carrying broker-dealers, but some clearing broker-dealers clear only
their own transactions and do not hold customer securities and cash.
---------------------------------------------------------------------------

    \737\ Rule 15c3-1, the Commission's net capital rule, specifies
that a broker-dealer shall be deemed to carry customer or broker-
dealer accounts ``if, in connection with its activities as a broker
or dealer, it receives checks, drafts, or other evidences of
indebtedness made payable to itself or persons other than the
requisite registered broker or dealer carrying the account of a
customer, escrow agent, issuer, underwriter, sponsor, or other
distributor of securities'' or ``if it does not promptly forward or
promptly deliver all of the securities of customers or of other
brokers or dealers received by the firm in connection with its
activities as a broker or dealer.'' 17 CFR 240.15c3-11(a)(2)(i).
Further, Rule 15c3-3, the Commission's customer protection rule
governing reserves and custody of securities, defines the term
``securities carried for the account of a customer'' to mean
``securities received by or on behalf of a broker or dealer for the
account of any customer and securities carried long by a broker or
dealer for the account of any customer,'' as well as securities sold
to, or bought for, a customer by a broker-dealer. 17 CFR 240.15c3-
3(a)(2).
    \738\ See Definitions of Terms and Exemptions Relating to the
``Broker'' Exceptions for Banks, Final Rule, Exchange Act Release
No. 56501 (Sept. 24, 2007), 72 FR 56514, 56541 n.269 (Oct. 3, 2007).
---------------------------------------------------------------------------

    As stated in section I.B.1. above, a broker-dealer that claims an
exemption from Rule 15c3-3 is generally referred to as ``non-carrying
broker-dealer.'' Non-carrying broker-dealers include ``introducing
brokers.'' \739\ These non-carrying broker-dealers accept customer
orders and introduce their customers to a carrying broker-dealer that
will hold the customers' securities and cash along with the securities
and cash of customers of other introducing broker-dealers and those of
direct customers of the carrying broker-dealer. The carrying broker-
dealer generally receives and executes the orders of the introducing
broker-dealer's customers.\740\ Carrying broker-dealers also prepare
trade confirmations, settle trades, and organize book entries of the
securities.\741\ Introducing broker-dealers also may use carrying
broker-dealers to clear the firm's proprietary trades and carry the
firm's securities. Another group of non-carrying broker-dealers effects
transactions in securities such as mutual funds on a subscription-way
basis, where customers purchase the securities by providing the funds
directly to the issuer. \742\ Finally, some non-carrying broker-dealers
act as finders by referring prospective purchasers of securities to
issuers.\743\
---------------------------------------------------------------------------

    \739\ Id. at ] 1.15; see also Exchange Act Release No. 31511
(Nov. 24, 1992), 57 FR 56973 (Dec. 2, 1992) (describing role of
introducing broker-dealers).
    \740\ Exchange Act Release No. 31511 (Nov. 24, 1992), 57 FR
56973 (Dec. 2, 1992).
    \741\ See, e.g., FINRA Rule 4311 (Carrying Agreements). This
FINRA rule governs the requirements applicable to FINRA members when
entering into agreements for the carrying of any customer accounts
in which securities transactions can be effected. Historically, the
purpose of this rule has been to ensure that certain functions and
responsibilities are clearly allocated to either the introducing or
carrying firm, consistent with the requirements of the SRO's and
Commission's financial responsibility and other rules and
regulations, as applicable. See also Notice of Filing of Amendment
No. 1 and Order Granting Accelerated Approval of a Proposed Rule
Change Adopting, as Modified by Amendment No. 1, Rules Governing
Guarantees, Carrying Agreements, Security Counts and Supervision of
General Ledger Accounts in the Consolidated FINRA Rulebook, Exchange
Act Release 34-63999 (Mar. 7, 2011), 76 FR 12380 (Mar. 7, 2011).
    \742\ See Books and Records Requirement for Brokers and Dealers
Under the Securities Exchange Act of 1934, Exchange Act Release 34-
44992 (Nov. 2, 2001) (``[T]he Commission recognizes that for some
types of transactions, such as purchases of mutual funds or variable
annuities, the customer may simply fill out an application or a
subscription agreement that the broker-dealer then forwards directly
to the issuer.'').
    \743\ See American Bar Association, Report and Recommendations
of the Task Force on Private Placement Broker-Dealers 23-24 (2005);
see also Exchange Act Release No. 31511 (Nov. 24, 1992), 57 FR 56973
(Dec. 2, 1992).
---------------------------------------------------------------------------

    The broker-dealer industry is the primary industry affected by the
rule amendments and the new form. In some cases, the amendments impose
different requirements on different types of broker-dealers. For
example, carrying broker-dealers must file the compliance report and an
independent public accountant's report covering the compliance report,
while non-carrying broker-dealers must file the exemption report and an
independent public accountant's report covering the exemption report.
Only carrying and clearing broker-dealers must agree to allow
Commission and DEA examiners to review the audit documentation of their
independent public accountants and to allow accountants to discuss
their findings with the examiners. All broker-dealers must file Form
Custody, but many of the line items on the form apply only to carrying
broker-dealers.
    To establish a baseline for competition among broker-dealers, the
Commission looks at the status of the broker-dealer industry detailed
below. In terms of size, the following tables illustrate the variance
among broker-dealers with respect to total capital. The information in
the table is based on FOCUS Report data for calendar year 2011.

          Broker-Dealer Capital at Calendar Year End 2011\744\
                              [$ millions]
------------------------------------------------------------------------
                                                        Aggregate total
              Capital                Number of firms        capital
------------------------------------------------------------------------
Less than $500,000................              2,506               $347
Greater than or equal to $500,000               1,320              2,212
 and less than $5 million.........
Greater than or equal to $5                       608             10,520
 million and less than $50 million
Greater than or equal to $50                       80              5,672
 million and less than $100
 million..........................
Greater than or equal to $100                     125             26,655
 million and less than $500
 million..........................
Greater than or equal to $500                      28             19,248
 million and less than $1 billion.
Greater than or equal to $1                        27             61,284
 billion and less than $5 billion.
Greater than or equal to $5                         6             41,175
 billion and less than $10 billion
Greater than or equal to $10                        9            175,585
 billion..........................
                                   -------------------------------------
    Total.........................              4,709            342,698
------------------------------------------------------------------------

    According to FOCUS Report data, as of December 31, 2011, there were
approximately 4,709 broker-dealers registered with the Commission.\745\
Nine broker-dealers dominate the broker-dealer industry, holding over
half of all capital held by broker-dealers. Of the 4,709 registered
broker-dealers, 4,417 firms claimed exemptions from Rule 15c3-3 on
their FOCUS Reports. Accordingly, the Commission estimates that there
are approximately 292

carrying broker-dealers (4,709-4,417 = 292). Further, based on FOCUS
Report data, the Commission also estimates that there are approximately
513 broker-dealers that are clearing or carrying firms. The Commission
staff has estimated that approximately 18% of broker-dealers registered
with FINRA \746\ also are registered as investment advisers with the
Commission or with a state.\747\
---------------------------------------------------------------------------

    \744\ The information in this chart is based on FOCUS Report
data filed by broker-dealers in 2011.
    \745\ Not all broker-dealers registered with the Commission are
SIPC members. According to SIPC, as of March 31, 2012, 217 broker-
dealers claimed exemptions from SIPC membership. The Commission
therefore estimates that 4,492 (4,709 - 217 = 4,492) broker-dealers
are members of SIPC.
    \746\ Per FINRA's Web site, there were 4,456 FINRA member firms
at year end 2011. See http://www.finra.org/Newsroom/Statistics/.
    \747\ See Commission staff, Study on Investment Advisers and
Broker-Dealers, as required by Section 913 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Jan. 2011).
---------------------------------------------------------------------------

2. Independent Public Accountants That Audit Broker-Dealer Reports
    Independent public accountants that audit broker-dealer reports
also will be impacted by the rule amendments. Based on the audit
reports filed by broker-dealers in 2011, approximately 900 accounting
firms audited broker-dealer reports that were filed with the
Commission. However, six large accounting firms dominate the market
performing audits for approximately 20% of all broker-dealers
registered with the Commission, and those broker-dealers audited by the
six large accounting firms had total capital that was more than 90% of
the total capital of all broker-dealers registered with the
Commission.\748\ These statistics highlight the current baseline for
competition under which the accountants are operating.
---------------------------------------------------------------------------

    \748\ This data is based on audited reports filed by broker-
dealers in 2011 and FOCUS Report data.
---------------------------------------------------------------------------

    Prior to today's amendments, the AICPA established the auditing and
attestation standards to be followed by the independent public
accountants of broker-dealers (i.e., GAAS). The AICPA's auditing
standards are revised and updated from time to time. For example, the
AICPA recently revised GAAS (including audit standards that apply to
audits of broker-dealer financial statements), and the revised
standards were generally effective for fiscal years that ended on or
after December 31, 2012.\749\ Consequently, the independent public
accountants of broker-dealers have from time to time had to familiarize
themselves with updates and revisions to GAAS.
---------------------------------------------------------------------------

    \749\ See AICPA, Improving the Clarity of Auditing Standards,
available at http://www.aicpa.org/InterestAreas/FRC/AuditAttest/Pages/ImprovingClarityASBStandards.aspx. The AICPA announced the
clarification and convergence project in July 2008. See http://www.aicpa.org/InterestAreas/FRC/AuditAttest/DownloadableDocuments/Clarity/Archive/ASB_Clarity_%20and_Convergence_(8.5x11).pdf.
---------------------------------------------------------------------------

3. SIPC Lawsuits Against Accountants
    SIPC was established in 1971. In the period from 1971 to 2011, SIPC
initiated 324 proceedings under SIPA to liquidate a failed broker-
dealer.\750\ This results in an average of approximately 8 SIPA
proceedings per year, though 109 of the 324 proceedings were initiated
in the period from 1971 to 1974, which was the immediate aftermath of
the financial crisis of 1968-1970.\751\ According to SIPC staff, SIPC
has brought 9 lawsuits against accountants since 1971, which is one
lawsuit for every 36 SIPA proceedings.\752\ The SIPC staff reports that
two of these lawsuits were brought after the 2001 New York decision
discussed in section II.B.6.iii. of this release and three lawsuits
were brought in liquidation proceedings that were active at or about
the same time as the 2001 New York decision. The suits initiated around
the time of the 2001 decision and thereafter were brought in
jurisdictions other than New York.
---------------------------------------------------------------------------

    \750\ See SIPC, Annual Report 2011, at 6.
    \751\ Id. See also Commission, Study of Unsafe and Unsound
Practices of Brokers and Dealers: Report and Recommendations of the
Securities and Exchange Commission (December 1971) (discussing the
financial crisis of 1968-1970). Since its inception through 2001,
SIPC initiated 299 proceedings under SIPA.
    \752\ See discussion above in section II.B.6. of this release.
---------------------------------------------------------------------------

4. Overview of Broker-Dealer Reporting, Auditing, and Notification
Requirements Before Today's Amendments
i. Broker-Dealer Reporting
    Before today's amendments, Rule 17a-5 generally required broker-
dealers to prepare and file a financial report with the Commission and
the broker-dealer's DEA, as well as a report of a PCAOB-registered
independent public accountant covering the financial report. Brokers-
dealers also were required to file concurrently with the audited
financial report a material inadequacy report prepared by the
independent public accountant.
    With regard to the material inadequacy report, broker-dealers
generally made representations to their independent public accountants
about their compliance with certain financial responsibility rules in a
representation letter.\753\ However, broker-dealers did not file
reports with the Commission or their DEA containing such
representations. GAAS does not prescribe specific or standardized
representations to be made by a broker-dealer to its accountant with
regard to an attestation engagement performed under Rule 17a-5.\754\
Therefore, broker-dealers' representations to their independent public
accountant relating to compliance with certain financial responsibility
rules varied depending on what was required by the terms of the
individual engagements.
---------------------------------------------------------------------------

