule 17a–5 to revisethe statement regarding identification of a broker-dealer’s independent publicaccountant that broker-dealers must file

each year with the Commission andtheir DEA (except that if the engagementis of a continuing nature, no furtherfiling is required). 853 The revisedstatement contains additionalinformation that includes arepresentation that the independentpublic accountant has undertaken toprovide a report regarding the broker-dealer’s financial reports and a reportregarding the broker-dealer’scompliance or exemption report, asapplicable. 854 In addition, the statementprovided by a clearing or carrying

broker-dealer must includerepresentations regarding the access toaccountant requirements describedabove. 855 Therefore, all broker-dealerswill generally be required to file a new


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856 See CAI Letter.857 See Broker-Dealer Reports, 76 FR at 37596.858 See Section VI.D.1.vi. Based on staff

experience, a broker-dealer that carries customer

accounts or clears transactions likely would have itsController and an Assistant General Counselinvolved in renegotiating the agreement withauditors, and that those discussions would take, onaverage, approximately four hours. Broker-dealerswould likely have an attorney prepare a newnotification of designation of accountant, and thattask would take the attorney, on average,approximately two hours. According to the SIFMAReport on Management and Professional Earningsin the Securities Industry, as modified byCommission staff to account for an 1,800-hourwork-year and multiplied by 5.35 to account for

bonuses, firm size, employee benefits and overhead,the hourly cost of a Controller is approximately$409/hour, the hourly cost of an Assistant GeneralCounsel is approximately $407/hour, and thehourly cost of an Attorney is approximately $378/hour. 513 broker-dealers that carry customeraccounts or clear transactions × 4 hours × $409 =$839,268. 513 broker-dealers that carry customeraccounts or clear transactions × 4 hours × $407 =$835,164. 4,709 broker-dealers × 2 hours × $378 =$3,560,004. $839,268 + $835,164 + $3,560,004 =$5,234,436.

859 See Section VI.D.1.vi. 4,709 broker-dealers ×$0.45 cost for first class postage × 3 mailings =$6,375.15.

860 See Section VI.D.1.vii.d. In the proposingrelease the Commission multiplied 528 clearing andcarrying broker-dealers × 5 hours × $250/hour =$660,000.

861 See Section VI.D.1.vii.d. 513 clearing andcarrying broker-dealers × $1,250 in increased costsper clearing broker-dealer = $641,250.

862 See Broker-Dealer Reports, 76 FR at 37597.863 Based on staff experience, a broker-dealer

likely would have a Financial Reporting Managercomplete and file Form Custody. According to the

Continued

statement regarding their independentpublic accountant.

As discussed above in section III. of this release, one commenter stated that,the amendments would discourage or‘‘chill’’ communications between a

broker-dealer and its auditor because of the possibility that an auditor maymisconstrue communications fromrepresentatives of the broker-dealer andwrongly conclude that therepresentatives lack knowledge or admitto an issue. 856 Presumably, this‘‘chilling effect’’ would result from a

broker-dealer’s desire to avoid thecreation of audit documentationmemorializing misunderstandings andmiscommunications, which whenaccessed by Commission and DEAexaminers could result in regulatoryscrutiny. As stated in section III. of thisrelease, the Commission is notpersuaded by this comment; while it ispossible for miscommunications to

occur between representatives of a broker-dealer and its auditor, potentialmisunderstandings ormiscommunications should not limitthe ability of the Commission or a DEAto have access to audit documentationor a broker-dealer’s independent publicaccountant. Further, to the extent amisunderstanding ormiscommunication between a broker-dealer and its accountant is reflected inthe accountant’s audit documentationrelating to the broker-dealer, the broker-dealer could clarify the nature of themisunderstanding ormiscommunication to examiners andhow it was rectified if such clarificationand rectification is not alreadydescribed in subsequent auditdocumentation.

The Commission estimated that theone-time hour burden associated withamending its existing statement andfiling the new statement with theCommission, in order to comply withthe proposed amendments, would be anaverage of approximately two hours ona one-time basis for each broker-dealer,as the statement can be continuing innature. 857

As discussed in the PRA, theCommission is revising this estimate forclearing and carrying broker-dealers, asthese broker-dealers will likely berequired to renegotiate their agreementswith their independent publicaccountants. The Commission estimatesthat the total one-time cost associatedwith this burden is approximately $5.2million. 858 Additionally, the

Commission believes there will bepostage costs associated with sendingthe amended statement regarding theaccountant and estimates that eachmailing will cost approximately $0.45,for a total cost of approximately $6,357for all broker-dealers on a one-time

basis. 859 In addition, in the proposing release,

the Commission estimated that acarrying or clearing broker-dealer’saccountant would charge the broker-dealer for time its personnel spendspeaking with the Commission or the

broker-dealer’s DEA or providing themwith audit documents and that, onaverage, the Commission or the broker-dealer’s DEA may speak with eachaccountant for approximately five hoursper year. Thus, the Commissionestimated that the additional cost of accountant time associated with thisamendment to all clearing and carrying

broker-dealers would be approximately

$660,000 annually.860

As theCommission now estimates that thenumber of carrying or clearing broker-dealers is 513, the new estimate isapproximately $641,250. 861

3. Form CustodyThe newly adopted Form Custody is

to be filed quarterly at the same timethat a broker-dealer is required to file itsFOCUS Reports. The form elicitsinformation concerning whether, and if so, how, a broker-dealer maintainscustody of customer assets and, asdiscussed above, consolidates

information about the broker-dealer’scustodial responsibility andrelationships with other custodians inone report so that the Commission andother securities regulators will beprovided with a comprehensive profileof the broker-dealer’s custody practicesand arrangements. This should reducethe likelihood that fraudulent conduct,including misappropriation or othermisuse of investor assets, can continueundetected. Further, the informationprovided in Form Custody should aid inthe examination of broker-dealers,

because the examination staff can usethe information provided as another toolto prioritize and plan examinations.

The Form Custody amendments alsoshould enhance investor confidence inthe ability of the securities regulators tooversee broker-dealers and broker-dealercustody of investor assets. Byestablishing a discipline under which

broker-dealers are required to report

greater detail as to their custodialfunctions, investor perception as to thesafety of their funds and securities held

by broker-dealers should improve.Investors may be more willing toprovide capital for investment. Further,the requirement by broker-dealers toprovide detail as to their custodialpractices may prompt them to identifyand correct deficiencies. For example, if a broker-dealer preparing theinformation to be disclosed on the formdiscovers a discrepancy between itsown records and the records of acustodian as to the nature or quantity of

assets held by the custodian, the broker-dealer can act to resolve the discrepancy before filing the form.

The Commission estimated that thetime required to complete and file FormCustody would be approximately 12hours per quarter, or 48 hours per year,on average, for each broker-dealer. 862 The Commission did not receivecomments regarding this estimate. TheCommission now estimates that thereare approximately 4,709 broker-dealersthat must file Form Custody. TheCommission therefore estimates that thetotal time required to complete and fileForm Custody for all 4,709 broker-dealers is approximately 226,032 hoursper year (4,709 broker-dealer times fourresponses per year times 12 hours =226,032 hours). Further, theCommission estimates that the total costassociated with completing and filingForm Custody is approximately $69.8million. 863


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SIFMA Report on Management and ProfessionalEarnings in the Securities Industry, as modified byCommission staff to account for an 1,800-hourwork-year and multiplied by 5.35 to account for

bonuses, firm size, employee benefits and overhead,the hourly cost of a Financial Reporting Manager isapproximately $309/hour. 4,709 broker-dealers × 48hours × $309 = $69,843,888.

864 See IMS Letter. The cost of $69,179,670 wasreflected in the economic analysis in the proposingrelease. See Broker-Dealer Reports, 76 FR at 37601.This cost was calculated as an internal cost of theestimated PRA hours and is the total cost dividedamong 5,057 firms. Id. at 37601 n.215. This internalcost would amount to an average of $13,680 per

broker-dealer. Id.865 1 broker-dealer × 48 hours × $309 = $14,832.866 See, e.g., SEC v. Bernard L. Madoff, et al.,

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

867 See IMS Letter.868 See Custody of Funds or Securities of Clients

by Investment Advisers, 75 FR at 1456.

One commenter stated that theestimated costs to the industry of $69,179,670 in the proposing releasewas ‘‘staggering,’’ and that such costswould likely indirectly be passed on tocustomers. 864 The commenter did notdisagree with the estimated cost in theproposing release; rather, thecommenter focused on the size of thetotal estimated costs. The Commissionnotes that the $69 million estimate inthe proposing release and the $69.8million estimate in this release areestimates of the aggregate cost to theindustry. The average cost to anindividual broker-dealer would beapproximately $15,000 per year. 865 Asan average, the costs incurred by a

broker-dealer to comply with therequirement to file Form Custody willdepend on its size and the complexityof its business activities.

