July 2014
SIGNIFICANT AMENDMENTS TO SEC RULES
During the summer of 2013 the Securities and Exchange Commission (SEC) issued two releases: Release No. 34-70073 pertaining to the financial reporting requirements of broker-dealers (Customer Statements, FOCUS reporting, annual certified audits, etc.); and Release No. 34-70072 pertaining to the financial responsibility rules (net capital,
customer protection, etc.). In addition, Release No. 34-70701 was issued as a follow-up to the latter release. Its purpose was to extend the effective date of certain amendments contained in that release from October 21, 2013 to March 3, 2014.
Since the last of the amendments contained in the foregoing releases became effective last month (June 1, 2014) this newsletter is being issued solely to address the most significant changes contained in both releases.
FINANCIAL REPORTING RULE AMENDMENTS
SEC Release No. 34-70073 contains significant amendments to the financial reporting rules (primarily SEC Rules 17a5 and 17a11). Since the release consists of 316 pages, any attempt to cover all of the information contained therein is far beyond the scope of this newsletter. A summary of the most significant changes/additions follows:
Effective for calendar years ending on December 31, 2013 and thereafter, brokerdealer’s audited financial statements must now also be filed with the Securities Investor
Protection Corporation (SIPC) if the broker-dealer is a member of SIPC.
For calendar quarters ending on and after December 31, 2013, all broker-dealers, not just those holding customer funds and/or securities (carrying BDs), must file “Form
Custody” by the 17 th business day following the end of each calendar quarter (the same
date the quarterly FOCUS II or IIA is due). Form Custody must be filed with the brokerdealer’s designated examining authority (DEA) (not the SEC) through the Gateway system. The form and instructions may be downloaded from: www.finra.org/industry/compliance/regulatoryfilings/focus/p385570.
A discussion of the form’s contents was covered in our last newsletter and, therefore, will not be covered here. However, we do wish to repeat two final notes regarding Form
Custody:1) broker-dealers with off calendar quarter year-ends will be required to file an

additional (fifth) form 17 business days after the broker-dealer’s fiscal year end; and 2) it is not necessary for the Form Custody prepared as of the broker-dealer’s fiscal year end to be reviewed or otherwise examined by the broker-dealer’s auditors.
Audits to be filed in compliance with PCAOB standards – Effective June 1, 2014, SEC
Rule 17a-5 no longer requires audits of financial statements and other required financial information to be conducted in accordance with Generally Accepted Auditing Standards
(GAAS), but with the standards of the Public Company Accounting Oversight Board
(PCAOB). Due to the June 1, 2014 effective date, the first audits to be affected will
be for those broker/dealers with fiscal years ending June 30, 2014.
Compliance or Exemption Reports – Effective June 1, 2014, in addition to the audited financial statements and auditors’ report thereon to be filed, broker-dealers will also be required to file either a “Compliance Report” (for carrying broker-dealers) or an
“Exemption Report” (for non-carrying broker-dealers claiming an exemption to SEC
Rule 15c3-3). These reports must be accompanied by a report prepared by a PCAOBregistered independent public accountant regarding the results of the accountants’ examination of certain enumerated statements made in the compliance report or a review of the statements made in the exemption report, as applicable. The appropriate report is to be prepared in accordance with the standards of the PCAOB.
Compliance Report – Carrying broker-dealers that did not claim an exemption from the provisions of the Customer Protection Rule (SEC Rule 15c3-3) during the period being audited, or claimed an exemption for only a part of the year, must file a compliance report. The report must contain representations as to the existence, maintenance and effectiveness of Internal Controls Over Compliance (ICOC)*. Also, if applicable, the report must contain a description of any material weaknesses in Internal Control Over
Compliance during or at the end of the most recent fiscal year that were identified and any instance of non-compliance with SEC Rules 15c3-1 (Net Capital Rule), or 15c3-3(e)
(Required Deposits to the Special Reserved Bank Account pursuant to the Customer
Protection Rule) as of the end of the most recent fiscal year. If one or more weaknesses exist in ICOC or if the internal controls do not provide the broker-dealer with reasonable assurance that non-compliance with the financial responsibility rules will be prevented or detected on a timely basis, the broker-dealer may not state that it has established and maintained Internal Control Over Compliance.
* Internal Control Over Compliance (ICOC) is defined as, “internal controls that have the objective of providing the broker-dealer with reasonable assurance that noncompliance with the financial responsibility rules will be prevented or detected on a timely basis”.
The filing of the accountants’ report on the examination of certain enumerated statements made in the Compliance Report will satisfy the internal control report requirement under the Custody Rule [Rule 206(4)-2)] for broker-dealer custodians affiliated with investment advisers. However, the report will not satisfy the Custody
Rule’s independent verification requirement (the annual surprise examination) or any other requirements of the rule.

