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Preventing Another Madoff: Proposed New Broker-Dealer Reporting Requirements

June 24, 2011

On June 15th, the SEC published for comment proposed amendments to the broker-dealer financial reporting rule under the Securities Exchange Act of 1934.

Overview. The proposal consists of three sets of amendments:

Photo by Sjoerd van Oosten. Some rights rreserved.

First, the “Annual Reporting Amendments” would update the existing requirements of Exchange Act Rule 17a-5, to facilitate the Public Company Accounting Oversight Board’s (“PCAOB”) oversight of independent public accountants of broker-dealers, as required by the Dodd-Frank Act. These amendments also eliminate potentially redundant requirements for certain broker-dealers affiliated with, or dually-registered as, investment advisers.

Second, the “Access to Audit Documentation Amendments” would require broker-dealers that either clear transactions or carry customer accounts to allow the Commission and designated examining authorities (“DEAs”) to review work papers of the public accounting firm that audits the broker-dealer and discuss any findings with the accounting firm.

Third, 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 a new “Form Custody” quarterly. 

The Annual Reporting Amendments (Sarbanes-Oxley Comes to Broker-Dealers). The Annual Reporting Amendments would require a broker-dealer who maintains custody of its customers’ securities or cash to submit to an examination by their auditor of the broker-dealer’s compliance and internal controls to ensure that they are complying with the SEC’s Financial Responsibility Rules: the net capital rule; the customer protection rule; the quarterly security count rule; and the accountant statement rule.

The broker-dealer would further be required to annually submit a “Compliance Report” to the SEC that states whether the broker-dealer has established and maintained a system of internal controls. The broker-dealer’s auditor would, in turn, issue an “Examiners Report” which the broker-dealer would also file with the SEC. Although the auditor would not be required to opine on the effectiveness of the broker-dealer’s internal controls, the auditor would be required to provide an opinion concerning the broker-dealer’s compliance, and internal control over compliance, with key regulatory requirements.

The proposed amendments would further require the auditor to notify the Commission within one business day if the auditor determines that an instance of “material non-compliance” exists with respect to any of the Financial Responsibility Rules during the course of the examination. That notification would occur when the material non-compliance is found and would not wait until the end of the examination.

“Form Custody.” The proposed amendments include a new 8-1/2-page “Form Custody” which the broker-dealer would submit quarterly with its FOCUS reports. The proposed new form is intended to provide additional information about a broker-dealer’s custodial activities. The information solicited by the form includes: (i) the broker-dealer’s relationship with other broker-dealers; (ii) the location at which the broker-dealer holds customer securities or proprietary securities; (iii) 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; (iv) whether the broker-dealer acts as a carrying broker-dealer; (v) whether the broker-dealer sends trade confirmations and account statements directly to its customers; and (vi) whether the broker-dealer’s customers have electronic access to information concerning their accounts.

Comments should be submitted within 60 days after publication in the Federal Register, which is expected shortly. View the proposing release and text here.

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