
[Federal Register Volume 78, Number 162 (Wednesday, August 21, 2013)]
[Rules and Regulations]
[Pages 51909-52003]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-18738]



[[Page 51909]]

Vol. 78

Wednesday,

No. 162

August 21, 2013

Part III





Securities and Exchange Commission





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17 CFR Parts 240 and 249





 Broker-Dealer Reports; Final Rule

  Federal Register / Vol. 78, No. 162 / Wednesday, August 21, 2013 / 
Rules and Regulations  

[[Page 51910]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 249

[Release No. 34-70073; File No. S7-23-11]
RIN 3235-AK56


Broker-Dealer Reports

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission''), under 
the Securities Exchange Act of 1934 (``Exchange Act''), is amending 
certain broker-dealer annual reporting, audit, and notification 
requirements. The amendments include a requirement that broker-dealer 
audits be conducted in accordance with standards of the Public Company 
Accounting Oversight Board (``PCAOB'') in light of explicit oversight 
authority provided to the PCAOB by the Dodd-Frank Wall Street Reform 
and Consumer Protection Act (``Dodd-Frank Act'') to oversee these 
audits. The amendments further require a broker-dealer that clears 
transactions or carries customer accounts to agree to allow 
representatives of the Commission or the broker-dealer's designated 
examining authority (``DEA'') to review the documentation associated 
with certain reports of the broker-dealer's independent public 
accountant and to allow the accountant to discuss the findings relating 
to the reports of the accountant with those representatives when 
requested in connection with a regulatory examination of the broker-
dealer. Finally, the amendments require a broker-dealer to file a new 
form with its DEA that elicits information about the broker-dealer's 
practices with respect to the custody of securities and funds of 
customers and non-customers.

DATES: This rule is effective June 1, 2014, except the amendment to 
Sec.  240.17a-5(e)(5), which is effective October 21, 2013 and the 
amendments to Sec.  240.17a-5(a) and (d)(6) and Sec.  249.639, which 
are effective December 31, 2013.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate 
Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate 
Director, at (202) 551-5521; Randall W. Roy, Assistant Director, at 
(202) 551-5522; Mark M. Attar, Branch Chief, at (202) 551-5889; Rose 
Russo Wells, Special Counsel, at (202) 551-5527; Sheila Dombal Swartz, 
Special Counsel, at (202) 551-5545; or Kimberly N. Chehardy, Attorney, 
at (202) 551-5791, Office of Financial Responsibility, Division of 
Trading and Markets; or Kevin Stout, Senior Associate Chief Accountant, 
at (202) 551-5930, Office of the Chief Accountant, Securities and 
Exchange Commission, 100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to 
Rule 17a-5 (17 CFR 240.17a-5) and technical and conforming amendments 
to Rule 17a-11 (17 CFR 240.17a-11) and is adopting Form Custody (17 CFR 
249. 639) under the Exchange Act.

Contents

I. Background
    A. Overview
    B. Rules Governing Broker-Dealer Financial and Custodial 
Responsibility
    1. The Broker-Dealer Net Capital Rule
    2. The Broker-Dealer Customer Protection Rule
    3. The Broker-Dealer Quarterly Securities Count Rule
    4. The Broker-Dealer Account Statement Rules
II. Final Amendments to Broker-Dealer Reporting, Audit, 
Notification, and Other Requirements
    A. Overview of New Requirements
    B. Annual Reports To Be Filed--Paragraph (d) of Rule 17a-5
    1. Requirement To File Reports--Paragraph (d)(1) of Rule 17a-5
    i. Proposed Amendments
    ii. Comments Received
    iii. The Final Rule
    2. The Financial Report--Paragraph (d)(2) of Rule 17a-5
    3. The Compliance Report--Paragraph (d)(3) of Rule 17a-5
    i. The Proposed Amendments
    ii. Comments Received
    iii. The Final Rule
    4. The Exemption Report--Paragraph (d)(4) of Rule 17a-5
    i. Proposed Amendments
    ii. Comments Received
    iii. The Final Rule
    5. Time for Filing Annual Reports--Paragraph (d)(5) of Rule 17a-
5
    6. Filing of Annual Reports with SIPC--Paragraph (d)(6) of Rule 
17a-5
    i. The Proposed Amendments
    ii. Comments Received
    iii. The Final Rule
    C. The Nature and Form of the Annual Reports
    1. Exemptions From Audit Requirement--Paragraph (e)(1) of Rule 
17a-5
    2. Affirmation--Paragraph (e)(2) of Rule 17a-5
    3. Confidentiality of Annual Reports--Paragraph (e)(3) of Rule 
17a-5
    4. Supplemental Report on SIPC Membership--Paragraph (e)(4) of 
Rule 17a-5
    D. Engagement of the Accountant
    1. Statutory Requirements and Commission Authority
    2. Engagement of Accountant Requirements Prior to Today's 
Amendments
    3. Amended Engagement of Accountant Requirements
    i. Proposed Amendments
    ii. Comments
    iii. The Final Rule
    E. PCAOB Registration of Independent Public Accountant--
Paragraph (f)(1) of Rule 17a-5
    F. Notification of Non-Compliance or Material Weakness
    1. New Notification Requirements--Paragraph (h) of Rule 17a-5
    i. The Proposed Amendments
    ii. Comments Received
    iii. The Final Rule
    2. Conforming and Technical Amendments to Rule 17a-11
    G. Other Amendments to Rule 17a-5
    1. Information Provided to Customers--Paragraph (c) of Rule 17a-
5
    i. Background
    ii. Availability of Independent Public Accountant's Comments on 
Material Inadequacies--Paragraph (c)(2) of Rule 17a-5
    iii. Exemption From Mailing Financial Information to Customers--
Paragraph (c)(5) of Rule 17a-5
    2. Technical Amendments
    i. Deletion of Paragraph (b)(6) of Rule 17a-5
    ii. Deletion of Provisions Relating to the Year 2000
    iii. Deletion of Paragraph (i)(5) of Rule 17a-5
    iv. Amendments to Paragraph (f)(2) of Rule 17a-5
    v. Further Technical Amendments
    H. Coordination With Investment Advisers Act Rule 206(4)-2
    1. Background
    2. Rule 206(4)-2
    3. Broker-Dealers Acting as Qualified Custodians Under Rule 
206(4)-2
    4. Proposal To Allow Report Based on Examination of Compliance 
Report to Satisfy Rule 206(4)-2
    i. The Proposal
    ii. Comments on the Proposal
    5. Adoption of Proposal Relating to Rule 206(4)-2
III. Access to Accountant and Audit Documentation
IV. Form Custody
    A. Background
    B. Filing of Form Custody
    1. Requirement to File Form Custody with FOCUS Reports
    2. Requests for Exemption From Filing Form Custody
    3. Attest Engagement Not Required for Form Custody
    C. Form Custody
    1. Item 1--Accounts Introduced on a Fully Disclosed Basis
    2. Item 2--Accounts Introduced on an Omnibus Basis
    3. Item 3--Carrying Broker-Dealers
    i. Items 3.A and 3.B
    ii. Item 3.C
    a. Background
    b. General Comments to Item 3.C
    c. Item 3.C.i
    d. Item 3.C.ii
    e. Item 3.C.iii
    iii. Items 3.D and 3.E
    a. Items 3.D.i and 3.E.i
    b. Items 3.D.ii and 3.E.ii

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    c. Items 3.D.iii and 3.E.iii
    4. Item 4--Carrying for Other Broker-Dealers
    5. Item 5--Trade Confirmations
    6. Item 6--Account Statements
    7. Item 7--Electronic Access to Account Information
    8. Item 8--Broker-Dealers Registered as Investment Advisers
    9. Item 9--Broker-Dealers Affiliated with Investment Advisers
V. Effective Dates
    A. Amendments Effective 60 Days After Publication in the Federal 
Register
    B. Amendments Effective on December 31, 2013
    C. Amendments Effective on June 1, 2014
VI. Paperwork Reduction Act
    A. Summary of the Collection of Information Requirements
    B. Use of Information
    C. Respondents
    D. Total Initial and Annual Burdens
    1. Annual Reports To Be Filed
    i. The Financial Report
    ii. The Compliance Report
    iii. The Exemption Report
    iv. Additional Burden and Cost To File the Annual Reports
    v. Supplemental Report on SIPC Membership
    vi. Statement Regarding Independent Public Accountant
    vii. External Costs of Engagement of Accountant
    a. Financial Report (including Change from GAAS to PCAOB 
Standards)
    b. Compliance Report
    c. Exemption Report
    d. Access to Accountant and Audit Documentation
    2. Conforming and Technical Amendments to Rule 17a-11
    3. Form Custody
    E. Collection of Information Is Mandatory
    F. Confidentiality
VII. Economic Analysis
    A. Motivation for the Amendments
    B. Economic Baseline
    1. Broker-Dealers
    2. Independent Public Accountants That Audit Broker-Dealer 
Reports
    3. SIPC Lawsuits Against Accountants
    4. Overview of Broker-Dealer Reporting, Auditing, and 
Notification Requirements Before Today's Amendments
    i. Broker-Dealer Reporting
    ii. Engagement of the Accountant
    iii. Filing of Annual Reports with SIPC
    iv. Notification Requirements
    v. Information Provided to Customers
    vi. Access to Accountants and Audit Documentation
    vii. Form Custody
    C. Costs and Benefits of the Rule Amendments
    1. Broker-Dealer Annual Reporting Amendments
    i. Changing the Broker-Dealer Audit Standard Setter From the 
AICPA to the PCAOB and the Standards From GAAS to PCAOB Standards
    ii. Requirement To File New Reports
    a. Compliance Report
    b. Exemption Report
    iii. Engagement of the Accountant
    iv. Filing of Annual Reports With SIPC
    v. Notification Requirements
    a. Amendments to Rule 17a-5
    b. Conforming and Technical Amendments to Rule 17a-11
    vi. Information Provided to Customers
    vii. Coordination With Investment Advisers Act Rule 206(4)-2
    2. Access to Accountant and Audit Documentation
    3. Form Custody
    4. Consideration of Burden on Competition, and Promotion of 
Efficiency, Competition, and Capital Formation
VIII. Final Regulatory Flexibility Analysis
    A. Need for and Objectives of the Amendments and New Form
    B. Significant Issues Raised by Public Comments
    C. Small Entities Subject to the Rules
    D. Reporting, Recordkeeping, and Other Compliance Requirements
    E. Agency Action To Minimize Effect on Small Entities
IX. Statutory Authority

I. Background

A. Overview

    In 2009, the Commission began reviewing rules regarding the 
safekeeping of investor assets in connection with several cases the 
Commission brought alleging fraudulent conduct by investment advisers 
and broker-dealers, including, among other things, misappropriation or 
other misuse of customer securities and funds.\1\ As part of the rule 
review effort, the Commission amended Rule 206(4)-2 under the 
Investment Advisers Act of 1940 (``Rule 206(4)-2''), which governs the 
custody of client securities and funds by investment advisers.\2\ When 
adopting this amendment, the Commission stated that it represented ``a 
first step in the effort to enhance custody protections, with 
consideration of additional enhancements of the rules governing custody 
of customer assets by broker-dealers to follow.'' \3\
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    \1\ See, e.g., SEC v. Bernard L. Madoff, et al., Litigation 
Release No. 20889 (Feb. 9, 2009); SEC v. Stanford International 
Bank, et al., Litigation Release No. 20901 (Feb. 17, 2009); SEC v. 
Donald Anthony Walker Young, et al., Litigation Release No. 21006 
(Apr. 20, 2009); SEC v. Isaac I. Ovid, et al., Litigation Release 
No. 20998 (Apr. 14, 2009); SEC v. The Nutmeg Group, LLC, et al., 
Litigation Release No. 20972 (Mar. 25, 2009); SEC v. WG Trading 
Investors, L.P., et al., Litigation Release No. 20912 (Feb. 25, 
2009).
    \2\ See Custody of Funds or Securities of Clients by Investment 
Advisers, Investment Advisers Act of 1940 (``Advisers Act'') Release 
No. 2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010). See also 17 
CFR 275.206(4)-2.
    \3\ See Custody of Funds or Securities of Clients by Investment 
Advisers, 75 FR at 1456.
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    In June 2011, the Commission proposed rule amendments and a new 
form designed, among other things, to provide additional safeguards 
with respect to broker-dealer custody of customer securities and 
funds.\4\ The proposed amendments would have amended certain annual 
reporting, audit, and notification requirements for broker-dealers.\5\ 
The proposed amendments also would have required a broker-dealer that 
clears transactions or carries customer accounts (each, a ``clearing 
broker-dealer'') to agree to allow representatives of the Commission or 
the broker-dealer's DEA to review the documentation associated with 
certain reports of the broker-dealer's independent public accountant 
and to allow the accountant to discuss with representatives of the 
Commission or DEA the accountant's findings associated with those 
reports when requested in connection with an examination of the broker-
dealer.\6\ Further, the proposed amendments would have required a 
broker-dealer to file with its DEA on a quarterly basis a new form--
Form Custody--that would have elicited information as to whether, and 
if so how, a broker-dealer maintains custody of securities and funds of 
customers and others.\7\ The Commission also proposed requiring that a 
broker-dealer file its annual reports with the Securities Investor 
Protection Corporation (``SIPC'').\8\
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    \4\ See Broker-Dealer Reports, Exchange Act Release No. 64676 
(June 15, 2011), 76 FR 37572 (June 27, 2011).
    \5\ Id. at 37575-37583.
    \6\ Id. at 37583-37584.
    \7\ Id. at 37584-37592.
    \8\ Id. at 37592-37594.
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    The proposed amendments were designed to enhance the ability of the 
Commission to oversee broker-dealer custody practices and, among other 
things, to: (1) Increase the focus of broker-dealers that maintain 
custody of customer funds and securities (``carrying broker-dealers'') 
and their independent public accountants on compliance, and internal 
control over compliance, with certain financial and custodial 
requirements; (2) strengthen and clarify broker-dealer audit and 
reporting requirements in order to facilitate consistent compliance 
with these requirements; (3) facilitate the ability of the PCAOB to 
implement the explicit oversight authority over broker-dealer audits 
provided to the PCAOB by the Dodd-Frank Act; \9\ (4) ensure that SIPC 
receives the necessary information to assess whether the liquidation 
fund it maintains is appropriately sized to the risks of a large 
broker-dealer failure; (5) enable Commission and DEA examiners to 
conduct risk-based examinations of carrying and clearing broker-dealers 
by

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assisting the examiners in selecting areas of focus for their 
examinations; and (6) provide the Commission and the DEAs with a 
comprehensive overview of a broker-dealer's custody practices.\10\
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    \9\ Public Law 111-203, 124 Stat. 1376, H.R. 4173 (July 21, 
2010).
    \10\ The proposed amendments also were designed to avoid 
duplicative requirements for broker-dealers that are dually-
registered as investment advisers in view of the internal control 
report requirement that was added by the amendment to Rule 206(4)-2. 
See discussion below in section VII.A. of this release identifying 
further motivations for the amendments.
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    The Commission received 27 comment letters on the proposal.\11\ The 
Commission has considered the comments and, as discussed in detail 
below, is adopting the amendments and the new form with modifications, 
in part in response to comments received. A number of commenters stated 
that the Commission should coordinate with the Commodity Futures 
Trading Commission (``CFTC'') to account for broker-dealers that also 
are registered as futures commission merchants (``FCMs'') in order to 
align the broker-dealer reporting and audit requirements with FCM 
reporting and audit requirements.\12\ The Commission staff is in 
discussions with the CFTC staff concerning ways to align the reporting 
and audit requirements for dually-registered broker-dealer/FCMs with 
the goal of coordinating these requirements, including the requirements 
that the Commission is adopting today.
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    \11\ Comment letter of Naphtali M. Hamlet (June 22, 2011) 
(``Hamlet Letter''); comment letter of Robert R. Kelley (June 27, 
2011) (``Kelley Letter''); comment letter of Chris Barnard (July 20, 
2011) (``Barnard Letter''); comment letter of Suzanne Shatto (July 
25, 2011) (``Shatto Letter''); comment letter of Suzanne H. Shatto 
(July 25, 2011) (``Shatto Letter II''); comment letter of Todd 
Genger (Aug. 2, 2011) (``Genger Letter''); comment letter of Suzanne 
Shatto (Aug. 14, 2011) (``Shatto Letter III''); comment letter of 
Deloitte & Touche LLP (Aug. 25, 2011) (``Deloitte Letter''); comment 
letter of the Securities Industry and Financial Markets Association 
(Aug. 25, 2011) (``SIFMA Letter''); comment letter of the Center for 
Audit Quality (Aug. 25, 2011) (``CAQ Letter''); comment letter of 
KPMG LLP (Aug. 25, 2011) (``KPMG Letter''); comment letter of 
PricewaterhouseCoopers, LLP (Aug. 25, 2011) (``PWC Letter''); 
comment letter of Citrin Cooperman & Co., LLP (Aug. 25, 2011) 
(``Citrin Letter''); comment letter of Grant Thornton LLP (Aug. 26, 
2011) (``Grant Thornton Letter''); comment letter of James J. Angel 
(Aug. 26, 2011) (``Angel Letter''); comment letter of James J. Angel 
(Aug. 26, 2011) (``Angel Letter II''); comment letter of McGladrey & 
Pullen, LLP (Aug. 26, 2011) (``McGladrey Letter''); comment letter 
of the Certified Financial Planner Board of Standards, Inc. (Aug. 
26, 2011) (``CFP Letter''); comment letter of Integrated Management 
Solutions USA LLC (Aug. 26, 2011) (``IMS Letter''); comment letter 
of the American Institute of Certified Public Accountants (Aug. 26, 
2011) (``AICPA Letter''); comment letter of the Committee of Annuity 
Insurers (Aug. 26, 2011) (``CAI Letter''); comment letter of Ernst & 
Young LLP (Aug. 26, 2011) (``E&Y Letter''); comment letter of Van 
Kampen Funds Inc. and Invesco Distributors, Inc. (Aug. 26, 2011) 
(``Van Kampen/Invesco Letter''); comment letter of Suzanne H. Shatto 
(Sept. 13, 2011) (``Shatto Letter IV); comment letter N.M. Hamlet 
(Sept. 14, 2011) (``Hamlet Letter II''); comment letter of the 
Federal Regulation of Securities Committee, Business Law Section, 
American Bar Association (Sept. 15, 2011) (``ABA Letter''); and 
comment letter of the Committee of Annuity Insurers (Apr. 17, 2012) 
(``CAI II Letter''). The comment letters are available on the 
Commission's Web site at http://www.sec.gov/comments/s7-23-11/s72311.shtml. Comments are also available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street 
NE., Washington, DC (File No. S7-23-11).
    \12\ See CAQ Letter; Deloitte Letter; E&Y Letter; Grant Thornton 
Letter; KPMG Letter; PWC Letter.
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B. Rules Governing Broker-Dealer Financial and Custodial Responsibility

    Rule 15c3-1,\13\ Rule 15c3-3,\14\ and Rule 17a-13,\15\ under the 
Exchange Act and applicable DEA rules that require broker-dealers to 
periodically send account statements to customers (``Account Statement 
Rules'') \16\ (collectively for the purposes of this release, ``the 
financial responsibility rules'') are central to today's amendments to 
the broker-dealer reporting, audit, and notification requirements. In 
light of the significance of the financial responsibility rules to 
today's amendments, the following section briefly summarizes the 
requirements of each rule in order to provide a foundation for the 
later discussion of the amendments.
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    \13\ 17 CFR 240.15c3-1 (a rule prescribing net capital 
requirements for broker-dealers).
    \14\ 17 CFR 240.15c3-3 (a rule prescribing requirements 
regarding the holding of customer securities and funds by broker-
dealers).
    \15\ 17 CFR 240.17a-13 (a rule requiring broker-dealers to 
perform quarterly securities counts).
    \16\ See, e.g., Rule 9.12 of the Chicago Board Options Exchange 
(``CBOE''); NASD Rule 2340 of the Financial Industry Regulatory 
Authoirty (``FINRA'').
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1. The Broker-Dealer Net Capital Rule
    Rule 15c3-1 requires broker-dealers to maintain a minimum level of 
net capital (consisting of highly liquid assets) at all times.\17\ In 
computing net capital, a broker-dealer must, among other things, 
calculate net worth in accordance with U.S. generally accepted 
accounting principles (``GAAP'') and then make certain adjustments to 
net worth, such as deducting illiquid assets and taking other capital 
charges and adding qualifying subordinated loans.\18\ The amount 
remaining after these deductions is defined as ``tentative net 
capital.'' \19\ The final step in computing net capital is to deduct 
certain percentages (``haircuts'') from the market value of the broker-
dealer's proprietary positions to account for the market risk inherent 
in the positions \20\ and to create a buffer of liquidity to protect 
against other risks associated with the broker-dealer's business.\21\ 
The broker-dealer must cease conducting a securities business if the 
amount of net capital maintained by the firm falls below the minimum 
required amount.\22\
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    \17\ See 17 CFR 240.15c3-1. The rule requires that a broker-
dealer perform two calculations: (1) A computation of the minimum 
amount of net capital the broker-dealer must maintain; and (2) a 
computation of the amount of net capital the broker-dealer is 
maintaining. See 17 CFR 240.15c3-1(a) and (c)(2). The computation of 
net capital is based on the definition of the term ``net capital'' 
in paragraph (c)(2) of Rule 15c3-1. Id. Generally, a broker-dealer's 
minimum net capital requirement is the greater of a fixed-dollar 
amount specified in the rule and an amount determined by applying 
one of two financial ratios. See 17 CFR 240.15c3-1(a).
    \18\ See 17 CFR 240.15c3-1(c)(2)(i)-(xiii).
    \19\ See 17 CFR 240.15c3-1(c)(15).
    \20\ See 17 CFR 240.15c3-1(c)(2)(vi).
    \21\ See, e.g., Uniform Net Capital Rule, Exchange Act Release 
No. 13635 (June 16, 1977), 42 FR 31778 (June 23, 1977).
    \22\ See 15 U.S.C. 78o(c)(3)(A).
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2. The Broker-Dealer Customer Protection Rule
    Rule 15c3-3 imposes two key requirements on a carrying broker-
dealer: first, the broker-dealer must maintain physical possession or 
control over customers' fully paid and excess margin securities; \23\ 
and second, the firm must maintain a reserve of funds or qualified 
securities \24\ in an account at one or more banks that is at least 
equal in value to the amount of net funds owed to customers.\25\ These 
requirements are designed to protect customers by requiring broker-
dealers to segregate customers' securities and

[[Page 51913]]

funds from the broker-dealer's proprietary business activities. If the 
broker-dealer fails financially, customers' securities and funds should 
be readily available to be returned to customers. In addition, if the 
failed broker-dealer is liquidated in a proceeding under the Securities 
Investor Protection Act of 1970 (``SIPA''), as amended, the customers' 
securities and funds should be isolated and readily identifiable as 
``customer property'' and, consequently, available to be distributed to 
customers ahead of other creditors.\26\
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    \23\ See 17 CFR 240.15c3-3(d). Control means the broker-dealer 
must hold these securities free of lien in one of several locations 
specified in the rule (e.g., at a bank or clearing agency). See 17 
CFR 240.15c3-3(c). The broker-dealer must make a daily determination 
from its books and records (as of the preceding day) of the quantity 
of fully paid and excess margin securities not in its possession or 
control. See 17 CFR 240.15c3-3(d). If the amount in the broker-
dealer's possession or control is less than the amount indicated as 
being held for customers on the broker-dealer's books and records, 
the broker-dealer generally must initiate steps to retrieve customer 
securities from non-control locations or otherwise obtain possession 
of them or place them in control locations. Id. The terms fully paid 
securities, margin securities, and excess margin securities are 
defined in Rule 15c3-3. See 17 CFR 240.15c3-3(a)(3), (a)(4), and 
(a)(5), respectively.
    \24\ The term qualified security is defined in Rule 15c3-3 to 
mean a security issued by the U.S. or a security in respect of which 
the principal and interest are guaranteed by the U.S. See 17 CFR 
240.15c3-3(a)(6).
    \25\ See 17 CFR 240.15c3-3(e). The amount of the net funds owed 
to customers (``customer reserve requirement'') is computed by 
adding customer credit items (e.g., cash in securities accounts) and 
subtracting from that amount customer debit items (e.g., margin 
loans) pursuant to a formula in Exhibit A to Rule 15c3-3. See 17 CFR 
240.15c3-3a. Carrying broker-dealers are required to compute the 
customer reserve requirement on a weekly basis, except where 
customer credit balances do not exceed $1 million (in which case the 
computation can be performed monthly, although the broker-dealer 
must maintain 105% of the required deposit amount and may not exceed 
a specified aggregate indebtedness limit). See 17 CFR 240.15c3-
3(e)(3).
    \26\ See 15 U.S.C. 78aaa et seq.
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    Provisions of Rule 15c3-3 exempt a broker-dealer from the 
requirements of Rule 15c3-3 under certain circumstances.\27\ Generally, 
a broker-dealer is exempt from Rule 15c3-3 if it does not hold customer 
securities or funds, or, if it does receive customer securities or 
funds, it promptly delivers the securities or promptly transmits the 
funds to appropriate persons.\28\
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    \27\ See 17 CFR 240.15c3-3(k).
    \28\ Id.
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3. The Broker-Dealer Quarterly Securities Count Rule
    Rule 17a-13 generally requires a broker-dealer that maintains 
custody of securities (proprietary, customer, or both), on a quarterly 
basis, to physically examine and count the securities it holds, account 
for the securities that are subject to its control or direction but are 
not in its physical possession (e.g., securities held at a control 
location), verify the locations of securities under certain 
circumstances, and compare the results of the count and verification 
with its records.\29\ In accordance with a schedule, the broker-dealer 
must take an operational capital charge under Rule 15c3-1 for short 
securities differences (which include securities positions reflected on 
the broker-dealer's securities record that are not susceptible to 
either count or confirmation) that are unresolved after discovery.\30\ 
The differences also must be recorded in the broker-dealer's books and 
records.\31\
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    \29\ See 17 CFR 240.17a-13(b).
    \30\ See 17 CFR 240.15c3-1(c)(2)(v).
    \31\ See 17 CFR 240.17a-3(a)(4)(vi).
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4. The Broker-Dealer Account Statement Rules
    The Account Statement Rules of DEAs require member broker-dealers 
to send, at least once every calendar quarter, a statement of account 
containing a description of any securities positions, money balances, 
or account activity to each customer whose account had a security 
position, money balance, or account activity during the period since 
the last such statement was sent to the customer.\32\ The Account 
Statement Rules provide a key safeguard for customers by requiring that 
they receive information concerning securities positions and other 
assets held in their accounts on a regular basis, which they can use to 
identify discrepancies and monitor the performance of their accounts.
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    \32\ See, e.g., CBOE Rule 9.12; NASD Rule 2340.
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II. Final Amendments to Broker-Dealer Reporting, Audit, Notification, 
and Other Requirements

A. Overview of New Requirements

    The Commission is adopting amendments to the reporting, audit, and 
notification requirements in Rule 17a-5, and additional amendments to 
other provisions of the rule, including technical changes. The 
Commission also is adopting amendments to the notification requirements 
in Rule 17a-11, and certain other technical amendments to that rule.
    Under the amendments to the reporting and audit requirements, 
broker-dealers must, among other things, file with the Commission 
annual reports consisting of a financial report and either a compliance 
report or an exemption report that are prepared by the broker-dealer, 
as well as certain reports that are prepared by an independent public 
accountant covering the financial report and the compliance report or 
the exemption report.\33\ The filing of a compliance or exemption 
report and the related report of the independent public accountant are 
new requirements. The financial report must contain the same types of 
financial statements that were required to be filed under Rule 17a-5 
prior to these amendments (a statement of financial condition, a 
statement of income, a statement of cash flows, and certain other 
financial statements).\34\ In addition, the financial report must 
contain, as applicable, the supporting schedules that were required to 
be filed under Rule 17a-5 prior to these amendments (a computation of 
net capital under Rule 15c3-1, a computation of the reserve 
requirements under Rule 15c3-3, and information relating to the 
possession or control requirements under Rule 15c3-3).\35\
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    \33\ See paragraph (d) of Rule 17a-5.
    \34\ See paragraph (d)(2)(i) of Rule 17a-5. The requirements for 
the financial report are discussed below in more detail in section 
II.B.2. of this release.
    \35\ See paragraph (d)(2)(ii) of Rule 17a-5.
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    A broker-dealer that did not claim that it was exempt from Rule 
15c3-3 throughout the most recent fiscal year must file the compliance 
report, and a broker-dealer that did claim it was exempt from Rule 
15c3-3 throughout the most recent fiscal year (generally, a ``non-
carrying broker-dealer'') must file the exemption report.\36\ Broker-
dealers must make certain statements and provide certain information 
relating to the financial responsibility rules in these reports.\37\
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    \36\ See paragraphs (d)(1)(i)(B)(1) and (2) of Rule 17a-5.
    \37\ See paragraphs (d)(3) and (4) of Rule 17a-5. The 
requirements for the compliance report and the exemption report are 
discussed below in more detail in section II.B.3. and section 
II.B.4. of this release, respectively.
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    In addition to preparing and filing the financial report and the 
compliance report or exemption report, a broker-dealer must engage a 
PCAOB-registered independent public accountant to prepare a report 
based on an examination of the broker-dealer's financial report in 
accordance with PCAOB standards.\38\ A carrying broker-dealer also must 
engage the PCAOB-registered independent public accountant to prepare a 
report based on an examination of certain statements in the broker-
dealer's compliance report.\39\ A non-carrying broker-dealer must 
engage the PCAOB-registered independent public accountant to prepare a 
report based on a review of certain statements in the broker-dealer's 
exemption report.\40\ In each case, the examination or review must be 
conducted in accordance with PCAOB standards. The broker-dealer must 
file these reports with the Commission along with the financial report 
and the compliance report or exemption report prepared by the broker-
dealer.\41\
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    \38\ See paragraphs (f)(1) and (g)(1) of Rule 17a-5.
    \39\ See paragraphs (f)(1) and (g)(2)(i) of Rule 17a-5.
    \40\ See paragraphs (f)(1) and (g)(2)(ii) of Rule 17a-5.
    \41\ See paragraph (d)(1)(i)(C) of Rule 17a-5. The requirements 
for the engagement of the independent public accountant are 
discussed below in more detail in section II.D.3. of this release.
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    The annual reports also must be filed with SIPC if the broker-
dealer is a member of SIPC.\42\ In addition, broker-dealers must 
generally file with SIPC a supplemental report on the status of the 
membership of the broker-dealer in SIPC.\43\ The supplemental report 
must include a report of the independent public accountant that covers 
the SIPC annual general assessment reconciliation or exclusion from 
membership forms based on certain

[[Page 51914]]

procedures specified in the rule. In the future, SIPC may determine the 
format of this report by rule, subject to Commission approval.\44\
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    \42\ See paragraph (d)(6) of Rule 17a-5. This requirement is 
discussed below in more detail in section II.B.6. of this release.
    \43\ See paragraph (e)(4) of Rule 17a-5. This requirement is 
discussed below in more detail in section II.C.4. of this release.
    \44\ Id. Currently, Rule 17a-5 prescribes the format of the 
report. See 17 CFR 240.17a-5.
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    Finally, the PCAOB-registered independent public accountant must 
immediately notify the broker-dealer if the accountant determines 
during the course of preparing the accountant's reports that the 
broker-dealer is not in compliance with the financial responsibility 
rules or if the accountant determines that any material weakness exists 
in the broker-dealer's internal control over compliance with the 
financial responsibility rules.\45\ The broker-dealer, in turn, must 
file a notification with the Commission and its DEA under Rule 15c3-1, 
Rule 15c3-3, or Rule 17a-11 if the independent public accountant's 
notice concerns an instance of non-compliance that would trigger 
notification under those rules.\46\ Under the amendments to Rule 17a-
11, a broker-dealer also must file a notification with the Commission 
and its DEA if the broker-dealer discovers or is notified by the 
independent public accountant of the existence of any material weakness 
(as defined in the amendments) in the broker-dealer's internal control 
over compliance with the financial responsibility rules.\47\
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    \45\ See paragraph (h) of Rule 17a-5. As discussed below, 
material weakness is defined for purposes of the compliance report 
and, therefore, the notification of a material weakness only can 
occur in the context of the audit of a broker-dealer that files a 
compliance report.
    \46\ Id. Notifications under Rule 17a-11 also must be filed with 
the CFTC if the broker-dealer is registered as a FCM with the CFTC. 
See 17 CFR 240.17a-11(g).
    \47\ See paragraph (e) of Rule 17a-11. These notification 
provisions are discussed below in more detail in section II.F. of 
this release.
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    Each of these amendments is discussed in more detail in the 
following sections of this release.

B. Annual Reports To Be Filed--Paragraph (d) of Rule 17a-5

    Prior to today's amendments, paragraph (d) of Rule 17a-5 generally 
required a broker-dealer to annually file the financial statements and 
supporting schedules discussed below in section II.B.2. of this release 
and a report prepared by the broker-dealer's independent public 
accountant covering the financial statements and supporting 
schedules.\48\ The Commission proposed amendments that would, among 
other things, restructure paragraph (d) and--as part of the proposed 
revisions to the attestation engagement provisions--add the requirement 
that a broker-dealer file either a compliance report or an exemption 
report, as applicable, and a report prepared by the broker-dealer's 
independent public accountant based on an examination of the compliance 
report or a review of the exemption report.\49\ As discussed in 
sections II.B.1. through II.B.6. of this release, the Commission is 
adopting the proposed amendments to paragraph (d) with 
modifications.\50\
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    \48\ See 17 CFR 240.17a-5(d)(1)(i). Certain types of broker-
dealers were exempt from the requirement to file the reports or to 
file reports that had been audited by an independent public 
accountant. See 17 CFR 240.17a-5(d)(1)(ii)-(iii).
    \49\ See Broker-Dealer Reports, 76 FR at 37575-37581.
    \50\ Before today's amendments, paragraph (d) of Rule 17a-5 was 
titled ``Annual filing of audited financial statements.'' In the 
proposing release, the Commission proposed to change the title to 
``Annual reports'' to reflect that, under the proposed amendments to 
paragraph (d), broker-dealers would be required to prepare and file 
two reports with the Commission--a financial report and a compliance 
report or an exemption report. See Broker-Dealer Reports, 76 FR at 
37575. The Commission received no comments on this proposal and is 
adopting the new title as proposed. See paragraph (d) of Rule 17a-5. 
In addition, the Commission is making a technical amendment to 
paragraph (d) of Rule 17a-5 to replace the term ``fiscal or calendar 
year'' with the term ``fiscal year.'' The Commission is adopting 
this technical amendment because the term ``fiscal year'' includes 
instances in which December 31st, i.e., the calendar year end, is 
the broker-dealer's fiscal year end.
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1. Requirement To File Reports--Paragraph (d)(1) of Rule 17a-5
i. Proposed Amendments
    The Commission proposed to amend paragraph (d)(1) of Rule 17a-5 
\51\ to require that a broker-dealer file a financial report containing 
financial statements and supporting schedules and either a compliance 
report or an exemption report, as applicable.\52\ The proposal provided 
that a broker-dealer must file a compliance report ``unless the 
[broker-dealer] is exempt from the provisions of [Rule 15c3-3]'' in 
which case the broker-dealer would be required to file an exemption 
report.\53\ The proposed amendments also would have required a broker-
dealer generally to file reports prepared by an independent public 
accountant covering the financial report and compliance report or 
exemption report, as applicable, unless the broker-dealer was exempt 
from the requirement to file the reports or from the requirement to 
engage an independent public accountant with respect to the 
reports.\54\ To accommodate these changes, the Commission also proposed 
to reorganize the provisions of paragraph (d)(1) of Rule 17a-5, and to 
make other technical amendments.\55\
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    \51\ See 17 CFR 240.17a-5(d)(1).
    \52\ See Broker-Dealer Reports, 76 FR at 37575.
    \53\ Id.
    \54\ Id.
    \55\ Id. at 37575-37578, 37603-37604.
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    The proposed amendments with respect to the compliance report and 
exemption report set forth different requirements for carrying broker-
dealers as compared with broker-dealers that do not hold customer 
securities and funds.\56\ In order to provide clarity with respect to 
this distinction, the proposed amendments referenced Rule 15c3-3, which 
applies to carrying broker-dealers and contains provisions under which 
a broker-dealer is exempt from the requirements in the rule. The goal 
was to establish a clear way of determining whether a broker-dealer 
would need to file a compliance report or an exemption report. However, 
not all broker-dealers that are subject to Rule 15c3-3 regularly hold 
customer securities or funds. This prompted the Commission to inquire 
in the proposing release as to whether there are broker-dealers that 
would not qualify to file the proposed exemption report because they 
are not exempt from Rule 15c3-3, but that should be allowed to file a 
more limited report than the proposed compliance report based on the 
limited scope of their business.\57\
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    \56\ Id. at 37575-37578, 37580-37581 (discussing the compliance 
report and exemption report, respectively).
    \57\ Id. at 37581.
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ii. Comments Received
    The Commission received several comments on its proposed amendments 
to paragraph (d)(1) of Rule 17a-5.\58\ Some commenters asked whether 
the provision that would require the broker-dealer to file an exemption 
report instead of a compliance report related to a period end date or 
to a period of time.\59\ Further, as discussed in more detail in 
sections II.B.4. and II.D.3. of this release, commenters raised 
questions and concerns about how instances of exceptions to meeting the 
exemption provisions of paragraph (k) of Rule 15c3-3 would be treated 
under the proposed reporting requirements.\60\ One commenter also 
stated that ``limited purpose'' carrying broker-dealers should not be 
required to file a compliance report, and broker-dealers with certain 
business model characteristics should not be required to file the 
compliance report.\61\ Similarly, another commenter stated that broker-
dealers engaging

[[Page 51915]]

exclusively in proprietary trading or investment banking may not 
technically be exempt from Rule 15c3-3 but nonetheless should not have 
to file the compliance report as they do not have ``customers.'' \62\ 
Finally, one commenter stated that the Commission should clarify who 
must sign the compliance reports and exemption reports and the 
liability that attaches in the event of a misstatement or omission in 
the reports.\63\
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    \58\ See, e.g., CAI Letter; CAI II Letter; CAQ Letter; Citrin 
Letter; Deloitte Letter; Grant Thornton Letter; KPMG Letter; 
McGladrey Letter.
    \59\ See CAQ Letter; Deloitte Letter; Grant Thornton Letter; 
KPMG Letter.
    \60\ See CAI Letter; SIFMA Letter.
    \61\ See CAI Letter; CAI II Letter.
    \62\ See McGladrey Letter.
    \63\ See CAI Letter.
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iii. The Final Rule
    After considering these comments, the Commission is adopting the 
proposed amendments with certain modifications.\64\ Under the final 
rule, all broker-dealers generally must prepare and file a financial 
report and either the compliance report or the exemption report.\65\ A 
broker-dealer that did not claim an exemption from Rule 15c3-3 at any 
time during the most recent fiscal year or claimed an exemption for 
only part of the fiscal year must prepare and file the compliance 
report.\66\ A broker-dealer must prepare and file the exemption report 
if the firm did claim that it was exempt from Rule 15c3-3 throughout 
the most recent fiscal year.\67\ Broker-dealers also must file reports 
prepared by a PCAOB-registered independent public accountant covering 
the financial report and the compliance report or exemption report, as 
applicable.\68\
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    \64\ See paragraph (d)(1) of Rule 17a-5. Paragraph (d)(1)(iii) 
of Rule 17a-5 (now re-designated as paragraph (d)(1)(iv)) contains 
an exemption from filing an annual report if the broker-dealer is a 
member of a national securities exchange and has transacted business 
in securities solely with or for other members of a national 
securities exchange, and has not carried any margin account, credit 
balance or security for any person who is defined as a ``customer'' 
in paragraph (c)(4) of Rule 17a-5. See paragraph (d)(1)(iv) of Rule 
17a-5. The Commission also proposed to move the exemptions from 
having to file financial statements under paragraph (d) of Rule 17a-
5 from paragraphs (d)(1)(ii) and (d)(1)(iii) of Rule 17a-5 to 
paragraphs (d)(1)(iii) and (d)(1)(iv), respectively. The Commission 
received no comments on these amendments and is adopting them as 
proposed. See paragraphs (d)(1)(iii) and (d)(1)(iv) of Rule 17a-5. 
For clarity, the amendments to paragraph (d)(1)(i) of Rule 17a-5 
include a reference to the exemptions from the requirement for a 
broker-dealer to file the annual reports so that the paragraph now 
states ``[e]xcept as provided in paragraphs (d)(1)(iii) and 
(d)(1)(iv) of this section, every broker or dealer registered under 
section 15 of the Act must file annually . . . .'' See paragraph 
(d)(1)(i) of Rule 17a-5. As proposed, the final rule provided that 
the reports must be filed annually ``on a calendar or fiscal year 
basis.'' The final rule deletes the phrase ``on a calendar or fiscal 
year basis'' as the rule provides elsewhere that the annual reports 
must be filed on a fiscal year basis. Id. In addition, the 
Commission proposed to move the requirement that reports under 
paragraph (d) of Rule 17a-5 be as of the same fixed or determinable 
date each year, unless a change is approved in writing by the 
broker-dealer's DEA, from paragraph (d)(1)(i) of Rule 17a-5 to 
paragraph (d)(1)(ii). The Commission received no comments on this 
proposed amendment and is adopting it substantially as proposed. See 
paragraph (d)(1)(ii) of Rule 17a-5. The final rule also includes a 
technical modification from the proposal to require that the reports 
required to be filed under paragraph (d) must be as of the same 
``fiscal year end each year,'' rather than as of the same ``fixed or 
determinable date each year.'' See paragraph (d)(1)(ii) of Rule 17a-
5. This change, by having the rule refer to the broker-dealer's 
``fiscal year,'' eliminates outdated language and conforms the 
language in paragraph (d) of Rule 17a-5 to language in paragraph (n) 
of Rule 17a-5. See 17 CFR 240.17a-5(n). The final rule also adds a 
clarifying cross-reference to the provision in Rule 17a-5 pursuant 
to which a broker-dealer requests a change of its fiscal year end. 
See paragraph (d)(1)(i) of Rule 17a-5. Furthermore, the final rule 
requires that a copy of the written approval by the broker-dealer's 
DEA of a change in the broker-dealer's fiscal year be sent to the 
Commission's principal office in Washington, DC, in addition to the 
regional office of the Commission for the region in which the 
broker-dealer has its principal place of business. Id. This change 
is consistent with paragraph (n) of Rule 17a-5, which requires that 
when a broker-dealer changes its fiscal year, it must file a notice 
with the Commission's principal office in Washington, DC as well as 
the regional office of the Commission for the region in which the 
broker-dealer has its principal place of business. See 17 CFR 
240.17a-5(n).
    \65\ See paragraph (d)(1)(i) of Rule 17a-5. The financial 
report, compliance report, and exemption report are discussed below 
in more detail in sections II.B.2., II.B.3., and II.B.4., 
respectively, of this release.
    \66\ See paragraph (d)(1)(i)(B)(1) of Rule 17a-5.
    \67\ See paragraph (d)(1)(i)(B)(2) of Rule 17a-5.
    \68\ See paragraph (d)(1)(i)(C) of Rule 17a-5. The proposed 
requirements and final rule with respect to the attestation 
engagement for the independent public accountant are discussed below 
in section II.D. of this release.
---------------------------------------------------------------------------

    The final rule is modified from the proposal in three key ways. 
First, the final rule provides that the broker-dealer must file the 
exemption report if it did ``claim that it was exempt'' from Rule 15c3-
3 \69\ throughout the most recent fiscal year.\70\ This modification 
from the proposal--which provided that a broker-dealer ``shall'' file 
the exemption report if the broker-dealer ``is exempt from the 
provisions of [Rule 15c3-3]''--is designed to provide greater clarity 
as to whether a broker-dealer must file the exemption report (as 
opposed to the compliance report), particularly when the broker-dealer 
had exceptions to meeting the exemption provisions in paragraph (k) of 
Rule 15c3-3 during the fiscal year.\71\ Specifically, if the broker-
dealer claimed an exemption from Rule 15c3-3 in its Financial and 
Operational Combined Uniform Single Reports (``FOCUS Reports'') 
throughout the fiscal year,\72\ it must file the exemption report even 
it had exceptions to the exemption provisions.\73\ Consequently, the 
applicability of the exemption report under the final rule is based on 
an objective and easily ascertainable factor: whether the broker-dealer 
claimed an exemption from Rule 15c3-3 throughout the most recent fiscal 
year.\74\
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    \69\ See paragraph (d)(1)(i)(B)(2) of Rule 17a-5. A broker-
dealer claiming an exemption from Rule 15c3-3 is required to 
indicate the basis for the exemption on the periodic reports it 
files with securities regulators. See, e.g., Item 24 of Part IIa of 
the Financial and Operational Combined Uniform Single Report. See 17 
CFR 249.617.
    \70\ As discussed below in more detail in section II.B.4. of 
this release, the provisions of paragraph (k) of Rule 15c3-3 
prescribe ``exemptions'' from the requirements of Rule 15c3-3. See 
17 CFR 240.15c3-3(k)(1), (k)(2)(i), (k)(2)(ii), and (k)(3).
    \71\ See CAI Letter; SIFMA Letter.
    \72\ The FOCUS Reports are: Form X-17A-5 Schedule I; Form X-17A-
5 Part II; Form X-17A-5 Part IIa; Form X-17A-5 Part IIb; and Form X-
17A-5 Part III.
    \73\ As discussed in detail below in section II.B.4. of this 
release, a broker-dealer that has exceptions to meeting the 
exemption provisions in paragraph (k) of Rule 15c3-3 must identify 
them in the exemption report.
    \74\ See discussion in section II.B.4. of this release. There 
may be circumstances in which a broker-dealer has not held customer 
securities or funds during the fiscal year, but does not fit into 
one of the exemptive provisions listed under Item 24 of Part IIa. 
Even though there is not a box to check on the FOCUS Report, these 
broker-dealers should file an exemption report and related 
accountant's report.
---------------------------------------------------------------------------

    As noted above, several commenters argued that broker-dealers that 
engage in limited custodial activities and, therefore, are not exempt 
from Rule 15c3-3, should not be required to file a compliance 
report.\75\ Specifically, one of these commenters suggested that a 
``new'' category of ``limited purpose'' broker-dealer with certain 
business model characteristics should be addressed in the rule and that 
this ``new'' category of broker-dealer should not be required to file 
the compliance report.\76\ The Commission has considered these comments 
but has determined not to provide for a broader exception from the 
requirement to file a compliance report for broker-dealers with limited 
custodial activities. The objectives of the compliance report and 
related examination of the compliance report are intended, among other 
things, to ``increase the focus of independent public accountants on 
the custody practices of broker-dealers'' and to ``help identify 
broker-dealers that have weak controls for safeguarding investor 
assets.'' \77\ Therefore, broker-dealers that hold customer assets--
even if their custodial activities are limited--generally should be 
subject to the requirement to file the compliance report and related 
accountant's report.\78\
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    \75\ See, e.g., CAI Letter; CAI II Letter; McGladrey Letter.
    \76\ See CAI II Letter.
    \77\ See Broker-Dealer Reports, 76 FR at 37599.
    \78\ Broker-dealers with extremely limited custodial activities 
(e.g., holding customer checks made out to a third party for limited 
periods of time) could seek exemptive relief under section 36 of the 
Exchange Act (15 U.S.C. 77mm) from the requirement to file the 
compliance report and report of the independent public accountant 
covering the compliance report.

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[[Page 51916]]

    The level of effort required by carrying broker-dealers to prepare 
a compliance report will depend on the nature and extent of their 
activities. For example, the controls of a carrying broker-dealer that 
engages in limited custodial activities could be less complex than the 
controls of a carrying broker-dealer that engages in more extensive 
custodial activities.\79\ Therefore, this requirement is intended to be 
scalable so that a carrying broker-dealer with limited custodial 
activities generally should have to expend less effort to support its 
statements in the compliance report, particularly with respect to the 
statements relating to Rules 15c3-3 and 17a-13.
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    \79\ As discussed below in section II.D. of this release, the 
PCAOB has proposed attestation standards for an independent public 
accountant's examination of the compliance report and the review of 
the exemption report. The proposed examination standard provides 
procedural requirements for independent public accountants that are 
``designed to be scalable based on the broker's or dealer's size and 
complexity.'' See Proposed Standards for Attestation Engagements 
Related to Broker and Dealer Compliance or Exemption Reports 
Required by the U.S. Securities and Exchange Commission and Related 
Amendments to PCAOB Standards, PCAOB Release No. 2011-004, PCAOB 
Rulemaking Docket Matter No. 035 (July 12, 2011) at 8 (``PCAOB 
Proposing Release'').
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    The second key modification is that the final rule provides that 
the requirement to file the exemption report applies if the broker-
dealer did claim that it was exempt from Rule 15c3-3 ``throughout the 
most recent fiscal year.'' \80\ Thus, a broker-dealer that did not 
claim an exemption from Rule 15c3-3 at any time during the most recent 
fiscal year or claimed an exemption for only part of the fiscal year 
must file the compliance report.\81\
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    \80\ See paragraphs (d)(1)(i)(B)(1)-(2) of Rule 17a-5.
    \81\ There will be cases where a broker-dealer changes its 
business model to convert from a carrying broker-dealer to a non-
carrying broker-dealer during the fiscal year. In this case, the 
broker-dealer could seek exemptive relief under section 36 of the 
Exchange Act (15 U.S.C. 78mm) from the requirement to file the 
compliance report and to instead file the exemption report. In 
analyzing such a request, the period of time the broker-dealer 
operated as a carrying broker-dealer would be a relevant 
consideration.
---------------------------------------------------------------------------

    The third key modification is that the final rule specifies the 
individual who must execute the compliance reports and exemption 
reports.\82\ As noted above, one commenter stated that the Commission 
should make clear who should sign the compliance reports and exemption 
reports and what liability attaches in the event of a misstatement or 
omission.\83\ The commenter suggested a reasonableness standard, and 
stated that the Commission should make clear that the reports do not 
create a new private right of action.\84\ In response to this comment, 
the final rule provides that the compliance report and the exemption 
report must be executed by the person who makes the oath or affirmation 
under paragraph (e)(2) of Rule 17a-5.\85\ As discussed below in more 
detail in section II.C.2. of this release, paragraph (e)(2) of Rule 
17a-5 requires an oath or affirmation to be attached to the financial 
report and provides that the oath or affirmation must be made by 
certain types of persons depending on the corporate form of the broker-
dealer (e.g., a duly authorized officer if the broker-dealer is a 
corporation).\86\ The requirement to file these new reports with the 
Commission is not intended to establish a new private cause of action.
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    \82\ See paragraphs (d)(1)(i)(B)(1)-(2) of Rule 17a-5.
    \83\ See CAI Letter. The filings discussed above constitute a 
``report'' for purposes of 15 U.S.C. 78ff(a) and other applicable 
provisions of the Exchange Act. As a consequence, it would be 
unlawful for a broker-dealer to willfully make or cause to be made, 
a false or misleading statement of a material fact or omit to state 
a material fact in the filings.
    \84\ Id.
    \85\ See paragraphs (d)(1)(i)(B)(1)-(2) of Rule 17a-5.
    \86\ See paragraph (e)(2) of Rule 17a-5.
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2. The Financial Report--Paragraph (d)(2) of Rule 17a-5
    Before today's amendments, paragraph (d)(2) of Rule 17a-5 required 
that the annual audited report of a broker-dealer contain certain 
financial statements in a format consistent with Form X-17A-5 Part II 
or Form X-17A-5 Part IIa, as applicable, including a statement of 
financial condition, an income statement, a statement of cash flows, a 
statement of changes in owners' equity, and a statement of changes in 
liabilities subordinated to claims of general creditors.\87\ Paragraph 
(d)(3) of Rule 17a-5 required that the annual audited report contain 
supporting schedules, including a computation of net capital under Rule 
15c3-1, a computation for determining reserve requirements under Rule 
15c3-3, and information relating to the possession and control 
requirements of Rule 15c3-3.\88\ Paragraph (d)(4) of Rule 17a-5 
required a reconciliation between the net capital and reserve 
computations in the audited report and those in the most recent Form X-
17A-5 Part II or Form X-17A-5 Part IIa, if there were material 
differences between the annual audited report and the form.\89\
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    \87\ See 17 CFR 240.17a-5(d)(2). As noted above, Form X-17A-5 
Part II and Form X-17A-5 Part IIa are among the FOCUS Reports that 
broker-dealers complete and file with the Commission or their DEA on 
a periodic basis. See 17 CFR 240.17a-5(a) and 17 CFR 249.617. These 
two forms require broker-dealers to file monthly or quarterly 
financial information with the Commission or their DEA, including 
information about the broker-dealer's: (1) Assets and liabilities; 
ownership equity; net capital computation under Rule 15c3-1; minimum 
net capital requirement under Rule 15c3-1; income (loss); 
computation of the customer reserve requirement under Rule 15c3-3 in 
the case of Form X-17A-5 Part II; the possession and control 
requirements under Rule 15c3-3 in the case of Form X-17A-5 Part II; 
and changes in ownership equity.
    \88\ See 17 CFR 240.17a-5(d)(3).
    \89\ See 17 CFR 240.17a-5(d)(4).
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    The Commission proposed combining the provisions in paragraphs 
(d)(2) through (d)(4) of Rule 17a-5 in revised paragraph (d)(2) without 
substantive modification to those provisions.\90\ In addition, the 
Commission proposed that revised paragraph (d)(2) be titled ``Financial 
report'' to reflect that the information required in this report would 
be financial in nature and to differentiate it from the proposed 
compliance reports and exemption reports. The Commission did not 
receive comments concerning the amendments to paragraph (d)(2) of Rule 
17a-5 and is adopting them substantially as proposed.\91\
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    \90\ See Broker-Dealer Reports, 76 FR at 37575.
    \91\ See paragraph (d)(2) of Rule 17a-5. The Commission has made 
plain English changes to the language of the paragraph (e.g., 
replacing the term ``shall'' with ``must''). The Commission also, 
consistent with current practice, has clarified that the financial 
statements must be prepared in accordance with U.S. GAAP to 
distinguish from other accounting frameworks. See paragraph (d)(2) 
of Rule 17a-5. In addition, the Commission has replaced the words 
``notes to the consolidated statement of financial condition'' with 
``notes to the financial statements.'' This change in terminology is 
designed to conform the language in Rule 17a-5 to current accounting 
practice. Under GAAP, notes to a complete set of financial 
statements must cover all the financial statements, and not just one 
of the statements, such as the consolidated statement of financial 
condition.
---------------------------------------------------------------------------

3. The Compliance Report--Paragraph (d)(3) of Rule 17a-5
i. The Proposed Amendments
    As proposed, the requirements for the contents of the compliance 
report were prescribed in paragraph (d)(3) of Rule 17a-5.\92\ Under the 
proposal, a carrying broker-dealer would need to include in the 
compliance report a specific statement, certain assertions, and 
descriptions.\93\ The independent public accountant would examine the 
assertions in the compliance report in preparing the report of the 
accountant.\94\
---------------------------------------------------------------------------

    \92\ See Broker-Dealer Reports, 76 FR at 37575-37578.
    \93\ Id.
    \94\ Id. The independent public accountant would not have been 
required to examine the proposed ``statement'' and descriptions in 
the compliance report.

