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On July 31, 20113, the Securities and Exchange Commission (the “SEC”)  announced the adoption of rules created to increase safeguards for investor assets held at broker-dealers registered with the SEC and Financial Industry Regulatory Authority (“FINRA”). According to the SEC, the new rules require broker-dealers to file new reports with the SEC which will result in higher levels of compliance with the SEC’s financial responsibility rules.

Mary Jo White, Chair of the SEC, stated, “These rules will strengthen the audit requirements for broker-dealers and enhance our oversight of the way they maintain custody of their customers’ assets.”

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. The SEC’s Fact Sheet concerning the new rules is set forth below.

Increasing Protections for Investors Whose Assets Are Held by Their Broker-Dealer

The new rules amend a broker-dealer reporting rule (Rule 17a-5) and the broker-dealer notification rule (Rule 17a-11) under the Securities Exchange Act of 1934.

What Are Broker-Dealers?  
Broker-dealers are generally entities that engage in the business of carrying out securities transactions either for someone else’s account or for their own account.  Under the federal securities laws, most entities engaged in these activities (with the notable exception of certain commercial banks) must register with the SEC and be subject to Commission rules.  Broker-dealers must be members of at least one self-regulatory organization (SRO) such as the Financial Industry Regulatory Authority or a national securities exchange.

How Are Customer Assets at Broker-Dealers Protected?  

Broker-dealers that maintain custody of a customer’s securities and cash are subject to strict requirements under the Exchange Act that are designed to protect and account for these assets.

These requirements include:

Net Capital Rule (Rule 15c3-1) – Requires a broker-dealer to maintain more than a dollar of highly liquid assets for each dollar of liabilities.  If the broker-dealer fails, this rule helps to ensure that the broker-dealer has sufficient liquid assets to pay all liabilities to customers.

Customer Protection Rule (Rule 15c3-3) – Broker-dealers sometime use their own funds to conduct trades and other transactions.  When engaging in such “proprietary business activities,” this rule prohibits broker-dealers from using customer securities and cash to finance their own business.  By segregating customer securities and cash from a firm’s proprietary business activities, the rule increases the likelihood that customer assets will be readily available to be returned to customers if a broker-dealer fails.

Quarterly Security Count Rule (Rule 17a-13) – This rule requires a broker-dealer on a quarterly basis to count, examine, and verify the securities it actually holds for customers and for itself.  It must compare that count with the amounts of such securities it should be holding as indicated by its records.  If there are differences between the actual amounts held and the amounts that records indicate should be held, the broker-dealer must take capital charges until the differences are resolved.

Account Statement Rule – Each SRO has rules that require a broker-dealer to send a statement – at least quarterly – to each customer reflecting the customer’s securities and cash positions held at the broker-dealer, as well as the activity in the account.

These requirements are designed to protect customer assets held at broker-dealers.  However, if a broker-dealer violates these requirements by, for example, misappropriating these assets, the securities and cash may not be available to be returned to customers.

In a situation where a broker-dealer misappropriates funds or converts securities from its customer, the Securities Investor Protection Corporation (SIPC) may step in and initiate a liquidation proceeding, which is the process that determines whether SIPC will pay the customers for any shortfalls in their accounts up to $500,000 per customer (of which $250,000 can be used to make up a cash shortfall.)

The Rule Amendments
Strengthening Audit Requirements

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 PCAOB.

 Under the rule amendments:

A broker-dealer that has custody of the customers’ assets must file a “compliance report” with the SEC to verify they are adhering to broker-dealer capital requirements, protecting customer assets they hold, and periodically sending account statements to customers. The 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.

A broker-dealer that does not have custody of its customers’ assets must file an “exemption report” with the Commission 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 examination of the financial statements must be conducted in accordance with PCAOB standards.

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.

Strengthening Oversight of Broker-Dealer Custody Practices

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, the amendments require a broker-dealer to 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, the amendments require broker-dealers – regardless of whether they have custody of their clients’ assets – to 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 allow the accountant to discuss its findings with the examiners.

Relation of Broker-Dealer Custody Rule Amendments to Audits of Investment Advisers

In 2010, the SEC adopted Rule 206(4)-2 under the Investment Advisers Act of 1940, indicating what an investment adviser or its affiliate must do if it is a qualified custodian of its client funds and securities.  In those situations, the adviser must obtain annually (or receive from its related person as defined by Rule 206(4)(2)) a written internal control report prepared by an accountant registered with, and subject to regular inspection by, the PCAOB.  This report must be supported by the accountant’s examination of the qualified custodian’s custody controls.

The SEC has determined that the independent public accountant’s report based on an examination of the compliance report will satisfy the internal control report requirement under Rule 206(4)-2.  In this way, the rule changes better align the controls that relate to protection of customer assets of both broker-dealers and investment advisers.

 What’s Next 

The effective date for the requirement to file Form Custody and the requirement to file annual reports with SIPC is Dec. 31, 2013.  The effective date for the requirements relating to broker-dealer annual reports is June 1, 2014.

For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit   This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855