[Federal Register Volume 76, Number 123 (Monday, June 27, 2011)]
[Proposed Rules]
[Pages 37572-37616]
[FR Doc No: 2011-15341]

Vol. 76

Monday,

No. 123

June 27, 2011

Part III

Securities and Exchange Commission

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17 CFR Parts 240 and 249

Broker-Dealer Reports; Proposed Rule

Federal Register / Vol. 76 , No. 123 / Monday, June 27, 2011 /
Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 249

[Release No. 34-64676; File No. S7-23-11]
RIN 3235-AK56

Broker-Dealer Reports

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is
proposing amendments to the broker-dealer financial reporting rule
under the Securities Exchange Act of 1934 (the ``Exchange Act''). The
first set of amendments would, among other things, update the existing
requirements of Exchange Act Rule 17a-5, facilitate the ability of the
Public Company Accounting Oversight Board (the ``PCAOB'') to implement
oversight of independent public accountants of broker-dealers as
required by the Dodd-Frank Wall Street Reform and Consumer Protection
Act (the ``Dodd-Frank Act''), and eliminate potentially redundant
requirements for certain broker-dealers affiliated with, or dually-
registered as, investment advisers. The second set of amendments would
require broker-dealers that either clear transactions or carry customer
accounts to consent to allowing the Commission and designated examining
authorities (``DEAs'') to have access to independent public accountants
to discuss their findings with respect to annual audits of the broker-
dealers and to review related audit documentation. The third set of
amendments would enhance the ability of the Commission and examiners of
a DEA to oversee broker-dealers' custody practices by requiring broker-
dealers to file a new Form Custody.

DATES: Comments should be received on or before August 26, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File Number S7-23-11 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.

All submissions should refer to File Number S7-23-11. This file number
should be included on the subject line if e-mail is used. To help the
Commission process and review your comments more efficiently, please
use only one method. The Commission will post all comments on the
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for Web site viewing and
printing in the Commission's Public Reference Room, 100 F Street, NE.,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. All comments received will be posted without change;
the Commission does not edit personal identifying information from
submissions. You should submit only information that you wish to make
publicly available.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at<PHONE_NUMBER>; Thomas K. McGowan, Deputy Associate
Director, at<PHONE_NUMBER>; Randall W. Roy, Assistant Director, at
(202) 551-5522; and Mark M. Attar, Branch Chief, at<PHONE_NUMBER>,
Division of Trading and Markets; or John F. Offenbacher, Senior
Associate Chief Accountant, at<PHONE_NUMBER>, Office of the Chief
Accountant, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment
on proposed amendments to Exchange Act Rule 17a-5 and proposed Form
Custody.

I. Introduction

    The Commission is proposing three sets of amendments to Exchange
Act Rule 17a-5--the broker-dealer financial reporting rule.\1\ The
first set of amendments (collectively, the ``Annual Reporting
Amendments'') relates to the requirement that a broker-dealer file
annual financial reports with the Commission. The Annual Reporting
Amendments are designed to, among other things: (1) Update the existing
requirements of Rule 17a-5; (2) facilitate the ability of the PCAOB to
implement oversight of independent public accountants of broker-dealers
as required by the Dodd-Frank Act; \2\ and (3) eliminate potentially
redundant requirements for certain broker-dealers affiliated with, or
dually-registered as, investment advisers.
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    \1\ 17 CFR 240.17a-5 (``Rule 17a-5'').
    \2\ Public Law 111-203 (Jul. 21, 2010).
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    The second set of amendments (collectively, the ``Access to Audit
Documentation Amendments'') would require broker-dealers that either
clear transactions or carry customer accounts to consent to provide the
Commission and DEAs with access to independent public accountants to
discuss their findings with respect to annual audits of broker-dealers
and to review related audit documentation.\3\
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    \3\ 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.''
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    The third set of amendments (collectively, the ``Form Custody
Amendments'') would enhance the ability of the Commission and examiners
of a DEA to oversee broker-dealers' custody practices by requiring
broker-dealers to file on a quarterly basis a new Form Custody. Form
Custody would elicit information as to whether and how a broker-dealer
maintains custody of cash and securities of customers and others.

II. The Proposed Annual Reporting Amendments

A. Background

    Sections 17(a) and (e) of the Exchange Act and Rule 17a-5 together
require a broker-dealer to, among other things, file an annual report
(an ``Annual Audit Report'') containing audited financial statements,
supporting schedules, and supplemental reports, as applicable, with the
Commission and the broker-dealer's DEA.\4\ The financial statements
must be comprised of a statement of financial condition, a statement of
income, a statement of cash flows, a statement of changes in
stockholders' or partners' or sole proprietor's equity, and a statement
of changes in liabilities subordinated to claims of general
creditors.\5\ The supporting schedules must be comprised of a
computation of required and actual net capital under

Exchange Act Rule 15c3-1, and, for broker-dealers that maintain custody
of customer funds or securities (``carrying broker-dealers''), a
computation of the customer reserve requirement and information
relating to the possession or control requirements under Exchange Act
Rule 15c3-3.\6\ The supplemental reports include: (1) A report of an
independent public accountant that is the result of a review of, among
other things, the broker-dealer's accounting system, internal
accounting control and procedures for safeguarding securities, and
practices and procedures in complying with various Commission financial
responsibility rules and Regulation T of the Board of Governors of the
Federal Reserve System; \7\ (2) a report of an independent public
accountant provided to, among others, the Securities Investor
Protection Corporation (``SIPC'') to help administer the collection of
assessments from broker-dealers for purposes of establishing and
maintaining its broker-dealer liquidation fund (the ``SIPC Fund''); \8\
and (3) for broker-dealers that compute net capital under an
alternative model-based standard, a report of an independent public
accountant indicating the results of the accountant's review of the
internal risk management control system established and documented by
the broker-dealer in accordance with Exchange Act Rule 15c3-4.\9\
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    \4\ See 15 U.S.C 78q(a), 15 U.S.C 78q(e), and Rule 17a-5(d).
    \5\ See Rule 17a-5(d)(2).
    \6\ See Rule 17a-5(d)(3). See also 17 CFR 240.15c3-1 (``Rule
15c3-1'') and 17 CFR 240.15c3-3 (``Rule 15c3-3'').
    \7\ See Rule 17a-5(g). See also 12 CFR part 220 et seq.
(``Regulation T'').
    \8\ See Rule 17a-5(e)(4). These reports will be collectively
referred to in this release as the ``SIPC Reports.'' As part of the
Annual Reporting Amendments, the Commission is proposing to amend
how the SIPC Reports are filed; see infra Section II.C.
    \9\ See Rule 17a-5(k); see also 17 CFR 240.15c3-4.
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    Paragraph (g) of Rule 17a-5, entitled ``Audit objectives,''
describes the objectives that should be achieved by an independent
public accountant in preparing a report for the broker-dealer to file
with its Annual Audit Report.\10\ For example, the audit is required to
be performed in accordance with generally accepted auditing standards
(``GAAS'').\11\ In addition, paragraph (g)(1) of Rule 17a-5 requires
that the audit include a ``review'' and appropriate tests of the
broker-dealer's accounting system, internal accounting control and
procedures for safeguarding securities for the period since the prior
examination date.\12\ The paragraph further states that the scope of
the audit and review of the accounting system, internal accounting
control, and procedures for safeguarding securities shall be sufficient
to provide reasonable assurance that any material inadequacies existing
in those items, including in the procedures for obtaining and
maintaining physical possession and control of all fully paid and
excess margin securities, complying with Regulation T, and making the
quarterly securities examinations, counts, verifications, and
comparisons and recordation of differences required by Exchange Act
Rule 17a-13 would be disclosed.\13\ Currently, with respect to these
requirements, independent public accountants for broker-dealers issue a
report describing a ``study'' of these practices and procedures and, if
applicable, notification to the Commission of the discovery of any
material inadequacies (the ``Study''). The form of the report that
describes the Study is specified in an AICPA publication entitled AICPA
Audit & Accounting Guide: Brokers and Dealers in Securities; \14\
however, the form of the report does not specify the level of assurance
required to be obtained by the independent public accountant when
performing the Study.
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    \10\ See Rule 17a-5(g).
    \11\ Auditing and attestation standards for broker-dealers are
currently established by the American Institute of Certified Public
Accountants (the ``AICPA'').
    \12\ See Rule 17a-5(g)(1).
    \13\ Id. See also 17 CFR 240.17a-13 (``Rule 17a-13''). The term
``material inadequacy'' is defined in Rule 17a-5(g)(3).
    \14\ See the AICPA Audit & Accounting Guide: Brokers and Dealers
in Securities (Jul. 2010) (the ``Broker-Dealer Audit Guide'').
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    Professional auditing standards provide for three levels of
attestation engagement by an accountant.\15\ Under the highest level of
attestation engagement, the accountant obtains ``reasonable assurance''
with respect to the matter that is the subject of the accountant's
attestation engagement and provides an opinion. This standard is
required with respect to audits and examinations.\16\ The second level
of attestation engagement is a review, which results in the accountant
obtaining a moderate level of assurance with respect to the matter that
is the subject of the accountant's attestation engagement. The third
type of attestation engagement is one in which the accountant performs
agreed-upon procedures, which results in no assurance, but rather a
reporting of the accountant's findings after the performance of
procedures that have been agreed to by specified parties. Rule 17a-5
currently requires that a broker-dealer engage an independent public
accountant to audit the broker-dealer's financial statements. Some of
the supporting schedules are also subject to financial statement audit
procedures.
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    \15\ Professional auditing standards include both GAAS and
standards promulgated by the PCAOB.
    \16\ This proposing release generally refers to an ``audit'' of
a broker-dealer's financial statements and an ``examination'' of the
broker-dealer's compliance with a particular rule or implementation
of controls designed to achieve compliance with a particular rule.
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    Rule 17a-5 also requires that a broker-dealer that is claiming an
exemption from the requirements of Rule 15c3-3 file a report with the
Commission.\17\ Rule 15c3-3(k) sets forth certain conditions that a
broker-dealer must meet to be exempt from the rule's requirements.
Generally, the broker-dealer would be exempt if it does not hold
customer funds or securities, or, if it does, it promptly forwards all
funds and securities received. Rule 17a-5 provides that the independent
public accountant engaged by the broker-dealer must ``ascertain that
the conditions of the exemption were being complied with as of the
examination date and that no facts came to the independent public
accountant's attention to indicate that the exemption had not been
complied with during the period since the independent public
accountant's last examination.'' \18\ This requirement has resulted in
independent public accountants providing a statement concerning whether
they have ascertained that the broker-dealer was complying with the
conditions of the exemption.\19\
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    \17\ See Rule 17a-5(g)(2).
    \18\ Id.
    \19\ See Broker-Dealer Audit Guide, supra note 14 at Section
3.32.
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    Many of the requirements currently contained in Rule 17a-5 have
existed since 1975, and, for the most part, have remained substantially
unchanged.\20\ For example, as noted above, to comply with the
requirement of paragraph (g) of Rule 17a-5 to conduct an audit and
review of the identified matters, independent public accountants
currently issue a report based on a Study. The practice of conducting
the Study is relatively unique to broker-dealer audits and, while audit
literature at one time referred to the performance of a ``study,'' the
performance of a study is no longer included in contemporary audit
standards governing the work to be performed by an independent public
accountant.
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    \20\ See Broker-Dealer Reports, Exchange Act Release No. 11935
(Dec. 17, 1975), 40 FR 59706 (Dec. 30, 1975). In this release, the
Commission adopted amendments to Rule 17a-5, which included, among
other things, the adoption of the requirement for broker-dealers to
file Financial and Operational Combined Uniform Single (or
``FOCUS'') Reports.