The Commission recognizes that therequirement to file Form Custody willincrease compliance costs for broker-dealers and that these costs may bepassed on to customers. TheCommission, however, believes theinvestor protection benefits of the FormCustody requirements outweigh thesecosts. As noted above, Form Custody isdesigned to assist Commission and DEAexaminers in identifying potentialmisrepresentations relating to broker-dealers’ custody of assets. Further, therequirements to file the form willpromote greater focus and attention tocustody practices by requiring that

broker-dealers make specificrepresentations in this regard. Thesafeguarding of customer securities andcash held by broker-dealers is of paramount importance as demonstrated

by recent cases where broker-dealersfailed to protect customer securities andcash. 866

4. Consideration of Burden onCompetition, and Promotion of Efficiency, Competition, and CapitalFormation

As discussed above, incremental costswill result from the annual reportingrequirement amendments, the access toaccountant amendments, and the FormCustody amendments. Theseincremental costs could result in higher

barriers to entry for broker-dealers ascompared with the baseline that existedprior to the amendments. This could bethe case particularly for carrying broker-dealers given the incremental costsassociated with the compliance reportrequirements, the applicability of theaccess to accountant amendments tocarrying and clearing broker-dealers,and that most of the information elicitedin Form Custody relates to carrying

broker-dealer activities.The annual reporting requirements

have a mixed effect on competitionacross broker-dealers. The requirementto prepare and file a compliance reportor exemption report may impose a

burden on competition for smallercarrying broker-dealers to the extent thatit imposes relatively high fixed costs,which would represent a greater amountof net income for smaller broker-dealers.On the other hand, as previously noted,a carrying broker-dealer with limitedcustodial activities should have toexpend less effort to support itsstatements in the compliance reportthan a broker-dealer with moreextensive custodial activities, and the

attendant costs should similarly belower. While the incremental costs of the annual reporting requirements may

be lower for non-carrying broker-dealers(which generally are smaller broker-dealers), the costs coulddisproportionately impact smaller

broker-dealers due to fixed costcomponents of the cost of compliancewith these requirements.

The access to accountant amendmentsmay place a burden on carrying andclearing broker dealers. To the extentthat addressing contracts betweenauditors and broker-dealers is a fixed

cost, the rule may impact smaller broker-dealers to a greater extent than itwill larger broker-dealers. Theamendments should not place a burdenon competition for non-carrying broker-dealers.

The requirement to file Form Custodycould have a burden on competition

because it will increase compliancecosts for broker-dealers. However, therequirement should not have adisproportionate effect on smaller

broker-dealers. Smaller firms will incurfewer costs to complete Form Custody

because less information is required to be disclosed. For example, broker-dealers that introduce customers on afully disclosed basis and do not havecustody of customer funds or assetswould leave much of the form blank.

In sum, the costs of complianceresulting from the requirements in theseamendments should not impose a

burden on competition not necessary orappropriate in furtherance of thepurposes of the Exchange Act and inlight of the benefits discussed above.

Today’s amendments are designed toreduce the likelihood that fraudulentconduct, or lack of appropriate custodyprocedures or other internal controls,will jeopardize customer securities andfunds held by broker-dealers. To theextent that the amendments achieve thatgoal, investors should be more confidentthat the customer assets held by broker-dealers are safe. This in turn maypromote capital formation as investor

assets are able to be allocated moreefficiently across the opportunity set.One commenter asserted that the

proposed amendments ‘‘placeunnecessary regulatory burdens andcosts on industry, in general, andsmaller firms, in particular’’ and that‘‘broker-dealers compete againstinvestment advisers who are not

burdened by the same regulatoryrequirements,’’ including therequirements in the proposedamendments. 867 The Commissionrecognizes, as explained above, that theamendments adopted today imposecosts on broker-dealers that could resultin higher barriers to entry. However, theCommission is of the opinion that thesecosts are justified by the numerous andsignificant benefits, in particular withrespect to protection of customer assets,described in this economic analysis.

With respect to the commenter’sstatement about broker-dealerscompeting with investment advisers,recent Commission amendments toinvestment adviser rules are ‘‘designedto provide additional safeguards . . .when a registered adviser has custody of client funds or securities’’ including arequirement to undergo an annual

surprise examination by an independentpublic accountant to verify client assetsand a requirement to have a report of the internal controls relating to thecustody of client assets from anaccountant registered with, and subjectto inspection by, the PCAOB unlessclient assets are maintained by anindependent custodian. 868 Consequently, the regulations governing


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869 Id.870 The Commission stated in the proposing

release that its preliminary view was that theproposed rule amendments promote efficiency,competition, and capital formation and that any

burden on competition is justified by the benefitsprovided by the amendments. See Broker-Dealer Reports, 76 FR at 37598.

871 5 U.S.C. 601 et seq.872 5 U.S.C. 603(a).873 5 U.S.C. 551 et seq.874 Although section 601(b) of the RFA defines

the term small entity, the statute permits agenciesto formulate their own definitions. The Commissionhas adopted definitions for the term ‘‘small entity’’for the purposes of Commission rulemaking inaccordance with the RFA. Those definitions, asrelevant to this rulemaking, are set forth in Rule 0–10. See 17 CFR 240.0–10. See Statement of Management on Internal Accounting Control,Exchange Act Release No. 18451 (Jan. 28, 1982), 47FR 5215 (Feb. 4, 1982).

875 See 5 U.S.C. 605(b).876 See Broker-Dealer Reports, 76 FR at 37601–

37602.

investment advisers have beenstrengthened in recent years throughnew requirements aimed at safeguardingcustomer assets. Today’s amendmentsalso are aimed at safeguarding customerassets. As both investment advisers and

broker-dealers are now subject to newrequirements, today’s amendmentsshould not create a competitiveadvantage for either class of registrant.Moreover, the recently adoptedrequirements for investment advisersand the amendments adopted today are,among other things, part of an effort tostrengthen the Commission’s rulesregarding the safekeeping of customerassets, in part in response to severalfraud cases brought by the Commissioninvolving investment advisers and

broker-dealers. 869 If the amendments increase investor

confidence in broker-dealers, they willpromote capital formation. Moreover,for the reasons discussed above, today’samendments should not unduly restrictcompetition and should promote capitalformation. 870

The amendments also should increaseefficiencies. With respect to the annualreporting amendments, updating thelanguage of Rule 17a–5 to replaceoutdated or inconsistent auditterminology is designed to ensure thatthe requirements of the rule are betteraligned with applicable current auditstandards. Further, the amendmentsfacilitate PCAOB oversight authority,including its ability to inspect audits of

broker-dealers, by providing thatexaminations or reviews of broker-dealer annual reports be made inaccordance with PCAOB standards. Inaddition, the amendments strengthenand promote consistent compliancewith the financial responsibility rulesfor broker-dealers that maintain custodyof customer securities and funds byincreasing the focus of these broker-dealers and their independent publicaccountants on compliance, andinternal control over compliance, withthe financial responsibility rules. This,in turn, should help the Commissionand the broker-dealer’s DEA identify

broker-dealers that have weak internalcontrols for safeguarding investor assetsand improve the financial andoperational condition of broker-dealersand thereby provide more protection forinvestor assets held by broker-dealers.

The access to accountant amendmentsshould increase efficiencies bypromoting more risk-basedexaminations by Commission and DEAstaff. For example, the examiners insome cases may be able to leverage thework performed by the independentpublic accountants and, therefore, focuson areas the accountants did not review.Similarly, the Form Custodyamendments should increaseefficiencies by promoting more risk-

based examinations by Commission andDEA staff as they will be able to use theprofile of the broker-dealer’s custodypractices documented in Form Custodyto focus their reviews. For this reason,examinations may also place fewer timedemands on broker-dealer personnel.

In significant part, the effect of theserules on efficiency and capital formationare linked to the effect of these rules oncompetition. For example, markets thatare competitive and trusted may beexpected to promote the efficientallocation of capital. Similarly, rulesthat promote, or do not unduly restrict,trust in broker-dealers can beaccompanied by regulatory benefits thatminimize the risk of market failure andthus promote efficiency within themarket. Such competitive marketswould increase the efficiency by whichmarket participants could transact with

broker-dealers.

VIII. Final Regulatory FlexibilityAnalysis

The Regulatory Flexibility Act(‘‘RFA’’) 871 requires Federal agencies, inpromulgating rules, to consider theimpact of those rules on small entities.Section 603(a) 872 of the AdministrativeProcedure Act, 873 as amended by theRFA, generally requires the Commissionto undertake a regulatory flexibilityanalysis of all proposed rules, orproposed rule amendments, todetermine the impact of suchrulemaking on small entities. 874 Section605(b) of the RFA provides that thisrequirement does not apply to anyproposed rule or proposed ruleamendment, which if adopted, would

not ‘‘have a significant economic impact

on a substantial number of smallentities.’’ 875

The Commission proposedamendments to Rules 17a-5 and 17a-11and proposed new Form Custody. AnInitial Regulatory Flexibility Analysis(‘‘IRFA’’) was included in the proposingrelease. 876 This Final Regulatory

Flexibility Analysis has been preparedin accordance with the provisions of theRFA.

