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SEC Adopts Sweeping Changes to Broker-Dealer Financial Responsibility, Reporting, and Audit Rules

Investment Management Law Alert Hoyt R. Stastney

Summary: On July 31, 2013, the SEC adopted sweeping amendments to the financial responsibility, reporting, and audit rules applicable to broker-dealers. Broker-dealers must act now to evaluate their current operations and determine the revisions to contractual arrangements, systems and capitalization that may be necessary to comply with the amendments to the financial responsibility rules, as well as the information that will need to be collected in order to properly comply with the new reporting and audit requirements.

Financial Responsibility Rules Amendments

The amendments to the broker-dealer financial responsibility rules (the "Financial Responsibility Rules Amendments")[i] are designed to better protect a broker-dealer's customers and enhance the ability of the Securities and Exchange Commission ("SEC") to monitor and prevent unsound business practices. The amendments, which were originally proposed in March 2007, include revisions to the customer protection rule, the net capital rule, the books and records rules, and the notification rules that apply to broker-dealers under the Securities Exchange Act of 1934 ("Exchange Act"). The amendments become effective on October 21, 2013.

Customer Protection Rules

Proprietary Accounts of Broker-Dealers 

The SEC adopted amendments to Rules 15c3-3[ii] and 15c3-3a under the Exchange Act that will require registered broker-dealers which carry proprietary accounts on behalf of other registered broker-dealers (PAB Accounts)[iii] to take the following actions: (i) perform a separate reserve computation for PAB Accounts; (ii) establish and fund separate reserve accounts for PAB Account holders; and (iii) obtain and maintain control of non-margin securities carried for PAB Accounts unless the carrying broker has informed the PAB Account holder that it intends to use such securities in the ordinary course of its business and has provided the PAB Account holder the opportunity to object.

Reserve Accounts 

Under new Rule 15c3-3(e)(5), a registered broker-dealer must exclude the amount of cash deposited into an account at an affiliated bank when determining whether the broker-dealer maintains the required reserve account deposits. Practically speaking, those broker-dealers that use affiliated banks to hold customer cash reserve accounts will need to deposit qualified securities into the accounts or transfer the accounts to non-affiliated banks. With respect to broker-dealers which maintain the required reserve account deposits at non-affiliated banks, the amendments require such broker-dealers to exclude the amount of those deposits from the required reserves to the extent they exceed 15% of the bank's equity capital as reported by the bank in its most recent Call Report. Recognizing that U.S. branches of foreign banks generally do not file Call Reports, the SEC has stated that it will consider requests for exemptive relief from broker-dealers that wish to hold reserve accounts at U.S. branches of foreign banks.

Sweep Programs 

The amendments provide that a broker-dealer may not convert, invest, or transfer to another account or institution customer free credit balances, except (i) upon the customer's specific order, authorization, or draft or (ii) pursuant to a "sweep program"[iv] that sweeps free credit balances into money market funds or a bank deposit account that is insured by the Federal Deposit Insurance Corporation, but only if that broker-dealer has satisfied specified disclosure and notification requirements.[v] Furthermore, for accounts opened on or after the effective date of the amendments (October 21, 2013), the broker-dealer must obtain from the customer affirmative written consent to participate in the sweep program.

Futures Positions in Portfolio Margin Accounts 

The amendments expand the terms "free credit balance" and "other credit balances" in Rules 15c3-3(a)(8) and (9), respectively, to include funds carried in a securities account pursuant to an SRO portfolio margin rule approved by the SEC, including initial margin or variation margin, marks to market, and proceeds resulting from margin paid or released in connection with settling, closing out, or exercising futures contracts and options. As amended, Rule 15c3-3a will also permit a broker-dealer to include, as a debit item, the amount of customer margin required and on deposit at a derivatives clearing organization related to futures positions carried in a portfolio margin account.

Net Capital Rules

Securities Loans and Repurchase Agreements 

The amendments create a presumption, for net capital purposes, that a broker-dealer providing securities lending and borrowing services is deemed to be acting as a principal, rather than as an agent, unless specified procedures are followed: (i) the broker-dealer fully discloses the identity of each party to the other; (ii) each party agrees in writing that the obligations of the broker-dealer do not include a guarantee of performance by the other party; and (iii) each party agrees in writing that the other party's remedies in the event of a default are limited as against the broker-dealer. The amendments also require new SEC reporting by a broker-dealer when the total amount of money payable against all securities loaned or subject to a repurchase agreement, or the total contract value of all securities borrowed or subject to a reverse purchase agreement, exceeds 2,500% of the broker-dealer's tentative net capital.

