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93-72 SEC Approves Major Revisions to Rule 17a-11

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Internal Audit
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Executive Summary

The Securities and Exchange Commission (SEC) recently approved changes to Rule 17a-11 that eliminate certain burdensome filing requirements. The requirements to give notice basically are unchanged. These amendments are the first major revisions to the rule in more than 20 years, which took effect August 12, 1993.

Background

Adopted in 1971, SEC Rule 17a-11 requires broker/dealers to report net capital and other operational problems and to file reports regarding those problems within certain time periods.

In October 1992, the SEC solicited comments on its proposal to relieve broker/dealers of the obligation to submit FOCUS reports when their net capital declines below certain levels. During the public comment period, the SEC Division of Market Regulation issued a no-action letter authorizing broker/dealers' designated examining authority (DEA) to waive the FOCUS filing requirements of paragraphs (a) and (b) of the rule when the notification was given by the broker/dealer within the specified time frames.

After reviewing the comments, the SEC decided these changes would not compromise the ability of the DEA or the SEC to monitor the condition of broker/dealers. The SEC adopted the proposed amendments substantially as proposed.

Summary of Amendments

In general, the amendments reduce certain reporting burdens on broker/dealers by eliminating the requirement that a broker/dealer submit supplemental reports to the SEC and other regulatory organizations when its net capital declines below certain specified levels, or in other instances that indicate the existence of financial or operational difficulties. The specific rule changes are discussed below.

Notice of Net Capital Deficiency

Broker/dealers still have to transmit notice of a net capital deficiency on the same day it occurs. That notice must now specify the broker/dealer's net capital requirement and its current amount of net capital. However, the amended rule eliminates the requirement that broker/dealers file a FOCUS report within 24 hours after notifying the SEC of a net capital deficiency.

The amended rule also requires a broker/dealer to give notice of a net capital deficiency when informed of such by its DEA or the SEC, even if the broker/dealer disagrees with the finding. The broker/dealer may specify in the notice its reasons for disagreeing.

Notification Regarding Subordination Agreements

The changes eliminate reference to the requirement that a broker/dealer notify the SEC telegraphically when its total outstanding principal amounts of satisfactory subordination agreements exceed the maximum allowable for more than 90 days. The SEC decided this reference was not needed since such a condition is a net capital violation that requires same-day notification to the DEA.

Early Warning Levels

Rule 17a-11 currently contains three early warning levels. First, a broker/dealer that computes its net capital under the basic method must give notice if its aggregate indebtedness exceeds 1,200 percent of its net capital. Second, a broker/dealer that computes its net capital under the alternative standard has to give notice if its net capital falls below 5 percent of its aggregate debit items computed under the Reserve Formula. Third, a broker/dealer that computes its net capital under either standard is required to give notice if its total net capital declines below 120 percent of its minimum requirement.

Before, if any of these events occurred, a broker/dealer had to file a FOCUS report within 15 days after month end for three successive months. The amendments to the rule eliminate this filing requirement and replace it with a provision that requires a broker/dealer to give notice of any of these events within 24 hours of its occurrence. The SEC determined that the prompt notice requirement provides regulators with sufficient warning. Thereafter, any additional information necessary to monitor a broker/dealer's financial or operational condition may be requested by the DEA or the SEC.

Notification of Books and Records Deficiency

The amendments to the rule clarify the time within which a broker/ dealer must give notice if it fails to make and keep current its required books and records. Instead of requiring a broker/dealer to give notice "immediately," the rule now specifies that notice must be given the same day of the event.

Transmittal of Required Notices and Reports

The amended rule lets a broker/ dealer transmit any required notice by facsimile transmission or by telegraph. In addition, the reports regarding a books and records deficiency or a material inadequacy may be transmitted by overnight delivery.

References to Other Financial Responsibility Notice Requirements

The amended rule expands the list of references to the SEC's financial responsibility notice requirements to include all notice requirements contained in the net capital rule, the customer protection rule, and Rule 17a-5. This change does not add any additional reporting requirements; instead, it clarifies the references by including all pertinent ones rather than just some of them.

Other Amendments

The adopted amendments also include other changes. The structure of the rule has been reorganized and includes certain technical revisions.

In addition, because some paragraphs have been redesignated, the SEC had to make technical revisions to Rule 17a-5 that refer to paragraphs in Rule 17a-11.

One final amendment concerns Appendix D of the net capital rule. Currently Rule 15c3-1d prohibits a broker/dealer from entering into a temporary subordinated loan during any period in which the firm is subject to any of the reporting provisions of Rule 17a-11, including the period in which a broker/dealer had to file FOCUS reports, which requirement has now been eliminated.