    \753\ See, e.g., AICPA Broker-Dealer Audit Guide app. H (sample
representation letter).
    \754\ According to GAAS, auditors ``should consider obtaining a
representation letter'' in an examination or review engagement, and
``specific written representations will depend on the circumstances
of the engagement and the nature of the subject matter and the
criteria.'' See AICPA, AT Section 101 at ] .60. Further, while the
AICPA Broker-Dealer Audit Guide contains a sample representation
letter, publications such as this guide ``are not auditing
standards'' but are ``recommendations on the application of the
[auditing standards] in specific circumstances, including
engagements for entities in specialized industries.'' See AICPA, AU
Section 150, at ] .05.
---------------------------------------------------------------------------

ii. Engagement of the Accountant
    As noted above, prior to today's amendments, broker-dealers
generally were required to file with the Commission: (1) A report of an
independent public accountant based on an audit of the broker-dealer's
financial statements and supporting schedules; and (2) a material
inadequacy report prepared by the accountant, based on, among other
things, a review of a broker-dealer's accounting system, internal
accounting control, and procedures for safeguarding securities. The
accountant was required to be registered with the PCAOB. However, Rule
17a-5 required that the audit be performed in accordance with GAAS,
which are issued by the AICPA. Consequently, the standard setting body
for broker-dealer audits has been the AICPA (rather than the PCAOB)
notwithstanding the requirement that broker-dealers be audited by a
PCAOB-registered independent public accountant.\755\
---------------------------------------------------------------------------

    \755\ See below discussion in section VII.C.1.i. of this
release.
---------------------------------------------------------------------------

    With regard to the independent public accountant's preparation of
the material inadequacy report, Rule 17a-5 required that the scope of
the accountant's review be sufficient to provide ``reasonable
assurance'' that any material inadequacies\756\ existing at the

date of examination would be disclosed. As discussed above in section
II.D.3. of this release, the AICPA Broker-Dealer Audit Guide provided
guidance regarding preparation of the material inadequacy report.
Specifically, AICPA guidance stated that the material inadequacy report
should address what the independent public accountant concluded in its
``study'' of the adequacy of the broker-dealer's practices and
procedures in complying with the financial responsibility rules in
relation to the definition of material inadequacy as stated in Rule
17a-5. The requirement to issue a ``study'' does not generally exist
outside the context of broker-dealer audits, however, and, while
auditing standards at one time referred to the performance of a study,
current auditing standards no longer contain such references.
---------------------------------------------------------------------------

    \756\ Prior to today's amendments, paragraph (g)(3) of Rule 17a-
5 describes a ``material inadequacy'' in a broker-dealer's
accounting system, internal accounting controls, procedures for
safeguarding securities, and practices and procedures to include
``any condition which has contributed substantially to or, if
appropriate corrective action is not taken, could reasonably be
expected to: (i) inhibit a broker or dealer from promptly completing
securities transactions or promptly discharging his responsibilities
to customers, other brokers or dealers or creditors; (ii) result in
material financial loss; (iii) result in material misstatements in
the broker's or dealer's financial statements; or (iv) result in
violations of the Commission's recordkeeping or financial
responsibility rules to an extent that could reasonably be expected
to result in the conditions described in [(i) through (iii)
above].'' 17 CFR 240.17a-5.
---------------------------------------------------------------------------

    If the broker-dealer was exempt from Rule 15c3-3, Rule 17a-5
required the independent public accountant to ascertain that the
conditions of the exemption were being complied with as of the
examination date and that no facts came to the independent public
accountant's attention to indicate that the exemption had not been
complied with during the period since the last examination.
iii. Filing of Annual Reports With SIPC
    Prior to today's amendments, broker-dealers that are members of
SIPC were required to file only limited information with SIPC. This
information is elicited on Form SIPC-6, the ``General Assessment
Payment Form'' and Form SIPC-7, the ``Annual General Assessment
Reconciliation.'' In addition, for any period during which the SIPC
assessment was not a minimum assessment as provided for in section
4(d)(1)(c) of SIPA, paragraph (e)(4) of Rule 17a-5 generally required
broker-dealers to submit to SIPC a supplemental report on the status of
the membership of the broker-dealer in SIPC. The supplemental report,
among other things, had to include a comparison of the amounts
reflected in the annual financial report the broker-dealer filed with
the Commission with amounts reported on Form SIPC-7. Form SIPC-6 is
filed for the first half of the fiscal year and Form SIPC-7 is filed at
the end of the fiscal year with a place to deduct the assessment due
and paid as reflected on Form SIPC-6. These forms elicit information
from a broker-dealer that is a SIPC member about the broker-dealer's
sources of revenue attributable to its securities business.
    Prior to today's amendments, broker-dealers did not file with SIPC
the annual audited financial statements and accompanying schedules and
reports they filed with the Commission and their DEA under Rule 17a-5.
Therefore, for example, broker-dealers did not file their balance
sheets, which contain information concerning their assets, liabilities,
and net worth, or notes to their financial statements with SIPC. This
information is necessary to understand the financial conditions of the
broker-dealer and, therefore, in order for SIPC to determine whether
the SIPC Fund is appropriately sized to the risks of the broker-dealer
industry.
iv. Notification Requirements
    Prior to today's amendments, the reporting provisions of Rule 17a-5
included references to the term ``material inadequacy.'' \757\ The term
also was used in the Rule 17a-5 and Rule 17a-11 notification provisions
discussed below.
---------------------------------------------------------------------------

    \757\ See supra note 756, at 216.
---------------------------------------------------------------------------

    Rule 17a-5 required that if, during the course of the audit, the
independent public accountant determined that any material inadequacies
existed, the independent public accountant was required to inform the
CFO of the broker-dealer, who was required to give notice to the
Commission and the broker-dealer's DEA within 24 hours. The rule also
provided that the broker-dealer must furnish the independent public
accountant with the notice. If the independent public accountant failed
to receive the notice within the 24-hour period, or if the accountant
disagreed with the statements contained in the notice, the accountant
was required to inform the Commission and the DEA within the next 24
hours and describe any material inadequacies found to exist or, if the
broker-dealer filed a notice, detail the aspects of the broker-dealer's
notice with which the accountant did not agree.
    In addition, Rule 17a-11 required that when a broker-dealer
discovers a material inadequacy, or is notified by its independent
public accountant under Rule 17a-5 that a material inadequacy exists,
the broker-dealer must notify the Commission and its DEA and must
transmit a report stating what the broker-dealer has done or is doing
to correct the situation.
v. Information Provided to Customers
    Prior to today's amendments, Rule 17a-5 provided that, if the
independent public accountant commented on any material inadequacies,
the financial information a broker-dealer was required to send to
customers annually must include a statement that a copy of the
accountant's report and comments was available for customers'
inspection. In addition, Rule 17a-5 provided a conditional exemption
from the requirement that a broker-dealer send paper copies of
financial information to customers, if the broker-dealer was not
required during the prior year to give notice of a material inadequacy.
vi. Access to Accountants
    Prior to today's amendments, carrying and clearing broker-dealers
were not required to provide Commission and DEA examination staff
access to their independent public accountants and accountant work
papers. Such access would enable Commission and DEA examiners to obtain
information, for example, regarding areas on which the accountants
focused in order to plan and conduct risk-based examinations of
carrying and clearing broker-dealers.
vii. Form Custody
    Generally, prior to today's amendments, broker-dealers were not
required to provide comprehensive or consolidated information about
their custody practices to the Commission or their DEA. Some
information relating to a broker-dealer's custody practices is included
in a broker-dealer's exchange membership agreements and clearing
agreements, and in the books and records of the broker-dealer. In
addition, some information is included on Form ADV and, therefore, if
the broker-dealer also is a registered investment adviser, the
information is available to the Commission. Although Commission and DEA
examiners could obtain the information provided on Form Custody through
detailed examinations of the broker-dealer's books and records and by
requesting information from other sources, the Commission and the
broker-dealer's DEA did not have a profile of a broker-dealer's
custodial activities that could serve as a starting point to perform
more focused examinations.

C. Costs and Benefits of the Rule Amendments

    This section discusses costs and benefits of the rule amendments
and new forms for the affected parties against the economic baseline
identified above, both in terms of each of the specific changes from
the baseline, as well as in terms of the overall impact. In considering
these costs, benefits, and impacts, this discussion addresses, among
other things, comments received,

modifications made to the proposed amendments and form, and reasonable
alternatives, where applicable.
    The costs incurred by a broker-dealer to comply with the rule
amendments and new form generally will depend on its size and the
complexity of its business activities. Because the size and complexity
of broker-dealers vary significantly as indicated in the economic
baseline, their costs could vary significantly. In some cases, the
Commission is providing estimates of the average cost per broker-dealer
across all broker-dealers, taking into consideration the variance in
the size of broker-dealers and the complexity of their business
activities.
1. Broker-Dealer Annual Reporting Amendments
i. Changing the Broker-Dealer Audit Standard Setter From the AICPA to
the PCAOB and the Standards From GAAS to PCAOB Standards
    Today's amendments require that audits of broker-dealer financial
statements and schedules be conducted in accordance with the standards
of the PCAOB, thereby replacing the AICPA as the standard setter. The
amendments also require that broker-dealers file one of two new
reports--either a compliance report or an exemption report--and a
report of an independent public accountant based on an examination of
the compliance report or a review of the exemption report. This section
discusses the costs and benefits of the change from the AICPA to the
PCAOB as the standard setter for broker-dealer audits and the
corresponding change from GAAS to PCAOB standards with respect to the
audit of the financial statements and schedules. The costs and benefits
of requiring the use of PCAOB standards with respect to examinations
and reviews of the new compliance report and exemption report are
discussed separately below in section VII.C.1.iii. of this economic
analysis regarding the engagement of the accountant.
    The change from the AICPA to the PCAOB as standard setter for
broker-dealer audits and the corresponding change from GAAS to PCAOB
auditing standards for audits of broker-dealer financial reports and
supporting schedules provides several benefits. By requiring that these
audits be conducted in accordance with PCAOB standards, the amendments
align Rule 17a-5 with statutory provisions. As discussed above, the
Sarbanes-Oxley Act amended the Exchange Act to require that certain
broker-dealer financial reports filed with the Commission be audited by
an accounting firm registered with the PCAOB. The Dodd-Frank Act,
enacted in July 2010, amended the Sarbanes-Oxley Act to provide the
PCAOB with explicit authority to, among other things, establish
(subject to Commission approval) auditing and related attestation,
quality control, ethics, and independence standards for registered
public accounting firms with respect to their preparation of audit
reports to be included in broker-dealer filings with the Commission,
and the authority to conduct an inspection program of registered public
accounting firms that audit broker-dealers.\758\ However, Rule 17a-5
provided that broker-dealer audits be performed in accordance with
GAAS; namely, auditing standards issued by the AICPA.
---------------------------------------------------------------------------

    \758\ See Public Law 111-203 Sec.  982.
---------------------------------------------------------------------------

    After today's amendments, the PCAOB will be the standard setter for
two types of entities: issuers that are public companies and broker-
dealers. Given this mandate, the PCAOB can focus on establishing
standards tailored to these types of entities. For example, with
respect to the audit of the financial report, the PCAOB has proposed a
standard for auditing supplemental information accompanying audited
financial statements filed with the Commission, including supporting
schedules broker-dealers must file with the Commission and the broker-
dealer's DEA, such as schedules regarding the computation of net
capital and the customer reserve requirement and information related to
the broker-dealer's possession or control of customer securities.\759\
In addition, the PCAOB included the Commission's proposal to amend Rule
17a-5 as one of the factors that led the PCAOB to ``reexamine its
requirements regarding supplemental information.'' \760\ Consequently,
the PCAOB has proposed a standard that would be used for the
supplemental reports to the broker-dealer's financial report.\761\ The
PCAOB stated that ``[t]he proposed standard enhances existing PCAOB
standards by: (1) [R]equiring the auditor to perform certain audit
procedures to test and evaluate the supplemental information, and (2)
[e]stablishing requirements that promote enhanced coordination between
the work performed on the supplemental information with work performed
on the financial statement audit and other engagements, such as a
compliance attestation engagement for brokers and dealers.'' \762\
---------------------------------------------------------------------------

    \759\ See Proposed Auditing Standard, Auditing Supplemental
Information Accompanying Audited Financial Statements and Related
Amendments to PCAOB Standards, PCAOB Release No. 2011-05, PCAOB
Rulemaking Docket Matter No. 036, 3 (July 12, 2011) (``PCAOB
Proposed Auditing Standard for Supplemental Information''). As
discussed above, the PCAOB has also proposed standards for
attestation engagements related to broker-dealer compliance or
exemption reports. See PCAOB Proposing Release.
    \760\ See PCAOB Proposed Auditing Standard for Supplemental
Information at 2-3.
    \761\ Id. at 2 (``The proposed standard would benefit investors
and other users of financial statements by updating and enhancing
the required audit procedures when the auditor of the financial
statements is engaged to audit and report on whether supplemental
information accompanying the financial statements is fairly stated,
in all material respects, in relation to the financial statements as
a whole.'').
    \762\ Id. at 4-5.
---------------------------------------------------------------------------

