SEC Adopts Rules Affecting Broker-Dealers

In its continuing efforts to protect investors, on July 31 the SEC announced a series of new rules as well as amendments to existing rules that will alter the way broker-dealers conduct business. “Investors need to feel confident that their money is safe when it’s being held by their broker-dealers,” SEC chair Mary Jo White said in a statement. “These measures will significantly bolster the protections that our rules already offer.”

Let’s take a brief look at what’s new and what’s changed.

New Rules

Second, the SEC has now placed restrictions on cash bank deposits for purposes of the requirement to maintain a reserve to protect customer cash under Rule 15c3-3. The rule is amended to exclude cash deposits held at affiliated banks and limit cash held at nonaffiliated banks to an amount no greater than 15 percent of the bank’s equity capital, as reported by the bank in its most recent call report.

And third, the SEC has established customer disclosure, notice, and affirmative consent requirements (for new accounts) for programs in which customer cash in a securities account is “swept” to a money market or bank deposit product.

In addition, broker-dealers must now treat as a liability any capital contributed under an agreement giving the investor the option to withdraw it. The rule also requires broker-dealers to treat as a liability any capital contribution withdrawn within a year of its contribution unless the broker-dealer receives permission for the withdrawal in writing from its designated examining authority (DEA).

The new rule also requires broker-dealers to deduct from net capital (with regard to fidelity bonding requirements prescribed by a broker-dealer’s self-regulatory organization, or SRO) the excess of any deductible amount over the amount permitted by SRO rules.

And finally, any broker-dealer that becomes “insolvent” as that term is now defined in Rule 15c3-1 is required to cease conducting a securities business. The companion amendment to Rule 17a-11 requires insolvent broker-dealers to provide notice to regulatory authorities.

The amendments to Rules 17a-3 and 17a-4 will require large broker-dealers to document their market, credit, and liquidity risk management controls.

This rule is amended to establish new notification requirements for when a broker-dealer’s repurchase and securities lending activities exceed a certain threshold. In lieu of the notification requirement, the final rule provides that a broker-dealer may report monthly its stock loan and repurchase activity to its DEA, in a form acceptable to its DEA.

Amended Rules

Currently, Section 17 of the Exchange Act and Rule 17a-5 together require a broker-dealer to file an annual report with the SEC and the SRO designated to examine that broker-dealer. The report must contain audited financial statements conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB).

Under the rule amendments, a broker-dealer that has custody of customer assets must file a “compliance report” with the SEC to verify that it’s adhering to broker-dealer capital requirements, protecting customer assets it holds, and periodically sending account statements to customers. A broker-dealer also must engage a PCAOB-registered independent public accountant to prepare a report based on an examination of certain statements in the broker-dealer’s compliance report.

In addition, a broker-dealer that doesn’t have custody of its customers’ assets must file an “exemption report” with the SEC, citing its exemption from requirements applicable to carrying broker-dealers. The broker-dealer also must engage a PCAOB-registered independent public accountant to prepare a report based on a review of certain statements in the broker-dealer’s exemption report.

The examination or review of the new reports as well as the audit of the financial statements must be conducted in accordance with PCAOB standards. This represents a change from the previous requirement for the audit to be conducted in accordance with US generally accepted auditing standards, which differ from PCAOB standards.

And finally, a broker-dealer that is a member of SIPC also must file its annual reports with SIPC so that SIPC can better monitor industry trends and enhance its knowledge of particular firms.

Currently, Section 17(b) of the Exchange Act requires broker-dealers to submit to routine inspections and examinations by SEC staff and the relevant SRO.

The rule amendments enhance these broker-dealer examinations in two ways. First, a broker-dealer must now file a new quarterly report (called Form Custody) that contains information about whether and how it maintains custody of its customers’ securities and cash. The reports will establish a custody profile for the broker-dealer that examiners can use as a starting point to focus their custody examinations.

Second, regardless of whether they have custody of their clients’ assets, broker-dealers must agree to allow SEC or SRO staff to review the work papers of the independent public accountant if it’s requested in writing for purposes of an examination of the broker-dealer. They must also allow the accountant to discuss its findings with the examiners.

Effective Dates

The amendments discussed above will become effective 60 days after their publication in the Federal Register. Broker-dealers are required to begin filing new quarterly reports with the SEC and annual reports with SIPC by the end of 2013. The requirement for broker-dealers to file annual reports with the SEC is effective June 1, 2014.

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