United States: SEC Adopts Final Rule Amendments To Reporting, Notification And Audit Rules For Broker-Dealers (Financial Services Alert - August 20, 2013)

Last Updated: August 27 2013
Article by Robert M. Kurucza

Edited by: Eric R. Fischer, Jackson B.R. Galloway and Elizabeth Shea Fries

On July 30, 2013, the SEC issued a release (the "Release") adopting final amendments to the reporting, audit and notification provisions contained in certain investor protection and financial responsibility rules for broker-dealers, which, among other things, require that broker-dealers file new annual reports with the SEC and file new Form Custody with each broker-dealer's designated examining authority ("DEA") on a quarterly basis (the "Reporting and Audit Amendments").  Concurrently with the adoption of the Reporting and Audit Amendments, the SEC also adopted amendments to the net capital, customer protection, books and records, and related notification rules for broker-dealers (the "Financial Responsibility Amendments").  The Financial Responsibility Amendments were discussed in the August 13, 2013 Financial Services Alert.

This article summarizes the principal elements of the Reporting and Audit Amendments, which amend Rule 17a-5 under the Securities Exchange Act of 1934 (the "Exchange Act"), make technical and conforming amendments to Rule 17a-11 under the Exchange Act, and adopt new Form Custody.  This article refers to Rule 15c3-1 under the Exchange Act (the "Net Capital Rule"), Rule 15c3-3 under the Exchange Act (the "Customer Protection Rule"), and Rule 17a-13 under the Exchange Act (the "Quarterly Securities Account Rule"), in addition to applicable rules of a broker-dealer's DEA that require the broker-dealer to periodically send account statements to customers, collectively as the "Financial Responsibility Rules."

The SEC originally proposed the Reporting and Audit Amendments in June 2011 (the "Proposed Amendments").  The Proposed Amendments were discussed in the July 5, 2011 Financial Services Alert.

Final Rule Amendments

The Reporting and Audit Amendments require broker-dealers to file a new annual report, file new Form Custody on a quarterly basis, and engage a PCAOB-registered independent public accountant (an "Independent Accountant")  to examine certain reports in accordance with standards promulgated by the PCAOB.

New Reporting Requirements

Under the provisions of Rule 17a-5 under the Exchange Act as they existed prior to the Reporting and Audit Amendments, broker-dealers were required to annually file certain reports with the SEC regarding their financial condition, including a statement of financial condition, a statement of income, a statement of cash flows, and certain other financial statements (collectively a "Financial Report").   Under the Reporting and Audit Amendments, broker‑dealers will also be required to file either a "Compliance Report" or an "Exemption Report" in connection with the filing of their Financial Report.  A broker-dealer that does not claim that it was exempt from the Customer Protection Rule throughout its most recent fiscal year (a "carrying broker-dealer") will be required to file a Compliance Report, and a broker-dealer claiming it was exempt from the Customer Protection Rule throughout its most recent fiscal year (a "non-carrying broker-dealer") will be required to file an Exemption Report.  In general, the Customer Protection Rule requires that broker-dealers maintain physical possession or control over certain of its customers' securities and segregate customers' securities and funds from the broker-dealer's proprietary business activities, in an amount that is at least equal to the amount of net funds owed to customers.  A broker-dealer is exempt from the requirements of the Customer Protection Rule under certain circumstances, one of which is that it does not hold customer securities or funds.

All broker-dealers generally will be required to prepare and file a Financial Report and either a Compliance Report or an Exemption Report.

Compliance Report.  A carrying broker-dealer (i.e., a broker-dealer that has custody of customer funds or securities) will be required to file a Compliance Report with the SEC to verify that it is adhering to broker-dealer capital requirements, protecting customer assets that it holds, and periodically sending account statements to customers.  The Reporting and Audit Amendments require that the Compliance Report contain statements as to whether:

  • the broker-dealer has established and maintained Internal Control Over Compliance (as defined in the amended Rule 17a-5);
  • the broker-dealer's Internal Control Over Compliance was effective during and as of the end of its most recent fiscal year;
  • the broker-dealer was in compliance with applicable provisions of the Net Capital Rule and the Customer Protection Rule as of the end of its most recent fiscal year; and
  • the information the broker-dealer used to state whether it was in compliance with applicable provisions of the Net Capital Rule and the Customer Protection Rule was derived from the books and records of the broker-dealer. 

