[Federal Register Volume 76, Number 123 (Monday, June 27, 2011)]
[Proposed Rules]
[Pages 37572-37616]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-15341]



[[Page 37571]]

Vol. 76

Monday,

No. 123

June 27, 2011

Part III





Securities and Exchange Commission





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17 CFR Parts 240 and 249





Broker-Dealer Reports; Proposed Rule

  Federal Register / Vol. 76 , No. 123 / Monday, June 27, 2011 / 
Proposed Rules  

[[Page 37572]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 249

[Release No. 34-64676; File No. S7-23-11]
RIN 3235-AK56


Broker-Dealer Reports

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is 
proposing amendments to the broker-dealer financial reporting rule 
under the Securities Exchange Act of 1934 (the ``Exchange Act''). The 
first set of amendments would, among other things, update the existing 
requirements of Exchange Act Rule 17a-5, facilitate the ability of the 
Public Company Accounting Oversight Board (the ``PCAOB'') to implement 
oversight of independent public accountants of broker-dealers as 
required by the Dodd-Frank Wall Street Reform and Consumer Protection 
Act (the ``Dodd-Frank Act''), and eliminate potentially redundant 
requirements for certain broker-dealers affiliated with, or dually-
registered as, investment advisers. The second set of amendments would 
require broker-dealers that either clear transactions or carry customer 
accounts to consent to allowing the Commission and designated examining 
authorities (``DEAs'') to have access to independent public accountants 
to discuss their findings with respect to annual audits of the broker-
dealers and to review related audit documentation. The third set of 
amendments would enhance the ability of the Commission and examiners of 
a DEA to oversee broker-dealers' custody practices by requiring broker-
dealers to file a new Form Custody.

DATES: Comments should be received on or before August 26, 2011.

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

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number S7-23-11 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

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

All submissions should refer to File Number S7-23-11. This file number 
should be included on the subject line if e-mail is used. To help the 
Commission process and review your comments more efficiently, please 
use only one method. The Commission will post all comments on the 
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street, NE., 
Washington, DC 20549, on official business days between the hours of 10 
a.m. and 3 p.m. All comments received will be posted without change; 
the Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
publicly available.

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; and Mark M. Attar, Branch Chief, at (202) 551-5889, 
Division of Trading and Markets; or John F. Offenbacher, Senior 
Associate Chief Accountant, at (202) 551-5300, Office of the Chief 
Accountant, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on proposed amendments to Exchange Act Rule 17a-5 and proposed Form 
Custody.

I. Introduction

    The Commission is proposing three sets of amendments to Exchange 
Act Rule 17a-5--the broker-dealer financial reporting rule.\1\ The 
first set of amendments (collectively, the ``Annual Reporting 
Amendments'') relates to the requirement that a broker-dealer file 
annual financial reports with the Commission. The Annual Reporting 
Amendments are designed to, among other things: (1) Update the existing 
requirements of Rule 17a-5; (2) facilitate the ability of the PCAOB to 
implement oversight of independent public accountants of broker-dealers 
as required by the Dodd-Frank Act; \2\ and (3) eliminate potentially 
redundant requirements for certain broker-dealers affiliated with, or 
dually-registered as, investment advisers.
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    \1\ 17 CFR 240.17a-5 (``Rule 17a-5'').
    \2\ Public Law 111-203 (Jul. 21, 2010).
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    The second set of amendments (collectively, the ``Access to Audit 
Documentation Amendments'') would require broker-dealers that either 
clear transactions or carry customer accounts to consent to provide the 
Commission and DEAs with access to independent public accountants to 
discuss their findings with respect to annual audits of broker-dealers 
and to review related audit documentation.\3\
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    \3\ 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.''
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    The third set of amendments (collectively, the ``Form Custody 
Amendments'') would enhance the ability of the Commission and examiners 
of a DEA to oversee broker-dealers' custody practices by requiring 
broker-dealers to file on a quarterly basis a new Form Custody. Form 
Custody would elicit information as to whether and how a broker-dealer 
maintains custody of cash and securities of customers and others.

II. The Proposed Annual Reporting Amendments

A. Background

    Sections 17(a) and (e) of the Exchange Act and Rule 17a-5 together 
require a broker-dealer to, among other things, file an annual report 
(an ``Annual Audit Report'') containing audited financial statements, 
supporting schedules, and supplemental reports, as applicable, with the 
Commission and the broker-dealer's DEA.\4\ The financial statements 
must be comprised of 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.\5\ The supporting schedules must be comprised of a 
computation of required and actual net capital under

[[Page 37573]]

Exchange Act Rule 15c3-1, and, for broker-dealers that maintain custody 
of customer funds or securities (``carrying broker-dealers''), a 
computation of the customer reserve requirement and information 
relating to the possession or control requirements under Exchange Act 
Rule 15c3-3.\6\ The supplemental reports include: (1) A report of an 
independent public accountant that is the result of a review of, among 
other things, the broker-dealer's accounting system, internal 
accounting control and procedures for safeguarding securities, and 
practices and procedures in complying with various Commission financial 
responsibility rules and Regulation T of the Board of Governors of the 
Federal Reserve System; \7\ (2) a report of an independent public 
accountant provided to, among others, the Securities Investor 
Protection Corporation (``SIPC'') to help administer the collection of 
assessments from broker-dealers for purposes of establishing and 
maintaining its broker-dealer liquidation fund (the ``SIPC Fund''); \8\ 
and (3) for broker-dealers that compute net capital under an 
alternative model-based standard, a 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 Exchange Act Rule 15c3-4.\9\
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    \4\ See 15 U.S.C 78q(a), 15 U.S.C 78q(e), and Rule 17a-5(d).
    \5\ See Rule 17a-5(d)(2).
    \6\ See Rule 17a-5(d)(3). See also 17 CFR 240.15c3-1 (``Rule 
15c3-1'') and 17 CFR 240.15c3-3 (``Rule 15c3-3'').
    \7\ See Rule 17a-5(g). See also 12 CFR part 220 et seq. 
(``Regulation T'').
    \8\ See Rule 17a-5(e)(4). These reports will be collectively 
referred to in this release as the ``SIPC Reports.'' As part of the 
Annual Reporting Amendments, the Commission is proposing to amend 
how the SIPC Reports are filed; see infra Section II.C.
    \9\ See Rule 17a-5(k); see also 17 CFR 240.15c3-4.
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    Paragraph (g) of Rule 17a-5, entitled ``Audit objectives,'' 
describes the objectives that should be achieved by an independent 
public accountant in preparing a report for the broker-dealer to file 
with its Annual Audit Report.\10\ For example, the audit is required to 
be performed in accordance with generally accepted auditing standards 
(``GAAS'').\11\ In addition, paragraph (g)(1) of Rule 17a-5 requires 
that the audit include a ``review'' and appropriate tests of the 
broker-dealer's accounting system, internal accounting control and 
procedures for safeguarding securities for the period since the prior 
examination date.\12\ The paragraph further states that the scope of 
the audit and review of the accounting system, internal accounting 
control, and procedures for safeguarding securities shall be sufficient 
to provide reasonable assurance that any material inadequacies existing 
in those items, including in the procedures for obtaining and 
maintaining physical possession and control of all fully paid and 
excess margin securities, complying with Regulation T, and making the 
quarterly securities examinations, counts, verifications, and 
comparisons and recordation of differences required by Exchange Act 
Rule 17a-13 would be disclosed.\13\ Currently, with respect to these 
requirements, independent public accountants for broker-dealers issue a 
report describing a ``study'' of these practices and procedures and, if 
applicable, notification to the Commission of the discovery of any 
material inadequacies (the ``Study''). The form of the report that 
describes the Study is specified in an AICPA publication entitled AICPA 
Audit & Accounting Guide: Brokers and Dealers in Securities; \14\ 
however, the form of the report does not specify the level of assurance 
required to be obtained by the independent public accountant when 
performing the Study.
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    \10\ See Rule 17a-5(g).
    \11\ Auditing and attestation standards for broker-dealers are 
currently established by the American Institute of Certified Public 
Accountants (the ``AICPA'').
    \12\ See Rule 17a-5(g)(1).
    \13\ Id. See also 17 CFR 240.17a-13 (``Rule 17a-13''). The term 
``material inadequacy'' is defined in Rule 17a-5(g)(3).
    \14\ See the AICPA Audit & Accounting Guide: Brokers and Dealers 
in Securities (Jul. 2010) (the ``Broker-Dealer Audit Guide'').
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    Professional auditing standards provide for three levels of 
attestation engagement by an accountant.\15\ Under the highest level of 
attestation engagement, the accountant obtains ``reasonable assurance'' 
with respect to the matter that is the subject of the accountant's 
attestation engagement and provides an opinion. This standard is 
required with respect to audits and examinations.\16\ The second level 
of attestation engagement is a review, which results in the accountant 
obtaining a moderate level of assurance with respect to the matter that 
is the subject of the accountant's attestation engagement. The third 
type of attestation engagement is one in which the accountant performs 
agreed-upon procedures, which results in no assurance, but rather a 
reporting of the accountant's findings after the performance of 
procedures that have been agreed to by specified parties. Rule 17a-5 
currently requires that a broker-dealer engage an independent public 
accountant to audit the broker-dealer's financial statements. Some of 
the supporting schedules are also subject to financial statement audit 
procedures.
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    \15\ Professional auditing standards include both GAAS and 
standards promulgated by the PCAOB.
    \16\ This proposing release generally refers to an ``audit'' of 
a broker-dealer's financial statements and an ``examination'' of the 
broker-dealer's compliance with a particular rule or implementation 
of controls designed to achieve compliance with a particular rule.
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    Rule 17a-5 also requires that a broker-dealer that is claiming an 
exemption from the requirements of Rule 15c3-3 file a report with the 
Commission.\17\ Rule 15c3-3(k) sets forth certain conditions that a 
broker-dealer must meet to be exempt from the rule's requirements. 
Generally, the broker-dealer would be exempt if it does not hold 
customer funds or securities, or, if it does, it promptly forwards all 
funds and securities received. Rule 17a-5 provides that the independent 
public accountant engaged by the broker-dealer 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 independent public 
accountant's last examination.'' \18\ This requirement has resulted in 
independent public accountants providing a statement concerning whether 
they have ascertained that the broker-dealer was complying with the 
conditions of the exemption.\19\
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    \17\ See Rule 17a-5(g)(2).
    \18\ Id.
    \19\ See Broker-Dealer Audit Guide, supra note 14 at Section 
3.32.
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    Many of the requirements currently contained in Rule 17a-5 have 
existed since 1975, and, for the most part, have remained substantially 
unchanged.\20\ For example, as noted above, to comply with the 
requirement of paragraph (g) of Rule 17a-5 to conduct an audit and 
review of the identified matters, independent public accountants 
currently issue a report based on a Study. The practice of conducting 
the Study is relatively unique to broker-dealer audits and, while audit 
literature at one time referred to the performance of a ``study,'' the 
performance of a study is no longer included in contemporary audit 
standards governing the work to be performed by an independent public 
accountant.
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    \20\ See Broker-Dealer Reports, Exchange Act Release No. 11935 
(Dec. 17, 1975), 40 FR 59706 (Dec. 30, 1975). In this release, the 
Commission adopted amendments to Rule 17a-5, which included, among 
other things, the adoption of the requirement for broker-dealers to 
file Financial and Operational Combined Uniform Single (or 
``FOCUS'') Reports.

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    In addition, recent legislation and Commission rulemaking have 
further prompted the need to reexamine the requirements pertaining to 
the Annual Audit Report. First, Section 982 of the Dodd-Frank Act 
amended the Sarbanes-Oxley Act of 2002 (the ``Sarbanes-Oxley Act'') 
\21\ 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 to be 
used by registered public accounting firms with respect to the 
preparation and issuance of audit reports to be included in broker-
dealer filings with the Commission.\22\ The Dodd-Frank Act also 
authorizes the PCAOB to inspect registered public accounting firms that 
provide audit reports for broker-dealers and to enforce standards 
relative to their audits.
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    \21\ 17 U.S.C. 7202 et seq.
    \22\ See Section 982 of the Dodd-Frank Act.
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    Further, in December 2009, the Commission amended Rule 206(4)-2 
(the ``IA Custody Rule'') under the Investment Advisers Act of 1940 
(the ``Advisers Act''),\23\ which governs investment advisers' custody 
practices.\24\ Among other requirements, registered investment advisers 
that have custody of client funds or securities must maintain those 
assets at a qualified custodian, such as a bank or broker-dealer.\25\ 
If an investment adviser that also is, for example, a bank, or its 
related person, serves as a qualified custodian for advisory client 
funds or securities, the adviser must annually 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. Broker-dealers that also are registered as 
investment advisers may, acting in their capacity as broker-dealers, 
maintain client funds and securities as qualified custodians in 
connection with advisory services provided to clients, and under the IA 
Custody Rule are required to obtain internal control reports. Broker-
dealers acting as qualified custodians also may maintain advisory 
assets in connection with advisory services provided by related or 
affiliated investment advisers. In such instances, these broker-dealers 
are also required to provide internal control reports to their related 
investment advisers.
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    \23\ 17 CFR 275.206(4)-2 (``Rule 206(4)-2'').
    \24\ See Custody of Funds or Securities by Investment Advisers, 
Advisers Act Release No. 2876 (May 20, 2009), 74 FR 25354 (May 27, 
2009) (``IA Custody Proposing Release''); Advisers Act Release No. 
2968 (Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010) (``IA Custody 
Adopting Release'').
    \25\ See Rule 206(4)-2.
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    For the reasons discussed above, the Commission is proposing 
amendments to Rule 17a-5. The amendments proposed by the Commission are 
intended to update the broker-dealer audit requirements and provide for 
an examination of compliance, and internal control over compliance, 
with key regulatory requirements that would provide the Commission with 
greater assurance as to a broker-dealer's compliance with the 
requirements. In addition, the proposed changes are intended to 
facilitate the ability of the PCAOB to set standards for, and implement 
its inspection authority over, broker-dealers' independent public 
accountants by providing an improved foundation for the PCAOB to 
establish new broker-dealer audit standards. Moreover, the proposed 
changes, as they pertain to compliance with requirements concerning the 
custody of customer funds and securities, are intended to complement 
and reinforce the regulatory changes effected by the IA Custody Rule. 
In particular, the Commission preliminarily believes that broker-
dealers that also are registered as investment advisers and hold 
advisory client funds or securities, or that hold funds or securities 
for related investment advisers, would be able to use the Examination 
Report described below to satisfy the internal control report 
requirements under both Rule 17a-5, as it is proposed to be amended, 
and the IA Custody Rule.
    As discussed below, the proposed changes would provide, as to 
broker-dealers subject to the requirements of Rule 15c3-3, for an 
examination of compliance, and internal control over compliance, with 
respect to Rule 15c3-1, Rule 15c3-3, Rule 17a-5, and rules prescribed 
by DEAs requiring broker-dealers to send account statements to 
customers (``Account Statement Rules''). Rule 15c3-1 requires broker-
dealers to maintain at all times a minimum amount of net liquid assets, 
or ``net capital.'' Under Rule 15c3-1, broker-dealers must perform two 
calculations: (1) A computation of required minimum net capital; \26\ 
and (2) a computation of actual net capital.\27\
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    \26\ A broker-dealer's required minimum net capital is the 
greater of a fixed-dollar amount prescribed in Rule 15c3-1, or an 
amount computed using one of two financial ratios. The first 
financial ratio generally provides that a broker-dealer shall not 
permit its aggregate indebtedness to exceed 1500% of its net 
capital. See Rule 15c3-1(a)(1)(i). The second financial ratio 
provides that a broker-dealer shall not permit its net capital to be 
less than 2% of aggregate customer debit items. See Rule 15c3-
1(a)(1)(ii). Customer debit items--computed pursuant to Exhibit A to 
Rule 15c3-3, which is described below--consist of, among other 
things, margin loans to customers and securities borrowed to 
effectuate customer deliveries of securities on short sales.
    \27\ A broker-dealer computes its actual net capital by first 
calculating its net worth using United States (``U.S.'') generally 
accepted accounting principles. Second, qualifying subordinated 
loans are added to net worth. Third, illiquid assets such as real 
estate, fixtures, furniture, goodwill, and most unsecured 
receivables are subtracted from net worth. Illiquid securities also 
must be deducted. Finally, the broker-dealer must reduce 
(``haircut'') the market value of the liquid securities it owns by a 
percentage amount. This ``haircut'' provides a cushion against 
adverse market movements and other risks faced by the broker-dealer.
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    Rule 15c3-3 imposes two key requirements on carrying broker-
dealers. First, each carrying broker-dealer must obtain physical 
possession or control over customers' fully paid and excess margin 
securities.\28\ ``Control'' means the broker-dealer must hold these 
securities free of lien in one of several locations specified in the 
rule (e.g., a bank or clearing agency).\29\ Under Rule 15c3-3, 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 in its possession or control and the quantity 
of fully paid and excess margin securities not in its possession or 
control.\30\ If the amount in the broker-dealer's possession and 
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.\31\
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    \28\ See Rule 15c3-3(b)(1).
    \29\ See Rule 15c3-3(c).
    \30\ See Rule 15c3-3(d).
    \31\ Id.
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    The second key requirement in Rule 15c3-3 is that the carrying 
broker-dealer must maintain at a bank or banks cash or qualified 
securities \32\ on deposit in a ``Special Reserve Bank Account for the 
Exclusive Benefit of Customers'' equaling at least the net amount 
computed by adding customer credit

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items (e.g., cash in securities accounts) and subtracting from that 
amount customer debit items (e.g., margin loans).\33\ Rule 15c3-3 is 
designed to protect customer funds and securities by generally 
segregating them from the broker-dealer's proprietary business 
activities. If the carrying broker-dealer fails, customer funds and 
securities should be readily available for return to customers. The 
rule requires carrying broker-dealers 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, in this case, the broker-dealer must maintain 105% 
of the required deposit amount).\34\
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    \32\ The term ``qualified security'' is defined in Rule 15c3-3 
to include securities issued by the U.S. or guaranteed by the U.S. 
with respect to principal and interest. See Rule 15c3-3(a)(6).
    \33\ See Rule 15c3-3(e).
    \34\ See Rule 15c3-3(e)(3).
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    Rule 17a-13 requires a broker-dealer that holds securities 
(proprietary, customer, or both), on a quarterly basis, to examine and 
count the securities it physically 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 securities, and compare the results of the count and 
verification with its records. The broker-dealer must take an 
operational capital charge under Rule 15c3-1 for all short securities 
differences (which include securities positions reflected on the 
broker-dealer's securities record that are not susceptible to either 
count or confirmation) unresolved after discovery.\35\ The differences 
also must be recorded on the broker-dealer's records.\36\
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    \35\ See Rule 15c3-1(c)(2)(v).
    \36\ See Rule 17a-3(a)(4)(vi).
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    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.\37\
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    \37\ For example, NASD Rule 2340 requires broker-dealers that 
are members of FINRA that conduct a general securities business to 
send account statements to customers at least quarterly. The current 
FINRA rulebook consists of: (1) FINRA rules; (2) NASD rules; and (3) 
rules incorporated from the NYSE (``Incorporated NYSE Rules'') 
(together, the NASD rules and Incorporated NYSE Rules are referred 
to as the ``Transitional Rulebook''). While the NASD rules generally 
apply to all FINRA members, the Incorporated NYSE Rules apply only 
to those members of FINRA that are also members of the NYSE. The 
FINRA rules apply to all FINRA members, unless such rules have a 
more limited application by their terms. For more information see 
FINRA's Information Notice, Mar. 12, 2008 (Rulebook Consolidation 
Process). If a broker-dealer's DEA is the Chicago Board Options 
Exchange (the ``CBOE''), the broker-dealer would be subject to 
CBOE's account statement rule, CBOE Rule 9.12.
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B. Proposed Audit Reports and Changes to Applicable Auditing Standards

    As part of the Annual Reporting Amendments, the Commission is 
proposing changes that would revise the reports that broker-dealers 
file under Rule 17a-5. While the requirement that broker-dealers file a 
report consisting of the audited financial statements and supporting 
schedules that are currently required under Rule 17a-5 (the ``Financial 
Report'') would remain unchanged, carrying broker-dealers would be 
required to file a new report asserting to compliance with specified 
rules and related internal controls (the ``Compliance Report''). These 
broker-dealers also would be required to file a report from their 
independent public accountants (the ``Examination Report'') that 
addresses the assertions in the Compliance Report. Broker-dealers that 
do not hold customer funds or securities would be required to file a 
report asserting their exemption from the requirements of Rule 15c3-3 
(the ``Exemption Report) and a report from their independent public 
accountants that would be the result of a review of the broker-dealer's 
assertion that it is exempt from Rule 15c3-3. Finally, the proposed 
amendments would change the audit standards applicable to broker-dealer 
audits and compliance examinations from GAAS to standards promulgated 
by the PCAOB.
    To implement these changes, the Commission proposes a number of 
amendments to Rule 17a-5. The Commission proposes that paragraph (d) of 
Rule 17a-5 be re-titled from ``Annual filing of audited financial 
statements'' to ``Annual reports,'' because under the proposed 
revisions to paragraph (d), broker-dealers would generally be required 
to file a Financial Report and a Compliance Report or an Exemption 
Report with the Commission.\38\ Paragraph (d)(1) of Rule 17a-5 would be 
amended to set forth the general requirement for broker-dealers to file 
annual financial reports with the Commission. These reports would 
include: (1) A ``Financial Report'' as described in paragraph (d)(2), 
which would consist of the audited financial statements and supporting 
schedules that broker-dealers are currently required to file with the 
Commission; \39\ (2) a Compliance Report as described in paragraph 
(d)(3) unless the broker-dealer is exempt from the provisions of Rule 
15c3-3,\40\ or an Exemption Report as described in paragraph (d)(4) if 
the broker-dealer claims an exemption from the provisions of Rule 15c3-
3; \41\ and (3) reports prepared by the independent public accountant 
pursuant to the engagement provisions in paragraph (g), unless the 
broker-dealer is exempt from the requirement to either file the annual 
audit report or engage an independent public accountant pursuant to 
paragraphs (d)(1) and (e)(1) of Rule 17a-5.\42\ The proposed 
requirements for the Compliance Report and Exemption Report are 
described in greater detail below.
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    \38\ Paragraph (d) of Rule 17a-5, currently titled ``Annual 
filing of audited financial statements,'' is being renamed to 
reflect that the Commission will now require broker-dealers to file 
two reports with the Commission (i.e., a Financial Report and a 
Compliance Report, or a Financial Report and an Exemption Report).
    \39\ Proposed paragraph (d)(1)(i)(A) of Rule 17a-5. See also 
Rule 17a-5(d)(2), which lists the requirements to be included in the 
Financial Report and would continue to do so because the Commission 
is not proposing any amendment to the financial statements and 
supporting schedules required of the broker-dealer. The Commission 
proposes a technical amendment, to rename the annual audit report to 
``Financial Report,'' to reflect that proposed paragraph (d)(2) 
relates to the financial audit requirements.
    \40\ Proposed paragraph (d)(1)(i)(B)(1) of Rule 17a-5.
    \41\ Proposed paragraph (d)(1)(i)(B)(2) of Rule 17a-5.
    \42\ Proposed paragraph (d)(1)(i)(C) of Rule 17a-5. 
Specifically, Rule 17a-5(d)(1)(ii) states that ``a broker or dealer 
succeeding to and continuing the business of another broker or 
dealer need not file a report * * * if the predecessor broker or 
dealer has filed a report in compliance with [Rule 17a-5(d)] * * 
*.'' Rule 17a-5(d)(1)(iii) contains an exemption for broker-dealers 
from filing an annual audit report if the broker-dealer is a member 
of a national securities exchange and ``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 [Rule 17a-5].'' Rule 17a-5(e)(1) provides that for certain 
broker-dealers, the financial statements that must be filed pursuant 
to Rule 17a-5(d) need not be audited. The exceptions in paragraphs 
(e)(1)(A)-(B) of Rule 17a-5 are applicable when either: (1) The 
broker-dealer's securities business has been limited to acting as 
broker (agent) for an issuer in soliciting subscriptions for 
securities of the issuer and the broker has promptly transmitted to 
the issuer all funds and promptly delivered to the subscriber all 
securities received in connection with the issuance, and the broker 
has not otherwise held funds or securities for or owed money or 
securities to customers; or (2) the broker-dealer's securities 
business has been limited to buying and selling evidences of 
indebtedness secured by mortgage, deed or trust, or other lien upon 
real estate or leasehold interests, and the broker-dealer has not 
carried any margin account, credit balance or security for any 
securities customer.
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1. Compliance Report
    Under the proposed amendments to paragraph (d) of Rule 17a-5, each 
carrying broker-dealer would be required annually to file a Compliance

