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

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.

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).

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.

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.

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.

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).

• 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.

• 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.

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.

• 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.