    The change to the PCAOB as the audit standard setter for broker-
dealers should facilitate the development of the PCAOB's permanent
inspection program as contemplated by the Dodd-Frank Act, because
audits of broker-dealers will be inspected by the PCAOB in accordance
with its own standards, and not those of another standard setter, and
because of feedback that can be obtained through the inspections
process regarding gaps and areas that may need improvement. Further,
the Commission has direct oversight authority over the PCAOB, including
the ability to approve or disapprove the PCAOB's rules.\763\ This may
help to increase investor confidence in the independent public
accountants that audit broker-dealers. In addition, as previously
stated, the Commission has greater confidence in the quality of audits
conducted by an independent public accountant registered with, and
subject to regular inspection by, the PCAOB.\764\
---------------------------------------------------------------------------

    \763\ Section 107 of the Sarbanes-Oxley Act states that no rule
of the PCAOB ``shall become effective without prior approval of the
Commission in accordance with this section, other than as provided
in section 103(a)(3)(B) with respect to initial or transitional
standards.'' See Public Law 107-204 Sec.  107. This section also
states that the Commission ``shall approve a proposed rule, if it
finds that the rule is consistent with the requirements of this Act
and the securities laws, or is necessary or appropriate in the
public interest or for the protection of investors'', and generally
provides that the proposed rule procedures follow the same rule
filing procedure for SROs under section 19(b) of the Exchange Act.
Id.
    \764\ See Custody of Funds or Securities of Clients by
Investment Advisers, 75 FR at 1456.
---------------------------------------------------------------------------

    As an alternative approach, one commenter argued that GAAS should
apply for audits of non-carrying broker-dealers.\765\ Another commenter
stated that PCAOB standards should apply only for broker-dealers
``permanently subject to PCAOB inspection,'' and that the Commission
should not require that audits of broker-dealers be performed in
accordance with PCAOB standards for non-issuer broker-dealers until the
PCAOB determines which non-issuer

broker-dealers will be subject to its permanent inspection
program.\766\
---------------------------------------------------------------------------

    \765\ See Citrin Letter.
    \766\ See AICPA Letter.
---------------------------------------------------------------------------

    The Commission has determined that all audits of broker-dealer
financial statements and supporting schedules should be performed in
accordance with PCAOB standards for several reasons. First, allowing
the use of more than one auditing standard would introduce
inconsistencies in audits of broker-dealer financial reports. Second,
allowing the use of non-PCAOB auditing standards for certain broker-
dealer audits would reduce the benefits discussed above of requiring
that all audits of broker-dealer financial reports be conducted in
accordance with PCAOB standards. Third, as discussed in more detail
below, the switch from GAAS to PCAOB standards should not result in
significant incremental costs.
    Independent public accountants that audit issuers are already
familiar with PCAOB audit standards, which should ease any transition
to PCAOB standards for their audits of broker-dealers. Although the
retention of two standards could reduce the incremental costs of
switching from GAAS to PCAOB standards for some independent public
accountants that do not audit issuers, it would not reduce the
incremental costs for all such independent public accountants. For
example, a requirement that the financial statements of one class of
broker-dealer be audited in accordance with GAAS and the financial
statements of another class of broker-dealer be audited in accordance
with PCAOB standards would avoid the incremental costs only for
independent public accountants that limit their audit engagements to
the former class of broker-dealer. These independent public accountants
would not need to stay current with PCAOB standards and adopt their
procedures to those standards. However, independent public accountants
that were engaged to audit broker-dealers in both classes would need to
stay current with both sets of standards and adopt their procedures to
both sets of standards, which could increase their incremental costs.
Further, the PCAOB may determine, subject to Commission approval, to
adopt specific auditing standards for certain types of broker-dealers
(for example, carrying and non-carrying broker-dealers). This could
decrease costs for certain broker-dealer audits.
    The Commission received several comments on the costs of its
proposal to replace GAAS with PCAOB standards with respect to audits of
broker-dealer financial reports. Several commenters stated that the
Commission did not address the costs associated with the change from
GAAS to PCAOB standards.\767\ One commenter also stated that the
transition to PCAOB standards from GAAS may require substantial
revisions to broker-dealer audit programs.\768\
---------------------------------------------------------------------------

    \767\ See, e.g., McGladrey Letter; SIFMA Letter.
    \768\ See ABA Letter.
---------------------------------------------------------------------------

    Current PCAOB standards for audits of financial information
generally incorporate concepts and requirements contained within GAAS,
thereby minimizing the potential costs of this change to independent
public accountants that audit broker-dealers. For example, in April
2003, the PCAOB adopted interim auditing standards consisting of GAAS
then in existence, to the extent not superseded or amended by the
PCAOB.\769\ The PCAOB's Web site lists 50 such standards, including,
for example, a standard relating to auditing accounting estimates (AU
342) and a standard relating to auditing fair value measurements and
disclosures (AU 328).\770\ The PCAOB has adopted, and the Commission
has approved, 16 PCAOB auditing standards, beginning with a standard
relating to references in audit reports to PCAOB standards.\771\
---------------------------------------------------------------------------

    \769\ See PCAOB Auditing Standards (AS) and Interim Auditing
Standards (AU) (2013), available at www.pcaobus.org/standards/auditing.
    \770\ Id.
    \771\ See PCAOB Auditing Standard No. 1 (AS No. 1). At least one
of these audit standards would not apply to audits of broker-dealer
financial reports. See PCAOB Auditing Standard No. 5, ``An Audit of
Internal Control Over Financial Reporting that is Integrated with an
Audit of Financial Statements.''
---------------------------------------------------------------------------

    While some independent public accountants of broker-dealers may
incur one-time implementation costs to update their broker-dealer audit
programs to reflect PCAOB standards, the costs should not be
significant. As stated above, most of the PCAOB's current standards for
audits of financial reports incorporate concepts and requirements
contained within GAAS. Thus, the independent public accountants of
broker-dealers already should be familiar with many of the PCAOB's
standards. In addition, as discussed in the economic baseline, the
AICPA from time-to-time updates and revises its standards. On such an
occurrence, an independent public accountant would need to take steps
to become familiar with the updates and revisions and change its
broker-dealer audit program accordingly. This need for continuing
education presumably already is priced into the audit fees independent
public accountants charge broker-dealers.
    In contrast to the views expressed by some commenters, the
Commission does not expect that a requirement that an audit of
financial statements and supporting schedules be conducted in
accordance with standards of the PCAOB instead of with GAAS will result
in substantial changes for broker-dealer audit programs and therefore
the Commission does not anticipate that this change will result in
significant costs to broker-dealers in the form of increased audit
fees.\772\
---------------------------------------------------------------------------

    \772\ As discussed in section V. of this release, the Commission
has delayed the compliance date for this requirement to provide
sufficient time for broker-dealers and their accountants to prepare
to comply with the new requirement.
---------------------------------------------------------------------------

ii. Requirement To File New Reports
    Under the amendments, a broker-dealer will need to file one of two
new reports: a compliance report or an exemption report.\773\ A
carrying broker-dealer (i.e., one that does not claim an exemption from
Rule 15c3-3) must file the compliance report, and a broker-dealer that
claimed an exemption from Rule 15c3-3 throughout the most recent fiscal
year must file the exemption report. In the reports, a broker-dealer
must make certain statements and provide certain information relating
to the financial responsibility rules. In addition to preparing and
filing the compliance report, a carrying broker-dealer must engage the
PCAOB-registered independent public accountant to prepare a report
based on an examination of certain statements in the broker-dealer's
compliance report.\774\ A broker-dealer that claimed an exemption from
Rule 15c3-3 throughout the most recently ended fiscal year must engage
the PCAOB-registered independent public accountant to prepare a report
based on a review of certain statements in the broker-dealer's
exemption report. In each case, the examination or review must be
conducted in accordance with PCAOB standards.
---------------------------------------------------------------------------

    \773\ See discussion above in sections II.B.1., II.B.3., and
II.B.4. of this release.
    \774\ See paragraphs (f)(1) and (g)(2)(i) of Rule 17a-5.
---------------------------------------------------------------------------

a. Compliance Report
    Under the amendments, a carrying broker-dealer must prepare and
file with the Commission a new compliance report each year, along with
a report prepared by a PCAOB-registered independent public accountant
based on an examination of certain statements made in the compliance
report in accordance with PCAOB standards.\775\ The compliance report
must contain statements as to whether: (1) The broker-dealer has
established and

maintained Internal Control Over Compliance; (2) the Internal Control
Over Compliance of the broker-dealer was effective during the most
recent fiscal year; (3) the Internal Control Over Compliance of the
broker-dealer was effective as of the end of the most recent fiscal
year; (4) the broker-dealer was in compliance with Rule 15c3-1 and
paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal
year; and (5) the information the broker-dealer used to state whether
it was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3
was derived from the books and records of the broker-dealer. In
addition, if applicable, the compliance report must contain a
description of: (1) Each identified material weakness in the Internal
Control Over Compliance during the most recent fiscal year, including
those that were identified as of the end of the fiscal year; and (2)
any instance of non-compliance with Rule 15c3-1 or paragraph (e) of
Rule 15c3-3 as of the end of the most recent fiscal year.
---------------------------------------------------------------------------

    \775\ See discussion above in sections II.B.1., II.B.3., and
II.D.3. of this release.
---------------------------------------------------------------------------

    The compliance report requirements provide a number of benefits.
For example, specifying and standardizing the statements required in
the compliance report should promote consistent compliance with Rule
17a-5 and should ensure that the Commission receives information
relating to aspects of a carrying broker-dealer's compliance with the
financial responsibility rules that are of particular concern.
Although, as discussed above in section II.D.3. of this release,
current auditing standards require that independent public accountants
obtain written representations from management as part of the audits of
financial statements and attestation engagements, GAAS only provide
examples of management representations and do not mandate that specific
management representations be made. By clearly specifying and
standardizing the statements, the compliance report should increase
consistency with respect to the matters examined by the independent
public accountants as part of the examination of the compliance report.
    The specification and standardization of the statements also should
facilitate Commission and DEA oversight of broker-dealer compliance
with the financial responsibility rules to the benefit of broker-dealer
customers, by helping the Commission and DEAs to more quickly identify
broker-dealers with potential problems. Moreover, as adopted, the final
rule requires a broker-dealer's compliance report to include
information regarding whether the broker-dealer's internal control was
effective as of the end of the fiscal year, in addition to information
regarding whether there were material weaknesses in the Internal
Control Over Compliance during the fiscal year. This will provide the
Commission and the DEA with information on whether the broker-dealer
has taken action by the end of the fiscal year to cure any material
weaknesses in the Internal Control Over Compliance that existed during
the fiscal year.
    Requiring the compliance report to be filed with the Commission and
the broker-dealer's DEA also should increase broker-dealers' focus on
ensuring the accuracy of the statements being made and enhance
compliance with the financial responsibility rules given the penalties
for false filings. For example, filers are subject to penalties for
willfully making false statements in any application, report, or
document filed with the Commission.\776\
---------------------------------------------------------------------------

    \776\ See, e.g., 15 U.S.C. 78ff(a).
---------------------------------------------------------------------------

    One commenter stated that incremental benefits of having the
assertion in the compliance report with respect to internal controls
pertain to the whole year rather than the fiscal year end does not
justify the costs.\777\ In response, the Commission notes that key
requirements in the financial responsibility rules must be complied
with on an on-going basis throughout the year. Therefore, it is
critical to have internal controls over compliance with these rules
that are effective throughout the year rather than just at fiscal year
end. Therefore, the Commission believes that there are benefits to
having a carrying broker-dealer state that its Internal Control Over
Compliance was effective throughout the year.
---------------------------------------------------------------------------

    \777\ See E&Y Letter.
---------------------------------------------------------------------------