[[Page 37576]]

Report containing a statement and assertions concerning compliance, and 
internal control over compliance, with specified rules. Specifically, 
the Compliance Report would include a statement as to whether the 
broker-dealer has established and maintained a system of internal 
control to provide the broker-dealer with reasonable assurance \43\ 
that any instances of material non-compliance with Rule 15c3-1, Rule 
15c3-3, Rule 17a-13, or the Account Statement Rule (collectively, the 
``Financial Responsibility Rules'') will be prevented or detected on a 
timely basis. The Compliance Report is intended to enhance a broker-
dealer's focus on compliance with the specified rules and provide a 
foundation for the proposed ``Compliance Examination'' described below 
in Section II.B.2 of this release.\44\
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    \43\ Exchange Act Section 13(b)(7) defines ``reasonable 
assurance'' and ``reasonable detail'' as ``such level of detail and 
degree of assurance as would satisfy prudent officials in the 
conduct of their own affairs.'' 15 U.S.C. 78m(b)(7). The Commission 
has long held that ``reasonableness'' is not an ``absolute standard 
of exactitude for corporate records.'' See Foreign Corrupt Practices 
Act of 1977, Exchange Act Release No. 17500 (Jan. 29, 1981), 46 FR 
11544, 11546 (Feb. 9, 1981). These concepts differ from the concept 
of ``reasonable assurance'' in an audit context.
    \44\ The Compliance Examination is discussed below in Section 
II.B.2 of this release. As is discussed in Section II.B.2, the 
Commission does not propose the statement in the Compliance Report 
to be included within the scope of the Compliance Examination.
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    In addition, the Compliance Report would include the following 
three assertions by the broker-dealer: (1) Whether the broker-dealer 
was in compliance in all material respects with the Financial 
Responsibility Rules as of its fiscal year-end; \45\ (2) whether the 
information used to assert compliance with the Financial Responsibility 
Rules was derived from the books and records of the broker-dealer; \46\ 
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.\47\ Further, 
the Compliance Report would be required to contain a description of 
each identified instance of material non-compliance and each identified 
material weakness in internal control over compliance with the 
specified rules.\48\
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    \45\ See proposed paragraph (d)(3)(i)(B)(1) of Rule 17a-5.
    \46\ See proposed paragraph (d)(3)(i)(B)(2) of Rule 17a-5.
    \47\ See proposed paragraph (d)(3)(i)(B)(3) of Rule 17a-5.
    \48\ See proposed paragraph (d)(3)(i)(C) of Rule 17a-5.
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    Rule 17a-5(g) currently requires that the audit include a review of 
compliance with and controls pertaining to Rule 15c3-1, Rule 15c3-3, 
and Rule 17a-13. As described above, these rules contain important 
baseline protections concerning broker-dealer capital adequacy and the 
protection of customer funds and securities, and the Commission 
preliminarily believes that it is important that they be addressed in 
any annual report of a carrying broker-dealer. The proposed Compliance 
Report would not cover Regulation T, which is currently addressed in 
existing Rule 17a-5(g)(1)(iii). The Commission believes that the 
inclusion of Regulation T in the scope of the Compliance Report would 
not be necessary given the broker-dealer's assertion in the Compliance 
Report of its compliance with Rule 15c3-1. In particular, a broker-
dealer's failure to comply with Regulation T, which governs broker-
dealers' extensions of credit on securities, could require a broker-
dealer to reduce its net capital by the amount of any deficit in 
customer unsecured and partly secured accounts after calls for 
margin.\49\
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    \49\ See Rule 15c3-1(c)(2)(iv)(B).
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    The Commission also is proposing to require that the Compliance 
Report include a statement and three assertions concerning the Account 
Statement Rule. The Account Statement rule provides a key safeguard for 
customers by ensuring that they receive on a regular basis information 
concerning securities positions and other assets held in their 
accounts. Customers can use that information to identify discrepancies 
and monitor the performance of their accounts. The Commission believes 
that, taken together, the objectives of the Compliance Report are 
consistent with the control objectives of the internal control report 
required under the IA Custody Rule.\50\
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    \50\ See Section II.B.4 of this release for a discussion of the 
IA Custody Rule and the control objectives required under the IA 
Custody Rule.
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    The assertions contained in the Compliance Report would pertain to 
compliance at year-end and also over the course of a fiscal quarter, 
depending on the particular requirement.\51\ The proposed assertions 
with respect to compliance with Rules 15c3-1 and 15c3-3 would relate to 
compliance as of the broker-dealer's fiscal year-end. The assertions as 
to compliance with Rule 17a-13 and the Account Statement Rule also 
would be made as of the broker-dealer's fiscal year-end. However, 
because these rules impose obligations on a quarterly basis (the 
broker-dealer must conduct the quarterly count of securities and must 
send statements to all customers at least once during each quarter, but 
not necessarily on the last day of the quarter), to be able to make the 
assertions in the Compliance Report, the broker-dealer would need to 
determine that it had satisfied the requirements over the course of the 
fiscal quarter immediately preceding the broker-dealer's fiscal year-
end. In contrast, the broker-dealer's assertions related to the 
effectiveness of internal control over compliance with the Financial 
Responsibility Rules would not pertain to a fixed point in time, but 
instead would cover the entire fiscal year. The proposed time periods 
related to internal control over compliance would be consistent with 
those in the IA Custody Rule.\52\
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    \51\ The broker-dealer is required to be in compliance with the 
Financial Responsibility Rules at all times. The assertions made by 
the broker-dealer for purposes of the Compliance Report are as of a 
point in time to facilitate the independent public accountant's 
attestation to the broker-dealer's assertions.
    \52\ See Rule 206(4)-2(a)(6).
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    The Commission preliminarily believes that broker-dealers would be 
able to make assertions regarding both compliance and the effectiveness 
of internal control over compliance with the Financial Responsibility 
Rules. The Commission is not proposing that effectiveness of internal 
control over financial reporting be included as one of the assertions 
made by the broker-dealer in the Compliance Report.\53\ The Commission 
preliminarily believes that the Compliance Report should focus on 
oversight of custody arrangements and protection of customer assets, 
and therefore, should be focused on compliance with the Financial 
Responsibility Rules.
---------------------------------------------------------------------------

    \53\ For example, the Commission is not proposing an assessment 
of internal control over financial reporting similar to the 
assessment required under Section 404 of the Sarbanes-Oxley Act for 
issuers.
---------------------------------------------------------------------------

    The proposed amendments to Rule 17a-5 would provide that a broker-
dealer could not assert compliance with the Financial Responsibility 
Rules, as of its most recent fiscal year-end, if it identifies one or 
more instances of material non-compliance.\54\ Instead, the broker-
dealer would need to identify and describe any instance of material 
non-compliance, as of its most recent fiscal year-end, in the 
Compliance Report.\55\ Rule 17a-5 presently requires that independent 
public accountants include any instances of material inadequacies in 
their reports based on the Study.\56\ The term ``material

[[Page 37577]]

inadequacies,'' however, is not defined in existing auditing 
literature. The Commission is proposing to remove the reference to 
``material inadequacies'' in Rule 17a-5 and replace it, for purposes of 
reporting on the broker-dealer's compliance, with a reference to 
``material non-compliance.'' Further, the Commission is proposing to 
define an instance of material non-compliance, in new paragraph 
(d)(3)(ii) of Rule 17a-5, as a failure by the broker-dealer to comply 
with any of the requirements of the Financial Responsibility Rules in 
all material respects. The Commission preliminarily believes that any 
failure by the broker-dealer to perform any of the procedures 
enumerated in the Financial Responsibility Rules would be an instance 
of non-compliance; therefore, the broker-dealer should evaluate any 
such failure to determine whether it is material.
---------------------------------------------------------------------------

    \54\ See proposed paragraph (d)(3)(ii) of Rule 17a-5. The 
Commission notes that reporting on material non-compliance is 
discussed, for example, in AT Sec.  601 of the PCAOB's Interim 
Attestation Standards; see PCAOB Attestation Standard Sec.  601.
    \55\ See proposed paragraph (d)(3)(ii) of Rule 17a-5.
    \56\ See Rule 17a-5(g).
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    When determining whether an instance of non-compliance is material, 
the Commission preliminarily believes 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.\57\ The 
Commission also preliminarily believes that some deficiencies would 
necessarily constitute instances of material non-compliance. For 
example, failing to maintain the required minimum amount of net capital 
as required 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,\58\ would be instances of 
material non-compliance. These two instances of material non-compliance 
would not, however, represent all possible instances of material non-
compliance with respect to Rules 15c3-1 and 15c3-3.
---------------------------------------------------------------------------

    \57\ See, e.g., paragraph 36 of PCAOB Attestation Standard Sec.  
601.
    \58\ See Section 15(c)(3) of the Exchange Act, which provides 
that no broker or dealer shall make use of the mails or any means or 
instrumentality of interstate commerce to effect any transaction in, 
or to induce or attempt to induce the purchase or sale of, any 
security ``in contravention of such rules and regulations as the 
Commission shall prescribe * * * to provide safeguards with respect 
to the financial responsibility and related practices of the brokers 
and dealers including, but not limited to the acceptable custody and 
use of customers' securities and the carrying and use of customers' 
deposits or credit balances.'' 15 U.S.C. 78o(c)(3)(A).
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    The Commission is proposing several conforming amendments to Rule 
17a-5 to incorporate the proposed use of the term ``material non-
compliance.'' The Commission proposes to amend paragraph (c)(5) of Rule 
17a-5, which requires broker-dealers to send Statements of Financial 
Condition to customers twice per year. Paragraph (c) of Rule 17a-5 
provides that a broker-dealer can make these statements available 
through its Internet Web site in lieu of sending the statements to the 
customers in paper form.\59\ However, paragraph (c)(5)(vi) of Rule 17a-
5 prohibits broker-dealers from making the statements available online, 
in lieu of sending statements to customers in paper form, if the 
broker-dealer was required by paragraph (e) of Rule 17a-11 to give 
notice of a material inadequacy. The Commission is proposing to delete 
the reference to the term ``material inadequacy'' and amend paragraph 
(c)(5)(vi) of Rule 17a-5 to provide that the broker-dealer may make the 
customer statements available online, in lieu of sending statements to 
customers in paper form, provided its financial statements receive an 
unqualified opinion from the independent public accountant and neither 
the broker-dealer nor the independent public accountant identifies a 
material weakness or an instance of material non-compliance pursuant to 
proposed new paragraph (g) of Rule 17a-5, described below.
---------------------------------------------------------------------------

    \59\ Rule 17a-5 requires that the statements be sent to its 
customers, except if the activities of the broker-dealer are limited 
to certain enumerated activities or except as provided in paragraph 
(c)(5), which permits the broker-dealer to instead make the 
statements available online if certain requirements are met. See 
Rule 17a-5(c)(1) and (c)(5).
---------------------------------------------------------------------------

    The proposed amendments to Rule 17a-5 also would provide that a 
broker-dealer could not assert that its internal control over 
compliance with the Financial Responsibility Rules during the fiscal 
year was effective if one or more material weaknesses exist with 
respect to internal control over compliance.\60\ The Commission 
preliminarily believes that a broker-dealer's internal control over 
compliance with the Financial Responsibility Rules would not be 
effective if a material weakness exists, given the meaning of the term 
``material weakness'' as described below. Consequently, if one or more 
material weaknesses exist, the broker-dealer would need to describe in 
the Compliance Report each material weakness identified during the 
fiscal year.\61\ This would provide the Commission with notice of the 
nature of any weakness and allow the Commission and DEA examination 
staff to ascertain how the broker-dealer addressed each weakness.
---------------------------------------------------------------------------

    \60\ See proposed paragraph (d)(3)(iii) of Rule 17a-5.
    \61\ See proposed paragraph (d)(3)(i)(C) of Rule 17a-5.
---------------------------------------------------------------------------

    The Commission is proposing to define the term ``material 
weakness'' in paragraph (d)(3)(iii) of Rule 17a-5 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 those provisions will not 
be prevented or detected on a timely basis. For purposes of this 
paragraph, 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.\62\ The Commission proposes these definitions, 
in part, because they are based on previous Commission action.\63\
---------------------------------------------------------------------------

    \62\ See proposed paragraph (d)(3)(iii) of Rule 17a-5.
    \63\ See Amendments to Rules Regarding Management's Report on 
Internal Control Over Financial Reporting, Exchange Act Release No. 
55928 (Jun. 27, 2007), 72 FR 35310 (Jun. 27, 2007). See also 
Exchange Act Rule 12b-2 (17 CFR 240.12b-2) and Rule 1-02 of 
Regulation S-X (17 CFR 210.1-02), which state that a ``material 
weakness is 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 Commission preliminarily believes 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.'' An event is ``probable'' if the future event 
or events are likely to occur.\64\ An event is ``reasonably possible'' 
if the chance of the future event or events occurring is more than 
remote, but less than likely.\65\
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    \64\ 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, Securities Act of 1933 
Release No. 8810 (Jun. 20, 2007), 72 FR 35324 (Jun. 27, 2007), at 
note 47 and corresponding text.
    \65\ Id.
---------------------------------------------------------------------------

    The Commission preliminarily believes that an instance of non-
compliance that the broker-dealer has determined does not constitute 
material non-compliance may nonetheless be indicative of a control 
deficiency that constitutes a material weakness. The broker-dealer's 
evaluation of whether an instance of non-compliance is material would 
be based upon the consideration of the specifically identified instance 
of non-compliance; whereas the broker-

[[Page 37578]]

dealer's conclusions with respect to whether the related control 
deficiency or deficiencies are material weaknesses would relate to 
whether it is reasonably possible that the control deficiency or 
deficiencies could result in material non-compliance. This evaluation 
would require the broker-dealer to consider not only the specifically 
identified instance of non-compliance but also any additional possible 
effect that the control deficiency or deficiencies could have on 
compliance.
    The Commission generally requests comment on the proposed 
amendments associated with the proposed Compliance Report. In addition, 
the Commission requests comment on the following questions:
     Should other rules be included in the scope of the 
Compliance Report, in addition to, or as an alternative to, the 
Financial Responsibility Rules? If so, which rules? Commenters should 
explain their choices.
     Should the proposed Compliance Report cover Regulation T?
     Are the proposed assertions appropriate? Are there other 
assertions that the broker-dealer should make regarding either 
compliance or internal control over compliance? Why would any 
additional assertions result in improved reporting to the Commission?
     Would all of the proposed assertions achieve the 
Commission's goals to, among other things, strengthen broker-dealers' 
compliance with the Financial Responsibility Rules, and, in turn, 
improve the financial and operational condition of broker-dealers and 
the safeguarding of investor assets?
     What additional steps would a broker-dealer likely have to 
take in order to comply with the proposed requirements and make each 
additional proposed assertion?
     Are there any practical issues the Commission should 
consider with respect to the proposal to assert compliance with the 
Financial Responsibility Rules?
     Is the proposed definition of the term ``material non-
compliance'' understandable in the context of broker-dealer audits? 
What alternative definition could be used? Why would any alternative 
definition be more appropriate?
     Are the examples of material non-compliance described 
above appropriate? What other examples of material non-compliance 
should be specifically identified, if any? Should the Commission 
include examples of material non-compliance in the text of the rule?
     Is the proposed definition of the term ``material 
weakness'' understandable in the context of Rule 17a-5? What 
alternative definition could be used? Why would any alternative 
definition be more appropriate?
     Is the proposed definition of ``deficiency in internal 
control over compliance'' understandable in the context of Rule 17a-5? 
What alternative definition could be used? Why would any alternative 
definition be more appropriate?
2. Compliance Examination and Examination Report
    The Commission proposes to require each carrying broker-dealer to 
engage an independent public accountant to examine the broker-dealer's 
assertions in the Compliance Report (``Compliance Examination'') and 
issue an Examination Report. Under the proposal, following the 
Compliance Examination, carrying broker-dealers would be required to 
file the resulting Examination Report of the independent public 
accountant with the Commission. This Compliance Examination and 
Examination Report would replace the existing practice that results in 
the independent public accountant issuing a report based on a Study.
    The Commission proposes to amend paragraph (g) of Rule 17a-5 and 
rename it ``Engagement of independent public accountant.'' As proposed, 
paragraph (g) would provide that a broker-dealer subject to the 
requirement to file annual reports pursuant to paragraph (d) would need 
to engage an independent public accountant to examine or review, as 
applicable, the reports that are required under that provision. Each 
carrying broker-dealer would be required to engage its independent 
public accountant to prepare the Examination Report based on an 
examination of the assertions contained in the Compliance Report 
required to be filed pursuant to paragraph (d)(3) of Rule 17a-5.\66\ 
The Examination Report would be required to be prepared in accordance 
with PCAOB standards.\67\
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    \66\ See proposed paragraph (g)(2)(i) of Rule 17a-5.
    \67\ Id. The Commission preliminarily believes that the 
independent public accountant's examination would be conducted 
pursuant to existing PCAOB Attestation Standards or other standards 
established by the PCAOB for such purposes.
---------------------------------------------------------------------------

    The proposed changes would not affect existing obligations of 
broker-dealers or their accountants with respect to financial 
reporting.\68\ Further, the assertions in the Compliance Report would 
not cover the effectiveness of internal control over financial 
reporting. Therefore, the independent public accountant would not be 
required in the Examination Report to opine on the effectiveness of the 
broker-dealer's internal control over financial reporting. However, the 
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 statement audit, would remain unchanged.\69\ 
Further, the Examination Report would pertain solely to the assertions 
in the Compliance Report and not to the broker-dealer's process for 
arriving at the assertions. Because the report of the independent 
public accountant required by proposed paragraph (g) of Rule 17a-5 
would require the accountant to perform its own independent examination 
of the related controls and procedures, the Commission preliminarily 
does not believe that it is 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.
---------------------------------------------------------------------------

    \68\ The Commission is not proposing to change existing 
requirements with regard to the broker-dealer's audited financial 
statements, the computation of required and actual net capital under 
Rule 15c3-1, or, for carrying broker-dealers, the computation of the 
customer reserve requirement under Rule 15c3-3. The computation of 
net capital and the computation of the customer reserve requirement 
would continue to be subject to audit procedures by the accountant.
    \69\ See PCAOB Auditing Standard No. 12, Identifying and 
Assessing Risks of Material Misstatements for audits of fiscal years 
beginning on or after December 15, 2010.
---------------------------------------------------------------------------

    The Commission preliminarily intends that the proposed amendments 
and requirements pertaining to the Examination Report would result in 
the following fundamental changes to broker-dealer audits. First, 
broker-dealer examinations would be performed in accordance with PCAOB 
standards, rather than GAAS, consistent with the Dodd-Frank Act.\70\ 
Second, in connection with their engagement, independent public 
accountants would be required to provide an opinion concerning the 
broker-dealer's compliance, and internal control over compliance, with 
key regulatory requirements. Further, the independent public 
accountant's report, as it applies to internal control over compliance, 
would cover the full fiscal year instead of relating to the 
effectiveness of controls only at year-end. Compliance with the Account 
Statement Rules would be included as part of the review. These changes 
are intended to encourage, in connection with broker-dealer audits, 
greater focus by the auditor on internal control over

[[Page 37579]]

compliance as it pertains to key regulatory requirements, including, in 
particular, greater focus on broker-dealer custody practices under the 
Financial Responsibility Rules. In addition, the Commission intends 
that the amendments, as they pertain to custody of customer funds and 
securities, will better align the broker-dealer custody requirements 
with certain requirements in the IA Custody Rule.\71\
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    \70\ See Section 982 of the Dodd-Frank Act.
    \71\ See Rule 206(4)-2(a)(6)(ii)(A).
---------------------------------------------------------------------------

    The Commission generally requests comment on the proposed 
amendments and, in particular, the Compliance Examination and 
Examination Report provisions. In addition, the Commission requests 
comment on the following questions:
     Should the Compliance Examination also cover a broker-
dealer's statement in the Compliance Report as to whether the broker-
dealer 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? If so, why? If not, why 
not?
     Should the independent public accountant provide an 
opinion with regard to the process that the broker-dealer used to 
arrive at its assertions?
3. Notification Requirements
    The proposed amendments would require that the independent public 
accountant notify the Commission within one business day if the 
accountant determines that an instance of ``material non-compliance'' 
exists with respect to any of the Financial Responsibility Rules during 
the course of the examination.\72\ This notice requirement would be 
triggered at the time that the independent public accountant determines 
that material non-compliance exists, not at the time of completion of 
the examination. Alerting the Commission to a broker-dealer's material 
non-compliance with the Financial Responsibility Rules on an expedited 
basis could enable the Commission to react to the non-compliance more 
quickly for the protection of investors and others. Currently, Rule 
17a-5 requires notification in the event the independent public 
accountant determines the existence of a ``material inadequacy.'' \73\ 
Specifically, the independent public accountant must call the material 
inadequacy to the attention of the broker-dealer's chief financial 
officer, who is then obligated to notify the Commission and the broker-
dealer's DEA.
---------------------------------------------------------------------------

    \72\ See proposed paragraph (h) of Rule 17a-5.
    \73\ See Rule 17a-5(h)(2). ``Material inadequacy'' is not a 
defined term in existing auditing literature.
---------------------------------------------------------------------------

    The Commission proposes modifying the notification requirement to 
replace the term ``material inadequacy'' with ``material non-
compliance'' and to require the independent public accountant to notify 
the Commission directly. Specifically, the Commission proposes to amend 
paragraph (h) of Rule 17a-5 to provide that upon determining the 
existence of any material non-compliance during the course of preparing 
the independent public accountant's reports, the independent public 
accountant must notify the Commission within one business day of the 
determination by means of a facsimile transmission or electronic mail, 
followed by first class mail, and must provide a copy of the 
notification in the same manner to the principal office of the DEA for 
the broker-dealer. The Commission preliminarily believes that this 
change would provide more effective and timely notice of broker-dealer 
compliance deficiencies, and, as noted above, enable the Commission to 
react more quickly to protect customers and others adversely affected 
by those deficiencies. It also would be consistent with current 
notification requirements applicable to independent public accountants 
examining investment advisers pursuant to the IA Custody Rule.\74\
---------------------------------------------------------------------------

    \74\ See Rule 206(4)-2(a)(4)(ii).
---------------------------------------------------------------------------

    The Commission is proposing a conforming amendment to paragraph (e) 
of Rule 17a-11, which now requires that broker-dealers provide notice 
to the Commission of the existence of any material inadequacy. The 
Commission also is proposing two technical amendments to correct 
certain references to Rule 17a-12 in paragraph (e) of Rule 17a-11.\75\ 
Further, the Commission is proposing to delete paragraph (h)(1) of Rule 
17a-5, which relates to the extent and timing of broker-dealer audits, 
and which would now be superseded by paragraphs (d) and (g).\76\ 
Finally, the Commission is proposing to delete paragraph (j) of Rule 
17a-5, which currently requires the filing of an independent public 
accountant's report describing any material inadequacies concurrent 
with the annual audit report. This requirement likewise would be 
superseded by the proposed amendments.
---------------------------------------------------------------------------