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[[Page 51917]]

    Specifically, as proposed, the carrying broker-dealer would be 
required to include in the compliance report a statement as to whether 
the firm has established and maintained a system of internal control to 
provide the broker-dealer with reasonable assurance that any instances 
of material non-compliance with the financial responsibility rules will 
be prevented or detected on a timely basis.\95\ In addition, the 
compliance report would need to include the following three assertions: 
(1) Whether the broker-dealer was in compliance in all material 
respects with the financial responsibility rules as of its fiscal year 
end; (2) whether the information used to assert compliance with the 
financial responsibility rules was derived from the books and records 
of the broker-dealer; and (3) whether internal control over compliance 
with the financial responsibility rules was effective during the most 
recent fiscal year such that there were no instances of material 
weakness.\96\ Finally, the carrying broker-dealer would need to include 
in the compliance report a description of each identified instance of 
material non-compliance and each identified material weakness in 
internal control over compliance with the financial responsibility 
rules.\97\ The independent public accountant would examine the 
assertions in preparing the report of the accountant.\98\ The 
independent public accountant would not examine the statement regarding 
the establishment of the system of internal control.
---------------------------------------------------------------------------

    \95\ See Broker-Dealer Reports, 76 FR at 37575-37576.
    \96\ Id.
    \97\ Id.
    \98\ Id. GAAS and PCAOB standards for attestation engagements 
provide that accountants ordinarily should obtain written assertions 
in an examination or review engagement. See, e.g., PCAOB Interim 
Attestation Standard, AT Section 101 at ] .09. Accordingly, the 
Commission proposed that the independent public accountant's report 
cover only the three assertions in the compliance report.
---------------------------------------------------------------------------

    Under the proposal, the broker-dealer would not be able to assert 
compliance with the financial responsibility rules as of its most 
recent fiscal year end if it identified one or more instances of 
material non-compliance.\99\ Similarly, the broker-dealer would not be 
able to assert that its internal control over compliance with the 
financial responsibility rules during the fiscal year was effective if 
one or more material weaknesses existed with respect to internal 
control over compliance.\100\
---------------------------------------------------------------------------

    \99\ See Broker-Dealer Reports, 76 FR at 37576-37577.
    \100\ Id. at 37577.
---------------------------------------------------------------------------

    An instance of material non-compliance was proposed to be defined 
as a failure by the broker-dealer to comply with any of the 
requirements of the financial responsibility rules in all material 
respects.\101\ When determining whether an instance of non-compliance 
is material, the Commission stated that the broker-dealer should 
consider all relevant factors including but not limited to: (1) The 
nature of the compliance requirements, which may or may not be 
quantifiable in monetary terms; (2) the nature and frequency of non-
compliance identified; and (3) qualitative considerations.\102\ The 
Commission also stated that some deficiencies would necessarily be 
instances of material non-compliance, including failing to maintain the 
required minimum amount of net capital under Rule 15c3-1 or failing to 
maintain the minimum deposit requirement in a special reserve bank 
account for the exclusive benefit of customers under Rule 15c3-3.\103\
---------------------------------------------------------------------------

    \101\ Id.
    \102\ Id.
    \103\ Id.
---------------------------------------------------------------------------

    The term material weakness was proposed to be defined as a 
deficiency, or a combination of deficiencies, in internal control over 
compliance with the financial responsibility rules, such that there is 
a reasonable possibility that material non-compliance with the 
financial responsibility rules will not be prevented or detected on a 
timely basis.\104\ The proposed definition of material weakness was 
modeled on the definition of material weakness in a Commission rule--
Rule 1-02(a)(4) of Regulation S-X \105\--and in auditing literature 
governing financial reporting.\106\ In the proposing release, the 
Commission stated that a deficiency in internal control over compliance 
would exist when the design or operation of a control does not allow 
the broker-dealer, in the normal course of performing its assigned 
functions, to prevent or detect non-compliance with the financial 
responsibility rules on a timely basis.\107\ The Commission also stated 
that, for purposes of the proposed definition of the term material 
weakness, there is a reasonable possibility of an event occurring if it 
is probable or reasonably possible.\108\ The Commission further stated 
that an event is probable if the future event or events are likely to 
occur and that an event is reasonably possible if the chance of the 
future event or events occurring is more than remote, but less than 
likely.\109\
---------------------------------------------------------------------------

    \104\ Id.
    \105\ See 17 CFR 210.1-02(a)(4); 17 CFR 240.12b-2.
    \106\ See PCAOB Auditing Standard, AS No. 5 app. A at ] A7; 
American Institute of Certified Public Accountants (``AICPA''), AU 
Section 325 at ] .06.
    \107\ See Broker-Dealer Reports, 76 FR at 37577.
    \108\ Id. See also Commission Guidance Regarding Management's 
Report on Internal Control Over Financial Reporting Under Section 
13(a) or 15(d) of the Securities Exchange Act of 1934, Securities 
Act of 1933 Release No. 8810 (June 20, 2007), 72 FR 35324, 35332 
n.47 and corresponding text (June 27, 2007).
    \109\ Broker-Dealer Reports, 76 FR at 37577. The Commission has 
stated in other contexts that there is a reasonable possibility of 
an event occurring if it is ``probable'' or ``reasonably possible.'' 
See Amendments to Rules Regarding Management's Report on Internal 
Control Over Financial Reporting, Exchange Act Release No. 55928 
(June 20, 2007), 72 FR 35310 (June 27, 2007). See also 17 CFR 
240.12b-2; 17 CFR 210.1-02. Commission guidance provides that an 
event is ``probable'' if the future event or events are likely to 
occur, and that an event is ``reasonably possible'' if the chance of 
the future event or events occurring is more than remote, but less 
than likely. See Commission Guidance Regarding Management's Report 
on Internal Control Over Financial Reporting Under Section 13(a) or 
15(d) of the Securities Exchange Act of 1934, 72 FR at 35332 n.47 
and corresponding text.
---------------------------------------------------------------------------

ii. Comments Received
    The Commission received a number of comments on the proposed 
compliance report. Generally, the comments focused on the intended 
scope of the compliance report and the assertions to be included. 
Specifically, many commenters raised concerns about what would 
constitute ``material non-compliance.'' \110\ Several of these 
commenters urged the Commission to provide guidance with additional 
specific examples or quantitative and qualitative factors to be 
considered when determining whether non-compliance was material.\111\ 
One commenter proposed alternate definitions for material non-
compliance and material weakness and provided examples of non-
compliance that should not be regarded as material.\112\
---------------------------------------------------------------------------

    \110\ See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter; 
E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; 
PWC Letter; SIFMA Letter; Van Kampen/Invesco Letter.
    \111\ See ABA Letter; CAQ Letter; E&Y Letter; KPMG Letter; 
McGladrey Letter; PWC Letter.
    \112\ See SIFMA Letter.
---------------------------------------------------------------------------

    Commenters also addressed the time period covered by the assertion 
relating to effectiveness of internal control. In particular, some 
commenters stated that the proposed assertion that internal control was 
effective should be as of a point in time, as opposed to ``during the 
fiscal year.'' \113\ One commenter stated that broker-dealers that must 
file the internal control report required under

[[Page 51918]]

Rule 206(4)-2 should be able to elect to make the assertion pertain to 
the entire fiscal year in order to satisfy reporting requirements under 
the IA Custody Rule.\114\ Others stated that broker-dealers should have 
the opportunity to remediate any material weaknesses in internal 
control that were identified during the period and, if corrective 
action was taken, not be required to include them in the compliance 
report.\115\
---------------------------------------------------------------------------

    \113\ See Deloitte Letter; E&Y Letter; Grant Thornton Letter; 
KPMG Letter.
    \114\ See E&Y Letter. This commenter also stated that a point-
in-time assessment would be consistent with the requirement for 
issuers subject to internal control reporting under section 404 of 
the Sarbanes-Oxley Act. Further, for carrying broker-dealers that 
are not subject to Rule 206(4)-2, this commenter stated that the 
incremental benefits of having the assertion pertain to the entire 
year rather than the year end assessment does not justify the cost. 
Id.
    \115\ See CAQ Letter; Deloitte Letter; McGladrey Letter.
---------------------------------------------------------------------------

    Regarding the proposed assertion that the broker-dealer was in 
compliance with the financial responsibility rules, one commenter 
stated that broker-dealers may need to interpret certain requirements 
and in other cases broker-dealers may be relying on informal 
interpretations obtained through dialogue with the Commission or its 
DEA.\116\ This commenter recommended that in those circumstances the 
Commission require broker-dealers to formally document such 
interpretations and obtain evidence of agreements reached with the 
Commission or the DEA.
    Some commenters stated that the Commission should provide 
additional guidance about the control objectives that would need to be 
met to achieve effective internal control over compliance with the 
financial responsibility rules.\117\ Several commenters urged the 
Commission to clarify the interaction between material weaknesses in 
internal control over financial reporting and material weaknesses in 
internal control over compliance with the financial responsibility 
rules.\118\ One commenter stated that the compliance report was over-
inclusive and burdensome, and suggested that the final rule focus 
instead on ``issues most vital to the financial condition of the 
broker-dealer and its compliance and internal control over 
compliance.'' \119\
---------------------------------------------------------------------------

    \116\ See E&Y Letter.
    \117\ See Angel Letter; Deloitte Letter.
    \118\ See Deloitte Letter; KPMG Letter; PWC Letter.
    \119\ See CAI Letter.
---------------------------------------------------------------------------

    Some commenters had questions and comments about the proposed 
assertion that information used to assert compliance with the financial 
responsibility rules was derived from the books and records of the 
broker-dealer. Three commenters asked whether ``books and records'' 
means records maintained under Rule 17a-3.\120\
---------------------------------------------------------------------------

    \120\ See CAQ Letter; Deloitte Letter; E&Y Letter.
---------------------------------------------------------------------------

iii. The Final Rule
    The Commission is adopting the proposed amendments to Rule 17a-5 
requiring a carrying broker-dealer to prepare and file a compliance 
report, with modifications, some of which are in response to 
comments.\121\ Generally, as adopted, the broker-dealer's compliance 
report will include five specific statements, and two descriptions, if 
applicable.
---------------------------------------------------------------------------

    \121\ See paragraph (d)(3) of Rule 17a-5.
---------------------------------------------------------------------------

    Specifically, paragraph (d)(3) of Rule 17a-5 requires that the 
compliance report contain statements as to whether: (1) The broker-
dealer has established and maintained Internal Control Over Compliance 
(which, as discussed below, is a defined term in the final rule); (2) 
the Internal Control Over Compliance of the broker-dealer was effective 
during the most recent fiscal year; (3) the Internal Control Over 
Compliance of the broker-dealer was effective as of the end of the most 
recent fiscal year; (4) the broker-dealer was in compliance with Rule 
15c3-1 and paragraph (e) of Rule 15c3-3 as of the end of the most 
recent fiscal year; and (5) the information the broker-dealer used to 
state whether it was in compliance with Rule 15c3-1 and paragraph (e) 
of Rule 15c3-3 was derived from the books and records of the broker-
dealer. Further, if applicable, the compliance report must contain a 
description of: (1) Each identified material weakness in the Internal 
Control Over Compliance during the most recent fiscal year, including 
those that were identified as of the end of the fiscal year; and (2) 
any instance of non-compliance with Rule 15c3-1 or paragraph (e) of 
Rule 15c3-3 as of the end of the most recent fiscal year.
    The final rule does not use the term assertion--the assertions 
contained in the proposal are now referred to as statements.\122\ The 
consistent use of the term statements is designed to simplify the 
structure of the rule rather than to substantively change the nature of 
the matters stated in the compliance report or which of the statements 
are to be examined by the independent public accountant.
---------------------------------------------------------------------------

    \122\ See paragraphs (d)(3)(i)(A)(1)-(5) of Rule 17a-5.
---------------------------------------------------------------------------

    In the final rule, the first statement in the compliance report is 
whether the broker-dealer has established and maintained Internal 
Control Over Compliance.\123\ The rule defines Internal Control Over 
Compliance to mean internal controls that have the objective of 
providing the broker-dealer with reasonable assurance that non-
compliance with the financial responsibility rules will be prevented or 
detected on a timely basis.\124\ In order to clarify the application of 
the rule, the proposal has been modified so that part of the statement 
contained in the proposed compliance report, as to the broker-dealer's 
system of internal control, has been incorporated in the definition of 
Internal Control Over Compliance in the final rule.\125\ Under the 
final rule, a broker-dealer cannot state that it has established and 
maintained Internal Control Over Compliance if the internal controls do 
not provide the broker-dealer with reasonable assurance that non-
compliance with the financial responsibility rules will be prevented or 
detected on a timely basis.
---------------------------------------------------------------------------

    \123\ See paragraph (d)(3)(i)(A)(1) of Rule 17a-5.
    \124\ See paragraph (d)(3)(ii) of Rule 17a-5.
    \125\ Id.
---------------------------------------------------------------------------

    The final rule also provides that a broker-dealer is not permitted 
to conclude that its Internal Control Over Compliance was effective if 
there were one or more material weaknesses in its Internal Control Over 
Compliance.\126\ A material weakness is defined as a deficiency, or a 
combination of deficiencies, in the broker-dealer's Internal Control 
Over Compliance such that there is a reasonable possibility \127\ that 
non-compliance with Rule 15c3-1 or paragraph (e) of Rule 15c3-3 will 
not be prevented or detected on a timely basis, or that non-compliance 
to a material extent with Rule 15c3-3, except for paragraph (e), Rule 
17a-13 or any Account Statement Rule will not be prevented or detected 
on a timely

[[Page 51919]]

basis.\128\ A deficiency in Internal Control Over Compliance exists 
when the design or operation of a control does not allow the management 
or employees of the broker-dealer to prevent or detect on a timely 
basis non-compliance with the financial responsibility rules in the 
normal course of performing their assigned functions.
---------------------------------------------------------------------------

    \126\ See paragraph (d)(3)(iii) of Rule 17a-5. See also 17 CFR 
229.308(a)(3) (providing that ``[m]anagement is not permitted to 
conclude that the registrant's internal control over financial 
reporting is effective if there are one or more material weaknesses 
in the registrant's internal control over financial reporting.'').
    \127\ As noted above, the Commission has stated in other 
contexts that there is a reasonable possibility of an event 
occurring if it is ``probable'' or ``reasonably possible.'' See 
Amendments to Rules Regarding Management's Report on Internal 
Control Over Financial Reporting, 72 FR 35310. See also 17 CFR 
240.12b-2; 17 CFR 210.1-02. Commission guidance provides that an 
event is ``probable'' if the future event or events are likely to 
occur, and that an event is ``reasonably possible'' if the chance of 
the future event or events occurring is more than remote, but less 
than likely. See Commission Guidance Regarding Management's Report 
on Internal Control Over Financial Reporting Under Section 13(a) or 
15(d) of the Securities Exchange Act of 1934, 72 FR at 35332 n.47 
and corresponding text.
    \128\ See paragraph (d)(3)(iii) of Rule 17a-5. See also 17 CFR 
240.12b-2; 17 CFR 210.1-02(a)(4) (providing that a ``[m]aterial 
weakness means a deficiency, or a combination of deficiencies, in 
internal controls over financial reporting . . . such that there is 
a reasonable possibility that a material misstatement of the 
registrant's annual or interim financial statements will not be 
prevented or detected on a timely basis.'').
---------------------------------------------------------------------------

    The final amendments reflect several other key changes from the 
proposal. For example, one commenter stated that the compliance report 
was overinclusive and burdensome, and therefore suggested that the 
final rule focus on ``issues most vital to the financial condition of 
the broker-dealer and its compliance and internal control over 
compliance.'' \129\ The final rule requires a statement as to whether 
the broker-dealer was in compliance with Rule 15c3-1 and paragraph (e) 
of Rule 15c3-3 as of the end of the most recent fiscal year and, if 
applicable, a description of any instances of non-compliance with these 
rules as of the fiscal year end. This is a modification from the 
proposed assertion that the broker-dealer is in compliance with the 
financial responsibility rules in all material respects and proposed 
description of any material non-compliance with the financial 
responsibility rules. Thus, the final rule reflects two changes from 
the proposal: (1) Elimination of the concepts of ``material non-
compliance'' and ``compliance in all material respects'' for the 
purposes of reporting in the compliance report; and (2) a narrowing of 
these statements and requirements from compliance with all of the 
financial responsibility rules to compliance with Rule 15c3-1 and 
paragraph (e) of Rule 15c3-3. In this way, the final rule more narrowly 
focuses on the core requirements of the financial responsibility rules, 
as suggested by the commenter.
---------------------------------------------------------------------------

    \129\ See CAI Letter.
---------------------------------------------------------------------------

    The ``material non-compliance'' and ``compliance in all material 
respects'' concepts were designed to limit the types of instances of 
non-compliance that would prevent a carrying broker-dealer from stating 
that it was in compliance with the financial responsibility rules. In 
order to retain a limiting principle, the final rule focuses on 
provisions that trigger notification requirements when they are not 
complied with, namely, Rule 15c3-1 and the customer reserve requirement 
in paragraph (e) of Rule 15c3-3.\130\ Any instance of non-compliance 
with these requirements as of the fiscal year end must be addressed in 
the compliance report. As stated in the proposing release, failing to 
maintain the required minimum amount of net capital under Rule 15c3-1 
or failing to maintain the minimum deposit requirement in a special 
reserve bank account under paragraph (e) of Rule 15c3-3 would have been 
instances of material non-compliance under the proposed rule.\131\ 
Accordingly, under the proposal, a broker-dealer would have been 
required to describe all instances of non-compliance with Rule 15c3-1 
and paragraph (e) of Rule 15c3-3. Under the proposal, a broker-dealer 
also would have been required to describe instances of material non-
compliance with Rule 17a-13 and the Account Statement Rules. The final 
rule is narrower in that a broker-dealer is only required to describe 
instances of non-compliance with Rule 15c3-1 and paragraph (e) of Rule 
15c3-3.
---------------------------------------------------------------------------

    \130\ See 17 CFR 240.15c3-1(a)(6)(iv)(B), (a)(6)(v), (a)(7)(ii), 
(a)(7)(iii), (c)(2)(x)(B)(1), (c)(2)(x)(F)(3) (notification 
requirements with respect to Rule 15c3-1); 17 CFR 240.17a-11(b)-(c) 
(notification requirements with respect to Rule 15c3-1); 17 CFR 
240.15c3-3(i) (notification requirement in the event of a failure to 
make a required deposit to the reserve account).
    \131\ See Broker-Dealer Reports, 76 FR at 37577.
---------------------------------------------------------------------------

    Consistent with these changes, the final rule requires a statement 
as to whether the carrying broker-dealer has established and maintained 
Internal Control Over Compliance, which is defined as internal controls 
that have the objective of providing the broker-dealer with reasonable 
assurance that non-compliance with the financial responsibility rules 
will be prevented or detected on a timely basis.\132\ The definition of 
Internal Control Over Compliance modifies the proposed statement that 
the carrying broker-dealer has established and maintained a system of 
internal control to provide the firm with reasonable assurance that any 
instances of material non-compliance with the financial responsibility 
rules will be prevented or detected on a timely basis.\133\ Thus, the 
definition eliminates the concept of material non-compliance. 
Similarly, the proposed assertion as to whether the information used to 
assert compliance with the financial responsibility rules was derived 
from the books and records of the carrying broker-dealer has been 
modified to a statement as to whether the information used to state 
whether the carrying broker-dealer was in compliance with Rule 15c3-1 
and paragraph (e) of Rule 15c3-3 was derived from the broker-dealer's 
books and records.\134\
---------------------------------------------------------------------------

    \132\ See paragraphs (d)(3)(i)(A)(1) and (d)(3)(ii) of Rule 17a-
5. As indicated above, the independent public accountant is not 
required to examine this statement. See paragraph (g)(2)(i) of Rule 
17a-5.
    \133\ See paragraphs (d)(3)(i)(A)(1) and (d)(3)(ii) of Rule 17a-
5.
    \134\ See paragraph (d)(3)(i)(A)(5) of Rule 17a-5.
---------------------------------------------------------------------------

    The definition of material weakness similarly has been modified 
from the proposal. Under the final rule, a material weakness would 
include deficiencies in internal control relating to ``non-compliance'' 
with Rule 15c3-1 or paragraph (e) of Rule 15c3-3, and ``non-compliance 
to a material extent'' with Rule 15c3-3, except for paragraph (e), Rule 
17a-13, and the Account Statement Rules.\135\ This modification of the 
definition of material weakness is based on the practical difficulties 
in creating a system of control that will eliminate a reasonable 
possibility of the occurrence of any instances of non-compliance with 
certain requirements of the financial responsibility rules. For 
example, the inadvertent failure to send one account statement out of 
thousands of such statements would not constitute non-compliance to a 
material extent with the Account Statement Rules though it would be an 
instance of non-compliance.
---------------------------------------------------------------------------

    \135\ See paragraph (d)(3)(iii) of Rule 17a-5.
---------------------------------------------------------------------------

    Further, and consistent with current auditing standards, the 
definition of ``deficiency in internal control'' in the final rule has 
been modified to include the phrase ``the management or employees of 
the broker or dealer'' in place of the phrase ``the broker or dealer.'' 
\136\
---------------------------------------------------------------------------

    \136\ Id. See also PCAOB Auditing Standard, AS No. 5 app. A, at 
] A3 (providing that ``[a] deficiency in internal control over 
financial reporting exists when the design or operation of a control 
does not allow management or employees, in the normal course of 
performing their assigned functions, to prevent or detect 
misstatements on a timely basis.'').
---------------------------------------------------------------------------

    The final rule--substantially as proposed--requires the carrying 
broker-dealer to state whether its Internal Control Over Compliance was 
effective during the most recent fiscal year.\137\ Some commenters 
suggested that a broker-dealer that has remediated a material weakness 
be permitted to provide an assertion about whether a material weakness 
still exists at the end of the year, instead of having to state whether 
internal control was effective during the most recent fiscal year.\138\ 
In light of the importance of a broker-dealer being in continual 
compliance

[[Page 51920]]

with the financial responsibility rules, the Commission believes it is 
appropriate for the broker-dealer's statement to address effectiveness 
of its Internal Control Over Compliance throughout the fiscal year. 
Consequently, the final rule requires the statement to cover the entire 
fiscal year as opposed to the date that is the end of the fiscal year 
as suggested by commenters.
---------------------------------------------------------------------------

    \137\ See paragraph (d)(3)(i)(A)(2) of Rule 17a-5.
    \138\ See CAQ Letter; E&Y Letter; KPMG Letter; PWC Letter.
---------------------------------------------------------------------------

    However, in response to comments suggesting that the broker-dealer 
be permitted to report the remediation or whether a material weakness 
still exists at the end of the year,\139\ the final rule also requires 
the carrying broker-dealer to state whether its Internal Control Over 
Compliance was effective as of the end of the most recent fiscal 
year.\140\ Thus, if there was a material weakness in the Internal 
Control Over Compliance of the broker-dealer during the year that has 
been addressed such that the broker-dealer no longer considers there to 
be a material weakness at fiscal year end, the compliance report would 
reflect both the identification of the material weakness and that its 
Internal Control Over Compliance was effective as of the end of the 
most recent fiscal year, thereby indicating that the material weakness 
had been addressed as of the fiscal year end.
---------------------------------------------------------------------------

    \139\ See CAQ Letter; Deloitte Letter; E&Y Letter; McGladrey 
Letter.
    \140\ See paragraph (d)(3)(i)(A)(3) of Rule 17a-5.
---------------------------------------------------------------------------

    Consistent with these changes, the final rule provides that the 
carrying broker-dealer cannot conclude that its Internal Control Over 
Compliance was effective during the most recent fiscal year if there 
were one or more material weaknesses in Internal Control Over 
Compliance of the broker-dealer during the fiscal year.\141\ The final 
rule adds a similar provision relating to the effectiveness of a 
broker-dealer's Internal Control Over Compliance at the end of the most 
recent fiscal year \142\ to respond to comments \143\ and to align with 
the additional statement discussed above as to whether the broker-
dealer's Internal Control Over Compliance was effective as of the end 
of the fiscal year.\144\
---------------------------------------------------------------------------

    \141\ See paragraph (d)(3)(iii) of Rule 17a-5. See also 17 CFR 
229.308(a)(3) (providing that ``[m]anagement is not permitted to 
conclude that the registrant's internal control over financial 
reporting is effective if there are one or more material weaknesses 
in the registrant's internal control over financial reporting.'').
    \142\ See paragraph (d)(3)(iii) of Rule 17a-5.
    \143\ See CAQ Letter; Deloitte Letter; E&Y Letter; McGladrey 
Letter.
    \144\ See paragraph (d)(3)(i)(A)(3) of Rule 17a-5.
---------------------------------------------------------------------------

    The final rule also retains the proposed requirement that the 
carrying broker-dealer provide a description of each identified 
material weakness in the broker-dealer's Internal Control Over 
Compliance, but, in conformity with other modifications to the 
proposal, the final rule requires that the material weaknesses include 
those identified during the most recent fiscal year as well as those 
that were identified as of the end of the fiscal year.\145\ This change 
should not add a significant burden because broker-dealers should know 
whether any material weaknesses identified before year end have been 
remediated.
---------------------------------------------------------------------------

    \145\ See paragraph (d)(3)(i)(B) of Rule 17a-5.
---------------------------------------------------------------------------

    As noted above, one commenter recommended that the Commission 
require broker-dealers to document oral guidance obtained through 
dialogue with Commission or DEA staff.\146\ While such a requirement 
was not proposed and is not being adopted in the final rule, it may be 
appropriate and prudent for a broker-dealer to maintain documentation 
in its books and records of the matters discussed with the Commission 
or DEA staff, the broker-dealer's own views and conclusion on those 
matters, and any guidance received by the broker-dealer.
---------------------------------------------------------------------------

    \146\ See E&Y Letter.
---------------------------------------------------------------------------

    Also as noted above, two commenters asked the Commission to provide 
additional guidance about the control objectives that should be met to 
achieve effective internal control over compliance with the financial 
responsibility rules.\147\ As stated in the proposing release, the 
control objectives identified in the Commission's guidance on Rule 
206(4)-2 are more general than the specific operational requirements in 
the financial responsibility rules.\148\ In particular, broker-dealers 
are subject to operational requirements with respect to handling and 
accounting for customer assets.\149\ Given the specificity of the 
financial responsibility rules, the Commission does not believe that 
additional guidance about the control objectives is necessary.
---------------------------------------------------------------------------

    \147\ See Angel Letter; Deloitte Letter.
    \148\ See Broker-Dealer Reports, 76 FR at 37580.
    \149\ Id.
---------------------------------------------------------------------------

    As noted above, several commenters sought assurances that the 
independent public accountant's examination of the compliance report 
would not cover the effectiveness of internal control over financial 
reporting.\150\ The final rule does not require that the broker-dealer 
include a statement regarding the effectiveness of its internal control 
over financial reporting, nor does it require that the independent 
public accountant attest to the effectiveness of internal control over 
financial reporting. The requirement in the final rule is for the 
broker-dealer to state whether its Internal Control Over Compliance was 
effective during the most recent fiscal year and at the end of the 
fiscal year and for the accountant to express an opinion based on an 
examination of those statements.
---------------------------------------------------------------------------

    \150\ See Deloitte Letter; KPMG Letter; PWC Letter.
---------------------------------------------------------------------------

    A broker-dealer's Internal Control Over Compliance is intended to 
focus, for example, on a broker-dealer's oversight of custody 
arrangements and protection of customer assets. In contrast, internal 
control over financial reporting is focused on the reliability of 
financial reporting and the preparation of financial statements in 
accordance with GAAP. As stated in the proposing release, the 
Commission did not propose that effectiveness of internal control over 
financial reporting be included as one of the assertions made by the 
broker-dealer in the compliance report. The Commission intends that the 
compliance report should focus on oversight of net capital, custody 
arrangements, and protection of customer assets, and therefore, should 
be focused on compliance with the financial responsibility rules.
    Further, the examination of the compliance report would pertain 
solely to certain statements in the compliance report and not to the 
broker-dealer's process for arriving at the statements. The report of 
the independent public accountant, based on the examination of the 
compliance report, requires the accountant to perform its own 
independent examination of the related internal controls. Consequently, 
it is not necessary for the independent public accountant to provide an 
opinion with regard to the process that the broker-dealer used to 
arrive at its conclusions.
    As noted above, commenters sought clarification of the meaning of 
``books and records'' as used in the compliance report statement. The 
reference in paragraph (d)(3)(i)(A)(5) of Rule 17a-5 to books and 
records refers to the books and records a broker-dealer is required to 
make and maintain under Commission rules (e.g., Rule 17a-3 and Rule 
17a-4).\151\
---------------------------------------------------------------------------

    \151\ See 17 CFR 240.17a-3; 17 CFR 240.17a-4.
---------------------------------------------------------------------------

4. The Exemption Report--Paragraph (d)(4) of Rule 17a-5
i. Proposed Amendments
    The Commission proposed that the exemption report must contain an 
assertion by the broker-dealer that it is exempt from Rule 15c3-3 
because it meets conditions set forth in paragraph (k) of Rule 15c3-3 
and ``should identify

[[Page 51921]]

the specific conditions.'' \152\ As discussed below in section II.D.3. 
of this release, under the proposal, the independent public accountant, 
as part of the engagement, would have been required to prepare a report 
based on a review of the exemption report in accordance with PCAOB 
standards.\153\
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    \152\ See Broker-Dealer Reports, 76 FR at 37580-37581.
    \153\ Id. at 37578-37579. PCAOB standards for attestation 
engagements provide that accountants ordinarily should obtain 
written assertions in an examination or review engagement.
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ii. Comments Received
    The Commission received several comments regarding the exemption 
report.\154\ Some commenters stated that the Commission should clarify 
whether the assertion would cover the entire fiscal year or be as of a 
fixed date.\155\ One commenter stated that the assertion should be as 
of a fixed date.\156\ With respect to the independent public 
accountant's review of the exemption report, one commenter provided the 
example of a bank or clerical error that results in a broker-dealer 
that operates under an exemption to Rule 15c3-3 finding itself in 
possession of customer assets overnight once during the fiscal 
year.\157\ This commenter stated that such a situation should not 
``warrant the `material modification' of a broker-dealer's Exemption 
Report.'' \158\ Similarly, another commenter noted that ``to consider a 
single instance of a broker-dealer failing to promptly forward a 
customer's securities as an instance that would necessitate a material 
modification creates an unworkable standard.'' \159\
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    \154\ See CAQ Letter; Deloitte Letter; Grant Thornton Letter; 
KPMG Letter. Some of the comments relating to the exemption report 
and the response to the comments are discussed above in section 
II.B.1. of this release.
    \155\ See CAQ Letter; Deloitte Letter; Grant Thornton Letter; 
KPMG Letter.
    \156\ See KPMG Letter.
    \157\ See SIFMA Letter.
    \158\ Id.
    \159\ See CAI Letter.
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    One commenter stated that the exemption report relates only to Rule 
15c3-3 and asked how the Commission intended to assess, for a firm that 
claims an exemption from Rule 15c3-3, compliance with Rule 15c3-1 and 
the adequacy of the firm's internal control over compliance with that 
rule.\160\ Another commenter asked whether the exemption report should 
be replaced with a box to check on the FOCUS Report, as the amount of 
paperwork involved for small firms ``seems rather excessive.'' \161\
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    \160\ See McGladrey Letter.
    \161\ See Angel Letter.
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iii. The Final Rule
    The Commission is adopting, with modifications discussed below, the 
requirements regarding the exemption report.\162\ The modifications are 
designed to address commenters' concerns that the proposed exemption 
report assertion would create an unworkable standard given the 
possibility that a broker-dealer might have instances of exceptions to 
meeting the exemption provisions in paragraph (k) of Rule 15c3-3 and 
that the proposed requirements with respect to the exemption report did 
not explicitly provide how exceptions should be treated. In response to 
these concerns, the final rule provides that exemption reports must 
contain the following statements made to the best knowledge and belief 
of the broker-dealer: (1) A statement that identifies the provisions in 
paragraph (k) of Rule 15c3-3 under which the broker-dealer claimed an 
exemption from Rule 15c3-3; (2) a statement the broker-dealer met the 
identified exemption provisions in paragraph (k) of Rule 15c3-3 
throughout the most recent fiscal year without exception or that it met 
the identified exemption provisions in paragraph (k) of Rule 15c3-3 
throughout the most recent fiscal year except as described in the 
exemption report; and (3) if applicable, a statement that identifies 
each exception during the most recent fiscal year in meeting the 
identified provisions in paragraph (k) of Rule 15c3-3 and that briefly 
describes the nature of each exception and the approximate date(s) on 
which the exception existed.\163\
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    \162\ See paragraph (d)(4) of Rule 17a-5.
    \163\ Id.
---------------------------------------------------------------------------

    In response to comments seeking clarity as to whether the assertion 
in the exemption report should cover a fixed date or the fiscal 
year,\164\ the final rule explicitly provides that the statement and 
certain information in the exemption report must cover the most recent 
fiscal year.\165\ This corresponds to the provisions of paragraph 
(d)(1)(i)(B) of Rule 17a-5 governing when a broker-dealer must file the 
exemption report instead of the compliance report. In particular, a 
broker-dealer that claimed an exemption from Rule 15c3-3 throughout the 
most recent fiscal year must file the exemption report.\166\
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    \164\ See CAQ Letter; Deloitte Letter; Grant Thornton Letter; 
KPMG Letter.
    \165\ See paragraph (d)(4)(ii) of Rule 17a-5.
    \166\ See paragraph (d)(1)(i)(B) of Rule 17a-5.
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    In addition, as proposed, the exemption report was required to 
contain an assertion that the broker-dealer ``is exempt from the 
provisions'' of Rule 15c3-3 ``because it meets conditions set forth 
in'' paragraph (k) of Rule 15c3-3 and ``should identify the specific 
conditions.'' \167\ Thus, the exemption report would have required the 
broker-dealer to state definitively that ``it is exempt'' from Rule 
15c3-3 because it ``meets the conditions set forth in'' in paragraph 
(k).\168\ As noted above, commenters raised questions and concerns 
about how certain exceptions would be handled under the proposed 
exemption report requirements. The final rule addresses these comments 
in a number of ways.
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    \167\ See Broker-Dealer Reports, 76 FR at 37604.
    \168\ Id.
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    First, it provides that the statements in the exemption report must 
be made to the ``best knowledge and belief of the broker or dealer.'' 
\169\ This modification is designed to address situations where the 
broker-dealer is unaware of an instance or instances in which it had an 
exception to meeting the exemption provisions in paragraph (k) of Rule 
15c3-3 during the most recent fiscal year. As discussed below, the 
broker-dealer must state in the report that it met the exemption 
provisions throughout the year without exceptions or with exceptions 
that must be identified.\170\
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    \169\ See paragraph (d)(4) of Rule 17a-5.
    \170\ As discussed above in section II.B.3. of this release, a 
carrying broker-dealer must state in the compliance report whether 
it was in compliance with Rule 15c3-1 and paragraph (e) of Rule 
15c3-3 as of the end of the most recent fiscal year. See paragraph 
(d)(3)(i)(A)(4) of Rule 17a-5. In response to comments and in light 
of the nature of the statements required in the exemption report, 
the Commission added the best knowledge and belief standard to the 
exemption report requirement.
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    Second, the final rule provides that the broker-dealer first must 
identify in the exemption report the ``provisions'' in paragraph (k) of 
Rule 15c3-3 under which it ``claimed'' an exemption from Rule 15c3-
3.\171\ As discussed above in section II.B.1. of this release, the 
final rule has been modified to provide that a broker-dealer must file 
the exemption report if it did ``claim that it was exempt'' from Rule 
15c3-3 throughout

[[Page 51922]]

the most recent fiscal year.\172\ This change is designed to remove any 
ambiguity as to when a broker-dealer must file the exemption report as 
opposed to the compliance report, particularly in situations where the 
broker-dealer had exceptions to meeting the exemption provisions in 
paragraph (k) of Rule 15c3-3. Consistent with this change, the final 
rule requires the broker-dealer to identify in the exemption report the 
provisions in paragraph (k) under which it ``claimed the 
exemption.''\173\
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    \171\ See paragraph (d)(4)(i) of Rule 17a-5. As proposed, 
paragraph (d)(4) of Rule 17a-5 provided that the exemption report 
``shall contain a statement by the broker or dealer that it is 
exempt from the provisions of [Rule 15c3-3] because it meets the 
conditions set forth in [paragraph (k) of Rule 15c3-3] and should 
identify the specific conditions.'' See Broker-Dealer Reports, 76 FR 
37604 (emphasis added). The Commission intended that the broker-
dealer be required to identify the provisions of paragraph (k) of 
Rule 15c3-3 under which the broker-dealer was claiming the 
exemption. To make clear that this requirement and the other 
requirements of the exemption report are mandatory, the final rule 
uses the word ``must'' in relation to each element of the exemption 
report. See paragraph (d)(4) of Rule 17a-5.
    \172\ See paragraph (d)(1)(i)(B)(2) of Rule 17a-5. A broker-
dealer claiming an exemption from Rule 15c3-3 is required to 
indicate the basis for the exemption on the periodic reports it 
files with securities regulators. See, e.g., Item 24 of Part IIa of 
the FOCUS Reports. See 17 CFR 249.617.
    \173\ See paragraph (d)(4)(i) of Rule 17a-5.
---------------------------------------------------------------------------

    Further, as proposed, the broker-dealer would have been required to 
identify the exemption ``conditions'' in paragraph (k) of Rule 15c3-
3.\174\ The use of the word ``provisions'' in the final rule is 
designed to eliminate a potential ambiguity as to whether the exemption 
provisions in paragraphs (k)(2) and (3) of Rule 15c3-3 applied to the 
exemption report. In particular, paragraph (k) of Rule 15c3-3 
prescribes ``exemptions'' from the requirements of Rule 15c3-3.\175\ 
Paragraph (k)(1) provides that the requirements of Rule 15c3-3 do not 
apply to a broker-dealer that meets all of the ``conditions'' set forth 
in the paragraph.\176\ Paragraph (k)(2) identifies two sets of 
conditions (without using the word ``conditions'') either of which 
exempts a broker-dealer from the requirements of Rule 15c3-3.\177\ 
Paragraph (k)(3) provides that the Commission may exempt a broker-
dealer from the provisions of Rule 15c3-3, either unconditionally or on 
specified terms and conditions, if the Commission finds that the 
broker-dealer has established safeguards for the protection of funds 
and securities of customers comparable with those provided for by Rule 
15c3-3 and that it is not necessary in the public interest or for the 
protection of investors to subject the particular broker-dealer to the 
provisions of Rule 15c3-3.\178\ The Commission intended that a broker-
dealer file an exemption report if it is exempt from Rule 15c3-3 under 
the provisions in either paragraph (k)(1), (k)(2)(i), (k)(2)(ii), or 
(k)(3) of Rule 15c3-3. To make this clear, the final rule refers to the 
``provisions'' of paragraph (k) of Rule 15c3-3.\179\ Consequently, a 
broker-dealer filing the exemption report must identify the provisions 
in paragraph (k) that it relied on to claim an exemption from Rule 
15c3-3.\180\
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    \174\ See paragraph (d)(4)(ii) of Rule 17a-5. The proposed rule 
provided that the broker-dealer must assert that it is exempt from 
the provisions of Rule 15c3-3 because it meets ``conditions'' set 
forth in paragraph (k) and should identify the specific 
``conditions.'' See Broker-Dealer Reports, 76 FR at 37580-37581.
    \175\ See 17 CFR 240.15c3-3(k)(1), (k)(2)(i), (k)(2)(ii), and 
(k)(3).
    \176\ See 17 CFR 240.15c3-3(k)(1)(i)-(iv).
    \177\ See 17 CFR 240.15c3-3(k)(2)(i)-(ii).
    \178\ See 17 CFR 240.15c3-3(k)(3).
    \179\ This modification is consistent with Item 24 of Part IIa 
of the FOCUS Report, which is titled ``EXEMPTIVE PROVISION UNDER 
RULE 15c3-3'' and requires a broker-dealer that claims to be exempt 
from the requirements of Rule 15c3-3 to identify the provision in 
Rule 15c3-3--paragraph (k)(1), paragraph (k)(2)(i), paragraph 
(k)(2)(ii), or paragraph (k)(3)--under which it is claiming to be 
exempt. See 17 CFR 249.617.
    \180\ This change also is intended to make clear that the 
broker-dealer can identify the provisions of paragraph (k) of Rule 
15c3-3 that the broker-dealer is relying on to claim the exemption 
by simply identifying in the exemption report the subparagraph in 
paragraph (k) (i.e., (k)(1), (k)(2)(i), (k)(2)(ii), or (k)(3)) that 
contains the particular conditions the broker-dealer is relying on 
to claim the exemption rather than repeating the conditions 
themselves in the exemption report. For example, it would be 
sufficient for a broker-dealer relying on the exemption provisions 
in paragraph (k)(2)(ii) of Rule 15c3-3 to identify the provisions in 
the exemption report under which in claimed an exemption by 
referring to ``paragraph (k)(2)(ii) of Rule 15c3-3'' or ``17 CFR 
240.15c3-3(k)(2)(ii).''
---------------------------------------------------------------------------

    The third modification designed to address commenters' questions 
and concerns about how to handle exceptions to meeting the exemption 
provisions in paragraph (k) of Rule 15c3-3 relates to the proposed 
assertion that the broker-dealer ``is exempt from the provisions'' of 
Rule 15c3-3 ``because it meets conditions set forth in'' paragraph (k). 
The final rule provides that the exemption report must contain a 
statement that the broker-dealer met the identified exemption 
provisions in paragraph (k) of Rule 15c3-3 throughout the most recent 
fiscal year without exception or that it met the identified exemption 
provisions in paragraph (k) of Rule 15c3-3 throughout the most recent 
fiscal year except as described in the exemption report.\181\ This 
modification from requiring the broker-dealer to state an absolute 
(i.e., that it is exempt from Rule 15c3-3) allows the broker-dealer to 
account for instances in which it had exceptions to meeting the 
exemption provisions in paragraph (k) of Rule 15c3-3 directly in the 
exemption report (rather than having to file the compliance report). 
Specifically, if to the broker-dealer's best knowledge and belief, it 
had no exceptions during the most recent fiscal year to the identified 
exemption provisions in paragraph (k) of Rule 15c3-3, it must state in 
the exemption report that it met the identified exemption provisions in 
paragraph (k) without exception. Alternatively, a broker-dealer that 
had exceptions must state that it met the identified exemption 
provisions except as described in the exemption report.
---------------------------------------------------------------------------

    \181\ See paragraph (d)(4)(ii) of Rule 17a-5.
---------------------------------------------------------------------------

    If the broker-dealer states that it had exceptions (e.g., 
exceptions identified during the year, such as through routine 
monitoring of its compliance processes as part of the execution of its 
internal controls, internal or external audits, or regulatory 
examinations), the final rule requires the firm to identify, to its 
best knowledge and belief, each exception and briefly describe the 
nature of the exception and the approximate date(s) on which the 
exception existed.\182\ The Commission expects that non-carrying 
broker-dealers generally track exceptions as part of monitoring 
compliance with the exemption provisions in paragraph (k) of Rule 15c3-
3.\183\ Further, a non-carrying broker-dealer's adherence to the 
exemption provisions in paragraph (k) of Rule 15c3-3 generally is a 
focus of Commission examiners when they conduct financial 
responsibility examinations on this class of firm. For example, 
examiners will review whether a non-carrying broker-dealer promptly 
forwards checks in accordance with provisions in paragraph (k) of Rule 
15c3-3. The Commission also notes that the 2011 AICPA Broker Dealer 
Audit Guide states: ``In auditing the financial statements of a broker-
dealer claiming exemption from SEC Rule 15c3-3, the auditor should 
determine whether and to what extent the broker-dealer complied with 
the specific exemption during the audit period as well as the quality 
of the broker-dealer's controls and procedures to ensure ongoing 
compliance.''\184\ In addition, under the PCAOB's proposed standards, 
the independent public accountant should inquire of individuals at the 
broker-dealer who have relevant knowledge of controls relevant to the 
broker-dealer's compliance with the exemption provisions and who are 
responsible for monitoring compliance with the exemption provisions 
whether they are aware of any deficiencies in controls over compliance 
or instances of non-compliance with the exemption conditions.\185\ 
Moreover, in the independent public accountant's report, ``[i]f the 
broker's or dealer's statement is not fairly stated, in all material 
respects,

[[Page 51923]]

because of an instance or certain instances of non-compliance with the 
exemption conditions, the auditor must modify the review report to 
describe those instances of non-compliance and state that the broker or 
dealer is not in compliance with the specified exemption conditions.'' 
\186\
---------------------------------------------------------------------------

    \182\ See paragraph (d)(4)(iii) of Rule 15c3-3.
    \183\ See, e.g., Net Capital Rule, Exchange Act Release No. 
31511 (Nov. 24, 1992), 57 FR 56973 (Dec. 2, 1992), at 56981 n.25 
(stating that non-carrying broker-dealers must develop procedures to 
ensure that they do not receive customer securities or checks made 
payable to themselves).
    \184\ See AICPA Broker-Dealer Audit Guide at ] 3.35.
    \185\ See PCAOB Proposing Release app. 2 at ] 10.
    \186\ Id. at ] 20.
---------------------------------------------------------------------------

    Under the final rule, a non-carrying broker-dealer must identify in 
the exemption report and describe each exception during the most recent 
fiscal year in meeting the identified exemption provisions in paragraph 
(k) of Rule 15c3-3. The description must include the approximate 
date(s) on which the exception existed. Without such reporting, the 
Commission and the broker-dealer's DEA would have no information to 
assess the nature, extent, and significance of the exceptions.
    As noted above, one commenter asked whether the exemption report 
should be replaced with a box to check on the FOCUS Report, as the 
amount of paperwork involved for small firms ``seems rather 
excessive.'' \187\ The Commission does not believe this is an 
appropriate alternative. First, as indicated above, a broker-dealer 
claiming an exemption from Rule 15c3-3 already is required to indicate 
the basis for the exemption on its FOCUS Report.\188\ Second, the 
exemption report requires the broker-dealer to make certain statements 
that the independent public accountant must review. Thus, the exemption 
report will provide a standardized statement across all broker-dealers 
claiming an exemption from Rule 15c3-3 for the independent public 
accountant to review. Third, the exemption report will provide the 
Commission and the broker-dealer's DEA with more information than 
currently is reported by non-carrying broker-dealers in the FOCUS 
Report. Specifically, it requires the broker-dealer to, among other 
things, state either that it met the identified exemption provisions in 
paragraph (k) throughout the most recent fiscal year without exception 
or that it met the identified exemption provisions throughout the most 
recent fiscal year except as described in the report. This will provide 
the Commission and the broker-dealer's DEA with information as to 
whether a broker-dealer is meeting the exemption provisions of 
paragraph (k) of Rule 15c3-3 (not simply that the broker-dealer is 
claiming the exemption as is reported in the FOCUS Report). Fourth, 
requiring that the exemption report be filed with the Commission should 
increase broker-dealers' focus on the statements being made, 
facilitating consistent compliance with the exemption provisions in 
Rule 15c3-3, and therefore, providing better protection of customer 
assets. Fifth, the requirement to prepare and file the exemption report 
should not result in excessive paperwork, as stated by one 
commenter.\189\
---------------------------------------------------------------------------

    \187\ See Angel Letter.
    \188\ See Item 24 of Part IIa of the FOCUS Report.
    \189\ See Angel Letter. The commenter did not explain why the 
exemption report would result in excessive paperwork. Id. See also 
discussion below in section VI.D.1.iii. of this release for the 
estimated paperwork hour burden associated with this requirement.
---------------------------------------------------------------------------

    As noted above, one commenter pointed out that the exemption report 
relates solely to Rule 15c3-3 and asked how the adequacy of a non-
carrying broker-dealer's internal controls over compliance with Rule 
15c3-1 would be assessed.\190\ Under the final amendments, a broker-
dealer's financial report will continue to include a supporting 
schedule containing a net capital computation under Rule 15c3-1, which 
will be covered by the independent public accountant's examination of 
the financial report. Moreover, the PCAOB has proposed standards for 
auditing supplemental information accompanying audited financial 
statements.\191\
---------------------------------------------------------------------------

    \190\ See McGladery Letter. The material inadequacy report--
which applied to carrying and non-carrying broker-dealers--covered 
Rule 15c3-1. See 17 CFR 240.17a-5(g).
    \191\ See Proposed Auditing Standard, Auditing Supplemental 
Information Accompanying Audited Financial Statements and Related 
Amendments to PCAOB Standards, PCAOB Release No. 2011-05, PCAOB 
Rulemaking Docket Matter No. 036 (July 12, 2011) (``PCAOB Proposed 
Auditing Standard for Supplemental Information'').
---------------------------------------------------------------------------

5. Time for Filing Annual Reports--Paragraph (d)(5) of Rule 17a-5
    Prior to today's amendments, paragraph (d)(5) of Rule 17a-5 
required that the annual audit report be filed not more than 60 days 
after the date of the financial statements.\192\ The Commission 
proposed amending paragraph (d)(5) to replace the term annual audit 
report with annual reports.\193\ This change was designed to reflect 
the fact that, under the proposal, broker-dealers must file a financial 
report, a compliance report or exemption report, and reports prepared 
by an independent public accountant covering these reports. While the 
Commission did not receive comments on this proposed change, one 
commenter stated that the existing requirement in Rule 17a-5 that the 
annual audit report be filed 60 days after the date of the financial 
statements should be lengthened to 90 days.\194\ In support of this 
recommendation, the commenter cited CFTC Rule 1.10, which allows an FCM 
up to 90 days to file annual audit reports.\195\
---------------------------------------------------------------------------

    \192\ See 17 CFR 240.17a-5(d)(5).
    \193\ See Broker-Dealer Reports, 76 FR at 37604.
    \194\ See IMS Letter.
    \195\ See 17 CFR 1.10(b)(ii). Rule 1.10 also provides that if 
the FCM is registered with the Commission as a broker-dealer, the 
FCM must file the report not later than the time permitted for 
filing an annual audit report under Rule 17a-5.
---------------------------------------------------------------------------

    The Commission is adopting, with modifications, the proposed 
amendment to paragraph (d)(5) of Rule 17a-5.\196\ The modifications add 
the term ``calendar'' to make explicit that the time for filing the 
annual reports is 60 calendar days after the fiscal year end (as 
opposed to business days). The modifications replace the words ``date 
of the financial statements'' with the words ``end of the fiscal year 
of the broker or dealer'' to provide consistency in the language of 
Rule 17a-5.\197\ The final rule does not change the time limit for 
filing the annual reports to 90 days after the end of the fiscal year. 
The 60-day time frame is a long standing requirement and it provides 
the Commission and other regulators with relatively current information 
to, among other things, monitor the financial condition of broker-
dealers. Further, broker-dealers may seek an extension of time to file 
the annual reports from their DEAs.\198\
---------------------------------------------------------------------------

    \196\ See paragraph (d)(5) of Rule 17a-5.
    \197\ Id. See also paragraph (n) of Rule 17a-5.
    \198\ See paragraph (m) of Rule 17a-5.
---------------------------------------------------------------------------

6. Filing of Annual Reports With SIPC--Paragraph (d)(6) of Rule 17a-5
    Prior to today's amendments, paragraph (d)(6) of Rule 17a-5 
provided that the ``annual audit report'' must be filed at the regional 
office of the Commission for the region in which the broker-dealer has 
its principal place of business, the Commission's principal office in 
Washington, DC, and the principal office of the DEA of the broker-
dealer.\199\ Copies were required to be provided to all self-regulatory 
organizations (``SROs'') of which the broker-dealer is a member.
---------------------------------------------------------------------------

    \199\ See 17 CFR 240.17a-5(d)(6).
---------------------------------------------------------------------------

i. The Proposed Amendments
    The Commission proposed two amendments to this provision. First, 
the Commission proposed that an SRO that is not a broker-dealer's DEA 
could by rule waive the requirement that broker-dealers file annual 
reports with it because many SROs do not believe that it is necessary 
to receive copies of broker-dealer annual reports if they are not the 
broker-dealer's DEA.\200\ The

[[Page 51924]]

Commission received no comments on this proposal and is adopting it as 
proposed.\201\
---------------------------------------------------------------------------

    \200\ See Broker-Dealer Reports, 76 FR at 37592.
    \201\ See paragraph (d)(6) of Rule 17a-5.
---------------------------------------------------------------------------

    Second, the Commission proposed amending this provision to require 
a broker-dealer to file its annual reports with SIPC.\202\ SIPC, a 
nonprofit, nongovernmental membership corporation established by SIPA, 
is responsible for providing financial protection to customers of 
failed broker-dealers. SIPA also provided for the establishment of a 
fund (``SIPC Fund'') to pay for SIPC's operations and activities. SIPC 
uses the fund to make advances to satisfy customer claims for 
securities and cash that cannot be readily returned to the customer. 
SIPA limits the amount of the advance to $500,000 per customer, of 
which $250,000 can be used to satisfy the cash portion of a customer's 
claim. The SIPC Fund also covers the administrative expenses of 
liquidation proceedings for failed broker-dealers when the general 
estate of the failed firm is insufficient; these include costs incurred 
by a trustee, trustee's counsel, and other advisors. SIPC finances the 
SIPC Fund through annual assessments, set by SIPC, on all member firms, 
plus interest generated from its permitted investments. Generally, all 
broker-dealers registered with the Commission under section 15(b) of 
the Exchange Act \203\ are required to be members of SIPC.\204\ Before 
today's amendments, broker-dealers were required to file only limited 
information with SIPC. Specifically: (1) Information elicited on Form 
SIPC-6, the ``General Assessment Payment Form;'' (2) information 
elicited on Form SIPC-7, the ``Annual General Assessment 
Reconciliation;'' and (3) for periods in which the SIPC assessment is 
not a minimum assessment, a comparison by the independent public 
accountant of the amounts reflected in the annual report the broker-
dealer filed with the Commission with amounts reported on Form SIPC-7.
---------------------------------------------------------------------------

    \202\ See Broker-Dealer Reports, 76 FR at 37592.
    \203\ See 15 U.S.C. 78o(b).
    \204\ See 15 U.S.C. 78ccc(a)(2). However, broker-dealers engaged 
exclusively in the distribution of mutual fund shares, the sale of 
variable annuities, the insurance business, the furnishing of 
investment advice to investment companies or insurance company 
separate accounts, or whose principal business is conducted outside 
the U.S. are not required to be members of SIPC. See 15 U.S.C. 
78ccc(a)(2)(A)(i)-(iii).
---------------------------------------------------------------------------