    Broker-dealers will incur costs associated with preparing the
compliance report. The level of effort required by carrying broker-
dealers to prepare a compliance report will depend on the nature of the
activities of the broker-dealer. For example, the controls necessary
for a carrying broker-dealer that engages in limited custodial
activities generally should be less complex than the controls necessary
for a carrying broker-dealer that engages in more extensive custodial
activities. Therefore, a carrying broker-dealer with limited custodial
activities should have to expend less effort to make its statements in
the compliance report relating to the effectiveness of its Internal
Control Over Compliance. To the extent that the amount of custodial
activity is related to the size of a broker-dealer, the cost of
preparing the compliance report should be lower for smaller carrying
broker-dealers.
    The Commission estimated in the proposing release that, on average,
carrying broker-dealers would spend approximately 60 hours each year to
prepare the proposed compliance report.\778\ One commenter stated that
the proposal did not ``address the additional costs broker-dealers
would incur in preparing Compliance Reports.'' \779\ However, the
commenter did not comment on the estimated hour burden or provide
specific data and analysis on the additional costs that broker-dealers
would incur in preparing compliance reports. Another commenter stated
that the proposed estimate of 60 hours ``is not an accurate estimate of
the time burden to complete the Compliance Report'' and that the
burdens in the proposing release are understated.\780\ This commenter,
however, did not provide a quantified alternative estimate of the costs
or specific data to support its statement.
---------------------------------------------------------------------------

    \778\ See Broker-Dealer Reports, 76 FR 37596.
    \779\ See SIFMA Letter.
    \780\ See Van Kampen/Invesco Letter.
---------------------------------------------------------------------------

    The Commission is retaining the 60-hour estimate for the reasons
discussed below. The final rules contain two changes from the proposal
that could result in lower costs than if the rules had been adopted as
proposed: (1) Elimination of the concepts of ``material non-
compliance'' and ``compliance in all material respects'' with Rule
15c3-1 and 15c3-3 for the purposes of reporting in the compliance
report; and (2) a narrowing of these statements and description
requirements from compliance with all of the financial responsibility
rules to compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3.
    As previously discussed, many commenters raised concerns about how
firms would determine whether an instance of non-compliance constitutes
material non-compliance.\781\ Commenters urged the Commission to
provide guidance with additional specific examples or quantitative and
qualitative factors to be considered when determining whether non-
compliance was material,\782\ or proposing alternate definitions or
examples of non-compliance that should not be regarded as
material.\783\ Under the rules as adopted, broker-dealers will not be
required to conduct

a separate evaluation of materiality when determining instances of non-
compliance that must be reported. This should reduce the likelihood
that inconsistent approaches be taken both among broker-dealers and
between broker-dealers and their independent public accountants.
---------------------------------------------------------------------------

    \781\ See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter;
E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter;
PWC Letter; SIFMA Letter; Van Kampen/Invesco Letter.
    \782\ See ABA Letter; CAQ Letter; E&Y Letter; KPMG Letter;
McGladrey Letter; PWC Letter.
    \783\ See SIFMA Letter.
---------------------------------------------------------------------------

    The ``material non-compliance'' and ``compliance in all material
respects'' concepts were designed to limit the types of instances of
non-compliance that would need to be identified in the report. To
retain a limiting principle, the final rule focuses on provisions that
trigger notification requirements when they are not complied with,
namely, Rule 15c3-1 and the customer reserve requirement in paragraph
(e) of Rule 15c3-3.\784\ Any instances of non-compliance with these
requirements as of the fiscal year end must be described in the
compliance report. As stated in the proposing release, failing to
maintain the required minimum amount of net capital under Rule 15c3-1
or failing to maintain the minimum deposit requirement in a special
reserve bank account under Rule 15c3-3 would have been instances of
material non-compliance under the proposed rule.\785\ Accordingly,
under the proposal, a broker-dealer would have been required to
describe all instances of non-compliance with Rule 15c3-1 and paragraph
(e) of Rule 15c3-3. Under the proposal, a broker-dealer also would have
been required to describe instances of material non-compliance with
Rule 17a-13 and the Account Statement Rules. The final rule is narrower
in that a broker-dealer only is required to describe instances of non-
compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3. While the
final rules increase costs relative to the baseline, they should result
in modestly lower costs to broker-dealers relative to the proposal.
---------------------------------------------------------------------------

    \784\ See 17 CFR 240.15c3-1(a)(6)(iv)(B), (a)(6)(v), (a)(7)(ii),
(a)(7)(iii), (c)(2)(x)(B)(1), (c)(2)(x)(F)(3); 17 CFR 240.17a -
11(b)-(c); 17 CFR 240.15c3-3(i).
    \785\ See Broker-Dealer Reports, 76 FR at 37577.
---------------------------------------------------------------------------

    The final rule also retains the proposed requirement that the
carrying broker-dealer provide a description of each identified
material weakness in the internal control of the broker-dealer over
compliance with the financial responsibility rules, but, in conformity
with other modifications to the proposal, the final rule specifies that
the material weaknesses include those identified during the most recent
fiscal year as well as those that were identified as of the end of the
fiscal year.\786\ The Commission believes that the modifications to the
final rule discussed above may modestly reduce the hour burden of the
final rule as compared to the hour burden that would have resulted from
the proposed rule; namely, because a broker-dealer will not need to
evaluate whether instances of non-compliance with the financial
responsibility rules are material and will only need to report
instances of non-compliance with Rule 15c3-1 and paragraph (e) of Rule
15c3-3. While these modifications will result in additional costs to
broker-dealers over the baseline, they are not expected to increase
costs over those estimated for the proposed rule. This is because the
proposed statement as to whether the broker-dealer's Internal Control
Over Compliance was effective during the most recent fiscal year, and
the related statement about material weakness, would also cover the
fiscal year end. As noted above, the modification to require two
statements (one covering the fiscal year and one covering the fiscal
year end) was prompted by commenter suggestions that broker-dealers be
permitted to report the remediation of a material weakness, or whether
a material weakness still exists, at the end of the fiscal year. These
changes will provide information to the Commission and DEAs as to
whether material weaknesses during the year have been remediated as of
the fiscal year end. They also afford the broker-dealer the opportunity
to state in the report that a material weakness has been remediated, if
applicable.
---------------------------------------------------------------------------

    \786\ See 17 CFR 240.17a-5(d)(3)(i)(B).
---------------------------------------------------------------------------

    The changes discussed above, in some cases, may result in a modest
reduction in burden relative to the proposal. However, while some
commenters suggested that the proposing release underestimated the
burden, the Commission is not changing its estimate of the time
required for a broker-dealer to prepare the compliance report. The
Commission notes that, while commenters questioned the estimate, they
did not provide data that would enable the Commission to revise its
estimate.
    The Commission, however, is updating its estimates of the number of
broker-dealers that would be required to file the compliance report,
which affects the cost estimates. The Commission now estimates that
there are approximately 292 carrying broker-dealers. Therefore, the
Commission estimates that the time required for all 292 carrying
broker-dealers to prepare the report is approximately 17,520 hours per
year.\787\ Further, the Commission estimates that the total cost \788\
associated with this requirement is approximately $5.6 million per
year.\789\
---------------------------------------------------------------------------

    \787\ See discussion above in section VI.D.1.ii. of this
release. 60 hours x 292 carrying broker-dealers = 17,520 hours per
year.
    \788\ For purposes of this economic analysis, salary data is
from the Securities Industry and Financial Markets Association
(``SIFMA'') Report on Management and Professional Earnings in the
Securities Industry 2011 (``SIFMA Report on Management and
Professional Earnings in the Securities Industry''), which provides
base salary and bonus information for middle-management and
professional positions within the securities industry. The salary
costs derived from the report and referenced in this cost benefit
section are modified to account for an 1800-hour work year and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits, and overhead.
    \789\ See discussion above in section VI.D.1.ii. of this
release. Based on staff experience, the Commission believes that a
carrying broker-dealer likely would have a Compliance Manager gather
information necessary to validate the statements to be provided and
that it would take the Compliance Manager approximately 45 hours to
perform this task. In addition, the Commission believes that a
carrying broker-dealer likely would have a Chief Compliance Officer
review the information and make the attestation and that it would
take the Chief Compliance Officer approximately 15 hours per year to
perform this task. According to the SIFMA Report on Management and
Professional Earnings in the Securities Industry, as modified by
Commission staff to account for an 1,800-hour work-year and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead, the hourly cost of a Compliance Manager is
approximately $279/hour, and the hourly cost of a Chief Compliance
Officer is approximately $433/hour. 292 carrying broker-dealers x 45
hours x $279 = $3,666,060. 292 carrying broker-dealers x 15 hours x
$433 = $1,896,540. $3,666,060 + $1,896,540 = $5,562,600 per year.
---------------------------------------------------------------------------

b. Exemption Report
    Broker-dealers that claim an exemption from Rule 15c3-3 are
required to file an exemption report and a report of the independent
public accountant based on a review of the exemption report. The
exemption report must contain the following statements made to the best
knowledge and belief of the broker-dealer: (1) A statement that
identifies the provisions in paragraph (k) of Rule 15c3-3 under which
the broker-dealer claimed an exemption from Rule 15c3-3; (2) a
statement the broker-dealer met the identified exemption provisions in
paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year
without exception or that it met the identified exemption provisions in
paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year
except as described in the exemption report; and (3) if applicable, a
statement that identifies each exception during the most recent fiscal
year in meeting the identified provisions in paragraph (k) of Rule
15c3-3 and that briefly describes the

nature of each exception and the approximate date(s) on which the
exception existed.
    The preparation of exemption reports by broker-dealers that claim
an exemption from Rule 15c3-3 throughout the most recent fiscal year,
as well as reviews of certain statements in the exemption reports by
independent public accountants, should strengthen and facilitate
consistent compliance with the Commission's financial responsibility
rules, for many of the same reasons identified above with respect to
the compliance report. Among other things, these reports should enhance
compliance with the exemption provisions in Rule 15c3-3, thereby
providing better protection of customer assets. This increased focus is
enhanced further by requiring the direct filing of the exemption report
with the Commission and the broker-dealer's DEA because of the
potential penalties for false statements. In addition, the Commission
and the broker-dealer's DEA will benefit from the information provided
in the exemption report in conducting their supervisory oversight of
the broker-dealer.
    The Commission considered an alternative suggested by one commenter
to replace the exemption report with a box to check on the FOCUS
Report.\790\ After careful consideration of this alternative, the
Commission determined that it is not an appropriate alternative to the
exemption report. As discussed above in section II.B.4.iii. of this
release, a broker-dealer claiming an exemption from Rule 15c3-3 already
is required to indicate the basis for the exemption on its FOCUS
Report.\791\ Second, the exemption report requires the broker-dealer to
make certain statements that the independent public accountant must
review. Thus, the exemption report will provide a standardized
statement across all broker-dealers claiming an exemption from Rule
15c3-3 for the independent public accountant to review. Third, the
exemption report will provide the Commission and the broker-dealer's
DEA with more information than currently is reported by non-carrying
broker-dealer's in the FOCUS Report. Specifically, it requires the
broker-dealer to, among other things, state either that it met the
identified exemption provisions in paragraph (k) throughout the most
recent fiscal year without exception or that it met the identified
exemption provisions throughout the most recent fiscal year except as
described in the report. This will provide the Commission and the
broker-dealer's DEA with information as to whether a broker-dealer is
meeting the exemption provisions of paragraph (k) of Rule 15c3-3 (not
simply that the broker-dealer is claiming the exemption as is reported
in the FOCUS Report). The Commission expects that non-carrying broker-
dealers generally track exceptions as part of monitoring compliance
with the exemption provisions in paragraph (k) of Rule 15c3-3. Fourth,
requiring that the exemption report be filed with the Commission should
increase broker-dealers' focus on the statements being made,
facilitating consistent compliance with the exemption provisions in
Rule 15c3-3, and therefore, providing better protection of customer
assets. Further, employing a ``check the box'' alternative would not
substantially reduce compliance costs because the broker-dealer would
need to take steps to ascertain that it has a valid basis for claiming
the exemption, whether or not these steps result in an exemption report
or ``check the box.''
---------------------------------------------------------------------------

    \790\ See Angel Letter.
    \791\ See Item 24 of Part IIa of the FOCUS Report.
---------------------------------------------------------------------------

