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Presented By:
1
Gary R. Purwin, CPA Chief Executive Officer FINOP, LLC
Bob E. Lehman, Esq. PartnerLehman & Eilen LLP
David H. Grumer, CPAPartnerCitrin Cooperman
December 3, 2014
Presented by
David H. Grumer, CPA, Partner
COMPLIANCE AND EXEMPTION REPORTS
Compliance and Exemption Reports
What: SEC Release No. 34-70073, File No. S7-23-11
When: July 30, 2013
Why: To enhance the rules governing custody of customer assets by broker-dealers following similar changes in 2009 to the custody rule (Rule 206(4)-2) applicable to registered investment advisers under the Investment Advisers Act of 1940.
Who Must File What?
A broker-dealer that did not claim an exemption from Rule 15c3-3 at any time during the most recent fiscal year or claimed an exemption for only part of the fiscal year must prepare and file the compliance report.
A broker-dealer that claimed it was exempt from Rule 15c3-3 throughout the most recent fiscal year report must prepare and file the exemption report.
Effective Dates
• For fiscal years ended on or after June 1, 2014
• The SEC’s staff will not object if the broker-dealer submits statements in its compliance report or exemption report that do not cover the period of the fiscal year that is prior to June 1, 2014, and instead cover only the period beginning after June 1, 2014.
How does the Public Company Accounting Oversight Board (“PCAOB”) play a role in this reporting?
Broker-dealers must also file reports prepared by a PCAOB-registered independent public accountant covering the financial report and the compliance report or exemption report, as applicable.
See PCAOB Release No. 2013-007 dated October 10, 2013: Standards For Attestation Statements Related To Broker And Dealer Compliance Or Exemption Reports Required By The U.S. Securities And Exchange Commission.
Documentation
The SEC’s comments about documentation required of the broker-dealer: None
The PCAOB’s comments to auditors:
In planning the examination engagement, the auditor should……obtain an
understanding of the broker's or dealer's processes, including relevant controls, regarding compliance with the financial responsibility rules….. The nature, timing, and extent of procedures that are necessary to obtain an understanding of the broker's or dealer's processes, including relevant controls, regarding compliance with the financial responsibility rules depend on the size and complexity of the broker or dealer; the auditor's existing knowledge of the broker's or dealer's processes and controls; the degree to which the broker's or dealer's compliance depends on the completeness and accuracy of the broker's or dealer's internally-generated data; the nature and extent of changes in systems and operations, if any; and the nature of the broker's or dealer's documentation of its processes and controls.
THE COMPLIANCE REPORT
The Compliance Report by the Broker-Dealer
Generally, the broker-dealer’s compliance report will include five specific statements and two descriptions, if applicable.
Five statements
Two descriptions
The Five Statements of the Compliance Report
• The broker-dealer has established and maintained Internal Control Over Compliance.
• The Internal Control Over Compliance of the broker-dealer was effective during the most recent fiscal year.
• The Internal Control Over Compliance of the broker-dealer was effective as of the end of the most recent fiscal year. • The broker-dealer was in compliance with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal year.
• The information the broker-dealer used to state whether it was in compliance
with Rule 15c3-1 and paragraph (e) of Rule 15c3-3 was derived from the books and records of the broker-dealer.
The Two Descriptions (if applicable)
• Each identified material weakness in Internal Control Over Compliance during the most recent fiscal year, including those that were identified as of the end of the fiscal year.
• Any instance of non-compliance with Rule 15c3-1 or paragraph (e) of Rule 15c3-3 as of the end of the most recent fiscal year.
Internal Control Over Compliance
Internal controls that have the objective of providing the broker or dealer with reasonable assurance that non-compliance with § 240.15c3-1, § 240.15c3-3, § 240.17a-13, or any rule of the designated examining authority of the broker or dealer that requires account statements to be sent to the customers of the broker or dealer (an “Account Statement Rule”), will be prevented or detected on a timely basis.
Internal Control over Financial Reporting
The final rule does not require that the broker-dealer includes a statement regarding the effectiveness of its internal control over financial reporting, nor does it require that the independent public accountant attest to the effectiveness of internal control over financial reporting.
Internal Control Over Compliance
The rule of the designated examining authority of the broker-dealer that requires account statements to be sent to the customers of the broker-dealer (an “Account Statement Rule”).
Examples:
• Net capital requirements§ 240.15c3-1
• Customer protection – reserve and custody of securities § 240.15c3-3
• Quarterly security counts § 240.17a-13
FINRA Rule 2340
CFTC Regulation §1.33
The Four Rules(the Financial Responsibility Rules)
Findings by the Independent Public Accountant
Therefore, the independent public accountant will be required to provide notification to the broker-dealer of all instances of non-compliance with the financial responsibility rules.