    The Commission explained in the proposing release that the proposed 
requirement for broker-dealers to file their annual reports with SIPC 
could allow SIPC to better monitor industry trends and enhance its 
knowledge of particular firms.\205\ The Commission also explained that 
the requirement that broker-dealers file copies of their annual reports 
with SIPC was designed to address cases where the SIPC Fund has been 
used to pay the administrative expenses of the liquidation of a failed 
broker-dealer and SIPC sought to recover the money advanced when the 
estate had insufficient assets.\206\ In some of these cases, SIPC has 
sought to recover money damages from the broker-dealer's auditing firm 
based on an alleged failure to comply with auditing standards. At least 
one court, however, has held under New York law that SIPC could not 
maintain such a claim because it was not a recipient of the annual 
audit filing and could not have relied on it.\207\
---------------------------------------------------------------------------

    \205\ See Broker-Dealer Reports, 76 FR at 37592.
    \206\ Id. See also SIPC, 2010 Annual Report, at 18, available at 
http://www.sipc.org/pdf/2010%20Annual%20Report.pdf.
    \207\ See SIPC v. BDO Seidman, LLP, 746 NE.2d 1042 (N.Y. 2001).
---------------------------------------------------------------------------

ii. Comments Received
    The Commission received seven comments on the proposal that broker-
dealers be required to file their annual reports with SIPC.\208\ Six 
commenters generally opposed the requirement.\209\ One commenter 
indicated that it is appropriate for broker-dealers to file their 
annual reports with SIPC if SIPC uses the reports to reconcile the 
annual reports with the Form SIPC-7 or otherwise places reliance on 
them.\210\ Three of the commenters stated that the Commission failed to 
adequately articulate the policy considerations driving the proposed 
change and also failed to discuss the possible costs of increased 
litigation risk to accountants.\211\ Some of the commenters argued that 
this change would contradict limitations on SIPC's authority to bring 
claims against accountants under SIPA and the securities laws imposed 
by the U.S. Supreme Court.\212\
---------------------------------------------------------------------------

    \208\ See CAQ Letter; Deloitte Letter; E&Y Letter; Grant 
Thornton Letter; KPMG Letter; McGladrey Letter; PWC Letter.
    \209\ See CAQ Letter; Deloitte Letter; E&Y Letter; Grant 
Thornton Letter; KPMG Letter; PWC Letter.
    \210\ See McGladrey Letter. Form SIPC-7 is discussed in more 
detail below in section II.C.4. of this release.
    \211\ See CAQ Letter; Deloitte Letter; KPMG Letter.
    \212\ See CAQ Letter; Deloitte Letter; E&Y Letter; KPMG Letter; 
PWC Letter.
---------------------------------------------------------------------------

    After the proposal, a task force established by SIPC to undertake a 
comprehensive review of SIPA and SIPC's operations and policies and to 
propose reforms to modernize SIPA and SIPC recommended to the SIPC 
Board that SIPC members be required to file audit reports with SIPC 
concurrently with their filing with the SEC, a position consistent with 
the proposal. In a report presented to the SIPC Board of Directors in 
February 2012,\213\ the task force stated that including SIPC as a 
designated recipient of the audit report ``would further the goal of 
investor protection by providing another layer of review of the report 
by an organization directly affected by its contents.'' \214\ In 
addition, the task force stated that ``including SIPC as a recipient 
would help to address the persistent concern that any signs of 
`financial weakness, as by non-compliance with net capital requirements 
or otherwise, [be] watched very carefully and followed up' in order to 
augment the financial responsibility requirements SIPA was intended to 
enhance, and to provide greater investor protection.'' \215\
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    \213\ See Report and Recommendations of the SIPC Modernization 
Task Force (Feb. 2012), available at http://www.sipc.org/pdf/Final%Report%202012.pdf. The Task Force was comprised of volunteers, 
and included investor advocates, regulatory specialists, and 
academic experts, including the trustee for the liquidation of 
Lehman Brothers Inc. and MF Global Inc.
    \214\ See Report and Recommendations of the SIPC Modernization 
Task Force, at 19.
    \215\ Id. (quoting the SEC, Study of Unsafe and Unsound 
Practices of Broker-Dealers, H.R. Doc. No. 92-231, at 152 (1971)).
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iii. The Final Rule
    The Commission is adopting the amendment requiring broker-dealers 
to file their annual reports with SIPC substantially as proposed.\216\ 
SIPC plays an important role in the securities markets and the SIPC 
Fund can help reduce losses to investors from the failure of their 
broker-dealer. SIPC has a legitimate interest in receiving the annual 
reports of its broker-dealer members to assist it with its maintenance 
of the SIPC Fund and to monitor trends in the broker-dealer industry. 
SIPC presently obtains revenue information from broker-dealers, through 
Form SIPC-7, to determine how best to structure broker-dealer 
assessments to maintain the SIPC Fund at an appropriate level. However, 
the information collected in the form is limited and may not assist 
SIPC in assessing whether the SIPC Fund is appropriately sized to the 
risks of a large broker-dealer failure. The annual audited reports 
contain much more detailed information about the assets, liabilities, 
income, net capital, and Rule

[[Page 51925]]

15c3-3 customer reserve requirements of broker-dealers, and also 
include, for carrying broker-dealers, a compliance report containing 
information about the broker-dealer's compliance with, and controls 
over compliance with, the broker-dealer financial responsibility rules. 
The annual reports also generally include the independent public 
accountant's reports covering the financial report and compliance 
report or exemption report, as applicable, prepared by the broker-
dealer. This information will assist SIPC in monitoring the financial 
strength of broker-dealers and, therefore, in assessing the adequacy of 
the SIPC Fund.\217\
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    \216\ See paragraph (d)(6) of Rule 17a-5. The Commission 
clarified that the broker-dealer must file the annual reports with 
SIPC only ``if the broker or dealer is a member of SIPC.'' The 
Commission believes that SIPC has an interest in receiving annual 
reports only from broker-dealers that are SIPC members, because only 
these broker-dealers may pose a risk to the SIPC Fund.
    \217\ See McGladrey Letter.
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    In addition, by receiving the annual reports, SIPC may be able to 
overcome a legal hurdle to pursuing claims against a broker-dealer's 
accountant where the accountant's failure to adhere to professional 
standards in auditing a broker-dealer caused a loss to the SIPC Fund. 
Although this amendment is intended to remove one potential legal 
hurdle to SIPC actions against accountants, the other elements of any 
relevant cause of action would be unaffected. The Commission does not 
intend by this amendment to take a position on the circumstances under 
which SIPC may have a viable cause of action against an independent 
public accountant.\218\
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    \218\ Several commenters argue that requiring the annual report 
to be filed with SIPC would contradict limitations the Supreme Court 
has imposed on SIPC's authority to bring claims against accountants. 
The decisions cited by these commenters, however, do not speak to 
the precise issue the amended rule is intended, among other things, 
to address--the New York Court of Appeals' decision held that SIPC 
could not state a cause of action for either fraudulent or negligent 
misrepresentation against an auditing firm because it was not a 
recipient of the annual audit report. See SIPC v. BDO Seidman, LLP, 
746 NE.2d 1042 (N.Y. 2001); aff'd, 245 F.3d 174 (2d Cir. 2001). 
Rather, in Holmes v. Securities Investor Protection Corporation, the 
Supreme Court found that the statutory provision relied on by SIPC, 
15 U.S.C. 78eee(d), did not, either alone or with the Racketeer 
Influenced and Corrupt Organizations Act, confer standing. 503 U.S. 
258, 275 (1992). And, in Touche Ross & Co. v. Redington, the Supreme 
Court determined that customers of securities brokerage firms do not 
have an implied cause of action for damages under section 17(a) of 
the Exchange Act against accountants who audit the financial reports 
filed by such firms; thus, SIPC could not assert this implied cause 
of action on behalf of these customers. 442 U.S. 560, 567 (1979). As 
already noted, the Commission does not intend by this amendment to 
take a position on the circumstances under which SIPC may have a 
viable cause of action against an independent public accountant.
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    Several commenters stated that the Commission did not address the 
potential costs and benefits of requiring broker-dealers to file copies 
of their annual reports with SIPC, including potential accounting 
litigation costs.\219\ As discussed below in section VII. of this 
release, the Commission recognizes that there may be increased 
litigation costs (or reserves for potential litigation costs) as a 
result of the amendment and that to the extent that there are such 
costs, some of them may be passed on to broker-dealers in the form of 
increased audit fees. But, while this amendment may facilitate the 
ability of SIPC to bring actions against accountants for malpractice or 
material misrepresentation under state law by removing one potential 
legal hurdle to such actions, it will not necessarily result in a 
significant increase in such actions. Generally, SIPC initiates a small 
number of proceedings each year, and most of these proceedings have not 
involved a claim against a broker-dealer's accountant. Specifically, 
SIPC was established in 1971. In the period from 1971-2011, SIPC 
initiated 324 proceedings under SIPA to liquidate a failed broker-
dealer.\220\ This results in an average of approximately 8 SIPA 
proceedings per year, though 109 of the 324 proceedings were initiated 
in the period from 1971-1974, which was the immediate aftermath of the 
financial crisis of 1968-1970.\221\ According to SIPC staff, SIPC has 
brought 9 lawsuits against accountants since 1971, which is one lawsuit 
for every 36 SIPA proceedings.\222\ Accordingly, the likelihood of a 
lawsuit against an accountant is small and the Commission anticipates 
that the overall costs related to litigation as a result of the filing 
requirement should not be significant. The Commission believes that any 
such costs are justified by the benefits of enhanced customer 
protection and the associated ability of SIPC to better assess the 
financial condition of broker-dealers and the adequacy of the SIPC 
Fund.
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    \219\ See, e.g., CAQ Letter; Deloitte Letter; KPMG Letter.
    \220\ See SIPC, Annual Report 2011, at 6.
    \221\ Id. See also Commission, Study of Unsafe and Unsound 
Practices of Brokers and Dealers: Report and Recommendations of the 
Securities and Exchange Commission (December 1971) (discussing the 
financial crisis of 1968-1970). Since its inception through 2001, 
SIPC initiated 299 proceedings under SIPA.
    \222\ See Redington v. Touche Ross & Co., 592 F.2d 617 (2d Cir. 
1978); In re Bell & Beckwith, 77 B.R. 606 (Bkrtcy. N.D. Ohio, 1987); 
Mishkin v. Peat, Marwick, Mitchell & Co., 658 F.Supp. 271 (S.D.N.Y. 
1987); SIPC v. BDO Seidman, LLP, 49 F.Supp.2d 644 (S.D.N.Y. 1999); 
In re Donahue Securities Inc., 2004 WL 3152763 (Bkrtcy S.D. Ohio, 
2004); In re SIPC v. R.D. Kushnir & Co, 274 B.R. 768 (Bkrtcy. N.D. 
Ill., 2002); In re Sunpoint Securities, Inc., 377 B.R. 513 (Bkrtcy. 
E.D. Tex., 2007); Compliant at 5-6, Gilbert v. Ohab, Bkrtcy. M.D. 
Fl. (May 2010) (No. 6:08-ap-00145-KSJ); Complaint at 2, Shively v. 
Mortland, Bkrtcy. D. Co. (Feb. 2004) (No. 03-BK-1102-HRT).
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C. The Nature and Form of the Annual Reports

1. Exemptions From Audit Requirement--Paragraph (e)(1) of Rule 17a-5
    Prior to today's amendments, paragraph (e)(1)(i) of Rule 17a-5 
provided, among other things, that the audit of the broker-dealer's 
financial statements needed to be performed by an accountant that is 
independent as defined in paragraph (f) of Rule 17a-5.\223\ Paragraph 
(e)(1)(i) also contained provisions under which certain broker-dealers 
were not required to engage an accountant to audit their financial 
statements.\224\
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    \223\ See 17 CFR 240.17a-5(e)(1)(i).
    \224\ Id.
---------------------------------------------------------------------------

    The Commission proposed amending paragraph (e)(1)(i) of Rule 17a-5 
to remove the words ``An audit shall be conducted by a public 
accountant who shall be in fact independent as defined in paragraph 
(f)(3) of this section herein, and he shall give an opinion covering 
the statements filed pursuant to paragraph (d).'' This amendment would 
consolidate the requirements with respect to the qualifications of the 
accountant in paragraph (f) of Rule 17a-5, and paragraph (e)(1)(i) of 
Rule 17a-5 would address only exemptions from the requirement to engage 
an independent public accountant to audit the annual reports prepared 
by the broker-dealer.\225\ The Commission received no comments on this 
proposal, and is adopting it with modifications.\226\ The 
modifications: (1) Modernize certain terms in the rule in a manner 
consistent with the Commission's ``plain English'' initiative; and (2) 
cite to the reports required under ``Rule 17a-5(d)(1)(i)(C)'' to 
provide a more precise cross reference than the former citation to 
reports required under ``Rule 17a-5(d).'' \227\
---------------------------------------------------------------------------

    \225\ See Broker-Dealer Reports, 76 FR at 37593-37594. The 
proposed and final amendments to paragraph (f) of Rule 17a-5 are 
discussed below in section II.E. of this release.
    \226\ See paragraph (e)(1)(i) of Rule 17a-5.
    \227\ Id. Prior to today's amendments, paragraph (e)(1)(ii) of 
Rule 17a-5 provided that ``[a] broker or dealer who files a report 
which is not covered by an accountant's opinion shall include in the 
oath or affirmation required by paragraph (e)(2) of this section a 
statement of the facts and circumstances relied upon as a basis for 
exemption from the requirement that financial statements and 
schedules filed pursuant to paragraph (d) of this section be covered 
by the opinion of an accountant.'' See 17 CFR 240.17a-5(e)(1)(ii). 
The Commission did not propose amendments to this subparagraph. 
However, to be consistent with today's amendments, the Commission is 
making technical amendments to paragraph (e)(1)(ii) of Rule 17a-5 so 
that it now provides that ``[a] broker or dealer that files annual 
reports under paragraph (d) of this section that are not covered by 
reports prepared by an independent public accountant must include in 
the oath or affirmation required by paragraph (e)(2) of this section 
a statement of the facts and circumstances relied upon as a basis 
for exemption from the requirement that the annual reports filed 
under paragraph (d) of this section be covered by reports prepared 
by an independent public accountant.'' See paragraph (e)(1)(ii) of 
Rule 17a-5.

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[[Page 51926]]

2. Affirmation--Paragraph (e)(2) of Rule 17a-5
    Prior to today's amendments, paragraph (e)(2) of Rule 17a-5 
provided that an oath or affirmation must be attached to the annual 
audit report that, to the best knowledge and belief of the person 
making the oath or affirmation, the financial statements and schedules 
are true and correct and, among other things, that the oath or 
affirmation must be made by the proprietor if a sole proprietorship, by 
a general partner, if a partnership, or by a duly authorized officer, 
if a corporation.\228\ The Commission proposed amending the first 
sentence of paragraph (e)(2) of Rule 17a-5 by adding the word 
``financial'' before the word ``report.''\229\ The Commission is 
adopting this amendment as proposed.
---------------------------------------------------------------------------

    \228\ See 17 CFR 240.17a-5(e)(2).
    \229\ See Broker-Dealer Reports, 76 FR at 37603.
---------------------------------------------------------------------------

    One commenter stated that currently paragraph (e)(2) of Rule 17a-5 
does not specifically cover limited liability companies, and its 
reference to partnerships assumes that a general partner is a natural 
person.\230\ The commenter argued that it should be updated to conform 
to generally accepted business laws.
---------------------------------------------------------------------------

    \230\ See IMS Letter.
---------------------------------------------------------------------------

    In response to this comment, the Commission is adopting amendments 
to paragraph (e)(2) of Rule 17a-5 that modify the proposed 
amendments.\231\ In particular, the Commission is adding that if the 
broker-dealer is a limited liability company or limited liability 
partnership, the oath or affirmation must be made by the chief 
executive officer, chief financial officer, manager, managing member, 
or any of those members vested with management authority for the 
limited liability company or limited liability partnership.\232\
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    \231\ See paragraph (e)(2) of Rule 17a-5.
    \232\ See IMS Letter.
---------------------------------------------------------------------------

3. Confidentiality of Annual Reports--Paragraph (e)(3) of Rule 17a-5
    Prior to today's amendments, paragraph (e)(3) of Rule 17a-5 
provided that the financial statements filed under paragraph (d) are 
public, except that if the Statement of Financial Condition is bound 
separately from the balance of the annual audited financial statements 
filed under paragraph (d)(1), the balance of the annual audited 
financial statements will be deemed confidential.\233\ As noted in the 
proposing release, the wording of this provision has led to 
confusion.\234\ In particular, Commission staff has received inquiries 
on how broker-dealers can indicate that they are requesting 
confidential treatment for the portion of the financial statements 
intended to be kept confidential to the extent permitted by law and, on 
occasion, financial statements broker-dealers intended to be 
confidential are inadvertently made public.\235\ This could happen, for 
example, if a broker-dealer fails to bind the balance sheet separately 
from the other portion of the financial statements when it files the 
financial statements with the Commission.\236\
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    \233\ See 17 CFR 240.17a-5(e)(3).
    \234\ See Broker-Dealer Reports, 76 FR at 37592-37593.
    \235\ The public portions of broker-dealer annual audited 
reports are available on the Commission's Web site. These reports 
may be accessed via the Search for Company Filings link under 
Filings & Forms on the Commission's home page.
    \236\ The Commission staff has previously posted guidance on the 
Commission Web site on how to request confidential treatment for the 
financial statements other than the statement of financial 
condition. See http://www.sec.gov/divisions/marketreg/bdnotices.htm.
---------------------------------------------------------------------------

    Consequently, the Commission proposed amending paragraph (e)(3) of 
Rule 17a-5 to provide that the annual reports filed pursuant to 
paragraph (d) are public, except that if the Statement of Financial 
Condition is bound separately from the annual report filed pursuant to 
``paragraph (d)(2) of Rule 17a-5,'' and each page of the balance of the 
annual report is stamped ``confidential,'' the balance of the annual 
report shall be deemed confidential.\237\ The proposed rule text 
inadvertently referenced only the financial report. It was intended 
that the financial report, compliance report, exemption report, and 
related accountant reports would be treated the same under paragraph 
(e)(3) of Rule 17a-5. Consequently, the Commission is modifying the 
proposed amendment. Specifically, paragraph (e)(3) of Rule 17a-5, as 
adopted, provides that if the Statement of Financial Condition is bound 
separately from the balance of the ``annual reports filed under 
paragraph (d) of this section,'' and each page of the balance of the 
annual reports is stamped ``confidential,'' then the balance of the 
annual reports will be deemed confidential to the extent permitted by 
law.\238\ Consequently, if the compliance reports and exemption reports 
and the related reports of the independent public accountant are 
submitted in accordance with the procedures specified in paragraph 
(e)(3) of Rule 17a-5, these reports will be deemed confidential to the 
extent permitted by law.\239\
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    \237\ See Broker-Dealer Reports, 76 FR at 37592-37593.
    \238\ See paragraph (e)(3) of Rule 17a-5.
    \239\ See 5 U.S.C. 552 et seq. (Freedom of Information Act--
``FOIA''). FOIA provides at least two potentially pertinent 
exemptions under which the Commission has authority to withhold 
certain information. FOIA Exemption 4 provides an exemption for 
``trade secrets and commercial or financial information obtained 
from a person and privileged or confidential.'' 5 U.S.C. 552(b)(4). 
FOIA Exemption 8 provides an exemption for matters that are 
``contained in or related to examination, operating, or condition 
reports prepared by, on behalf of, or for the use of an agency 
responsible for the regulation or supervision of financial 
institutions.'' 5 U.S.C. 552(b)(8). However, as discussed below, 
under paragraph (c)(2)(iv) of Rule 17a-5, if there are material 
weaknesses, the accountant's report on the compliance report must be 
made available for customers' inspection and, consequently, it would 
not be deemed confidential. In addition, paragraph (c)(2)(i) of Rule 
17a-5 (which is not being amended today) requires a broker-dealer to 
furnish to its customers annually a balance sheet with appropriate 
notes prepared in accordance with GAAP and which must be audited if 
the broker-dealer is required to file audited financial statements 
with the Commission. See 17 CFR 240.17a-5(c)(2)(i).
---------------------------------------------------------------------------

    Prior to today's amendments, paragraph (e)(3) of Rule 17a-5 also 
provided that the broker-dealer's reports, including the confidential 
portions, will be available, for example, for official use by any 
official or employee of the U.S. and an official or employee of any 
national securities exchange and registered national securities 
association of which the broker-dealer is a member and ``by any other 
person to whom the Commission authorizes disclosure of such information 
as being in the public interest.'' \240\ The Commission proposed 
amending this list of permitted recipients to include the PCAOB.\241\ 
The Commission did not receive comments on this proposal and is 
adopting it essentially as proposed with a minor wording edit for 
clarity.\242\
---------------------------------------------------------------------------

    \240\ See 17 CFR 240.17a-5(e)(3).
    \241\ See Broker-Dealer Reports, 76 FR at 37592-37593.
    \242\ See paragraph (e)(3) of Rule 17a-5.
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4. Supplemental Report on SIPC Membership--Paragraph (e)(4) of Rule 
17a-5
    As discussed above in section II.B.6. of this release, SIPC 
maintains the SIPC Fund to be used in liquidations of broker-dealers 
under SIPA. The SIPC Fund is established and maintained through 
assessments on broker-dealers that are required to be members of

[[Page 51927]]

SIPC.\243\ In order to assist in the collection of assessments from 
member broker-dealers, SIPC has promulgated two forms that broker-
dealers must file with SIPC, as applicable: Form SIPC-3 and Form SIPC-
7. Form SIPC-3 is required when a broker-dealer is claiming an 
exemption from SIPC membership (i.e., when the broker-dealer does not 
have to pay an assessment). In this case, the broker-dealer must file 
Form SIPC-3 each year certifying that the broker-dealer remained 
qualified for the exemption during the prior year. Form SIPC-7 elicits 
information from a broker-dealer that is a SIPC member about the 
broker-dealer's sources of revenue attributable to its securities 
business. Every broker-dealer that is a member of SIPC must file this 
form annually.
---------------------------------------------------------------------------

    \243\ Broker-dealers engaged exclusively in the distribution of 
mutual fund shares, the sale of variable annuities, the insurance 
business, the furnishing of investment advice to investment 
companies or insurance company separate accounts, or whose principal 
business is conducted outside the U.S. are not required to be 
members of SIPC. See 15 U.S.C. 78ccc(a)(2)(A)(i)-(iii).
---------------------------------------------------------------------------

    Prior to today's amendments, paragraph (e)(4) of Rule 17a-5 
provided that a broker-dealer must file with its annual report a 
supplemental report on the status of the membership of the broker-
dealer in SIPC, which was required to be ``covered by an opinion of the 
independent public accountant'' if the annual report of the broker-
dealer was required to be audited.\244\ Among other things, the 
supplemental report needed to cover the SIPC annual general assessment 
reconciliation or exclusion from membership forms (i.e., Form SIPC-7 or 
Form SIPC-3).\245\ Paragraph (e)(4)(iii) of Rule 17a-5 used the terms 
``review'' and ``opinion'' in describing the accountant's report that 
must cover the supplement report.\246\ In addition, it required that 
the review by the accountant include certain minimum procedures.\247\
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    \244\ See 17 CFR 240.17a-5(e)(4).
    \245\ Id.
    \246\ See 17 CFR 240.17a-5(e)(4)(iii).
    \247\ See 17 CFR 240.17a-5(e)(4)(iii)(A)-(F).
---------------------------------------------------------------------------

    Under this provision, the supplemental report did not need to be 
filed if the SIPC Fund assessments were the minimum assessment provided 
for under SIPA.\248\ Between 1996 and 2009, the annual assessment for 
SIPC members remained at the $150 minimum assessment level provided for 
under SIPA.\249\ In 2009, SIPC raised the assessment above the minimum, 
which triggered the requirement in paragraph (e)(4) of Rule 17a-5 to 
file a supplemental report with the Commission, the broker-dealer's 
DEA, and SIPC.\250\
---------------------------------------------------------------------------

    \248\ See 17 CFR 240.17a-5(e)(4); 15 U.S.C. 78ddd(d)(1)(c).
    \249\ See SIPC, SIPC to Reinstitute Assessments of Member Firms' 
Operating Revenues (Mar. 2, 2009) (news release).
    \250\ Id.
---------------------------------------------------------------------------

    The Commission stated in the proposing release that, because Forms 
SIPC-3 and SIPC-7 are used solely by SIPC for purposes of levying its 
assessments, the supplemental report required pursuant to paragraph 
(e)(4) of Rule 17a-5 relating to these forms would be more 
appropriately filed exclusively with SIPC and that SIPC (rather than 
the Commission) should prescribe by rule the form of the supplemental 
report.\251\ The Commission stated that it would continue to have a 
role in establishing the requirements for a supplemental report because 
the Commission must approve SIPC rules.\252\
---------------------------------------------------------------------------

    \251\ See Broker-Dealer Reports, 76 FR at 37582.
    \252\ Id.
---------------------------------------------------------------------------

    For these reasons, the Commission proposed to amend paragraph 
(e)(4) of Rule 17a-5 to require that broker-dealers file with SIPC a 
report on the SIPC annual general assessment reconciliation or 
exclusion from membership forms that contains such information and is 
in such format as determined by SIPC by rule and approved by the 
Commission.\253\ However, because there would be an interim period 
before a rule determined by SIPC became effective, the Commission 
proposed amendments to paragraph (e)(4) under which broker-dealers 
would continue to file a supplemental report with the Commission, the 
broker-dealer's DEA, and SIPC until SIPC adopts a rule pursuant to 
paragraph (e)(4)(i) of Rule 17a-5 and the rule is approved by the 
Commission.\254\ Consequently, a broker-dealer would be required to 
file the SIPC supplemental reports with SIPC using the existing formats 
for the reports until the earlier of the Commission approving a rule 
adopted by SIPC or two years. If after two years, a rule promulgated by 
SIPC has not been approved by the Commission, broker-dealers would no 
longer be required to file these reports.
---------------------------------------------------------------------------

    \253\ Id.
    \254\ Id.
---------------------------------------------------------------------------

    Further, to facilitate this change, the Commission proposed to 
update the rule text to conform it to existing professional standards 
and industry practices.\255\ Specifically, the Commission proposed 
amending paragraph (e)(4) of Rule 17a-5 to eliminate the ambiguity that 
stems from the differing auditing terms used in that rule by removing 
all references to ``review'' and ``opinion.'' \256\ In their place, the 
Commission proposed that the supplemental report include an independent 
public accountant's report based on the performance of the procedures 
listed in paragraph (e)(4)(iii) of Rule 17a-5, which the Commission did 
not propose to change.\257\
---------------------------------------------------------------------------

    \255\ Id.
    \256\ Id.
    \257\ See Broker-Dealer Reports, 76 FR at 37582. The Commission 
proposed one modification to the procedures listed in former 
paragraph (e)(4)(iii); namely, amending the procedure described in 
paragraph (e)(4)(iii)(F), which is now renumbered (e)(4)(ii)(6), to 
change the reference from ``Form SIPC-7'' to ``Form SIPC-3'' because 
the reference to Form SIPC-7 is inaccurate. Id.
---------------------------------------------------------------------------

    The Commission received two comments relating to the proposed 
amendments to paragraph (e)(4) of Rule 17a-5, both of which supported 
the proposed change.\258\ One commenter indicated that the proposed 
amendment would decrease the burden on broker-dealers associated with 
filing the supplemental report with the Commission and the broker-
dealer's DEA.\259\ In addition, the other commenter indicated that 
until the supplemental reports are filed exclusively with SIPC, they 
should be subject to confidential treatment.\260\
---------------------------------------------------------------------------

    \258\ See CAI Letter; McGladrey Letter.
    \259\ See CAI Letter.
    \260\ See McGladrey Letter.
---------------------------------------------------------------------------

    The Commission is adopting the amendments to paragraph (e)(4) of 
Rule 17a-5 as proposed.\261\ With respect to the comment about the 
Commission keeping the supplemental report confidential, a broker-
dealer can request confidential treatment for the report.\262\ If such 
a request is made, the Commission anticipates that it will accord the 
supplemental report confidential treatment to the extent permitted by 
law.\263\
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    \261\ See paragraph (e)(4) of Rule 17a-5.
    \262\ See 17 CFR 200.83. Information about how to request 
confidential treatment of information submitted to the Commission is 
available at http://www.sec.gov/foia/howfo2.htm#privacy.
    \263\ See, e.g., Exchange Act section 24, 15 U.S.C. 78x 
(governing the public availability of information obtained by the 
Commission) and 5 U.S.C. 552 et seq. (Freedom of Information Act--
``FOIA''). FOIA provides at least two pertinent exemptions under 
which the Commission has authority to withhold certain information. 
FOIA Exemption 4 provides an exemption for ``trade secrets and 
commercial or financial information obtained from a person and 
privileged or confidential.'' 5 U.S.C. 552(b)(4). FOIA Exemption 8 
provides an exemption for matters that are ``contained in or related 
to examination, operating, or condition reports prepared by, on 
behalf of, or for the use of an agency responsible for the 
regulation or supervision of financial institutions.'' 5 U.S.C. 
552(b)(8).

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[[Page 51928]]

D. Engagement of the Accountant

    As part of today's amendments to the broker-dealer annual reporting 
requirements in Rule 17a-5, the Commission is amending certain 
requirements relating to a broker-dealer's engagement of an independent 
public accountant. Specifically, the Commission is requiring that a 
broker-dealer engage an independent public accountant to prepare 
reports based on an examination of the broker-dealer's financial report 
and either an examination of certain statements in the broker-dealer's 
compliance report or a review of certain statements in the broker-
dealer's exemption report. The examinations and reviews must be made in 
accordance with the standards of the PCAOB, consistent with the 
explicit authority granted to the PCAOB by the Dodd-Frank Act to 
establish (subject to Commission approval) auditing and attestation 
standards with respect to broker-dealer audits.\264\ Among other 
things, the amendments replace provisions that required the filing of a 
``material inadequacy'' report and are intended to update terminology 
in the rule to make the rule's requirements clear and to provide for a 
more consistent approach to engaging broker-dealer independent public 
accountants.
---------------------------------------------------------------------------

    \264\ See Public Law 111-203 Sec.  982.
---------------------------------------------------------------------------

    This section addresses statutory requirements for broker-dealer 
annual reports and the Commission's authority with regard to these 
reports, describes the engagement of accountant requirements in Rule 
17a-5 prior to today's amendments, summarizes the Commission's proposed 
amendments and comments received, and discusses the final rule 
amendments.
1. Statutory Requirements and Commission Authority
    Section 17(e)(1)(A) of the Exchange Act requires a broker-dealer to 
file annually with the Commission a ``certified'' balance sheet and 
income statement as well as ``such other financial statements (which 
shall, as the Commission specifies, be certified) and information 
concerning its financial condition as the Commission, by rule, may 
prescribe as necessary or appropriate in the public interest or for the 
protection of investors.'' \265\ Section 17(e)(2) of the Exchange Act 
provides the Commission with authority, by rule, to prescribe the form 
and content of the financial statements and the accounting principles 
and standards used in their preparation as it deems necessary or 
appropriate in the public interest or for the protection of 
investors.\266\ In addition, section 17(a) of the Exchange Act more 
generally requires registered broker-dealers to make and disseminate 
such reports as the Commission, by rule, may prescribe as necessary or 
appropriate in the public interest, for the protection of 
investors.\267\ The Commission adopted Rule 17a-5, in part, under these 
provisions.\268\
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    \265\ See 15 U.S.C. 78q(e)(1)(A).
    \266\ See 15 U.S.C. 78q(e)(2).
    \267\ See 15 U.S.C. 78q(a).
    \268\ See Broker-Dealer Reports, Exchange Act Release No. 11935 
(Dec. 17, 1975), 40 FR 59706 (Dec. 30, 1975).
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    Prior to the enactment of the Sarbanes-Oxley Act of 2002 
(``Sarbanes-Oxley Act''),\269\ section 17(e)(1)(A) required that the 
annual financial statements a broker-dealer must file with the 
Commission be certified by ``an independent public accountant.'' The 
Sarbanes-Oxley Act established the PCAOB \270\ and amended section 
17(e)(1)(A) by replacing the words ``certified by an independent public 
accountant'' with the words ``certified by a registered public 
accounting firm.'' \271\ Title I of the Sarbanes-Oxley Act prescribed 
specific PCAOB registration, standards-setting, inspection, 
investigation, disciplinary, foreign application, oversight, and 
funding programs in connection with audits of issuers.\272\ However, as 
originally enacted, the Sarbanes-Oxley Act did not expressly prescribe 
similar programs in connection with audits of broker-dealers that are 
not issuers.
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    \269\ Public Law 107-204, 116 Stat. 745 (2002).
    \270\ Public Law 107-204 Sec.  101.
    \271\ See Public Law 107-204 Sec.  205(c)(2). The term 
Registered Public Accounting Firm is defined in section 2(a)(12) as 
``a public accounting firm registered with the [PCAOB] in accordance 
with this Act.'' See Public Law 107-204 Sec.  2(a)(12).
    \272\ Section 2(a)(7) of the Sarbanes-Oxley Act defines the term 
issuer as ``an issuer as defined in section 3 of the [Exchange Act], 
the securities of which are registered under section 12 of [the 
Exchange Act], or that files or has filed a registration statement 
that has not yet become effective under the Securities Act of 
1933[hellip], and that it has not withdrawn'' (U.S.C. citations 
omitted). See Public Law 107-204 Sec.  2(a)(7).
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    The Dodd-Frank Act, enacted in July 2010, amended the Sarbanes-
Oxley Act to provide the PCAOB with explicit authority to, among other 
things, establish (subject to Commission approval) auditing and related 
attestation, quality control, ethics, and independence standards for 
registered public accounting firms with respect to their preparation of 
audit reports to be included in broker-dealer filings with the 
Commission, and the authority to conduct and require an inspection 
program of registered public accounting firms that audit broker-
dealers.\273\ The Dodd-Frank Act addressed inspection authority by 
adding section 104(a)(2)(A) to the Sarbanes-Oxley Act, which provides 
that the PCAOB ``may, by rule, conduct and require a program of 
inspection* * *of registered public accounting firms that provide one 
or more audit reports for a broker or dealer'' and that the PCAOB, in 
establishing a program for inspection, ``may allow for differentiation 
among classes of brokers or dealers, as appropriate.'' \274\
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    \273\ See Public Law 111-203 Sec.  982.
    \274\ See Public Law 111-203 Sec.  982(e)(1).
---------------------------------------------------------------------------

    The Dodd-Frank Act also added section 104(a)(2)(D) to the Sarbanes-
Oxley Act, which provides that a public accounting firm is not required 
to register with the PCAOB if the public accounting firm is exempt from 
an inspection program established by the PCAOB.\275\ The Dodd-Frank Act 
made a conforming amendment to section 17(e)(1)(A) of the Exchange Act 
to replace the words ``certified by a registered public accounting 
firm'' with the words ``certified by an independent public accounting 
firm, or by a registered public accounting firm if the firm is required 
to be registered under the Sarbanes-Oxley Act of 2002.'' \276\
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    \275\ Id.
    \276\ See Public Law 111-203 Sec.  982(e)(2). As discussed 
below, today's amendments to the qualifications of the independent 
public accountant provisions require, consistent with amended 
section 17(e)(1)(A), that the accountant be qualified, independent, 
and registered with the PCAOB ``if required by the Sarbanes-Oxley 
Act of 2002.'' See paragraph (f)(1) of Rule 17a-5.
---------------------------------------------------------------------------

    Before today's amendments, paragraph (g)(1) of Rule 17a-5 required 
that audits of broker-dealer reports filed with the Commission under 
Rule 17a-5 be made in accordance with generally accepted auditing 
standards (``GAAS''), which are established by the Auditing Standards 
Board of the American Institute of Certified Public Accountants 
(``AICPA''). In light of the authority granted to the PCAOB by the 
Dodd-Frank Act to establish standards governing audit reports to be 
included in broker-dealer filings with the Commission, the Commission 
issued transitional interpretive guidance to clarify that references in 
Commission rules, staff guidance, and in the federal securities laws to 
GAAS or to specific standards under GAAS, as they relate to non-issuer 
brokers or dealers, should continue to be understood to mean auditing 
standards generally accepted in the U.S., in addition to any applicable 
rules of the Commission.\277\ The

[[Page 51929]]

guidance also stated that the Commission intended to revisit the 
interpretation in connection with a rulemaking project to update the 
audit and related attestation requirements under the federal securities 
laws for broker-dealers.\278\ As discussed below, the Commission is now 
adopting amendments to Rule 17a-5 to require that audits and 
attestations of broker-dealer reports filed under Rule 17a-5 be made in 
accordance with standards of the PCAOB--the rule as amended does not 
contain references to GAAS.
---------------------------------------------------------------------------

    \277\ See Commission Guidance Regarding Auditing, Attestation, 
and Related Professional Practice Standards Related to Brokers and 
Dealers, Exchange Act Release No. 62991 (Sept. 24, 2010), 75 FR 
60616, 60617 (Oct. 1, 2010).
    \278\ Id.
---------------------------------------------------------------------------

    Since the Commission proposed these amendments, the PCAOB has taken 
a number of actions to implement the explicit authority over broker-
dealer audits provided to it by the Dodd-Frank Act. For example, on 
August 18, 2011, the Commission approved two PCAOB rule changes: a 
temporary PCAOB rule that established an interim program of inspection 
of audits of broker-dealers,\279\ and a PCAOB rule change providing 
that funds to cover the PCAOB's annual budget be allocated among 
issuers, brokers, and dealers.\280\ In addition, as discussed below, 
subsequent to the Commission's proposal to amend Rule 17a-5, the PCAOB 
proposed attestation standards to establish requirements for examining 
broker-dealer compliance reports and reviewing broker-dealer exemption 
reports ``to align its attestation standards more closely with the 
auditor's responsibilities under [the proposed amendments to Rule 17a-
5].'' \281\ The PCAOB concurrently proposed an auditing standard for 
supplemental information accompanying audited financial statements that 
would supersede the current standard.\282\ The auditing standard would 
apply to supporting schedules broker-dealers must file under Rule 17a-
5, including schedules regarding the computation of net capital and the 
customer reserve requirement and information related to the broker-
dealer's possession or control of customer assets.\283\ The PCAOB also 
proposed amendments ``to tailor certain of its rules to the audits and 
[independent public accountants] of broker-dealers.'' \284\
---------------------------------------------------------------------------

    \279\ See Public Company Accounting Oversight Board; Order 
Approving Proposed Temporary Rule for an Interim Program of 
Inspection Related to Audits of Brokers and Dealers, Exchange Act 
Release No. 65163 (Aug. 18, 2011), 76 FR 52996 (Aug. 24, 2011).
    \280\ See Public Company Accounting Oversight Board; Order 
Approving Proposed Board Funding Rules for Allocation of the Board's 
Accounting Support Fee Among Issuers, Brokers, and Dealers, and 
Other Amendments to the Board's Funding Rules, Exchange Act Release 
No. 65162 (Aug. 18, 2011), 76 FR 52997 (Aug. 24, 2011).
    \281\ See PCAOB Proposing Release at 5.
    \282\ See PCAOB Proposed Auditing Standard for Supplemental 
Information.
    \283\ Id. at 3.
    \284\ See Proposed Amendments to Conform the Board's Rules and 
Forms to the Dodd-Frank Act and Make Certain Updates and 
Clarifications, PCAOB Release No. 2012-002, PCAOB Rulemaking Docket 
Matter No. 039 (Feb. 28, 2012).
---------------------------------------------------------------------------

2. Engagement of Accountant Requirements Prior to Today's Amendments
    Rule 17a-5 requires that a broker-dealer prepare and file certain 
financial statements and supporting schedules in addition to the 
balance sheet and income statement required under section 17(e)(1)(A) 
of the Exchange Act.\285\ Before today's amendments, the financial 
statements and supporting schedules were generally required to be 
audited in accordance with GAAS by an independent public accountant 
registered with the PCAOB.\286\
---------------------------------------------------------------------------

    \285\ See 17 CFR 240.17a-5(d).
    \286\ See 17 CFR 240.17a-5(g). An engagement to perform an audit 
(or examination) of financial statements is designed to provide 
reasonable assurance about whether the financial statements are free 
of material misstatement. See, e.g., PCAOB Interim Auditing 
Standard, AU Section 110 at ] .02. The term audit is defined in 
section 110(1) of the Sarbanes-Oxley Act, as amended by the Dodd-
Frank Act, to mean ``an examination of the financial statements, 
reports, documents, procedures, controls, or notices of an issuer, 
broker, or dealer by an independent public accountant in accordance 
with the rules of the [PCAOB] or the Commission, for the purpose of 
expressing an opinion on the financial statements or providing an 
audit report.''
---------------------------------------------------------------------------

    In addition to filing a report of the independent public accountant 
covering the financial statements and supporting schedules, paragraph 
(j) of Rule 17a-5 required the broker-dealer to file with the annual 
audit a supplemental report prepared by the accountant (``material 
inadequacy report'') that either: (1) Indicated that the accountant did 
not find any material inadequacies; or (2) described any material 
inadequacies in internal control the accountant found during the course 
of the audit of the financial statements and supporting schedules and 
any corrective action taken or proposed by the broker-dealer.\287\
---------------------------------------------------------------------------

    \287\ See 17 CFR 240.17a-5(j). Prior to today's amendments, 
paragraph (g)(3) of Rule 17a-5 describes a material inadequacy in a 
broker-dealer's accounting system, internal accounting controls, 
procedures for safeguarding securities, and practices and procedures 
to include any condition which has contributed substantially to or, 
if appropriate corrective action is not taken, could reasonably be 
expected to: (1) Inhibit a broker-dealer from promptly completing 
securities transactions or promptly discharging its responsibilities 
to customers, other broker-dealers or creditors; (2) result in 
material financial loss; (3) result in material misstatements of the 
broker-dealer's financial statements; or (4) result in violations of 
the Commission's recordkeeping or financial responsibility rules to 
an extent that could reasonably be expected to result in the 
conditions described in (1) through (3) above. See 17 CFR 240.17a-
5(g)(3). In addition to the material inadequacy report, a broker-
dealer was required to file during certain periods a supplemental 
report covered by an opinion of the independent public accountant on 
the status of the broker-dealer's membership in SIPC. See 17 CFR 
240.17a-5(e)(4). The Commission is amending this requirement as 
discussed above in section II.C.4. of this release. Further, a 
broker-dealer that computes net capital under the alternative model-
based standard in Appendix E to Rule 15c3-1 (17 CFR 240.15c3-1e) is 
required to file a supplemental report of an independent public 
accountant indicating the results of the accountant's review of the 
internal risk management control system established and documented 
by the broker-dealer in accordance with Rule 15c3-4 (17 CFR 
240.15c3-4). See 17 CFR 240.17a-5(k). The Commission is not amending 
this requirement today.
---------------------------------------------------------------------------

    For purposes of preparing the material inadequacy report, paragraph 
(g)(1) of Rule 17a-5 required that the audit include a ``review'' of 
the broker-dealer's accounting system, internal accounting control, and 
procedures for safeguarding securities.\288\ Further, the accountant 
was required to review the practices and procedures of the broker-
dealer in: (1) Making the periodic computations of aggregate 
indebtedness and net capital under paragraph (a)(11) of Exchange Act 
Rule 17a-3 and the reserve required by paragraph (e) of Rule 15c3-3; 
\289\ (2) making the quarterly securities examinations, counts, 
verifications, and comparisons and the recordation of differences 
required by Rule 17a-13; \290\ (3) complying with the requirement for 
prompt payment for securities under Regulation T of the Board of 
Governors of the Federal Reserve System (``Regulation T''); \291\ and 
(4) obtaining and maintaining physical possession or control of all 
fully paid and excess margin securities of customers as required by 
Rule 15c3-3.\292\ The scope of the independent public accountant's 
procedures was required to be sufficient to provide ``reasonable 
assurance'' that any material inadequacies existing at the date of the 
examination in the broker-dealer's accounting system, internal 
accounting control, and procedures for safeguarding securities as well 
as in the practices and procedures described in items (1) through (4) 
above would be disclosed.\293\
---------------------------------------------------------------------------

    \288\ See 17 CFR 240.17a-5(g)(1).
    \289\ See 17 CFR 240.17a-5(g)(1)(i).
    \290\ See 17 CFR 240.17a-5(g)(1)(ii).
    \291\ See 17 CFR 240.17a-5(g)(1)(iii). See also 12 CFR 220 et 
seq. (Regulation T).
    \292\ See 17 CFR 240.17a-5(g)(1)(iv).
    \293\ See 17 CFR 240.17a-5(g)(1).
---------------------------------------------------------------------------

    The AICPA Broker-Dealer Audit Guide provided that the material 
inadequacy report should address what the independent public accountant 
concluded in its ``study'' of the adequacy of the broker-dealer's

[[Page 51930]]

practices and procedures in complying with the financial responsibility 
rules in relation to the definition of material inadequacy as stated in 
paragraph (g)(3) of Rule 17a-5.\294\ The issuance of a study is 
relatively unique to broker-dealer audits, however, and while auditing 
standards at one time referred to the performance of a study, current 
auditing standards no longer contain such references.
---------------------------------------------------------------------------

    \294\ The material inadequacy report is addressed in the AICPA's 
Audit & Accounting Guide: Brokers and Dealers in Securities (Sept. 
1, 2011 ed.) (``AICPA Broker-Dealer Audit Guide''), which provides 
that the report should: (1) Address what auditors concluded in their 
study of the adequacy of the broker-dealer's practices and 
procedures in complying with the Commission's financial 
responsibility rules in relation to the definition of a material 
inadequacy in Rule 17a-5; and (2) disclose material weaknesses in 
internal control over financial reporting (including procedures for 
safeguarding securities) that are revealed through auditing 
procedures designed and conducted for the purpose of expressing an 
opinion on the financial statements. See AICPA Broker-Dealer Audit 
Guide at ] 3.77. The AICPA Broker-Dealer Audit Guide further 
provides that if conditions believed to be material weaknesses are 
found to exist or have existed during the year, the report should 
disclose the nature of the weaknesses and the corrective action 
taken or proposed to be taken by the broker-dealer. See AICPA 
Broker-Dealer Audit Guide at ] 3.80. The AICPA Broker-Dealer Audit 
Guide also provides sample reports ``on internal control required by 
SEC Rule 17a-5(g)(1).'' See AICPA Broker-Dealer Audit Guide apps. C, 
D, and F.
---------------------------------------------------------------------------

    Additional engagement of accountant requirements prior to today's 
amendments were set forth in paragraphs (g) and (i) of Rule 17a-5. 
Paragraph (g)(2) of Rule 17a-5 provided that, if the broker-dealer was 
exempt from Rule 15c3-3, the independent public accountant must 
ascertain that the conditions of the exemption were being complied with 
as of the examination date and that no facts came to the independent 
public accountant's attention to indicate that the exemption had not 
been complied with during the period since the last examination.\295\
---------------------------------------------------------------------------

    \295\ See 17 CFR 240.17a-5(g)(2).
---------------------------------------------------------------------------

    Paragraph (i) of Rule 17a-5, before today's amendments, was titled, 
``Accountant's reports--general provisions.'' \296\ Paragraph (i)(1) of 
Rule 17a-5 provided that the accountant's report must be dated, signed 
manually, indicate the city and state where issued, and identify the 
financial statements and schedules covered by the report.\297\ 
Paragraph (i)(2) of Rule 17a-5 provided that the accountant's report 
must state whether the audit was made in accordance with generally 
accepted auditing standards; state whether the accountant reviewed the 
procedures followed for safeguarding securities; and designate any 
auditing procedures deemed necessary by the accountant under the 
circumstances of the particular case which have been omitted, and the 
reason for their omission.\298\ Further, the rule provided that 
``[n]othing in this section shall be construed to imply authority for 
the omission of any procedure which independent accountants would 
ordinarily employ in the course of an audit made for the purpose of 
expressing the opinions required under [Rule 17a-5].'' \299\
---------------------------------------------------------------------------

    \296\ See 17 CFR 240.17a-5(i).
    \297\ See 17 CFR 240.17a-5(i)(1).
    \298\ See 17 CFR 240.17a-5(i)(2).
    \299\ Id.
---------------------------------------------------------------------------

    Prior to today's amendments, paragraph (i)(3) of Rule 17a-5 
provided that the accountant's report must state clearly the opinion of 
the accountant: (i) with respect to the financial statements and 
schedules covered by the report and the accounting principles and 
practices; and (ii) as to the consistency of the application of the 
accounting principles, or as to any changes in such principles that 
have a material effect on the financial statements.\300\ Paragraph 
(i)(4) provided that any matters to which the accountant took exception 
must be clearly identified, the exception specifically and clearly 
stated, and, to the extent practicable, the effect of each such 
exception on the related financial statements given.\301\ Paragraph 
(i)(5) of Rule 17a-5 provided that the terms audit (or examination), 
accountant's report, and certified have the meanings given in Rule 1-02 
of Regulation S-X (17 CFR 210.1-02).\302\
---------------------------------------------------------------------------

    \300\ See 17 CFR 240.17a-5(i)(3).
    \301\ See 17 CFR 240.17a-5(i)(4).
    \302\ See 17 CFR 240.17a-5(i)(5).
---------------------------------------------------------------------------

3. Amended Engagement of Accountant Requirements
i. Proposed Amendments
    The Commission proposed to substantially amend paragraph (g) and 
remove paragraph (j) of Rule 17a-5, in part, to update the engagement 
of the accountant requirements to address outdated or inconsistent 
terminology in the rule.\303\ The proposed amendments to paragraph (g) 
and removal of paragraph (j) of Rule 17a-5 would have eliminated the 
requirement for the accountant to prepare and the broker-dealer to file 
a material inadequacy report.\304\ In its place, the independent public 
accountant would have been required to prepare, and the broker-dealer 
would have been required to file, in addition to a report covering the 
financial report, a report covering either the broker-dealer's 
compliance report or exemption report, as applicable.\305\ 
Specifically, the Commission proposed to amend paragraph (g) of Rule 
17a-5 to be titled ``Engagement of independent public accountant'' and 
to require a broker-dealer required to file annual reports under 
paragraph (d) of Rule 17a-5 to engage an independent public accountant, 
unless the broker-dealer is subject to the exclusions in paragraphs 
(d)(1) and (e)(1)(i) of Rule 17a-5. The independent public accountant, 
as part of the engagement, would have been required to undertake to: 
(1) Prepare a report based on an examination of the broker-dealer's 
financial report in accordance with standards of the PCAOB; and (2) 
prepare a report based on an ``examination'' of the assertions of the 
broker-dealer in the compliance report in accordance with standards of 
the PCAOB \306\ or to prepare a report based on a ``review'' of the 
broker-dealer's exemption report in accordance with standards of the 
PCAOB.\307\ This provision would have retained the requirement that the 
financial statements and supporting schedules be audited by the 
independent public accountant, so that the accountant would have 
continued to be required to obtain ``reasonable assurance'' about 
whether they were free of material misstatement, but would have changed

[[Page 51931]]

the audit standards from GAAS to standards of the PCAOB.\308\
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    \303\ See Broker-Dealer Reports, 76 FR at 37578-37579. In 
addition, the Commission proposed changing the title of paragraph 
(g) from Audit objectives to Engagement of the independent public 
accountant. Id. at 37606.
    \304\ Id. at 37578-37579.
    \305\ Id.
    \306\ An attest engagement designed to provide a high level of 
assurance is referred to as an ``examination.'' See, e.g., PCAOB 
Interim Attestation Standard, AT Section 101 at ] .54. For this type 
of engagement, the accountant's conclusion will be expressed in the 
form of an opinion. For example, the accountant's conclusion based 
on an examination of an assertion could state that in the 
accountant's opinion, [the assertion] is fairly stated in all 
material respects. See, e.g., PCAOB Interim Attestation Standard, AT 
Section 101 at ] .84. The proposed rule provided that the 
examination and related report would apply to the broker-dealer's 
``assertions'' in the compliance report (and therefore would not 
apply to other items in the proposed compliance report; namely, a 
statement as to whether the broker-dealer has established a system 
of internal control and a description of instances of material non-
compliance, and material weaknesses over compliance with, the 
financial responsibility rules).
    \307\ An attest engagement designed to provide a moderate level 
of assurance is referred to as a ``review.'' See, e.g., PCAOB 
Interim Attestation Standard, AT Section 101 at ]] .55, .89. For 
this type of engagement, the accountant's conclusion will be 
expressed, not in the form of an opinion, but in the form of 
``negative assurance.'' See, e.g., PCAOB Interim Attestation 
Standard, AT Section 101 at ] .68. For example, the accountant's 
conclusion based on a review of an assertion could state that no 
information came to the accountant's attention that indicates that 
the assertion is not fairly stated in all material respects. See, 
e.g., PCAOB Interim Attestation Standard, AT Section 101 at ] .88.
    \308\ See Broker-Dealer Reports, 76 FR at 37606. As stated 
above, an engagement to perform an audit of financial statements is 
designed to provide ``reasonable assurance'' about whether the 
financial statements are free of material misstatement. See, e.g., 
PCAOB Interim Attestation Standard, AT Section 101 at ] .54.
---------------------------------------------------------------------------

    The Commission proposed making conforming amendments to paragraph 
(i) of Rule 17a-5, substituting the words ``examinations'' and 
``reviews'' for the word ``audits,'' substituting the words ``standards 
of the PCAOB'' for ``generally accepted auditing standards,'' 
substituting ``annual reports'' for ``financial statements,'' and 
changing the title to ``Reports prepared by the independent public 
accountant.'' The Commission also proposed deleting paragraph (i)(5) of 
Rule 17a-5, which provided that the terms ``audit,'' ``examination,'' 
``accountant's report,'' and ``certified'' have the meanings given in 
Rule 1-02 of Regulation S-X. As proposed, paragraph (i)(1) of Rule 17a-
5 would have provided that the independent public accountant's reports 
must: be dated; be signed manually; indicate the city and state where 
issued; and identify without detailed enumeration the items covered by 
the reports. Paragraph (i)(2) of Rule 17a-5 would have provided that 
the accountant's report must state whether the examination or review 
was made in accordance with standards of the PCAOB and must designate 
any examination, and, if applicable, review procedures deemed necessary 
by the independent public accountant under the circumstances of the 
particular case that have been omitted, and the reason for their 
omission. Further, the rule would have provided that ``[n]othing in 
this section shall be construed to imply authority for the omission of 
any procedure that independent public accountants would ordinarily 
employ in the course of an examination or review made for the purpose 
of expressing the opinions or statement required under [Rule 17a-5].'' 
Paragraph (i)(3) of Rule 17a-5 would have provided that the independent 
public accountant's reports must state clearly the opinion of the 
independent public accountant: (i) with respect to the financial report 
and the accounting principles and practices reflected therein and the 
compliance report; and (ii) with respect to the financial report, as to 
the consistency of the application of the accounting principles, or as 
to any changes in such principles that have a material effect on the 
financial statements. Paragraph (i)(4) of Rule 17a-5 would have 
provided that any matters to which the independent public accountant 
takes exception must be clearly identified, the exception thereto 
specifically and clearly stated, and, to the extent practicable, the 
effect of each such exception on any related items contained in the 
annual reports.
    As stated above, after the Commission proposed the amendments to 
Rule 17a-5, the PCAOB issued proposed standards that ``would establish 
requirements for examining the assertions in a broker's or dealer's 
compliance report and reviewing a broker's or dealer's assertion in the 
exemption report.'' \309\ The PCAOB stated that the proposed standards 
were ``tailored to the requirements'' in Rule 17a-5 as proposed to be 
amended by the Commission.\310\
---------------------------------------------------------------------------