A. Need for and Objectives of theAmendments and New Form

The final rules amend certain broker-dealer annual reporting, audit, andnotification requirements. Theamendments include a requirement that

broker-dealer audits be conducted inaccordance with standards of thePCAOB, that broker-dealers file either acompliance report or an exemptionreport covered by a report prepared byan independent public accountant, andthat clearing broker-dealers allowrepresentatives of the Commission orthe broker-dealer’s DEA to review thedocumentation associated with certainreports of the broker-dealer’sindependent public accountant and toallow the accountant to discuss itsfindings with the representatives whenrequested in connection with aregulatory examination of the broker-dealer. The amendments also require a

broker-dealer to file a new form with itsDEA that elicits information about the

broker-dealer’s practices with respect tothe custody of securities and funds of customers and others.

The amendments and new form aredesigned, among other things, toprovide additional safeguards withrespect to broker-dealer custody of customer securities and funds, toenhance the ability of the Commissionto oversee broker-dealer custodypractices, to increase the focus of carrying broker-dealers and theirindependent public accountants oncompliance, and internal control overcompliance, with certain financial andcustodial requirements, to facilitate theability of the PCAOB to implement theexplicit oversight authority over broker-dealer audits provided to the PCAOB bythe Dodd-Frank Act, and to satisfy theinternal control report requirement inRule 206(4)–2 for certain broker-dealersaffiliated with, or dually-registered as,investment advisers.


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877 Id. at 37602.878 See IMS Letter.879 See Citrin Letter.880 See Angel Letter.881 See Citrin Letter.882 Id. The commenter also specifically suggested

that if non-carrying and smaller broker-dealers mustuse PCAOB standards, that the Commission shoulddefer the effective date for one year after theapproval of the amendments. Id.

883 As is discussed below, small broker-dealersare in most instances not carrying broker-dealers.See section VIII.C. of this release.

884 See SIFMA Letter. As discussed above insection II.B.1. of this release, there will be caseswhere a broker-dealer changes its business modelto convert from a carrying broker-dealer to a non-carrying broker-dealer during the fiscal year. In thiscase, 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 compliancereport and to instead file the exemption report. Inanalyzing such a request, the period of time the

broker-dealer operated as a carrying broker-dealerwould be a relevant consideration. 885 See section II.B.4.iii. of this release.

B. Significant Issues Raised by Public Comments

The Commission requested commentwith regard to matters discussed in theIRFA, including comments with respectto the number of small entities that may

be affected by the proposed ruleamendments and whether the effect onsmall entities would be economicallysignificant. 877

The Commission did not receive anycomments specifically addressing theIRFA. However, several commentersdiscussed the impact of the proposal onsmall broker-dealers. One commenterstated that the proposed amendments‘‘place unnecessary regulatory burdensand costs on the industry, in general,and smaller firms in particular.’’ 878 Another commenter stated that small

broker-dealers may find the timing of the transition to be a ‘‘burden,’’ andrequested that the Commission providea longer transition period. 879 A thirdcommenter suggested that theexemption report and the accountant’sreport on the exemption report bereplaced with a ‘‘check box on theFOCUS report’’ and that with regard tothese reports ‘‘[t]he amount of paperwork involved for small firms thatdo not carry customer securities seemsrather excessive.’’ 880 A fourthcommenter stated that the proposedtransition period may burden smaller

broker-dealers, and suggested that tofacilitate the transition, the Commissionshould provide examples of bestpractices and deficiencies, with the

cooperation of the AICPA.881

Thiscommenter also suggested that theeffective date for the annual reportingrequirements should be one year afterpublication of the final rule. 882

The Commission is sensitive to the burdens the rule amendments and newform will have on small broker-dealers.To remove unnecessary burdens, thefinal rule amendments contain certainmodifications from the proposaldesigned to alleviate some of theconcerns regarding small broker-dealers. 883 The modifications arediscussed in the following paragraphs.

As is discussed above, theCommission has modified the proposed

amendments with respect to theexemption report in a manner that willlikely result in lower costs for small

broker-dealers than would have beenthe case if the Commission had adoptedthe proposed amendments without themodifications. In particular, the finalrule provides that a broker-dealer canfile the exemption report if it ‘‘claimedthat it was exempt’’ from Rule 15c3–3throughout the most recent fiscal year.This modification from the proposal—which provided that a broker-dealercould file the exemption report if the

broker-dealer ‘‘is exempt from Rule15c3–3’’—is designed to addressconcerns raised by commenters that anon-carrying broker-dealer might berequired to file the compliance report

because of an instance during the yearin which it did not meet the relied onexemption provision in paragraph (k) of Rule 15c3–3. 884 As discussed in theeconomic analysis, the compliance

report costs are significantly greaterthan the exemption report costs. Thefinal rule clarifies that a non-carrying

broker-dealer that has an exception tomeeting the exemption provisions inparagraph (k) of Rule 15c3–3 need notfile the compliance report; however, the

broker-dealer would be required toidentify, to its best knowledge and

belief, in its exemption report eachexception during the most recent fiscalyear, if applicable, including a brief description of the exception and theapproximate date on which theexception existed.

In addition, only clearing broker-dealers will be subject to therequirements that the Commission isadopting today that provideCommission and DEA examination staff with the ability to review auditdocumentation associated with broker-dealers’ annual audit reports and allowtheir independent public accountants todiscuss findings relating to the auditreports with Commission and DEAexamination staff.

To alleviate burdens associated withForm Custody, the Commission hasmodified the form’s instructions to

make clear that questions on the formthat cannot be answered because the broker-dealer does not engage in a

particular activity do not need to beanswered.

In response to comments, theCommission also has delayed theeffective dates associated with theproposed reporting and attestationamendments, which will provide all

broker-dealers, including smaller broker-dealers, with a longer transitionperiod to prepare for the newrequirements.

As is discussed above, theCommission considered the commentthat it should replace the exemptionreport with a box to check on theFOCUS Report as the amount of paperwork for small firms ‘‘seems ratherexcessive.’’ 885 After carefulconsideration of this and otheralternatives, the Commissiondetermined that of the alternativesconsidered, none are appropriatealternatives to the exemption report.Requiring the broker-dealer to (1) createa separate written report stating that itis claiming the exemption andidentifying the basis for the exemption,including any identified exceptions inmeeting the conditions set forth in§ 240.15c3–3(k) and (2) file this reportwith the Commission and the broker-dealer’s DEA should increase broker-dealers’ focus on the accuracy of itscompliance with the statements beingmade because of the potential forliability for false statements, enhancecompliance with the exemptionconditions in Rule 15c3–3, andtherefore provide better protection of customer assets.

Finally, with respect to the commentthat the Commission should provideexamples of best practices anddeficiencies with the cooperation of theAICPA, the Commission notes that thequestion of whether further guidance isnecessary is best answered after therequirements become effective andpractical compliance questions arise. Inaddition, the Commission will publish aSmall Entity Compliance Guide relatingto these amendments.C. Small Entities Subject to the Rules

Paragraph (c) of Rule 0–10 provides

that, for purposes of the RFA, a smallentity when used with reference to a broker-dealer (‘‘small broker-dealer’’)means a broker-dealer that: (1) Had totalcapital (net worth plus subordinatedliabilities) of less than $500,000 on thedate in the prior fiscal year as of whichits audited financial statements wereprepared pursuant to Rule 17a–5(d) or,if not required to file such statements,a broker-dealer that had total capital(net worth plus subordinated liabilities)


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886 17 CFR 240.0–10(c).887 See Broker-Dealer Reports, 76 FR at 37602.

Although the Commission received no commentsregarding the its initial estimate that there were nosmall carrying broker-dealers, the estimate isnonetheless being revised based on additionalanalysis of available information. 888 5 U.S.C. 603(c).

of less than $500,000 on the last business day of the preceding fiscal year(or in the time that it has been in

business if shorter); and (2) is notaffiliated with any person (other than anatural person) that is not a small

business or small organization. 886 Basedon December 31, 2011 FOCUS Reportdata, the Commission estimates thatthere are approximately 812 broker-dealers that are classified as ‘‘small’’entities for purposes of the RFA. Of these, the Commission estimates thatthere are approximately eight broker-dealers that are carrying broker-dealers.The Commission estimated for purposesof the IRFA that there wereapproximately 871 broker-dealers thatwere classified as small entities forpurposes of the RFA and that there wereno broker-dealers that were carryingfirms that satisfied the definition of asmall broker-dealer. 887

D. Reporting, Recordkeeping, and Other Compliance Requirements

The Commission’s amendments toRule 17a–5 retain the currentrequirement that broker-dealersannually file financial statements andsupporting schedules (‘‘financialreport’’) that must be audited by aPCAOB-registered accountant. Underthe amendments, the financial reportmust be audited in accordance withstandards of the PCAOB, instead of inaccordance with GAAS, as previouslyrequired.

