[Federal Register: March 19, 2007 (Volume 72, Number 52)]
[Proposed Rules]
[Page 12861-12899]
[DOCID:fr19mr07-19]

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

Part II

Securities and Exchange Commission

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

17 CFR Part 240

Amendments to Financial Responsibility Rules for Broker-Dealers;
Proposed Rule

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

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-55431; File No. S7-08-07]
RIN 3235-AJ85

Amendments to Financial Responsibility Rules for Broker-Dealers

AGENCY: Securities and Exchange Commission (the ``Commission'').

ACTION: Proposed rule.

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

SUMMARY: The Commission is proposing for comment amendments to its net
capital, customer protection, books and records, and notification rules
for broker-dealers under the Securities Exchange Act of 1934
(``Exchange Act''). The proposed amendments would address several
emerging areas of concern regarding the financial requirements for
broker-dealers. They also would update the financial responsibility
rules and make certain technical amendments.

DATES: Comments should be received on or before May 18, 2007.

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.
); or     Send an e-mail to<EMAIL_ADDRESS>Please include

File Number S7-08-07 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 Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.

    All submissions should refer to File Number S7-08-07. This file
number should be included on the subject line if e-mail is used. To
help us 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).

Comments will also be available for public inspection and copying in
the Commission's Public Reference Room, 100 F Street, NE., Washington,
DC 20549. All comments received will be posted without change; we do
not edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at<PHONE_NUMBER>; Thomas K. McGowan, Assistant Director, at
(202) 551-5521; Randall Roy, Branch Chief, at<PHONE_NUMBER>; or Bonnie
Gauch, Attorney,<PHONE_NUMBER>; Division of Market Regulation,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-6628.

SUPPLEMENTARY INFORMATION:

I. Background

    We are proposing for comment amendments to the broker-dealer net
capital rule (Rule 15c3-1),\1\ customer protection rule (Rule 15c3-
3),\2\ books and records rules (Rules 17a-3 and 17a-4),\3\ and
notification rule (Rule 17a-11).\4\
---------------------------------------------------------------------------

    \1\ 17 CFR 240.15c3-1.
    \2\ 17 CFR 240.15c3-3.
    \3\ 17 CFR 240.17a-3 and 17 CFR 240.17a-4.
    \4\ 17 CFR 240.17a-11.
---------------------------------------------------------------------------

II. Proposed Amendments

A. Amendments to the Customer Protection Rule

    The Commission adopted the customer protection rule (Rule 15c3-3)
in 1972 in response to a congressional directive to strengthen the
financial responsibility requirements for broker-dealers that carry
customer assets.\5\ The rule requires a broker-dealer to take certain
steps to protect the credit balances and securities it holds for
customers. Under the rule, a broker-dealer must, in essence, segregate
customer funds and fully paid and excess margin securities held by the
firm for the accounts of customers.\6\ The intent of the rule is to
require a broker-dealer to hold customer assets in a manner that
enables their prompt return in the event of an insolvency, which, in
turn, increases the ability of the firm to wind down in an orderly
self-liquidation and, thereby avoid the need for a proceeding under the
Securities Investor Protection Act of 1970 (``SIPA'').\7\
---------------------------------------------------------------------------

    \5\ See Exchange Act Release No. 9856 (November 10, 1972), 1972
SEC LEXIS 189.
    \6\ Subparagraph (a)(3) of Rule 15c3-3 defines ``fully paid
securities'' as securities carried in any type of account for which
the customer has made a full payment. Subparagraph (a)(5) defines
``excess margin securities'' as securities having a market value in
excess of 140% of the amount the customer owes the broker-dealer and
which the broker-dealer has designated as not constituting margin
securities.
    \7\ 15 U.S.C. 78aaa et seq.
---------------------------------------------------------------------------

    The required amount of customer funds to be segregated is
calculated pursuant to a formula set forth in Exhibit A to Rule 15c3-
3.\8\ Under the formula, the broker-dealer adds up various credit and
debit line items. The credit items include cash balances in customer
accounts and funds obtained through the use of customer securities. The
debit items include money owed by customers (e.g., from margin
lending), securities borrowed by the broker-dealer to effectuate
customer short sales, and required margin posted to certain clearing
agencies as a consequence of customer securities transactions. If,
under the formula, customer credit items exceed customer debit items,
the broker-dealer must maintain cash or qualified securities in that
net amount in a ``Special Reserve Bank Account for the Exclusive
Benefit of Customers.'' This account must be segregated from any other
bank account of the broker-dealer. Generally, a broker-dealer with a
deposit requirement of $1 million or more computes its reserve
requirement on a weekly basis as of the close of the last business day
of the week (usually Friday).\9\ The weekly calculation determines the
required minimum balance the broker-dealer must maintain in the reserve
account.
---------------------------------------------------------------------------

    \8\ 17 CFR 240.15c3-3a.
    \9\ 17 CFR 240.15c3-3(e)(3).
---------------------------------------------------------------------------

    As noted, Rule 15c3-3 also requires a broker-dealer to maintain
physical possession or control of all fully paid and excess margin
securities carried for customers.\10\ This means the broker-dealer
cannot lend or hypothecate these securities and must hold them itself
or, as is more common, in a satisfactory control location. Under the
rule, satisfactory control locations include regulated securities
clearing agencies, U.S. banks, and, with the approval of the
Commission, certain foreign financial institutions.\11\ In order to
meet the possession or control requirement, a broker-dealer must
determine on a daily basis the amount of customer fully paid and excess
margin securities (by issuer and class) it holds for customers.\12\ It
then compares that amount with the amount of securities it holds free
of lien in its own possession or at one of the satisfactory control
locations. If a shortfall exists, the firm must take certain actions
under the rule.\13\ The actions include: removing liens on securities
collateralizing a bank loan; recalling securities loaned to a bank or
clearing corporation; buying-in securities that have been failed to
receive over thirty days; or buying-in securities receivable as a
result of dividends, stock splits or similar

distributions that are outstanding over forty-five days.\14 \
---------------------------------------------------------------------------

    \10\ 17 CFR 240.15c3-3(b)(1).
    \11\ 17 CFR 240.15c3-3(c).
    \12\ 17 CFR 240.15c3-3(d).
    \13\ Id.
    \14\ Id.
---------------------------------------------------------------------------

1. Proprietary Accounts of Broker-Dealers
    We are proposing an amendment to Rule 15c3-3 that would require
broker-dealers to treat accounts they carry for domestic and foreign
broker-dealers in the same manner generally as ``customer'' accounts
for the purposes of the reserve formula of Rule 15c3-3.\15\ The
amendment is intended to address an inconsistency between the way these
proprietary accounts of broker-dealers are protected under Rule 15c3-3
and the SIPA.
---------------------------------------------------------------------------

    \15\ See 17 CFR 240.15c3-3(a)(1). This paragraph defines
``customer'' for the purposes of Rule 15c3-3. Broker-dealers, both
domestic and foreign, are excluded from the definition and,
consequently, are not treated as ``customers'' for the purposes of
the rule's reserve and possession and control requirements. Some
foreign broker-dealers also operate as banks. These firms are not
deemed ``customers'' to the extent that their accounts at the U.S.
broker-dealer involve proprietary broker-dealer activities.
---------------------------------------------------------------------------

    Specifically, because broker-dealers are not ``customers'' for
purposes of Rule 15c3-3, a broker-dealer that carries the proprietary
accounts of other broker-dealers is not required to include credit and
debit items associated with those accounts in the customer reserve
formula. Conversely, under SIPA, broker-dealers are considered
``customers'' and, consequently, entitled to certain protections. When
a broker-dealer is liquidated under SIPA, an estate of customer
property is created.\16\ Customers of the failed broker-dealer,
including customers that are broker-dealers, are entitled to a pro rata
share of the estate of customer property. Thus, while broker-dealers
need not reserve for accounts carried for other broker-dealers under
Rule 15c3-3, in a SIPA liquidation, broker-dealer accountholders may
share in the fund of customer property. This disparity increases the
risk that, in the event a clearing broker is liquidated under SIPA,
customer claims will exceed the amount of customer property.
---------------------------------------------------------------------------

    \16\ In particular, under SIPA, the pool of ``customer
property'' is established using assets recovered from the failed
broker-dealer. The statute determines the assets that become a part
of the pool of customer property. 15 U.S.C. 78lll(4). Customer
property includes ``cash and securities * * * at any time received,
acquired, or held by or for the account of the debtor from or for
the securities accounts of a customer, and the proceeds of any such
property transferred by the debtor, including property unlawfully
converted.'' Therefore, ``customer property'' includes those
securities positions that are held for customers and the cash that
is owed to customers. After being established, customer property is
distributed to customers pro rata based on the amounts of their
claims (i.e., their net equity). While broker-dealers are not
entitled to advances from the SIPC fund to make up for shortfalls in
the fund of customer property (see 15 U.S.C 78fff-3(a)(5)), they may
be ``customers'' as that term is defined in SIPA and, therefore,
entitled to a pro rata distribution from the fund of customer
property.
---------------------------------------------------------------------------

    In order to correct the gap between Rule 15c3-3 and SIPA, we are
proposing amendments to Rules 15c3-1, 15c3-3 and 15c3-3a that would
require carrying broker-dealers to perform a separate reserve
computation for proprietary accounts of other domestic and foreign
broker-dealers in addition to the reserve computation currently
required for ``customer'' accounts, and establish and fund a separate
reserve account for the benefit of these domestic and foreign broker-
dealers.\17\ This added protection also would mitigate potential
contagion that might arise in the event of a failure of a broker-dealer
with a large number of broker-dealer customers.
---------------------------------------------------------------------------

    \17\ The amendment would exclude from the broker-dealer reserve
computation accounts established by a broker-dealer that fully
guarantees the obligations of, or whose accounts are fully
guaranteed by, the clearing broker. In these circumstances, the
guarantor must take deductions under Rule 15c3-1 for guaranteed
obligations of the other firm. In addition, the amendment would
exclude delivery-versus-payment and receipt-versus-payment accounts.
These types of accounts pose little risk of reducing the estate of
customer property in a SIPA liquidation since they only hold assets
for short periods of time.
---------------------------------------------------------------------------

    The proposed amendments, in many respects, would codify a no-action
letter regarding proprietary accounts of introducing brokers (``PAIB
Letter'') previously issued by Commission staff.\18\ One significant
difference is that the amendments would have a broader scope by
including proprietary accounts of foreign brokers-dealers and banks
acting as broker-dealers. In the PAIB Letter, the staff stated it would
not recommend any action to the Commission if an introducing broker-
dealer did not take a net capital deduction under Rule 15c3-1 for cash
held in a securities account at another broker-dealer, provided the
other broker-dealer agreed to (1) perform a reserve computation for
broker-dealer accounts, (2) establish a separate special reserve bank
account, and (3) maintain cash or qualified securities in the reserve
account equal to the computed reserve requirement (``PAIB
agreement'').\19\ The PAIB Letter, however, did not completely address
the disparity between Rule 15c3-3 and SIPA, because the procedures set
forth in the letter are voluntary and foreign broker-dealers are not
subject to Rule 15c3-1 and, consequently, have no incentive to enter
into PAIB agreements. Therefore, carrying firms do not include the
accounts of foreign broker-dealers in either the Rule 15c3-3 or PAIB
computations. However, these entities may be customers for the purposes
of SIPA.
---------------------------------------------------------------------------

    \18\ See Letter from Michael A. Macchiaroli, Associate Director,
Division of Market Regulation, Commission, to Raymond J. Hennessy,
Vice President, NYSE, and Thomas Cassella, Vice President, NASD
Regulation, Inc. (Nov. 10, 1998).
    \19\ Under Rule 15c3-1, broker-dealers generally are required to
deduct unsecured receivables from their net worth when computing
their net capital. Paragraph (c) of the rule contains certain
exceptions to this requirement. Among the enumerated exceptions are
commissions receivable from another broker-dealer outstanding 30
days or less. This exception is limited to receivables from a
clearing broker-dealer related to transactions in accounts
introduced by the broker-dealer. Frequently, introducing broker-
dealers as well as other broker-dealers will have receivables from
another broker-dealer arising from proprietary transactions in an
account at the other broker-dealer. There is no exception in Rule
15c3-1 permitting these receivables to be included in a broker-
dealer's net capital amount. However, under the terms of the PAIB
Letter, a broker-dealer could include them.
---------------------------------------------------------------------------

