

[Federal Register: March 19, 2007 (Volume 72, Number 52)]
[Proposed Rules]               
[Page 12861-12899]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr19mr07-19]                         


[[Page 12861]]

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Part II





Securities and Exchange Commission





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17 CFR Part 240



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


[[Page 12862]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

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

 
Amendments to Financial Responsibility Rules for Broker-Dealers

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

ACTION: Proposed rule.

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

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

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

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number S7-08-07 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.


Paper Comments

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

    All submissions should refer to File Number S7-08-07. This file 
number should be included on the subject line if e-mail is used. To 
help us process and review your comments more efficiently, please use 
only one method. The Commission will post all comments on the 
Commission's Internet Web site (http://www.sec.gov/rules/proposed). 

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

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate 
Director, at (202) 551-5525; Thomas K. McGowan, Assistant Director, at 
(202) 551-5521; Randall Roy, Branch Chief, at (202) 551-5522; or Bonnie 
Gauch, Attorney, (202) 551-5524; Division of Market Regulation, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-6628.

SUPPLEMENTARY INFORMATION: 

I. Background

    We are proposing for comment amendments to the broker-dealer net 
capital rule (Rule 15c3-1),\1\ customer protection rule (Rule 15c3-
3),\2\ books and records rules (Rules 17a-3 and 17a-4),\3\ and 
notification rule (Rule 17a-11).\4\
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    \1\ 17 CFR 240.15c3-1.
    \2\ 17 CFR 240.15c3-3.
    \3\ 17 CFR 240.17a-3 and 17 CFR 240.17a-4.
    \4\ 17 CFR 240.17a-11.
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II. Proposed Amendments

A. Amendments to the Customer Protection Rule

    The Commission adopted the customer protection rule (Rule 15c3-3) 
in 1972 in response to a congressional directive to strengthen the 
financial responsibility requirements for broker-dealers that carry 
customer assets.\5\ The rule requires a broker-dealer to take certain 
steps to protect the credit balances and securities it holds for 
customers. Under the rule, a broker-dealer must, in essence, segregate 
customer funds and fully paid and excess margin securities held by the 
firm for the accounts of customers.\6\ The intent of the rule is to 
require a broker-dealer to hold customer assets in a manner that 
enables their prompt return in the event of an insolvency, which, in 
turn, increases the ability of the firm to wind down in an orderly 
self-liquidation and, thereby avoid the need for a proceeding under the 
Securities Investor Protection Act of 1970 (``SIPA'').\7\
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    \5\ See Exchange Act Release No. 9856 (November 10, 1972), 1972 
SEC LEXIS 189.
    \6\ Subparagraph (a)(3) of Rule 15c3-3 defines ``fully paid 
securities'' as securities carried in any type of account for which 
the customer has made a full payment. Subparagraph (a)(5) defines 
``excess margin securities'' as securities having a market value in 
excess of 140% of the amount the customer owes the broker-dealer and 
which the broker-dealer has designated as not constituting margin 
securities.
    \7\ 15 U.S.C. 78aaa et seq.
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    The required amount of customer funds to be segregated is 
calculated pursuant to a formula set forth in Exhibit A to Rule 15c3-
3.\8\ Under the formula, the broker-dealer adds up various credit and 
debit line items. The credit items include cash balances in customer 
accounts and funds obtained through the use of customer securities. The 
debit items include money owed by customers (e.g., from margin 
lending), securities borrowed by the broker-dealer to effectuate 
customer short sales, and required margin posted to certain clearing 
agencies as a consequence of customer securities transactions. If, 
under the formula, customer credit items exceed customer debit items, 
the broker-dealer must maintain cash or qualified securities in that 
net amount in a ``Special Reserve Bank Account for the Exclusive 
Benefit of Customers.'' This account must be segregated from any other 
bank account of the broker-dealer. Generally, a broker-dealer with a 
deposit requirement of $1 million or more computes its reserve 
requirement on a weekly basis as of the close of the last business day 
of the week (usually Friday).\9\ The weekly calculation determines the 
required minimum balance the broker-dealer must maintain in the reserve 
account.
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    \8\ 17 CFR 240.15c3-3a.
    \9\ 17 CFR 240.15c3-3(e)(3).
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    As noted, Rule 15c3-3 also requires a broker-dealer to maintain 
physical possession or control of all fully paid and excess margin 
securities carried for customers.\10\ This means the broker-dealer 
cannot lend or hypothecate these securities and must hold them itself 
or, as is more common, in a satisfactory control location. Under the 
rule, satisfactory control locations include regulated securities 
clearing agencies, U.S. banks, and, with the approval of the 
Commission, certain foreign financial institutions.\11\ In order to 
meet the possession or control requirement, a broker-dealer must 
determine on a daily basis the amount of customer fully paid and excess 
margin securities (by issuer and class) it holds for customers.\12\ It 
then compares that amount with the amount of securities it holds free 
of lien in its own possession or at one of the satisfactory control 
locations. If a shortfall exists, the firm must take certain actions 
under the rule.\13\ The actions include: removing liens on securities 
collateralizing a bank loan; recalling securities loaned to a bank or 
clearing corporation; buying-in securities that have been failed to 
receive over thirty days; or buying-in securities receivable as a 
result of dividends, stock splits or similar

[[Page 12863]]

distributions that are outstanding over forty-five days.\14 \
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    \10\ 17 CFR 240.15c3-3(b)(1).
    \11\ 17 CFR 240.15c3-3(c).
    \12\ 17 CFR 240.15c3-3(d).
    \13\ Id.
    \14\ Id.
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1. Proprietary Accounts of Broker-Dealers
    We are proposing an amendment to Rule 15c3-3 that would require 
broker-dealers to treat accounts they carry for domestic and foreign 
broker-dealers in the same manner generally as ``customer'' accounts 
for the purposes of the reserve formula of Rule 15c3-3.\15\ The 
amendment is intended to address an inconsistency between the way these 
proprietary accounts of broker-dealers are protected under Rule 15c3-3 
and the SIPA.
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    \15\ See 17 CFR 240.15c3-3(a)(1). This paragraph defines 
``customer'' for the purposes of Rule 15c3-3. Broker-dealers, both 
domestic and foreign, are excluded from the definition and, 
consequently, are not treated as ``customers'' for the purposes of 
the rule's reserve and possession and control requirements. Some 
foreign broker-dealers also operate as banks. These firms are not 
deemed ``customers'' to the extent that their accounts at the U.S. 
broker-dealer involve proprietary broker-dealer activities.
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    Specifically, because broker-dealers are not ``customers'' for 
purposes of Rule 15c3-3, a broker-dealer that carries the proprietary 
accounts of other broker-dealers is not required to include credit and 
debit items associated with those accounts in the customer reserve 
formula. Conversely, under SIPA, broker-dealers are considered 
``customers'' and, consequently, entitled to certain protections. When 
a broker-dealer is liquidated under SIPA, an estate of customer 
property is created.\16\ Customers of the failed broker-dealer, 
including customers that are broker-dealers, are entitled to a pro rata 
share of the estate of customer property. Thus, while broker-dealers 
need not reserve for accounts carried for other broker-dealers under 
Rule 15c3-3, in a SIPA liquidation, broker-dealer accountholders may 
share in the fund of customer property. This disparity increases the 
risk that, in the event a clearing broker is liquidated under SIPA, 
customer claims will exceed the amount of customer property.
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    \16\ In particular, under SIPA, the pool of ``customer 
property'' is established using assets recovered from the failed 
broker-dealer. The statute determines the assets that become a part 
of the pool of customer property. 15 U.S.C. 78lll(4). Customer 
property includes ``cash and securities * * * at any time received, 
acquired, or held by or for the account of the debtor from or for 
the securities accounts of a customer, and the proceeds of any such 
property transferred by the debtor, including property unlawfully 
converted.'' Therefore, ``customer property'' includes those 
securities positions that are held for customers and the cash that 
is owed to customers. After being established, customer property is 
distributed to customers pro rata based on the amounts of their 
claims (i.e., their net equity). While broker-dealers are not 
entitled to advances from the SIPC fund to make up for shortfalls in 
the fund of customer property (see 15 U.S.C 78fff-3(a)(5)), they may 
be ``customers'' as that term is defined in SIPA and, therefore, 
entitled to a pro rata distribution from the fund of customer 
property.
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    In order to correct the gap between Rule 15c3-3 and SIPA, we are 
proposing amendments to Rules 15c3-1, 15c3-3 and 15c3-3a that would 
require carrying broker-dealers to perform a separate reserve 
computation for proprietary accounts of other domestic and foreign 
broker-dealers in addition to the reserve computation currently 
required for ``customer'' accounts, and establish and fund a separate 
reserve account for the benefit of these domestic and foreign broker-
dealers.\17\ This added protection also would mitigate potential 
contagion that might arise in the event of a failure of a broker-dealer 
with a large number of broker-dealer customers.
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    \17\ The amendment would exclude from the broker-dealer reserve 
computation accounts established by a broker-dealer that fully 
guarantees the obligations of, or whose accounts are fully 
guaranteed by, the clearing broker. In these circumstances, the 
guarantor must take deductions under Rule 15c3-1 for guaranteed 
obligations of the other firm. In addition, the amendment would 
exclude delivery-versus-payment and receipt-versus-payment accounts. 
These types of accounts pose little risk of reducing the estate of 
customer property in a SIPA liquidation since they only hold assets 
for short periods of time.
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    The proposed amendments, in many respects, would codify a no-action 
letter regarding proprietary accounts of introducing brokers (``PAIB 
Letter'') previously issued by Commission staff.\18\ One significant 
difference is that the amendments would have a broader scope by 
including proprietary accounts of foreign brokers-dealers and banks 
acting as broker-dealers. In the PAIB Letter, the staff stated it would 
not recommend any action to the Commission if an introducing broker-
dealer did not take a net capital deduction under Rule 15c3-1 for cash 
held in a securities account at another broker-dealer, provided the 
other broker-dealer agreed to (1) perform a reserve computation for 
broker-dealer accounts, (2) establish a separate special reserve bank 
account, and (3) maintain cash or qualified securities in the reserve 
account equal to the computed reserve requirement (``PAIB 
agreement'').\19\ The PAIB Letter, however, did not completely address 
the disparity between Rule 15c3-3 and SIPA, because the procedures set 
forth in the letter are voluntary and foreign broker-dealers are not 
subject to Rule 15c3-1 and, consequently, have no incentive to enter 
into PAIB agreements. Therefore, carrying firms do not include the 
accounts of foreign broker-dealers in either the Rule 15c3-3 or PAIB 
computations. However, these entities may be customers for the purposes 
of SIPA.
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    \18\ See Letter from Michael A. Macchiaroli, Associate Director, 
Division of Market Regulation, Commission, to Raymond J. Hennessy, 
Vice President, NYSE, and Thomas Cassella, Vice President, NASD 
Regulation, Inc. (Nov. 10, 1998).
    \19\ Under Rule 15c3-1, broker-dealers generally are required to 
deduct unsecured receivables from their net worth when computing 
their net capital. Paragraph (c) of the rule contains certain 
exceptions to this requirement. Among the enumerated exceptions are 
commissions receivable from another broker-dealer outstanding 30 
days or less. This exception is limited to receivables from a 
clearing broker-dealer related to transactions in accounts 
introduced by the broker-dealer. Frequently, introducing broker-
dealers as well as other broker-dealers will have receivables from 
another broker-dealer arising from proprietary transactions in an 
account at the other broker-dealer. There is no exception in Rule 
15c3-1 permitting these receivables to be included in a broker-
dealer's net capital amount. However, under the terms of the PAIB 
Letter, a broker-dealer could include them.
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    The proposed amendments--like the PAIB Letter--would establish 
reserve requirements for a carrying broker with respect to proprietary 
accounts it carries for other broker-dealers. Paragraph (e) of Rule 
15c3-3 would be amended to require the carrying broker to perform a 
reserve computation for a proprietary account of another broker-dealer 
(referred to as a ``PAB account'') and to establish and maintain a 
reserve account at a bank for these PAB accounts.\20\ A new paragraph 
(a)(16) would be added to define ``PAB account,'' paragraph (f) would 
be amended to require the carrying broker-dealer to notify the bank 
about the status of the PAB reserve account and obtain an agreement and 
notification from the bank that the PAB reserve account will be 
maintained for the benefit of the PAB accountholders. In addition, 
paragraph (g) would be amended to specify when the carrying broker-
dealer could make withdrawals from a PAB reserve account. The carrying 
broker would have to maintain cash or qualified securities in the PAB 
reserve account in an amount equal to the PAB reserve requirement. 
Consistent with the no-action relief provided in the PAIB Letter, if 
the PAB reserve computation results in a deposit

[[Page 12864]]

requirement, the proposed amendment would allow the requirement to be 
offset to the extent there are excess debits in the customer reserve 
computation of the same date. However, in order to provide greater 
protection to customers that are not broker-dealers, a deposit 
requirement resulting from the customer reserve computation would not 
be able to be offset by excess debits in the PAB reserve computation. 
This means the carrying broker-dealer could use PAB credits to finance 
``customer'' debits, but not the other way around. Thus, ``customers'' 
(which include retail investors but exclude broker-dealers) would 
receive greater protection.
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    \20\ Under paragraph (e), broker-dealers are required to perform 
the customer reserve computation as of the close of business on the 
last business day of the week or, in some cases, the month. Broker-
dealers from time to time may perform a mid-week computation if it 
would permit them to make a withdrawal. Under the proposed 
amendments, a broker-dealer would need to compute both the customer 
and PAB reserve requirements simultaneously before making a 
withdrawal from either account based on a mid-week computation. 
Moreover, a withdrawal could not be made from one account if the 
mid-week computation demonstrated an increased requirement in the 
other account.
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    Paragraph (b) of Rule 15c3-3 would be amended to provide that a 
broker-dealer carrying PAB accounts would not be required to maintain 
physical possession or control of fully paid and excess margin 
securities carried for PAB accounts, provided it obtains the written 
permission of the PAB accountholder to use such securities in the 
ordinary course of its securities business. This provision would be 
consistent with Rule 15c3-3, which is intended to provide greater 
protection to customers that are not broker-dealers customers. It also 
would accommodate industry practice of carrying broker-dealers using 
the securities of their broker-dealer accountholders, which contributes 
to the liquidity of the securities markets.
    Finally, paragraph (c)(2)(iv)(E) of Rule 15c3-1 would be amended to 
require a broker-dealer to deduct from net worth when calculating net 
capital the amount of its cash in a proprietary account at another 
broker-dealer where the other broker-dealer is not treating the cash in 
compliance with the proposed requirements described above. This would 
prevent broker-dealers from including assets in their net capital 
amounts that may not be readily available. We would not expect broker-
dealers to audit or examine their carrying broker-dealers to determine 
whether the carrying broker-dealer is in compliance with the proposed 
rules.
    We request comment on all aspects of these proposed amendments, 
including whether the accounts of other non-customers under Rule 15c3-3 
(e.g., principal officers of the broker-dealer) should be included in 
the PAB computation.
2. Banks Where Special Reserve Deposits May Be Held
    Broker-dealers must deposit cash or ``qualified securities'' into 
the customer reserve account maintained at a ``bank'' under Rule 15c3-
3(e).\21\ Rule 15c3-3(f) further requires the broker-dealer to obtain a 
written contract from the bank in which the bank agrees not to re-lend 
or hypothecate securities deposited into the reserve account.\22\ 
Consequently, the securities should be readily available to the broker-
dealer. Cash deposits, however, are fungible with other deposits 
carried by the bank and may be freely used in the course of the bank's 
commercial lending activities. Therefore, to the extent a broker-dealer 
deposits cash in a reserve bank account, there is a risk the cash could 
be lost or inaccessible for a period if the bank experiences financial 
difficulties. This could adversely impact the broker-dealer and its 
customers if the balance of the reserve deposit is concentrated at one 
bank in the form of cash.
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    \21\ The term ``qualified securities'' is defined in paragraph 
(a)(6) of Rule 15c3-3 to mean a securities issued by the United 
States or guaranteed by the United States with respect to principal 
and interest. 17 CFR 240.15c3-3(a)(6). The term ``bank'' is defined 
in paragraph (a)(7) of Rule 15c3-3.
    \22\ See 17 CFR 240.15c3-3(f).
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    This risk may be heightened when the deposit is held at an 
affiliated bank in that the broker-dealer may not exercise due 
diligence with the same degree of impartiality when assessing the 
financial soundness of an affiliate bank as it would with a non-
affiliate bank. Moreover, the broker-dealer's customers may not derive 
any significant protection from the reserve requirement in the event of 
the parent's insolvency.
    To address these risks, we are proposing an amendment to Rule 15c3-
3 that would exclude cash deposits at affiliate banks for the purposes 
of meeting customer or PAB reserve requirements and place limitations 
on the amount of cash a broker-dealer could maintain in a customer or 
PAB special reserve bank account at one unaffiliated bank. The 
exclusion and limitations would not apply to deposits of securities 
since these assets do not become a part of a bank's working capital. As 
discussed below, the limitations would prevent a broker-dealer from 
maintaining a reserve deposit in the form of cash at a single 
unaffiliated bank that exceeds a percentage of the broker-dealer's or 
the bank's capital. This is designed to mitigate the risk that an 
impairment of the reserve deposit at an unaffiliated single bank will 
have a material negative impact on the broker-dealer's ability to meet 
its obligations to customers and PAB accountholders.\23\
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    \23\ These amendments are not intended to affect the practice 
whereby customer free credit balances are swept into a bank deposit 
account and the customer receives Federal Deposit Insurance 
Protection.
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    Under the proposal, a paragraph (e)(5) would be added to Rule 15c3-
3. This new paragraph would provide that--in determining whether the 
broker-dealer maintains the minimum reserve deposits required (customer 
and PAB)--the broker-dealer would be required to exclude a cash deposit 
at an affiliated bank. With respect to unaffiliated banks, the broker-
dealer would be required to exclude the deposit to the extent that it 
exceeded (1) 50% of the broker-dealer's excess net capital (based on 
the most recently filed FOCUS Report),\24\ or (2) 10% of the bank's 
equity capital (based on the bank's most recently filed Call Report or 
Thrift Financial Report).\25\ The goal is to limit cash reserve account 
deposits to reasonably safe amounts as measured against the 
capitalization of the broker-dealer and the bank. Excess net capital is 
the amount that a broker-dealer's net capital exceeds its minimum 
requirement and, therefore, constitutes a cushion to absorb unexpected 
losses. We believe limiting a cash deposit in one bank to 50% of excess 
net capital means the broker-dealer has a reserve to absorb the loss or 
impairment of the deposit plus an additional amount to absorb other 
losses. The amount of a bank's equity capital is a measure of its 
financial solvency. We believe limiting the cash deposit to 10% of the 
bank's equity capital means the broker-dealer would not commit customer 
cash to an institution in an amount that is out of proportion to the 
bank's capital base.
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    \24\ Under Rule 17a-5 (17 CFR 240.17a-5) broker-dealers must 
file periodic reports on Form X-17a-5 (Financial and Operational 
Combined Uniform Single Reports (``FOCUS Reports'')). The FOCUS 
Report form requires, among other financial information, a balance 
sheet, income statement, and net capital and customer reserve 
computations.
    \25\ Commercial banks insured by the Federal Deposit Insurance 
Corporation (``FDIC''), savings banks supervised by the FDIC, and 
non-insurance trust companies supervised by the Office of the 
Comptroller of the Currency file quarterly Call Reports. Savings 
Associations and non-insured trust companies supervised by the 
Office of Thrift Supervision file Thrift Financial Reports (TFRs). 
These reports include a line item for equity capital. A report for a 
specific institution can be obtained by accessing the following Web 
site: http://www2.fdic.gov/call_tfr_rpts/search.asp.

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

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3. Expansion of the Definition of Qualified Securities To Include 
Certain Money Market Funds
    As noted above, a broker-dealer is limited to depositing cash or 
``qualified securities'' into the bank account it maintains to meet the 
customer reserve deposit requirements under Rule 15c3-3. Paragraph 
(a)(6) of Rule 15c3-3 defines ``qualified securities'' as securities 
issued by the United States or guaranteed by the United States with 
respect to principal and interest (``US Treasury securities'').\26\ 
These strict limitations on the types of assets that can be used to 
fund a broker-dealer's customer reserve account are designed to further 
the purpose of Rule 15c3-3; namely, that customer assets be segregated 
and held in a manner that makes them readily available to be returned 
to the customer. For example, paragraph (e)(2) of Rule 15c3-3 makes it 
unlawful for a broker-dealer to use customer credits (generally, cash 
balances in securities accounts) for any purpose other than financing 
customer debits (fully secured margin loans).\27\ Under the rule, the 
amount of excess credits (i.e., credits net of debits) must be held in 
the customer reserve account and, as noted, the account must be funded 
with either cash or U.S. Treasury securities.\28\
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    \26\ 17 CFR 240.15c3-3(a)(6).
    \27\ 17 CFR 240.15c3-3(e)(2).
    \28\ Id.
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    Federated Investors, Inc. (``Federated'') has filed a petition with 
the Commission requesting that Rule 15c3-3 be amended to include 
certain types of money market funds in the definition of qualified 
securities.\29\ We believe expanding the definition to include money 
market funds that only invest in securities meeting the definition of 
``qualified security'' in Rule 15c3-3 would be appropriate. The assets 
held by such a money market fund would be same as those a broker-dealer 
can hold directly in its customer reserve account. Consequently, a 
broker-dealer might choose to deposit qualifying money market fund 
shares into the customer reserve account based on operational 
considerations such as avoiding the need to actively manage a portfolio 
of U.S. Treasury securities. This operational benefit also could 
decrease burdens on those broker-dealers that would be impacted by our 
proposed amendments discussed above with respect to customer reserve 
account cash deposits into affiliate and non-affiliate banks. A broker-
dealer that deposits cash into the customer reserve account to avoid 
the operational aspects of holding and managing U.S. Treasury 
securities would have the option of depositing a qualifying money 
market fund to replace the cash deposit.
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    \29\ See Public Petition for Rulemaking No. 4-478 (April 3, 
2003), as amended (April 4, 2005), available at http://www.sec.gov/rules/petitions/petn4-478.htm
.

