with the broker-dealer to provide notice to the Commission and the
broker-dealer's DEA.
---------------------------------------------------------------------------

    Second, the final rule amendments require that, if the independent
public accountant determines that the broker-dealer ``is not in
compliance with'' any of the financial responsibility rules during the
course of preparing the accountant's reports, the independent public
accountant must immediately notify the broker-dealer's CFO of the
nature of the non-compliance.\417\ As proposed, the independent public
accountant would have been required to provide notification if the
accountant determined that any ``material non-compliance'' existed. As
discussed above in section II.D.3. of this release, the final rule does
not include a definition of the term material non-compliance, as in the
proposal. Thus, the independent public accountant will be required to
provide notification to the broker-dealer of all instances of non-
compliance with the financial responsibility rules as opposed to the
proposal, which required the independent public accountant to report to
the Commission and the DEA only instances of material non-compliance.
While this may increase the number of times the independent public
accountant must provide notification of non-compliance with the
financial responsibility rules, the independent public accountant will
not have to analyze whether an instance of non-compliance is ``material
non-compliance'' under the proposed definition.
---------------------------------------------------------------------------

    \417\ Id. Under the current provisions of paragraph (h) of Rule
17a-5 (which are being amended), the independent public accountant
``shall call it to the attention'' of the CFO of the broker-dealer
any material inadequacies. See 17 CFR 240.17a-5(h)(2). In the final
rule, the independent public accountant is required to ``immediately
notify'' the CFO of the ``nature'' of any non-compliance with the
financial responsibility rules or material weakness. This change
from the current notification requirement is designed to make the
rule more clear as ``shall call it to the attention'' does not
specify when the notification must be given. Further, as proposed,
the independent public accountant would have been required to
provide the Commission with notice of any material non-compliance
within one business day of determining that the material non-
compliance exists. See Broker-Dealer Reports, 76 FR at 37606. Under
the final rule, the independent public accountant provides notice to
the broker-dealer's CFO of any non-compliance with the financial
responsibility rules or material weakness and the CFO, in turn, is
required to provide the Commission and other securities regulators
with notice if the non-compliance requires notice under Rule 15c3-1,
Rule 15c3-3, or Rule 17a-11 or in the case of a material weakness.
Consequently, because there is an intermediate step before the
Commission receives notice, it is important that the independent
public accountant notify the CFO immediately so that the Commission
and other securities regulators receive timely notice.
---------------------------------------------------------------------------

    If the independent public accountant provides notice to the broker-
dealer of an instance of non-compliance with the financial
responsibility rules, the broker-dealer must provide notice to the
Commission and its DEA in accordance with the notification provisions
of Rule 15c3-1, Rule 15c3-3, or Rule 17a-11, but only if the notice
provided by the independent public accountant concerns an instance of
non-compliance that requires the broker-dealer to provide notification
under those rules. The proposal would have required the accountant to
notify the Commission ``upon determining that any material non-
compliance exists.'' \418\ Rule 15c3-1, Rule 15c3-3, and Rule 17a-11
specify instances of non-compliance that require notification by the
broker-dealer, and paragraph (h) of Rule 17a-5, as amended, refers to
the notification provisions in those rules.
---------------------------------------------------------------------------

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

    The broker-dealer must provide a copy of the notification to the
accountant within one business day and, if the accountant does not
receive the notice or the accountant does not agree with any statements
in the notice, the accountant must provide a report to the Commission
and the broker-dealer's

DEA within one business day.\419\ The report 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 the
independent public accountant does not agree with the statements in the
notice, the report from the accountant must detail the aspects of the
notification of the broker-dealer with which the accountant does not
agree.\421\ This notification process is generally the same as that in
place before today's amendments.
---------------------------------------------------------------------------

    \419\ See paragraph (h) of Rule 17a-5.
    \420\ Id.
    \421\ Id.
---------------------------------------------------------------------------

    While the final rule incorporates the existing notification
process, the Commission wants to emphasize the importance of broker-
dealers providing notification to the Commission and other securities
regulators of non-compliance with Rule 15c3-1 as required by Rule 17a-
11 and non-compliance with paragraph (e) of Rule 15c3-3 as required by
paragraph (i) of Rule 15c3-3.\422\ Consequently, the Commission is
adding a note to paragraph (h) of Rule 17a-5 calling the attention of
the broker-dealer and independent public accountant to these
notification requirements.\423\ Further, an important element of this
process is the back-up provided by the independent public accountant in
terms of the obligation under the rule to provide the Commission and
DEA with notification of the instance of non-compliance if the
accountant does not receive a copy of the broker-dealer's notification
or the accountant does not agree with the statements in the
notification. Therefore, of necessity, the independent public
accountant would have to have measures in place to determine whether,
and if so when, the accountant received a copy of the notification
required to be provided by the broker-dealer to the Commission or the
broker-dealer's DEA. An independent public accountant could decide not
to rely solely on the receipt of a copy of the notice from the broker
dealer and take other steps to check whether the broker-dealer provided
notice to the Commission and the DEA, such as obtaining a copy of a
facsimile transmission from the broker-dealer to the Commission and
DEA.
---------------------------------------------------------------------------

    \422\ Paragraph (b)(1) of Rule 17a-11 provides, among other
things, that every broker-dealer whose net capital declines below
the minimum amount required pursuant to Rule 15c3-1 shall give
notice of such deficiency that same day in accordance with paragraph
(g) of Rule 17a-11 and that the notice shall specify the broker-
dealer's net capital requirement and its current amount of net
capital. See 17 CFR 240.17a-11(b)(1). Paragraph (g) of Rule 17a-11
provides, among other things, that the notice shall be given or
transmitted to the principal office of the Commission in Washington,
DC, the regional office of the Commission for the region in which
the broker-dealer has its principal place of business, the DEA of
which such broker-dealer is a member, and the CFTC if the broker-
dealer is registered as a futures commission merchant with such
Commission, and that the notice shall be given or transmitted by
telegraphic notice or facsimile transmission. See 17 CFR 240.17a-
11(g). Paragraph (i) of Rule 15c3-3 provides that if a broker-dealer
shall fail to make a reserve bank account or special account
deposit, as required by Rule 15c3-3, the broker-dealer shall by
telegram immediately notify the Commission and the regulatory
authority for the broker-dealer, which examines such broker-dealer
as to financial responsibility and shall promptly thereafter confirm
such notification in writing. See 17 CFR 240.15c3-3(i). The
Commission staff is considering ways to modernize the process by
which broker-dealers file these and other notices with the
Commission.
    \423\ See note to paragraph (h) of Rule 17a-5, as adopted.
---------------------------------------------------------------------------

    Third, the proposal has been modified to add that, if the
accountant determines in connection with the audit of a carrying
broker-dealer's annual reports that any material weakness (as defined
in paragraph (d)(3)(iii) of Rule 17a-5) exists, the independent public
accountant must immediately notify the broker-dealer's CFO of the
nature of the material weakness.\424\ As discussed above, before
today's amendments, paragraph (h)(2) of Rule 17a-5 required the
accountant to notify the broker-dealer's CFO if the accountant
determined that any ``material inadequacies'' existed. However, as
explained above in section II.B.3. of this release, the final rules do
not contain the concept of material inadequacy. Also, as the term
material weakness is defined with respect to the compliance report,
this notification requirement only applies to carrying broker-dealers,
whereas the requirement to provide notification of a material
inadequacy applied to carrying and non-carrying broker-dealers.
---------------------------------------------------------------------------

    \424\ See paragraph (h) of Rule 17a-5.
---------------------------------------------------------------------------

    As discussed in more detail below in section II.F.2. of this
release, the Commission is amending Rule 17a-11 to provide that a
broker-dealer must provide notification to the Commission and its DEA
if the broker-dealer discovers, or is notified by its independent
public accountant, of the existence of a material weakness.\425\
Paragraph (h) of Rule 17a-5, as stated above, requires that the
independent public accountant notify the broker-dealer if the
accountant determines that a material weakness exists.\426\ The rule
also requires the broker-dealer to provide notice in accordance with
the provisions of Rule 17a-11, which, among other things, require the
broker-dealer to provide notice to the Commission and its DEA in
accordance with paragraph (g) of Rule 17a-11 within 24 hours and
transmit a report within 48 hours of the notice stating what the
broker-dealer has done or is doing to correct the situation.\427\
Paragraph (h) of Rule 17a-5 requires the broker-dealer to provide the
accountant with a copy of the notice it sends to the Commission within
one business day and, if the accountant does not receive the notice or
the accountant does not agree with the statements in the notice, the
accountant must provide a report to the Commission and the broker-
dealer's DEA within one business day.\428\ The report 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 and the accountant does not agree with the statements in
the notification, the report from the accountant must detail the
aspects of the notification of the broker-dealer with which the
accountant does not agree.\430\ Again, this notification process is
generally the same as the one in place before today's amendments.\431\
In response to the comment that the rule should require simultaneous
notice by the accountant to the Commission and to the firm's
management, the notification procedures adopted today require that the
accountant notify management of the broker-dealer and also ensure that
the Commission receives timely notice.
---------------------------------------------------------------------------

    \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 CFR 240.17a-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'' as opposed to within a ``24 hour period.'' This
change is designed to account for non-business days during which
certain actions may not be feasibly completed.
---------------------------------------------------------------------------

    As stated above, one commenter asked whether the notification
provisions apply to a review of an exemption report.\432\ The
notification provisions in paragraph (h) of Rule 17a-5 with respect to
non-compliance with the financial responsibility rules apply regardless
of whether the independent public accountant is engaged to prepare a
report based on examination of a broker-dealer's compliance report or a
review of a broker-dealer's exemption report.\433\ An independent
public accountant may determine that a broker-dealer is not in
compliance with a requirement in the financial responsibility rules
(e.g., not in compliance with Rule 15c3-1) during

the course of an audit engagement of a non-carrying broker-dealer that
files an exemption report either as part of the examination of the
broker-dealer's financial statements or the review of certain
statements the broker-dealer's exemption report. In this case, the
independent public accountant would need to immediately notify the CFO
of the broker-dealer of the nature of the non-compliance. The
notification provisions with respect to an instance of material
weakness only apply to broker-dealers that file a compliance report
because material weakness is defined for purposes of the compliance
report.
---------------------------------------------------------------------------

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

    The rule as amended does not require the accountant to notify the
Commission directly when the accountant determines that a non-
compliance with the financial responsibility rules exists, which
eliminates the concern of a commenter that a report of non-compliance
by the accountant, as proposed, would also trigger a Rule 17a-11
notice, which would be duplicative and create confusion.\434\ As
adopted, the responsibility to provide notification rests with the
broker-dealer in the first instance.
---------------------------------------------------------------------------

    \434\ See ABA Letter.
---------------------------------------------------------------------------

2. Conforming and Technical Amendments to Rule 17a-11
    Before today's amendments, paragraph (e) of Rule 17a-11 provided
that whenever a broker-dealer discovered, or was notified by an
independent public accountant, pursuant to paragraph (h)(2) of Rule
17a-5 or paragraph (f)(2) of Rule 17a-12 of the existence of any
material inadequacy as defined in paragraph (g) of Rule 17a-5 or
paragraph (e)(2) of Rule 17a-12, the broker-dealer was required to give
notice to the Commission within 24 hours of the discovery or
notification and transmit a report to the Commission within 48 hours of
the notice stating what the broker-dealer has done or was doing to
correct the situation.\435\ The Commission proposed amending paragraph
(e) of Rule 17a-11 to delete the references to Rule 17a-5 and to
correct the references to Rule 17a-12.\436\
---------------------------------------------------------------------------