    The proposed amendments--like the PAIB Letter--would establish
reserve requirements for a carrying broker with respect to proprietary
accounts it carries for other broker-dealers. Paragraph (e) of Rule
15c3-3 would be amended to require the carrying broker to perform a
reserve computation for a proprietary account of another broker-dealer
(referred to as a ``PAB account'') and to establish and maintain a
reserve account at a bank for these PAB accounts.\20\ A new paragraph
(a)(16) would be added to define ``PAB account,'' paragraph (f) would
be amended to require the carrying broker-dealer to notify the bank
about the status of the PAB reserve account and obtain an agreement and
notification from the bank that the PAB reserve account will be
maintained for the benefit of the PAB accountholders. In addition,
paragraph (g) would be amended to specify when the carrying broker-
dealer could make withdrawals from a PAB reserve account. The carrying
broker would have to maintain cash or qualified securities in the PAB
reserve account in an amount equal to the PAB reserve requirement.
Consistent with the no-action relief provided in the PAIB Letter, if
the PAB reserve computation results in a deposit

requirement, the proposed amendment would allow the requirement to be
offset to the extent there are excess debits in the customer reserve
computation of the same date. However, in order to provide greater
protection to customers that are not broker-dealers, a deposit
requirement resulting from the customer reserve computation would not
be able to be offset by excess debits in the PAB reserve computation.
This means the carrying broker-dealer could use PAB credits to finance
``customer'' debits, but not the other way around. Thus, ``customers''
(which include retail investors but exclude broker-dealers) would
receive greater protection.
---------------------------------------------------------------------------

    \20\ Under paragraph (e), broker-dealers are required to perform
the customer reserve computation as of the close of business on the
last business day of the week or, in some cases, the month. Broker-
dealers from time to time may perform a mid-week computation if it
would permit them to make a withdrawal. Under the proposed
amendments, a broker-dealer would need to compute both the customer
and PAB reserve requirements simultaneously before making a
withdrawal from either account based on a mid-week computation.
Moreover, a withdrawal could not be made from one account if the
mid-week computation demonstrated an increased requirement in the
other account.
---------------------------------------------------------------------------

    Paragraph (b) of Rule 15c3-3 would be amended to provide that a
broker-dealer carrying PAB accounts would not be required to maintain
physical possession or control of fully paid and excess margin
securities carried for PAB accounts, provided it obtains the written
permission of the PAB accountholder to use such securities in the
ordinary course of its securities business. This provision would be
consistent with Rule 15c3-3, which is intended to provide greater
protection to customers that are not broker-dealers customers. It also
would accommodate industry practice of carrying broker-dealers using
the securities of their broker-dealer accountholders, which contributes
to the liquidity of the securities markets.
    Finally, paragraph (c)(2)(iv)(E) of Rule 15c3-1 would be amended to
require a broker-dealer to deduct from net worth when calculating net
capital the amount of its cash in a proprietary account at another
broker-dealer where the other broker-dealer is not treating the cash in
compliance with the proposed requirements described above. This would
prevent broker-dealers from including assets in their net capital
amounts that may not be readily available. We would not expect broker-
dealers to audit or examine their carrying broker-dealers to determine
whether the carrying broker-dealer is in compliance with the proposed
rules.
    We request comment on all aspects of these proposed amendments,
including whether the accounts of other non-customers under Rule 15c3-3
(e.g., principal officers of the broker-dealer) should be included in
the PAB computation.
2. Banks Where Special Reserve Deposits May Be Held
    Broker-dealers must deposit cash or ``qualified securities'' into
the customer reserve account maintained at a ``bank'' under Rule 15c3-
3(e).\21\ Rule 15c3-3(f) further requires the broker-dealer to obtain a
written contract from the bank in which the bank agrees not to re-lend
or hypothecate securities deposited into the reserve account.\22\
Consequently, the securities should be readily available to the broker-
dealer. Cash deposits, however, are fungible with other deposits
carried by the bank and may be freely used in the course of the bank's
commercial lending activities. Therefore, to the extent a broker-dealer
deposits cash in a reserve bank account, there is a risk the cash could
be lost or inaccessible for a period if the bank experiences financial
difficulties. This could adversely impact the broker-dealer and its
customers if the balance of the reserve deposit is concentrated at one
bank in the form of cash.
---------------------------------------------------------------------------

    \21\ The term ``qualified securities'' is defined in paragraph
(a)(6) of Rule 15c3-3 to mean a securities issued by the United
States or guaranteed by the United States with respect to principal
and interest. 17 CFR 240.15c3-3(a)(6). The term ``bank'' is defined
in paragraph (a)(7) of Rule 15c3-3.
    \22\ See 17 CFR 240.15c3-3(f).
---------------------------------------------------------------------------

    This risk may be heightened when the deposit is held at an
affiliated bank in that the broker-dealer may not exercise due
diligence with the same degree of impartiality when assessing the
financial soundness of an affiliate bank as it would with a non-
affiliate bank. Moreover, the broker-dealer's customers may not derive
any significant protection from the reserve requirement in the event of
the parent's insolvency.
    To address these risks, we are proposing an amendment to Rule 15c3-
3 that would exclude cash deposits at affiliate banks for the purposes
of meeting customer or PAB reserve requirements and place limitations
on the amount of cash a broker-dealer could maintain in a customer or
PAB special reserve bank account at one unaffiliated bank. The
exclusion and limitations would not apply to deposits of securities
since these assets do not become a part of a bank's working capital. As
discussed below, the limitations would prevent a broker-dealer from
maintaining a reserve deposit in the form of cash at a single
unaffiliated bank that exceeds a percentage of the broker-dealer's or
the bank's capital. This is designed to mitigate the risk that an
impairment of the reserve deposit at an unaffiliated single bank will
have a material negative impact on the broker-dealer's ability to meet
its obligations to customers and PAB accountholders.\23\
---------------------------------------------------------------------------

    \23\ These amendments are not intended to affect the practice
whereby customer free credit balances are swept into a bank deposit
account and the customer receives Federal Deposit Insurance
Protection.
---------------------------------------------------------------------------

    Under the proposal, a paragraph (e)(5) would be added to Rule 15c3-
3. This new paragraph would provide that--in determining whether the
broker-dealer maintains the minimum reserve deposits required (customer
and PAB)--the broker-dealer would be required to exclude a cash deposit
at an affiliated bank. With respect to unaffiliated banks, the broker-
dealer would be required to exclude the deposit to the extent that it
exceeded (1) 50% of the broker-dealer's excess net capital (based on
the most recently filed FOCUS Report),\24\ or (2) 10% of the bank's
equity capital (based on the bank's most recently filed Call Report or
Thrift Financial Report).\25\ The goal is to limit cash reserve account
deposits to reasonably safe amounts as measured against the
capitalization of the broker-dealer and the bank. Excess net capital is
the amount that a broker-dealer's net capital exceeds its minimum
requirement and, therefore, constitutes a cushion to absorb unexpected
losses. We believe limiting a cash deposit in one bank to 50% of excess
net capital means the broker-dealer has a reserve to absorb the loss or
impairment of the deposit plus an additional amount to absorb other
losses. The amount of a bank's equity capital is a measure of its
financial solvency. We believe limiting the cash deposit to 10% of the
bank's equity capital means the broker-dealer would not commit customer
cash to an institution in an amount that is out of proportion to the
bank's capital base.
---------------------------------------------------------------------------

    \24\ Under Rule 17a-5 (17 CFR 240.17a-5) broker-dealers must
file periodic reports on Form X-17a-5 (Financial and Operational
Combined Uniform Single Reports (``FOCUS Reports'')). The FOCUS
Report form requires, among other financial information, a balance
sheet, income statement, and net capital and customer reserve
computations.
    \25\ Commercial banks insured by the Federal Deposit Insurance
Corporation (``FDIC''), savings banks supervised by the FDIC, and
non-insurance trust companies supervised by the Office of the
Comptroller of the Currency file quarterly Call Reports. Savings
Associations and non-insured trust companies supervised by the
Office of Thrift Supervision file Thrift Financial Reports (TFRs).
These reports include a line item for equity capital. A report for a
specific institution can be obtained by accessing the following Web
site: http://www2.fdic.gov/call_tfr_rpts/search.asp.

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

    We request comment on all aspects of these proposed amendments,
including whether the proposed reserve deposit limitations of 50% of
excess net capital or 10% of the bank's equity capital adequately
address the risks of concentrating cash deposits at any one bank or
whether other thresholds should apply.

3. Expansion of the Definition of Qualified Securities To Include
Certain Money Market Funds
    As noted above, a broker-dealer is limited to depositing cash or
``qualified securities'' into the bank account it maintains to meet the
customer reserve deposit requirements under Rule 15c3-3. Paragraph
(a)(6) of Rule 15c3-3 defines ``qualified securities'' as securities
issued by the United States or guaranteed by the United States with
respect to principal and interest (``US Treasury securities'').\26\
These strict limitations on the types of assets that can be used to
fund a broker-dealer's customer reserve account are designed to further
the purpose of Rule 15c3-3; namely, that customer assets be segregated
and held in a manner that makes them readily available to be returned
to the customer. For example, paragraph (e)(2) of Rule 15c3-3 makes it
unlawful for a broker-dealer to use customer credits (generally, cash
balances in securities accounts) for any purpose other than financing
customer debits (fully secured margin loans).\27\ Under the rule, the
amount of excess credits (i.e., credits net of debits) must be held in
the customer reserve account and, as noted, the account must be funded
with either cash or U.S. Treasury securities.\28\
---------------------------------------------------------------------------

    \26\ 17 CFR 240.15c3-3(a)(6).
    \27\ 17 CFR 240.15c3-3(e)(2).
    \28\ Id.
---------------------------------------------------------------------------

    Federated Investors, Inc. (``Federated'') has filed a petition with
the Commission requesting that Rule 15c3-3 be amended to include
certain types of money market funds in the definition of qualified
securities.\29\ We believe expanding the definition to include money
market funds that only invest in securities meeting the definition of
``qualified security'' in Rule 15c3-3 would be appropriate. The assets
held by such a money market fund would be same as those a broker-dealer
can hold directly in its customer reserve account. Consequently, a
broker-dealer might choose to deposit qualifying money market fund
shares into the customer reserve account based on operational
considerations such as avoiding the need to actively manage a portfolio
of U.S. Treasury securities. This operational benefit also could
decrease burdens on those broker-dealers that would be impacted by our
proposed amendments discussed above with respect to customer reserve
account cash deposits into affiliate and non-affiliate banks. A broker-
dealer that deposits cash into the customer reserve account to avoid
the operational aspects of holding and managing U.S. Treasury
securities would have the option of depositing a qualifying money
market fund to replace the cash deposit.
---------------------------------------------------------------------------

    \29\ See Public Petition for Rulemaking No. 4-478 (April 3,
2003), as amended (April 4, 2005), available at http://www.sec.gov/rules/petitions/petn4-478.htm
.

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

    We believe, however, that there should be safeguards in place
designed to ensure that qualifying money market fund shares could be
redeemed quickly. A broker-dealer in financial difficulty must be able
to liquidate quickly the assets in its customer reserve account so that
customer credit balances can be returned without delay. Consequently,
in addition to the limitations on holdings discussed above, our
proposal to expand the definition of ``qualified securities'' to
include money market funds includes the following safeguards. First,
the money market fund could not be a company affiliated with the
broker-dealer. The broker-dealer may experience financial difficulty
caused by liquidity problems at the holding company level that are
adversely impacting an affiliated money market fund as well in terms of
the fund's ability to promptly redeem shares. Second, our proposal
would require the broker-dealer to use a fund that agrees to redeem
fund shares in cash on the next business day. There should be no
ability of the fund to delay redemption beyond one day or to require a
multi-day redemption notification period.
    Finally, our proposal would require that the money market fund have
an amount of net assets (assets net of liabilities) that is at least 10
times the value of the fund's shares held by the broker-dealer in its
customer reserve account. This is designed to prevent a broker-dealer
from holding too concentrated a position in a single fund. It also
limits a potential redemption request by the broker-dealer to 10% or
less of the fund's assets. While a redemption request that equaled 10%
of a fund's net assets would be very substantial, we believe it is a
reasonable threshold between a request that could be handled promptly
and one that could have the potential to cause the fund some degree of
difficulty in meeting the request within one business day. We seek
comment on this threshold, particularly with respect to whether it
should be smaller (e.g., 5% or 2%) or higher (e.g., 15% or 25%).
    For the foregoing reasons, we propose amending the definition of
``qualified security'' in paragraph (a)(6) of Rule 15c3-3 to include an
unaffiliated money market fund that: (1) Is described in Rule 2a-7 of
the Investment Company Act of 1940; (2) invests solely in securities
issued by the United States or guaranteed by the United States as to
interest and principal; (3) agrees to redeem fund shares in cash no
later than the business day following a redemption request by a
shareholder; and (4) has an amount of net assets equal to at least 10
times the value of the shares deposited by the broker-dealer in its
customer reserve account.
    We solicit comment on all aspects of this proposal, including
whether these types of money market funds are appropriate for the
customer reserve account in terms of liquidity and safety and whether
the 10% net asset limitation would be an adequate safeguard in terms of
ensuring a broker-dealer could quickly redeem its shares.
4. Allocation of Customers' Fully Paid and Excess Margin Securities to
Short Positions
    Paragraph (d) of Rule 15c3-3 sets forth steps a broker-dealer must
take to retrieve securities from non-control locations if there is a
shortfall in the fully paid or excess margin securities it is required
to hold. The rule does not require the broker-dealer to act when a
short position on the broker-dealer's stock record allocates to a
customer long position; for example, if the broker-dealer sells short a
security to its customer. In such a circumstance, the broker-dealer
would not be required to have possession or control of the security its
customer has paid for in full. Instead, the broker-dealer would put the
mark-to-market value of the security as a credit item in the reserve
formula. The cash paid by the customer to purchase the security could
be used by the broker-dealer to make any increased deposit requirement
caused by the credit item. If the increase is less than the cash paid,
the broker-dealer could use the excess funds in its own business
operations. Moreover, if the value of the security decreases, the
broker-dealer could withdraw funds out of the reserve account and use
them as well. In effect, this permits the broker-dealer to monetize the
customer's security. This is contrary to the customer protection goals
of Rule 15c3-3, which seeks to ensure that broker-dealers do not use
customer assets for proprietary purposes.
    Accordingly, we are proposing to add a new paragraph (d)(4) to Rule
15c3-3, which would add an additional action with respect to retrieving
securities from non-control positions when the broker-dealer needs to
obtain possession or control over a specific issue and class of

securities.\30\ Specifically, under the proposal, the broker-dealer
would be required to take prompt steps to obtain physical possession or
control over securities of the same issue and class as those included
on the broker-dealer's books as a proprietary short position or as a
short position for another person. By requiring the broker-dealer to
obtain physical possession or control over the security, it would no
longer be able to monetize the value of the security and use the cash
for proprietary activities.
---------------------------------------------------------------------------

