SEC Adopts New Financial Responsibility and Reporting Requirements for U.S.-Registered Broker-Dealers

Elliott Curzon
Dechert LLP
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The Securities and Exchange Commission (“SEC” or “Commission”) recently approved amendments to its net capital, customer protection, books and records, notification and reporting requirements for broker-dealers, in an effort to enhance financial responsibility and investor asset safekeeping obligations.1 Several of the amendments codify long-standing SEC staff interpretations of the rules and accounting standards that govern these requirements. As discussed in greater detail below, some of the amendments are applicable only to firms that carry customer accounts on their books (commonly referred to as “carrying brokers”), while other amendments also apply to limited-purpose broker-dealers that do not carry customer accounts on their books. The amendments that were approved have different effective dates, commencing in October 2013.

Financial Responsibility Rules

A U.S.-registered broker-dealer must meet certain liquid net capital and customer asset protection requirements under the Securities Exchange Act of 1934, as amended (“Exchange Act”), and keep records and notify regulators in the event of certain financial events. These requirements are intended to protect customers in the event of a broker-dealer’s financial or recordkeeping disruptions. The amendments are designed to further protect customers and improve the SEC’s ability to monitor and prevent unsound business practices. The amendments were approved by a unanimous vote of the Commissioners and are effective October 21, 2013.

Customer Protection Rule (Rule 15c3-3)

Exchange Act Rule 15c3-3 prohibits a broker-dealer from using customer securities and cash in the ordinary course of business, by requiring the broker-dealer to reserve cash or qualified securities representing net liabilities to customers in a reserve account held at a bank or clearing agency for the benefit of the broker-dealer’s customers and segregated from the broker-dealer’s other assets. One of the amendments requires carrying broker-dealers that carry accounts for other broker-dealers (“Proprietary Accounts of Brokers” or “PABs”) to maintain a new segregated reserve account similar to the one they maintain for customers.2 However, the new definition of PAB accounts excludes broker-dealer accounts that trade on a delivery-versus-payment/receipt-versus-payment basis. In addition, in a tightening of prior practice, the amendments require a carrying broker-dealer to provide written notice to another broker-dealer if the carrying broker-dealer plans to use the other broker-dealer’s non-margin securities in its business activities.

Amended Rule 15c3-3 also prohibits a broker-dealer from meeting reserve requirements through the use of cash deposits held at affiliated banks and limits cash held at a non-affiliated bank to an amount no greater than 15% of the bank’s equity capital (as reported by the bank in its most recent Call Report). The amended Customer Protection Rule also establishes requirements regarding customer disclosure, notice and affirmative consent in connection with “Sweep Programs,” including those utilizing money market mutual funds (“MMMF”).3

Net Capital Rule (Rule 15c3-1)

To ensure that a broker-dealer has sufficient liquid assets to pay all of its liabilities to customers, the Net Capital Rule requires a broker-dealer to maintain more than $1.00 of cash and/or “qualified securities” for each $1.00 of liabilities. As originally proposed by the SEC in 2007, the amendments would have expanded the definition of “qualified securities”4 for purposes of satisfying the reserve requirement to include shares of MMMFs. Because the SEC recently proposed separate amendments to the rules governing MMMFs, the Commission deferred a decision on the 2007 proposal until a later undetermined date.5 Accordingly, the definition of “qualified securities” does not currently include shares of MMMFs for the purpose of funding the reserve requirement.

The amended Net Capital Rule requires a broker-dealer to treat as a liability: (i) any capital that is contributed under an agreement giving the investor the opportunity to withdraw the contribution; and (ii) any capital contribution that is intended to be or is withdrawn within a year of its contribution. The first of these two requirements tracks the changes to Financial Accounting Standard 150, which was adopted in 2003. The second is a codification of an SEC staff interpretation issued in 2000 that requires a broker-dealer to treat capital withdrawn within one year as a liability. In addition, the amended Net Capital Rule requires a broker-dealer to adjust net worth when calculating net capital to include any liabilities that are assumed by a third party, if the broker-dealer cannot demonstrate that the third party has the resources (independent of the broker-dealer’s income and assets) to pay the liabilities.6

With respect to fidelity bonding requirements, the amended Net Capital Rule requires a broker-dealer to deduct from its net capital the excess of any deductible amount over the amount permitted by the applicable self-regulatory organization (“SRO”).7 In addition, the Net Capital Rule by its terms prohibits a broker-dealer from doing business if it is out of compliance with the Rule, regardless of the cause. The amendment clarifies the distinction between being out of compliance with the Net Capital Rule and being “insolvent,” and specifies the actions required of a broker-dealer that becomes insolvent, including that it must cease conducting a securities business.8