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    In addition, recent legislation and Commission rulemaking have
further prompted the need to reexamine the requirements pertaining to
the Annual Audit Report. First, Section 982 of the Dodd-Frank Act
amended the Sarbanes-Oxley Act of 2002 (the ``Sarbanes-Oxley Act'')
\21\ to provide the PCAOB with explicit authority to, among other
things, establish, subject to Commission approval, auditing and related
attestation, quality control, ethics, and independence standards to be
used by registered public accounting firms with respect to the
preparation and issuance of audit reports to be included in broker-
dealer filings with the Commission.\22\ The Dodd-Frank Act also
authorizes the PCAOB to inspect registered public accounting firms that
provide audit reports for broker-dealers and to enforce standards
relative to their audits.
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    \21\ 17 U.S.C. 7202 et seq.
    \22\ See Section 982 of the Dodd-Frank Act.
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    Further, in December 2009, the Commission amended Rule 206(4)-2
(the ``IA Custody Rule'') under the Investment Advisers Act of 1940
(the ``Advisers Act''),\23\ which governs investment advisers' custody
practices.\24\ Among other requirements, registered investment advisers
that have custody of client funds or securities must maintain those
assets at a qualified custodian, such as a bank or broker-dealer.\25\
If an investment adviser that also is, for example, a bank, or its
related person, serves as a qualified custodian for advisory client
funds or securities, the adviser must annually 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. Broker-dealers that also are registered as
investment advisers may, acting in their capacity as broker-dealers,
maintain client funds and securities as qualified custodians in
connection with advisory services provided to clients, and under the IA
Custody Rule are required to obtain internal control reports. Broker-
dealers acting as qualified custodians also may maintain advisory
assets in connection with advisory services provided by related or
affiliated investment advisers. In such instances, these broker-dealers
are also required to provide internal control reports to their related
investment advisers.
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    \23\ 17 CFR 275.206(4)-2 (``Rule 206(4)-2'').
    \24\ See Custody of Funds or Securities by Investment Advisers,
Advisers Act Release No. 2876 (May 20, 2009), 74 FR 25354 (May 27,
2009) (``IA Custody Proposing Release''); Advisers Act Release No.
2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010) (``IA Custody
Adopting Release'').
    \25\ See Rule 206(4)-2.
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    For the reasons discussed above, the Commission is proposing
amendments to Rule 17a-5. The amendments proposed by the Commission are
intended to update the broker-dealer audit requirements and provide for
an examination of compliance, and internal control over compliance,
with key regulatory requirements that would provide the Commission with
greater assurance as to a broker-dealer's compliance with the
requirements. In addition, the proposed changes are intended to
facilitate the ability of the PCAOB to set standards for, and implement
its inspection authority over, broker-dealers' independent public
accountants by providing an improved foundation for the PCAOB to
establish new broker-dealer audit standards. Moreover, the proposed
changes, as they pertain to compliance with requirements concerning the
custody of customer funds and securities, are intended to complement
and reinforce the regulatory changes effected by the IA Custody Rule.
In particular, the Commission preliminarily believes that broker-
dealers that also are registered as investment advisers and hold
advisory client funds or securities, or that hold funds or securities
for related investment advisers, would be able to use the Examination
Report described below to satisfy the internal control report
requirements under both Rule 17a-5, as it is proposed to be amended,
and the IA Custody Rule.
    As discussed below, the proposed changes would provide, as to
broker-dealers subject to the requirements of Rule 15c3-3, for an
examination of compliance, and internal control over compliance, with
respect to Rule 15c3-1, Rule 15c3-3, Rule 17a-5, and rules prescribed
by DEAs requiring broker-dealers to send account statements to
customers (``Account Statement Rules''). Rule 15c3-1 requires broker-
dealers to maintain at all times a minimum amount of net liquid assets,
or ``net capital.'' Under Rule 15c3-1, broker-dealers must perform two
calculations: (1) A computation of required minimum net capital; \26\
and (2) a computation of actual net capital.\27\
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    \26\ A broker-dealer's required minimum net capital is the
greater of a fixed-dollar amount prescribed in Rule 15c3-1, or an
amount computed using one of two financial ratios. The first
financial ratio generally provides that a broker-dealer shall not
permit its aggregate indebtedness to exceed 1500% of its net
capital. See Rule 15c3-1(a)(1)(i). The second financial ratio
provides that a broker-dealer shall not permit its net capital to be
less than 2% of aggregate customer debit items. See Rule 15c3-
1(a)(1)(ii). Customer debit items--computed pursuant to Exhibit A to
Rule 15c3-3, which is described below--consist of, among other
things, margin loans to customers and securities borrowed to
effectuate customer deliveries of securities on short sales.
    \27\ A broker-dealer computes its actual net capital by first
calculating its net worth using United States (``U.S.'') generally
accepted accounting principles. Second, qualifying subordinated
loans are added to net worth. Third, illiquid assets such as real
estate, fixtures, furniture, goodwill, and most unsecured
receivables are subtracted from net worth. Illiquid securities also
must be deducted. Finally, the broker-dealer must reduce
(``haircut'') the market value of the liquid securities it owns by a
percentage amount. This ``haircut'' provides a cushion against
adverse market movements and other risks faced by the broker-dealer.
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    Rule 15c3-3 imposes two key requirements on carrying broker-
dealers. First, each carrying broker-dealer must obtain physical
possession or control over customers' fully paid and excess margin
securities.\28\ ``Control'' means the broker-dealer must hold these
securities free of lien in one of several locations specified in the
rule (e.g., a bank or clearing agency).\29\ Under Rule 15c3-3, the
broker-dealer must make a daily determination from its books and
records (as of the preceding day) of the quantity of fully paid and
excess margin securities in its possession or control and the quantity
of fully paid and excess margin securities not in its possession or
control.\30\ If the amount in the broker-dealer's possession and
control is less than the amount indicated as being held for customers
on the broker-dealer's books and records, the broker-dealer generally
must initiate steps to retrieve customer securities from non-control
locations or otherwise obtain possession of them or place them in
control locations.\31\
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    \28\ See Rule 15c3-3(b)(1).
    \29\ See Rule 15c3-3(c).
    \30\ See Rule 15c3-3(d).
    \31\ Id.
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    The second key requirement in Rule 15c3-3 is that the carrying
broker-dealer must maintain at a bank or banks cash or qualified
securities \32\ on deposit in a ``Special Reserve Bank Account for the
Exclusive Benefit of Customers'' equaling at least the net amount
computed by adding customer credit

items (e.g., cash in securities accounts) and subtracting from that
amount customer debit items (e.g., margin loans).\33\ Rule 15c3-3 is
designed to protect customer funds and securities by generally
segregating them from the broker-dealer's proprietary business
activities. If the carrying broker-dealer fails, customer funds and
securities should be readily available for return to customers. The
rule requires carrying broker-dealers to compute the customer reserve
requirement on a weekly basis, except where customer credit balances do
not exceed $1 million (in which case the computation can be performed
monthly, although, in this case, the broker-dealer must maintain 105%
of the required deposit amount).\34\
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    \32\ The term ``qualified security'' is defined in Rule 15c3-3
to include securities issued by the U.S. or guaranteed by the U.S.
with respect to principal and interest. See Rule 15c3-3(a)(6).
    \33\ See Rule 15c3-3(e).
    \34\ See Rule 15c3-3(e)(3).
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    Rule 17a-13 requires a broker-dealer that holds securities
(proprietary, customer, or both), on a quarterly basis, to examine and
count the securities it physically holds, account for the securities
that are subject to its control or direction but are not in its
physical possession (e.g., securities held at a control location),
verify the securities, and compare the results of the count and
verification with its records. The broker-dealer must take an
operational capital charge under Rule 15c3-1 for all short securities
differences (which include securities positions reflected on the
broker-dealer's securities record that are not susceptible to either
count or confirmation) unresolved after discovery.\35\ The differences
also must be recorded on the broker-dealer's records.\36\
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    \35\ See Rule 15c3-1(c)(2)(v).
    \36\ See Rule 17a-3(a)(4)(vi).
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    The Account Statement Rules of DEAs require member broker-dealers
to send, at least once every calendar quarter, a statement of account
containing a description of any securities positions, money balances,
or account activity to each customer whose account had a security
position, money balance, or account activity during the period since
the last such statement was sent to the customer.\37\
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    \37\ For example, NASD Rule 2340 requires broker-dealers that
are members of FINRA that conduct a general securities business to
send account statements to customers at least quarterly. The current
FINRA rulebook consists of: (1) FINRA rules; (2) NASD rules; and (3)
rules incorporated from the NYSE (``Incorporated NYSE Rules'')
(together, the NASD rules and Incorporated NYSE Rules are referred
to as the ``Transitional Rulebook''). While the NASD rules generally
apply to all FINRA members, the Incorporated NYSE Rules apply only
to those members of FINRA that are also members of the NYSE. The
FINRA rules apply to all FINRA members, unless such rules have a
more limited application by their terms. For more information see
FINRA's Information Notice, Mar. 12, 2008 (Rulebook Consolidation
Process). If a broker-dealer's DEA is the Chicago Board Options
Exchange (the ``CBOE''), the broker-dealer would be subject to
CBOE's account statement rule, CBOE Rule 9.12.
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B. Proposed Audit Reports and Changes to Applicable Auditing Standards