    The Commission estimated that it would take a non-carrying broker-
dealer approximately five hours to prepare and file the proposed
exemption report.\792\ The Commission did not receive comments
specifically addressing this estimate. However, because the rule was
modified from the proposal to also require the identification of
exceptions to the exemption provisions, the Commission is increasing
the estimate to seven hours.\793\ The Commission now estimates that
there are approximately 4,417 non-carrying broker-dealers that must
file exemption reports. Therefore, the Commission estimates that the
annual reporting burden for all non-carrying broker-dealers to prepare
and file the exemption report is approximately 30,919 hours per
year.\794\ The Commission estimates that the total industry-wide cost
to prepare the exemption report is approximately $9.3 million per
year.\795\
---------------------------------------------------------------------------

    \792\ See Broker-Dealer Reports, 76 FR at 37596.
    \793\ See discussion above in section VI.D.1.iii. of this
release.
    \794\ See discussion above in section VI.D.1.iii. of this
release. 7 hours x 4,417 non-carrying broker-dealers = 30,919 hours
per year. See the discussion below regarding the external costs
associated with obtaining the accountant's report on the exemption
report.
    \795\ See discussion above in section VI.D.1.iii. of this
release. Based on staff experience, a non-carrying broker-dealer
likely would have a Compliance Manager gather information necessary
to validate the information to be provided in the exemption report,
and it would take the Compliance Manager approximately six hours to
perform this task. In addition, a non-carrying broker-dealer likely
would have a Chief Compliance Officer review the information and
make the attestation, and it would take the Chief Compliance Officer
approximately one hour to perform this task. According to the SIFMA
Report on Management and Professional Earnings in the Securities
Industry, as modified by Commission staff to account for an 1,800-
hour work-year and multiplied by 5.35 to account for bonuses, firm
size, employee benefits and overhead, the hourly cost of a
Compliance Manager is approximately $279/hour, and the hourly cost
of a Chief Compliance Officer is approximately $433/hour. 4,417 non-
carrying broker-dealers x 6 hours x $279 = $7,394,058 per year.
4,417 non-carrying broker-dealers x 1 hour x $433 = $1,912,561 per
year. $7,394,058 + $1,912,561 = $9,306,619 per year.
---------------------------------------------------------------------------

iii. Engagement of the Accountant
    As discussed above, the amendments to Rule 17a-5 eliminate the
requirement that the broker-dealer's independent public accountant
prepare, and the broker-dealer file with the Commission and its DEA
concurrently with its annual audited financial statements, a material
inadequacy report, based on, among other things, a review of a broker-
dealer's accounting system, internal accounting control, and procedures
for safeguarding securities. The amendments replace this requirement
with a requirement, among other things, that the broker-dealer file
with its annual reports a report prepared by an accountant covering
either the broker-dealer's compliance report or exemption report, as
applicable. The accountant engaged by the broker-dealer must, as part
of the engagement, undertake to prepare its reports based on an
examination of certain statements in the compliance report or a review
of certain statements in the exemption report, as applicable, in
accordance with PCAOB standards.
    With regard to the independent public accountant's preparation of
the material inadequacy report, Rule 17a-5 required that the scope of
the accountant's review be sufficient to provide ``reasonable
assurance'' that any material inadequacies existing at the date of
examination would be disclosed. If the broker-dealer was exempt from
Rule 15c3-3, Rule 17a-5 provided that the accountant must ascertain
that the conditions of the exemption were being complied with as of the
examination date and that no facts came to the accountant's attention
to indicate that the conditions of the exemption had not been complied
with since the last examination. As discussed above, AICPA guidance
provided that the material inadequacy report should address what the
independent public accountant concluded in its ``study'' of the
adequacy of the broker-dealer's practices and procedures in complying
with the financial responsibility rules in

relation to the definition of material inadequacy as stated in Rule
17a-5.\796\
---------------------------------------------------------------------------

    \796\ See AICPA Broker-Dealer Audit Guide at ] 3.77.
---------------------------------------------------------------------------

    However, in the PCAOB's first report on the progress of its interim
inspection program of broker-dealer audits, the PCAOB stated that as to
21 of the 23 audits inspected, the accountant ``failed to perform
sufficient audit procedures to obtain reasonable assurance that any
material inadequacies found to exist since the date of the last
examination . . . would have been disclosed in the accountant's
supplement report.'' \797\ Further, for all of the 14 audits of broker-
dealers that claimed an exemption from Rule 15c3-3, the PCAOB stated
that the accountant ``did not perform sufficient procedures to
ascertain that the broker or dealer complied with the conditions of the
exemption.'' \798\ The deficiencies noted in the PCAOB's report on the
progress of the interim inspection program provide further support for
the amendments that the Commission is adopting today to establish the
foundation for the PCAOB's development of standards that are tailored
to Rule 17a-5, and to strengthen and facilitate consistent compliance
with broker-dealer audit and reporting requirements.
---------------------------------------------------------------------------

    \797\ See PCAOB Inspection Report at iii.
    \798\ Id.
---------------------------------------------------------------------------

    Generally, the engagement of accountant amendments should result in
higher levels of compliance with the Commission's financial
responsibility rules by increasing the focus of carrying broker-dealers
and their independent public accountants on specific statements made in
the compliance report relating to the broker-dealer's compliance, and
internal control over compliance, with the financial responsibility
rules and increasing the focus of non-carrying broker-dealers and their
independent public accountants on whether the broker-dealer meets the
exemption provisions in paragraph (k) of Rule 15c3-3. These amendments
also clarify the scope and the standards that apply to broker-dealer
audits and conform language in the rule with terminology in existing
audit literature, which should reduce inconsistencies in broker-dealer
compliance with Rule 17a-5. The replacement of the material inadequacy
report with the report based on an examination of the compliance report
or review of the exemption report facilitates the Commission's
objective to provide clear and consistent terminology focused
separately on compliance with the financial responsibility rules and
internal control over compliance with the financial responsibility
rules.
    With regard to the examination of the compliance report, the
amendments are intended to encourage greater focus by the independent
public accountant on Internal Control Over Compliance, including, in
particular, broker-dealer custody practices. By specifying the
statements that must be made by a broker-dealer to the Commission, and
hence, examined by the auditor, the compliance report should provide
clarity and facilitate consistent compliance with Rule 17a-5 by
independent public accountants. Additionally, the focus of independent
public accountants on internal control over the custody practices of
broker-dealers should better identify broker-dealers that have weak
internal controls for safeguarding investor securities and cash.
Similarly, with regard to the review of the exemption report, the
amendments encourage greater focus by the accountant on whether the
broker-dealer has appropriately claimed an exemption from Rule 15c3-3
by, among other things, reviewing whether the broker-dealer's
statements in the exemption report as to meeting the exemption
provisions without or with exceptions, and, if applicable, identifying
exceptions to meeting those provisions, were fairly stated.\799\ As
stated above, the terminology in Rule 17a-5 with regard to the material
inadequacy report was outdated and inconsistent with current audit
practices.
---------------------------------------------------------------------------

    \799\ As stated above, a review engagement is designed to
provide a moderate level of assurance, and the accountant's
conclusion could state, for example, that no information came to the
accountant's attention that indicates that the exemption report is
not fairly stated in all material respects.
---------------------------------------------------------------------------

    The PCAOB stated that its proposed attestation standards for
examining compliance reports and reviewing exemption reports were
``tailored'' to the proposed amendments to Rule 17a-5.\800\ These
standards, if adopted, are expected to establish a single and broker-
dealer-specific approach to examining compliance reports and reviewing
exemption reports and are expected to enable the accountant to scale
the engagement based on the broker-dealer's size and complexity.
---------------------------------------------------------------------------

    \800\ See PCAOB Proposing Release at 5.
---------------------------------------------------------------------------

    Based on its estimates of the costs associated with the cost of an
internal control report under Rule 206(4)-2, the Commission estimated
that the external cost to a carrying broker-dealer of obtaining the
independent public accountant's report based on an examination of the
proposed compliance report would be an average incremental cost of
approximately $150,000 per carrying broker-dealer per year.\801\ Based
on staff experience, including communications with broker-dealers,
broker-dealer independent public accountants, and independent public
accountant industry groups, the Commission estimated that the external
cost to a non-carrying broker-dealer of obtaining the independent
public accountant's report based on a review of the proposed exemption
report would cost an average of approximately $3,000 per non-carrying
broker-dealer per year.\802\ Before today's amendments, independent
public accountants of broker-dealers were required to prepare a
material inadequacy report. As that report is no longer required, the
costs associated with engaging the independent public accountant to
prepare a material inadequacy report have been eliminated and replaced
by the costs associated with engaging the independent public accountant
to prepare a report covering the compliance report or the exemption
report. Therefore, the incremental cost of today's amendments related
to the engagement of the independent public accountant is the amount
that the cost exceeds the cost of engaging the independent public
accountant to prepare the material inadequacy report. However, the
Commission has not previously estimated the average cost of preparing
the material inadequacy report. Consequently, the Commission is
retaining the cost estimates set forth in the proposing release, while
recognizing that costs could be lower as a result of cost savings
attributable to the elimination of the material inadequacy report
requirements.
---------------------------------------------------------------------------

    \801\ See Broker-Dealer Reports, 76 FR at 37599. See also
discussion above in section VI.D.1.vii.b. of this release.
    \802\ See Broker-Dealer Reports, 76 FR at 37600. The Commission
estimated that the average cost of an audit of a non-carrying
broker-dealer's financial report was approximately $30,000 per year,
based on a weighted average of estimates of that cost for broker-
dealers with varying levels of net income. The Commission further
estimated that the additional cost for a review of the exemption
report would be an average of approximately $3,000 per non-carrying
broker-dealer per year. Id. See also discussion above in section
VI.D.1.vii.c. of this release.
---------------------------------------------------------------------------

    The Commission received various comments regarding the engagement
of accountant provisions as they relate to examining or reviewing the
proposed compliance reports and exemption reports, respectively. One
commenter stated that the Commission underestimated the cost of
examining the compliance report and that the Commission may need to
consider the

PCAOB's proposed rules before it can reasonably estimate this
cost.\803\ Another commenter stated that the proposed amendments have
``the potential to double the total current audit fees and have a
material impact'' on firms.\804\ A third commenter stated that the
economic analysis was ``inconclusive'' because the PCAOB has not yet
established auditing and attestation standards for broker-dealers.\805\
The commenters, however, did not provide quantified alternative cost
estimates.
---------------------------------------------------------------------------

    \803\ See ABA Letter.
    \804\ See Van Kampen/Invesco Letter.
    \805\ See CAI Letter.
---------------------------------------------------------------------------

    The Commission acknowledges that the total costs associated with
these requirements will depend on the final PCAOB standards for
attestation engagements to examine compliance reports or review
exemption reports. However, as the PCAOB's proposed standards were
tailored to the proposed amendments, nothing in those standards causes
the Commission to change its estimates of the costs associated with
these requirements, or to question that the benefits will justify the
costs.
    Before today's amendments, Rule 17a-5 required the independent
public accountant to, among other things, review the accounting system,
internal accounting control, and procedures for safeguarding securities
of the broker-dealer, including appropriate tests, for the period since
the prior examination date. The scope of the independent public
accountant's review was required to be sufficient to provide reasonable
assurance that any material inadequacies existing at the date of the
auditor examination would be disclosed. Similarly, an examination of a
compliance report performed under the PCAOB's attestation standard for
examination engagements would require that the auditor obtain
reasonable assurance to express an opinion on whether the broker-
dealer's statements in the compliance report are fairly stated, in all
material respects.\806\
---------------------------------------------------------------------------

    \806\ See PCAOB Proposing Release at 5. An examination
engagement is designed to provide a high level of assurance. See,
e.g., PCAOB Interim Attestation Standard, AT Section 101 at ] .54.
In this case, the accountant's conclusion will be expressed in the
form of an opinion. For example, the accountant's conclusion based
on an examination of an assertion could state that in the
accountant's opinion, [the assertion] is fairly stated in all
material respects. See, e.g., PCAOB Interim Attestation Standard, AT
Section 101 at ] .84.
---------------------------------------------------------------------------