Books and Records Rules (Rules 17a-3 and 17a-4)

The Books and Records Rules require a broker-dealer to make and maintain certain business records to assist in accounting for business activities and to assist securities regulators in examining for compliance with the securities laws. The amended Books and Records Rules require a large broker-dealer to document its market, credit and liquidity risk management controls. This documentation requirement applies only to a broker-dealer that has more than: (i) $1,000,000 in aggregate credit items as computed under the customer reserve formula of Rule 15c3-3, or (ii) $20,000,000 in capital, including debt subordinated in accordance with Appendix D to Rule 15c3-1. According to the adopting release for the Financial Responsibility Rules, the additional documentation requirement for a large broker-dealer is appropriate because such a broker-dealer generally engages in a wide range of highly complex activities across many different markets and geographical locations. However, the Commission is neither mandating any specific risk management controls, procedures, or policies that must be established by a broker-dealer nor is it requiring any minimum elements or specifying any risk management procedures. According to the adopting release, the Commission anticipates that most brokers-dealers that will be subject to this requirement already have in place documented risk management controls, procedures, and policies.

Notification Rule (Rule 17a-11)

The Notification Rule (also referred to as the “Early Warning Rule”) requires a broker-dealer to give notice to the SEC and other securities regulators upon the occurrence of certain events (e.g., an insolvency or the decrease of net capital below the required minimum). The amended Notification Rule requires a broker-dealer to notify the SEC and other securities regulators when the broker-dealer’s repurchase and securities lending activities exceed 25 times its tentative net capital. According to the adopting release, based on a review of FOCUS reports, the Commission anticipates that fewer than 10 broker-dealers will be subject to this requirement. As an alternative to such notification, a broker-dealer may report monthly its stock loan and repurchase activity to its designated examining authority (“DEA”), in a form acceptable to its DEA.

Additional Amendments

Certain of the additional amendments approved are technical in nature and are not discussed in detail here, but include:

  • Changing rules regarding the allocation of customers’ fully paid and excess margin securities to short positions;
  • Repealing SEC Rule 15c3-2 and establishing conditions for the treatment of free credit balances within and outside of a Sweep Program; and
  • Clarifying that funds held in a commodities account that is a “proprietary account” under Commodity Exchange Act regulations may not be included as free credit balances for purposes of Rule 15c3-3 reserve requirements.

Reporting Rules

The Reporting Rules were approved by a 3-2 vote of the Commissioners and require a broker-dealer to file new reports in an effort to increase compliance with the Financial Responsibility Rules.9

Audit Requirements

Section 17 of the Exchange Act and Rule 17a-5 thereunder require a broker-dealer to file audited annual reports with the SEC and the applicable SRO. The annual reporting requirement varies based on whether or not the broker-dealer is subject to Rule 15c3-3 because it has custody of customer assets.10

  • A broker-dealer that has custody of customer assets must file a “Compliance Report” to permit the SEC to verify that the broker-dealer is adhering to the applicable capital requirements, protecting customer assets, and periodically sending account statements to customers. Such a broker-dealer must also engage a Public Company Accounting Oversight Board (“PCAOB”)-registered independent public accounting firm to prepare a report based on an examination of certain statements in the broker-dealer’s Compliance Report.
  • A broker-dealer that does not have custody of customer assets must file an “Exemption Report” with the SEC, citing the broker-dealer’s exemption from the requirements applicable to a broker-dealer with custody of customer assets.11 Such broker-dealer must also engage a PCAOB-registered independent public accounting firm to prepare a report based on a review of certain statements in the broker-dealer’s Exemption Report.12

The annual reporting requirements relating to Compliance and Exemption Reports are effective June 1, 2014 and should be filed within 60 calendar days after the broker-dealer’s fiscal year-end as part of the broker-dealer’s annual compliance audit.