In addition to the financial report, the

amendments require broker-dealers tofile one of two new reports: either acompliance report or an exemptionreport. If a broker-dealer did not claimthat it was exempt from Rule 15c3–3throughout the most recent fiscal year,the broker-dealer must prepare and filewith the Commission a compliancereport containing certain statementsregarding the broker-dealer’s internalcontrol over compliance with thefinancial responsibility rules andcompliance with certain of those rules.Alternatively, if the broker-dealerclaimed that it was exempt from Rule

15c3–3 throughout the most recentfiscal year, the broker-dealer mustprepare and file with the Commissionan exemption report containing astatement that it claimed that it wasexempt from Rule 15c3–3 during thatperiod and identify the provisions

under which it claimed that it wasexempt from Rule 15c3–3.

The amendments to Rule 17a–5 alsoeliminate the ‘‘material inadequacy’’concept and, among other things,replace the requirement that the broker-dealer’s independent public accountantprepare, and the broker-dealer file withthe Commission, a material inadequacyreport with a requirement for theaccountant to prepare a new reportcovering either the compliance report orthe exemption report, as applicable. If the broker-dealer is a carrying broker-dealer, the accountant must prepare areport based on an examination, inaccordance with PCAOB standards, of certain statements by the broker-dealerin the compliance report. If the broker-dealer claimed an exemption from Rule15c3–3, the accountant must prepare areport based on a review, in accordancewith PCAOB standards, of theexemption report. Broker-dealers must

file these reports of the accountant withthe Commission along with the financialreport and either the compliance reportor the exemption report.

Together, the financial report and thecompliance report or the exemptionreport and the accountant’s reportscovering those reports comprise theannual reports that the broker-dealermust file each fiscal year with theCommission and the broker-dealer’sDEA. The amendments require that the

broker-dealer also file the annual reportswith SIPC if the broker-dealer is amember of SIPC.

Amendments to Rule 17a–5 alsorequire that if, during the course of anaudit, a broker-dealer’s independentpublic accountant determines that the

broker-dealer is not in compliance withthe financial responsibility rules, or thatany material weaknesses exist, theaccountant must immediately notify the

broker-dealer. The broker-dealer mustnotify the Commission and its DEA of the material weakness and must notifythe Commission and the DEA of thenon-compliance if that non-compliancewould otherwise trigger a notificationrequirement.

Amendments to Rule 17a–11 require

that when a broker-dealer discovers, oris notified by its independent publicaccountant, of the existence of anymaterial weakness under Rule 17a–5,the broker-dealer must notify theCommission and transmit a report to theCommission stating what the broker-dealer has done or is doing to correctthe situation. The amendmentssubstituted the term material weaknessfor the term material inadequacy withregard to Rule 17a–5.

Under the amendments, carrying broker-dealers or those that clear

transactions must agree to allowCommission or DEA examination staff,if requested in writing for purposes of an examination of the broker-dealer, toreview ‘‘the documentation associatedwith the reports of the accountant’’ andto discuss the accountant’s findingswith the accountant.

The amendments require broker-dealers to file a new ‘‘Form Custody’’each quarter to elicit informationconcerning whether a broker-dealermaintains custody of customer and non-customer assets, and, if so, how suchassets are maintained. Form Custodymust be filed with the broker-dealer’sDEA. The DEA must transmit theinformation obtained from FormCustody to the Commission at the sametime that it transmits FOCUS Reportdata to the Commission underparagraph (a)(4) of Rule 17a–5.

The impact of the amendments onsmall broker-dealers will besubstantially less than on larger firms.Most small broker-dealers are exemptfrom Rule 15c3–3 and therefore mustfile the exemption report. As discussedabove, the exemption report must bereviewed by the independent publicaccountant, in lieu of the compliancereport, which must be examined by theaccountant. In addition, Form Custodywould elicit less information from

broker-dealers that do not maintaincustody of customer assets, andtherefore the form should be less

burdensome for these broker-dealers.E. Agency Action To Minimize Effect on

Small EntitiesPursuant to section 3(a) of the RFA, 888 the Commission must considersignificant alternatives that wouldaccomplish the Commission’s statedobjectives, while minimizing anysignificant adverse impact on smallentities. In connection with the finalrules, the Commission considered thefollowing alternatives: (1) Establishingdiffering compliance or reportingrequirements or timetables that take intoaccount the resources available tosmaller entities; (2) clarifying,consolidating, or simplifying

compliance and reporting requirementsfor smaller entities; (3) the use of performance standards rather thandesign standards; and (4) exemptingsmaller entities from coverage of therules, or any part of the rules.

The Commission considered differingcompliance and reporting requirementsand timetables in adopting theamendments discussed in this release,which took into account the resourcesavailable to smaller entities. For


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889 See sections II.B.4.iii. and VII.C.1.ii.b. of thisrelease.

890 15 U.S.C. 78mm.891 15 U.S.C. 78o, 78q, 78w(a) and 78mm.

example, as is discussed above, theCommission considered alternatives tothe exemption report requirements,which resulted in modifications to thefinal rule that make clear that broker-dealers claiming exemptions from Rule15c3–3 will remain subject to thoserequirements even if certain exceptionsarise. 889 This reduces the burden onsmall broker-dealers that wouldotherwise be subject to the moreresource-intensive compliance andexamination report requirementsapplicable to carrying broker-dealers.

In addition, the Commission, inestablishing effective dates for theseamendments, considered the resourcesavailable to small broker-dealers. In thisregard, the Commission is delaying theeffective dates for the audit andreporting requirements, which willprovide small broker-dealers withgreater flexibility in allocating theirresources while preparing to comply

with applicable amendments.The Commission also clarified,consolidated, and simplifiedcompliance and reporting requirementsfor broker-dealers in connection withthe amendments. As discussed above,the Commission clarified and simplifiedrequirements applicable to FormCustody by specifying in the final formthat broker-dealers are not required toanswer questions that do not apply totheir business activities. Further, interms of consolidating regulatoryrequirements applicable to broker-dealers, a broker-dealer affiliated with,or dually-registered as, an investmentadviser that is subject to the compliancereport requirement can use theindependent public accountant’sexamination of the compliance report tosatisfy reporting obligations underAdvisers Act Rule 206(4)–2.

The Commission generally useddesign standards rather thanperformance standards in connectionwith the final rule amendments becausethe Commission believes designstandards will better accomplish itsobjectives of enhancing safeguards withrespect to broker-dealer custody of securities and funds. The specific

disclosure requirements in the final rulewill promote comparable and consistenttypes of disclosures by broker-dealers,which will facilitate the ability of Commission and DEA staff to assess

broker-dealer compliance withapplicable requirements.

The Commission also considered, andis adopting, amendments that exemptcertain types of broker-dealers fromcertain requirements. For example,

broker-dealers that are not clearing broker-dealers, which include mostsmall broker-dealers, do not need tocomply with the access to accountantand audit documentation amendments.Most small broker-dealers also will not

be subject to the new compliance andexamination report requirements, assmall broker-dealers are in mostinstances not carrying broker-dealers.