    \30\ Current paragraph (d)(4) of Rule 15c3-3 would be re-
designated as paragraph (d)(5).
---------------------------------------------------------------------------

    Under the proposal, the action would not be required until the
short position had aged more than 10 business days (or more than 30
calendar days if the broker or dealer is a market maker in the
securities).\31\ Allowing broker-dealers 10 business days before they
must take action is consistent with paragraph (m) of Rule 15c3-3, which
similarly allows a broker-dealer up to 10 business days after
settlement date to purchase securities that a customer has sold through
the broker-dealer but failed to deliver. As with the requirement in
paragraph (m), the proposal's objective is to require a broker-dealer
to close an open transaction but within a timeframe that permits a
degree of flexibility. The longer 30 calendar day period for securities
in which the broker-dealer makes a market is intended to accommodate
the short-selling that is integral to market-making activities.
---------------------------------------------------------------------------

    \31\ The proposed amendment would not apply to securities that
are sold for a customer but not obtained from the customer within 10
days after the settlement date. This circumstance is addressed by
paragraph (m) of Rule 15c3-3, which requires the broker-dealer to
close the transaction by purchasing securities of like kind and
quantity. 17 CFR 240.15c3-3(m).
---------------------------------------------------------------------------

    We request comment on all aspects of this proposed amendment,
including whether the proposed time periods should be longer or
shorter.
5. Treatment of Free Credit Balances and Importation of Rule 15c3-2
Requirements Into Rule 15c3-3
i. Treatment of Free Credit Balances
    Free credit balances are funds payable by a broker-dealer to its
customers on demand.\32\ They may result from cash deposited by the
customer to purchase securities, proceeds from the sale of securities
or other assets held in the customer's account, or earnings from
dividends and interest on securities and other assets held in the
customer's account. Broker-dealers may, among other things, pay
interest to customers on their free credit balances, or offer to
transfer (sweep) them into a specific money market fund or interest
bearing bank account. The customer earns dividends on the money market
fund or interest on the bank account until such time as the customer
chooses to liquidate the position in order to use the cash, for
example, to purchase securities.
---------------------------------------------------------------------------

    \32\ See 17 CFR 240.15c3-3(a)(8).
---------------------------------------------------------------------------

    In recent years, broker-dealers have on occasion changed the
product to which a customer's free credit balances are swept--most
frequently from a money market fund product to an interest bearing bank
account. There are differences in these two types of products,
including the type of protection afforded the customer in the event of
an insolvency. The money market shares--as securities--would receive up
to $500,000 in SIPA protection in the event the broker-dealer failed.
The bank deposits--as cash--would receive $100,000 in protection from
the Federal Deposit Insurance Corporation (``FDIC'') in the event the
bank failed. On the other hand, the money market fund as a security
theoretically could lose its principal; whereas the bank deposit would
be guaranteed up to the FDIC's $100,000 limit. There also may be
differences in the amount of interest earned from the two products. In
short, while not judging the appropriateness of either option, we note
there may be consequences to changing options and believe that
customers should have a sufficient opportunity to make an informed
decision.\33\
---------------------------------------------------------------------------

    \33\ In 2005, The New York Stock Exchange LLC (``NYSE'')
addressed the issue of disclosure. Specifically, the NYSE issued an
information memo to its members discussing, among other things, the
disclosure responsibilities of a broker-dealer offering a bank sweep
program to its customers. See Information Memo 05-11 (February 15,
2005). The Memo stated that broker-dealers should disclose material
differences in interest rates between the different products and,
with respect to the bank sweep program, the terms and conditions,
risks and features, conflicts of interest, current interest rates,
the manner by which future interest rates will be determined, and
the nature and extent of FDIC and SIPC protection. See id.
---------------------------------------------------------------------------

    For these reasons, we are proposing to amend Rule 15c3-3 by adding
a new paragraph (j) that would make it unlawful for a broker-dealer to
convert, invest or otherwise transfer free credit balances except under
three circumstances. The first circumstance, set forth in proposed
paragraph (j)(2)(i) of Rule 15c3-3, would permit a broker-dealer to
convert, invest, or otherwise transfer the free credit balances to any
type of investment or other product, or to a different account within
the broker-dealer or at another institution, or otherwise dispose of
the free credit balances, but only upon a specific order,
authorization, or draft from the customer, and only under the terms and
conditions specified by the customer in the order, authorization or
draft. This proposal is not addressing free credit balance sweeps to
money market funds and bank deposit accounts, but rather the use of
customer free credit balances for other purposes (e.g., to purchase
securities other than money market funds, or to transfer to a different
account or financial institution). In these circumstances, the proposed
paragraph would prohibit any investment, conversion, or other transfer
of the free credit balances except on the customer's specific order,
authorization, or draft.
    The second and third circumstances, set forth in proposed
paragraphs (j)(2)(ii) and (iii) of Rule 15c3-3, address the sweeping of
free credit balances to either a money market fund or a bank deposit
account. The former applies to new customers and the latter to existing
customers as of the date the proposed amendments would become
effective.
    Proposed paragraph (j)(2)(ii) of Rule 15c3-3 would permit a broker-
dealer to have the ability to change the sweep option of a new customer
from a money market fund to a bank deposit account (and vice versa),
provided certain specific conditions are met. First, the customer would
need to agree prior to the change (e.g., in the account opening
agreement) that the broker-dealer could switch the sweep option between
those two types of products. Second, the broker-dealer would need to
provide the customer with all notices and disclosures regarding the
investment and deposit of free credit balances required by the self-
regulatory organizations for which the broker-dealer is a member.\34\
Third, the broker-dealer would need to provide the customer with notice
in the customer's quarterly statement that the money market fund or
bank deposit account can be liquidated on the customer's demand and
converted back into free credit balances held in the customer's
securities account. Fourth, the broker-dealer would need to provide the
customer with notice at least 30 calendar days before changing the
product (e.g., from one money market fund to another), the product type
(e.g., from a money market fund to a bank account), or the terms and
conditions under which the free credit balances are swept. The notice
would need to describe the change and explain how the customer could
opt out of it.
---------------------------------------------------------------------------

    \34\ See NYSE Information Memo 05-11 (February 15, 2005).
---------------------------------------------------------------------------

    The third circumstance, set forth in proposed paragraph (j)(2)(iii)
of Rule

15c3-3, would apply to existing customers as of the effective date of
the proposed rule. It would permit a broker-dealer to have the option
to change an existing customer's sweep option from a money market fund
to a bank deposit account (and vice versa), provided the second, third,
and fourth conditions set forth in proposed paragraph (j)(2)(ii)
discussed above were met. To minimize the burden on the broker-dealer,
proposed paragraph (j)(2)(iii) would not require the broker-dealer to
obtain the customer's previous agreement to permit the broker-dealer to
switch the sweep option between money market fund products and bank
deposit account products. This would avoid the necessity of having to
amend each existing customer account agreement. Because all the other
conditions in proposed paragraph (j)(2)(ii) would apply, the broker-
dealer would be required to provide existing customers with the various
notices and disclosures that must be made to new customers, including
giving notice at least 30 calendar days before the sweep option was
changed and in that notice explain the change and how the customer
could opt out of it.
    We request comment on all aspects of this proposed amendment,
including: (1) Whether it would provide adequate protection to
customers with respect to changes in the treatment of their free credit
balances, (2) on the cost burdens (quantified to the extent possible)
that would result if the condition in proposed paragraph (j)(2)(ii)(A)
of Rule 15c3-3 to obtain a new customer's prior agreement were to be
applied to existing customers, (3) whether there are other sweep
products in addition to money market mutual funds and bank deposit
accounts that could be contemplated in proposed paragraphs (j)(2)(ii)
and (iii) of Rule 15c3-3, and (4) whether the treatment of free credit
balances has already been adequately addressed by the self-regulatory
organizations.
ii. Importation of Rule 15c3-2
    Rule 15c3-2 requires a broker-dealer holding free credit balances
to provide its customers (defined as any person other than a broker-
dealer) at least once every three months with a statement of the amount
due the customer and a notice that (1) the funds are not being
segregated, but rather are being used in the broker-dealer's business,
and (2) that the funds are payable on demand. The rule was adopted in
1964 before the adoption of Rule 15c3-3.\35\ Since the adoption of Rule
15c3-3, a broker-dealer, as noted above, has been limited in how it may
use customer free credit balances. While the reserve account required
under Rule 15c3-3 is in the name of the broker-dealer and the assets
therein remain a part of its capital, the assets in the account are
held for the exclusive benefit of the broker-dealer's customers. In a
liquidation of the broker-dealer, the assets in the account will be
available to satisfy customer claims ahead of all other creditors.
---------------------------------------------------------------------------

    \35\ See Exchange Act Release No. 7266 (March 12, 1964).
---------------------------------------------------------------------------

    We believe the adoption of Rule 15c3-3 has eliminated the need to
have a separate Rule 15c3-2. At the same time, we believe certain of
the requirements in Rule 15c3-2 should be imported into Rule 15c3-3;
namely, the requirements that broker-dealers inform customers of the
amounts due to them and that such amounts are payable on demand.\36\
Accordingly, we are proposing to eliminate Rule 15c3-2 and amend Rule
15c3-3 to include these latter requirements.
---------------------------------------------------------------------------

    \36\ Rule 15c3-2 contains an exemption for broker-dealers that
also are banking institutions supervised by a Federal authority.
This exemption would not be imported into Rule 15c3-3 because there
are no broker-dealers left that fit within the exemption. Further,
under the proposed amendment, the definition of ``customer'' for
purposes of the imported 15c3-2 requirements would be the definition
of ``customer'' in Rule 15c3-3, which is somewhat narrower than the
definition in Rule 15c3-2.
---------------------------------------------------------------------------

    We request comment on all aspects of this proposed amendment.
Commenters are encouraged to provide data to support their views.
6. Aggregate Debit Items Charge
    Note E(3) to the customer reserve formula (Rule 15c3-3a) requires a
broker-dealer using the ``basic method'' of computing net capital under
Rule 15c3-1 to reduce by 1% the total debits in Item 10 of the formula
(i.e., debit balances in customer's cash and margin accounts).\37\ This
1% reduction in Item 10 debits lowers the amount of total debit items
in the formula. Because the debits offset aggregate credits in
determining customer reserve requirements, the reduction has the
potential to increase the amount a broker-dealer must maintain in the
reserve account. Under paragraph (a)(1)(ii)(A) of Rule 15c3-1 however,
broker-dealers using the ``alternative standard'' \38\ to compute their
minimum net capital requirement must reduce aggregate debit items by 3%
in lieu of the 1% reduction required by Note E(3).\39\ Thus, the
deduction applicable to alternative standard firms can result in an
even larger reserve deposit requirement.
---------------------------------------------------------------------------

    \37\ Under the ``basic method,'' a broker-dealer cannot permit
its aggregate indebtedness (generally total money liabilities) to
exceed 1500% of its net capital. 17 CFR 15c3-1(a)(1)(i).
    \38\ Under the ``alternative standard,'' a broker-dealer's
minimum net capital requirement is equal to 2% of the firm's
aggregate debit items. 17 CFR 240.15c3-1(a)(1)(ii).
    \39\ 17 CFR 240.15c3-1(a)(1)(ii)(A).
---------------------------------------------------------------------------