    Moreover, before today's amendments, if a broker-dealer was exempt
from Rule15c3-3, Rule 17a-5 required the independent public accountant
to ``ascertain that the conditions of the exemption were being complied
with as of the examination date and that no facts came to [the
independent public accountant's] attention to indicate that the
exemption had not been complied with during the period since [the
independent public accountant's] last examination.'' \807\ The PCAOB's
proposed review standard for the exemption report would require that
the independent public accountant make inquiries and perform other
procedures that are commensurate with the auditor's responsibility to
obtain moderate assurance that the broker-dealer meets the identified
conditions for an exemption from Rule 15c3-3.\808\ These procedures
would include evaluating relevant evidence obtained from the audit of
the financial statements and supporting schedules and are designed to
enable the auditor to scale the review engagement based on the broker-
dealer's size and complexity.\809\
---------------------------------------------------------------------------

    \807\ See 17 CFR 240.17a-5(g)(2).
    \808\ See PCAOB Proposing Release at 8.
    \809\ Id. at 9.
---------------------------------------------------------------------------

    The compliance report as adopted includes an additional statement
(relative to the proposal) as to whether the broker-dealer's Internal
Control Over Compliance was effective as of the end of the most recent
fiscal year. Therefore, costs of compliance with the final rules may be
higher than costs of compliance with the proposed rules to the extent
Internal Control Over Compliance has changed near or as of the fiscal
year end. However, this increased cost is not expected to be
significant, since the procedures needed to opine on these matters as
of the fiscal year end should not be materially different from the
procedures employed to opine as to the effectiveness of internal
control over the course of the fiscal year.
    As proposed, the broker-dealer would have been required to assert
whether it was in compliance, in all material respects, with all of the
financial responsibility rules as of its fiscal year end. As adopted,
the broker-dealer must assert whether it is in compliance with Rule
15c3-1 and paragraph (e) of Rule 15c3-3 (i.e., a narrower range of rule
compliance than proposed). This modification of the broker-dealer's
assertion could result in lower costs for accountants' reports on the
compliance report as compared to the proposal as the scope of the
matters to be covered by accountants' examinations will be narrower.
    Although these modifications could modestly lower costs associated
with the accountant's report covering the compliance report as compared
to the proposal, the Commission is not changing its estimate of costs
associated with accountants' reports covering compliance reports and
exemption reports. Based on updated data, the Commission now estimates
that there are approximately 292 carrying broker-dealers. The
Commission therefore estimates that the industry-wide annual average
incremental external reporting cost of accountants' reports based on
examinations of compliance reports is approximately $44 million per
year ($150,000 times 292 carrying broker-dealers = $43,800,000).\810\
Based on updated data, the Commission now estimates that there are
approximately 4,417 non-carrying broker-dealers. The Commission
therefore estimates that the total industry-wide annual reporting cost
of accountant's reports based on reviews of exemption reports is
approximately $13.3 million per year (4,417 non-carrying broker-dealers
times $3,000 = $13,251,000).\811\ The Commission therefore estimates
that the total industry-wide incremental external annual reporting cost
to broker-dealers associated with the accountants' reports covering the
compliance report and exemption report is approximately $57.3 million
per year.
---------------------------------------------------------------------------

    \810\ See discussion above in section VI.D.1.vii.b. of this
release.
    \811\ See discussion above in section VI.D.1.vii.c. of this
release.
---------------------------------------------------------------------------

    Finally, one commenter suggested that the Commission use an
``agreed-upon procedures'' engagement for the exemption report.\812\
This alternative was considered. The final rule, however, requires a
review engagement as proposed. Under an ``agreed-upon procedures''
engagement, the independent public accountant is engaged by a client to
issue a report of findings based on specific procedures performed on
subject matter that the specified parties believe are appropriate.\813\
Additionally, in an ``agreed-upon procedures'' engagement, the
independent public accountant does not perform an examination or a
review, and does not provide an opinion or negative assurance. Thus, no
conclusion would be rendered as to the broker-dealer's statements in
the exemption report.
---------------------------------------------------------------------------

    \812\ See E&Y Letter.
    \813\ See PCAOB Interim Attestation Standard, AT Section 201 at
] .03.
---------------------------------------------------------------------------

    Another commenter stated that the benefit of receiving an audit
report covering the exemption report would not justify the cost \814\
and, similarly, a second commenter did not see a benefit from the
auditor attestation of the

exemption report.\815\ As noted above, before today's amendments, if a
broker-dealer was exempt from Rule15c3-3, Rule 17a-5 required the
independent public accountant to ``ascertain that the conditions of the
exemption were being complied with as of the examination date and that
no facts came to [the independent public accountant's] attention to
indicate that the exemption had not been complied with during the
period since [the independent public accountant's] last examination.''
\816\ Consequently, the current rule requires the independent public
accountant to reach a conclusion with respect to a broker-dealer's
claimed exemption from Rule 15c3-3.
---------------------------------------------------------------------------

    \814\ See Citrin Letter.
    \815\ See Angel Letter.
    \816\ See 17 CFR 240.17a-5(g)(2).
---------------------------------------------------------------------------

    The Commission believes the rule should continue to require a
conclusion from the independent public accountant on the broker-
dealer's claimed exemption from Rule 15c3-3 because of the importance
of safeguarding customer securities and cash. While the Commission
anticipates there will be costs related to the audit of the exemption
report, the Commission does not believe it would be appropriate to use
a lower standard (i.e., the agreed-upon procedures standard) or have no
requirement for the independent public accountant to perform any work
with respect to the exemption report.
iv. Filing of Annual Reports With SIPC
    The amendments to Rule 17a-5 require broker-dealers that are SIPC
members to file their annual reports with SIPC. SIPC plays an important
role in the securities markets by serving as a backstop to protect
customers of a failed broker-dealer that cannot promptly return
customer securities and funds. In this capacity, SIPC has a legitimate
interest in receiving the annual reports of its broker-dealer members
to assist it with its maintenance of the SIPC Fund and to monitor
trends in the broker-dealer industry. For example, SIPC presently
obtains revenue information from broker-dealers, through Form SIPC-7,
to determine how best to structure broker-dealer assessments to
maintain the SIPC Fund at an appropriate level. However, the
information collected in the form is limited and may not assist SIPC in
assessing whether the SIPC Fund is appropriately sized to the risks of
a large broker-dealer failure. The annual reports contain much more
detailed information about the assets, liabilities, income, net
capital, and Rule 15c3-3 customer reserve requirements of broker-
dealers, and also include, for carrying broker-dealers, a compliance
report containing information about the broker-dealer's compliance
with, and controls over compliance with, the broker-dealer financial
responsibility rules. The annual reports also generally include the
independent public accountant's reports covering the financial report
and compliance report or exemption report, as applicable, prepared by
the broker-dealer. This information also will assist SIPC in monitoring
the financial strength of broker-dealers and, therefore, in assessing
the adequacy of the SIPC Fund.
    In addition, by receiving the annual reports, SIPC may be able to
overcome a potential legal hurdle to pursuing claims against a broker-
dealer's accountant where the accountant's failure to adhere to
professional standards in auditing a broker-dealer causes a loss to the
SIPC Fund. As discussed in section II.B.6. of this release, SIPC has
sought to recover money damages from the broker-dealer's independent
public accountant based on an alleged failure to comply with auditing
standards, but at least one court has held under New York law that SIPC
could not maintain a claim because it was not a recipient of the annual
audit filing and could not have relied on it.\817\
---------------------------------------------------------------------------

    \817\ See SIPC v. BDO Seidman, LLP, 746 NE.2d 1042 (N.Y. 2001);
aff'd, 245 F.3d 174 (2d Cir. 2001).
---------------------------------------------------------------------------

    SIPC's improved ability to maintain the SIPC Fund will benefit
investors. First, if the SIPC Fund is appropriately sized, customers of
a failed broker-dealer in a SIPA liquidation should be able to recover
their assets more quickly through advances from the fund than if the
fund is not adequate. Also, to the extent the amendments overcome a
potential legal hurdle to pursuing claims against a broker-dealer's
accountant, the ability to recover damages from the broker-dealer's
accountant in the context of a SIPA liquidation proceeding could
increase the size of the estate of a failed broker-dealer. Increasing
the size of the estate could benefit customers with claims that cannot
be fully satisfied through distributions of customer property held by
the failed broker-dealer and the SIPC advances.
    The new requirement that broker-dealers that are members of SIPC
file their annual reports with SIPC will increase these broker-dealers'
compliance costs.\818\ In the proposing release, the Commission
estimated that it would take broker-dealers approximately 30 minutes to
prepare and file the annual reports with SIPC, and commenters did not
disagree with this estimate. Thus, the Commission estimates that the
annual industry-wide reporting burden associated with this amendment is
approximately 2,246 hours per year (\1/2\ hour times 4,492 SIPC members
= 2,246 hours) and that the total annual cost is approximately
$694,000.\819\ There would be postage costs associated with sending a
copy of the annual report to SIPC that are estimated to be, on
average,\820\ approximately $12.05 per broker-dealer per year.\821\
Thus, the Commission estimates that the total annual postage costs
associated with sending a copy of the annual report to SIPC would be
approximately $54,128 per year for all broker-dealers that are SIPC
members.\822\
---------------------------------------------------------------------------

    \818\ See Broker-Dealer Reports, 76 FR at 37596.
    \819\ Based on staff experience, a broker-dealer likely would
have a Financial Reporting Manager prepare an additional copy of its
annual report and mail it to SIPC. According to the SIFMA Report on
Management and Professional Earnings in the Securities Industry, as
modified by Commission staff to account for an 1,800-hour work-year
and multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead, the hourly cost of a Financial Reporting
Manager is approximately $309/hour. 4,492 SIPC-member broker-dealers
x \1/2\ hour x $309 = $694,014.
    \820\ The number of pages of an annual report, and consequently
the associated postage costs, likely will vary significantly based
on the size of the broker-dealer and the types of business in which
it engages.
    \821\ Based on Commission staff experience with annual report
filings of broker-dealers under Rule 17a-5, the Commission staff
estimates that approximately 50% of broker-dealers file their annual
reports using an overnight mail delivery service. These broker-
dealers would consequently incur higher postage costs than broker-
dealers which choose to mail their annual reports using first class
mail or delivery methods other than overnight mail. Therefore,
postages costs will vary depending on the size of the annual report
and method of delivery. The Commission estimates that the cost to
mail the additional reports would be, on average, $12.05 per broker-
dealer. As of October 2012, the $12.05 rate is an average rate of
the cost of an Express Mail Flat Rate Envelope of $18.95 and a
Priority Mail Flat Rate Envelope of $5.15, based on costs obtained
on the Web site of the U.S. Postal Service, available at
www.usps.gov. ($18.95 + $5.15) = $24.10/2 = $12.05.
    \822\ 4,492 broker-dealers x $12.05 = $54,128.
---------------------------------------------------------------------------

    While they did not provide estimates of potential litigation costs,
several commenters stated that the Commission did not address the
potential costs and benefits of requiring broker-dealers to file copies
of their annual reports with SIPC, including potential litigation costs
for independent public accountants.\823\ The Commission recognizes that
there may be increased litigation costs (or reserves for potential
litigation costs) for accountants as a result of the amendment and that
to the extent that there are such costs, some of them may be passed on
to broker-dealers in the

form of increased fees charged by broker-dealers' independent public
accountants. However, commenters did not provide estimates of potential
litigation costs, and Commission staff were unable to find readily-
available public information from which to estimate specific costs of
possible litigation. To the extent that SIPC does bring an individual
lawsuit as a direct result of this amendment (e.g., a suit brought in
New York), there would be costs in terms of legal fees. Based on staff
experience, depending on the complexity, scope, and length of the
litigation, the costs to defend an individual case could be quite
signficant given the hourly fees charged by outside counsel. However,
the Commission does not believe these costs would be significant in the
aggregate. As indicated in the economic baseline, SIPC initiates a
small number of proceedings each year, and most of these proceedings
have not involved litigation by SIPC against the firm's independent
public accountant. Moreover, SIPC continued to bring lawsuits against
broker-dealer accountants after the 2001 New York decision in
jurisdictions other than New York.\824\ Consequently, while the
amendment removes one potential legal hurdle to such suits, it may not
significantly increase the frequency with which SIPC brings such
lawsuits. Moreover, the other elements of any relevant cause of action
would be unaffected. Accordingly, the Commission continues to believe
that the requirement to file copies of the annual reports with SIPC is
appropriate.
---------------------------------------------------------------------------

