SEC Proposes Audits of Broker-Dealers’ Custody Practices
The SEC proposed rules that it said would strengthen the annual audits of broker-dealers by requiring an increased focus on their custody activities. Current rules require broker-dealers to protect and account for customer assets. The proposed rule amendments would mandate an audit of those controls.
Comments on the proposal are due 60 days after publication in the Federal Register, which is expected shortly. The PCAOB on Tuesday approved a temporary rule to create an interim inspection program for registered public accounting firms’ audits of securities brokers and dealers (see prior JofA coverage, “PCAOB OKs Temporary Rule to Govern Broker-Dealer Audits”).
The introduction to the proposed rules outlines three sets of amendments to the broker-dealer financial reporting rule under the Securities Exchange Act of 1934 (the “Exchange Act”). They include:
- Updating the existing requirements of Exchange Act Rule 17a-5, to facilitate the ability of the PCAOB to implement oversight of independent public accountants of broker-dealers as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and eliminate potentially redundant requirements for certain broker-dealers affiliated with, or dually registered as, investment advisers.
- Requiring broker-dealers that either clear transactions or carry customer accounts to consent to allowing the SEC and designated examining authorities (DEAs) to have access to independent public accountants to discuss their findings with respect to annual audits of the broker-dealers and to review related audit documentation.
- Enhancing the ability of the SEC and DEA examiners to oversee broker-dealers’ custody practices by requiring broker-dealers to file a new form.
The SEC said in a press release that the proposal would strengthen oversight of broker-dealer custody practices by requiring broker-dealers that maintain custody of customer assets or self-clear transactions to allow SEC staff and the relevant designated examining authority to review work papers of the public accounting firm that audits the broker-dealer and discuss any findings with the accounting firm. The proposed amendments also would require all broker-dealers to file quarterly a proposed new form containing information about their custody practices. This form would be used as a starting point for regulatory examinations.
Broker-dealers that maintain custody of a customer’s securities and cash are subject to requirements of the Securities Exchange Act of 1934. The requirements designed to protect and account for these assets include:
- The Net Capital Rule (Rule 15c3-1). This requires a broker-dealer to maintain more than a dollar of highly liquid assets for each dollar of liabilities.
- The Customer Protection Rule (Rule 15c3-3). This requires a broker-dealer to segregate customer securities and cash from the firm’s proprietary business activities.
- The Quarterly Security Count Rule (Rule 17a-13). This requires a broker-dealer on a quarterly basis to count, examine and verify the securities it actually holds for customers and for itself—and compare that with the amounts of such securities it should be holding as indicated by its records.
- The Account Statement Rule. This requires 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.
The proposal would require a broker-dealer that maintains custody of customer securities and cash to undergo an examination—by a PCAOB-registered public accounting firm—of:
- Whether it is in compliance with the four rules described above; and
- Its controls for complying with these rules.
A broker-dealer that does not maintain custody of customer securities and cash would be required to undergo a review by an independent public accountant of its assertion that it is not subject to segregation requirements because it does not maintain custody of customer securities and cash.
The SEC said the proposed amendments would enhance these broker-dealer examinations by requiring a broker-dealer that maintains custody of customer securities and cash or clears transactions to allow SEC and self-regulatory organization (SRO) examiners to:
- Access the work papers of the registered public accounting firm that audits the broker-dealer.
- Discuss any findings with the personnel of the registered public accounting firm.
The SEC said examiners could use this information to better focus their examinations.
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