    \435\ See 17 CFR 240.17a-11(e).
    \436\ See Broker-Dealer Reports, 76 FR at 37579. Rule 17a-12
contains reporting requirements for over-the-counter (``OTC'')
derivatives dealers. See 17 CFR 240.17a-12. The rule is similar to
Rule 17a-5. Compare 17 CFR 240.17a-12, with 17 CFR 240.17a-5. For
example, paragraph (h)(2) of Rule 17a-12 describes material
inadequacies and paragraph (i)(2) of Rule 17a-12 provides that if
the accountant determines that any material inadequacy exists, the
accountant must call it to the attention of the CFO of the OTC
derivatives dealer, who must inform the Commission. See 17 CFR
240.17a-12(h)(2) and (i). The Commission did not propose amending
Rule 17a-12. Consequently, Rule 17a-12 retains the concept of
material inadequacy.
---------------------------------------------------------------------------

    One commenter stated that the current notification process under
paragraph (h)(2) of Rule 17a-5 and paragraph (e) of Rule 17a-11
satisfies the objective of notifying the Commission in a timely manner
and that the commenter was concerned that the proposal could undermine
the effectiveness of the notification process in part because it would
require notice to the Commission only when the accountant determines
that there is a deficiency, and not when it is independently discovered
by the broker-dealer.\437\
---------------------------------------------------------------------------

    \437\ See Deloitte Letter.
---------------------------------------------------------------------------

    The Commission agrees with the commenter that notification should
be provided to the Commission when a deficiency in internal control is
discovered by the broker-dealer, in addition to when it is notified by
its accountant of the existence of any material weakness. Therefore,
the final rule retains references to Rule 17a-5 in paragraph (e) of
Rule 17a-11. The Commission is conforming paragraph (e) of Rule 17a-11
to today's amendments to Rule 17a-5 to substitute the term material
weakness as defined in paragraph (d)(3)(iii) of Rule 17a-5 for the term
material inadequacy with respect to Rule 17a-5 and to replace the
reference to paragraph (h)(2) of Rule 17a-5 with a reference to
paragraph (h) of Rule 17a-5. Specifically, the final rule provides that
whenever a broker-dealer discovers, or is notified by its accountant
under paragraph (h) of Rule 17a-5 of the existence of any material
weakness, the broker-dealer must: (1) Give notice of the material
weakness within 24 hours of the discovery or notification; and (2)
transmit a report within 48 hours of the notice stating what the broker
or dealer has done or is doing to correct the situation.\438\ The rule
retains a reference to material inadequacy as defined in paragraph
(h)(2) of Rule 17a-12, but the amendments correct citations to that
rule.
---------------------------------------------------------------------------

    \438\ See paragraph (e) of Rule 17a-11. As stated above, this
provision only applies to broker-dealers that file compliance
reports, as the tern material weakness is defined with respect to
the compliance report.
---------------------------------------------------------------------------

G. Other Amendments to Rule 17a-5

1. Information Provided to Customers--Paragraph (c) of Rule 17a-5
i. Background
    Paragraph (c) of Rule 17a-5 generally requires a broker-dealer that
carries customer accounts to send its balance sheet with appropriate
notes and certain other financial information to each of its customers
twice a year.\439\ The Commission did not propose to amend this
requirement. Accordingly, a broker-dealer that carries customer
accounts must continue to send its customers: (1) An audited balance
sheet with footnotes, including a footnote specifying the amount of the
broker-dealer's net capital and required net capital, under paragraph
(c)(2) of Rule 17a-5; \440\ and (2) an unaudited balance sheet dated
six months after the date of the audited balance sheet with footnotes,
including a footnote regarding the amount of the broker-dealer's net
capital and required net capital, under paragraph (c)(3) of Rule 17a-
5.\441\ The information required by paragraphs (c)(2) and (c)(3) of
Rule 17a-5 must either be mailed to customers, or, if the broker-dealer
meets certain conditions under paragraph (c)(5) of Rule 17a-5, the
broker-dealer can semi-annually send its customers summary information
regarding its net capital, as long as it also provides customers with a
toll-free number to call for a free copy of its balance sheet with
appropriate notes, makes its balance sheet with appropriate notes
available to customers on its Web site, and meets other specified
requirements.\442\
---------------------------------------------------------------------------

    \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 Release No. 48282 (Aug. 1, 2003), 68 FR 46446 (Aug. 6,
2003).
---------------------------------------------------------------------------

ii. Availability of Independent Public Accountant's Comments on
Material Inadequacies--Paragraph (c)(2) of Rule 17a-5
    Prior to today's amendments, paragraph (c)(2)(iii) of Rule 17a-5
provided that if, in conjunction with a broker-dealer's most recent
audit report, the broker-dealer's independent public accountant
commented on any material inadequacies in the broker-dealer's internal
controls, its accounting system, or certain of its practices and
procedures \443\ under paragraphs (g) and (h) of Rule 17a-5, and
paragraph (e) of Rule 17a-11, the broker-dealer's audited statements
sent to customers were required to include a statement that a copy of
the auditor's comments were available for inspection at the
Commission's principal office in Washington, DC, and the regional
office of the Commission in which the broker-

dealer had its principal place of business.\444\
---------------------------------------------------------------------------

    \443\ These practices and procedures include, for example,
periodic net capital computations under Rule 15c3-1 and periodic
counts of securities under Rule 17a-13.
    \444\ See 17 CFR 240.17a-5(c)(2)(iii).
---------------------------------------------------------------------------

    As discussed above in sections II.D.3. and II.F. of this release,
the Commission proposed deleting references to, and the definition of,
the term material inadequacy in Rule 17a-5, and proposed amending
paragraph (h) of Rule 17a-5 to require a broker-dealer's independent
public accountant to notify the Commission and the broker-dealer's DEA
if the accountant determined that any material non-compliance existed
at the broker-dealer during the course of preparing its reports.\445\
Consequently, the Commission proposed replacing paragraph (c)(2)(iii)
of Rule 17a-5, which contained the term material inadequacies, with a
requirement that, if a broker-dealer's accountant provided notice to
the Commission of an instance of material non-compliance, the financial
information sent to customers under paragraph (c)(2) of Rule 17a-5 must
include a statement that a copy of the accountant's notice was
available for customers' inspection at the principal office of the
Commission in Washington, DC.\446\ Under this proposal, notices to the
Commission regarding an accountant's determination that one or more
instances of material non-compliance existed at a broker-dealer would
be publicly available.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    Three commenters responded to the proposed amendments to paragraph
(c)(2) of Rule 17a-5.\447\ These commenters each stated that the
Commission should accord confidential treatment to accountants' notices
to the Commission regarding determinations of material non-
compliance.\448\ One commenter stated that due to the technical nature
of the financial responsibility rules, there was a risk that notices of
material non-compliance could be misinterpreted by the media and
others.\449\
---------------------------------------------------------------------------

    \447\ See ABA Letter; CAI Letter; Deloitte Letter.
    \448\ Id.
    \449\ See ABA Letter.
---------------------------------------------------------------------------

    The Commission is revising its proposal to amend paragraph (c)(2)
of Rule 17a-5 to be consistent with the new notification provisions in
paragraph (h) described above relating to the identification by a
broker-dealer's accountant of a material weakness rather than an
instance of material non-compliance.\450\ Specifically, if, in
connection with the most recent annual reports, the report of the
independent public accountant covering the broker-dealer's compliance
report identifies a material weakness, the broker-dealer must include a
statement that one or more material weaknesses have been identified and
that a copy of the report of the independent public accountant is
currently available for the customer's inspection at the principal
office of the Commission in Washington, DC, and the regional office of
the Commission for the region in which the broker-dealer has its
principal place of business.\451\
---------------------------------------------------------------------------

    \450\ See paragraph (c)(2)(iv) of Rule 17a-5.
    \451\ Id.
---------------------------------------------------------------------------

    In response to commenters' concerns about making the report of
material non-compliance available to the public, the report that now
will be made publicly available is a report that identifies the
existence of a material weakness--not a report of material non-
compliance. In addition, making the report of the independent public
accountant covering the compliance report publicly available if it
identifies the existence of a material weakness is consistent with the
previous treatment of a report of a material inadequacy. Providing
customers notice of an accountant's finding that goes directly to the
financial and operational condition of their broker-dealer and making
the report containing the finding publicly available will make
available to customers information that facilitates their ability to
make more informed decisions in selecting broker-dealers through which
they prefer to conduct business. For these reasons, the final rule does
not accord confidential treatment to a report of an independent public
accountant covering the compliance report if it identifies a material
weakness as some commenters suggested should be the case with respect
to the proposed--but not adopted--report of material non-compliance.
Consequently, an independent public accountant's report covering the
compliance report will be made available for the customer's inspection
at the principal office of the Commission in Washington, DC, and the
regional office of the Commission for the region in which the broker-
dealer has its principal place of business if the report identifies the
existence of a material weakness.\452\
---------------------------------------------------------------------------

    \452\ Paragraph (c)(2)(iv) of Rule 17a-5, as adopted, includes
both the principal office of the Commission in Washington, DC and
the regional office of the Commission for the region in which a
broker-dealer has its principal place of business as locations where
the accountant's reports are available. Including the applicable
regional office of the Commission as a location where these notices
are available will make them more accessible to customers and is
consistent with the previous treatment of material inadequacy
reports.
---------------------------------------------------------------------------

iii. Exemption From Mailing Financial Information to Customers--
Paragraph (c)(5) of Rule 17a-5
    Before today's amendments, paragraph (c)(5) of Rule 17a-5 provided
a conditional exemption from the requirement that a broker-dealer send
paper copies of financial information to customers if the broker-dealer
mailed to customers a financial disclosure statement with summary
information and an Internet link to its balance sheet and other
information on the broker-dealer's Web site.\453\ One of the conditions
of the exemption, contained in paragraph (c)(5)(vi) of Rule 17a-5, was
that the broker-dealer was not required by paragraph (e) of Rule 17a-11
to give notice of a material inadequacy during the prior year. The
Commission proposed revising the condition in paragraph (c)(5)(vi) of
Rule 17a-5 to provide that the broker-dealer's financial statements
must receive an unqualified opinion from the independent public
accountant and neither the broker-dealer, under proposed paragraph (d)
of Rule 17a-5, nor the independent public accountant, under proposed
paragraph (g) of Rule 17a-5, identified a material weakness or an
instance of material non-compliance.\454\
---------------------------------------------------------------------------

    \453\ 17 CFR 240.17a-5(c)(5).
    \454\ See Broker-Dealer Reports, 76 FR at 37577.
---------------------------------------------------------------------------

    The Commission received several comments on the proposal.\455\ One
commenter stated that broker-dealers should be able to deliver the
financial information available to customers via its Web site
regardless of whether an instance of material non-compliance or
material weakness was identified.\456\ Another commenter stated that
the rule should not require a 100% rate of compliance with the
financial responsibility rules to qualify for the exemption.\457\ A
third commenter stated that the proposed amendment should be
eliminated, or replaced with the requirement that broker-dealers
include a notice of the material weakness or non-compliance on customer
account

statements for a year following its identification.\458\
---------------------------------------------------------------------------

    \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 send customer account statements
monthly instead of quarterly, broker-dealers are already potentially
facing ``extremely high'' costs of sending information to customers.
FINRA withdrew its proposals to send customer account statements
monthly instead of quarterly on July 30, 2012. See Proposed 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/<EMAIL_ADDRESS>(withdrawal of proposed
rule change).
    \458\ See SIFMA Letter.
---------------------------------------------------------------------------

