About 300 of the 5,000 or so broker-dealers registered with the SEC maintain custody of their customers’ securities and cash.  Those custodians are subject to strict requirements under the Securities Exchange Act of 1934, which include:

Net Capital Rule (Rule 15c3-1) ... which 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.   

Customer Protection Rule (Rule 15c3-3) ...  which 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. 

Quarterly Security Count Rule (Rule 17a-13) ... which 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 - e.g., DTCC.  Differences between the actual amounts held and the amounts that should be held result in capital charges until the differences are resolved.    

(SRO) Account Statement Rule ...   which 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.

Misappropriated assets may be covered by the SIPC, or Securities Investor Protection Corporation, which will initiate a liquidation proceeding to protect customers - and make 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 Amendments to Rule 17a-5.   They would:

    1.  Strengthen Audit Requirements.   Currently, a B/D broker-dealer is required to, among other things, file an annual report with the SEC and the B/D's DEA.  The report must contain audited financial statements and certain supporting schedules and supplemental reports, as applicable. An independent public accountant registered with the 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.

A B/D that doesn't 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.

2.  Strengthen Oversight of Broker-Dealer Custody Practices. B/D's are subjected to routine inspections and exams by staff of the SEC and the relevant SRO.

As proposed ... these B/D exams would be enhanced in 2 ways:

1. A B/D that maintains custody of customer securities and cash or clears transactions must allow Commission and SRO examiners to:   (i) Access the work papers of the registered public accounting firm that audits the B/D;  (ii)  Discuss any findings with the personnel of the registered public accounting firm.  The examiners could use this information to better focus their examinations.
2. A B/D must file quarterly a report 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 B/D 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 IA's - 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 B/D to obtain - from the entity that maintains the assets of the IA'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 B/D's that serve as the custodian for the assets of IA clients must provide the internal control report.  Those B/D's would be able to rely on the examination outlined in the proposed amendments and, therefore, not also have to obtain the internal control report.

This summary was taken from ... [SEC PR 11-128, 6/15/11]