    \75\ Specifically, the Commission proposes to amend the 
references for Rule 17a-12(f)(2) and Rule 17a-12(e)(2) to be Rule 
17a-12(i)(2) and Rule 17a-12(h)(2), respectively.
    \76\ As discussed above, the broker-dealer must assert that it 
is in compliance in all material respects with the Financial 
Responsibility Rules as of the fiscal year-end and that its internal 
controls over compliance were effective throughout the fiscal year. 
See proposed paragraph (d)(3) of Rule 17a-5.
---------------------------------------------------------------------------

    The Commission generally requests comment on the proposed 
amendments and the notification provisions. In addition, the Commission 
requests comment on the following questions:
     Would an alternative means to notify the Commission of an 
instance of material non-compliance be appropriate? If so, what 
alternative and why?
4. Comparison to the IA Custody Rule
    The IA Custody Rule provides that a registered investment adviser 
is prohibited from having 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.\77\ Under the IA Custody Rule, only banks, certain savings 
associations, registered broker-dealers, registered futures commission 
merchants (``FCMs''),\78\ and certain foreign financial institutions 
may act as qualified custodians.\79\
---------------------------------------------------------------------------

    \77\ See Rule 206(4)-2(a)(1)(i)-(ii).
    \78\ FCMs are individuals, associations, partnerships, 
corporations, and trusts that solicit or accept orders for the 
purchase or sale of any commodity for future delivery on or subject 
to the rules of any exchange and that accept payment from or extend 
credit to those whose orders are accepted. See the Commodity Futures 
Trading Commission Glossary available at http://www.cftc.gov.
    \79\ For the complete definition of the term ``qualified 
custodian,'' see infra note 154.
---------------------------------------------------------------------------

    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. This 
report must be supported by the independent public accountant's 
examination of the qualified custodian's custody controls.\80\ The 
Commission has

[[Page 37580]]

issued guidance identifying the control objectives that would need to 
be included in the scope of the examination.\81\
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    \80\ The IA Custody Rule 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.'' The required 
controls are not enumerated in the rule, however.
    \81\ 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 1942 (Jan. 11, 2010). The Commission guidance on 
the IA Custody Rule provided 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.
---------------------------------------------------------------------------

    The control objectives identified in the Commission's guidance on 
the IA Custody Rule are more general than the specific operational 
requirements in the Financial Responsibility Rules. These general 
control objectives are appropriate for purposes of the IA Custody Rule, 
since this approach allows the different types of qualified custodians 
(banks, certain savings associations, registered broker-dealers, 
registered 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. For example, the manner in 
which an FCM maintains custody of assets \82\ differs from that of a 
bank, and the different entities are subject to different regulations 
governing their custodial functions.
---------------------------------------------------------------------------

    \82\ See section 4d(a) and (b) of the Commodity Exchange Act (7 
U.S.C. 4d); see also 17 CFR 1.20 to 1.30.
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    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.\83\ The Commission preliminarily believes that the 
operational requirements of those rules are consistent with the control 
objectives outlined in the Commission's guidance on the IA Custody 
Rule. Consequently, the Commission has preliminarily determined that, 
if the proposed rule amendments are adopted, a broker-dealer subject to 
the proposed Compliance Examination that also acts as a qualified 
custodian for itself as an investment adviser or for its related 
investment advisers under the IA Custody Rule would be able to use the 
Examination Report to satisfy the reporting requirements under Rule 
17a-5 and the IA Custody Rule's internal control report requirement.
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    \83\ 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 Rule 15c3-1(c)(2)(v)(A).
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    The Commission generally requests comment on the comparability of 
the scope of the internal control report under the IA Custody Rule and 
the scope of the proposed Compliance Examination under the proposed 
amendments to Rule 17a-5. In addition, the Commission requests comment 
on the following question:
     Should the Commission add additional elements to the scope 
of the proposed Examination Report? Commenters should identify any such 
elements and discuss the feasibility, benefits and costs of including 
them as elements in the scope of the proposed Compliance Examination.
5. Proposed Exemption Report
    As discussed above, broker-dealers claiming an exemption from Rule 
15c3-3 (i.e., non-carrying broker-dealers) are required to have their 
independent public accountants ``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.'' 
\84\ The Commission proposes to amend this requirement by requiring a 
non-carrying broker-dealer claiming an exemption from Rule 15c3-3 to 
file a new Exemption Report.\85\ This Exemption Report would replace 
the existing requirement described above.
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    \84\ See Rule 17a-5(g)(2).
    \85\ A non-carrying broker-dealer would file the Exemption 
Report and corresponding report prepared by its independent public 
accountant in lieu of the Compliance Report and Examination Report. 
The Commission notes, however, that under the IA Custody Rule, a 
non-carrying or ``introducing'' broker-dealer may be a ``qualified 
custodian.'' In this case, in order to receive an internal control 
report that would satisfy the IA Custody Rule, the non-carrying 
broker-dealer would have to be separately examined by an independent 
public accountant for that purpose.
---------------------------------------------------------------------------

    Specifically, under new paragraph (d)(4) of Rule 17a-5, the 
Exemption Report would require an assertion by a broker-dealer that it 
is exempt from the provisions of Rule 15c3-3 because it meets one or 
more of the conditions set forth in paragraph (k) of Rule 15c3-3 with 
respect to all of its business activities.\86\ In addition, the non-
carrying broker-dealer would be required to engage an independent 
public accountant to review the assertion in the Exemption Report and 
prepare a report based on that review and in accordance with standards 
of the PCAOB.\87\ If the independent public accountant is aware of any 
material modifications \88\ that should be made to the assertion 
contained in the Exemption Report, the independent public accountant 
would be required to disclose them in its report. The Commission 
preliminarily believes that an example of a discovery that would 
necessitate a material modification would be a discovery that the 
broker-dealer failed to promptly forward any customer securities it 
received.\89\
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    \86\ See Rule 15c3-3(k), which sets forth the exemptions to Rule 
15c3-3.
    \87\ See proposed paragraph (g)(2)(ii) of Rule 17a-5.
    \88\ See paragraph 90 of PCAOB Attestation Standard Sec.  101.
    \89\ See Rule 15c3-3(k)(2)(ii), which provides that an 
introducing broker-dealer is exempt from the requirements of Rule 
15c3-3 if the introducing broker-dealer ``promptly transmits all 
customer funds and securities to the clearing broker or dealer which 
carries all of the accounts of such customers * * *''
---------------------------------------------------------------------------

    The Commission preliminarily believes that the independent public 
accountant would be able to obtain the moderate level of assurance 
contemplated by the required review \90\ through a combination of 
procedures that the accountant would perform in connection with the 
financial audit currently required under Rule 17a-5 \91\ and certain 
inquiries and other procedures targeted specifically to the exemption 
asserted by the broker-dealer.
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    \90\ See paragraph 55 of PCAOB Attestation Standard Sec.  101.
    \91\ See Rule 17a-5(d). As noted previously, the Commission is 
not proposing to change the requirement that broker-dealers file 
annual audited financial statements. Therefore, the Commission 
preliminarily believes that the independent public accountant can 
leverage the work related to the financial audit in the course of 
undertaking its review of the broker-dealer's assertion with respect 
to the claimed exemption from Rule 15c3-3.
---------------------------------------------------------------------------

    The Commission generally requests comment on the proposed Exemption 
Report. In addition, the Commission requests comment on the following 
questions:

[[Page 37581]]

     Are there other types of broker-dealers that would not 
qualify to file an Exemption Report, but, based on the limited scope of 
their businesses, should be allowed to file a more limited report than 
the Compliance Report? If so, please identify the types of broker-
dealers and indicate why they should not be required to file Compliance 
Reports.
     What additional processes and controls might a broker-
dealer put in place in order to comply with the new requirements 
relating to the Exemption Report and to accommodate a review of the 
report by an independent public accountant?
     Should the Commission require that the assertion made by 
the broker-dealer with respect to the exemption from Rule 15c3-3 be 
examined by the accountant (i.e., the independent public accountant 
issues an opinion based on obtaining reasonable assurance) as opposed 
to being reviewed (i.e., the independent public accountant issues a 
report based on obtaining a moderate level of assurance)? Commenters 
should discuss the feasibility, benefits and costs of such a 
requirement.
     What additional costs and burdens would a non-carrying 
broker-dealer incur under the proposal requiring an independent public 
accountant to review the broker-dealer's claim that it qualifies for an 
exemption from Rule 15c3-3?
6. Change in Applicable Audit Standards
    The Commission is proposing to require that the audit of the 
Financial Report, the examination of the Compliance Report, and the 
review of the Exemption Report be performed pursuant to standards 
established by the PCAOB. The Dodd-Frank Act provided authority to the 
PCAOB to establish, subject to Commission approval, auditing and 
related attestation, quality control, ethics, and independence 
standards to be used by registered public accounting firms with respect 
to the preparation and issuance of audit reports to be included in 
broker-dealer filings with the Commission pursuant to Section 17(e) of 
the Exchange Act.\92\ To enable the PCAOB to effectively implement the 
authority provided to it by the Dodd-Frank Act, the Commission is 
proposing to amend paragraph (g) of Rule 17a-5 to provide that the 
independent public accountants' reports required under the rule must be 
prepared in accordance with the standards of the PCAOB.\93\
---------------------------------------------------------------------------

    \92\ See Section II.A. of this release for a discussion of the 
PCAOB's new oversight authority under the Dodd-Frank Act.
    \93\ See proposed paragraph (g)(1) of Rule 17a-5.
---------------------------------------------------------------------------

    In September 2010, the Commission issued interpretive guidance 
concerning the auditing standards that should be applied by broker-
dealer accountants with respect to the current requirements in Rule 
17a-5.\94\ That guidance stated 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 broker-
dealers, should continue to be understood to mean auditing and 
attestation standards generally accepted in the U.S., in addition to 
any applicable rules of the Commission.\95\
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    \94\ See Commission Guidance Regarding Auditing, Attestation, 
and Related Professional Practice Standards Related to Brokers and 
Dealers, Exchange Act Release No. 62991 (Sep. 24, 2010), 75 FR 60616 
(Oct. 1, 2010). The Commission also noted in its guidance that it 
intended to revisit this interpretation in connection with this 
rulemaking.
    \95\ Id. at 60617.
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    Because PCAOB auditing standards differ from existing standards 
governing broker-dealer audits, the proposed change to paragraph (g) 
would result in a change in the procedures accountants would have to 
undertake as part of their engagement for audits of broker-dealers. For 
example, certain audit documentation requirements contained in PCAOB 
Auditing Standard 3 (Audit Documentation) and the engagement quality 
review requirement in PCAOB Auditing Standard 7 (Engagement Quality 
Review) are not required by GAAS.
    The Commission generally requests comment on the proposed change to 
applicable auditing standards. In addition, the Commission requests 
comment on the following questions:
     Are there implications to the differences that were 
identified that the Commission should consider? Are there other 
differences that exist that would have significant implications to the 
audits of broker-dealers?
     Should the requirement to be audited in accordance with 
PCAOB standards be phased in for non-carrying broker-dealers? Why or 
why not? If so, what time-table should the Commission adopt?
7. Compliance Date and Transition Period
    The Commission is proposing to make the Annual Reporting Amendments 
effective for annual reports filed with the Commission for fiscal years 
ending on or after December 15, 2011. The Commission is proposing this 
date to include fiscal years that end on or after December 31, 2011. 
The Commission preliminarily intends to implement a transition period 
for carrying broker-dealers required to file Compliance Reports with 
the Commission with fiscal years ending on or after December 15, 2011 
but before September 15, 2012. During this transition period, a 
carrying broker-dealer's assertion in its Compliance Report as to 
whether internal control over compliance with the Financial 
Responsibility Rules was effective would be a point-in-time assertion 
as of the date of the Compliance Report, rather than covering the 
broker-dealer's entire fiscal year. The Commission preliminarily 
believes that the compliance date and transition period set forth above 
will provide adequate time for broker-dealers to prepare the additional 
required reports and for independent public accountants to plan and 
perform the Compliance Examination procedures.
    The Commission generally requests comment on the proposed 
compliance date and transition period. In addition, the Commission 
requests comment on the following questions:
     Will the proposed compliance date and transition period 
for the Annual Reporting Amendments provide sufficient time for broker-
dealers to prepare the additional reports and for independent public 
accountants to comply with PCAOB standards? Will it provide sufficient 
time to plan and perform Compliance Examination procedures? If not, 
what are the impediments and what would be a more appropriate time 
frame for implementation?
8. General Solicitation of Comments
    The Commission generally requests comment on all aspects of these 
proposed amendments. In addition, the Commission requests comment on 
the following questions related to the proposal:
     Certain broker-dealers conducting a limited and specific 
type of business are not presently required to file an annual audit 
report.\96\ Should the Commission

[[Page 37582]]

require all broker-dealers to file an annual audit of their financial 
statements and supporting schedules? Should any of the proposed 
amendments to Rule 17a-5 applicable to carrying firms be applied to 
other specific types of broker-dealers? If so, which types of firms and 
why? What impact would extension of the audit requirement or the 
proposed amendments relating to non-carrying firms have on small 
businesses?
---------------------------------------------------------------------------

    \96\ See Rule 17a-5(e)(1)(A) and (B), which provide limited 
exemptions to broker-dealers from having their financial statements 
and supporting statements audited by an independent public 
accountant, so long as specified factors are met (e.g., if the 
securities business of the broker-dealer has been limited to acting 
as a broker for an issuer in soliciting subscriptions for securities 
of such issuer and the broker has promptly transmitted to such 
issuer all funds and promptly delivered to the subscriber all 
securities received in connection therewith, and the broker has not 
otherwise held funds or securities for or owed money or securities 
to customers, then the broker-dealer does not have to have the 
financial statements audited by an independent public accountant). 
See Rule 17a-5(e)(1)(A).
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C. Proposed Amendment to the Filing of SIPC Reports

1. Existing Requirement
    SIPC is a non-profit, membership corporation created under the 
Securities Investor Protection Act of 1970 (``SIPA'').\97\ SIPC is 
designed to protect the custodial function of a broker-dealer in the 
event it fails financially. For example, SIPC can fund the liquidation 
of a broker-dealer that cannot wind itself down in an orderly self-
liquidation.\98\ As part of the liquidation, SIPC can advance up to 
$500,000 per customer to satisfy claims for securities and cash.\99\ 
However, of the $500,000, only $250,000 can be used to satisfy claims 
for cash.\100\ In order to pay for these liquidations and advances, 
SIPC maintains the SIPC Fund.\101\ The SIPC Fund is established and 
maintained by collecting assessments from broker-dealers that are 
required to be members of SIPC.\102\ Generally all broker-dealers 
registered with the Commission under Section 15(b) of the Exchange Act 
\103\ are required to be members of SIPC.\104\ 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.\105\
---------------------------------------------------------------------------

    \97\ 15 U.S.C. 78 et seq.
    \98\ 15 U.S.C. 78eee(a)(3).
    \99\ 15 U.S.C. 78fff-3(a).
    \100\ 15 U.S.C. 78fff-3(d).
    \101\ 15 U.S.C. 78ddd.
    \102\ 15 U.S.C. 78ddd(c).
    \103\ 15 U.S.C. 78o(b).
    \104\ 15 U.S.C. 78ccc(a)(2).
    \105\ 15 U.S.C. 78ccc(a)(2)(A)(i)-(iii).
---------------------------------------------------------------------------

    Under SIPA, SIPC may assess each of its member broker-dealers a fee 
determined as a percentage of the firm's revenues.\106\ There are 
required percentage assessments that must be made when the SIPC Fund 
falls below deposited amounts or such other amount as the Commission 
may determine in the public interest (``the SIPC Fund Target 
Level'').\107\ SIPC can assess broker-dealers a fee based on a greater 
percentage of their revenues when the SIPC Fund falls below the SIPC 
Fund Target Level.\108\
---------------------------------------------------------------------------

    \106\ See 15 U.S.C. 78ddd(c)(2). See also SIPC Bylaws, Article 
6.
    \107\ Prior to the Lehman Brothers Inc. and Bernard L. Madoff 
Investment Securities LLC SIPA liquidations, the SIPC Fund was 
maintained at a target level of not less than $1 billion. Currently, 
the SIPC Fund Target Level is $2.5 billion. See SIPC Bylaws, Article 
6, Section 1(a)(1)(A) (specifying the $2.5 billion SIPC Fund Target 
Level). See also Securities Investor Protection Corporation 
Modernization Task Force, Adequacy of the SIPC Fund (Jun. 2010), at 
5 (describing the increase in the SIPC Fund Target Level from $1 
billion to $2.5 billion).
    \108\ SIPC Bylaws, Article 6, Section 1(a).
---------------------------------------------------------------------------

    In order to assist in the collection of these assessments, 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). Such a 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.
    When SIPC raises SIPC Fund assessments above the minimum assessment 
provided for in Section 4(d)(1)(c) of SIPA,\109\ Rule 17a-5(e)(4) 
requires a broker-dealer that files Form SIPC-3 or Form SIPC-7 to also 
file with the Commission, the broker-dealer's DEA, and SIPC a 
supplemental report (``Supplemental Report'') covered by an opinion of 
the broker-dealer's independent public accountant that covers the 
information in the respective form. Among other things, the 
Supplemental Report also is required to: (1) Include a statement that 
the broker-dealer qualified for an exclusion from SIPC membership under 
SIPA during the prior year if exclusion from membership is claimed; and 
(2) include an independent public accountant's report stating that ``in 
the accountant's opinion * * * [the broker-dealer's] claim for 
exclusion from membership was consistent with income reported'' or 
``the assessments were determined fairly in accordance with applicable 
instructions and forms'' (as applicable).\110\
---------------------------------------------------------------------------

    \109\ 15 U.S.C. 78ddd(d)(1)(c).
    \110\ See Rule 17a-5(e)(4).
---------------------------------------------------------------------------

2. Proposed Amendment
    Because Forms SIPC-3 and SIPC-7 are used solely by SIPC for 
purposes of levying its assessments, the Commission preliminarily 
believes that Supplemental Reports relating to these forms would be 
more appropriately filed with SIPC and that SIPC, rather than the 
Commission, should, by rule, prescribe the form of the Supplemental 
Reports. This would provide SIPC with the discretion to determine the 
need for and form of a Supplemental Report and the nature and extent of 
the review by an independent public accountant, if any. The Commission 
would continue to have a role in establishing the requirements for a 
Supplemental Report because the Commission must approve SIPC rule 
proposals.
    The Commission proposes to amend Rule 17a-5 to require that broker-
dealers continue to file a Supplemental Report with the Commission, the 
broker-dealer's DEA, and SIPC until the Commission considers and 
determines to approve any such rule adopted by SIPC. Because, for an 
interim period, broker-dealers would be required to continue to file 
their Supplemental Reports with the Commission, the Commission is 
proposing to update the rule text to conform it to existing 
professional standards and industry practices. Specifically, the 
Commission is proposing to amend Rule 17a-5(e)(4) to eliminate the 
ambiguity that stems from the differing auditing terms used therein by 
removing all references to ``review'' and ``opinion'' where those terms 
are used in Rule 17a-5(e)(4).\111\ In their place, the Commission 
proposes to amend paragraph (e)(4) of Rule 17a-5 to provide that 
Supplemental Reports shall include the independent public accountant's 
report prepared pursuant to agreed-upon procedures based on the 
performance of the procedures outlined in current paragraph (e)(4)(iii) 
of Rule 17a-5, which the Commission is not proposing to change.\112\
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    \111\ See Rule 17a-5(e)(4), Rule 17a-5(e)(4)(iii), and Rule 17a-
5(e)(4)(iii)(F).
    \112\ See Rule 17a-5(e)(4)(iii). The Commission notes that as 
part of the proposed amendments to this paragraph, the procedures 
outlined in current paragraph (e)(4)(iii) of Rule 17a-5 would 
remain, but would be renumbered to be included in paragraph 
(e)(4)(ii)(C).
---------------------------------------------------------------------------

    The Commission generally requests comment on all aspects of these 
proposed amendments. In addition, the Commission requests comment on 
the following questions related to the proposal:

[[Page 37583]]

     Should the Commission and/or a broker-dealer's DEA 
continue to receive SIPC Reports relating to assessments, and, if so, 
for what reasons?
     Should the Commission continue to require that the broker-
dealer engage an independent public accountant to perform some level of 
work with respect to the information contained in the SIPC Reports? If 
so, should the Commission also specify what type of engagement the 
broker-dealer must have with its independent public accountant with 
respect to the information contained in the SIPC Reports? For example, 
should the Commission require a broker-dealer to engage its independent 
public accountant to perform a review of the information in the SIPC 
Reports pursuant to PCAOB standards? Commenters should discuss the 
feasibility, benefits, and costs of such requirements.
     Should the Commission impose any requirements or 
limitations on SIPC with respect to its ability to propose rules to 
have SIPC Reports filed solely with SIPC? If so, what requirements and/
or limitations?

III. The Proposed Access to Audit Documentation Amendments

    Pursuant to Section 17(b) of the Exchange Act, broker-dealers are 
subject to routine inspection and examination by Commission and DEA 
staff. To facilitate the examination of a broker-dealer that clears 
transactions or carries customer accounts (a ``clearing broker-
dealer''), the Commission is proposing that each clearing broker-dealer 
be required to consent to permitting its independent public accountant 
to make available to Commission and DEA examination staff the audit 
documentation associated with its annual audit reports required under 
Rule 17a-5 and to discuss findings relating to the audit reports with 
Commission and DEA examination staff.\113\ The Commission preliminarily 
believes that it is appropriate to limit these requirements to broker-
dealers that maintain customer funds and securities or self-custody 
their proprietary securities because these firms generally have more 
complex business operations than other broker-dealers. Consequently, 
having access to audit documentation and the independent public 
accountants that audit these broker-dealers would be of greater 
assistance to examiners in performing examinations of these firms, as 
compared to firms with simpler business models.
---------------------------------------------------------------------------

    \113\ The sole obligation of the broker-dealer under this 
proposed requirement would be to provide the proposed consent in the 
manner discussed below. The Commission is not addressing in this 
release any rights, obligations, or responsibilities of a broker-
dealer's independent public accountant with respect to its work 
papers.
---------------------------------------------------------------------------

    The Commission is not proposing that the Commission or DEA staff 
would use any audit documentation they may request, or discuss findings 
related to the audit reports, for purposes of examining independent 
public accountants; the PCAOB carries out that function. Rather, the 
Commission preliminarily intends that any such requests would be made 
exclusively in connection with conducting a regulatory examination of 
the clearing broker-dealer.
    The Commission preliminarily intends that examiners generally would 
use any information obtained from audit documentation and discussions 
with the independent public accountants to establish the scope and 
focus of a pending examination of a clearing broker-dealer. The 
Commission preliminarily believes that, in cases in which such 
information is obtained, it would enhance and improve the efficiency 
and effectiveness of Commission and DEA examinations of clearing 
broker-dealers by providing examiners with access to additional 
relevant information to plan their examinations. This additional 
relevant information would enable representatives of the Commission and 
a clearing broker-dealer's DEA to better focus and tailor their 
examination efforts relating to asset verification and other matters 
pertinent to customer protection. 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 sub-
custodians, examiners could focus their efforts on other matters that 
had not been the subject of prior testing and review.
    In connection with these proposals, the Commission is proposing to 
amend paragraph (f)(2) of Rule 17a-5, which contains the requirement 
for broker-dealers to file notices with the Commission and their DEAs 
to designate their independent public accountants, to require that the 
broker-dealer represent that the engagement of the independent public 
accountant by the broker-dealer meets the required undertakings of 
amended paragraph (g).\114\ Currently, paragraph (f)(2) of Rule 17a-5 
provides that a broker-dealer 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 is called ``Notice 
pursuant to Rule 17a-5(f)(2)'' (``Notice'').\115\ Paragraph (f)(2)(iii) 
of Rule 17a-5 prescribes the items that are 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.\116\
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    \114\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
    \115\ See Rule 17a-5(f)(2).
    \116\ See Rule 17a-5(f)(2)(iii)(A) through (C).
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    The proposed amendments to Rule 17a-5 would require: (1) That the 
Notice include a statement as to whether the broker-dealer's engagement 
letter with its independent public accountant is for a single year or 
is of a continuing nature; \117\ (2) a representation that the 
engagement of the independent public accountant by the broker-dealer 
meets the required undertakings of paragraph (g); \118\ (3) in the case 
of a clearing broker-dealer, a representation that the broker-dealer 
agrees to allow representatives of the Commission or the DEA, if 
requested for purposes of an examination of the broker-dealer, to 
review the audit documentation associated with the reports of the 
independent public accountant prepared pursuant to paragraph (g) of 
Rule 17a-5; \119\ and (4) in the case of a clearing broker-dealer, a 
representation that the broker-dealer agrees to permit the independent 
public accountant to discuss with representatives of the Commission and 
the DEA of the broker-dealer, if requested for purposes of an 
examination of the broker-dealer, the findings associated with the 
reports of the independent public accountant prepared pursuant to 
paragraph (g) of Rule 17a-5.\120\ Subparagraph (f)(2)(iii) of Rule 17a-
5 would provide that a non-clearing broker-dealer is not required to 
include the third and fourth representations above.\121\
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    \117\ See proposed paragraph (f)(2)(ii)(D) of Rule 17a-5. The 
Commission notes that FINRA currently provides its members with a 
template for the Rule 17a-5(f)(2) Notice that includes a provision 
as to whether the engagement is continuing in nature, which is 
available at http://www.finra.org/web/groups/industry/@ip/@comp/@regis/documents/industry/p009841.pdf.
    \118\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
    \119\ See proposed paragraph (f)(2)(ii)(F) of Rule 17a-5.
    \120\ See proposed paragraph (f)(2)(ii)(G) of Rule 17a-5.
    \121\ See proposed paragraph (f)(2)(iii) of Rule 17a-5, which 
would provide that a ``broker or dealer who does not carry nor clear 
transactions nor carry customer accounts is not required to include 
the representations in paragraph (e)(ii)(F).''