Therefore, to prevent a broker/dealer from obtaining temporary subordinated loans during periods of financial or operational difficulties, the SEC is prohibiting a broker/ dealer from obtaining a temporary subordinated loan if it has given notice under Rule 17a-11 within the preceding 30 calendar days.

* * * * *

A copy of the SEC's release concerning the change to Rule 17a-11, which was published in the Federal Register, Volume 58, Number 132, for July 13, 1993, is attached for your review. If you have any questions, please call Derick Black, Compliance Department, at (202) 728-8225.

FEDERAL REGISTER

EFFECTIVE DATE: The amendments shall become effective on August 12, 1993.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, (202) 272-2904. Roger G. Coffin, (202) 272-7375. or Elizabeth K. King, (202) 272-3738. Division of Market Regulation, 450 Fifth Street. NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction
A. Background

Section 17(a) of the Exchange Act provides the Commission with the authority to promulgate rules requiring registered broker-dealers to make and transmit reports that the Commission deems necessary in the public interest or for the protection of investors. Pursuant to this authority, the Commission adopted Rule 17a-11 (the "Rule") in 1971.1 The Rule imposes a duty on broker-dealers to report net capital and other operational problems and to file reports regarding those problems within certain time periods. Although there have been minor revisions to the Rule since it was adopted, this is the first comprehensive examination of Rule 17a-11 in over 20 years. The Commission believes that the requirements to file FOCUS Reports may be eliminated without compromising the ability of the Commission or the Designated Examining Authorities ("DEAs") to monitor the condition of broker-dealers.
B. Proposal

On October 26.1992, the Commission proposed for comment amendments to Rule 17a-112 that, in part, would relieve broker-dealers of the obligation to furnish the Commission with Part II or Part HA of Form X-17A-5 ("FOCUS Report")3 when their net capital declines below certain levels. During the public comment period, the Commission authorized the Division to issue a no-action letter permitting the DEAs to waive the requirement to file a FOCUS Report as currently required by paragraphs (a) and (b) of Rule 17a-11. In response to its proposal to amend Rule 17a-11, the Commission received two comment letters, one from the National Association of Securities Dealers, Inc. (the "NASD"), and one from the Chicago Mercantile Exchange (the "CME"), both of which supported the proposed amendments. The Commission is adopting the proposed amendments in substantially the form as proposed.
II. Rule Amendments
A. Paragraph (a)

Currently, paragraph (a) of Rule Hall requires every broker-dealer whose net capital falls below its required minimum level, or whose total outstanding principal amounts of satisfactory subordination agreements exceed allowable levels for more than 90 days, to do two things. First, the broker-dealer must give notice of the event on that same day. Second, the broker-dealer must file a FOCUS Report within 24 hours of the notice.

The Commission is eliminating the requirement that broker-dealers file a FOCUS Report within 24 hours after notifying the Commission of a net capital deficiency. Broker-dealers will remain obligated to transmit notice of a net capital deficiency on the same day of the occurrence. Unlike the previous rule, however, the amendments require the notice to specify the broker-dealer's net capital requirement and its current amount of net capital.4 The amendments also require a broker-dealer who has been notified by the Commission or its DEA of a net capital deficiency to give notice of the deficiency, even if the broker-dealer disagrees with the Commission's or the DEA's determination. In such a case, the amendments permit the broker-dealer to specify the reasons for its disagreement in the notice.

The same-day notice requirement gives the Commission and the DEAs adequate early warning of financial or operational problems. After receiving notice of a capital deficiency, the Commission or a DEA will be able to increase its surveillance of a broker-dealer experiencing difficulty and to obtain any additional information necessary to assess the broker-dealer's financial condition.

The amendments also eliminate the notification requirement for broker-dealers whose total outstanding principal amounts of satisfactory subordination agreements exceed the maximum allowable for a period in excess of 90 days. A broker-dealer is currently required, pursuant to paragraph (c)(2) of Rule 15c3-1d, to give notice to its DEA if, after giving effect to all subordinated loans that are mature or which are scheduled to mature within six months, its net capital declines below the identical levels contained in paragraph (a) of Rule 17a-11. The Commission believes that the notice provided for in Rule 15c3-1d is sufficient to give regulators an early warning of problems involving a broker-dealer's subordinated loan agreements.
B. Paragraph (b)

Paragraph (b) of Rule 17a-11 currently requires every broker-dealer whose net capital does not equal or exceed a certain level to file a monthly FOCUS Report for at least three months. The capital level contained in paragraph (b) is higher than the minimum level referred to in paragraph (a), and is referred to as an "early warning level."5 When a broker-dealer's net capital level is declining, it would first trigger the filing requirements set forth in paragraph (b) of the Rule. If the broker-dealer's net capital continues to drop, and it falls below the broker-dealer's base minimum capital requirement, the broker-dealer would be required to comply with the additional FOCUS Report filing and notice requirements of paragraph (a) of the Rule.