    \309\ See PCAOB Proposing Release at 5.
    \310\ Id.
---------------------------------------------------------------------------

ii. Comments
    The Commission received several comments regarding the proposed 
revisions to the independent accountant engagement requirements in Rule 
17a-5.\311\ One commenter stated that GAAS should be used for audits of 
non-carrying broker-dealers; or, in the alternative, that the 
Commission should delay the effective date for the requirement that the 
audit be conducted in accordance with PCAOB standards for smaller 
broker-dealers until one year after the approval of the 
amendments.\312\ A second commenter stated that PCAOB standards should 
apply only for broker-dealers ``permanently subject to PCAOB 
inspection'' and that the Commission should not require that audits of 
broker-dealers be performed in accordance with PCAOB standards for non-
issuer broker-dealers until the PCAOB determines which non-issuer 
broker-dealers will be subject to its permanent inspection 
program.\313\
---------------------------------------------------------------------------

    \311\ See, e.g., ABA Letter; AICPA Letter; Citrin Letter; E&Y 
Letter; Van Kampen/Invesco Letter.
    \312\ See Citrin Letter. The Commission also received many 
comments seeking additional time to transition to the final rules. 
Those comments are discussed below in section V. of this release.
    \313\ See AICPA Letter.
---------------------------------------------------------------------------

    One commenter noted that the proposing release states that broker-
dealers will be required to file a report by the accountant that 
``addresses'' the assertions in the compliance report,\314\ and stated 
that the Commission should provide more guidance on what an accountant 
must address, as ``nowhere in the Release or in the proposed rules is 
there guidance as to what `addresses' means or entails.'' \315\ This 
commenter further stated that the Commission ``presumably'' will rely 
on PCAOB rules, and suggested that final rules regarding the 
accountant's obligations with respect to its examination of the 
compliance report should be deferred until after a comment period of at 
least 60 days after the PCAOB rules are finalized or the Commission 
amends its proposal to include specifics as to what ``address'' means 
and what type of review is required by the accountant.\316\ The 
commenter also stated that the requirement should not be effective 
unless the AICPA Broker-Dealer Audit Guide is revised and updated.\317\ 
One commenter asked what was expected of the auditor with respect to 
the books and records assertion and stated that a separate opinion on 
this assertion may entail more detailed procedures as to the source of 
the information.\318\
---------------------------------------------------------------------------

    \314\ See Broker-Dealer Reports, 76 FR at 37575.
    \315\ See ABA Letter.
    \316\ Id.
    \317\ Id. As stated below, AICPA guidance will no longer be 
applicable once standards of the PCAOB apply to broker-dealer annual 
reports.
    \318\ See Grant Thornton Letter.
---------------------------------------------------------------------------

    Another commenter stated that a review engagement should not be 
employed for the exemption report because inquiry and observation would 
not provide sufficient evidence regarding a broker-dealer's assertion 
that it is exempt from the requirements of Rule 15c3-3 and stated that, 
under the PCAOB's interim attestation standards, an auditor should not 
accept an engagement to perform a ``review'' level of service related 
to an entity's compliance with specified requirements or an assertion 
with regard to that compliance.\319\ As an alternative, this commenter 
suggested an ``agreed-upon procedures'' approach addressing the results 
of procedures specified by the Commission or the performance of an 
examination engagement if suitable criteria were developed.\320\ 
Another commenter stated that the benefit of receiving an audit report 
covering the exemption report would not justify the cost.\321\ 
Similarly, a commenter stated that the exemption report should be 
replaced with a box to check on the FOCUS Report as the auditor 
attestation provided no added benefit.\322\
---------------------------------------------------------------------------

    \319\ See E&Y Letter.
    \320\ Id.
    \321\ See Citrin Letter.
    \322\ See Angel Letter.
---------------------------------------------------------------------------

    Several commenters urged the Commission to clarify the interaction 
between material weaknesses in internal control over financial 
reporting and material weaknesses in internal control over compliance 
with the financial responsibility rules.\323\ One commenter stated that 
due to the reliance placed on the financial books and records to

[[Page 51932]]

calculate net capital, it will not be feasible to attest to the 
effectiveness of internal control over the financial responsibility 
rules without also attesting to internal control over financial 
reporting.\324\ The commenter stated that, accordingly, it is necessary 
to include internal control over financial reporting within the scope 
of the rule. The commenter stated its understanding that accountants 
expect to include internal control over financial reporting in their 
attestation scope over the financial responsibility rules, and that the 
process will include documenting all existing processes and engaging 
internal audit to validate the effectiveness of the procedures 
implemented through procedural walkthroughs and control testing to 
validate management's assertions.\325\ This commenter also stated its 
belief that independent public accountants will need ``to include an 
attestation of the additional in scope processes within the scope of 
their audit work in order to comply with PCAOB requirements.'' \326\
---------------------------------------------------------------------------

    \323\ See Deloitte Letter; KPMG Letter; PWC Letter.
    \324\ See Van Kampen/Invesco Letter.
    \325\ Id.
    \326\ Id.
---------------------------------------------------------------------------

    As noted above in section II.B.4.ii. of this release, with respect 
to the independent public accountant's review of the exemption reports, 
one commenter stated that, for example, a bank or clerical error that 
results in a broker-dealer that operates under an exemption to Rule 
15c3-3 finding itself in possession of customer assets overnight once 
during the fiscal year should not ``warrant the `material modification' 
of a broker-dealer's Exemption Report.'' \327\ Another commenter noted 
that ``to consider a single instance of a broker-dealer failing to 
promptly forward a customer's securities as an instance that would 
necessitate a material modification creates an unworkable standard.'' 
\328\
---------------------------------------------------------------------------

    \327\ See SIFMA letter.
    \328\ See CAI Letter.
---------------------------------------------------------------------------

iii. The Final Rule
    The Commission is adopting amendments to the engagement of the 
accountant requirements in Rule 17a-5 substantially as proposed, except 
for revisions, as discussed in detail below, to clarify the rule's 
requirements and to make technical changes. Paragraph (g) of Rule 17a-5 
as adopted provides that the independent public accountant engaged by 
the broker-dealer to provide reports on the financial report and either 
the compliance report or exemption report must, as part of the 
engagement undertake to: (1) Prepare a report based on an examination 
of the broker-dealer's financial report in accordance with standards of 
the PCAOB; and (2) prepare a report based on an examination of certain 
enumerated statements of the broker-dealer in the compliance report 
\329\ in accordance with standards of the PCAOB or prepare a report 
based on a review of the statements in the broker-dealer's exemption 
report in accordance with standards of the PCAOB. Additionally, as 
proposed, the amendments delete paragraph (j) of Rule 17a-5, which, as 
explained above, required that the broker-dealer file with the annual 
audit report a material inadequacy report, as well as provisions in 
paragraph (g) of Rule 17a-5 requiring that the audit be conducted in 
accordance with GAAS and addressing the accountant's review for 
material inadequacies.
---------------------------------------------------------------------------

    \329\ As discussed above in section II.B.3. of this release, the 
final rule does not use the term assertion--the assertions contained 
in the proposal are now referred to as statements. These changes are 
not intended to be substantive. Paragraph (g) of Rule 17a-5 
specifies that the accountant prepare a report based on an 
examination of certain statements enumerated in the rule. Similar to 
the proposal, the statements subject to the examination do not 
include a statement as to whether the broker-dealer has established 
a system of internal control or a description of instances of non-
compliance with certain financial responsibility rules.
---------------------------------------------------------------------------

    Various commenters suggested that GAAS instead of PCAOB standards 
should apply for engagements of accountants with respect to certain 
broker-dealer reports, such as reports of non-carrying broker-
dealers.\330\ The Commission believes that requiring GAAS for audits of 
broker-dealers that are exempt from Rule 15c3-3 would not be consistent 
with the provisions of the Dodd-Frank Act that provide the PCAOB with 
explicit authority to establish standards with regard to audits of 
broker-dealer reports filed with the Commission.\331\ These provisions 
enable the PCAOB to exercise its standard-setting authority over audits 
of broker-dealers registered with the Commission. The change from GAAS 
to PCAOB auditing standards will facilitate the Commission's regulatory 
oversight authority because the Commission has direct oversight 
authority over the PCAOB, including the ability to approve or 
disapprove the PCAOB's rules and standards. The Commission also has 
greater confidence in the quality of audits conducted by an independent 
public accountant registered with, and subject to regular inspection 
by, the PCAOB.\332\ Further, as the PCAOB develops and implements an 
inspection program of broker-dealer audits as contemplated by the Dodd-
Frank Act, that program will include inspection of, among other things, 
``registered public accounting firms' current compliance with laws, 
rules, and standards in performing audits of brokers and dealers.'' 
\333\ The requirement that all broker-dealer independent public 
accountants comply with the standards established by the PCAOB should 
facilitate the development and implementation of its permanent 
inspection program, as contemplated by the Dodd-Frank Act.
---------------------------------------------------------------------------

    \330\ See AICPA Letter; Citrin Letter.
    \331\ See Public Law 111-203 Sec.  982. For example, section 
982(a) of the Dodd-Frank Act added section 110 to the Sarbanes-Oxley 
Act, which contains definitions of terms such as audit, audit 
report, and professional standards. These definitions apply to 
audits, audit reports, and professional standards with respect to 
audits of broker-dealers as well as audits of issuers. In addition, 
section 982(b) of the Dodd-Frank Act amended section 101 of the 
Sarbanes-Oxley Act to substitute the words ``issuers, brokers, and 
dealers'' for the word ``issuers.''
    \332\ See Custody of Funds or Securities of Clients by 
Investment Advisers, 75 FR at 1460.
    \333\ See Temporary Rule for an Interim Program of Inspection 
Related to Audits of Brokers and Dealers, PCAOB Release No. 2011-
001, PCAOB Rulemaking Docket Matter No. 32, 1 (June 14, 2011).
---------------------------------------------------------------------------

    As noted above, the PCAOB has proposed an auditing standard for 
supplemental information accompanying audited financial statements, 
including the supporting schedules broker-dealers must file as part of 
the financial report.\334\ The PCAOB stated that a primary factor that 
led it to reexamine its requirements regarding supplemental information 
was the Commission's proposal to amend the reporting requirements of 
Rule 17a-5.\335\ In addition, as noted above, the PCAOB has proposed 
specific attestation standards for examining compliance reports and 
reviewing exemption reports. The PCAOB's proposing release noted that 
the proposed standards ``are tailored to the requirements in SEC 
Proposed Rule 17a-5.'' \336\ The proposed standards, if adopted, would 
establish a single and broker-dealer-specific approach to examining 
compliance reports and reviewing exemption reports. This should provide 
greater clarity as to procedures an independent public accountant 
should use in examining a compliance report and reviewing an exemption 
report.
---------------------------------------------------------------------------

    \334\ See PCAOB Proposed Auditing Standard for Supplemental 
Information.
    \335\ Id. at 2-3.
    \336\ See PCAOB Proposing Release at 5.
---------------------------------------------------------------------------

    With respect to comments suggesting that PCAOB standards should 
apply only to auditors of broker-dealers ``permanently subject to PCAOB 
inspection,'' \337\ the PCAOB has not exempted the audits by 
independent

[[Page 51933]]

public accountants of any class of broker-dealer from the PCAOB's 
permanent inspection program.\338\ In fact, the PCAOB has established 
an interim inspection program for all broker-dealer audits by 
independent public accountants that will ``allow the Board to begin 
inspections of relevant audits and auditors and provide a source of 
information to help guide decisions about the scope and elements of a 
permanent program.'' \339\ The PCAOB stated that it did not intend ``to 
postpone all use of its new inspection authority until after those 
judgments were made.'' \340\
---------------------------------------------------------------------------

    \337\ See AICPA Letter.
    \338\ See Public Company Accounting Oversight Board: Order 
Approving Proposed Temporary Rule for an Interim Program of 
Inspection Related to Audits of Brokers and Dealers, Exchange Act 
Release No. 65163 (Aug. 18, 2011), 76 FR at 52996 (Aug. 24, 2011).
    \339\ Id. at 52997.
    \340\ Id.
---------------------------------------------------------------------------

    At this time, there is no reason to expect that any type of broker-
dealer audit will be exempt from the PCAOB's permanent inspection 
program, and any PCAOB determination to exempt broker-dealer audits 
from the PCAOB's permanent inspection program must be approved by the 
Commission. Therefore, notwithstanding any such exemption, paragraph 
(g) of Rule 17a-5 is amended to require that broker-dealer independent 
public accountants prepare reports covering the financial report and 
compliance report or exemption report in accordance with standards of 
the PCAOB.
    On August 20, 2012, the PCAOB published its first report on the 
progress of the interim inspection program.\341\ The report contains 
observations from inspections of portions of 23 broker-dealer audits 
conducted by ten independent public accounting firms that were all 
conducted in accordance with GAAS.\342\ The inspections did not exclude 
any broker-dealer audits from being eligible for selection.\343\ PCAOB 
staff identified deficiencies in all of the audits inspected.\344\ For 
example, as to all of the 14 audits of broker-dealers that claimed an 
exemption from Rule 15c3-3, the staff stated that the accountant ``did 
not perform sufficient procedures to ascertain that the broker or 
dealer complied with the conditions of the exemption,'' \345\ and in 21 
of the 23 audits, that the accountant ``failed to perform sufficient 
audit procedures to obtain reasonable assurance that any material 
inadequacies found to exist since the date of the last examination . . 
. would have been disclosed in the accountant's supplemental report.'' 
\346\ The deficiencies noted in the PCAOB's report on the progress of 
the interim inspection program provide further support for the 
amendments that the Commission is adopting today to establish the 
foundation for the PCAOB's development of standards that are tailored 
to Rule 17a-5, and to strengthen and facilitate consistent compliance 
with broker-dealer audit and reporting requirements.
---------------------------------------------------------------------------

    \341\ See PCAOB, Report on the Progress of the Interim 
Inspection Program Related to Audits of Brokers and Dealers, PCAOB 
Release No. 2012-005 (August 20, 2012) (``PCAOB Inspection 
Report'').
    \342\ Id. at ii.
    \343\ Id. at 8.
    \344\ Id. at ii.
    \345\ Id. at iii.
    \346\ Id.
---------------------------------------------------------------------------

    Several commenters suggested that the Commission delay the 
applicability of these requirements because, among other things, PCAOB 
standards regarding broker-dealer audits, including standards that 
apply to compliance reports and exemption reports, will not be final 
when these rule amendments are adopted.\347\ In response, as discussed 
below in section V. of this release, the Commission is delaying the 
effective dates of most of the rule amendments. In accordance with the 
effective dates, broker-dealers must file compliance reports or 
exemption reports, as applicable, and broker-dealers must file reports 
of independent public accountants covering compliance reports or 
exemption reports in accordance with Rule 17a-5 as amended, for fiscal 
years ending on or after June 1, 2014. In the interim, broker-dealers 
must continue to file material inadequacy reports in accordance with 
the provisions of Rule 17a-5 as they existed before today's amendments. 
Broker-dealer independent public accountants must prepare reports based 
on an examination of broker-dealer financial reports in accordance with 
PCAOB standards for fiscal years ending on or after June 1, 2014. In 
the interim, audits of broker-dealer financial statements filed with 
the Commission under Rule 17a-5 should continue to be understood to 
mean auditing standards generally accepted in the U.S., plus any 
applicable rules of the Commission.\348\ The June 1, 2014 effective 
date should provide sufficient time for the PCAOB to finalize, subject 
to Commission approval, the standards for broker-dealer audits and for 
broker-dealers and their independent public accountants to prepare to 
comply with the new requirements and standards.
---------------------------------------------------------------------------

    \347\ See, e.g., CAQ Letter; Deloitte Letter; Grant Thornton 
Letter; KPMG Letter; McGladrey Letter.
    \348\ See Commission Guidance Regarding Auditing, Attestation, 
and Related Professional Practice Standards Related to Brokers and 
Dealers, Exchange Act Release No. 62991 (Sept. 24, 2010), 75 FR 
60616, 60617 (Oct. 1, 2010).
---------------------------------------------------------------------------

    As noted above, one commenter stated the Commission should provide 
more guidance on what an independent public accountant must address, 
and that the requirement for PCAOB standards should not be effective 
unless the AICPA Broker-Dealer Audit Guide is revised and updated.\349\ 
Another commenter sought clarification on what was expected of the 
auditor with respect to the books and records assertion.\350\ In 
response to these comments, the Commission notes that the PCAOB's 
proposed standards with respect to the examination of the compliance 
report by the independent public accountant address, among other 
things: (1) The objective of the examination; (2) the relationship 
between the examination engagement and the audit of the financial 
report; (3) considerations for broker-dealers with multiple divisions 
or branches; (4) identifying risks of material non-compliance; (5) 
testing controls over compliance; (6) performing compliance tests; (7) 
testing information used to assert compliance; (8) evaluating the 
results of the examination procedures; (9) subsequent events; (10) 
obtaining a representation letter; (11) communication requirements; 
(12) reporting on the examination engagement; (13) the examination 
report date; and (14) examination report modifications.\351\ The 
PCAOB's proposed standards with respect to the review of the exemption 
report by the independent public accountant address, among other 
things: (1) The objective of the review; (2) the relationship between 
the review engagement and the audit of the financial report; (3) the 
review procedures; (4) evaluating the results of the examination 
procedures; (5) obtaining a representation letter; (6) communication 
requirements; (7) reporting on the review engagement; (8) the review 
report date; and (9) review report modifications.\352\ The Commission 
expects that the final standards of the PCAOB, which are subject to 
Commission approval, will provide sufficient guidance to independent 
public accountants performing examinations of compliance reports and 
reviews of exemption reports.
---------------------------------------------------------------------------

    \349\ See ABA Letter.
    \350\ See Grant Thorton Letter.
    \351\ See PCAOB Proposing Release app. 1.
    \352\ See PCAOB Proposing Release app. 2.
---------------------------------------------------------------------------

    In response to the comment that the requirements with respect to 
the compliance reports and exemption reports should not be effective 
unless

[[Page 51934]]

the AICPA Broker-Dealer Audit Guide is revised and updated, as stated 
above, once adopted, only the standards of the PCAOB apply to broker-
dealer annual reports. The PCAOB has proposed standards with respect to 
the examination of the compliance report and the review of the 
exemption report and it is expected that final standards will be in 
place before the audit requirements with respect to the compliance 
report and the exemption report are effective. Consequently, there is 
no need to wait for the AICPA Broker-Dealer Audit Guide to be updated.
    As noted above, several commenters requested clarity about the 
interaction between material weaknesses in internal control over 
financial reporting and material weaknesses in internal control over 
compliance with the financial responsibility rules.\353\ Additionally, 
one commenter stated that due to the reliance placed on the financial 
books and records of the broker-dealer, it will not be feasible for the 
independent public accountant to attest to the effectiveness of 
internal control over the financial responsibility rules without also 
attesting to internal control over financial reporting.\354\ As 
discussed above in section II.B.3.iii. of this release, although a 
broker-dealer is required to state in the compliance report that the 
information it used to state whether it was in compliance with Rule 
15c3-1 and paragraph (e) of Rule 15c3-3 was derived from its books and 
records, the final rule does not require that the broker-dealer include 
a statement regarding the effectiveness of its internal control over 
the accuracy of its books and records, nor does it require that the 
independent public accountant attest to the effectiveness of internal 
control over the accuracy of the broker-dealer's books and records. 
Additionally, under the final rule, the independent public accountant 
is not required to opine on the effectiveness of the broker-dealer's 
internal control over financial reporting. However, the independent 
public accountant's existing obligation to gain an understanding and 
perform appropriate procedures relative to the broker-dealer's internal 
control over financial reporting, as a necessary part of the 
independent public accountant's financial report audit, remains 
unchanged.\355\ Further, as discussed above in section II.B.3.iii. of 
this release, the examination of the compliance report would pertain 
solely to certain statements in the compliance report and not to the 
broker-dealer's process for arriving at the statements. The report of 
the independent public accountant, based on the examination of the 
compliance report, requires the accountant to perform its own 
independent examination of the related controls and procedures. 
Consequently, it is not necessary for the independent public accountant 
to provide an opinion with regard to the process that the broker-dealer 
used to arrive at its conclusions.
---------------------------------------------------------------------------

    \353\ See Deloitte Letter; KPMG Letter; PWC Letter.
    \354\ See Van Kampen/Invesco Letter.
    \355\ See PCAOB Auditing Standard, AS No. 12 (for audits of 
fiscal years beginning on or after December 15, 2010).
---------------------------------------------------------------------------

    As noted above, one commenter stated that a review engagement 
should not be employed for the exemption report, because an 
accountant's inquiry and observation would not provide sufficient 
evidence regarding a broker-dealer's assertion that it is exempt from 
Rule 15c3-3, and under the PCAOB's attestation standards, an auditor 
should not accept an engagement to perform a ``review'' engagement 
related to an entity's compliance with specified requirements.\356\ As 
an alternative, this commenter suggested an ``agreed-upon procedures'' 
approach or an examination engagement.\357\
---------------------------------------------------------------------------

    \356\ See E&Y Letter.
    \357\ Id.
---------------------------------------------------------------------------

    The PCAOB's attestation standards currently provide that an 
accountant should not accept an engagement to perform a review of an 
entity's compliance with specified requirements or about the 
effectiveness of an entity's internal control over compliance, and that 
an agreed upon procedures engagement be considered as an 
alternative.\358\ Irrespective of the PCAOB's current standards, Rule 
17a-5, as amended, provides that the broker-dealer engage an 
independent public accountant to perform a review of the exemption 
report. Moreover, in July 2011, as part of its proposed standards for 
attestation engagements related to broker-dealer compliance reports or 
exemption reports, the PCAOB proposed replacing the provision cited by 
the commenter with the following: ``When a practitioner is engaged to 
perform a review engagement on assertions made by a broker or dealer in 
an exemption report that is prepared pursuant to SEC Proposed Rule 17a-
5, the practitioner must conduct the review engagement pursuant to 
Proposed Attestation Standard, Review Engagements Regarding Exemption 
Reports of Brokers and Dealers.'' \359\ In addition, as discussed 
above, the PCAOB has proposed specific standards for an accountant to 
perform a review of the exemption report.\360\ The PCAOB's final 
standards, which must be approved by the Commission, are intended by 
the PCAOB to clarify the procedures an independent public accountant 
will need to perform in a review of an exemption report.\361\
---------------------------------------------------------------------------

    \358\ See PCAOB Interim Attestation Standard, AT Section 601 at 
] 7.
    \359\ See PCAOB Proposing Release app. 3 at A3-4. The PCAOB's 
attestation standards currently provide that an accountant should 
not accept an engagement to perform a review of an entity's 
compliance with specified requirements or about the effectiveness of 
an entity's internal control over compliance or an assertion 
regarding those items. See PCAOB Interim Attestation Standard, AT 
Section 601 at ] 7.
    \360\ See PCAOB Proposing Release app. 2.
    \361\ Id.
---------------------------------------------------------------------------

    In response to the comment that a review engagement should not be 
employed for the exemption report because inquiry and observation would 
not provide sufficient evidence,\362\ the independent public accountant 
would be able to obtain the moderate level of assurance contemplated by 
the required review through a combination of procedures that the 
accountant would perform in connection with the financial audit 
currently required under Rule 17a-5 and certain inquiries and other 
procedures specifically targeting the exemption report. Also, the 
PCAOB's proposal includes specific requirements for a review engagement 
regarding exemption reports of brokers and dealers. In addition to 
inquiry and observation, the PCAOB's proposal states that ``in 
performing the review engagement, the auditor should . . . [e]valuate 
whether the evidence obtained and the results of the procedures 
performed in the audit of the financial statements and supplemental 
information corroborate or contradict the broker's or dealer's 
assertion regarding compliance with the exemption conditions.'' \363\ 
Additionally, the auditor should ``[p]erform other procedures as 
necessary in the circumstances to obtain moderate assurance.'' \364\ 
The PCAOB's final standards will provide clarity on the procedures to 
be performed by the independent public accountant to obtain a moderate 
level of assurance to form a conclusion with respect to the review of 
the exemption report.\365\
---------------------------------------------------------------------------

    \362\ See E&Y Letter.
    \363\ See PCAOB Proposing Release app. 2.
    \364\ Id.
    \365\ Id.
---------------------------------------------------------------------------

    The commenter's suggestion to use an ``agreed-upon procedures'' 
engagement for the exemption report was considered. The final rule, 
however, requires a review engagement as proposed. Under an ``agreed-
upon procedures'' engagement, the independent public accountant is

[[Page 51935]]

engaged by a client to issue a report of findings based on specific 
procedures performed on subject matter that the specified parties 
believe are appropriate.\366\ Additionally, in an ``agreed-upon 
procedures'' engagement, the independent public accountant does not 
perform an examination or a review, and does not provide an opinion or 
negative assurance. Thus, no conclusion would be rendered as to the 
broker-dealer's statement that it met certain exemption provisions in 
Rule 15c3-3.
---------------------------------------------------------------------------

    \366\ See PCAOB Interim Attestation Standard, AT Section 201 at 
] .03.
---------------------------------------------------------------------------

    In addition to the commenter advocating an ``agreed-upon 
procedures'' standard,\367\ a second commenter stated that the cost 
``would not justify the need'' for an audit report covering the 
exemption report \368\ and a third commenter stated that the exemption 
report should be replaced with a box to check on the FOCUS Report as 
the auditor attestation provided no added benefit.\369\ In response to 
all these comments, the Commission notes that previously Rule 17a-5 
required that if a broker-dealer is exempt from Rule 15c3-3, the 
independent public accountant is required to ascertain whether the 
conditions of the exemption were being complied with and that no facts 
came to the accountant's attention to indicate that the exemption had 
not been complied with.\370\ Consequently, the rule previously required 
the independent public accountant to reach a conclusion with respect to 
a broker-dealer's claimed exemption from Rule 15c3-3. The Commission 
believes that the rule should continue to require a conclusion from the 
independent public accountant on the broker-dealer's claimed exemption 
from Rule 15c3-3 because of the importance of safeguarding customer 
securities and cash. Consequently, the Commission does not believe that 
it would be appropriate to use a lower standard (i.e., the agreed-upon 
procedures standard) or to have no requirement for the independent 
public accountant to perform any work with respect to the exemption 
report. Moreover, because the independent public accountant was 
previously required to render a conclusion with respect to the broker-
dealer's claimed exemption from Rule 15c3-3, the exemption report 
review should not result in significant incremental cost over the 
existing requirement.
---------------------------------------------------------------------------

    \367\ See E&Y Letter.
    \368\ See Citrin Letter.
    \369\ See Angel Letter.
    \370\ See 17 CFR 240.17a-5(g)(2).
---------------------------------------------------------------------------

    As noted above, two commenters raised concerns that minor 
exceptions to meeting the exemption provisions of paragraph (k) of Rule 
15c3-3 could result in the independent public accountant becoming aware 
of material modifications that should be made to the statement in the 
exemption report.\371\ Under PCAOB standards for attestation 
engagements, the independent public accountant's review report on a 
statement in an exemption report would be required to include a 
statement about whether the accountant is aware of any material 
modifications that should be made to the statement in the exemption 
report in order for it to be fairly stated in all material 
respects.\372\ As discussed above in section II.B.4.iii. of this 
release, the exemption report requirements have been modified from the 
proposal so that a broker-dealer must either state that it met the 
identified exemption provisions in paragraph (k) throughout the most 
recent fiscal year without exception or that it met the identified 
exemption provisions throughout the most recent fiscal year except as 
described in the report. Consequently, a broker-dealer that had 
exceptions will state that fact in the exemption report and describe 
the exceptions. Under PCAOB standards, if the statement is fairly 
stated in all material respects, including descriptions of any 
exceptions, the broker-dealer's independent public accountant would not 
need to state that the accountant is aware of any material 
modifications that should be made to the statement.\373\
---------------------------------------------------------------------------

    \371\ See CAI Letter; SIFMA letter.
    \372\ See PCAOB Interim Attestation Standard, AT Section 101 at 
] .90. See also PCAOB Proposing Release app. 2 at ] 11 (``The 
auditor should evaluate the identified instances of non-compliance 
with the exemption conditions to determine whether the instances of 
non-compliance, individually or in combination, cause the broker's 
or dealer's assertion not to be fairly stated, in all material 
respects. If the broker's or dealer's assertion is not fairly 
stated, in all material respects, the auditor should: (a) Modify the 
review report . . . and (b) evaluate the effect of the matter on the 
audit of the financial statements and supplemental information.'').
    \373\ See PCAOB Interim Attestation Standard, AT Section 101 at 
] .67 (stating that in expressing its conclusion, an independent 
public accounting ``should consider an omission or a misstatement to 
be material if the omission or misstatement--individually or when 
aggregated with others--is such that a reasonable person would be 
influenced by the omission or misstatement.'').
---------------------------------------------------------------------------

    The Commission did not receive comments regarding the proposed 
amendments to paragraph (i) of Rule 17a-5. However, the final rule has 
been revised from the proposal for clarity and consistency with the 
other amendments to Rule 17a-5. The title of the rule has been modified 
from the proposal to add a citation for clarity. As adopted, the title 
is, ``Reports of the independent public accountant required under 
paragraph (d)(1)(i)(C) of [Rule 17a-5].'' As adopted, paragraph (i)(1) 
of Rule 17a-5 provides, as proposed, that the independent public 
accountant's reports must: Be dated; be signed manually; indicate the 
city and state where issued; and identify without detailed enumeration 
the items covered by the reports.
    Paragraph (i)(2) of Rule 17a-5, as adopted, is also consistent with 
the proposal except that the word ``Identify'' is substituted for the 
word ``Designate'' for clarity and the phrase ``opinions or 
conclusions'' is substituted for the phrase ``opinions or statement'' 
because as explained above, consistent with auditing standards, a 
review engagement will not result in an opinion, but in the 
accountant's conclusion in the form of ``negative assurance''--for 
example, a conclusion that no information came to the accountant's 
attention that indicates that a statement is not fairly stated in all 
material respects.\374\ The rule therefore provides that the 
independent public accountant's reports must: (i) State whether the 
examinations or review, as applicable, were made in accordance with 
standards of the PCAOB; (ii) identify any examination and, if 
applicable, review procedures deemed necessary by the independent 
public accountant under the circumstances of the particular case that 
have been omitted and the reason for their omission. The rule also 
provides that: ``[n]othing in this section may be construed to imply 
authority for the omission of any procedure that independent public 
accountants would ordinarily employ in the course of an examination or 
review made for the purpose of expressing the opinions or conclusions 
required under [Rule 17a-5].''
---------------------------------------------------------------------------

    \374\ Id. at ]] .68, .88.
---------------------------------------------------------------------------

    Paragraph (i)(3) of Rule 17a-5, as adopted, is re-organized for 
clarity. Specific reference has been added to those statements in the 
compliance report that the accountant must examine, consistent with 
other amendments to Rule 17a-5 (e.g., the amendments to paragraph 
(g)(2)(i) of Rule 17a-5 regarding the engagement of the accountant to 
prepare a report based on the examination of specified statements in 
the compliance report). In addition, a subparagraph is added to include 
a reference to the exemption

[[Page 51936]]

report.\375\ The rule provides that the independent public accountant's 
reports must state clearly: (i) The opinion of the independent public 
accountant with respect to the financial report required under 
paragraph (d)(1)(i)(A) of Rule 17a-5 and the accounting principles and 
practices reflected in that report; (ii) the opinion of the independent 
public accountant with respect to the financial report required under 
paragraph (d)(1)(i)(A) of Rule 17a-5, as to the consistency of the 
application of the accounting principles, or as to any changes in those 
principles, that have a material effect on the financial statements; 
and (iii) either (A) the opinion of the independent public accountant 
with respect to the statements required under paragraphs 
(d)(3)(i)(A)(2), (3), (4), and (5) of Rule 17a-5 in the compliance 
report required under paragraph (d)(1)(i)(B)(1) of Rule 17a-5, or (B) 
the conclusion of the independent public accountant with respect to the 
statements required under paragraphs (d)(4)(i), (ii), and (iii) of Rule 
17a-5. The specific references to the compliance report and exemption 
report in paragraph (i)(3) are intended to provide a complete 
description of what must be contained in the report of the independent 
public accountant under current attestation standards, which require a 
conclusion in the case of an examination to be expressed in the form of 
an opinion and a conclusion in the case of a review that is not 
expressed in the form of an opinion, but in the form of ``negative 
assurance.'' \376\
---------------------------------------------------------------------------

    \375\ As proposed, paragraph (i)(3) did not contain a reference 
to the exemption report. See Broker-Dealer Reports, 76 FR at 37607. 
The final rule makes clear that the auditor's conclusion must be 
included in the independent public accountant's report covering the 
exemption report.
    \376\ As noted above, the accountant's conclusion in an 
examination engagement will be expressed in the form of an opinion. 
For example, the accountant's conclusion based on an examination of 
an assertion could state that in the accountant's opinion, the 
assertion is fairly stated in all material respects. See, e.g., 
PCAOB Interim Attestation Standard, AT Section 101 at ] .84. The 
accountant's conclusion in a review engagement will be expressed, 
not in the form of an opinion, but in the form of ``negative 
assurance.'' See, e.g., PCAOB Interim Attestation Standard, AT 
Section 101 at ] .68. For example, the accountant's conclusion based 
on a review of an assertion could state that no information came to 
the accountant's attention that indicates that the assertion is not 
fairly stated in all material respects. See, e.g., PCAOB Interim 
Attestation Standard, AT Section 101 at ] .88.
---------------------------------------------------------------------------

    Paragraph (i)(4) of Rule 17a-5 has been modified from the proposal 
to add a reference to paragraph (d) to make it more clear that the 
annual reports referenced in the paragraph are the financial report, 
compliance report, and exemption report prescribed in paragraph (d). In 
addition--in the interest of using ``plain English'' in the 
Commission's rules--the word ``must'' has been substituted for the word 
``shall'' and the word ``thereto'' has been eliminated. The rule as 
adopted therefore provides that ``[a]ny matters to which the 
independent public accountant takes exception must be clearly 
identified, the exceptions must be specifically and clearly stated, 
and, to the extent practicable, the effect of each such exception on 
any related items contained in the annual reports required under 
paragraph (d) of [Rule 17a-5] must be given.''

E. PCAOB Registration of Independent Public Accountant--Paragraph 
(f)(1) of Rule 17a-5

    Prior to today's amendments, paragraph (f)(1) of Rule 17a-5 was 
titled ``Qualification of accountants'' and provided that: ``The 
Commission will not recognize any person as a certified public 
accountant who is not duly registered and in good standing as such 
under the laws of his place of residence or principal office.'' \377\ 
Paragraph (f)(3) of Rule 17a-5 provided that the accountant ``shall be 
independent in accordance with the provisions of Sec.  210.2-01 (b) and 
(c) of this chapter'' and, paragraph (e)(1)(i) of Rule 17a-5 provided 
that the accountant ``shall be in fact independent as defined in 
paragraph (f)(3) of this section.'' \378\
---------------------------------------------------------------------------

    \377\ See 17 CFR 240.17a-5(f)(1).
    \378\ See 17 CFR 240.17a-5(f)(3).
---------------------------------------------------------------------------

    As discussed above, section 17(e)(1)(A) of the Exchange Act, as 
amended by the Dodd-Frank Act, requires registered broker-dealers to 
annually file financial statements with the Commission certified by 
``an independent public accounting firm, or by a registered public 
accounting firm if the firm is required to be registered under the 
Sarbanes-Oxley Act of 2002.'' Accordingly, the Commission proposed 
amending paragraph (f)(1) to provide that: ``The independent public 
accountant must be qualified and independent in accordance with Sec.  
210.2-01 of this chapter and, in addition, the independent public 
accountant must be registered with the Public Company Accounting 
Oversight Board if required by the Sarbanes-Oxley Act of 2002.'' \379\ 
The Commission further proposed deleting the accountant independence 
language in paragraph (e)(1)(i) of Rule 17a-5.\380\ In addition, the 
Commission proposed deleting paragraph (f)(3) and re-designating 
paragraph (f)(4) as paragraph (f)(3).\381\ These proposed amendments to 
paragraph (f) of Rule 17a-5 would consolidate the provisions of 
paragraphs (e)(1)(i), (f)(1), and (f)(3) of Rule 17a-5 into paragraph 
(f)(1) and make Rule 17a-5 consistent with other Commission 
requirements governing the qualifications of accountants. The 
Commission received no comments on these proposals and is adopting them 
substantially as proposed.\382\
---------------------------------------------------------------------------

    \379\ See Broker-Dealer Reports, 76 FR at 37593-37594.
    \380\ Id.
    \381\ Id.
    \382\ See paragraph (f)(1) of Rule 17a-5. The Commission has 
revised paragraph (f)(1) of Rule 17a-5 from the proposal to: Change 
the title from ``Qualification of accountants'' to ``Qualifications 
of independent public accountant;'' and deleting the words ``in 
addition.''
---------------------------------------------------------------------------

    Although the underlying independence requirements have not changed, 
broker-dealers and their independent public accountants are reminded 
that they must comply with the independence requirements of Rule 2-01 
of Regulation S-X.\383\ As a result of the Sarbanes-Oxley Act of 2002, 
Rule 2-01 of Regulation S-X was strengthened, including increased 
restrictions on the provision of certain non-audit services to an audit 
client.\384\
---------------------------------------------------------------------------

    \383\ See 17 CFR 210.2-01.
    \384\ See Strengthening the Commission's Requirements Regarding 
Auditor Independence, Exchange Act Release No. 47265 (Jan. 28, 
2003), 68 FR 6006 (Feb. 5, 2003). See also Auditor Independence: SEC 
Review of Auditor Independence Rules, NASD Notice to Members 02-19 
(Mar. 2002).
---------------------------------------------------------------------------

    Under the Commission's rules, an accountant will not be recognized 
as independent with respect to an audit client if the accountant is 
not, or a reasonable investor with knowledge of all relevant facts and 
circumstances would conclude that the accountant is not, capable of 
exercising objective and impartial judgment on all issues encompassed 
within the accountant's engagement. In determining whether an 
accountant is independent, the Commission will consider all relevant 
circumstances, including all relationships between the accountant and 
the audit client, and not just those relating to reports filed with the 
Commission.\385\ The standard is predicated largely on whether a 
relationship or the provision of a service: (1) Creates a mutual or 
conflicting interest between the accountant and the audit client; (2) 
places the accountant in the position of auditing his or her own work; 
(3) results in the accountant acting as management or an employee of 
the audit client; or (4) places the accountant in a position of being 
an advocate for the audit client.\386\
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    \385\ See 17 CFR 210.2-01(b).
    \386\ See 17 CFR 210.2-01, Preliminary Note 2.
---------------------------------------------------------------------------

    Further, Rule 2-01 of Regulation S-X sets forth a non-exclusive 
specification

[[Page 51937]]

of circumstances that are inconsistent with the general standard. For 
example, the accountant is prohibited from providing the following non-
audit services, among others, to an audit client: \387\
---------------------------------------------------------------------------

    \387\ See 17 CFR 210.2-01(c).
---------------------------------------------------------------------------

     Bookkeeping or other services related to the accounting 
records or financial statements of the audit client;
     Financial information systems design and implementation; 
and
     Management functions or human resources.
    With respect to bookkeeping or other services related to the 
accounting records or financial statements of the audit client, Rule 2-
01(c)(4)(i) of Regulation S-X specifies that these services include: 
(1) Maintaining or preparing the audit client's accounting records; (2) 
preparing financial statements that are filed with the Commission or 
the information that forms the basis of financial statements filed with 
the Commission; or (3) preparing or originating source data underlying 
the audit client's financial statements.\388\
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    \388\ See 17 CFR 210.2-01(c)(4)(i).
---------------------------------------------------------------------------

    Not all of the independence requirements in Rule 2-01 of Regulation 
S-X that are applicable to audits of issuers are applicable to 
engagements under Rule 17a-5. Specifically, auditors of broker-dealers 
are not subject to the partner rotation requirements or the 
compensation requirements of the Commission's independence rules 
because the statute mandating those requirements is limited to 
issuers.\389\ Additionally, auditors of broker-dealers are not subject 
to the audit committee pre-approval requirements \390\ or the cooling-
off period requirements for employment \391\ because those requirements 
only reference issuers.
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    \389\ See 15 U.S.C. 78j-1.
    \390\ See 17 CFR 210.2-01(c)(7).
    \391\ See 17 CFR 210.2-01(c)(2).
---------------------------------------------------------------------------

F. Notification of Non-Compliance or Material Weakness

    As discussed in detail below, the Commission is amending the 
notification provisions in Rule 17a-5 and amending Rule 17a-11 to align 
that rule with the amendments to Rule 17a-5. Under Rule 17a-11, a 
broker-dealer must provide notice to the Commission and its DEA in 
certain circumstances.\392\ For example, paragraph (b)(1) of Rule 17a-
11 requires a broker-dealer to give notice if its net capital declines 
below the minimum amount required under Rule 15c3-1.\393\ Rule 15c3-1 
and Rule 15c3-3 also require broker-dealers to provide notification in 
certain circumstances.\394\ For example, paragraph (i) of Rule 15c3-3 
requires a carrying broker-dealer to immediately notify the Commission 
and its DEA if it fails to make a deposit into its customer reserve 
account as required by paragraph (e) of Rule 15c3-3.\395\
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    \392\ See 17 CFR 240.17a-11.
    \393\ See 17 CFR 240.17a-11(b)(1).
    \394\ See, e.g., 17 CFR 240.15c3-1(a)(6)(iv)(B); 17 CFR 
240.15c3-1(a)(6)(v); 17 CFR 240.15c3-1(a)(7)(ii); 17 CFR 240.15c3-
1(c)(2)(x)(C)(1); 17 CFR 240.15c3-1(e); 17 CFR 240.15c3-1d(c)(2); 17 
CFR 240.15c3-3(i).
    \395\ See 17 CFR 240.15c3-3(i).
---------------------------------------------------------------------------

1. New Notification Requirements--Paragraph (h) of Rule 17a-5
    Prior to today's amendments, paragraph (h)(2) of Rule 17a-5 
provided that if, during the course of the audit or interim work, the 
independent public accountant determined that any ``material 
inadequacies'' existed, then the independent public accountant was 
required to inform the chief financial officer (``CFO'') of the broker-
dealer, who, in turn, was required to give notice to the Commission and 
the broker-dealer's DEA within 24 hours in accordance with the 
provisions of Rule 17a-11.\396\ The rule also provided that the broker-
dealer must furnish the independent public accountant with the notice, 
and if the independent public accountant failed to receive the notice 
within the 24 hour period, or if the accountant disagreed with any 
statements contained in the notice, the independent public accountant 
was required to inform the Commission and the DEA within the next 24 
hours.\397\ In that event, the independent public accountant was 
required to describe any material inadequacies found to exist or, if 
the broker or dealer filed a notice, the independent public accountant 
was required to detail the aspects of the broker-dealer's notice with 
which the independent public accountant did not agree.\398\
---------------------------------------------------------------------------

    \396\ See 17 CFR 240.17a-5(h)(2).
    \397\ Id.
    \398\ Id.
---------------------------------------------------------------------------

i. The Proposed Amendments
    The proposed amendments to Rule 17a-5 would have replaced 
references to material inadequacies, including the material inadequacy 
report, with a requirement applicable to carrying broker-dealers to 
identify an instance of ``material non-compliance'' with the financial 
responsibility rules and any material weakness in internal control over 
compliance with the financial responsibility rules in the compliance 
report and the requirement to engage an independent public accountant 
to examine the compliance report.\399\ Consistent with those proposed 
changes, the Commission proposed amending the notification provisions 
of paragraph (h)(2) of Rule 17a-5 to replace the term ``material 
inadequacy'' with the term ``material non-compliance,'' which would 
result in a requirement to notify the Commission upon the discovery by 
the accountant during the course of preparing a report based on an 
examination of the compliance report of an instance of material non-
compliance as that term was proposed to be defined under the 
amendments.\400\
---------------------------------------------------------------------------

    \399\ See Broker-Dealer Reports, 76 FR at 37575-37579.
    \400\ Id. at 37579.
---------------------------------------------------------------------------

    The Commission also proposed amending provisions regarding the 
notification process.\401\ Under the proposal, the accountant would 
have been required to notify the Commission and the broker-dealer's DEA 
directly.\402\ In the proposing release, the Commission stated that it 
preliminarily believed these changes would provide more effective and 
timely notice of broker-dealer compliance deficiencies and enable the 
Commission to react more quickly to protect customers and others 
adversely affected by those deficiencies.\403\ The amendments also 
would have been consistent with the notification requirement in Rule 
206(4)-2 that is triggered in the context of a ``surprise'' examination 
of an investment adviser.\404\
---------------------------------------------------------------------------

    \401\ Id.
    \402\ Id.
    \403\ Id.
    \404\ Id. Rule 206(4)-2 provides, in pertinent part, that upon 
finding any ``material discrepancies'' during the ``surprise'' 
examination of an investment adviser to verify client funds and 
securities, the independent public accountant must notify the 
Commission within one business day. 17 CFR 275.206(4)-2(a)(4)(ii).
---------------------------------------------------------------------------

ii. Comments Received
    The Commission received numerous comments in response to this 
proposal.\405\ Most of these commenters objected to the proposed 
notification process.\406\ Among the reasons given were that it would 
be inappropriate to require the accountant to notify the Commission and 
the DEA directly, because, among other things, the broker-dealer is 
principally responsible for compliance with the securities laws,

[[Page 51938]]

including timely notification; \407\ that PCAOB standards provide that 
``the practitioner should not take on the role of the responsible 
party;'' \408\ and that PCAOB attestation standards (which were 
referenced in the proposing release) clearly provide that management is 
responsible for the subject matter to which it is asserting, and not 
the accountant.\409\ In addition, one commenter stated that alignment 
of notification procedures (that is, to require the accountant to 
notify the Commission directly) between Rule 17a-5 and Rule 206(4)-2 is 
not necessary, given the other auditing and reporting responsibilities 
in place or proposed.\410\ In addition to suggestions that the 
notification process that existed prior to today's amendments should 
not be changed,\411\ one commenter stated that the rule should require 
simultaneous notice by the accountant to the Commission and to the 
firm's management.\412\
---------------------------------------------------------------------------

    \405\ See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter; 
E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; 
PWC Letter; SIFMA Letter; Van Kampen/Invesco Letter.
    \406\ See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter; 
E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; 
PWC Letter; Van Kampen/Invesco Letter.
    \407\ See Deloitte Letter.
    \408\ See KPMG Letter. See also PCAOB Interim Attestation 
Standard, AT Section 101 at ] .13.
    \409\ See PWC Letter. See also PCAOB Interim Attestation 
Standard, AT Section 101 at ]] .11-.13.
    \410\ See E&Y Letter.
    \411\ See, e.g., ABA Letter; E&Y Letter; McGladrey Letter.
    \412\ See Van Kampen/Invesco Letter.
---------------------------------------------------------------------------

    In addition, one commenter asked whether the notification 
provisions apply to a review of the exemption report.\413\ Another 
commenter stated that a report of non-compliance also will trigger a 
Rule 17a-11 notice, which would be duplicative and create 
confusion.\414\
---------------------------------------------------------------------------

    \413\ See KPMG Letter.
    \414\ See ABA Letter.
---------------------------------------------------------------------------

iii. The Final Rule
    In part in response to comments received, and to achieve 
consistency with other revisions to the proposed rule amendments 
described above, the notification provisions in the final rule have 
been modified from the proposed amendments.\415\ First, the Commission 
is persuaded by comments received that the primary obligation to notify 
the Commission should remain with the broker-dealer.\416\ Therefore, 
the notification process in place before today's amendments generally 
has been retained.
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    \415\ See paragraph (h) of Rule 17a-5.
    \416\ As the proposal noted, the proposed amendment to require 
the independent public accountant to notify the Commission directly 
of material non-compliance would have been consistent with the 
surprise examination notification requirement in Rule 206(4)-2 under 
the Advisers Act. A surprise examination of an investment adviser by 
an independent public accountant generally verifies that client 
funds and securities of which the investment adviser has custody are 
held by a qualified custodian, such as a bank or broker-dealer. The 
accountant's surprise examination report opines on the adviser's 
compliance with the custody rule requirement that client funds and 
securities are maintained by a qualified custodian and also opines 
on the adviser's compliance with certain recordkeeping obligations 
between surprise examinations. The difference in nature and scope of 
custodial and other activities between broker-dealers and advisers 
results in significantly broader examination requirements for 
broker-dealers. Broker-dealers are required to undergo an annual 
examination by an independent public accountant of their financial 
statements and certain supporting schedules: A computation of net 
capital under Rule 15c3-1, a computation for determining reserve 
requirements under Rule 15c3-3, and information relating to the 
possession and control requirements of Rule 15c3-3. Moreover, under 
today's amendments, the independent public accountant must examine 
the compliance report of broker-dealers that maintain custody of 
customer funds or securities. The differences in the overall nature 
of an examination also supports continuing to maintain today's model 
under which a broker-dealer has the primary notification obligation 
(e.g., unlike in the case of a surprise examination of an investment 
adviser, a broker-dealer would already be making its own assessment 
and preparing its own report in the case of a compliance report 
examination). Further, the Dodd-Frank Act provided the PCAOB with 
explicit authority to, among other things, establish (subject to 
Commission approval) auditing and related attestation, quality 
control, ethics, and independence standards for registered public 
accounting firms with respect to their preparation of audit reports 
to be included in broker-dealer filings with the Commission, and the 
authority to conduct and require an inspection program of registered 
public accounting firms that audit broker-dealers. The PCAOB 
oversight of broker-dealer examinations provides additional 
regulatory oversight with respect to the examination of the broker-
dealer further supporting the retention of the primary obligation 
with the broker-dealer to provide notice to the Commission and the 
broker-dealer's DEA.
---------------------------------------------------------------------------

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

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

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

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

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

[[Page 51939]]

DEA within one business day.\419\ The report from the accountant must, 
if the broker-dealer failed to file a notification, describe any 
instances of non-compliance that required the broker-dealer to provide 
a notification.\420\ If the broker-dealer filed a notification but the 
independent public accountant does not agree with the statements in the 
notice, the report from the accountant must detail the aspects of the 
notification of the broker-dealer with which the accountant does not 
agree.\421\ This notification process is generally the same as that in 
place before today's amendments.
---------------------------------------------------------------------------

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

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

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

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

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

    As discussed in more detail below in section II.F.2. of this 
release, the Commission is amending Rule 17a-11 to provide that a 
broker-dealer must provide notification to the Commission and its DEA 
if the broker-dealer discovers, or is notified by its independent 
public accountant, of the existence of a material weakness.\425\ 
Paragraph (h) of Rule 17a-5, as stated above, requires that the 
independent public accountant notify the broker-dealer if the 
accountant determines that a material weakness exists.\426\ The rule 
also requires the broker-dealer to provide notice in accordance with 
the provisions of Rule 17a-11, which, among other things, require the 
broker-dealer to provide notice to the Commission and its DEA in 
accordance with paragraph (g) of Rule 17a-11 within 24 hours and 
transmit a report within 48 hours of the notice stating what the 
broker-dealer has done or is doing to correct the situation.\427\ 
Paragraph (h) of Rule 17a-5 requires the broker-dealer to provide the 
accountant with a copy of the notice it sends to the Commission within 
one business day and, if the accountant does not receive the notice or 
the accountant does not agree with the statements in the notice, the 
accountant must provide a report to the Commission and the broker-
dealer's DEA within one business day.\428\ The report from the 
accountant must, if the broker-dealer failed to file a notification, 
describe any material weakness.\429\ If the broker-dealer filed a 
notification and the accountant does not agree with the statements in 
the notification, the report from the accountant must detail the 
aspects of the notification of the broker-dealer with which the 
accountant does not agree.\430\ Again, this notification process is 
generally the same as the one in place before today's amendments.\431\ 
In response to the comment that the rule should require simultaneous 
notice by the accountant to the Commission and to the firm's 
management, the notification procedures adopted today require that the 
accountant notify management of the broker-dealer and also ensure that 
the Commission receives timely notice.
---------------------------------------------------------------------------

    \425\ See paragraph (e) of Rule 17a-11.
    \426\ See paragraph (h) of Rule 17a-5.
    \427\ See paragraph (h) of Rule 17a-5; 17 CFR 240.17a-11(g).
    \428\ See paragraph (h) of Rule 17a-5.
    \429\ Id.
    \430\ Id.
    \431\ One change from the current rule (which is being amended) 
is to provide that required actions be completed within ``one 
business day'' as opposed to within a ``24 hour period.'' This 
change is designed to account for non-business days during which 
certain actions may not be feasibly completed.
---------------------------------------------------------------------------

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

[[Page 51940]]

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

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

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

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

2. Conforming and Technical Amendments to Rule 17a-11
    Before today's amendments, paragraph (e) of Rule 17a-11 provided 
that whenever a broker-dealer discovered, or was notified by an 
independent public accountant, pursuant to paragraph (h)(2) of Rule 
17a-5 or paragraph (f)(2) of Rule 17a-12 of the existence of any 
material inadequacy as defined in paragraph (g) of Rule 17a-5 or 
paragraph (e)(2) of Rule 17a-12, the broker-dealer was required to give 
notice to the Commission within 24 hours of the discovery or 
notification and transmit a report to the Commission within 48 hours of 
the notice stating what the broker-dealer has done or was doing to 
correct the situation.\435\ The Commission proposed amending paragraph 
(e) of Rule 17a-11 to delete the references to Rule 17a-5 and to 
correct the references to Rule 17a-12.\436\
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    \435\ See 17 CFR 240.17a-11(e).
    \436\ See Broker-Dealer Reports, 76 FR at 37579. Rule 17a-12 
contains reporting requirements for over-the-counter (``OTC'') 
derivatives dealers. See 17 CFR 240.17a-12. The rule is similar to 
Rule 17a-5. Compare 17 CFR 240.17a-12, with 17 CFR 240.17a-5. For 
example, paragraph (h)(2) of Rule 17a-12 describes material 
inadequacies and paragraph (i)(2) of Rule 17a-12 provides that if 
the accountant determines that any material inadequacy exists, the 
accountant must call it to the attention of the CFO of the OTC 
derivatives dealer, who must inform the Commission. See 17 CFR 
240.17a-12(h)(2) and (i). The Commission did not propose amending 
Rule 17a-12. Consequently, Rule 17a-12 retains the concept of 
material inadequacy.
---------------------------------------------------------------------------

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

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

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

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

G. Other Amendments to Rule 17a-5

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

    \439\ See 17 CFR 240.17a-5(c).
    \440\ 17 CFR 240.17a-5(c)(2).
    \441\ 17 CFR 240.17a-5(c)(3).
    \442\ See 17 CFR 240.17a-5(c)(5). See also Broker-Dealer 
Exemption from Sending Certain Financial Information to Customers, 
Exchange Act Release No. 48282 (Aug. 1, 2003), 68 FR 46446 (Aug. 6, 
2003).
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ii. Availability of Independent Public Accountant's Comments on 
Material Inadequacies--Paragraph (c)(2) of Rule 17a-5
    Prior to today's amendments, paragraph (c)(2)(iii) of Rule 17a-5 
provided that if, in conjunction with a broker-dealer's most recent 
audit report, the broker-dealer's independent public accountant 
commented on any material inadequacies in the broker-dealer's internal 
controls, its accounting system, or certain of its practices and 
procedures \443\ under paragraphs (g) and (h) of Rule 17a-5, and 
paragraph (e) of Rule 17a-11, the broker-dealer's audited statements 
sent to customers were required to include a statement that a copy of 
the auditor's comments were available for inspection at the 
Commission's principal office in Washington, DC, and the regional 
office of the Commission in which the broker-