    The Commission adopted the alternative standard as part of the 1975
amendments to Rule 15c3-1, which expanded the rule's scope to apply to
all broker-dealers.\40\ The alternative standard constituted a new way
of providing for the capital adequacy of a broker-dealer in that it
diverged from the traditional notion of limiting a firm's leverage.\41\
The alternative standard instead imposes a capital requirement based on
the size of the broker-dealer's commitments to its customers through
margin lending and other transactions. Thus, it requires a broker-
dealer to hold net capital equal to a percentage of its customer
commitments. The alternative standard was designed to integrate a
broker-dealer's capital requirement under Rule 15c3-1 with the customer
protection requirements in Rule 15c3-3; hence it uses the aggregate
debit computation required by Rule 15c3-3 to determine a broker-
dealer's net capital requirement under Rule 15c3-1.\42\
---------------------------------------------------------------------------

    \40\ See Exchange Act Release No. 11497 (June 26, 1975). Prior
to 1975, the rule only applied to broker-dealers that were not a
member of a securities exchange, since exchange members were subject
to capital rules promulgated by the exchanges. Id.
    \41\ See id.
    \42\ Id.
---------------------------------------------------------------------------

    As part of the amendments adopting the alternative standard, the
Commission lowered the haircut on equity securities from 30% to 15% for
a broker-dealer using the standard.\43\ At the same time, it amended
Rule 15c3-1 to require alternative standard firms to employ the greater
3% reduction of debit items.\44\ The Commission explained the greater
requirement as providing, ``in the event of a liquidation [of the
broker-dealer], an additional cushion of secured debit items which will
be available to satisfy customers with whom the broker or dealer
effects transactions.'' \45\
---------------------------------------------------------------------------

    \43\ Id.
    \44\ Id.
    \45\ Id.
---------------------------------------------------------------------------

    Originally, the alternative standard required a broker-dealer to
hold net capital equal to 4% of its customer debits.\46\ The Commission
lowered this requirement to 2% in 1982.\47\ It explained its decision
as being based on broker-dealers' improved back-office systems and
increased use of clearing

agencies.\48\ These developments made it possible for the firms to
handle large volumes of trading without experiencing operational and
bookkeeping problems.\49\ The Commission also noted that the SROs had
upgraded their surveillance programs and that the early warning rules
of both the Commission and the SROs remained significantly higher than
the 2% minimum requirement.\50\
---------------------------------------------------------------------------

    \46\ Id.
    \47\ Exchange Act Release 18417 (January 13, 1982), 47 FR 3512
(January 25, 1982).
    \48\ Id.
    \49\ Id.
    \50\ Id.
---------------------------------------------------------------------------

    In recent years, the amount of debit items carried by broker-
dealers has increased substantially. Consequently, the 3% reduction in
debit items has required many broker-dealers using the alternative
standard to increase their reserve deposits by additional amounts that
are far in excess of the additional cushion envisioned when the
amendment was adopted in 1975. Furthermore, the level of risk assumed
by broker-dealers does not increase proportionately as the aggregate
amount of debits increases; due, in part, to an increase in diversity
among the debits. The proportional 3% reduction of debit items does not
recognize this diversification benefit.
    Moreover, in 1992, the Commission amended Rule 15c3-1 to lower the
haircut for broker-dealers using the basic method to 15%, which brought
their requirement in line with the alternative standard firms.\51\ The
15% haircut for equity securities has proven sufficient to cover most
market moves and, therefore, we believe the increased level of
protection derived from the greater 3% debit item reduction likely
would not provide a benefit justified by the costs.
---------------------------------------------------------------------------

    \51\ Exchange Act Release No. 31511 (November 24, 1992), 57 FR
56973 (December 2, 1992).
---------------------------------------------------------------------------

    For these reasons, we believe it is now appropriate to treat
broker-dealers using the alternative standard on a par with firms using
the basic method and, therefore, propose lowering the debit reduction
applicable to alternative standard firms. We would apply a 1%
reduction, rather than a 3% reduction, for alternative standard firms.
The 1% reduction should provide an adequate cushion, given these firms'
current levels of debit items, which--as noted--are far greater than
existed when the rule was adopted in 1975 or amended in 1982. Our
proposal would amend paragraph (a)(1)(ii)(A) of Rule 15c3-1 by removing
the provision requiring the 3% reduction. This would make alternative
standard firms subject to the 1% reduction in debit items as required
in Note E(3) of Rule 15c3-3a.
    We request comment on all aspects of this proposed amendment,
including whether the benefits of the 3% reduction outweigh any costs
that might arise from the proposal. Commenters are requested to
identify potential costs and provide data to support their views.
7. ``Proprietary Accounts'' Under the Commodity Exchange Act
    Certain broker-dealers also are registered as futures commission
merchants under the Commodity Exchange Act (``CEA''). These firms carry
both securities and commodities accounts for customers. The definition
of ``free credit balances'' in paragraph (a)(8) of Rule 15c3-3 excludes
funds that are carried in commodities accounts that are segregated in
accordance with the requirements of the CEA.\52\ However, regulations
promulgated under the CEA exclude certain types of accounts
(``proprietary accounts'') from the segregation requirement.\53\ The
question has arisen as to whether a broker-dealer holding these types
of accounts must include funds in them as ``free credit balances'' when
performing a customer reserve computation.
---------------------------------------------------------------------------

    \52\ 17 CFR 240.15c3-3(a)(8).
    \53\ Rule 1.20 (17 CFR 1.20) requires a futures commission
merchant to segregate ``customer'' funds. Rule 1.3(k) (17 CFR
1.3(k)) defines the term ``customer'' for this purpose. The
definition of ``customer'' excludes persons who own or hold a
``proprietary account'' as that term is defined in Rule 1.3(y) (17
CFR 1.3(y)). Generally, the definition of ``proprietary account''
refers to persons who have an ownership interest in the futures
commission merchant. See 17 CFR 1.3(y).
---------------------------------------------------------------------------

    These funds likely would not be protected in a SIPA proceeding
because they are related to commodities transactions.\54\ The purpose
behind the cash reserve requirements in Rule 15c3-3 is to require
broker-dealers to hold sufficient funds with which to satisfy customer
claims arising from securities (not commodities) transactions and,
thereby, to minimize the need for a SIPA liquidation. This purpose
would not be served by treating funds held in commodities accounts
(that are not segregated under CEA regulations) as ``free credit
balances.'' Accordingly, we are proposing an amendment to paragraph
(a)(8) of Rule 15c3-3, which would clarify that funds held in a
commodity account meeting the definition of a ``proprietary account''
under CEA regulations are not to be included as ``free credit
balances'' in the customer reserve formula.
---------------------------------------------------------------------------

    \54\ To receive protection under SIPA, a claimant must first
qualify as a ``customer'' as that term is defined in the statute.
Generally, a ``customer'' is any person who has (1) ``a claim on
account of securities received, acquired, or held by the [broker-
dealer],'' (2) ``a claim against the [broker-dealer] arising out of
sales or conversions of such securities'' or (3) ``deposited cash
with the debtor for the purposes of purchasing securities.'' 15
U.S.C. 78lll(2). The definition of ``security'' in SIPA specifically
excludes commodities and non-securities futures contracts (see 15
U.S.C. 78lll(14)) and, thus, a person with a claim for such assets
would not meet the definition of ``customer.''
---------------------------------------------------------------------------

    We request comment on all aspects of this proposed amendment.
Commenters are encouraged to provide data to support their views.

B. Holding Futures Positions in a Securities Portfolio Margin Account

    The Chicago Board of Options Exchange, Incorporated (``CBOE'') and
the NYSE have amended their margin rules to permit broker-dealer
members to compute customer margin requirements using a portfolio
margin methodology (``Portfolio Margin Rules'').\55\ A portfolio
margining methodology computes margin requirements based on the net
market risk of all positions in an account assuming certain potential
market movements. Under the Portfolio Margin Rules, a broker-dealer can
combine securities and futures positions into the portfolio margin
account. SIPA, however, only protects customer claims for securities
and cash and specifically excludes from protection futures contracts
that are not also securities.\56\ This raises a question as to how
futures positions in a portfolio margin account would be treated in a
SIPA liquidation. Consequently, we are proposing amendments to Rules
15c3-3 and 15c3-3a that are designed to provide the protections of Rule
15c3-3 and SIPA to futures positions in a securities account under the
Portfolio Margin Rules.
---------------------------------------------------------------------------

    \55\ Exchange Act Release No. 54918 (December 12, 2006), 72 FR
1044 (January 9, 2007) (SR-NYSE-2006-13); Exchange Act Release No.
54919 (December 12, 2006), (SR-CBOE 2006-14); Exchange Act Release
No. 52031 (July 14, 2005), 70 FR 42130 (July 21, 2005) (SR-NYSE-
2002-19); Exchange Act Release No. 52032 (July 14, 2005), 70 FR
42118 (July 21, 2005) (SR-CBOE-2002-03).
    \56\ The definition of ``security'' in SIPA includes a futures
contract that also is a security; namely, a ``security future'' as
defined in section 3(a)(55)(A) of the Exchange Act. See 15 U.S.C.
78lll(14).
---------------------------------------------------------------------------

    First, we propose amending the definition of ``free credit
balances'' in paragraph (a)(8) of Rule 15c3-3 to include funds
resulting from margin deposits and daily marks to market related to,
and proceeds from the liquidation of, futures on stock indices and
options thereon carried in a securities account pursuant to a portfolio
margining rule of an SRO. Under this amendment, a broker-dealer holding
such funds would have to treat them as ``credit items'' for purposes of
the customer reserve computation. Consequently, the futures-related
funds

in a portfolio margin account would need to be included with all other
credit items when a broker-dealer computed its customer reserve
requirement under Rule 15c3-3. Further, because free credit balances
constitute ``cash'' in a customer's account, they are ``cash'' for
purposes of determining a customer's ``net equity'' in a SIPA
liquidation.\57\
---------------------------------------------------------------------------

    \57\ If a person qualifies as a ``customer'' under SIPA, the
next inquiry is to value the amount of the customer's claim. This
step is accomplished by reference to the definition of ``net
equity'' in SIPA. 15 U.S.C 78lll(11). Generally, ``net equity'' is
the ``dollar amount of the [customer's] account'' as determined by
calculating the sum that would have been owed the customer had the
securities in the customer's account been liquidated on the date the
SIPA proceeding was commenced minus any amounts owed by the customer
to the broker-dealer.
---------------------------------------------------------------------------

    Our proposed amendment to the definition of ``free credit
balances'' also would bring within the definition's scope the market
value of futures options in a portfolio margin account as of the SIPA
``filing date.'' \58\ Unlike futures contracts, futures options do not
take the form of cash balances in the account (i.e., they have market
value at the end of a trading day). Since the broker-dealer is not
holding cash for the customer there is not the need to treat the
futures options as a ``free credit balance'' and require a credit in
the reserve formula. However, if the broker-dealer is liquidated under
SIPA, the unrealized gains or losses of the futures options should be
included in calculating the customer's net equity in the account (along
with the cash balances related to the futures contracts and the
securities positions and related cash balances). The proposed amendment
is designed to provide for this outcome by defining the market value of
the futures options as a free credit balance in the event the broker-
dealer becomes subject to a SIPA proceeding. As ``free credit
balances,'' funds resulting from margin deposits and daily marks to
market related to futures and the market value of futures options as of
the SIPA filing date would constitute claims for cash in a SIPA
proceeding and, therefore, become a part of a customer's ``net equity''
claim and be entitled to up to $100,000 in advances to make up for
shortfalls.\59\
---------------------------------------------------------------------------

    \58\ The term ``filing date'' is defined in SIPA as, generally,
being the date a SIPA proceeding is commenced. See 15 U.S.C.
78lll(7).
    \59\ Generally, futures and futures options in a portfolio
margin account would be transferred to a solvent broker-dealer or
liquidated before the initiation of a SIPA proceeding. Consequently,
these proposals are highly cautionary as it is unlikely that a
broker-dealer would be placed in a SIPA liquidation while still
holding these types of positions in customer accounts.
---------------------------------------------------------------------------

    On the debit side of the customer reserve formula, we are proposing
an amendment to Rule 15c3-3a Item 14 that would permit the broker-
dealer to include as a debit item the amount of customer margin
required and on deposit at a futures clearing organization related to
futures positions carried in a securities account pursuant to an SRO
portfolio margin rule. Under SIPA, the term ``customer property''
includes ``resources provided through the use or realization of
customers'' debit cash balances and other customer-related debit items
as the Commission defines by rule.'' \60\ Under this provision of SIPA,
this proposed amendment to Rule 15c3-3a would make the margin required
and on deposit at a futures clearing organization part of the
``customer property'' in the event the broker-dealer is placed in a
SIPA liquidation.\61\ Thus, it would be available to the liquidation
trustee for distribution to the failed firm's customers.
---------------------------------------------------------------------------

    \60\ 15 U.S.C. 78lll(4)(B).
    \61\ Margin posted at a futures clearing organization for
securities futures products currently is treated in this manner. See
17 CFR 240.15c3-3a.
---------------------------------------------------------------------------

    We believe our proposed amendments designed to provide the
protections of Rule 15c3-3 and SIPA to all positions in a securities
account established under an SRO portfolio margin rule are warranted
given that the futures positions in the account serve as hedges for the
securities positions and, therefore, reduce the risk of the securities
positions. The intermingled nature of the positions, margin or deposit,
and the fact that the futures positions reduce the amount of margin
necessary to carry the securities positions makes it highly practical
to treat all the positions in accordance with the requirements of Rule
15c3-3 and, as part of the customer's ``net equity'' in a SIPA
liquidation.
    We solicit comment on whether this approach represents a workable
solution to providing SIPA protection to portfolio margin
accountholders. In particular, we request comment as to whether there
are other approaches the Commission may pursue that are designed to
provide SIPA protection to futures related cash and futures options in
portfolio margin accounts.