    In response to comments received, the Commission has decided not to
adopt the proposed condition in paragraph (c)(5)(vi) of Rule 17a-5 for
qualifying for the conditional exemption. Requiring paper delivery of
financial information to customers when a broker-dealer's financial
statements do not receive an unqualified opinion from its independent
public accountant, or when the broker-dealer fails to comply with
certain regulatory requirements, will not necessarily result in a more
effective means of communication to customers and runs counter to the
dominant trend toward electronic communications between financial
entities and their customers. Further, as discussed above, if a broker-
dealer or its independent public accountant provides notice to the
Commission of a material weakness in the broker-dealer's Internal
Control Over Compliance, paragraph (c)(2)(iv) of Rule 17a-5 as adopted
requires the broker-dealer to include with the semi-annual financial
disclosure statement it sends its customers a statement that the
independent public accountant identified a material weakness and that a
copy of the report of the independent public accountant is available
for the customers' inspection.
2. Technical Amendments
i. Deletion of Paragraph (b)(6) of Rule 17a-5
    Before today's amendments, paragraph (b)(6) of Rule 17a-5 provided
that ``a copy of [a broker-dealers] annual audit report shall be filed
at the regional office of the Commission for the region in which the
broker or dealer has its principal place of business and the principal
office of the designated examining authority for said broker or dealer.
Two copies of said report shall be filed at the Commission's principal
office in Washington, DC. Copies thereof shall be provided to all self-
regulatory organizations of which said broker or dealer is a member.''
The Commission proposed to delete this paragraph because the same
provisions are in paragraph (d)(6) of Rule 17a-5.\459\ The Commission
received no comments on this proposal and is deleting paragraph (b)(6)
of Rule 17a-5 as proposed.
---------------------------------------------------------------------------

    \459\ See Broker-Dealer Reports, 76 FR at 37593. As discussed
above in section II.B.6. of this release, the Commission is amending
paragraph (d)(6) of Rule 17a-5 to require that a copy of a broker-
dealer's annual report must be filed with SIPC. Specifically, the
Commission is amending paragraph (d)(6) to provide that a broker-
dealer's annual reports ``must be filed at the regional office of
the Commission for the region in which the broker or dealer has its
principal place of business, the Commission's principal office in
Washington, DC, the principal office of the designated examining
authority for the broker or dealer, and with the Securities Investor
Protection Corporation (`SIPC') if the broker or dealer 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 the self-regulatory organization by rule waives this
requirement.''
---------------------------------------------------------------------------

ii. Deletion of Provisions Relating to the Year 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
with respect to a broker-dealer's readiness for the year 2000 and any
potential problems that could arise with the advent of the new
millennium.\460\ Form BD-Y2K was required to be filed in April 1999 and
only then. In the proposing release, the Commission proposed to delete
paragraph (e)(5) of Rule 17a-5 in its entirety because the provisions
of that paragraph are now moot.\461\ The Commission received no
comments on this proposal and is deleting paragraph (e)(5) of Rule 17a-
5 as proposed.
---------------------------------------------------------------------------

    \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.
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iii. Deletion of Paragraph (i)(5) of Rule 17a-5
    In the proposing release, the Commission proposed to delete
paragraph (i)(5) of Rule 17a-5, which, before today's amendments,
provided that ``the terms audit (or examination), accountant's report,
and certified shall have the meanings given in Sec.  210.1-02 of this
chapter.'' \462\ The Commission received no comments on this proposal
and is deleting paragraph (i)(5) of Rule 17a-5 as proposed.
---------------------------------------------------------------------------

    \462\ Id. at 37594.
---------------------------------------------------------------------------

iv. Amendments to Paragraph (f)(2) of Rule 17a-5
    Before today's amendments, paragraph (f)(2) of Rule 17a-5 provided
that a broker-dealer that was required to file an annual audit report
must file a statement with the Commission and its DEA that it has
designated an independent public accountant responsible for performing
the annual audit of the broker-dealer, which was called ``Notice
pursuant to Rule 17a-5(f)(2)''.\463\ Paragraph (f)(2)(iii) of Rule 17a-
5 prescribed the items that were required 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 the audit date of the broker-dealer for the year covered by
the agreement.\464\
---------------------------------------------------------------------------

    \463\ See 17 CFR 240.17a-5(f)(2).
    \464\ See 17 CFR 240.17a-5(f)(2)(iii)(A)-(C).
---------------------------------------------------------------------------

    In addition to the proposed amendments discussed below in section
III. of this release, the Commission proposed certain technical
amendments to paragraph (f)(2) of Rule 17a-5.\465\ First, the
Commission proposed amending the language in paragraph (f)(2)(i) of
Rule 17a-5 to streamline the paragraph and to add a reference to
proposed paragraph (f)(2)(ii) of Rule 17a-5, which would have
prescribed the information a broker-dealer would have been required to
include in its notice designating its accountant. In addition, the
Commission proposed to amend paragraph (f)(2)(i) of Rule 17a-5 to
require that a broker-dealer include a statement in its notice as to
whether the engagement with its independent public accountant was for a
single year or was of a continuing nature. This statement was
previously required by paragraph (f)(2)(ii) of Rule 17a-5, which the
Commission proposed to delete as part of its revisions to that
paragraph. The Commission did not receive any comments on these
proposed changes and is adopting them as proposed. The Commission also
proposed to retain the annual December 10 filing deadline for the
statements provided pursuant to paragraph (f)(2), but also added the
language ``(or 30 calendar days after the effective date of its
registration as a broker or dealer, if earlier).'' The Commission did
not receive any comments on this amendment and is adopting it as
proposed. In addition, the final rule adds a conforming change to the
date of the statement designating the independent public accountant.
Under the proposal, the statement must be dated ``no later than
December 1.'' Under the final rules, the statement must be dated ``no
later than December 1 (or 20 calendar days after the effective date of
its registration as a broker or dealer, if earlier)'' to make the
timing consistent with the filing deadlines described above.
---------------------------------------------------------------------------

    \465\ See Broker-Dealer Reports, 76 FR at 37583-37584, 37605-
37606.
---------------------------------------------------------------------------

    As discussed in the proposing release, notices pursuant to
paragraph (f)(2) of Rule 17a-5 currently on file with the Commission do
not contain the representations that are required by the amendments to
paragraph (f)(2) that the Commission is adopting today. Accordingly,
broker-dealers subject to paragraph (f)(2) of Rule 17a-5 (i.e., all
broker-dealers that are required to file audited annual reports) must
file a new ``statement regarding the independent

public accountant under Rule 17a-5(f)(2).'' \466\ As specified in the
new rule, if the engagement covered by the new statement is of a
continuing nature, no subsequent filing would be required unless and
until the broker-dealer changes its independent public accountant or
amends the engagement with the accountant.\467\
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    \466\ See paragraph (f)(2) of Rule 17a-5.
    \467\ See paragraph (f)(2)(i) of Rule 17a-5.
---------------------------------------------------------------------------

v. Further Technical Amendments
    In the proposing release, the Commission proposed additional
technical amendments to Rule 17a-5, including changes that would
consistently use the term ``independent public accountant'' throughout
Rule 17a-5 when referring to a broker-dealer's accountant,\468\ to make
the rule gender neutral,\469\ and to replace the term ``balance sheet''
with the term ``Statement of Financial Condition'' in all places where
that term appeared in Rule 17a-5.\470\ These technical amendments were
designed to modernize the language of Rule 17a-5, and to make the rule
easier to understand. The Commission received no comments on these
amendments and is adopting them as proposed.
---------------------------------------------------------------------------

    \468\ See Broker-Dealer Reports, 76 FR at 37594.
    \469\ Id.
    \470\ Id. at 37593.
---------------------------------------------------------------------------

    The Commission is making further technical amendments that are
consistent with the Commission's ``plain English'' initiative and do
not substantively affect the requirements of Rule 17a-5.\471\ In
addition, for clarity and consistency throughout Rule 17a-5, the
Commission is amending Rule 17a-5 to replace the words ``date selected
for the annual audit of financial statements'' that were previously
contained in paragraphs (a)(2)(ii) and (iii) of Rule 17a-5 with the
words ``end of the fiscal year of the broker or dealer.'' \472\ The
phrase ``date selected for the annual audit of the financial
statements'' has the same meaning as the phrase ``end of the fiscal
year of the broker or dealer.'' As discussed earlier, this change
eliminates outdated language and conforms the text in paragraph (a) of
Rule 17a-5 to the text in paragraph (n) of Rule 17a-5. The Commission
is making a technical amendment to paragraph (a)(3) of Rule 17a-5. As
proposed, paragraph (a)(3) provided that the reports required under
paragraph (a) of Rule 17a-5 were considered filed when received at the
Commission's principal office and the regional office of the Commission
where the broker-dealer has its principal place of business. However,
Form Custody, which broker-dealers must file under paragraph (a)(5) of
Rule 17a-5, as amended, must be filed with the broker-dealer's DEA and
not with the Commission. The Commission is therefore amending paragraph
(a)(3) of Rule 17a-5 to clarify that this provision applies to reports
``that must be filed with the Commission.'' As a result, the Commission
is making technical amendments to paragraphs (a)(2)(i) through
(a)(2)(iv) of Rule 17a-5 to specify that the FOCUS Reports required
under these provisions must be filed with the Commission.
---------------------------------------------------------------------------

    \471\ These amendments replace the term ``shall'' with ``must,''
the term ``pursuant to'' with ``under,'' the term ``said'' with
``the'' or ``that,'' the term ``such'' with ``the'' or ``that,'' the
term ``other than'' with ``not,'' and the term ``therewith'' with
``with the.''
    \472\ For example, 17 CFR 240.17a-5(a)(5), (d)(3)(i)(B), and
(d)(5) each refer to the ``end of the fiscal year of the broker or
dealer.''
---------------------------------------------------------------------------

    The Commission also is making technical amendments to paragraph
(m)(1) of Rule 17a-5, which relates to extensions and exemptions for
filing annual reports, and (n)(2) of Rule 17a-5, which relates to a
broker-dealer's notification requirements when changing its fiscal
year, to replace the words ``annual audit reports'' and ``audit
report,'' respectively, with the words ``annual reports.'' The
Commission also is deleting an unnecessary citation to paragraph
(d)(1)(i) of Rule 17a-5 that was previously included in paragraph
(n)(2) of Rule 17a-5.

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

1. Background
    The amendments to Rule 17a-5 that the Commission is adopting today
will permit carrying broker-dealers that either also are registered as
investment advisers or maintain client assets of an affiliated
investment adviser and are subject to the internal control report
requirement in Rule 206(4)-2 to satisfy that requirement with a report
prepared by the broker-dealer's independent public accountant based on
an examination of certain of the broker-dealer's statements in the
compliance report.
2. Rule 206(4)-2
    Rule 206(4)-2 provides that a registered investment adviser is
prohibited from maintaining custody of client funds or securities
unless a ``qualified custodian'' maintains those funds and securities:
(1) In a separate account for each client under that client's name; or
(2) in accounts that contain only the investment adviser's clients'
funds and securities, under the investment adviser's name as agent or
trustee for the clients.\473\ Under Rule 206(4)-2, only banks, certain
savings associations, registered broker-dealers, FCMs, and certain
foreign financial institutions may act as qualified custodians.\474\
---------------------------------------------------------------------------

    \473\ See 17 CFR 275.206(4)-2(a)(1)(i)-(ii).
    \474\ See 17 CFR 275.206(4)-2(d)(6).
---------------------------------------------------------------------------

    In addition, when an investment adviser or its related person
maintains client funds and securities as qualified custodian in
connection with advisory services provided to clients, the adviser
annually must obtain, or receive from its related person, a written
internal control report prepared by an independent public accountant
registered with, and subject to regular inspection by, the PCAOB.\475\
This report must be supported by the independent public accountant's
examination of the qualified custodian's custody controls.\476\
---------------------------------------------------------------------------