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[[Page 37584]]

    The Commission also is proposing several technical changes to 
paragraph (f)(2) of Rule 17a-5. Specifically, the Commission proposes 
to amend the language in the preamble of paragraph (f)(2) to streamline 
the paragraph and to add a reference to the requirements of the Notice. 
The Commission proposes to delete paragraph (f)(2)(ii), which provides 
that the agreement can be continuing in nature, because the amended 
preamble to paragraph (f)(2) captures this concept.
    If the Access to Audit Documentation Amendments described above 
were adopted, Notices on file with the Commission at the time of the 
effectiveness of the amendment would not be in compliance with the new 
rules. Accordingly, broker-dealers subject to paragraph (f)(2) would 
have to file new Notices if the proposals were adopted. However, if the 
engagement covered by the new Notice was of a continuing nature, no 
subsequent filing would be required unless the broker-dealer changed 
independent public accountants.\122\
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    \122\ See Rule 17a-5(f)(2)(ii).
---------------------------------------------------------------------------

    The Commission generally requests comment on all aspects of these 
proposed amendments. In addition, the Commission requests comment on 
the following questions:
     Should the proposed Access to Audit Documentation 
Amendments apply to all broker-dealers, or additional broker-dealers 
rather than just clearing broker-dealers?
     Would applying the proposed Access to Audit Documentation 
Amendments to non-clearing broker-dealers provide any advantages in 
terms of enhancing the examination of the broker-dealers or gaining 
efficiencies?
     Are there any other types of broker-dealers whose conduct 
may pose risks to the investing public that should be subject to the 
proposed Access to Audit Documentation Amendments?
     Are there additional reasons why examiners should obtain 
documentation from independent public accountants other than those 
described above (i.e., to establish the scope and focus of a pending 
examination of a clearing broker-dealer)? If so, please explain the 
reasons and the objectives behind the reasons and how the information 
could be used to achieve those objectives.
     Would any limitations on the ability of examiners to have 
access to audit documentation or to discuss the findings of the 
independent public accountant be appropriate? If so, what are those 
restrictions, why would they be appropriate, and what effect would they 
have on broker-dealer examinations?
     Should examiners be required to request access to the 
audit documentation in writing?
     Should the Commission require a broker-dealer to submit a 
statement consenting to provide access to its independent public 
accountant and the audit documentation (``statement of consent'') only 
when it files the ``Notice pursuant to Rule 17a-5(f)(2)''?
     How often should the statement of consent be filed (e.g., 
on an annual or more frequent basis)?
     Are the proposed representations in the Notice sufficient 
to provide effective access to the independent public accountant's 
audit documentation? If not, what additional representations, or what 
other measures, would be more effective?
     Will the terms of engagement between clearing broker-
dealers and their independent public accountants, including 
compensation terms, be affected by the proposed amendments? What 
additional costs might this place on clearing broker-dealers? In this 
respect, would there be a disproportionate impact on smaller clearing 
broker-dealers?
     What is the risk, if any, that clearing broker-dealers and 
their current independent public accountants will not be able to agree 
on mutually-agreeable terms in order to compensate them for additional 
burdens they may incur as a result of the proposed amendments?

IV. The Proposed Form Custody Amendments

    The Commission has brought numerous enforcement actions against 
investment advisers and broker-dealers alleging fraudulent conduct that 
includes misappropriation or other misuse of customer assets.\123\ 
Consequently, the Commission recently took steps to enhance oversight 
of the custody function of investment advisers,\124\ and is now 
proposing enhancements to the oversight of the custody function of 
broker-dealers. The Commission is proposing amendments to Rule 17a-5 
that are designed to provide greater information regarding the custody 
function at broker-dealers and their compliance with requirements 
relating to custody of customer and non-customer assets. Specifically, 
the Commission is proposing a new form to be filed by broker-dealers--
Form Custody--which is designed to elicit information concerning 
whether a broker-dealer maintains custody of customer and non-customer 
assets, and, if so, how such assets are maintained.\125\ As discussed 
below, the Commission proposes to require that a broker-dealer file 
proposed Form Custody with its quarterly FOCUS Report.\126\
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    \123\ See, e.g., SEC v. Donald Anthony Walker Young, et al., 
Litigation Release No. 21006 (Apr. 20, 2009) (complaint alleges 
registered investment adviser and its principal misappropriated in 
excess of $23 million, provided false account statements to 
investors in limited partnership, and provided false custodial 
statements to limited partnership's introducing broker); SEC v. 
Isaac I. Ovid, et al, Litigation Release No. 20998 (Apr. 14, 2009) 
(complaint alleges that defendants, including registered investment 
adviser and manager of purported hedge funds, misappropriated in 
excess of $12 million); SEC v. The Nutmeg Group, LLC, et al., 
Litigation Release No. 20972 (Mar. 25, 2009) (complaint alleges that 
registered investment adviser misappropriated in excess of $4 
million of client assets, failed to maintain client assets with a 
qualified custodian, and failed to obtain a surprise examination); 
SEC v. WG Trading Investors, L.P., et al., Litigation Release No. 
20912 (Feb. 25, 2009) (complaint alleges that registered broker-
dealer and affiliated registered adviser orchestrated fraudulent 
investment scheme, including misappropriating as much as $554 
million of the $667 million invested by clients and sending clients 
misleading account information); SEC v. Stanford International Bank, 
et al., Litigation Release No. 20901 (Feb. 17, 2009) (complaint 
alleges that affiliated bank, broker-dealer, and advisers colluded 
with each other in carrying out an $8 billion fraud); SEC v. Bernard 
L. Madoff, et al., Litigation Release No. 20889 (Feb. 9, 2009) 
(complaint alleges that Madoff and Bernard L. Madoff Investment 
Securities LLC--a registered investment adviser and registered 
broker-dealer--committed a $50 billion fraud).
    \124\ See, e.g., Custody of Funds or Securities by Investment 
Advisers, Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456 
(Jan. 11, 2010).
    \125\ 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 Rule 15c3-3(a) and FINRA's 
Interpretations of Financial and Operational Rules, Rule 15c3-3, 
Rule 15c3-3(a)(1)/01, available on FINRA's Internet Web site at 
http://www.finra.org/Industry/Regulation/Guidance/FOR/.
    \126\ See Rule 17a-5(a). FOCUS Reports, filed with the 
Commission and SROs by broker-dealers, 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 are also 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. See supra note 20. The Commission notes that FOCUS Reports 
are, and proposed Form Custody would be, deemed to be confidential 
pursuant to paragraph (a)(3) of Rule 17a-5.
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    Currently, a broker-dealer's FOCUS Report provides the Commission 
and other regulators (e.g., a broker-dealer's DEA) with information 
relating to the broker-dealer's financial and operational 
condition.\127\ A broker-dealer's FOCUS Report does not, however, 
solicit

[[Page 37585]]

detailed information on how a broker-dealer maintains custody of 
assets. The proposed new form is intended to provide additional 
information about a broker-dealer's custodial activities. The 
Commission preliminarily believes that proposed Form Custody could make 
it easier for examiners to determine whether broker-dealers are in 
compliance with laws and regulations concerning the custody of assets. 
If, upon reviewing Form Custody, regulatory authorities became aware of 
inconsistencies or other red flags in information contained in the 
form, they could initiate a more detailed and focused analysis of the 
broker-dealer's custodial activities. Such an analysis may, in turn, 
identify potential abuses related to customer assets. Moreover, 
proposed Form Custody could 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.
---------------------------------------------------------------------------

    \127\ See Form X-17A-5 Schedule I, Part II, Part IIa, Part IIb, 
and Part III.
---------------------------------------------------------------------------

    The Commission is proposing that broker-dealers file Form Custody 
with their quarterly FOCUS Reports. The Commission preliminarily 
believes that Form Custody would help provide applicable regulators 
with current information about a broker-dealer's custodial activities 
and, as described below, would promote compliance with applicable laws 
and rules. The Commission is proposing that Form Custody be filed on a 
quarterly basis to ensure that the information disclosed on the form is 
current and to enable examiners to identify significant recent changes 
in a broker-dealer's custody practices. For example, examiners could 
more promptly investigate instances in which a broker-dealer frequently 
changes the locations where customer securities are held. While a 
broker-dealer may have valid and lawful reasons for changes in the 
custody arrangements for its customers' securities, such actions also 
could suggest improper activity and could cause examiners to make 
further inquiries.
    Proposed Form Custody is comprised of nine line items (each, an 
``Item'') that elicit information about a broker-dealer's custodial 
activities. Several Items contain multiple questions, and a few Items 
require completion of charts and disclosure of custody-related 
information specific to the broker-dealer completing the form. Each 
Item and its subparts are discussed below.

A. Item 1--Accounts Introduced on a Fully Disclosed Basis

    Item 1.A of Form Custody would elicit information concerning 
whether the broker-dealer introduces customer accounts to another 
broker-dealer on a fully disclosed basis by requiring the broker-dealer 
to check the appropriate ``Yes'' or ``No'' box. 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.\128\ These carrying agreements are 
governed by applicable self-regulatory organization (``SRO'') rules, 
which require broker-dealers entering into a carrying agreement to 
allocate certain responsibilities associated with introduced 
accounts.\129\
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    \128\ To be consistent with the definition of the term 
``customer'' in Rule 15c3-3, the Commission proposes to define the 
term ``customer'' in the General Instructions to Form Custody the 
same. See Rule 15c3-3(a)(1).
    \129\ See, e.g., NYSE Rule 382, NASD Rule 3230, and FINRA Rule 
4311.
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    Typically, under a carrying agreement, one broker-dealer (the 
``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.
    Proposed Item 1.A would elicit 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 proposing 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 the broker-dealer is not equipped 
to maintain. Broker-dealers also may introduce customer accounts on an 
omnibus basis, as is discussed in detail in Section IV.B. of this 
release.
    If the broker-dealer answers Item 1.A by checking the ``Yes'' box, 
the broker-dealer would be required under Item 1.B to identify each 
broker-dealer to which customer accounts are introduced. As discussed 
above, the carrying broker-dealer in such an arrangement maintains the 
cash and securities of the introduced customers. Consequently, Item 1.B 
would elicit the identity of each broker-dealer obligated to return 
cash and securities to the introduced customers. Commission and DEA 
examiners could use this information to confirm the existence of an 
introducing/carrying relationship and to confirm that the carrying 
broker-dealer acknowledges its obligation to return the cash and 
securities belonging to the introduced customers.\130\
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    \130\ See Letter from Richard G. Ketchum, Director, Division of 
Market Regulation, Commission, to David Marcus, New York Stock 
Exchange (Jan. 14, 1985), which states that the customers of 
introducing broker-dealers are presumed to be customers of the 
clearing broker-dealer for purposes of the Commission's financial 
responsibility rules and SIPA.
---------------------------------------------------------------------------

    The Commission generally requests comment on all aspects of 
proposed Item 1. In addition, the Commission requests comment on the 
following questions relating to proposed Items 1.A and 1.B:
     Should the Commission require additional information about 
accounts introduced to carrying broker-dealers on a fully disclosed 
basis? If so, what type of information?
     Should the Commission require the broker-dealer to 
disclose the number of accounts it introduces on a fully disclosed 
basis?
     Should the Commission require the broker-dealer to 
disclose the approximate dollar amount of assets held in fully 
disclosed accounts at the carrying broker-dealer?
     Should the Commission solicit information as to whether a 
broker-dealer other than the carrying broker-dealer clears transactions 
that are ultimately maintained by the carrying broker-dealer on a fully 
disclosed basis?
     Should the Commission require the broker-dealer to 
identify whether it relies on the carrying broker-dealer or another 
third party to maintain books and records relating to introduced 
accounts?

B. Item 2--Accounts Introduced on an Omnibus Basis

    Item 2.A would elicit information concerning whether the broker-
dealer

[[Page 37586]]

introduces customer accounts to another broker-dealer on an omnibus 
basis by requiring the broker-dealer to check the appropriate ``Yes'' 
or ``No'' box. 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.\131\ Disclosure of this 
information is important because a broker-dealer that introduces 
customer accounts to another broker-dealer on an omnibus basis is 
considered to be a carrying broker-dealer with respect to those 
accounts under the Commission's broker-dealer financial responsibility 
rules.\132\ Thus, in these arrangements, the broker-dealer introducing 
the omnibus account to a carrying broker-dealer is obligated to return 
cash and securities in the account to customers.\133\
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    \131\ See Broker-Dealer Audit Guide, supra note 14.
    \132\ See Net Capital Rule, Exchange Act Release No. 31511 (Nov. 
24, 1992); 57 FR 56973 (Dec. 2, 1992), n. 16.
    \133\ Id.
---------------------------------------------------------------------------

    If the broker-dealer checks the ``Yes'' box in Item 2.A, it would 
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.
    The Commission generally requests comment on all aspects of 
proposed Item 2. In addition, the Commission requests comment on the 
following questions relating to proposed Items 2.A and 2.B:
     Should the Commission require additional information about 
accounts introduced to carrying broker-dealers on an omnibus basis? For 
example, should the Commission require a broker-dealer to provide 
information about the specific types of products or customers 
introduced to a carrying broker-dealer on an omnibus basis? What other 
information about accounts introduced to carrying- broker-dealers on an 
omnibus basis should the Commission require to be disclosed? Why?
     Should the Commission require a broker-dealer to disclose 
the number of omnibus accounts it introduces to other broker-dealers? 
If yes, please explain why. If no, please explain why not.
     Should the Commission require a broker-dealer to disclose 
the approximate dollar amount of assets held in omnibus accounts at the 
carrying broker-dealer? If yes, please explain why. If no, please 
explain why not.
     Should the Commission solicit information as to whether a 
broker-dealer other than the carrying broker-dealer clears transactions 
where the securities are ultimately maintained by the carrying broker-
dealer on an omnibus basis? If yes, please explain why. If no, please 
explain why not.

C. Item 3--Carrying Broker-Dealers

1. Items 3.A and 3.B
    Item 3 elicits information concerning how a carrying broker-dealer 
holds cash and securities. Item 3 is comprised of five subparts. The 
first question--Item 3.A--elicits information concerning whether the 
broker-dealer carries securities accounts for customers by requiring 
the broker-dealer to check the appropriate ``Yes'' or ``No'' box. As 
noted above, the proposed General Instructions to Form Custody would 
specify that the term ``customer'' as used in the Form means a 
``customer'' as defined in Rule 15c3-3. The next question--Item 3.B--
elicits information concerning whether the broker-dealer carries 
securities accounts for persons that are not ``customers'' under the 
definition in Rule 15c3-3. 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.
2. Item 3.C
    Item 3.C requires the broker-dealer to identify in three charts the 
types of locations where it holds securities and the frequency with 
which it performs reconciliations between the information on its stock 
record and information on the records of those locations. The proposed 
instructions to Item 3.C provide that the broker-dealer must identify 
the types of locations where it holds securities. The broker-dealer 
would be required to identify locations that are used at any one time 
for maintaining customer, non-customer, and proprietary securities. The 
proposed instructions also require the broker-dealer to specify the 
locations where the broker-dealer holds securities directly in the name 
of the broker-dealer (i.e., the broker-dealer should not identify a 
type of location if the broker-dealer only holds securities at the 
location through an intermediary). For example, when a broker-dealer is 
not a member of a securities clearing organization but, instead, 
accesses the securities processing facilities of the organization by 
holding securities at an entity that is a member of the organization 
(e.g., a U.S. bank), the broker-dealer would be required to identify 
the category of location for which the broker-dealer has a direct 
custodial relationship (i.e., the U.S. bank), but not the securities 
clearing organization.
    The first chart--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.
    The first location identified in the chart is the broker-dealer's 
vault. As noted above, 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 
hold securities in an omnibus account at another broker-dealer.
    The third and fourth potential locations identified in the chart 
are the Depository Trust Company (``DTC'') and the Options Clearing 
Corporation. These are two of the predominant securities clearing 
organizations in the U.S. and, consequently, are identified by name 
rather than type.
    The fifth potential 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 proposed 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 cannot be pledged as collateral for a 
loan to the broker-dealer, 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

[[Page 37587]]

margin securities are not pledged as collateral.
    The sixth potential 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 would hold them in 
the broker-dealer's name on the books of the mutual fund.
    The second chart--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 could include securities held in book-entry form by the issuer of 
the securities or the issuer's transfer agent. A broker-dealer that 
holds securities in such locations would be required to 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 third chart--set forth in Item 3.C.iii--pertains to foreign 
locations where the broker-dealer maintains securities. The Commission 
is not proposing to list categories of foreign locations because 
terminology used to identify certain locations may differ by 
jurisdiction. 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 would be required to 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.
3. Items 3.D and 3.E
    Items 3.D and 3.E of proposed Form Custody each have three 
identical subparts that elicit information about the types and amounts 
of securities and cash the broker-dealer holds, whether those 
securities are recorded on the broker-dealer's stock record and, if 
not, why they are not recorded, and where the broker-dealer holds free 
credit balances. The General Instructions to proposed Form Custody 
would define ``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.\134\
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    \134\ 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 proposed Form contemplates liabilities to 
customers and non-customers. See Rule 15c3-3(a)(8).
---------------------------------------------------------------------------

    The difference between Item 3.D and Item 3.E is that the former 
would elicit information with respect to securities and free credit 
balances held for the accounts of customers, whereas the latter would 
elicit information with respect to securities and free credit balances 
held for the accounts of persons that are not customers.\135\ 
Accordingly, the form would ask two sets of identical questions to 
elicit information about each category of accountholder--customer and 
non-customer.
---------------------------------------------------------------------------

    \135\ As discussed above, the term ``customer'' on proposed Form 
Custody would mean a ``customer'' as defined in Rule 15c3-3(a)(1). 
Broker-dealers may carry securities accounts for ``customers'' as 
defined in Rule 15c3-3 and for persons that are not customers (such 
as insiders and other broker-dealers).
---------------------------------------------------------------------------

    Proposed Items 3.D.i and 3.E.i would elicit information about the 
types and dollar amounts of the securities the broker-dealer carries 
for the accounts of customers and non-customers, respectively. 
Specifically, for each Item, the broker-dealer would be required to 
complete information on a chart to the extent applicable. The charts 
have twelve rows, with each row representing a category of security. 
The categories are: (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 is included in each chart to 
identify any securities not specifically listed in the first twelve 
rows. The types of securities are 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 are 
maintained at locations generally known to hold such securities. If the 
form indicates that some types of securities are held at a location 
that is atypical for such securities, the examiner can refine the focus 
of the examination to ensure customer assets are properly safeguarded.
    The charts in Items 3.D.i and 3.E.i each have eight columns. The 
first column contains boxes for each category of security specified in 
the Item. The broker-dealer would be 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 identifies the category of security. The third through eighth 
columns represent 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. The broker-dealer would be required to check the box 
in each chart reflecting the approximate dollar value for every 
category of security the broker-dealer carries for the accounts of 
customers and non-customers, respectively.
    The Commission is proposing dollar ranges for the values of the 
securities, as opposed to actual values, to ease compliance burdens. 
The intent is to elicit information about the relative dollar value of 
securities the broker-dealer holds 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.
    Proposed Items 3.D.ii and 3.E.ii would elicit information 
concerning whether the broker-dealer has recorded all the securities it 
carries 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. If the broker-dealer checks ``No,'' 
it would be required to explain in the space provided why it has 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.
    The Commission anticipates that a broker-dealer 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--is a record of custody and movements 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

[[Page 37588]]

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).
    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 proposing this question are twofold. 
First, the question could 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. 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 did not 
include securities on its stock record as required by Rule 17a-3.
    Proposed Items 3.D.iii and 3.E.iii would elicit information as to 
how the broker-dealer treats free credit balances in securities 
accounts of customers and non-customers, respectively. The information 
is elicited through a chart the broker-dealer would be required to 
complete. The chart in Item 3.D.iii has five rows with each row 
representing a different process for treating free credit balances. The 
treatment options (referred to as ``processes'' on the form) would be 
that free credit balances are: (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 (5) 
``other,'' with a space to describe such other treatment. The options 
are 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).
    A broker-dealer would 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 Rule 15c3-3(e). Rule 15c3-3(e) 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.\136\ Rule 15c3-3 requires a broker-dealer to 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.\137\
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    \136\ See Rule 15c3-3(e) and Rule 15c3-3a.
    \137\ See Amendments to Financial Responsibility Rules for 
Broker-Dealers, Exchange Act Release No. 55431 (Mar. 9, 2007), 72 FR 
12862 (Mar. 19, 2007). See also Letter from Michael A. Macchiaroli, 
Associate Director, Division of Market Regulation, Commission, to 
Raymond J. Hennessy, Vice President, NYSE, and Thomas Cassella, Vice 
President, NASD Regulation, Inc. (Nov. 10, 1998).
---------------------------------------------------------------------------

    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).'' Rule 15c3-3(k)(2)(i) 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).'' 
\138\
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    \138\ See Rule 15c3-3(k)(2)(i).
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    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.\139\ 
Customers must make a request to the broker-dealer for the return of 
funds swept from their securities accounts to the bank.
---------------------------------------------------------------------------

    \139\ 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 is 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 would cover any other 
process that is not described in the other options.
    The Commission generally requests comment on all aspects of 
proposed Item 3. In addition, the Commission requests comment on the 
following questions relating to proposed Item 3:
     Should the Commission identify additional U.S. locations 
in Item 3.C.i relating to where broker-dealers maintain custody of 
securities held in the U.S.?
     Should the Commission include separate charts to identify 
locations where customer, non-customer, and proprietary securities are 
held?
     Should the charts in Item 3.C solicit information from 
broker-dealers other than the location where securities are held and 
reconciliation frequency?
     Should the broker-dealer be required to identify only the 
types of locations in Items 3.C.i, ii and iii where un-hypothecated 
securities are located? For example, should the broker-dealer not be 
required to identify locations where securities are hypothecated in 
transactions such as stock loans, bank loans and repurchase agreements?