In addition, if the Commissionsubsequently determines that it isappropriate to exempt a broker-dealer,or type of broker-dealer, from suchrequirements, the Commission hasexisting authority under which it canact. In particular, under Exchange Actsection 36, the Commission, by rule,regulation, or order, may exempt anyperson, or any class or classes of persons, from any rule under theExchange Act to the extent that suchexemption is necessary or appropriatein the public interest and is consistent

with the protection of investors.890

IX. Statutory Authority

The Commission is amending Rule17a–5 and Rule 17a–11 under theExchange Act (17 CFR 240.17a–5 and 17CFR 240.17a–11) and adopting newForm Custody (17 CFR 249.639)pursuant to the authority conferred bythe Exchange Act, including sections 15,17, 23(a) and 36. 891

List of Subjects in 17 CFR Parts 240 and249

Brokers, Confidential businessinformation, Fraud, Reporting andrecordkeeping requirements, Securities.Text of the Amendments

For the reasons set out in thepreamble, the Commission is amendingTitle 17, Chapter II, of the Code of Federal Regulations as follows:

PART 240—GENERAL RULES ANDREGULATIONS, SECURITIESEXCHANGE ACT OF 1934

■ 1. The authority citation for part 240continues to read, in part, as follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j,77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn,77sss, 77ttt, 78c, 78c–3, 78c–5, 78d, 78e, 78f,78g, 78i, 78j, 78j–1, 78k, 78k–1, 78 l, 78m,78n, 78n–1, 78o, 78o–4, 78o–10, 78p, 78q,78q–1, 78s, 78u–5, 78w, 78x, 78 ll, 78mm,80a–20, 80a–23, 80a–29, 80a–37, 80b–3, 80b–4, 80b–11, 7201 et seq., and 8302; 7 U.S.C.2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C.1350; and Pub. L. 111–203, 939A, 124 Stat.1376, (2010), unless otherwise noted.* * * * *■ 2. Section 240.17a–5 is amended by:

■ a. In paragraph (a)(2)(i), adding theword ‘‘transactions’’ after the word‘‘clears’’ and removing the words ‘‘shallfile’’ and adding in their place ‘‘mustfile with the Commission.’’■ b. In paragraph (a)(2)(ii), removing thewords ‘‘shall file’’ and adding in theirplace ‘‘must file with the Commission’’and removing the phrase ‘‘date selectedfor the annual audit of financialstatements where said date is other thana calendar quarter’’ and adding in itsplace ‘‘end of the fiscal year of the

broker or dealer where that date is notthe end of a calendar quarter.’’;■ c. In paragraph (a)(2)(iii), removingthe phrase ‘‘who does not carry norclear transactions nor carry customeraccounts shall file’’ and adding in itsplace ‘‘that neither clears transactionsnor carries customer accounts must filewith the Commission’’ and removingthe phrase ‘‘date selected for the annualaudit of financial statements where said

date is other than the end of thecalendar quarter.’’ and adding in itsplace ‘‘end of the fiscal year of the

broker or dealer where that date is notthe end of a calendar quarter.’’;■ d. In paragraph (a)(2)(iv), removingthe words ‘‘shall file’’ and adding intheir place ‘‘must file with theCommission’’ and adding the phrase‘‘(‘‘designated examining authority’’)’’after the phrase ‘‘section 17(d) of theAct’’;■ e. In paragraph (a)(3), in the firstsentence, adding the words ‘‘that must

be filed with the Commission’’ after thewords ‘‘provided for in this paragraph(a)’’;■ f. Redesignating paragraphs (a)(5) and(6) as paragraphs (a)(6) and (7);■ g. In newly redesignated paragraph(a)(6)(ii)(A), removing the phrase‘‘(a)(5)(i)’’ and adding in its place‘‘(a)(6)(i)’’;■ h. Adding new paragraph (a)(5);■ i. Revising paragraph (b)(2);■ j. In paragraph (b)(4), removing theword ‘‘he’’ and adding in its place ‘‘the

broker or dealer’’.■ k. Removing paragraph (b)(6);■ l. In paragraph (c)(1)(i), removing thephrase ‘‘his customers’’ and adding in

its place ‘‘customers of the introducing broker or dealer’’;■ m. In paragraph (c)(1)(iii), removingthe phrase ‘‘in the manner contemplated

by the $2,500 minimum net capitalrequirement of §240.15c3–1’’ andadding in its place ‘‘and otherwisequalified to maintain net capital of noless than what is required under§ 240.15c3–1(a)(2)(iv)’’;■ n. In paragraph (c)(2) introductorytext, in the first sentence, removing thephrase ‘‘date of the audited financialstatements required by paragraph (d) of


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this section’’ and adding in its place‘‘end of the fiscal year of the broker ordealer’’;■ o. In paragraph (c)(2)(i) removing thephrase ‘‘balance sheet with appropriatenotes prepared in accordance with’’ andadding in its place ‘‘Statement of Financial Condition with appropriatenotes prepared in accordance withU.S.’’;■ p. Removing paragraph (c)(2)(iii);■ q. Redesignating paragraph (c)(2)(iv)as (c)(2)(iii);■ r. In newly redesignated paragraph(c)(2)(iii), removing the phrase ‘‘annualaudit report of the broker or dealerpursuant to §240.17a-5’’ and adding inits place ‘‘financial report of the brokeror dealer under paragraph (d)(1)(i)(A) of this section’’ and adding at the end theword ‘‘and’’;■ s. Adding new paragraph (c)(2)(iv);■ t. In paragraph (c)(4) introductory textremoving the word ‘‘‘customer’’’ and

adding in its place ‘‘ customer’’; ■ u. In paragraphs (c)(5)(ii)(A) and(c)(5)(iii) introductory text, removingthe phrases ‘‘Web site’’ and ‘‘Web sites’’and adding in their place ‘‘website’’ and‘‘websites’’;■ v. Removing paragraph (c)(5)(vi);■ w. Revising paragraph (d);■ x. In paragraph (e) introductory text,removing the phrase ‘‘financialstatements’’ and adding in its place‘‘annual reports’’ and removing theword ‘‘shall’’ and adding in its place‘‘must’’;■ y. Revising paragraphs (e)(1) through(4);■ z. Removing paragraph (e)(5);■ aa. Revising paragraphs (f) through (i);■ bb. Removing and reserving paragraph(j);■ cc. In paragraph (m)(1), removing theword ‘‘audit’’ after the word ‘‘annual’’;and■ dd. In paragraph (n)(2) removing thephrase ‘‘audit report’’ and adding in itsplace ‘‘annual reports’’; adding thephrase ‘‘in writing’’ after the word‘‘approved’’ and removing the phrase‘‘pursuant to paragraph (d)(1)(i) of thissection’’ and adding in its place ‘‘of the

broker or dealer’’.

The revisions and additions read asfollows:

§ 240.17a–5 Reports to be made by certainbrokers and dealers.

(a) * * *(5) Every broker or dealer subject to

this paragraph (a) must file FormCustody (§ 249.639 of this chapter) withits designated examining authoritywithin 17 business days after the end of each calendar quarter and within 17

business days after the end of the fiscalyear of the broker or dealer where that

date is not the end of a calendar quarter.The designated examining authoritymust maintain the information obtainedthrough the filing of Form Custody andtransmit the information to theCommission, at such time as it transmitsthe applicable part of Form X–17A–5(§ 249.617 of this chapter) as required inparagraph (a)(4) of this section.* * * * *

(b) * * *(2) The broker or dealer must attach

to the report required by paragraph(b)(1) of this section an oath oraffirmation that to the best knowledgeand belief of the person making the oathor affirmation the information containedin the report is true and correct. Theoath or affirmation must be made beforea person duly authorized to administersuch oaths or affirmations. If the brokeror dealer is a sole proprietorship, theoath or affirmation must be made by theproprietor; if a partnership, by a generalpartner; if a corporation, by a dulyauthorized officer; or if a limitedliability company or limited liabilitypartnership, by the chief executiveofficer, chief financial officer, manager,managing member, or those membersvested with management authority forthe limited liability company or limitedliability partnership.* * * * *

(c) * * *(2) * * *(iv) If, in connection with the most

recent annual reports required underparagraph (d) of this section, the report

of the independent public accountantrequired under paragraph (d)(1)(i)(C) of this section covering the report of the

broker or dealer required underparagraph (d)(1)(i)(B)( 1) of this sectionidentifies one or more material weaknesses, a statement by the broker ordealer that one or more material weaknesses have been identified andthat a copy of the report of theindependent public accountant requiredunder paragraph (d)(1)(i)(C) of thissection is currently available for thecustomer’s inspection at the principaloffice of the Commission inWashington, DC, and the regional officeof the Commission for the region inwhich the broker or dealer has itsprincipal place of business.* * * * *

(d) Annual reports. (1)(i) Except asprovided in paragraphs (d)(1)(iii) and(d)(1)(iv) of this section, every broker ordealer registered under section 15 of theAct must file annually:

(A) A financial report as described inparagraph (d)(2) of this section; and

(B)(1) If the broker or dealer did notclaim it was exempt from § 240.15c3–3

throughout the most recent fiscal year,a compliance report as described inparagraph (d)(3) of this section executed

by the person who makes the oath oraffirmation under paragraph (e)(2) of this section; or

(2) If the broker or dealer did claimthat it was exempt from § 240.15c3–3throughout the most recent fiscal year,an exemption report as described inparagraph (d)(4) of this section executed

by the person who makes the oath oraffirmation under paragraph (e)(2) of this section;

(C) Except as provided in paragraph(e)(1)(i) of this section, a report prepared

by an independent public accountant,under the engagement provisions inparagraph (g) of this section, coveringeach report required to be filed underparagraphs (d)(1)(i)(A) and (B) of thissection.

