SEC Passes New Rules for Broker Dealers

By Christopher L. Wallace, CPA, Business Assurance & Advisory Services Partner and
Andrew K. Sledd, CPA, CFE, Business Assurance & Advisory Services Partner

On July 31, 2013, the Securities and Exchange Commission (SEC) passed rules, in a split decision (3-2 vote), to amend certain rules for broker-dealers with the objective of increasing protections for investors.

The rules require broker-dealers to file new reports with the SEC that are expected to result in higher levels of compliance with the Commission’s financial responsibility regulations. The new rules amend existing Rule 17(a)-5 (annual reporting requirement), Rule 15(c)-3-3 (Customer Protection Rule), Rule 15(c)3-1 (Net Capital Rule), Rules 17(a)-3 and 17(a)-4 (Books and Records Rules) and Rule 17(a)-11 (Broker-dealer Notification Rule), as well as establish rules for filing a new quarterly “Form Custody” report.

Currently, Rule 17a-5 requires broker-dealers to file audited financial statements with the SEC and FINRA. The financial statements must be audited by an independent public accounting firm registered with the Public Company Accounting Oversight Board (“PCAOB”). The audits are currently performed in accordance with Generally Accepted Auditing Standards (GAAS). The new rules will require the following:

• A broker-dealer that has custody of the customers’ assets must file a “compliance report” with the SEC to verify they are adhering to broker-dealer capital requirements, protecting customer assets they hold, and periodically sending account statements to customers. The broker-dealer also must engage a PCAOB-registered independent public accounting firm to prepare a report based on an examination of certain statements in the broker-dealer’s compliance report.
• A broker-dealer that does not have custody of their customers’ assets must file an “exemption report” with the Commission citing its exemption from requirements applicable to carrying broker-dealers. The broker-dealer also must engage a PCAOB- registered independent public accounting firm to prepare a report based on a review of certain statements in the broker-dealer’s exemption report.

The examination or review of the new reports, as well as the audit of the financial statements, must be conducted in accordance with PCAOB standards. The annual reporting requirement rule amendments are effective on June 1, 2014.

The SEC also made changes to the Customer Protection Rule:

• The new rules require carrying broker-dealers to maintain a new segregated reserve account for account holders that are broker-dealers.
• The SEC also approved changes that place restrictions on cash deposits for purposes of this reserve account and establish customer disclosure, notice, and affirmative consent requirements for programs where customer cash in a securities account is swept to a money market or bank deposit product.
• The effective date of the changes to the Customer Protection Rule was originally scheduled to be October 21, 2013. However, on October 17, 2013, the SEC issued an order providing a temporary exemption which will expire on March 3, 2014.

There were also several changes to the Net Capital Rule. These changes include:

• A requirement for a broker-dealer to treat as a liability any capital that is contributed under an agreement giving the investor the option to withdraw it. A broker-dealer is required to treat as a liability any contributed capital that is withdrawn within a year of its contribution, unless approved in writing from the broker- dealer’s designated examining authority.
• A requirement for a broker-dealer to adjust its net worth when calculating net capital by including any liabilities that would be assumed by a third party if the broker-dealer cannot demonstrate that the third party has the resources, independent of the broker-dealer’s income and assets, to pay the liabilities.

This amendment has the potential to impact broker-dealers that are structured as subsidiaries of a holding company where the holding company maintains debt or other significant liabilities. The effective date of the changes to the Net Capital Rule was originally scheduled to be October 21, 2013. However, on October 17, 2013, the SEC issued an order providing a temporary exemption which will expire on March 3, 2014.

Other rule amendments for the Books and Records Rules and the Notification Rule increase documentation standards and establish certain other new notification requirements. The SEC’s order provides a temporary exemption for these rules until March 3, 2014.

In addition, the SEC amended Section 17(b). Currently, Section 17(b) requires broker-dealers to submit to routine inspections and examinations by the SEC staff. The rule amendments require a broker-dealer to file a new quarterly report (the “Form Custody” Report) that contains information about whether and how it maintains custody of its customers’ securities and cash. The reports will establish a custody profile for the broker-dealer that examiners can use as a starting point to focus their custody examinations. The requirement for broker-dealers to file the Form Custody Report is effective as of December 31, 2013.

The wording in the Section 17(b) amendment specifically refers to “whether and how a broker-dealer maintains custody of client securities”. Therefore, we believe that non-carrying broker-dealers will also be expected to file this report by documenting their considerations regarding custody that clarify it as a non-carrying broker-dealer.

In addition, the amendments require broker-dealers, regardless of whether they have custody of client assets, to agree to allow SEC staff to review the work papers of the independent registered public accounting firm that conducts the audit, if the SEC makes this request in writing for purposes of an examination of the broker-dealer. The broker-dealer must also allow the independent registered public accounting firm to discuss its findings with the examiners. There is still a great deal of uncertainty as to how this amendment will be enforced, as well as how confidential information obtained during the review of the audit work papers will be controlled by the SEC.

Audits of Broker-Dealers

Audits of broker-dealers that are not traded on a public exchange are currently performed under generally accepted auditing standards (“GAAS”) promulgated by the AICPA. Effective June 1, 2014, all audits of registered broker-dealers will be conducted under the standards of the PCAOB, which are likely to significantly increase the nature and scope of the audit. The PCAOB standards require increased communications with governance committees, additional review of broker-dealers’ custody arrangements and heighten requirements to examine internal controls and net capital computations. The standards also stipulate that management must have an effective financial statement close process, including preparation of financial statements in accordance with Generally Accepted Accounting Principles (GAAP).

On October 10, 2013, the PCAOB adopted new standards for broker-dealer audits and for auditing supplemental information. While these standards are applicable to the auditors of broker-dealers and not the broker-dealers themselves, the revised audit standards will have an impact on the conduct of the audit in accordance with the SEC amendment to Rule 17(a)-5 which requires, as of June 1, 2014, all audits of broker-dealers to be conducted in accordance with PCAOB standards.

We will continue to monitor information released from the SEC, FINRA, and other regulatory bodies as well as current industry practices for adopting the new rules and will continue to keep you informed of developments as they occur.

Questions? Please contact your Keiter representative or our office for assistance.

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