In addition, a Compliance Report must also contain, if applicable, a description of:

  • each identified material weakness in the Internal Control Over Compliance during the broker-dealer's most recent fiscal year, including those that were identified as of the end of such fiscal year; and
  • any instance of non-compliance with applicable provisions of the Net Capital Rule and the Customer Protection Rule as of the end of the most recent fiscal year.

The Reporting and Audit Amendments define Internal Control Over Compliance to mean internal controls that have the objective of providing the broker-dealer with reasonable assurance that non-compliance with the Financial Responsibility Rules will be prevented or detected on a timely basis.

In adopting the Reporting and Audit Amendments, the SEC also provided guidance with respect to various aspects of the Compliance Report requirements.  For example, the Reporting and Audit Amendments provide that a broker-dealer cannot state that it has established and maintained Internal Control Over Compliance if the internal controls do not provide the broker-dealer with reasonable assurance that non-compliance with the Financial Responsibility Rules will be prevented or detected on a timely basis.  In addition, the Reporting and Audit Amendments provide that a broker-dealer is not permitted to conclude that its Internal Control Over Compliance was effective if there were one or more material weaknesses in its Internal Control Over Compliance.

A material weakness is defined by the Reporting and Audit Amendments as a deficiency, or a combination of deficiencies, in the broker-dealer's Internal Control Over Compliance such that there is a reasonable possibility that non-compliance with certain provisions of the Net Capital Rule or the Customer Protection Rule will not be prevented or detected on a timely basis, or that non-compliance to a material extent with the Financial Responsibility Rules will not be prevented or detected on a timely basis.

Exemption Report.  A non-carrying broker-dealer (i.e., a broker-dealer that does not have custody of customer assets) will be required to file an Exemption Report with the SEC citing its exemption from requirements of the Customer Protection Rule applicable to carrying broker‑dealers.  The Exemption Report must contain the following statements, made to the best knowledge and belief of the broker-dealer:

  • a statement that identifies the provisions in paragraph (k) of the Customer Protection Rule under which the broker-dealer claimed an exemption from such rule;
  • a statement that the broker-dealer met the identified exemption provisions throughout its most recent fiscal year without exception or except as identified in the Exemption Report; and
  • if applicable, a statement that identifies each exception during its most recent fiscal year in meeting the identified provisions of paragraph (k) of the Customer Protection Rule that briefly describes the nature of each exception and the approximate date(s) on which the exception existed.

Filing of the Reports with Securities Investor Protection Corporation.  To the extent that a broker-dealer is a member of the Securities Investor Protection Corporation ("SIPC"), the Reporting and Audit Amendments will require the broker-dealer to concurrently file its Financial Report and Compliance Report or Exemption Report with SIPC.

Engagement of Accountant

A broker-dealer also must engage an Independent Accountant to prepare a report based on a review of certain statements in the broker-dealer's Exemption or Compliance Report.

The Reporting and Audit Amendments provide that the Independent Accountant must, as part of the engagement and in accordance with standards promulgated by the PCAOB, undertake to: (i) prepare a report based on an examination of the broker-dealer's Financial Report and (ii) prepare a report based on an examination of certain enumerated statements of the broker-dealer in the Compliance Report or the Exemption Report, as applicable.  The Release provides that an Independent Accountant's report based on an examination of a broker-dealer's Compliance Report will satisfy the internal control requirement that applies under Rule 206(4)-2 pursuant to the Investment Advisers Act of 1940 with regard to a broker-dealer acting as qualified custodian under certain circumstances.