Expense-Sharing Agreements

Under the amendments, a registered broker-dealer, in calculating net capital, must deduct from net worth liabilities assumed by third parties (such as those under expense-sharing arrangements) if it cannot demonstrate the ability of the third party, independent of the broker-dealer's income and assets, to repay the obligations. The SEC has stated that this amendment codifies existing guidance requiring broker-dealers that enter into expense-sharing arrangements with affiliates, including a parent, to demonstrate that each third party assuming liability has sufficient financial resources to meet that expense without relying on distributions or funding from the broker-dealer. The broker-dealer can demonstrate the adequacy of the third party's financial resources by providing its most recent audited financial statements, tax return, or regulatory filings containing financial statements.

Short-Term Capital Contributions 

The amendments will require a registered broker-dealer to treat as a liability (rather than as part of its net worth) (i) any capital that is contributed under an agreement giving the investor the option to withdraw it; and (ii) any capital contribution that is intended to be withdrawn within one year of its contribution. Capital that is withdrawn within one year of its contribution is deemed to have been intended to be withdrawn within one year for net capital purposes unless the broker-dealer receives written permission from its designated examining authority.

Temporary Restrictions on Capital Withdrawals

Under the amendments, the SEC may restrict, for up to 20 business days, any withdrawal by a broker-dealer of equity capital, unsecured loan, or advance to a stockholder, sole proprietor, partner, member, employee, or affiliate of a broker-dealer as the SEC deems necessary or appropriate in the public interest when the withdrawal is deemed detrimental to the financial integrity of the broker-dealer.

Financial Reporting Rules Amendments

The amendments to the broker-dealer financial reporting and audit rules (the "Financial Reporting Rules Amendments")[vi] are designed to substantially increase protections for investors who turn their money and securities over to broker-dealers registered with the SEC. The amendments, which were originally proposed in June 2011, require broker-dealers to file a compliance report or an exemption report annually, which reports must be attested to by an independent registered public accountant. All broker-dealers will also be required to complete a new form (Form Custody) each quarter providing information related to their custodial practices. Finally, with respect to clearing and carrying broker-dealers, the amendments provide the SEC and the designated examining authority access to such broker-dealer's accountants and audit documentation. The reporting and audit requirements of these amendments become effective as outlined below.

New Annual Reports

The amendments require the filing of new types of annual reports as described below. Rule 17a-5 currently requires a broker-dealer to file an audited annual report that includes financial statements, related footnotes, and supplemental information related to certain financial responsibility rules. The current annual report also includes a supplemental report on internal control that describes any material inadequacies or material weaknesses found to exist or to have existed since the date of the previous audit.

Under the amendments, all broker-dealers will continue to be required to file an annual report that includes financial statements, related footnotes, and supplemental information related to certain financial responsibility rules. The audit must now be performed under Public Company Accounting Oversight Board ("PCAOB") standards. The supplemental report on internal control will no longer be required and will essentially be replaced by the compliance report described below. The new reports must be filed with respect to fiscal years ending on or after June 1, 2014, and are due 60 calendar days after the end of each fiscal year.

Annual Compliance Report

A broker-dealer subject to the customer protection requirements of Exchange Act Rule 15c3-3 (a "carrying broker dealer") must file on an annual basis a "Compliance Report" that would include specified information about its compliance with the net capital rule, customer protection rule, quarterly security count rule and customer account statement rules of the broker-dealer's designated examining authority. The compliance report must include statements as to whether: (i) the broker-dealer has established and maintained internal control over compliance[vii]; (ii) the internal control over compliance of the broker-dealer was effective during the most recent fiscal year; (iii) the internal control over compliance of the broker-dealer was effective as of the end of the most recent fiscal year; (iv) the broker-dealer was in compliance with the net capital and reserve bank account rules as of the end of the most recent fiscal year; and (v) the information the broker-dealer used to state whether it was in compliance with the net capital and reserve bank account rules was derived from the books and records of the broker-dealer. If applicable, the compliance report must also describe each identified material weakness in the internal control over compliance during the most recent fiscal year and any instance of non-compliance with the net capital or reserve bank account rules. A broker-dealer will also be required to engage an independent registered public accountant to examine the broker-dealer's statements in the compliance report and, applying PCAOB standards, the accountant must issue a report based on that examination.