[[Page 37589]]

     Should the Commission identify additional categories of 
securities in the charts specified under Item 3.D and 3.E? For example, 
are the securities listed on those charts sufficiently comprehensive to 
cover most, if not all, types of securities carried by broker-dealers?
     Should the Commission require the broker-dealer to provide 
the identities of all custodians, as opposed to, or in addition to, 
describing the types of custodians?
     Should the Commission use different dollar ranges in the 
charts specified in Items 3.D.i and 3.E.i? If so, what ranges?
     Should the Commission require broker-dealers to provide 
specific dollar amounts, rather than indicating ranges, in Items 3.D.i 
and 3.E.i?
     Should the Commission require broker-dealers to identify 
in Items 3.D.iii and 3.E.iii the specific locations where free credit 
balances are held (e.g., the names of banks and money market funds)?

D. Item 4--Carrying for Other Broker-Dealers

    Item 4 of proposed Form Custody requires a broker-dealer to 
disclose whether it acts as a carrying broker-dealer for other broker-
dealers. There are 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 
elicit information from a broker-dealer as to whether it carries 
transactions for other broker-dealers on a fully disclosed basis. The 
second set of questions would elicit information from a broker-dealer 
as to whether it carries transactions for other broker-dealers on an 
omnibus basis.
    Proposed 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.
    The Commission has stated that related person custody arrangements 
can present higher risks to ``advisory clients'' than maintaining 
assets with an independent custodian,\140\ and the Commission believes 
the same to be true for broker-dealer clients. Consistent with the 
definition of the term in other contexts applicable to broker-dealers, 
including Form BD,\141\ the General Instructions for proposed Form 
Custody would 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 would specify 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 definition is consistent with the definition 
used in Form BD.\142\
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    \140\ See Custody of Funds or Securities by Investment Advisers, 
Advisers Act Release No. 2968 (Dec. 30, 2009), 75 FR 1456 at 1462 
(Jan. 11, 2010).
    \141\ 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.
    \142\ 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.
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    Item 4 in proposed Form Custody would elicit information about 
broker-dealers' custodial responsibilities with respect to accounts 
held for the benefit of other broker-dealers, and would require broker-
dealers to identify such broker-dealers that are affiliates of the 
broker-dealer.\143\ The Commission believes that this information will 
be useful for examination purposes and 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.
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    \143\ Form Custody would 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 preliminarily 
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 proposed 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.
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    The Commission generally requests comment on all aspects of 
proposed Item 4. In addition, the Commission requests comment on the 
following questions relating to proposed Item 4:
     The Commission is proposing to require that broker-dealers 
carrying accounts of other broker-dealers specify on proposed Form 
Custody the identities of only affiliated broker-dealers that introduce 
accounts to the carrying broker-dealer. Should the Commission require 
that broker-dealers carrying accounts of other, unaffiliated, broker-
dealers specify on proposed Form Custody the identities of all broker-
dealers that introduce accounts to the carrying broker-dealer?
     For purposes of defining the term ``affiliate'' in Item 4, 
should the Commission use the Form BD definition of the term 
``affiliate''? Is there a more appropriate definition? If so, which 
definition? For example, should ownership by a carrying broker-dealer 
of 10% or more of the common stock of the introducing broker-dealer 
qualify such entities as affiliates?

E. Item 5--Trade Confirmations

    Item 5 of proposed Form Custody would require broker-dealers to 
disclose whether they send transaction confirmations to customers and 
other accountholders by checking the appropriate ``Yes'' or ``No'' box. 
Confirmations are important safeguards that enable customers to monitor 
transactions that occur in their securities accounts. Timely 
confirmations would alert customers of unauthorized transactions and 
would provide customers with an opportunity to object to the 
transactions.
    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.\144\ 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

[[Page 37590]]

information in most transactions involving debt securities).
---------------------------------------------------------------------------

    \144\ 17 CFR 240.10b-10.
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    The information contained on a trade confirmation should reconcile 
with customer statements and the broker-dealer's journal entries.\145\ 
In this regard, there is a direct link between trade confirmations sent 
by a broker-dealer and the broker-dealer's custody of customer 
assets.\146\ How a broker-dealer answers Item 5 of proposed Form 
Custody could assist examiners in focusing their inspection. For 
example, if a broker-dealer claims that a third-party is responsible 
for sending trade confirmations, the examiners can confirm with that 
third-party that it is sending them on behalf of the broker-dealer.
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    \145\ See 17 CFR 240.17a-3(a)(1), which requires the broker-
dealer to make ``blotters'' ``(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.''
    \146\ Although broker-dealers may allocate the function of 
sending confirmations to other broker-dealers or to service 
providers, the 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 note 2 (``* * * 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'').
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    The Commission generally requests comment on all aspects of 
proposed Item 5. In addition, the Commission requests comment on the 
following questions relating to proposed Item 5:
     If the broker-dealer answers ``No'' to Item 5.A, what 
information in addition to the identity of the broker-dealer that sends 
the confirmations would be useful to elicit in the form? For example, 
if the broker-dealer is a party to a carrying agreement pursuant to 
which a carrying broker-dealer agrees to issue trade confirmations for 
the broker-dealer, should the Commission require the broker-dealer to 
identify the date the agreement was made with the carrying broker-
dealer and/or which SRO approved the carrying agreement?
     If the broker-dealer answers ``Yes'' to Item 5.A, and the 
broker-dealer has hired a third party service provider to prepare and 
send trade confirmations on the broker-dealer's behalf, should the 
broker-dealer be required to disclose the name of the third party 
service provider?
     Is there any additional information related to trade 
confirmations that the Commission should request in Item 5?

F. Item 6--Account Statements

    Item 6 of proposed Form Custody would require broker-dealers to 
disclose whether they send account statements directly to customers and 
other accountholders by checking the appropriate ``Yes'' or ``No'' box. 
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.\147\ 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.\148\ The account statement 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.\149\ 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.\150\
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    \147\ See NASD Rule 2340 (Customer Account Statements) and NYSE 
Rule 409 (Statements of Accounts to Customers).
    \148\ See NASD Rule 2340, which 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. 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. See also 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).
    \149\ 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).
    \150\ Id.
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    Like trade confirmations, account statements are important investor 
safeguards to monitor transactions that occur in an investor's 
securities account. As noted above, an introducing broker-dealer and 
clearing broker-dealer that are parties to a carrying agreement may 
allocate the sending of account statements to the clearing broker-
dealer.\151\ If the allocation has been made to a broker-dealer other 
than the broker-dealer completing Form Custody, this would be disclosed 
on the Form in Item 6.B. Item 6.C would elicit whether the broker-
dealer sends account statements to anyone other than the beneficial 
owner of the account.\152\
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    \151\ As with trade confirmations, broker-dealers can allocate 
the function but not the responsibility; see supra note 146.
    \152\ 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 (17 CFR 240.13d-3).
---------------------------------------------------------------------------

    The Commission is proposing to require 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. The Commission notes that broker-
dealers do not currently disclose to the Commission whether they send 
account statements directly to customers. Collecting this information 
on proposed Form Custody would 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 
assets, which would be disclosed in response to Item 3.C. of Form 
Custody. Examiners could then review and reconcile these documents to 
verify whether customer assets are held at the custodian(s) identified 
by the broker-dealer.
    The Commission generally requests comment on all aspects of 
proposed Item 6. In addition, the Commission requests comment on the 
following questions relating to proposed Item 6:

[[Page 37591]]

     If the broker-dealer answers ``No'' to Item 6.A, what 
information in addition to the identity of the broker-dealer that sends 
the account statements would be useful to elicit in the form?
     If a broker-dealer sends account statements to persons 
other than the beneficial owner of the account, should the Commission 
require the broker-dealer to explain why those persons receive account 
statements from the broker-dealer?

G. Item 7--Electronic Access To Account Information

    Item 7 of proposed Form Custody would require broker-dealers to 
indicate whether they provide 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. 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 preliminarily 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 proposes to 
include this item in proposed Form Custody because it would help to 
inform examiners as to how readily customers can access and review 
account information.
    The Commission generally requests comment on all aspects of Item 7 
to Form Custody. In addition, the Commission requests comment on the 
following questions related to Item 7:
     If a broker-dealer checks ``Yes'' in response to Item 7, 
should the Commission require additional disclosure on Form Custody 
relating to the types of electronic access the broker-dealer provides 
to customers and other accountholders?
     If a broker-dealer checks ``Yes'' in response to Item 7, 
should the Commission require broker-dealers to indicate on Form 
Custody if customers that elect to receive certain account-related 
communications (e.g., trade confirmations) electronically also are sent 
copies of those documents via mail or whether they are limited to 
accessing those documents electronically?

H. Item 8--Broker-Dealers Registered as Investment Advisers

    Item 8 of proposed Form Custody would elicit information, if 
applicable, about whether and how the broker-dealer operates as an 
investment adviser. The first question in proposed Item 8.A would 
require the broker-dealer to indicate whether it is 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.\153\ If the broker-
dealer indicates that it is registered with the Commission under the 
Advisers Act or pursuant to state law (or both), then it would be 
required to respond to the remaining questions under proposed Item 8.
---------------------------------------------------------------------------

    \153\ 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.
---------------------------------------------------------------------------

    Proposed Item 8.B. would require the broker-dealer to disclose the 
number of clients it has as an investment adviser. This would provide 
the Commission with information about the scale of the broker-dealer's 
investment adviser activities.
    Proposed Items 8.C would require the broker-dealer to complete a 
chart, which would consist of six columns, in which the broker-dealer 
would provide information about the custodians where the assets of the 
investment adviser clients are held.\154\
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    \154\ Under the IA Custody Rule, 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 to have custody of client funds or 
securities unless, among other things, a qualified custodian 
maintains those funds or securities. See Rule 206(4)-2. The 
Commission defines a qualified custodian as: (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 
Rule 206(4)-2(d)(6). The Commission requires that the qualified 
custodian 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 
Rule 206(4)-2(a)(1).
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    In the first column, the broker-dealer would be required to 
disclose the name of the custodian, and in the second column, the 
broker-dealer would be required to identify the custodian by either SEC 
file number or CRD number, as applicable.
    The third and fourth columns of the chart would elicit 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. 
Specifically, in the third column, the broker-dealer/investment adviser 
would indicate whether it has the authority to effect transactions in 
the advisory client accounts at the custodian. In the fourth column, 
the broker-dealer/investment adviser would indicate whether it has the 
authority to withdraw funds and securities out of the accounts at the 
custodian.
    In the fifth column, the broker-dealer/investment adviser would 
indicate whether the custodian sends account statements directly to the 
investment adviser clients. The Commission recently adopted amendments 
to the IA Custody Rule 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 will provide greater 
assurance of the integrity of account statements received by 
clients.\155\
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    \155\ See, e.g., Custody of Funds or Securities by Investment 
Advisers, Advisers Act Release No. 2876 (May 20, 2009), 74 FR 25354 
(May 27, 2009) (proposing release); Advisers Act Release No. 2968 
(Dec. 30, 2009), 75 FR 1456 (Jan. 11, 2010) (adopting release).
---------------------------------------------------------------------------

    In the sixth column, the broker-dealer/investment adviser would 
indicate whether investment adviser client assets are recorded on the 
broker-dealer's stock record. If the broker-dealer is acting as 
custodian for such assets, the Commission anticipates that those assets 
would be recorded on the stock record.
    The information solicited in Item 8 differs from the information 
that would be elicited in Item 3, because Item 3 requires a broker-
dealer to provide detailed information about its custodial functions. 
In contrast, the goal of the information elicited in Item 8 is to 
assist the Commission and DEA examiners in developing a profile of the 
firm with respect to its functions as an investment adviser, and not as 
a custodian.
    The Commission generally requests comment on all aspects of 
proposed Item 8. In addition, the Commission requests comment on the 
following questions:
     Should the Commission request additional information from 
dually-registered broker-dealer/investment

[[Page 37592]]

advisers in the chart located in Item 8.C? If so, what information 
should the Commission request?
     Should the Commission require broker-dealer/investment 
advisers to disclose the type of client assets held by custodians 
(e.g., fixed income securities or equity securities, etc.)?
     Should the Commission amend the charts in Item 8 to 
require broker-dealer/investment advisers to disclose the dollar amount 
of assets held at the custodian in ranges?

I. Item 9--Broker-Dealers Affiliated with Investment Advisers

    Item 9 of Form Custody would elicit information concerning whether 
the broker-dealer is an affiliate of an investment adviser. For these 
purposes, 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.\156\ If the broker-dealer is such an 
affiliate, Item 9 would also elicit information concerning whether the 
broker-dealer has custody of client assets of an affiliated investment 
advisor and, if so, the approximate U.S. dollar market value of the 
assets.
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    \156\ See supra note 141 and corresponding text which specifies 
the same ownership percentage on Form BD.
---------------------------------------------------------------------------

    The Commission generally requests comment on all aspects of 
proposed Item 9. In addition, the Commission requests comment on the 
following question related to Item 9:
     Should the Commission define affiliate differently? Should 
the Commission use a different percentage of ownership for prima facie 
evidence of control?

J. Proposed Text Amendments To Require the Filing of Form Custody

    The Commission is proposing to add a new paragraph (a)(5) to Rule 
17a-5 to implement the Form Custody filing requirement. Specifically, 
proposed paragraph (a)(5) would provide that ``[e]very broker or dealer 
subject to this paragraph (a) shall file Form Custody with its 
designated examining authority within 17 business days after the end of 
each calendar quarter and within 17 business days after the date 
selected for the annual reports where said date is other than the end 
of a calendar quarter. The designated examining authority shall 
maintain the information obtained through the filing of the Form 
Custody and transmit such information to the Commission.'' \157\ The 
proposed language, including filing proposed Form Custody within 17 
business days after the end of each calendar quarter, is the same as 
the existing requirements under Rule 17a-5 pertaining to the time frame 
for broker-dealers to file their FOCUS Reports,\158\ and the 
maintenance of the FOCUS Reports filed with the DEAs.\159\
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    \157\ See proposed paragraph (a)(5) of Rule 17a-5. The 
Commission proposes to amend the numbering of the remaining 
subparagraphs--for example, current paragraph (a)(5) of Rule 17a-5 
would be renumbered as paragraph (a)(6) and current paragraph (a)(6) 
would be renumbered as paragraph (a)(7).
    \158\ See Rule 17a-5(a)(2)(ii).
    \159\ See Rule 17a-5(a)(4).
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    The Commission generally requests comment on all aspects of 
proposed new paragraph (a)(5) of Rule 17a-5. In addition, the 
Commission requests comment on the following question related to 
proposed new paragraph (a)(5):
     Should the Commission require the proposed Form Custody be 
filed on a different schedule? If so, what schedule?

K. General Solicitation of Comments on Form Custody

    In addition to the questions above with respect to the specific 
Items of Form Custody, the Commission requests comment more generally 
on the overall approach of the proposal. In addition, the Commission 
requests comment on the following questions:
     Should the Commission require that the broker-dealer 
engage an independent public accountant with respect to Form Custody? 
If so, what level of engagement should be required? For example, should 
the Form Custody be audited by the independent public accountant?

V. Additional Amendments to Rule 17a-5

    In addition to the proposed amendments discussed above and their 
corresponding technical amendments, the Commission proposes several 
``clean up'' amendments to Rule 17a-5 that would modernize the rule and 
delete unnecessary or outdated provisions.

A. Requirement To File Annual Reports

    The Commission proposes to amend paragraph (d)(6) of Rule 17a-5 to 
provide that copies of the annual reports shall be provided to all SROs 
of which the broker-dealer is a member ``unless the self-regulatory 
organization by rule waives this requirement.'' The Commission proposes 
this addition because in some cases SROs do not believe it is necessary 
to receive copies of broker-dealer annual reports, particularly when 
they are not the broker-dealer's DEA.
    The Commission also proposes to amend paragraph (d)(6) of Rule 17a-
5 to require broker-dealers to file copies of their annual reports with 
SIPC. As discussed above, SIPC may be required to fund the liquidation 
of a broker-dealer that cannot wind itself down in an orderly fashion. 
As part of the liquidation process, SIPC may be required to advance up 
to $500,000 per customer to satisfy claims for cash and securities of 
which $250,000 can be used to satisfy claims for cash.\160\ In order to 
pay for these liquidations and advances, SIPC maintains the SIPC Fund. 
This SIPC Fund is established and maintained by collecting assessments 
from broker-dealers that are required to be members of SIPC.\161\
---------------------------------------------------------------------------

    \160\ 15 U.S.C. 78fff-3(a), (d).
    \161\ 15 U.S.C. 78ddd.
---------------------------------------------------------------------------

    In some cases where SIPC has used the SIPC Fund to liquidate failed 
broker-dealers and make advances to customers, SIPC has not been able 
to recover the money advanced because the estate of the failed broker-
dealer had insufficient assets.\162\ SIPC has sought to recover money 
damages from auditing firms, 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.\163\ Therefore, if SIPC had received a copy of the annual reports 
as contemplated under this proposed amendment, SIPC could have brought 
a claim against the auditing firm. In addition, the filing of annual 
reports with SIPC could allow it to better monitor industry trends and 
enhance its knowledge of particular firms.
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    \162\ The most recent example of a SIPA liquidation in which 
SIPC does not expect to recover money advanced to a trustee is the 
liquidation of Bernard L. Madoff Investment Securities LLC. SIPC 
2010 Annual Report, p.18, available at http://www.sipc.org/pdf/2010%20Annual%20Report.pdf.
    \163\ See SIPC v. BDO Seidman, LLP, 746 N.E.2d 1042 (N.Y. 2001).
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    The Commission generally requests comment on all aspects of these 
proposed amendments. In addition, the Commission requests comment on 
the following question related to the proposal:
     Rather than filing the annual reports directly with SIPC, 
should the Commission propose that the broker-dealers make the reports 
available to SIPC upon request? If so, why? If no, why not?

B. Confidentiality of Annual Reports

    The Commission also proposes to update the method in which broker-

[[Page 37593]]

dealers request that their annual reports be filed with the Commission 
on a confidential basis. Currently, under paragraph (e)(3) of Rule 17a-
5, in order for a broker-dealer to receive confidential treatment for 
the financial statements it files with the Commission, other than the 
Statement of Financial Condition, the broker-dealer must bind the 
Statement of Financial Condition separately from the remaining 
financial statements and denote the Statement of Financial Condition as 
``Public'' and the separate document as ``Confidential.''\164\ The 
wording of this provision has led to confusion, resulting in inquiries 
to the Commission staff on how broker-dealers can receive confidential 
treatment for financial statements filed with the Commission under 
paragraph (e)(3) of Rule 17a-5, and, on occasion, broker-dealers 
inadvertently making publicly available financial statements intended 
to be confidential. The Commission proposes that broker-dealers 
continue to bind separately the Statement of Financial Condition from 
the remaining pages of the annual reports. In order to provide better 
clarity as to which part of the annual report is public and which part 
should be kept confidential, the Commission proposes to require that 
the broker-dealer stamp each page of the separately bound confidential 
portion of its annual reports as ``Confidential.''
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    \164\ The Commission's Web site provides guidance that the 
public and non-public portions of the financial statements must be 
clearly segregated and the Facing Page must be appropriately marked. 
For example, the Facing Page attached to the Statement of Financial 
Condition should not be marked ``Confidential.'' Further, if the 
Statement of Financial Condition is not bound separately or placed 
in a separate package, then, in accordance with Rule 17a-5(e)(3), 
none of the statements will be accorded confidential treatment. See 
``Broker-Dealer Notices and Reports'' at http://www.sec.gov/divisions/marketreg/bdnotices.htm.
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    Paragraph (e)(3) of Rule 17a-5 currently provides that the annual 
reports, including the confidential portions, shall be available, for 
example, for official use by any official or employee of the U.S., and 
national securities exchanges and registered national securities 
associations of which the person filing is a member. The Commission 
proposes to amend paragraph (e)(3) of Rule 17a-5 to include the PCAOB 
as a permitted recipient. The Commission further proposes to amend 
paragraph (e)(3) of Rule 17a-5 by updating references to the revised 
rule and reflecting the proposed Annual Audit Reports.
    The Commission generally requests comment on all aspects of this 
proposed amendment. In addition, the Commission requests comment on the 
following question related to the proposal:
     Would this proposed amendment be the simplest method to 
request confidentiality treatment, or is there a better alternative?

C. Removing Obsolete Provisions

    The Commission proposes to delete paragraph (e)(5) of Rule 17a-5 in 
its entirety because the provisions are now moot. Paragraph (e)(5) of 
Rule 17a-5 discusses the requirement for broker-dealers to file Form 
BD-Y2K. Form BD-Y2K elicited information with respect to the broker-
dealer's readiness for the year 2000 and any potential problems that 
could arise with the advent of the new millennium.\165\ Form BD-Y2K was 
required to be filed in April of 1999 and only then.
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    \165\ See Reports to be Made by Certain Brokers and Dealers, 
Exchange Act Release No. 40608 (Oct. 28, 1998), 63 FR 59208 (Nov. 
3,1998).
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D. Classification of Qualified Accountant

    The Commission proposes to amend paragraph (f)(1) of Rule 17a-5, 
which determines how the Commission classifies a qualified independent 
public accountant, by adding a sentence to the paragraph stating that 
the ``accountant must be registered with the Public Company Accounting 
Oversight Board if required by the Sarbanes-Oxley Act of 2002.'' This 
is a technical, non-substantive amendment because broker-dealer 
accountants are already required to be registered with the PCAOB.

E. Technical Amendments

    The Commission proposes to delete paragraph (b)(6) of Rule 17a-5, 
which currently provides that a ``copy of the 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 proposes to delete this paragraph because it 
is redundant to the requirement in paragraph (d)(6) of the rule.\166\
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    \166\ As previously discussed, the Commission proposes to amend 
paragraph (d)(6) of Rule 17a-5 to require that a copy of the annual 
report be filed with SIPC. Specifically, the Commission proposes 
that paragraph (d)(6) provide that the annual reports 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, the 
Commission's principal office in Washington, DC, and the principal 
office of the designated examining authority for said broker or 
dealer and with the Securities Investor Protection Corporation. 
Copies thereof shall be provided to all self-regulatory 
organizations of which said broker or dealer is a member, unless the 
self-regulatory organization by rule waives this requirement.''
---------------------------------------------------------------------------

    For consistency purposes, the Commission proposes to delete 
references to ``balance sheet'' and replace them with references to 
``Statement of Financial Condition.'' \167\
---------------------------------------------------------------------------

    \167\ See, e.g., Rule 17a-5(c)(2)(i).
---------------------------------------------------------------------------

    The Commission also proposes technical amendments to paragraph 
(e)(1)(i) of Rule 17a-5. Paragraph (e)(1)(i) provides the exemption for 
broker-dealers that are not required to engage an independent public 
accountant to audit their financial statements. The technical 
amendments that the Commission is proposing include updating references 
and clarifying the existing language.\168\ The Commission also proposes 
technical amendments to paragraph (e)(1)(ii) of Rule 17a-5, which 
requires a broker-dealer to include an oath or affirmation related to 
the claimed exemption from the annual audit requirement. Specifically, 
the Commission proposes to update references and other non-substantive 
changes to the text of the paragraph.
---------------------------------------------------------------------------

    \168\ See, e.g., proposed Rule 17a-5(e)(1).
---------------------------------------------------------------------------

    Further, the Commission is proposing to amend paragraph 
(e)(4)(iii)(F) of Rule 17a-5 to correct an inaccurate reference to a 
form filed in connection with the SIPC Reports. Currently, paragraph 
(e)(4)(iii)(F) refers to the ``Certificate of Exclusion from 
Membership'' as Form SIPC-7. The proposed amendments would change the 
reference in proposed paragraph (e)(4)(iii)(F) from Form SIPC-7 to Form 
SIPC-3 in proposed paragraph (e)(4)(ii)(C).
    In addition, the Commission is proposing to amend paragraphs (f)(1) 
and (f)(3) of Rule 17a-5. Currently, paragraph (f)(1) of Rule 17a-5 
contains the ``Qualification of accountants.'' Specifically, paragraph 
(f)(1) states 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. The Commission will not recognize any person as a public 
accountant who is not in good standing and entitled to practice as such 
under the laws of his place of residence or principal office.'' \169\ 
Paragraph (f)(3) of Rule 17a-5 contains the requirement for 
independence: ``[a]n accountant shall be independent in accordance with 
the provisions of Sec.  210.2-01(b) and (c) of

[[Page 37594]]

this chapter.'' The Commission proposes to delete paragraph (f)(3) and 
amend (f)(1) to state that ``the independent public accountant must be 
qualified and independent in accordance with Sec.  210.2-01 of this 
chapter. In addition, the accountant must be registered with the Public 
Company Accounting Oversight Board if required by the Sarbanes-Oxley 
Act of 2002.'' The Commission is proposing this technical amendment to 
update the definition of an independent public accountant to be 
consistent with other Commission rules. Furthermore, by citing to Sec.  
210.2-01 in its entirety, rather than the provisions of (b) and (c), 
the text of (f)(1) becomes unnecessary. The Commission is also 
proposing a conforming amendment to paragraph (f)(4), which contains a 
notice provision concerning the replacement of the broker-dealer's 
independent public accountant. Paragraph (f)(4) would be renumbered as 
(f)(3).
---------------------------------------------------------------------------

    \169\ See Rule 17a-5(f)(1).
---------------------------------------------------------------------------

    The Commission is proposing to delete paragraph (i)(5) of Rule 17a-
5, which provides that the terms ``audit,'' ``accountant's report,'' 
and ``certified'' ``shall have the meanings given in Sec.  210.1-02 of 
this chapter.'' The Commission is proposing to delete this paragraph 
because the terms are defined under existing auditing standards 
promulgated by the PCAOB.
    The Commission is proposing additional technical amendments 
throughout Rule 17a-5, including changes to consistently use the 
defined term ``independent public accountant'' \170\ and to make the 
rule gender neutral.\171\
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    \170\ See, e.g., proposed paragraph (f)(4) of Rule 17a-5.
    \171\ Id.
---------------------------------------------------------------------------

     The Commission generally requests comment on all aspects 
of the amendments proposed in this Section V.