    \475\ Id.
    \476\ Rule 206(4)-2 provides that the internal control report
must include an opinion of an independent public accountant as to
whether controls have been placed in operation as of a specific
date, and are suitably designed and are operating effectively to
meet control objectives relating to custodial services, including
the safeguarding of funds and securities held by either the adviser
or its related person on behalf of advisory clients, during the
year. The rule also requires that the accountant ``verify that the
funds and securities are reconciled to a custodian other than [the
adviser or its] related person.'' See 17 CFR 275.206(4)-2.
---------------------------------------------------------------------------

    The Commission has issued guidance identifying the control
objectives that should be included in the scope of the internal control
examination required under Rule 206(4)-2.\477\ The control objectives
for the Rule 206(4)-2 examination are more general than the specific
operational requirements in the

financial responsibility rules.\478\ This approach allows different
types of qualified custodians (banks, certain savings associations,
broker-dealers, FCMs, and certain foreign financial institutions) to
establish controls and procedures that meet the identified control
objectives in a manner that reflects differences in business models,
regulatory requirements, and other factors.\479\
---------------------------------------------------------------------------

    \477\ See Commission Guidance Regarding Independent Public
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the
Investment Advisers Act of 1940, Advisers Act Release No. 2969 (Dec.
30, 2009), 75 FR 1492 (Jan. 11, 2010) (identifying the following
specified objectives: (1) Documentation for the opening and
modification of client accounts is received, authenticated, and
established completely, accurately, and timely on the applicable
system; (2) client transactions, including contributions and
withdrawals, are authorized and processed in a complete, accurate,
and timely manner; (3) trades are properly authorized, settled, and
recorded completely, accurately, and timely in the client account;
(4) new securities and changes to securities are authorized and
established in a complete, accurate and timely manner; (5)
securities income and corporate action transactions are processed to
client accounts in a complete, accurate, and timely manner; (6)
physical securities are safeguarded from loss or misappropriation;
(7) cash and security positions are reconciled completely,
accurately and on a timely basis between the custodian and
depositories; and (8) account statements reflecting cash and
security positions are provided to clients in a complete, accurate
and timely manner).
    \478\ Compare the control objectives described in Commission
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 the requirements in 17 CFR
240.15c3-1, 17 CFR 240.15c3-3, 17 CFR 240.17a-13, and the DEA
Account Statement Rules.
    \479\ See Broker-Dealer Reports, 76 FR at 37580.
---------------------------------------------------------------------------

3. Broker-Dealers Acting as Qualified Custodians Under Rule 206(4)-2
    Broker-dealers that also are registered as investment advisers may,
acting in their capacity as broker-dealers, maintain client securities
and funds as qualified custodians in connection with advisory services
provided to clients.\480\ As a result of being the adviser and
qualified custodian to its clients, under Rule 206(4)-2 these broker-
dealers must obtain an internal control report relating to the custody
of those assets from an independent public accountant that is
registered with, and subject to regular inspection by, the PCAOB. In
addition, broker-dealers acting as qualified custodians also may
maintain advisory client assets in connection with advisory services
provided by related or affiliated investment advisers. Rule 206(4)-2
requires such a broker-dealer to provide an internal control report to
its related investment adviser.\481\
---------------------------------------------------------------------------

    \480\ The Commission staff has estimated that approximately 18%
of FINRA-registered broker-dealers also are registered as investment
advisers with the Commission or with a state. See Commission staff,
Study on Investment Advisers and 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 data collected
from the Investment Adviser Registration Depository as of August
2012, close to 200 investment advisers reported on Form ADV that
client assets were being held at a qualified custodian that was
related to the adviser.
---------------------------------------------------------------------------

4. Proposal to Allow Report Based on Examination of Compliance Report
to Satisfy Rule 206(4)-2
i. The Proposal
    Broker-dealers that maintain custody of customer funds and
securities are subject to specific operational requirements in the
financial responsibility rules with respect to handling and accounting
for customer assets.\482\ The operational requirements of the financial
responsibility rules are consistent with the control objectives
outlined in the Commission's guidance on Rule 206(4)-2.\483\ As a
result of the proposed amendments to Rule 17a-5, the Commission stated
in the proposing release that a broker-dealer subject to an examination
by an independent public accountant of its compliance report that also
acts as a qualified custodian for itself as an investment adviser or
for its related investment advisers under Rule 206(4)-2 would be able
to use the independent public accountant's report resulting from the
examination to satisfy the internal control report requirement under
Rule 206(4)-2.\484\
---------------------------------------------------------------------------

    \482\ While Rule 15c3-1 prescribes broker-dealer net capital
requirements, it also contains provisions relating to custody. For
example, a broker-dealer must take net capital charges for short
security differences unresolved after specifically enumerated
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
Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment
Advisers Act of 1940, 75 FR at 1493-1494.
    \484\ See Broker-Dealer Reports, 76 FR at 37579-37580.
---------------------------------------------------------------------------

ii. Comments on the Proposal
    The Commission received several comments regarding the proposal
that the independent public accountant's report based on an examination
of the compliance report would satisfy the internal control report
under Rule 206(4)-2. One commenter stated that it is ``critically
important'' that there be a single independent public accountant
engagement of the custody function at both the broker-dealer and
investment adviser operations of any dually registered entity (or of
affiliated broker-dealers and investment advisers) and that this
engagement use a single, consistent standard for evaluating custody at
both the broker-dealer and investment adviser operations.\485\ Two
commenters noted that there are non-carrying broker-dealers that act as
qualified custodians under the Advisers Act and that these broker-
dealers would not be subject to the proposed compliance report
requirements and, consequently, would not be able to use the report of
the independent public accountant covering the compliance report to
satisfy the internal control report requirement in Rule 206(4)-2
because the broker-dealers would be filing exemption reports instead of
compliance reports.\486\ One commenter characterized this as an area of
redundancy that could be eliminated by allowing an accountant's review
of a non-carrying broker-dealer's transmittal procedures to be
``recognized by the Investment Adviser regulatory regime promulgated by
the Commission.'' \487\
---------------------------------------------------------------------------

    \485\ See CFP Letter.
    \486\ See CAI Letter; Deloitte Letter.
    \487\ See Deloitte Letter.
---------------------------------------------------------------------------

    In addition, two commenters asked for clarification regarding the
interaction of the proposed compliance report requirements with the
requirement in Rule 206(4)-2 that investment advisers undergo an annual
surprise examination by an independent accountant to verify customer
funds and securities held in custody.\488\ Specifically, both asked
that the Commission clarify whether the independent public accountant
performing the surprise examination would be able to place reliance on
the proposed compliance report and related compliance examination to
determine the nature and extent of the procedures for the surprise
examination.\489\ One of the commenters also asked that, if the
Commission clarifies that the independent public accountant performing
the surprise examination is expected to rely on the proposed compliance
report requirements, what factors should the independent public
accountant consider, given that the report based on an examination of
the compliance report would not be required to be completed until 60
days after the fiscal year end while the surprise examination may occur
at any time.\490\
---------------------------------------------------------------------------

    \488\ See CAQ Letter; PWC Letter. Paragraph (a)(4) of Rule
206(4)-2 requires, among other things, that client funds and
securities of which an investment adviser has custody must be
verified by actual examination at least once during each calendar
year by an independent public accountant, pursuant to a written
agreement between the investment adviser and the accountant, at a
time that is chosen by the accountant without prior notice or
announcement to the investment adviser and that is irregular from
year to year. See 17 CFR 275.206(4)-2.
    \489\ See CAQ Letter; PWC Letter.
    \490\ See PWC Letter.
---------------------------------------------------------------------------

5. Adoption of Proposal Relating to Rule 206(4)-2
    As discussed above, under today's amendments, a carrying broker-
dealer must prepare, and file with the Commission and its DEA, a
compliance report on, among other things, its Internal Control Over
Compliance, and must file with the compliance report a report prepared
by its independent public accountant based on an examination of the
compliance report.\491\ As a result of the amendments to Rule 17a-5,
the Commission has determined that the independent public accountant's
report based on an examination of the compliance report

will satisfy the internal control report requirement under Rule 206(4)-
2 because the operational requirements of the financial responsibility
rules are consistent with the control objectives outlined in the
Commission's guidance on Rule 206(4)-2.\492\ For example, to be able to
include a statement that the broker-dealer has established and
maintained Internal Control Over Compliance (which is defined as
internal controls that have the objective of providing the broker-
dealer with reasonable assurance that non-compliance with the financial
responsibility rules will be prevented or detected on a timely
basis),\493\ a broker-dealer's internal control over compliance with
Rule 17a-13 will result in controls over the safeguarding of securities
from loss or misappropriation and the completeness, accuracy, and
timeliness of the securities reconciliation process.\494\ To make a
similar statement with respect to the Account Statement Rules, a
broker-dealer would of necessity have internal controls over compliance
with the Account Statement Rules designed to ensure that customers
receive complete, accurate, and timely information concerning
securities positions and other assets held in their accounts.\495\ A
statement that the broker-dealer has established and maintained
Internal Control Over Compliance would cover these and other internal
controls over compliance with the financial responsibility rules and
would be examined by the independent public accountant during the
examination of the compliance report.
---------------------------------------------------------------------------

    \491\ See 17 CFR 240.17a-5(d)(3) and (g)(2)(i).
    \492\ See Commission Guidance Regarding Independent Public
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the
Investment Advisers Act of 1940, 75 FR at 1494; Broker-Dealer
Reports, 76 FR at 37579-37580. As discussed above in section II.D.3.
of this release, the independent public accountant must examine the
compliance report in accordance with attestation standards
promulgated by the PCAOB. Consequently, the PCAOB's attestation
standards are integral to the Commission's determination that the
independent public accountant's report based on an examination of
the compliance report satisfies the internal control report
requirement under Rule 206(4)-2. The Commission could revisit this
determination if the PCAOB's attestation standards 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 in section
II.D.3. of this release, the PCAOB proposed attestation standards
related to the compliance report. The PCAOB's proposed attestation
standards include a requirement that the independent public
accountant must perform procedures to obtain evidence about the
existence of customer funds or securities held for customers, e.g.,
confirmation of customer security positions directly with
depositories and clearing organizations. See PCAOB Proposing Release
app. 1, at ] 26. This procedure would be consistent with the tests
of the qualified custodian's reconciliation that the Commission
specified in the guidance on Rule 206(4)-2. See Commission 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
Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment
Advisers Act of 1940, Advisers Act Release No. 2969 (Dec. 30, 2009),
75 FR 1494 (Jan. 11, 2010), which describes as a control objective
for qualified custodians (including broker-dealer qualified
custodians) that account statements reflecting cash and security
positions are provided to clients in a complete, accurate and timely
manner.
---------------------------------------------------------------------------

    As commenters noted, broker-dealers that are not carrying broker-
dealers are not subject to the compliance report requirements and,
therefore, those broker-dealers must comply with the internal control
report requirement in Rule 206(4)-2 if they are subject to that
requirement. The exemption report is not redundant of the internal
control report requirement in Rule 206(4)-2 because, among other
things, the scope of the required statements included in a broker-
dealer's exemption report is different than the scope of the internal
control report requirement in Rule 206(4)-2.\496\
---------------------------------------------------------------------------

    \496\ See supra notes 299, 300.
---------------------------------------------------------------------------

    As noted above, commenters also asked whether the accountant would
be able to place reliance on the proposed compliance report and related
examination of the compliance report to determine the nature and extent
of the procedures for the surprise examination. PCAOB attestation
standards require an independent public accountant ``to obtain an
understanding of internal control over compliance sufficient to plan
the engagement and to assess control risk for compliance with specified
requirements.'' \497\ The Commission agrees that the independent public
accountant's understanding of internal controls related to custody at
the broker-dealer acting as a qualified custodian, as well as other
facts and circumstances, may affect the nature and extent of procedures
performed for the annual surprise examination.\498\ The Commission has
provided interpretive guidance on the relationship between the annual
surprise examination and the internal control report for engagements
performed pursuant to Rule 206(4)-2.\499\
---------------------------------------------------------------------------