C. Amendments With Respect to Securities Lending and Borrowing and
Repurchase/Reverse Repurchase Transactions

    Securities lending and repurchase transactions by institutions are
an important element of the financial markets. In a typical securities
lending transaction, the parties agree that the owner of the securities
(e.g., a pension fund, institutional investor, bank, or broker-dealer)
will lend securities to a borrower, and the borrower will be required
to return securities of like kind and quantity to the lender. To
protect the lender's interest, the borrower typically will provide cash
or other securities as collateral in excess of the market value of the
securities loaned.\62\ In the typical securities repurchase/reverse
repurchase transaction (``repo transactions''), a buyer agrees to
purchase securities from a seller and the seller agrees to repurchase
them at some time in the future at the sale price plus some additional
consideration. Thus, if the securities increase in value, the seller is
at risk that the buyer will default on its obligation to resell them at
the original contract price. Conversely, if the securities decrease in
value, the buyer is at risk that the seller will default on its
obligation to repurchase them at the original contract price. To
address these risks, the securities underlying the agreement are marked
to market daily and, if their value rises above the contract price, the
buyer provides margin to the seller to secure the buyer's obligation to
resell the securities at a price lower than market value.
Alternatively, if the value of the securities falls below the contract
price, the seller provides margin to the buyer to secure the seller's
obligation to repurchase the securities at a price above the market
value.
---------------------------------------------------------------------------

    \62\ In computing net capital under Rule 15c3-1, a broker-dealer
generally must make a deduction in the amount that the market value
of securities loaned exceeds the value of collateral received. 17
CFR 240.15c3-1(c)(2)(iv)(B). Likewise, a broker-dealer must make a
deduction in the amount the value of collateral posted exceeds the
value of securities borrowed to the extent the excess is greater
than certain percentages. This permits the broker-dealer to provide
excess collateral in conformance with industry standards without
taking the deduction. In either case, the broker-dealer is not
required to take the deduction, provided it issues a mark-to-market
call and collects payment the same day.
---------------------------------------------------------------------------

    In addition to participating in securities lending transactions,
broker-dealers provide a variety of services to other borrowers and
lenders, including counterparty credit evaluation, collateral
management, and administration of distributions and corporate actions.
Moreover, a broker-dealer may negotiate the loan as agent for both
parties (divulging their identities just prior to the transaction) or
by interposing itself as principal between two undisclosed
counterparties as a conduit lender.
    The failure of MJK Clearing, Inc. (``MJK'')--the largest SIPA
liquidation to date--raised several concerns regarding securities
lending transactions. The

Commission, in two civil complaints,\63\ alleged that MJK engaged in
conduit securities lending transactions involving shares of a company
called GenesisIntermedia, Inc. According to the complaints, MJK
borrowed shares of GenesisIntermedia from one broker-dealer, providing
cash collateral equal to the market value of the borrowed shares. MJK
then re-lent the GenesisIntermedia shares to other broker-dealers that
provided cash collateral in return. As indicated in the complaints,
after the transactions, the market value of the GenesisIntermedia
shares declined dramatically. The complaints also describe how MJK
returned cash collateral to the borrowing broker-dealers as the shares
declined in value but did not collect excess cash collateral provided
to the broker-dealer that lent the shares to MJK. Eventually, MJK went
out of business. At the time of its failure, MJK still owed cash
collateral to several of the borrowing broker-dealers.\64\
---------------------------------------------------------------------------

    \63\ See SEC Litigation Release No. 18641, 2004 LEXIS 706 (March
26, 2004); SEC Complaint, SEC v. Thomas G. Brooks, Civil Action No.
CV 03-3319 ADM/AJB, United States District Court (D. Minn. June 2,
2003); SEC v. Thomas G. Brooks, SEC Litigation Release No. 18168,
2003 SEC LEXIS 1321 (June 3, 2003); SEC Complaint, SEC v. Kenneth P.
D'Angelo et al., Case No. LACV 03-6499 CAS (VBKx), United States
District Court (C.D.Cal. September 11, 2003); SEC Litigation Release
No. 18344, 2003 SEC LEXIS 2173 (September 11, 2003).
    \64\ Id.; See also, In re MJK Clearing, Inc., 2003 U.S. Dist.
LEXIS 5954 (D.Minn. 2003).
---------------------------------------------------------------------------

    MJK's failure caused losses to the borrowing broker-dealers and to
other firms to whom those broker-dealers re-lent the borrowed
securities.\65\ In subsequent litigation, disputes have arisen as to
whether certain of these broker-dealers were acting as principals or
agents.\66\ Uncertainty as to whether broker-dealers are acting as
principal or agent in a securities loan transaction raises concerns as
to whether firms are taking required net capital charges related to
their securities lending activities.\67\ A broker-dealer might not take
the required charges on the theory that it was arranging the loans as
agent, rather than principal, notwithstanding the fact that there was
no express disclaimer of principal liability.
---------------------------------------------------------------------------

    \65\ See, e.g., Nomura v. E*Trade, 280 F.Supp. 2d 184 (S.D.N.Y.
2003).
    \66\ See id.
    \67\ Under paragraph (c)(2)(iv)(B) of Rule 15c3-1, broker-
dealers are required to deduct from net worth most unsecured
receivables, including the amount that the market value of a
securities loan exceeds the value of collateral obtained for the
loan. Similarly, with respect to repo transactions, a broker-dealer
obligated to resell securities must, in computing net capital,
deduct the amount that the market value of the securities is less
than the resale price. 17 CFR 240.15c3-1(c)(2)(iv)(F). A broker-
dealer obligated to repurchase securities must, in computing net
capital, deduct the amount that the market value of the securities
is greater than the repurchase price to the extent the excess is
greater than certain percentages. 17 CFR 240.15c3-1(c)(2)(iv)(F).
---------------------------------------------------------------------------

    We are proposing two amendments designed to improve regulatory
oversight of securities lending and repo transactions. The first
proposal would amend subparagraph (c)(2)(iv)(B) to Rule 15c3-1 to
clarify that broker-dealers providing securities lending and borrowing
settlement services are assumed, for purposes of the rule, to be acting
as principals and are subject to applicable capital deductions. Under
the proposed amendment, these deductions could be avoided if a broker-
dealer takes certain steps to disclaim principal liability. Namely, the
broker-dealer would be required to disclose the identities of the
borrower and lender to each other and obtain written agreements from
the borrower and lender stating that the broker-dealer is acting
exclusively as agent and assumes no principal liability in connection
with the transaction.\68\
---------------------------------------------------------------------------

    \68\ Standard master securities loan agreements (including the
annexes thereto) commonly used by the parties to a securities
lending transaction contain similar provisions for establishing
agent (as opposed to principal) status in a securities lending and
borrowing transaction. See, e.g., 2000 Master Securities Loan
Agreement, Annex I, published by The Bond Market Association.
---------------------------------------------------------------------------

    The second proposal would add a paragraph (c)(5) to Rule 17a-11,
which would require broker-dealers to notify the Commission whenever
the total amount of money payable against all securities loaned or
subject to a repurchase agreement, or the total contract value of all
securities borrowed or subject to a reverse repurchase agreement
exceeds 2,500 percent of tentative net capital; provided that, for
purposes of this leverage threshold, transactions involving
``government securities'' as defined in Section 3(a)(42) of the
Exchange Act, are excluded from the calculation.\69\ Based on FOCUS
report data, we estimate that a leverage threshold of 25 times
tentative net capital would be triggered by 21 broker-dealers on a
regular basis. We believe that this indicates the proposed threshold is
high enough to only capture on a regular basis those few firms highly
active in securities lending and repos. Accordingly, it is an
appropriate notice trigger for a firm that historically has not been as
active in these transactions but rapidly leverages up its positions.
---------------------------------------------------------------------------

    \69\ 15 U.S.C. 78c(a)(42). ``Government securities'' generally
present less market risk than other types of securities used in
securities lending and repo transactions. Consequently, they are
excluded from the scope of this proposed rule.
---------------------------------------------------------------------------

    We believe that receiving notice when this threshold is exceeded
would help identify broker-dealers with highly leveraged non-government
securities lending and borrowing and repo operations and make it easier
for regulators to respond more quickly and protect customers in the
event a firm is approaching insolvency. To avoid frequent filing by
firms that engage predominantly in securities lending and repo
transactions, the proposal would give a broker-dealer the option of
submitting monthly reports regarding its securities lending and repo
activities to its designated examining authority.
    We request comment on all aspects of these proposed amendments,
including whether there are other steps the Commission should take to
reduce the risk that a broker-dealer will fail as a consequence of a
breakdown in its securities lending or repurchase activities. We also
seek comment on the appropriateness of the 2,500% of tentative net
capital early warning trigger and whether a smaller or larger leverage
test should be employed.

D. Documentation of Risk Management Procedures

    The failure of MJK highlights the importance of broker-dealers
documenting their implemented controls for managing the material risk
exposures that arise from their business activities. For example, a
broker-dealer active in securities lending is exposed to a variety of
risks, including market risk,\70\ credit risk,\71\ liquidity risk \72\
and operational risk.\73\ Other broker-dealer activities give rise to
these risks as well, including managing a repo book, dealing in OTC
derivatives, trading proprietary positions and lending on margin. A
well-documented system of internal controls designed to manage material
risk exposures enables a broker-dealer's management to identify,
analyze, and manage the risks inherent in the firm's business
activities with a view to preventing significant losses. The need for
such controls is particularly urgent with respect to the

largest broker-dealers, which generally engage in a wide range of
highly complex businesses across many different markets and
geographical locations.
---------------------------------------------------------------------------

    \70\ Market risk involves the risk that prices or rates will
adversely change due to economic forces. Such risks include adverse
effects of movements in equity and interest rate markets, currency
exchange rates, and commodity prices. Market risk can also include
the risks associated with the cost of borrowing securities, dividend
risk, and correlation risk.
    \71\ Credit risk comprises risk of loss resulting from
counterparty default on loans, swaps, options, and during
settlement.
    \72\ Liquidity risk includes the risk that a firm will not be
able to unwind or hedge a position or meet cash demands as they
become due.
    \73\ Operational risk encompasses the risk of loss due to the
breakdown of controls within the firm including, but not limited to,
unidentified limit excesses, unauthorized trading, fraud in trading
or in back office functions, inexperienced personnel, and unstable
and easily accessed computer systems.
---------------------------------------------------------------------------

    We believe that, for the most part, these firms as a matter of
business practice already have well-documented procedures and controls
for managing risks. Moreover, many are part of a public company subject
to the requirements of section 404 of the Sarbanes-Oxley Act of
2002,\74\ and the Commission's rules thereunder,\75\ which require the
company to include in its annual report a report of management on the
company's internal control over financial reporting. Notwithstanding
the fact that many broker-dealers already have documented their
implemented internal controls as a matter of business practice or
because they are part of public companies subject to the requirements
under Sarbanes-Oxley, we believe it is important to reinforce the
practice, particularly for broker-dealers that are not part of public
companies, and make it easier for regulators to access a broker-
dealer's procedures and controls. Consequently, we are proposing
amendments to the books and records rules that would require certain
broker-dealers to make and keep current records documenting their
implemented systems of internal risk management control.
---------------------------------------------------------------------------

    \74\ Pub. L. 107-204, 116 Stat. 745 (2002).
    \75\ See Securities Act Release No. 8238, Exchange Act Release
No. 47986; Investment Company Act Release No. 26068 (June 5, 2003),
68 FR 36635 (June 18, 2003).
---------------------------------------------------------------------------