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

[[Page 12866]]

securities.\30\ Specifically, under the proposal, the broker-dealer 
would be required to take prompt steps to obtain physical possession or 
control over securities of the same issue and class as those included 
on the broker-dealer's books as a proprietary short position or as a 
short position for another person. By requiring the broker-dealer to 
obtain physical possession or control over the security, it would no 
longer be able to monetize the value of the security and use the cash 
for proprietary activities.
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    \30\ Current paragraph (d)(4) of Rule 15c3-3 would be re-
designated as paragraph (d)(5).
---------------------------------------------------------------------------

    Under the proposal, the action would not be required until the 
short position had aged more than 10 business days (or more than 30 
calendar days if the broker or dealer is a market maker in the 
securities).\31\ Allowing broker-dealers 10 business days before they 
must take action is consistent with paragraph (m) of Rule 15c3-3, which 
similarly allows a broker-dealer up to 10 business days after 
settlement date to purchase securities that a customer has sold through 
the broker-dealer but failed to deliver. As with the requirement in 
paragraph (m), the proposal's objective is to require a broker-dealer 
to close an open transaction but within a timeframe that permits a 
degree of flexibility. The longer 30 calendar day period for securities 
in which the broker-dealer makes a market is intended to accommodate 
the short-selling that is integral to market-making activities.
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    \31\ The proposed amendment would not apply to securities that 
are sold for a customer but not obtained from the customer within 10 
days after the settlement date. This circumstance is addressed by 
paragraph (m) of Rule 15c3-3, which requires the broker-dealer to 
close the transaction by purchasing securities of like kind and 
quantity. 17 CFR 240.15c3-3(m).
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    We request comment on all aspects of this proposed amendment, 
including whether the proposed time periods should be longer or 
shorter.
5. Treatment of Free Credit Balances and Importation of Rule 15c3-2 
Requirements Into Rule 15c3-3
i. Treatment of Free Credit Balances
    Free credit balances are funds payable by a broker-dealer to its 
customers on demand.\32\ They may result from cash deposited by the 
customer to purchase securities, proceeds from the sale of securities 
or other assets held in the customer's account, or earnings from 
dividends and interest on securities and other assets held in the 
customer's account. Broker-dealers may, among other things, pay 
interest to customers on their free credit balances, or offer to 
transfer (sweep) them into a specific money market fund or interest 
bearing bank account. The customer earns dividends on the money market 
fund or interest on the bank account until such time as the customer 
chooses to liquidate the position in order to use the cash, for 
example, to purchase securities.
---------------------------------------------------------------------------

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

    In recent years, broker-dealers have on occasion changed the 
product to which a customer's free credit balances are swept--most 
frequently from a money market fund product to an interest bearing bank 
account. There are differences in these two types of products, 
including the type of protection afforded the customer in the event of 
an insolvency. The money market shares--as securities--would receive up 
to $500,000 in SIPA protection in the event the broker-dealer failed. 
The bank deposits--as cash--would receive $100,000 in protection from 
the Federal Deposit Insurance Corporation (``FDIC'') in the event the 
bank failed. On the other hand, the money market fund as a security 
theoretically could lose its principal; whereas the bank deposit would 
be guaranteed up to the FDIC's $100,000 limit. There also may be 
differences in the amount of interest earned from the two products. In 
short, while not judging the appropriateness of either option, we note 
there may be consequences to changing options and believe that 
customers should have a sufficient opportunity to make an informed 
decision.\33\
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    \33\ In 2005, The New York Stock Exchange LLC (``NYSE'') 
addressed the issue of disclosure. Specifically, the NYSE issued an 
information memo to its members discussing, among other things, the 
disclosure responsibilities of a broker-dealer offering a bank sweep 
program to its customers. See Information Memo 05-11 (February 15, 
2005). The Memo stated that broker-dealers should disclose material 
differences in interest rates between the different products and, 
with respect to the bank sweep program, the terms and conditions, 
risks and features, conflicts of interest, current interest rates, 
the manner by which future interest rates will be determined, and 
the nature and extent of FDIC and SIPC protection. See id.
---------------------------------------------------------------------------

    For these reasons, we are proposing to amend Rule 15c3-3 by adding 
a new paragraph (j) that would make it unlawful for a broker-dealer to 
convert, invest or otherwise transfer free credit balances except under 
three circumstances. The first circumstance, set forth in proposed 
paragraph (j)(2)(i) of Rule 15c3-3, would permit a broker-dealer to 
convert, invest, or otherwise transfer the free credit balances to any 
type of investment or other product, or to a different account within 
the broker-dealer or at another institution, or otherwise dispose of 
the free credit balances, but only upon a specific order, 
authorization, or draft from the customer, and only under the terms and 
conditions specified by the customer in the order, authorization or 
draft. This proposal is not addressing free credit balance sweeps to 
money market funds and bank deposit accounts, but rather the use of 
customer free credit balances for other purposes (e.g., to purchase 
securities other than money market funds, or to transfer to a different 
account or financial institution). In these circumstances, the proposed 
paragraph would prohibit any investment, conversion, or other transfer 
of the free credit balances except on the customer's specific order, 
authorization, or draft.
    The second and third circumstances, set forth in proposed 
paragraphs (j)(2)(ii) and (iii) of Rule 15c3-3, address the sweeping of 
free credit balances to either a money market fund or a bank deposit 
account. The former applies to new customers and the latter to existing 
customers as of the date the proposed amendments would become 
effective.
    Proposed paragraph (j)(2)(ii) of Rule 15c3-3 would permit a broker-
dealer to have the ability to change the sweep option of a new customer 
from a money market fund to a bank deposit account (and vice versa), 
provided certain specific conditions are met. First, the customer would 
need to agree prior to the change (e.g., in the account opening 
agreement) that the broker-dealer could switch the sweep option between 
those two types of products. Second, the broker-dealer would need to 
provide the customer with all notices and disclosures regarding the 
investment and deposit of free credit balances required by the self-
regulatory organizations for which the broker-dealer is a member.\34\ 
Third, the broker-dealer would need to provide the customer with notice 
in the customer's quarterly statement that the money market fund or 
bank deposit account can be liquidated on the customer's demand and 
converted back into free credit balances held in the customer's 
securities account. Fourth, the broker-dealer would need to provide the 
customer with notice at least 30 calendar days before changing the 
product (e.g., from one money market fund to another), the product type 
(e.g., from a money market fund to a bank account), or the terms and 
conditions under which the free credit balances are swept. The notice 
would need to describe the change and explain how the customer could 
opt out of it.
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    \34\ See NYSE Information Memo 05-11 (February 15, 2005).
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    The third circumstance, set forth in proposed paragraph (j)(2)(iii) 
of Rule

[[Page 12867]]

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

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

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

    \36\ Rule 15c3-2 contains an exemption for broker-dealers that 
also are banking institutions supervised by a Federal authority. 
This exemption would not be imported into Rule 15c3-3 because there 
are no broker-dealers left that fit within the exemption. Further, 
under the proposed amendment, the definition of ``customer'' for 
purposes of the imported 15c3-2 requirements would be the definition 
of ``customer'' in Rule 15c3-3, which is somewhat narrower than the 
definition in Rule 15c3-2.
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    We request comment on all aspects of this proposed amendment. 
Commenters are encouraged to provide data to support their views.
6. Aggregate Debit Items Charge
    Note E(3) to the customer reserve formula (Rule 15c3-3a) requires a 
broker-dealer using the ``basic method'' of computing net capital under 
Rule 15c3-1 to reduce by 1% the total debits in Item 10 of the formula 
(i.e., debit balances in customer's cash and margin accounts).\37\ This 
1% reduction in Item 10 debits lowers the amount of total debit items 
in the formula. Because the debits offset aggregate credits in 
determining customer reserve requirements, the reduction has the 
potential to increase the amount a broker-dealer must maintain in the 
reserve account. Under paragraph (a)(1)(ii)(A) of Rule 15c3-1 however, 
broker-dealers using the ``alternative standard'' \38\ to compute their 
minimum net capital requirement must reduce aggregate debit items by 3% 
in lieu of the 1% reduction required by Note E(3).\39\ Thus, the 
deduction applicable to alternative standard firms can result in an 
even larger reserve deposit requirement.
---------------------------------------------------------------------------

    \37\ Under the ``basic method,'' a broker-dealer cannot permit 
its aggregate indebtedness (generally total money liabilities) to 
exceed 1500% of its net capital. 17 CFR 15c3-1(a)(1)(i).
    \38\ Under the ``alternative standard,'' a broker-dealer's 
minimum net capital requirement is equal to 2% of the firm's 
aggregate debit items. 17 CFR 240.15c3-1(a)(1)(ii).
    \39\ 17 CFR 240.15c3-1(a)(1)(ii)(A).
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    The Commission adopted the alternative standard as part of the 1975 
amendments to Rule 15c3-1, which expanded the rule's scope to apply to 
all broker-dealers.\40\ The alternative standard constituted a new way 
of providing for the capital adequacy of a broker-dealer in that it 
diverged from the traditional notion of limiting a firm's leverage.\41\ 
The alternative standard instead imposes a capital requirement based on 
the size of the broker-dealer's commitments to its customers through 
margin lending and other transactions. Thus, it requires a broker-
dealer to hold net capital equal to a percentage of its customer 
commitments. The alternative standard was designed to integrate a 
broker-dealer's capital requirement under Rule 15c3-1 with the customer 
protection requirements in Rule 15c3-3; hence it uses the aggregate 
debit computation required by Rule 15c3-3 to determine a broker-
dealer's net capital requirement under Rule 15c3-1.\42\
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    \40\ See Exchange Act Release No. 11497 (June 26, 1975). Prior 
to 1975, the rule only applied to broker-dealers that were not a 
member of a securities exchange, since exchange members were subject 
to capital rules promulgated by the exchanges. Id.
    \41\ See id.
    \42\ Id.
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    As part of the amendments adopting the alternative standard, the 
Commission lowered the haircut on equity securities from 30% to 15% for 
a broker-dealer using the standard.\43\ At the same time, it amended 
Rule 15c3-1 to require alternative standard firms to employ the greater 
3% reduction of debit items.\44\ The Commission explained the greater 
requirement as providing, ``in the event of a liquidation [of the 
broker-dealer], an additional cushion of secured debit items which will 
be available to satisfy customers with whom the broker or dealer 
effects transactions.'' \45\
---------------------------------------------------------------------------

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

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

[[Page 12868]]

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

    \46\ Id.
    \47\ Exchange Act Release 18417 (January 13, 1982), 47 FR 3512 
(January 25, 1982).
    \48\ Id.
    \49\ Id.
    \50\ Id.
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    In recent years, the amount of debit items carried by broker-
dealers has increased substantially. Consequently, the 3% reduction in 
debit items has required many broker-dealers using the alternative 
standard to increase their reserve deposits by additional amounts that 
are far in excess of the additional cushion envisioned when the 
amendment was adopted in 1975. Furthermore, the level of risk assumed 
by broker-dealers does not increase proportionately as the aggregate 
amount of debits increases; due, in part, to an increase in diversity 
among the debits. The proportional 3% reduction of debit items does not 
recognize this diversification benefit.
    Moreover, in 1992, the Commission amended Rule 15c3-1 to lower the 
haircut for broker-dealers using the basic method to 15%, which brought 
their requirement in line with the alternative standard firms.\51\ The 
15% haircut for equity securities has proven sufficient to cover most 
market moves and, therefore, we believe the increased level of 
protection derived from the greater 3% debit item reduction likely 
would not provide a benefit justified by the costs.
---------------------------------------------------------------------------

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

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

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

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

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

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

B. Holding Futures Positions in a Securities Portfolio Margin Account

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

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

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

[[Page 12869]]

in a portfolio margin account would need to be included with all other 
credit items when a broker-dealer computed its customer reserve 
requirement under Rule 15c3-3. Further, because free credit balances 
constitute ``cash'' in a customer's account, they are ``cash'' for 
purposes of determining a customer's ``net equity'' in a SIPA 
liquidation.\57\
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    \57\ If a person qualifies as a ``customer'' under SIPA, the 
next inquiry is to value the amount of the customer's claim. This 
step is accomplished by reference to the definition of ``net 
equity'' in SIPA. 15 U.S.C 78lll(11). Generally, ``net equity'' is 
the ``dollar amount of the [customer's] account'' as determined by 
calculating the sum that would have been owed the customer had the 
securities in the customer's account been liquidated on the date the 
SIPA proceeding was commenced minus any amounts owed by the customer 
to the broker-dealer.
---------------------------------------------------------------------------

    Our proposed amendment to the definition of ``free credit 
balances'' also would bring within the definition's scope the market 
value of futures options in a portfolio margin account as of the SIPA 
``filing date.'' \58\ Unlike futures contracts, futures options do not 
take the form of cash balances in the account (i.e., they have market 
value at the end of a trading day). Since the broker-dealer is not 
holding cash for the customer there is not the need to treat the 
futures options as a ``free credit balance'' and require a credit in 
the reserve formula. However, if the broker-dealer is liquidated under 
SIPA, the unrealized gains or losses of the futures options should be 
included in calculating the customer's net equity in the account (along 
with the cash balances related to the futures contracts and the 
securities positions and related cash balances). The proposed amendment 
is designed to provide for this outcome by defining the market value of 
the futures options as a free credit balance in the event the broker-
dealer becomes subject to a SIPA proceeding. As ``free credit 
balances,'' funds resulting from margin deposits and daily marks to 
market related to futures and the market value of futures options as of 
the SIPA filing date would constitute claims for cash in a SIPA 
proceeding and, therefore, become a part of a customer's ``net equity'' 
claim and be entitled to up to $100,000 in advances to make up for 
shortfalls.\59\
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    \58\ The term ``filing date'' is defined in SIPA as, generally, 
being the date a SIPA proceeding is commenced. See 15 U.S.C. 
78lll(7).
    \59\ Generally, futures and futures options in a portfolio 
margin account would be transferred to a solvent broker-dealer or 
liquidated before the initiation of a SIPA proceeding. Consequently, 
these proposals are highly cautionary as it is unlikely that a 
broker-dealer would be placed in a SIPA liquidation while still 
holding these types of positions in customer accounts.
---------------------------------------------------------------------------

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

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

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

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

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

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

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

[[Page 12870]]

Commission, in two civil complaints,\63\ alleged that MJK engaged in 
conduit securities lending transactions involving shares of a company 
called GenesisIntermedia, Inc. According to the complaints, MJK 
borrowed shares of GenesisIntermedia from one broker-dealer, providing 
cash collateral equal to the market value of the borrowed shares. MJK 
then re-lent the GenesisIntermedia shares to other broker-dealers that 
provided cash collateral in return. As indicated in the complaints, 
after the transactions, the market value of the GenesisIntermedia 
shares declined dramatically. The complaints also describe how MJK 
returned cash collateral to the borrowing broker-dealers as the shares 
declined in value but did not collect excess cash collateral provided 
to the broker-dealer that lent the shares to MJK. Eventually, MJK went 
out of business. At the time of its failure, MJK still owed cash 
collateral to several of the borrowing broker-dealers.\64\
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    \63\ See SEC Litigation Release No. 18641, 2004 LEXIS 706 (March 
26, 2004); SEC Complaint, SEC v. Thomas G. Brooks, Civil Action No. 
CV 03-3319 ADM/AJB, United States District Court (D. Minn. June 2, 
2003); SEC v. Thomas G. Brooks, SEC Litigation Release No. 18168, 
2003 SEC LEXIS 1321 (June 3, 2003); SEC Complaint, SEC v. Kenneth P. 
D'Angelo et al., Case No. LACV 03-6499 CAS (VBKx), United States 
District Court (C.D.Cal. September 11, 2003); SEC Litigation Release 
No. 18344, 2003 SEC LEXIS 2173 (September 11, 2003).
    \64\ Id.; See also, In re MJK Clearing, Inc., 2003 U.S. Dist. 
LEXIS 5954 (D.Minn. 2003).
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    MJK's failure caused losses to the borrowing broker-dealers and to 
other firms to whom those broker-dealers re-lent the borrowed 
securities.\65\ In subsequent litigation, disputes have arisen as to 
whether certain of these broker-dealers were acting as principals or 
agents.\66\ Uncertainty as to whether broker-dealers are acting as 
principal or agent in a securities loan transaction raises concerns as 
to whether firms are taking required net capital charges related to 
their securities lending activities.\67\ A broker-dealer might not take 
the required charges on the theory that it was arranging the loans as 
agent, rather than principal, notwithstanding the fact that there was 
no express disclaimer of principal liability.
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    \65\ See, e.g., Nomura v. E*Trade, 280 F.Supp. 2d 184 (S.D.N.Y. 
2003).
    \66\ See id.
    \67\ Under paragraph (c)(2)(iv)(B) of Rule 15c3-1, broker-
dealers are required to deduct from net worth most unsecured 
receivables, including the amount that the market value of a 
securities loan exceeds the value of collateral obtained for the 
loan. Similarly, with respect to repo transactions, a broker-dealer 
obligated to resell securities must, in computing net capital, 
deduct the amount that the market value of the securities is less 
than the resale price. 17 CFR 240.15c3-1(c)(2)(iv)(F). A broker-
dealer obligated to repurchase securities must, in computing net 
capital, deduct the amount that the market value of the securities 
is greater than the repurchase price to the extent the excess is 
greater than certain percentages. 17 CFR 240.15c3-1(c)(2)(iv)(F).
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    We are proposing two amendments designed to improve regulatory 
oversight of securities lending and repo transactions. The first 
proposal would amend subparagraph (c)(2)(iv)(B) to Rule 15c3-1 to 
clarify that broker-dealers providing securities lending and borrowing 
settlement services are assumed, for purposes of the rule, to be acting 
as principals and are subject to applicable capital deductions. Under 
the proposed amendment, these deductions could be avoided if a broker-
dealer takes certain steps to disclaim principal liability. Namely, the 
broker-dealer would be required to disclose the identities of the 
borrower and lender to each other and obtain written agreements from 
the borrower and lender stating that the broker-dealer is acting 
exclusively as agent and assumes no principal liability in connection 
with the transaction.\68\
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    \68\ Standard master securities loan agreements (including the 
annexes thereto) commonly used by the parties to a securities 
lending transaction contain similar provisions for establishing 
agent (as opposed to principal) status in a securities lending and 
borrowing transaction. See, e.g., 2000 Master Securities Loan 
Agreement, Annex I, published by The Bond Market Association.
---------------------------------------------------------------------------

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

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

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

D. Documentation of Risk Management Procedures

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

[[Page 12871]]

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

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

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

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

E. Amendments to the Net Capital Rule

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

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

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

[[Page 12872]]

proposing to codify these views by amending Rule 15c3-1 to add a 
paragraph (c)(2)(i)(G), which would require a broker-dealer to treat as 
a liability any capital that is contributed under an agreement giving 
the investor the option to withdraw it. The provision also would 
require a broker-dealer to treat as a liability any capital 
contribution that is intended to be withdrawn within a year unless the 
broker-dealer receives permission in writing from its designated 
examining authority.\79\ Under paragraph (c)(2)(i)(G)(2) of the 
proposed rule, a withdrawal made within one year of the contribution is 
presumed to have been intended to be withdrawn within a year and, 
therefore, presumed to be subject to the deduction.
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    \77\ See Study of Unsafe and Unsound Practices of Broker-
Dealers, Report and Recommendations of the Securities and Exchange 
Commission, H.R. Doc. NO. 92-231 (1971).
    \78\ Letter from Michael A. Macchiaroli, Associate Director, 
Division of Market Regulation, Commission, to Raymond J. Hennessy, 
Vice President, NYSE, and Susan DeMando, Vice President, NASD 
Regulation, Inc. (February 23, 2000).
    \79\ These requirements would not apply to withdrawals covered 
by paragraph (e) (4)(iii) of Rule 15c3-1, namely, withdrawals used 
to make tax payments or to pay reasonable compensation to partners. 
These types of payments are ordinary business expenditures and do 
not raise the types of concerns the proposed rule is designed to 
address.
---------------------------------------------------------------------------

    We request comment on all aspects of these proposed amendments, 
including suggestions for records (in addition to audited financial 
statements, tax returns and regulatory filings) by which a broker-
dealer could demonstrate a third-party's current financial capacity. We 
also request comment on potential metrics for measuring whether the 
third-party has sufficient financial resources to assume the broker-
dealer's expenses for the purposes of calculating net capital under 
Rule 15c3-1. For example, would it be sufficient if the third-party's 
most recent financial statement, tax return or filing showed an amount 
of annual net revenue, excluding income derived from the broker-dealer 
(e.g., from management fees or dividends) that equaled or exceeded the 
broker-dealer's annual expenses assumed by the third-party? Would it be 
sufficient if a financial statement or filing showed the third-party 
had an amount of equity capital that, at a minimum, equaled 100%, 150%, 
200%, 1000% or some other percentage of the broker-dealer's annual 
expenses assumed by the third-party?
    With respect to the proposal on capital contributions and 
withdrawals, we request comment on whether the time period within which 
withdrawn and intended to be withdrawn contributions must be treated as 
liabilities should be longer than one year.
2. Requirement To Deduct the Amount a Fidelity Bond Deductible Exceeds 
SRO Limits
    Under SRO rules, certain broker-dealers that do business with the 
public or are required to become members of the Securities Investor 
Protection Corporation (``SIPC'') must comply with mandatory fidelity 
bonding requirements.\80\ While the form and amounts of the bonding 
requirements vary based on the nature of a broker-dealer's business, 
the SRO rules typically permit a broker-dealer to have a deductible 
provision included in the bond. However, the rules provide that the 
deductible may not exceed certain amounts.\81\ With regard to firms 
that maintain deductible amounts over the maximum amount permitted, a 
number of SRO rules provide that the broker-dealer must deduct this 
excess amount from net worth when calculating net capital under Rule 
15c3-1.\82\
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    \80\ See, e.g., NYSE Rule 319, NASD Rule 3020, CBOE Rule 9.22, 
and Amex Rule 330. SRO fidelity bonding requirements typically 
contain agreements covering the following areas: A ``Fidelity'' 
insuring clause to indemnify against loss of property through 
dishonest or fraudulent acts of employees; an ``On Premises'' 
agreement insuring against losses resulting from crimes such as 
burglary and theft and from misplacement of property of the insured; 
an ``In Transit'' clause indemnifying against losses occurring while 
property is in transit; a ``Forgery and Alteration'' agreement 
insuring against loss due to forgery or alteration of various kinds 
of negotiable instruments; and a ``Securities Loss'' clause 
protecting against losses incurred through forgery and alteration of 
securities. Id.
    \81\ See, e.g., NYSE Rule 319(b), which permits NYSE members and 
member organizations to self-insure to the extent of $10,000 or 10% 
of the minimum insurance requirement as prescribed by the NYSE.
    \82\ See, e.g., NYSE Rule 319(b); NASD Rule 3020(b)(2).
---------------------------------------------------------------------------

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

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

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

[[Page 12873]]

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

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

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

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

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

    \94\ See Exchange Act Release No. 28927 (February 28, 1991), 56 
FR 9124 (March 5, 1991).
    \95\ Id.
    \96\ Id.
    \97\ Id.
    \98\ Id.
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    Since the adoption of Rule 15c3-1(e) in 1991, the Commission only 
once has issued an order restricting a broker-dealer from withdrawing 
capital.\99\ Specifically, on October 13, 2005, the Commission ordered 
the two broker-dealer subsidiaries of REFCO, Inc.--REFCO Securities, 
LLC and REFCO Clearing, LLC--to restrict capital withdrawals, advances, 
and loans.\100\ The Commission issued the order after REFCO, Inc. 
announced that its financial statements for 2002 through 2005 should 
not be relied on and that a material unregulated subsidiary (REFCO 
Capital Markets, Ltd.) had ceased all activities for a 15-day 
period.\101\
---------------------------------------------------------------------------