    \497\ See PCAOB Interim Attestation Standard, AT Section 601. AT
Section 601 requires an independent public accountant ``to obtain an
understanding of internal control over compliance sufficient to plan
the engagement and to assess control risk for compliance with
specified requirements. In planning the examination, such knowledge
should be used to identify types of potential non-compliance, to
consider factors that affect the risk of material noncompliance, and
to design appropriate tests of compliance.'' Id. at ] .45.
    \498\ Id.
    \499\ See Commission Guidance Regarding Independent Public
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the
Investment Advisers Act of 1940, Advisers Act Release No. 2969 (Dec.
30, 2009), 75 FR 1492 (Jan. 11, 2010).
---------------------------------------------------------------------------

III. Access to Accountant and Audit Documentation

    The Commission proposed amending paragraph (f)(2) of Rule 17a-5 to
require that each clearing broker-dealer \500\ include a representation
in its statement regarding its independent public accountant that the
broker-dealer agrees to allow Commission and DEA examination staff to
review the audit documentation associated with its annual audit reports
required under Rule 17a-5 and to allow its independent public
accountant to discuss findings relating to the audit reports with
Commission and DEA examination staff if requested for the purposes of
an examination of the broker-dealer.\501\ This proposed requirement was
intended to facilitate examinations of clearing broker-dealers by
Commission and DEA examination staff.\502\ Access to information
obtained from audit documentation and discussions with a clearing
broker-dealer's independent public accountant would enhance the
efficiency and effectiveness of Commission and DEA examinations by
providing examiners with access to additional relevant information to
plan their examinations.\503\
---------------------------------------------------------------------------

    \500\ For the purpose of this release, a ``clearing broker-
dealer'' is a broker-dealer that clears transactions or carries
customer accounts.
    \501\ See Broker-Dealer Reports, 76 FR at 37583-37584.
    \502\ Id.
    \503\ For example, where an independent public accountant has
performed extensive testing of a carrying broker-dealer's custody of
funds and securities by confirming holdings at custodians and sub-
custodians, examiners could focus their efforts on other matters
that had not been the subject of prior testing and review.
---------------------------------------------------------------------------

    The Commission proposed to limit this requirement to clearing
broker-dealers, which generally have more complex business operations
than non-carrying firms.\504\ Thus, access to accountants and audit
documentation was considered of substantially greater value when
preparing for regulatory examinations of these types of broker-dealers,
as compared to firms with more limited business models.
---------------------------------------------------------------------------

    \504\ See Broker-Dealer Reports, 76 FR at 37583.
---------------------------------------------------------------------------

    To facilitate Commission and DEA examination staff access to a
clearing broker-dealer's independent public accountant and the
accountant's audit documentation, the Commission proposed amending
paragraph (f)(2) of

Rule 17a-5 to require that a clearing broker-dealer's notice
designating its independent public accountant include, among other
things, representations: (1) That the broker-dealer agrees to allow
representatives of the Commission or the broker-dealer's DEA, if
requested for purposes of an examination of the broker-dealer, to
review the documentation associated with the reports of its independent
public accountant prepared pursuant to paragraph (g) of Rule 17a-5; and
(2) that the broker-dealer agrees to permit its independent public
accountant to discuss with representatives of the Commission and the
DEA, if requested for the purposes of an examination of the broker-
dealer, the findings associated with the reports of the accountant
prepared pursuant to paragraph (g) of Rule 17a-5.\505\ Proposed
paragraph (f)(2)(iii) of Rule 17a-5 provided that a broker-dealer that
does not clear transactions or carry customer accounts would not be
required to include these representations in its notice.\506\
---------------------------------------------------------------------------

    \505\ Id.
    \506\ Id.
---------------------------------------------------------------------------

    Eight commenters addressed the proposed changes to paragraph (f)(2)
of Rule 17a-5.\507\ Generally, commenters requested that the Commission
do one or more of the following: (1) Clarify the type of documentation
that the Commission and DEA examiners would seek to access \508\; (2)
grant confidential treatment to documentation obtained by the
Commission under this provision \509\; (3) clarify the process by which
Commission and DEA examiners would seek access to a broker-dealer's
independent public accountant and its audit documentation \510\; and
(4) limit the use of information and documentation obtained from a
broker-dealer's independent public accountant.\511\ In addition, one
commenter raised general concerns that providing Commission and DEA
examiners with access to a broker-dealer's auditor and audit
documentation will discourage communications between broker-dealers and
their auditors and may require auditors to produce documentation
protected by attorney-client and/or accountant-client privilege.\512\
Finally, one commenter asserted that it is reasonable for securities
regulators to be able to validate any concerns promptly with a broker-
dealer's accountant.\513\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    In response to requests for clarity as to the types of audit
documentation that Commission and DEA examiners would seek to access
under the proposal, the Commission revised proposed paragraph
(f)(2)(ii)(F) of Rule 17a-5 to clarify that ``audit documentation'' has
the meaning established by PCAOB standards.\514\ This revision, which
was specifically suggested by two commenters,\515\ is not intended to
alter an independent public accountant's obligations with respect to
audit documentation; rather, it is intended to clarify the types of
audit documentation that the Commission and DEA examiners may ask to
review in connection with a broker-dealer examination.
---------------------------------------------------------------------------

    \514\ PCAOB Auditing Standard 3 defines ``Audit documentation''
as the ``written record of the basis for the auditor's conclusions
that provides the support for the auditor's representations, whether
those representations are contained in the auditor's report or
otherwise. Audit documentation also facilitates the planning,
performance, and supervision of the engagement, and is the basis for
the review of the quality of the work because it provides the
reviewer with written documentation of the evidence supporting the
auditor's significant conclusions. Among other things, audit
documentation includes records of the planning and performance of
the work, the procedures performed, evidence obtained, and
conclusions reached by the auditor. Audit documentation also may be
referred to as work papers or working papers.''
    \515\ See CAQ Letter; KPMG Letter.
---------------------------------------------------------------------------

    In response to questions regarding the process by which Commission
and DEA examiners might seek to access audit documentation, the
Commission agrees with a commenter that suggested that these requests
be in writing because that will provide independent public accountants
with a record of requests for information and specify the documentation
the Commission or DEA examination staff would like to access.\516\
Therefore, the Commission has modified the rule from the proposal to
provide that a request to a broker-dealer's independent public
accountant for the accountant to discuss audit findings or for access
to audit documentation be made in writing.
---------------------------------------------------------------------------

    \516\ See KPMG Letter. See also Deloitte Letter, which suggests
that Commission and DEA examiners first provide notice to the
broker-dealer, in writing, of plans to request access to the broker-
dealer's audit documentation and then make a written request to the
accountant. Although, in practice, Commission and DEA examiners may
provide advance or simultaneous notice to a broker-dealer of
requests to access audit documentation from the broker-dealer's
accountant, the Commission is not adopting a requirement that
examiners so notify broker-dealers of such requests. This additional
notification would likely delay an examiner's ability to gain access
to the broker-dealer's audit documentation and is not necessary
given the broker-dealer's prior consent. In addition, a broker-
dealer can request that its accountant provide notice when examiners
request audit documentation, and, expects that, in practice,
accountants will provide such notice. See also E&Y Letter.
---------------------------------------------------------------------------

    Independent public accountants can seek to protect information
obtained by examiners from being disclosed to Freedom of Information
Act (``FOIA'') requestors by specifically requesting confidential
treatment of audit documentation following the process described in
Rule 83 of the Commission's Rules on Information and Requests.\517\ The
Commission anticipates that it will accord confidential treatment to
such documents to the extent permitted by law.\518\
---------------------------------------------------------------------------

    \517\ 17 CFR 200.83. Generally, persons who submit information
to the Commission may request that the Commission accord
confidential treatment to the information for any reason permitted
by federal law.
    \518\ The Commission believes that this audit documentation
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).
---------------------------------------------------------------------------

    Two commenters requested that the Commission clarify the intended
use of information and documents obtained from an independent public
accountant.\519\ One recommended that the Commission clarify that the
information obtained from the independent public accountant not be used
for any purpose other than in connection with a regulatory examination
of the broker-dealer.\520\ The other suggested that the rule text state
that the requests for information should be solely for the purposes of
conducting a regulatory examination of the clearing broker-dealer.\521\
The Commission does not believe that it is necessary to modify the
proposed rule text in response to these comments. The Commission stated
that it did not propose that examiners would use the requested
information for the purpose of inspecting independent public
accountants.\522\ As the Commission stated in the proposing release,
the purpose of this access requirement is to enhance and improve the
efficiency and effectiveness of Commission and DEA examinations of
broker-dealers.\523\ The PCAOB is responsible for inspections of
independent public accountants that audit broker-dealers.\524\ In
response to these comments, the Commission reiterates its intention, as
stated in the proposing release, that any requests for

audit documentation under this provision would be made exclusively in
connection with conducting a regulatory examination of a broker-
dealer.\525\
---------------------------------------------------------------------------

    \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.
    \525\ Id.
---------------------------------------------------------------------------

    One commenter stated that Commission and DEA examiners should be
limited to inspecting audit documentation relating to a broker-dealer
in the offices of the broker-dealer's independent public accountant and
that the broker-dealer should be permitted to be present during
conversations between Commission or DEA staff and the accountant.\526\
The Commission has considered these comments and decided not to modify
the proposal in response to these comments. However, Commission and DEA
examiners may exercise discretion in determining whether to review
audit documentation in the offices of the broker-dealer's accountant
and whether to permit the broker-dealer to be present during
conversations with the accountant. This commenter also requested that
the Commission establish a process by which broker-dealers can object
to overly broad or unduly burdensome requests.\527\ The rule will not
be modified in response to this comment and the Commission recommends
that any concerns regarding the scope of audit documentation requests
be directed to the examiner from whom the request was received. The
examiner will consider the concerns and determine whether and how to
limit the scope of the audit documentation request, if appropriate. The
independent public accountant also can express concerns to senior
examination staff if the scope of the audit documentation request
remains a concern after discussions with the examiner.
---------------------------------------------------------------------------

    \526\ See SIFMA Letter.
    \527\ Id.
---------------------------------------------------------------------------

    Another commenter stated that the Commission must be responsible
for returning all audit work papers that it receives for purposes of an
examination of the broker-dealer to either the broker-dealer or its
accountant.\528\ The purpose of requesting access to audit
documentation is to assist examiners in conducting a regulatory
examination of the clearing broker-dealer. Upon completion of the
examination, if the Commission and DEA, and any offices and divisions
thereof, no longer need the audit documentation, the Commission and DEA
will, upon the request of the independent public accountant and in the
absence of unusual circumstances, return audit documentation to the
independent public accountant or the broker-dealer within a reasonable
time after the examination is complete.
---------------------------------------------------------------------------

    \528\ See CAI Letter.
---------------------------------------------------------------------------

    One commenter stated that, if adopted, this requirement will
discourage or ``chill'' communications between a broker-dealer and its
auditor because ``the broker-dealer knows that regardless of the nature
of an auditing issue and how it was discovered . . . it cannot freely
seek advice from, or discuss the issue openly with[] the auditor[]
without fear of the auditor misunderstanding the broker-dealer's
response or simply drawing a conclusion that a broker-dealer's
questions indicate the broker-dealer's lack of knowledge or admission
of an issue.'' \529\ Presumably, this ``chilling effect'' would result
from a broker-dealer's desire to avoid the creation of audit
documentation memorializing misunderstandings and miscommunications,
which, when accessed by Commission and DEA examiners, could result in
regulatory scrutiny. The Commission is not persuaded by this comment;
while it is possible for miscommunications to occur between
representatives of a broker-dealer and its auditor, potential
misunderstandings or miscommunications should not limit the ability of
the Commission or a DEA to have access to audit documentation or a
broker-dealer's independent public accountant. Further, to the extent a
misunderstanding or miscommunication between a broker-dealer and its
accountant is reflected in the accountant's audit documentation
relating to the broker-dealer, the broker-dealer could clarify the
nature of the misunderstanding or miscommunication to examiners and
explain how it was rectified if such clarification and rectification is
not already described in subsequent audit documentation.
---------------------------------------------------------------------------