Other Audit-Related Changes

The Reporting and Audit Amendments also make certain other changes to the manner in which audits of broker-dealer financial statements are conducted, including:

  • effective as of December 31, 2013 audits of broker-dealer financial statements and schedules must be conducted in accordance with standards promulgated by the PCAOB;
  • carrying broker-dealers and broker-dealers that clear transactions must allow representatives of the SEC or the broker-dealer's DEA to review certain audit-related documentation and reports; and
  • the Independent Accountant must be permitted to discuss the findings of such reports with representatives of the SEC or DEA when requested in connection with a regulatory examination of the broker-dealer. 

Notification Requirements

The Reporting and Audit Amendments also provide that the Independent Accountant must immediately notify the broker-dealer's Chief Financial Officer ("CFO") if certain determinations are made during the course of preparing the Independent Accountant's reports required by amended Rule 17a-5 under the Exchange Act.  Specifically, the Independent Accountant will be required to notify the CFO if it determines that the broker-dealer is not in compliance with any of the Financial Responsibility Rules, regardless of whether a compliance failure is material or immaterial.  In addition, the Independent Accountant must notify the broker-dealer's CFO if, during the course of preparing a report based on an examination of a Compliance Report, the accountant determines or becomes aware that any material weakness (as described above) exists in the broker-dealer's Internal Control Over Compliance.

The SEC clarified in the Release that the examination of the Compliance Report pertains only to certain statements contained in the Compliance Report and not to the broker-dealer's process for arriving at the statements.  Accordingly, the report based on the examination of the Compliance Report requires the Independent Accountant to perform its own independent examination of the related internal controls.  It is not necessary for the accountant to provide an opinion with regard to the process for arriving at the statements and conclusions.

In certain circumstances, as required under applicable rules under the Exchange Act, a broker‑dealer must provide notice to the SEC and its DEA of any instances of non-compliance or material weakness noted above, within the time period prescribed in such rules.

Form Custody

The Reporting and Audit Amendments require a broker-dealer to file with its DEA new Form Custody following each calendar quarter and any fiscal year that does not coincide with a calendar quarter.  Form Custody includes items designed to elicit information about whether and how the broker-dealer maintains custody of its customers' securities and cash, such as:

  • Whether the broker-dealer introduces customers to another broker-dealer on a fully disclosed basis;
  • Whether the broker-dealer introduces customer accounts to another broker-dealer on an omnibus basis;
  • Whether the broker-dealer carries securities accounts for customers;
  • Whether the broker-dealer carries securities accounts for non-customers;
  • If the broker-dealer carries securities accounts, the locations where the securities are held; and
  • Separately for customer and non-customer accounts, the approximate market value of various types of securities held by the broker-dealer.

Form Custody also contains questions for carrying broker-dealers for other broker-dealers, including questions about how responsibility for providing trade confirmations and customer account statements is managed between the carrying broker-dealer and the other broker-dealer.

Broker-dealers will be required to file Form Custody within 17 business days after the end of each calendar quarter and, in certain cases, each fiscal year.

Compliance and Effective Dates

The Reporting and Audit Amendments will be effective 60 days after publication in the Federal Register which is expected to be on August 21, 2013.  The new reporting requirements contained in the Reporting and Audit Amendments will apply to fiscal years ending on or after June 1, 2014 and will be due 60 calendar days after the end of each fiscal year.  The requirement to annually file the Financial Report and the Compliance Report or Exemption Report with SIPC, however, is effective as of December 31, 2013.  The requirements with respect to filing of Form Custody will become effective on December 31, 2013.