    The proposal would add a paragraph (a)(23) to Rule 17a-3, which
would require certain large broker-dealers to document any implemented
internal risk management control designed to assist in analyzing and
managing the risks (e.g., market, credit, liquidity, operational)
arising from the business activities it engages in, including, for
example, securities lending and repo transactions, OTC derivative
transactions, proprietary trading and margin lending. The requirement
only would apply to broker-dealers that have more than (1) $1,000,000
in aggregate credit items as computed under the customer reserve
formula of Rule 15c3-3, or (2) $20,000,000 in total capital including
debt subordinated in accordance with Appendix D to Rule 15c3-1. This
would limit the proposed rule's application to the broker-dealers that,
because of their complexity and size, are subject to the greatest risks
and whose failure to adequately manage the risks could have the largest
systemic impact. We estimate there are approximately 500 such firms.
    The proposal also would add a paragraph (e)(9) to Rule 17a-4, which
would require a broker-dealer to maintain these records for three years
after the date the broker-dealer ceases to use the system of controls.
We believe that the additional three years creates an audit trail
between former and current procedures and provides regulators with
sufficient opportunity to review the records during the broker-dealer's
normal exam cycle.
    We are not proposing any minimum elements that would be required to
be included in a firm's internal controls or specifying issues that
should be addressed. Rather, the amendment is designed to ensure that
broker-dealers clearly identify the procedures, if any, they use to
manage the risks in their business. We believe the proposed
documentation requirement would help firms and their designated
examining authorities identify gaps in their internal procedures.
Moreover, broker-dealers that have already documented their internal
controls would not be required to take any further steps other than to
retain the written procedures for three years after new controls were
put in place and maintain the procedures in a manner that makes them
readily available to the Commission and other securities regulators (to
the extent they were not already readily available).
    We request comment on all aspects of these amendments, including
whether either of the criteria as to which broker-dealers would be
subject to the proposed requirement should be lower or higher, or
whether we should consider some other criteria for application of the
proposed requirement.

E. Amendments to the Net Capital Rule

1. Requirement To Subtract From Net Worth Certain Liabilities or
Expenses Assumed by Third Parties and Non-Permanent Capital
Contributions
    Under Rule 15c3-1, broker-dealers are required to maintain, at all
times, a minimum amount of net capital. The rule generally defines
``net capital'' as a broker-dealer's net worth (assets minus
liabilities), plus certain subordinated liabilities, less certain
assets that are not readily convertible into cash (e.g., fixed assets),
and less a percentage (haircut) of certain other liquid assets (e.g.,
securities).\76\ Broker-dealers are required to calculate net worth
using generally accepted accounting principles.
---------------------------------------------------------------------------

    \76\ See 17 CFR 240.15c3-1(c)(2).
---------------------------------------------------------------------------

    Based on our experience, we are concerned that some broker-dealers
may be excluding from their calculations of net worth certain
liabilities that relate directly to expenses or debts incurred by the
broker-dealer. The accounting justification for the exclusion is that a
third-party (usually a parent or affiliate) has assumed responsibility
for these expenses and debts through an expense sharing agreement. In
some cases, however, the third-party does not have the resources--
independent of the broker-dealer's revenues and assets--to assume these
liabilities. Thus, the third-party is dependent on the resources of the
broker-dealer to pay the expenses and debts. Excluding liabilities from
the broker-dealer's net worth calculation in these situations may
misrepresent the firm's actual financial condition, deceive the firm's
customers, and hamper the ability of regulators to monitor the firm's
financial condition.
    For these reasons, we are proposing an amendment to Rule 15c3-1
that would add a new paragraph (c)(2)(i)(F) requiring a broker-dealer
to adjust its net worth when calculating net capital by including any
liabilities that are assumed by a third-party if the broker-dealer
cannot demonstrate that the third-party has the resources independent
of the broker-dealer's income and assets to pay the liabilities. To
evidence a third-party's financial capacity, the broker-dealer could
maintain as a record the third party's most recent and current (i.e.,
as of a date within the previous twelve months) audited financial
statements, tax return or regulatory filing containing financial
reports.
    Based on our experience, we also are concerned that broker-dealers
may be receiving capital contributions from individual investors that
are subsequently withdrawn after a short period of time (often less
than a year). In some cases, the capital may be contributed under an
agreement giving the investor the option to withdraw the capital at the
investor's discretion. In the past, the Commission has emphasized that
capital contributions to broker-dealers should not be temporary \77\
and the Commission staff has explained that a capital contribution
should be treated as a liability if it is made with the understanding
that the contribution can be withdrawn at the option of the
investor.\78\ We are

proposing to codify these views by amending Rule 15c3-1 to add a
paragraph (c)(2)(i)(G), which would require a broker-dealer to treat as
a liability any capital that is contributed under an agreement giving
the investor the option to withdraw it. The provision also would
require a broker-dealer to treat as a liability any capital
contribution that is intended to be withdrawn within a year unless the
broker-dealer receives permission in writing from its designated
examining authority.\79\ Under paragraph (c)(2)(i)(G)(2) of the
proposed rule, a withdrawal made within one year of the contribution is
presumed to have been intended to be withdrawn within a year and,
therefore, presumed to be subject to the deduction.
---------------------------------------------------------------------------

    \77\ See Study of Unsafe and Unsound Practices of Broker-
Dealers, Report and Recommendations of the Securities and Exchange
Commission, H.R. Doc. NO. 92-231 (1971).
    \78\ Letter from Michael A. Macchiaroli, Associate Director,
Division of Market Regulation, Commission, to Raymond J. Hennessy,
Vice President, NYSE, and Susan DeMando, Vice President, NASD
Regulation, Inc. (February 23, 2000).
    \79\ These requirements would not apply to withdrawals covered
by paragraph (e) (4)(iii) of Rule 15c3-1, namely, withdrawals used
to make tax payments or to pay reasonable compensation to partners.
These types of payments are ordinary business expenditures and do
not raise the types of concerns the proposed rule is designed to
address.
---------------------------------------------------------------------------

    We request comment on all aspects of these proposed amendments,
including suggestions for records (in addition to audited financial
statements, tax returns and regulatory filings) by which a broker-
dealer could demonstrate a third-party's current financial capacity. We
also request comment on potential metrics for measuring whether the
third-party has sufficient financial resources to assume the broker-
dealer's expenses for the purposes of calculating net capital under
Rule 15c3-1. For example, would it be sufficient if the third-party's
most recent financial statement, tax return or filing showed an amount
of annual net revenue, excluding income derived from the broker-dealer
(e.g., from management fees or dividends) that equaled or exceeded the
broker-dealer's annual expenses assumed by the third-party? Would it be
sufficient if a financial statement or filing showed the third-party
had an amount of equity capital that, at a minimum, equaled 100%, 150%,
200%, 1000% or some other percentage of the broker-dealer's annual
expenses assumed by the third-party?
    With respect to the proposal on capital contributions and
withdrawals, we request comment on whether the time period within which
withdrawn and intended to be withdrawn contributions must be treated as
liabilities should be longer than one year.
2. Requirement To Deduct the Amount a Fidelity Bond Deductible Exceeds
SRO Limits
    Under SRO rules, certain broker-dealers that do business with the
public or are required to become members of the Securities Investor
Protection Corporation (``SIPC'') must comply with mandatory fidelity
bonding requirements.\80\ While the form and amounts of the bonding
requirements vary based on the nature of a broker-dealer's business,
the SRO rules typically permit a broker-dealer to have a deductible
provision included in the bond. However, the rules provide that the
deductible may not exceed certain amounts.\81\ With regard to firms
that maintain deductible amounts over the maximum amount permitted, a
number of SRO rules provide that the broker-dealer must deduct this
excess amount from net worth when calculating net capital under Rule
15c3-1.\82\
---------------------------------------------------------------------------

    \80\ See, e.g., NYSE Rule 319, NASD Rule 3020, CBOE Rule 9.22,
and Amex Rule 330. SRO fidelity bonding requirements typically
contain agreements covering the following areas: A ``Fidelity''
insuring clause to indemnify against loss of property through
dishonest or fraudulent acts of employees; an ``On Premises''
agreement insuring against losses resulting from crimes such as
burglary and theft and from misplacement of property of the insured;
an ``In Transit'' clause indemnifying against losses occurring while
property is in transit; a ``Forgery and Alteration'' agreement
insuring against loss due to forgery or alteration of various kinds
of negotiable instruments; and a ``Securities Loss'' clause
protecting against losses incurred through forgery and alteration of
securities. Id.
    \81\ See, e.g., NYSE Rule 319(b), which permits NYSE members and
member organizations to self-insure to the extent of $10,000 or 10%
of the minimum insurance requirement as prescribed by the NYSE.
    \82\ See, e.g., NYSE Rule 319(b); NASD Rule 3020(b)(2).
---------------------------------------------------------------------------

    Rule 15c3-1, however, does not specifically reference the SRO
deductible requirements as a charge to capital. Accordingly, while the
SROs require that the excess fidelity bond be deducted from net
capital, the Commission's rule does not specify such a deduction. This
means that a broker-dealer would not be required for the purposes of
Commission rules to show the impact of the deduction in the net capital
computation on the FOCUS report it is required to periodically
file.\83\ To address this gap, we are proposing to amend Rule 15c3-1 by
adding a paragraph (c)(2)(xiv) that would require a broker-dealer to
deduct, with regard to fidelity bonding requirements prescribed by a
broker-dealer's examining authority, the excess of any deductible
amount over the maximum deductible amount permitted. We believe the
fidelity bonding requirement is an important prudential safeguard
because it serves as a measure to protect the broker-dealer's capital
from unforeseen losses arising from, among other events, improper
activity by an employee.\84\
---------------------------------------------------------------------------

    \83\ See 17 CFR 240.17a-5.
    \84\ See, e.g., NYSE Rule 319, which specifies the type of
coverage the bond must provide.
---------------------------------------------------------------------------

    We request comment on all aspects of this proposed amendment.
3. Broker-Dealer Solvency Requirement
    We are proposing an amendment to Rule 15c3-1 that would require a
broker-dealer to cease its securities business activities if certain
insolvency events occur. The proposed amendment would prevent a broker-
dealer from continuing to conduct a securities business while it is
seeking protection in a bankruptcy proceeding. A broker-dealer that has
made an admission of insolvency, or is otherwise deemed insolvent or
entitled to protection from creditors, does not possess the financial
resources necessary to operate a securities business. Continuing to
operate in such circumstances poses a significant credit risk to
counterparties and to the clearance and settlement system, and, in the
event the firm ends up in a liquidation proceeding under SIPA, may
impair the ability of the SIPA trustee to make customers of the broker-
dealer whole and satisfy claims of other creditors out of the assets of
the general estate.
    We are proposing to amend paragraph (a) of Rule 15c3-1 to provide
that a broker-dealer shall not be in compliance with the rule if the
firm is ``insolvent'' as that term is defined in the rule.
``Insolvent'' would be defined in a new paragraph (c)(16) as, among
other things, a broker-dealer's placement in a voluntary or involuntary
bankruptcy or similar proceeding; the appointment of a trustee,
receiver or similar official; a general assignment by the broker-dealer
for the benefit of its creditors; an admission of insolvency; or the
inability to make computations necessary to establish compliance with
Rule 15c3-1. The proposed definition of ``insolvent'' is intended to be
broad enough to encompass any type of insolvency proceeding or
condition of insolvency.\85\ By making solvency a requirement of Rule
15c3-1, a broker-dealer that is insolvent would have to cease
conducting business because section 15(c)(3) of the Exchange Act
generally prohibits a broker-dealer from effecting any transaction in,
or inducing or attempting to induce the purchase or sale of, any
security in contravention of

the Commission's financial responsibility rules (which include Rule
15c3-1).\86\
---------------------------------------------------------------------------

    \85\ For example, the proposed definition incorporates concepts
of insolvency in the U.S. Bankruptcy Code and SIPA. See 11 U.S.C.
101; 15 U.S.C. 78eee(b)(1).
    \86\ 15 U.S.C. 78o.
---------------------------------------------------------------------------