    \529\ Id.
---------------------------------------------------------------------------

    The same commenter also asserted that the requirement that broker-
dealers allow regulators to access audit documentation may, in effect,
require auditors to produce documentation protected by attorney-client
privilege or accountant-client privilege.\530\ The rule language
providing Commission and DEA examiners with access to a broker-dealer's
auditor and audit documentation is not designed to affect the
circumstances in which privilege can be asserted. Any claims of
privilege can be addressed on a case-by-case basis by appropriate
Commission and DEA staff as those claims arise.
---------------------------------------------------------------------------

    \530\ Id.
---------------------------------------------------------------------------

IV. Form Custody

A. Background

    Proposed Form Custody was comprised of nine line items (each, an
``Item'') designed to elicit information about a broker-dealer's
custodial activities.\531\ As is discussed below, several Items on the
proposed form contained multiple questions, and some required the
completion of charts and the disclosure of custody-related information
specific to the broker-dealer completing the form.\532\
---------------------------------------------------------------------------

    \531\ See Broker-Dealer Reports, 76 FR at 37584-37592.
    \532\ Id.
---------------------------------------------------------------------------

    The Commission received nine comment letters on proposed Form
Custody.\533\ While commenters generally supported the proposed form,
the Commission received several comments on the timing of, exemptions
from, and the compliance date for filing the form and whether a broker-
dealer also would be required to file an accountant's attestation
covering the form.\534\ In addition, several commenters suggested that
the Commission make certain revisions to the form and address certain
technical interpretative questions.\535\ One commenter, who agreed ``in
concept'' that Form Custody is appropriate for custodial broker-
dealers, also stated that the aggregate cost estimate of the proposed
form was ``staggering.'' \536\
---------------------------------------------------------------------------

    \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 costs associated with Form Custody.
See section VII. below for an economic analysis of the costs and
benefits relating to Form Custody.
---------------------------------------------------------------------------

    The Commission is adopting the requirement that broker-dealers file
Form Custody with their DEAs, subject to modifications that, in part,
respond to issues raised by commenters. A description of the comments
on the proposed process for filing Form Custody is set forth below in
section IV.B. of this release, together with a discussion of the final
rule amendments that the Commission is adopting today. A description of
the comments on the proposed form is set forth below in section IV.C.
of this release, together with a discussion of the final form the
Commission is adopting today.

B. Filing of Form Custody

1. Requirement to File Form Custody with FOCUS Reports
    Under paragraph (a) of Rule 17a-5, a broker-dealer is required to
file periodic

FOCUS Reports with the Commission and the broker-dealer's DEA.\537\ In
the proposing release, the Commission proposed adding paragraph (a)(5)
to Rule 17a-5 to require the filing of Form Custody, which was designed
to elicit information concerning whether a broker-dealer maintained
custody of customer and non-customer assets, and, if so, how such
assets were maintained.\538\ Under this proposed amendment, a broker-
dealer would be required to file Form Custody with its DEA at the same
time it filed its periodic FOCUS Report with its DEA under paragraph
(a) of Rule 17a-5.\539\ The DEA, in turn, would be required to maintain
the information obtained through the filing of Form Custody and to
transmit such information to the Commission at such time as it
transmits FOCUS Report data to the Commission under paragraph (a)(4) of
Rule 17a-5.\540\
---------------------------------------------------------------------------

    \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
condition of broker-dealers and enforcing the broker-dealer
financial responsibility rules. The completed forms also are used to
determine which firms are engaged in various securities-related
activities and how economic events and government policies might
affect various segments of the securities industry. The FOCUS Report
was designed to eliminate overlapping regulatory reports required by
various SROs and the Commission and to reduce reporting burdens as
much as possible. FOCUS Reports and Form Custody are deemed
confidential under paragraph (a)(3) of Rule 17a-5.
    \538\ See Broker-Dealer Reports, 76 FR at 37592. For purposes of
Form Custody, the term ``customer'' means a person that is a
``customer'' for purposes of Rule 15c3-3(a), and a ``non-customer''
means a person other than a ``customer'' as that term is defined 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, available at
http://www.finra.org/Industry/Regulation/Guidance/FOR/.
    \539\ See Broker-Dealer Reports, 76 FR at 37592.
    \540\ Id.
---------------------------------------------------------------------------

    A broker-dealer's FOCUS Report provides the Commission and a
broker-dealer's DEA with information relating to the broker-dealer's
financial and operational condition but does not solicit detailed
information on how a broker-dealer maintains custody of assets.\541\
Proposed Form Custody was intended to provide additional information
about a broker-dealer's custodial activities and to make it easier for
examiners to identify risks and possible violations of laws and
regulations concerning the broker-dealer's custody of assets.\542\ If,
upon reviewing Form Custody, regulatory authorities were to become
aware of inconsistencies or other red flags in information contained on
the form, they could initiate a more focused and detailed analysis of
the broker-dealer's custodial activities. Such an analysis could, in
turn, identify potential abuses related to customer assets. Moreover,
proposed Form Custody was intended to expedite the examination of a
broker-dealer's custodial activities and reduce examination costs, as
examiners would no longer need to request basic custody-related
information already disclosed on the form.\543\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    The Commission proposed that a broker-dealer file Form Custody with
its DEA within 17 business days after the end of each calendar quarter
and within 17 business days after the date selected for the broker-
dealer's annual report where that date was other than the end of a
calendar quarter.\544\ The Commission received one comment regarding
proposed paragraph (a)(5) of Rule 17a-5, which supported the
Commission's proposal as to when a broker-dealer should be required to
file Form Custody.\545\
---------------------------------------------------------------------------

    \544\ Id. at 37592.
    \545\ See Shatto Letter.
---------------------------------------------------------------------------

    The Commission is adopting paragraph (a)(5) of Rule 17a-5
substantially as proposed. As to when a broker-dealer must file its
Form Custody with its DEA, the Commission is adopting its proposal that
a broker-dealer file Form Custody with its DEA within 17 business days
after the end of each calendar quarter.\546\ However, for year end
filings of Form Custody by a broker-dealer that has selected a fiscal
year end date that is not the end of a calendar year, the Commission
has modified its proposal to provide that a broker-dealer also must
file Form Custody with its DEA within 17 business days after the end of
the broker-dealer's fiscal year.\547\
---------------------------------------------------------------------------

    \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 the same time that the broker-
dealer files its FOCUS Report with its DEA. However, since the final
rule changes the date for the filing of the year end FOCUS Report to
``within 17 business days after the end of the fiscal year where
that date is not the end of a calendar quarter,'' the deadline for
the year end filing of Form Custody is correspondingly changed to
``within 17 business days after the end of the fiscal year of the
broker or dealer where that date is not the end of a calendar
quarter.''
---------------------------------------------------------------------------

    The Commission did not receive any comments relating to when DEAs
are required to transmit Form Custody information to the Commission and
is adopting this requirement as proposed.
2. Requests for Exemption From Filing Form Custody
    One commenter recommended that the Commission include a provision
in Rule 17a-5 that would enable the Commission to exempt broker-dealers
from the requirement to file Form Custody if the Commission determined
that receiving the form for a particular firm, or type of firm, would
serve no useful purpose.\548\ For example, the commenter stated that no
useful purpose would be served by receiving Form Custody from a firm
that has no customer or non-customer accounts.\549\
---------------------------------------------------------------------------

    \548\ See CAI Letter.
    \549\ Id.
---------------------------------------------------------------------------

    The Commission intends for all broker-dealers to file Form Custody
without exception. The Commission is concerned about circumstances
where broker-dealers falsely represent to regulators and others that
they do not handle funds or securities or issue trade confirmations or
account statements. One of the purposes of Form Custody is to assist
Commission and DEA examiners in identifying potential
misrepresentations relating to broker-dealers' custody of assets.
Through Form Custody, examiners will be in a position to better
understand a broker-dealer's custody profile and identify custody-
related violations and misconduct. For example, if a broker-dealer
represents on Form Custody that it does not issue account statements,
but an examiner receives an account statement issued by the broker-
dealer (e.g., in connection with a customer complaint or in the course
of an examination of the broker-dealer), the examiner will be able to
react more quickly to the misrepresentation. Further, the requirements
to file the form will promote greater focus and attention to custody
practices by requiring that broker-dealers make specific
representations in this regard.
    In addition, although the Commission does not currently contemplate
any circumstance in which it would exempt a broker-dealer from having
to file Form Custody, if the Commission subsequently determines that it
is appropriate to exempt a broker-dealer, or type of broker-dealer,
from such requirements, the Commission can act under existing
authority. In particular, under section 36 of the Exchange Act, the
Commission, by rule, regulation, or order, may exempt any person, or
any class or classes of persons, from any rule under the Exchange Act
to the extent that such exemption is necessary or appropriate in the
public interest and is consistent with the protection of
investors.\550\
---------------------------------------------------------------------------

    \550\ 15 U.S.C. 78mm.
---------------------------------------------------------------------------

    Nonetheless, the Commission understands that a number of Items on
Form Custody may not apply to certain types of broker-dealers (e.g.,
broker-

dealers that do not carry customer, non-customer, or proprietary
securities accounts) and has modified the form's instructions to make
clear that questions on the form that cannot be answered because the
broker-dealer does not engage in a particular activity do not need to
be answered.\551\
---------------------------------------------------------------------------

    \551\ See General Instruction A to Form Custody.
---------------------------------------------------------------------------

3. Attest Engagement Not Required for Form Custody
    In response to a question posed by the Commission in the proposing
release, one commenter stated that the Commission should not require a
broker-dealer to engage a PCAOB-registered independent public
accountant to audit Form Custody.\552\ This commenter stated that an
audit of Form Custody is not necessary since the intent of the form is
to gather custody-related information, which in some cases may not be
derived from the broker-dealer's books and records.\553\ This commenter
also does not believe that the benefits of performing an audit of the
information included on Form Custody would outweigh the costs or that
an audit is necessary for the Commission to achieve its principal
objective of using the information in the examination of a broker-
dealer's custody activities.\554\
---------------------------------------------------------------------------

    \552\ See KPMG Letter. See also Broker-Dealer Reports, 76 FR at
37592.
    \553\ See KPMG Letter.
    \554\ Id.
---------------------------------------------------------------------------

    The Commission did not propose to require that a broker-dealer
engage an independent public accountant to review Form Custody, and
agrees that such a requirement should not be imposed. Accordingly,
under today's amendments, broker-dealers are not required to enter into
an attestation engagement with an independent public accountant for
purposes of reviewing Form Custody.

