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Navigating Through the New Broker-Dealer Reporting & Financial Responsibility Rules

Table of Contents

New Rules Affecting All Broker-Dealers

On July 30, 2013, the Securities and Exchange Commission (the "SEC") amended various rules relating to the annual reporting requirements, including the audit responsibilities, net capital requirements, and segregation rules.  These changes, which are substantial, also have various effective dates, further complicating the implementation.

EisnerAmper has produced various articles discussing the various changes.  In addition, we held an event, in November 2013, titled Navigating Through the New Broker-Dealer Reporting & Financial Responsibility Rules, to summarize these changes for broker-dealers.

Based on a poll taken at the event, fewer than 10% of broker-dealers present are ready for all the new rules and fewer than 30% have an action plan in place. After considering these results, we decided to provide information regarding the new rules in one convenient location in order to help broker-dealers prepare for the new reporting requirements and financial responsibility rules. 

How far along is your broker-dealer in the implementation process related to the new reporting requirements and financial responsibility rules?
2014 Broker Dealer chart 1  2014 Broker Dealer  We're ready.
2014 Broker Dealer  We understand the new requirements and have an action plan in place, but still have some open items before complete implementation.
2014 Broker Dealer  We have had preliminary discussions about the new rules, but have a long way to go before being fully compliant.
2014 Broker Dealer  We have not begun discussion regarding the new rules.
"The new broker-dealer rules were passed with the goal of creating additional safeguards of customer assets."

– Peter W. Testaverde, Partner, EisnerAmper LLP 



Form Custody
What is Form Custody? Form Custody is intended to be a single source of readily available information to assist examiners in preparing for and performing focused custody exams. It is designed to provide information concerning whether a broker-dealer maintained custody of customer and non-customer assets, and, if so, how such assets were maintained. This will make it easier for examiners to identify risks and possible violations of laws and regulations concerning the broker-dealer's custody of assets.
When does Form Custody become effective? Commencing December 31, 2013, a broker-dealer must file Form Custody within 17 business days after the end of each calendar quarter. If the broker-dealer has a fiscal year-end date that is not the end of a calendar year, the broker-dealer must also file Form Custody within 17 business days after the broker-dealer's fiscal year-end.
How often does Form Custody have to be filed and with whom? Form Custody must be filed with a broker-dealer's designated examining authority ("DEA") within 17 business days after the end of each calendar quarter, regardless of the broker-dealer's year-end. Broker-dealers that select a fiscal year-end date that is not the end of a calendar quarter must also file Form Custody with their DEA within 17 business days after their fiscal year-end.
Are any broker-dealers exempt from filing Form Custody? The rule requires that all broker-dealers registered with the SEC file Form Custody with their DEA.

The SEC is concerned about circumstances where broker-dealers falsely represent to regulators and others that they do not handle funds or securities or issue trade confirmations or account statements. The requirements to file Form Custody will promote greater focus and attention to custody practices by requiring that broker-dealers make specific representations in this regard.
If the broker-dealer is dually registered as an investment advisor subject to Form ADV, is it also required to file Form Custody? Broker-dealers are required to file Form Custody even if they are also registered as an investment advisor and subject to Form ADV. The SEC acknowledges that although some overlap exists between the information collected on both forms, there is also a significant amount of information and data collected that is not overlapping and therefore both forms will be required to be completed. As such, these broker-dealers will file both Form Custody and Form ADV.
Does Form Custody require an audit by a PCAOB-registered independent public accountant? Broker-dealers are not required to engage an independent public accountant for purposes of reviewing Form Custody.
Summary Form Custody provides a comprehensive profile of a broker-dealer's custody practices and arrangements by consolidating information about the broker-dealer's custodial responsibility and relationships with other custodians into one report. We expect that the workload related to preparing this new form will be manageable for most broker-dealers.



Compliance and Exemption Reports

Effective June 1, 2014, the independent report on internal control will be replaced by one of two new reports: a compliance report or an exemption report, one of which will be required to be filed by all registered broker-dealers.

"The Independent Auditors' Report on Internal Control—affectionately known as the MI Letter—is no more."

– Nancy Grimaldi, Partner, EisnerAmper LLP 
 Compliance ReportExemption Report
Who files which report? 

Registered broker-dealers who:

  • Did not claim an exemption from Rule 15c3-3 throughout the most recent fiscal year or claimed an exemption for only part of the fiscal year; and
  • Have held customer funds or securities at any time during the fiscal year.
 

Registered broker-dealers who:

  • Claimed exemption from Rule 15c3-3 (even if exceptions to the exemption provisions existed); or
  • Did not claim an exemption but had not held customer securities or funds at any time during the year.
 
What are the objectives of the report? 