    As part of the Annual Reporting Amendments, the Commission is
proposing changes that would revise the reports that broker-dealers
file under Rule 17a-5. While the requirement that broker-dealers file a
report consisting of the audited financial statements and supporting
schedules that are currently required under Rule 17a-5 (the ``Financial
Report'') would remain unchanged, carrying broker-dealers would be
required to file a new report asserting to compliance with specified
rules and related internal controls (the ``Compliance Report''). These
broker-dealers also would be required to file a report from their
independent public accountants (the ``Examination Report'') that
addresses the assertions in the Compliance Report. Broker-dealers that
do not hold customer funds or securities would be required to file a
report asserting their exemption from the requirements of Rule 15c3-3
(the ``Exemption Report) and a report from their independent public
accountants that would be the result of a review of the broker-dealer's
assertion that it is exempt from Rule 15c3-3. Finally, the proposed
amendments would change the audit standards applicable to broker-dealer
audits and compliance examinations from GAAS to standards promulgated
by the PCAOB.
    To implement these changes, the Commission proposes a number of
amendments to Rule 17a-5. The Commission proposes that paragraph (d) of
Rule 17a-5 be re-titled from ``Annual filing of audited financial
statements'' to ``Annual reports,'' because under the proposed
revisions to paragraph (d), broker-dealers would generally be required
to file a Financial Report and a Compliance Report or an Exemption
Report with the Commission.\38\ Paragraph (d)(1) of Rule 17a-5 would be
amended to set forth the general requirement for broker-dealers to file
annual financial reports with the Commission. These reports would
include: (1) A ``Financial Report'' as described in paragraph (d)(2),
which would consist of the audited financial statements and supporting
schedules that broker-dealers are currently required to file with the
Commission; \39\ (2) a Compliance Report as described in paragraph
(d)(3) unless the broker-dealer is exempt from the provisions of Rule
15c3-3,\40\ or an Exemption Report as described in paragraph (d)(4) if
the broker-dealer claims an exemption from the provisions of Rule 15c3-
3; \41\ and (3) reports prepared by the independent public accountant
pursuant to the engagement provisions in paragraph (g), unless the
broker-dealer is exempt from the requirement to either file the annual
audit report or engage an independent public accountant pursuant to
paragraphs (d)(1) and (e)(1) of Rule 17a-5.\42\ The proposed
requirements for the Compliance Report and Exemption Report are
described in greater detail below.
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    \38\ Paragraph (d) of Rule 17a-5, currently titled ``Annual
filing of audited financial statements,'' is being renamed to
reflect that the Commission will now require broker-dealers to file
two reports with the Commission (i.e., a Financial Report and a
Compliance Report, or a Financial Report and an Exemption Report).
    \39\ Proposed paragraph (d)(1)(i)(A) of Rule 17a-5. See also
Rule 17a-5(d)(2), which lists the requirements to be included in the
Financial Report and would continue to do so because the Commission
is not proposing any amendment to the financial statements and
supporting schedules required of the broker-dealer. The Commission
proposes a technical amendment, to rename the annual audit report to
``Financial Report,'' to reflect that proposed paragraph (d)(2)
relates to the financial audit requirements.
    \40\ Proposed paragraph (d)(1)(i)(B)(1) of Rule 17a-5.
    \41\ Proposed paragraph (d)(1)(i)(B)(2) of Rule 17a-5.
    \42\ Proposed paragraph (d)(1)(i)(C) of Rule 17a-5.
Specifically, Rule 17a-5(d)(1)(ii) states that ``a broker or dealer
succeeding to and continuing the business of another broker or
dealer need not file a report * * * if the predecessor broker or
dealer has filed a report in compliance with [Rule 17a-5(d)] * *
*.'' Rule 17a-5(d)(1)(iii) contains an exemption for broker-dealers
from filing an annual audit report if the broker-dealer is a member
of a national securities exchange and ``has transacted a business in
securities solely with or for other members of a national securities
exchange, and has not carried any margin account, credit balance or
security for any person who is defined as a `customer' in paragraph
(c)(4) of [Rule 17a-5].'' Rule 17a-5(e)(1) provides that for certain
broker-dealers, the financial statements that must be filed pursuant
to Rule 17a-5(d) need not be audited. The exceptions in paragraphs
(e)(1)(A)-(B) of Rule 17a-5 are applicable when either: (1) The
broker-dealer's securities business has been limited to acting as
broker (agent) for an issuer in soliciting subscriptions for
securities of the issuer and the broker has promptly transmitted to
the issuer all funds and promptly delivered to the subscriber all
securities received in connection with the issuance, and the broker
has not otherwise held funds or securities for or owed money or
securities to customers; or (2) the broker-dealer's securities
business has been limited to buying and selling evidences of
indebtedness secured by mortgage, deed or trust, or other lien upon
real estate or leasehold interests, and the broker-dealer has not
carried any margin account, credit balance or security for any
securities customer.
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1. Compliance Report
    Under the proposed amendments to paragraph (d) of Rule 17a-5, each
carrying broker-dealer would be required annually to file a Compliance

Report containing a statement and assertions concerning compliance, and
internal control over compliance, with specified rules. Specifically,
the Compliance Report would include a statement as to whether the
broker-dealer has established and maintained a system of internal
control to provide the broker-dealer with reasonable assurance \43\
that any instances of material non-compliance with Rule 15c3-1, Rule
15c3-3, Rule 17a-13, or the Account Statement Rule (collectively, the
``Financial Responsibility Rules'') will be prevented or detected on a
timely basis. The Compliance Report is intended to enhance a broker-
dealer's focus on compliance with the specified rules and provide a
foundation for the proposed ``Compliance Examination'' described below
in Section II.B.2 of this release.\44\
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    \43\ Exchange Act Section 13(b)(7) defines ``reasonable
assurance'' and ``reasonable detail'' as ``such level of detail and
degree of assurance as would satisfy prudent officials in the
conduct of their own affairs.'' 15 U.S.C. 78m(b)(7). The Commission
has long held that ``reasonableness'' is not an ``absolute standard
of exactitude for corporate records.'' See Foreign Corrupt Practices
Act of 1977, Exchange Act Release No. 17500 (Jan. 29, 1981), 46 FR
11544, 11546 (Feb. 9, 1981). These concepts differ from the concept
of ``reasonable assurance'' in an audit context.
    \44\ The Compliance Examination is discussed below in Section
II.B.2 of this release. As is discussed in Section II.B.2, the
Commission does not propose the statement in the Compliance Report
to be included within the scope of the Compliance Examination.
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    In addition, the Compliance Report would include the following
three assertions by the broker-dealer: (1) Whether the broker-dealer
was in compliance in all material respects with the Financial
Responsibility Rules as of its fiscal year-end; \45\ (2) whether the
information used to assert compliance with the Financial Responsibility
Rules was derived from the books and records of the broker-dealer; \46\
and (3) whether internal control over compliance with the Financial
Responsibility Rules was effective during the most recent fiscal year
such that there were no instances of material weakness.\47\ Further,
the Compliance Report would be required to contain a description of
each identified instance of material non-compliance and each identified
material weakness in internal control over compliance with the
specified rules.\48\
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    \45\ See proposed paragraph (d)(3)(i)(B)(1) of Rule 17a-5.
    \46\ See proposed paragraph (d)(3)(i)(B)(2) of Rule 17a-5.
    \47\ See proposed paragraph (d)(3)(i)(B)(3) of Rule 17a-5.
    \48\ See proposed paragraph (d)(3)(i)(C) of Rule 17a-5.
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    Rule 17a-5(g) currently requires that the audit include a review of
compliance with and controls pertaining to Rule 15c3-1, Rule 15c3-3,
and Rule 17a-13. As described above, these rules contain important
baseline protections concerning broker-dealer capital adequacy and the
protection of customer funds and securities, and the Commission
preliminarily believes that it is important that they be addressed in
any annual report of a carrying broker-dealer. The proposed Compliance
Report would not cover Regulation T, which is currently addressed in
existing Rule 17a-5(g)(1)(iii). The Commission believes that the
inclusion of Regulation T in the scope of the Compliance Report would
not be necessary given the broker-dealer's assertion in the Compliance
Report of its compliance with Rule 15c3-1. In particular, a broker-
dealer's failure to comply with Regulation T, which governs broker-
dealers' extensions of credit on securities, could require a broker-
dealer to reduce its net capital by the amount of any deficit in
customer unsecured and partly secured accounts after calls for
margin.\49\
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    \49\ See Rule 15c3-1(c)(2)(iv)(B).
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    The Commission also is proposing to require that the Compliance
Report include a statement and three assertions concerning the Account
Statement Rule. The Account Statement rule provides a key safeguard for
customers by ensuring that they receive on a regular basis information
concerning securities positions and other assets held in their
accounts. Customers can use that information to identify discrepancies
and monitor the performance of their accounts. The Commission believes
that, taken together, the objectives of the Compliance Report are
consistent with the control objectives of the internal control report
required under the IA Custody Rule.\50\
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    \50\ See Section II.B.4 of this release for a discussion of the
IA Custody Rule and the control objectives required under the IA
Custody Rule.
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    The assertions contained in the Compliance Report would pertain to
compliance at year-end and also over the course of a fiscal quarter,
depending on the particular requirement.\51\ The proposed assertions
with respect to compliance with Rules 15c3-1 and 15c3-3 would relate to
compliance as of the broker-dealer's fiscal year-end. The assertions as
to compliance with Rule 17a-13 and the Account Statement Rule also
would be made as of the broker-dealer's fiscal year-end. However,
because these rules impose obligations on a quarterly basis (the
broker-dealer must conduct the quarterly count of securities and must
send statements to all customers at least once during each quarter, but
not necessarily on the last day of the quarter), to be able to make the
assertions in the Compliance Report, the broker-dealer would need to
determine that it had satisfied the requirements over the course of the
fiscal quarter immediately preceding the broker-dealer's fiscal year-
end. In contrast, the broker-dealer's assertions related to the
effectiveness of internal control over compliance with the Financial
Responsibility Rules would not pertain to a fixed point in time, but
instead would cover the entire fiscal year. The proposed time periods
related to internal control over compliance would be consistent with
those in the IA Custody Rule.\52\
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    \51\ The broker-dealer is required to be in compliance with the
Financial Responsibility Rules at all times. The assertions made by
the broker-dealer for purposes of the Compliance Report are as of a
point in time to facilitate the independent public accountant's
attestation to the broker-dealer's assertions.
    \52\ See Rule 206(4)-2(a)(6).
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    The Commission preliminarily believes that broker-dealers would be
able to make assertions regarding both compliance and the effectiveness
of internal control over compliance with the Financial Responsibility
Rules. The Commission is not proposing that effectiveness of internal
control over financial reporting be included as one of the assertions
made by the broker-dealer in the Compliance Report.\53\ The Commission
preliminarily believes that the Compliance Report should focus on
oversight of custody arrangements and protection of customer assets,
and therefore, should be focused on compliance with the Financial
Responsibility Rules.
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    \53\ For example, the Commission is not proposing an assessment
of internal control over financial reporting similar to the
assessment required under Section 404 of the Sarbanes-Oxley Act for
issuers.
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    The proposed amendments to Rule 17a-5 would provide that a broker-
dealer could not assert compliance with the Financial Responsibility
Rules, as of its most recent fiscal year-end, if it identifies one or
more instances of material non-compliance.\54\ Instead, the broker-
dealer would need to identify and describe any instance of material
non-compliance, as of its most recent fiscal year-end, in the
Compliance Report.\55\ Rule 17a-5 presently requires that independent
public accountants include any instances of material inadequacies in
their reports based on the Study.\56\ The term ``material