    \823\ See, e.g., CAQ Letter; Deloitte Letter; KPMG Letter.
    \824\ See SIPC v. BDO Seidman, LLP, 746 NE.2d 1042 (N.Y. 2001);
aff'd, 245 F.3d 174 (2d Cir. 2001).
---------------------------------------------------------------------------

v. Notification Requirements
    As discussed above in section II.F. of this release, the Commission
is amending the notification provisions in Rule 17a-5 and is making
conforming amendments to Rule 17a-11. Prior to today's amendments,
paragraph (h)(2) of Rule 17a-5 provided that if, during the course of
the audit or interim work, the independent public accountant determined
that any ``material inadequacies'' existed, the independent public
accountant was required to inform the CFO of the broker-dealer, who, in
turn, was required to give notice to the Commission and the broker-
dealer's DEA within 24 hours in accordance with the provisions of Rule
17a-11.\825\
---------------------------------------------------------------------------

    \825\ See 17 CFR 240.17a-5(h)(2).
---------------------------------------------------------------------------

    Under Rule 17a-11, a broker-dealer must provide notice to the
Commission and its DEA in certain circumstances.\826\ For example,
paragraph (b)(1) of Rule 17a-11 requires a broker-dealer to give notice
if its net capital declines below the minimum amount required under
Rule 15c3-1.\827\ Before today's amendments, Rule 17a-11 required that
whenever a broker-dealer discovered, or was notified by an independent
public accountant of the existence of any material inadequacy, the
broker-dealer must give notice to the Commission and transmit a report
to the Commission stating what the broker or dealer has done or is
doing to correct the situation. Rule 15c3-1 and Rule 15c3-3 also
require broker-dealers to provide notification in certain
circumstances.\828\ For example, paragraph (i) of Rule 15c3-3 requires
a carrying broker-dealer to immediately notify the Commission and its
DEA if it fails to make a deposit into its customer reserve account as
required by paragraph (e) of Rule 15c3-3.\829\
---------------------------------------------------------------------------

    \826\ See 17 CFR 240.17a-11.
    \827\ See 17 CFR 240.17a-11(b)(1).
    \828\ See, e.g., 17 CFR 240.15c3-1(a)(6)(iv)(B); 17 CFR
240.15c3-1(a)(6)(v); 17 CFR 240.15c3-1(a)(7)(ii); 17 CFR 240.15c3-
1(c)(2)(x)(C)(1); 17 CFR 240.15c3-1(e); 17 CFR 240.15c3-1d(c)(2); 17
CFR 240.15c3-3(i).
    \829\ See 17 CFR 240.15c3-3(i).
---------------------------------------------------------------------------

a. Amendments to Rule 17a-5
    The Commission proposed amending the notification provisions in
Rule 17a-5 to replace the term ``material inadequacy'' with the term
``material non-compliance.'' The term ``material non-compliance'' was
defined in the context of the compliance report, which was required to
be prepared and filed by carrying broker-dealers. This provision would
therefore have applied to broker-dealers that filed compliance reports
with the Commission. The Commission also proposed amending the
notification process. Under the proposed new process, the accountant
would be required to notify the Commission and the broker-dealer's DEA
directly.
    The Commission received numerous comments in response to this
proposal.\830\ Most of these commenters objected to the proposed
notification process.\831\ Among the reasons given were that it would
be inappropriate to require the accountant to notify the Commission and
the DEA directly, because, among other things, the broker-dealer is
principally responsible for compliance with the securities laws,
including timely notification; \832\ that PCAOB standards provide that
``the practitioner should not take on the role of the responsible
party'' \833\; and that PCAOB attestation standards (which were
referenced in the proposing release) clearly provide that management is
responsible for the subject matter to which it is asserting, and not
the accountant.\834\ In addition to suggestions that the notification
process that existed prior to today's amendments should not be
changed,\835\ one commenter stated that the rule should require
simultaneous notice by the accountant to the Commission and to the
firm's management.\836\ In addition, one commenter asked whether the
notification provisions apply to a review of the exemption report.\837\
Another commenter stated that non-compliance also will trigger a Rule
17a-11 notice, which would be duplicative and create confusion.\838\
---------------------------------------------------------------------------

    \830\ See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter;
E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter;
PWC Letter; SIFMA Letter; Van Kampen/Invesco Letter.
    \831\ See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter;
E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter;
PWC Letter; Van Kampen/Invesco Letter.
    \832\ See Deloitte Letter.
    \833\ See KPMG Letter. See also PCAOB Interim Attestation
Standard, AT Section 101 at  13.
    \834\ See PWC Letter. See also PCAOB Interim Attestation
Standard, AT Section 101 at  11-13.
    \835\ See, e.g., ABA Letter; E&Y Letter; McGladrey Letter.
    \836\ See Van Kampen/Invesco Letter.
    \837\ See KPMG Letter.
    \838\ See ABA Letter.
---------------------------------------------------------------------------

    The final rule requires that if the accountant determines that
there are any instances of non-compliance (as opposed to an instance of
material non-compliance, as proposed) with the financial responsibility
rules during the course of preparing the accountant's reports, the
accountant must immediately notify the CFO of the broker-dealer of the
nature of the non-compliance. If the accountant provides notice of an
instance of non-compliance, the broker-dealer must notify the
Commission and its DEA, but only if required to do so by existing
provisions of Rule 15c3-1, Rule 15c3-3, or Rule 17a-11 that require
such notification.\839\

Consequently, the final rule requires that any instance of non-
compliance identified by the accountant will trigger a notification by
the broker-dealer to the Commission and the firm's DEA to the same
extent that notification is required if discovered by the broker-dealer
other than in connection with its annual audit. Therefore, under the
final rule, if the accountant determines that an instance of non-
compliance with the financial responsibility rules exists, the
accountant is not required to make a determination of whether that
instance of non-compliance is material. This modification likely will
result in a lower burden relative to the proposal on the independent
public accountant as the accountant will not need to analyze whether an
instance of non-compliance is material to determine whether the
notification requirement has been triggered. On the other hand, the
independent public accountant will need to provide notice to the
broker-dealer of all instances of non-compliance rather than only
instances of material non-compliance. Therefore, the modification will
result in more required notifications from the independent public
accountant to the broker-dealer.
---------------------------------------------------------------------------

    \839\ Under Rule 17a-11, a broker-dealer must provide notice to
the Commission and its DEA in certain circumstances. For example,
paragraph (b)(1) of Rule 17a-11 requires a broker-dealer to give
notice if its net capital declines below the minimum amount required
under Rule 15c3-1. In addition, Rule 15c3-1 and Rule 15c3-3 require
broker-dealers to provide notifications in certain circumstances.
For example, paragraph (a)(6)(iv) of Rule 15c3-1 requires a broker-
dealer that operates as a specialist or market-maker and that
operates under the provisions of paragraph (a)(6) of Rule 15c3-1 to
obtain certain representations from the broker-dealer that carries
its market maker or specialist account. The representations include
that the broker-dealer carrying the account will provide a
notification under Rule 17a-11 if the market maker or specialist
fails to deposit the required amount of equity into the account
within the required time frame as prescribed in paragraph (a)(6) of
Rule 15c3-1. In addition, under paragraph (i) of Rule 15c3-3, a
carrying broker-dealer must immediately notify the Commission and
its DEA if it fails to make a deposit into its customer reserve
account as required by paragraph (e) of Rule 15c3-3.
---------------------------------------------------------------------------

    Under the final rule, the independent public accountant also will
be required to provide notice to the broker-dealer if the accountant
determines that any material weaknesses exist. As in the proposal,
material weakness is defined with regard to the compliance report and
therefore applies only to broker-dealers that file compliance reports.
In that report, a carrying broker-dealer must state whether its
internal controls were effective during the fiscal year as well as at
the end of the fiscal year. Internal controls are not effective if
there are one or more material weaknesses in the controls. The broker-
dealer also is required to describe any identified material weaknesses.
The independent public accountant must undertake to prepare a report
based on an examination of certain statements in the compliance report,
including the statements as to whether the carrying broker-dealer's
internal controls were effective.
    As stated above, before today's amendments, Rule 17a-5 required the
accountant to notify the broker-dealer if the accountant determined
that any material inadequacies existed. The concept of material
inadequacy generally applied to all broker-dealers and, therefore, the
notification requirement applied with respect to independent public
accountant engagements for non-carrying as well as carrying broker-
dealers under Rule 17a-5. This requirement, however, may not have
produced the intended benefits.
    As discussed in section II.D.3. above, PCAOB inspection staff found
that in 21 of 23 broker-dealer audits inspected, the accountant
``failed to perform sufficient audit procedures to obtain reasonable
assurance that any material inadequacies found to exist since the date
of the last examination . . . would have been disclosed in the
accountant's supplemental report.'' \840\ Material inadequacies which
were expected to be reported by the accountant included any condition
which contributed substantially to or, if appropriate corrective action
was not taken, could reasonably be expected to: (1) Inhibit a broker-
dealer from promptly completing securities transactions or promptly
discharging its responsibilities to customers, other broker-dealers, or
creditors; (2) result in material financial loss; (3) result in
material misstatements of the broker-dealer's financial statements; or
(4) result in violations of the Commission's recordkeeping or financial
responsibility rules to an extent that could reasonably be expected to
result in the conditions described in (1) through (3) above. The
definition of material weakness is more specific: a material weakness
includes a deficiency in internal control such that there is a
reasonable possibility that non-compliance with Rule 15c3-1 and
paragraph (e) of Rule 15c3-3 will not be prevented or detected on a
timely basis or that non-compliance to a material extent with Rule
15c3-3, except paragraph (e), Rule 17a-13, or the Account Statement
Rules will not be prevented or detected on a timely basis.
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    \840\ See PCAOB Inspection Report, at ii.
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    As discussed above, today's amendments generally replace the term
material inadequacy and separate it into two components--a compliance
component (non-compliance with the financial responsibility rules) and,
for carrying broker-dealers, an internal control component (material
weakness in Internal Control Over Compliance). The change is consistent
with one of the objectives of the amendments: to provide clear and
consistent terminology focused separately on compliance with key
financial responsibility rules and internal control over compliance
with the financial responsibility rules. The amended notification
provisions in Rule 17a-5 reflect this change in terminology.
    The Commission proposed amending the notification process so that
the accountant would be required to notify the Commission and the
broker-dealer's DEA directly. However, the Commission is not adopting
this alternative because it agrees with the comments, discussed above,
that the notification process in place before today's amendments should
be retained.
    As stated above, Rule 17a-5 before today's amendments required the
accountant to notify the broker-dealer, and the broker-dealer to notify
the Commission, if the accountant determined during the course of the
audit or interim work that a material inadequacy existed. This
requirement generally applied to all broker-dealer audits. The
notification provisions in themselves did not direct the accountant to
perform specific procedures with respect to the audit--those
requirements were contained in other provisions of Rule 17a-5. The
notification provisions in Rule 17a-5 were intended to require
notification if, during the course of the audit, the accountant became
aware of any material inadequacies. As amended, the notification
provisions in Rule 17a-5 likewise do not in themselves require the
accountant to perform specific procedures with respect to the
examination of the financial report or an examination of a compliance
report or review of an exemption report. Instead, the notification
provisions are triggered when the accountant becomes aware, during the
course of preparing the reports of the accountant required under Rule
17a-5, that the broker-dealer is not in compliance with the financial
responsibility rules or, during the course of preparing a report based
on an examination of a compliance report, that a material weakness
exists. These notification requirements are designed to put the broker-
dealer in a position to correct controls, processes, and systems that
have caused or potentially could cause the firm to not comply with the
financial responsibility rules. As discussed throughout this release,
the financial responsibility rules serve an important investor
protection function by requiring broker-dealers to maintain prudent
levels of net capital and take steps to safeguard customer securities
and cash.
    The requirement to notify the broker-dealer when the independent
public accountant determines that the broker-dealer is not in
compliance with the financial responsibility rules or that any material
weaknesses exist is not expected to increase costs for broker-dealers
when compared to the baseline requirement to provide the broker-