[[Page 51941]]

dealer had its principal place of business.\444\
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    \443\ These practices and procedures include, for example, 
periodic net capital computations under Rule 15c3-1 and periodic 
counts of securities under Rule 17a-13.
    \444\ See 17 CFR 240.17a-5(c)(2)(iii).
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    As discussed above in sections II.D.3. and II.F. of this release, 
the Commission proposed deleting references to, and the definition of, 
the term material inadequacy in Rule 17a-5, and proposed amending 
paragraph (h) of Rule 17a-5 to require a broker-dealer's independent 
public accountant to notify the Commission and the broker-dealer's DEA 
if the accountant determined that any material non-compliance existed 
at the broker-dealer during the course of preparing its reports.\445\ 
Consequently, the Commission proposed replacing paragraph (c)(2)(iii) 
of Rule 17a-5, which contained the term material inadequacies, with a 
requirement that, if a broker-dealer's accountant provided notice to 
the Commission of an instance of material non-compliance, the financial 
information sent to customers under paragraph (c)(2) of Rule 17a-5 must 
include a statement that a copy of the accountant's notice was 
available for customers' inspection at the principal office of the 
Commission in Washington, DC.\446\ Under this proposal, notices to the 
Commission regarding an accountant's determination that one or more 
instances of material non-compliance existed at a broker-dealer would 
be publicly available.
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    \445\ See Broker-Dealer Reports, 76 FR at 37579.
    \446\ This proposal would have been codified in paragraph 
(c)(2)(iv) of Rule 17a-5 as a result of paragraph (c)(2)(iii) being 
removed and paragraph (c)(2)(iv) being redesignated as paragraph 
(c)(iii). See Broker-Dealer Reports, 76 FR at 37603.
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    Three commenters responded to the proposed amendments to paragraph 
(c)(2) of Rule 17a-5.\447\ These commenters each stated that the 
Commission should accord confidential treatment to accountants' notices 
to the Commission regarding determinations of material non-
compliance.\448\ One commenter stated that due to the technical nature 
of the financial responsibility rules, there was a risk that notices of 
material non-compliance could be misinterpreted by the media and 
others.\449\
---------------------------------------------------------------------------

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

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

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

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

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

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

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

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

[[Page 51942]]

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

    \455\ See ABA Letter; CAI Letter; SIFMA Letter.
    \456\ See ABA Letter.
    \457\ See CAI Letter. This commenter stated that as FINRA has 
proposed that broker-dealers send customer account statements 
monthly instead of quarterly, broker-dealers are already potentially 
facing ``extremely high'' costs of sending information to customers. 
FINRA withdrew its proposals to send customer account statements 
monthly instead of quarterly on July 30, 2012. See Proposed Rule 
Change to Adopt FINRA Rule 2231 (Customer Account Statements) in the 
Consolidated FINRA Rulebook, File No. SR-2009-028, (July 30, 2012), 
available at http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p143262.pdf (withdrawal of proposed 
rule change).
    \458\ See SIFMA Letter.
---------------------------------------------------------------------------

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

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

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

    \460\ See Reports to be Made by Certain Brokers and Dealers, 
Exchange Act Release No. 40608 (Oct. 28, 1998), 63 FR 59208 (Nov. 3, 
1998).
    \461\ See Broker-Dealer Reports, 76 FR at 37593.
---------------------------------------------------------------------------

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

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

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

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

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

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

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

[[Page 51943]]

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

    \466\ See paragraph (f)(2) of Rule 17a-5.
    \467\ See paragraph (f)(2)(i) of Rule 17a-5.
---------------------------------------------------------------------------

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

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

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

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

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

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

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

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

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

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

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

[[Page 51944]]

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

    \477\ See Commission Guidance Regarding Independent Public 
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the 
Investment Advisers Act of 1940, Advisers Act Release No. 2969 (Dec. 
30, 2009), 75 FR 1492 (Jan. 11, 2010) (identifying the following 
specified objectives: (1) Documentation for the opening and 
modification of client accounts is received, authenticated, and 
established completely, accurately, and timely on the applicable 
system; (2) client transactions, including contributions and 
withdrawals, are authorized and processed in a complete, accurate, 
and timely manner; (3) trades are properly authorized, settled, and 
recorded completely, accurately, and timely in the client account; 
(4) new securities and changes to securities are authorized and 
established in a complete, accurate and timely manner; (5) 
securities income and corporate action transactions are processed to 
client accounts in a complete, accurate, and timely manner; (6) 
physical securities are safeguarded from loss or misappropriation; 
(7) cash and security positions are reconciled completely, 
accurately and on a timely basis between the custodian and 
depositories; and (8) account statements reflecting cash and 
security positions are provided to clients in a complete, accurate 
and timely manner).
    \478\ Compare the control objectives described in Commission 
Guidance Regarding Independent Public Accountant Engagements 
Performed Pursuant to Rule 206(4)-2 Under the Investment Advisers 
Act of 1940, 75 FR at 1494, with the requirements in 17 CFR 
240.15c3-1, 17 CFR 240.15c3-3, 17 CFR 240.17a-13, and the DEA 
Account Statement Rules.
    \479\ See Broker-Dealer Reports, 76 FR at 37580.
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3. Broker-Dealers Acting as Qualified Custodians Under Rule 206(4)-2
    Broker-dealers that also are registered as investment advisers may, 
acting in their capacity as broker-dealers, maintain client securities 
and funds as qualified custodians in connection with advisory services 
provided to clients.\480\ As a result of being the adviser and 
qualified custodian to its clients, under Rule 206(4)-2 these broker-
dealers must obtain an internal control report relating to the custody 
of those assets from an independent public accountant that is 
registered with, and subject to regular inspection by, the PCAOB. In 
addition, broker-dealers acting as qualified custodians also may 
maintain advisory client assets in connection with advisory services 
provided by related or affiliated investment advisers. Rule 206(4)-2 
requires such a broker-dealer to provide an internal control report to 
its related investment adviser.\481\
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    \480\ The Commission staff has estimated that approximately 18% 
of FINRA-registered broker-dealers also are registered as investment 
advisers with the Commission or with a state. See Commission staff, 
Study on Investment Advisers and Broker-Dealers, as required by 
Section 913 of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (Jan. 2011).
    \481\ See 17 CFR 275.206(4)-2(a)(6). Based on data collected 
from the Investment Adviser Registration Depository as of August 
2012, close to 200 investment advisers reported on Form ADV that 
client assets were being held at a qualified custodian that was 
related to the adviser.
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4. Proposal to Allow Report Based on Examination of Compliance Report 
to Satisfy Rule 206(4)-2
i. The Proposal
    Broker-dealers that maintain custody of customer funds and 
securities are subject to specific operational requirements in the 
financial responsibility rules with respect to handling and accounting 
for customer assets.\482\ The operational requirements of the financial 
responsibility rules are consistent with the control objectives 
outlined in the Commission's guidance on Rule 206(4)-2.\483\ As a 
result of the proposed amendments to Rule 17a-5, the Commission stated 
in the proposing release that a broker-dealer subject to an examination 
by an independent public accountant of its compliance report that also 
acts as a qualified custodian for itself as an investment adviser or 
for its related investment advisers under Rule 206(4)-2 would be able 
to use the independent public accountant's report resulting from the 
examination to satisfy the internal control report requirement under 
Rule 206(4)-2.\484\
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    \482\ While Rule 15c3-1 prescribes broker-dealer net capital 
requirements, it also contains provisions relating to custody. For 
example, a broker-dealer must take net capital charges for short 
security differences unresolved after specifically enumerated 
timeframes. See 17 CFR 240.15c3-1(c)(2)(v)(A).
    \483\ See Broker-Dealer Reports, 76 FR at 37579-37580; 
Commission Guidance Regarding Independent Public Accountant 
Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment 
Advisers Act of 1940, 75 FR at 1493-1494.
    \484\ See Broker-Dealer Reports, 76 FR at 37579-37580.
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ii. Comments on the Proposal
    The Commission received several comments regarding the proposal 
that the independent public accountant's report based on an examination 
of the compliance report would satisfy the internal control report 
under Rule 206(4)-2. One commenter stated that it is ``critically 
important'' that there be a single independent public accountant 
engagement of the custody function at both the broker-dealer and 
investment adviser operations of any dually registered entity (or of 
affiliated broker-dealers and investment advisers) and that this 
engagement use a single, consistent standard for evaluating custody at 
both the broker-dealer and investment adviser operations.\485\ Two 
commenters noted that there are non-carrying broker-dealers that act as 
qualified custodians under the Advisers Act and that these broker-
dealers would not be subject to the proposed compliance report 
requirements and, consequently, would not be able to use the report of 
the independent public accountant covering the compliance report to 
satisfy the internal control report requirement in Rule 206(4)-2 
because the broker-dealers would be filing exemption reports instead of 
compliance reports.\486\ One commenter characterized this as an area of 
redundancy that could be eliminated by allowing an accountant's review 
of a non-carrying broker-dealer's transmittal procedures to be 
``recognized by the Investment Adviser regulatory regime promulgated by 
the Commission.'' \487\
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    \485\ See CFP Letter.
    \486\ See CAI Letter; Deloitte Letter.
    \487\ See Deloitte Letter.
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    In addition, two commenters asked for clarification regarding the 
interaction of the proposed compliance report requirements with the 
requirement in Rule 206(4)-2 that investment advisers undergo an annual 
surprise examination by an independent accountant to verify customer 
funds and securities held in custody.\488\ Specifically, both asked 
that the Commission clarify whether the independent public accountant 
performing the surprise examination would be able to place reliance on 
the proposed compliance report and related compliance examination to 
determine the nature and extent of the procedures for the surprise 
examination.\489\ One of the commenters also asked that, if the 
Commission clarifies that the independent public accountant performing 
the surprise examination is expected to rely on the proposed compliance 
report requirements, what factors should the independent public 
accountant consider, given that the report based on an examination of 
the compliance report would not be required to be completed until 60 
days after the fiscal year end while the surprise examination may occur 
at any time.\490\
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    \488\ See CAQ Letter; PWC Letter. Paragraph (a)(4) of Rule 
206(4)-2 requires, among other things, that client funds and 
securities of which an investment adviser has custody must be 
verified by actual examination at least once during each calendar 
year by an independent public accountant, pursuant to a written 
agreement between the investment adviser and the accountant, at a 
time that is chosen by the accountant without prior notice or 
announcement to the investment adviser and that is irregular from 
year to year. See 17 CFR 275.206(4)-2.
    \489\ See CAQ Letter; PWC Letter.
    \490\ See PWC Letter.
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5. Adoption of Proposal Relating to Rule 206(4)-2
    As discussed above, under today's amendments, a carrying broker-
dealer must prepare, and file with the Commission and its DEA, a 
compliance report on, among other things, its Internal Control Over 
Compliance, and must file with the compliance report a report prepared 
by its independent public accountant based on an examination of the 
compliance report.\491\ As a result of the amendments to Rule 17a-5, 
the Commission has determined that the independent public accountant's 
report based on an examination of the compliance report

[[Page 51945]]

will satisfy the internal control report requirement under Rule 206(4)-
2 because the operational requirements of the financial responsibility 
rules are consistent with the control objectives outlined in the 
Commission's guidance on Rule 206(4)-2.\492\ For example, to be able to 
include a statement that the broker-dealer has established and 
maintained Internal Control Over Compliance (which is defined as 
internal controls that have the objective of providing the broker-
dealer with reasonable assurance that non-compliance with the financial 
responsibility rules will be prevented or detected on a timely 
basis),\493\ a broker-dealer's internal control over compliance with 
Rule 17a-13 will result in controls over the safeguarding of securities 
from loss or misappropriation and the completeness, accuracy, and 
timeliness of the securities reconciliation process.\494\ To make a 
similar statement with respect to the Account Statement Rules, a 
broker-dealer would of necessity have internal controls over compliance 
with the Account Statement Rules designed to ensure that customers 
receive complete, accurate, and timely information concerning 
securities positions and other assets held in their accounts.\495\ A 
statement that the broker-dealer has established and maintained 
Internal Control Over Compliance would cover these and other internal 
controls over compliance with the financial responsibility rules and 
would be examined by the independent public accountant during the 
examination of the compliance report.
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    \491\ See 17 CFR 240.17a-5(d)(3) and (g)(2)(i).
    \492\ See Commission Guidance Regarding Independent Public 
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the 
Investment Advisers Act of 1940, 75 FR at 1494; Broker-Dealer 
Reports, 76 FR at 37579-37580. As discussed above in section II.D.3. 
of this release, the independent public accountant must examine the 
compliance report in accordance with attestation standards 
promulgated by the PCAOB. Consequently, the PCAOB's attestation 
standards are integral to the Commission's determination that the 
independent public accountant's report based on an examination of 
the compliance report satisfies the internal control report 
requirement under Rule 206(4)-2. The Commission could revisit this 
determination if the PCAOB's attestation standards do not support 
the determination.
    \493\ See paragraphs (d)(3)(i)(A)(1) and (d)(3)(ii) of Rule 17a-
5.
    \494\ See 17 CFR 240.17a-13. As discussed above in section 
II.D.3. of this release, the PCAOB proposed attestation standards 
related to the compliance report. The PCAOB's proposed attestation 
standards include a requirement that the independent public 
accountant must perform procedures to obtain evidence about the 
existence of customer funds or securities held for customers, e.g., 
confirmation of customer security positions directly with 
depositories and clearing organizations. See PCAOB Proposing Release 
app. 1, at ] 26. This procedure would be consistent with the tests 
of the qualified custodian's reconciliation that the Commission 
specified in the guidance on Rule 206(4)-2. See Commission Guidance 
Regarding Independent Public Accountant Engagements Performed 
Pursuant to Rule 206(4)-2 Under the Investment Advisers Act of 1940, 
75 FR 1494.
    \495\ See, e.g., CBOE Rule 9.12; NASD Rule 2340. See also 
Commission Guidance Regarding Independent Public Accountant 
Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment 
Advisers Act of 1940, Advisers Act Release No. 2969 (Dec. 30, 2009), 
75 FR 1494 (Jan. 11, 2010), which describes as a control objective 
for qualified custodians (including broker-dealer qualified 
custodians) that account statements reflecting cash and security 
positions are provided to clients in a complete, accurate and timely 
manner.
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    As commenters noted, broker-dealers that are not carrying broker-
dealers are not subject to the compliance report requirements and, 
therefore, those broker-dealers must comply with the internal control 
report requirement in Rule 206(4)-2 if they are subject to that 
requirement. The exemption report is not redundant of the internal 
control report requirement in Rule 206(4)-2 because, among other 
things, the scope of the required statements included in a broker-
dealer's exemption report is different than the scope of the internal 
control report requirement in Rule 206(4)-2.\496\
---------------------------------------------------------------------------

    \496\ See supra notes 299, 300.
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    As noted above, commenters also asked whether the accountant would 
be able to place reliance on the proposed compliance report and related 
examination of the compliance report to determine the nature and extent 
of the procedures for the surprise examination. PCAOB attestation 
standards require an independent public accountant ``to obtain an 
understanding of internal control over compliance sufficient to plan 
the engagement and to assess control risk for compliance with specified 
requirements.'' \497\ The Commission agrees that the independent public 
accountant's understanding of internal controls related to custody at 
the broker-dealer acting as a qualified custodian, as well as other 
facts and circumstances, may affect the nature and extent of procedures 
performed for the annual surprise examination.\498\ The Commission has 
provided interpretive guidance on the relationship between the annual 
surprise examination and the internal control report for engagements 
performed pursuant to Rule 206(4)-2.\499\
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    \497\ See PCAOB Interim Attestation Standard, AT Section 601. AT 
Section 601 requires an independent public accountant ``to obtain an 
understanding of internal control over compliance sufficient to plan 
the engagement and to assess control risk for compliance with 
specified requirements. In planning the examination, such knowledge 
should be used to identify types of potential non-compliance, to 
consider factors that affect the risk of material noncompliance, and 
to design appropriate tests of compliance.'' Id. at ] .45.
    \498\ Id.
    \499\ See Commission Guidance Regarding Independent Public 
Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the 
Investment Advisers Act of 1940, Advisers Act Release No. 2969 (Dec. 
30, 2009), 75 FR 1492 (Jan. 11, 2010).
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III. Access to Accountant and Audit Documentation

    The Commission proposed amending paragraph (f)(2) of Rule 17a-5 to 
require that each clearing broker-dealer \500\ include a representation 
in its statement regarding its independent public accountant that the 
broker-dealer agrees to allow Commission and DEA examination staff to 
review the audit documentation associated with its annual audit reports 
required under Rule 17a-5 and to allow its independent public 
accountant to discuss findings relating to the audit reports with 
Commission and DEA examination staff if requested for the purposes of 
an examination of the broker-dealer.\501\ This proposed requirement was 
intended to facilitate examinations of clearing broker-dealers by 
Commission and DEA examination staff.\502\ Access to information 
obtained from audit documentation and discussions with a clearing 
broker-dealer's independent public accountant would enhance the 
efficiency and effectiveness of Commission and DEA examinations by 
providing examiners with access to additional relevant information to 
plan their examinations.\503\
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    \500\ For the purpose of this release, a ``clearing broker-
dealer'' is a broker-dealer that clears transactions or carries 
customer accounts.
    \501\ See Broker-Dealer Reports, 76 FR at 37583-37584.
    \502\ Id.
    \503\ For example, where an independent public accountant has 
performed extensive testing of a carrying broker-dealer's custody of 
funds and securities by confirming holdings at custodians and sub-
custodians, examiners could focus their efforts on other matters 
that had not been the subject of prior testing and review.
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    The Commission proposed to limit this requirement to clearing 
broker-dealers, which generally have more complex business operations 
than non-carrying firms.\504\ Thus, access to accountants and audit 
documentation was considered of substantially greater value when 
preparing for regulatory examinations of these types of broker-dealers, 
as compared to firms with more limited business models.
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    \504\ See Broker-Dealer Reports, 76 FR at 37583.
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    To facilitate Commission and DEA examination staff access to a 
clearing broker-dealer's independent public accountant and the 
accountant's audit documentation, the Commission proposed amending 
paragraph (f)(2) of

[[Page 51946]]

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

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

    \507\ See CAI Letter; CAQ Letter; CFP Letter; Deloitte Letter; 
E&Y Letter; KPMG Letter; PWC Letter; SIFMA Letter.
    \508\ See CAQ Letter; Deloitte Letter; E&Y Letter; KPMG Letter.
    \509\ See CAI Letter; KPMG Letter; PWC Letter; SIFMA Letter.
    \510\ See Deloitte Letter; E&Y Letter; KPMG Letter.
    \511\ See E&Y Letter; PWC Letter.
    \512\ See CAI Letter.
    \513\ See CFP Letter.
---------------------------------------------------------------------------

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

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

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

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

    Independent public accountants can seek to protect information 
obtained by examiners from being disclosed to Freedom of Information 
Act (``FOIA'') requestors by specifically requesting confidential 
treatment of audit documentation following the process described in 
Rule 83 of the Commission's Rules on Information and Requests.\517\ The 
Commission anticipates that it will accord confidential treatment to 
such documents to the extent permitted by law.\518\
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    \517\ 17 CFR 200.83. Generally, persons who submit information 
to the Commission may request that the Commission accord 
confidential treatment to the information for any reason permitted 
by federal law.
    \518\ The Commission believes that this audit documentation 
likely would fall under exemptions (b)(8) and/or (b)(4) of FOIA. See 
5 U.S.C. 522(b)(8); 5 U.S.C. 522(b)(4).
---------------------------------------------------------------------------

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

[[Page 51947]]

audit documentation under this provision would be made exclusively in 
connection with conducting a regulatory examination of a broker-
dealer.\525\
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    \519\ See E&Y Letter; PWC Letter.
    \520\ See PWC Letter.
    \521\ See E&Y Letter.
    \522\ See Broker-Dealer Reports, 76 FR at 37583.
    \523\ Id.
    \524\ Id.
    \525\ Id.
---------------------------------------------------------------------------

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

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

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

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

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

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

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

    \530\ Id.
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IV. Form Custody

A. Background

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

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

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

    \533\ See Angel Letter; Barnard Letter; CAI Letter; CFP Letter; 
E&Y Letter; IMS Letter; KPMG Letter; Shatto Letter; SIFMA Letter.
    \534\ See CAI Letter; E&Y Letter; KPMG Letter; Shatto Letter; 
SIFMA Letter.
    \535\ See Angel Letter; CFP Letter; SIFMA Letter.
    \536\ See IMS Letter. This commenter, however, did not provide 
any suggestion for reducing the costs associated with Form Custody. 
See section VII. below for an economic analysis of the costs and 
benefits relating to Form Custody.
---------------------------------------------------------------------------

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

B. Filing of Form Custody

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

[[Page 51948]]

FOCUS Reports with the Commission and the broker-dealer's DEA.\537\ In 
the proposing release, the Commission proposed adding paragraph (a)(5) 
to Rule 17a-5 to require the filing of Form Custody, which was designed 
to elicit information concerning whether a broker-dealer maintained 
custody of customer and non-customer assets, and, if so, how such 
assets were maintained.\538\ Under this proposed amendment, a broker-
dealer would be required to file Form Custody with its DEA at the same 
time it filed its periodic FOCUS Report with its DEA under paragraph 
(a) of Rule 17a-5.\539\ The DEA, in turn, would be required to maintain 
the information obtained through the filing of Form Custody and to 
transmit such information to the Commission at such time as it 
transmits FOCUS Report data to the Commission under paragraph (a)(4) of 
Rule 17a-5.\540\
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    \537\ See 17 CFR 240.17a-5(a); 17 CFR 249.617. FOCUS Reports are 
one of the primary means of monitoring the financial and operational 
condition of broker-dealers and enforcing the broker-dealer 
financial responsibility rules. The completed forms also are used to 
determine which firms are engaged in various securities-related 
activities and how economic events and government policies might 
affect various segments of the securities industry. The FOCUS Report 
was designed to eliminate overlapping regulatory reports required by 
various SROs and the Commission and to reduce reporting burdens as 
much as possible. FOCUS Reports and Form Custody are deemed 
confidential under paragraph (a)(3) of Rule 17a-5.
    \538\ See Broker-Dealer Reports, 76 FR at 37592. For purposes of 
Form Custody, the term ``customer'' means a person that is a 
``customer'' for purposes of Rule 15c3-3(a), and a ``non-customer'' 
means a person other than a ``customer'' as that term is defined in 
Rule 15c3-3(a). See 17 CFR 240.15c3-3(a); FINRA, Interpretations of 
Financial and Operational Rules, Rule 15c3-3(a)(1)/01, available at 
http://www.finra.org/Industry/Regulation/Guidance/FOR/.
    \539\ See Broker-Dealer Reports, 76 FR at 37592.
    \540\ Id.
---------------------------------------------------------------------------

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

    \541\ See Form X-17A-5 Schedule I, Part II, Part IIa, Part IIb, 
and Part III.
    \542\ See Broker-Dealer Reports, 76 FR at 37585.
    \543\ Id.
---------------------------------------------------------------------------

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

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

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

    \546\ See paragraph (a)(5) of Rule 17a-5.
    \547\ Id. Consistent with the proposal, a broker-dealer must 
file Form Custody with its DEA at the same time that the broker-
dealer files its FOCUS Report with its DEA. However, since the final 
rule changes the date for the filing of the year end FOCUS Report to 
``within 17 business days after the end of the fiscal year where 
that date is not the end of a calendar quarter,'' the deadline for 
the year end filing of Form Custody is correspondingly changed to 
``within 17 business days after the end of the fiscal year of the 
broker or dealer where that date is not the end of a calendar 
quarter.''
---------------------------------------------------------------------------

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

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

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

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

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

[[Page 51949]]

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

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

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

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

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

C. Form Custody

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

    \555\ See Broker-Dealer Reports, 76 FR at 37585. See AICPA 
Broker-Dealer Audit Guide glossary (defining the term fully 
disclosed basis as a ``situation in which a nonclearing broker 
introduces a customer to a clearing broker and the customer's name 
and statement are carried by, and disclosed to, that clearing 
broker.'').
    \556\ See Broker-Dealer Reports, 76 FR at 37585.
---------------------------------------------------------------------------

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

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

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

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

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

[[Page 51950]]

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

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

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

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

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

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

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

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

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

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

b. General Comments to Item 3.C
    One commenter suggested that it would be helpful to require the 
broker-dealer to disclose the identities of specific entities at which 
it custodies securities.\571\ This commenter stated that such 
disclosure would allow regulators to identify potential discrepancies 
more easily, as well as changes in custody relationships that may 
warrant further investigations.\572\
---------------------------------------------------------------------------

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

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

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

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

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

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

[[Page 51951]]

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

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

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

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

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

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

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

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

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

[[Page 51952]]

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

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

    The charts in Items 3.D.i and 3.E.i, as proposed, would have each 
had eight columns. The first column contained boxes for each category 
of security specified in the Item (and identified in the second 
column), as discussed above.\583\ The broker-dealer would have been 
required to check the box in each chart for every applicable category 
of security it holds for the accounts of customers and non-customers, 
respectively. The second column would have identified the category of 
security. The third through eighth columns represented ranges of dollar 
values: (1) Up to $50 million; (2) greater than $50 million up to $100 
million; (3) greater than $100 million up to $500 million; (4) greater 
than $500 million up to $1 billion; (5) greater than $1 billion up to 
$5 billion; and (6) greater than $5 billion. In each chart, the broker-
dealer would have been required to check the box in the column 
reflecting the approximate dollar value for every category of security 
that the broker-dealer carried for the accounts of customers and non-
customers, respectively.\584\
---------------------------------------------------------------------------

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

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

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

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

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

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

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

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

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

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

[[Page 51953]]

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

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

c. Items 3.D.iii and 3.E.iii
    Items 3.D.iii and 3.E.iii of proposed Form Custody would have 
elicited information as to how the broker-dealer treated free credit 
balances in securities accounts of customers and non-customers, 
respectively.\593\ The information would have been elicited through a 
chart the broker-dealer would be required to complete. The chart in 
Item 3.D.iii of proposed Form Custody had five rows with each row 
representing a different process for treating free credit balances. The 
chart would have disclosed whether free credit balances were: (1) 
Included in a computation under Rule 15c3-3(e); (2) held in a bank 
account under Rule 15c3-3(k)(2)(i); (3) swept to a U.S. bank; (4) swept 
to a U.S. money market fund; and/or (5) ``other,'' with a space to 
describe such other treatment. The options were not intended to be 
mutually exclusive in that a broker-dealer may treat free credit 
balances in several different ways (e.g., a broker-dealer may be 
instructed by certain customers to sweep their free credit balances to 
a bank, and by other customers to sweep their free credit balances to a 
U.S. money market fund). The Commission did not receive any comments on 
Items 3.D.iii and 3.E.iii of proposed Form Custody and is adopting 
these Items as proposed.
---------------------------------------------------------------------------

    \593\ Id.
---------------------------------------------------------------------------

    A broker-dealer will be required to check the box in the first 
column of the chart for every process that applies to the broker-
dealer's treatment of free credit balances in customer and non-customer 
accounts, respectively. The first process identified on each chart is 
that the broker-dealer treats customer and non-customer free credit 
balances in accordance with the customer reserve computation required 
under paragraph (e) of Rule 15c3-3. Paragraph (e) of Rule 15c3-3 
requires a broker-dealer to maintain a special reserve bank account for 
the exclusive benefit of its customers and maintain deposits in that 
account (to the extent a deposit is required) in amounts computed in 
accordance with Exhibit A to Rule 15c3-3.\594\ Rule 15c3-3 requires 
that a broker-dealer comply with these reserve account provisions only 
with respect to customer-related credit balances. The Commission has, 
however, proposed amendments to Rule 15c3-3 that would require a 
broker-dealer to maintain a reserve account and perform a reserve 
computation for non-customer accountholders that are domestic and 
foreign broker-dealers.\595\
---------------------------------------------------------------------------

    \594\ See Rule 15c3-3(e) and Rule 15c3-3a.
    \595\ See Amendments to Financial Responsibility Rules for 
Broker-Dealers, Exchange Act Release No. 55431 (Mar. 9, 2007), 72 FR 
12862 (Mar. 19, 2007); Amendments to Financial Responsibility Rules 
for Broker-Dealers (Reopening of Comment Period), Exchange Act 
Release No. 34-66910 (May 3, 2012), 77 FR 27150 (May 9, 2012). See 
also letter from Michael A. Macchiaroli, Associate Director, 
Division of Market Regulation, Commission, to Raymond J. Hennessy, 
Vice President, New York Stock Exchange (``NYSE''), and Thomas 
Cassella, Vice President, NASD Regulation, Inc. (Nov. 10, 1998).
---------------------------------------------------------------------------

    The second process identified on the chart is that the broker-
dealer handles free credit balances by placing funds in a ``bank 
account under Rule 15c3-3(k)(2)(i).'' Paragraph (k)(2)(i) of Rule 15c3-
3 prescribes a process by which a broker-dealer can qualify for an 
exemption from the requirements of Rule 15c3-3. Specifically, the 
exemption applies to a broker-dealer that does not carry margin 
accounts, promptly transmits all customer funds and delivers all 
securities received in connection with its activities, does not 
otherwise hold funds or securities for, or owe money or securities to, 
customers and effectuates all financial transactions between the 
broker-dealer and its customers through one or more bank accounts that 
are each designated as a ``Special Account for the Exclusive Benefit of 
Customers of (the name of broker or dealer).'' \596\
---------------------------------------------------------------------------

    \596\ See 17 CFR240.15c3-3(k)(2)(i).
---------------------------------------------------------------------------

    The third process identified in the chart--``swept to a U.S. 
bank''--is included because some broker-dealers engage in ``bank sweep 
programs.'' Rather than hold customer funds in securities accounts, 
some broker-dealers require or offer the option to transfer free credit 
balances in securities accounts to a specific money market fund or 
interest bearing bank account (``Sweep Programs''). 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.\597\ 
Customers must make a request to the broker-dealer for the return of 
funds swept from their securities accounts to the bank.
---------------------------------------------------------------------------

    \597\ See Amendments to Financial Responsibility Rules for 
Broker-Dealers, Exchange Act Release No. 55431 (Mar. 9, 2007), 72 FR 
12862 (Mar. 19, 2007) at 12866.
---------------------------------------------------------------------------

    The fourth option identified in the chart is that the broker-dealer 
sweeps free credit balances into a money market fund as part of a Sweep 
Program. In most cases when a broker-dealer sweeps free credit balances 
into a money market fund, the broker-dealer purchases shares in the 
money market fund, which are registered in the name of the broker-
dealer. The money market fund understands that these shares are not 
proprietary positions of the broker-dealer, and any interest earned on 
the shares from the money market fund are payable to the customers.
    Finally, the fifth option in the chart covers any other process 
that is not described in the other options.
4. Item 4--Carrying for Other Broker-Dealers
    Item 4 of proposed Form Custody would have required a broker-dealer 
to disclose whether it acted as a carrying broker-dealer for other 
broker-dealers.\598\ There were two sets of questions in Item 4--Item 
4.A.i, ii, and iii and Item 4.B.i, ii, and iii. The first set of 
questions would have elicited information from a broker-dealer as to 
whether it carried transactions for other broker-dealers on a fully 
disclosed basis.\599\ The second set of questions would have elicited 
information from a broker-dealer as to whether it carried transactions 
for other broker-dealers on an omnibus basis.\600\ The Commission did 
not receive any comments to Item 4 of proposed Form Custody and is 
adopting this Item as proposed.
---------------------------------------------------------------------------

    \598\ See Broker-Dealer Reports, 76 FR at 37589.
    \599\ Id.
    \600\ Id.
---------------------------------------------------------------------------

    Items 4.A.i and 4.B.i require a broker-dealer to indicate by 
checking the appropriate ``Yes'' or ``No'' box whether it carries 
customer accounts for another broker-dealer on a fully disclosed basis 
and on an omnibus basis, respectively. Items 4.A.ii and 4.B.ii require 
a broker-dealer, if applicable, to indicate the number of broker-
dealers with which it has an arrangement to carry accounts on a fully 
disclosed basis and on an omnibus basis, respectively. Items 4.A.iii 
and 4.B.iii require a broker-dealer, if applicable, to identify any 
affiliated broker-dealers that introduce accounts to the broker-dealer 
on a fully disclosed basis and on an omnibus basis, respectively.
    As the Commission has noted, related person custody arrangements 
can present higher risks to ``advisory clients'' than maintaining 
assets with an independent custodian.\601\ Consistent with the 
definition of the term in other contexts applicable to broker-dealers, 
including Form BD,\602\ the General

[[Page 51954]]

Instructions for Form Custody define the term ``affiliate'' as any 
person who directly or indirectly controls the broker-dealer or any 
person who is directly or indirectly controlled by or under common 
control with the broker-dealer. The definition also specifies that 
ownership of 25% or more of the common stock of the broker-dealer 
introducing accounts to the broker-dealer submitting the Form Custody 
is deemed prima facie evidence of control; this provision also is 
consistent with the definition used in Form BD.\603\
---------------------------------------------------------------------------

    \601\ See Custody of Funds or Securities of Clients by 
Investment Advisers, 75 FR at 1462.
    \602\ Form BD is the uniform application for broker-dealer 
registration with the Commission. Form BD states that a person is 
presumed to control a company if, among other things, that person 
has directly or indirectly the right to vote 25% or more of a class 
of a voting security or has the power to sell or direct the sale of 
25% or more of a class of voting securities, or, in the case of a 
partnership, the right to receive upon dissolution, or has 
contributed, 25% or more of the firm's capital.
    \603\ This definition of the term affiliate is the same as the 
definition in Form BD, including the specification that ownership of 
25% or more of the common stock is deemed prima facie evidence of 
control.
---------------------------------------------------------------------------

    Item 4 in Form Custody elicits information about broker-dealers' 
custodial responsibilities with respect to accounts held for the 
benefit of other broker-dealers, and requires broker-dealers to 
identify such broker-dealers that are affiliates of the broker-
dealer.\604\ The Commission believes that this information will provide 
the Commission with an enhanced understanding of, and useful and 
readily available information relating to, the scope of broker-dealer 
introducing/carrying relationships and activities, and the custodial 
practices of broker-dealers involved in such relationships.
---------------------------------------------------------------------------

    \604\ Form Custody does not require a broker-dealer to identify 
unaffiliated broker-dealers for which it carries accounts, though, 
as discussed above, it would need to indicate that it carries 
accounts for such broker-dealers. The Commission believes that this 
approach provides the Commission and DEA examiners with access to 
useful information involving a broker-dealer's custody practices 
while alleviating potential time and cost burdens associated with 
completing Form Custody given that some broker-dealers carry 
accounts for hundreds of unaffiliated broker-dealers. The Commission 
notes that information about these broker-dealers would be part of 
the books and records of the carrying broker-dealer. Therefore, an 
affirmative answer to Item 4 could prompt the Commission and DEA 
examiners to request information about the identities of the 
unaffiliated broker-dealers. See Broker-Dealer Reports, 76 FR at 
37589 n.143.
---------------------------------------------------------------------------

5. Item 5--Trade Confirmations
    Item 5 of Form Custody, as proposed, would have required broker-
dealers to disclose whether they send transaction confirmations to 
customers and other accountholders by checking the appropriate ``Yes'' 
or ``No'' box.\605\ Confirmations are important safeguards that enable 
customers to monitor transactions that occur in their securities 
accounts. Timely confirmations alert customers of unauthorized 
transactions and provide customers with an opportunity to object to the 
transactions. The Commission received one comment on Item 5 of proposed 
Form Custody. As discussed below, the Commission is modifying the 
instructions to Item 5 in response to this comment and is otherwise 
adopting Item 5 as proposed.
---------------------------------------------------------------------------

    \605\ See Broker-Dealer Reports, 76 FR at 37589-37590.
---------------------------------------------------------------------------

    Exchange Act Rule 10b-10 specifies the information a broker-dealer 
must disclose to customers on a trade confirmation at or before 
completion of a securities transaction.\606\ Generally, Rule 10b-10 
requires a confirmation to include, among other things: (1) The date 
and time of the transaction and the identity, price, and number of 
shares or units (or principal amount) of such security purchased or 
sold by such customer; (2) the broker-dealer's capacity (agent or 
principal) and its compensation; (3) the source and amount of any third 
party remuneration it has received or will receive; and (4) other 
information, both general (e.g., that the broker-dealer is not a SIPC 
member, if such is the case) and transaction-specific (e.g., certain 
yield information in most transactions involving debt securities).\607\
---------------------------------------------------------------------------

    \606\ 17 CFR 240.10b-10.
    \607\ Id.
---------------------------------------------------------------------------

    The information contained on a trade confirmation should reconcile 
with customer statements and the broker-dealer's journal entries.\608\ 
In this regard, there is a link between trade confirmations sent by a 
broker-dealer and the broker-dealer's records pertaining to custody of 
customer assets.\609\ How a broker-dealer answers Item 5 could assist 
examiners in focusing their inspections. For example, if the form 
indicates that a third party is responsible for sending trade 
confirmations, the examiners can confirm with that third party that it 
is in fact sending confirmations.
---------------------------------------------------------------------------

    \608\ See 17 CFR 240.17a-3(a)(1), which requires the broker-
dealer to make ``[b]lotters (or other records of original entry) 
containing an itemized daily record of all purchases and sales of 
securities, all receipts and deliveries of securities (including 
certificate numbers), all receipts and disbursements of cash and all 
other debits and credits. Such records shall show the account for 
which each such transaction was effected, the name and amount of 
securities, the unit and aggregate purchase or sale price (if any), 
the trade date, and the name or other designation of the person from 
whom purchased or received or to whom sold or delivered.''
    \609\ Although broker-dealers may allocate the function of 
sending confirmations to other broker-dealers or to service 
providers, the allocating broker-dealer retains the responsibility 
for sending confirmations. See New York Stock Exchange, Inc.; Order 
Approving Proposed Rule Change, Exchange Act Release No. 18497 (Feb. 
19, 1982), 47 FR 8284 (Feb. 25, 1982) at n.2 (providing ``no 
contractual arrangement for the allocation of functions between an 
introducing and carrying organization can operate to relieve either 
organization from their respective responsibilities under the 
federal securities laws and applicable SRO rules'').
---------------------------------------------------------------------------

    With respect to Item 5.A, one commenter requested clarification as 
to whether a broker-dealer should indicate that it sends trade 
confirmations directly to customers (by checking ``yes'') where it 
employs a vendor to do so.\610\ The Commission has considered this 
comment and determined that a broker-dealer should affirmatively 
respond to Item 5 of Form Custody, as adopted, by checking the ``yes'' 
box on the form if it employs a vendor to send trade confirmations to 
customers on its behalf because, in such an arrangement, the broker-
dealer is ultimately responsible for complying with its trade 
confirmation obligations, not the vendor. The Commission has modified 
the instructions to Item 5 to reflect this clarification.
---------------------------------------------------------------------------

    \610\ See SIFMA Letter.
---------------------------------------------------------------------------

6. Item 6--Account Statements
    Item 6 of proposed Form Custody would have required broker-dealers 
to disclose whether they send account statements directly to customers 
and other accountholders by checking the appropriate ``Yes'' or ``No'' 
box.\611\ The Commission received one comment on Item 6 of proposed 
Form Custody.\612\ As is discussed below, the Commission is modifying 
the instructions to Item 6 in response to this comment and is otherwise 
adopting Item 6 as proposed.
---------------------------------------------------------------------------

    \611\ See Broker-Dealer Reports, 76 FR at 37590-37591.
    \612\ See SIFMA Letter.
---------------------------------------------------------------------------

    Account statements generally are sent to customers and other 
accountholders on a monthly or quarterly basis and typically set forth 
the assets held in the investor's securities account as of a specific 
date and the transactions that occurred in the account during the 
relevant period. SROs impose requirements on broker-dealers with 
respect to the statements they must send to their customers.\613\ For 
example, FINRA generally requires any member that conducts a general 
securities business and also carries customer accounts or holds 
customer funds or securities, at least once each calendar quarter, to 
send an account statement to each customer whose account had a security 
position, money balance, or account activity since the last statement 
was sent.\614\ The account statement

[[Page 51955]]

must contain a description of any securities positions, money balances, 
or account activity in the account. In addition, the account statement 
must include a statement that advises the customer to report promptly 
any inaccuracy or discrepancy in that person's account to the brokerage 
firm.\615\ The statement also is required to advise the customer that 
any oral communications made to the broker-dealer regarding 
inaccuracies or discrepancies should be re-confirmed in writing to 
further protect the customer's rights, including rights under 
SIPA.\616\
---------------------------------------------------------------------------

    \613\ See, e.g., NASD Rule 2340.
    \614\ See NASD Rule 2340. NASD Rule 2340 defines a general 
securities member as any member that conducts a general securities 
business and is required to calculate its net capital pursuant to 
Rule 15c3-1. NASD Rule 2340(d)(2). Additionally, NASD Rule 2340 
defines account activity broadly so that it includes, but is not 
limited to, purchases, sales, interest credits or debits, charges or 
credits, dividend payments, transfer activity, securities receipts 
or deliveries and/or journal entries relating to securities or funds 
in the possession or control of the member. NASD Rule 2340(d)(1). 
See also Order Approving Proposed Rule Change Relating to Rule 2340 
Concerning Customer Account Statements, Exchange Act Release No. 
54411 (Sept. 7, 2006), 71 FR 54105 (Sept. 13, 2006) (order granting 
approval of a proposed rule change relating to Rule 2340 concerning 
customer account statements).
    \615\ If the customer's account is serviced by both an 
introducing broker-dealer and a clearing broker-dealer, the 
statement must inform customers that such reports must be made to 
both firms. See NASD Rule 2340(a).
    \616\ Id.
---------------------------------------------------------------------------

    Like trade confirmations, account statements are important 
safeguards that allow investors to monitor transactions that occur in 
their securities accounts. If the account statements are sent by a 
broker-dealer other than the broker-dealer completing Form Custody, 
this fact will need to be disclosed on the Form in Item 6.B. Item 6.C 
asks whether the broker-dealer sends account statements to anyone other 
than the beneficial owner of the account.\617\ In response to a request 
for clarification raised by one commenter to proposed Item 6.C,\618\ a 
broker-dealer also would check ``Yes'' to Item 6.C if the broker-dealer 
sends account statements to the beneficial owner of an account and 
duplicate account statements to persons other than the beneficial owner 
of the account. The Commission has modified the instructions to Item 6 
to reflect this clarification.
---------------------------------------------------------------------------

    \617\ Generally, the beneficial owner of an account represents 
the person entitled to the economic benefits of ownership. With 
respect to securities, the term beneficial owner is defined in Rule 
13d-3 under the Exchange Act. See 17 CFR 240.13d-3.
    \618\ See SIFMA Letter.
---------------------------------------------------------------------------

    The Commission is requiring broker-dealers to answer the questions 
in Item 6 to enhance its understanding of a broker-dealer's 
relationship with customers, particularly in the context of the broker-
dealer's custodial responsibilities. Broker-dealers do not currently 
disclose to the Commission whether they send account statements 
directly to customers. Collecting this information on Form Custody will 
provide examiners with additional background information that could be 
used to refine the focus of their inspections. Further, the Commission 
anticipates that examiners would make further inquiries to the extent 
the Form reveals answers that are inconsistent with industry practice.
    A review of Item 6 also may facilitate an examiner's preparation 
for an inspection. For example, if a broker-dealer indicates on Form 
Custody that it holds customer accounts and sends account statements to 
customers, the examiner could prepare a more targeted document request 
to the broker-dealer. In this regard, an examiner could request 
customer account statements from the broker-dealer, as well as 
statements from the custodian(s) of the broker-dealer's customer 
securities and cash.\619\ Examiners could then review and reconcile 
these documents to verify whether customer securities and cash are held 
at the custodian(s) identified by the broker-dealer.
---------------------------------------------------------------------------

    \619\ As is discussed above in section IV.C.3. of this release, 
the fact that a broker-dealer uses a custodian to hold customer 
securities and cash, and the type of custodian, will be disclosed in 
response to Items 3.C and 3.D of Form Custody.
---------------------------------------------------------------------------

7. Item 7--Electronic Access to Account Information
    Item 7 of proposed Form Custody would have required broker-dealers 
to indicate whether they provided customers and other accountholders 
with electronic access to information about the securities and cash 
positions in their accounts by checking the appropriate ``Yes'' or 
``No'' box.\620\ Electronic access to account information can provide 
investors with an efficient means of monitoring transactions that occur 
in their securities accounts. This inquiry would inform the Commission 
as to how readily customers are able to access and review their account 
information. The Commission did not receive any comments to Item 7 of 
proposed Form Custody and is adopting this Item as proposed.
---------------------------------------------------------------------------

    \620\ See Broker-Dealer Reports, 76 FR at 37591.
---------------------------------------------------------------------------

    The Commission believes that electronic access to account 
information is beneficial to customers, who can more easily monitor the 
performance of their accounts and perhaps more quickly identify any 
discrepancies or inaccuracies. The Commission is including this Item in 
Form Custody because it will help to inform examiners as to how readily 
customers can access and review account information.
8. Item 8--Broker-Dealers Registered as Investment Advisers
    Item 8 of Form Custody, as proposed, would have elicited 
information, if applicable, as to whether and how the broker-dealer 
operated as an investment adviser.\621\ Proposed Item 8 was comprised 
of three subparts, as described below.
---------------------------------------------------------------------------

    \621\ Id. at 37591-37592.
---------------------------------------------------------------------------

    The first question of Item 8--Item 8.A--would have required the 
broker-dealer to indicate whether it was registered as an investment 
adviser with the Commission under the Advisers Act or with one or more 
states pursuant to the laws of a state.\622\ If the broker-dealer 
indicated that it was registered with the Commission under the Advisers 
Act or pursuant to state law (or both), then it would have been 
required to respond to the remaining questions under Item 8.\623\
---------------------------------------------------------------------------

    \622\ Id. Section 203A of the Advisers Act prohibits certain 
investment advisers from registering with the Commission based on 
the advisers' assets under management, among other factors. See 17 
CFR 275.203A.
    \623\ See Broker-Dealer Reports, 76 FR at 37591.
---------------------------------------------------------------------------

    The next question of Item 8 of proposed Form Custody--Item 8.B--
would have required the broker-dealer to disclose the number of its 
investment adviser clients.\624\ This would provide the Commission with 
information about the scale of the broker-dealer's investment adviser 
activities.
---------------------------------------------------------------------------

    \624\ Id.
---------------------------------------------------------------------------

    The third question of Item 8 of proposed Form Custody--Item 8.C--
would have required the broker-dealer to complete a chart, consisting 
of six columns, in which the broker-dealer would have provided 
information about the custodians where the assets of the investment 
adviser clients were held.\625\

[[Page 51956]]

In the first column, the broker-dealer would have been required to 
disclose the name of the custodian, and in the second column, the 
broker-dealer would have been required to identify the custodian by 
either SEC file number or CRD number, as applicable.\626\
---------------------------------------------------------------------------

    \625\ Id. Under Rule 206(4)-2, it is a ``fraudulent, deceptive, 
or manipulative act, practice or course of business'' for an 
investment adviser registered or required to be registered under 
section 203 of the Advisers Act (15 U.S.C. 80b-3) to have custody of 
client funds or securities unless, among other things, a qualified 
custodian maintains those funds or securities. See 17 CFR 
275.206(4)-2(a)(1). A qualified custodian is: (1) A bank as defined 
in section 202(a)(2) of the Advisers Act or savings association as 
defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 
U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit 
Insurance Corporation under the Federal Deposit Insurance Act (2 
U.S.C. 1811); (2) a broker-dealer registered under section 15(b)(1) 
of the Exchange Act holding the client assets in customer accounts; 
(3) an FCM registered under section 4f(a) of the Commodity Exchange 
Act (7 U.S.C. 6f(a)), holding the client assets in customer 
accounts, but only with respect to clients' funds and security 
futures, or other securities incidental to transactions in contracts 
for the purchase or sale of a commodity for future delivery and 
options thereon; and (4) a foreign financial institution that 
customarily holds financial assets for its customers, provided that 
the foreign financial institution keeps the advisory clients' assets 
in customer accounts segregated from its proprietary assets. See 17 
CFR 275.206(4)-2(d)(6). A qualified custodian must maintain client 
funds and securities: (1) In a separate account for each client 
under that client's name; or (2) in accounts that contain only the 
clients' funds and securities, under the investment adviser's name 
as agent or trustee for the clients. See 17 CFR 275.206(4)-2(a)(1).
    \626\ See Broker-Dealer Reports, 76 FR at 37591.
---------------------------------------------------------------------------

    The third and fourth columns of the chart would have elicited 
information about the scope of the broker-dealer/investment adviser's 
authority over the accounts held at the custodian by requiring the 
broker-dealer/investment adviser to check the appropriate ``Yes'' or 
``No'' box.\627\ Specifically, in the third column, the broker-dealer/
investment adviser would have been required to indicate whether it had 
the authority to effect transactions in the advisory client accounts at 
the custodian. In the fourth column, the broker-dealer/investment 
adviser would have been required to indicate whether it had the 
authority to withdraw funds and securities from those accounts.
---------------------------------------------------------------------------

    \627\ Id.
---------------------------------------------------------------------------

    In the fifth column, the broker-dealer/investment adviser would 
have been required to indicate whether the custodian sends account 
statements directly to the broker-dealer's investment adviser 
clients.\628\ The Commission recently adopted amendments to Rule 
206(4)-2 to require that investment advisers have a reasonable basis, 
after due inquiry, for believing that qualified custodians of advisory 
client assets send account statements to the investment advisers' 
clients. As stated in the release adopting that requirement, the 
Commission believes that the direct delivery of account statements by 
qualified custodians provides greater assurance of the integrity of 
account statements received by clients.\629\
---------------------------------------------------------------------------

    \628\ Id.
    \629\ See, e.g., Custody of Funds or Securities of Clients by 
Investment Advisers, 75 FR at 1465.
---------------------------------------------------------------------------

    In the sixth column, the broker-dealer/investment adviser would 
have been required to indicate whether investment adviser client assets 
were recorded on the broker-dealer's stock record.\630\ If the broker-
dealer was acting as custodian for such assets, the Commission 
anticipates that those assets would be recorded on the broker-dealer's 
stock record.\631\
---------------------------------------------------------------------------

    \630\ See Broker-Dealer Reports, 76 FR at 37591.
    \631\ If the broker-dealer acts as custodian for an investment 
adviser client's securities, and does not record those securities on 
its stock record, the broker-dealer would need to explain why those 
securities were not recorded on its stock record in response to the 
question in Item 3.D.ii of Form Custody.
---------------------------------------------------------------------------

    The Commission received one comment in response to Item 8 of Form 
Custody, as proposed.\632\ This commenter stated that the information 
sought in Item 8 was largely redundant with information collected from 
investment advisers on Form ADV. The Commission is aware that some 
overlap exists between the information collected from investment 
advisers on Form ADV and the information that would be collected from 
broker-dealers dually-registered as investment advisers in Item 8 of 
proposed Form Custody. However, these two forms also contain a 
significant amount of non-overlapping material, reflecting their 
different purposes and uses. Form Custody is intended to be a single 
source of readily-available information to assist Commission and DEA 
examiners in preparing for and performing focused custody exams, and it 
is particularly important that such information be readily available in 
the case of dually-registered firms. Accordingly, the Commission is 
adopting Item 8 of Form Custody substantially as proposed.\633\
---------------------------------------------------------------------------

    \632\ See Angel Letter.
    \633\ Column 2 of Item 8.C of Form Custody, as proposed, would 
have required a broker-dealer/investment adviser to identify the SEC 
File No. or CRD No. of each custodian where assets of investment 
adviser clients were held. However, not all custodians of investment 
adviser client assets have an SEC File No. or CRD No. Accordingly, 
the instructions applicable to Column 2 of Item 8.C, as adopted, 
have been modified to provide that a broker-dealer needs to identify 
custodians in the column by SEC File No. or CRD No., ``if 
applicable.'' Thus, a broker-dealer can leave Column 2 of Item 8.C 
blank if assets of its investment adviser clients are held at a 
custodian that does not have an SEC File No. or CRD No.
---------------------------------------------------------------------------

9. Item 9--Broker-Dealers Affiliated With Investment Advisers
    Item 9 of Form Custody consists of two subparts. Item 9.A, as 
proposed, would have elicited information concerning whether the 
broker-dealer was an affiliate of an investment adviser.\634\ Item 
9.B.i, as proposed, would have elicited information from a broker-
dealer that checks ``Yes'' in response to Item 9.A to identify whether 
it has custody of client assets of the adviser, and, if Item 9.B.i is 
checked ``Yes,'' to indicate the approximate U.S. dollar market value 
of the adviser client assets of which the broker-dealer has 
custody.\635\ The Commission did not receive any comments to Item 9 of 
proposed Form Custody and is adopting this Item as proposed. The 
additional information obtained from a broker-dealer in response to 
Item 9 will provide SEC and DEA examiners with a better understanding 
of a broker-dealer's custody profile and, in particular, custodial 
relationships with investment adviser affiliates.
---------------------------------------------------------------------------

    \634\ See Broker-Dealer Reports, 76 FR at 37592.
    \635\ Id.
---------------------------------------------------------------------------

    For purposes of Item 9, an affiliate is any person who directly or 
indirectly controls the broker-dealer or any person who is directly or 
indirectly controlled by or under common control with the broker-
dealer. Ownership of 25% or more of the common stock of the investment 
adviser is deemed prima facie evidence of control.\636\
---------------------------------------------------------------------------

    \636\ See supra note 603 and corresponding text which specifies 
the same ownership percentage on Form BD.
---------------------------------------------------------------------------

V. Effective Dates

    As discussed below, the Commission has established December 31, 
2013 as the effective date for the requirement to file Form Custody and 
the requirement to file annual reports with SIPC. The Commission is 
delaying the effective date for the requirements relating to broker-
dealer annual reports to June 1, 2014. These delayed effective dates 
are intended to provide time for broker-dealers, broker-dealer 
independent public accountants, and broker-dealer DEAs to prepare for 
the changes that will result from these new requirements. The 
amendments relating to broker-dealer annual reports and the other 
amendments to Rule 17a-5 (including the technical amendments) affect 
numerous paragraphs in that rule and two paragraphs in Rule 17a-11. 
Given the complexity and practical difficulty of having certain 
provisions become effective before others, the amendments to Rule 17a-5 
and the amendments to Rule 17a-11 will become effective on June 1, 
2014, regardless of whether they relate to the annual report 
requirements, except that there will be different effective dates for 
the amendments to paragraph (a) of Rule 17a-5 (which includes the 
filing requirement for Form Custody), Form Custody, the deletion of 
paragraph (e)(5) of Rule 17a-5 (which sets forth the requirement to 
file Form BD-Y2K), and the requirement to file annual reports with 
SIPC. The effective dates for the remaining paragraphs of Rule 17a-5 
and Rule 17a-11 are discussed further below.