This report is intended to increase the focus of independent public accountants on the custody practices of broker-dealers and to help identify broker-dealers that have weak controls for safeguarding investor assets.  It replaces the term "material inadequacy" and separates it into two components:

  • Compliance component (non-compliance with the financial responsibility rules) and
  • Internal control component (material weakness in internal control over compliance).
 
This report is intended to provide a standardized statement across all broker-dealers claiming an exemption from Rule 15c3-3 for the independent public accountant to review.  The exemption report will provide the SEC and the broker-dealer's DEA with more information than currently is reported by non-carrying broker-dealers in the FOCUS report.  The SEC seeks to identify exceptions to the exemptive provisions in paragraph (k) of Rule 15c3-3 in order to assess the nature, extent, and significance of the exceptions.
What are the requirements of the report? 

As of the end of the most recent fiscal year, the compliance report is required to contain statements as to whether:

  • The broker-dealer established and maintained internal control over compliance;
  • The broker-dealer had effective internal control over compliance during and as of the end of the most recent fiscal year; and
  • The broker-dealer was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3.

The compliance report must also contain a description of:

  • Each identified material weakness in the internal control over compliance; and
  • Any instance of non-compliance with Rule 15c3-1.
 

The exemption report is required to contain statements which:

  • Assert, by identifying the provision in 15c3-3(k), that the broker-dealer is exempt from Rule 15c3-3; and
  • Identify each exception and briefly describe the nature of each exception and the approximate date(s) on which each exception existed.
 



Changes to Net Capital Rule

As part of the SEC's final rule relating to broker-dealers, numerous changes were made relating to the Net Capital Rule (15c3-1). These changes had an effective date of October 21, 2013, except for broker-dealer accounts maintained at another brokerdealer which have an effective date of March 3, 2014.

RuleBeforeAfter
Broker-dealer accounts maintained at another broker-dealer  To avoid a charge, a non-clearing broker must have a PAIB (Primary Account of Introducing Brokers and Dealers) agreement with the clearing broker under which the clearing broker-dealer agrees to segregate the credit balances of the non-clearing broker. A PAIB agreement is no longer required. The non-clearing broker is no longer required to take a charge for cash or securities held in the account at the clearing broker provided the account is not subordinated to the general creditor claims of the carrying firm.
Securities lending/ borrowing, repurchase/ reverse repurchase transactions   A charge is taken against net capital under certain conditions where the broker-dealer acted as principal to the transaction.

Broker-dealers are assumed to be acting as principal and subject to the charges appropriate for these activities, unless:

  1. The broker-dealer fully discloses to each party the identity of the other party to the transaction;
  2. Each party expressly agrees in writing that the broker-dealer is not a guarantor to the transaction; and
  3. Each party acknowledges that in the event of default by the counterparty, the remedies do not include a right of set off against the broker-dealer.
 
Deduct certain liabilities or expenses assumed by third parties from net worth 

Under the "Third Party Expense Letter" (from the SEC to the NYSE and NASD, dated July 11, 2003), a charge must be taken for each expense incurred related to its business and any corresponding liability, regardless of whether a third party has agreed to assume the expense or liability, unless:

  1. The vendor or other party agreed in writing that the broker-dealer is not directly or indirectly liable to the vendor or other party for the expense;
  2. The third party agreed in writing that the broker-dealer is not directly or indirectly liable to the third party for the expense;
  3. There is no other indication that the broker-dealer is directly or indirectly liable to any person for the expense;
  4. The liability is not a liability of the broker-dealer under GAAP; and
  5. The broker-dealer can demonstrate that the third party has adequate resources independent of the broker-dealer to pay the liability or expense.
 
The portion of the "Third Party Expense Letter" is now codified into 15c3-1.  The additional staff guidance not incorporated into the rule will remain relevant as staff guidance with respect to complying with the amendment to 15c3-1.
Solvency Requirement  A solvency requirement was not explicitly stated prior to the amendments.

A broker-dealer must cease conducting securities business if deemed to be insolvent, as defined. Insolvency includes:

  1. Being placed in voluntary or involuntary bankruptcy;
  2. The appointment of a trustee, receiver, or similar person;
  3. A general assignment for the benefit of creditors;
  4. An admission of insolvency; or
  5. The inability to make computations necessary to establish compliance with the Net Capital Rule or Customer Protection Rule (Rule 15c3-3).
 