Custody-Related Requirements

Section 17(b) of the Exchange Act requires a broker-dealer to submit to routine inspections and examinations by the staff of the SEC and the applicable SRO. The Reporting Rules enhance these provisions by:

  • Requiring all broker-dealers to file a new quarterly report (“Form Custody”) that contains information about whether and how the broker-dealer maintains custody of customer assets. Such report is intended to assist examiners in creating a custody profile for the broker-dealer in order to focus custody examinations.13
  • Requiring a broker-dealer (regardless of whether it has custody of customer assets) to agree to allow staff of the SEC and the applicable SRO to: (i) review the working papers of the PCAOB-registered independent public accounting firm if requested in writing for purposes of an examination of a broker-dealer; and (ii) discuss the findings of the PCAOB-registered independent public accounting firm with the accounting firm’s representatives.14

Pursuant to Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended (“Advisers Act”), an investment adviser that is a qualified custodian of its assets under management must obtain annually (or receive from its affiliate), a written internal control report prepared by an accounting firm registered with and examined by the PCAOB. The SEC has determined that the independent public accounting firm’s report which is based on an examination of the Compliance Report will satisfy the internal control report requirement of Rule 206(4)-2 under the Advisers Act. The SEC staff believes that this change better aligns the controls that relate to protection of customer assets by broker-dealers and investment advisers.

The requirement to file a Form Custody with the SEC is effective December 31, 2013. A broker-dealer must file Form Custody with its DEA within 17 business days after the end of each calendar quarter. In addition, for year-end filings of Form Custody by a broker-dealer that has selected a fiscal-year end-date that is not the end of a calendar year, the broker-dealer also must file Form Custody with its DEA within 17 business days after the end of the broker-dealer’s fiscal year.

Conclusion

Because the approved amendments become effective starting in October 2013, a broker-dealer should begin to consider whether changes to its operations, policies and procedures, and reporting obligations will be required as a result of the amendments. Moreover, in developing an implementation plan, a broker-dealer should consider that any such changes may require significant lead time to implement.

Footnotes

1. Financial Responsibility Rules for Broker-Dealers, 78 Fed. Reg. 78 FR 51823 (Aug. 21, 2013) (hereinafter referred to as the “Financial Responsibility Rules”). Broker-Dealer Reports, 78 Fed. Reg. 78 FR 51909 (Aug. 21, 2013) (hereinafter referred to as the “Reporting Rules”).

2. This amendment to Rule 15c3-3 closes a gap between the definition of “customer” in Rule 15c3-3 under the Exchange Act (which does not include a broker-dealer) and the definition of “customer” in the Securities Investor Protection Act, as amended (which includes a broker-dealer) for purposes of the reserve requirement and better protects customers of broker-dealers whose accounts are carried by other broker-dealers from the insolvency of the carrying broker. The amendment codifies many of the provisions of an SEC staff No-Action Letter regarding “Proprietary Accounts of Introducing Brokers” from Michael A. Macchiaroli, Associate Director, SEC Division of Market Regulation, to Raymond J. Hennessey, Vice President, NYSE and Thomas Cassella, Vice President, NASD Regulation, Inc. (Nov. 3, 1998) (“PAIB Letter”). With the adoption of these amendments, the Commission is directing the Commission staff to withdraw the PAIB Letter.

3. Amended Rule 15c3-3 defines a “Sweep Program” as “a service provided by a broker or dealer where it offers to its customers the option to automatically transfer free credit balances in the securities account of the customer to either a money market mutual fund product as described in [Rule 2a-7 under the Investment Company Act of 1940, as amended] or an account at a bank whose deposits are insured by the Federal Deposit Insurance Corporation.” Neither a one-time or other special transfer of a customer’s free credit balances nor a bulk transfer of customer assets between two MMMFs or between a bank deposit product and an MMMF would qualify as a Sweep Program. Accordingly, such transfers are not subject to the additional customer disclosure, notice and affirmative consent requirements.

4. Rule 15c3-3 under the Exchange Act currently defines “qualified securities” to mean securities issued by the United States or guaranteed by the United States with respect to principal and interest.

5. In addition, the adopting release for the Financial Responsibility Rules notes that the Securities Investor Protection Corporation (“SIPC”) has expressed concerns about the ability to use shares of MMMFs to meet the net capital requirements (e.g., that the use of such shares introduces another party – the MMMF – at which problems might arise). See footnotes 239 and 240 and the related text thereto in the adopting release for the Financial Responsibility Rules.

6. This amendment follows FINRA Notice to Members 03-63, which addresses situations in which another party has agreed to pay expenses related to the business of the broker-dealer. In a letter from the staff of the SEC’s Division of Market Regulation accompanying the FINRA Notice, the SEC staff stated that if a third party agrees to assume responsibility for an expense relating to the business of the broker-dealer, and the expense is not recorded on the reports of the broker-dealer, any corresponding liability will be considered a liability of the broker-dealer for net capital purposes, unless: (i) if the expense results in payment owed to a vendor or other party, the vendor or other party has agreed in writing that the broker-dealer is not directly or indirectly liable to the vendor or other party for the expense; (ii) the third party has agreed in writing that the broker-dealer is not directly or indirectly liable to the third party for the expense; (iii) there is no other indication that the broker-dealer is directly or indirectly liable to any person for the expense; (iv) the liability is not a liability of the broker-dealer under Generally Accepted Accounting Principles (GAAP); and (v) the broker-dealer can demonstrate that the third party has adequate resources independent of the broker-dealer to pay the liability or expense.