[[Page 51957]]

A. Amendments Effective 60 Days After Publication in the Federal 
Register

    Before today's amendments, paragraph (e)(5) of Rule 17a-5 required 
a broker-dealer to file Form BD-Y2K, which elicits information with 
respect to a broker-dealer's readiness for the year 2000 and any 
potential problems that could arise with the advent of the new 
millennium. The Commission is deleting this paragraph from Rule 17a-5 
as the requirement is no longer applicable. The amendment deleting 
paragraph (e)(5) of Rule 17a-5 will be effective 60 days after this 
release is published in the Federal Register.

B. Amendments Effective on December 31, 2013

    The amendments to paragraph (a) of Rule 17a-5 and the rule 
establishing Form Custody (17 CFR 249.639) are effective on December 
31, 2013. The amendments to paragraph (a) include the requirement for a 
broker-dealer to file Form Custody with its DEA.\637\ Consequently, 
broker-dealers subject to this filing requirement must begin filing 
Form Custody with their DEAs 17 business days after the calendar 
quarter or fiscal year, as applicable, ended December 31, 2013.
---------------------------------------------------------------------------

    \637\ See paragraph (a)(5) of Rule 17a-5.
---------------------------------------------------------------------------

    Two commenters requested that the Commission provide broker-dealers 
with sufficient time to develop, test, and implement the systems that 
they will use to comply with the Form Custody filing requirements.\638\ 
The Commission understands that broker-dealers will need to allocate 
personnel and systems resources to comply with the Form Custody filing 
requirements, particularly for a broker-dealer's initial filing. DEAs 
also will need to be prepared to receive the forms that are filed by 
broker-dealers. Establishing December 31, 2013 as the effective date of 
the Form Custody requirements is designed to accommodate the efforts 
that need to be undertaken by both broker-dealers and DEAs in 
connection with the filing and receipt of Form Custody.
---------------------------------------------------------------------------

    \638\ See E&Y Letter; SIFMA Letter.
---------------------------------------------------------------------------

    Additionally, the amendment to paragraph (d)(6) of Rule 17a-5 is 
effective on December 31, 2013. Broker-dealer annual reports must be 
filed with SIPC for fiscal years ending on or after December 31, 2013.

C. Amendments Effective on June 1, 2014

    The amendments to paragraphs (b), (c), (d)(1), (d)(2), (d)(3), 
(d)(4), (d)(5), (e)(1), (e)(2), (e)(3), (e)(4), (f), (g), (h), (i), 
(k), (l), (m) and (n) and the deletion of paragraph (j) of Rule 17a-5 
and the amendments to Rule 17a-11 are effective on June 1, 2014. 
Consequently, all of the amendments to Rule 17a-5 not discussed above 
in sections V.A. and V.B. of this release and the amendments to Rule 
17a-11 are effective on that date. This includes the amendments 
relating to the annual report requirements, with the exception of the 
requirement to file annual reports with SIPC, which is effective on 
December 31, 2013. In 2014, therefore, the annual report requirements 
will apply to all broker-dealers subject to these requirements that 
have a fiscal year ending on or after June 1, 2014.
    The Commission proposed that the amendments would apply for fiscal 
years ending on or after December 15, 2011, with a first-year 
transition period for carrying broker-dealers required to file 
compliance reports with fiscal years ending on or after December 15, 
2011 but before September 15, 2012.\639\ The Commission received 14 
comments concerning the compliance date of the amendments.\640\ Most 
commenters recommended that the Commission delay the compliance date. 
One commenter, however, stated that broker-dealers should start working 
on compliance immediately.\641\ Several stated that the compliance date 
of the amendments should be aligned with the effective date of the 
proposed PCAOB standards for engagements related to compliance reports 
and exemption reports.\642\ One commenter suggested that the Commission 
postpone the assertion requirements until the rule has been in effect 
for one year.\643\ Another commenter stated that the rules should be 
effective for fiscal years ending on or before December 15, 2012 ``to 
allow sufficient time to complete robust documentation and testing of 
the processes related to the Financial Responsibility Rules and the 
Financial Statements.'' \644\ Similarly, another commenter stated that 
the effective date should be deferred to fiscal years ending on or 
before December 15, 2012 ``to give broker-dealers and their auditors 
time to adequately address the final rules,'' and that the effective 
date should be aligned with the effective date of PCAOB standards.\645\ 
Another commenter stated that the rule amendments should apply only to 
annual reports filed on or after December 15, 2012, and that 
implementation of the proposal must be postponed until after the PCAOB 
establishes auditing and attestation standards and broker-dealers have 
had ample time to plan and budget for the new standards.\646\ Finally, 
a commenter stated that broker-dealers should be required to file the 
first compliance report or exemption report no earlier than one quarter 
after the adoption of the final rule amendments and to report 
identified instances of material non-compliance or material weaknesses 
in annual reports filed no earlier than five quarters after the 
adoption of the final rule amendments, with a transition period as 
proposed of no less than five quarters after the adoption of the final 
rule amendments.\647\ This commenter also suggested that the Commission 
require the filing of the first Form Custody no earlier than three 
quarters after the effective date of the final rule.\648\
---------------------------------------------------------------------------

    \639\ See Broker-Dealer Reports, 76 FR at 37581. During the 
transition period, the statement in the compliance report as to 
whether internal control was effective would have been a point-in-
time statement as of the date of the report, rather than covering 
the entire fiscal year.
    \640\ See, e.g., ABA Letter; AICPA Letter; CAQ Letter; Citrin 
Letter; Deloitte Letter; E&Y Letter; Grant Thornton Letter; KPMG 
Letter; McGladrey Letter; PWC Letter; SIFMA Letter; Shatto Letter; 
CAI Letter; Van Kampen/Invesco Letter.
    \641\ See Shatto Letter.
    \642\ See, e.g., CAQ Letter; Deloitte Letter; Grant Thornton 
Letter; KPMG Letter; McGladrey Letter.
    \643\ See ABA Letter.
    \644\ See Van Kampen/Invesco Letter.
    \645\ See E&Y Letter.
    \646\ See CAI Letter.
    \647\ See SIFMA Letter.
    \648\ Id.
---------------------------------------------------------------------------

    The amendments, among other things, establish important new 
safeguards with respect to broker-dealer custody of customer funds and 
securities. However, the Commission recognizes that broker-dealers and 
other affected parties may need additional time to prepare to comply 
with the new requirements.
    Amendments to provisions regarding broker-dealer annual reports and 
the engagement of an independent public accountant in paragraphs 
(d)(1), (d)(2), (d)(3), (d)(4), (d)(5), (e)(1), (e)(2), (e)(3), (e)(4), 
(g), and (i) of Rule 17a-5 and the deletion of paragraph (j) of Rule 
17a-5 generally will apply for broker-dealers with fiscal years ending 
on or after June 1, 2014. In particular, broker-dealers must file 
compliance reports or exemption reports, as applicable, and broker-
dealers must file reports of independent public accountants covering 
compliance reports or exemption reports in accordance with Rule 17a-5 
as amended, for fiscal years ending on or after June 1, 2014, with no 
transition period. Similarly, PCAOB standards, rather than GAAS, apply 
to examinations of financial reports for fiscal years ending on or 
after June 1, 2014. For broker-dealers with fiscal years that end 
before June 1, 2014,

[[Page 51958]]

applicable reports must be filed in accordance with the provisions of 
Rule 17a-5 as they existed before today's amendments.
    Amendments to the customer statement provisions of paragraph (c) of 
Rule 17a-5 apply for fiscal years ending on or after June 1, 2014, and 
in the interim broker-dealers must comply with those provisions as they 
existed before today's amendments.
    Paragraph (f)(2) of Rule 17a-5 requires a broker-dealer to file a 
statement regarding its independent public accountant on December 10 of 
each year. As a result of today's amendments, all broker-dealers that 
are required by Rule 17a-5 to engage an independent public accountant 
must file a new statement by December 10, 2013 that contains the 
information and representations required under paragraph (f)(2) of Rule 
17a-5 as amended. For example, after today's amendments, the statement 
must include a representation that the accountant has undertaken the 
engagement of the accountant provisions of paragraph (g) of Rule 17a-5 
as amended. The statement also must include, if applicable, 
representations regarding access to the broker-dealer's independent 
public accountant and the audit documentation of the independent public 
accountant.
    The amendments to the notification provisions in paragraph (h) of 
Rule 17a-5 and amendments to Rule 17a-11 are effective on June 1, 2014. 
In the interim, these provisions as they existed before today's 
amendments continue to apply.
    Finally, the amendments to paragraphs (b), (c), (d)(1), (d)(2), 
(d)(3), (d)(4), (d)(5), (e)(1), (e)(2), (e)(3), (e)(4), (f), (g), (h), 
(i), (k), (l), (m), and (n) of Rule 17a-5 and the amendments to Rule 
17a-11 not discussed above, including technical amendments, are 
effective on June 1, 2014.
    With respect to the annual report requirements, the June 1, 2014 
effective date should provide sufficient time for the PCAOB to 
finalize, and for the Commission to consider, proposed standards 
applicable to broker-dealer examinations and reviews and for broker-
dealers and their accountants to become familiar with, and be prepared 
to comply with, those standards. The Commission has chosen a specific 
effective date, instead of aligning that date with the date of adoption 
of the rule amendments or the date that the Commission approves PCAOB 
standards applicable to broker-dealer examinations and reviews, as 
suggested by commenters, to provide certainty regarding the date by 
which broker-dealers and their accountants must comply with the new 
requirements. Certain commenters referenced AICPA guidance with respect 
to broker-dealer audits. However, this guidance will no longer be 
applicable for fiscal years ending on or after June 1, 2014, when 
standards of the PCAOB begin to apply.
    One commenter suggested that the effective date for non-carrying 
and smaller broker-dealers to comply with amendments to the annual 
reporting requirements should be one year after the adoption of the 
amendments.\649\ The Commission notes that most smaller broker-dealers 
are non-carrying firms and, therefore, will be required to file the 
exemption report and a report of the independent public accountant 
based on a review of the exemption report. As discussed in sections VI. 
and VII. of this release, the hour burdens and costs of the exemption 
report requirements will be substantially less than the hour burdens 
and costs of the compliance report requirements. Consequently, the 
Commission does not believe the effective date should be extended 
further for smaller broker-dealers.
---------------------------------------------------------------------------

    \649\ See Citrin Letter.
---------------------------------------------------------------------------

    As stated above, another commenter suggested that the Commission 
postpone the assertion requirements until the rule has been in effect 
for one year.\650\ The Commission recognizes that all broker-dealers 
subject to these requirements and their independent public accountants 
will need time to prepare to comply with the requirements. The 
effective date the Commission is establishing should provide sufficient 
time for small or non-carrying firms, as well as larger carrying firms, 
to prepare for compliance with the new requirements.
---------------------------------------------------------------------------

    \650\ See ABA Letter.
---------------------------------------------------------------------------

VI. Paperwork Reduction Act

    Certain provisions of the final rule amendments contain 
``collection of information'' requirements within the meaning of the 
Paperwork Reduction Act of 1995 (``PRA'').\651\ The Commission 
solicited comment on the estimated burden associated with the 
collection of information requirements in the proposed amendments.\652\ 
The Commission submitted the proposed collection of information 
requirements to the Office of Management and Budget (``OMB'') for 
review in accordance with 44 U.S.C. 3507 and 5 CFR 1320.11.
---------------------------------------------------------------------------

    \651\ 44 U.S.C. 3501 et seq.
    \652\ See Broker-Dealer Reports, 76 FR at 37594-37598.
---------------------------------------------------------------------------

    The titles and OMB control numbers for the collections of 
information are:
    (1) Rule 17a-5, Reports to be made by certain brokers and dealers 
(OMB Control Number 3235-0123);
    (2) Rule 17a-11, Notification provisions for brokers and dealers 
(OMB Control Number 3235-0085); and
    (3) Form Custody (OMB Control Number 3235-0691).
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information requirement unless it 
displays a currently valid OMB control number. As discussed above, the 
Commission received 27 comment letters on the proposed rulemaking. Some 
of these comments relate directly or indirectly to the PRA. These 
comments are addressed below. Finally, some initial burden estimates 
have been adjusted, as discussed below, to reflect updated information 
used to make the estimates.

A. Summary of the Collection of Information Requirements

    As discussed in greater detail above in sections II., III., and IV. 
of this release, the Commission is adopting amendments to Rules 17a-5 
and 17a-11 and is adopting new Form Custody for broker-dealers to file 
with their DEA.
    Under the amendments to Rule 17a-5, broker-dealers must, among 
other things, file with the Commission annual reports consisting of a 
financial report and one of two new reports--either a compliance report 
or an exemption report that are prepared by the broker-dealer, and 
generally must also file reports prepared by an independent public 
accountant registered with the PCAOB covering those reports in 
accordance with PCAOB standards.\653\ The financial report must contain 
the same types of financial statements that were required to be filed 
under Rule 17a-5 prior to these amendments (a statement of financial 
condition, a statement of income, a statement of cash flows, and 
certain other financial statements).\654\ In addition, the financial 
report must contain, as applicable, the supporting schedules that were 
required to be filed under Rule 17a-5 prior to these amendments (a 
computation of net capital under Rule 15c3-1, a computation of the 
reserve requirements under Rule 15c3-3, and information relating to the 
possession or control requirements under Rule 15c3-3).
---------------------------------------------------------------------------

    \653\ See discussion above in sections II.B.1., II.B.2., 
II.B.3., and II.B.4. of this release.
    \654\ See discussion above in section II.B.2. of this release.
---------------------------------------------------------------------------

    A broker-dealer that does not claim an exemption from Rule 15c3-3 
through the most recent fiscal year--generally a carrying broker-
dealer--must file the compliance report, and a broker-dealer that 
claimed an exemption from Rule 15c3-3 throughout the most recent

[[Page 51959]]

fiscal year must file the exemption report. In the compliance report 
and exemption report, a broker-dealer must make certain statements and 
provide certain information relating to the financial responsibility 
rules.
    In addition to preparing and filing the financial report and the 
compliance report or exemption report, a broker-dealer must engage a 
PCAOB-registered independent public accountant to prepare a report 
based on an examination of the broker-dealer's financial report in 
accordance with PCAOB standards.\655\ A broker-dealer that files a 
compliance report also must engage the PCAOB-registered independent 
public accountant to prepare a report based on an examination of 
certain statements in the compliance report.\656\ A broker-dealer that 
files an exemption report must engage the PCAOB-registered independent 
public accountant to prepare a report based on a review of certain 
statements in the broker-dealer's exemption report. In each case, the 
examination or review must be conducted in accordance with PCAOB 
standards. A broker-dealer must file these reports of the independent 
public accountant with the Commission along with the financial report 
and the compliance report or exemption report prepared by the broker-
dealer.
---------------------------------------------------------------------------

    \655\ See discussion above in section II.D.3. of this release.
    \656\ See paragraphs (f)(1) and (g)(2)(i) of Rule 17a-5.
---------------------------------------------------------------------------

    The amendments add a requirement that the annual reports also be 
filed with SIPC if the broker-dealer is a member of SIPC.\657\ In 
addition, broker-dealers must generally file with SIPC a supplemental 
report on the status of the membership of the broker-dealer in 
SIPC.\658\ The supplemental report must include a report of the 
independent public accountant based on certain procedures specified in 
the rule in accordance with PCAOB standards. In the future, SIPC may 
determine the format of this report by rule, subject to Commission 
approval.
---------------------------------------------------------------------------

    \657\ See discussion above in section II.B.6. of this release.
    \658\ See discussion above in section II.C.4. of this release.
---------------------------------------------------------------------------

    Under the amendments, the PCAOB-registered independent public 
accountant must immediately notify the broker-dealer if the accountant 
determines during the course of preparing the accountant's reports that 
the broker-dealer was not in compliance at any time during the fiscal 
year with the financial responsibility rules or if the accountant 
determines that any material weakness existed in the broker-dealer's 
Internal Control Over Compliance during the fiscal year.\659\ The 
broker-dealer, in turn, must file a notification with the Commission 
and its DEA under Rule 15c3-1, Rule 15c3-3, or Rule 17a-11 if the 
accountant's notice concerns an instance of non-compliance that would 
trigger notification under those rules. Under amendments to Rule 17a-
11, a broker-dealer also must file a notification with the Commission 
and its DEA if the accountant's notice concerns (or if the broker-
dealer discovers) a material weakness in the broker-dealer's Internal 
Control Over Compliance.
---------------------------------------------------------------------------

    \659\ See discussion above in section II.F. of this release.
---------------------------------------------------------------------------

    The amendments also require a broker-dealer that clears 
transactions or carries customer accounts to agree to allow 
representatives of the Commission or the broker-dealer's DEA to review 
the documentation associated with the reports of the broker-dealer's 
independent public accountant and to allow the accountant to discuss 
its findings with the representatives, if requested in writing for 
purposes of an examination of the broker-dealer.\660\
---------------------------------------------------------------------------

    \660\ See discussion above in section III. of this release.
---------------------------------------------------------------------------

    Finally, the amendments require broker-dealers to file a new Form 
Custody, which elicits information concerning the custody practices of 
the broker-dealer.\661\ Form Custody must be filed with the DEA each 
quarter. The DEA must transmit the information obtained from Form 
Custody to the Commission at the same time that it transmits FOCUS 
Report data to the Commission under paragraph (a)(4) of Rule 17a-5.
---------------------------------------------------------------------------

    \661\ See discussion above in section IV. of this release.
---------------------------------------------------------------------------

    The burdens associated with the collection of information 
requirements in the amendments are discussed below.

B. Use of Information

    The proposed amendments relating to the reports to be filed by the 
broker-dealer are designed to enhance the ability of the Commission to 
oversee broker-dealer custody practices and, among other things, to: 
(1) Increase the focus of carrying broker-dealers and their independent 
public accountants on compliance, and internal control over compliance, 
with the financial responsibility rules; (2) facilitate the ability of 
the PCAOB to implement the explicit oversight authority of broker-
dealer audits provided to the PCAOB by the Dodd-Frank Act; and (3) with 
respect to broker-dealers that are dually-registered as investment 
advisers, satisfy the internal control report requirement that was 
added by the amendment to Rule 206(4)-2 noted above with the 
accountant's report based on an examination of the compliance report. 
Securities regulators will use these reports to monitor the financial 
condition of broker-dealers. In addition, the components of the reports 
that are made public may be used by investors to review the financial 
condition of broker-dealers with which they have accounts or obtain 
other securities related services. SIPC can use the annual reports to 
monitor the financial strength of broker-dealers and to assess the 
adequacy of the SIPC Fund.
    The amendment requiring a broker-dealer that clears transactions or 
carries customer accounts to allow Commission and DEA examination staff 
to review the audit documentation associated with its annual audit 
reports required under Rule 17a-5 and to allow its independent public 
accountant to discuss findings relating to the audit reports with 
Commission and DEA examination staff is intended to facilitate 
examinations of clearing broker-dealers by Commission and DEA 
examination staff. Commission and DEA examiners will use the 
information obtained from audit documentation and discussions with the 
broker-dealer's independent public accountant to plan their 
examinations.
    Finally, Commission and DEA examiners will use Form Custody to 
understand a broker-dealer's custody profile and identify custody-
related violations and misconduct. For example, if a broker-dealer 
represents on Form Custody that it does not issue account statements, 
but an examiner discovers that an account statement has been issued by 
the broker-dealer (e.g., in connection with a customer complaint or in 
the course of an examination of the broker-dealer), the examiner will 
be able to react more quickly to the misrepresentation. Further, the 
requirement to prepare and file the form should motivate broker-dealers 
to focus more attention on their custody practices.

C. Respondents

    The Commission estimated in the proposal that there were 5,063 
registered broker-dealers that would be affected by the proposed 
amendments and that, of these, 305 were carrying broker-dealers, 528 
were carrying or clearing broker-dealers, and 4,752 were broker-dealers 
that claimed exemptions from Rule 15c3-3.\662\ The Commission did not 
receive comments regarding these estimates, but the Commission has

[[Page 51960]]

updated the estimates to reflect more recent information.\663\
---------------------------------------------------------------------------

    \662\ See Broker-Dealer Reports, 76 FR at 37595.
    \663\ The updated estimates are based on FOCUS Report data as of 
year end 2011. As discussed above, FOCUS Reports are deemed 
confidential pursuant to paragraph (a)(3) of Rule 17a-5.
---------------------------------------------------------------------------

    As of December 31, 2011, 4,709 broker-dealers filed FOCUS Reports 
with the Commission. Of these, 4,417 broker-dealers claimed exemptions 
from Rule 15c3-3. Consequently, the Commission estimates that there are 
approximately 292 carrying broker-dealers (4,709 - 4,417 = 292). Based 
on FOCUS Report data, the Commission further estimates that there are 
approximately 513 carrying or clearing broker-dealers. According to 
SIPC, as of March 31, 2012, 217 broker-dealers claimed exemptions from 
SIPC membership. Therefore, the Commission estimates that 4,492 (4,709 
- 217 = 4,492) broker-dealers are members of SIPC.

D. Total Initial and Annual Burdens

    As discussed in detail below, the Commission estimates that the 
total PRA burden resulting from the amendments to Rules 17a-5 and 17a-
11 and new Form Custody include an initial, one-time burden of 
approximately 13,522 hours \664\ and an annual burden of approximately 
276,717 hours.\665\ There is significant variance between the largest 
broker-dealers and the smallest broker-dealers. Consequently, the 
estimates described below are averages across all types of broker-
dealers expected to be affected by the amendments.
---------------------------------------------------------------------------

    \664\ As discussed below, the total one-time burden relates to 
the requirement to draft and file a revised statement regarding the 
independent public accountant under Rule 17a-5(f)(2). The Commission 
estimated a total one-time burden of 10,214 hours in the proposing 
release for the statement regarding the independent public 
accountant and for SIPC forms. See Broker-Dealer Reports, 76 FR at 
37595.
    \665\ As discussed below, the total annual hour burden relates 
to the compliance report (17,520 hours), the exemption report 
(30,919 hours), the filing of annual reports with SIPC (2,246 
hours), and Form Custody (226,032 hours). The Commission estimated a 
total annual burden of 287,325 hours in the proposing release. See 
Broker-Dealer Reports, 76 at FR 37595.
---------------------------------------------------------------------------

1. Annual Reports To Be Filed
i. The Financial Report
    The Commission's amendments to Rule 17a-5 retain the current 
requirement that broker-dealers annually file financial statements and 
supporting schedules that must be audited by a PCAOB-registered 
accountant. As a result, the Commission's estimate of the hour burden 
for broker-dealers to prepare and file the financial report has not 
changed as a result of the amendments to Rule 17a-5.
ii. The Compliance Report
    Under the amendments, a carrying broker-dealer must prepare and 
file with the Commission a new compliance report each year. The 
compliance report must contain statements as to whether: (1) The 
broker-dealer has established and maintained Internal Control Over 
Compliance; (2) the Internal Control Over Compliance of the broker-
dealer was effective during the most recent fiscal year; (3) the 
Internal Control Over Compliance of the broker-dealer was effective as 
of the end of the most recent fiscal year; (4) the broker-dealer was in 
compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 as of the 
end of the most recent fiscal year; and (5) the information the broker-
dealer used to state whether it was in compliance with Rule 15c3-1 and 
paragraph (e) of Rule 15c3-3 was derived from the books and records of 
the broker-dealer. In addition, if applicable, the compliance report 
must contain a description of: (1) Each identified material weakness in 
the broker-dealer's Internal Control Over Compliance during the most 
recent fiscal year, including those that were identified as of the end 
of the fiscal year; and (2) any instance of non-compliance with Rule 
15c3-1 or paragraph (e) of Rule 15c3-3 as of the end of the most recent 
fiscal year.
    The Commission estimated that, on average, carrying broker-dealers 
would spend approximately 60 hours each year to prepare the compliance 
report, as proposed.\666\
---------------------------------------------------------------------------

    \666\ See Broker-Dealer Reports, 76 FR at 37596.
---------------------------------------------------------------------------

    One commenter stated that the proposal did not ``address the 
additional costs broker-dealers would incur in preparing Compliance 
Reports.''\667\ The commenter, however, did not comment directly on the 
estimated hour burden or provide specific examples of costs, in 
addition to the hour burdens, that broker-dealers would bear.\668\ 
Another commenter also stated that the proposed estimate of 60 hours 
``is not an accurate estimate of the time burden to complete the 
Compliance Report'' and that the burdens in the proposing release are 
understated.\669\ The commenter stated that completing the compliance 
report will require extensive collaboration between management, 
internal audit and the independent public accountants resulting in 
added hours to perform the validation and evidence gathering of the 
existing processes necessary to make the assertions in the proposed 
compliance report.\670\ The commenter, however, did not provide a 
different estimate of the number of hours it would take to complete the 
compliance report.
---------------------------------------------------------------------------

    \667\ See SIFMA Letter.
    \668\ Id.
    \669\ See Van Kampen/Invesco Letter.
    \670\ Id.
---------------------------------------------------------------------------

    In response to these comments, the Commission notes that the final 
rule modifies the proposal in ways that may modestly reduce the time 
burden. For example, the final rule requires a statement as to whether 
the broker-dealer was in compliance with Rule 15c3-1 and paragraph (e) 
of Rule 15c3-3 as of the end of the most recent fiscal year and, if 
applicable, a description of any instances of non-compliance with these 
rules as of the fiscal year end, rather than the proposed assertion 
that the broker-dealer is in compliance with the financial 
responsibility rules in all material respects and proposed description 
of any material non-compliance with the financial responsibility rules. 
This reflects two changes from the proposal: (1) Elimination of the 
concepts of ``material non-compliance'' and ``compliance in all 
material respects'' with Rule 15c3-1 and 15c3-3 for the purposes of 
reporting in the compliance report; and (2) a narrowing of these 
statements and description requirements from compliance with all of the 
financial responsibility rules to compliance with Rule 15c3-1 and 
paragraph (e) of Rule 15c3-3.
    As modified, the final rule no longer requires the broker-dealer to 
evaluate whether an instance of non-compliance with the financial 
responsibility rules was material, a component of the proposal that 
generated significant comment. In addition, the broker-dealer only 
needs to report instances of non-compliance with Rule 15c3-1 and 
paragraph (e) of Rule 15c3-3. In this regard, broker-dealers currently 
are required to include supporting schedules to their financial 
statements containing a computation of net capital and the reserve 
requirement under paragraph (e) of Rule 15c3-3. Consequently, the work 
required under this pre-existing requirement should provide the broker-
dealer with the information it needs to make the statement as to 
whether it is in compliance with Rule 15c3-1 and paragraph (e) of Rule 
15c3-3 as of the fiscal year end.
    Given these modifications, the statements in the compliance report 
concerning the broker-dealer's Internal Control Over Compliance likely 
will be responsible for the bulk of the hour burden associated with 
preparing the

[[Page 51961]]

compliance report. For example, the broker-dealer will need to evaluate 
whether its Internal Control Over Compliance with the financial 
responsibility rules was effective during the most recent fiscal year.
    The Commission believes that the modifications to the final rule 
discussed above may modestly reduce the hour burden of the final rule 
as compared to the hour burden that would have resulted from the 
proposed rule; namely, because a broker-dealer will not need to 
evaluate whether instances of non-compliance with the financial 
responsibility rules are material and will only need to report 
instances of non-compliance with Rule 15c3-1 and paragraph (e) of Rule 
15c3-3. In light of the comments suggesting that the proposing release 
underestimated the burden, the Commission is not reducing the hour 
burden estimate for the rule to reflect the potential reduction in hour 
burden associated with the requirement. Thus, to the extent the 
proposing release underestimated the burden associated with making the 
statements in the compliance report about the broker-dealer's Internal 
Control Over Compliance, the amount of the burden reduction realized 
through the modifications discussed above is now attributed to the 
burden associated with the statements about Internal Control Over 
Compliance.
    For these reasons, the Commission is retaining the rule's overall 
hour burden estimate without revision. The Commission, however, is 
updating the number of carrying broker-dealers to reflect more recently 
available data from the broker-dealer FOCUS Reports. The Commission now 
estimates that there are 292 carrying broker-dealers. Consequently, the 
Commission estimates that the total annual reporting burden to prepare 
and file the compliance report is approximately 17,520 hours per year 
for all carrying broker-dealers.\671\
---------------------------------------------------------------------------

    \671\ 60 hours x 292 carrying broker-dealers = 17,520 hours. See 
the discussion below regarding the external costs associated with 
obtaining the accountant's report on the compliance report.
---------------------------------------------------------------------------

iii. The Exemption Report
    Under the amendments, a non-carrying broker-dealer must file the 
exemption report.\672\ In the exemption report, the broker-dealer must 
provide to its best knowledge and belief: (1) A statement that 
identifies the provisions in paragraph (k) of Rule 15c3-3 under which 
the broker-dealer claimed an exemption from Rule 15c3-3; (2) a 
statement that the broker-dealer met the identified exemption 
provisions in paragraph (k) throughout the most recent fiscal year 
without exception or that it met the identified exemption provisions in 
paragraph (k) throughout the most recent fiscal year except as 
described in the exemption report; and (3) if applicable, a statement 
that identifies each exception during the most recent fiscal year in 
meeting the identified provisions in paragraph (k) and that briefly 
describes the nature of each exception and the approximate date(s) on 
which the exception existed.
---------------------------------------------------------------------------

    \672\ See discussion above in sections II.B.1. and II.B.4. of 
this release.
---------------------------------------------------------------------------

    The Commission estimated that it would take a non-carrying broker-
dealer approximately five hours to prepare and file the proposed 
exemption report.\673\ The Commission did not receive any comments on 
this hour estimate. As discussed above in section II.B.4. of this 
release, the Commission is adopting, with modifications, the 
requirements regarding the exemption report. These provisions generally 
clarified the scope and application of the report. However, one 
modification provides that if the broker-dealer states that it met the 
identified exemption provisions in paragraph (k) of Rule 15c3-3 
throughout the most recent fiscal year except as described in the 
report, the broker-dealer must identify each exception during the most 
recent fiscal year in meeting the identified provisions in paragraph 
(k) of Rule 15c3-3 and that briefly describes the nature of each 
exception and the approximate date(s) on which the exception existed. 
The Commission expects that non-carrying broker-dealers generally track 
exceptions as part of monitoring compliance with the exemption 
provisions in paragraph (k) of Rule 15c3-3. The requirement to identify 
and describe exceptions would create an incremental burden over the 
rule as proposed. Based on staff experience with the application of 
Rule 17a-5, the Commission estimates that the additional work 
associated with describing exceptions in the exemption report would 
take two hours. Therefore, the Commission is revising the hour estimate 
associated with the exemption report to seven hours.
---------------------------------------------------------------------------

    \673\ See Broker-Dealer Reports, 76 FR at 37596.
---------------------------------------------------------------------------

    The Commission now estimates that there are approximately 4,417 
non-carrying broker-dealers that must file exemption reports. 
Therefore, the Commission estimates that the annual reporting burden 
for all non-carrying broker-dealers to prepare and file the exemption 
report is approximately 30,919 hours per year.\674\
---------------------------------------------------------------------------

    \674\ 7 hours x 4,417 non-carrying broker-dealers = 30,919 
hours. See the discussion below regarding the external costs 
associated with obtaining the accountant's report on the exemption 
report.
---------------------------------------------------------------------------

iv. Additional Burden and Cost To File the Annual Reports
    The filing requirements for the annual reports are being 
amended.\675\ In particular, Rule 17a-5 previously provided that a 
broker-dealer must file two copies of its annual reports with the 
Commission's principal office in Washington, DC. The final rule no 
longer requires that two copies be filed, so that, in accordance with 
paragraph (d)(6) of Rule 17a-5, broker-dealers must file only one copy 
of the annual reports with the Commission's principal office. This 
change could reduce slightly the hour burden and cost associated with 
filing the annual reports with the Commission.\676\
---------------------------------------------------------------------------

    \675\ See discussion above in section II.B.6. of this release.
    \676\ The Commission does not expect the compliance report, 
exemption report, and related reports of the independent public 
accountant to increase the mailing costs of the annual reports 
because these additional reports in the aggregate should not 
significantly increase the size and weight of the package of annual 
reports.
---------------------------------------------------------------------------

    Amendments to paragraph (d)(6) of Rule 17a-5 require that a broker-
dealer also file a copy of its annual reports with SIPC. The Commission 
estimated that it would take 30 minutes to prepare an additional copy 
of the annual reports and mail it to SIPC as required by the proposed 
amendments.\677\ The Commission did not receive comments regarding this 
estimate. In addition, the clarification to the final rule that only 
broker-dealers that are members of SIPC must file a copy of their 
annual reports with SIPC will not affect the final PRA hour burden 
estimate. Therefore, the Commission is retaining this estimate without 
revision. The Commission now estimates that 4,492 broker-dealers are 
members of SIPC.\678\ Therefore, the Commission estimates that the 
annual industry-wide reporting burden associated with this amendment is 
approximately 2,246 hours per year.\679\
---------------------------------------------------------------------------

    \677\ See Broker-Dealer Reports, 76 FR at 37596.
    \678\ As discussed in subsection C. above, according to SIPC, as 
of March 31, 2012, 217 broker-dealers claimed exemptions from SIPC 
membership. The Commission therefore estimates that 4,492 (4,709-217 
= 4,492) broker-dealers are members of SIPC.
    \679\ \1/2\ hour x 4,492 broker-dealers = 2,246 hours.
---------------------------------------------------------------------------

    There would be postage costs associated with sending a copy of the 
annual reports to SIPC that are estimated to be, on average,\680\ 
approximately $12.05 per broker-dealer

[[Page 51962]]

per year.\681\ Thus, the Commission estimates that the total annual 
postage costs associated with sending a copy of the annual reports to 
SIPC would be approximately $54,128 per year for all broker-dealers 
that are SIPC members.\682\
---------------------------------------------------------------------------

    \680\ The number of pages of an annual report, and consequently 
the associated postage costs, likely will vary significantly based 
on the size of the broker-dealer and the types of business in which 
it engages.
    \681\ Based on Commission staff experience with annual report 
filings of broker-dealers under Rule 17a-5, the Commission staff 
estimates that approximately 50% of broker-dealers file their annual 
reports using an overnight mail delivery service. These broker-
dealers would consequently incur higher postage costs than broker-
dealers which choose to mail their annual reports using first class 
mail or delivery methods other than overnight mail. Therefore, 
postage costs will vary depending on the size of the annual report 
and method of delivery. The Commission estimates that the cost to 
mail the additional reports would be, on average, $12.05 per broker-
dealer. As of October 2012, the $12.05 rate is an average rate of 
the cost of an Express Mail Flat Rate Envelope of $18.95 and a 
Priority Mail Flat Rate Envelope of $5.15, based on costs obtained 
on the Web site of the U.S. Postal Service at: www.usps.gov. ($18.95 
+ $5.15) = $24.10/2 = $12.05.
    \682\ 4,492 broker-dealers x $12.05 = $54,128.
---------------------------------------------------------------------------

    Finally, the Commission notes that paragraph (d)(1)(ii) of Rule 
17a-5 of the final rule was amended to require that a copy of a DEA's 
written approval to change a broker-dealer's fiscal year end must be 
sent to the Commission's principal office in Washington DC, in addition 
to the regional office of the Commission for the region in which the 
broker-dealer has its principal place of business. Based on the number 
of copies of approvals received by the Commission and staff experience 
in the application of Rule 17a-5, the Commission estimates that 
approximately 75 broker-dealers will receive approval each year to 
change their fiscal year end. The Commission estimates that it would 
take 10 minutes to copy and send an additional copy of the approval to 
the Commission's principal office in Washington, DC for a total 
industry-wide annual hour burden of approximately 12.5 hours,\683\ and 
a total industry-wide cost of approximately $33.75 per year to mail the 
approval.\684\
---------------------------------------------------------------------------

    \683\ (75 approvals x 10 minutes)/60 = 12.5 hours.
    \684\ 75 approvals x $0.45 (current price of a letter sent first 
class) = $33.75.
---------------------------------------------------------------------------

v. Supplemental Report on SIPC Membership
    Prior to today's amendments, paragraph (e)(4) of Rule 17a-5 
provided that a broker-dealer must file with its annual report a 
supplemental report on the status of the membership of the broker-
dealer in SIPC, which was required to be ``covered by an opinion of the 
independent public accountant'' if the annual report of the broker-
dealer was required to be audited. The Commission is adopting 
amendments to paragraph (e)(4) of Rule 17a-5 to provide that broker-
dealers must file with SIPC--but no longer with the Commission after an 
interim period if SIPC adopts a rule under paragraph (e)(4)(i) that is 
approved by the Commission--a report of an independent public 
accountant designed to help administer the collection of assessments 
from broker-dealers for purposes of establishing and maintaining SIPC's 
broker-dealer liquidation fund.\685\ The Commission is adopting the 
proposed amendments to paragraph (e)(4) of Rule 17a-5 substantially as 
proposed. One modification is that, as adopted, the final rule provides 
that the accountant must perform the procedures specified in the rule 
in accordance with PCAOB standards. SIPC may determine the format of 
this report by rule, subject to Commission approval.
---------------------------------------------------------------------------

    \685\ See discussion above in section II.C.4. of this release.
---------------------------------------------------------------------------

    Because broker-dealers are currently required to file these reports 
with both the Commission and SIPC, the final rule amendment does not 
result in any change to the Commission's current estimate of the hour 
burden for broker-dealers to comply with this requirement under the 
current PRA collection for Rule 17a-5. Although broker-dealers will 
file the supplemental report on SIPC membership only with SIPC if a 
SIPC rule change to implement this amendment is approved by the 
Commission, as noted in the current PRA collection, the variation in 
the size and complexity of broker-dealers subject to Rule 17a-5 makes 
it difficult to calculate the burden of the information collection of 
Rule 17a-5. Therefore, the Commission will determine whether it is 
appropriate to revise the PRA estimate for Rule 17a-5 after any SIPC 
rule filing is approved or after the end of the two-year sunset 
provision.
    In the proposing release the Commission estimated, however, that 
SIPC would incur a one-time burden associated with filing a rule change 
with the Commission to implement this proposed amendment of 
approximately 100 hours.\686\ The process and requirements for SIPC to 
file rule changes with the Commission, however, is set out in 
SIPA.\687\ Any burden on SIPC to file a rule change with the Commission 
would be associated with the requirements under SIPA. Therefore, the 
Commission is deleting the proposed one-time 100 hours from the final 
rule amendments.
---------------------------------------------------------------------------

    \686\ See Broker-Dealer Reports, 76 FR at 37597.
    \687\ 15 U.S.C. 78ccc(e)(2). The statute generally requires that 
the Board of Directors of SIPC file with the Commission a copy of 
any proposed rule change accompanied by a concise general statement 
of the basis and purpose of such proposed rule change. In addition, 
the statute states that ``the Commission shall, upon the filing of 
any proposed rule change, publish notice thereof, together with the 
terms of substance of such proposed rule change or a description of 
the subjects and issues involved'' and that the ``Commission shall 
give interested persons an opportunity to submit written data, 
views, and arguments with respect to such proposed rule change.'' 15 
U.S.C. 78ccc(e)(2)(A).
---------------------------------------------------------------------------

vi. Statement Regarding Independent Public Accountant
    The Commission is amending paragraph (f)(2) of Rule 17a-5 to revise 
the statement regarding identification of a broker-dealer's independent 
public accountant that broker-dealers must file each year with the 
Commission and their DEA (except that if the engagement is of a 
continuing nature, no further filing is required).\688\ The revised 
statement contains additional information that includes a 
representation that the independent public accountant has undertaken to 
provide a report regarding the broker-dealer's financial reports and a 
report regarding the broker-dealer's compliance report or exemption 
report, as applicable.\689\ In addition, the statement provided by a 
clearing or carrying broker-dealer must include representations 
regarding the access to its accountant requirements described 
above.\690\ Therefore, all broker-dealers will generally be required to 
file a new statement regarding their independent public accountant. The 
Commission estimated that the one-time hour burden associated with 
amending its existing statement and filing the new statement with the 
Commission, in order to comply with the proposed amendments, would be 
an average of approximately two hours on a one-time basis for each 
broker-dealer, as the statement can be continuing in nature.\691\
---------------------------------------------------------------------------

    \688\ See discussion above in section III. of this release.
    \689\ See Rule 17a-5(f)(2)(ii). 17 CFR 240.17a-5(f)(2)(ii).
    \690\ See Rule 17a-5(f)(2)(ii)(F) and (G).
    \691\ See Broker-Dealer Reports, 76 FR at 37596.
---------------------------------------------------------------------------

    The Commission is revising this estimate for clearing and carrying 
broker-dealers, as these broker-dealers will likely need to renegotiate 
their agreements with their independent public accountants. The 
Commission estimates, based on staff experience, that it will take a 
carrying or clearing broker-dealer approximately ten hours on a one-
time basis to renegotiate its agreement with its accountant, amend its 
statement regarding its accountant, and file the new statement with the 
Commission. The Commission estimates that the one-time burden for all 
carrying

[[Page 51963]]

or clearing broker-dealers is approximately 5,130 hours \692\ and the 
one-time burden for all broker-dealers that neither carry customer 
accounts nor clear transactions is approximately 8,392 hours,\693\ for 
a total industry-wide reporting burden of approximately 13,522 hours on 
a one-time basis.
---------------------------------------------------------------------------

    \692\ 10 hours x 513 carrying or clearing broker-dealers = 5,130 
hours.
    \693\ 2 hours x 4,196 non-carrying and non-clearing broker-
dealers = 8,392 hours.
---------------------------------------------------------------------------

    Finally, the Commission believes there will be postage costs 
associated with sending the amended statement regarding the accountant, 
which must be sent to the Commission's principal office in Washington, 
DC, the regional office of the Commission for the region in which the 
broker-dealer's principal place of business is located, and to its DEA. 
The Commission estimates that each mailing will cost approximately 
$0.45, for a total cost of approximately $6,357 for all broker-dealers 
on a one-time basis.\694\
---------------------------------------------------------------------------

    \694\ 4,709 broker-dealers x $0.45 cost for first class postage 
x 3 mailings = $6,357.15.
---------------------------------------------------------------------------

vii. External Costs of Engagement of Accountant
    The amendments to Rule 17a-5 retain the current requirement that 
broker-dealers annually file with the Commission a financial report and 
a report prepared by a PCAOB-registered accountant based on an audit of 
the financial report.\695\ However, the financial report must be 
audited in accordance with standards of the PCAOB, instead of in 
accordance with GAAS, as previously required. The amendments also 
require a broker-dealer to file with the Commission either a compliance 
report or an exemption report and to obtain an independent accountant's 
report based on an examination or review of those reports, 
respectively.\696\
---------------------------------------------------------------------------

    \695\ See discussion above in section II.D.3. of this release.
    \696\ Id.
---------------------------------------------------------------------------

    Broker-dealers incur annual external costs associated with the PRA 
burden in terms of hiring outside auditors and accountants to comply 
with the requirements of Rule 17a-5. Any external costs of accountants' 
reports included in the PRA collection of information for these final 
rule amendments are averages across all broker-dealers. The external 
PRA costs incurred by a broker-dealer to comply with the final rule 
amendments will generally depend on its size and the complexity of its 
business activities. Because the size and complexity of broker-dealers 
varies significantly, the Commission provides estimates of the average 
external cost per broker-dealer across all broker-dealers.\697\
---------------------------------------------------------------------------

    \697\ In the proposing release, these costs were included in the 
Economic Analysis. The Commission is also including these costs in 
the PRA amendments to more accurately reflect external costs 
incurred by broker-dealers as a result of the PRA hour burdens 
imposed by the final rule amendments, and in response to comments.
---------------------------------------------------------------------------

    The Commission received various comments regarding the costs of the 
proposed requirements and engagement of the accountant provisions. More 
specifically, the Commission received comments addressing: (1) The 
costs of the change from GAAS to PCAOB standards for the financial 
report; (2) the costs of the examination of the new compliance report; 
and (3) the costs of the review of the new exemption report. The 
comments received with respect to these three areas and the 
Commission's responses are addressed in detail in each subsection 
below.
a. Financial Report (Including Change From GAAS to PCAOB Standards)
    Two commenters stated that the Commission did not address the costs 
associated with the change from GAAS to PCAOB standards.\698\ These 
costs would affect the external costs of broker-dealers under the PRA 
burden to the extent the change in standards caused an increase in 
external accounting fees incurred by broker-dealers. One commenter also 
stated that the Commission may need to consider the PCAOB's proposed 
rules before it can make a reasonable estimate, and that transition to 
PCAOB standards may require substantial revisions to audit 
programs.\699\ Another commenter stated that the economic analysis was 
``inconclusive'' because the PCAOB has not yet established auditing and 
attestation standards for broker-dealers.\700\ In response to this 
comment, the Commission estimates the costs of its rules using the best 
information available to it at the time.
---------------------------------------------------------------------------

    \698\ See, e.g., McGladrey Letter; SIFMA Letter.
    \699\ See ABA Letter.
    \700\ See CAI Letter.
---------------------------------------------------------------------------

    Based on information currently available, including the proposed 
PCAOB standards, the Commission does not expect that the move to PCAOB 
standards for audits of broker-dealer financial reports will result in 
significant one-time implementation costs or recurring annual costs. 
The proposed PCAOB standards for audits of financial reports (financial 
statements and supporting schedules) generally incorporate concepts and 
requirements contained within GAAS, thereby minimizing the potential 
costs to broker-dealer auditors of this change. As such, the Commission 
is not including any additional external PRA costs related to the 
change from GAAS to PCAOB auditing standards.\701\ However, in response 
to the comment, the Commission will examine the effect of any final 
PCAOB standards on the external costs associated with this collection 
of information in subsequent extensions of this collection of 
information and make any necessary cost adjustments.
---------------------------------------------------------------------------

    \701\ See section VII. of this release (discussing benefits and 
costs of changing from GAAS to PCAOB auditing standards).
---------------------------------------------------------------------------

b. Compliance Report
    The Commission estimated that the incremental external cost to a 
carrying broker-dealer of obtaining the independent public accountant's 
report based on an examination of the proposed compliance report would 
be an average incremental cost of approximately $150,000 per carrying 
broker-dealer per year.\702\ The Commission is including these external 
costs in this collection of information.
---------------------------------------------------------------------------

    \702\ See Broker-Dealer Reports, 76 FR at 37599.
---------------------------------------------------------------------------

    One commenter stated that the Commission underestimated the cost of 
examining the compliance report.\703\ This commenter believed that the 
auditing costs associated with the compliance examinations were 
underestimated given that the proposing release contemplated a move 
from GAAS to PCAOB auditing standards.\704\ This commenter stated that 
the transition may require substantial revisions to independent public 
accountant audit programs, including implementation of new auditing 
techniques and processes and the associated training programs and noted 
that the proposed PCAOB standards were not released until after the 
publication of the proposing release.\705\ Another commenter stated 
that completing both the compliance reports and exemption reports 
``will require extensive collaboration between management, internal 
audit, and the independent public accountants'' and that due to the 
``significant increase in hours,'' the proposed amendments have ``the 
potential to double the total current audit fees and have a material 
impact'' on firms.\706\ These commenters did not quantify their cost 
estimates in terms of dollars; nor did they provide data to support 
their conclusions.
---------------------------------------------------------------------------

    \703\ See ABA Letter.
    \704\ Id.
    \705\ Id.
    \706\ See Van Kampen/Invesco Letter.
---------------------------------------------------------------------------

    As explained above in section II.D. of this release, before today's 
amendments, Rule 17a-5 required a broker-dealer to

[[Page 51964]]

engage an independent public accountant to prepare a material 
inadequacy report based on, among other things, a review of the 
accounting system, internal accounting control, and procedures for 
safeguarding securities of the broker-dealer, including appropriate 
tests, for the period since the prior examination date. In addition, 
the accountant was required to review the practices and procedures 
followed by the broker-dealer in, among other things, (1) making 
periodic computations of net capital and under paragraph (e) of Rule 
15c3-3, (2) making quarterly securities examinations, counts, 
verifications, and comparisons under Rule 17a-13, and (3) obtaining and 
maintaining physical possession or control of all fully paid and excess 
margin securities of customers as required by Rule 15c3-3.
    Consequently, under requirements before today's amendments relating 
to a material inadequacy report that are being replaced by the 
examination of the compliance report, the broker-dealer was required to 
engage the independent public accountant to review the internal 
controls, practices, and procedures of the broker-dealer with respect 
to key elements of the financial responsibility rules.
    For these reasons, the Commission continues to believe that the 
average incremental cost of $150,000 per carrying broker-dealer to 
obtain the accountant's report covering the compliance report is 
reasonable. Moreover, as stated above, the Commission is adopting the 
proposed amendments to Rule 17a-5 with respect to the compliance report 
with modifications. For example, the final rule requires a statement as 
to whether the broker-dealer was in compliance with Rule 15c3-1 and 
paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal 
year and, if applicable, a description of any instances of non-
compliance with these rules as of the fiscal year end, rather than the 
proposed assertion that the broker-dealer is in compliance with the 
financial responsibility rules in all material respects and the 
proposed description of any material non-compliance with the financial 
responsibility rules. This reflects two changes from the proposal: (1) 
Elimination of the concepts of ``material non-compliance'' and 
``compliance in all material respects'' with Rule 15c3-1 and 15c3-3 for 
the purposes of reporting in the compliance report; and (2) a narrowing 
of these statements and description requirements from compliance with 
all of the financial responsibility rules to compliance with Rule 15c3-
1 and paragraph (e) of Rule 15c3-3.
    As modified, the final rule no longer requires the independent 
public accountant to evaluate whether an instance of non-compliance 
with the financial responsibility rules was material. While there may 
be an increase in the number of reported instances of non-compliance 
than under the proposal, the independent public accountant will not be 
required to determine whether an instance of non-compliance is 
material. Consequently, the reporting of instances of non-compliance 
(as compared to instances of material non-compliance) is not expected 
to increase costs of the engagement of the accountant from those 
estimated for the proposal and may decrease costs.
    In addition, the final rule has been modified from the proposal so 
that the independent public accountant will not be required to examine 
a broker-dealer statement that encompassed compliance with all the 
financial responsibility rules. Instead, the independent public 
accountant must examine a statement about compliance with Rule 15c3-1 
and paragraph (e) of Rule 15c3-3. In this regard, the Commission has 
not amended the requirement, which existed before today's amendments, 
that the independent public accountant examine the supporting schedules 
to the broker-dealer's financial statements, which contain a 
computation of net capital under Rule 15c3-1 and the reserve 
requirement under paragraph (e) of Rule 15c3-3.
    Given these modifications, the statements in the compliance report 
concerning the broker-dealer's Internal Control Over Compliance will 
likely account for the bulk of the work of the independent public 
accountant and, as noted above, before today's amendments, the 
independent public accountant was required to include internal control 
within the scope of the audit.
    The Commission believes that the modifications to the final rule 
discussed above should modestly reduce the external cost of the final 
rule as compared to the cost that would have resulted from the proposed 
rule. Further, elimination of the requirement that the accountant 
prepare a material inadequacy report will result in some cost 
savings.\707\ While these modifications to the final rule may result in 
reduced costs, the Commission continues to believe that the average 
estimated incremental cost of $150,000 per carrying broker-dealer, 
which may be at the high end of the range of estimated costs, is 
reasonable.
---------------------------------------------------------------------------

    \707\ The Commission also stated in the proposing release that 
the Commission estimated that amendments to the IA Custody Rule 
would impose external costs of $250,000 per investment adviser, and 
that the Commission estimated that the examination of the compliance 
report would incrementally cost $150,000 because the IA Custody Rule 
imposed new requirements on investment advisers, and, unlike the 
final rule amendments being adopted today, was not based on existing 
obligations. See Broker-Dealer Reports, 76 FR at 37599. Based on 
this comparison, the Commission continues to believe that the 
average estimated incremental cost of $150,000 per carrying broker-
dealer is reasonable and that the changes discussed above generally 
should not materially impact the cost estimate as they may, in some 
cases, result in a modest reduction in burden.
---------------------------------------------------------------------------

    For these reasons, the Commission has not changed its average 
estimate of the incremental cost of the accountants' reports covering 
the compliance report. The Commission therefore estimates that the 
average industry-wide annual external reporting incremental cost of 
this requirement is approximately $43,800,000 per year ($150,000 x 292 
carrying broker-dealers = $43,800,000).
c. Exemption Report
    The Commission estimated that the external cost to a non-carrying 
broker-dealer of obtaining the independent public accountant's report 
based on a review of the proposed exemption report would be an average 
of approximately $3,000 per non-carrying broker-dealer per year, for a 
total estimated annual cost associated with this proposal of 
$14,256,000.\708\ The Commission did not receive any specific comments 
regarding this cost estimate.
---------------------------------------------------------------------------

    \708\ See Broker-Dealer Reports, 76 FR at 37599-37600. The 
Commission estimated that there were 4,752 non-carrying broker-
dealers. 4,752 x $3,000 = $14,256,000.
---------------------------------------------------------------------------

    In the proposing release, the Commission stated its belief that an 
independent public accountant's review of the exemption assertion would 
add an incremental cost to that incurred as a result of the annual 
financial audit.\709\ As discussed above, independent public 
accountants engaged by broker-dealers were required, before today's 
amendments, to ``ascertain that the conditions of the exemption were 
being complied with as of the examination date and that no facts came 
to [the independent public accountant's] attention to indicate that the 
exemption had not been complied with during the period since [the 
independent public accountant's] last examination.'' \710\
---------------------------------------------------------------------------

    \709\ Id. at 37599.
    \710\ See 17 CFR 240.17a-5(g)(2).
---------------------------------------------------------------------------

    The Commission continues to believe that $3,000 is a reasonable 
estimate of the cost of obtaining the accountant's report covering the 
exemption report. The Commission now estimates that

[[Page 51965]]

there are approximately 4,417 non-carrying broker-dealers. The 
Commission therefore estimates that the total industry-wide external 
annual reporting cost of this requirement is approximately $13,251,000 
per year (4,417 non-carrying broker-dealers x $3,000 = $13,251,000).
d. Access to Accountant and Audit Documentation
    The amendments to Rule 17a-5 require that carrying or clearing 
broker-dealers agree to allow Commission and DEA staff, if requested in 
writing for purposes of an examination of the broker-dealer, to review 
the work papers of the independent public accountant and to allow the 
accountant to discuss its findings with the examiners.
    In the proposing release, the Commission estimated that a carrying 
or clearing broker-dealer's accountant would charge the broker-dealer 
for time its personnel spend speaking with the Commission or the 
broker-dealer's DEA and providing them with audit documentation.\711\ 
Thus, the Commission estimated that the additional cost of accountant 
time associated with this amendment to all clearing and carrying 
broker-dealers would be approximately $660,000 annually.\712\ As the 
Commission now estimates that the number of carrying or clearing 
broker-dealers is 513, the new estimate is approximately $641,250.\713\
---------------------------------------------------------------------------

    \711\ In the proposing release, the Commission estimated that a 
broker-dealer's accountant would spend approximately 5 hours per 
year speaking with Commission or DEA staff and providing them with 
audit documentation.
    \712\ In the proposing release, the Commission multiplied 528 
clearing and carrying broker-dealers x 5 hours x $250/hour = 
$660,000.
    \713\ 513 clearing and carrying broker-dealers x $1,250 in 
increased costs per clearing broker-dealer = $641,250.
---------------------------------------------------------------------------

2. Conforming and Technical Amendments to Rule 17a-11
    The Commission proposed technical amendments to Rule 17a-5 and 
proposed amending paragraph (e) of Rule 17a-11 to eliminate a reference 
to Rule 17a-5.\714\ The Commission stated that these changes should not 
result in an additional hour burden for the Rule 17a-11 collection of 
information. As discussed above in section II.F.2. of this release, in 
response to a comment, paragraph (e) of Rule 17a-11, as adopted, 
retains a reference to Rule 17a-5. In addition, the Commission is 
adopting conforming amendments to substitute the term material weakness 
as defined in paragraph (d)(3)(iii) of Rule 17a-5 for the term material 
inadequacy with respect to Rule 17a-5. Specifically, the final rule 
provides that whenever a broker-dealer discovers, or is notified by its 
accountant under paragraph (h) of Rule 17a-5 of the existence of any 
material weakness, the broker-dealer must: (1) Give notice of the 
material weakness within 24 hours of the discovery or notification; and 
(2) transmit a report within 48 hours of the notice stating what the 
broker-dealer has done or is doing to correct the situation.\715\
---------------------------------------------------------------------------

    \714\ See Broker-Dealer Reports, 76 FR at 37597.
    \715\ See paragraph (e) of Rule 17a-11. This provision retains 
references to material inadequacy with respect to Rule 17a-12.
---------------------------------------------------------------------------

    The Commission does not expect any change in the number of notices 
filed per year as a result of the final amendments because the material 
inadequacy notification requirement is being replaced by a material 
weakness notification requirement. Therefore, the final amendments to 
Rule 17a-11 should not result in a change in the current PRA burden for 
Rule 17a-11. However, the Commission will take into account any changes 
in the number of notices associated with this collection of information 
in subsequent extensions of this collection of information and make any 
necessary adjustments, as appropriate.
3. Form Custody
    As described more fully above, the amendments require that all 
broker-dealers registered with the Commission file Form Custody 
quarterly with their DEA. The Commission estimated that the hour burden 
associated with completing and filing proposed Form Custody would be 
approximately 12 hours per quarter, or 48 hours per year, on average, 
for each broker-dealer.\716\
---------------------------------------------------------------------------

    \716\ See Broker-Dealer Reports, 76 FR at 37597.
---------------------------------------------------------------------------

    In section IV. of this release, in adopting the final amendments to 
Form Custody, the Commission received one comment in response to Item 8 
of Form Custody, as proposed, noting that the information sought in 
Item 8 was largely the same as information collected from investment 
advisers on Form ADV.\717\ As stated above in section IV. of this 
release, the Commission is aware that some overlap exists between the 
information collected from investment advisers on Form ADV and the 
information that would be collected from broker-dealers dually-
registered as investment advisers in Item 8 of proposed Form Custody. 
However, these two forms also contain a significant amount of non-
overlapping material, reflecting their different purposes and uses. 
Form Custody is intended to be a single source of readily-available 
information to assist Commission and DEA examiners in preparing for and 
performing focused custody exams, and it is particularly important that 
such information be readily available in the case of dually-registered 
firms. Consequently, the Commission believes that the PRA burden for 
Form Custody is reasonable in light of its intended purpose, as 
discussed above in section IV. of this release. Additionally, the 
commenter did not indicate disagreement with the hour burden estimate 
as proposed. Therefore, the Commission is retaining the hour burden 
estimate without revision.
---------------------------------------------------------------------------

    \717\ See Angel Letter.
---------------------------------------------------------------------------

    The Commission now estimates that there are approximately 4,709 
broker-dealers that must file Form Custody. The Commission therefore 
estimates that the total annual burden associated with completing and 
filing Form Custody for all 4,709 broker-dealers is approximately 
226,032 hours per year (4,709 broker-dealer times 4 responses per year 
times 12 hours = 226,032 hours).
    One commenter stated that the estimated costs to the industry of 
$69,179,670 is ``staggering,'' and that such costs would likely 
indirectly be passed on to customers.\718\ The commenter did not 
disagree with the PRA estimate in the proposing release; rather, the 
commenter focused on size of the total estimated costs. The Commission 
recognizes that the requirement to file Form Custody will increase 
compliance costs for broker-dealers and, consequently, the PRA 
estimates reflect these costs. The PRA hour burden estimates (and 
associated internal burden costs), however, are averages across all 
broker-dealers. The costs incurred by a broker-dealer to comply with 
the requirement to file Form Custody will depend on its size and the 
complexity of its business activities. Because the size and complexity 
of broker-dealers varies significantly, the Commission provides 
estimates of the average cost per broker-dealer across all broker-
dealers.
---------------------------------------------------------------------------

    \718\ See IMS Letter. The cost of $69,179,670 was reflected in 
the Economic Analysis in the proposing release. See Broker-Dealer 
Reports, 76 FR at 37601. This cost was calculated as an internal 
cost of the estimated PRA hours and is the total cost divided among 
5,057 firms. Id. at 37601 n.215. This internal cost would amount to 
an average of $13,680 per broker-dealer.
---------------------------------------------------------------------------

    For these reasons, the Commission believes the internal costs 
related to the PRA for this hour burden are reasonable and, therefore, 
the Commission is not adjusting the final cost estimate, except to 
reflect updated data with respect to

[[Page 51966]]

the number of broker-dealers and compensation.\719\
---------------------------------------------------------------------------

    \719\ Id.
---------------------------------------------------------------------------

E. Collection of Information Is Mandatory

    The collection of information obligations imposed by the rule 
amendments are mandatory for broker-dealers that are registered with 
the Commission.