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

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

[[Page 12874]]

conditions involving high levels of market volatility.
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    \102\ 17 CFR 240.15c3-1a.
    \103\ 17 CFR 240.15c3-1(c)(2)(x).
    \104\ See Exchange Act Release No. 38248 (February 6, 1997), 62 
FR 6474 (February 12, 1997). Under Appendix A to Rule 15c3-1, a 
broker-dealer calculating net capital charges for its options 
portfolios shocks the products in each portfolio (grouped by 
underlying instrument) at ten equidistant points along a potential 
market move range. The market move ranges for major market foreign 
currencies, high-capitalization diversified indexes, and non-high-
capitalization diversified indexes are, respectively: +(-) 6%, +(-) 
10% and +(-) 15%. The temporary rule lowered these market move 
ranges to respectively: +(-) 4\1/2\%, + 6% (-) 8% and +(-) 10% in 
terms of calculating haircuts for positions of non-clearing options 
specialists and market makers. See id.
    \105\ 17 CFR 240.15c3-1a(b)(1)(iv)(B).
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    The relief expired two years from its effective date. The 
Commission staff subsequently issued a no-action letter on January 13, 
2000 continuing the relief.\106\ Since the no-action letter was issued, 
there have been periods of significant volatility in the securities 
markets, including the markets for major market foreign currencies and 
high-capitalization and non-high-capitalization diversified indexes. 
These periods of volatility include the Russian debt crisis in 1998, 
the internet bubble and the September 11, 2001 terrorist attacks. 
Despite periods of substantial volatility, there have been no 
significant increases in the number of deficits in non-clearing option 
specialist and market-maker accounts, nor did the lower capital charges 
under paragraph (b)(1)(iv) result in excessive leverage. Consequently, 
we are proposing to amend paragraph (b)(1)(iv) of Appendix A to Rule 
15c3-1 to make permanent the previously granted relief. We believe 
permitting the lower requirement with respect to these types of 
positions carried in non-clearing option specialist and market-maker 
accounts better aligns the capital requirements in Rule 15c3-1 with the 
risks associated with these positions and accounts.
---------------------------------------------------------------------------

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

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

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

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

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

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

F. Technical Amendments

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

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

III. Further Requests for Comment

A. In General

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

B. Requests for Comment on Certain Specific Matters

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

[[Page 12875]]

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

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

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

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

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

IV. Paperwork Reduction Act

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

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

A. Collections of Information Under the Proposed Amendments

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

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

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[[Page 12876]]

B. Proposed Use of Information

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

C. Respondents

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

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

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

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

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

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

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

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

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

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

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

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

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

D. Total Annual Reporting and Recordkeeping Burden

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

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

1. Securities Lending Agreements and Disclosures
    The proposed amendment to Rule 15c3-1 would require a broker-dealer 
to make disclosures to, and obtain certain agreements from, securities 
lending principals in situations where the firm participates in the 
settlement of a securities lending transaction but wants to be deemed 
an agent for purposes of Rule 15c3-1. We understand that most existing 
standard securities lending master agreements in use today already 
contain language requiring agent lenders to disclose principals and 
principals to agree not to hold the agents liable for a counterparty 
default and, consequently, the proposed amendment would be codifying 
industry practice. Thus, the standard agreement used by the vast 
majority of broker-dealers should contain the representations and 
disclosures required by the proposed amendment. However, a small 
percentage of broker-dealers may need to modify their standard 
agreements.
    We estimate that 5% of the approximately 170 firms engaged in this 
business, or 9 firms, would not have used the standard agreements. We 
further estimate each of these firms would spend approximately 20 hours 
of employee resources updating their standard agreement template. 
Therefore, we estimate that the total one-time burden to the industry 
as a result of this proposed requirement would be approximately 180 
hours.\134\ We do not believe firms would incur costs arising from 
updating systems, purchasing software, or engaging outside counsel in 
meeting this proposed requirement but seek comment on that estimate.
---------------------------------------------------------------------------

    \134\ 9 broker-dealers x 20 hours per firm = 180 hours.
---------------------------------------------------------------------------

2. PAB Customer Reserve Account Recordkeeping Requirements
    This proposed amendment to Rule 15c3-3 would require a broker-
dealer to perform a PAB reserve computation and obtain certain 
agreements and notices related to PAB accounts and, therefore,

[[Page 12877]]

would impose recordkeeping burdens on a broker-dealer to the extent it: 
(1) Has to perform a PAB computation; (2) chooses to use PAB securities 
and, therefore, needs to obtain agreements from PAB accountholders; and 
(3) opens a PAB reserve account at a new bank. The customer agreement 
requirement would be a one-time burden. It is standard for a broker-
dealer to enter into a written agreement with an accountholder 
concerning the terms and conditions under which the account would be 
maintained. Therefore, requiring a written agreement would not result 
in additional burden. Rather, additional burdens would arise from the 
need to amend existing agreements and the standard agreement template 
that would be used for future customers.
    Based on FOCUS Report filings, we estimate that there are 
approximately 2,533 existing PAB customers and, therefore, broker-
dealers would have to amend approximately 2,533 existing PAB 
agreements. We further estimate that, on average, a firm would spend 
approximately 10 hours of employee resources amending each agreement. 
We also estimate, based on FOCUS Reports, that approximately 75 broker-
dealers carry PAB accounts and, therefore, these 75 firms would have to 
amend their standard PAB agreement template. We estimate a firm would 
spend, on average, approximately 20 hours of employee resources on this 
task. Therefore, we estimate the total one-time burden to the industry 
from these requirements would be approximately 26,830 total hours.\135\ 
We do not believe firms would incur costs arising from updating 
systems, purchasing software, or engaging outside counsel in meeting 
these proposed requirements but seek comment on that estimate.
---------------------------------------------------------------------------

    \135\ (2,533 PAB customers x 10 hours per customer) + (75 firms 
x 20 hours per firm) = 26,830 hours.
---------------------------------------------------------------------------

    The proposed requirements to perform a PAB computation and obtain 
agreements and notices from banks holding PAB accounts would result in 
annual burdens based on the number of broker-dealers that hold PAB 
accounts and the number of times per year these broker-dealers open new 
PAB bank accounts. Currently, to obtain the relief provided in the PAIB 
Letter, broker-dealers are required to obtain the agreements and 
notices from the banks. We understand that broker-dealers generally 
already obtain these agreements and notices. Therefore, we estimate 
there would be no additional burden imposed by this requirement but 
seek comment on this estimate.
    The proposed amendment requiring a PAB computation would produce a 
one-time burden. Based on FOCUS Report filings, we estimate that 
approximately 75 broker-dealers would perform a PAB computation. These 
firms already perform a reserve computation for domestic broker-dealer 
customers under the PAIB letter. Nonetheless, we estimate these firms 
would spend, on average, approximately 30 hours of employee resources 
per firm updating their systems to implement changes that would be 
necessitated by our proposed amendment. Therefore, we estimate that the 
total one-time burden to the industry arising from this proposed 
requirement would be approximately 2,250 hours.\136\
---------------------------------------------------------------------------

    \136\ 75 broker-dealers x 30 hours per firm = 2,250 hours.
---------------------------------------------------------------------------

    The proposed amendment requiring a PAB computation also would 
produce an annual burden. Based on FOCUS Report filings, we estimate 
that approximately 71 broker-dealers would perform the PAB computation 
on a weekly basis and four broker-dealers would perform it on a monthly 
basis. We further estimate that a broker-dealer would spend, on 
average, approximately 2.5 additional hours to complete the Rule 15c3-3 
reserve computation as a result of our proposed amendment. Therefore, 
we estimate that the total annual burden to the industry from this 
proposed requirement would be approximately 9,350 hours.\137\ We do not 
believe firms would incur costs arising from purchasing software or 
engaging outside counsel in meeting these proposed requirements but 
seek comment on that estimate.
---------------------------------------------------------------------------

    \137\ ([71 weekly filers] x [52 weeks] x [2.5 hours per 
computation]) + ([4 monthly filers] x [12 months] x [2.5 hours per 
computation]) = 9,350 total hours.
---------------------------------------------------------------------------

3. Affirmative Consent
    This proposed amendment to Rule 15c3-3 would require a broker-
dealer to obtain the affirmative consent of a new customer before 
changing the terms under which the customer's free credit balances are 
treated and provide notice to existing customers prior to changing how 
their free credit balances are treated. The broker-dealer also would be 
required to make certain disclosures.
    This proposed requirement would result in one-time and annual 
burdens to the broker-dealer industry. We note, however, that the 
requirement only would apply to a firm that carries customer free 
credit balances and opts to have the ability to change how its 
customers' free credit balances are treated.
    Based on staff experience, we estimate that 50 broker-dealers would 
choose to provide existing and new customers with the disclosures and 
notices required under the proposed amendment in order to have the 
ability to change how their customers' free credit balances are 
treated. We further estimate these firms would spend, on average, 
approximately 200 hours of employee resources per firm updating their 
systems (including processes for generating customer account 
statements) to incorporate changes that would be necessitated by our 
proposed amendment. Therefore, we estimate that the total one-time 
burden to the industry arising from this proposed requirement would be 
approximately 10,000 hours.\138\
---------------------------------------------------------------------------

    \138\ 50 broker-dealers x 200 hours per firm = 2,250.
---------------------------------------------------------------------------

    We also estimate that these firms would consult with outside 
counsel in making these systems changes, particularly with respect to 
the language in the disclosures and notices. The Commission estimates 
that, on average, an outside counsel would spend, on average, 
approximately 50 hours assisting a broker-dealer in updating its 
systems for a one-time aggregate burden to the industry of 2,500 
hours.\139\ The Commission further estimates that this work would be 
split between a partner and associate, with an associate performing a 
majority of the work. Therefore, the Commission estimates that the 
average hourly cost for an outside counsel would be approximately $400 
per hour. For these reasons, the Commission estimates that the average 
one-time cost to a broker-dealer would be approximately $20,000 \140\ 
and the one-time cost to the industry would be approximately 
$1,000,000.\141\
---------------------------------------------------------------------------

    \139\ 50 broker-dealers x 50 hours per firm = 2,500 hours.
    \140\ $400 per hour x 50 hours = $20,000.
    \141\ 50 broker-dealers x $20,000 = $1,000,000.
---------------------------------------------------------------------------

    As for annual burden, we estimate these proposed requirements would 
impact 5% of the total broker-dealer customer accounts per year. Based 
on FOCUS Report filings, we estimate there are approximately 
109,300,000 customer accounts and, consequently, 5% of the accounts 
(5,465,000 accounts per year) would be impacted. We further estimate 
that a broker-dealer would spend, on average, four minutes of employee 
resources to process an affirmative consent for new customers and a 
disclosure for existing customers. Therefore, we estimate that the 
annual burden to the industry arising from the

[[Page 12878]]

requirement would be approximately 364,333 hours.\142\
---------------------------------------------------------------------------

    \142\ 5,465,000 accounts x 4 minutes/account = 364,333 hours.
---------------------------------------------------------------------------

4. Internal Control Recordkeeping Requirements
    These proposed amendments to Rules 17a-3 and 17a-4 would require 
certain large broker-dealers to make and maintain records documenting 
internal controls that assist in analyzing and managing risks. The 
requirement would apply to broker-dealers that have more than 
$1,000,000 in customer credits or $20,000,000 in capital. This 
requirement would result in a one-time burden to the industry.
    Based on FOCUS Report filings, we estimate there are approximately 
517 broker-dealers that meet the applicability threshold of this 
amendment ($1,000,000 in credits or $20,000,000 in capital). Based on 
staff experience, we estimate that these larger broker-dealers 
generally already have documented the procedures and controls they have 
established to manage the risks arising from their business activities. 
Moreover, among these firms, the time per firm likely would vary 
depending on the size and complexity of the firm. For some firms, the 
burden may be close to 0 hours and for others it may be hundreds of 
hours. Taking this into account, we estimate that a broker-dealer would 
spend, on average, approximately 120 hours of employee resources 
augmenting its documented procedures to come into compliance with this 
proposed amendment. Therefore, we estimate the total one-time burden to 
the industry would be approximately 62,040 hours.\143\
---------------------------------------------------------------------------

    \143\ 517 broker-dealers x 120 hours = 62,040 hours.
---------------------------------------------------------------------------

    We do not believe broker-dealers would incur costs arising from 
updating systems, purchasing software, or engaging outside counsel in 
meeting this proposed requirement but seek comment on that estimate.
5. Notice Requirements
    The proposed amendments to Rule 17a-11 would require a broker-
dealer to provide notice to the Commission and other regulatory 
authorities if the broker-dealer becomes subject to certain insolvency 
events, and notice to the Commission and other regulatory authorities 
if the broker-dealer's securities borrowed and loan or securities 
repurchase/reverse repurchase activity reaches a certain threshold or, 
alternatively, provide regulatory authorities with a monthly report of 
the broker-dealer's securities borrowed and loan or securities 
repurchase/reverse repurchase activity.
    The notice requirements would result in irregular filings from a 
small number of broker-dealers. As noted above, SIPC's 2005 annual 
report indicates that in recent years an average of six broker-dealers 
per year have become subject to a liquidation proceeding under the 
Securities Investor Protection Act of 1970 (15 U.S.C. 78aaa et seq.) 
(``SIPA''). Accordingly, we estimate that approximately six insolvency 
notices would be sent per year and that a broker-dealer would spend, on 
average, approximately ten minutes of employee resources to prepare and 
send the notice. Therefore, we estimate that the total annual burden to 
the industry arising from this proposal would be approximately one 
hour.\144\ Based on FOCUS Report filings, we estimate that 
approximately twelve stock loan/borrow notices would be sent per year. 
We further estimate that a broker-dealer would spend, on average, 
approximately ten minutes of employee resources to prepare and send the 
notice. Therefore, we estimate that the total annual burden to the 
industry arising from this proposal would be approximately two 
hours.\145\
---------------------------------------------------------------------------

    \144\ 6 notices x 10 minutes per notice = 1 hour.
    \145\ 12 notices x 10 minutes per notice = 2 hours.
---------------------------------------------------------------------------

    Based on FOCUS Report filings, we estimate that 21 broker-dealers 
per year would submit the monthly stock loan/borrow report. We estimate 
each firm would spend, on average, approximately 100 hours of employee 
resources updating its systems to generate the report. Therefore, we 
estimate that the total one-time burden to the industry arising from 
this proposed requirement would be approximately 2,100 hours.\146\ As 
for annual burden, we estimate each firm would spend, on average, 
approximately one hour per month (or twelve hours per year) of employee 
resources to prepare and send the report. Therefore, we estimate the 
total annual burden arising from this proposal would be approximately 
255 hours.\147\
---------------------------------------------------------------------------

    \146\ 21 broker-dealers x 100 hours per firm = 2,100 hours.
    \147\ 21 broker-dealers x 12 hours per year or 252 hours.
---------------------------------------------------------------------------

    We do not believe firms would incur costs arising from purchasing 
software or engaging outside counsel in meeting these proposed 
requirements but seek comment on this estimate.

E. Collection of Information Is Mandatory

    These recordkeeping and notice requirements are mandatory with the 
exception of the option for a broker-dealer to provide a monthly notice 
of its securities lending activities to its designated examining 
authority in lieu of filing the notice required under the proposed 
amendment to Rule 17a-11.

F. Confidentiality

    The information collected under the amendments to Rules 15c3-1, 
15c3-3, 17a-3 and 17a-4 would be stored by the broker-dealers and made 
available to the various regulatory authorities as required in 
connection with examinations, investigations, and enforcement 
proceedings.
    The information collected under the amendments to Rule 17a-11 would 
be generated from the internal records of the broker-dealers. It would 
be provided to the Commission and other regulatory agencies but not on 
a regular basis (except for the optional monthly reports). The 
information provided to the Commission would be kept confidential to 
the extent permitted by law.

G. Record Retention Period

    The proposed amendment to Rule 15c3-1 would require broker-dealers 
to make disclosures to principals and obtain agreements from principals 
with respect to securities lending transactions where the broker-dealer 
acts as agent. These records would have to be maintained for at least 
three years under paragraph (b)(7) of Rule 17a-4.\148\ The retention 
period for the agreements also would depend on the length of time the 
relationship between the broker-dealer and the principal lasts.
---------------------------------------------------------------------------

    \148\ 17 CFR 240.17a-4(b)(7).
---------------------------------------------------------------------------

    The proposed amendments to Rule 15c3-3 would require broker-dealers 
to obtain written permission from a PAB customer if they want to use 
the customer's fully paid and excess margin securities and to obtain 
the affirmative consent of customers with respect to changing the terms 
under which free credit balances are maintained. These agreements would 
relate to the terms and conditions of the maintenance of the customer's 
account and, accordingly, fall within the record retention requirements 
of paragraph (c) of Rule 17a-4.\149\ Under this paragraph, the records 
must be retained until six years after the closing of the customer's 
account. The amendments to Rule 15c3-3 also would require broker-
dealers to obtain notices and contracts from the banks holding their 
PAB customer reserve accounts. In order to comply with Rule 15c3-3, 
broker-dealers would need to have these notices and contracts in place 
and documented. Accordingly,

[[Page 12879]]

the retention period for these records is, at a minimum, equal to the 
life of the PAB customer reserve account for which they are obtained.
---------------------------------------------------------------------------

    \149\ 17 CFR 240.17a-4(c).
---------------------------------------------------------------------------

    The proposed amendments to Rules 17a-3 and 17a-4 would require 
broker-dealers to document various internal control systems, policies 
and guidelines. The amendments to Rule 17a-4 include the establishment 
of a retention period for these records, which would be until three 
years after the termination of the use of such system, policy or 
guideline.
    The proposed amendments to Rule 17a-11 would require broker-dealers 
to provide notice or monthly reports to the Commission and other 
regulatory authorities under certain circumstances. These notices and 
reports would constitute communications relating to a broker-dealer's 
``business as such'' and, therefore, would need to be retained for 
three years.\150\
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    \150\ 17 CFR 240.17a-4(b)(4).
---------------------------------------------------------------------------

H. Request for Comment

    We request comment on the proposed collections of information in 
order to (1) evaluate whether the proposed collection of information is 
necessary for the proper performance of the functions of the 
Commission, including whether the information would have practical 
utility, (2) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collection of information, (3) determine whether 
there are ways to enhance the quality, utility, and clarity of the 
information to be collected, and (4) evaluate whether there are ways to 
minimize the burden of the collection of information on those who 
respond, including through the use of automated collection techniques 
or other forms of information technology.
    Persons who desire to submit comments on the collection of 
information requirements should direct their comments to the OMB, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Washington, DC 20503, and 
should also send a copy of their comments to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090, and refer to File No. S7-08-07. OMB is 
required to make a decision concerning the collections of information 
between 30 and 60 days after publication of this document in the 
Federal Register; therefore, comments to OMB are best assured of having 
full effect if OMB receives them within 30 days of this publication. 
The Commission has submitted the proposed collections of information to 
OMB for approval. Requests for the materials submitted to OMB by the 
Commission with regard to these collections of information should be in 
writing, refer to File No. S7-08-07, and be submitted to the Securities 
and Exchange Commission, Records Management, Office of Filings and 
Information Services, 100 F Street, NE., Washington, DC 20549.

V. Costs and Benefits of the Proposed Amendments

    We are sensitive to the costs and benefits that result from 
Commission rules. We have identified certain costs and benefits of the 
proposed amendments and request comment on all aspects of this cost-
benefit analysis, including identification and assessment of any costs 
and benefits not discussed in the analysis.\151\ We seek comment and 
data on the value of the benefits identified. We also welcome comments 
on the accuracy of the cost estimates in each section of this cost-
benefit analysis, and request those commenters to provide data so we 
can improve these cost estimates.
---------------------------------------------------------------------------

    \151\ For the purposes of this cost/benefit analysis, we are 
using salaries for New York-based employees, which tend to be higher 
than the salaries for comparable positions located outside of New 
York. This conservative approach is intended to capture unforeseen 
costs and to account for the fact that a substantial portion of the 
work will be undertaken in New York. The salary information is 
derived from the SIA Report on Management and Professional Earnings 
in the Securities Industry 2005 (``SIA Management Report 2005''). 
The hourly costs derived from the SIA Management Report 2005, and 
referenced in this cost benefit section, are modified to account for 
an 1800-hour work week and multiplied by 5.35 to account for 
bonuses, firm size, employee benefits, and overhead.
---------------------------------------------------------------------------

    We also seek estimates and views regarding these costs and benefits 
for particular types of market participants, as well as any other costs 
or benefits that may result from the adoption of these proposed rules.

A. Amendments to the Customer Protection Rule

1. Proprietary Accounts of Broker-Dealers
    The proposed amendment to Rule 15c3-3 would require broker-dealers 
to perform a reserve calculation for the proprietary accounts (``PAB'') 
of domestic and foreign broker-dealers and foreign banks acting as 
broker-dealers. It also would require them to obtain agreements from 
these broker-dealer customers with respect to the use of their fully 
paid and excess margin securities. Finally, it would require broker-
dealers to obtain agreements and notices from the banks holding the PAB 
reserve deposits.
    As discussed above, there is a disparity between the customer 
reserve requirements in Rule 15c3-3 and the treatment of customers in a 
liquidation proceeding under the Securities Investor Protection Act of 
1970 (``SIPA'').\152\ Rule 15c3-3 requires broker-dealers to reserve 
the net amount of money they owe their customers. If the broker-dealer 
fails, this net amount is available to be returned to customers ahead 
of all other creditors. Moreover, if the failed broker-dealer is 
subject to a SIPA proceeding, this net amount becomes part of the 
estate of customer property, which is distributed pro rata to 
customers.
---------------------------------------------------------------------------

    \152\ 15 U.S.C. 78aaa et seq.
---------------------------------------------------------------------------

    Foreign and domestic broker-dealers are not ``customers'' under 
Rule 15c3-3. Therefore, broker-dealers are not required to reserve the 
net amount of money owed to these entities. However, they are 
``customers'' for the purposes of SIPA and, consequently, are entitled 
to a pro rata share of the estate of customer property. Thus, even if a 
failed broker-dealer properly reserved the net amount it owed its Rule 
15c3-3 ``customers,'' the estate of customer property nonetheless may 
be insufficient to return the money owed to these ``customers'' because 
broader definition of ``customer'' in SIPA entitles foreign and 
domestic broker-dealers to a pro rata share of the funds.
i. Benefits
    Our proposed amendment would address this discrepancy by requiring 
broker-dealers to reserve for the net amount of money they owe other 
broker-dealers. This would benefit the other customers as well as the 
broker-dealer account holders by eliminating the inconsistency between 
Rule 15c3-3 and SIPA, which could decrease the estate of customer 
property in a SIPA liquidation. It also would minimize the risk that 
advances from the fund administered by the Securities Investor 
Protection Corporation (``SIPC'') would be necessary to protect 
customer cash claims. We request comment on available metrics to 
quantify these benefits and any other benefits the commenter may 
identify. Commenters are requested to identify sources of empirical 
data that could be used for the metrics they propose.
ii. Costs
    The proposed requirements to perform a PAB computation and obtain 
agreements and notices from banks holding PAB accounts would result in 
one-time and annual costs to broker-dealers that hold PAB accounts. 
Under the no-action relief set forth in the PAIB Letter, these broker-
dealers already are performing a reserve computation for

[[Page 12880]]

domestic broker-dealer accounts and have obtained the necessary 
agreements and notices from the banks holding their PAIB reserve 
deposits. Therefore, the proposed amendments would result in 
incremental costs.
    The proposed requirement to obtain written agreements from PAB 
customers in order to use their fully paid and excess margin securities 
would result in a one-time cost to the industry. As discussed above 
with respect to the Paper Work Reduction Act of 1995 (``PRA''), it is 
standard for broker-dealers to enter into written agreements with their 
broker-dealer customers concerning the terms and conditions under which 
the customers' accounts will be maintained. Therefore, requiring a 
written agreement should not result in additional costs. Rather, the 
one-time costs would arise from the need to amend existing agreements 
and the standard agreement template that would be used for future 
customers.
    As discussed with respect to the PRA, based on FOCUS Report 
filings, we estimate that there are approximately 2,533 existing PAB 
customers and, therefore, broker-dealers would have to amend 
approximately 2,533 existing PAB agreements. We further estimate that, 
on average, a firm would spend approximately 10 hours of employee 
resources amending each agreement. We also estimate, based on FOCUS 
Reports, that approximately 75 broker-dealers carry PAB accounts and, 
therefore, these 75 firms would have to amend their standard PAB 
agreement template. We estimate a firm would spend, on average, 
approximately 20 hours of employee resources on this task. Therefore, 
as noted with respect to the PRA, we estimate the total one-time hourly 
burden to the industry from these requirements would be approximately 
26,830 hours.\153\ For the purposes of this cost analysis, we estimate 
this work would be undertaken by a broker-dealer's in-house attorneys. 
The SIA Management Report 2005 indicates that the average hourly cost 
of an attorney is $327. Therefore, we estimate that there would be a 
one-time cost to the industry from these proposed requirements of 
approximately $8,773,410.\154\
---------------------------------------------------------------------------