dealer with notice when the independent public accountant determines
that a material inadequacy exists. As discussed above, the notice
requirements under today's amendments do not require the independent
public accountant to perform specific procedures. Instead, they are
triggered when the independent public accountant determines that any
non-compliance or material weakness exists during the course of
performing procedures to examine the financial report and to examine
the compliance report or review the exemption report, as applicable. To
the extent the obligation to provide the broker-dealer with notice is
factored into the fee charged by the accountant, the Commission notes
that before today's amendments the independent public accountant was
required to give notice of a material inadequacy. This notification
requirement has been eliminated and, therefore, to the extent it was
factored into the fee, that cost has been eliminated. The Commission
does not believe that the component of the independent public
accountants' fee associated with the new notification requirements
would be materially different than the component of the fee associated
with the material inadequacy notification requirements. Therefore, the
Commission believes these requirements would not result in increased
compliance costs relative to the requirements in place before today's
amendments.
b. Conforming and Technical Amendments to Rule 17a-11
    As discussed above in section II.F.2., prior to today's amendments,
paragraph (e) of Rule 17a-11 required that whenever a broker-dealer
discovered, or was notified by an independent public accountant,
pursuant to paragraph (h)(2) of Rule 17a-5 or paragraph (f)(2) of Rule
17a-12, of the existence of any material inadequacy, the broker-dealer
was required to give notice to the Commission and transmit a report to
the Commission stating what the broker-dealer has done or is doing to
correct the situation.
    The Commission is adopting conforming amendments to paragraph (e)
of Rule 17a-11 to substitute a notice of the existence of any material
weakness as defined in paragraph (d)(3)(iii) of Rule 17a-5 for a notice
of the existence of any material inadequacy and to replace a reference
to paragraph (h)(2) of Rule 17a-5 with a reference to paragraph (h) of
Rule 17a-5.\841\ Specifically, the final rule provides that whenever a
broker-dealer discovers, or is notified by its accountant under
paragraph (h) of Rule 17a-5 of the existence of any material weakness,
the broker-dealer must: (1) Give notice of the material weakness within
24 hours of the discovery or notification; and (2) transmit a report
within 48 hours of the notice stating what the broker-dealer has done
or is doing to correct the situation.\842\
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    \841\ The final rule retains a reference to material inadequacy
as defined in paragraph (h)(2) of Rule 17a-12, but amendments
correct citations to that rule.
    \842\ See paragraph (e) of Rule 17a-11. The rule retains
provisions referencing the term material inadequacy as defined in
Rule 17a-12.
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    The notification requirements, among other things, alert the
Commission and the DEA of the need to increase their monitoring of a
broker-dealer and to obtain additional information when appropriate in
order to address any concerns the Commission or the DEA may have as a
result of the notification. A notification of a material weakness will
alert the Commission and the broker-dealer's DEA to the existence of a
condition that could impact the broker-dealer's ability to remain in
compliance with the financial responsibility rules, which serve an
important investor protection function by requiring broker-dealers to
maintain prudent levels of net capital and take steps to safeguard
customer securities and cash. Once alerted, the Commission and the DEA
can respond to the situation through, for example, heightened
monitoring of the broker-dealer to assess whether it has corrected the
problem and whether it is properly safeguarding customer securities and
cash.
    The Commission believes these amendments will not result in
increased compliance costs to broker-dealers. Material weakness is
defined with regard to the compliance report and therefore applies only
to broker-dealers that file compliance reports (i.e., carrying broker-
dealers). In contrast, the concept of material inadequacy generally
applied to all broker-dealers and, therefore, the notification
requirement applied with respect to independent public accountant
engagements under Rule 17a-5 for non-carrying as well as carrying
broker-dealers. As discussed above in section VII.B.1. of this release,
the Commission estimates that there are approximately 4,709 broker-
dealers registered with the Commission and that of those firms,
approximately 292 are carrying broker-dealers. Consequently, before
today's amendments, the notification requirements with respect to
material inadequacy applied to approximately 4,709 broker-dealers,
whereas after today's amendments the notification requirement with
respect to material weakness will apply to approximately 292 broker-
dealers.
    The Commission proposed amending paragraph (e) of Rule 17a-11 to
delete the references to Rule 17a-5. However, the Commission is not
adopting this alternative because it agrees with a commenter that
notification should be provided to the Commission when a deficiency in
internal control is discovered by the broker-dealer. \843\
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    \843\ See Deloitte Letter.
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vi. Information Provided to Customers
    Prior to today's amendments, paragraph (c)(2)(iii) of Rule 17a-5
provided that if, in conjunction with a broker-dealer's most recent
audit report, the broker-dealer's independent public accountant
commented on any material inadequacies in the broker-dealer's internal
controls, its accounting system, or certain of its practices and
procedures\844\ under paragraphs (g) and (h) of Rule 17a-5, and
paragraph (e) of Rule 17a-11, the broker-dealer's audited statements
sent to customers were required to include a statement that a copy of
the auditor's comments were available for inspection at the
Commission's principal office in Washington, DC, and the regional
office of the Commission in which the broker-dealer had its principal
place of business.\845\
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    \844\ These practices and procedures include, for example,
periodic net capital computations under Rule 15c3-1 and periodic
counts of securities under Rule 17a-13.
    \845\ See 17 CFR 240.17a-5(c)(2)(iii).
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    The Commission is revising its proposal with respect to amending
paragraph (c)(2) of Rule 17a-5 to be consistent with the new
notification provisions in paragraph (h) described above relating to
the identification by a broker-dealer's accountant of a material
weakness rather than an instance of material non-compliance.\846\
Specifically, if, in connection with the most recent annual reports,
the report of the independent public accountant on the broker-dealer's
compliance report identifies a material weakness, the broker-dealer
must include a statement that one or more material weaknesses have been
identified and that a copy of the report of the independent public
accountant is currently available for the customer's inspection at the
principal office of the Commission in Washington, DC, and the regional
office of the Commission for the region in

which the broker-dealer has its principal place of business.\847\
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    \846\ See paragraph (c)(2)(iv) of Rule 17a-5.
    \847\ Id.
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    The Commission does not believe these amendments will result in
incremental costs to broker-dealers over the baseline. Material
weakness is defined with regard to the compliance report and therefore
applies only to broker-dealers that file compliance reports (i.e.,
carrying broker-dealers). In contrast, the concept of material
inadequacy generally applied to all broker-dealers and, therefore, the
customer notification requirement applied with respect to independent
public accountant engagements under Rule 17a-5 for non-carrying as well
as carrying broker-dealers. As discussed above in section VII.B.1. of
this release, the Commission estimates that there are approximately
4,709 broker-dealers registered with the Commission and that of those
firms, approximately 292 are carrying broker-dealers. Consequently,
before today's amendments, the notification requirements with respect
to material inadequacy applied to approximately 4,709 broker-dealers,
whereas after today's amendments the notification requirement with
respect to material weakness will apply to approximately 292 broker-
dealers.
    Rule 17a-5 also provides a conditional exemption from the
requirement to send paper copies of financial information to customers
if the broker-dealer mails a financial disclosure statement with
summary information and an Internet link to the balance sheet and other
information on the broker-dealer's Web site. Before today's amendments,
one of the conditions of the exemption was that the broker-dealer was
not required during the prior year to give notice of a material
inadequacy. The Commission proposed revising this condition for using
Web site disclosure to provide that the broker-dealer's financial
statements must receive an unqualified opinion from the accountant and
that neither the broker-dealer nor the accountant identified a material
weakness or an instance of material non-compliance.
    One commenter stated that a broker-dealer should be able to deliver
the financial information available to customers via its Web site
regardless of whether an instance of material non-compliance or
material weakness was identified.\848\ Another commenter stated that
the rule should not require a 100% rate of compliance with the
financial responsibility rules to qualify for the exemption.\849\ A
third commenter stated that the proposed amendment should be
eliminated, or replaced with the requirement that broker-dealers
include a notice of the material weakness or non-compliance on customer
account statements for a year following its identification.\850\
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    \848\ See ABA Letter.
    \849\ See CAI Letter. This commenter stated that FINRA has
proposed that broker-dealers send customer account statements
monthly instead of quarterly, broker-dealers are already potentially
facing ``extremely high'' costs of sending information to customers.
FINRA withdrew its proposals to send customer account statements
monthly instead of quarterly on July 30, 2012. See SR-FINRA-2009-
028, Proposed Rule Change to Adopt FINRA Rule 2231 (Customer Account
Statements) in the Consolidated FINRA Rulebook, Withdrawal of
Proposed Rule Change (July 30, 2012), available at http://www.finra.org/web/groups/industry/@ip/<EMAIL_ADDRESS>    \850\ See SIFMA Letter.
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    The Commission has decided not to adopt the proposed condition for
qualifying for the conditional exemption. The decision not to adopt
should result in lower costs than would have been incurred had the
Commission adopted the proposal without modification. Using the
Internet to disclose information should be less costly and more
efficient for the broker-dealer than mailing paper copies to all
customers. It also will benefit customers, since they will be able to
access relevant broker-dealer information more efficiently through the
Internet (alternatively, customers can request a paper copy by phone at
no cost to the customer).\851\
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    \851\ See 17 CFR 240.17a-5(c)(5)(ii), (iv), and (v).
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vii. Coordination With Investment Advisers Act Rule 206(4)-2
    Advisers Act Rule 206(4)-2 provides that when a registered
investment adviser or its related person maintains client funds and
securities as a qualified custodian in connection with advisory
services provided to clients, the adviser annually must obtain, or
receive from its related person, a written internal control report
prepared by an independent public accountant registered with, and
subject to regular inspection by, the PCAOB. This report must be
supported by the accountant's examination of the qualified custodian's
custody controls. Under the amendments, a broker-dealer that also acts
as a qualified custodian for itself as an investment adviser or for its
related investment advisers may use the report of the independent
public accountant based on an examination of its compliance report to
meet the reporting obligations under Rule 206(4)-2. Therefore, such a
broker-dealer will not be required to obtain an internal control report
under Rule 206(4)-2 in addition to a report covering the compliance
report from its independent public accountant. It also will result in
efficiencies as a single audit will be able to address two audit
requirements.
2. Access to Accountant and Audit Documentation
    The amendments to Rule 17a-5 require that carrying or clearing
broker-dealers agree to allow Commission and DEA staff, if requested in
writing for purposes of an examination of the broker-dealer, to review
the work papers of the independent public accountant and to allow the
accountant to discuss the its findings with the examiners.
    This requirement will enable the Commission and DEAs to more
efficiently deploy examination resources.\852\ Examiners reviewing the
accountant's work papers will be able to tailor the scope of their
examinations by identifying areas where extensive audit work was
performed by the independent public accountant and focusing their
examinations on other areas, allowing for more efficient oversight of
broker-dealers by the Commission and DEA examination staff. Enabling
Commission and DEA examination staff to conduct more focused and
efficient examinations of broker-dealers could, in turn, allow for
examination resources to be allocated more strategically.
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    \852\ As discussed previously, where an independent public
accountant has performed extensive testing of a carrying broker-
dealer's custody of securities and cash by confirming holdings at
subcustodians, examiners could focus their efforts on matters that
had not been the subject of prior testing and review.
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    The Commission is amending paragraph (f)(2) of Rule 17a-5 to revise
the statement regarding identification of a broker-dealer's independent
public accountant that broker-dealers must file each year with the
Commission and their DEA (except that if the engagement is of a
continuing nature, no further filing is required).\853\ The revised
statement contains additional information that includes a
representation that the independent public accountant has undertaken to
provide a report regarding the broker-dealer's financial reports and a
report regarding the broker-dealer's compliance or exemption report, as
applicable.\854\ In addition, the statement provided by a clearing or
carrying broker-dealer must include representations regarding the
access to accountant requirements described above.\855\ Therefore, all
broker-dealers will generally be required to file a new

statement regarding their independent public accountant.
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    \853\ See discussion above in section III. of this release.
    \854\ See 17 CFR 240. 17a-5(f)(2)(ii).
    \855\ See 17 CFR 17a-5(f)(2)(ii)(F)-(G).
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    As discussed above in section III. of this release, one commenter
stated that, the amendments would discourage or ``chill''
communications between a broker-dealer and its auditor because of the
possibility that an auditor may misconstrue communications from
representatives of the broker-dealer and wrongly conclude that the
representatives lack knowledge or admit to an issue.\856\ Presumably,
this ``chilling effect'' would result from a broker-dealer's desire to
avoid the creation of audit documentation memorializing
misunderstandings and miscommunications, which when accessed by
Commission and DEA examiners could result in regulatory scrutiny. As
stated in section III. of this release, the Commission is not persuaded
by this comment; while it is possible for miscommunications to occur
between representatives of a broker-dealer and its auditor, potential