Exemption Report – Broker-dealers that claimed an exemption from the provisions of the Customer Protection Rule (SEC Rule 15c3-3) throughout the entire period being audited must file an exemption report. In the report the broker-dealer must identify the exemption to SEC Rule 15c3-3 that it has claimed, state that it met the provisions of the exemption throughout the entire year or period, and, if applicable, identify the nature and the date of each exception where the exemption was not met and describe the nature of each exception.
Material Weaknesses – Accountants must notify broker-dealers if, during the course of an attestation engagement for the broker-dealer, they note any instances of noncompliance with the financial responsibility rules or if the accountant determines that a material weakness in internal control over compliance with the financial responsibility rules exists. The broker-dealer and the accountant are then to follow the notification provisions (and follow-up notification provisions for the accountant, if appropriate) of
SEC Rules, 15c3-1, 15c3-3 and/or 17a-11, as applicable.
Designation of Accountant – Broker-dealers are required to designate the accounting firm performing their audit by the 10 th day of the month in which their fiscal year ends
(or 30 days after the effective date of the broker-dealer’s registration as a broker-
dealer, if earlier). In the case of a broker-dealer with a fiscal year ending on December
31st, the notification is required to be filed on or before December 10 th . The
notification must be filed with the SEC in Washington, the regional office of the SEC in which the broker-dealer is located and the principal office of the
broker-dealer’s designated examining authority (DEA). A new filing must be made each year unless the initial notification states that the engagement is of a continuing nature. The latter is the case for most existing broker-dealers. In addition, for clearing broker-dealers, a statement permitting the SEC to obtain information from the clearing broker-dealer’s auditors is also to be included on the designation (see
below).
For the above stated reasons, the SEC is requiring all broker-dealers to file a new
designation of accountant notification. Therefore, all broker-dealers with fiscal years ending after June 1, 2014 must now file a new designation by the 10 th day in which their fiscal year ends. Broker-dealers with fiscal years ending on December 31,
2014 must file the notification no later than December 10, 2014. However, since there is no penalty for an early filing, we recommend that the reader of this newsletter, regardless of the date of their fiscal year end, file a new designation
form as soon as possible. (See (f)(2)(ii)(A) through (G), pages 297 and 298 of SEC
Release No. 34-70073 for the information required to be included on the notification.)
Access to Auditors’ Work Papers – In the same “Designation of Accountant” notification mentioned above, the SEC requires that clearing broker-dealers (not non-carrying broker-dealers) also represent on the notification form that access to the clearing broker-dealer’s auditors and the auditors’ work papers will be permitted.
Other provisions – The release also contains changes/additions and/or expanded

definitions regarding: material weaknesses and required notifications; filing audited financial statements with regulatory agencies that are not the broker-dealer’s DEA; confidentiality of reports filed with the SEC; the filing of Supplemental SIPC reports; unqualified opinions required; notifications regarding non-compliance with the financial responsibility rules; and various other technical amendments.
To assist smaller broker-dealers, the SEC’s Division of Trading and Markets has made available a nine page document entitled “Frequently Asked Questions Concerning the
July 30, 2013 Amendments to the Broker-Dealer Financial Reporting Rule” that may be obtained at: www.sec.gov/divisions/marketreg/amendments-to-broker-dealer-reporting-rulefaq.htm
FINANCIAL RESPONSIBILITY RULES AMENDMENTS
With Release No. 34-70072, the Securities and Exchange Commission adopted numerous amendments to SEC Rules 15c3-1 (Net Capital), Rule 15c3-3 (Customer
Protection) and Rules 17a-3 and 17a-4 (Books and Records required to be maintained).
The release is 318 pages in length. As a follow-up, Release No. 34-70701 consists of 4 pages and merely extended the effective date of certain amendments in the former release from October 21, 2013 to March 3, 2014.
The most significant changes contained in Release No. 34-70072 are:
PAB Accounts – In a “no-action letter” issued in 1998, the SEC staff stated that it would not recommend enforcement action to the Commission if an introducing broker-dealer
(BD) did not take a net capital deduction under Rule 15c3-1 for cash held in a securities account at another broker-dealer (a clearing broker-dealer), provided the clearing broker-dealer agreed to: 1) perform a reserve computation for those BD accounts; and 2) establish and maintain a separate special reserve bank account containing cash and/or qualified securities equal to the computed reserve requirement determined in the reserve computation previously described in “1” above.
The accounts of introducing BDs which a clearing broker-dealer holds were referred to in the “no action letter” as “Proprietary Accounts of Introducing Broker-dealers” (PAIB accounts). Carrying broker-dealers have since then incorporated the “PAIB” terms into their clearing agreements with introducing broker-dealers.
The SEC has now amended Rule 15c3-3 to require that a broker-dealer carrying accounts for any other broker-dealer (not merely clearing broker-dealers carrying the
accounts of its introducing BDs) perform the same procedures listed above. Since the new requirement is not limited to introducing BDs, the accounts are now designated
Proprietary Accounts of Broker-Dealers (PAB accounts).