inadequacies,'' however, is not defined in existing auditing
literature. The Commission is proposing to remove the reference to
``material inadequacies'' in Rule 17a-5 and replace it, for purposes of
reporting on the broker-dealer's compliance, with a reference to
``material non-compliance.'' Further, the Commission is proposing to
define an instance of material non-compliance, in new paragraph
(d)(3)(ii) of Rule 17a-5, as a failure by the broker-dealer to comply
with any of the requirements of the Financial Responsibility Rules in
all material respects. The Commission preliminarily believes that any
failure by the broker-dealer to perform any of the procedures
enumerated in the Financial Responsibility Rules would be an instance
of non-compliance; therefore, the broker-dealer should evaluate any
such failure to determine whether it is material.
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    \54\ See proposed paragraph (d)(3)(ii) of Rule 17a-5. The
Commission notes that reporting on material non-compliance is
discussed, for example, in AT Sec.  601 of the PCAOB's Interim
Attestation Standards; see PCAOB Attestation Standard Sec.  601.
    \55\ See proposed paragraph (d)(3)(ii) of Rule 17a-5.
    \56\ See Rule 17a-5(g).
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    When determining whether an instance of non-compliance is material,
the Commission preliminarily believes that the broker-dealer should
consider all relevant factors including but not limited to: (1) The
nature of the compliance requirements, which may or may not be
quantifiable in monetary terms; (2) the nature and frequency of non-
compliance identified; and (3) qualitative considerations.\57\ The
Commission also preliminarily believes that some deficiencies would
necessarily constitute instances of material non-compliance. For
example, failing to maintain the required minimum amount of net capital
as required under Rule 15c3-1, or failing to maintain the minimum
deposit requirement in a special reserve bank account for the exclusive
benefit of customers under Rule 15c3-3,\58\ would be instances of
material non-compliance. These two instances of material non-compliance
would not, however, represent all possible instances of material non-
compliance with respect to Rules 15c3-1 and 15c3-3.
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    \57\ See, e.g., paragraph 36 of PCAOB Attestation Standard Sec.
601.
    \58\ See Section 15(c)(3) of the Exchange Act, which provides
that no broker or dealer shall make use of the mails or any means or
instrumentality of interstate commerce to effect any transaction in,
or to induce or attempt to induce the purchase or sale of, any
security ``in contravention of such rules and regulations as the
Commission shall prescribe * * * to provide safeguards with respect
to the financial responsibility and related practices of the brokers
and dealers including, but not limited to the acceptable custody and
use of customers' securities and the carrying and use of customers'
deposits or credit balances.'' 15 U.S.C. 78o(c)(3)(A).
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    The Commission is proposing several conforming amendments to Rule
17a-5 to incorporate the proposed use of the term ``material non-
compliance.'' The Commission proposes to amend paragraph (c)(5) of Rule
17a-5, which requires broker-dealers to send Statements of Financial
Condition to customers twice per year. Paragraph (c) of Rule 17a-5
provides that a broker-dealer can make these statements available
through its Internet Web site in lieu of sending the statements to the
customers in paper form.\59\ However, paragraph (c)(5)(vi) of Rule 17a-
5 prohibits broker-dealers from making the statements available online,
in lieu of sending statements to customers in paper form, if the
broker-dealer was required by paragraph (e) of Rule 17a-11 to give
notice of a material inadequacy. The Commission is proposing to delete
the reference to the term ``material inadequacy'' and amend paragraph
(c)(5)(vi) of Rule 17a-5 to provide that the broker-dealer may make the
customer statements available online, in lieu of sending statements to
customers in paper form, provided its financial statements receive an
unqualified opinion from the independent public accountant and neither
the broker-dealer nor the independent public accountant identifies a
material weakness or an instance of material non-compliance pursuant to
proposed new paragraph (g) of Rule 17a-5, described below.
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    \59\ Rule 17a-5 requires that the statements be sent to its
customers, except if the activities of the broker-dealer are limited
to certain enumerated activities or except as provided in paragraph
(c)(5), which permits the broker-dealer to instead make the
statements available online if certain requirements are met. See
Rule 17a-5(c)(1) and (c)(5).
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    The proposed amendments to Rule 17a-5 also would provide that a
broker-dealer could not assert that its internal control over
compliance with the Financial Responsibility Rules during the fiscal
year was effective if one or more material weaknesses exist with
respect to internal control over compliance.\60\ The Commission
preliminarily believes that a broker-dealer's internal control over
compliance with the Financial Responsibility Rules would not be
effective if a material weakness exists, given the meaning of the term
``material weakness'' as described below. Consequently, if one or more
material weaknesses exist, the broker-dealer would need to describe in
the Compliance Report each material weakness identified during the
fiscal year.\61\ This would provide the Commission with notice of the
nature of any weakness and allow the Commission and DEA examination
staff to ascertain how the broker-dealer addressed each weakness.
---------------------------------------------------------------------------

    \60\ See proposed paragraph (d)(3)(iii) of Rule 17a-5.
    \61\ See proposed paragraph (d)(3)(i)(C) of Rule 17a-5.
---------------------------------------------------------------------------

    The Commission is proposing to define the term ``material
weakness'' in paragraph (d)(3)(iii) of Rule 17a-5 as a deficiency, or a
combination of deficiencies, in internal control over compliance with
the Financial Responsibility Rules, such that there is a reasonable
possibility that material non-compliance with those provisions will not
be prevented or detected on a timely basis. For purposes of this
paragraph, a deficiency in internal control over compliance would exist
when the design or operation of a control does not allow the broker-
dealer, in the normal course of performing its assigned functions, to
prevent or detect non-compliance with the Financial Responsibility
Rules on a timely basis.\62\ The Commission proposes these definitions,
in part, because they are based on previous Commission action.\63\
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    \62\ See proposed paragraph (d)(3)(iii) of Rule 17a-5.
    \63\ See Amendments to Rules Regarding Management's Report on
Internal Control Over Financial Reporting, Exchange Act Release No.
55928 (Jun. 27, 2007), 72 FR 35310 (Jun. 27, 2007). See also
Exchange Act Rule 12b-2 (17 CFR 240.12b-2) and Rule 1-02 of
Regulation S-X (17 CFR 210.1-02), which state that a ``material
weakness is a deficiency, or a combination of deficiencies, in
internal controls over financial reporting such that there is a
reasonable possibility that a material misstatement of the
registrant's annual or interim financial statements will not be
prevented or detected on a timely basis.''
---------------------------------------------------------------------------

    The Commission preliminarily believes that, for purposes of the
proposed definition of the term ``material weakness,'' there is a
reasonable possibility of an event occurring if it is ``probable'' or
``reasonably possible.'' An event is ``probable'' if the future event
or events are likely to occur.\64\ An event is ``reasonably possible''
if the chance of the future event or events occurring is more than
remote, but less than likely.\65\
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    \64\ See Commission Guidance Regarding Management's Report on
Internal Control Over Financial Reporting Under Section 13(a) or
15(d) of the Securities Exchange Act of 1934, Securities Act of 1933
Release No. 8810 (Jun. 20, 2007), 72 FR 35324 (Jun. 27, 2007), at
note 47 and corresponding text.
    \65\ Id.
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    The Commission preliminarily believes that an instance of non-
compliance that the broker-dealer has determined does not constitute
material non-compliance may nonetheless be indicative of a control
deficiency that constitutes a material weakness. The broker-dealer's
evaluation of whether an instance of non-compliance is material would
be based upon the consideration of the specifically identified instance
of non-compliance; whereas the broker-

dealer's conclusions with respect to whether the related control
deficiency or deficiencies are material weaknesses would relate to
whether it is reasonably possible that the control deficiency or
deficiencies could result in material non-compliance. This evaluation
would require the broker-dealer to consider not only the specifically
identified instance of non-compliance but also any additional possible
effect that the control deficiency or deficiencies could have on
compliance.
    The Commission generally requests comment on the proposed
amendments associated with the proposed Compliance Report. In addition,
the Commission requests comment on the following questions:
     Should other rules be included in the scope of the
Compliance Report, in addition to, or as an alternative to, the
Financial Responsibility Rules? If so, which rules? Commenters should
explain their choices.
     Should the proposed Compliance Report cover Regulation T?
     Are the proposed assertions appropriate? Are there other
assertions that the broker-dealer should make regarding either
compliance or internal control over compliance? Why would any
additional assertions result in improved reporting to the Commission?
     Would all of the proposed assertions achieve the
Commission's goals to, among other things, strengthen broker-dealers'
compliance with the Financial Responsibility Rules, and, in turn,
improve the financial and operational condition of broker-dealers and
the safeguarding of investor assets?
     What additional steps would a broker-dealer likely have to
take in order to comply with the proposed requirements and make each
additional proposed assertion?
     Are there any practical issues the Commission should
consider with respect to the proposal to assert compliance with the
Financial Responsibility Rules?
     Is the proposed definition of the term ``material non-
compliance'' understandable in the context of broker-dealer audits?
What alternative definition could be used? Why would any alternative
definition be more appropriate?
     Are the examples of material non-compliance described
above appropriate? What other examples of material non-compliance
should be specifically identified, if any? Should the Commission
include examples of material non-compliance in the text of the rule?
     Is the proposed definition of the term ``material
weakness'' understandable in the context of Rule 17a-5? What
alternative definition could be used? Why would any alternative
definition be more appropriate?
     Is the proposed definition of ``deficiency in internal
control over compliance'' understandable in the context of Rule 17a-5?
What alternative definition could be used? Why would any alternative
definition be more appropriate?
2. Compliance Examination and Examination Report
    The Commission proposes to require each carrying broker-dealer to
engage an independent public accountant to examine the broker-dealer's
assertions in the Compliance Report (``Compliance Examination'') and
issue an Examination Report. Under the proposal, following the
Compliance Examination, carrying broker-dealers would be required to
file the resulting Examination Report of the independent public
accountant with the Commission. This Compliance Examination and
Examination Report would replace the existing practice that results in
the independent public accountant issuing a report based on a Study.
    The Commission proposes to amend paragraph (g) of Rule 17a-5 and
rename it ``Engagement of independent public accountant.'' As proposed,
paragraph (g) would provide that a broker-dealer subject to the
requirement to file annual reports pursuant to paragraph (d) would need
to engage an independent public accountant to examine or review, as
applicable, the reports that are required under that provision. Each
carrying broker-dealer would be required to engage its independent
public accountant to prepare the Examination Report based on an
examination of the assertions contained in the Compliance Report
required to be filed pursuant to paragraph (d)(3) of Rule 17a-5.\66\
The Examination Report would be required to be prepared in accordance
with PCAOB standards.\67\
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    \66\ See proposed paragraph (g)(2)(i) of Rule 17a-5.
    \67\ Id. The Commission preliminarily believes that the
independent public accountant's examination would be conducted
pursuant to existing PCAOB Attestation Standards or other standards
established by the PCAOB for such purposes.
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    The proposed changes would not affect existing obligations of
broker-dealers or their accountants with respect to financial
reporting.\68\ Further, the assertions in the Compliance Report would
not cover the effectiveness of internal control over financial
reporting. Therefore, the independent public accountant would not be
required in the Examination Report to opine on the effectiveness of the
broker-dealer's internal control over financial reporting. However, the
accountant's existing obligation to gain an understanding and perform
appropriate procedures relative to the broker-dealer's internal control
over financial reporting, as a necessary part of the independent public
accountant's financial statement audit, would remain unchanged.\69\
Further, the Examination Report would pertain solely to the assertions
in the Compliance Report and not to the broker-dealer's process for
arriving at the assertions. Because the report of the independent
public accountant required by proposed paragraph (g) of Rule 17a-5
would require the accountant to perform its own independent examination
of the related controls and procedures, the Commission preliminarily
does not believe that it is necessary for the independent public
accountant to provide an opinion with regard to the process that the
broker-dealer used to arrive at its conclusions.
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    \68\ The Commission is not proposing to change existing
requirements with regard to the broker-dealer's audited financial
statements, the computation of required and actual net capital under
Rule 15c3-1, or, for carrying broker-dealers, the computation of the
customer reserve requirement under Rule 15c3-3. The computation of
net capital and the computation of the customer reserve requirement
would continue to be subject to audit procedures by the accountant.
    \69\ See PCAOB Auditing Standard No. 12, Identifying and
Assessing Risks of Material Misstatements for audits of fiscal years
beginning on or after December 15, 2010.
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    The Commission preliminarily intends that the proposed amendments
and requirements pertaining to the Examination Report would result in
the following fundamental changes to broker-dealer audits. First,
broker-dealer examinations would be performed in accordance with PCAOB
standards, rather than GAAS, consistent with the Dodd-Frank Act.\70\
Second, in connection with their engagement, independent public
accountants would be required to provide an opinion concerning the
broker-dealer's compliance, and internal control over compliance, with
key regulatory requirements. Further, the independent public
accountant's report, as it applies to internal control over compliance,
would cover the full fiscal year instead of relating to the
effectiveness of controls only at year-end. Compliance with the Account
Statement Rules would be included as part of the review. These changes
are intended to encourage, in connection with broker-dealer audits,
greater focus by the auditor on internal control over