    We also are proposing an amendment to the first sentence of
paragraph (b)(1) of Rule 17a-11 that would require a broker-dealer
meeting the definition of ``insolvent'' to provide immediate notice to
the Commission, the firm's designated examining authority and, if
applicable, the CFTC. This notice would assist regulators in taking
steps to protect the insolvent firm's customers, including, if
appropriate, notifying SIPC of the need to commence an SIPA
liquidation.
    We request comment on all aspects of these proposed amendments,
including whether there are other insolvency events that should be
captured in the definition.
4. Amendment To Rule Governing Orders Restricting Withdrawal of Capital
From a Broker-Dealer
    Paragraph (e) of Rule 15c3-1 places certain conditions on a broker-
dealer when withdrawing capital.\87\ For example, a broker-dealer must
give the Commission two days notice before a withdrawal that would
exceed 30% of the firm's excess net capital and two days notice after a
withdrawal that exceeded 20% of that measure.\88\ Paragraph (e) also
restricts capital withdrawals that would have certain financial impacts
on a broker-dealer such as lowering net capital below certain
levels.\89\ Finally, under the rule, the Commission may issue an order
temporarily restricting a broker-dealer from withdrawing capital or
making loans or advances to stockholders, insiders, and affiliates
under certain circumstances.\90\ The rule, however, limits such orders
to withdrawals, advances, or loans that, when aggregated with all other
withdrawals, advances, or loans on a net basis during a thirty calendar
day period, exceed thirty percent of the firm's excess net capital.\91\
The rule also requires that the Commission conclude, based on the facts
and information available that a withdrawal, advance, or loan in excess
of thirty percent of the broker-dealer's excess net capital may be
detrimental to the financial integrity of the firm, or may unduly
jeopardize the firm's ability to repay its customer claims or other
liabilities which may cause a significant impact on the markets or
expose the customers or creditors of the firm to loss without taking
into account the application of the SIPA.\92\ The order may restrict
such withdrawals, advances, or loans for a period of up to twenty
business days.\93\
---------------------------------------------------------------------------

    \87\ See 17 CFR 240.15c3-1(e).
    \88\ 17 CFR 240.15c3-1(e)(1).
    \89\ 17 CFR 240.15c3-1(e)(2).
    \90\ 17 CFR 240.15c3-1(e)(3).
    \91\ Id.
    \92\ Id.
    \93\ Id.
---------------------------------------------------------------------------

    Paragraph (e) of Rule 15c3-1 was adopted in the aftermath of the
failure of the investment bank holding company Drexel Burnham Lambert,
Inc. (``Drexel'').\94\ At the time of its adoption, the Commission
pointed out that Drexel, prior to its failure, withdrew substantial
capital from its regulated broker-dealer subsidiary over a period of
three weeks in the form of short term loans.\95\ The withdrawals were
made without notifying the Commission or the broker-dealer's designated
examining authority.\96\ Moreover, part of the broker-dealer's capital
consisted of hard to price high yield bonds.\97\ This made it difficult
to determine the firm's actual net capital amount and, consequently,
whether it was in capital compliance.\98\
---------------------------------------------------------------------------

    \94\ See Exchange Act Release No. 28927 (February 28, 1991), 56
FR 9124 (March 5, 1991).
    \95\ Id.
    \96\ Id.
    \97\ Id.
    \98\ Id.
---------------------------------------------------------------------------

    Since the adoption of Rule 15c3-1(e) in 1991, the Commission only
once has issued an order restricting a broker-dealer from withdrawing
capital.\99\ Specifically, on October 13, 2005, the Commission ordered
the two broker-dealer subsidiaries of REFCO, Inc.--REFCO Securities,
LLC and REFCO Clearing, LLC--to restrict capital withdrawals, advances,
and loans.\100\ The Commission issued the order after REFCO, Inc.
announced that its financial statements for 2002 through 2005 should
not be relied on and that a material unregulated subsidiary (REFCO
Capital Markets, Ltd.) had ceased all activities for a 15-day
period.\101\
---------------------------------------------------------------------------

    \99\ See Exchange Act Release No. 52606 (October 13, 2005).
    \100\ See id.
    \101\ Id.
---------------------------------------------------------------------------

    As required under Rule 15c3-1(e), the Commission's order with
respect to REFCO's broker-dealer subsidiaries only restricted capital
withdrawals, loans and advances to the extent they would exceed 30% of
the broker-dealer's excess net capital when aggregated with other such
transactions over a 30-day period. The Commission and other securities
regulators often discover that the books and records of a troubled
broker-dealer are incomplete or inaccurate. This can make it difficult
to determine the firm's actual net capital and excess net capital
amounts. In such a case, an order that limits withdrawals to a
percentage of excess net capital would be difficult to enforce as it
would not be clear when that threshold had been reached. Given the
circumstances, we believe the better approach is to remove the 30% of
excess net capital limitation. This would simplify the orders by
allowing the Commission to restrict all withdrawals, advances, and
loans. All the other conditions in the rule would be preserved.
    We request comment on all aspects of this proposed amendment.
5. Adjusted Net Capital Requirements
i. Amendment to Appendix A of Rule 15c3-1
    We are proposing an amendment to Appendix A of Rule 15c3-1, which
permits broker-dealers to employ theoretical option pricing models to
calculate haircuts for listed options and related positions that hedge
those options.\102\ Non-clearing option specialists and market makers
need not apply haircuts to their proprietary listed options positions,
provided the broker-dealer carrying their account takes a charge to its
own net capital based on the charge computed using the theoretical
pricing model.\103\ In 1997, the Commission adopted a temporary
amendment to Appendix A that, by virtue of decreasing the range of
pricing inputs to the model, effectively reduced the haircuts applied
by the carrying firm with respect to non-clearing option specialist and
market maker accounts.\104\ The temporary amendment, which only applied
to these types of accounts, was limited to major market foreign
currencies and diversified indexes. The Commission made this relief--
which is contained in paragraph (b)(1)(iv) of Appendix A \105\--
temporary so the Commission could evaluate the effects of the reduced
capital charges, particularly under

conditions involving high levels of market volatility.
---------------------------------------------------------------------------

    \102\ 17 CFR 240.15c3-1a.
    \103\ 17 CFR 240.15c3-1(c)(2)(x).
    \104\ See Exchange Act Release No. 38248 (February 6, 1997), 62
FR 6474 (February 12, 1997). Under Appendix A to Rule 15c3-1, a
broker-dealer calculating net capital charges for its options
portfolios shocks the products in each portfolio (grouped by
underlying instrument) at ten equidistant points along a potential
market move range. The market move ranges for major market foreign
currencies, high-capitalization diversified indexes, and non-high-
capitalization diversified indexes are, respectively: +(-) 6%, +(-)
10% and +(-) 15%. The temporary rule lowered these market move
ranges to respectively: +(-) 4\1/2\%, + 6% (-) 8% and +(-) 10% in
terms of calculating haircuts for positions of non-clearing options
specialists and market makers. See id.
    \105\ 17 CFR 240.15c3-1a(b)(1)(iv)(B).
---------------------------------------------------------------------------

    The relief expired two years from its effective date. The
Commission staff subsequently issued a no-action letter on January 13,
2000 continuing the relief.\106\ Since the no-action letter was issued,
there have been periods of significant volatility in the securities
markets, including the markets for major market foreign currencies and
high-capitalization and non-high-capitalization diversified indexes.
These periods of volatility include the Russian debt crisis in 1998,
the internet bubble and the September 11, 2001 terrorist attacks.
Despite periods of substantial volatility, there have been no
significant increases in the number of deficits in non-clearing option
specialist and market-maker accounts, nor did the lower capital charges
under paragraph (b)(1)(iv) result in excessive leverage. Consequently,
we are proposing to amend paragraph (b)(1)(iv) of Appendix A to Rule
15c3-1 to make permanent the previously granted relief. We believe
permitting the lower requirement with respect to these types of
positions carried in non-clearing option specialist and market-maker
accounts better aligns the capital requirements in Rule 15c3-1 with the
risks associated with these positions and accounts.
---------------------------------------------------------------------------

    \106\ Letter from Michael Macchiaroli, Associate Director,
Division of Market Regulation, Commission, to Richard Lewandowski,
Vice President, Regulatory Division, The Chicago Board Options
Exchange, Inc. (Jan. 13, 2000).
---------------------------------------------------------------------------

    We request comment on all aspects of this proposed amendment,
including whether the lower market move ranges for positions held by
non-clearing options specialists and market makers are appropriate and
whether data or other information suggests that these lower ranges did
result in an increase in the number of deficits in non-clearing option
specialist and market-maker accounts or in excessive leverage on the
part of these firms. Commenters are encouraged to provide data to
support their views.
ii. Money Market Funds
    We are proposing an amendment that would reduce the ``haircut''
broker-dealers apply under Rule 15c3-1 for money market funds from 2%
to 1% when computing net capital. In 1982, the Commission adopted a 2%
haircut requirement for redeemable securities of an investment company
registered under the Investment Company Act of 1940 that holds assets
consisting exclusively of cash or money market instruments and which is
known as a ``money market fund.'' \107\ The 2% haircut was adopted
before the Commission adopted certain amendments to Rule 2a-7 under the
Investment Company Act of 1940 (17 CFR 270.2a-7) that strengthened the
risk limiting investment restrictions for money market funds.\108\ Rule
2a-7 defines a money market fund generally as an investment company
limited to investing in U.S. dollar denominated securities that present
minimal credit risks and that are, at the time of acquisition,
``eligible securities.'' \109\ In particular, the rule requires that
the securities purchased by a money market fund be short-term
instruments of issuers that are deemed a low credit risk.\110\ The rule
also requires the fund to diversify its portfolio of securities.\111\
Based on the enhancements to Rule 2a-7, as well as the historical
stability of money market funds as investments, we are proposing to
amend paragraph (c)(2)(vi)(D)(1) of Rule 15c3-1 to reduce the haircut
on such funds from 2% to 1%. This amendment is designed to better align
the net capital charge with the risk associated with holding a money
market fund. A further amendment would clarify that a money market
fund, for the purposes of paragraph (c)(2)(vi)(D)(1), is a fund
described in Rule 2a-7.
---------------------------------------------------------------------------

    \107\ Exchange Act Release No. 18737 (May 13, 1982), 47 FR 21759
(May 20, 1982). See 17 CFR 240.15c3-1(c)(2)(vi)(D)(1).
    \108\ Investment Company Act Release No. 18005 (February 20,
1991), 56 FR 8113 (February 27, 1991).
    \109\ 17 CFR 270.2a-7.
    \110\ See id.
    \111\ Id.
---------------------------------------------------------------------------

    We request comment on all aspects of this amendment, including on
whether it is appropriate to reduce the haircut to 1% and,
alternatively, whether the haircut for certain types of money market
funds should be reduced to 0% as suggested by Federated in its petition
to the Commission.\112\ Commenters are encouraged to provide data to
support their views.
---------------------------------------------------------------------------

    \112\ See Public Petition for Rulemaking No. 4-478 (April 3,
2003), as amended (April 4, 2005), available at http://www.sec.gov/rules/petitions/petn4-478.htm
.

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

F. Technical Amendments

    Finally, we are proposing a number of technical amendments to these
rules in order to, for example, update or correct citations to other
regulations. These technical amendments include proposed amendments to
the definitions of ``fully paid securities,'' ``margin securities,''
and ``bank'' in Rule 15c3-3.\113\ Our proposed amendments are not
intended to substantively change the meanings of these defined terms
but, rather, to remove text that is superfluous or redundant.
Consequently, we specifically seek comment on whether our proposed
amendments to these definitions would substantively alter the meaning
of ``fully paid securities,'' ``margin securities,'' and ``bank'' as
those terms are defined in Rule 15c3-3. Commenters should describe how
the amendment would result in a substantive change.
---------------------------------------------------------------------------

    \113\ 17 CFR 240.15c3-3(a)(3), (4), and (7) respectively.
---------------------------------------------------------------------------

III. Further Requests for Comment

A. In General

    We invite interested persons to submit written comments on any
aspect of the proposed amendments, in addition to the specific requests
for comments. Further, we invite comment on other matters that might
have an effect on the proposals contained in the release, including any
competitive impact.