    \153\ (2,533 PAB customers x 10 hours per customer) + (75 
broker-dealers x 20 hours per firm) = 26,830 hours.
    \154\ $327 per hour x 26,830 hours = $8,773,410.
---------------------------------------------------------------------------

    As discussed with respect to the PRA, the requirement to perform a 
PAB computation also would produce a one-time burden to the extent the 
system for performing the calculation would need to be updated. Based 
on FOCUS Report filings, we estimate that approximately 75 broker-
dealers would perform a PAB computation. These firms already perform a 
reserve computation for domestic broker-dealer customers under the PAIB 
letter. Nonetheless, we estimate these firms would spend, on average, 
approximately 30 hours of employee resources per firm updating their 
systems to implement changes that would be necessitated by our proposed 
amendment. With respect to the PRA, we estimate that the total one-time 
hourly burden to the industry arising from this proposed requirement 
would be approximately 2,250 hours.\155 \For the purposes of the cost 
analysis, we estimate that this work would be undertaken by a Senior 
Programmer. The SIA Management Report 2005 indicates the average hourly 
cost of this position is approximately $268. Therefore, we estimate 
that there would be a one-time cost to the industry from the proposed 
requirement of approximately $603,000.\156\
---------------------------------------------------------------------------

    \155\ 75 broker-dealers x 30 hours per firm = 2,250 hours.
    \156\ $268 per hour x 2,250 hours = $603,000.
---------------------------------------------------------------------------

    As noted with respect to the PRA, the proposed requirement to 
perform a PAB computation would result in an annual hourly burden to 
the extent the new requirement would lengthen the time needed to 
complete the computation. Based on FOCUS Report filings, we estimate 
that approximately 71 broker-dealers would perform the PAB computation 
on a weekly basis and four broker-dealers would perform it on a monthly 
basis. We further estimate that a broker-dealer would spend, on 
average, approximately 2.5 additional hours to complete the Rule 15c3-3 
reserve computation as a result of our proposed amendment. Therefore, 
as noted with respect to the PRA, we estimate that the total annual 
hourly burden to the industry from this proposed requirement would be 
approximately 9,350 hours.\157\ For purposes of this cost analysis, we 
estimate that the responsibility for performing the PAB computation 
would be undertaken by a financial reporting manager. As noted above, 
the SIA Management Report 2005 indicates that the average hourly cost 
for a financial reporting manager is $278. Therefore, we estimate that 
the total annual cost to the industry resulting from these requirements 
would be approximately $2,599,300.\158\
---------------------------------------------------------------------------

    \157\ ([71 weekly filers] x [52 weeks] x [2.5 hours per 
computation]) + ([4 monthly filers] x [12 months] x [2.5 hours per 
computation]) = 9,350 total hours.
    \158\ $278 per hour x 9,350 hours = $2,599,300.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on whether there would be 
additional costs to broker-dealers as a consequence of these proposals. 
For example, with respect to the PRA, we estimate that these 
requirements would not result in costs arising from purchasing software 
or engaging outside counsel. Therefore, we request comment on whether 
these requirements would result in such costs and, if so, how to 
quantify the costs. We also request comment on whether these proposals 
would impose costs on other market participants, including broker-
dealer customers. Commenters should identify the metrics and sources of 
any empirical data that support their costs estimates.
2. Banks Where Special Reserve Deposits May Be Held
    The proposed amendment to Rule 15c3-3 would limit the amount of 
cash a broker-dealer could deposit at any one bank for the purposes of 
maintaining a required customer or PAB reserve requirement and exclude 
customer and PAB reserve cash deposits at affiliated banks from 
counting towards the broker-dealer's reserve requirement.
i. Benefits
    The intent of this proposed amendment is to prevent broker-dealers 
from concentrating customer related deposits that are large relative to 
the broker-dealer or the bank in order to limit the risk arising from a 
financial collapse and to prevent such deposits from being lost in a 
group-wide financial collapse. Concentration poses a risk that some or 
all of the deposit may be lost. Depending on the size of the deposit 
and the broker-dealer, a lost deposit could cause the broker-dealer to 
fail. If the broker-dealer fails and the deposit is not recovered, the 
SIPC fund likely would not recover advances from the fund made for the 
purpose of returning customer assets. Moreover, to the extent that 
customer losses exceeded the SIPA advance limits, customers would 
suffer permanent losses. The benefits that would be derived from this 
proposed amendment are an increased safeguarding of SIPC funds and 
customer assets.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are 
requested to identify sources of empirical data that could be used for 
the metrics they propose.

[[Page 12881]]

ii. Costs
    We estimate that the costs resulting from this proposed amendment 
would be incremental. Specifically, we estimate that approximately 216 
broker-dealers would have reserve deposit requirements.\159\ A majority 
of these firms meet a substantial portion of their deposit requirement 
using qualified government securities as opposed to cash and, 
therefore, would not be impacted by this proposal. Moreover, to the 
extent that a broker-dealer's cash deposits exceed the limits, it could 
open up one or more accounts at different banks or, alternatively, use 
qualified securities to meet part of its deposit requirement.
---------------------------------------------------------------------------

    \159\ This estimate is based on FOCUS Report filings.
---------------------------------------------------------------------------

    In terms of quantifying costs, we estimate that, of the 216 firms 
with reserve deposit requirements, only 5%, namely 11, would need to 
open new bank accounts or substitute qualified securities for cash in 
an existing reserve account. We estimate that the responsibility for 
opening a new reserve bank account or substituting qualified securities 
for cash in an existing account would be undertaken by a Senior 
Treasury/Cash Management Manager. The SIA Management Report 2005 
indicates that the average hourly cost of this position is $263. We 
estimate that the senior treasury/cash management manager would spend 
approximately 10 hours performing these changes. Therefore, we estimate 
that the average cost per firm to make these changes would be 
approximately $2,630.\160\ For these reasons, we estimate that the 
total one-time cost to the industry would be approximately 
$28,930.\161\
---------------------------------------------------------------------------

    \160\ $263 per hour x 10 hours = $2,630.
    \161\ 11 broker-dealers x $2,630 = $28,930.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on whether there would be 
additional costs to broker-dealers as a consequence of these proposals, 
such as costs arising from implementing systems changes, maintaining 
additional bank or securities accounts, and managing pools of qualified 
securities as opposed to a deposit of cash. We also request comment on 
whether these proposals would impose costs on other market 
participants, including broker-dealer customers. Commenters should 
identify the metrics and sources of any empirical data that support 
their cost estimates.
3. Expansion of the Definition of Qualified Securities To Include 
Certain Money Market Funds
    The proposed amendment to Rule 15c3-3 would permit broker-dealers 
to deposit certain money market funds in the customer reserve account. 
This would benefit broker-dealers subject to the customer reserve 
requirements in Rule 15c3-3 by creating a deposit alternative to cash 
and United States Treasury securities. It would not result in any 
additional costs to broker-dealers.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are 
requested to identify sources of empirical data that could be used for 
the metrics they propose.
    In addition, while we do not believe the proposal would result in 
costs to broker-dealers, we request comment on whether it would result 
in costs to other market participants, including broker-dealer 
customers, and banks. Commenters should identify the metrics and 
sources of any empirical data that support their costs estimates.
4. Allocation of Customers' Fully Paid and Excess Margin Securities to 
Short Positions
    The proposed amendment to Rule 15c3-3 would require broker-dealers 
to obtain possession or control over fully paid or excess margin 
securities that allocate to a proprietary or customer short position.
i. Benefits
    This proposed amendment would protect broker-dealer customers by 
requiring broker-dealers to reduce long customer positions to 
possession and control even if the positions may allocate to a customer 
or proprietary short position. The possession or control requirement 
seeks to ensure that customer securities are available to be returned 
in the event the broker-dealer fails. Therefore, in addition to broker-
dealer customers, the proposal would benefit the SIPC fund to the 
extent it mitigates outlays from the fund to make advances to customers 
of a failed broker-dealer that cannot return all customer securities.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are 
requested to identify sources of empirical data that could be used for 
the metrics they propose.
ii. Costs
    We estimate this proposed requirement would result in a one-time 
cost to firms that carry customer securities to update systems for 
complying with the possession and control requirements in Rule 15c3-3. 
Based on FOCUS Report filings, we estimate that approximately 350 
broker-dealers carry customer securities. We further estimate these 
firms would spend, on average, approximately 40 hours of employee 
resources per firm updating their systems to implement changes that 
would be necessitated by our proposed amendment. For the purposes of 
this cost analysis, we estimate that this work would be undertaken by a 
Senior Programmer. The SIA Management Report 2005 indicates the average 
hourly cost of this position is approximately $268. Therefore, we 
estimate that the average cost per firm to make these changes would be 
approximately $10,720.\162\ For these reasons, we estimate that the 
total one-time cost to the industry would be approximately 
$3,752,000.\163\
---------------------------------------------------------------------------

    \162\ $268 per hour x 40 hours = $10,720.
    \163\ 350 broker-dealers x $10,720 = $3,752,000.
---------------------------------------------------------------------------

    We believe the annual costs resulting from this amendment would be 
de minimis. The proposal could result in some broker-dealers borrowing 
securities to cover proprietary short positions rather than using 
customer securities. However, currently when broker-dealers use 
customer securities they are required to put a credit in the Rule 15c3-
3 reserve formula equal to the value of the securities. This credit 
item can result in higher reserve deposit requirements, which must be 
made using the broker-dealer's own capital. Thus, increased costs 
associated with having to borrow securities to cover a short position 
likely would be offset by decreased costs associated with devoting 
capital to customer reserve requirements.
    As noted above, we request comment on these cost estimates. In 
particular, we request comment on whether there would be additional 
costs to broker-dealers as a consequence of these proposals. We also 
request comment on whether these proposals would impose costs on other 
market participants, including broker-dealer customers. Commenters 
should identify the metrics and sources of any empirical data that 
support their costs estimates.
5. Requirement To Obtain Customers' Affirmative Consent
    This proposed amendment to Rule 15c3-3 would require a broker-
dealer to obtain the affirmative consent of a new

[[Page 12882]]

customer in order to be able to change the terms under which the 
customer's free credit balances are treated and provide notice to 
existing customers prior to changing how their free credit balances are 
treated. The broker-dealer also would be required to make certain 
disclosures.
i. Benefits
    Free credit balances constitute money that a broker-dealer owes its 
customers. Customers may maintain these balances at the broker-dealer 
in anticipation of future stock purchases. Generally, customer account 
agreements set forth how the broker-dealer will invest these balances. 
For example, the broker-dealer may sweep them into a money market fund 
or, alternatively, pay an amount of interest on the funds. This 
proposed amendment is designed to ensure that customers are provided 
meaningful notice if a broker-dealer seeks to change the terms under 
which their free credit balances are invested. This would provide the 
customers with an opportunity to opt out of the proposed change or re-
direct their free credit balances.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are 
requested to identify sources of empirical data that could be used for 
the metrics they propose.
ii. Costs
    As discussed above with respect to the PRA, based on staff 
experience, we estimate that 50 broker-dealers would choose to provide 
existing and new customers with the disclosures and notices required 
under the proposed amendment in order to have the flexibility to change 
how their customers' free credit balances are treated. We further 
estimate these firms would spend, on average, approximately 200 hours 
of employee resources per firm updating their systems (including 
processes for generating customer account statements) to incorporate 
changes that would be necessitated by our proposed amendment. For the 
purposes of this cost analysis, we estimate that this work would be 
undertaken by a Senior Programmer. The SIA Management Report 2005 
indicates the average hourly cost of this position is approximately 
$268. Therefore, we estimate that the average cost per firm to make 
these changes would be approximately $53,600.\164\ For these reasons, 
we estimate that the total one-time cost to the industry would be 
approximately $2,680,000.\165\
---------------------------------------------------------------------------

    \164\ $268 per hour x 200 hours = $53,600.
    \165\ 50 broker-dealers x $53,600 = $2,680,000.
---------------------------------------------------------------------------

    Also, as discussed above with respect to the PRA, we estimate that 
these firms would consult with outside counsel in making these systems 
changes, particularly with respect to the language in the disclosures 
and notices. The Commission estimates that, on average, an outside 
counsel would spend approximately 50 hours assisting a broker-dealer in 
updating its systems for a one-time aggregate burden to the industry of 
2,500 hours.\166\ The Commission further estimates that this work would 
be split between a partner and associate, with an associate performing 
a majority of the work. Therefore, the Commission estimates that the 
average hourly cost for an outside counsel would be approximately $400 
per hour. For these reasons, the Commission estimates that the average 
one-time cost to a broker-dealer for engaging outside counsel would be 
approximately $20,000 \167\ and the one-time cost to the industry would 
be approximately $1,000,000.\168\
---------------------------------------------------------------------------

    \166\ 50 broker-dealers x 50 hours per firm = 2,500 hours.
    \167\ $400 per hour x 50 hours = $20,000.
    \168\ 50 broker-dealers x $20,000 = $1,000,000.
---------------------------------------------------------------------------

    As for annual burden, as discussed above with respect to the PRA, 
we estimate that this requirement would impact approximately 5,465,000 
customer accounts in a given year. We further estimate that a broker-
dealer would spend, on average, four minutes of employee resources to 
process an affirmative consent for new customers and a disclosure for 
existing customers. For the purposes of this cost analysis, we estimate 
that the responsibility for processing the affirmative consents would 
be undertaken by a compliance clerk. The SIA Report on Office Salaries 
in the Securities Industry 2005 (``SIA Report on Office Salaries'') 
indicates that the average hourly cost of this position is $68. 
Additionally, we estimate the compliance clerk would spend 
approximately four minutes per consent and notice. Therefore, we 
estimate that the cost per account to process the affirmative consents 
and notices would be approximately $4.50.\169\ Therefore, the total 
annual cost to the industry would be approximately $24.5 million.\170\
---------------------------------------------------------------------------

    \169\ 4 minutes x $68 per hour = $4.50.
    \170\ 5,465,000 consents/notices x $4.50 per consent/notice = 
$24,592,500.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on whether there would be 
additional costs to broker-dealers as a consequence of these proposals. 
We also request comment on whether these proposals would impose costs 
on other market participants, including broker-dealer customers. 
Commenters should identify the metrics and sources of any empirical 
data that support their costs estimates.
6. Eliminating the 3% Reduction for Aggregate Debit Items
    The proposed amendment to paragraph (a)(1)(ii)(A) of Rule 15c3-1 
would eliminate the requirement that broker-dealers using the 
alternative standard reduce their Exhibit A--Item 10 debits by 3% in 
lieu of the 1% reduction applicable to basic method firms. This would 
benefit broker-dealers subject to the 3% reduction by potentially 
reducing the amount of their reserve deposit requirements and, thereby, 
freeing up capital. Based on FOCUS data, we estimate that broker-
dealers in the aggregate currently carry approximately $550 billion in 
total credits and $380 billion in total debits. Moreover, we further 
estimate that the amount of credits and debits held by firms that are 
subject to the 1% reduction is insignificant and, consequently, for 
purposes of this cost analysis, assume that the $550 billion in credits 
and $380 billion in debits are held by firms subject to the 3% 
reduction.
    Under the current requirement to reduce total debits by 3%, broker-
dealers, in the aggregate, reduce the approximately $380 billion in 
total debits by $11.4 billion.\171\ This decreases the amount of debits 
that can offset total credits from $380 billion to $368.6 billion. 
Based on our estimates, this potentially increases the industry-wide 
reserve requirement from approximately $170 billion \172\ to $181.4 
billion.\173\ Under the proposed 1% reduction, broker-dealers, in the 
aggregate, would reduce the approximately $380 billion in total debits 
by $3.8 billion.\174\ This would decrease the amount of debits that can 
offset credits from $380 billion to $376.2 billion. Based on our 
estimates, this would potentially increase the industry-wide reserve 
requirement from $170 billion \175\ to $173.8 billion (as opposed to 
$181.4 billion).\176\ Accordingly, our proposed amendment would result 
in a decrease in the industry-wide reserve requirement of approximately 
$7.6

[[Page 12883]]

billion, which broker-dealers could re-direct to other business 
activities.\177\
---------------------------------------------------------------------------

    \171\ $380 billion x 0.03% = $11.4 billion.
    \172\ $550 billion-$380 billion = $170 billion.
    \173\ $550 billion-$368.6 billion = $181.4 billion.
    \174\ $380 billion x 0.01% = $3.8 billion.
    \175\ $550 billion-$380 billion = $170 billion.
    \176\ $550 billion-$376.2 billion = $173.8 billion
    \177\ $11.4 billion-$3.8 billion = $7.6 billion.
---------------------------------------------------------------------------

    We do not anticipate any net costs to broker-dealers that would 
result from the proposed amendment, given that the benefits from the 
freed-up capital of potentially $7.6 billion would significantly offset 
any costs arising from making necessary systems changes to implement 
this proposed change to the customer reserve computation. However, it 
could result in costs to other market participants. Therefore, we 
request comment on whether it would result in such costs, including 
costs to broker-dealer customers and banks. Commenters should identify 
the metrics and sources of any empirical data that support their costs 
estimates.
7. Clarification Regarding Funds in Certain Commodity Accounts
    The proposed amendment to paragraph (a)(8) of Rule 15c3-3 would 
clarify that broker-dealers need not treat funds in certain commodities 
accounts as ``free credit balances'' for purposes of the customer 
reserve formula. This would benefit broker-dealers that are registered 
as futures commission merchants by eliminating any ambiguity with 
respect to such accounts and avoiding situations where they 
unnecessarily increase reserve amounts. We do not anticipate the 
proposed amendment would result in any costs to broker-dealers and, as 
these funds are not protected under SIPA, would not expose the SIPC 
fund to increased liabilities.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are 
requested to identify sources of empirical data that could be used for 
the metrics they propose.
    In addition, while we do not believe the proposal would result in 
costs to broker-dealers, we request comment on whether it would result 
in costs to other market participants, including broker-dealer 
customers, and banks. Commenters should identify the metrics and 
sources of any empirical data that support their costs estimates.

B. Portfolio Margining

    There are two proposed amendments to accommodate SRO rules that 
permit broker-dealers to determine customer margin requirements using a 
portfolio-margining methodology. The first amendment would revise the 
definition of ``free credit balances'' in paragraph (a)(8) of Rule 
15c3-3. The revision would expand the definition to include funds in a 
portfolio margin account relating to certain futures and futures 
options positions and the market value of futures options as of the 
filing date in a SIPA proceeding. The second amendment would add a 
debit line item to the customer reserve formula in Rule 15c3-3a 
consisting of margin posted by a broker-dealer to a futures clearing 
agency.
1. Benefits
    The proposed amendments are designed to provide greater protection 
to customers with portfolio margin accounts. They would require broker-
dealers to treat all cash balances in the accounts under the reserve 
computation provisions of Rule 15c3-3, which are designed to ensure 
that customer cash is available to be returned to customers in the 
event the broker-dealer fails. The proposed amendments also are 
designed to provide the protections of SIPA to these cash balances and 
to futures options in the accounts.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify, including the 
identification of sources of empirical data that could be used for such 
metrics.
2. Costs
    The requirements imposed by the proposed amendments would be 
elective. They only would apply to broker-dealers choosing to offer 
their customers portfolio margin accounts with a cross-margin feature 
(i.e., the ability to hold futures and futures options in the account). 
We estimate that approximately thirty-three broker-dealers would elect 
to offer their customers portfolio margin accounts that would include 
futures and futures options.\178\
---------------------------------------------------------------------------

    \178\ This estimate is based on data from FOCUS Report filings.
---------------------------------------------------------------------------

    The proposed amendment to the definition of ``free credit 
balances'' in Rule 15c3-3 would require broker-dealers to include in 
the customer reserve formula credit balances related to futures 
positions in a portfolio margin account. The proposed amendment to add 
a line item to the debits in the customer reserve formula of Rule 15c3-
3a would require broker-dealers to include the amount of customer 
margin required and on deposit at a futures clearing organization as a 
``debit'' in the reserve formula. Accordingly, these proposed 
amendments would require changes to the systems broker-dealers use to 
compute and account for their customer reserve requirements. We assume 
that the responsibility for updating these systems will be undertaken 
by a Senior Programmer. The SIA Management Report 2005 indicates the 
average hourly cost of this position is approximately $268. We estimate 
the senior programmer would spend approximately 130 hours to modify 
software to conform it to the requirements of the proposed amendments. 
Therefore, we estimate that the program and systems changes would 
result, on average, in a one-time cost of approximately $34,840 on per 
broker-dealer.\179\ For these reasons, we estimate the total one-time 
cost to the industry would be approximately $1,149,720.\180\
---------------------------------------------------------------------------

    \179\ 130 hours x $268 = $34,840.
    \180\ 33 broker-dealers x $34,840 = $1,149,720.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on additional costs to 
broker-dealers that would arise from these proposals, such as system 
costs in addition to those discussed above (e.g., costs associated with 
purchasing new software and updates to existing software). We also 
request comment on whether these proposals would impose costs on other 
market participants, including broker-dealer customers. Commenters 
should identify the metrics and sources of any empirical data that 
support their costs estimates.