C. Form Custody

    As is discussed above, proposed Form Custody was comprised of nine
Items designed to elicit information about a broker-dealer's custodial
activities. Set forth below is a description of each of the Items.
1. Item 1--Accounts Introduced on a Fully Disclosed Basis
    Item 1 consists of two subparts. Item 1.A, as proposed, would have
elicited information concerning whether the broker-dealer introduced
customer accounts to another broker-dealer on a fully disclosed basis
by requiring the broker-dealer to check the appropriate ``Yes'' or
``No'' box.\555\ Item 1.B of Form Custody would require broker-dealers
that check ``Yes'' on Item 1.A to identify each broker-dealer to which
customer accounts are introduced on a fully disclosed basis.\556\ The
Commission did not receive any comments on Item 1.A or 1.B and is
adopting this Item as proposed.
---------------------------------------------------------------------------

    \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
introduces a customer to a clearing broker and the customer's name
and statement are carried by, and disclosed to, that clearing
broker.'').
    \556\ See Broker-Dealer Reports, 76 FR at 37585.
---------------------------------------------------------------------------

    As is discussed in the proposing release, many broker-dealers enter
into agreements (``carrying agreements'') with another broker-dealer in
which the two firms allocate certain responsibilities with respect to
the handling of accounts.\557\ These carrying agreements are governed
by applicable SRO rules, which require a broker-dealer entering into a
carrying agreement to allocate certain responsibilities associated with
introduced accounts.\558\
---------------------------------------------------------------------------

    \557\ Id.
    \558\ See, e.g., FINRA Rule 4311.
---------------------------------------------------------------------------

    Typically, under a carrying agreement, one broker-dealer
(``introducing broker-dealer'') agrees to act as the customer's account
representative (e.g., by providing the customer with account opening
documents, ascertaining the customer's investment objectives, and
making investment recommendations). The carrying broker-dealer
typically agrees to receive and hold the customer's cash and
securities, clear transactions, make and retain records relating to the
transactions and the receipt and holding of assets, and extend credit
to the customer in connection with the customer's securities
transactions.
    Item 1.A, as adopted, elicits information concerning whether the
broker-dealer introduces customer accounts to another broker-dealer on
a fully disclosed basis, rather than asking whether the broker-dealer
is an ``introducing broker-dealer.'' The Commission is presenting the
question in this manner because some broker-dealers operate as carrying
broker-dealers (i.e., they hold cash and securities) for one group of
customers but also introduce the accounts of a second group of
customers on a fully disclosed basis to another broker-dealer. For
example, a broker-dealer may incur the capital expense and cost of
acting as a carrying broker-dealer for certain products (e.g.,
equities) but not for other products (e.g., options). In this case, the
firm operates as a hybrid introducing/carrying broker-dealer by
introducing on a fully disclosed basis to a carrying broker-dealer
those customers that trade securities for which the broker-dealer is
not prepared to provide a full range of services. Broker-dealers also
may introduce customer accounts on an omnibus basis, as is discussed
below in section 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.B to identify each
broker-dealer to which customer accounts are introduced on a fully
disclosed basis. The carrying broker-dealer in such an arrangement
maintains the cash and securities of the introduced customers and is
therefore obligated to return cash and securities to the introduced
customers. Commission and DEA examiners could use the identification
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 an Omnibus Basis
    Item 2 of Form Custody consists of two subparts. Item 2.A, as
proposed, would have elicited information concerning whether the
broker-dealer introduced customer accounts to another broker-dealer on
an omnibus basis by requiring the broker-dealer to check the
appropriate ``Yes'' or ``No'' box.\559\ Item 2.B, as proposed, would
require a broker-dealer that checks ``Yes'' in response to Item 2.A to
identify each broker-dealer to which customer accounts are introduced
on an omnibus basis.\560\ The Commission did not receive any comments
on Items 2.A or 2.B and is adopting this Item as proposed.
---------------------------------------------------------------------------

    \559\ See Broker-Dealer Reports, 76 FR at 37585-37586.
    \560\ Id. at 37586.
---------------------------------------------------------------------------

    An omnibus account is an account carried and cleared by another
broker-dealer that contains accounts of undisclosed customers on a
commingled basis and that are carried individually on the books of the
broker-dealer introducing the accounts.\561\ Disclosure of this
information is important because when a broker-dealer introduces
customer accounts to another broker-dealer on an omnibus basis, the
introducing broker-dealer (in addition to the broker-dealer carrying
the omnibus account) is considered to be a carrying broker-dealer with
respect to those accounts under the Commission's broker-dealer
financial responsibility

rules.\562\ Thus, in these arrangements, the broker-dealer introducing
the omnibus account is obligated to return cash and securities in the
account to customers.\563\
---------------------------------------------------------------------------

    \561\ See AICPA Broker-Dealer Audit Guide at ]] 5.144-5.145.
    \562\ See Net Capital Rule, Exchange Act Release No. 31511 (Nov.
24, 1992), 57 FR 56973, 56978 n.16 (Dec. 2, 1992).
    \563\ Id.
---------------------------------------------------------------------------

    If the broker-dealer checks the ``Yes'' box in Item 2.A, it will be
required to identify in Item 2.B each broker-dealer to which accounts
are introduced on an omnibus basis. Commission and DEA examiners could
use this information to confirm whether the cash and securities
introduced to the carrying broker-dealer are in fact being held in an
omnibus account at the carrying broker-dealer and that the books and
records of the broker-dealer that introduced the customer accounts to
the carrying broker-dealer reflect the correct amounts of customer cash
and securities held in the omnibus account.
3. Item 3--Carrying Broker-Dealers
    Item 3 of Form Custody, as proposed, would have elicited
information concerning how a carrying broker-dealer held cash and
securities.\564\ Proposed Item 3 was comprised of five subparts, as
described below.\565\ Two commenters specifically addressed this Item,
in particular regarding subparts 3.C., 3.D, and 3.E, which also are
discussed below.\566\
---------------------------------------------------------------------------

    \564\ See Broker-Dealer Reports, 76 FR at 37586.
    \565\ Id. at 37586-37589.
    \566\ See CFP Letter; SIFMA Letter.
---------------------------------------------------------------------------

i. Items 3.A and 3.B
    The first question of Item 3 of proposed Form Custody--Item 3.A--
would have elicited information concerning whether the broker-dealer
carried securities accounts for customers by requiring the broker-
dealer to check the appropriate ``Yes'' or ``No'' box.\567\ The General
Instructions to Form Custody specify that the term ``customer'' as used
in the Form means a ``customer'' as defined in Rule 15c3-3.
---------------------------------------------------------------------------

    \567\ See Broker-Dealer Reports, 76 FR at 37586.
---------------------------------------------------------------------------

    The next question of Item 3--Item 3.B--would have elicited
information concerning whether the broker-dealer carried securities
accounts for persons that are not ``customers'' under the definition in
Rule 15c3-3.\568\ For example, under Rule 15c3-3, persons that are not
``customers'' include an accountholder that is a general partner,
director, or principal officer of the carrying broker-dealer, and
accountholders that are themselves broker-dealers.\569\ The Commission
did not receive any comments on Item 3.A or 3.B and is adopting these
questions as proposed.
---------------------------------------------------------------------------

    \568\ Id.
    \569\ See 17 CFR 240.15c3-3(a)(1).
---------------------------------------------------------------------------

ii. Item 3.C
a. Background
    Item 3.C, as proposed, would have required the broker-dealer to
identify in three charts the types of locations where it held
securities and the frequency with which it performed reconciliations
between the information on its stock record and information on the
records of those locations.\570\ Each of these charts, which are set
forth in Items 3.C.i through 3.C.iii, is discussed in more detail
below.
---------------------------------------------------------------------------

    \570\ See Broker-Dealer Reports, 76 FR at 37586-37587.
---------------------------------------------------------------------------

b. General Comments to Item 3.C
    One 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 stated that such
disclosure would allow regulators to identify potential discrepancies
more easily, as well as changes in custody relationships that may
warrant further investigations.\572\
---------------------------------------------------------------------------

    \571\ See CFP Letter.
    \572\ Id.
---------------------------------------------------------------------------

    The Commission has considered this suggestion and determined that
providing the identities of a broker-dealer's custodians instead of the
types of locations would significantly increase the burden on broker-
dealers in preparing the form, which is intended to be a starting point
for Commission and DEA examiners in assessing a broker-dealer's
compliance with its custody requirements. Large broker-dealers often
maintain custody of customers' securities in many locations, which can
total in the hundreds, particularly if the broker-dealer carries a
large number of uncertificated investments for customers, such as
alternative investments. Requiring broker-dealers to disclose this
level of detail on Form Custody could significantly increase the costs
of preparing the form for a number of broker-dealers. Although the
Commission acknowledges that requiring the additional information the
commenter suggested would enhance the ability of regulators to identify
discrepancies, the Commission believes that the information on Form
Custody provides sufficient information to allow examiners to determine
whether it is appropriate to seek additional information from a
particular broker-dealer. To the extent a Commission or DEA examiner
believes that it is appropriate to obtain this information from a
particular broker-dealer, the examiner could do so in a document
request to that firm, a method that the Commission expects would be
less costly than requiring this information from all broker-dealers on
Form Custody. Accordingly, the Commission has determined not to require
that broker-dealers identify on the form the specific identities of all
of their custodians.
    Another commenter to Item 3.C requested that the Commission clarify
the distinction between ``locations where the broker-dealer holds
securities directly in the name of the broker-dealer'' and ``locations
where the broker-dealer holds securities only through an
intermediary.'' \573\ In making this distinction, the Commission
intended to distinguish between locations that are aware of the
identity of the broker-dealer and act directly upon the broker-dealer's
instructions and locations that are not aware of the identity of the
broker-dealer or that will not act on instructions directly from the
broker-dealer. In the latter scenario, the location holding securities
for the broker-dealer would act only on instructions relating to the
broker-dealer's securities from the broker-dealer's intermediary. The
Commission has modified the instructions to Item 3.C of Form Custody to
reflect this clarification.
---------------------------------------------------------------------------

    \573\ See SIFMA Letter.
---------------------------------------------------------------------------

c. Item 3.C.i
    The first chart in Item 3.C--set forth in Item 3.C.i--identifies
the most common locations where broker-dealers hold securities. Many of
the locations identified on the first chart, and described below, are
locations deemed to be satisfactory control locations under paragraph
(c) of Rule 15c3-3.\574\ The Commission did not receive any comments on
Item 3.C.i of proposed Form Custody and is adopting it as proposed.
---------------------------------------------------------------------------

    \574\ See 17 CFR 240.15c3-3(c).
---------------------------------------------------------------------------

    The first location identified in the chart is the broker-dealer's
vault. Broker-dealers primarily hold securities in fungible bulk at
other institutions. In some cases, however, broker-dealers may
physically hold securities certificates (e.g., in the case of
restricted securities).
    The second location identified in the chart is another U.S.
registered broker-dealer. For example, a broker-dealer may hold
customers' foreign securities at another U.S. broker-dealer, or may

hold securities in an omnibus account at another broker-dealer.
    The third and fourth locations identified in the chart are the
Depository Trust Company and the Options Clearing Corporation. These
are the two most common securities clearing and depository
organizations for equities and options in the U.S. and, consequently,
are identified by name rather than by type of location.
    The fifth location identified in the chart is a U.S. bank. Broker-
dealers may have arrangements with U.S. banks to receive and hold
securities for the accounts of the broker-dealer's customers and non-
customers, as well as for the broker-dealer's own account. Obtaining
information about a broker-dealer's relationships with U.S. banks could
enable examiners to test and confirm the accuracy of the broker-
dealer's representations on Form Custody (i.e., that a U.S. bank holds
securities for the broker-dealer), and, in addition, facilitate the
collection of information regarding the relationship between the
broker-dealer and the bank. For instance, customer fully paid and
excess margin securities must be in the possession or control of the
broker-dealer and therefore cannot be pledged as collateral for a loan
to the broker-dealer, among other things, and customer margin
securities may not be commingled with proprietary securities that are
pledged as collateral for a bank loan. Form Custody could, for example,
lead examiners to seek account statements and documentation governing
the broker-dealer's relationship with the U.S. bank to ensure customer
fully paid and excess margin securities are not pledged as collateral
for a loan to the broker-dealer.
    The sixth location identified in the chart is the transfer agent of
an open-end investment management company registered under the
Investment Company Act of 1940 (i.e., a mutual fund). Generally, mutual
funds issue securities only in book-entry form. This means that the
ownership of securities is not reflected on a certificate that can be
transferred but rather through a journal entry on the books of the
issuer maintained by the issuer's transfer agent. A broker-dealer that
holds mutual funds for customers generally holds them 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--set forth in Item 3.C.ii--is intended
to capture all other types of U.S. locations where a broker-dealer may
hold securities that are not specified in the chart included in Item
3.C.i. This category would include, for example, securities held in
book-entry form by the issuer of the securities or the issuer's
transfer agent. A broker-dealer that holds securities at such locations
must list the types of locations in the spaces provided in the chart
and indicate the frequency with which the broker-dealer performs asset
reconciliations with those locations. The Commission did not receive
any comments on Item 3.C.ii of proposed Form Custody and is adopting it
as proposed.
e. Item 3.C.iii
    The third chart in Item 3.C--set forth in Item 3.C.iii--pertains to
foreign locations where the broker-dealer maintains securities. Under
the proposal, the Commission did not list categories of foreign
locations because terminology used to identify certain locations may
differ by jurisdiction.\575\ For example, in some foreign
jurisdictions, banks may operate a securities business, making it
difficult to classify whether securities are held at a bank or a
broker-dealer. A broker-dealer that holds securities in a foreign
location must list the types of foreign locations where it maintains
securities in the spaces provided in the chart and indicate the
frequency with which reconciliations are performed with the location.
The Commission did not receive any comments on Item 3.C.iii of proposed
Form Custody and is adopting it as proposed.
---------------------------------------------------------------------------