(ii) The reports required to be filedunder this paragraph (d) must be as of the same fiscal year end each year,unless a change is approved in writing

by the designated examining authorityfor the broker or dealer under paragraph(n) of this section. A copy of the writtenapproval must be sent to theCommission’s principal office inWashington, DC, and the regional officeof the Commission for the region inwhich the broker or dealer has itsprincipal place of business.

(iii) A broker or dealer succeeding toand continuing the business of another

broker or dealer need not file the reportsunder this paragraph (d) as of a date inthe fiscal year in which the successionoccurs if the predecessor broker ordealer has filed reports in compliancewith this paragraph (d) as of a date insuch fiscal year.

(iv) A broker or dealer that is amember of a national securitiesexchange, has transacted a business insecurities solely with or for othermembers of a national securitiesexchange, and has not carried anymargin account, credit balance, orsecurity for any person who is definedas a customer in paragraph (c)(4) of thissection, is not required to file reportsunder this paragraph (d).

(2) Financial report. The financialreport must contain:(i) A Statement of Financial

Condition, a Statement of Income, aStatement of Cash Flows, a Statement of Changes in Stockholders’ or Partners’ orSole Proprietor’s Equity, and aStatement of Changes in LiabilitiesSubordinated to Claims of GeneralCreditors. The statements must beprepared in accordance with U.S.generally accepted accountingprinciples and must be in a format thatis consistent with the statements


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contained in Form X–17A–5 (§ 249.617of this chapter) Part II or Part IIA. If theStatement of Financial Condition filedin accordance with instructions to FormX–17A–5, Part II or Part IIA, is notconsolidated, a summary of financialdata, including the assets, liabilities,and net worth or stockholders’ equity,for subsidiaries not consolidated in thePart II or Part IIA Statement of FinancialCondition as filed by the broker ordealer must be included in the notes tothe financial statements reported on bythe independent public accountant.

(ii) Supporting schedules thatinclude, from Part II or Part IIA of FormX–17A–5 (§ 249.617 of this chapter), aComputation of Net Capital Under§ 240.15c3–1, a Computation forDetermination of the ReserveRequirements under Exhibit A of § 240.15c3–3, and Information Relatingto the Possession or ControlRequirements Under §240.15c3–3.

(iii) If either the Computation of NetCapital under §240.15c3–1 or theComputation for Determination of theReserve Requirements Under Exhibit Aof § 240.15c3–3 in the financial report ismaterially different from thecorresponding computation in the mostrecent Part II or Part IIA of Form X–17A–5 (§ 249.617 of this chapter) filed

by the broker or dealer pursuant toparagraph (a) of this section, areconciliation, including appropriateexplanations, between the computationin the financial report and thecomputation in the most recent Part II

or Part IIA of Form X–17A–5 filed bythe broker or dealer. If no materialdifferences exist, a statement soindicating must be included in thefinancial report.

(3) Compliance report. (i) Thecompliance report must contain:

(A) Statements as to whether:(1) The broker or dealer has

established and maintained Internal Control Over Compliance as that term isdefined in paragraph (d)(3)(ii) of thissection;

(2) The Internal Control OverCompliance of the broker or dealer waseffective during the most recent fiscalyear;

(3) The Internal Control OverCompliance of the broker or dealer waseffective as of the end of the most recentfiscal year;

(4) The broker or dealer was incompliance with §§240.15c3–1 and240.15c3–3(e) as of the end of the mostrecent fiscal year; and

(5) The information the broker ordealer used to state whether it was incompliance with §§240.15c3–1 and240.15c3–3(e) was derived from the

books and records of the broker ordealer.

(B) If applicable, a description of eachmaterial weakness in the InternalControl Over Compliance of the brokeror dealer during the most recent fiscalyear.

(C) If applicable, a description of anyinstance of non-compliance with

§§ 240.15c3–1 or 240.15c3–3(e) as of theend of the most recent fiscal year.(ii) The term Internal Control Over

Compliance means internal controls thathave the objective of providing the

broker or dealer with reasonableassurance that non-compliance with§ 240.15c3–1, §240.15c3–3, § 240.17a–13, or any rule of the designatedexamining authority of the broker ordealer that requires account statementsto be sent to the customers of the brokeror dealer (an ‘‘Account Statement Rule’’)will be prevented or detected on atimely basis.

(iii) The broker or dealer is notpermitted to conclude that its InternalControl Over Compliance was effectiveduring the most recent fiscal year if there were one or more materialweaknesses in its Internal Control OverCompliance during the most recentfiscal year. The broker or dealer is notpermitted to conclude that its InternalControl Over Compliance was effectiveas of the end of the most recent fiscalyear if there were one or more materialweaknesses in its internal control as of the end of the most recent fiscal year. Amaterial weakness is a deficiency, or acombination of deficiencies, in InternalControl Over Compliance such thatthere is a reasonable possibility thatnon-compliance with §§ 240.15c3–1 or240.15c3–3(e) will not be prevented ordetected on a timely basis or that non-compliance to a material extent with§ 240.15c3–3, except for paragraph (e),§ 240.17a–13, or any Account StatementRule will not be prevented or detectedon a timely basis. A deficiency inInternal Control Over Compliance existswhen the design or operation of acontrol does not allow the managementor employees of the broker or dealer, inthe normal course of performing their

assigned functions, to prevent or detecton a timely basis non-compliance with§ 240.15c3–1, §240.15c3–3, § 240.17a–13, or any Account Statement Rule.

(4) Exemption report. The exemptionreport must contain the followingstatements made to the best knowledgeand belief of the broker or dealer:

(i) A statement that identifies theprovisions in §240.15c3–3(k) underwhich the broker or dealer claimed anexemption from § 240.15c3–3;

(ii) A statement that the broker ordealer met the identified exemption

provisions in § 240.15c3–3(k)throughout the most recent fiscal yearwithout exception or that it met theidentified exemption provisions in§ 240.15c3–3(k) throughout the mostrecent fiscal year except as describedunder paragraph (d)(4)(iii) of thissection; and

(iii) If applicable, a statement thatidentifies each exception during themost recent fiscal year in meeting theidentified exemption provisions in§ 240.15c3–3(k) and that brieflydescribes the nature of each exceptionand the approximate date(s) on whichthe exception existed.

(5) The annual reports must be filednot more than sixty (60) calendar daysafter the end of the fiscal year of the

broker or dealer.(6) The annual reports must be filed

at the regional office of the Commissionfor the region in which the broker ordealer has its principal place of

business, the Commission’s principaloffice in Washington, DC, the principaloffice of the designated examiningauthority for the broker or dealer, andwith the Securities Investor ProtectionCorporation (‘‘SIPC’’) if the broker ordealer is a member of SIPC. Copies of the reports must be provided to all self-regulatory organizations of which the

broker or dealer is a member, unless theself-regulatory organization by rulewaives this requirement.

(e) * * *(1)(i) The broker or dealer is not

required to engage an independentpublic accountant to provide the reportsrequired under paragraph (d)(1)(i)(C) of this section if, since the date of theregistration of the broker or dealer undersection 15 of the Act (15 U.S.C. 78o) orof the previous annual reports filedunder paragraph (d) of this section:

(A) The securities business of the broker or dealer has been limited toacting as broker (agent) for the issuer insoliciting subscriptions for securities of the issuer, the broker has promptlytransmitted to the issuer all funds andpromptly delivered to the subscriber allsecurities received in connection withthe transaction, and the broker has not

otherwise held funds or securities for orowed money or securities to customers;or

(B) The securities business of the broker or dealer has been limited to buying and selling evidences of indebtedness secured by mortgage, deedof trust, or other lien upon real estate orleasehold interests, and the broker ordealer has not carried any marginaccount, credit balance, or security forany securities customer.

(ii) A broker or dealer that files annualreports under paragraph (d) of this


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section that are not covered by reportsprepared by an independent publicaccountant must include in the oath oraffirmation required by paragraph (e)(2)of this section a statement of the factsand circumstances relied upon as a

basis for exemption from therequirement that the annual reportsfiled under paragraph (d) of this section

be covered by reports prepared by anindependent public accountant.

(2) The broker or dealer must attachto the financial report an oath oraffirmation that, to the best knowledgeand belief of the person making the oathor affirmation,

(i) The financial report is true andcorrect; and

(ii) Neither the broker or dealer, norany partner, officer, director, orequivalent person, as the case may be,has any proprietary interest in anyaccount classified solely as that of acustomer.