F. Confidentiality

    The Commission expects to receive confidential information in 
connection with the proposed collections of information. Paragraph 
(e)(3) of Rule 17a-5, as amended, provides that broker-dealer annual 
reports filed with the Commission are not confidential, except that if 
the Statement of Financial Condition is bound separately from the 
balance of the annual reports, and each page of the balance of the 
annual reports is stamped ``confidential,'' then the balance of the 
annual reports shall be deemed confidential to the extent permitted by 
law.\720\ However, under paragraph (c)(2)(iv) of Rule 17a-5, if there 
are material weaknesses, the accountant's report on the compliance 
report must be made available for customers' inspection and, 
consequently, it would not be deemed confidential. In addition, 
paragraph (c)(2)(i) of Rule 17a-5 requires a broker-dealer to furnish 
to its customers annually a balance sheet with appropriate notes 
prepared in accordance with GAAP and which must be audited if the 
broker-dealer is required to file audited financial statements with the 
Commission.\721\ With respect to the other information collected under 
the amendments, a broker-dealer can request the confidential treatment 
of the information.\722\ If such a confidential treatment request is 
made, the Commission anticipates that it will keep the information 
confidential to the extent permitted by law.\723\
---------------------------------------------------------------------------

    \720\ See paragraph (e)(3) of Rule 17a-5.
    \721\ See 17 CFR 240.17a-5(c)(2)(i).
    \722\ See 17 CFR 200.83. Information regarding requests for 
confidential treatment of information submitted to the Commission is 
available at http://www.sec.gov/foia/howfo2.htm#privacy.
    \723\ See, e.g., 15 U.S.C. 78x (governing the public 
availability of information obtained by the Commission); 5 U.S.C. 
552 et seq.
---------------------------------------------------------------------------

VII. Economic Analysis

    The Commission is sensitive to the costs and benefits of its rules. 
When engaging in rulemaking that requires the Commission to consider or 
determine whether an action is necessary or appropriate in the public 
interest, section 3(f) of the Exchange Act requires that the Commission 
consider, in addition to the protection of investors, whether the 
action will promote efficiency, competition, and capital 
formation.\724\ In addition, section 23(a)(2) of the Exchange Act 
requires that the Commission consider the effects on competition of any 
rules the Commission adopts under the Exchange Act, and 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.\725\
---------------------------------------------------------------------------

    \724\ 15 U.S.C. 78c(f).
    \725\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    In the proposing release, the Commission solicited comment on the 
costs and benefits of the proposed amendments and new form, including 
whether estimates of the costs and benefits were accurate and 
comprehensive.\726\ The Commission further encouraged commenters to 
provide specific data and analysis in support of their views.\727\ The 
Commission also requested comment on whether the proposed amendments 
would place a burden on competition, and promote efficiency, 
competition, and capital formation.\728\
---------------------------------------------------------------------------

    \726\ See Broker-Dealer Reports, 76 FR at 37598. An economic 
analysis was included in the proposing release. Id. at 37598-37601.
    \727\ Id. at 37598.
    \728\ Id.
---------------------------------------------------------------------------

    The Commission received 27 comment letters on the proposed 
amendments. A number of commenters addressed the Commission's estimates 
of the cost and benefits of the proposed amendments.\729\ Generally, 
these commenters stated that the Commission's cost and benefit 
estimates failed to include all of the costs associated with the 
proposed amendments and that the costs that the Commission did include 
in its analysis were underestimated. For example, one commenter stated 
that the proposed amendments ``place unnecessary regulatory burdens and 
costs on industry, in general, and smaller firms, in particular'' and 
that ``broker-dealers compete against investment advisers who are not 
burdened by the same regulatory requirements,'' including the 
requirements in the proposed amendments.\730\ While commenters stated 
that the Commission underestimated costs, they did not provide 
alternative quantified estimates of the costs.\731\
---------------------------------------------------------------------------

    \729\ See ABA Letter; AICPA Letter; Angel Letter; CAI Letter; 
Citrin Letter; IMS Letter; KPMG Letter; McGladrey Letter; SIFMA 
Letter; Van Kampen/Invesco Letter.
    \730\ See IMS Letter.
    \731\ For example, one commenter stated that the Commission's 
estimate of the costs of the compliance report have ``the potential 
to double the total current audit fees and have a material impact'' 
on firms. See Van Kampen/Invesco Letter. The commenter, however, did 
not provide a quantified baseline estimate of current audit fees 
incurred by broker-dealers with which to compare the Commission's 
estimate of the incremental cost that the compliance report 
amendments will have on audit fees.
---------------------------------------------------------------------------

    As discussed throughout this release, in part in response to 
comments, the Commission has modified the proposed rules to reduce 
compliance burdens where consistent with investor protection. In 
addition, as discussed below, where commenters identified costs the 
Commission did not consider, the Commission has revised its economic 
analysis of the final rules to take these costs into account.
    In adopting the rule amendments and new form, the Commission has 
been mindful of the associated costs and benefits. The costs and 
benefits that the Commission has considered in adopting these 
amendments and new form are discussed below. The discussion focuses on 
the Commission's reasons for adopting these amendments and new form, 
the affected parties, and the costs and benefits of the amendments and 
new form compared to the baseline, described below, and to alternative 
courses of action.
    Many of the benefits and costs discussed below are difficult to 
quantify, in particular when discussing increases in investor 
confidence and improvements in investor protection. For example, the 
extent to which the increased ability of the Commission and DEAs to 
oversee compliance with the financial responsibility rules will help 
limit future violations of the rules is unknown. Similarly, it is 
unknown how much increasing the focus of broker-dealers on the 
financial responsibility rules will result in enhanced compliance with 
those rules. Moreover, limited public data exists to study the costs of 
broker-dealer audits. Therefore, much of the discussion is qualitative 
in nature but, where possible, the Commission attempted to quantify the 
costs.

A. Motivation for the Amendments

    The rule amendments and new form being adopted today are designed 
to provide additional safeguards with respect to broker-dealer custody 
of customer securities and funds. The motivation for these amendments, 
which are discussed throughout this release, are summarized below.

[[Page 51967]]

    First, as mentioned above in section I.A. of this release, over the 
last several years, the Commission has brought several cases alleging 
fraudulent conduct by investment advisers and broker-dealers, including 
among other things, alleged misappropriation or other misuse of 
customer securities and funds.\732\ These cases highlight the need for 
enhancements to the rules governing broker-dealer custody of customer 
assets. Such enhancements include both increased focus on compliance 
and internal compliance controls by broker-dealers and their auditors, 
as well as measures to increase the ability of the Commission and 
broker-dealer DEAs to oversee broker-dealer custody practices by 
requiring broker-dealers to provide more information about these 
practices.
---------------------------------------------------------------------------

    \732\ See, e.g., SEC v. Donald Anthony Walker Young, et al., 
Litigation Release No. 21006 (Apr. 20, 2009); SEC v. Isaac I. Ovid, 
et al., Litigation Release No. 20998 (Apr. 14, 2009); SEC v. The 
Nutmeg Group, LLC, et al., Litigation Release No. 20972 (Mar. 25, 
2009); SEC v. WG Trading Investors, L.P., et al., Litigation Release 
No. 20912 (Feb. 25, 2009); SEC v. Stanford International Bank, et 
al., Litigation Release No. 20901 (Feb. 17, 2009); SEC v. Bernard L. 
Madoff, et al., Litigation Release No. 20889 (Feb. 9, 2009). The 
Commission also has brought an enforcement action against an 
accountant that purported to audit financial statements and 
disclosures of one of these broker-dealers. See SEC v. David G. 
Friehling, C.P.A., et al., Litigation Release No. 20959 (Mar. 18, 
2009).
---------------------------------------------------------------------------

    Second, as discussed above in section II.D. of this release, 
certain provisions of Rule 17a-5 before today's amendments were 
inconsistent with current audit practices, standards, and terminology, 
which have evolved since these provisions were adopted. This 
inconsistency has resulted in disparate audit practices and 
inconsistent compliance with the rule. As discussed above in section 
II.D.3.iii. of this release, the PCAOB has published a report 
containing observations from inspections of portions of 23 broker-
dealer audits conducted by ten accounting firms.\733\ According to the 
report, PCAOB inspections staff identified deficiencies in all of the 
audits inspected.\734\ The deficiencies noted in the report provide 
support for the need to strengthen and clarify broker-dealer audit and 
reporting requirements in order to facilitate consistent compliance 
with these requirements.
---------------------------------------------------------------------------

    \733\ See PCAOB Inspection Report at p. ii.
    \734\ Id.
---------------------------------------------------------------------------

    Third, as discussed in section II.D. of this release, prior to 
today's amendments, Rule 17a-5 required that broker-dealer audits be 
conducted in accordance with GAAS, which are established by the 
Auditing Standards Board of the AICPA. The amendments--by requiring 
that the audits be conducted in accordance with PCAOB standards--
recognize the PCAOB's explicit oversight authority over broker-dealer 
audits as provided by the Dodd-Frank Act, including the authority to 
establish (subject to Commission approval) and enforce auditing and 
related attestation, quality control, ethics, and independence 
standards.\735\ In addition, the Commission has direct oversight 
authority over the PCAOB, including the authority to approve or 
disapprove the PCAOB's rules and standards.\736\ Consequently, 
requiring that broker-dealer audits be conducted in accordance with 
standards the Commission has approved will better ensure alignment 
between broker-dealer audits and the regulatory policy objectives 
reflected in the Commission's financial responsibility rules.
---------------------------------------------------------------------------

    \735\ See discussion in section II.D.3. of this release.
    \736\ Section 107(a) of the Sarbanes-Oxley Act provides that the 
Commission ``shall have oversight and enforcement authority over the 
[PCAOB] as provided by the [Sarbanes-Oxley Act].'' Section 107(b) of 
the Sarbanes-Oxley act provides that ``[n]o rule of the [PCAOB] 
shall become effective without prior approval of the Commission'' 
other than certain initial or transitional standards. Section 107(c) 
of the Sarbanes-Oxley Act provides for Commission review of 
disciplinary action taken by the PCAOB. Section 107(d) of the 
Sarbanes-Oxley Act provides that the Commission may censure and 
impose other sanctions on the PCAOB in certain circumstances.
---------------------------------------------------------------------------

    Fourth, as discussed in section II.B.6. of this release, because 
broker-dealers have not been required to file with SIPC their annual 
audited financial statements, SIPC has received limited information 
regarding the financial condition of its broker-dealer members. SIPC 
can use this information, among other things, to assess whether the 
SIPC Fund is appropriately sized to the risks of a large broker-dealer 
failure. In addition, at least one court, the New York Court of 
Appeals, has held that in cases where SIPC is required to fund the 
liquidation of a broker-dealer, SIPC could not maintain a claim against 
the auditor of the broker-dealer based on an alleged failure to comply 
with auditing standards because SIPC did not receive the audited 
financial statements and therefore could not have relied upon them.
    Fifth, as discussed in section III. of this release, the audit work 
performed by independent public accountants with respect to audits of 
carrying and clearing broker-dealers can provide useful information to 
Commission and DEA examiners in terms of planning the scope and focus 
of the examination of the broker-dealer. Providing Commission and DEA 
examiners with access to the independent public accountant that audited 
the broker-dealer and audit documentation related to the audit will 
allow the examiners to gain an understanding of the work the accountant 
did in auditing the broker-dealer and any areas of concern highlighted 
by the auditor. This will enable the examiners to conduct risk-based 
examinations of carrying and clearing broker-dealers and assist the 
examiners in determining areas of focus for their examinations. 
Furthermore, the amendments will make it clear to the independent 
public accountant that the broker-dealer has agreed that the accountant 
can provide this information and, consequently, eliminate uncertainty 
as to whether the broker-dealer consents to the disclosure of the 
information.
    Sixth, as discussed in section IV. of this release, because broker-
dealers were not required to provide comprehensive or consolidated 
information about their custody practices to the Commission or their 
DEA, the Commission and the broker-dealer's DEA had a fragmented and 
incomplete picture of whether a broker-dealer maintained custody of 
customer and non-customer assets, and if so, how such assets were 
maintained. This hindered the ability of the Commission and DEAs to 
efficiently plan, prioritize, and perform examinations.

B. Economic Baseline

    The regulatory changes adopted today amend requirements that apply 
to broker-dealers registered with the Commission and independent public 
accountants that audit or attest to broker-dealer annual reports. The 
discussion below includes approximate numbers of broker-dealers and 
accountants that would be affected by today's amendments and a 
description of the economic baseline against which the costs and 
benefits, as well as the impact on efficiency, competition, and capital 
formation, of today's amendments and new form are measured.
1. Broker-Dealers
    The broker-dealers registered with the Commission vary 
significantly in terms of their size, business activities, and the 
complexity of their operations. For example, carrying broker-dealers 
hold customer securities and funds.\737\

[[Page 51968]]

Clearing broker-dealers clear transactions as members of security 
exchanges and the Depository Trust & Clearing Corporation and the 
Options Clearing Corporation.\738\ Many clearing broker-dealers are 
carrying broker-dealers, but some clearing broker-dealers clear only 
their own transactions and do not hold customer securities and cash.
---------------------------------------------------------------------------

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

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

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

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

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

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

[[Page 51969]]

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

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

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

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

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

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

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

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

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

    \753\ See, e.g., AICPA Broker-Dealer Audit Guide app. H (sample 
representation letter).
    \754\ According to GAAS, auditors ``should consider obtaining a 
representation letter'' in an examination or review engagement, and 
``specific written representations will depend on the circumstances 
of the engagement and the nature of the subject matter and the 
criteria.'' See AICPA, AT Section 101 at ] .60. Further, while the 
AICPA Broker-Dealer Audit Guide contains a sample representation 
letter, publications such as this guide ``are not auditing 
standards'' but are ``recommendations on the application of the 
[auditing standards] in specific circumstances, including 
engagements for entities in specialized industries.'' See AICPA, AU 
Section 150, at ] .05.
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ii. Engagement of the Accountant
    As noted above, prior to today's amendments, broker-dealers 
generally were required to file with the Commission: (1) A report of an 
independent public accountant based on an audit of the broker-dealer's 
financial statements and supporting schedules; and (2) a material 
inadequacy report prepared by the accountant, based on, among other 
things, a review of a broker-dealer's accounting system, internal 
accounting control, and procedures for safeguarding securities. The 
accountant was required to be registered with the PCAOB. However, Rule 
17a-5 required that the audit be performed in accordance with GAAS, 
which are issued by the AICPA. Consequently, the standard setting body 
for broker-dealer audits has been the AICPA (rather than the PCAOB) 
notwithstanding the requirement that broker-dealers be audited by a 
PCAOB-registered independent public accountant.\755\
---------------------------------------------------------------------------

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

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

[[Page 51970]]

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

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

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

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

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

C. Costs and Benefits of the Rule Amendments

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

[[Page 51971]]

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

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

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

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

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

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

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

[[Page 51972]]

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

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

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

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

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

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

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

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

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

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

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

[[Page 51973]]

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

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

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

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

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

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

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

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

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

[[Page 51974]]

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

    \781\ See ABA Letter; CAI Letter; CAQ Letter; Deloitte Letter; 
E&Y Letter; Grant Thornton Letter; KPMG Letter; McGladrey Letter; 
PWC Letter; SIFMA Letter; Van Kampen/Invesco Letter.
    \782\ See ABA Letter; CAQ Letter; E&Y Letter; KPMG Letter; 
McGladrey Letter; PWC Letter.
    \783\ See SIFMA Letter.
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    The ``material non-compliance'' and ``compliance in all material 
respects'' concepts were designed to limit the types of instances of 
non-compliance that would need to be identified in the report. To 
retain a limiting principle, the final rule focuses on provisions that 
trigger notification requirements when they are not complied with, 
namely, Rule 15c3-1 and the customer reserve requirement in paragraph 
(e) of Rule 15c3-3.\784\ Any instances of non-compliance with these 
requirements as of the fiscal year end must be described in the 
compliance report. As stated in the proposing release, failing to 
maintain the required minimum amount of net capital under Rule 15c3-1 
or failing to maintain the minimum deposit requirement in a special 
reserve bank account under Rule 15c3-3 would have been instances of 
material non-compliance under the proposed rule.\785\ Accordingly, 
under the proposal, a broker-dealer would have been required to 
describe all instances of non-compliance with Rule 15c3-1 and paragraph 
(e) of Rule 15c3-3. Under the proposal, a broker-dealer also would have 
been required to describe instances of material non-compliance with 
Rule 17a-13 and the Account Statement Rules. The final rule is narrower 
in that a broker-dealer only is required to describe instances of non-
compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3. While the 
final rules increase costs relative to the baseline, they should result 
in modestly lower costs to broker-dealers relative to the proposal.
---------------------------------------------------------------------------

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

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

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

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

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

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

[[Page 51975]]

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

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

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

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

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

[[Page 51976]]

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

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

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

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

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

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

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

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

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

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

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

[[Page 51977]]

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

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

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

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

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

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

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

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

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

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

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

[[Page 51978]]

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

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

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

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

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

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

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

[[Page 51979]]

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

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

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

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

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

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

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

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

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

[[Page 51980]]

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

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

    Under the final rule, the independent public accountant also will 
be required to provide notice to the broker-dealer if the accountant 
determines that any material weaknesses exist. As in the proposal, 
material weakness is defined with regard to the compliance report and 
therefore applies only to broker-dealers that file compliance reports. 
In that report, a carrying broker-dealer must state whether its 
internal controls were effective during the fiscal year as well as at 
the end of the fiscal year. Internal controls are not effective if 
there are one or more material weaknesses in the controls. The broker-
dealer also is required to describe any identified material weaknesses. 
The independent public accountant must undertake to prepare a report 
based on an examination of certain statements in the compliance report, 
including the statements as to whether the carrying broker-dealer's 
internal controls were effective.
    As stated above, before today's amendments, Rule 17a-5 required the 
accountant to notify the broker-dealer if the accountant determined 
that any material inadequacies existed. The concept of material 
inadequacy generally applied to all broker-dealers and, therefore, the 
notification requirement applied with respect to independent public 
accountant engagements for non-carrying as well as carrying broker-
dealers under Rule 17a-5. This requirement, however, may not have 
produced the intended benefits.
    As discussed in section II.D.3. above, PCAOB inspection staff found 
that in 21 of 23 broker-dealer audits inspected, the accountant 
``failed to perform sufficient audit procedures to obtain reasonable 
assurance that any material inadequacies found to exist since the date 
of the last examination . . . would have been disclosed in the 
accountant's supplemental report.'' \840\ Material inadequacies which 
were expected to be reported by the accountant included any condition 
which contributed substantially to or, if appropriate corrective action 
was not taken, could reasonably be expected to: (1) Inhibit a broker-
dealer from promptly completing securities transactions or promptly 
discharging its responsibilities to customers, other broker-dealers, or 
creditors; (2) result in material financial loss; (3) result in 
material misstatements of the broker-dealer's financial statements; or 
(4) result in violations of the Commission's recordkeeping or financial 
responsibility rules to an extent that could reasonably be expected to 
result in the conditions described in (1) through (3) above. The 
definition of material weakness is more specific: a material weakness 
includes a deficiency in internal control such that there is a 
reasonable possibility that non-compliance with Rule 15c3-1 and 
paragraph (e) of Rule 15c3-3 will not be prevented or detected on a 
timely basis or that non-compliance to a material extent with Rule 
15c3-3, except paragraph (e), Rule 17a-13, or the Account Statement 
Rules will not be prevented or detected on a timely basis.
---------------------------------------------------------------------------

    \840\ See PCAOB Inspection Report, at ii.
---------------------------------------------------------------------------

    As discussed above, today's amendments generally replace the term 
material inadequacy and separate it into two components--a compliance 
component (non-compliance with the financial responsibility rules) and, 
for carrying broker-dealers, an internal control component (material 
weakness in Internal Control Over Compliance). The change is consistent 
with one of the objectives of the amendments: to provide clear and 
consistent terminology focused separately on compliance with key 
financial responsibility rules and internal control over compliance 
with the financial responsibility rules. The amended notification 
provisions in Rule 17a-5 reflect this change in terminology.
    The Commission proposed amending the notification process so that 
the accountant would be required to notify the Commission and the 
broker-dealer's DEA directly. However, the Commission is not adopting 
this alternative because it agrees with the comments, discussed above, 
that the notification process in place before today's amendments should 
be retained.
    As stated above, Rule 17a-5 before today's amendments required the 
accountant to notify the broker-dealer, and the broker-dealer to notify 
the Commission, if the accountant determined during the course of the 
audit or interim work that a material inadequacy existed. This 
requirement generally applied to all broker-dealer audits. The 
notification provisions in themselves did not direct the accountant to 
perform specific procedures with respect to the audit--those 
requirements were contained in other provisions of Rule 17a-5. The 
notification provisions in Rule 17a-5 were intended to require 
notification if, during the course of the audit, the accountant became 
aware of any material inadequacies. As amended, the notification 
provisions in Rule 17a-5 likewise do not in themselves require the 
accountant to perform specific procedures with respect to the 
examination of the financial report or an examination of a compliance 
report or review of an exemption report. Instead, the notification 
provisions are triggered when the accountant becomes aware, during the 
course of preparing the reports of the accountant required under Rule 
17a-5, that the broker-dealer is not in compliance with the financial 
responsibility rules or, during the course of preparing a report based 
on an examination of a compliance report, that a material weakness 
exists. These notification requirements are designed to put the broker-
dealer in a position to correct controls, processes, and systems that 
have caused or potentially could cause the firm to not comply with the 
financial responsibility rules. As discussed throughout this release, 
the financial responsibility rules serve an important investor 
protection function by requiring broker-dealers to maintain prudent 
levels of net capital and take steps to safeguard customer securities 
and cash.
    The requirement to notify the broker-dealer when the independent 
public accountant determines that the broker-dealer is not in 
compliance with the financial responsibility rules or that any material 
weaknesses exist is not expected to increase costs for broker-dealers 
when compared to the baseline requirement to provide the broker-

[[Page 51981]]

dealer with notice when the independent public accountant determines 
that a material inadequacy exists. As discussed above, the notice 
requirements under today's amendments do not require the independent 
public accountant to perform specific procedures. Instead, they are 
triggered when the independent public accountant determines that any 
non-compliance or material weakness exists during the course of 
performing procedures to examine the financial report and to examine 
the compliance report or review the exemption report, as applicable. To 
the extent the obligation to provide the broker-dealer with notice is 
factored into the fee charged by the accountant, the Commission notes 
that before today's amendments the independent public accountant was 
required to give notice of a material inadequacy. This notification 
requirement has been eliminated and, therefore, to the extent it was 
factored into the fee, that cost has been eliminated. The Commission 
does not believe that the component of the independent public 
accountants' fee associated with the new notification requirements 
would be materially different than the component of the fee associated 
with the material inadequacy notification requirements. Therefore, the 
Commission believes these requirements would not result in increased 
compliance costs relative to the requirements in place before today's 
amendments.
b. Conforming and Technical Amendments to Rule 17a-11
    As discussed above in section II.F.2., prior to today's amendments, 
paragraph (e) of Rule 17a-11 required that whenever a broker-dealer 
discovered, or was notified by an independent public accountant, 
pursuant to paragraph (h)(2) of Rule 17a-5 or paragraph (f)(2) of Rule 
17a-12, of the existence of any material inadequacy, the broker-dealer 
was required to give notice to the Commission and transmit a report to 
the Commission stating what the broker-dealer has done or is doing to 
correct the situation.
    The Commission is adopting conforming amendments to paragraph (e) 
of Rule 17a-11 to substitute a notice of the existence of any material 
weakness as defined in paragraph (d)(3)(iii) of Rule 17a-5 for a notice 
of the existence of any material inadequacy and to replace a reference 
to paragraph (h)(2) of Rule 17a-5 with a reference to paragraph (h) of 
Rule 17a-5.\841\ Specifically, the final rule provides that whenever a 
broker-dealer discovers, or is notified by its accountant under 
paragraph (h) of Rule 17a-5 of the existence of any material weakness, 
the broker-dealer must: (1) Give notice of the material weakness within 
24 hours of the discovery or notification; and (2) transmit a report 
within 48 hours of the notice stating what the broker-dealer has done 
or is doing to correct the situation.\842\
---------------------------------------------------------------------------

    \841\ The final rule retains a reference to material inadequacy 
as defined in paragraph (h)(2) of Rule 17a-12, but amendments 
correct citations to that rule.
    \842\ See paragraph (e) of Rule 17a-11. The rule retains 
provisions referencing the term material inadequacy as defined in 
Rule 17a-12.
---------------------------------------------------------------------------

    The notification requirements, among other things, alert the 
Commission and the DEA of the need to increase their monitoring of a 
broker-dealer and to obtain additional information when appropriate in 
order to address any concerns the Commission or the DEA may have as a 
result of the notification. A notification of a material weakness will 
alert the Commission and the broker-dealer's DEA to the existence of a 
condition that could impact the broker-dealer's ability to remain in 
compliance with the financial responsibility rules, which serve an 
important investor protection function by requiring broker-dealers to 
maintain prudent levels of net capital and take steps to safeguard 
customer securities and cash. Once alerted, the Commission and the DEA 
can respond to the situation through, for example, heightened 
monitoring of the broker-dealer to assess whether it has corrected the 
problem and whether it is properly safeguarding customer securities and 
cash.
    The Commission believes these amendments will not result in 
increased compliance costs to broker-dealers. Material weakness is 
defined with regard to the compliance report and therefore applies only 
to broker-dealers that file compliance reports (i.e., carrying broker-
dealers). In contrast, the concept of material inadequacy generally 
applied to all broker-dealers and, therefore, the notification 
requirement applied with respect to independent public accountant 
engagements under Rule 17a-5 for non-carrying as well as carrying 
broker-dealers. As discussed above in section VII.B.1. of this release, 
the Commission estimates that there are approximately 4,709 broker-
dealers registered with the Commission and that of those firms, 
approximately 292 are carrying broker-dealers. Consequently, before 
today's amendments, the notification requirements with respect to 
material inadequacy applied to approximately 4,709 broker-dealers, 
whereas after today's amendments the notification requirement with 
respect to material weakness will apply to approximately 292 broker-
dealers.
    The Commission proposed amending paragraph (e) of Rule 17a-11 to 
delete the references to Rule 17a-5. However, the Commission is not 
adopting this alternative because it agrees with a commenter that 
notification should be provided to the Commission when a deficiency in 
internal control is discovered by the broker-dealer. \843\
---------------------------------------------------------------------------

    \843\ See Deloitte Letter.
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vi. Information Provided to Customers
    Prior to today's amendments, paragraph (c)(2)(iii) of Rule 17a-5 
provided that if, in conjunction with a broker-dealer's most recent 
audit report, the broker-dealer's independent public accountant 
commented on any material inadequacies in the broker-dealer's internal 
controls, its accounting system, or certain of its practices and 
procedures\844\ under paragraphs (g) and (h) of Rule 17a-5, and 
paragraph (e) of Rule 17a-11, the broker-dealer's audited statements 
sent to customers were required to include a statement that a copy of 
the auditor's comments were available for inspection at the 
Commission's principal office in Washington, DC, and the regional 
office of the Commission in which the broker-dealer had its principal 
place of business.\845\
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    \844\ These practices and procedures include, for example, 
periodic net capital computations under Rule 15c3-1 and periodic 
counts of securities under Rule 17a-13.
    \845\ See 17 CFR 240.17a-5(c)(2)(iii).
---------------------------------------------------------------------------

    The Commission is revising its proposal with respect to amending 
paragraph (c)(2) of Rule 17a-5 to be consistent with the new 
notification provisions in paragraph (h) described above relating to 
the identification by a broker-dealer's accountant of a material 
weakness rather than an instance of material non-compliance.\846\ 
Specifically, if, in connection with the most recent annual reports, 
the report of the independent public accountant on the broker-dealer's 
compliance report identifies a material weakness, the broker-dealer 
must include a statement that one or more material weaknesses have been 
identified and that a copy of the report of the independent public 
accountant is currently available for the customer's inspection at the 
principal office of the Commission in Washington, DC, and the regional 
office of the Commission for the region in

[[Page 51982]]

which the broker-dealer has its principal place of business.\847\
---------------------------------------------------------------------------

    \846\ See paragraph (c)(2)(iv) of Rule 17a-5.
    \847\ Id.
---------------------------------------------------------------------------

    The Commission does not believe these amendments will result in 
incremental costs to broker-dealers over the baseline. Material 
weakness is defined with regard to the compliance report and therefore 
applies only to broker-dealers that file compliance reports (i.e., 
carrying broker-dealers). In contrast, the concept of material 
inadequacy generally applied to all broker-dealers and, therefore, the 
customer notification requirement applied with respect to independent 
public accountant engagements under Rule 17a-5 for non-carrying as well 
as carrying broker-dealers. As discussed above in section VII.B.1. of 
this release, the Commission estimates that there are approximately 
4,709 broker-dealers registered with the Commission and that of those 
firms, approximately 292 are carrying broker-dealers. Consequently, 
before today's amendments, the notification requirements with respect 
to material inadequacy applied to approximately 4,709 broker-dealers, 
whereas after today's amendments the notification requirement with 
respect to material weakness will apply to approximately 292 broker-
dealers.
    Rule 17a-5 also provides a conditional exemption from the 
requirement to send paper copies of financial information to customers 
if the broker-dealer mails a financial disclosure statement with 
summary information and an Internet link to the balance sheet and other 
information on the broker-dealer's Web site. Before today's amendments, 
one of the conditions of the exemption was that the broker-dealer was 
not required during the prior year to give notice of a material 
inadequacy. The Commission proposed revising this condition for using 
Web site disclosure to provide that the broker-dealer's financial 
statements must receive an unqualified opinion from the accountant and 
that neither the broker-dealer nor the accountant identified a material 
weakness or an instance of material non-compliance.
    One commenter stated that a broker-dealer should be able to deliver 
the financial information available to customers via its Web site 
regardless of whether an instance of material non-compliance or 
material weakness was identified.\848\ Another commenter stated that 
the rule should not require a 100% rate of compliance with the 
financial responsibility rules to qualify for the exemption.\849\ A 
third commenter stated that the proposed amendment should be 
eliminated, or replaced with the requirement that broker-dealers 
include a notice of the material weakness or non-compliance on customer 
account statements for a year following its identification.\850\
---------------------------------------------------------------------------

    \848\ See ABA Letter.
    \849\ See CAI Letter. This commenter stated that FINRA has 
proposed that broker-dealers send customer account statements 
monthly instead of quarterly, broker-dealers are already potentially 
facing ``extremely high'' costs of sending information to customers. 
FINRA withdrew its proposals to send customer account statements 
monthly instead of quarterly on July 30, 2012. See SR-FINRA-2009-
028, Proposed Rule Change to Adopt FINRA Rule 2231 (Customer Account 
Statements) in the Consolidated FINRA Rulebook, Withdrawal of 
Proposed Rule Change (July 30, 2012), available at http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p143262.pdf.
    \850\ See SIFMA Letter.
---------------------------------------------------------------------------

    The Commission has decided not to adopt the proposed condition for 
qualifying for the conditional exemption. The decision not to adopt 
should result in lower costs than would have been incurred had the 
Commission adopted the proposal without modification. Using the 
Internet to disclose information should be less costly and more 
efficient for the broker-dealer than mailing paper copies to all 
customers. It also will benefit customers, since they will be able to 
access relevant broker-dealer information more efficiently through the 
Internet (alternatively, customers can request a paper copy by phone at 
no cost to the customer).\851\
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    \851\ See 17 CFR 240.17a-5(c)(5)(ii), (iv), and (v).
---------------------------------------------------------------------------

vii. Coordination With Investment Advisers Act Rule 206(4)-2
    Advisers Act Rule 206(4)-2 provides that when a registered 
investment adviser or its related person maintains client funds and 
securities as a qualified custodian in connection with advisory 
services provided to clients, the adviser annually must obtain, or 
receive from its related person, a written internal control report 
prepared by an independent public accountant registered with, and 
subject to regular inspection by, the PCAOB. This report must be 
supported by the accountant's examination of the qualified custodian's 
custody controls. Under the amendments, a broker-dealer that also acts 
as a qualified custodian for itself as an investment adviser or for its 
related investment advisers may use the report of the independent 
public accountant based on an examination of its compliance report to 
meet the reporting obligations under Rule 206(4)-2. Therefore, such a 
broker-dealer will not be required to obtain an internal control report 
under Rule 206(4)-2 in addition to a report covering the compliance 
report from its independent public accountant. It also will result in 
efficiencies as a single audit will be able to address two audit 
requirements.
2. Access to Accountant and Audit Documentation
    The amendments to Rule 17a-5 require that carrying or clearing 
broker-dealers agree to allow Commission and DEA staff, if requested in 
writing for purposes of an examination of the broker-dealer, to review 
the work papers of the independent public accountant and to allow the 
accountant to discuss the its findings with the examiners.
    This requirement will enable the Commission and DEAs to more 
efficiently deploy examination resources.\852\ Examiners reviewing the 
accountant's work papers will be able to tailor the scope of their 
examinations by identifying areas where extensive audit work was 
performed by the independent public accountant and focusing their 
examinations on other areas, allowing for more efficient oversight of 
broker-dealers by the Commission and DEA examination staff. Enabling 
Commission and DEA examination staff to conduct more focused and 
efficient examinations of broker-dealers could, in turn, allow for 
examination resources to be allocated more strategically.
---------------------------------------------------------------------------

    \852\ As discussed previously, where an independent public 
accountant has performed extensive testing of a carrying broker-
dealer's custody of securities and cash by confirming holdings at 
subcustodians, examiners could focus their efforts on matters that 
had not been the subject of prior testing and review.
---------------------------------------------------------------------------

    The Commission is amending paragraph (f)(2) of Rule 17a-5 to revise 
the statement regarding identification of a broker-dealer's independent 
public accountant that broker-dealers must file each year with the 
Commission and their DEA (except that if the engagement is of a 
continuing nature, no further filing is required).\853\ The revised 
statement contains additional information that includes a 
representation that the independent public accountant has undertaken to 
provide a report regarding the broker-dealer's financial reports and a 
report regarding the broker-dealer's compliance or exemption report, as 
applicable.\854\ In addition, the statement provided by a clearing or 
carrying broker-dealer must include representations regarding the 
access to accountant requirements described above.\855\ Therefore, all 
broker-dealers will generally be required to file a new

[[Page 51983]]

statement regarding their independent public accountant.
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    \853\ See discussion above in section III. of this release.
    \854\ See 17 CFR 240. 17a-5(f)(2)(ii).
    \855\ See 17 CFR 17a-5(f)(2)(ii)(F)-(G).
---------------------------------------------------------------------------

    As discussed above in section III. of this release, one commenter 
stated that, the amendments would discourage or ``chill'' 
communications between a broker-dealer and its auditor because of the 
possibility that an auditor may misconstrue communications from 
representatives of the broker-dealer and wrongly conclude that the 
representatives lack knowledge or admit to an issue.\856\ Presumably, 
this ``chilling effect'' would result from a broker-dealer's desire to 
avoid the creation of audit documentation memorializing 
misunderstandings and miscommunications, which when accessed by 
Commission and DEA examiners could result in regulatory scrutiny. As 
stated in section III. of this release, the Commission is not persuaded 
by this comment; while it is possible for miscommunications to occur 
between representatives of a broker-dealer and its auditor, potential 
misunderstandings or miscommunications should not limit the ability of 
the Commission or a DEA to have access to audit documentation or a 
broker-dealer's independent public accountant. Further, to the extent a 
misunderstanding or miscommunication between a broker-dealer and its 
accountant is reflected in the accountant's audit documentation 
relating to the broker-dealer, the broker-dealer could clarify the 
nature of the misunderstanding or miscommunication to examiners and how 
it was rectified if such clarification and rectification is not already 
described in subsequent audit documentation.
---------------------------------------------------------------------------

    \856\ See CAI Letter.
---------------------------------------------------------------------------

    The Commission estimated that the one-time hour burden associated 
with amending its existing statement and filing the new statement with 
the Commission, in order to comply with the proposed amendments, would 
be an average of approximately two hours on a one-time basis for each 
broker-dealer, as the statement can be continuing in nature.\857\
---------------------------------------------------------------------------

    \857\ See Broker-Dealer Reports, 76 FR at 37596.
---------------------------------------------------------------------------

    As discussed in the PRA, the Commission is revising this estimate 
for clearing and carrying broker-dealers, as these broker-dealers will 
likely be required to renegotiate their agreements with their 
independent public accountants. The Commission estimates that the total 
one-time cost associated with this burden is approximately $5.2 
million.\858\ Additionally, the Commission believes there will be 
postage costs associated with sending the amended statement regarding 
the accountant and estimates that each mailing will cost approximately 
$0.45, for a total cost of approximately $6,357 for all broker-dealers 
on a one-time basis.\859\
---------------------------------------------------------------------------

    \858\ See Section VI.D.1.vi. Based on staff experience, a 
broker-dealer that carries customer accounts or clears transactions 
likely would have its Controller and an Assistant General Counsel 
involved in renegotiating the agreement with auditors, and that 
those discussions would take, on average, approximately four hours. 
Broker-dealers would likely have an attorney prepare a new 
notification of designation of accountant, and that task would take 
the attorney, on average, approximately two hours. According to the 
SIFMA Report on Management and Professional Earnings in the 
Securities Industry, as modified by Commission staff to account for 
an 1,800-hour work-year and multiplied by 5.35 to account for 
bonuses, firm size, employee benefits and overhead, the hourly cost 
of a Controller is approximately $409/hour, the hourly cost of an 
Assistant General Counsel is approximately $407/hour, and the hourly 
cost of an Attorney is approximately $378/hour. 513 broker-dealers 
that carry customer accounts or clear transactions x 4 hours x $409 
= $839,268. 513 broker-dealers that carry customer accounts or clear 
transactions x 4 hours x $407 = $835,164. 4,709 broker-dealers x 2 
hours x $378 = $3,560,004. $839,268 + $835,164 + $3,560,004 = 
$5,234,436.
    \859\ See Section VI.D.1.vi. 4,709 broker-dealers x $0.45 cost 
for first class postage x 3 mailings = $6,375.15.
---------------------------------------------------------------------------

    In addition, in the proposing release, the Commission estimated 
that a carrying or clearing broker-dealer's accountant would charge the 
broker-dealer for time its personnel spend speaking with the Commission 
or the broker-dealer's DEA or providing them with audit documents and 
that, on average, the Commission or the broker-dealer's DEA may speak 
with each accountant for approximately five hours per year. Thus, the 
Commission estimated that the additional cost of accountant time 
associated with this amendment to all clearing and carrying broker-
dealers would be approximately $660,000 annually.\860\ As the 
Commission now estimates that the number of carrying or clearing 
broker-dealers is 513, the new estimate is approximately $641,250.\861\
---------------------------------------------------------------------------

    \860\ See Section VI.D.1.vii.d. In the proposing release the 
Commission multiplied 528 clearing and carrying broker-dealers x 5 
hours x $250/hour = $660,000.
    \861\ See Section VI.D.1.vii.d. 513 clearing and carrying 
broker-dealers x $1,250 in increased costs per clearing broker-
dealer = $641,250.
---------------------------------------------------------------------------

3. Form Custody
    The newly adopted Form Custody is to be filed quarterly at the same 
time that a broker-dealer is required to file its FOCUS Reports. The 
form elicits information concerning whether, and if so, how, a broker-
dealer maintains custody of customer assets and, as discussed above, 
consolidates information about the broker-dealer's custodial 
responsibility and relationships with other custodians in one report so 
that the Commission and other securities regulators will be provided 
with a comprehensive profile of the broker-dealer's custody practices 
and arrangements. This should reduce the likelihood that fraudulent 
conduct, including misappropriation or other misuse of investor assets, 
can continue undetected. Further, the information provided in Form 
Custody should aid in the examination of broker-dealers, because the 
examination staff can use the information provided as another tool to 
prioritize and plan examinations.
    The Form Custody amendments also should enhance investor confidence 
in the ability of the securities regulators to oversee broker-dealers 
and broker-dealer custody of investor assets. By establishing a 
discipline under which broker-dealers are required to report greater 
detail as to their custodial functions, investor perception as to the 
safety of their funds and securities held by broker-dealers should 
improve. Investors may be more willing to provide capital for 
investment. Further, the requirement by broker-dealers to provide 
detail as to their custodial practices may prompt them to identify and 
correct deficiencies. For example, if a broker-dealer preparing the 
information to be disclosed on the form discovers a discrepancy between 
its own records and the records of a custodian as to the nature or 
quantity of assets held by the custodian, the broker-dealer can act to 
resolve the discrepancy before filing the form.
    The Commission estimated that the time required to complete and 
file Form Custody would be approximately 12 hours per quarter, or 48 
hours per year, on average, for each broker-dealer.\862\ The Commission 
did not receive comments regarding this estimate. The Commission now 
estimates that there are approximately 4,709 broker-dealers that must 
file Form Custody. The Commission therefore estimates that the total 
time required to complete and file Form Custody for all 4,709 broker-
dealers is approximately 226,032 hours per year (4,709 broker-dealer 
times four responses per year times 12 hours = 226,032 hours). Further, 
the Commission estimates that the total cost associated with completing 
and filing Form Custody is approximately $69.8 million.\863\
---------------------------------------------------------------------------

    \862\ See Broker-Dealer Reports, 76 FR at 37597.
    \863\ Based on staff experience, a broker-dealer likely would 
have a Financial Reporting Manager complete and file Form Custody. 
According to the SIFMA Report on Management and Professional 
Earnings in the Securities Industry, as modified by Commission staff 
to account for an 1,800-hour work-year and multiplied by 5.35 to 
account for bonuses, firm size, employee benefits and overhead, the 
hourly cost of a Financial Reporting Manager is approximately $309/
hour. 4,709 broker-dealers x 48 hours x $309 = $69,843,888.

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[[Page 51984]]

    One commenter stated that the estimated costs to the industry of 
$69,179,670 in the proposing release was ``staggering,'' and that such 
costs would likely indirectly be passed on to customers.\864\ The 
commenter did not disagree with the estimated cost in the proposing 
release; rather, the commenter focused on the size of the total 
estimated costs. The Commission notes that the $69 million estimate in 
the proposing release and the $69.8 million estimate in this release 
are estimates of the aggregate cost to the industry. The average cost 
to an individual broker-dealer would be approximately $15,000 per 
year.\865\ As an average, the costs incurred by a broker-dealer to 
comply with the requirement to file Form Custody will depend on its 
size and the complexity of its business activities.
---------------------------------------------------------------------------

    \864\ See IMS Letter. The cost of $69,179,670 was reflected in 
the economic analysis in the proposing release. See Broker-Dealer 
Reports, 76 FR at 37601. This cost was calculated as an internal 
cost of the estimated PRA hours and is the total cost divided among 
5,057 firms. Id. at 37601 n.215. This internal cost would amount to 
an average of $13,680 per broker-dealer. Id.
    \865\ 1 broker-dealer x 48 hours x $309 = $14,832.
---------------------------------------------------------------------------

    The Commission recognizes that the requirement to file Form Custody 
will increase compliance costs for broker-dealers and that these costs 
may be passed on to customers. The Commission, however, believes the 
investor protection benefits of the Form Custody requirements outweigh 
these costs. As noted above, Form Custody is designed to assist 
Commission and DEA examiners in identifying potential 
misrepresentations relating to broker-dealers' custody of assets. 
Further, the requirements to file the form will promote greater focus 
and attention to custody practices by requiring that broker-dealers 
make specific representations in this regard. The safeguarding of 
customer securities and cash held by broker-dealers is of paramount 
importance as demonstrated by recent cases where broker-dealers failed 
to protect customer securities and cash.\866\
---------------------------------------------------------------------------

    \866\ See, e.g., SEC v. Bernard L. Madoff, et al., Litigation 
Release No. 20889 (Feb. 9, 2009).
---------------------------------------------------------------------------

4. Consideration of Burden on Competition, and Promotion of Efficiency, 
Competition, and Capital Formation
    As discussed above, incremental costs will result from the annual 
reporting requirement amendments, the access to accountant amendments, 
and the Form Custody amendments. These incremental costs could result 
in higher barriers to entry for broker-dealers as compared with the 
baseline that existed prior to the amendments. This could be the case 
particularly for carrying broker-dealers given the incremental costs 
associated with the compliance report requirements, the applicability 
of the access to accountant amendments to carrying and clearing broker-
dealers, and that most of the information elicited in Form Custody 
relates to carrying broker-dealer activities.
    The annual reporting requirements have a mixed effect on 
competition across broker-dealers. The requirement to prepare and file 
a compliance report or exemption report may impose a burden on 
competition for smaller carrying broker-dealers to the extent that it 
imposes relatively high fixed costs, which would represent a greater 
amount of net income for smaller broker-dealers. On the other hand, as 
previously noted, a carrying broker-dealer with limited custodial 
activities should have to expend less effort to support its statements 
in the compliance report than a broker-dealer with more extensive 
custodial activities, and the attendant costs should similarly be 
lower. While the incremental costs of the annual reporting requirements 
may be lower for non-carrying broker-dealers (which generally are 
smaller broker-dealers), the costs could disproportionately impact 
smaller broker-dealers due to fixed cost components of the cost of 
compliance with these requirements.
    The access to accountant amendments may place a burden on carrying 
and clearing broker dealers. To the extent that addressing contracts 
between auditors and broker-dealers is a fixed cost, the rule may 
impact smaller broker-dealers to a greater extent than it will larger 
broker-dealers. The amendments should not place a burden on competition 
for non-carrying broker-dealers.
    The requirement to file Form Custody could have a burden on 
competition because it will increase compliance costs for broker-
dealers. However, the requirement should not have a disproportionate 
effect on smaller broker-dealers. Smaller firms will incur fewer costs 
to complete Form Custody because less information is required to be 
disclosed. For example, broker-dealers that introduce customers on a 
fully disclosed basis and do not have custody of customer funds or 
assets would leave much of the form blank.
    In sum, the costs of compliance resulting from the requirements in 
these amendments should not impose a burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act and in light of the benefits discussed above.
    Today's amendments are designed to reduce the likelihood that 
fraudulent conduct, or lack of appropriate custody procedures or other 
internal controls, will jeopardize customer securities and funds held 
by broker-dealers. To the extent that the amendments achieve that goal, 
investors should be more confident that the customer assets held by 
broker-dealers are safe. This in turn may promote capital formation as 
investor assets are able to be allocated more efficiently across the 
opportunity set.
    One commenter asserted that the proposed amendments ``place 
unnecessary regulatory burdens and costs on industry, in general, and 
smaller firms, in particular'' and that ``broker-dealers compete 
against investment advisers who are not burdened by the same regulatory 
requirements,'' including the requirements in the proposed 
amendments.\867\ The Commission recognizes, as explained above, that 
the amendments adopted today impose costs on broker-dealers that could 
result in higher barriers to entry. However, the Commission is of the 
opinion that these costs are justified by the numerous and significant 
benefits, in particular with respect to protection of customer assets, 
described in this economic analysis.
---------------------------------------------------------------------------

    \867\ See IMS Letter.
---------------------------------------------------------------------------

    With respect to the commenter's statement about broker-dealers 
competing with investment advisers, recent Commission amendments to 
investment adviser rules are ``designed to provide additional 
safeguards . . . when a registered adviser has custody of client funds 
or securities'' including a requirement to undergo an annual surprise 
examination by an independent public accountant to verify client assets 
and a requirement to have a report of the internal controls relating to 
the custody of client assets from an accountant registered with, and 
subject to inspection by, the PCAOB unless client assets are maintained 
by an independent custodian.\868\ Consequently, the regulations 
governing

[[Page 51985]]

investment advisers have been strengthened in recent years through new 
requirements aimed at safeguarding customer assets. Today's amendments 
also are aimed at safeguarding customer assets. As both investment 
advisers and broker-dealers are now subject to new requirements, 
today's amendments should not create a competitive advantage for either 
class of registrant. Moreover, the recently adopted requirements for 
investment advisers and the amendments adopted today are, among other 
things, part of an effort to strengthen the Commission's rules 
regarding the safekeeping of customer assets, in part in response to 
several fraud cases brought by the Commission involving investment 
advisers and broker-dealers.\869\
---------------------------------------------------------------------------

    \868\ See Custody of Funds or Securities of Clients by 
Investment Advisers, 75 FR at 1456.
    \869\ Id.
---------------------------------------------------------------------------

    If the amendments increase investor confidence in broker-dealers, 
they will promote capital formation. Moreover, for the reasons 
discussed above, today's amendments should not unduly restrict 
competition and should promote capital formation.\870\
---------------------------------------------------------------------------

    \870\ The Commission stated in the proposing release that its 
preliminary view was that the proposed rule amendments promote 
efficiency, competition, and capital formation and that any burden 
on competition is justified by the benefits provided by the 
amendments. See Broker-Dealer Reports, 76 FR at 37598.
---------------------------------------------------------------------------

    The amendments also should increase efficiencies. With respect to 
the annual reporting amendments, updating the language of Rule 17a-5 to 
replace outdated or inconsistent audit terminology is designed to 
ensure that the requirements of the rule are better aligned with 
applicable current audit standards. Further, the amendments facilitate 
PCAOB oversight authority, including its ability to inspect audits of 
broker-dealers, by providing that examinations or reviews of broker-
dealer annual reports be made in accordance with PCAOB standards. In 
addition, the amendments strengthen and promote consistent compliance 
with the financial responsibility rules for broker-dealers that 
maintain custody of customer securities and funds by increasing the 
focus of these broker-dealers and their independent public accountants 
on compliance, and internal control over compliance, with the financial 
responsibility rules. This, in turn, should help the Commission and the 
broker-dealer's DEA identify broker-dealers that have weak internal 
controls for safeguarding investor assets and improve the financial and 
operational condition of broker-dealers and thereby provide more 
protection for investor assets held by broker-dealers.
    The access to accountant amendments should increase efficiencies by 
promoting more risk-based examinations by Commission and DEA staff. For 
example, the examiners in some cases may be able to leverage the work 
performed by the independent public accountants and, therefore, focus 
on areas the accountants did not review. Similarly, the Form Custody 
amendments should increase efficiencies by promoting more risk-based 
examinations by Commission and DEA staff as they will be able to use 
the profile of the broker-dealer's custody practices documented in Form 
Custody to focus their reviews. For this reason, examinations may also 
place fewer time demands on broker-dealer personnel.
    In significant part, the effect of these rules on efficiency and 
capital formation are linked to the effect of these rules on 
competition. For example, markets that are competitive and trusted may 
be expected to promote the efficient allocation of capital. Similarly, 
rules that promote, or do not unduly restrict, trust in broker-dealers 
can be accompanied by regulatory benefits that minimize the risk of 
market failure and thus promote efficiency within the market. Such 
competitive markets would increase the efficiency by which market 
participants could transact with broker-dealers.