Annual Exemption Report

A non-carrying broker-dealer must file on an annual basis an "Exemption Report" that would specify the particular exemption from Exchange Act Rule 15c3-3 on which the broker-dealer is relying. The Exemption Report, for which there is no prescribed form, must contain the following statements made to the best knowledge and belief of the broker-dealer: (i) a statement that identifies the specific exemption relied upon under Rule 15c3-3; (ii) a statement that the broker-dealer met the identified exemption conditions throughout the most recent completed fiscal year without exception; and (iii) if applicable, a statement that identifies each exception from the exemption that occurred during the most recent completed fiscal year. A non-carrying broker-dealer must engage an independent registered public accountant to perform a review of the statements in the exemption report and, applying PCAOB standards, the accountant must issue a report based on that examination.

Statement Regarding Independent Public Accountant

Every broker dealer must file with the SEC, no later than December 10 of each year (and every year thereafter unless there has been no change in its independent registered public accountant), a statement containing the following information and representations: (i) name, address, telephone number, and registration number of broker-dealer; (ii) name, address, and telephone number of independent registered public accountant; (iii) date of the fiscal year of the annual reports of the broker-dealer covered by the engagement; (iv) whether the engagement is for a single year or is of a continuing nature; (v) a representation that the independent registered public accountant has undertaken its auditing responsibilities enumerated under the rules; and (vi) if the broker-dealer is a clearing or carrying broker-dealer, a statement permitting its independent public accountant to make available to the SEC and designated examining authority the audit documentation associated with the annual audit reports under Rule 17a-5.

Form Custody 

The amendments require all registered broker-dealers to file a new unaudited form, called Form Custody, with their designated examining authority, generally within 17 business days after the end of each calendar quarter and at the same time that they file their FOCUS reports with their designated examining authority. Form Custody is a prescribed form and is comprised of nine categories of questions generally designed to elicit information about a broker-dealer's custodial activities. The requirement to file Form Custody begins as of the calendar quarter ending December 31, 2013, and the form is due within 17 business days of calendar quarter ends. The filing deadline for the initial Form Custody is January 27, 2014.

Conclusion

Given the impending effective dates of the amendments, it is imperative that broker-dealers take action now to ensure compliance. With respect to the Financial Responsibility Rules Amendments, broker-dealers will need to review, among other things, their practices, policies and contractual arrangements with respect to proprietary accounts, the banks at which special reserve deposits may be maintained, the holding of futures positions in securities portfolio margin accounts, securities lending and borrowing activities, the treatment of free credit balances in connection with sweep programs, and certain net capital calculations. With respect to the Financial Reporting Rules Amendments, broker-dealers need to evaluate the information needed to comply with the new reports, evaluate the design and effectiveness of their internal controls over compliance, and discuss the annual reporting requirements with their auditors to ensure a mutual understanding of the changes and expectations.

For more information, please contact Hoyt R. Stastney at (414) 277-5143 / hoyt.stastney@quarles.com, Peter J. Kaiser at (414) 277-3051 / peter.kaiser@quarles.com, Barbara R. Olson at (608) 283-2648 / barbara.olson@quarles.com, or your Quarles & Brady attorney.




[i] See Financial Responsibility Rules for Broker-Dealers, Release No. 34-70072, 78 Fed. Reg. 51,824 (Aug. 21, 2013).
[ii] The existing customer protection rule, Rule 15c3-3, generally prohibits broker-dealers from using customer securities and cash to finance their own business. By segregating customer securities and cash from a firm's proprietary business activities, the rule increases the likelihood that customer assets will be readily available to be returned to customers if a broker-dealer fails.
[iii] Rule 15c3-3(a)(16) defines the term "PAB Account" to include certain entities that are not deemed "customers" under Rule 15c3-3, which entities may include introducing broker-dealers, foreign broker-dealers, and foreign banks acting as broker-dealers.
[iv] Rule 15c3-3(a)(17) generally defines a "sweep account" to mean a service provided by a broker-dealer under which it offers to its customers the option to automatically transfer the free credit balances in the securities account to either a money market mutual fund or an account at a financial institution whose deposits are insured by the FDIC.
[v] For example, under the amendments, broker-dealers must provide notice to customers at least 30 days before changing the terms and conditions of a sweep program or any product available in the sweep program or changing a customer's investment from one product to another in the sweep program. The notice, which must be written, must describe the new terms and conditions or new product, and the options the customer has available if it does not accept the changes.
[vi] See Broker-Dealer Reports, Release No. 34-70073, 78 Fed. Reg. 51,909 (Aug. 21, 2013).
[vii] Internal control over compliance, as defined by the rule, includes 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.