compliance as it pertains to key regulatory requirements, including, in
particular, greater focus on broker-dealer custody practices under the
Financial Responsibility Rules. In addition, the Commission intends
that the amendments, as they pertain to custody of customer funds and
securities, will better align the broker-dealer custody requirements
with certain requirements in the IA Custody Rule.\71\
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    \70\ See Section 982 of the Dodd-Frank Act.
    \71\ See Rule 206(4)-2(a)(6)(ii)(A).
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    The Commission generally requests comment on the proposed
amendments and, in particular, the Compliance Examination and
Examination Report provisions. In addition, the Commission requests
comment on the following questions:
     Should the Compliance Examination also cover a broker-
dealer's statement in the Compliance Report as to whether the broker-
dealer has established and maintained a system of internal control to
provide the broker-dealer with reasonable assurance that any instances
of material non-compliance with the Financial Responsibility Rules will
be prevented or detected on a timely basis? If so, why? If not, why
not?
     Should the independent public accountant provide an
opinion with regard to the process that the broker-dealer used to
arrive at its assertions?
3. Notification Requirements
    The proposed amendments would require that the independent public
accountant notify the Commission within one business day if the
accountant determines that an instance of ``material non-compliance''
exists with respect to any of the Financial Responsibility Rules during
the course of the examination.\72\ This notice requirement would be
triggered at the time that the independent public accountant determines
that material non-compliance exists, not at the time of completion of
the examination. Alerting the Commission to a broker-dealer's material
non-compliance with the Financial Responsibility Rules on an expedited
basis could enable the Commission to react to the non-compliance more
quickly for the protection of investors and others. Currently, Rule
17a-5 requires notification in the event the independent public
accountant determines the existence of a ``material inadequacy.'' \73\
Specifically, the independent public accountant must call the material
inadequacy to the attention of the broker-dealer's chief financial
officer, who is then obligated to notify the Commission and the broker-
dealer's DEA.
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    \72\ See proposed paragraph (h) of Rule 17a-5.
    \73\ See Rule 17a-5(h)(2). ``Material inadequacy'' is not a
defined term in existing auditing literature.
---------------------------------------------------------------------------

    The Commission proposes modifying the notification requirement to
replace the term ``material inadequacy'' with ``material non-
compliance'' and to require the independent public accountant to notify
the Commission directly. Specifically, the Commission proposes to amend
paragraph (h) of Rule 17a-5 to provide that upon determining the
existence of any material non-compliance during the course of preparing
the independent public accountant's reports, the independent public
accountant must notify the Commission within one business day of the
determination by means of a facsimile transmission or electronic mail,
followed by first class mail, and must provide a copy of the
notification in the same manner to the principal office of the DEA for
the broker-dealer. The Commission preliminarily believes that this
change would provide more effective and timely notice of broker-dealer
compliance deficiencies, and, as noted above, enable the Commission to
react more quickly to protect customers and others adversely affected
by those deficiencies. It also would be consistent with current
notification requirements applicable to independent public accountants
examining investment advisers pursuant to the IA Custody Rule.\74\
---------------------------------------------------------------------------

    \74\ See Rule 206(4)-2(a)(4)(ii).
---------------------------------------------------------------------------

    The Commission is proposing a conforming amendment to paragraph (e)
of Rule 17a-11, which now requires that broker-dealers provide notice
to the Commission of the existence of any material inadequacy. The
Commission also is proposing two technical amendments to correct
certain references to Rule 17a-12 in paragraph (e) of Rule 17a-11.\75\
Further, the Commission is proposing to delete paragraph (h)(1) of Rule
17a-5, which relates to the extent and timing of broker-dealer audits,
and which would now be superseded by paragraphs (d) and (g).\76\
Finally, the Commission is proposing to delete paragraph (j) of Rule
17a-5, which currently requires the filing of an independent public
accountant's report describing any material inadequacies concurrent
with the annual audit report. This requirement likewise would be
superseded by the proposed amendments.
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    \75\ Specifically, the Commission proposes to amend the
references for Rule 17a-12(f)(2) and Rule 17a-12(e)(2) to be Rule
17a-12(i)(2) and Rule 17a-12(h)(2), respectively.
    \76\ As discussed above, the broker-dealer must assert that it
is in compliance in all material respects with the Financial
Responsibility Rules as of the fiscal year-end and that its internal
controls over compliance were effective throughout the fiscal year.
See proposed paragraph (d)(3) of Rule 17a-5.
---------------------------------------------------------------------------

    The Commission generally requests comment on the proposed
amendments and the notification provisions. In addition, the Commission
requests comment on the following questions:
     Would an alternative means to notify the Commission of an
instance of material non-compliance be appropriate? If so, what
alternative and why?
4. Comparison to the IA Custody Rule
    The IA Custody Rule provides that a registered investment adviser
is prohibited from having 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.\77\ Under the IA Custody Rule, only banks, certain savings
associations, registered broker-dealers, registered futures commission
merchants (``FCMs''),\78\ and certain foreign financial institutions
may act as qualified custodians.\79\
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    \77\ See Rule 206(4)-2(a)(1)(i)-(ii).
    \78\ FCMs are individuals, associations, partnerships,
corporations, and trusts that solicit or accept orders for the
purchase or sale of any commodity for future delivery on or subject
to the rules of any exchange and that accept payment from or extend
credit to those whose orders are accepted. See the Commodity Futures
Trading Commission Glossary available at http://www.cftc.gov.
    \79\ For the complete definition of the term ``qualified
custodian,'' see infra note 154.
---------------------------------------------------------------------------

    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. This
report must be supported by the independent public accountant's
examination of the qualified custodian's custody controls.\80\ The
Commission has

issued guidance identifying the control objectives that would need to
be included in the scope of the examination.\81\
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    \80\ The IA Custody Rule 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.'' The required
controls are not enumerated in the rule, however.
    \81\ 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 1942 (Jan. 11, 2010). The Commission guidance on
the IA Custody Rule provided 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.
---------------------------------------------------------------------------

    The control objectives identified in the Commission's guidance on
the IA Custody Rule are more general than the specific operational
requirements in the Financial Responsibility Rules. These general
control objectives are appropriate for purposes of the IA Custody Rule,
since this approach allows the different types of qualified custodians
(banks, certain savings associations, registered broker-dealers,
registered 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. For example, the manner in
which an FCM maintains custody of assets \82\ differs from that of a
bank, and the different entities are subject to different regulations
governing their custodial functions.
---------------------------------------------------------------------------

    \82\ See section 4d(a) and (b) of the Commodity Exchange Act (7
U.S.C. 4d); see also 17 CFR 1.20 to 1.30.
---------------------------------------------------------------------------

    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.\83\ The Commission preliminarily believes that the
operational requirements of those rules are consistent with the control
objectives outlined in the Commission's guidance on the IA Custody
Rule. Consequently, the Commission has preliminarily determined that,
if the proposed rule amendments are adopted, a broker-dealer subject to
the proposed Compliance Examination that also acts as a qualified
custodian for itself as an investment adviser or for its related
investment advisers under the IA Custody Rule would be able to use the
Examination Report to satisfy the reporting requirements under Rule
17a-5 and the IA Custody Rule's internal control report requirement.
---------------------------------------------------------------------------

    \83\ 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 Rule 15c3-1(c)(2)(v)(A).
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    The Commission generally requests comment on the comparability of
the scope of the internal control report under the IA Custody Rule and
the scope of the proposed Compliance Examination under the proposed
amendments to Rule 17a-5. In addition, the Commission requests comment
on the following question:
     Should the Commission add additional elements to the scope
of the proposed Examination Report? Commenters should identify any such
elements and discuss the feasibility, benefits and costs of including
them as elements in the scope of the proposed Compliance Examination.
5. Proposed Exemption Report
    As discussed above, broker-dealers claiming an exemption from Rule
15c3-3 (i.e., non-carrying broker-dealers) are required to have their
independent public accountants ``ascertain that the conditions of the
exemption were being complied with as of the examination date and that
no facts came to the [independent public accountant's] attention to
indicate that the exemption had not been complied with during the
period since [the independent public accountant's] last examination.''
\84\ The Commission proposes to amend this requirement by requiring a
non-carrying broker-dealer claiming an exemption from Rule 15c3-3 to
file a new Exemption Report.\85\ This Exemption Report would replace
the existing requirement described above.
---------------------------------------------------------------------------

    \84\ See Rule 17a-5(g)(2).
    \85\ A non-carrying broker-dealer would file the Exemption
Report and corresponding report prepared by its independent public
accountant in lieu of the Compliance Report and Examination Report.
The Commission notes, however, that under the IA Custody Rule, a
non-carrying or ``introducing'' broker-dealer may be a ``qualified
custodian.'' In this case, in order to receive an internal control
report that would satisfy the IA Custody Rule, the non-carrying
broker-dealer would have to be separately examined by an independent
public accountant for that purpose.
---------------------------------------------------------------------------

    Specifically, under new paragraph (d)(4) of Rule 17a-5, the
Exemption Report would require an assertion by a broker-dealer that it
is exempt from the provisions of Rule 15c3-3 because it meets one or
more of the conditions set forth in paragraph (k) of Rule 15c3-3 with
respect to all of its business activities.\86\ In addition, the non-
carrying broker-dealer would be required to engage an independent
public accountant to review the assertion in the Exemption Report and
prepare a report based on that review and in accordance with standards
of the PCAOB.\87\ If the independent public accountant is aware of any
material modifications \88\ that should be made to the assertion
contained in the Exemption Report, the independent public accountant
would be required to disclose them in its report. The Commission
preliminarily believes that an example of a discovery that would
necessitate a material modification would be a discovery that the
broker-dealer failed to promptly forward any customer securities it
received.\89\
---------------------------------------------------------------------------

    \86\ See Rule 15c3-3(k), which sets forth the exemptions to Rule
15c3-3.
    \87\ See proposed paragraph (g)(2)(ii) of Rule 17a-5.
    \88\ See paragraph 90 of PCAOB Attestation Standard Sec.  101.
    \89\ See Rule 15c3-3(k)(2)(ii), which provides that an
introducing broker-dealer is exempt from the requirements of Rule
15c3-3 if the introducing broker-dealer ``promptly transmits all
customer funds and securities to the clearing broker or dealer which
carries all of the accounts of such customers * * *''
---------------------------------------------------------------------------

    The Commission preliminarily believes that the independent public
accountant would be able to obtain the moderate level of assurance
contemplated by the required review \90\ through a combination of
procedures that the accountant would perform in connection with the
financial audit currently required under Rule 17a-5 \91\ and certain
inquiries and other procedures targeted specifically to the exemption
asserted by the broker-dealer.
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    \90\ See paragraph 55 of PCAOB Attestation Standard Sec.  101.
    \91\ See Rule 17a-5(d). As noted previously, the Commission is
not proposing to change the requirement that broker-dealers file
annual audited financial statements. Therefore, the Commission
preliminarily believes that the independent public accountant can
leverage the work related to the financial audit in the course of
undertaking its review of the broker-dealer's assertion with respect
to the claimed exemption from Rule 15c3-3.
---------------------------------------------------------------------------

    The Commission generally requests comment on the proposed Exemption
Report. In addition, the Commission requests comment on the following
questions:

     Are there other types of broker-dealers that would not
qualify to file an Exemption Report, but, based on the limited scope of
their businesses, should be allowed to file a more limited report than
the Compliance Report? If so, please identify the types of broker-
dealers and indicate why they should not be required to file Compliance
Reports.
     What additional processes and controls might a broker-
dealer put in place in order to comply with the new requirements
relating to the Exemption Report and to accommodate a review of the
report by an independent public accountant?
     Should the Commission require that the assertion made by
the broker-dealer with respect to the exemption from Rule 15c3-3 be
examined by the accountant (i.e., the independent public accountant
issues an opinion based on obtaining reasonable assurance) as opposed
to being reviewed (i.e., the independent public accountant issues a
report based on obtaining a moderate level of assurance)? Commenters
should discuss the feasibility, benefits and costs of such a
requirement.
     What additional costs and burdens would a non-carrying
broker-dealer incur under the proposal requiring an independent public
accountant to review the broker-dealer's claim that it qualifies for an
exemption from Rule 15c3-3?
6. Change in Applicable Audit Standards
    The Commission is proposing to require that the audit of the
Financial Report, the examination of the Compliance Report, and the
review of the Exemption Report be performed pursuant to standards
established by the PCAOB. The Dodd-Frank Act provided authority to the
PCAOB to establish, subject to Commission approval, auditing and
related attestation, quality control, ethics, and independence
standards to be used by registered public accounting firms with respect
to the preparation and issuance of audit reports to be included in
broker-dealer filings with the Commission pursuant to Section 17(e) of
the Exchange Act.\92\ To enable the PCAOB to effectively implement the
authority provided to it by the Dodd-Frank Act, the Commission is
proposing to amend paragraph (g) of Rule 17a-5 to provide that the
independent public accountants' reports required under the rule must be
prepared in accordance with the standards of the PCAOB.\93\
---------------------------------------------------------------------------

    \92\ See Section II.A. of this release for a discussion of the
PCAOB's new oversight authority under the Dodd-Frank Act.
    \93\ See proposed paragraph (g)(1) of Rule 17a-5.
---------------------------------------------------------------------------

    In September 2010, the Commission issued interpretive guidance
concerning the auditing standards that should be applied by broker-
dealer accountants with respect to the current requirements in Rule
17a-5.\94\ That guidance stated that references in Commission rules,
staff guidance, and in the federal securities laws to GAAS or to
specific standards under GAAS, as they relate to non-issuer broker-
dealers, should continue to be understood to mean auditing and
attestation standards generally accepted in the U.S., in addition to
any applicable rules of the Commission.\95\
---------------------------------------------------------------------------

    \94\ See Commission Guidance Regarding Auditing, Attestation,
and Related Professional Practice Standards Related to Brokers and
Dealers, Exchange Act Release No. 62991 (Sep. 24, 2010), 75 FR 60616
(Oct. 1, 2010). The Commission also noted in its guidance that it
intended to revisit this interpretation in connection with this
rulemaking.
    \95\ Id. at 60617.
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    Because PCAOB auditing standards differ from existing standards
governing broker-dealer audits, the proposed change to paragraph (g)
would result in a change in the procedures accountants would have to
undertake as part of their engagement for audits of broker-dealers. For
example, certain audit documentation requirements contained in PCAOB
Auditing Standard 3 (Audit Documentation) and the engagement quality
review requirement in PCAOB Auditing Standard 7 (Engagement Quality
Review) are not required by GAAS.
    The Commission generally requests comment on the proposed change to
applicable auditing standards. In addition, the Commission requests
comment on the following questions:
     Are there implications to the differences that were
identified that the Commission should consider? Are there other
differences that exist that would have significant implications to the
audits of broker-dealers?
     Should the requirement to be audited in accordance with
PCAOB standards be phased in for non-carrying broker-dealers? Why or
why not? If so, what time-table should the Commission adopt?
7. Compliance Date and Transition Period
    The Commission is proposing to make the Annual Reporting Amendments
effective for annual reports filed with the Commission for fiscal years
ending on or after December 15, 2011. The Commission is proposing this
date to include fiscal years that end on or after December 31, 2011.
The Commission preliminarily intends to implement a transition period
for carrying broker-dealers required to file Compliance Reports with
the Commission with fiscal years ending on or after December 15, 2011
but before September 15, 2012. During this transition period, a
carrying broker-dealer's assertion in its Compliance Report as to
whether internal control over compliance with the Financial
Responsibility Rules was effective would be a point-in-time assertion
as of the date of the Compliance Report, rather than covering the
broker-dealer's entire fiscal year. The Commission preliminarily
believes that the compliance date and transition period set forth above
will provide adequate time for broker-dealers to prepare the additional
required reports and for independent public accountants to plan and
perform the Compliance Examination procedures.
    The Commission generally requests comment on the proposed
compliance date and transition period. In addition, the Commission
requests comment on the following questions:
     Will the proposed compliance date and transition period
for the Annual Reporting Amendments provide sufficient time for broker-
dealers to prepare the additional reports and for independent public
accountants to comply with PCAOB standards? Will it provide sufficient
time to plan and perform Compliance Examination procedures? If not,
what are the impediments and what would be a more appropriate time
frame for implementation?
8. General Solicitation of Comments
    The Commission generally requests comment on all aspects of these
proposed amendments. In addition, the Commission requests comment on
the following questions related to the proposal:
     Certain broker-dealers conducting a limited and specific
type of business are not presently required to file an annual audit
report.\96\ Should the Commission

require all broker-dealers to file an annual audit of their financial
statements and supporting schedules? Should any of the proposed
amendments to Rule 17a-5 applicable to carrying firms be applied to
other specific types of broker-dealers? If so, which types of firms and
why? What impact would extension of the audit requirement or the
proposed amendments relating to non-carrying firms have on small
businesses?
---------------------------------------------------------------------------

    \96\ See Rule 17a-5(e)(1)(A) and (B), which provide limited
exemptions to broker-dealers from having their financial statements
and supporting statements audited by an independent public
accountant, so long as specified factors are met (e.g., if the
securities business of the broker-dealer has been limited to acting
as a broker for an issuer in soliciting subscriptions for securities
of such issuer and the broker has promptly transmitted to such
issuer all funds and promptly delivered to the subscriber all
securities received in connection therewith, and the broker has not
otherwise held funds or securities for or owed money or securities
to customers, then the broker-dealer does not have to have the
financial statements audited by an independent public accountant).
See Rule 17a-5(e)(1)(A).
---------------------------------------------------------------------------

C. Proposed Amendment to the Filing of SIPC Reports

1. Existing Requirement
    SIPC is a non-profit, membership corporation created under the
Securities Investor Protection Act of 1970 (``SIPA'').\97\ SIPC is
designed to protect the custodial function of a broker-dealer in the
event it fails financially. For example, SIPC can fund the liquidation
of a broker-dealer that cannot wind itself down in an orderly self-
liquidation.\98\ As part of the liquidation, SIPC can advance up to
$500,000 per customer to satisfy claims for securities and cash.\99\
However, of the $500,000, only $250,000 can be used to satisfy claims
for cash.\100\ In order to pay for these liquidations and advances,
SIPC maintains the SIPC Fund.\101\ The SIPC Fund is established and
maintained by collecting assessments from broker-dealers that are
required to be members of SIPC.\102\ Generally all broker-dealers
registered with the Commission under Section 15(b) of the Exchange Act
\103\ are required to be members of SIPC.\104\ However, broker-dealers
engaged exclusively in the distribution of mutual fund shares, the sale
of variable annuities, the insurance business, the furnishing of
investment advice to investment companies or insurance company separate
accounts, or whose principal business is conducted outside the U.S. are
not required to be members of SIPC.\105\
---------------------------------------------------------------------------

    \97\ 15 U.S.C. 78 et seq.
    \98\ 15 U.S.C. 78eee(a)(3).
    \99\ 15 U.S.C. 78fff-3(a).
    \100\ 15 U.S.C. 78fff-3(d).
    \101\ 15 U.S.C. 78ddd.
    \102\ 15 U.S.C. 78ddd(c).
    \103\ 15 U.S.C. 78o(b).
    \104\ 15 U.S.C. 78ccc(a)(2).
    \105\ 15 U.S.C. 78ccc(a)(2)(A)(i)-(iii).
---------------------------------------------------------------------------

    Under SIPA, SIPC may assess each of its member broker-dealers a fee
determined as a percentage of the firm's revenues.\106\ There are
required percentage assessments that must be made when the SIPC Fund
falls below deposited amounts or such other amount as the Commission
may determine in the public interest (``the SIPC Fund Target
Level'').\107\ SIPC can assess broker-dealers a fee based on a greater
percentage of their revenues when the SIPC Fund falls below the SIPC
Fund Target Level.\108\
---------------------------------------------------------------------------

    \106\ See 15 U.S.C. 78ddd(c)(2). See also SIPC Bylaws, Article
6.
    \107\ Prior to the Lehman Brothers Inc. and Bernard L. Madoff
Investment Securities LLC SIPA liquidations, the SIPC Fund was
maintained at a target level of not less than $1 billion. Currently,
the SIPC Fund Target Level is $2.5 billion. See SIPC Bylaws, Article
6, Section 1(a)(1)(A) (specifying the $2.5 billion SIPC Fund Target
Level). See also Securities Investor Protection Corporation
Modernization Task Force, Adequacy of the SIPC Fund (Jun. 2010), at
5 (describing the increase in the SIPC Fund Target Level from $1
billion to $2.5 billion).
    \108\ SIPC Bylaws, Article 6, Section 1(a).
---------------------------------------------------------------------------

    In order to assist in the collection of these assessments, SIPC has
promulgated two forms that broker-dealers must file with SIPC, as
applicable: Form SIPC-3 and Form SIPC-7. Form SIPC-3 is required when a
broker-dealer is claiming an exemption from SIPC membership (i.e., when
the broker-dealer does not have to pay an assessment). Such a broker-
dealer must file Form SIPC-3 each year certifying that the broker-
dealer remained qualified for the exemption during the prior year. Form
SIPC-7 elicits information from a broker-dealer that is a SIPC member
about the broker-dealer's sources of revenue attributable to its
securities business. Every broker-dealer that is a member of SIPC must
file this form annually.
    When SIPC raises SIPC Fund assessments above the minimum assessment
provided for in Section 4(d)(1)(c) of SIPA,\109\ Rule 17a-5(e)(4)
requires a broker-dealer that files Form SIPC-3 or Form SIPC-7 to also
file with the Commission, the broker-dealer's DEA, and SIPC a
supplemental report (``Supplemental Report'') covered by an opinion of
the broker-dealer's independent public accountant that covers the
information in the respective form. Among other things, the
Supplemental Report also is required to: (1) Include a statement that
the broker-dealer qualified for an exclusion from SIPC membership under
SIPA during the prior year if exclusion from membership is claimed; and
(2) include an independent public accountant's report stating that ``in
the accountant's opinion * * * [the broker-dealer's] claim for
exclusion from membership was consistent with income reported'' or
``the assessments were determined fairly in accordance with applicable
instructions and forms'' (as applicable).\110\
---------------------------------------------------------------------------

    \109\ 15 U.S.C. 78ddd(d)(1)(c).
    \110\ See Rule 17a-5(e)(4).
---------------------------------------------------------------------------

