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SEC Adds to and Amends Broker-Dealer Financial Responsibility and Investor Protection Rules

On July 30, 2013, the Securities and Exchange Commission (“SEC”) made two significant announcements affecting broker-dealers: the adoption of new rules designed to increase protections for investors whose money and securities are held by SEC-registered broker-dealers, and amendments to several of the financial responsibility rules applicable to broker-dealers.

What Are Broker-Dealers?

Broker-dealers are entities that perform securities transactions for either a customer’s or their own account. Most entities engaged in these activities (except for certain commercial banks) must register with the SEC and are subject to a variety of SEC rules. Broker-dealers must also register with at least one self-regulatory organization (“SRO”), such as the Financial Industry Regulatory Authority or a national securities exchange.

How Are Customer Assets that Are Held by Broker-Dealers Protected? 

Broker-dealers that maintain custody of a customer’s money and securities are subject to strict requirements under the Securities Exchange Act of 1934 (“Exchange Act”) designed to protect and account for these assets. These rules include:

  • Net Capital Rule (Rule 15c3-1): Requires a broker-dealer to maintain a minimum level of net capital (consisting of highly liquid assets) at all times.
  • Customer Protection Rule (Rule 15c3-3): Prohibits broker-dealers from using customers’ securities or cash to finance the broker-dealer’s own trades and other transactions.
  • Quarterly Security Count Rule (Rule 17a-13): Requires that each quarter, broker-dealers count, examine, and verify the securities they hold for customers and for themselves. Broker-dealers must take capital charges if the actual amounts held differ from the amounts that the broker-dealer’s records reflect.
  • Account Statement Rule: Under SRO rules, broker-dealers must send a statement to each customer, at least quarterly, reflecting the customer’s securities and cash positions held by the broker-dealer and showing the customer’s account activity.

These requirements are intended to protect customer assets held at broker-dealers and prevent their misappropriation. Of course, if a broker-dealer violates these requirements, customer securities and cash may be misused by the broker-dealer or, even worse, lost altogether. If a broker-dealer misappropriates customer funds or converts securities from its customers, the Securities Investor Protection Corporation (“SIPC”) may initiate a liquidation proceeding to determine whether the SIPC will pay customers for shortfalls in their accounts, up to certain maximum amounts. The SEC hopes that the new investor protection rules, which subject broker-dealers to new compliance reporting obligations, will result in improved compliance with existing investor protection rules.

New Investor Protection Rules

Strengthening Audit Requirements

Currently, Section 17 of the Exchange Act and Rule 17a-5 require a broker-dealer to file an annual report with the SEC and the broker-dealer’s chosen SRO. These annual reports must include audited financial statements prepared by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Under the new investor protection rules, a broker-dealer that maintains custody of a customer’s assets (a “carrying broker-dealer”) must also file a “compliance report” with the SEC. The compliance report confirms to the SEC that the broker-dealer is (1) complying with broker-dealer capital requirements, (2) protecting customer assets hold by the broker-dealer, and (3) sending periodic account statements to its customers. A broker-dealer would state in its compliance report that it has established and maintained “Internal Control Over Compliance” such that internal controls provide the broker-dealer with reasonable assurance that non-compliance with the financial responsibility rules will be prevented or detected on a timely basis. The broker-dealer also must engage an independent public accountant registered with the PCAOB to prepare a report based on an examination of the broker-dealer’s compliance report.

A broker-dealer that does not maintain custody of its customers’ assets must file an “exemption report” with the SEC instead of the compliance report. The exemption report must cite the claimed exemption from requirements applicable to carrying broker-dealers and note and describe any exceptions to the broker-dealer’s exempt status. The broker-dealer also must engage an independent public accountant registered with the PCAOB to prepare a report based on an examination of the broker-dealer’s exemption report.

The independent public accountant’s examination of these new reports and broker-dealer financial statements must adhere to PCAOB standards. A broker-dealer that is a member of the SIPC will be required to file its annual reports with the SIPC, which will allow the SIPC to better monitor industry trends and enhance its awareness of industry participants.

Additionally, the scope of required disclosures has been expanded under the amended rules. Going forward, the independent accountant will be required to provide notification to the broker-dealer of all discovered instances of non-compliance with the financial responsibility rules, which notifications in turn trigger certain broker-dealer disclosure requirements.

Strengthening Oversight of Broker-Dealer Custody Practices

Section 17(b) of the Exchange Act requires a broker-dealer to submit to routine inspections and examinations by SEC staff and the broker-dealer’s SRO. The new rules provide additional oversight over broker-dealer custody practices in two ways. First, all broker-dealers will be required to file a new quarterly report called “Form Custody” that contains information about whether and how the broker-dealer maintains custody of its customers’ securities and cash. Form Custody information will help regulators evaluate a broker-dealer’s custody practices. Second, all broker-dealers will be required to agree to allow SEC or SRO staff to review the work papers of the independent public accountant in connection with an examination of the broker-dealer. Broker-dealers will be required to permit the independent accountant to discuss its findings with the broker-dealer’s regulators.