C. Amendments With Respect to Securities Borrowed and Loaned and Repo 
Activities

    We are proposing amendments to strengthen the financial 
responsibility of broker-dealers engaging in a securities lending 
business. The proposed amendments would require broker-dealers to (1) 
disclose the principals and obtain certain agreements from the 
principals in a transaction where they provide settlement services in 
order to be considered an agent (as opposed to a principal) for the 
purposes of the net capital rule, and (2) provide notice to the 
Commission and other regulatory authorities if the broker-dealer's 
securities borrowed and loan or securities repurchase/reverse 
repurchase activity reaches a certain threshold or, alternatively, 
provide regulatory authorities with a monthly report of the broker-
dealer's securities borrowed and loan or securities repurchase/reverse 
repurchase activity.
1. Benefits
    The proposed amendments are intended to strengthen the financial 
responsibility of broker-dealers engaged in a securities lending or 
repo business and to assist securities regulators in

[[Page 12884]]

monitoring such activities. This would assist securities regulators in 
responding to situations where a broker-dealer was in financial 
difficulty due to a large securities lending or repo position. This 
would help prevent significant losses to the firm's customers and other 
broker-dealers, and reduce financial system risk.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are 
requested to identify sources of empirical data that could be used for 
the metrics they propose.
2. Costs
i. Requirements To Avoid Principal Liability
    As discussed with respect to the PRA, we understand that most 
existing standard securities lending master agreements in use today 
already contain language requiring agent lenders to disclose principals 
and for principals to agree not to hold the agents liable for a 
counterparty default. Thus, the standard agreement used by the vast 
majority of broker-dealers should contain the representations and 
disclosures required by the proposed amendment. However, a small 
percentage of broker-dealers may need to modify their standard 
agreements. As discussed with respect to the PRA, we estimate that 
approximately nine broker-dealers would need to amend their securities 
lending agreements to include the required provision and that they 
would each spend, on average, approximately 20 hours in making the 
changes. We estimate that the responsibility for changing the language 
in the securities lending master agreement template would be undertaken 
collectively by an associate general counsel and attorney. The SIA 
Management Report 2005 indicates that the average hourly cost of these 
positions respectively is $431 for the associate general counsel and 
$327 for the attorney. We estimate that, on average, the attorney would 
spend 16 hours changing the template and the associate general counsel 
would spend four hours overseeing the project. Therefore, we estimate 
that the one-time cost to make these changes would be, on average, 
$6,956 per firm.\181\ For these reasons, we estimate the total one-time 
cost to the industry would be approximately $62,604.\182\
---------------------------------------------------------------------------

    \181\ ([16 hours] x [$327 per hour]) + ([4 hours] x [$431 per 
hour]) = $6,956.
    \182\ 9 broker-dealers x $6,956 = $62,604.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on additional costs to 
broker-dealers that would arise from these proposals, such as costs 
arising from making systems changes. We also request comment on whether 
these proposals would impose costs on other market participants, 
including broker-dealer customers. Commenters should identify the 
metrics and sources of any empirical data that support their costs 
estimates.
ii. Notices or Monthly Reports
    The proposed amendment to Rule 17a-11 would require broker-dealers 
engaged in securities lending or repurchase activities to either: (1) 
File a notice with the Commission and their designated examining 
authority whenever the total money payable against all securities 
loaned, subject to a reverse repurchase agreement or the contract value 
of all securities borrowed or subject to a repurchase agreement exceeds 
2500% of tentative net capital; or, alternatively, (2) file a monthly 
report on their securities lending and repurchase activities with their 
designated examining authority.
    As discussed with respect to the PRA, based on FOCUS Report 
filings, we estimate that approximately twelve notices per year would 
be sent pursuant to this proposed amendment. We further estimate that a 
broker-dealer would spend, on average, approximately ten minutes of 
employee resources to prepare and send the notice. Therefore, we 
estimate that the costs to the industry associated with this 
requirement would be de minimis.
    As for the monthly reports, we estimated with respect to the PRA 
that approximately 21 broker-dealers would choose the option under the 
proposed rule of filing the reports. We also estimated with respect to 
the PRA that each firm would spend, on average, approximately 100 hours 
of employee resources updating its systems to generate the report. For 
the purposes of this cost analysis, we assume that the responsibility 
for updating these systems would be undertaken by a Senior Programmer. 
The SIA Management Report 2005 indicates the average hourly cost of 
this position is approximately $268. Therefore, we estimate that the 
systems changes would result, on average, in a one-time cost of 
approximately $26,800 per broker-dealer.\183\ For these reasons, we 
estimate the total one-time cost to the industry would be approximately 
$562,800.\184\
---------------------------------------------------------------------------

    \183\ 100 hours x $268 = $26,800.
    \184\ 21 broker-dealers x $26,800 = $562,800.
---------------------------------------------------------------------------

    As for the annual costs of generating and filing the monthly 
report, we estimated with respect to the PRA that a broker-dealer would 
spend, on average, approximately one hour per month (or twelve hours 
per year) of employee resources to generate and send the report. We 
assume the responsibility for generating and filing the monthly report 
would be undertaken by a junior stock loan manager. The SIA Management 
Report 2005 indicates the average hourly cost for this position is 
$208. We further estimate that a junior stock loan manager would spend, 
on average, approximately one hour per month compiling and filing this 
report for an average monthly cost of $208. Therefore, we estimate the 
cost to file the reports would be approximately $2,496 per firm.\185\ 
For these reasons, we estimate the total annual cost to the industry 
would be approximately $52,416.\186\
---------------------------------------------------------------------------

    \185\ ([1 hour] x [$208 per hour]) x 12 months = $2,496.
    \186\ 21 broker-dealers x $2,496 = $52,416.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on additional costs to 
broker-dealers that would arise from these proposals. We also request 
comment on whether these proposals would impose costs on other market 
participants, including persons active in the securities lending and 
repo markets. Commenters should identify the metrics and sources of any 
empirical data that support their costs estimates.

D. Documentation of Risk Management Procedures

    We are proposing amendments to the broker-dealer books and records 
rules that would require certain large broker-dealers to document in 
writing the procedures and guidelines they use for managing risk. The 
proposed amendments do not require broker-dealers to implement 
procedures. Rather, they require the documentation of procedures that 
have been established by the broker-dealer.
1. Benefits
    These proposed amendments would require large broker-dealers to 
document the controls they have implemented to address the risks they 
face as a result of their business activities. This would benefit the 
firms by mitigating the risk of financial loss or collapse and their 
customers by mitigating the risk of losses associated with a firm's 
failure or an employee's improper activities. Moreover, by 
strengthening the internal processes of the broker-dealers, these 
proposed amendments would benefit market participants and reduce 
systemic financial risk. In addition, by making the documented controls 
a required

[[Page 12885]]

record, securities regulators would have better access to them. This 
would assist regulators in monitoring the risks faced by broker-dealers 
and understanding the controls they implement to address the risks.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are 
requested to identify sources of empirical data that could be used for 
the metrics they propose.
2. Costs
    These proposed amendments would apply to a limited number of 
broker-dealers, namely, those firms with more than $1 million in 
customer credits or $20 million in capital. This proposed requirement 
would result in a one-time cost to some of these firms to the extent 
they had established procedures that had not been documented. We 
believe, generally, that most of these firms have documented their 
established risk management controls and procedures. For these reasons, 
we estimated with respect to the PRA that the one-time hourly burden to 
meet the requirements of these proposed rules would range from 0 hours 
for some firms and to hundreds of hours for other firms. Taking this 
into account, we estimated with respect to the PRA that a broker-dealer 
would spend, on average, approximately 120 hours of employee resources 
augmenting its documented procedures to come into compliance with this 
proposed amendment.
    For the purposes of this cost analysis, we estimate that the 
responsibility for documenting the risk management procedures and 
controls a broker-dealer has established would be coordinated by an 
attorney working with operations specialists from the various risk 
management departments in the firm. We further estimate that the 
project would be overseen by an associate general counsel. The SIA 
Management Report 2005 indicates the average hourly costs of these 
positions respectively are approximately $431 for an associate general 
counsel, $327 for an attorney and $144 for an operations specialist. We 
estimate that the attorney would spend 40 hours compiling and 
documenting the procedures, the operations specialists collectively 
would spend 70 hours working with the attorney, and the associate 
general counsel would spend ten hours overseeing the project. 
Therefore, we estimate that the average one-time cost per firm to 
comply with these proposed amendments would be $27,470.\187\ We 
estimated with respect to the PRA that these amendments would apply to 
approximately 517 broker-dealers. For these reasons, we estimate that 
the total one-time cost to the industry would be approximately 
$14,201,990.\188\
---------------------------------------------------------------------------

    \187\ ([40 hours] x [$327 per hour]) + ([70 hours] x [$144 per 
hour]) + ([10 hours] x [$431 per hour]) = $27,470.
    \188\ 517 broker-dealers x $27,470 = $14,201,990.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on additional costs to 
broker-dealers that would arise from these proposals, such as costs 
arising from making changes to systems and costs associated with 
maintaining these records. We also request comment on whether these 
proposals would impose costs on other market participants, including 
broker-dealer customers. Commenters should identify the metrics and 
sources of any empirical data that support their costs estimates.

E. Amendments to the Net Capital Rule

1. Requirement to Add Back Certain Liabilities to Net Worth and Treat 
Certain Capital Contributions as Liabilities
    These proposed amendments to Rule 15c3-1 would require a broker-
dealer to add back to net worth, when calculating net capital, 
liabilities assumed by a third-party if the third-party did not have 
the financial wherewithal to pay the liabilities. The proposed 
amendments also would require a broker-dealer to treat as liabilities 
capital contributions where the investor has the option to withdraw the 
capital at any time.
i. Benefits
    These proposed amendments to Rule 15c3-1 would assist investors and 
regulators by requiring broker-dealers to provide a more accurate 
picture of their financial condition. This would permit regulators to 
react more quickly if a firm experiences financial difficulty. This 
would benefit customers of a troubled broker-dealer as well as its 
counterparties and, accordingly, reduce systemic risk in the securities 
markets. We request comment on available metrics to quantify these 
benefits and any other benefits the commenter may identify. Commenters 
are requested to identify sources of empirical data that could be used 
for the metrics they propose.
ii. Costs
    These proposed amendments would apply to all broker-dealers. 
However, the requirements only would impact a few broker-dealers, 
namely those that have sought to shift their liabilities to a third-
party that lacks the resources--independent of the broker-dealer--to 
assume the liabilities or those that provide investors with options to 
withdraw capital. We believe the vast majority of broker-dealers either 
do not seek to transfer responsibility for their liabilities to a 
third-party or, if they do so, rely on a third-party that has the 
financial resources--independent of the assets and revenue of the 
broker-dealer--to pay the obligations as they become due. We also 
believe that most broker-dealers do not accept capital contributions 
under agreements permitting the investor to withdraw the capital at any 
time.
    FOCUS Report filings indicate that approximately 702 broker-dealers 
report having no liabilities. For the purposes of this analysis, we 
conservatively estimate that the proposed amendment would impact all of 
these firms. Requiring these broker-dealers to book liabilities would 
decrease the amount of equity capital held by the firms and in some 
cases may require them to obtain additional capital. The majority of 
broker-dealers reporting no liabilities are introducing broker-dealers 
that have a $5,000 minimum net capital requirement. The reported 
average for total aggregate liabilities of introducing broker-dealers 
is $280,354 per firm. Therefore, conservatively estimating that the 702 
broker-dealers would have to each raise $280,354 in additional capital 
as result of the proposed requirement, the total aggregate amount of 
additional capital that would need to be raised would be 
$196,808,508.\189\ We further estimate that the cost of capital is 
approximately 5%.\190\ Therefore, we estimate that the total annual 
cost to the industry would be approximately $10 million.\191\
---------------------------------------------------------------------------

    \189\ 702 broker-dealers x $280,354 = $196,808,508.
    \190\ We estimate this generally would be the cost to a broker-
dealer to obtain a subordinated loan that meets requirements of 
Rules 15c3-1 and 15c3-1d (17 CFR 240.15c3-1d).
    \191\ $196,809,000 x 5% = $9,840,300.
---------------------------------------------------------------------------

    We estimate that amendments requiring broker-dealers to treat 
certain capital contributions as liabilities should not result in 
significant additional costs. Generally, broker-dealers do not enter 
into agreements permitting an owner to withdraw capital at any time. To 
the extent some firms may have engaged in this practice, they could 
have to pay more for capital. Conservatively, we estimate that no more 
than $100 million in capital at broker-dealers is subject to such 
agreements. Assuming an incremental

[[Page 12886]]

cost of capital of 2.5%, we estimate that the proposed amendment would 
result in an annual cost of approximately $2.5 million.\192\
---------------------------------------------------------------------------

    \192\ $100,000,000 x 2.5% = $2,500,000.
---------------------------------------------------------------------------

    As noted above, we request comment on these proposed cost 
estimates. In particular, we request comment on additional costs to 
broker-dealers that would arise from these proposals. We also request 
comment on whether these proposals would impose costs on other market 
participants, including broker-dealer customers. Commenters should 
identify the metrics and sources of any empirical data that support 
their costs estimates.
2. Account for Excess Fidelity Bond Deductibles
    This proposed amendment would require broker-dealers to deduct from 
net capital, with regard to fidelity bonding requirements prescribed by 
a broker-dealer's examining authority, the excess of any deductible 
amount over the maximum amount permitted by self-regulatory 
organization rules.
i. Benefits
    Self-regulatory organization rules relating to fidelity bonding 
requirements provide safeguards with respect to the financial 
responsibility and related practices of broker-dealers. This proposed 
amendment would clarify that broker-dealers subject to capital charges 
under self-regulatory organization rules for excess fidelity bond 
deductibles also should include such deductions when determining net 
capital for purposes of Rule 15c3-1.\193\ This would help in ensuring 
that broker-dealers do not exceed regulatory limitations for fidelity 
bond deductibles.
---------------------------------------------------------------------------

    \193\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

ii. Costs
    This proposed amendment would codify in a Commission rule capital 
charges that broker-dealers are currently required to take pursuant to 
the rules of various self-regulatory organizations. The proposed 
amendment would not impose additional costs on broker-dealers with 
respect to the purchasing or carrying of fidelity bond coverage. Nor 
would the proposed amendment cause broker-dealers to incur additional 
costs in determining or reporting excess deductible amounts over the 
maximum amount permitted. Broker-dealers already make such 
determinations under self-regulatory organization rules, and the manner 
in which such excesses are typically reported (i.e., through periodic 
FOCUS and other reports) would remain the same. For these reasons, we 
believe any costs arising from this proposed amendment would be de 
minimis.
    As noted above, we request comment on this cost estimate. In 
particular, we request comment on whether there would be any costs to 
broker-dealers as a consequence of this proposal. We also request 
comment on whether this proposal would impose costs on other market 
participants, including broker-dealer customers. Commenters should 
identify the metrics and sources of any empirical data that support 
their costs estimates.
3. Broker-Dealer Solvency Requirement
    This proposed amendment to Rule 15c3-1 would require broker-dealers 
to cease doing a securities business if they become subject to certain 
insolvency events. The companion amendment to Rule 17a-11 would require 
such broker-dealers to provide notice of their insolvency to regulatory 
authorities.
i. Benefits
    The proposed amendment to Rule 15c3-1 would benefit the securities 
markets by removing risks associated with having a financially unstable 
firm continue to operate. For example, the broker-dealer would not be 
able to take on new customers and place their assets at risk of being 
lost in its financial collapse or frozen in a liquidation proceeding. 
Furthermore, the broker-dealer would not be able to enter into 
proprietary transactions with other broker-dealers and place them or 
clearing agencies at risk of counterparty default. The broker-dealer's 
existing customers also would benefit in that ceasing a securities 
business would assist in preserving any remaining capital of the firm, 
which could be used to facilitate on orderly liquidation.
    The proposed amendment to Rule 17a-11 also would benefit the 
securities markets in that it would provide regulators with the 
opportunity to take steps to protect customers and counterparties at 
the onset of the insolvency. These steps could include facilitating the 
transfer of customer accounts to a solvent broker-dealer and monitoring 
the liquidation of proprietary positions.
ii. Costs
    For the most part, the proposed amendments would have no impact on 
existing broker-dealers. Should a broker-dealer become subject to an 
insolvency proceeding, it would incur the cost of sending notice of 
that fact to the Commission and its designated examining authority. We 
believe this would be a rare occurrence and, accordingly, with respect 
to the PRA estimated it would happen approximately six times a year. 
For these reasons, we estimate that any costs arising from this 
proposed amendment would be de minimis.
    As noted above, we request comment on this cost estimate. In 
particular, we request comment on whether there would be costs to 
broker-dealers as a consequence of this proposal. We also request 
comment on whether this proposal would impose costs on other market 
participants, including broker-dealer customers. Commenters should 
identify the metrics and sources of any empirical data that support 
their costs estimates.
4. Order Restricting Withdrawal of Capital From a Broker or Dealer 
Amendment
    This proposed amendment to Rule 15c3-1(e) would eliminate the 
qualification on Commission orders restricting withdrawals, advances 
and unsecured loans made by broker-dealers that limits the order to 
instances when recent withdrawals, advances or loans, in the aggregate, 
exceed thirty percent of the broker-dealer's excess net capital.
i. Benefits
    The proposed amendment to Rule 15c3-1 would benefit the securities 
markets by protecting customers and counterparties of a financially 
stressed broker-dealer. For example, the broker-dealer would not be 
able to make an unsecured loan to a stockholder or withdraw equity 
capital while the order was outstanding, thereby preserving the assets 
and liquidity of the broker-dealer and enabling the Commission and its 
staff to examine the broker-dealer's financial condition, net capital 
position and the risk exposure to the customers and creditors of the 
broker-dealer to ensure the financial integrity of the firm.
ii. Costs
    The current rule permitting the Commission to restrict withdrawals 
of capital from a financially distressed broker-dealer was adopted in 
1991.\194\ Based on this experience with the rule, we estimate that the 
proposed amendment would result in no or de minimis costs to broker-
dealers.
---------------------------------------------------------------------------

    \194\ See Exchange Act Release No. 28927 (February 28, 1991), 56 
FR 9124 (March 5, 1991).
---------------------------------------------------------------------------

    As noted above, we request comment on this cost estimate. In 
particular, we request comment on whether there would be costs to 
broker-dealers as a consequence of this proposal. We also request 
comment on whether this proposal would impose costs on other

[[Page 12887]]

market participants. Commenters should identify the metrics and sources 
of any empirical data that support their costs estimates.
5. Adjusted Net Capital Requirements
    These proposed amendments would adjust required charges for broker-
dealers under Rule 15c3-1. The adjustments would better align the net 
capital requirements of affected firms with the risks Rule 15c3-1 seeks 
to mitigate. The amendments are relaxing existing requirements and, 
therefore, would not result in costs to broker-dealers. Moreover, 
because they seek to better match capital requirements with actual 
risk, they should not have an adverse impact on the financial strength 
of broker-dealers.
i. Calculating Theoretical Pricing Charges
    The proposed amendment to paragraph (b)(1)(vi) of Rule 15c3-1a 
would make permanent the reduced net capital requirements that apply to 
listed option positions in major market foreign currencies and high-
capitalization and non-high-capitalization diversified indexes in non-
clearing option specialist and market maker accounts. This would 
benefit the broker-dealers that have been calculating charges under the 
temporary relief granted by the Commission staff. Because broker-
dealers are already operating under the temporary relief, we believe 
the amendment would not result in any costs.
    We request comment on available metrics to quantify the benefits 
identified above and any other benefits the commenter may identify. 
Commenters are requested to identify sources of empirical data that 
could be used for the metrics they propose.
    In addition, we request comment on whether the proposal would 
result in costs. Commenters should identify the metrics and sources of 
any empirical data that support their costs estimates.
ii. Reduced Haircut on Money Market Funds
    Reducing the money market funds haircut from 2% to 1% would benefit 
all broker-dealers in that it will make it less costly, in terms of 
capital allocation, to hold these investments. We do not believe the 
proposed amendment would result in any costs.
    We request comment on available metrics to quantify the benefits 
identified above and any other benefits the commenter may identify. 
Commenters are requested to identify sources of empirical data that 
could be used for the metrics they propose.
    In addition, we request comment on whether the proposal would 
result in costs. Commenters should identify the metrics and sources of 
any empirical data that support their costs estimates.

F. Total Estimates Costs

    Given the estimates set forth above, the total one-time estimated 
cost to the industry resulting from these rule proposals would be 
approximately $32,814,454 \195\ and the total estimated annual cost to 
the industry resulting from these rule proposals would be approximately 
$39,651,716.\196\
---------------------------------------------------------------------------

    \195\ $8,773,410 + $603,000 + $28,930 + $3,752,000 + $2,680,000 
+ $1,000,000 + $1,149,720 + $62,604 + $562,800 + $14,201,990 = 
$32,814,454.
    \196\ $2,599,300 + $24,500,000 + $52,416 + $10,000,000 + 
$2,500,000 = $39,651,716.
---------------------------------------------------------------------------

VI. Consideration of Burden on Competition, and Promotion of 
Efficiency, Competition, And Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, whenever 
it engages in rulemaking and must consider or determine if an action is 
necessary or appropriate in the public interest, to consider if the 
action will promote efficiency, competition, and capital 
formation.\197\ In addition, Section 23(a)(2) of the Exchange Act 
requires the Commission, when adopting rules under the Exchange Act, to 
consider the impact that any such rule would have on competition.\198\ 
Exchange Act Section 23(a)(2) prohibits the Commission from adopting 
any rule that would impose a burden on competition not necessary or 
appropriate in furtherance of the purposes of the Exchange Act. The 
proposed amendments are intended to promote efficiency, competition, 
and capital formation. They should not have any anti-competitive 
effects.
---------------------------------------------------------------------------

    \197\ 15 U.S.C. 78c(f).
    \198\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The Commission requests comment on whether the proposed amendments 
are likely to promote efficiency, competition, and capital formation.

A. Amendments to the Customer Protection Rule

    The proposed amendments to the customer protection rule respecting 
PAB accounts,\199\ cash deposits at special reserve bank accounts,\200\ 
allocation of short positions,\201\ and the treatment of free credit 
balances \202\ are designed to protect and preserve customer property 
held at broker-dealers. These protections would reduce the risks to 
individual investors and, thereby, promote participation in the 
securities markets. Also, by strengthening requirements designed to 
protect customer property, they would mitigate potential exposure of 
the fund administered by the Securities Investor Protection Corporation 
(``SIPC'') that is used to make advances to customers whose securities 
or cash are unable to be returned by a failed broker-dealer. The 
amendments reducing the debit reduction for alternative standard firms 
from 3% to 1% and clarifying that funds in certain commodities accounts 
need not be treated as ``free credit balances'' would free up capital 
and, in the latter case, clarify an ambiguity in Rule 15c3-3.\203\ 
These results would promote capital formation and increase efficiency. 
The amendment expanding the definition of qualified securities would 
reduce operational burdens associated with holding securities in the 
customer reserve account and, thereby, promote efficiency.\204\
---------------------------------------------------------------------------

    \199\ See section II.A.1 of this release.
    \200\ See section II.A.2 of this release.
    \201\ See section II.A.4 of this release.
    \202\ See section II.A.5.i of this release.
    \203\ See sections II.A.6 and II.A.7 of this release.
    \204\ See section II.A.3 of this release.
---------------------------------------------------------------------------

B. Portfolio Margining Amendments

    The proposed amendments to accommodate portfolio margining \205\ 
would promote greater efficiency, competition and capital formation. 
They are designed to provide portfolio margin customers with greater 
protection through the reserve requirements of Rule 15c3-3 and SIPA. 
This, in turn, would make portfolio margining more attractive to 
investors. Portfolio margining can significantly reduce customer margin 
requirements for offsetting positions involving securities and futures 
products, which in turn reduces the costs of trading such products. 
Moreover, portfolio margining promotes competition and better price 
discovery across securities and futures products by allowing customers 
to offset a position assumed in one market with a product traded on 
another market.
---------------------------------------------------------------------------

    \205\ See section II.B of this release.
---------------------------------------------------------------------------

C. Securities Lending and Borrowing Amendments

    The proposed amendment requiring broker-dealers to disclaim 
principal liability in securities lending transactions to avoid certain 
capital charges under Rule 15c3-1 \206\ is consistent with the goal of 
promoting efficiency and competition in the marketplace. This proposed 
amendment would help eliminate the legal uncertainty among 
counterparties as to the role played by market participants

[[Page 12888]]

in such transactions and clarify the nature of the services that 
securities lending intermediaries provide their counterparties. The 
proposed amendment to Rule 17a-11 \207\ to require a broker-dealer to 
provide notice if its securities lending or repo transactions reach a 
certain threshold, or alternatively provide its DEA with a monthly 
report, is designed to enhance the monitoring of these activities by 
securities regulators and, thereby, protect broker-dealer customers and 
counterparties from the impact of a financial collapse. This would 
strengthen the securities markets and make them more attractive to 
investors.
---------------------------------------------------------------------------

    \206\ See section II.C of this release.
    \207\ Id.
---------------------------------------------------------------------------

D. Documentation of Risk Management Procedures

    The proposed amendments to Rules 17a-3 and 17a-4 \208\ requiring 
firms to document their risk management controls and procedures are 
designed to reduce the risks inherent to the business of operating as a 
broker-dealer and, thereby, enhance a broker-dealer's financial 
soundness. This would strengthen the securities markets making them 
more attractive to investors.
---------------------------------------------------------------------------

    \208\ See section II.D of this release.
---------------------------------------------------------------------------

E. Amendments to the Net Capital Rule

    The proposed amendments to Rule 15c3-1 (1) requiring a broker-
dealer to account for certain liabilities or treat certain capital 
contributions as liabilities,\209\ (2) requiring a broker-dealer to 
account for certain excess fidelity bond deductibles,\210\ (3) 
requiring an insolvent broker-dealer to cease conducting a securities 
business and provide notice under the proposed amendment to Rule 17a-
11,\211\ (4) eliminating the qualification on Commission orders 
restricting withdrawals, advances, and unsecured loans to instances 
where recent withdrawals, advances or loans, in the aggregate, exceed 
thirty percent of the broker-dealer's excess net capital,\212\ (5) 
making permanent the reduced net capital requirements under Appendix A 
for market makers,\213\ and (6) lowering the haircut for money market 
funds,\214\ are consistent with promoting efficiency and competition in 
the market place.
---------------------------------------------------------------------------

    \209\ See section II.E.1 of this release.
    \210\ See section II.E.2 of this release.
    \211\ See section II.E.3 of this release.
    \212\ See section II.E.4 of this release.
    \213\ See section II.E.5.i of this release.
    \214\ See section II.E.5.ii of this release.
---------------------------------------------------------------------------

    A broker-dealer that fails to account for liabilities that depend 
on the broker-dealer's assets and revenues and accepts temporary 
capital is obscuring its true financial condition. This interferes with 
the process by which regulators monitor the financial condition of 
broker-dealers and, thereby, impedes their ability to take proactive 
steps to minimize the harm to customers, counterparties and clearing 
agencies resulting from a broker-dealer failure.
    Requiring broker-dealers to take net capital charges for excess 
fidelity bond deductibles imposed under self-regulatory organization 
rules would promote efficiency by providing certainty as to the 
applicability of such rules for purposes of Rule 15c3-1. Because 
fidelity bond requirements provide a safeguard with regard to broker-
dealer financial responsibility, the proposed amendment would enhance 
competition through the operation of more financially sound firms.
    The continued operation of an insolvent broker-dealer or the 
withdrawal of capital from a broker-dealer that may jeopardize such 
broker-dealer's financial integrity poses financial risk to its 
customers, counterparties and the securities industry clearance 
organizations. These risks increase costs.
    The elimination of the limitation on Commission orders restricting 
capital withdrawals from a financially troubled broker-dealer would 
provide greater protection to customers and counterparties of the firm 
and securities industry clearance organizations. While such orders 
would be infrequent, when issued they would lower costs to these 
entities associated with having an outstanding obligation from the 
troubled broker-dealer.
    The proposed amendments to the net capital rule that would reduce 
the amount of net capital certain broker-dealers must maintain would 
improve efficiency and competition and promote capital formation by 
allowing firms to employ such capital in other areas of their business 
activities. They also would lower the costs of capital for broker-
dealers.