2. Proposed Amendment
    Because Forms SIPC-3 and SIPC-7 are used solely by SIPC for
purposes of levying its assessments, the Commission preliminarily
believes that Supplemental Reports relating to these forms would be
more appropriately filed with SIPC and that SIPC, rather than the
Commission, should, by rule, prescribe the form of the Supplemental
Reports. This would provide SIPC with the discretion to determine the
need for and form of a Supplemental Report and the nature and extent of
the review by an independent public accountant, if any. The Commission
would continue to have a role in establishing the requirements for a
Supplemental Report because the Commission must approve SIPC rule
proposals.
    The Commission proposes to amend Rule 17a-5 to require that broker-
dealers continue to file a Supplemental Report with the Commission, the
broker-dealer's DEA, and SIPC until the Commission considers and
determines to approve any such rule adopted by SIPC. Because, for an
interim period, broker-dealers would be required to continue to file
their Supplemental Reports with the Commission, the Commission is
proposing to update the rule text to conform it to existing
professional standards and industry practices. Specifically, the
Commission is proposing to amend Rule 17a-5(e)(4) to eliminate the
ambiguity that stems from the differing auditing terms used therein by
removing all references to ``review'' and ``opinion'' where those terms
are used in Rule 17a-5(e)(4).\111\ In their place, the Commission
proposes to amend paragraph (e)(4) of Rule 17a-5 to provide that
Supplemental Reports shall include the independent public accountant's
report prepared pursuant to agreed-upon procedures based on the
performance of the procedures outlined in current paragraph (e)(4)(iii)
of Rule 17a-5, which the Commission is not proposing to change.\112\
---------------------------------------------------------------------------

    \111\ See Rule 17a-5(e)(4), Rule 17a-5(e)(4)(iii), and Rule 17a-
5(e)(4)(iii)(F).
    \112\ See Rule 17a-5(e)(4)(iii). The Commission notes that as
part of the proposed amendments to this paragraph, the procedures
outlined in current paragraph (e)(4)(iii) of Rule 17a-5 would
remain, but would be renumbered to be included in paragraph
(e)(4)(ii)(C).
---------------------------------------------------------------------------

    The Commission generally requests comment on all aspects of these
proposed amendments. In addition, the Commission requests comment on
the following questions related to the proposal:

     Should the Commission and/or a broker-dealer's DEA
continue to receive SIPC Reports relating to assessments, and, if so,
for what reasons?
     Should the Commission continue to require that the broker-
dealer engage an independent public accountant to perform some level of
work with respect to the information contained in the SIPC Reports? If
so, should the Commission also specify what type of engagement the
broker-dealer must have with its independent public accountant with
respect to the information contained in the SIPC Reports? For example,
should the Commission require a broker-dealer to engage its independent
public accountant to perform a review of the information in the SIPC
Reports pursuant to PCAOB standards? Commenters should discuss the
feasibility, benefits, and costs of such requirements.
     Should the Commission impose any requirements or
limitations on SIPC with respect to its ability to propose rules to
have SIPC Reports filed solely with SIPC? If so, what requirements and/
or limitations?

III. The Proposed Access to Audit Documentation Amendments

    Pursuant to Section 17(b) of the Exchange Act, broker-dealers are
subject to routine inspection and examination by Commission and DEA
staff. To facilitate the examination of a broker-dealer that clears
transactions or carries customer accounts (a ``clearing broker-
dealer''), the Commission is proposing that each clearing broker-dealer
be required to consent to permitting its independent public accountant
to make available to Commission and DEA examination staff the audit
documentation associated with its annual audit reports required under
Rule 17a-5 and to discuss findings relating to the audit reports with
Commission and DEA examination staff.\113\ The Commission preliminarily
believes that it is appropriate to limit these requirements to broker-
dealers that maintain customer funds and securities or self-custody
their proprietary securities because these firms generally have more
complex business operations than other broker-dealers. Consequently,
having access to audit documentation and the independent public
accountants that audit these broker-dealers would be of greater
assistance to examiners in performing examinations of these firms, as
compared to firms with simpler business models.
---------------------------------------------------------------------------

    \113\ The sole obligation of the broker-dealer under this
proposed requirement would be to provide the proposed consent in the
manner discussed below. The Commission is not addressing in this
release any rights, obligations, or responsibilities of a broker-
dealer's independent public accountant with respect to its work
papers.
---------------------------------------------------------------------------

    The Commission is not proposing that the Commission or DEA staff
would use any audit documentation they may request, or discuss findings
related to the audit reports, for purposes of examining independent
public accountants; the PCAOB carries out that function. Rather, the
Commission preliminarily intends that any such requests would be made
exclusively in connection with conducting a regulatory examination of
the clearing broker-dealer.
    The Commission preliminarily intends that examiners generally would
use any information obtained from audit documentation and discussions
with the independent public accountants to establish the scope and
focus of a pending examination of a clearing broker-dealer. The
Commission preliminarily believes that, in cases in which such
information is obtained, it would enhance and improve the efficiency
and effectiveness of Commission and DEA examinations of clearing
broker-dealers by providing examiners with access to additional
relevant information to plan their examinations. This additional
relevant information would enable representatives of the Commission and
a clearing broker-dealer's DEA to better focus and tailor their
examination efforts relating to asset verification and other matters
pertinent to customer protection. 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 sub-
custodians, examiners could focus their efforts on other matters that
had not been the subject of prior testing and review.
    In connection with these proposals, the Commission is proposing to
amend paragraph (f)(2) of Rule 17a-5, which contains the requirement
for broker-dealers to file notices with the Commission and their DEAs
to designate their independent public accountants, to require that the
broker-dealer represent that the engagement of the independent public
accountant by the broker-dealer meets the required undertakings of
amended paragraph (g).\114\ Currently, paragraph (f)(2) of Rule 17a-5
provides that a broker-dealer 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 is called ``Notice
pursuant to Rule 17a-5(f)(2)'' (``Notice'').\115\ Paragraph (f)(2)(iii)
of Rule 17a-5 prescribes the items that are 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.\116\
---------------------------------------------------------------------------

    \114\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
    \115\ See Rule 17a-5(f)(2).
    \116\ See Rule 17a-5(f)(2)(iii)(A) through (C).
---------------------------------------------------------------------------

    The proposed amendments to Rule 17a-5 would require: (1) That the
Notice include a statement as to whether the broker-dealer's engagement
letter with its independent public accountant is for a single year or
is of a continuing nature; \117\ (2) a representation that the
engagement of the independent public accountant by the broker-dealer
meets the required undertakings of paragraph (g); \118\ (3) in the case
of a clearing broker-dealer, a representation that the broker-dealer
agrees to allow representatives of the Commission or the DEA, if
requested for purposes of an examination of the broker-dealer, to
review the audit documentation associated with the reports of the
independent public accountant prepared pursuant to paragraph (g) of
Rule 17a-5; \119\ and (4) in the case of a clearing broker-dealer, a
representation that the broker-dealer agrees to permit the independent
public accountant to discuss with representatives of the Commission and
the DEA of the broker-dealer, if requested for purposes of an
examination of the broker-dealer, the findings associated with the
reports of the independent public accountant prepared pursuant to
paragraph (g) of Rule 17a-5.\120\ Subparagraph (f)(2)(iii) of Rule 17a-
5 would provide that a non-clearing broker-dealer is not required to
include the third and fourth representations above.\121\
---------------------------------------------------------------------------

    \117\ See proposed paragraph (f)(2)(ii)(D) of Rule 17a-5. The
Commission notes that FINRA currently provides its members with a
template for the Rule 17a-5(f)(2) Notice that includes a provision
as to whether the engagement is continuing in nature, which is
available at http://www.finra.org/web/groups/industry/@ip/<EMAIL_ADDRESS>    \118\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
    \119\ See proposed paragraph (f)(2)(ii)(F) of Rule 17a-5.
    \120\ See proposed paragraph (f)(2)(ii)(G) of Rule 17a-5.
    \121\ See proposed paragraph (f)(2)(iii) of Rule 17a-5, which
would provide that a ``broker or dealer who does not carry nor clear
transactions nor carry customer accounts is not required to include
the representations in paragraph (e)(ii)(F).''

---------------------------------------------------------------------------

    The Commission also is proposing several technical changes to
paragraph (f)(2) of Rule 17a-5. Specifically, the Commission proposes
to amend the language in the preamble of paragraph (f)(2) to streamline
the paragraph and to add a reference to the requirements of the Notice.
The Commission proposes to delete paragraph (f)(2)(ii), which provides
that the agreement can be continuing in nature, because the amended
preamble to paragraph (f)(2) captures this concept.
    If the Access to Audit Documentation Amendments described above
were adopted, Notices on file with the Commission at the time of the
effectiveness of the amendment would not be in compliance with the new
rules. Accordingly, broker-dealers subject to paragraph (f)(2) would
have to file new Notices if the proposals were adopted. However, if the
engagement covered by the new Notice was of a continuing nature, no
subsequent filing would be required unless the broker-dealer changed
independent public accountants.\122\
---------------------------------------------------------------------------

    \122\ See Rule 17a-5(f)(2)(ii).
---------------------------------------------------------------------------

    The Commission generally requests comment on all aspects of these
proposed amendments. In addition, the Commission requests comment on
the following questions:
     Should the proposed Access to Audit Documentation
Amendments apply to all broker-dealers, or additional broker-dealers
rather than just clearing broker-dealers?
     Would applying the proposed Access to Audit Documentation
Amendments to non-clearing broker-dealers provide any advantages in
terms of enhancing the examination of the broker-dealers or gaining
efficiencies?
     Are there any other types of broker-dealers whose conduct
may pose risks to the investing public that should be subject to the
proposed Access to Audit Documentation Amendments?
     Are there additional reasons why examiners should obtain
documentation from independent public accountants other than those
described above (i.e., to establish the scope and focus of a pending
examination of a clearing broker-dealer)? If so, please explain the
reasons and the objectives behind the reasons and how the information
could be used to achieve those objectives.
     Would any limitations on the ability of examiners to have
access to audit documentation or to discuss the findings of the
independent public accountant be appropriate? If so, what are those
restrictions, why would they be appropriate, and what effect would they
have on broker-dealer examinations?
     Should examiners be required to request access to the
audit documentation in writing?
     Should the Commission require a broker-dealer to submit a
statement consenting to provide access to its independent public
accountant and the audit documentation (``statement of consent'') only
when it files the ``Notice pursuant to Rule 17a-5(f)(2)''?
     How often should the statement of consent be filed (e.g.,
on an annual or more frequent basis)?
     Are the proposed representations in the Notice sufficient
to provide effective access to the independent public accountant's
audit documentation? If not, what additional representations, or what
other measures, would be more effective?
     Will the terms of engagement between clearing broker-
dealers and their independent public accountants, including
compensation terms, be affected by the proposed amendments? What
additional costs might this place on clearing broker-dealers? In this
respect, would there be a disproportionate impact on smaller clearing
broker-dealers?
     What is the risk, if any, that clearing broker-dealers and
their current independent public accountants will not be able to agree
on mutually-agreeable terms in order to compensate them for additional
burdens they may incur as a result of the proposed amendments?