7. FINRA Rule 4360 requires SIPC member firms to maintain blanket fidelity bond coverage with specified amounts of coverage based on the firm’s net capital requirement, with certain exceptions. FINRA Rule 4360 provides for an allowable deductible amount of up to 25% of the fidelity bond coverage purchased by a firm. Any deductible amount elected by the firm that is greater than 10% of the coverage purchased by the firm must be deducted from the firm’s net worth in the calculation of its net capital for purposes of Rule 15c3-1 under the Exchange Act.

8. Pursuant to Rule 15c3-1, a broker-dealer is “insolvent” if the broker or dealer: (i) is the subject of any bankruptcy, equity receivership proceeding or any other proceeding to reorganize, conserve, or liquidate such broker or dealer or its property or is applying for the appointment or election of a receiver, trustee, or liquidator or similar official for such broker or dealer or its property; (ii) has made a general assignment for the benefit of creditors; (iii) is insolvent within the meaning of Section 101 of Title 11 of the United States Code, or is unable to meet its obligations as they mature and has made an admission to such effect in writing or in any court or before any agency of the United States or any state; or (iv) is unable to make such computations as may be necessary to establish compliance with Rule 15c3-1 or Rule 15c3-3. Pursuant to the amendments, an insolvent broker-dealer must also provide its securities regulators with notice of its insolvency.

9. SEC Commissioners Daniel Gallagher and Troy Paredes dissented.

10. This SEC reporting requirement is separate from and in addition to the requirement, effective December 31, 2013, that annual reports must be filed with SIPC by its member broker-dealers. A broker-dealer engaged exclusively in the distribution of mutual fund shares, the sale of variable annuities, the insurance business, the furnishing of investment advice to investment companies or insurance company separate accounts, or whose principal business is conducted outside the United States is not required to be a member of SIPC and, therefore, is not subject to this reporting requirement.

11. A broker-dealer that effects transactions in mutual fund shares on a subscription-way basis (whereby a customer purchases the shares by providing funds directly to the issuer) does not have custody of customer assets. Moreover, a broker-dealer that acts as a finder by referring prospective purchasers of securities to an issuer for a private placement transaction does not have custody of customer assets. See, e.g., footnotes 600 and 601 and the related text thereto in the adopting release for the Financial Responsibility Rules.

12. The Exemption Report must: (i) identify the provision(s) under which the broker-dealer is claiming an exemption from Rule 15c3-3; (ii) indicate that the broker-dealer met the identified exemption in Rule 15c3-3 throughout the most recent fiscal year without exception or that it met the identified exemption throughout the most recent fiscal year except as described in the Exemption Report; and (iii) if applicable, contain a statement that identifies each exception during the most recent fiscal year in meeting the identified provisions in Rule 15c3-3 and that briefly describes the nature of each exception and the approximate date(s) on which the exception existed.

13. Among other things, the Form Custody requires that a broker-dealer identify the location used by the broker-dealer to hold securities that it carries (e.g., at the transfer agent for a mutual fund). Because mutual funds generally issue shares only in book-entry form, the ownership of such shares is generally reflected in a journal entry on the books of the mutual fund maintained by the mutual fund’s transfer agent. A broker-dealer that holds shares of mutual funds for customers generally holds them in the broker-dealer’s name on the books of the mutual fund. The Form Custody also requires that a broker-dealer identify the types of securities (e.g., shares in mutual funds, exchange-traded funds and privately offered funds) carried for the accounts of customers.

14. Commissioners Gallagher and Paredes issued a public dissent to the adoption of the Reporting Rules, arguing that the rules give the SEC too much latitude in obtaining audit documents and that “[t]he final rule could chill important discussions between a broker-dealer and its auditor . . . . In addition, the rule could compromise any privileges that cover communications between a broker-dealer and its auditor, or between a broker-dealer and its attorney, depending on the documents that are produced. In our view, the Commission’s decision to adopt a final rule that places such privileges at risk sets a problematic precedent.” See “Statement by Commissioners Gallagher and Paredes Concerning Commission Adoption of a Final Rule Regarding Assets Being Held by Broker-Dealers” (July 31, 2013) available here.

 

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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