[Editor’s Note: The following update is authored by Davis Polk & Wardwell LLP]
The SEC recently adopted amendments to its financial responsibility, reporting and audit rules applicable to registered broker-dealers. While some of the amendments will affect all firms, the amendments are particularly significant for those that carry customer accounts or act as clearing brokers.
The amendments to the broker-dealer financial responsibility rules (the “Financial Responsibility Rules Amendments”) were originally proposed in March 2007, prior to the financial crisis. The amendments address a number of technical issues, including protections associated with “sweep programs” for customer free credit balances, proprietary accounts of broker-dealers that are held at other broker- dealers and limitations on banks eligible to hold special reserve accounts.
The amendments to the broker-dealer financial reporting and audit rules (the “Financial Reporting Rules Amendments”) were proposed in June 2011, partly in response to the Madoff scandal. The final rules require registered broker-dealers to file new types of reports with the SEC. They also require clearing and carrying broker-dealers to permit their independent public accountants to make available to the SEC and their designated examining authority (“DEA”) the audit documentation associated with annual audit reports required under Rule 17a-5 of the Securities Exchange Act of 1934 (the “Exchange Act”).
The Financial Responsibility Rules Amendments become effective 60 days from the date of publication of the rules in the Federal Register, which is expected to occur soon. The effective dates for the new requirements imposed by the Financial Reporting Rules Amendments vary by requirement and are described below.
Financial Responsibility Rules Amendments
The amendments make various changes to the broker-dealer customer protection and net capital rules as described further below.
Customer Protection Rules
PAB Accounts
The amendments require registered broker-dealers carrying proprietary accounts on behalf of other registered broker-dealers, foreign broker-dealers and foreign banks acting as broker-dealers (“PAB accounts”) to establish special bank accounts for the benefit of PAB account holders and to fund those accounts on the basis of calculations that are similar to those that broker-dealers are required to make in relation to special reserve accounts for the benefit of customers under Exchange Act Rule 15c3-3.4 The final rules permit an account holder to have its proprietary account excluded from the new requirement if it agrees to having its claims relating to the account subordinated to the claims of creditors of the carrying broker-dealer. In large part, the amendment is intended to close the gap between the scope of the term “customer” in a liquidation proceeding under the Securities Investor Protection Act of 1970 (“SIPA”) and under Exchange Act Rule 15c3-3, which gap the SEC was concerned could potentially expose SIPA and customers to losses.
Under the final rules, broker-dealers will also be required to obtain and maintain the physical possession or control of non-margin securities carried for a PAB account, unless the carrying broker-dealer has given written notice to the account holder that the broker-dealer may use the securities in the ordinary course of its business and has provided an opportunity for the account holder to object.
Reserve Accounts
The amendments prohibit registered broker-dealers from maintaining customer or PAB reserve account cash deposits at any affiliated bank and limit the amount of reserve account cash deposits that the broker-dealer may maintain at any single unaffiliated bank to 15% of the bank’s equity capital, as reported by the bank in its most recent Call Report.
U.S. branches of foreign banks will not be eligible to hold customer or PAB reserve account cash deposits unless a specific exemptive order is obtained.
Sweep Programs
The amendments provide that a broker-dealer must not convert, invest or transfer to another account or institution customer free credit balances, except (i) upon the customer’s specific order, authorization or draft or (ii) pursuant to a “sweep program” that sweeps free credit balances into money market funds or a bank deposit account that is insured by the Federal Deposit Insurance Corporation (“FDIC”), but only if the broker-dealer has satisfied specified disclosure and notification requirements. In addition, for accounts opened after the effective date of the Financial Responsibility Rules Amendments, the broker- dealer must obtain affirmative written consent of the customer to participate in a sweep program.
A broker-dealer must also provide written notice to the customer at least 30 calendar days before making changes to terms and conditions of the sweep program, changing the terms and conditions of a product currently available through the sweep program, changing products available through the sweep program, or changing the customer’s investment from one product to another in the sweep program. The written notice must describe the new terms and conditions or product and the options available to the customer if the customer does not accept the new terms and conditions or product.
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