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SEC Proposes Ways to Strengthen Audits and Reporting of Broker-Dealers to Protect Customer Assets


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Washington, D.C., June 15, 2011 — The Securities and Exchange Commission today unanimously proposed amendments to the broker-dealer financial reporting rule in order to strengthen the audits of broker-dealers as well as the SEC’s oversight of the way broker-dealers handle their customers’ securities and cash.

The SEC’s proposal builds upon rules adopted in December 2009 that strengthened the protections provided to investors who turn their assets over to investment advisers.

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“When investors hand their assets over to a broker-dealer, they trust that their broker-dealer will hold and invest the assets as directed,” said SEC Chairman Mary L. Schapiro. “To protect investors and help maintain confidence in the market, we must take strong steps to help safeguard the assets held by broker-dealers.”

The SEC’s proposal is intended to strengthen the annual audits of broker-dealers by requiring an increased focus on the custody activities of broker-dealers. While current rules require broker-dealers to protect and account for customer assets, the proposed rule amendments would mandate an audit of the controls that the broker-dealer has put in place.

Additionally, 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 quarterly file a proposed new form that would elicit information about the custody practices of the broker-dealer to be used as a starting point for examinations by regulators.

Public comments on the SEC’s proposal should be received within 60 days of its publication in the Federal Register.

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Proposal to Amend Broker-Dealer Financial Reporting Rule
(Rule 17a-5)


What are broker-dealers? Broker-dealers are entities that engage in the business of effecting securities transactions — either for someone else’s account or for their own account. Under the U.S. securities laws, most entities engaged in these activities (with the notable exception of certain commercial banks) must register with the SEC as broker-dealers. Currently, there are approximately 5,000 broker-dealers registered with the SEC. Of those, about 300 maintain custody of their customers’ securities and cash. Broker-dealers also must be members of at least one self-regulatory organization (SRO) such as FINRA 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 Securities Exchange Act of 1934 that are designed to protect and account for these assets. These requirements include:

  • The Net Capital Rule (Rule 15c3-1). This SEC rule 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 there are sufficient liquid assets to pay all liabilities to customers.
  • The Customer Protection Rule (Rule 15c3-3). This SEC rule requires a broker-dealer to segregate customer securities and cash from the firm’s proprietary business activities. If the broker-dealer fails, these customer assets should be readily available to be returned to customers.
  • The Quarterly Security Count Rule (Rule 17a-13). This SEC rule 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. This process includes verifying the actual amount of securities located at sub-custodians such as the Depository Trust and Clearing Corporation, or DTCC. If there are differences between the actual amounts held and the amounts that should be held, the broker-dealer must take capital charges until the differences are resolved.
  • The Account Statement Rule. This SRO rule 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.

These requirements are designed to protect customer assets held at broker-dealer. 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 this situation, the Securities Investor Protection Corporation will initiate a liquidation proceeding to protect customers, including making up for shortfalls in customer accounts up to $500,000 per customer (of which $250,000 can be used to make up a cash shortfall.)

Proposed Rule Amendments

What would the amendments to Rule 17a-5 do?

The proposed amendments would:

Strengthen Audit RequirementsCurrently, Section 17 of the Exchange Act and Rule 17a-5 together require a broker-dealer to, among other things, file an annual report with the SEC and the broker-dealer’s designated examining authority. The report must contain audited financial statements and certain supporting schedules and supplemental reports, as applicable. An independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB) must conduct the audit.

Under the proposal, a broker-dealer that maintains custody of customer securities and cash would be required to undergo an examination — by a registered public accounting firm — of:

  • Whether it is in compliance with the four rules described above.
  • Its controls for complying with these rules.

In addition, 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.

Strengthen Oversight of Broker-Dealer Custody PracticesSection 17(b) of the Exchange Act subjects broker-dealers to routine inspections and examinations by staff of the Commission and the relevant SRO.

The proposed amendments would enhance these broker-dealer examinations in two ways:

First, the proposed amendments would require a broker-dealer that maintains custody of customer securities and cash or clears transactions to allow Commission and 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 examiners could use this information to better focus their examinations.

Second, the proposed amendments would require a broker-dealer to file a report on a quarterly basis that contains information about whether and, if so how, it maintains custody of its customers’ securities and cash. The report would establish a custody profile for the broker-dealer that examiners could use as a starting point to focus their custody examinations.

How do the amendments relate to the audits that Investment Advisers must undergo?

In 2009, the SEC adopted rules requiring investment advisers — depending on their custody arrangements — to engage an independent public accountant to conduct an annual “surprise exam” to verify that client assets exist. Depending on the custody arrangement, the rules also require some broker-dealers to obtain — from the entity that maintains the assets of the investment adviser’s client — a written internal control report prepared by a PCAOB registered public accounting firm. The internal control report must describe the controls in place at the custodian of the assets, test the operating effectiveness of the controls, and provide the results of the tests.

The proposed amendments recognize that some broker-dealers that serve as the custodian for the assets of investment adviser clients must provide the internal control report. Those broker-dealers would be able to rely on the examination outlined in the proposed amendments and, therefore, not also have to obtain the internal control report.

What’s Next?

How long is the public comment period?

The comment period lasts for 60 days after publication in the Federal Register.



Modified: 06/15/2011