The SEC has proposed amendments to Exchange Act Rule 17a-5 to strengthen the audits and reporting of broker-dealers in order to protect customer assets. Under Rule 17a-5, broker-dealers must file annual reports with the SEC and their examining authorities which contain audited financial statements. An independent public accountant registered with the Public Company Accounting Oversight Board must conduct the audit.

SEC Chairman Mary Schapiro said the proposal came about as a result of the Bernard Madoff Ponzi scheme and other frauds in which investor assets were misappropriated. The proposal would facilitate the PCAOB’s new responsibility that was established by the Dodd-Frank Act to oversee the registered public accounting firms that audit broker-dealers.

Under the SEC’s 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 to confirm whether it is in compliance with the net capital, customer protection, quarterly security count and account statement rules. A broker-dealer that does not maintain custody of customer securities and cash would have to undergo a review of its assertion that it is not subject to the segregation requirements because it does not maintain custody of customer securities and cash.

The proposed amendments would require a broker-dealer that maintains custody of customer securities and cash or that clears transactions to provide the SEC and self-regulatory organization examiners with access to the work papers of the firm that audits the broker-dealer and the ability to discuss any findings with the personnel of the audit firm. The amendments would require a broker-dealer to file a quarterly report on whether, and if so how, it maintains custody of customers’ securities and cash. The information will establish a custody profile for the examiners’ use.

In 2009, the SEC adopted rules to require certain investment advisers 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 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 and would not also have to obtain the internal control report.

Commissioner Kathleen Casey supported the issuance of the release but raised concerns about the provision on access to audit documentation. She questioned whether it raised broader policy implications for independent accountants. Commissioner Luis Aguilar said the proposal was a necessary companion to the rules that address the custodial practices of registered investment advisers. Broker-dealers hold far more investor assets than investment advisers do, he said, so the proposal will make long overdue improvements to the oversight of broker-dealer custody.

Commissioner Troy Paredes also supported the proposal but said he had certain hesitancies with respect to the costs and burdens it may impose, particularly on smaller broker-dealers. Commissioner Paredes also had concerns with the provision that gives the SEC and the designated examining authority access to auditors’ work papers. He said the proposal could evolve into a system where the SEC ends up inspecting accountants. He also questioned whether the proposal may chill communications between broker-dealers and their accountants.

The SEC will seek comment on its proposal for 60 days.

□ Release No. 34-64676 is reported at ¶89,462.