VIII. Final Regulatory Flexibility Analysis

    The Regulatory Flexibility Act (``RFA'') \871\ requires Federal 
agencies, in promulgating rules, to consider the impact of those rules 
on small entities. Section 603(a) \872\ of the Administrative Procedure 
Act,\873\ as amended by the RFA, generally requires the Commission to 
undertake a regulatory flexibility analysis of all proposed rules, or 
proposed rule amendments, to determine the impact of such rulemaking on 
small entities.\874\ Section 605(b) of the RFA provides that this 
requirement does not apply to any proposed rule or proposed rule 
amendment, which if adopted, would not ``have a significant economic 
impact on a substantial number of small entities.'' \875\
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    \871\ 5 U.S.C. 601 et seq.
    \872\ 5 U.S.C. 603(a).
    \873\ 5 U.S.C. 551 et seq.
    \874\ Although section 601(b) of the RFA defines the term small 
entity, the statute permits agencies to formulate their own 
definitions. The Commission has adopted definitions for the term 
``small entity'' for the purposes of Commission rulemaking in 
accordance with the RFA. Those definitions, as relevant to this 
rulemaking, are set forth in Rule 0-10. See 17 CFR 240.0-10. See 
Statement of Management on Internal Accounting Control, Exchange Act 
Release No. 18451 (Jan. 28, 1982), 47 FR 5215 (Feb. 4, 1982).
    \875\ See 5 U.S.C. 605(b).
---------------------------------------------------------------------------

    The Commission proposed amendments to Rules 17a-5 and 17a-11 and 
proposed new Form Custody. An Initial Regulatory Flexibility Analysis 
(``IRFA'') was included in the proposing release.\876\ This Final 
Regulatory Flexibility Analysis has been prepared in accordance with 
the provisions of the RFA.
---------------------------------------------------------------------------

    \876\ See Broker-Dealer Reports, 76 FR at 37601-37602.
---------------------------------------------------------------------------

A. Need for and Objectives of the Amendments and New Form

    The final rules amend certain broker-dealer annual reporting, 
audit, and notification requirements. The amendments include a 
requirement that broker-dealer audits be conducted in accordance with 
standards of the PCAOB, that broker-dealers file either a compliance 
report or an exemption report covered by a report prepared by an 
independent public accountant, and that clearing broker-dealers allow 
representatives of the Commission or the broker-dealer's DEA to review 
the documentation associated with certain reports of the broker-
dealer's independent public accountant and to allow the accountant to 
discuss its findings with the representatives when requested in 
connection with a regulatory examination of the broker-dealer. The 
amendments also require a broker-dealer to file a new form with its DEA 
that elicits information about the broker-dealer's practices with 
respect to the custody of securities and funds of customers and others.
    The amendments and new form are designed, among other things, to 
provide additional safeguards with respect to broker-dealer custody of 
customer securities and funds, to enhance the ability of the Commission 
to oversee broker-dealer custody practices, to increase the focus of 
carrying broker-dealers and their independent public accountants on 
compliance, and internal control over compliance, with certain 
financial and custodial requirements, to facilitate the ability of the 
PCAOB to implement the explicit oversight authority over broker-dealer 
audits provided to the PCAOB by the Dodd-Frank Act, and to satisfy the 
internal control report requirement in Rule 206(4)-2 for certain 
broker-dealers affiliated with, or dually-registered as, investment 
advisers.

[[Page 51986]]

B. Significant Issues Raised by Public Comments

    The Commission requested comment with regard to matters discussed 
in the IRFA, including comments with respect to the number of small 
entities that may be affected by the proposed rule amendments and 
whether the effect on small entities would be economically 
significant.\877\
---------------------------------------------------------------------------

    \877\ Id. at 37602.
---------------------------------------------------------------------------

    The Commission did not receive any comments specifically addressing 
the IRFA. However, several commenters discussed the impact of the 
proposal on small broker-dealers. One commenter stated that the 
proposed amendments ``place unnecessary regulatory burdens and costs on 
the industry, in general, and smaller firms in particular.'' \878\ 
Another commenter stated that small broker-dealers may find the timing 
of the transition to be a ``burden,'' and requested that the Commission 
provide a longer transition period.\879\ A third commenter suggested 
that the exemption report and the accountant's report on the exemption 
report be replaced with a ``check box on the FOCUS report'' and that 
with regard to these reports ``[t]he amount of paperwork involved for 
small firms that do not carry customer securities seems rather 
excessive.'' \880\ A fourth commenter stated that the proposed 
transition period may burden smaller broker-dealers, and suggested that 
to facilitate the transition, the Commission should provide examples of 
best practices and deficiencies, with the cooperation of the 
AICPA.\881\ This commenter also suggested that the effective date for 
the annual reporting requirements should be one year after publication 
of the final rule.\882\
---------------------------------------------------------------------------

    \878\ See IMS Letter.
    \879\ See Citrin Letter.
    \880\ See Angel Letter.
    \881\ See Citrin Letter.
    \882\ Id. The commenter also specifically suggested that if non-
carrying and smaller broker-dealers must use PCAOB standards, that 
the Commission should defer the effective date for one year after 
the approval of the amendments. Id.
---------------------------------------------------------------------------

    The Commission is sensitive to the burdens the rule amendments and 
new form will have on small broker-dealers. To remove unnecessary 
burdens, the final rule amendments contain certain modifications from 
the proposal designed to alleviate some of the concerns regarding small 
broker-dealers.\883\ The modifications are discussed in the following 
paragraphs.
---------------------------------------------------------------------------

    \883\ As is discussed below, small broker-dealers are in most 
instances not carrying broker-dealers. See section VIII.C. of this 
release.
---------------------------------------------------------------------------

    As is discussed above, the Commission has modified the proposed 
amendments with respect to the exemption report in a manner that will 
likely result in lower costs for small broker-dealers than would have 
been the case if the Commission had adopted the proposed amendments 
without the modifications. In particular, the final rule provides that 
a broker-dealer can file the exemption report if it ``claimed that it 
was exempt'' from Rule 15c3-3 throughout the most recent fiscal year. 
This modification from the proposal--which provided that a broker-
dealer could file the exemption report if the broker-dealer ``is exempt 
from Rule 15c3-3''--is designed to address concerns raised by 
commenters that a non-carrying broker-dealer might be required to file 
the compliance report because of an instance during the year in which 
it did not meet the relied on exemption provision in paragraph (k) of 
Rule 15c3-3.\884\ As discussed in the economic analysis, the compliance 
report costs are significantly greater than the exemption report costs. 
The final rule clarifies that a non-carrying broker-dealer that has an 
exception to meeting the exemption provisions in paragraph (k) of Rule 
15c3-3 need not file the compliance report; however, the broker-dealer 
would be required to identify, to its best knowledge and belief, in its 
exemption report each exception during the most recent fiscal year, if 
applicable, including a brief description of the exception and the 
approximate date on which the exception existed.
---------------------------------------------------------------------------

    \884\ See SIFMA Letter. As discussed above in section II.B.1. of 
this release, there will be cases where a broker-dealer changes its 
business model to convert from a carrying broker-dealer to a non-
carrying broker-dealer during the fiscal year. In this case, the 
broker-dealer could seek exemptive relief under section 36 of the 
Exchange Act (15 U.S.C. 78mm) from the requirement to file the 
compliance report and to instead file the exemption report. In 
analyzing such a request, the period of time the broker-dealer 
operated as a carrying broker-dealer would be a relevant 
consideration.
---------------------------------------------------------------------------

    In addition, only clearing broker-dealers will be subject to the 
requirements that the Commission is adopting today that provide 
Commission and DEA examination staff with the ability to review audit 
documentation associated with broker-dealers' annual audit reports and 
allow their independent public accountants to discuss findings relating 
to the audit reports with Commission and DEA examination staff.
    To alleviate burdens associated with Form Custody, the Commission 
has modified the form's instructions to make clear that questions on 
the form that cannot be answered because the broker-dealer does not 
engage in a particular activity do not need to be answered.
    In response to comments, the Commission also has delayed the 
effective dates associated with the proposed reporting and attestation 
amendments, which will provide all broker-dealers, including smaller 
broker-dealers, with a longer transition period to prepare for the new 
requirements.
    As is discussed above, the Commission considered the comment that 
it should replace the exemption report with a box to check on the FOCUS 
Report as the amount of paperwork for small firms ``seems rather 
excessive.'' \885\ After careful consideration of this and other 
alternatives, the Commission determined that of the alternatives 
considered, none are appropriate alternatives to the exemption report. 
Requiring the broker-dealer to (1) create a separate written report 
stating that it is claiming the exemption and identifying the basis for 
the exemption, including any identified exceptions in meeting the 
conditions set forth in Sec.  240.15c3-3(k) and (2) file this report 
with the Commission and the broker-dealer's DEA should increase broker-
dealers' focus on the accuracy of its compliance with the statements 
being made because of the potential for liability for false statements, 
enhance compliance with the exemption conditions in Rule 15c3-3, and 
therefore provide better protection of customer assets.
---------------------------------------------------------------------------

    \885\ See section II.B.4.iii. of this release.
---------------------------------------------------------------------------

    Finally, with respect to the comment that the Commission should 
provide examples of best practices and deficiencies with the 
cooperation of the AICPA, the Commission notes that the question of 
whether further guidance is necessary is best answered after the 
requirements become effective and practical compliance questions arise. 
In addition, the Commission will publish a Small Entity Compliance 
Guide relating to these amendments.

C. Small Entities Subject to the Rules

    Paragraph (c) of Rule 0-10 provides that, for purposes of the RFA, 
a small entity when used with reference to a broker-dealer (``small 
broker-dealer'') means a broker-dealer that: (1) 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) or, if not required to file 
such statements, a broker-dealer that had total capital (net worth plus 
subordinated liabilities)

[[Page 51987]]

of less than $500,000 on the last business day of the preceding fiscal 
year (or in the time that it has been in business if shorter); and (2) 
is not affiliated with any person (other than a natural person) that is 
not a small business or small organization.\886\ Based on December 31, 
2011 FOCUS Report data, the Commission estimates that there are 
approximately 812 broker-dealers that are classified as ``small'' 
entities for purposes of the RFA. Of these, the Commission estimates 
that there are approximately eight broker-dealers that are carrying 
broker-dealers. The Commission estimated for purposes of the IRFA that 
there were approximately 871 broker-dealers that were classified as 
small entities for purposes of the RFA and that there were no broker-
dealers that were carrying firms that satisfied the definition of a 
small broker-dealer.\887\
---------------------------------------------------------------------------

    \886\ 17 CFR 240.0-10(c).
    \887\ See Broker-Dealer Reports, 76 FR at 37602. Although the 
Commission received no comments regarding the its initial estimate 
that there were no small carrying broker-dealers, the estimate is 
nonetheless being revised based on additional analysis of available 
information.
---------------------------------------------------------------------------

D. Reporting, Recordkeeping, and Other Compliance Requirements

    The Commission's amendments to Rule 17a-5 retain the current 
requirement that broker-dealers annually file financial statements and 
supporting schedules (``financial report'') that must be audited by a 
PCAOB-registered accountant. Under the amendments, the financial report 
must be audited in accordance with standards of the PCAOB, instead of 
in accordance with GAAS, as previously required.
    In addition to the financial report, the amendments require broker-
dealers to file one of two new reports: either a compliance report or 
an exemption report. If a broker-dealer did not claim that it was 
exempt from Rule 15c3-3 throughout the most recent fiscal year, the 
broker-dealer must prepare and file with the Commission a compliance 
report containing certain statements regarding the broker-dealer's 
internal control over compliance with the financial responsibility 
rules and compliance with certain of those rules. Alternatively, if the 
broker-dealer claimed that it was exempt from Rule 15c3-3 throughout 
the most recent fiscal year, the broker-dealer must prepare and file 
with the Commission an exemption report containing a statement that it 
claimed that it was exempt from Rule 15c3-3 during that period and 
identify the provisions under which it claimed that it was exempt from 
Rule 15c3-3.
    The amendments to Rule 17a-5 also eliminate the ``material 
inadequacy'' concept and, among other things, replace the requirement 
that the broker-dealer's independent public accountant prepare, and the 
broker-dealer file with the Commission, a material inadequacy report 
with a requirement for the accountant to prepare a new report covering 
either the compliance report or the exemption report, as applicable. If 
the broker-dealer is a carrying broker-dealer, the accountant must 
prepare a report based on an examination, in accordance with PCAOB 
standards, of certain statements by the broker-dealer in the compliance 
report. If the broker-dealer claimed an exemption from Rule 15c3-3, the 
accountant must prepare a report based on a review, in accordance with 
PCAOB standards, of the exemption report. Broker-dealers must file 
these reports of the accountant with the Commission along with the 
financial report and either the compliance report or the exemption 
report.
    Together, the financial report and the compliance report or the 
exemption report and the accountant's reports covering those reports 
comprise the annual reports that the broker-dealer must file each 
fiscal year with the Commission and the broker-dealer's DEA. The 
amendments require that the broker-dealer also file the annual reports 
with SIPC if the broker-dealer is a member of SIPC.
    Amendments to Rule 17a-5 also require that if, during the course of 
an audit, a broker-dealer's independent public accountant determines 
that the broker-dealer is not in compliance with the financial 
responsibility rules, or that any material weaknesses exist, the 
accountant must immediately notify the broker-dealer. The broker-dealer 
must notify the Commission and its DEA of the material weakness and 
must notify the Commission and the DEA of the non-compliance if that 
non-compliance would otherwise trigger a notification requirement.
    Amendments to Rule 17a-11 require that when a broker-dealer 
discovers, or is notified by its independent public accountant, of the 
existence of any material weakness under Rule 17a-5, the broker-dealer 
must notify the Commission and transmit a report to the Commission 
stating what the broker-dealer has done or is doing to correct the 
situation. The amendments substituted the term material weakness for 
the term material inadequacy with regard to Rule 17a-5.
    Under the amendments, carrying broker-dealers or those that clear 
transactions must agree to allow Commission or DEA examination staff, 
if requested in writing for purposes of an examination of the broker-
dealer, to review ``the documentation associated with the reports of 
the accountant'' and to discuss the accountant's findings with the 
accountant.
    The amendments require broker-dealers to file a new ``Form 
Custody'' each quarter to elicit information concerning whether a 
broker-dealer maintains custody of customer and non-customer assets, 
and, if so, how such assets are maintained. Form Custody must be filed 
with the broker-dealer's DEA. The DEA must transmit the information 
obtained from Form Custody to the Commission at the same time that it 
transmits FOCUS Report data to the Commission under paragraph (a)(4) of 
Rule 17a-5.
    The impact of the amendments on small broker-dealers will be 
substantially less than on larger firms. Most small broker-dealers are 
exempt from Rule 15c3-3 and therefore must file the exemption report. 
As discussed above, the exemption report must be reviewed by the 
independent public accountant, in lieu of the compliance report, which 
must be examined by the accountant. In addition, Form Custody would 
elicit less information from broker-dealers that do not maintain 
custody of customer assets, and therefore the form should be less 
burdensome for these broker-dealers.

E. Agency Action To Minimize Effect on Small Entities

    Pursuant to section 3(a) of the RFA,\888\ the Commission must 
consider significant alternatives that would accomplish the 
Commission's stated objectives, while minimizing any significant 
adverse impact on small entities. In connection with the final rules, 
the Commission considered the following alternatives: (1) Establishing 
differing compliance or reporting requirements or timetables that take 
into account the resources available to smaller entities; (2) 
clarifying, consolidating, or simplifying compliance and reporting 
requirements for smaller entities; (3) the use of performance standards 
rather than design standards; and (4) exempting smaller entities from 
coverage of the rules, or any part of the rules.
---------------------------------------------------------------------------

    \888\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    The Commission considered differing compliance and reporting 
requirements and timetables in adopting the amendments discussed in 
this release, which took into account the resources available to 
smaller entities. For

[[Page 51988]]

example, as is discussed above, the Commission considered alternatives 
to the exemption report requirements, which resulted in modifications 
to the final rule that make clear that broker-dealers claiming 
exemptions from Rule 15c3-3 will remain subject to those requirements 
even if certain exceptions arise.\889\ This reduces the burden on small 
broker-dealers that would otherwise be subject to the more resource-
intensive compliance and examination report requirements applicable to 
carrying broker-dealers.
---------------------------------------------------------------------------

    \889\ See sections II.B.4.iii. and VII.C.1.ii.b. of this 
release.
---------------------------------------------------------------------------

    In addition, the Commission, in establishing effective dates for 
these amendments, considered the resources available to small broker-
dealers. In this regard, the Commission is delaying the effective dates 
for the audit and reporting requirements, which will provide small 
broker-dealers with greater flexibility in allocating their resources 
while preparing to comply with applicable amendments.
    The Commission also clarified, consolidated, and simplified 
compliance and reporting requirements for broker-dealers in connection 
with the amendments. As discussed above, the Commission clarified and 
simplified requirements applicable to Form Custody by specifying in the 
final form that broker-dealers are not required to answer questions 
that do not apply to their business activities. Further, in terms of 
consolidating regulatory requirements applicable to broker-dealers, a 
broker-dealer affiliated with, or dually-registered as, an investment 
adviser that is subject to the compliance report requirement can use 
the independent public accountant's examination of the compliance 
report to satisfy reporting obligations under Advisers Act Rule 206(4)-
2.
    The Commission generally used design standards rather than 
performance standards in connection with the final rule amendments 
because the Commission believes design standards will better accomplish 
its objectives of enhancing safeguards with respect to broker-dealer 
custody of securities and funds. The specific disclosure requirements 
in the final rule will promote comparable and consistent types of 
disclosures by broker-dealers, which will facilitate the ability of 
Commission and DEA staff to assess broker-dealer compliance with 
applicable requirements.
    The Commission also considered, and is adopting, amendments that 
exempt certain types of broker-dealers from certain requirements. For 
example, broker-dealers that are not clearing broker-dealers, which 
include most small broker-dealers, do not need to comply with the 
access to accountant and audit documentation amendments. Most small 
broker-dealers also will not be subject to the new compliance and 
examination report requirements, as small broker-dealers are in most 
instances not carrying broker-dealers.
    In addition, if the Commission subsequently determines that it is 
appropriate to exempt a broker-dealer, or type of broker-dealer, from 
such requirements, the Commission has existing authority under which it 
can act. In particular, under Exchange Act section 36, the Commission, 
by rule, regulation, or order, may exempt any person, or any class or 
classes of persons, from any rule under the Exchange Act to the extent 
that such exemption is necessary or appropriate in the public interest 
and is consistent with the protection of investors.\890\
---------------------------------------------------------------------------

    \890\ 15 U.S.C. 78mm.
---------------------------------------------------------------------------

IX. Statutory Authority

    The Commission is amending Rule 17a-5 and Rule 17a-11 under the 
Exchange Act (17 CFR 240.17a-5 and 17 CFR 240.17a-11) and adopting new 
Form Custody (17 CFR 249.639) pursuant to the authority conferred by 
the Exchange Act, including sections 15, 17, 23(a) and 36.\891\
---------------------------------------------------------------------------

    \891\ 15 U.S.C. 78o, 78q, 78w(a) and 78mm.
---------------------------------------------------------------------------

List of Subjects in 17 CFR Parts 240 and 249

    Brokers, Confidential business information, Fraud, Reporting and 
recordkeeping requirements, Securities.

Text of the Amendments

    For the reasons set out in the preamble, the Commission is amending 
Title 17, Chapter II, of the Code of Federal Regulations as follows:

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

0
1. The authority citation for part 240 continues to read, in part, as 
follows:

    Authority:  15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f, 
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4, 
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 
80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq., and 
8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; and 
Pub. L. 111-203, 939A, 124 Stat. 1376, (2010), unless otherwise 
noted.
* * * * *

0
2. Section 240.17a-5 is amended by:
0
a. In paragraph (a)(2)(i), adding the word ``transactions'' after the 
word ``clears'' and removing the words ``shall file'' and adding in 
their place ``must file with the Commission.''
0
b. In paragraph (a)(2)(ii), removing the words ``shall file'' and 
adding in their place ``must file with the Commission'' and removing 
the phrase ``date selected for the annual audit of financial statements 
where said date is other than a calendar quarter'' and adding in its 
place ``end of the fiscal year of the broker or dealer where that date 
is not the end of a calendar quarter.'';
0
c. In paragraph (a)(2)(iii), removing the phrase ``who does not carry 
nor clear transactions nor carry customer accounts shall file'' and 
adding in its place ``that neither clears transactions nor carries 
customer accounts must file with the Commission'' and removing the 
phrase ``date selected for the annual audit of financial statements 
where said date is other than the end of the calendar quarter.'' and 
adding in its place ``end of the fiscal year of the broker or dealer 
where that date is not the end of a calendar quarter.'';
0
d. In paragraph (a)(2)(iv), removing the words ``shall file'' and 
adding in their place ``must file with the Commission'' and adding the 
phrase ``(``designated examining authority'')'' after the phrase 
``section 17(d) of the Act'';
0
e. In paragraph (a)(3), in the first sentence, adding the words ``that 
must be filed with the Commission'' after the words ``provided for in 
this paragraph (a)'';
0
f. Redesignating paragraphs (a)(5) and (6) as paragraphs (a)(6) and 
(7);
0
g. In newly redesignated paragraph (a)(6)(ii)(A), removing the phrase 
``(a)(5)(i)'' and adding in its place ``(a)(6)(i)'';
0
h. Adding new paragraph (a)(5);
0
i. Revising paragraph (b)(2);
0
j. In paragraph (b)(4), removing the word ``he'' and adding in its 
place ``the broker or dealer''.
0
k. Removing paragraph (b)(6);
0
l. In paragraph (c)(1)(i), removing the phrase ``his customers'' and 
adding in its place ``customers of the introducing broker or dealer'';
0
m. In paragraph (c)(1)(iii), removing the phrase ``in the manner 
contemplated by the $2,500 minimum net capital requirement of Sec.  
240.15c3-1'' and adding in its place ``and otherwise qualified to 
maintain net capital of no less than what is required under Sec.  
240.15c3-1(a)(2)(iv)'';
0
n. In paragraph (c)(2) introductory text, in the first sentence, 
removing the phrase ``date of the audited financial statements required 
by paragraph (d) of

[[Page 51989]]

this section'' and adding in its place ``end of the fiscal year of the 
broker or dealer'';
0
o. In paragraph (c)(2)(i) removing the phrase ``balance sheet with 
appropriate notes prepared in accordance with'' and adding in its place 
``Statement of Financial Condition with appropriate notes prepared in 
accordance with U.S.'';
0
p. Removing paragraph (c)(2)(iii);
0
q. Redesignating paragraph (c)(2)(iv) as (c)(2)(iii);
0
r. In newly redesignated paragraph (c)(2)(iii), removing the phrase 
``annual audit report of the broker or dealer pursuant to Sec.  
240.17a-5'' and adding in its place ``financial report of the broker or 
dealer under paragraph (d)(1)(i)(A) of this section'' and adding at the 
end the word ``and'';
0
s. Adding new paragraph (c)(2)(iv);
0
t. In paragraph (c)(4) introductory text removing the word 
```customer''' and adding in its place ``customer'';
0
u. In paragraphs (c)(5)(ii)(A) and (c)(5)(iii) introductory text, 
removing the phrases ``Web site'' and ``Web sites'' and adding in their 
place ``website'' and ``websites'';
0
v. Removing paragraph (c)(5)(vi);
0
w. Revising paragraph (d);
0
x. In paragraph (e) introductory text, removing the phrase ``financial 
statements'' and adding in its place ``annual reports'' and removing 
the word ``shall'' and adding in its place ``must'';
0
y. Revising paragraphs (e)(1) through (4);
0
z. Removing paragraph (e)(5);
0
aa. Revising paragraphs (f) through (i);
0
bb. Removing and reserving paragraph (j);
0
cc. In paragraph (m)(1), removing the word ``audit'' after the word 
``annual''; and
0
dd. In paragraph (n)(2) removing the phrase ``audit report'' and adding 
in its place ``annual reports''; adding the phrase ``in writing'' after 
the word ``approved'' and removing the phrase ``pursuant to paragraph 
(d)(1)(i) of this section'' and adding in its place ``of the broker or 
dealer''.
    The revisions and additions read as follows:


Sec.  240.17a-5  Reports to be made by certain brokers and dealers.

    (a) * * *
    (5) Every broker or dealer subject to this paragraph (a) must file 
Form Custody (Sec.  249.639 of this chapter) with its designated 
examining authority within 17 business days after the end of each 
calendar quarter and within 17 business days after the end of the 
fiscal year of the broker or dealer where that date is not the end of a 
calendar quarter. The designated examining authority must maintain the 
information obtained through the filing of Form Custody and transmit 
the information to the Commission, at such time as it transmits the 
applicable part of Form X-17A-5 (Sec.  249.617 of this chapter) as 
required in paragraph (a)(4) of this section.
* * * * *
    (b) * * *
    (2) The broker or dealer must attach to the report required by 
paragraph (b)(1) of this section an oath or affirmation that to the 
best knowledge and belief of the person making the oath or affirmation 
the information contained in the report is true and correct. The oath 
or affirmation must be made before a person duly authorized to 
administer such oaths or affirmations. If the broker or dealer is a 
sole proprietorship, the oath or affirmation must be made by the 
proprietor; if a partnership, by a general partner; if a corporation, 
by a duly authorized officer; or if a limited liability company or 
limited liability partnership, by the chief executive officer, chief 
financial officer, manager, managing member, or those members vested 
with management authority for the limited liability company or limited 
liability partnership.
* * * * *
    (c) * * *
    (2) * * *
    (iv) If, in connection with the most recent annual reports required 
under paragraph (d) of this section, the report of the independent 
public accountant required under paragraph (d)(1)(i)(C) of this section 
covering the report of the broker or dealer required under paragraph 
(d)(1)(i)(B)(1) of this section identifies one or more material 
weaknesses, a statement by the broker or dealer that one or more 
material weaknesses have been identified and that a copy of the report 
of the independent public accountant required under paragraph 
(d)(1)(i)(C) of this section is currently available for the customer's 
inspection at the principal office of the Commission in Washington, DC, 
and the regional office of the Commission for the region in which the 
broker or dealer has its principal place of business.
* * * * *
    (d) Annual reports. (1)(i) Except as provided in paragraphs 
(d)(1)(iii) and (d)(1)(iv) of this section, every broker or dealer 
registered under section 15 of the Act must file annually:
    (A) A financial report as described in paragraph (d)(2) of this 
section; and
    (B)(1) If the broker or dealer did not claim it was exempt from 
Sec.  240.15c3-3 throughout the most recent fiscal year, a compliance 
report as described in paragraph (d)(3) of this section executed by the 
person who makes the oath or affirmation under paragraph (e)(2) of this 
section; or
    (2) If the broker or dealer did claim that it was exempt from Sec.  
240.15c3-3 throughout the most recent fiscal year, an exemption report 
as described in paragraph (d)(4) of this section executed by the person 
who makes the oath or affirmation under paragraph (e)(2) of this 
section;
    (C) Except as provided in paragraph (e)(1)(i) of this section, a 
report prepared by an independent public accountant, under the 
engagement provisions in paragraph (g) of this section, covering each 
report required to be filed under paragraphs (d)(1)(i)(A) and (B) of 
this section.
    (ii) The reports required to be filed under this paragraph (d) must 
be as of the same fiscal year end each year, unless a change is 
approved in writing by the designated examining authority for the 
broker or dealer under paragraph (n) of this section. A copy of the 
written approval must be sent to the Commission's principal office in 
Washington, DC, and the regional office of the Commission for the 
region in which the broker or dealer has its principal place of 
business.
    (iii) A broker or dealer succeeding to and continuing the business 
of another broker or dealer need not file the reports under this 
paragraph (d) as of a date in the fiscal year in which the succession 
occurs if the predecessor broker or dealer has filed reports in 
compliance with this paragraph (d) as of a date in such fiscal year.
    (iv) A broker or dealer that is a member of a national securities 
exchange, has transacted a business in securities solely with or for 
other members of a national securities exchange, and has not carried 
any margin account, credit balance, or security for any person who is 
defined as a customer in paragraph (c)(4) of this section, is not 
required to file reports under this paragraph (d).
    (2) Financial report. The financial report must contain:
    (i) A Statement of Financial Condition, a Statement of Income, a 
Statement of Cash Flows, a Statement of Changes in Stockholders' or 
Partners' or Sole Proprietor's Equity, and a Statement of Changes in 
Liabilities Subordinated to Claims of General Creditors. The statements 
must be prepared in accordance with U.S. generally accepted accounting 
principles and must be in a format that is consistent with the 
statements

[[Page 51990]]

contained in Form X-17A-5 (Sec.  249.617 of this chapter) Part II or 
Part IIA. If the Statement of Financial Condition filed in accordance 
with instructions to Form X-17A-5, Part II or Part IIA, is not 
consolidated, a summary of financial data, including the assets, 
liabilities, and net worth or stockholders' equity, for subsidiaries 
not consolidated in the Part II or Part IIA Statement of Financial 
Condition as filed by the broker or dealer must be included in the 
notes to the financial statements reported on by the independent public 
accountant.
    (ii) Supporting schedules that include, from Part II or Part IIA of 
Form X-17A-5 (Sec.  249.617 of this chapter), a Computation of Net 
Capital Under Sec.  240.15c3-1, a Computation for Determination of the 
Reserve Requirements under Exhibit A of Sec.  240.15c3-3, and 
Information Relating to the Possession or Control Requirements Under 
Sec.  240.15c3-3.
    (iii) If either the Computation of Net Capital under Sec.  
240.15c3-1 or the Computation for Determination of the Reserve 
Requirements Under Exhibit A of Sec.  240.15c3-3 in the financial 
report is materially different from the corresponding computation in 
the most recent Part II or Part IIA of Form X-17A-5 (Sec.  249.617 of 
this chapter) filed by the broker or dealer pursuant to paragraph (a) 
of this section, a reconciliation, including appropriate explanations, 
between the computation in the financial report and the computation in 
the most recent Part II or Part IIA of Form X-17A-5 filed by the broker 
or dealer. If no material differences exist, a statement so indicating 
must be included in the financial report.
    (3) Compliance report. (i) The compliance report must contain:
    (A) Statements as to whether:
    (1) The broker or dealer has established and maintained Internal 
Control Over Compliance as that term is defined in paragraph (d)(3)(ii) 
of this section;
    (2) The Internal Control Over Compliance of the broker or dealer 
was effective during the most recent fiscal year;
    (3) The Internal Control Over Compliance of the broker or dealer 
was effective as of the end of the most recent fiscal year;
    (4) The broker or dealer was in compliance with Sec. Sec.  
240.15c3-1 and 240.15c3-3(e) as of the end of the most recent fiscal 
year; and
    (5) The information the broker or dealer used to state whether it 
was in compliance with Sec. Sec.  240.15c3-1 and 240.15c3-3(e) was 
derived from the books and records of the broker or dealer.
    (B) If applicable, a description of each material weakness in the 
Internal Control Over Compliance of the broker or dealer during the 
most recent fiscal year.
    (C) If applicable, a description of any instance of non-compliance 
with Sec. Sec.  240.15c3-1 or 240.15c3-3(e) as of the end of the most 
recent fiscal year.
    (ii) The term Internal Control Over Compliance means internal 
controls that have the objective of providing the broker or dealer with 
reasonable assurance that non-compliance with Sec.  240.15c3-1, Sec.  
240.15c3-3, Sec.  240.17a-13, or any rule of the designated examining 
authority of the broker or dealer that requires account statements to 
be sent to the customers of the broker or dealer (an ``Account 
Statement Rule'') will be prevented or detected on a timely basis.
    (iii) The broker or dealer is not permitted to conclude that its 
Internal Control Over Compliance was effective during the most recent 
fiscal year if there were one or more material weaknesses in its 
Internal Control Over Compliance during the most recent fiscal year. 
The broker or dealer is not permitted to conclude that its Internal 
Control Over Compliance was effective as of the end of the most recent 
fiscal year if there were one or more material weaknesses in its 
internal control as of the end of the most recent fiscal year. A 
material weakness is a deficiency, or a combination of deficiencies, in 
Internal Control Over Compliance such that there is a reasonable 
possibility that non-compliance with Sec. Sec.  240.15c3-1 or 240.15c3-
3(e) will not be prevented or detected on a timely basis or that non-
compliance to a material extent with Sec.  240.15c3-3, except for 
paragraph (e), Sec.  240.17a-13, or any Account Statement Rule will not 
be prevented or detected on a timely basis. A deficiency in Internal 
Control Over Compliance exists when the design or operation of a 
control does not allow the management or employees of the broker or 
dealer, in the normal course of performing their assigned functions, to 
prevent or detect on a timely basis non-compliance with Sec.  240.15c3-
1, Sec.  240.15c3-3, Sec.  240.17a-13, or any Account Statement Rule.
    (4) Exemption report. The exemption report must contain the 
following statements made to the best knowledge and belief of the 
broker or dealer:
    (i) A statement that identifies the provisions in Sec.  240.15c3-
3(k) under which the broker or dealer claimed an exemption from Sec.  
240.15c3-3;
    (ii) A statement that the broker or dealer met the identified 
exemption provisions in Sec.  240.15c3-3(k) throughout the most recent 
fiscal year without exception or that it met the identified exemption 
provisions in Sec.  240.15c3-3(k) throughout the most recent fiscal 
year except as described under paragraph (d)(4)(iii) of this section; 
and
    (iii) If applicable, a statement that identifies each exception 
during the most recent fiscal year in meeting the identified exemption 
provisions in Sec.  240.15c3-3(k) and that briefly describes the nature 
of each exception and the approximate date(s) on which the exception 
existed.
    (5) The annual reports must be filed not more than sixty (60) 
calendar days after the end of the fiscal year of the broker or dealer.
    (6) The annual reports must be filed at the regional office of the 
Commission for the region in which the broker or dealer has its 
principal place of business, the Commission's principal office in 
Washington, DC, the principal office of the designated examining 
authority for the broker or dealer, and with the Securities Investor 
Protection Corporation (``SIPC'') if the broker or dealer is a member 
of SIPC. Copies of the reports must be provided to all self-regulatory 
organizations of which the broker or dealer is a member, unless the 
self-regulatory organization by rule waives this requirement.
    (e) * * *
    (1)(i) The broker or dealer is not required to engage an 
independent public accountant to provide the reports required under 
paragraph (d)(1)(i)(C) of this section if, since the date of the 
registration of the broker or dealer under section 15 of the Act (15 
U.S.C. 78o) or of the previous annual reports filed under paragraph (d) 
of this section:
    (A) The securities business of the broker or dealer has been 
limited to acting as broker (agent) for the issuer in soliciting 
subscriptions for securities of the issuer, the broker has promptly 
transmitted to the issuer all funds and promptly delivered to the 
subscriber all securities received in connection with the transaction, 
and the broker has not otherwise held funds or securities for or owed 
money or securities to customers; or
    (B) The securities business of the broker or dealer has been 
limited to buying and selling evidences of indebtedness secured by 
mortgage, deed of trust, or other lien upon real estate or leasehold 
interests, and the broker or dealer has not carried any margin account, 
credit balance, or security for any securities customer.
    (ii) A broker or dealer that files annual reports under paragraph 
(d) of this

[[Page 51991]]

section that are not covered by reports prepared by an independent 
public accountant must include in the oath or affirmation required by 
paragraph (e)(2) of this section a statement of the facts and 
circumstances relied upon as a basis for exemption from the requirement 
that the annual reports filed under paragraph (d) of this section be 
covered by reports prepared by an independent public accountant.
    (2) The broker or dealer must attach to the financial report an 
oath or affirmation that, to the best knowledge and belief of the 
person making the oath or affirmation,
    (i) The financial report is true and correct; and
    (ii) Neither the broker or dealer, nor any partner, officer, 
director, or equivalent person, as the case may be, has any proprietary 
interest in any account classified solely as that of a customer.
    The oath or affirmation must be made before a person duly 
authorized to administer such oaths or affirmations. If the broker or 
dealer is a sole proprietorship, the oath or affirmation must be made 
by the proprietor; if a partnership, by a general partner; if a 
corporation, by a duly authorized officer; or if a limited liability 
company or limited liability partnership, by the chief executive 
officer, chief financial officer, manager, managing member, or those 
members vested with management authority for the limited liability 
company or limited liability partnership.
* * * * *
    (3) The annual reports filed under paragraph (d) of this section 
are not confidential, except that, if the Statement of Financial 
Condition in a format that is consistent with Form X-17A-5 (Sec.  
249.617 of this chapter), Part II, or Part IIA, is bound separately 
from the balance of the annual reports filed under paragraph (d) of 
this section, and each page of the balance of the annual reports is 
stamped ``confidential,'' then the balance of the annual reports shall 
be deemed confidential to the extent permitted by law. However, the 
annual reports, including the confidential portions, will be available 
for official use by any official or employee of the U.S. or any State, 
by national securities exchanges and registered national securities 
associations of which the broker or dealer filing such a report is a 
member, by the Public Company Accounting Oversight Board, and by any 
other person if the Commission authorizes disclosure of the annual 
reports to that person as being in the public interest. Nothing 
contained in this paragraph may be construed to be in derogation of the 
rules of any registered national securities association or national 
securities exchange that give to customers of a member broker or dealer 
the right, upon request to the member broker or dealer, to obtain 
information relative to its financial condition.
    (4)(i) The broker or dealer must file with SIPC a report on the 
SIPC annual general assessment reconciliation or exclusion from 
membership forms that contains such information and is in such format 
as determined by SIPC by rule and approved by the Commission.
    (ii) Until the earlier of two years after the date paragraph 
(e)(4)(i) of this section is effective or SIPC adopts a rule under 
paragraph (e)(4)(i) of this section and the rule is approved by the 
Commission, the broker or dealer must file with SIPC a supplemental 
report on the status of the membership of the broker or dealer in SIPC 
if, under paragraph (d)(1)(i)(C) of this section, the broker or dealer 
is required to file reports prepared by an independent public 
accountant. The supplemental report must include the independent public 
accountant's report on applying agreed-upon procedures based on the 
performance of the procedures enumerated in paragraph (e)(4)(ii)(C) of 
this section. The supplemental report must cover the SIPC annual 
general assessment reconciliation or exclusion from membership forms 
not previously reported on under this paragraph (e)(4) that were 
required to be filed on or prior to the date of the annual reports 
required by paragraph (d) of this section: Provided, that the broker or 
dealer is not required to file the supplemental report on the SIPC 
annual general assessment reconciliation or exclusion from membership 
form for any period during which the SIPC assessment is a specified 
dollar value as provided for in section 4(d)(1)(c) of the Securities 
Investor Protection Act of 1970, as amended. The supplemental report 
must be filed with the regional office of the Commission for the region 
in which the broker or dealer has its principal place of business, the 
Commission's principal office in Washington, DC, the principal office 
of the designated examining authority for the broker or dealer, and the 
principal office of SIPC. The supplemental report must include the 
following:
    (A) A schedule of assessment payments showing any overpayments 
applied and overpayments carried forward including: payment dates, 
amounts, and name of SIPC collection agent to whom mailed; or
    (B) If exclusion from membership was claimed, a statement that the 
broker or dealer qualified for exclusion from membership under the 
Securities Investor Protection Act of 1970, as amended; and
    (C) An independent public accountant's report. The independent 
public accountant must be engaged to perform the following procedures:
    (1) Comparison of listed assessment payments with respective cash 
disbursements record entries;
    (2) For all or any portion of a fiscal year, comparison of amounts 
reflected in the annual reports required by paragraph (d) of this 
section with amounts reported in the Annual General Assessment 
Reconciliation (Form SIPC-7);
    (3) Comparison of adjustments reported in Form SIPC-7 with 
supporting schedules and working papers supporting the adjustments;
    (4) Proof of the arithmetical accuracy of the calculations 
reflected in Form SIPC-7 and in the schedules and working papers 
supporting any adjustments; and
    (5) Comparison of the amount of any overpayment applied with the 
Form SIPC-7 on which it was computed; or
    (6) If exclusion from membership is claimed, a comparison of the 
income or loss reported in the financial report required by paragraph 
(d)(2) of this section with the Certification of Exclusion from 
Membership (Form SIPC-3).
    (f)(1) Qualifications of independent public accountant. The 
independent public accountant must be qualified and independent in 
accordance with Sec.  210.2-01 of this chapter and the independent 
public accountant must be registered with the Public Company Accounting 
Oversight Board if required by the Sarbanes-Oxley Act of 2002.
    (2) Statement regarding independent public accountant. (i) Every 
broker or dealer that is required to file annual reports under 
paragraph (d) of this section must file no later than December 10 of 
each year (or 30 calendar days after the effective date of its 
registration as a broker or dealer, if earlier) a statement as 
prescribed in paragraph (f)(2)(ii) of this section with the 
Commission's principal office in Washington, DC, the regional office of 
the Commission for the region in which its principal place of business 
is located, and the principal office of the designated examining 
authority for the broker or dealer. The statement must be dated no 
later than December 1 (or 20 calendar days after the effective date of 
its registration as a broker or dealer, if earlier). If the engagement 
of an

[[Page 51992]]

independent public accountant is of a continuing nature, providing for 
successive engagements, no further filing is required. If the 
engagement is for a single year, or if the most recent engagement has 
been terminated or amended, a new statement must be filed by the 
required date.
    (ii) The statement must be headed ``Statement regarding independent 
public accountant under Rule 17a-5(f)(2)'' and must contain the 
following information and representations:
    (A) Name, address, telephone number, and registration number of the 
broker or dealer.
    (B) Name, address, and telephone number of the independent public 
accountant.
    (C) The date of the fiscal year of the annual reports of the broker 
or dealer covered by the engagement.
    (D) Whether the engagement is for a single year or is of a 
continuing nature.
    (E) A representation that the independent public accountant has 
undertaken the items enumerated in paragraphs (g)(1) and (2) of this 
section.
    (F) Except as provided in paragraph (f)(2)(iii) of this section, a 
representation that the broker or dealer agrees to allow 
representatives of the Commission or its designated examining 
authority, if requested in writing for purposes of an examination of 
the broker or dealer, to review the audit documentation associated with 
the reports of the independent public accountant filed under paragraph 
(d)(1)(i)(C) of this section. For purposes of this paragraph, ``audit 
documentation'' has the meaning provided in standards of the Public 
Company Accounting Oversight Board. The Commission anticipates that, if 
requested, it will accord confidential treatment to all documents it 
may obtain from an independent public accountant under this paragraph 
to the extent permitted by law.
    (G) Except as provided in paragraph (f)(2)(iii) of this section, a 
representation that the broker or dealer agrees to allow the 
independent public accountant to discuss with representatives of the 
Commission and its designated examining authority, if requested in 
writing for purposes of an examination of the broker or dealer, the 
findings associated with the reports of the independent public 
accountant filed under paragraph (d)(1)(i)(C) of this section.
    (iii) If a broker or dealer neither clears transactions nor carries 
customer accounts, the broker or dealer is not required to include the 
representations in paragraphs (f)(2)(ii)(F) and (G) of this section.
    (iv) Any broker or dealer that is not required to file reports 
prepared by an independent public accountant under paragraph 
(d)(1)(i)(C) of this section must file a statement required under 
paragraph (f)(2)(i) of this section indicating the date as of which the 
unaudited reports will be prepared.
    (3) Replacement of accountant. A broker or dealer must file a 
notice that must be received by the Commission's principal office in 
Washington, DC, the regional office of the Commission for the region in 
which its principal place of business is located, and the principal 
office of the designated examining authority for the broker or dealer 
not more than 15 business days after:
    (i) The broker or dealer has notified the independent public 
accountant that provided the reports the broker or dealer filed under 
paragraph (d)(1)(i)(C) of this section for the most recent fiscal year 
that the independent public accountant's services will not be used in 
future engagements; or
    (ii) The broker or dealer has notified an independent public 
accountant that was engaged to provide the reports required under 
paragraph (d)(1)(i)(C) of this section that the engagement has been 
terminated; or
    (iii) An independent public accountant has notified the broker or 
dealer that the independent public accountant would not continue under 
an engagement to provide the reports required under paragraph 
(d)(1)(i)(C) of this section; or
    (iv) A new independent public accountant has been engaged to 
provide the reports required under paragraph (d)(1)(i)(C) of this 
section without any notice of termination having been given to or by 
the previously engaged independent public accountant.
    (v) The notice must include:
    (A) The date of notification of the termination of the engagement 
or of the engagement of the new independent public accountant, as 
applicable; and
    (B) The details of any issues arising during the 24 months (or the 
period of the engagement, if less than 24 months) preceding the 
termination or new engagement relating to any matter of accounting 
principles or practices, financial statement disclosure, auditing scope 
or procedure, or compliance with applicable rules of the Commission, 
which issues, if not resolved to the satisfaction of the former 
independent public accountant, would have caused the independent public 
accountant to make reference to them in the report of the independent 
public accountant. The issues required to be reported include both 
those resolved to the former independent public accountant's 
satisfaction and those not resolved to the former accountant's 
satisfaction. Issues contemplated by this section are those that occur 
at the decision-making level--that is, between principal financial 
officers of the broker or dealer and personnel of the accounting firm 
responsible for rendering its report. The notice must also state 
whether the accountant's report filed under paragraph (d)(1)(i)(C) of 
this section for any of the past two fiscal years contained an adverse 
opinion or a disclaimer of opinion or was qualified as to 
uncertainties, audit scope, or accounting principles, and must describe 
the nature of each such adverse opinion, disclaimer of opinion, or 
qualification. The broker or dealer must also request the former 
independent public accountant to furnish the broker or dealer with a 
letter addressed to the Commission stating whether the independent 
public accountant agrees with the statements contained in the notice of 
the broker or dealer and, if not, stating the respects in which 
independent public accountant does not agree. The broker or dealer must 
file three copies of the notice and the accountant's letter, one copy 
of which must be manually signed by the sole proprietor, a general 
partner, or a duly authorized corporate, limited liability company, or 
limited liability partnership officer or member, as appropriate, and by 
the independent public accountant, respectively.
    (g) Engagement of independent public accountant. The independent 
public accountant engaged by the broker or dealer to provide the 
reports required under paragraph (d)(1)(i)(C) of this section must, as 
part of the engagement, undertake the following, as applicable:
    (1) To prepare an independent public accountant's report based on 
an examination of the financial report required to be filed by the 
broker or dealer under paragraph (d)(1)(i)(A) of this section in 
accordance with standards of the Public Company Accounting Oversight 
Board; and
    (2)(i) To prepare an independent public accountant's report based 
on an examination of the statements required under paragraphs 
(d)(3)(i)(A)(2) through (5) of this section in the compliance report 
required to be filed by the broker or dealer under paragraph 
(d)(1)(i)(B)(1) of this section in accordance with standards of the 
Public Company Accounting Oversight Board; or
    (ii) To prepare an independent public accountant's report based on 
a review of the statements required under paragraphs (d)(4)(i) through 
(iii) of this section in the exemption report required to be filed by 
the broker or dealer under

[[Page 51993]]

paragraph (d)(1)(i)(B)(2) of this section in accordance with standards 
of the Public Company Accounting Oversight Board.
    (h) Notification of non-compliance or material weakness. If, during 
the course of preparing the independent public accountant's reports 
required under paragraph (d)(1)(i)(C) of this section, the independent 
public accountant determines that the broker or dealer is not in 
compliance with Sec.  240.15c3-1, Sec.  240.15c3-3, or Sec.  240.17a-13 
or any rule of the designated examining authority of the broker or 
dealer that requires account statements to be sent to the customers of 
the broker or dealer, as applicable, or the independent public 
accountant determines that any material weaknesses (as defined in 
paragraph (d)(3)(iii) of this section) exist, the independent public 
accountant must immediately notify the chief financial officer of the 
broker or dealer of the nature of the non-compliance or material 
weakness. If the notice from the accountant concerns an instance of 
non-compliance that would require a broker or dealer to provide a 
notification under Sec.  240.15c3-1, Sec.  240.15c3-3, or Sec.  
240.17a-11, or if the notice concerns a material weakness, the broker 
or dealer must provide a notification in accordance with Sec.  
240.15c3-1, Sec.  240.15c3-3, or Sec.  240.17a-11, as applicable, and 
provide a copy of the notification to the independent public 
accountant. If the independent public accountant does not receive the 
notification within one business day, or if the independent public 
accountant does not agree with the statements in the notification, then 
the independent public accountant must notify the Commission and the 
designated examining authority within one business day. The report from 
the accountant must, if the broker or dealer failed to file a 
notification, describe any instances of non-compliance that required a 
notification under Sec.  240.15c3-1, Sec.  240.15c3-3, or Sec.  
240.17a-11, or any material weaknesses. If the broker or dealer filed a 
notification, the report from the accountant must detail the aspects of 
the notification of the broker or dealer with which the accountant does 
not agree.
    Note to paragraph (h): The attention of the broker or dealer and 
the independent public accountant is called to the fact that under 
Sec.  240.17a-11(b)(1), among other things, a broker or dealer whose 
net capital declines below the minimum required pursuant to Sec.  
240.15c3-1 shall give notice of such deficiency that same day in 
accordance with Sec.  240.17a-11(g) and the notice shall specify the 
broker or dealer's net capital requirement and its current amount of 
net capital. The attention of the broker or dealer and accountant also 
is called to the fact that under Sec.  240.15c3-3(i), if a broker or 
dealer shall fail to make a reserve bank account or special account 
deposit, as required by Sec.  240.15c3-3, the broker or dealer shall by 
telegram immediately notify the Commission and the regulatory authority 
for the broker or dealer, which examines such broker or dealer as to 
financial responsibility and shall promptly thereafter confirm such 
notification in writing.
    (i) Reports of the independent public accountant required under 
paragraph (d)(1)(i)(C) of this section--(1) Technical requirements. The 
independent public accountant's reports must:
    (i) Be dated;
    (ii) Be signed manually;
    (iii) Indicate the city and state where issued; and
    (iv) Identify without detailed enumeration the items covered by the 
reports.
    (2) Representations. The independent public accountant's reports 
must:
    (i) State whether the examinations or review, as applicable, were 
made in accordance with standards of the Public Company Accounting 
Oversight Board;
    (ii) Identify any examination and, if applicable, review procedures 
deemed necessary by the independent public accountant under the 
circumstances of the particular case that have been omitted and the 
reason for their omission.
    (iii) Nothing in this section may be construed to imply authority 
for the omission of any procedure that independent public accountants 
would ordinarily employ in the course of an examination or review made 
for the purpose of expressing the opinions or conclusions required 
under this section.
    (3) Opinion or conclusion to be expressed. The independent public 
accountant's reports must state clearly:
    (i) The opinion of the independent public accountant with respect 
to the financial report required under paragraph (d)(1)(i)(A) of this 
section and the accounting principles and practices reflected in that 
report;
    (ii) The opinion of the independent public accountant with respect 
to the financial report required under paragraph (d)(1)(i)(A) of this 
section, as to the consistency of the application of the accounting 
principles, or as to any changes in those principles, that have a 
material effect on the financial statements; and
    (iii)(A) The opinion of the independent public accountant with 
respect to the statements required under paragraphs (d)(3)(i)(A)(2) 
through (5) of this section in the compliance report required under 
paragraph (d)(1)(i)(B)(1) of this section; or
    (B) The conclusion of the independent public accountant with 
respect to the statements required under paragraphs (d)(4)(i) through 
(iii) of this section in the exemption report required under paragraph 
(d)(1)(i)(B)(2) of this section.
    (4) Exceptions. Any matters to which the independent public 
accountant takes exception must be clearly identified, the exceptions 
must be specifically and clearly stated, and, to the extent 
practicable, the effect of each such exception on any related items 
contained in the annual reports required under paragraph (d) of this 
section must be given.
* * * * *

0
3. Section 240.17a-11 is amended by:
0
a. Revising paragraph (e); and
0
b. In paragraph (h), removing the citation ``17a-5(h)(2)'' and adding 
in its place the citation ``17a-5(h)'' and removing the citation ``17a-
12(f)(2)'' and adding in its place the citation ``17a-12(i)(2).''
    The revision reads as follows:


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

* * * * *
    (e) Whenever any broker or dealer discovers, or is notified by an 
independent public accountant under Sec.  240.17a-12(i)(2), of the 
existence of any material inadequacy as defined in Sec.  240.17a-
12(h)(2), or whenever any broker or dealer discovers, or is notified by 
an independent public accountant under Sec.  240.17a-5(h), of the 
existence of any material weakness as defined in Sec.  240.17a-
5(d)(3)(iii), the broker or dealer must:
    (1) Give notice, in accordance with paragraph (g) of this section, 
of the material inadequacy or material weakness within 24 hours of the 
discovery or notification of the material inadequacy or the material 
weakness; and
    (2) Transmit a report, in accordance with paragraph (g) of this 
section, within 48 hours of the notice stating what the broker or 
dealer has done or is doing to correct the situation.
* * * * *

PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934

0
4. The authority citation for part 249 continues to read, in part, as 
follows:


[[Page 51994]]


    Authority:  15 U.S.C. 78a et seq. and 7201 et seq.; 12 U.S.C. 
5461 et seq.; and 18 U.S.C. 1350, unless otherwise noted.
* * * * *

Subpart G--Forms for Reports To Be Made by Certain Exchange 
Members, Brokers, and Dealers

0
5. Add Form Custody (referenced in Sec.  249.639) to subpart G to read 
as follows:


Sec.  249.639  Form custody.

    This form shall be used for reports of information required by 
Sec.  240.17a-5 of this chapter.

    Note: The text of Form Custody will not appear in the Code of 
Federal Regulations.

BILLING CODE 8011-01-P

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[[Page 52003]]


[GRAPHIC] [TIFF OMITTED] TR21AU13.008


    By the Commission.

     Dated: July 30, 2013.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2013-18738 Filed 8-20-13; 8:45 am]
BILLING CODE 8011-01-C