VII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \215\ we must advise the OMB as to whether 
the proposed regulation constitutes a ``major'' rule. Under SBREFA, a 
rule is considered ``major'' where, if adopted, it results or is likely 
to result in (1) an annual effect on the economy of $100 million or 
more (either in the form of an increase or a decrease), (2) a major 
increase in costs or prices for consumers or individual industries, or 
(3) significant adverse effect on competition, investment or 
innovation.
---------------------------------------------------------------------------

    \215\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

    If a rule is ``major,'' its effectiveness will generally be delayed 
for 60 days pending Congressional review. We request comment on the 
potential impact of each of the proposed amendments on the economy on 
an annual basis. Commenters are requested to provide empirical data and 
other factual support for their view to the extent possible.

VIII. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (IRFA), in accordance with the provisions of the 
Regulatory Flexibility Act,\216\ regarding the proposed amendments to 
Rules 15c3-1, 15c3-1a, 15c3-2, 15c3-3, 15c3-3a, 17a-3, 17a-4, and 17a-
11 under the Exchange Act.
---------------------------------------------------------------------------

    \216\ 5 U.S.C. 603.
---------------------------------------------------------------------------

    We encourage comments with respect to any aspect of this IRFA, 
including comments with respect to the number of small entities that 
may be affected by the proposed amendments. Comments should specify the 
costs of compliance with the proposed amendments, and suggest 
alternatives that would accomplish the goals of the amendments. 
Comments will be considered in determining whether a Final Regulatory 
Flexibility Analysis is required, and will be placed in the same public 
file as comments on the proposed amendments. Comments should be 
submitted to the Commission at the addresses previously indicated.

A. Amendments to the Customer Protection Rule

1. Reasons
    The proposed amendment that would require broker-dealers to perform 
a reserve computation for domestic and foreign broker-dealer accounts 
is responding to a disparity between Rule 15c3-3 and the SIPA. The 
proposed amendment that would require broker-dealers to limit the 
amount of cash deposited in a reserve account at any individual bank 
and exclude cash deposited with a parent or subsidiary bank is 
responding to the fact that some firms are concentrating such deposits 
or placing them at risk of group-wide financial collapses. The proposed 
amendment that would expand the definition of qualified securities is 
intended to provide broker-dealers with

[[Page 12889]]

another option with respect to assets that can be deposited into the 
customer reserve account. The proposed amendment that would require 
broker-dealers to obtain possession and control of customers' fully 
paid and excess margin securities allocated to a short position is 
responding to the fact that some firms are permitting these positions 
to accumulate, which puts customers at risk. The proposed amendment 
that would require broker-dealers to provide certain notices and 
disclosures before changing the terms and conditions under which the 
broker-dealer treats customer free credit balances is intended to help 
assure that the use of customer free credit balances accords with 
customer preferences. The proposed amendment lowering the aggregate 
debit item reduction from 3% to 1% is responding to the dramatic 
increase in debit items accumulating at broker-dealers. The proposed 
amendment clarifying that funds in certain commodities accounts are not 
to be treated as ``free credit balances'' is intended to remove 
uncertainty with respect to their treatment.
2. Objectives
    Most of the proposed amendments to Rule 15c3-3 are intended to 
strengthen the protections afforded to customer assets held at a 
broker-dealer. The intended result of the proposed amendments is to 
minimize the risk that customer assets will be lost, tied-up in a 
liquidation proceeding, or held in a manner that is inconsistent with a 
customer's expectations. The proposed amendment expanding the 
definition of qualified security is intended to lower operational 
burdens of broker-dealers. The proposed amendment eliminating the 3% 
reduction is intended to better align the requirement to reduce debits 
with the credit risk being addressed by the requirement. The proposed 
amendment clarifying the treatment of funds in certain commodities 
accounts is intended to remove an ambiguity in the rule.
3. Legal Basis
    Pursuant to the Exchange Act and, particularly, Section 15, 15 
U.S.C. 78o.
4. Small Entities Subject to the Rule
    Paragraph (c)(1) of Rule 0-10 \217\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that had total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the date in the 
prior fiscal year as of which its audited financial statements were 
prepared pursuant to Rule 17a-5(d); \218\ and is not affiliated with 
any person (other than a natural person) that is not a small business 
or small organization.
---------------------------------------------------------------------------

    \217\ 17 CFR 240.0-10(c)(1).
    \218\ 17 CFR 240.17a-5(d).
---------------------------------------------------------------------------

    The Commission estimates there are approximately eight broker-
dealers that performed a customer reserve computation pursuant to Rule 
15c3-3 and were ``small'' for the purposes of Rule 0-10.\219\
---------------------------------------------------------------------------

    \219\ This estimate is based on FOCUS Report filings.
---------------------------------------------------------------------------

5. Reporting, Recordkeeping, and Other Compliance Requirements
    The proposed amendments would (1) require broker-dealers to perform 
a reserve computation for domestic and foreign broker-dealer accounts, 
(2) limit the amount that a broker-dealer may deposit in a reserve 
account at any individual bank in the form of cash, (3) require broker-
dealers to obtain possession and control of customers' fully paid and 
excess margin securities allocated to a short position by borrowing 
equivalent securities within a specified period of time, (4) require 
broker-dealers to obtain an affirmative consent from a customer before 
changing the terms and conditions under which the broker-dealer holds 
credit balances related to the customer, and (5) lower the aggregate 
debit reduction.
6. Duplicative, Overlapping or Conflicting Federal Rules
    We believe that there are no Federal rules that duplicate, overlap 
or conflict with the proposed amendments.
7. Significant Alternatives
    Pursuant to section 3(a) of the RFA,\220\ the Commission must 
consider certain types of alternatives, including (1) the establishment 
of differing compliance or reporting requirements or timetables that 
take into account the resources available to small entities, (2) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities, (3) the use 
of performance rather than design standards, and (4) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \220\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    Given the negligible impact these amendments would have on small 
entities, we do not believe it is necessary or appropriate to establish 
different compliance or reporting requirements or timetables; clarify, 
consolidate, or simplify compliance and reporting requirements under 
the rule for small entities; or exempt small entities from coverage of 
the rule, or any part thereof. The Commission also does not believe 
that it is necessary to consider whether small entities should be 
permitted to use performance rather than design standards to comply 
with the proposed amendments as the amendments already propose 
performance standards and do not dictate for entities of any size any 
particular design standards (e.g., technology) that must be employed to 
achieve the objectives of the proposed amendments.
8. Request for Comments
    We encourage the submission of comments to any aspect of this 
portion of the IRFA. Comments should specify costs of compliance with 
the proposed amendment and suggest alternatives that would accomplish 
the objective of the proposed amendments.

B. Portfolio Margining Amendments

1. Reasons
    The CBOE and the NYSE rules permit broker-dealers to determine 
customer margin requirements using a portfolio margin methodology and 
permit cross-margining; namely, the inclusion in the portfolio margin 
account of futures and futures options on broad-based securities 
indices. These proposed amendments are designed to provide portfolio 
margin customers with protection for futures positions carried in their 
securities accounts.
2. Objectives
    These proposed amendments are designed to provide customers with 
futures and futures options in a portfolio margin account with SIPA 
protections.
3. Legal Basis
    Pursuant to the Exchange Act and, particularly, section 15.\221\
---------------------------------------------------------------------------

    \221\ 15 U.S.C. 78o.
---------------------------------------------------------------------------

4. Small Entities Subject to the Rule
    Paragraph (c)(1) of Rule 0-10 \222\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that had total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the date in the 
prior fiscal year as of which its audited financial statements were 
prepared pursuant to Rule 17a-5(d); \223\ and is not affiliated with 
any person (other than a natural

[[Page 12890]]

person) that is not a small business or small organization.
---------------------------------------------------------------------------

    \222\ 17 CFR 240.0-10(c)(1).
    \223\ 17 CFR 240.17a-5(d).
---------------------------------------------------------------------------

    The Commission estimates there are approximately eight broker-
dealers that performed a customer reserve computation pursuant to Rule 
15c3-3 and were ``small'' for the purposes of Rule 0-10.\224\
---------------------------------------------------------------------------

    \224\ This estimate is based on FOCUS Report filings.
---------------------------------------------------------------------------

5. Reporting, Recordkeeping, and Other Compliance Requirements
    These proposed amendments would (1) revise the definition of ``free 
credit balances'' in Rule 15c3-3 to include funds in a portfolio margin 
account relating to certain futures and futures options positions and 
the market value of futures options as of the filing date in a SIPA 
proceeding, and (2) add a debit line item to the customer reserve 
formula in Rule 15c3-3a consisting of margin posted by a broker-dealer 
to a futures clearing agency.
6. Duplicative, Overlapping or Conflicting Federal Rules
    We believe that there are no Federal rules that duplicate, overlap 
or conflict with the proposed amendments.
7. Significant Alternatives
    Pursuant to Section 3(a) of the RFA,\225\ the Commission must 
consider certain types of alternatives, including (1) the establishment 
of differing compliance or reporting requirements or timetables that 
take into account the resources available to small entities, (2) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities, (3) the use 
of performance rather than design standards, and (4) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \225\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    Given the negligible impact this amendment would have on small 
entities, we do not believe it is necessary or appropriate to establish 
different compliance or reporting requirements or timetables; clarify, 
consolidate, or simplify compliance and reporting requirements under 
the rule for small entities; or exempt small entities from coverage of 
the rule, or any part thereof.
    The Commission also does not believe that it is necessary to 
consider whether small entities should be permitted to use performance 
rather than design standards to comply with the proposed amendments as 
the amendments already propose performance standards and do not dictate 
for entities of any size any particular design standards (e.g., 
technology) that must be employed to achieve the objectives of the 
proposed amendments.
8. Request for Comments
    We encourage the submission of comments to any aspect of this 
portion of the IRFA. Comments should specify costs of compliance with 
the proposed amendment and suggest alternatives that would accomplish 
the objective of the proposed amendments.

C. Securities Lending, Borrowing, and Repurchase/Reverse Repurchase 
Amendments

1. Reasons
    In 2001, MJK Clearing, a broker-dealer with a substantial number of 
customer accounts, failed when it could not meet its securities lending 
obligations. This failure has highlighted the risks associated with 
securities lending and the economically similar repurchase and reverse 
repurchase agreements and the need to manage those risks.
2. Objectives
    These proposed amendments are intended to strengthen the 
documentation controls broker-dealers employ to manage their securities 
lending and borrowing and securities repurchase and reverse repurchase 
activities and to enhance regulatory monitoring. The intended result of 
the amendments is to minimize the risk that a firm would fail as a 
result of inadequate controls over its securities lending and borrowing 
securities repurchase and reverse repurchase activities.
3. Legal Basis
    Pursuant to the Exchange Act and, particularly, Sections 15 and 17 
thereof, 15 U.S.C. 78o and 78q.
4. Small Entities Subject to the Rule
    Paragraph (c)(1) of Rule 0-10 \226\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that had total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the date in the 
prior fiscal year as of which its audited financial statements were 
prepared pursuant to Rule 17a-5(d);\227\ and is not affiliated with any 
person (other than a natural person) that is not a small business or 
small organization.
---------------------------------------------------------------------------

    \226\ 17 CFR 240.0-10(c)(1).
    \227\ 17 CFR 240.17a-5(d).
---------------------------------------------------------------------------

    The Commission estimates that none of the broker-dealers that 
engage in securities lending and borrowing or securities repurchase and 
reverse repurchase activity are ``small'' for the purposes Rule 0-
10.\228\ Therefore, the proposed amendments should not impact on 
``small'' broker-dealers.
---------------------------------------------------------------------------

    \228\ This estimate is based on FOCUS Report filings.
---------------------------------------------------------------------------

5. Reporting, Recordkeeping, and Other Compliance Requirements
    These proposed amendments would require broker-dealers to (1) 
disclose the principals and obtain certain agreements from the 
principals in a transaction where they provide settlement services in 
order to be considered an agent (as opposed to a principal) for the 
purposes of the net capital rule, and (2) provide notice to the 
Commission and other regulatory authorities if the broker-dealer's 
securities lending or repo activity reaches a certain threshold or, 
alternatively, provide regulatory authorities with a monthly report of 
the broker-dealer's securities lending and repo activity.
6. Duplicative, Overlapping or Conflicting Federal Rules
    We believe that there are no Federal rules that duplicate, overlap 
or conflict with the proposed amendments.
7. Significant Alternatives
    Pursuant to Section 3(a) of the RFA,\229\ the Commission must 
consider certain types of alternatives, including (1) the establishment 
of differing compliance or reporting requirements or timetables that 
take into account the resources available to small entities, (2) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities, (3) the use 
of performance rather than design standards, and (4) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \229\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    As noted above, we estimate that this proposed amendment would have 
no impact on small entities. Thus, we do not believe it is necessary or 
appropriate to establish different compliance or reporting requirements 
or timetables; clarify, consolidate, or simplify compliance and 
reporting requirements under the rule for small entities; use 
performance rather than design standards, or any part thereof.
    The Commission also does not believe that it is necessary to 
consider whether small entities should be permitted to use performance 
rather than design standards to comply with the proposed amendments as 
the amendments already

[[Page 12891]]

propose performance standards and do not dictate for entities of any 
size any particular design standards (e.g., technology) that must be 
employed to achieve the objectives of the proposed amendments.
8. Request for Comments
    We encourage the submission of comments to any aspect of this 
portion of the IRFA. Comments should specify costs of compliance with 
the proposed amendment and suggest alternatives that would accomplish 
the objective of the proposed amendments.

D. Documentation of Risk Management Procedures

1. Reasons
    Requiring certain large broker-dealers to document their risk 
management procedures would assist firms in ensuring adherence to their 
established risk controls and regulators in reviewing the controls.
2. Objectives
    These proposed amendments are intended to strengthen the controls 
certain large broker-dealers employ to manage risk. The intended result 
of these proposed amendments is to lower systemic risk in the 
securities industry by enhancing risk management.
3. Legal Basis
    Pursuant to the Exchange Act and, particularly, Sections 15 and 17 
thereof, 15 U.S.C. 78o and 78q.
4. Small Entities Subject to the Rule
    Paragraph (c)(1) of Rule 0-10 \230\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that had total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the date in the 
prior fiscal year as of which its audited financial statements were 
prepared pursuant to Rule 17a-5(d); \231\ and is not affiliated with 
any person (other than a natural person) that is not a small business 
or small organization.
---------------------------------------------------------------------------

    \230\ 17 CFR 240.0-10(c)(1).
    \231\ 17 CFR 240.17a-5(d).
---------------------------------------------------------------------------

    The Commission estimates that none of the broker-dealers that would 
be subject to this proposed amendment would be ``small'' for the 
purposes Rule 0-10.\232\ Therefore, these amendments should not have 
any impact on ``small'' broker-dealers.
---------------------------------------------------------------------------

    \232\ This estimate is based on FOCUS Report filings.
---------------------------------------------------------------------------

5. Reporting, Recordkeeping, and Other Compliance Requirements
    These proposed amendments would require broker-dealers to document 
any controls, procedures and guidelines they use for managing risk. The 
proposed amendments do not require broker-dealers to implement 
procedures. Rather, they require the documentation of any procedures 
that are being used.
6. Duplicative, Overlapping or Conflicting Federal Rules
    We believe that there are no federal rules that duplicate, overlap 
or conflict with the proposed amendments.
7. Significant Alternatives
    Pursuant to section 3(a) of the RFA,\233\ the Commission must 
consider certain types of alternatives, including (1) the establishment 
of differing compliance or reporting requirements or timetables that 
take into account the resources available to small entities, (2) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities, (3) the use 
of performance rather than design standards, and (4) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \233\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    As noted above, these proposed amendments would have no impact on 
``small'' broker-dealers. Thus, we do not believe it is necessary or 
appropriate to establish different compliance or reporting requirements 
or timetables; clarify, consolidate, or simplify compliance and 
reporting requirements under the rule for small entities; or exempt 
small entities from coverage of the rule, or any part thereof.
    The Commission also does not believe that it is necessary to 
consider whether small entities should be permitted to use performance 
rather than design standards to comply with the proposed amendments as 
the amendments already propose performance standards and do not dictate 
for entities of any size any particular design standards (e.g., 
technology) that must be employed to achieve the objectives of the 
proposed amendments.
8. Request for Comments
    We encourage the submission of comments to any aspect of this 
portion of the IRFA. Comments should specify costs of compliance with 
the proposed amendment and suggest alternatives that would accomplish 
the objective of the proposed amendments.

E. Amendments to the Net Capital Rule

1. Limitations on Withdrawal of Capital, Solvency, Expense Sharing, 
Temporary Capital and Fidelity Bond Deductions
i. Reasons
    Some broker-dealers have excluded from their regulatory financial 
reports certain liabilities that have been shifted to third-parties 
that lack the resources--independent of the assets and revenue of the 
broker-dealer--to pay the liabilities or have utilized infusions of 
temporary capital. These practices obscure the true financial condition 
of the broker-dealer and, thereby, impede the ability of regulators to 
take proactive steps to reduce the harm to customers, counterparties 
and clearing agencies that may result from the broker-dealer's failure.
    Currently, broker-dealers are required to take net capital charges 
pursuant to self-regulatory organization rules relating to fidelity 
bond deductions, but Rule 15c3-1 does not explicitly incorporate such 
charges for purposes of computing net capital.
    In the past several years, a number of broker-dealers have sought 
to obtain protection under the bankruptcy laws while still engaging in 
a securities business. Permitting an insolvent broker-dealer to 
continue to transact a securities business endangers its customers and 
counterparties and places clearance organizations at risk.
    An important goal of the Commission is to protect the financial 
integrity of the broker-dealer so that if the firm must liquidate it 
may do so in an orderly fashion. Allowing a withdrawal of capital that 
may jeopardize the financial integrity of a broker-dealer exposes 
customers and creditors of the broker-dealer to unnecessary risk.
ii. Objectives
    The objective of these proposed amendments is to reduce systemic 
risk to the securities industry associated with the failure of the 
broker-dealer.
iii. Legal Basis
    Pursuant to the Exchange Act and, particularly, Sections 15 and 17 
thereof, 15 U.S.C. 78o and 78q.
iv. Small Entities Subject to the Rule
    Paragraph (c)(1) of Rule 0-10 \234\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that had total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the date in the 
prior fiscal year as of which its audited financial

[[Page 12892]]

statements were prepared pursuant to Rule 17a-5(d);\235\ and is not 
affiliated with any person (other than a natural person) that is not a 
small business or small organization.
---------------------------------------------------------------------------

    \234\ 17 CFR 240.0-10(c)(1).
    \235\ 17 CFR 240.17a-5(d).
---------------------------------------------------------------------------

    The Commission estimates that there are approximately 915 broker-
dealers that are ``small'' for the purposes Rule 0-10.\236\ These 
proposed amendments would apply to all ``small'' broker-dealers in that 
they would be subject to the requirements in the proposed amendments.
---------------------------------------------------------------------------

    \236\ This estimate is based on FOCUS Report filings.
---------------------------------------------------------------------------

v. Reporting, Recordkeeping, and Other Compliance Requirements
    The proposed amendments would require an insolvent broker-dealer to 
cease conducting a securities business and provide the securities 
regulators with notice of its insolvency. They also would require 
broker-dealers to add back certain liabilities and treat certain 
capital as a liability, as well as require broker-dealers to deduct 
from net capital, with regard to fidelity bonding requirements, the 
excess of any deductible amount over the maximum amount permitted by 
self-regulatory organization rules. Finally, under the proposed 
amendment to the rule on Commission orders restricting withdrawals of 
capital, a broker-dealer subject to an order would not be permitted to 
withdraw any capital.
vi. Duplicative, Overlapping or Conflicting Federal Rules
    We believe that there are no Federal rules that duplicate, overlap 
or conflict with the proposed amendments.
vii. Significant Alternatives
    Pursuant to section 3(a) of the RFA,\237\ the Commission must 
consider certain types of alternatives, including (1) the establishment 
of differing compliance or reporting requirements or timetables that 
take into account the resources available to small entities, (2) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities, (3) the use 
of performance rather than design standards, and (4) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \237\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    Given the minimal impact these amendments will have on small 
entities, we do not believe it is necessary or appropriate to establish 
different compliance or reporting requirements or timetables; clarify, 
consolidate, or simplify compliance and reporting requirements under 
the rule for small entities; or exempt small entities from coverage of 
the rule, or any part thereof.
    The Commission also does not believe that it is necessary to 
consider whether small entities should be permitted to use performance 
rather than design standards to comply with the proposed amendments as 
the amendments already propose performance standards and do not dictate 
for entities of any size any particular design standards (e.g., 
technology) that must be employed to achieve the objectives of the 
proposed amendments.
viii. Request for Comments
    We encourage the submission of comments to any aspect of this 
portion of the IRFA. Comments should specify costs of compliance with 
the proposed amendment and suggest alternatives that would accomplish 
the objective of the proposed amendments.
2. Adjusted Net Capital Requirements
i. Reasons
    The Commission's experience over the past several years in 
overseeing the capital requirements of broker-dealers indicates that 
certain capital charges may be adjusted downward without impairing the 
goal of the net capital rule. These proposed amendments are a result of 
this experience.
ii. Objective
    The proposed amendments are intended to better align the capital 
requirements with the risks these requirements are designed to address.
iii. Legal Basis
    Pursuant to the Exchange Act and, particularly, Sections 15 and 17 
thereof, 15 U.S.C. 78o and 78q.
iv. Small Entities Subject to the Rule
    Paragraph (c)(1) of Rule 0-10 \238\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that had total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the date in the 
prior fiscal year as of which its audited financial statements were 
prepared pursuant to Rule 17a-5(d); \239\ and is not affiliated with 
any person (other than a natural person) that is not a small business 
or small organization.
---------------------------------------------------------------------------