The oath or affirmation must be made before a person duly authorized toadminister such oaths or affirmations. If the broker or dealer is a soleproprietorship, the oath or affirmationmust be made by the proprietor; if apartnership, by a general partner; if acorporation, by a duly authorizedofficer; or if a limited liability companyor limited liability partnership, by thechief executive officer, chief financialofficer, manager, managing member, orthose members vested with managementauthority for the limited liabilitycompany or limited liability

partnership.* * * * *(3) The annual reports filed under

paragraph (d) of this section are notconfidential, except that, if theStatement of Financial Condition in aformat that is consistent with Form X–17A–5 (§ 249.617 of this chapter), PartII, or Part IIA, is bound separately fromthe balance of the annual reports filedunder paragraph (d) of this section, andeach page of the balance of the annualreports is stamped ‘‘confidential,’’ thenthe balance of the annual reports shall

be deemed confidential to the extent

permitted by law. However, the annualreports, including the confidentialportions, will be available for officialuse by any official or employee of theU.S. or any State, by national securitiesexchanges and registered nationalsecurities associations of which the

broker or dealer filing such a report isa member, by the Public CompanyAccounting Oversight Board, and by anyother person if the Commissionauthorizes disclosure of the annualreports to that person as being in thepublic interest. Nothing contained in

this paragraph may be construed to bein derogation of the rules of anyregistered national securities associationor national securities exchange that giveto customers of a member broker ordealer the right, upon request to themember broker or dealer, to obtaininformation relative to its financialcondition.

(4)(i) The broker or dealer must filewith SIPC a report on the SIPC annualgeneral assessment reconciliation orexclusion from membership forms thatcontains such information and is insuch format as determined by SIPC byrule and approved by the Commission.

(ii) Until the earlier of two years afterthe date paragraph (e)(4)(i) of thissection is effective or SIPC adopts a ruleunder paragraph (e)(4)(i) of this sectionand the rule is approved by theCommission, the broker or dealer mustfile with SIPC a supplemental report onthe status of the membership of the

broker or dealer in SIPC if, underparagraph (d)(1)(i)(C) of this section, the broker or dealer is required to filereports prepared by an independentpublic accountant. The supplementalreport must include the independentpublic accountant’s report on applyingagreed-upon procedures based on theperformance of the proceduresenumerated in paragraph (e)(4)(ii)(C) of this section. The supplemental reportmust cover the SIPC annual generalassessment reconciliation or exclusionfrom membership forms not previouslyreported on under this paragraph (e)(4)

that were required to be filed on or priorto the date of the annual reportsrequired by paragraph (d) of thissection: Provided, that the broker ordealer is not required to file thesupplemental report on the SIPC annualgeneral assessment reconciliation orexclusion from membership form forany period during which the SIPCassessment is a specified dollar value asprovided for in section 4(d)(1)(c) of theSecurities Investor Protection Act of 1970, as amended. The supplementalreport must be filed with the regionaloffice of the Commission for the regionin which the broker or dealer has itsprincipal place of business, theCommission’s principal office inWashington, DC, the principal office of the designated examining authority forthe broker or dealer, and the principaloffice of SIPC. The supplemental reportmust include the following:

(A) A schedule of assessmentpayments showing any overpaymentsapplied and overpayments carriedforward including: payment dates,amounts, and name of SIPC collectionagent to whom mailed; or

(B) If exclusion from membership wasclaimed, a statement that the broker ordealer qualified for exclusion frommembership under the SecuritiesInvestor Protection Act of 1970, asamended; and

(C) An independent public accountant’s report. The independentpublic accountant must be engaged toperform the following procedures:(1) Comparison of listed assessmentpayments with respective cashdisbursements record entries;

(2) For all or any portion of a fiscalyear, comparison of amounts reflectedin the annual reports required byparagraph (d) of this section withamounts reported in the Annual GeneralAssessment Reconciliation (Form SIPC–7);

(3) Comparison of adjustmentsreported in Form SIPC–7 withsupporting schedules and workingpapers supporting the adjustments;

(4) Proof of the arithmetical accuracyof the calculations reflected in FormSIPC–7 and in the schedules andworking papers supporting anyadjustments; and

(5) Comparison of the amount of anyoverpayment applied with the FormSIPC–7 on which it was computed; or

(6) If exclusion from membership isclaimed, a comparison of the income orloss reported in the financial reportrequired by paragraph (d)(2) of thissection with the Certification of Exclusion from Membership (FormSIPC–3).

(f)(1) Qualifications of independent

public accountant. The independentpublic accountant must be qualified andindependent in accordance with§ 210.2–01 of this chapter and theindependent public accountant must beregistered with the Public CompanyAccounting Oversight Board if required

by the Sarbanes-Oxley Act of 2002.(2) Statement regarding independent

public accountant. (i) Every broker ordealer that is required to file annualreports under paragraph (d) of thissection must file no later than December10 of each year (or 30 calendar daysafter the effective date of its registrationas a broker or dealer, if earlier) astatement as prescribed in paragraph(f)(2)(ii) of this section with theCommission’s principal office inWashington, DC, the regional office of the Commission for the region in whichits principal place of business is located,and the principal office of thedesignated examining authority for the

broker or dealer. The statement must bedated no later than December 1 (or 20calendar days after the effective date of its registration as a broker or dealer, if earlier). If the engagement of an


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independent public accountant is of acontinuing nature, providing forsuccessive engagements, no furtherfiling is required. If the engagement isfor a single year, or if the most recentengagement has been terminated oramended, a new statement must be filed

by the required date.(ii) The statement must be headed

‘‘Statement regarding independentpublic accountant under Rule 17a–5(f)(2)’’ and must contain the followinginformation and representations:

(A) Name, address, telephone number,and registration number of the broker ordealer.

(B) Name, address, and telephonenumber of the independent publicaccountant.

(C) The date of the fiscal year of theannual reports of the broker or dealercovered by the engagement.

(D) Whether the engagement is for asingle year or is of a continuing nature.

(E) A representation that theindependent public accountant hasundertaken the items enumerated inparagraphs (g)(1) and (2) of this section.

(F) Except as provided in paragraph(f)(2)(iii) of this section, a representationthat the broker or dealer agrees to allowrepresentatives of the Commission or itsdesignated examining authority, if requested in writing for purposes of anexamination of the broker or dealer, toreview the audit documentationassociated with the reports of theindependent public accountant filedunder paragraph (d)(1)(i)(C) of this

section. For purposes of this paragraph,‘‘audit documentation’’ has the meaningprovided in standards of the PublicCompany Accounting Oversight Board.The Commission anticipates that, if requested, it will accord confidentialtreatment to all documents it may obtainfrom an independent public accountantunder this paragraph to the extentpermitted by law.

(G) Except as provided in paragraph(f)(2)(iii) of this section, a representationthat the broker or dealer agrees to allowthe independent public accountant todiscuss with representatives of theCommission and its designatedexamining authority, if requested inwriting for purposes of an examinationof the broker or dealer, the findingsassociated with the reports of theindependent public accountant filedunder paragraph (d)(1)(i)(C) of thissection.

(iii) If a broker or dealer neither clearstransactions nor carries customeraccounts, the broker or dealer is notrequired to include the representationsin paragraphs (f)(2)(ii)(F) and (G) of thissection.

(iv) Any broker or dealer that is notrequired to file reports prepared by anindependent public accountant underparagraph (d)(1)(i)(C) of this sectionmust file a statement required underparagraph (f)(2)(i) of this sectionindicating the date as of which theunaudited reports will be prepared.

(3) Replacement of accountant. A broker or dealer must file a notice thatmust be received by the Commission’sprincipal office in Washington, DC, theregional office of the Commission forthe region in which its principal placeof business is located, and the principaloffice of the designated examiningauthority for the broker or dealer notmore than 15 business days after:

(i) The broker or dealer has notifiedthe independent public accountant thatprovided the reports the broker or dealerfiled under paragraph (d)(1)(i)(C) of thissection for the most recent fiscal yearthat the independent public

accountant’s services will not be used infuture engagements; or(ii) The broker or dealer has notified

an independent public accountant thatwas engaged to provide the reportsrequired under paragraph (d)(1)(i)(C) of this section that the engagement has

been terminated; or(iii) An independent public

accountant has notified the broker ordealer that the independent publicaccountant would not continue underan engagement to provide the reportsrequired under paragraph (d)(1)(i)(C) of this section; or

(iv) A new independent publicaccountant has been engaged to providethe reports required under paragraph(d)(1)(i)(C) of this section without anynotice of termination having been givento or by the previously engagedindependent public accountant.