Relation of Broker-Dealer Custody Rule Amendments to Audits of Investment Advisers

Under Rule 206(4)-2 under the Investment Advisers Act of 1940, an investment adviser that is a qualified custodian of its clients’ funds and securities must obtain annually a written internal control report prepared by an accountant registered with, and subject to regular inspection by, the PCAOB. This internal control report must be supported by the accountant’s examination of the qualified custodian’s custody controls. The SEC has determined that the independent public accountant’s internal control report, based on an examination of the new compliance report, will satisfy the internal control report requirement under Rule 206(4)-2. This rule change reflects the SEC’s determination that the operational requirements of the financial responsibility rules are consistent with the control objectives outlined in the SEC’s guidance on Rule 206(4)-2.

Effective Date of New Investor Protection Rules

The effective date for both the requirement that broker-dealers file the new Form Custody and the requirement that broker-dealers file annual reports with the SIPC is Dec. 31, 2013. The effective date for the requirements relating to broker-dealer annual reports, including with respect to the compliance report and exemption report, is June 1, 2014.

Amendments to Existing Financial Responsibility Rules for Broker-Dealers

The amendments to the existing broker-dealer financial responsibility rules are designed to increase protection for customers of broker-dealers and enhance the SEC’s ability to monitor and prevent unsound business practices. The SEC expects that these amendments will bolster the customer protection that existing SEC rules provide.

Customer Protection Rule (Rule 15c3-3)

The primary changes to the Customer Protection Rule will:

  • Close a “gap” between the definition of “customer” in Rule 15c3-3, which currently does not include broker-dealers, and the definition of “customer” under the Securities Investor Protection Act (“SIPA”), which does include broker-dealers. The amendment to the rule will require carrying broker-dealers to maintain a new segregated reserve account for the benefit of account holders that are broker-dealers (other than an account that has been subordinated to the claims of creditors of the carrying broker-dealer). This change is expected to reduce the risk that there will be insufficient customer property to fully satisfy all customer claims in a SIPA liquidation.
  • Place restrictions on cash bank deposits for purposes of the requirement to maintain a reserve to protect customer cash under Rule 15c3-3. The rule is amended to exclude cash deposits held at affiliated banks and limit cash held at non-affiliated banks to an amount no greater than 15 percent of the bank’s equity capital.
  • Establish customer disclosure and notice requirements for both new and existing accounts and customer affirmative consent requirements for new accounts for situations in which customer cash in a securities account is “swept” to a money market or bank deposit account.

Net Capital Rule (Rule 15c3-1) 

The key amendments to the Net Capital Rule will:

  • Require a broker-dealer to adjust its net worth when calculating net capital, by including any liabilities that are assumed by a third party if the broker-dealer cannot demonstrate that the third party has the resources – independent of the broker-dealer’s revenues and assets – to pay the liabilities.
  • Require a broker-dealer to treat as a liability, capital that is contributed under an agreement that gives the investor the option to withdraw it. The rule amendment will also require a broker-dealer to treat as a liability any capital contribution that is withdrawn within one year of its contribution unless the broker-dealer’s designated examining authority (“DEA”) provides written permission for the withdrawal.
  • Require broker-dealers to deduct from net capital, with regard to fidelity bonding requirements prescribed by a broker-dealer’s SRO, the excess of any deductible amount over the amount permitted by SRO rules.
  • Clarify that any broker-dealer that becomes “insolvent,” as defined in amended Rule 15c3-1, is required to cease conducting its securities business. A similar amendment to Rule 17a-11 requires insolvent broker-dealers to provide notice of the insolvency to regulatory authorities.

Books and Records Rules (Rules 17a-3 and 17a-4) 

The amendments to Rules 17a-3 and 17a-4 will require large broker-dealers to document their market, credit, and liquidity risk management controls. The amendments did not, however, mandate any specific controls, policies, or procedures.

Notification Rule (Rule 17a-11)

An amendment to Rule 17a-11 will establish new notification requirements for when a broker-dealer’s repurchase and securities lending activities exceed a newly created threshold. This notification is designed to alert regulators to situations in which a broker-dealer assumes new risk that it may have limited experience in managing. Broker-dealers with active repurchase and securities lending activities may opt to submit monthly reports of their stock loan and repurchase activity to their DEA instead of filing these new notifications.

The SEC also made certain substantive and technical amendments to existing rules, including the following:

  • Rule 15c3-1: the amendment will allow the SEC to restrict a broker-dealer from withdrawing capital or making loans or advances to stockholders, insiders, or affiliates so long as the other conditions under the rule (which remain unchanged) are met.
  • Appendix A of Rule 15c3-1: the amendment permits broker-dealers to employ theoretical option pricing models to calculate haircuts for listed options and for related positions that hedge those options.

Effective Date for Financial Responsibility Rule Amendments

The effective date for the financial responsibility rule amendments is 60 days after their publication in the Federal Register.