Restrictions on capital withdrawals (part 1)   A provision permitted the SEC to restrict withdrawals of capital from broker-dealers to the extent that the total of such withdrawals, loans, and advances over a 30 calendar-day period exceeded 30% of the firm's excess net capital. The 30% provision is eliminated.  The SEC can restrict withdrawals of capital from a broker-dealer "under such terms and conditions as the SEC deems necessary or appropriate in the public interest or consistent with the protection of investors."
Restrictions on capital withdrawals (part 2)   A contribution should record as a liability if the contribution is made with the understanding that the contribution can be withdrawn at the option of the investor. The new rule goes further than the initial rule: Capital contributed under an agreement allowing the capital to be withdrawn at any time or any capital contributed and intended to be withdrawn within 1 year of the contribution should be recorded as a liability.  Capital withdrawn within 1 year is deemed intended to be withdrawn within 1 year unless the DEA consents to the withdrawal.
Fidelity bonding deductible limits  There is no specific reference to self-regulatory organizations ("SRO") deductible requirements as a charge to net worth, thus not requiring a broker-dealer to account for the deduction required by the SRO rule in computing net capital. The broker-dealer shall deduct the amount specified by rule of the SRO for the broker-dealer with respect to a requirement to maintain fidelity bond coverage.



Changes to Customer Protection Rule

As part of the SEC's final rule relating to carrying broker-dealers, changes were made relating to the Custody Protection Rule (15c3-3). These changes are effective as of March 3, 2014 (unless otherwise noted), as summarized below:

RuleBeforeAfter
Broker-dealer accounts maintained at another broker-dealer (Proprietary Accounts of Broker-dealers or "PAB Accounts")  A carrying broker-dealer who carried a PAB Account was not required to consider the PAB Account in a reserve account computation unless it had contractually agreed to do so.
  • Carrying broker-dealers must now maintain a separate reserve account at a bank for the benefit of the PAB account holders and perform a reserve computation for PAB accounts (in addition to the customer reserve account computation already required to be performed in respect of regular customer accounts).
  • PAB accounts now include foreign broker-dealers.
  • The carrying broker-dealer must notify the PAB Account holder if it will be using or re-hypothecating the PAB Account's securities in the ordinary course of business and provide the PAB Account holder with an opportunity to object.
 
PAB Account Reserve, like customer reserve   Broker-dealers that carried accounts of other broker-dealers under PAIB agreements performed a calculation and reserved net credits in the proprietary accounts of non-carrying broker-dealer clients.
  • New limitations apply to banks in relation to both PAB reserve accounts and customer reserve accounts.
  • Cash deposited in an affiliate bank is excluded in determining whether the carrying broker-dealer has satisfied its reserve account obligations.
  • Cash deposited in an unaffiliated bank is excluded in determining whether the carrying broker-dealer has satisfied its reserve account obligations to the extent the amount deposited exceeds 15% of the bank's equity capital.
  • The bank must agree not to re-lend or hypothecate securities in the reserve account.
 
Sweep program – (adopted October 21, 2013) 

No comparable rule prior to the issuance of the new rules.

  • A carrying broker-dealer must comply with the new requirements before "sweeping" a customer's free credit balance into, for example, a money market fund or interest bearing account.
  • The carrying broker-dealer must obtain affirmative consent for new customers and provide certain periodic notices, statements and disclosures to all customers disclosing the amount of customer's free credit balance and the fact that the credit balance is payable to the customer on his/her demand.
 
Documenting Risk Management (adopted October 21, 2013)  No comparable rule prior to the issuance of the new rules.
  • In connection with the amendments to the Net Capital Rule (15c3-1) and the Customer Protection Rule (15c3-3), the SEC also amended Rules 17a-3 and 17a-4 to require a broker-dealer with more than $1 million in aggregate credit items or more than $20 million in capital to make and keep records with respect to its credit, market and liquidity risk until three years after the termination of the use of the risk management controls.
  • The SEC believes that many broker-dealers already maintain such records.
 



Broker-Dealer Concerns

With all the new rules, broker-dealers have much to be concerned with. Based on a poll taken at the Navigating Through the New Broker-Dealer Reporting & Financial Responsibility Rules event led by EisnerAmper LLP, almost half of the broker-dealers present were most concerned about the preparation of a compliance or exemption report; approximately one third are most concerned with the new financial responsibility rules.  Only 7% of broker-dealers stated that they were ready for the new rules.  More action appears to be necessary.

Which aspect of the broker-dealer rules will be most challenging to contend with?
2014 Broker Dealer chart 2  2014 Broker Dealer  Preparation of Form Custody.
2014 Broker Dealer  Other.
2014 Broker Dealer  Compliance with new financial responsibility rules.
2014 Broker Dealer  Preparation of a Compliance or Exemption Report.
"Carrying broker-dealers should act now to develop a process for evaluating the design and effectiveness of internal controls over regulatory compliance.  Exempt broker-dealers should ensure they are tracking any exceptions related to their exemption during the year."

– Matthew Maulbeck, Partner, EisnerAmper LLP 
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