(v) The notice must include:(A) The date of notification of the

termination of the engagement or of theengagement of the new independentpublic accountant, as applicable; and

(B) The details of any issues arisingduring the 24 months (or the period of the engagement, if less than 24 months)preceding the termination or newengagement relating to any matter of accounting principles or practices,financial statement disclosure, auditingscope or procedure, or compliance withapplicable rules of the Commission,which issues, if not resolved to thesatisfaction of the former independentpublic accountant, would have causedthe independent public accountant tomake reference to them in the report of the independent public accountant. Theissues required to be reported include

both those resolved to the formerindependent public accountant’s

satisfaction and those not resolved tothe former accountant’s satisfaction.Issues contemplated by this section arethose that occur at the decision-makinglevel—that is, between principalfinancial officers of the broker or dealerand personnel of the accounting firmresponsible for rendering its report. Thenotice must also state whether theaccountant’s report filed underparagraph (d)(1)(i)(C) of this section forany of the past two fiscal yearscontained an adverse opinion or adisclaimer of opinion or was qualifiedas to uncertainties, audit scope, oraccounting principles, and mustdescribe the nature of each such adverseopinion, disclaimer of opinion, orqualification. The broker or dealer mustalso request the former independentpublic accountant to furnish the brokeror dealer with a letter addressed to theCommission stating whether theindependent public accountant agrees

with the statements contained in thenotice of the broker or dealer and, if not,stating the respects in whichindependent public accountant does notagree. The broker or dealer must filethree copies of the notice and theaccountant’s letter, one copy of whichmust be manually signed by the soleproprietor, a general partner, or a dulyauthorized corporate, limited liabilitycompany, or limited liabilitypartnership officer or member, asappropriate, and by the independentpublic accountant, respectively.

(g) Engagement of independent public accountant. The independent publicaccountant engaged by the broker ordealer to provide the reports requiredunder paragraph (d)(1)(i)(C) of thissection must, as part of the engagement,undertake the following, as applicable:

(1) To prepare an independent publicaccountant’s report based on anexamination of the financial reportrequired to be filed by the broker ordealer under paragraph (d)(1)(i)(A) of this section in accordance withstandards of the Public CompanyAccounting Oversight Board; and

(2)(i) To prepare an independentpublic accountant’s report based on an

examination of the statements requiredunder paragraphs (d)(3)(i)(A)( 2) through(5) of this section in the compliancereport required to be filed by the brokeror dealer under paragraph (d)(1)(i)(B)( 1)of this section in accordance withstandards of the Public CompanyAccounting Oversight Board; or

(ii) To prepare an independent publicaccountant’s report based on a review of the statements required underparagraphs (d)(4)(i) through (iii) of thissection in the exemption report requiredto be filed by the broker or dealer under


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paragraph (d)(1)(i)(B)( 2) of this sectionin accordance with standards of thePublic Company Accounting OversightBoard.

(h) Notification of non-compliance or material weakness. If, during the courseof preparing the independent publicaccountant’s reports required underparagraph (d)(1)(i)(C) of this section, theindependent public accountantdetermines that the broker or dealer isnot in compliance with §240.15c3–1,§ 240.15c3–3, or §240.17a–13 or anyrule of the designated examiningauthority of the broker or dealer thatrequires account statements to be sent tothe customers of the broker or dealer, asapplicable, or the independent publicaccountant determines that any materialweaknesses (as defined in paragraph(d)(3)(iii) of this section) exist, theindependent public accountant mustimmediately notify the chief financialofficer of the broker or dealer of the

nature of the non-compliance ormaterial weakness. If the notice from theaccountant concerns an instance of non-compliance that would require a brokeror dealer to provide a notification under§ 240.15c3–1, §240.15c3–3, or§ 240.17a–11, or if the notice concernsa material weakness, the broker ordealer must provide a notification inaccordance with § 240.15c3–1,§ 240.15c3–3, or §240.17a–11, asapplicable, and provide a copy of thenotification to the independent publicaccountant. If the independent publicaccountant does not receive thenotification within one business day, orif the independent public accountantdoes not agree with the statements inthe notification, then the independentpublic accountant must notify theCommission and the designatedexamining authority within one

business day. The report from theaccountant must, if the broker or dealerfailed to file a notification, describe anyinstances of non-compliance thatrequired a notification under§ 240.15c3–1, §240.15c3–3, or§ 240.17a–11, or any materialweaknesses. If the broker or dealer fileda notification, the report from the

accountant must detail the aspects of the notification of the broker or dealerwith which the accountant does notagree.

Note to paragraph (h): The attention of the broker or dealer and theindependent public accountant is calledto the fact that under § 240.17a–11(b)(1),among other things, a broker or dealerwhose net capital declines below theminimum required pursuant to§ 240.15c3–1 shall give notice of suchdeficiency that same day in accordancewith §240.17a–11(g) and the notice

shall specify the broker or dealer’s netcapital requirement and its currentamount of net capital. The attention of the broker or dealer and accountant alsois called to the fact that under§ 240.15c3–3(i), if a broker or dealershall fail to make a reserve bank accountor special account deposit, as required

by § 240.15c3–3, the broker or dealershall by telegram immediately notify theCommission and the regulatoryauthority for the broker or dealer, whichexamines such broker or dealer as tofinancial responsibility and shallpromptly thereafter confirm suchnotification in writing.

(i) Reports of the independent public accountant required under paragraph(d)(1)(i)(C) of this section —(1) Technical requirements. The independent publicaccountant’s reports must:

(i) Be dated;(ii) Be signed manually;(iii) Indicate the city and state where

issued; and(iv) Identify without detailedenumeration the items covered by thereports.

(2) Representations. The independentpublic accountant’s reports must:

(i) State whether the examinations orreview, as applicable, were made inaccordance with standards of the PublicCompany Accounting Oversight Board;

(ii) Identify any examination and, if applicable, review procedures deemednecessary by the independent publicaccountant under the circumstances of the particular case that have beenomitted and the reason for theiromission.

(iii) Nothing in this section may beconstrued to imply authority for theomission of any procedure thatindependent public accountants wouldordinarily employ in the course of anexamination or review made for thepurpose of expressing the opinions orconclusions required under this section.

(3) Opinion or conclusion to beexpressed. The independent publicaccountant’s reports must state clearly:

(i) The opinion of the independentpublic accountant with respect to thefinancial report required under

paragraph (d)(1)(i)(A) of this section andthe accounting principles and practicesreflected in that report;

(ii) The opinion of the independentpublic accountant with respect to thefinancial report required underparagraph (d)(1)(i)(A) of this section, asto the consistency of the application of the accounting principles, or as to anychanges in those principles, that have amaterial effect on the financialstatements; and

(iii)(A) The opinion of theindependent public accountant with

respect to the statements required underparagraphs (d)(3)(i)(A)( 2) through ( 5) of this section in the compliance reportrequired under paragraph (d)(1)(i)(B)( 1)of this section; or

(B) The conclusion of theindependent public accountant withrespect to the statements required underparagraphs (d)(4)(i) through (iii) of thissection in the exemption report requiredunder paragraph (d)(1)(i)(B)( 2) of thissection.

(4) Exceptions. Any matters to whichthe independent public accountanttakes exception must be clearlyidentified, the exceptions must bespecifically and clearly stated, and, tothe extent practicable, the effect of eachsuch exception on any related itemscontained in the annual reports requiredunder paragraph (d) of this section must

be given.* * * * *■

3. Section 240.17a–11 is amended by:■ a. Revising paragraph (e); and■ b. In paragraph (h), removing thecitation ‘‘17a–5(h)(2)’’ and adding in itsplace the citation ‘‘17a–5(h)’’ andremoving the citation ‘‘17a–12(f)(2)’’and adding in its place the citation‘‘17a–12(i)(2).’’

The revision reads as follows:

§ 240.17a–11 Notification provision forbrokers and dealers.* * * * *

(e) Whenever any broker or dealerdiscovers, or is notified by an

independent public accountant under§ 240.17a–12(i)(2), of the existence of any material inadequacy as defined in§ 240.17a–12(h)(2), or whenever any

broker or dealer discovers, or is notified by an independent public accountantunder §240.17a–5(h), of the existence of any material weakness as defined in§ 240.17a–5(d)(3)(iii), the broker ordealer must:

(1) Give notice, in accordance withparagraph (g) of this section, of thematerial inadequacy or materialweakness within 24 hours of thediscovery or notification of the materialinadequacy or the material weakness;and

(2) Transmit a report, in accordancewith paragraph (g) of this section,within 48 hours of the notice statingwhat the broker or dealer has done oris doing to correct the situation.* * * * *

PART 249—FORMS, SECURITIESEXCHANGE ACT OF 1934

■ 4. The authority citation for part 249continues to read, in part, as follows:


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Authority: 15 U.S.C. 78a et seq. and 7201et seq.; 12 U.S.C. 5461 et seq.; and 18 U.S.C.1350, unless otherwise noted.* * * * *

Subpart G—Forms for Reports To BeMade by Certain Exchange Members,Brokers, and Dealers

■ 5. Add Form Custody (referenced in§ 249.639) to subpart G to read asfollows:

§ 249.639 Form custody.This form shall be used for reports of

information required by § 240.17a–5 of this chapter.

Note: The text of Form Custody will notappear in the Code of Federal Regulations.

BILLING CODE 8011–01–P


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