    \575\ See Broker-Dealer Reports, 76 FR at 37587.
---------------------------------------------------------------------------

iii. Items 3.D and 3.E
    Items 3.D and 3.E of proposed Form Custody each contained three
identical subparts (discussed in more detail below) designed to elicit
information about the types and amounts of securities and cash the
broker-dealer held, whether those securities were recorded on the
broker-dealer's stock record and, if not, why they were not recorded,
and where the broker-dealer held free credit balances.\576\ The General
Instructions to proposed Form Custody defined ``free credit balances''
as liabilities of a broker-dealer to customers or non-customers which
are subject to immediate cash payment to customers or non-customers on
demand, whether resulting from sales of securities, dividends,
interest, deposits, or otherwise.\577\
---------------------------------------------------------------------------

    \576\ Id. at 37587-37589.
    \577\ This definition is similar to the definition of the term
free credit balance in Rule 15c3-3, except that the definition in
the rule is limited to liabilities to customers whereas the
definition in the Form contemplates liabilities to customers and
non-customers. See 17 CFR 240.15c3-3(a)(8).
---------------------------------------------------------------------------

    The difference between proposed Item 3.D and proposed Item 3.E is
that the former would have elicited information with respect to
securities and free credit balances held for the accounts of customers,
whereas the latter would have elicited information with respect to
securities and free credit balances held for the accounts of persons
who are not customers.\578\ Accordingly, the proposed form asked two
sets of identical questions to elicit information about each category
of accountholder--customer and non-customer.\579\
---------------------------------------------------------------------------

    \578\ See Broker-Dealer Reports, 76 FR at 37587-37589.
    \579\ Id.
---------------------------------------------------------------------------

a. Items 3.D.i and 3.E.i
    Items 3.D.i and 3.E.i of proposed Form Custody would have elicited
information about the types and dollar amounts of the securities the
broker-dealer carried for the accounts of customers and non-customers,
respectively.\580\ Specifically, for each Item, the broker-dealer would
have been required to complete information on a chart to the extent
applicable.\581\ The proposed charts were comprised of twelve rows,
with each row representing a category of security. These categories
included: (1) U.S. Equity Securities; (2) Foreign Equity Securities;
(3) U.S. Listed Options; (4) Foreign Listed Options; (5) Domestic
Corporate Debt; (6) Foreign Corporate Debt; (7) U.S. Public Finance
Debt; (8) Foreign Public Finance Debt; (9) U.S. Government Debt; (10)
Foreign Sovereign Debt; (11) U.S. Structured Debt; and (12) Foreign
Structured Debt. A thirteenth row was included in each chart to
identify any securities not specifically listed in the first twelve
rows. The types of securities were categorized this way because the
various categories ordinarily are associated with certain types of
locations. Thus, as examiners review the form, they could assess
whether the types of securities held by the broker-dealer were
maintained at locations generally known to hold such securities. If a
broker-dealer's completed form indicated that some types of securities
were held at a location atypical for such securities, the examiner
could refine the focus of the examination to evaluate whether customer
assets were properly safeguarded. The Commission is adopting these
requirements, with modifications, as discussed below.
---------------------------------------------------------------------------

    \580\ Id. at 37587.
    \581\ Id.
---------------------------------------------------------------------------

    One commenter requested that the Commission clarify whether
alternative investments, mutual funds, and exchange traded funds fall
within the

scope of ``Other'' securities within the thirteenth row of Items 3.D.i
and 3.E.i.\582\ The Commission has considered this comment and
determined that those investments are other types of securities that
should be part of Items 3.D.i and 3.E.i, but that it would be useful to
separately identify each of these categories of securities in Items
3.D.i and 3.E.i, rather than group them together in the ``Other''
category. By identifying these types of investments separately on Form
Custody, Commission and DEA examiners will have a better understanding
of a broker-dealer's business activities and a more refined
understanding of the types of securities held by the broker-dealer.
This information, in turn, could facilitate more focused examinations
by Commission 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 both domestic and foreign alternative investments (referred to on
the form as ``private funds''), mutual funds, and exchange traded
funds. The Commission is referring to the term ``private funds'' on the
form, rather than the term ``alternative investments,'' for purposes of
clarity; while both terms are often used interchangeably in practice,
the term ``private fund'' is a regulatory term defined in other
contexts of the securities laws (e.g., on Form ADV), whereas the term
``alternative investments'' is not. For purposes of Form Custody, the
term ``private fund'' is given the same meaning as is used by the
Commission on Form ADV--that is, an investment company as defined in
section 3 of the Investment Company Act of 1940 but for section 3(c)(1)
or 3(c)(7) of that Act. Items 3.D.i and 3.E.i of Form Custody and the
related Instructions to those Items, as adopted, reflect these changes.
---------------------------------------------------------------------------

    \582\ See SIFMA Letter.
---------------------------------------------------------------------------

    The charts in Items 3.D.i and 3.E.i, as proposed, would have each
had eight columns. The first column contained boxes for each category
of security specified in the Item (and identified in the second
column), as discussed above.\583\ The broker-dealer would have been
required to check the box in each chart for every applicable category
of security it holds for the accounts of customers and non-customers,
respectively. The second column would have identified the category of
security. The third through eighth columns represented ranges of dollar
values: (1) Up to $50 million; (2) greater than $50 million 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-
dealer would have been required to check the box in the column
reflecting the approximate dollar value for every category of security
that the broker-dealer carried for the accounts of customers and non-
customers, respectively.\584\
---------------------------------------------------------------------------

    \583\ See Broker-Dealer Reports, 76 FR at 37587.
    \584\ Id.
---------------------------------------------------------------------------

    The Commission proposed identifying dollar ranges for the values of
the securities, as opposed to actual values, to ease compliance
burdens.\585\ The intent was to elicit information about the relative
dollar value of securities the broker-dealer held for customers and
non-customers in each category of security. Values would be reported as
of the date specified in the broker-dealer's accompanying quarterly
FOCUS Report.
---------------------------------------------------------------------------

    \585\ Id.
---------------------------------------------------------------------------

    One commenter noted that the charts set forth in Items 3.D.i and
3.E.i of proposed Form Custody did not include boxes to check to
reflect the approximate dollar values for the categories of securities
the broker-dealer carried for the accounts of customers and non-
customers.\586\ This commenter requested guidance on whether broker-
dealers would be required to populate the chart with checkmarks or more
precise estimates of market value.\587\ The Commission intended to
include boxes to check to reflect approximate dollar values in the
charts set forth in Items 3.D.i and 3.E.i of proposed Form Custody, and
the form, as adopted, includes these boxes.
---------------------------------------------------------------------------

    \586\ See SIFMA Letter.
    \587\ Id.
---------------------------------------------------------------------------

b. Items 3.D.ii and 3.E.ii
    Items 3.D.ii and 3.E.ii of proposed Form Custody would have
elicited information concerning whether the broker-dealer had recorded
all the securities it carried for the accounts of customers and non-
customers, respectively, on its stock record by requiring the broker-
dealer to check the appropriate ``Yes'' or ``No'' box.\588\ If the
broker-dealer checked ``No,'' it would have been required to explain in
the space provided why it had not recorded such securities on its stock
record and indicate the type of securities and approximate U.S. dollar
market value of such unrecorded securities.\589\ The Commission did not
receive any comments on Items 3.D.ii and 3.E.ii of proposed Form
Custody and is adopting these Items as proposed.
---------------------------------------------------------------------------

    \588\ See Broker-Dealer Reports, 76 FR at 37587.
    \589\ Id.
---------------------------------------------------------------------------

    The Commission anticipates that a broker-dealer ordinarily would
answer ``Yes'' in response to Items 3.D.ii and 3.E.ii because the stock
record--which a broker-dealer is required to create pursuant to Rule
17a-3 \590\--is a record of custody of securities. A long position in
the stock record indicates ownership of the security or a right to the
possession of the security. Thus, the ``long side'' of the stock record
indicates the person to whom the broker-dealer owes the securities.
Common examples of ``long side'' positions are securities received from
customers (e.g., fully paid or excess margin securities), securities
owned by the firm (i.e., securities held in the broker-dealer's
inventory for its own account), securities borrowed, and fails-to-
deliver (i.e., securities sold to or through another broker-dealer but
not delivered).
---------------------------------------------------------------------------

    \590\ See 17 CFR 240.17a-3(a)(5).
---------------------------------------------------------------------------

    A short position in the stock record indicates either the location
of the securities or the responsibility of other parties to deliver the
securities to the broker-dealer. Every security owned or held by the
broker-dealer must be accounted for by its location. Since securities
are fungible, the short side of the stock record does not in fact
designate where particular securities are located. Rather, it indicates
the total amount 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-dealer pledges securities to a bank as
collateral for a loan), stock loan counterparties (e.g., when a broker-
dealer lends securities to another firm as part of a securities lending
transaction), and counterparties failing to deliver securities to the
broker-dealer (e.g., when the broker-dealer has purchased securities
that have not yet been received from the counterparty).
    The Commission's goals in asking this question were twofold. First,
the question would elicit the disclosure of the unusual circumstance in
which a broker-dealer carries securities for the account of a customer
or non-customer but does not reflect them on its stock record.\591\ The
Commission and other securities regulators could use this information
to assess whether the broker-dealer is properly accounting for
securities. Second, this question could prompt a broker-dealer to
identify, and self-correct, circumstances in which it

did not include securities on its stock record as required by Rule 17a-
3.\592\
---------------------------------------------------------------------------

    \591\ See Broker-Dealer Reports, 76 FR at 37588.
    \592\ Id.
---------------------------------------------------------------------------

c. Items 3.D.iii and 3.E.iii
    Items 3.D.iii and 3.E.iii of proposed Form Custody would have
elicited information as to how the broker-dealer treated free credit
balances in securities accounts of customers and non-customers,
respectively.\593\ The information would have been elicited through a
chart the broker-dealer would be required to complete. The chart in
Item 3.D.iii of proposed Form Custody had five rows with each row
representing a different process for treating free credit balances. The
chart would have disclosed whether free credit balances were: (1)
Included in a computation under Rule 15c3-3(e); (2) held in a bank
account under Rule 15c3-3(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 to
describe such other treatment. The options were not intended to be
mutually exclusive in that a broker-dealer may treat free credit
balances in several different ways (e.g., a broker-dealer may be
instructed by certain customers to sweep their free credit balances to