    \238\ 17 CFR 240.0-10(c)(1).
    \239\ 17 CFR 240.17a-5(d).
---------------------------------------------------------------------------

    The Commission estimates that there are approximately 915 broker-
dealers that were ``small'' for the purposes Rule 0-10.\240\ The 
amendment to Appendix A of Rule 15c3-1 likely should have no, or 
little, impact on ``small'' broker-dealers, since most, if not all, of 
these firms do not carry non-clearing option specialist or market maker 
accounts. The reduction of the haircut for money market funds from 2% 
to 1% could impact all ``small'' firms, since they may hold these 
securities as part of their net capital.
---------------------------------------------------------------------------

    \240\ This estimate is based on FOCUS Report filings.
---------------------------------------------------------------------------

v. Reporting, Recordkeeping, and Other Compliance Requirements
    The proposed amendments would (1) make permanent a temporary rule 
that reduced the haircut for non-clearing options specialist and market 
maker accounts under Appendix A, and (2) lower the haircut for money 
market funds from 2% to 1%. As noted, we estimate that generally only 
the second proposed amendment would affect ``small'' broker-dealers.
vi. Duplicative, Overlapping or Conflicting Federal Rules
    We believe that there are no federal rules that duplicate, overlap 
or conflict with the proposed amendments.
vii. Significant Alternatives
    Pursuant to section 3(a) of the RFA,\241\ the Commission must 
consider certain types of alternatives, including (1) the establishment 
of differing compliance or reporting requirements or timetables that 
take into account the resources available to small entities, (2) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities, (3) the use 
of performance rather than design standards, and (4) an exemption from 
coverage of the rule, or any part thereof, for small entities.
---------------------------------------------------------------------------

    \241\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    Given the deregulatory impact of these amendments, we do not 
believe it is necessary or appropriate to establish different 
compliance or reporting requirements or timetables; clarify, 
consolidate, or simplify compliance and reporting requirements under 
the rule for small entities; or exempt small entities from coverage of 
the rule, or any part thereof.
    The Commission also does not believe that it is necessary to 
consider whether small entities should be permitted to use performance 
rather than design standards to comply with the proposed amendments as 
the amendments already propose performance standards and do not dictate 
for entities of any size any

[[Page 12893]]

particular design standards (e.g., technology) that must be employed to 
achieve the objectives of the proposed amendments.
viii. Request for Comments
    We encourage the submission of comments to any aspect of this 
portion of the IRFA. Comments should specify costs of compliance with 
the proposed amendment and suggest alternatives that would accomplish 
the objective of the proposed amendments.

IX. Statutory Authority

    The Commission is proposing amendments to Rules 15c3-1, 15c3-3, 
17a-3, 17a-4 and 17a-11 under the Exchange Act pursuant to the 
authority conferred by the Exchange Act, including Sections 15, 17, 
23(a) and 36.\242\
---------------------------------------------------------------------------

    \242\ 15 U.S.C. 78o, 78q. 78w and 78mm.
---------------------------------------------------------------------------

Text of Proposed Rule

List of Subjects in 17 CFR Part 240

    Brokers, Reporting and recordkeeping requirements, Securities.

    In accordance with the foregoing, the Commission hereby proposes 
that Title 17, Chapter II of the Code of Federal Regulation be amended 
as follows.

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The general authority for part 240 is revised to read as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-l, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 
and 80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise 
noted.
* * * * *
    2. Section 240.15c3-1 is amended by:
    a. Revising the first sentence of the introductory text of 
paragraph (a);
    b. Revising paragraph (a)(1)(ii)(A);
    c. Removing from paragraph (a)(6)(iii)(A) the text ``paragraph 
(c)(2)(x)(A)(1) through (9) of this section'' and in its place adding 
the text ``Appendix A (Sec.  240.15c3-1a)'';
    d. Revising the introductory text of paragraph (c)(2)(i);
    e. Adding paragraphs (c)(2)(i)(F) and (G);
    f. Revising paragraphs (c)(2)(iv)(B), (c)(2)(iv)(E), and 
(c)(2)(vi)(D)(1);
    g. Adding paragraph (c)(2)(xiv) before the undesignated heading;
    h. Adding paragraph (c)(16) and an undesignated heading;
    i. Revising paragraph (e)(3)(i); and
    j. Removing from the second sentence in paragraph (e)(3)(ii) the 
text ``The hearing'' and in its place adding the text ``A hearing on an 
order temporarily prohibiting the withdrawal of capital''.
    The revisions and additions read as follows:


Sec.  240.15c3-1  Net capital requirements for brokers or dealers.

    (a) Every broker or dealer shall at all times have and maintain net 
capital no less than the greater of the highest minimum requirement 
applicable to its ratio requirement under paragraph (a)(1) of this 
section, or to any of its activities under paragraph (a)(2) of this 
section, and shall otherwise not be ``insolvent'' as that term is 
defined in paragraph (c)(16) of this section. * * *
* * * * *
    (1)(i) * * *
    (ii) * * *
    (A) Make the computation required by Sec.  240.15c3-3(e) and set 
forth in Exhibit A, Sec.  240.15c3-3a, on a weekly basis;
* * * * *
    (c) * * *
    (2) * * *
    (i) Adjustments to net worth related to unrealized profit or loss, 
deferred tax provisions, and certain liabilities.* * *
* * * * *
    (F) Adding to net worth any liability or expense relating to the 
business of the broker-dealer for which a third party has assumed the 
responsibility, unless the broker or dealer can demonstrate that the 
third-party has adequate resources independent of the broker-dealer to 
pay the liability or expense.
    (G) Subtracting from net worth any contribution of capital to the 
broker or dealer:
    (1) Under an agreement that provides the investor with the option 
to withdraw the capital; or
    (2) That is intended to be withdrawn within a period of one year 
unless the withdrawal has been approved in writing by the Examining 
Authority for the broker or dealer. Any withdrawal of capital made 
within one year of its contribution to the broker or dealer is presumed 
to be subject to this deduction.
* * * * *
    (iv) * * *
    (B) All unsecured advances and loans; deficits in customers' and 
non-customers' unsecured and partly secured notes; deficits in omnibus 
credit accounts maintained in compliance with the requirements of 12 
CFR 220.7(f) of Regulation T under the Act, or similar accounts carried 
on behalf of another broker or dealer, after application of calls for 
margin, marks to the market or other required deposits that are 
outstanding 5 business days or less; deficits in customers' and non-
customers' unsecured and partly secured accounts after application of 
calls for margin, marks to market or other required deposits that are 
outstanding 5 business days or less, except deficits in cash accounts 
as defined in 12 CFR 220.8 of Regulation T under the Act for which not 
more than one extension respecting a specified securities transaction 
has been requested and granted, and deducting for securities carried in 
any of such accounts the percentages specified in paragraph (c)(2)(vi) 
of this section or Appendix A, Sec.  240.15c3-1a; the market value of 
stock loaned in excess of the value of any collateral received 
therefore; receivables arising out of free shipments of securities 
(other than mutual fund redemptions) in excess of $5,000 per shipment 
and all free shipments (other than mutual fund redemptions) outstanding 
more than 7 business days, and mutual fund redemptions outstanding more 
than 16 business days; and any collateral deficiencies in secured 
demand notes as defined in Appendix D, Sec.  240.15c3-1d; a broker or 
dealer that participates in a loan of securities by one party to 
another party shall be deemed a principal for the purpose of the 
deductions required under this section, unless the broker or dealer has 
fully disclosed the identity of each party to the other and each party 
has expressly agreed in writing that the obligations of the broker or 
dealer shall not include a guarantee of performance by the other party 
and that such party's remedies in the event of a default by the other 
party shall not include a right of setoff against obligations, if any, 
of the broker or dealer.
* * * * *
    (E) Other deductions. All other unsecured receivables; all assets 
doubtful of collection less any reserves established therefore; the 
amount by which the market value of securities failed to receive 
outstanding longer than thirty (30) calendar days exceeds the contract 
value of such fails to receive; the funds on deposit in a ``segregated 
trust account'' in accordance with 17 CFR 270.27d-1 under the 
Investment Company Act of 1940, but only to the extent that the amount 
on deposit in such segregated trust account exceeds the amount of 
liability reserves established and maintained for refunds of charges 
required by sections 27(d) and 27(f) of the Investment Company Act of 
1940; and cash and securities held in a securities account at another

[[Page 12894]]

broker-dealer if the other broker-dealer does not treat the account, 
and the assets therein, in compliance with paragraphs (b)(5) and (e) of 
Sec.  240.15c3-3; Provided, That any amounts deposited in special 
reserve bank accounts established for the exclusive benefit of 
customers or PAB accounts pursuant to Sec.  240.15c3-3(e) and clearing 
deposits shall not be deducted.
* * * * *
    (vi) * * *
    (D)(1) In the case of redeemable securities of an investment 
company registered under the Investment Company Act of 1940, which 
assets consist of cash or money market instruments and which is 
described in Sec.  270.2a-7 of this Chapter, the deduction shall be 1% 
of the market value of the greater of the long or short position.
* * * * *
    (xiv) Deduction from net worth for excess deductible amounts 
related to fidelity bond coverage. Deducting, with respect to fidelity 
bond coverage, the excess of any deductible amount over the maximum 
deductible amount permitted by the Examining Authority for the broker 
or dealer.
* * * * *

Insolvent

    (16) A broker or dealer is insolvent for the purposes of this 
section if the broker-dealer:
    (i) Is the subject of any bankruptcy, equity receivership 
proceeding or any other proceeding to reorganize, conserve, or 
liquidate such broker or dealer or its property whether commenced 
voluntarily or involuntarily or is applying for the appointment or 
election of a receiver, trustee, or liquidator or similar official for 
such broker or dealer or its property;
    (ii) Has made a general assignment for the benefit of creditors;
    (iii) Is insolvent within the meaning of section 101 of title 11 of 
the United States Code, or is unable to meet its obligations as they 
mature, and has made an admission to such effect in writing or in any 
court or before any agency of the United States or any State; or
    (iv) Is unable to make such computations as may be necessary to 
establish compliance with this section.
* * * * *
    (e) * * *
    (3)(i) Temporary restrictions on withdrawal of net capital. The 
Commission may by order restrict, for a period of up to twenty business 
days, any withdrawal by the broker-dealer of equity capital or 
unsecured loan or advance to a stockholder, partner, sole proprietor, 
member, employee or affiliate if the Commission, based on the 
information available, concludes that such withdrawal, advance or loan 
may be detrimental to the financial integrity of the broker or dealer, 
or may unduly jeopardize the broker or dealer's ability to repay its 
customer claims or other liabilities which may cause a significant 
impact on the markets or expose the customers or creditors of the 
broker or dealer to loss without taking into account the application of 
the Securities Investor Protection Act of 1970.
* * * * *
    3. Section 240.15c3-1a is amended by:
    a. Removing paragraph (b)(1)(iv)(B); and
    b. Redesignating paragraphs (b)(1)(iv)(A), (b)(1)(iv)(A)(1), 
(b)(1)(iv)(A)(2), and (b)(1)(iv)(A)(3) as paragraphs (b)(1)(iv), 
(b)(1)(iv)(A), (b)(1)(iv)(B), and (b)(1)(iv)(C) respectively.
    4. Section 240.15c3-2 is removed and reserved.

    5. Section 240.15c3-3 is amended by:
    a. Removing from paragraph (a)(1), third sentence, the citation 
``220.19'' and in its place adding the citation ``220.12'';
    b. In paragraph (a)(1)(iii), revising the phrase ``(15 U.S.C. 78aaa 
et seq.)'' to read ``(15 U.S.C. 78aaa et seq.) (SIPA)'';
    c. Revising paragraphs (a)(3), (a)(4), (a)(6), (a)(7) and (a)(8);
    d. Adding paragraph (a)(16);
    e. Removing from paragraph (b)(3)(iv) the text ``the Securities 
Investor Protection Act of 1970'' and in its place adding the text 
``SIPA'';
    f. Removing from paragraph (b)(4)(i)(C) the text ``the Securities 
Investor Protection Act of 1970'' and in its place adding the text 
``SIPA'';
    g. Adding paragraph (b)(5);
    h. Removing from paragraph (c)(2) the text ``special omnibus'' and 
in its place adding the text ``omnibus credit'' and removing the text 
``section 4(b) of Regulation T under the Act (12 CFR 220.4(b))'' and in 
its place adding the text ``section 7(f) of Regulation T (12 CFR 
220.7(f))'';
    i. Removing the period at the end of paragraph (d)(3) and in its 
place adding ``; or'';
    j. Redesignating paragraph (d)(4) as paragraph (d)(5);
    k. Adding a new paragraph (d)(4);
    l. Revising paragraphs (e) and (f);
    m. Revising the first sentence in paragraph (g);
    n. Removing from the first sentence of paragraph (i) the text 
``reserve bank account'' and in its place adding the text ``Reserve 
Bank Accounts'';
    o. Adding paragraph (j);
    p. Revising paragraph (l)(2);
    q. Removing from the last sentence in paragraph (m) the text 
``special omnibus'' and in its place adding the text ``omnibus credit'' 
and removing the text ``section 4(b) of Regulation T [12 CFR 
220.4(b)]'' and in its place adding ``section 7(f) of Regulation T (12 
CFR 220.7(f))''; and
    r. Removing from the first sentence in paragraph (n) the cite 
``paragraphs (d)(2) and (3)'' and its place adding the cite 
``paragraphs (d)(2), (3) and (4)''.
    The revisions and additions read as follows:


Sec.  240.15c3-3  Customer protection--reserves and custody of 
securities.

    (a) * * *
    (3) The term fully paid securities shall include all securities 
carried for the account of a customer unless such securities are 
purchased in a transaction for which the customer has not made full 
payment.
    (4) The term margin securities shall mean those securities carried 
for the account of a customer in a margin account as defined in section 
4 of Regulation T (12 CFR 220.4), as well as securities carried in any 
other account (such accounts hereinafter referred to as ``margin 
accounts'') other than the securities referred to in paragraph (a)(3) 
of this section.
* * * * *
    (6) The term qualified security shall mean:
    (i) A security issued by the United States or guaranteed by the 
United States with respect to principal or interest; and
    (ii) A redeemable security of an unaffiliated investment company 
registered under the Investment Company Act of 1940 and described in 
Sec.  270.2a-7 of this chapter that:
    (A) Has assets consisting solely of cash and securities issued by 
the United States or guaranteed by the United States with respect to 
principal and interest;
    (B) Agrees to redeem fund shares in cash no later than the business 
day following a redemption request by a shareholder; and
    (C) Has net assets (assets net of liabilities) equal to at least 10 
times the value of the fund shares held by the broker-dealer in the 
customer reserve account required under paragraph (e) of this section.
    (7) The term bank shall mean a bank as defined in section 3(a)(6) 
of the Act and shall also mean any building and loan, savings and loan 
or similar banking institution subject to supervision by a Federal 
banking

[[Page 12895]]

authority. With respect to a broker or dealer who maintains his 
principal place of business in Canada, the term bank shall also mean a 
Canadian bank subject to supervision by a Canadian authority.
    (8) The term free credit balances shall mean liabilities of a 
broker or dealer to customers which are subject to immediate cash 
payment to customers on demand, whether resulting from sales of 
securities, dividends, interest, deposits or otherwise, excluding, 
however, funds in commodity accounts which are segregated in accordance 
with the Commodity Exchange Act or in a similar manner, or which are 
funds carried in a proprietary account as that term is defined in 
regulations under the Commodity Exchange Act. The term free credit 
balances also shall include such liabilities carried in a securities 
account pursuant to a self-regulatory organization portfolio margining 
rule approved by the Commission under section 19(b) of the Act (``SRO 
portfolio margining rule''), including daily marks to market, and 
proceeds resulting from closing out futures contracts and options 
thereon, and, in the event the broker-dealer is the subject of a 
proceeding under SIPA, the market value as of the ``filing date'' as 
that term is defined in SIPA (15 U.S.C. 78lll(7)) of any long options 
on futures contracts.
* * * * *
    (16) The term PAB account means a proprietary securities account of 
a broker or dealer (which includes a foreign broker or dealer, or a 
foreign bank acting as a broker or dealer), but shall not include an 
account where the account owner is a guaranteed subsidiary of the 
carrying broker or dealer, the account owner guarantees all liabilities 
and obligations of the carrying broker or dealer, or the account is a 
delivery-versus-payment account or a receipt-versus-payment account.
    (b) * * *
    (5) A broker or dealer shall not be required to obtain and 
thereafter to maintain the physical possession or control of securities 
carried for a PAB account, provided that the broker or dealer has 
obtained the written permission of the account owner to use the 
securities in the ordinary course of its securities business.
* * * * *
    (d) * * *
    (4) Securities included on his books or records as a proprietary 
short position or as a short position for another person, excluding 
positions covered by paragraph (m) of this section, for more than 10 
business days (or more than 30 calendar days if the broker or dealer is 
a market maker in the securities), then the broker or dealer shall, not 
later than the business day following the day on which the 
determination is made, take prompt steps to obtain physical possession 
or control of such securities.
* * * * *
    (e) Special reserve bank accounts for the exclusive benefit of 
customers and PAB accounts.
    (1) Every broker or dealer shall maintain with a bank or banks at 
all times when deposits are required or hereinafter specified ``Special 
Reserve Bank Account for the Exclusive Benefit of Customers'' 
(hereinafter referred to as the Reserve Bank Account) and a ``Special 
Reserve Bank Account for Brokers and Dealers (hereinafter referred to 
as the PAB Reserve Bank Account, and together with the Reserve Bank 
Account, the Reserve Bank Accounts), each of which shall be separate 
from the other and from any other bank account of the broker or dealer. 
Such broker or dealer shall at all times maintain in the Reserve Bank 
Accounts, through deposits made therein, cash and/or qualified 
securities in amounts computed in accordance with the formula attached 
as Exhibit A, as applied to customer and PAB accounts respectively.
    (2) With respect to each computation required pursuant to paragraph 
(e)(1) of this section, it shall be unlawful for any broker or dealer 
to accept or use any of the amounts under items comprising Total 
Credits under the formula referred to in paragraph (e)(1) of this 
section except for the specified purposes indicated under items 
comprising Total Debits under the formula, and, to the extent Total 
Credits exceed Total Debits, at least the net amount thereof shall be 
maintained in the Reserve Bank Accounts pursuant to paragraph (e)(1) of 
this section.
    (3)(i) Computations necessary to determine the amount required to 
be deposited in Reserve Bank Accounts as specified in paragraph (e)(1) 
of this section shall be made weekly, as of the close of the last 
business day of the week, and the deposit so computed shall be made no 
later than one hour after the opening of banking business on the second 
following business day; provided, however, a broker or dealer which has 
aggregate indebtedness not exceeding 800 per centum of net capital (as 
defined in Sec.  240.15c3-1 or in the capital rules of a national 
securities exchange of which it is a member and exempt from Sec.  
240.15c3-1 by paragraph (b)(2) of that section) and which carries 
aggregate customer funds (as defined in paragraph (a)(10) of this 
section), as computed at the last required computation pursuant to this 
section, not exceeding $1,000,000, may in the alternative make the 
computation monthly, as of the close of the last business day of the 
month, and, in such event, shall deposit not less than 105 per centum 
of the amount so computed no later than one hour after the opening of 
banking business on the second following business day.
    (ii) If a broker or dealer, computing on a monthly basis, has, at 
the time of any required computation, aggregate indebtedness in excess 
of 800 per centum of net capital, such broker or dealer shall 
thereafter compute weekly as aforesaid until four successive weekly 
computations are made, none of which were made at a time when his 
aggregate indebtedness exceeded 800 per centum of his net capital.
    (iii) Any broker or dealer that does not carry the accounts of a 
``customer'' as defined by this section or conduct a proprietary 
trading business may make the computation to be performed with respect 
to PAB accounts under paragraph (e)(1) of this section monthly rather 
than weekly. If a broker or dealer performing the computation with 
respect to PAB accounts under paragraph (e)(1) of this section on a 
monthly basis is, at the time of any required computation, required to 
deposit additional cash or qualified securities in the PAB Special 
Reserve Account, the broker or dealer shall thereafter perform the 
computation required with respect to PAB accounts under paragraph 
(e)(1) of this section weekly until four successive weekly computations 
are made, none of which is made at a time when the broker or dealer was 
required to deposit additional cash or qualified securities in the PAB 
Special Reserve Account.
    (iv) Computations in addition to the computations required in this 
section, may be made as of the close of any business day, and the 
deposits so computed shall be made no later than one hour after the 
opening of banking business on the second following business day.
    (v) The broker or dealer shall make and maintain a record of each 
such computation made pursuant to this section or otherwise and 
preserve each such record in accordance with Sec.  240.17a-4.
    (4) If the computation performed under paragraph (e)(3) of this 
section with respect to PAB accounts results in a deposit requirement, 
the requirement may be satisfied to the extent of any excess debit in 
the computation performed under paragraph (e)(3) of this