VI. Paperwork Reduction Act

    The proposed amendments to Rule 17a-5 contain a ``collection of 
information'' within the meaning of the Paperwork Reduction Act of 1995 
(``PRA''). The Commission is submitting the proposed amendments and the 
proposed new collection to the Office of Management and Budget 
(``OMB'') for review in accordance with the PRA. An agency may not 
conduct or sponsor, and a person is not required to comply with, a 
collection of information unless it displays a currently valid control 
number. The titles 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 (a proposed new collection of information).

A. Collections of Information Under the Proposed Rule Amendments

    As discussed above, the Commission is proposing three sets of 
amendments to Rule 17a-5. The first set of proposed amendments, the 
Annual Reporting Amendments, would: (1) Update the existing 
requirements of the rule; (2) facilitate the PCAOB with its inspection 
and oversight authority over broker-dealer independent public 
accountants; and (3) enable a broker-dealer to use a single report to 
satisfy the proposed requirements under Rule 17a-5 and the IA Custody 
Rule's internal control report requirement.
    The second set of proposed amendments, the Access to Audit 
Documentation Amendments, applies only to clearing broker-dealers. The 
Access to Audit Documentation Amendments are designed to facilitate the 
communication between a clearing broker-dealer's independent public 
accountant and representatives of Commission and the DEA. Additionally, 
the Access to Audit Documentation Amendments are designed to enable 
representatives of the Commission and the DEA of the clearing broker-
dealer, in the scope of their examination of the firm, to have access 
to the audit documentation related to the examination of the broker-
dealer.
    The third set of proposed amendments, the Form Custody Amendments, 
would enhance the information received by the Commission and DEAs with 
respect to the custody practices of broker-dealers by requiring broker-
dealers to file on a quarterly basis a new Form Custody. Proposed Form 
Custody would elicit information as to whether and how a broker-dealer 
maintains custody of cash and securities of customers and others.
    Each set of proposed amendments has a corresponding paperwork 
burden, which is addressed below.

B. Proposed Use of Information

    As discussed above, the Commission is proposing three sets of 
amendments to Rule 17a-5. The first set of proposed amendments, the 
Annual Reporting Amendments, would require a broker-dealer to either 
file a Compliance Report or an Exemption Report as part of its annual 
audit requirements under Rule 17a-5. The Compliance Report would be 
filed by a carrying broker-dealer and contain assertions by the broker-
dealer with respect to the Financial Responsibility Rules. The 
Exemption Report would be filed by a broker-dealer that claims an 
exemption from Rule 15c3-3 because it does not operate as a carrying 
broker-dealer and would contain an assertion as to the basis for the 
claimed exemption. In addition, the broker-dealer would be required to 
engage an independent public accountant to provide a report addressing 
the accuracy of the assertions in either the Compliance Report or 
Exemption Report, as applicable.
    The Commission preliminarily believes that the information gathered 
from the proposed Annual Reporting Amendments would assist the PCAOB in 
establishing an effective oversight and inspection program over the 
independent public accountants of broker-dealers, and it would enable 
broker-dealers that are jointly registered as investment advisers to 
use a single report to satisfy the proposed requirements under Rule 
17a-5 and the IA Custody Rule's internal control report requirement.
    The second set of proposed amendments, the Access to Audit 
Documentation Amendments, would provide the Commission and DEA 
examiners with access to clearing broker-dealer independent public 
accountants to discuss the independent public accountants' findings 
with respect to broker-dealer annual audit reports and to review audit 
documentation associated with those reports. Specifically, the 
amendments would require a representation from the clearing broker-
dealer that it agrees to permit its independent public accountant to 
discuss with representatives of the Commission the findings with 
respect to annual audit reports of broker-dealers and review the 
related audit documentation. These proposed amendments would provide 
another tool to Commission and DEA examiners of broker-dealers by 
providing access to additional relevant information.
    The third set of proposed amendments, the Form Custody Amendments, 
would establish a new Form Custody that the broker-dealer would need to 
include when filing its quarterly FOCUS Reports. Form Custody would 
elicit information as to whether and how a broker-dealer maintains 
custody of cash and securities of customers and others. The Commission 
preliminarily believes that proposed Form Custody would provide more 
detailed information about a broker-dealer's custodial activities. 
Moreover, proposed Form Custody could assist in expediting the

[[Page 37595]]

Commission's or DEA's examination of a broker-dealer's custodial 
activities as examiners would no longer need to request basic custody-
related information already disclosed on the form.

C. Respondents

    The applicability of the proposed amendments discussed in this 
release depends on how a broker-dealer conducts its business. There are 
5,063 broker-dealers registered with the Commission as of year-end 
2009. Of the 5,063 registered broker-dealers, 305 broker-dealers are 
carrying broker-dealers--i.e., broker-dealers that maintain custody of 
customer funds and/or securities and are required to comply with the 
customer protection provisions of Rule 15c3-3. The type of report a 
broker-dealer would be required to file under the proposed Annual 
Reporting Amendments would be based on whether a broker-dealer is a 
carrying broker-dealer subject to Rule 15c3-3, or is exempt from Rule 
15c3-3. Carrying broker-dealers would be required to file Compliance 
Reports under the proposed Annual Reporting Amendments. Broker-dealers 
exempt from Rule 15c3-3 would be required to file Exemption Reports. 
There are 4,752 broker-dealers that claim exemptions to Rule 15c3-3. 
\172\ The Commission estimates 305 carrying broker-dealer respondents 
would file the proposed Compliance Report and 4,752 non-carrying 
broker-dealer respondents would file the proposed Exemption Report 
under the Annual Reporting Amendments.\173\
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    \172\ These numbers are based on FOCUS Report data as of year-
end 2009. See supra note 126 for a description of the FOCUS Report. 
As discussed in note 126, FOCUS Reports are deemed to be 
confidential pursuant to paragraph (a)(3) of Rule 17a-5.
    \173\ There are 4,752 broker-dealers that claim an exemption to 
Rule 15c3-3.
---------------------------------------------------------------------------

    The Access to Audit Documentation Amendments would apply to 
clearing broker-dealers, which, as defined above, includes broker-
dealers that clear transactions or carry customer accounts. There are 
528 clearing broker-dealers based on year-end 2009 FOCUS Report data, 
and, accordingly, the Commission estimates that there would be 528 
broker-dealer respondents with respect to the Access to Audit 
Documentation Amendments.\174\
---------------------------------------------------------------------------

    \174\ The clearing broker-dealers would be required to respond 
to the paperwork burdens associated with the Access to Audit 
Documentation Amendments, and 528 broker-dealers represent the 
number of Part II FOCUS filers.
---------------------------------------------------------------------------

    The Commission estimates that there would be approximately 5,057 
broker-dealer respondents with respect to the Form Custody 
Amendments.\175\
---------------------------------------------------------------------------

    \175\ Carrying broker-dealers and non-carrying broker-dealers 
would be required to file Form Custody; 305 + 4,752 = 5,057.
---------------------------------------------------------------------------

    Additionally, the Commission estimates that there could be 
approximately 550 independent public accountants affected by the 
amendments. This number represents the number of independent public 
accountants registered with the PCAOB that are engaged to perform 
broker-dealer audits.
    The Commission generally requests comment on all aspects of these 
estimates. In addition, the Commission requests specific comment on the 
following items related to these estimates:
     Should the Commission use different estimates for the 
number of respondents for the Annual Reporting Amendments? If so, what 
estimates should the Commission use and why? What are the sources of 
these estimates?
     Should the Commission use different estimates for the 
number of broker-dealer respondents for the Access to Audit 
Documentation Amendments? If so, what estimates should the Commission 
use and why? What are the sources of these estimates?
     Should the Commission use a different estimate of the 
number of independent public accountants that would be affected by the 
amendments? If so, what estimate should the Commission use and why? 
What is the source of this estimate?
    Commenters should provide specific data and analysis to support any 
comments they submit with respect to these estimates with respect to 
the number of respondents.

D. Total Annual Recordkeeping and Reporting Burden

    As discussed below, the Commission estimates the total 
recordkeeping burden resulting from the proposed Rule 17a-5 amendments 
would be approximately 287,325 hours on an annual basis \176\ and 
10,214 hours on a one-time basis.\177\ The Commission notes that, given 
the significant variance between the largest broker-dealer and the 
smallest broker-dealer, the total annual and one-time hour burden 
estimates described below are averages across all types of broker-
dealers expected to be affected by the proposed amendments.
---------------------------------------------------------------------------

    \176\ The total annual hour burden is estimated to be 287,325 
hours (18,300 hours for the Compliance Report + 23,760 hours for the 
Exemption Report + 2,529 hours for copies of the Annual Reports to 
be filed with SIPC + 242,736 hours for Form Custody).
    \177\ The total one-time burden is estimated to be 10,114 hours 
for the revised Notice Designating Accountant (required for the 
proposed Access to Audit Documentation Amendments) + 100 hours for 
SIPC forms to be filed with respect to the SIPC proposal.
---------------------------------------------------------------------------

1. Annual Reporting Amendments
a. Financial Reports Filed With the Commission
    Currently, broker-dealers are required to file their annual audit 
report, which, as discussed previously, the Commission proposes to 
rename as the broker-dealer's ``Financial report'' in Rule 17a-5. The 
Commission is not proposing any substantive changes to the financial 
audit; therefore the Commission believes the hour burden for broker-
dealers with respect to financial reports would remain the same.\178\ 
As is discussed in Section V.E. of this release, the Commission is 
proposing to delete paragraph (b)(6) of Rule 17a-5, which currently 
provides that two copies of a broker-dealer's annual audit report be 
filed at the Commission's principal office in Washington, DC, because 
it is redundant with paragraph (d)(6) of Rule 17a-5, which requires 
that only one copy of a broker-dealer's annual audit report be filed at 
the Commission's principal office in Washington, DC. By deleting 
paragraph (b)(6) of Rule 17a-5, only one copy of the annual audit 
report would need to be filed with the Commission, rather than two, 
which will result in a slight reduction in broker-dealers' hour burden 
in providing related papers to the Commission.\179\
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    \178\ The Commission notes that the financial audit would be 
subject to standards promulgated by the PCAOB; however, this would 
not change the Commission's prescribed reporting burden associated 
with the financial audit.
    \179\ As is discussed above in Section V.A. of this release, 
broker-dealers would be required to file a copy of their annual 
audit reports with SIPC under proposed paragraph (d)(6) of Rule 17a-
5, which would impose an annual hour burden on broker-dealers. This 
burden is discussed below in Section VI.D.1.d of this release.
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    The Commission requests comment on all aspects of these proposed 
burden estimates. Commenters should provide specific data and analysis 
to support any comments they submit with respect to these burden 
estimates, if possible.
b. Compliance Report and Examination Report
    The Commission proposes to require carrying broker-dealers to file 
two new reports: (1) The proposed Compliance Report, which is prepared 
by the carrying broker-dealer; and (2) the Examination Report, which is 
prepared by the broker-dealer's independent public accountant as a 
result of its examination of the Compliance

[[Page 37596]]

Report.\180\ Included in the Compliance Report would be a statement 
that the carrying broker-dealer is responsible for establishing and 
maintaining a system of internal control to provide the broker-dealer's 
management with reasonable assurance that there are no instances of 
material non-compliance with the Financial Responsibility Rules and 
three assertions. The three assertions would be whether the broker-
dealer: (1) Was in compliance with Financial Responsibility Rules as of 
its most recent fiscal year-end; (2) used information derived, in all 
periods during the fiscal year, from the broker-dealer's books and 
records; and (3) had a system of internal control over compliance with 
these rules that was effective during the most recent fiscal year such 
that there were no instances of material weakness.
---------------------------------------------------------------------------

    \180\ The Compliance Report and Examination Report are discussed 
in Section II.B.2 of this release.
---------------------------------------------------------------------------

    The Commission preliminarily believes that broker-dealers would 
validate, gather, and review records to enable them to make the 
assertions in the proposed Compliance Report. The Commission estimates, 
on average, that broker-dealers would spend an additional 60 hours to 
perform the validation and evidence gathering.\181\ For all carrying 
broker-dealers, we estimate the annual hour burden to be 18,300 
hours.\182\
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    \181\ The Commission's preliminary estimate of 60 hours is an 
average based on the varying sizes of carrying broker-dealers and is 
based on staff experience.
    \182\ 60 hours x 305 carrying broker-dealers = 18,300. See infra 
Economic Analysis Section for a discussion of the external cost 
estimates associated with the independent public accountant 
preparing the Examination Report based on an examination of the 
Compliance Report.
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    The Commission requests comment on all aspects of these proposed 
burden estimates. Commenters should provide specific data and analysis 
to support any comments they submit with respect to these burden 
estimates, if possible.
c. Exemption Report
    For a non-carrying broker-dealer claiming an exemption from Rule 
15c3-3, the proposed Exemption Report would require the broker-dealer 
to assert that it is exempt from Rule 15c3-3 and identify the provision 
of the rule that it is relying on to qualify for the exemption. The 
non-carrying broker-dealer would be required to include this assertion 
in its Exemption Report to be filed with the Commission. The Commission 
does not anticipate that this requirement will result in a significant 
hourly burden because the broker-dealer has been operating under the 
claimed exemption and is aware of what exemption it will claim on the 
Exemption Report. Therefore, the hour burden associated with this 
proposed amendment should be administrative and encompass the drafting 
and filing of the report. Based on staff experience with broker-dealers 
filing similar types of reports, the Commission estimates it should 
take a non-carrying broker-dealer five hours to prepare the Exemption 
Report and file the Exemption Report and copy of the associated 
independent public accountant's report with the Commission and 
applicable securities regulators. Thus, we estimate the annual hour 
burden for broker-dealers required to file the Exemption Report and 
associated independent public accountant's report would be 23,760 
hours.\183\
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    \183\ 5 hours x 4,752 non-carrying broker-dealers = 23,760 
hours. See infra Economic Analysis Section for a discussion of the 
external costs associated with engaging an independent public 
accountant to prepare its report based on the review of the broker-
dealer's Exemption Report.
---------------------------------------------------------------------------

    The Commission requests comment on all aspects of these proposed 
burden estimates. Commenters should provide specific data and analysis 
to support any comments they submit with respect to these burden 
estimates, if possible.
d. Copies of Annual Reports Filed With SIPC
    The Commission is proposing that copies of broker-dealer annual 
reports (including the Financial Report and either the Compliance 
Report and corresponding independent public accountant's report based 
on the Compliance Examination, or the Exemption Report and 
corresponding independent public accountant's report based on the 
review of the Exemption Report) be filed with SIPC. The Commission 
estimates that broker-dealers would incur an administrative cost 
associated with the additional filing. The Commission estimates that it 
would take 30 minutes to prepare the additional copies and mail them to 
SIPC. Therefore, the Commission estimates that there is an annual hour 
burden of 2,529 with respect to this requirement.\184\
---------------------------------------------------------------------------

    \184\ 1/2 hour x 5,057 broker-dealers = 2,528.50 hours, which is 
rounded up to 2,529 hours.
---------------------------------------------------------------------------

    The Commission requests comment on all aspects of these proposed 
burden estimates. Commenters should provide specific data and analysis 
to support any comments they submit with respect to these burden 
estimates, if possible.
e. Notice of Designated Accountant
    The Commission proposes amending Rule 17a-5(f)(2) and the Notice of 
Designated Accountant. As discussed above, the Commission proposes to 
require broker-dealers to state in their Notice that they have engaged 
an independent public accountant pursuant to proposed paragraph (g) of 
Rule 17a-5. Broker-dealers are currently required to file a Notice with 
the Commission designating the independent public accountant who will 
be conducting the broker-dealer's annual audit.
    The Commission proposes to require that broker-dealers file a 
revised Notice designating their independent public accountant and 
containing the proposed new provisions in subparagraphs (D) through (G) 
to Rule 17a-5(f)(2)(ii), as applicable. As previously discussed, 
proposed new subparagraph (D) requires the broker-dealer to indicate 
whether the engagement is for a single year or not. Proposed 
subparagraph (E) requires the broker-dealer to make a representation 
that the engagement of the independent public accountant by the broker 
or dealer meets the required undertakings of paragraph (g).\185\ Each 
clearing broker-dealer is required to make the following 
representations: (1) That it agrees to allow representatives of the 
Commission or its DEA, if requested for purposes of an examination of 
the broker-dealer, to review the audit documentation associated with 
the reports of the independent public accountant prepared pursuant to 
paragraph (g) of Rule 17a-5; \186\ and (2) to permit the independent 
public accountant to discuss with representatives of the Commission and 
the DEA of the broker-dealer, if requested for purposes of an 
examination of the broker-dealer, the findings associated with the 
reports of the independent public accountant prepared pursuant to 
paragraph (g) of Rule 17a-5.\187\
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    \185\ See proposed paragraph (f)(2)(ii)(E) of Rule 17a-5.
    \186\ See proposed paragraph (f)(2)(ii)(F) of Rule 17a-5.
    \187\ See proposed paragraph (f)(2)(ii)(G) of Rule 17a-5.
---------------------------------------------------------------------------

    The Commission notes that broker-dealers have previous versions of 
the Notice containing the current required information that could be 
used and revised to include the proposed new information. Therefore, 
the Commission estimates that it would take a broker-dealer 
approximately two hours to amend its existing Notice and file its new 
Notice pursuant to the proposed amendments. This estimate includes the 
time it would take a compliance officer and potentially other personnel 
to review the revised Notice to ensure that it complies with the 
proposed

[[Page 37597]]

requirements. The Commission notes that the Notice can be continuing in 
nature and therefore the designation of an independent public 
accountant can apply to successive audits. Thus, the Commission 
estimates that the filing of the proposed new Notice would result in a 
one-time burden for broker-dealers. The Commission further estimates 
that this would be a one-time hour burden associated with revising and 
filing the new Notice, which would total 10,114 hours for all broker-
dealers.\188\
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    \188\ 2 hours x 5,057 broker-dealers = 10,114.
---------------------------------------------------------------------------

    The Commission requests comment on all aspects of these proposed 
burden estimates. If possible, commenters should provide specific data 
and analysis to support any comments they submit with respect to these 
burden estimates.
f. SIPC Forms
    As previously discussed, the Commission proposes to amend Rule 17a-
5 to provide that broker-dealers continue to file their required SIPC 
Forms with the Commission and SIPC unless the Commission takes final 
action to approve any proposed rule change SIPC may file for Commission 
consideration to require the filing of the forms solely with SIPC. 
Because broker-dealers are currently required to file the forms with 
both the Commission and SIPC, the Commission does not believe there is 
any change in the hour burden for broker-dealers to comply with this 
requirement.
    However, the Commission notes that SIPC would have to file a 
proposed and final rule with the Commission, to, as discussed above, 
require broker-dealers to file the SIPC Forms with SIPC. Based on staff 
experience with filings related to SRO rule changes, the Commission 
estimates that it would take, conservatively, 100 hours for SIPC to 
prepare the filings necessary to require broker-dealers to file the 
SIPC Forms solely with SIPC. Therefore, the one-time hour burden 
associated with this requirement is 100 hours. Additionally, the 
Commission notes that subsequent to the adoption of SIPC's rule, that 
broker-dealers would benefit from only having to file the reports with 
one entity.
    The Commission requests comment on all aspects of these proposed 
burden estimates. Commenters should provide specific data and analysis 
to support any comments they submit with respect to these burden 
estimates, if possible.
2. Access to Audit Documentation Amendment
    The Commission proposes to amend Rule 17a-5 to require broker-
dealers to consent to allow representatives of the Commission and DEA 
to speak with, and review the audit documentation of, their independent 
public accountants, if requested in connection with a regulatory 
examination. As previously discussed, the rule proposal would require 
broker-dealers to amend and file a new Notice. As described above, the 
Commission calculated the hour burden associated with amending the 
Notice with respect to the proposed Annual Reporting. The Commission 
believes the estimated hour burden includes, if applicable, the needed 
representations associated with the Access to Audit Documentation.
    The Commission requests comment on all aspects of these proposed 
burden estimates. Commenters should provide specific data and analysis 
to support any comments they submit with respect to these burden 
estimates, if possible.
3. Proposed Form Custody
    The Commission is proposing a new form--Form Custody--that is 
designed to elicit information about whether and how a broker-dealer 
maintains custody of customer assets and handles customer cash. As 
discussed below, a broker-dealer would be required to file Form Custody 
quarterly and with its annual audit reports. The goal is to create a 
report that provides information about the custodial activities of 
broker-dealers that can serve as a starting point for securities 
regulators to undertake more in depth reviews as they deem appropriate.
    As discussed above, the proposed form is comprised of nine line 
items that elicit information about the broker-dealer's custodial 
responsibilities and operations. Some of the items contain multiple 
questions and also require the completion of charts or the disclosure 
of additional data points in designated spaces on the form.
    The Commission preliminarily believes that the hour burden 
associated with the FOCUS Report provides an appropriate baseline for 
estimating the hour burden associated with the proposed Form Custody 
because the FOCUS Report is a broker-dealer report that requires the 
broker-dealer to provide financial and operational information.\189\ 
Specifically, the Commission believes that the information the broker-
dealer uses to compute the required computation related to Rule 15c3-3 
in the FOCUS Report can be used in answering the questions contained in 
the proposed Form Custody. Thus, the Commission bases this estimate on 
the current hour burden estimate for broker-dealers to complete their 
FOCUS Reports, and that on average, each broker-dealer would require 12 
hours to complete Form Custody.\190\ This results in an estimated 
annual burden of 242,736 hours.\191\
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    \189\ See supra note 126.
    \190\ The Commission notes that the current PRA hour burden 
estimate for the FOCUS Report filing is 12 hours. See SEC File No. 
270-155, 75 FR 8759 (Feb. 25, 2010).
    \191\ 5,057 x 4 = 20,228 annual responses x 12 hours = 242,736.
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    The Commission requests comment on all aspects of these proposed 
burden estimates. Commenters should provide specific data and analysis 
to support any comments they submit with respect to these burden 
estimates, if possible.
4. Technical Amendments to Rule 17a-5 and to Rule 17a-11
    The Commission believes that the proposed technical amendments to 
Rule 17a-5 (e.g., making the rule gender-neutral) \192\ would not 
impose any additional time burden on broker-dealers. Additionally, the 
Commission's proposed conforming amendment to paragraph (e) of Rule 
17a-11 (eliminating a reference to current paragraph (h) of Rule 17a-5 
and correcting references) is also technical in nature and should not 
result in an additional hour burden.
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    \192\ See supra discussion in Section V. E. for specified 
technical amendments.
---------------------------------------------------------------------------

E. Collection of Information Is Mandatory

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

F. Confidentiality

    The Commission notes that a broker-dealer can seek confidential 
treatment for information filed with the Commission under existing laws 
and rules governing confidential treatment.\193\ The Commission will 
accord this information confidential treatment to the extent permitted 
by law.\194\
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    \193\ 15 U.S.C. 78o-7(k). A broker-dealer can request that the 
Commission keep this information confidential. See Section 24 of the 
Exchange Act (15 U.S.C. 78x), 17 CFR 240.24b-2, 17 CFR 200.80 and 17 
CFR 200.83.
    \194\ To the extent that the Commission receives confidential 
information pursuant to this collection of information, such 
information would be kept confidential, subject to the provisions of 
the Freedom of Information Act. 5 U.S.C. 552.