To be specific, any broker-dealer carrying accounts of other broker-dealers must now 1) perform a separate reserve computation (in addition to the customer reserve
computation currently required by the rule for customer accounts); 2) establish and fund a separate reserve account for the benefit of PAB account holders; and 3) obtain and maintain physical possession or control of non-margin securities carried for PAB accounts unless the carrying broker has provided written notice to the PAB account holders that it will use those securities in the ordinary course of its securities business and has provided opportunity for the PAB account holder to object to such use.**
** The rule does not specifically state that, should the carrying broker-dealer provide written notice to the PAB account holder that it will use the latter’s securities and the
PAB account holder has not objected, whether the PAB account holder must make any
deductions related to these securities in its computation of net capital.
Since this amendment to the Customer Protection Rule (Rule 15c3-3) incorporates and expands the provisions of the 1998 “no action letter”, the SEC staff has withdrawn that letter.
Because of the aforementioned amendment to Rule 15c3-3, the SEC has also adopted amendments to the net capital rule (Rule 15c3-1) to provide that “a broker-dealer need not deduct cash and securities held in a securities account at a carrying broker-dealer except where the account has been subordinated to the claims of creditors of the carrying broker-dealer”.
Exclusion of Certain Deposits to Special Reserve Bank Accounts – The SEC has adopted an amendment to the Customer Protection Rule to exclude cash deposited with an affiliated bank or cash deposited with an unaffiliated bank “to the extent that the amount of the deposit exceeds 15% of the bank’s equity capital as reported by the bank in its most recent Call Report or any successor form the bank is required to file by its appropriate Federal banking agency.
Liabilities assumed by a third party – Liabilities of the broker-dealer that have been assumed by a third party must be included in the broker-dealer’s net capital computation 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.
Non-permanent capital contributions – Broker-dealers are required to treat as a liability any capital contributed pursuant to an agreement giving the investor the option to withdraw it. Broker-dealers are also required to treat as a liability any capital contribution that is withdrawn within one year of the date its contribution unless the broker-dealer receives permission in writing from its designated examining authority
(DEA).
Insolvency – Broker-dealers are required to cease conducting a securities business if certain conditions exist indicating that the broker-dealer is insolvent.
Fidelity bond deduction limits – This amendment has finally brought SEC Rule 15c3-1

(Net Capital) in sync with the rules regarding fidelity bonds established by most DEAs.
Now the net capital rule requires a deduction from net worth for the amount that a fidelity bond deductible amount exceeds the amount permitted by the DEA. Previously this required deduction was only to be found in most DEA’s rules and regulations.
Restrictions in withdrawals of capital – In lieu of the former 30% requirement, the SEC staff has been given the ability to temporarily restrict all withdrawals, advances and loans made by a broker-dealer based solely upon the staff’s discretion.
Documentation of risk controls – Amendments to Rules 17a-3 and 17a-4 (maintenance
and retention of broker-dealer records) require broker-dealers to document their credit, market, and liquidity risk management controls. The amendments apply only to those broker-dealers with more than $1,000,000 in credit items (computed pursuant to
the customer reserve formula) or $20,000,000 in capital, including subordinated debt, computed in accordance with Appendix D to the net capital rule. The final rule does not specify the type of controls that must be established. It only requires the documentation of those controls that have been established.
Notification requirements – Amendments to SEC Rule 17a-11 establish requirements when broker-dealer’s repurchase and lending activities exceed a certain threshold. The final rule allows broker-dealers to report monthly stock loan and repurchase activity to its designated examining authority (DEA) in a form acceptable to the latter in lieu of the aforementioned notification requirements.
In addition, the above amendments to Rule 17a-11 also mandate that “insolvent” brokerdealers under Rule 15c3-1 (the Net capital rule) notify regulatory authorities.
Other amendments and/or additions contained in the release include: the establishment of customer disclosure, notice and affirmative consent requirements for customer accounts in which cash is “swept” to a money market fund or a bank; requirements when free credit balances in customer accounts are invested or transferred to another account or institution; the elimination of SEC Rule 15c3-2 and the transfer of certain requirements contained in that rule to SEC Rule 15c3-3; the exclusion of funds held in a commodity account meeting the definition of a “proprietary account” under CEA regulations from inclusion as “free credit balances” or “other credit balances” in the reserve formula pursuant to SEC Rule 15c3-3; the inclusion of SIPC protection to those holding futures in a portfolio margining account carried as a securities account; certain amendments regarding securities lending and borrowing and repurchase/reverse repurchase transactions; an amendment to Appendix A of the net capital rule making permanent a temporary provision decreasing the range of pricing inputs to the approved option pricing models; clarification that a money market fund, for purposes of Rule
15c3-1(c)(2)(vi)(D)(1) [haircuts pursuant to the net capital rule] is a fund described in
Rule 2a-7 under the Investment Company Act of 1940.
To assist smaller broker-dealers, the SEC’s Division of Trading and Markets has made available a five page document entitled “Amendments to Financial Responsibility Rules for Broker-Dealers – A Small Entity Compliance Guide” that may be obtained at:

www.sec.gov/info/smallbus/secg/bd-financial-resp-secg.htm
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