IV. The Proposed Form Custody Amendments

    The Commission has brought numerous enforcement actions against
investment advisers and broker-dealers alleging fraudulent conduct that
includes misappropriation or other misuse of customer assets.\123\
Consequently, the Commission recently took steps to enhance oversight
of the custody function of investment advisers,\124\ and is now
proposing enhancements to the oversight of the custody function of
broker-dealers. The Commission is proposing amendments to Rule 17a-5
that are designed to provide greater information regarding the custody
function at broker-dealers and their compliance with requirements
relating to custody of customer and non-customer assets. Specifically,
the Commission is proposing a new form to be filed by broker-dealers--
Form Custody--which is designed to elicit information concerning
whether a broker-dealer maintains custody of customer and non-customer
assets, and, if so, how such assets are maintained.\125\ As discussed
below, the Commission proposes to require that a broker-dealer file
proposed Form Custody with its quarterly FOCUS Report.\126\
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    \123\ See, e.g., SEC v. Donald Anthony Walker Young, et al.,
Litigation Release No. 21006 (Apr. 20, 2009) (complaint alleges
registered investment adviser and its principal misappropriated in
excess of $23 million, provided false account statements to
investors in limited partnership, and provided false custodial
statements to limited partnership's introducing broker); SEC v.
Isaac I. Ovid, et al, Litigation Release No. 20998 (Apr. 14, 2009)
(complaint alleges that defendants, including registered investment
adviser and manager of purported hedge funds, misappropriated in
excess of $12 million); SEC v. The Nutmeg Group, LLC, et al.,
Litigation Release No. 20972 (Mar. 25, 2009) (complaint alleges that
registered investment adviser misappropriated in excess of $4
million of client assets, failed to maintain client assets with a
qualified custodian, and failed to obtain a surprise examination);
SEC v. WG Trading Investors, L.P., et al., Litigation Release No.
20912 (Feb. 25, 2009) (complaint alleges that registered broker-
dealer and affiliated registered adviser orchestrated fraudulent
investment scheme, including misappropriating as much as $554
million of the $667 million invested by clients and sending clients
misleading account information); SEC v. Stanford International Bank,
et al., Litigation Release No. 20901 (Feb. 17, 2009) (complaint
alleges that affiliated bank, broker-dealer, and advisers colluded
with each other in carrying out an $8 billion fraud); SEC v. Bernard
L. Madoff, et al., Litigation Release No. 20889 (Feb. 9, 2009)
(complaint alleges that Madoff and Bernard L. Madoff Investment
Securities LLC--a registered investment adviser and registered
broker-dealer--committed a $50 billion fraud).
    \124\ See, e.g., Custody of Funds or Securities by Investment
Advisers, Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456
(Jan. 11, 2010).
    \125\ 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 Rule 15c3-3(a) and FINRA's
Interpretations of Financial and Operational Rules, Rule 15c3-3,
Rule 15c3-3(a)(1)/01, available on FINRA's Internet Web site at
http://www.finra.org/Industry/Regulation/Guidance/FOR/.
    \126\ See Rule 17a-5(a). FOCUS Reports, filed with the
Commission and SROs by broker-dealers, 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 are also 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. See supra note 20. The Commission notes that FOCUS Reports
are, and proposed Form Custody would be, deemed to be confidential
pursuant to paragraph (a)(3) of Rule 17a-5.
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    Currently, a broker-dealer's FOCUS Report provides the Commission
and other regulators (e.g., a broker-dealer's DEA) with information
relating to the broker-dealer's financial and operational
condition.\127\ A broker-dealer's FOCUS Report does not, however,
solicit

detailed information on how a broker-dealer maintains custody of
assets. The proposed new form is intended to provide additional
information about a broker-dealer's custodial activities. The
Commission preliminarily believes that proposed Form Custody could make
it easier for examiners to determine whether broker-dealers are in
compliance with laws and regulations concerning the custody of assets.
If, upon reviewing Form Custody, regulatory authorities became aware of
inconsistencies or other red flags in information contained in the
form, they could initiate a more detailed and focused analysis of the
broker-dealer's custodial activities. Such an analysis may, in turn,
identify potential abuses related to customer assets. Moreover,
proposed Form Custody could 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.
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    \127\ See Form X-17A-5 Schedule I, Part II, Part IIa, Part IIb,
and Part III.
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    The Commission is proposing that broker-dealers file Form Custody
with their quarterly FOCUS Reports. The Commission preliminarily
believes that Form Custody would help provide applicable regulators
with current information about a broker-dealer's custodial activities
and, as described below, would promote compliance with applicable laws
and rules. The Commission is proposing that Form Custody be filed on a
quarterly basis to ensure that the information disclosed on the form is
current and to enable examiners to identify significant recent changes
in a broker-dealer's custody practices. For example, examiners could
more promptly investigate instances in which a broker-dealer frequently
changes the locations where customer securities are held. While a
broker-dealer may have valid and lawful reasons for changes in the
custody arrangements for its customers' securities, such actions also
could suggest improper activity and could cause examiners to make
further inquiries.
    Proposed Form Custody is comprised of nine line items (each, an
``Item'') that elicit information about a broker-dealer's custodial
activities. Several Items contain multiple questions, and a few Items
require completion of charts and disclosure of custody-related
information specific to the broker-dealer completing the form. Each
Item and its subparts are discussed below.

A. Item 1--Accounts Introduced on a Fully Disclosed Basis

    Item 1.A of Form Custody would elicit information concerning
whether the broker-dealer introduces customer accounts to another
broker-dealer on a fully disclosed basis by requiring the broker-dealer
to check the appropriate ``Yes'' or ``No'' box. 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.\128\ These carrying agreements are
governed by applicable self-regulatory organization (``SRO'') rules,
which require broker-dealers entering into a carrying agreement to
allocate certain responsibilities associated with introduced
accounts.\129\
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    \128\ To be consistent with the definition of the term
``customer'' in Rule 15c3-3, the Commission proposes to define the
term ``customer'' in the General Instructions to Form Custody the
same. See Rule 15c3-3(a)(1).
    \129\ See, e.g., NYSE Rule 382, NASD Rule 3230, and FINRA Rule
4311.
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    Typically, under a carrying agreement, one broker-dealer (the
``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.
    Proposed Item 1.A would elicit 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 proposing 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 the broker-dealer is not equipped
to maintain. Broker-dealers also may introduce customer accounts on an
omnibus basis, as is discussed in detail in Section IV.B. of this
release.
    If the broker-dealer answers Item 1.A by checking the ``Yes'' box,
the broker-dealer would be required under Item 1.B to identify each
broker-dealer to which customer accounts are introduced. As discussed
above, the carrying broker-dealer in such an arrangement maintains the
cash and securities of the introduced customers. Consequently, Item 1.B
would elicit the identity of each broker-dealer obligated to return
cash and securities to the introduced customers. Commission and DEA
examiners could use this information to confirm the existence of an
introducing/carrying relationship and to confirm that the carrying
broker-dealer acknowledges its obligation to return the cash and
securities belonging to the introduced customers.\130\
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    \130\ See Letter from Richard G. Ketchum, Director, Division of
Market Regulation, Commission, to David Marcus, New York Stock
Exchange (Jan. 14, 1985), which states that the customers of
introducing broker-dealers are presumed to be customers of the
clearing broker-dealer for purposes of the Commission's financial
responsibility rules and SIPA.
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    The Commission generally requests comment on all aspects of
proposed Item 1. In addition, the Commission requests comment on the
following questions relating to proposed Items 1.A and 1.B:
     Should the Commission require additional information about
accounts introduced to carrying broker-dealers on a fully disclosed
basis? If so, what type of information?
     Should the Commission require the broker-dealer to
disclose the number of accounts it introduces on a fully disclosed
basis?
     Should the Commission require the broker-dealer to
disclose the approximate dollar amount of assets held in fully
disclosed accounts at the carrying broker-dealer?
     Should the Commission solicit information as to whether a
broker-dealer other than the carrying broker-dealer clears transactions
that are ultimately maintained by the carrying broker-dealer on a fully
disclosed basis?
     Should the Commission require the broker-dealer to
identify whether it relies on the carrying broker-dealer or another
third party to maintain books and records relating to introduced
accounts?

B. Item 2--Accounts Introduced on an Omnibus Basis

    Item 2.A would elicit information concerning whether the broker-
dealer

introduces customer accounts to another broker-dealer on an omnibus
basis by requiring the broker-dealer to check the appropriate ``Yes''
or ``No'' box. 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.\131\ Disclosure of this
information is important because a broker-dealer that introduces
customer accounts to another broker-dealer on an omnibus basis is
considered to be a carrying broker-dealer with respect to those
accounts under the Commission's broker-dealer financial responsibility
rules.\132\ Thus, in these arrangements, the broker-dealer introducing
the omnibus account to a carrying broker-dealer is obligated to return
cash and securities in the account to customers.\133\
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    \131\ See Broker-Dealer Audit Guide, supra note 14.
    \132\ See Net Capital Rule, Exchange Act Release No. 31511 (Nov.
24, 1992); 57 FR 56973 (Dec. 2, 1992), n. 16.
    \133\ Id.
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    If the broker-dealer checks the ``Yes'' box in Item 2.A, it would
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.
    The Commission generally requests comment on all aspects of
proposed Item 2. In addition, the Commission requests comment on the
following questions relating to proposed Items 2.A and 2.B:
     Should the Commission require additional information about
accounts introduced to carrying broker-dealers on an omnibus basis? For
example, should the Commission require a broker-dealer to provide
information about the specific types of products or customers
introduced to a carrying broker-dealer on an omnibus basis? What other
information about accounts introduced to carrying- broker-dealers on an
omnibus basis should the Commission require to be disclosed? Why?
     Should the Commission require a broker-dealer to disclose
the number of omnibus accounts it introduces to other broker-dealers?
If yes, please explain why. If no, please explain why not.
     Should the Commission require a broker-dealer to disclose
the approximate dollar amount of assets held in omnibus accounts at the
carrying broker-dealer? If yes, please explain why. If no, please
explain why not.
     Should the Commission solicit information as to whether a
broker-dealer other than the carrying broker-dealer clears transactions
where the securities are ultimately maintained by the carrying broker-
dealer on an omnibus basis? If yes, please explain why. If no, please
explain why not.

C. Item 3--Carrying Broker-Dealers

1. Items 3.A and 3.B
    Item 3 elicits information concerning how a carrying broker-dealer
holds cash and securities. Item 3 is comprised of five subparts. The
first question--Item 3.A--elicits information concerning whether the
broker-dealer carries securities accounts for customers by requiring
the broker-dealer to check the appropriate ``Yes'' or ``No'' box. As
noted above, the proposed General Instructions to Form Custody would
specify that the term ``customer'' as used in the Form means a
``customer'' as defined in Rule 15c3-3. The next question--Item 3.B--
elicits information concerning whether the broker-dealer carries
securities accounts for persons that are not ``customers'' under the
definition in Rule 15c3-3. 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.
2. Item 3.C
    Item 3.C requires the broker-dealer to identify in three charts the
types of locations where it holds securities and the frequency with
which it performs reconciliations between the information on its stock
record and information on the records of those locations. The proposed
instructions to Item 3.C provide that the broker-dealer must identify
the types of locations where it holds securities. The broker-dealer
would be required to identify locations that are used at any one time
for maintaining customer, non-customer, and proprietary securities. The
proposed instructions also require the broker-dealer to specify the
locations where the broker-dealer holds securities directly in the name
of the broker-dealer (i.e., the broker-dealer should not identify a
type of location if the broker-dealer only holds securities at the
location through an intermediary). For example, when a broker-dealer is
not a member of a securities clearing organization but, instead,
accesses the securities processing facilities of the organization by
holding securities at an entity that is a member of the organization
(e.g., a U.S. bank), the broker-dealer would be required to identify
the category of location for which the broker-dealer has a direct
custodial relationship (i.e., the U.S. bank), but not the securities
clearing organization.
    The first chart--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.
    The first location identified in the chart is the broker-dealer's
vault. As noted above, 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 potential locations identified in the chart
are the Depository Trust Company (``DTC'') and the Options Clearing
Corporation. These are two of the predominant securities clearing
organizations in the U.S. and, consequently, are identified by name
rather than type.
    The fifth potential 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 proposed 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 cannot be pledged as collateral for a
loan to the broker-dealer, 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