The independent public accountant will not have to analyze whether an instance of non-compliance is “material non-compliance” under the proposed definition.
Findings by the Independent Public Accountant(Continued)
If the independent public accountant provides notice to the broker-dealer of an instance of non-compliance with the financial responsibility rules, the broker-dealer must provide notice to the SEC and its DEA in accordance with the notification provisions of Rule 15c3-1, Rule 15c3-3, or Rule 17a-11, but only if the notice provided by the independent public accountant concerns an instance of non-compliance that requires the broker-dealer to provide notification under those rules.
The broker-dealer must provide a copy of the notification to the accountant within one business day. If the accountant does not receive the notice or the accountant does not agree with any statements in the notice, the accountant must provide a report to the Commission and the broker-dealer’s DEA within one business day.
Material Weakness
A material weakness
A deficiency, or a combination of deficiencies, in the broker-dealer’s Internal Control Over Compliance such that there is a reasonable possibility that non-compliance with Rule 15c3-1 or paragraph (e) of Rule 15c3-3 will not be prevented or detected on a timely basis, or that non-compliance to a material extent with Rule 15c3-3, except for paragraph (e), Rule 17a-13 or any Account Statement Rule, will not be prevented or detected on a timely basis.
A reasonable possibility
Commission guidance provides that an event is “probable” if the future event or events are likely to occur, and that an event is “reasonably possible” if the chance of the future event or events occurring is more than remote, but less than likely.
Proceed with Caution
The broker-dealer is not permitted to conclude that its Internal Control Over Compliance was effective during the most recent fiscal year if there were one or more material weaknesses in its Internal Control Over Compliance during the most recent fiscal year.
The broker-dealer is not permitted to conclude that its Internal Control Over Compliance was effective as of the end of the most recent fiscal year if there were one or more material weaknesses in its Internal Control Over Compliance as of the end of the most recent fiscal year.
Broker-Dealers Acting as Qualified Custodians under Rule 206(4)-2
A broker-dealer that also acts as a qualified custodian for itself as an investment adviser or for its related investment advisers may use the report of the independent public accountant based on an examination of its compliance report to meet the reporting obligations under Rule 206(4)-2.
Therefore, such broker-dealer will not be required to obtain an internal control report under Rule 206(4)-2 in addition to a report covering the compliance report from its independent public accountant.
The independent public accountant’s report is based on an examination of the compliance report and will not satisfy any other requirement under the Custody Rule.
Broker-Dealers Acting as Qualified Custodians under Rule 206(4)-2(Continued)
The dual registered broker-dealer/RIA can extend the period of the compliance report and corresponding accountant’s report based on an examination of the compliance report. The examination would cover the gap between the end of the covered period by the most recent internal control report under the Custody Rule and the beginning of the period covered by the compliance report and corresponding accountant’s report based on an examination of the compliance report.
Broker-Dealers Acting as Qualified Custodians under Rule 206(4)-2(Continued)
The SEC’s example at http://www.sec.gov/divisions/marketreg/amendments-to-broker-dealer-reporting-rule-faq.htm, Question 2.
• A broker-dealer with a fiscal year end of December 31, 2014 that obtained an internal control report as of and for the period ended September 30, 2013 can elect to have its compliance report and corresponding accountant’s report based on an examination of the compliance report. It should cover a period from October 1, 2013 through December 31, 2014 to satisfy its obligations under the Custody Rule.
Broker-Dealers Acting as Qualified Custodians under Rule 206(4)-2(Continued)
• However, a broker-dealer will need to obtain an internal control report under the Custody Rule if the firm’s compliance report and corresponding accountant’s report based on an examination of the compliance report do not cover all of the gap between the end of the period covered by the most recent internal control report and the beginning of the period covered by the compliance report and corresponding accountant’s report based on an examination of the compliance report.
• For example, a broker-dealer that obtained an internal control report as of and for the period ended September 30, 2013 and that files its 2014 compliance report and corresponding accountant’s report based on an examination of the compliance report for the period from June 1, 2014 through the end of its fiscal year (as indicated above, the SEC’s staff will not object to this approach) would need to obtain an internal control report for the period from October 1, 2013 to May 31, 2014 to satisfy the requirements in the Custody Rule.
Situations in Which the Exemption Should Be Filed Instead of the Compliance Report
If the broker-dealer:
• does not claim an exemption from Rule 15c3-3, and
• its business activities are limited to one or more of the following:
(1) proprietary trading;
(2) effecting securities transactions via subscriptions; and
(3) receiving transaction-based compensation for identifying potential merger and acquisition opportunities for clients, referring securities transactions to other broker-dealers, or providing technology or platform services.