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[[Page 37598]]

G. Request for Comment

    Pursuant to 44 U.S.C. 3306(c)(2)(B), the Commission requests 
comment on the proposed collections of information in order to: (1) 
Evaluate whether the proposed collections of information are necessary 
for the proper performance of the functions of the Commission, 
including whether the information would have practical utility; (2) 
evaluate the accuracy of the Commission's estimates of the burden of 
the proposed collections of information; (3) determine whether there 
are ways to enhance the quality, utility, and clarity of the 
information to be collected; (4) evaluate whether there are ways to 
minimize the burden of the collection of information on those who 
respond, including through the use of automated collection techniques 
or other forms of information technology; and (5) evaluate whether the 
proposed rule amendments would have any effects on any other collection 
of information not previously identified in this section.
    Persons who desire to submit comments on the collection of 
information requirements should direct their comments to the OMB, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Washington, DC 20503, and 
should also send a copy of their comments to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090, and refer to File No. S7-23-11. OMB is 
required to make a decision concerning the collections of information 
between 30 and 60 days after publication of this document in the 
Federal Register; therefore, comments to OMB are best assured of having 
full effect if OMB receives them within 30 days of this publication. 
Requests for the materials submitted to OMB by the Commission with 
regard to these collections of information should be in writing, refer 
to File No. S7-23-11, and be submitted to the Securities and Exchange 
Commission, Office of Investor Education and Advocacy, 100 F Street, 
NE., Washington, DC 20549.

VII. Economic Analysis

    The Commission recognizes that there are costs associated with the 
adoption of the proposed amendments to Rule 17a-5 and proposed Form 
Custody that are separate from the hour burdens discussed in the 
Paperwork Reduction Act. Thus, the Commission has identified certain 
costs and benefits of the proposed rule amendments and requests comment 
on all aspects of this cost-benefit analysis, including identification 
and assessment of any costs and benefits not discussed in the 
analysis.\195\ The Commission preliminarily believes that potential 
costs incurred by a broker-dealer to comply with the proposed rule 
amendments would depend on its size and the complexity of its business 
activities. The size and complexity of broker-dealers vary 
significantly. Therefore, their costs could vary significantly. The 
Commission is providing estimates on the average cost per broker-dealer 
taking into consideration the variance in size and complexity of the 
business activities of broker-dealers. Any costs incurred would also 
vary depending on whether the broker-dealers carry customer accounts or 
not. For these reasons, the cost estimates represent the average cost 
across all broker-dealers.
---------------------------------------------------------------------------

    \195\ For the purposes of this cost/benefit analysis, the 
Commission is using salary data from the Securities Industry and 
Financial Markets Association (``SIFMA'') Report on Management and 
Professional Earnings in the Securities Industry 2009, 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. Hereinafter, references to data derived from 
the report as modified in the manner described above will be cited 
as SIFMA's Management & Professional Earnings in the Securities 
Industry 2009.
---------------------------------------------------------------------------

    The Commission seeks comment and data on the benefits identified. 
The Commission also seeks comment on the accuracy of its cost estimates 
in each section of this cost-benefit analysis, and requests those 
commenters to provide data, including identification of statistics 
relied on by commenters to reach conclusions on cost estimates. 
Finally, the Commission seeks estimates and views regarding these costs 
and benefits for particular types of market participants (e.g., broker-
dealers, customers of broker-dealers and independent public 
accountants), as well as any other costs or benefits that may result 
from these proposed rule amendments and the new proposed Form.
    Under Section 3(f) of the Exchange Act,\196\ the Commission shall, 
when engaging in rulemaking that requires the Commission to consider or 
determine whether an action is necessary or appropriate in the public 
interest, consider, in addition to the protection of investors, whether 
the action will promote efficiency, competition, and capital formation. 
Section 23(a)(2) of the Exchange Act \197\ requires the Commission to 
consider the anticompetitive effects of any rules the Commission adopts 
under the Exchange Act. Section 23(a)(2) prohibits the Commission from 
adopting any rule that would impose a burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act. The Commission has considered the effects of each of the proposed 
amendments in this release on competition, efficiency and capital 
formation. The Commission's preliminary view, as discussed in greater 
detail with respect to each proposed amendment below, is that the 
proposed rule amendments may promote efficiency, competition, and 
capital formation and any burden on competition is justified by the 
benefits.
---------------------------------------------------------------------------

    \196\ 15 U.S.C. 78c(f).
    \197\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    In considering the effect of the proposed amendments on capital 
formation, the Commission notes that broker-dealers that lack 
appropriate custody procedures or internal controls may expose 
investors to unnecessary risks. For example, if losses are incurred by 
investors as a result of a broker-dealer's failure to properly 
safeguard customer assets, investors may lose confidence in broker-
dealers, which, in turn, could negatively impact the ability of 
companies to raise capital through securities issuances underwritten by 
broker-dealers. A perceived lack of such procedures should be expected 
to reduce investors' willingness to invest through broker-dealers, and 
measures, such as these proposed amendments, should thereby enhance 
capital formation by strengthening the operational controls of broker-
dealers with respect to safeguarding customer assets. At the same time, 
the Commission acknowledges that additional requirements designed to 
safeguard investor assets could impose a burden on competition by 
raising compliance costs for broker-dealers.
    The Commission generally requests comment on all aspects of this 
analysis of the burden on competition and promotion of efficiency, 
competition, and capital formation. Commenters should provide specific 
data and analysis to support their views.

A. Annual Reporting Amendments

1. Benefits
    The Commission preliminarily believes that the Annual Reporting 
Amendments will have a number of benefits. First, the Annual Reporting 
Amendments would update the existing requirements of Rule 17a-5, which 
is

[[Page 37599]]

used by the Commission to monitor the financial condition of broker-
dealers. This will align the text of Rule 17a-5 with current auditing 
literature. Second, the amendments would facilitate PCAOB inspection 
and oversight authority over broker-dealer independent public 
accountants by providing an improved foundation for the PCAOB to 
establish new broker-dealer audit standards. Third, the Commission 
preliminarily believes that the Annual Reporting Amendments proposed in 
this release, if adopted, would create an efficient process for broker-
dealers by enabling them to satisfy the proposed requirements under 
Rule 17a-5 and the IA Custody Rule's internal control report 
requirement.
    Additionally, the Commission preliminarily believes that the 
proposed Annual Reporting Amendments would strengthen and improve 
compliance with the Financial Responsibility Rules because it would 
increase the focus of independent public accountants on the custody 
practices of broker-dealers. This could help identify broker-dealers 
that have weak controls for safeguarding investor assets.
    The Commission preliminarily believes that the proposed Annual 
Reporting Amendments, by updating the existing requirements of Rule 
17a-5 and requiring reports prepared by independent public accountants 
that make custody a greater focus of the audit, would strengthen 
broker-dealer compliance with the Financial Responsibility Rules and, 
in turn, improve the financial and operational condition of broker-
dealers and the safeguarding of investor assets. These improvements 
could enhance investor trust in the financial markets and thereby 
potentially have a positive impact on capital formation.
    Additionally, the Commission preliminarily believes that the 
proposed Annual Reporting amendments create regulatory efficiencies for 
broker-dealers that are also registered as investment advisers because 
the proposals would potentially eliminate regulatory redundancy by 
enabling entities subject to the IA Custody Audit Rule and the 
Compliance Examination to submit a single report with the Commission.
2. Costs
    As discussed above, the Commission estimates that there are 305 
carrying broker-dealers that would be subject to the Compliance 
Examination and Report based on data included in FOCUS Reports. The 
Commission recognizes that the proposed amendments associated with the 
Compliance Examination would create additional costs incurred by the 
broker-dealers related to their annual audits. As stated previously, 
the proposed requirements with respect to the Compliance Examination 
are based on existing requirements in Rule 17a-5. The Commission is 
also proposing new requirements for the Compliance Examination that are 
not currently in Rule 17a-5.\198\
---------------------------------------------------------------------------

    \198\ See supra discussion in Section II.B.2; the proposed 
Compliance Examination would result in the following four changes to 
existing audit work: (1) Use of PCAOB standards; (2) revised 
reporting requirements for the examination of the broker-dealer's 
assertions regarding compliance and internal controls over 
compliance (i.e., expression of an opinion); (3) period of time of 
reporting on internal controls over compliance (i.e., controls over 
compliance effective through the year instead of only at year-end); 
and (4) including the Account Statement Rule as part of the 
examination.
---------------------------------------------------------------------------

    The Commission preliminarily believes that the costs associated 
with the Compliance Examination would be incremental to the current 
annual audit costs, because the proposed amendments are based on 
existing requirements. Consequently, the Commission preliminarily 
believes that the independent public accountants would be able to build 
upon existing work to satisfy the new requirements. For example, as 
discussed above, under existing requirements, the independent public 
accountant, among other things, must review the accounting system, 
internal accounting control and procedures for safeguarding securities, 
including appropriate tests therefore for the period since the prior 
examination date.\199\ The Commission preliminarily estimates that the 
additional costs incurred by carrying broker-dealers associated with 
paying their independent public accountants would average $150,000 per 
firm, per year. The Commission derived this cost estimate from its 
estimates of the costs associated with the IA Custody Rule.
---------------------------------------------------------------------------

    \199\ See Section II.A. of this release.
---------------------------------------------------------------------------

    The Commission estimated that the IA Custody Rule would impose 
costs of $250,000 per investment adviser.\200\ The Commission noted 
that the cost to prepare an internal control report relating to custody 
would vary based on the size and services offered by a qualified 
custodian, but that the average cost for an internal control report was 
approximately $250,000.\201\ The Commission notes that the IA Custody 
Rule imposed new requirements on investment advisers, and was not based 
on existing obligations. The Commission preliminarily believes that the 
costs associated with the Compliance Examination would be incremental 
to broker-dealers because of the existing work done by the independent 
public accountants. The Commission preliminarily estimates that the 
additional costs associated with the Compliance Examination and 
Examination Report to be, on average, $150,000 per year per broker-
dealer. As noted above, the Commission derived this cost estimate from 
its estimates of the costs associated with the IA Custody Rule.
---------------------------------------------------------------------------

    \200\ See IA Custody Adopting Release at 1478.
    \201\ See IA Custody Adopting Release at note 291 and 
corresponding text at 1479.
---------------------------------------------------------------------------

    Therefore the Commission estimates an annual cost associated with 
this proposal to be $45,750,000 per year.\202\
---------------------------------------------------------------------------

    \202\ $150,000 x 305 broker-dealers = $45,750,000.
---------------------------------------------------------------------------

    The Commission estimates that 4,752 non-carrying broker-dealers 
would be required to file the proposed Exemption Report. As discussed 
above, this number is based on the number of non-carrying broker-
dealers that claim exemptions from Rule 15c3-3.\203\ These non-carrying 
broker-dealers would be required to have an independent public 
accountant review the claimed assertion (exemption) and prepare a 
corresponding report that also would be filed with the Commission. The 
Commission preliminarily believes that an independent public 
accountant's review of the exemption assertion would add an incremental 
cost to that incurred by the annual financial audit. As discussed 
above, independent public accountants engaged by broker-dealers 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 
independent public accountant's] last examination.'' \204\ The 
Commission therefore estimates that the submission of the Exemption 
Report and any additional work done by the independent public 
accountant to conduct the review would result in an incremental 
increase to the current audit cost of the non-carrying broker-dealer.
---------------------------------------------------------------------------

    \203\ These numbers are based on FOCUS Report data as of year-
end 2009. See supra notes 172-173.
    \204\ See Rule 17a-5(g)(2). As noted previously, the independent 
public accountants currently satisfy this requirement by including a 
statement in the study providing that they have ascertained that the 
broker-dealer was complying with the conditions of the exemption; 
see Broker Dealer Audit Guide supra note 14 at Section 3.32.
---------------------------------------------------------------------------

    The cost for paying the independent public accountant to perform a 
financial audit of a non-carrying broker-dealer varies depending on the 
size and amount of net revenues. The Commission's preliminary estimates 
of

[[Page 37600]]

these costs as set forth below are based on staff experience, including 
communications with broker-dealers, broker-dealer auditors, and auditor 
industry groups. The Commission preliminarily estimates that the cost 
for an annual audit for a non-carrying broker-dealer with net revenue 
of less than $1 million to be $15,000. The Commission preliminarily 
estimates the average cost for an audit of a non-carrying broker-dealer 
with net revenue of $1 million to $10 million to be $20,000. The 
Commission preliminarily estimates the average cost of an audit of a 
non-carrying broker-dealer with net revenue greater than $10 million 
and less than $100 million to be $60,000. Finally, the Commission 
preliminarily estimates the average cost of an audit of a non-carrying 
broker-dealer with net revenue greater than $100 million to be 
$300,000. Therefore, the Commission preliminarily estimates the average 
cost for the financial audit for non-carrying broker-dealers is 
approximately $30,000.\205\ As noted, the Commission believes that the 
cost of the proposed review would be incremental to costs currently 
incurred for the financial audit. The Commission estimates that, on 
average, the additional average cost would be approximately $3,000 for 
each non-carrying broker-dealer.\206\ Therefore, the total annual cost 
for all non-carrying broker-dealers required to submit Exemption 
Reports is estimated to be $14,256,000.\207\
---------------------------------------------------------------------------

    \205\ The average is derived from applying the number of broker-
dealers with the given net revenue ranges and multiplying it by the 
estimated audit costs; for example there are over 2,000 non-carrying 
broker-dealers with net revenues under $1 million; however there are 
over 1500 firms with net revenue between $1 million and $10 million 
and so forth. The Commission preliminarily estimates the average 
audit cost to be $30,000.
    \206\ Based on staff experience the Commission believes that the 
incremental work done to conduct the review represents 10% of the 
current work done. Therefore the Commission estimates an average 
additional cost of around $3,000 (10% * $30,000).
    \207\ $3,000 x 4,752 = $14,256,000.
---------------------------------------------------------------------------

    The Commission preliminarily believes that the proposed amendments 
may impose a burden on competition for smaller broker-dealers to the 
extent that they impose relatively fixed costs, which would represent a 
higher percentage of net income for smaller broker-dealers. However, 
the Commission preliminary believes that the incremental costs 
resulting from the proposed amendments would not impose a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act.

B. Access to Audit Documentation Amendments

1. Benefits
    The Commission preliminarily believes that the proposed Access to 
Audit Documentation Amendments would have a number of benefits. These 
proposed rules would make it easier for the Commission and DEAs to 
access information about a clearing broker-dealer's independent public 
accountant's work and the steps taken by the independent public 
accountant to audit the broker-dealer's financial statements. In turn, 
this information would enable the Commission and DEA examiners to more 
efficiently deploy examination resources.\208\ The Commission 
preliminarily believes that examiners reviewing the audit documentation 
may 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. Enabling Commission and 
DEA examination staff to conduct more focused examinations of broker-
dealers could, in turn, provide investors with greater protection, as 
examination resources could be allocated more strategically for their 
benefit.
---------------------------------------------------------------------------

    \208\ As discussed previously, the Commission preliminarily 
believes that 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.
---------------------------------------------------------------------------

2. Costs
    The Commission notes that clearing broker-dealers would incur 
additional costs from the proposed Access to Audit Documentation 
Amendments by permitting representatives of the Commission and its DEA 
to discuss with the independent public accountants the findings in 
their audit reports and to review the audit documentation associated 
with the audit reports. While the Commission does not anticipate that 
its representatives would need to discuss findings and review audit 
documentation with respect to each clearing broker-dealer annually, the 
Commission's estimate is nevertheless based on the total number of 
clearing broker-dealers. Further, the Commission assumes that 
independent public accountants would charge their clearing broker-
dealer clients for any time spent with the Commission and DEA 
representatives discussing the findings associated with the annual 
audit reports and providing access to the documentation associated with 
the annual audit reports. The Commission estimates clearing broker-
dealers would incur an additional $660,000 per year in annual 
costs.\209\
---------------------------------------------------------------------------

    \209\ Based on industry sources, the Commission estimates that 
the hourly cost of an independent public accountant to be $250. With 
an additional 5 hours per year, the annual hour burden would be 
2,640 (528 clearing broker-dealers x 5 hours) for a yearly cost 
estimate of $660,000 (2,640 hours x $250 per hour).
---------------------------------------------------------------------------

    The Commission preliminarily believes that the proposed amendments 
may impose a burden on competition for smaller broker-dealers to the 
extent that they impose relatively fixed costs, which would represent a 
higher percentage of net income for smaller broker-dealers. However, 
the Commission preliminarily believes that the incremental costs 
resulting from the proposed amendments would not impose a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act, given the investor protection objectives of the 
proposed amendments.

C. Proposed Form Custody and Related Requirements

1. Benefits
    The Commission frequently brings enforcement actions against 
investment advisers and broker-dealers alleging fraudulent conduct, 
including misappropriation or other misuse of investor assets.\210\ The 
Commission also has brought an enforcement action against the 
accountant responsible for auditing one of these broker-dealers.\211\ 
In order to enhance protection, the Commission has taken steps to 
enhance oversight of the custody function of investment advisers \212\ 
and preliminarily believes that the proposal to adopt Form Custody will 
provide information related to custodial practices of broker-dealers 
that, in turn, will better protect investors who entrust funds and 
securities to broker-dealers. Proposed Form Custody would be filed with 
a broker-dealer's quarterly FOCUS Reports and would elicit information 
about whether and how the broker-dealer maintains custody of assets. 
This form would consolidate information about the broker-dealer's 
custodial responsibility and relationships with other custodians in one 
report so that the Commission and other securities regulators can have 
a more comprehensive understanding of the broker-dealer's custody 
practices and arrangements. Further, the Commission

[[Page 37601]]

believes that the additional information made available on the proposed 
form would aid in the examination of broker-dealers, because the 
examination staff could use the form as another tool for purposes of 
prioritizing and planning examinations.
---------------------------------------------------------------------------

    \210\ See supra note 123.
    \211\ SEC v. David G. Friehling, C.P.A., et al., Litigation 
Release No. 20959 (Mar. 18, 2009).
    \212\ See supra note 124.
---------------------------------------------------------------------------

    The Commission believes that the proposed Form Custody amendments 
also could enhance investor confidence. By establishing a discipline 
under which broker-dealers are required to report to the Commission 
greater detail as to their custodial functions, investor perception as 
to the safety of their funds and securities at broker-dealers could 
improve. This, in turn, could increase the willingness of investors to 
provide capital for investment through broker-dealers.
2. Costs
    The proposed form is comprised of nine line items that elicit 
information about the broker-dealer's custodial responsibilities and 
operations. Some of the Items contain multiple questions and also 
elicit information by requiring charts to be filled out or additional 
information to be provided in spaces provided.\213\
---------------------------------------------------------------------------

    \213\ See supra Section IV for discussion of each proposed item 
of Form Custody.
---------------------------------------------------------------------------

    The cost of compliance will vary given the variation in the size 
and complexity of the businesses of the brokers and dealers subject to 
Rule 17a-5. The Commission estimates that, on average, each report 
would require approximately 12 hours for a broker-dealer to 
complete.\214\ As noted above, the Commission proposes to require that 
firms file proposed Form Custody on a quarterly basis. Therefore, the 
Commission estimates that there would be 20,228 annual responses \215\ 
and therefore a total annual hour burden of 242,736 hours.\216\ Thus, 
the Commission anticipates that the annual cost to the industry will be 
$69,179,760.\217\
---------------------------------------------------------------------------

    \214\ See supra note 190; the Commission's current hour burden 
associated with a broker-dealer filing a FOCUS Report is 12 hours.
    \215\ 5,057 firms x 4 times a year = 20,228 total responses.
    \216\ 20,228 total responses x 12 hours per Form Custody = 
242,736.
    \217\ The Commission anticipates that one or more Financial 
Reporting Managers, at an average cost of $285 per hour, would be 
responsible for completion of Form Custody. This $285 per hour 
figure for a Financial Reporting Manager is based upon information 
obtained from SIFMA's Management & Professional Earnings in the 
Securities Industry 2009 publication, modified by Commission staff 
to account for an 1800-hour work-year and multiplied by 5.35 to 
account for bonuses, firm size, employee benefits and overhead. 
Thus, the annual cost burden is estimated to be $69,179,760 (242,736 
total hours x $285 per hour).
---------------------------------------------------------------------------

    The Commission preliminarily believes that the proposed amendments 
could have a burden on competition because they could increase 
compliance costs for broker-dealers. However, the Commission 
preliminarily believes that this proposed amendment would not have a 
disproportionate effect on smaller broker-dealers. The Commission 
expects that smaller firms in completing proposed Form Custody will 
incur fewer associated costs because the information required to be 
disclosed is less. 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.

C. Request for Comment on Economic Analysis

    The Commission seeks estimates of the costs and benefits identified 
in this Economic Analysis Section, as well as any costs and benefits 
not already discussed, which may result from the adoption of the 
proposed amendments and form.
    The Commission also requests comment on the potential costs and 
benefits of alternatives suggested by commenters. The Commission 
specifically requests comments with respect to the following:
     With respect to the costs estimates for the proposed 
Compliance Examination and corresponding Examination Report, is the 
cost associated with the IA Custody Rule comparable? Is the 
Commission's estimated cost for the proposed Compliance Examination and 
Examination Report conservative or too low?
     With respect to the costs estimates for the proposed 
Compliance Examination, do commenters believe that there could be some 
cost savings because some respondents would no longer have to engage an 
independent public accountant to perform the internal control 
examination required by the IA Custody Rule? If so, how much savings 
could be generated?
     With respect to the cost estimates for the proposed 
Exemption Report and review by the independent public accountant, would 
the amount of additional work for the review by the independent public 
accountant be greater than estimated by the Commission?
     Are there any additional costs associated with the 
proposed Access to Audit Documentation Amendments that are not 
currently contemplated in the Economic Analysis section? Will 
independent public accountants allocate the costs associated with the 
proposed Access to Audit Documentation Amendments to broker-dealers?
     With respect to the cost estimates for proposed Form 
Custody, do commenters believe that broker-dealers will need more than 
the estimated 12 hours to complete the form? If so, why? Also, please 
provide an alternative estimate.
     Are there any additional economic effects related to 
efficiency, capital formation or competition that the Commission has 
not identified?
    The Commission generally requests comment on the competitive or 
anticompetitive effects as well as efficiency and capital formation 
effects, of the proposed amendments and form on any market participants 
if the proposals are adopted. Commenters should provide analysis and 
empirical data to support their views on the costs and benefits 
associated with the proposed amendments and form.