B. Requests for Comment on Certain Specific Matters

1. Early Warning Levels
    The Capital Committee of the Securities Industry Association
(``SIA'') has proposed lowering the Rule 17a-11 early warning level for
broker-dealers that carry over $10 billion in debits. Currently, under
Rule 17a-11, a broker-dealer that computes its net capital requirement
using the alternative standard must provide regulators with notice if
their net capital level falls below 5% of aggregate debit items. The
SIA contends that a broker-dealer with aggregate debit items exceeding
$10 billion would not be approaching financial difficulty simply
because its net capital falls to the 5% early warning threshold. The
broker-dealer, because of the large amount of debits and corresponding
capital requirement, would continue to hold sufficient net capital in
the SIA's estimation. The SIA has suggested using a tiered approach in
which the early warning level would be calculated by adding: (5% of the
first $10 billion in debits) + (4% of the next $5 billion) + (3% of the
next $5 billion) + (2.5% of all remaining debits).
    We request comment on this proposal and note that the SROs would
need to alter their early warning levels as well to make any such
proposed amendment effective.
2. Harmonize Securities Lending and Repo Capital Charges
    We also are considering whether to harmonize the net capital
deductions required under paragraph (c)(2)(iv)(B) of Rule 15c3-1 for
securities lending and

borrowing transactions with the deductions required under paragraph
(c)(2)(iv)(F) for securities repo transactions. Securities lending and
borrowing transactions are economically similar to repo transactions.
However, the need to take a deduction (or the size of the deduction)
under Rule 15c3-1 may depend on whether the broker-dealer executes the
transaction as a securities loan/borrow or repo transaction.\114\ We
are concerned that this has created an opportunity for regulatory
arbitrage.
---------------------------------------------------------------------------

    \114\ Specifically, with respect to repurchase agreement and
securities borrowed transactions, the required deductions are
triggered only when the deficits exceed certain percentages. See 17
CFR 240.15c3-1(c)(2)(iv)(B) and (F). Conversely, with reverse
repurchase agreement and securities loaned transactions, the
deductions are triggered without regard to the size of the deficit.
---------------------------------------------------------------------------

    In order to eliminate this mismatch, we could make identical the
securities loaned and repurchase agreement deductions and, similarly,
the securities borrowed and reverse repurchase agreement deductions. We
seek comment on the feasibility of such a proposal and on how it should
be implemented.
3. Accounting for Third-Party Liens on Customer Securities Held at a
Broker-Dealer
    Under Rule 15c3-3, a broker-dealer is required to include as a
``credit'' item in the customer reserve formula the amount of any loan
it receives that is collateralized by securities carried for the
accounts of customers.\115\ The credit item is intended to ensure that
funds obtained through the use of customer securities are deployed to
support customer transactions (e.g., to make margin loans) and not used
in the broker-dealer's proprietary business.
---------------------------------------------------------------------------

    \115\ 17 CFR 240.15c3-3a, Item 2. A broker-dealer may finance
margin loans to its customers by obtaining a bank loan that is
secured by the customers' securities, which--because they are not
``excess margin securities''--do not have to be in the control of
the broker-dealer under Rule 15c3-3(b).
---------------------------------------------------------------------------

    In some cases, the customer's securities may be subject to a lien
arising from a third-party loan that is not made to the broker-dealer
(e.g., the loan is made directly to the customer). If the customer's
securities are not moved to a pledge account in the name of the third-
party lender, then the broker-dealer will continue to hold them in the
name of the customer. As between the broker-dealer and the customer,
the securities may be fully paid for and, consequently, subject to the
physical possession or control requirement of Rule 15c3-3. Moreover, if
the broker-dealer became insolvent and was liquidated in a SIPA
proceeding, the trustee could be placed in the situation of owing the
securities both to the customer and to the third-party holding the
lien. This could increase the costs of a SIPA liquidation, which is
underwritten by the fund administered by SIPC.
    The situation becomes even more complicated when the securities are
subject to liens held by multiple creditors. The amount of the
obligation to each creditor may change daily depending on market
movements or other factors. In a SIPA proceeding, this could increase
the number of parties with potentially competing claims for the
securities, and thereby increase the complexity and costs of the
liquidation.
    For these reasons, we request comment on how third-party liens
against customer fully paid securities carried by a broker-dealer
should be treated under the financial responsibility rules, including
Rule 15c3-3, Rule 17a-3 and Rule 17a-4. For example, should the broker-
dealer be required to: (1) Include the amount of the customer's
obligation to the third-party as a credit item in the reserve formula;
(2) move the securities subject to the lien into a separate pledge
account in the name of the pledgee or pledges; or (3) record on its
books and records and disclose to the customer the existence of the
lien, identity of the pledgee(s), obligation of the customer, and
amount of securities subject to the lien?

IV. Paperwork Reduction Act

    Certain provisions of the proposed amendments contain ``collection
of information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA''). We have submitted the proposed
amendments to the Office of Management and Budget (``OMB'') for review
in accordance with the PRA.\116\ An agency may not conduct or sponsor,
and a person is not required to respond to, a collection of information
unless it displays a currently valid control number. The rules being
amended--Rule 15c3-1, Rule 15c3-3, Rule 17a-3, Rule 17a-4 and Rule 17a-
11--contain currently approved collections of information under,
respectively, OMB control numbers 3235-0200, 3235-0078, 3235-0033,
3235-0279 and 3235-0085.
---------------------------------------------------------------------------

    \116\ 44 U.S.C. 3507(d); 5 CFR 1320.11
---------------------------------------------------------------------------

A. Collections of Information Under the Proposed Amendments

    The proposed rule amendments contain recordkeeping and disclosure
requirements that are subject to the PRA. In summary, the amendments
would require a broker-dealer, under certain circumstances, to (1)
disclose the principals and obtain certain agreements from the
principals in a securities lending transaction where it performs
settlement services if it wants to be considered an agent (as opposed
to a principal) for the purposes of the net capital rule,\117\ (2)
obtain written permission from broker-dealer (``PAB'') account holders
to use their fully paid and excess margin securities,\118\ (3) perform
a PAB reserve computation,\119\ (4) obtain written notification from a
bank holding its PAB Special Reserve Account that the bank has received
notice that the assets in the account are being held for the benefit of
PAB account holders,\120\ (5) enter into a written contract with a bank
holding its PAB Special Reserve Accounts in which the bank agrees the
assets in the account would not be used as security for a loan to the
broker-dealer and would not be subject to a right, charge, security
interest, lien, or claim of any kind in favor of the bank,\121\ (6)
obtain the affirmative consent of a customer before changing the terms
under which the customer's free credit balances are invested,\122\ (7)
make and maintain records documenting internal controls to assist the
broker-dealer in analyzing and managing market, risks arising from
business activities,\123\ (8) provide notice to the Commission and
other regulatory authorities if the broker-dealer becomes
insolvent,\124\ and (9) provide notice to the Commission and other
regulatory authorities if the broker-dealer's securities borrowed and
loan or securities repurchase/reverse repurchase activity reaches a
certain threshold or, alternatively, provide regulatory authorities
with a monthly report of the broker-dealer's securities borrowed and
loan or securities repurchase/reverse repurchase activity.\125\
---------------------------------------------------------------------------

    \117\ Proposed amendment revising paragraph (c)(2)(iv)(B) of
Rule 15c3-1.
    \118\ Proposed amendment adding paragraph (b)(5) to Rule 15c3-3.
    \119\ Proposed amendment revising paragraph (e)(1) of Rule 15c3-
3.
    \120\ Proposed amendment revising paragraph (f) of Rule 15c3-3.
    \121\ Id.
    \122\ Proposed amendment adding paragraph (j) to Rule 15c3-3.
    \123\ Proposed amendments adding paragraph (a)(24) to Rule 17a-3
and revising paragraph (e)(9) of Rule 17a-4.
    \124\ Proposed amendment revising paragraph (b)(1) of Rule 17a-
11.
    \125\ Proposed amendment adding paragraph (c)(5) to Rule 17a-11.

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

B. Proposed Use of Information

    The Commission and other regulatory authorities would use the
information collected under the proposed amendment to Rule 15c3-1 and
Rule 15c3-3 to determine whether the broker-dealer is in compliance
with each rule. In particular, the record with respect to acting as
agent in a securities loan transaction would assist examiners in
verifying that the broker-dealer is properly accounting for securities
loan deficits under Rule 15c3-1. The records with respect to the PAB
accounts would assist examiners in verifying that the PAB
accountholders had agreed to permit the broker-dealer to use their
securities, the broker-dealer had performed the PAB reserve computation
and the bank holding the PAB Special Reserve Account had agreed to do
so free of lien.
    The Commission and other regulatory authorities would use the
information collected under the proposed amendments to Rules 17a-3 and
17a-4 to determine whether the broker-dealer is operating in a manner
that mitigates the risk it will fail as a result of failing to document
internal controls.
    The Commission and other regulatory authorities would use the
information collected under the proposed amendments to Rule 17a-11 to
identify a broker-dealer experiencing financial difficulty. This
information would assist the Commission and other regulators in
promptly taking appropriate steps to protect customers, creditors, and
counterparties. In particular, a notice of insolvency would assist
regulators in responding more quickly to a failing institution. The
notices and reports with respect to securities lending and repos would
assist regulators in identifying broker-dealers that are active in
these transactions or suddenly take on large positions. This would
assist in monitoring the systemic risk in the markets.

C. Respondents

    The amendment to Rule 15c3-1 requiring a broker-dealer to make
disclosures to, and obtain certain agreements from, securities lending
principals only would apply to those firms that participate in the
settlement of securities lending transactions as agents. We estimate
that approximately 170 broker-dealers would be affected by this
requirement.\126\
---------------------------------------------------------------------------

    \126\ This estimate is derived from FOCUS Reports filed by
broker-dealers pursuant to Section 17 of the Exchange Act and Rule
17a-5 (17 CFR 240.17a-5).
---------------------------------------------------------------------------

    The amendments to Rule 15c3-3 requiring a broker-dealer to perform
a PAB reserve computation and to obtain certain agreements and notices
related to its PAB accounts only would affect those firms that carry
such accounts. We estimate that approximately 75 broker-dealers would
carry such accounts.\127\
---------------------------------------------------------------------------

    \127\ Id.
---------------------------------------------------------------------------

    The amendment to Rule 15c3-3 requiring a broker-dealer to obtain
the affirmative consent of a customer before changing the terms under
which the customer's free credit balances are maintained only would
apply to firms that carry free credit balances for customers. We
estimate that approximately 256 broker-dealers carry customer
accounts.\128\
---------------------------------------------------------------------------

    \128\ Id.
---------------------------------------------------------------------------

    The amendments to Rules 17a-3 and 17a-4 requiring a broker-dealer
to make and maintain records documenting internal controls for
analyzing and managing risks only would apply to firms that have more
than $1,000,000 in aggregate credit items, or $20,000,000 in capital.
Thus, its impact would be limited to the largest broker-dealers.
Generally, the broker-dealers that would be required to document
internal controls are exposed to all the risks identified in the
proposed amendment. Accordingly, the number of respondents would equal
the number of broker-dealers meeting the thresholds set forth in the
amendment. We estimate that approximately 517 broker-dealers would meet
at least one of these thresholds.\129\
---------------------------------------------------------------------------

    \129\ Id.
---------------------------------------------------------------------------

    The amendment to Rule 17a-11 would require a broker-dealer to
provide the Commission with notice if it becomes subject to certain
insolvency events only would affect a limited number of firms per year.
We estimate that approximately six broker-dealers would become subject
to one of these events in a given year.\130\
---------------------------------------------------------------------------

    \130\ This estimate is based on the Annual Report of the
Securities Investor Protection Corporation (``SIPC''), which
indicates that in recent years an average of six customer protection
proceedings per year have been initiated with respect to SIPC
members. A copy of the 2005 Annual Report can be obtained at: http://www.sipc.org/pdf/2005AnnualReport.pdf
.

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

    The amendment to Rule 17a-11 would require a broker-dealer to
provide notice to the Commission if its securities borrowed or loan or
securities repurchase or reverse repurchase activity reaches a certain
threshold or, alternatively, provide monthly reports to securities
regulators about such activities only would affect a limited number of
firms per year. We estimate that approximately 11 broker-dealers would
provide the notice and that 21 broker-dealers would opt to send the
monthly reports in a given year.\131\
---------------------------------------------------------------------------

    \131\ These estimates are derived from information filed by
broker-dealers in FOCUS Report filings.
---------------------------------------------------------------------------

D. Total Annual Reporting and Recordkeeping Burden

    As discussed in further detail below, we estimate the total
recordkeeping burden resulting from these amendments would be
approximately 373,938 annual hours,\132\ 105,900 one-time hours,\133\
and a one-time cost of $1,000,000 arising from the retention of outside
counsel.
---------------------------------------------------------------------------

    \132\ 9,350 hours + 364,333 hours + 255 hours = 373,938 hours.
    \133\ 180 hours + 26,830 hours + 2,250 hours + 10,000 hours +
2,500 hours + 62,040 hours + 2,100 hours = 105,900 hours.
---------------------------------------------------------------------------

1. Securities Lending Agreements and Disclosures
    The proposed amendment to Rule 15c3-1 would require a broker-dealer
to make disclosures to, and obtain certain agreements from, securities
lending principals in situations where the firm participates in the
settlement of a securities lending transaction but wants to be deemed
an agent for purposes of Rule 15c3-1. We understand that most existing
standard securities lending master agreements in use today already
contain language requiring agent lenders to disclose principals and
principals to agree not to hold the agents liable for a counterparty
default and, consequently, the proposed amendment would be codifying
industry practice. Thus, the standard agreement used by the vast
majority of broker-dealers should contain the representations and
disclosures required by the proposed amendment. However, a small
percentage of broker-dealers may need to modify their standard
agreements.
    We estimate that 5% of the approximately 170 firms engaged in this
business, or 9 firms, would not have used the standard agreements. We
further estimate each of these firms would spend approximately 20 hours
of employee resources updating their standard agreement template.
Therefore, we estimate that the total one-time burden to the industry
as a result of this proposed requirement would be approximately 180