THE EXEMPTION REPORT
The Exemption Report by the Broker-Dealer
The final rule provides that exemption reports must contain the following statements made to the best knowledge and belief of the broker-dealer:
(1) A statement that identifies the provisions in paragraph (k) of Rule 15c3-3 under which the broker-dealer claimed an exemption from Rule 15c3-3;
Note: either paragraph (k)(1), (k)(2)(i), (k)(2)(ii), or (k)(3) of Rule 15c3-3. To make this clear, the final rule refers to the “provisions” of paragraph (k) of Rule 15c3-3.
(2) A statement the broker-dealer met the identified exemption provisions in paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year without exception or that it met the identified exemptive provisions in paragraph (k) of Rule 15c3-3 throughout the most recent fiscal year except as described in the exemption report;
(3) if applicable, a statement that identifies each exception during the most recent fiscal year in meeting the identified provisions in paragraph (k) of Rule 15c3-3 and that briefly describes the nature of each exception and the approximate date(s) on which the exception existed.
and…
The Exemption Report by the Broker-Dealer(Continued)
The Exemption Report
The statements in the exemption report must be made to the “best knowledge and belief” of the broker-dealer.
The Exemption Report by the Broker-Dealer(Continued)
The Period Covered
The statement and certain information in the exemption report must cover the most recent fiscal year.
The Exemption Report
What about net capital?
One commenter on the rule as proposed pointed out that the exemption report relates solely to Rule 15c3-3 and asked how the adequacy of a non-carrying broker-dealer’s internal controls over compliance with Rule 15c3-1 would be assessed.
The SEC’s response:
Under the final amendments, a broker-dealer’s financial report will continue to include a supporting schedule containing a net capital computation under Rule 15c3-1, which will be covered by the independent public accountant’s examination of the financial report. Moreover, the PCAOB has proposed standards for auditing supplemental information accompanying audited financial statements.
The Exemption Report
The SEC wants you to know:
• The SEC expects that examiners will review whether a non-carrying broker-dealer promptly forwards checks in accordance with provisions in paragraph (k) of Rule 15c3-3.
• The SEC also notes that the 2011 AICPA Broker Dealer Audit Guide states: “In auditing the financial statements of a broker-dealer claiming an exemption from SEC Rule 15c3-3, the auditor should determine whether and to what extent the broker-dealer complied with the specific exemption during the audit period as well as the quality of the broker-dealer’s controls and procedures to ensure ongoing compliance.”
The Exemption Report
The SEC wants you to know (continued)
• Under the PCAOB’s standards, the independent public accountant should inquire of individuals at the broker-dealer who have relevant knowledge of controls relevant to the broker-dealer’s compliance with the exemption provisions and who are responsible for monitoring compliance with the exemption provisions whether they are aware of any deficiencies in controls over compliance or instances of non-compliance with the
exemption conditions.
• In the independent public accountant’s report, “[i]f the broker’s or dealer’s statement is not fairly stated, in all material respects, because of an instance or certain instances of non- compliance with the exemption conditions, the auditor must modify the review report to describe those instances of non-compliance and state that the broker or dealer is not in compliance with the specified exemption conditions.”
PCAOB PROCEDURES
Compliance Examination Reports
What are some of the procedures that the PCAOB expects independent public accountants to follow?
• Evaluate prior instances of noncompliance with the financial responsibility rules identified in prior audits and identified by management in the most recent fiscal year.
• Obtain an understanding of the broker-dealer’s processes, including relevant controls.• Read and evaluate FOCUS reports, regulatory correspondence and internal audit
reports.• Inquire of management and others who have relevant knowledge about compliance.• Obtain an understanding of the nature and frequency of customer complaints.• Test controls.• Obtain a representation letter.
Compliance Examination Reports(Continued)
What are some of the procedures that the PCAOB expects independent public accountants to do? (Continued)
Testing of controls:
Test those controls that are important to the auditor's conclusion about whether the broker-dealer maintained effective Internal Control Over Compliance for each financial responsibility rule during the fiscal year and as of the end of the fiscal year. The auditor must obtain evidence that the controls over compliance selected for testing are designed effectively and operated effectively during the fiscal year and as of the fiscal year end.
As the risk associated with the control being tested increases, the persuasiveness of the evidence that the auditor should obtain also increases.
The Exemption Review Report
What are some of the procedures that the PCAOB expects independent public accountants to follow? (Continued)
• Consider risk factors: i.e. history of non-compliance, changes in procedures or operations, employee competence, potential noncompliance associated with related parties and factors learned during the financial statement audit.
• Inquire of individuals with relevant knowledge about controls or awareness of exceptions.
• Inquire of individuals who are responsible for monitoring compliance with the exemption provisions.
• Read reports of internal auditors, regulatory filings and audit documentation.
• Perform other procedures as necessary in the circumstances to obtain moderate assurance regarding whether a material modification should be made to the broker's -dealer's assertions for the assertions to be fairly stated, in all material respects.
• Obtain a representation letter.