[[Page 12896]]

section with respect to customer accounts of the same date. However, a 
deposit requirement resulting from the computation performed under 
paragraph (e)(3) of this section with respect to customer accounts 
cannot be satisfied with excess debits from the computation performed 
under paragraph (e)(3) of this section with respect to PAB accounts.
    (5) In determining whether a broker or dealer maintains the minimum 
deposits required under this section, the broker or dealer shall 
exclude the total amount of any cash deposited with a parent or 
affiliate bank. The broker or dealer also shall exclude cash deposited 
with a non-parent and non-affiliated bank to the extent that:
    (i) The amount of the deposit exceeds 50% of the broker-dealer's 
excess net capital, based on the broker-dealer's most recently filed 
FOCUS report; or
    (ii) The amount of the deposit exceeds 10% of the bank's equity 
capital as reported by the bank in its most recent Call Report or 
Thrift Financial Report.
    (f) Notification of banks. A broker or dealer required to maintain 
the Reserve Bank Accounts prescribed by this section or who maintains a 
Special Account referred to in paragraph (k) of this section shall 
obtain and preserve in accordance with Sec.  240.17a-4 a written 
notification from each bank in which he has his Reserve Bank Accounts 
or Special Account that the bank was informed that all cash and/or 
qualified securities deposited therein are being held by the bank for 
the exclusive benefit of customers of the broker or dealer (or, in the 
case of the PAB Special Reserve Account, for the benefit of brokers or 
dealers) in accordance with the regulations of the Commission, and are 
being kept separate from any other accounts maintained by the broker or 
dealer with the bank, and the broker or dealer shall have a written 
contract with the bank which provides that the cash and/or qualified 
securities shall at no time be used directly or indirectly as security 
for a loan to the broker or dealer by the bank and, shall be subject to 
no right, charge, security interest, lien, or claim of any kind in 
favor of the bank or any person claiming through the bank.
    (g) Withdrawals from the reserve bank accounts. A broker or dealer 
may make withdrawals from his Reserve Bank Accounts if and to the 
extent that at the time of the withdrawal the amount remaining in each 
Reserve Bank Account is not less than the amount then required by 
paragraph (e) of this section. * * *
* * * * *
    (j) Treatment of free credit balances. (1) It shall be unlawful for 
a broker or dealer to accept or use any free credit balance carried for 
the account of any customer of the broker or dealer unless such broker 
or dealer has established adequate procedures pursuant to which each 
customer for whom a free credit balance is carried will be given or 
sent, together with or as part of the customer's statement of account, 
whenever sent but not less frequently than once every three months, a 
written statement informing the customer of the amount due to the 
customer by the broker or dealer on the date of the statement, and that 
the funds are payable on demand of the customer.
    (2) It shall be unlawful for a broker or dealer to convert, invest, 
or otherwise transfer to another account or institution, free credit 
balances held in a customer's account except as provided in paragraphs 
(j)(2)(i), (ii) and (iii).
    (i) A broker or dealer is permitted to convert, invest, or 
otherwise transfer to another account or institution, free credit 
balances in a customer's account only upon a specific order, 
authorization, or draft from the customer, and only in the manner, and 
under the terms and conditions, specified in the order, authorization, 
or draft.
    (ii) A broker or dealer is permitted to transfer free credit 
balances held in the account of a customer opened on or after the 
effective date of this paragraph to either a money market mutual fund 
product as described in Sec.  270.2a-7 of this chapter or an interest 
bearing account at a bank without a specific order, authorization or 
draft for each such transfer, provided:
    (A) The customer has previously affirmatively consented to such 
treatment of the free credit balances after being notified of the 
different general types of money market mutual fund and bank account 
products in which the broker or dealer may transfer the free credit 
balances and the applicable terms and conditions that will apply if the 
broker or dealer changes the product or type of product in which free 
credit balances are transferred;
    (B) The broker or dealer provides the customer on an ongoing basis 
with all disclosures and notices regarding the investment and deposit 
of free credit balances as required by the self-regulatory 
organizations for which the broker or dealer is a member;
    (C) The broker or dealer provides notice to the customer as part of 
the customer's quarterly statement of account that the money market 
mutual funds or bank deposits to which the free credit balances have 
been transferred can be liquidated on the customer's demand and held as 
free credit balances; and
    (D) The broker or dealer provides the customer with at least 30 
calendar days notice before the free credit balances will begin being 
transferred to a different product, different product type, or into the 
same product but under materially different terms and conditions. The 
notice must describe the new money market fund, bank deposit type, or 
terms and conditions, and how the customer can notify the broker or 
dealer if the customer chooses not to have the free credit balances 
transferred to the new product or product type, or under the new terms 
and conditions.
    (iii) A broker or dealer is permitted to transfer free credit 
balances that are held or will accumulate in the account of a customer 
opened before the effective date of this paragraph to either a money 
market mutual fund product as described in Sec.  270.2a-7 of this 
chapter or an interest bearing account product at a bank without a 
specific order, authorization or draft for each such transfer, 
provided:
    (A) The broker or dealer provides the customer on an ongoing basis 
with all disclosures and notices regarding the investment and deposit 
of free credit balances as required by the self-regulatory 
organizations for which the broker or dealer is a member;
    (B) The broker or dealer provides notice to the customer as part of 
the customer's quarterly statement of account that the money market 
mutual funds or bank deposits to which the free credit balances have 
been transferred can be liquidated on the customer's demand and held as 
free credit balances; and
    (C) The broker or dealer provides the customer with at least 30 
calendar days notice before the free credit balances will begin being 
transferred to a different product, different product type, or into the 
same product but under materially different terms and conditions. The 
notice must describe the new money market fund, bank deposit type, or 
terms and conditions, and how the customer can notify the broker or 
dealer if the customer chooses not to have the free credit balances 
transferred to the new product or product type, or under the new terms 
and conditions.
* * * * *
    (l) * * *
    (2) Margin securities upon full payment by such customer to the 
broker or dealer of his indebtedness to the

[[Page 12897]]

broker or dealer; and, subject to the right of the broker or dealer 
under Regulation T (12 CFR part 220) to retain collateral for his own 
protection beyond the requirements of Regulation T, excess margin 
securities not reasonably required to collateralize such customer's 
indebtedness to the broker or dealer.
* * * * *
    6. Section 240.15c3-3a is revised to read as follows:


Sec.  240.15c3-3a  Exhibit A--Formula for determination of customer and 
PAB account reserve requirements of brokers and dealers under Sec.  
240.15c3-3.

------------------------------------------------------------------------
                                                  Credits       Debits
------------------------------------------------------------------------
1. Free credit balances and other credit               $XXX  ...........
 balances in customers' security accounts.
 (See Note A).................................
2. Monies borrowed collateralized by                    XXX  ...........
 securities carried for the account of
 customers (See Note B).......................
3. Monies payable against customers'                    XXX  ...........
 securities loaned (See Note C)...............
4. Customers' securities failed to receive              XXX  ...........
 (See Note D).................................
5. Credit balances in firm accounts which are           XXX  ...........
 attributable to principal sales to customers.
6. Market value of stock dividends, stock               XXX  ...........
 splits and similar distributions receivable
 outstanding over 30 calendar days............
7. Market value of short security count                 XXX  ...........
 difference over 30 calendar days old.........
8. Market value of short securities and                 XXX  ...........
 credits (not to be offset by longs or by
 debits) in all suspense accounts over 30
 calendar days................................
9. Market value of securities which are in              XXX  ...........
 transfer in excess of 40 calendar days and
 have not been confirmed to be in transfer by
 the transfer agent or the issuer during the
 40 days......................................
10. Debit balances in customers' cash and       ...........         $XXX
 margin accounts excluding unsecured accounts
 and accounts doubtful of collection. (See
 Note E)......................................
11. Securities borrowed to effectuate short     ...........          XXX
 sales by customers and securities borrowed to
 make delivery on customers' securities failed
 to deliver...................................
12. Failed to deliver of customers' securities  ...........          XXX
 not older than 30 calendar days..............
13. Margin required and on deposit with the     ...........          XXX
 Options Clearing Corporation for all option
 contracts written or purchased in customer
 and PAB accounts. (See Note F)...............
14. Margin required and on deposit with a       ...........          XXX
 clearing agency registered with the
 Commission under section 17A of the Act (15
 U.S.C. 78q-1) or a derivatives clearing
 organization registered with the Commodity
 Futures Trading Commission under section 5b
 of the Commodity Exchange Act (7 U.S.C. 7a-1)
 related to the following types of positions
 written, purchased or sold in customer
 accounts: (1) Security futures products and
 (2) futures contracts (and options thereon)
 carried in a securities account pursuant to
 an SRO portfolio margining rule (See Note G).
                                               ==============
    Total credits.............................  ...........  ...........
    Total debits..............................  ...........  ...........
15. Excess of total credits (sum of items 1-9)  ...........          XXX
 over total debits (sum of items 10-14)
 required to be on deposit in the ``Reserve
 Bank Account'' (Sec.   240.15c3-3(c)). If the
 computation is made monthly as permitted by
 this section, the deposit shall be not less
 than 105% of the excess of total credits over
 total debits.................................
------------------------------------------------------------------------

Notes Regarding the Customer Reserve Computation

    Note A. Item 1 shall include all outstanding drafts payable to 
customers which have been applied against free credit balances or 
other credit balances and shall also include checks drawn in excess 
of bank balances per the records of the broker or dealer.


    Note B. Item 2 shall include the amount of options-related or 
security futures product-related Letters of Credit obtained by a 
member of a registered clearing agency or a derivatives clearing 
organization which are collateralized by customers' securities, to 
the extent of the member's margin requirement at the registered 
clearing agency or derivatives clearing organization. Item 2 shall 
also include the amount of such Letters of Credit related to other 
futures contracts (and options thereon) carried in a securities 
account pursuant to an SRO portfolio margining rule.


    Note C. Item 3 shall include in addition to monies payable 
against customers' securities loaned the amount by which the market 
value of securities loaned exceeds the collateral value received 
from the lending of such securities.


    Note D. Item 4 shall include in addition to customers' 
securities failed to receive the amount by which the market value of 
securities failed to receive and outstanding more than thirty (30) 
calendar days exceeds their contract value.


    Note E. (1) Debit balances in margin accounts shall be reduced 
by the amount by which a specific security (other than an exempted 
security) which is collateral for margin accounts exceeds in 
aggregate value 15 percent of all securities which collateralize all 
margin accounts receivable; provided, however, the required 
reduction shall not be in excess of the amounts of the debit balance 
required to be excluded because of this concentration rule. A 
specified security is deemed to be collateral for a margin account 
only to the extent it represents in value not more than 140 percent 
of the customer debit balance in a margin account.
    (2) Debit balances in special omnibus accounts, maintained in 
compliance with the requirements of Section 7(f) of Regulation T (12 
CFR 220.7(f)) or similar accounts carried on behalf of another 
broker or dealer, shall be reduced by any deficits in such accounts 
(or if a credit, such credit shall be increased) less any calls for 
margin, mark to the market, or other required deposits which are 
outstanding 5 business days or less.
    (3) Debit balances in customers' cash and margin accounts 
included in the formula under Item 10 shall be reduced by an amount 
equal to 1 percent of their aggregate value.
    (4) Debit balances in cash and margin accounts of household 
members and other persons related to principals of a broker or 
dealer and debit balances in cash and margin accounts of affiliated 
persons of a broker or dealer shall be excluded from the Reserve 
Formula, unless the broker or dealer can demonstrate that such debit 
balances are directly related to credit items in the formula.
    (5) Debit balances in margin accounts (other than omnibus 
accounts) shall be reduced by the amount by which any single 
customer's debit balance exceeds 25% (to the extent such amount is 
greater than $50,000) of the broker-dealer's tentative net capital 
(i.e., net capital prior to securities haircuts) unless the broker 
or dealer can demonstrate that the debit balance is directly related 
to credit items in the Reserve Formula. Related accounts (e.g., the 
separate accounts of an individual, accounts under common control or 
subject to cross guarantees) shall be deemed to be a single 
customer's accounts for purposes of this provision.
    If the registered national securities exchange or the registered 
national securities association having responsibility for examining 
the broker or dealer (``designated examining authority'') is 
satisfied, after

[[Page 12898]]

taking into account the circumstances of the concentrated account 
including the quality, diversity, and marketability of the 
collateral securing the debit balances of margin accounts subject to 
this provision, that the concentration of debit balances is 
appropriate, then such designated examining authority may grant a 
partial or plenary exception from this provision. The debit balance 
may be included in the reserve formula computation for five business 
days from the day the request is made.
    (6) Debit balances of joint accounts, custodian accounts, 
participation in hedge funds or limited partnerships or similar type 
accounts or arrangements of a person who would be excluded from the 
definition of customer (``noncustomer'') with persons included in 
the definition of customer shall be included in the Reserve Formula 
in the following manner: if the percentage ownership of the non-
customer is less than 5 percent then the entire debit balance shall 
be included in the formula; if such percentage ownership is between 
5 percent and 50 percent then the portion of the debit balance 
attributable to the non-customer shall be excluded from the formula 
unless the broker or dealer can demonstrate that the debit balance 
is directly related to credit items in the formula; or if such 
percentage ownership is greater that 50 percent, then the entire 
debit balance shall be excluded from the formula unless the broker 
or dealer can demonstrate that the debit balance is directly related 
to credit items in the formula.


    Note F. Item 13 shall include the amount of margin deposited 
with the Options Clearing Corporation to the extent such margin is 
represented by cash, proprietary qualified securities and letters of 
credit collateralized by customers' securities.


    Note G. (a) Item 14 shall include the amount of margin required 
and on deposit with a clearing agency registered with the Commission 
under section 17A of the Act (15 U.S.C. 78q-1) or a derivatives 
clearing organization registered with the Commodity Futures Trading 
Commission under section 5b of the Commodity Exchange Act (7 U.S.C. 
7a-1) for customer accounts to the extent that the margin is 
represented by cash, proprietary qualified securities, and letters 
of credit collateralized by customers' securities.

    (b) Item 14 shall apply only if the broker or dealer has the margin 
related to security futures products or futures (and options thereon) 
carried in a securities account pursuant to an approved SRO portfolio 
margining program on deposit with:
    (1) A registered clearing agency or derivatives clearing 
organization that:
    (i) Maintains the highest investment-grade rating from a nationally 
recognized statistical rating organization; or
    (ii) Maintains security deposits from clearing members in 
connection with regulated options or futures transactions and 
assessment power over member firms that equal a combined total of at 
least $2 billion, at least $500 million of which must be in the form of 
security deposits. For the purposes of this Note G, the term ``security 
deposits'' refers to a general fund, other than margin deposits or 
their equivalent, that consists of cash or securities held by a 
registered clearing agency or derivative clearing organization; or
    (iii) Maintains at least $3 billion in margin deposits; or
    (iv) Does not meet the requirements of paragraphs (b)(1)(i) through 
(b)(1)(iii) of this Note G, if the Commission has determined, upon a 
written request for exemption by or for the benefit of the broker or 
dealer, that the broker or dealer may utilize such a registered 
clearing agency or derivatives clearing organization. The Commission 
may, in its sole discretion, grant such an exemption subject to such 
conditions as are appropriate under the circumstances, if the 
Commission determines that such conditional or unconditional exemption 
is necessary or appropriate in the public interest, and is consistent 
with the protection of investors; and
    (2) A registered clearing agency or derivatives clearing 
organization that, if it holds funds or securities deposited as margin 
for security futures products or portfolio margin account futures in a 
bank, as defined in section 3(a)(6) of the Act (15 U.S.C. 78c(a)(6)), 
obtains and preserves written notification from the bank at which it 
holds such funds and securities or at which such funds and securities 
are held on its behalf. The written notification shall state that all 
funds and/or securities deposited with the bank as margin (including 
customer security futures products and portfolio margin account futures 
margin), or held by the bank and pledged to such registered clearing 
agency or derivatives clearing agency as margin, are being held by the 
bank for the exclusive benefit of clearing members of the registered 
clearing agency or derivatives clearing organization (subject to the 
interest of such registered clearing agency or derivatives clearing 
organization therein), and are being kept separate from any other 
accounts maintained by the registered clearing agency or derivatives 
clearing organization with the bank. The written notification also 
shall provide that such funds and/or securities shall at no time be 
used directly or indirectly as security for a loan to the registered 
clearing agency or derivatives clearing organization by the bank, and 
shall be subject to no right, charge, security interest, lien, or claim 
of any kind in favor of the bank or any person claiming through the 
bank. This provision, however, shall not prohibit a registered clearing 
agency or derivatives clearing organization from pledging customer 
funds or securities as collateral to a bank for any purpose that the 
rules of the Commission or the registered clearing agency or 
derivatives clearing organization otherwise permit; and
    (3) A registered clearing agency or derivatives clearing 
organization establishes, documents, and maintains:
    (i) Safeguards in the handling, transfer, and delivery of cash and 
securities;
    (ii) Fidelity bond coverage for its employees and agents who handle 
customer funds or securities. In the case of agents of a registered 
clearing agency or derivatives clearing organization, the agent may 
provide the fidelity bond coverage; and
    (iii) Provisions for periodic examination by independent public 
accountants; and
    (iv) A derivatives clearing organization that, if it is not 
otherwise registered with the Commission, has provided the Commission 
with a written undertaking, in a form acceptable to the Commission, 
executed by a duly authorized person at the derivatives clearing 
organization, to the effect that, with respect to the clearance and 
settlement of the customer securities futures products and portfolio 
margin account futures of the broker or dealer, the derivatives 
clearing organization will permit the Commission to examine the books 
and records of the derivatives clearing organization for compliance 
with the requirements set forth in Sec.  240.15c3-3a, Note G (b)(1) 
through (3).
    (c) Item 14 shall apply only if a broker or dealer determines, at 
least annually, that the registered clearing agency or derivatives 
clearing organization with which the broker or dealer has on deposit 
margin related to securities future products or portfolio margin 
account futures meets the conditions of this Note G.

Notes Regarding the PAB Reserve Computation

    Note 1. Broker-dealers should use the formula in Exhibit A for 
the purposes of computing the PAB reserve requirement substituting 
the term ``brokers or dealers'' for the term ``customers.''


    Note 2. Any credit (including a credit applied to reduce a 
debit) that is included in the computation required by Sec.  
240.15c3-3 with respect to customer accounts (the ``customer reserve 
computation'') may not be included as a credit in the computation 
required by Sec.  240.15c3-3 with respect to PAB accounts (the ``PAB 
reserve computation'').



[[Page 12899]]


    Note 3. Note E(1) to Sec.  240.15c3-3a shall not apply to the 
PAB reserve computation.


    Note 4. Note E(3) to Sec.  240.15c3-3a which reduces debit 
balances by 1% shall not apply to the PAB reserve computation.


    Note 5. Commissions receivable and other receivables of another 
broker or dealer from the broker or dealer (excluding clearing 
deposits) that are otherwise allowable assets under Sec.  240.15c3-1 
shall not be included in the PAB reserve computation, provided the 
amounts have been clearly identified as receivables on the books and 
records of the other broker or dealer and as payables on the books 
of the broker or dealer. Commissions receivable and other 
receivables of another broker or dealer from the broker or dealer 
that are otherwise non-allowable assets under Sec.  240.15c3-1 and 
clearing deposits of another broker or dealer may be included as 
``credit balances'' for purposes of the PAB reserve computation, 
provided the commissions receivable and other receivables are 
subject to immediate cash payment to the other broker or dealer and 
the clearing deposit is subject to payment within 30 days.


    Note 6. Credits included in the PAB reserve computation that 
result from the use of securities held for a PAB account (``PAB 
securities'') that are pledged to meet intra-day margin calls in a 
cross-margin account established between The Options Clearing 
Corporation and any regulated commodity exchange may be reduced to 
the extent that the excess margin held by the other clearing 
corporation in the cross-margin relationship is used the following 
business day to replace the PAB securities that were previously 
pledged. In addition, balances resulting from a portfolio margin 
account that are segregated pursuant to Commodity Futures Trading 
Commission regulations need not be included in the PAB reserve 
computation.


    Note 7. Deposits received prior to a transaction pending 
settlement which are $5 million or greater for any single 
transaction or $10 million in aggregate may be excluded as credits 
from the PAB reserve computation if such balances are placed and 
maintained in a separate PAB Reserve Account by 12 noon Eastern Time 
on the following business day. Thereafter, the money representing 
any such deposits may be withdrawn to complete the related 
transactions without performing a new PAB reserve computation.


    Note 8. A credit balance resulting from a PAB reserve 
computation may be reduced by the amount that items representing 
such credits are swept into money market funds or mutual funds of an 
investment company registered under the Investment Company Act of 
1940 on or prior to 10 a.m. Eastern Time on the deposit date 
provided that the credits swept into any such fund are not subject 
to any right, charge, security interest, lien, or claim of any kind 
in favor of the investment company or the broker or dealer. Any 
credits that have been swept into money market funds or mutual funds 
must be maintained in the name of a particular broker or for the 
benefit of another broker.


    Note 9. Clearing deposits required to be maintained at 
registered clearing agencies may be included as debits in the PAB 
reserve computation to the extent the percentage of the deposit, 
which is based upon the clearing agency's aggregate deposit 
requirements (e.g., dollar trading volume), that relates to the 
proprietary business of other brokers and dealers can be identified.


    Note 10. A broker or dealer that clears PAB accounts through an 
affiliate or third party clearing broker must include these PAB 
account balances and the omnibus PAB account balance in its PAB 
reserve computation.


    7. Section 240.17a-3 is amended by adding paragraph (a)(23) and to 
read as follows:


Sec.  240.17a-3  Records to be made by certain exchange members, 
brokers and dealers.

    (a) * * *
    (23) A record documenting the internal risk management controls 
established and maintained by the member, broker or dealer to assist it 
in analyzing and managing the risks associated with its business 
activities, Provided, That the records required by this paragraph 
(a)(23) need only be made if the member, broker or dealer has more 
than:
    (i) $1,000,000 in aggregate credit items as computed under Sec.  
240.15c3-3a; or
    (ii) $20,000,000 in capital, which includes debt subordinated in 
accordance with Sec.  240.15c3-1d.
* * * * *
    8. Section 240.17a-4 is amended by:
    a. Removing from paragraph (b)(1) the citation ``Sec.  240.17a-
3(f)'' and its place adding the citation ``Sec.  240.17a-3(g)'';
    b. Removing from paragraph (b)(9) the citation ``Sec.  240.15c3-
3(d)(4)'' and in its place adding the citation ``Sec.  240.15c3-
3(d)(5)''; and
    c. Adding paragraph (e)(9).
    The addition reads as follows:


Sec.  240.17a-4  Records to be preserved by certain exchange members, 
brokers and dealers.

* * * * *
    (e) * * *
    (9) All records required pursuant to paragraph (a)(23) of Sec.  
240.17a-3 until three years after the termination of the use of the 
system of controls or procedures documented therein.
* * * * *
    9. Section 240.17a-11 is amended by:
    a. Revising the first sentence of paragraph (b)(1);
    b. Removing from the introductory text of paragraph (c) the text 
``or (c)(4)'' and in its place adding the text ``(c)(4) or (c)(5)''; 
and
    c. Adding paragraph (c)(5).
    The revision and addition read as follows:


Sec.  240.17a-11  Notification provisions for brokers and dealers.

* * * * *
    (b)(1) Every broker or dealer whose net capital declines below the 
minimum amount required pursuant to Sec.  240.15c3-1, or is insolvent 
as that term is defined in paragraph (c)(16) of Sec.  240.15c3-1, shall 
give notice of such deficiency that same day in accordance with 
paragraph (g) of this section. * * *
* * * * *
    (c) * * *
    (5) If a computation made by a broker or dealer pursuant to Sec.  
240.15c3-1 shows that the total amount of money payable against all 
securities loaned or subject to a repurchase agreement or the total 
contract value of all securities borrowed or subject to a reverse 
repurchase agreement is in excess of 2500 percent of its tentative net 
capital; provided, however, that for purposes of this leverage test 
transactions involving government securities, as defined in section 
3(a)(42) of the Act (15 U.S.C. 78c(a)(42), shall be excluded from the 
calculation; provided further, however, that a broker or dealer shall 
not be required to send the notice required by this paragraph if it 
submits a monthly report of its securities lending and borrowing and 
repurchase and reverse repurchase activity (including the total amount 
of money payable against securities loaned or subject to a repurchase 
agreement and the total contract value of securities borrowed or 
subject to a reverse repurchase agreement) to its designated examining 
authority.
* * * * *

    By the Commission.

     Dated: March 9, 2007.
Nancy M. Morris,
Secretary.
[FR Doc. E7-4693 Filed 3-16-07; 8:45 am]

BILLING CODE 8010-01-P