VIII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \218\ the Commission must advise OMB 
whether a proposed regulation constitutes a major rule. Under SBREFA, a 
rule is ``major'' if it has resulted in, or is likely to result in:
---------------------------------------------------------------------------

    \218\ Public Law 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

     An annual effect on the economy of $100 million or more;
     A major increase in costs or prices for consumers or 
individual industries; or
     A significant adverse effect on competition, investment, 
or innovation.
    If a rule is ``major,'' its effectiveness will generally be delayed 
for 60 days pending Congressional review. The Commission requests 
comment on the potential impact of the proposed rule amendments on the 
economy on an annual basis. Commenters are requested to provide 
empirical data and other factual support for their view to the extent 
possible.

IX. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (``IRFA''), in accordance with the provisions of 
the Regulatory Flexibility Act,\219\ regarding the proposed rule 
amendments to Rule 17a-5 under the Exchange Act.
---------------------------------------------------------------------------

    \219\ 5 U.S.C. 603.
---------------------------------------------------------------------------

A. Reasons for the Proposed Action

    The proposed Annual Reporting Amendments are designed to, among 
other things: (1) Update the existing requirements of Rule 17a-5; (2) 
facilitate

[[Page 37602]]

the ability of the PCAOB to implement oversight of independent public 
accountants of broker-dealers as required by the Dodd-Frank Act; and 
(3) eliminate potentially redundant requirements for certain broker-
dealers affiliated with, or dually-registered as, investment advisers.
    The Commission preliminarily believes the Access to Audit 
Documentation Amendments would enhance Commission and DEA examinations 
of broker-dealers by providing examiners with access to additional 
relevant information, which could improve the efficiency and 
effectiveness of the examination process. The Commission preliminarily 
believes that Commission and DEA examiners could use the Access to 
Audit Documentation Amendments to develop the scope for their 
examinations of clearing broker-dealers.
    Currently, limited information is elicited about the scope of the 
broker-dealer's custodial function and the manner in which it handles 
assets of customers and other persons. The Commission, therefore, is 
proposing Form Custody, which it preliminarily believes would be useful 
because it provides information about the custodial activities of the 
broker-dealer that can serve as a starting point for examiners to 
undertake more in-depth reviews as they deem appropriate.

B. Objectives

    The objectives of the proposed Form Custody Amendments are to 
enhance the Commission's oversight of broker-dealers, especially with 
respect to broker-dealers' custody of assets. As stated previously, the 
Commission preliminarily believes that proposed Form Custody would 
provide useful information that is currently not routinely made 
available to the Commission. In addition, the proposed Access to Audit 
Documentation Amendments would assist the examination of broker-
dealers. Another objective of the proposed Annual Reporting Amendments 
is, among other things, to update the existing provisions of Rule 17a-5 
to align the text of the rule with current auditing literature.

C. Legal Basis

    Pursuant to the Exchange Act \220\ and, particularly, Sections 
15(c), 17(a), 17(E) and 23 of the Exchange Act, the Commission is 
proposing amendments to Rule 17a-5 and new Form Custody.\221\
---------------------------------------------------------------------------

    \220\ 15 U.S.C. 78a et seq.
    \221\ 15 U.S.C. 78o.
---------------------------------------------------------------------------

D. Small Entities Subject to the Rule

    Paragraph (a) of Rule 0-10 provides that for purposes of the 
Regulatory Flexibility Act, a small entity ``[w]hen used with reference 
to a broker or dealer, the Commission has defined the term ``small 
entity'' to mean a broker or dealer (``small 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 or dealer that had total 
capital (net worth plus subordinated debt) 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 as defined in this release.'' \222\ Currently, based 
on FOCUS Report data, there are 871 broker-dealers that are classified 
as ``small'' entities for purposes of the Regulatory Flexibility 
Act.\223\
---------------------------------------------------------------------------

    \222\ 17 CFR 240.0-10(c).
    \223\ See 17 CFR 240.0-10(a).
---------------------------------------------------------------------------

E. Reporting, Recordkeeping, and Other Compliance Requirements

    The Commission proposes three amendments to Rule 17a-5: The (1) 
Annual Reporting Amendments; (2) Access to Audit Documentation 
Amendments; and (3) Form Custody Amendments.
    The Commission preliminarily believes that the potential impact of 
the proposals on small broker-dealers would be substantially less than 
on larger firms. With respect to the Annual Reporting Amendments, small 
broker-dealers would be subject to the Exemption Report, and not the 
proposed Compliance Report and Examination.\224\ Therefore, small 
broker-dealers would engage their independent public accountant to 
review their Exemption Reports and would be subject to the additional 
costs associated with that review. Additionally, these firms could be 
required to pay additional fees to their independent public accountant, 
should the Commission or DEA examiners decide to interview them.
---------------------------------------------------------------------------

    \224\ There are no broker-dealers that are carrying firms that 
satisfy the definition of a ``small'' broker-dealer.
---------------------------------------------------------------------------

F. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission believes that there are no federal rules that 
duplicate, overlap, or conflict with the proposed rule amendments.

G. Significant Alternatives

    Pursuant to Section 3(a) of the Regulatory Flexibility Act,\225\ 
the Commission must consider certain types of alternatives, including: 
(1) The establishment of differing compliance or reporting requirements 
or timetables that take into account the resources available to small 
entities; (2) the clarification, consolidation, or simplification of 
compliance and reporting requirements under the rule for small 
entities; (3) the use of performance rather than design standards; and 
(4) an exemption from coverage of the rule, or any part of the rule, 
for small entities.
---------------------------------------------------------------------------

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

    The Commission considered whether it is necessary or appropriate to 
establish different compliance or reporting requirements or timetables; 
or clarify, consolidate, or simplify compliance and reporting 
requirements under the rule for small entities. Because the proposed 
rule amendments would enhance the Commission's oversight, the 
Commission preliminarily believes that small entities should be covered 
by the rule. The Commission also preliminarily believes that it would 
not be necessary to establish different compliance requirements for 
small broker-dealers, in that, as discussed previously, the proposed 
amendments are based in large part on existing compliance requirements 
in Rule 17a-5. Similarly, the Commission does not believe it would be 
necessary to establish different compliance requirements for small 
broker-dealers with respect to Form Custody. The information that would 
be elicited on the form is designed to allow examiners to obtain an 
understanding of the custody practices of all types of broker-dealers. 
Therefore, the Commission preliminarily believes that having 
inconsistent requirements could undermine the objectives of the 
proposed requirement.

H. Request for Comments

    The Commission encourages written comments on matters discussed in 
this IRFA. In particular, the Commission seeks comment on the number of 
small entities that would be affected by the proposed rule amendments 
and whether the effect on small entities would be economically 
significant. Commenters are asked to describe the nature of any effect 
and to provide empirical data to support their views.

[[Page 37603]]

X. Statutory Authority and Text of the Proposed Amendments

    The Commission is proposing amendments to Rule 17a-5 under the 
Exchange Act pursuant to the authority conferred by the Exchange Act, 
including Sections 15, 17, 23(a) and 36.\226\
---------------------------------------------------------------------------

    \226\ 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 Proposed Amendments

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

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

    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, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4, 78p, 78q, 
78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 
80b-3, 80b-4, 80b-11, and 7201 et seq., 18 U.S.C. 1350, and 12 
U.S.C. 5221(e)(3), unless otherwise noted.
* * * * *
    2. Section 240.17a-5 is amended by:
    a. In paragraph (a)(2)(ii), in the first sentence, removing the 
phrase ``annual audit of financial statements where said date is other 
than a calendar quarter'' and adding in its place ``annual reports 
where said date is other than the end of a calendar quarter.'';
    b. In paragraph (a)(2)(iii), removing the phrase ``the annual audit 
of financial statements where said date is other than the end of the 
calendar quarter.'' and adding in its place ``the annual reports where 
said date is other than the end of a calendar quarter.'';
    c. In paragraph (a)(2)(iv), adding the phrase ``(``designated 
examining authority'')'' after the phrase ``section 17(d) of the Act'';
    d. Redesignating paragraphs (a)(5) and (a)(6) as paragraphs (a)(6) 
and (a)(7);
    e. In newly redesignated paragraph (a)(6)(ii)(A), removing the 
phrase ``(a)(5)(i)'' and adding in its place ``(a)(6)(i)'';
    f. Adding new paragraph (a)(5);
    g. In paragraph (b)(4), removing the word ``he'' and adding in its 
place the phrase ``the broker or dealer''.
    h. Removing paragraph (b)(6);
    i. In paragraph (c)(1)(i), removing the phrase ``his customers'' 
and adding in its place the phrase ``customers of the introducing 
broker or dealer'';
    j. 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 pursuant to Sec.  
240.15c3-1(a)(2)(iv)'';
    k. In paragraph (c)(2), in the first sentence, removing the phrase 
``audited financial statements'' and adding in its place ``financial 
report'';
    l. 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.'';
    m. Removing paragraph (c)(2)(iii);
    n. Redesignating paragraph (c)(2)(iv) as (c)(2)(iii);
    o. In newly redesignated paragraph (c)(2)(iii), removing the phrase 
``annual audit report'' and adding in its place ``financial report'';
    p. Adding new paragraph (c)(2)(iv);
    q. In paragraph (c)(4) removing the word ``'customer''' and adding 
in its place the word ``customer'';
    r. In paragraphs (c)(5)(ii)(A) and (c)(5)(iii), removing the phrase 
``Web site'' and adding in its place ``website'';
    s. In paragraph (c)(5)(vi), removing the phrase ``was not required 
by paragraph (e) of Sec.  240.17a-11 to give notice and transmit a 
report to the Commission'' and replacing it with ``received an 
unqualified financial statement audit report pursuant to paragraph (g) 
of this section and neither the broker or dealer, pursuant to paragraph 
(d) of this section, or the independent public accountant, pursuant to 
paragraph (g) of this section, identified a material weakness or 
instance of material non-compliance'';
    t. Revising paragraph (d);
    u. In paragraph (e) introductory text, removing the phrase 
``financial statements'' and adding in its place ``annual reports'';
    v. Revising paragraph (e)(1);
    w. In paragraph (e)(2), in the first sentence, adding the word 
``financial'' before ``report'';
    x. Revising paragraphs (e)(3) and (e)(4);
    y. Removing paragraph (e)(5);
    z. Revising paragraphs (f), (g), (h), and (i); and
    aa. Removing and reserving paragraph (j).
    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) shall file 
Form Custody (Sec.  249.1900 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 date selected 
for the annual reports where said date is other than the end of a 
calendar quarter. The designated examining authority shall maintain the 
information obtained through the filing of Form Custody and transmit 
such 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.
* * * * *
    (c) * * *
    (2) * * *
    (iv) If in connection with the most recent annual report the 
independent public accountant provided notice to the Commission 
pursuant to paragraph (h) of this section, there shall be a statement 
by the broker or dealer that a copy of such notice is currently 
available for the customer's inspection at the principal office of the 
Commission in Washington, DC.
* * * * *
    (d) Annual reports. (1)(i) Every broker or dealer registered 
pursuant to section 15 of the Act shall file annually, on a calendar or 
fiscal year basis:
    (A) A financial report as described in paragraph (d)(2) of this 
section;
    (B)(1) A compliance report as described in paragraph (d)(3) of this 
section unless the broker or dealer is exempt from the provisions of 
Sec.  240.15c3-3; or
    (2) An exemption report described in paragraph (d)(4) of this 
section if the broker or dealer is exempt from the provisions of Sec.  
240.15c3-3; and
    (C) For each report filed pursuant to this paragraph (d), a report 
prepared by an independent public accountant pursuant to the engagement 
provisions set forth in paragraph (g)(1) of this section, except as 
provided in paragraphs (d)(1) and (e)(1) of this section.
    (ii) The reports required to be filed under this paragraph (d) 
shall be as of the same fixed or determinable date each year, unless a 
change is approved in writing by the designated examining authority for 
the broker or dealer. A copy of such written approval should be sent to 
the regional office of the Commission for the region in which the 
broker or dealer has its principal place of business.

[[Page 37604]]

    (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 or calendar year in which the 
succession occurs if the predecessor broker or dealer has filed a 
report in compliance with this paragraph (d) as of a date in such 
fiscal or calendar year.
    (iv) A broker or dealer that is a member of a national securities 
exchange and 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, shall not be 
required to file the reports under this paragraph.
    (2) Financial report. The financial report shall contain:
    (i) A Statement of Financial Condition (in a format and on a basis 
that is consistent with the total reported on the Statement of 
Financial Condition contained in Form X-17A-5 (Sec.  249.617 of this 
chapter) Part II or IIA), a Statement of Income, a Statement of Cash 
Flows, a Statement of Changes in Stockholders' or Partners' or Sole 
Proprietor's Equity, and Statement of Changes in Liabilities 
Subordinated to Claims of General Creditors. Such statements shall be 
in a format that is consistent with such statements as contained in 
Form X-17A-5 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 
should be included in the notes to the consolidated statement of 
financial condition reported on by the independent public accountant.
    (ii) Supporting schedules shall 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 and shall be filed with said report.
    (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, then the broker or dealer shall include in the 
financial report 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 
shall be included in the financial report.
    (3) Compliance report. (i) The compliance report shall contain:
    (A) A statement as to whether the broker or dealer has established 
and maintained a system of internal control to provide the broker or 
dealer with reasonable assurance that any instances of material non-
compliance with Sec. Sec.  240.15c3-1, 240.15c3-3, and 240.17a-13, and 
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 (``Account Statement Rule'') will be prevented or 
detected on a timely basis;
    (B) Assertions by the broker or dealer that include:
    (1) Whether it was in compliance in all material respects with 
Sec. Sec.  240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account 
Statement Rule as of the fiscal year-end;
    (2) Whether the information used to assert compliance with 
Sec. Sec.  240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account 
Statement Rule was derived from the books and records of the broker or 
dealer; and
    (3) Whether the internal control over compliance with Sec. Sec.  
240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account Statement Rule 
was effective during the most recent fiscal year such that there were 
no instances of material weakness; and
    (C) A description of each identified instance of material non-
compliance and each identified material weakness in internal control 
over compliance with Sec. Sec.  240.15c3-1, 240.15c3-3, and 240.17a-13, 
and the Account Statement Rule.
    (ii) The broker or dealer is not permitted to conclude that it is 
in compliance with Sec. Sec.  240.15c3-1, 240.15c3-3, and 240.17a-13 
and the Account Statement Rule if it identifies one or more instances 
of material non-compliance. For purposes of this paragraph material 
non-compliance would be a failure by the broker or dealer to comply 
with the requirements of Sec. Sec.  240.15c3-1, 240.15c3-3, and 
240.17a-13 or the Account Statement Rule in all material respects.
    (iii) The broker or dealer is not permitted to conclude that the 
internal control over compliance with Sec. Sec.  240.15c3-1, 240.15c3-
3, and 240.17a-13, and the Account Statement Rule were effective if 
there were one or more instances of material weakness in the internal 
control over compliance. For purposes of this paragraph, an instance of 
material weakness is defined as a deficiency, or a combination of 
deficiencies, in internal control over compliance with Sec. Sec.  
240.15c3-1, 240.15c3-3, and 240.17a-13, and the Account Statement Rule, 
such that there is a reasonable possibility that material non-
compliance with Sec. Sec.  240.15c3-1, 240.15c3-3, and 240.17a-13, or 
the Account Statement Rule will not be prevented or detected on a 
timely basis. For purposes of this paragraph a deficiency in internal 
control over compliance exists when the design or operation of a 
control does not allow the broker or dealer, in the normal course of 
performing their assigned functions, to prevent or detect non-
compliance with Sec. Sec.  240.15c3-1, 240.15c3-3, and 240.17a-13, or 
the Account Statement Rule on a timely basis.
    (4) Exemption report. The exemption report shall contain an 
assertion by the broker or dealer that it is exempt from the provisions 
of Sec.  240.15c3-3 because it meets conditions set forth in Sec.  
240.15c3-3(k) and should identify the specific conditions.
    (5) The annual reports shall be filed not more than sixty (60) days 
after the date of the financial statements.
    (6) The annual reports 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, the Commission's principal office in 
Washington, DC, and the principal office of the designated examining 
authority for said broker or dealer and with the Securities Investor 
Protection Corporation. Copies thereof shall be provided to all self-
regulatory organizations of which said broker or dealer is a member, 
unless the self-regulatory organization by rule waives this 
requirement.
    (e) * * *
    (1)(i) The broker or dealer need not engage an independent public 
accountant to provide the reports required pursuant to paragraph (d) of 
this section if, since the date of the registration of the broker or 
dealer pursuant to Section 15 of the Act (15 U.S.C. 78o) or of the 
previous annual reports filed pursuant to paragraph (d) of this 
section:

[[Page 37605]]

    (A) The securities business of such broker or dealer has been 
limited to acting as broker (agent) for the issuer in soliciting 
subscriptions for securities of such issuer, said broker has promptly 
transmitted to such issuer all funds and promptly delivered to the 
subscriber all securities received in connection therewith, and said 
broker has not otherwise held funds or securities for or owed money or 
securities to customers; or
    (B) Its securities business has been limited to buying and selling 
evidences of indebtedness secured by mortgage, deed or trust, or other 
lien upon real estate or leasehold interests, and said broker or dealer 
has not carried any margin account, credit balance or security for any 
securities customer.
* * * * *
    (3) The annual reports filed pursuant to paragraph (d) of this 
section shall be public, 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 report filed pursuant to paragraph (d)(2) of 
this section, and each page of the balance of the annual report is 
stamped confidential, then the balance of the annual report shall be 
deemed confidential. However, the annual reports, including the 
confidential portions, shall 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 
person filing such a report is a member, by the PCAOB and by any other 
person to whom the Commission authorizes disclosure of such information 
as being in the public interest. Nothing contained in this paragraph 
shall be deemed 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 such member broker or dealer, to obtain information relative to its 
financial condition.
    (4)(i) The broker or dealer shall file with the Securities Investor 
Protection Corporation (``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 pursuant 
to paragraph (e)(4)(i) of this section and the rule is approved by the 
Commission, the broker or dealer shall file a supplemental report on 
the status of the membership of the broker or dealer in SIPC if, 
pursuant to 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 shall include the independent 
public accountant's report on applying agreed-upon procedures based on 
the performance of the procedures outlined in paragraph (e)(4)(ii)(C). 
The supplemental report shall 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 reports required by paragraph (d) of 
this section: Provided, that the broker or dealer need not 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 shall 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 shall 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, and
    (C) An accountant's report. The accountant shall 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 ending, comparison of 
amounts reflected in the annual report as 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 adjustments;
    (4) Proof of the arithmetical accuracy of the calculations 
reflected in Form SIPC-7 and in the schedules and working papers 
supporting 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) of this section to the Certification of Exclusion from Membership 
(Form SIPC-3).
    (f)(1) Qualification of accountants. 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.
    (2) Designation of accountant. (i) Every broker or dealer that is 
required by paragraph (d) of this section to file annual reports shall 
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 designating an independent public accountant 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. If the engagement of the 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 ``Notice pursuant to 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 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 engagement of the independent public

[[Page 37606]]

accountant by the broker or dealer meets the required undertakings of 
paragraph (g) of this section; and
    (F) A representation that the broker or dealer agrees to allow 
representatives of the Commission or its designating examining 
authority, if requested for purposes of an examination of the broker or 
dealer, to review the documentation associated with the reports of the 
independent public accountant prepared pursuant to paragraph (g) of 
this section.
    (G) A representation that the broker or dealer agrees to permit the 
independent public accountant to discuss with representatives of the 
Commission and its designated examining authority, if requested for 
purposes of an examination of the broker or dealer, the findings 
associated with the reports of the independent public accountant 
prepared pursuant to paragraph (g) of this section.
    (iii) A broker or dealer that does not carry nor clear transactions 
nor carry customer accounts is not required to include the 
representations in paragraphs (e)(2)(ii)(F) and (e)(2)(ii)(G) of this 
section.
    (iv) Any broker or dealer that is exempted from the requirement to 
file an annual audited report of financial statements shall 
nevertheless file the notice specified herein indicating the date as of 
which the unaudited report will be prepared.
    (v) Notwithstanding the date of filing specified in paragraph 
(f)(2)(i) of this section, every broker or dealer shall file the notice 
provided for in paragraph (f)(2) of this section within 30 days 
following the effective date of registration as a broker or dealer.
    (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 such broker or dealer, 
not more than 15 business days after:
    (i) The broker or dealer has notified the independent public 
accountant whose reports covered the most recent annual reports filed 
under paragraph (d) of this section that the independent public 
accountant's services will not be utilized in future engagements; or
    (ii) The broker or dealer has notified an independent public 
accountant who was engaged to provide reports covering the annual 
reports to be filed under paragraph (d) 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 reports covering the annual reports to be 
filed under paragraph (d) of this section; or
    (iv) A new independent public accountant has been engaged to 
provide reports covering the annual reports to be filed under paragraph 
(d) of this section without any notice of termination having been given 
to or by the previously engaged independent public accountant.
    (v) Such notice must provide:
    (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) preceding such 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 decisionmaking level--i.e., 
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 covering the 
annual reports filed under paragraph (d) of this section for any of the 
past two 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, or a general partner or a duly authorized corporate 
officer, as appropriate, and by the independent public accountant, 
respectively.
    (g) Engagement of independent public accountant. Every broker or 
dealer required to file the annual reports pursuant to paragraph (d) of 
this section shall engage an independent public accountant, unless the 
broker or dealer is subject to the exclusions in paragraphs (d)(1) and 
(e)(1)(i) of this section. The independent public accountant as part of 
the engagement must 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)(2) 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 compliance report required to be filed by the 
broker or dealer under paragraph (d)(3) of this section in accordance 
with standards of the Public Company Accounting Oversight Board. This 
examination and the related report would apply to the assertions of the 
broker or dealer required under paragraph (d)(3) of this section; or
    (ii) To prepare an independent public accountant's report based on 
a review of the exemption report required to be filed by the broker or 
dealer under paragraph (d)(4) of this section in accordance with 
standards of the Public Company Accounting Oversight Board.
    (h) Notification of material non-compliance. Upon determining any 
material non-compliance exists during the course of preparing the 
independent public accountant's reports, the independent public 
accountant must notify the Commission within one business day of the 
determination by means of a facsimile transmission or electronic mail, 
followed by first class mail, directed to the attention of the Director 
of the Office of Compliance Inspections and Examinations and provide a 
copy of such notification in the same manner to the principal office of 
the designated examining authority for the broker or dealer within one 
business day of the finding.
    (i) Reports prepared by the independent public accountant.
    (1) Technical requirements. The independent public accountant's 
reports shall:
    (i) Be dated;
    (ii) Be signed manually;
    (iii) Indicate the city and state where issued; and

[[Page 37607]]

    (iv) Identify without detailed enumeration the items covered by the 
reports.
    (2) Representations as to the examinations and review. The 
accountant's report shall:
    (i) State whether the examination or review was made in accordance 
with standards of the Public Company Accounting Oversight Board;
    (ii) 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.
    (iii) Nothing 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 
this section.
    (3) Opinion to be expressed. The independent public accountant's 
reports shall 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.
    (4) Exceptions. Any matters to which the independent public 
accountant takes exception shall 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.
    3. Section 240.17a-11 is amended by revising paragraph (e) 
introductory text to read 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 pursuant to Sec.  240.17a-12(i)(2), of 
the existence of any material inadequacy as defined in Sec.  240.17a-
12(h)(2), the broker or dealer shall:
* * * * *

PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934

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

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

* * * * *

    Note:  The text of Form Custody does not, and this amendment 
will not, appear in the Code of Federal Regulations.

    5. Add Subpart T and Form Custody (referenced in Sec.  249.1900) to 
Part 249 to read as follows:

Subpart T--Form for Broker-Dealers


Sec.  249.1900  Form Custody

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    By the Commission.

    Dated: June 15, 2011.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-15341 Filed 6-24-11; 8:45 am]
BILLING CODE 8011-01-C