CFTC, SEC and FINRA Issue Joint Advisory on Business Continuity and Disaster Recovery Planning

The CFTC, SEC, and FINRA have issued an advisory following their joint investigation into firms' business continuity and disaster recovery plans ("BCPs") in the wake of Hurricane Sandy.  The regulators encourage firms to consider implementing the best practices described, which the advisory groups into the following categories: (1) widespread disruption considerations, (2) alternative locations considerations, (3) vendor relationships, (4) telecommunications services and technology considerations, (5) communications plans, (6) regulatory and compliance considerations, and (7) review and testing.  For example, the advisory encourages firms to consider their employees' ability to work from home during a crisis, including consideration of their ability to work remotely when telephone and Internet service may be disrupted.  It also lists a number of factors to consider in setting up back-up or alternative locations, suggests that firms consider the BCPs of their vendors, encourages firms to consider contracting with multiple telecommunications carriers in the event that one or more such carriers experiences a disruption, suggests that firms consider implementing a communication plan to allow communication and coordination with regulators, emergency officials, and others; urges firms to factor the time-sensitive nature of certain regulatory and exchange requirements into their BCPs; and encourages annual or more frequent BCP testing and training and the incorporation of stress testing into BCPs.

FRB Issues Final Rule Establishing Annual Assessment Fees for Large Banking and Other Financial Companies

The FRB issued a  final rule (the "Final Rule") establishing annual assessment fees intended to cover the costs of the FRB's supervision and regulation of bank holding companies and savings and loan companies with $50 billion or more in total assets and nonbank financial companies designated by the Financial Stability Oversight Council as subject to supervision by the FRB because they could potentially pose a threat to U.S. financial stability ("Assessed Companies").  The Final Rule implements Section 318 of the Dodd-Frank Act, which directs the FRB to collect from Assessed Companies assessments, fees, and other charges equal to the total expenses that the FRB estimates are necessary or appropriate to carry out the FRB's supervisory and regulatory responsibilities for Assessed Companies.

The Final Rule discusses how the FRB determines which companies are to be charged, estimates the applicable expenses, determines each Assessed Company's fee and bills for and collects such fees.   Under the Final Rule, each calendar year is an assessment period and for the 2012 assessment period payments will be due on December 15, 2013.  The FRB states that for subsequent assessment periods the FRB will notify Assessed Companies by June 30 of the year following the applicable assessment period and payments will be due by September 15 of the year following the applicable assessment period.  In its announcement of the establishment of the Final Rule, the FRB stated that, for the 2013 assessment period, it would collect an aggregate of approximately $440 million from a total of 70 Assessed Companies.

FRB Issues Order Approving BHC's Acquisition of Company that Provides Support Services to Lenders Who Make SBA and USDA Loans

The FRB issued an  Order (the "Order") approving, under Section 4 of the Bank Holding Company Act, the application of Live Oak Bancshares, Inc., a Wilmington, North Carolina based bank holding company with $342.9 million in total assets ("Live Oak") to acquire a nonbanking company, Government Loan Solutions, Inc. of Cleveland, Ohio ("GLS").  GLS provides support services in connection with the settlement, accounting and securitization process for government-guaranteed loans, including Small Business Administration ("SBA") loans and loans guaranteed under U.S. Department of Agriculture ("USDA") programs.

In approving Live Oak's application, the FRB analyzed the services provided by GLS and concluded that they all fell within the scope of five permissible nonbanking activities of bank holding companies under Regulation Y of the FRB's regulations.  Specifically, the Order states that the activities of GLS include: (1) making, acquiring, brokering or servicing loans; (2) providing appraisals of real estate and tangible and intangible property, including securities; (3) acting as an investment or financial advisor; (4) providing management consulting advice; and (5) providing data processing, data storing, data transmission, and related services.  In approving the Order the FRB found that "the acquisitions of GLS by Live Oak will enhance the ability of GLS to provide its services to lenders who make SBA and USDA loans, thereby potentially expanding the availability of those services."  The FRB also noted in the Order that it had received and considered public comments that questioned whether Live Oak, as a relatively small bank holding company, had the financial and managerial capacity to supervise the activities of GLS.  The FRB concluded that Live Oak has the resources, capacity, policies, procedures and controls to supervise GLS.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2013 Goodwin Procter LLP. All rights reserved.

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