The amendments to paragraph (b) of the Rule eliminate the requirement that a broker-dealer file a FOCUS Report within 15 days after the end of each month for three successive months. In lieu of this requirement, the amendments require brokers-dealers to give notice promptly (but within 24 hours) after the event triggering the filing requirement. The Commission expects that this notice requirement will be sufficient to alert the Commission and the broker-dealer's DEA that a broker-dealer, may be experiencing financial or operational difficulty.

Thereafter, the Commission or the DEA may require any additional information that it deems necessary to monitor the condition of the broker-dealer.

In their comment letters, both the NASD and the CME supported the proposed elimination of the reporting requirements. The NASD and the CME agreed that prompt notice by a broker-dealer experiencing financial or operational difficulties will provide its DEA with sufficient early warning to monitor the broker-dealer's condition.
C. Paragraph (b)(4)

The Commission is amending certain other paragraphs of Rule 17a-11. For example, there are references in paragraph (b)(4) of Rule 17a-11 to three existing notice provisions set forth in the net capital rule requiring broker-dealers subject to those provisions to give notice in accordance thereto. However, paragraph (b)(4) of Rule 17 a-11 does not reference all of the applicable net capital6 or customer protection rule7 notice provisions (such as the requirement to give notice of large withdrawals of capital under paragraph (e) of Rule 15c3-1), and the Commission believes it would be appropriate for the Rule to do so. Accordingly, the Commission is amending Rule 17a-11 to refer to five previously existing notice provisions contained in the net capital rule, the customer protection rule, and Rule 17a-5.

These amendments do not add any additional reporting burdens because they simply reference certain notice sections for clarification purposes and do not, by themselves, create an obligation to report. Additionally, the net capital rule, the customer protection rule and Rule 17a-5 will remain unchanged (with the exception of minor technical revisions to Rule 17a-5 and Rule 15c3-1d discussed below). Rather, the Rule will be clarified to contain a complete, rather than a partial, listing of the Commission's financial responsibility notice requirements.
D. Paragraph (c)

Under current paragraph (c) of Rule 17a-11, every broker-dealer is required to give notice immediately if it fails to make and keep current its required books and records. In order to clarify the time within which notice must be transmitted under paragraph (c) of the Rule, the amendments require notice to be provided the same day of the event.
E. Paragraph (f)

Paragraph (f) of the Rule (which will be redesignated as paragraph (g)) requires broker-dealers to give notice by telegraph and to transmit reports to the principal office of the Commission in Washington, DC, the regional office of the Commission for the region in which the broker-dealer has its principal place of business, and the broker-dealer's DEA. The amendments specify that notice required by the Rule may be given or transmitted by means of either a facsimile transmission or telegraph. The amendments also state that the report required by paragraph (c) or paragraph (d) of Rule 17a-11 may be transmitted by overnight delivery.
F. Other Amendments

The Commission is adopting amendments that reorganize the Rule 17a-11's structure and make certain technical revisions. For example, references in the current Rule to "his" will be changed to "its" in order to eliminate any gender-specific language.

In addition, because the amendments will redesignate the notice requirement currently contained in paragraph (f) of Rule 17a-11 to paragraph (g), certain sections of Rule 17a-5 that refer to paragraph (f) require technical modification. Accordingly, the Commission is adopting revisions to certain sections of Rule 17a-5 that would change the references to paragraph (f) of Rule 17a-11 to paragraph (g).

Finally, paragraph (c)(5)(i) of Rule 15c3-1d permits a broker-dealer to obtain temporary subordinated loans in certain circumstances in order to participate in activities such as securities underwritings. Currently. Rule 15c3-1d prohibits a broker-dealer from entering into a temporary subordinated loan during any period in which the broker-dealer is subject to "any of the reporting provisions" of Rule 17a-11.8 This provision was intended to cover the period in which a broker-dealer was required to file FOCUS reports under Rule 17a-11. which requirement is being eliminated by the Commission.

In order to retain the net capital rule's prohibition against a broker-dealer obtaining a temporary subordinated loan during a period of financial or operational difficulty, the Commission is making a technical amendment to paragraph (c)(5)(i) of Rule 15c3-1d. Based on a recommendation by the NASD, paragraph (c)(5)(i) is being amended to prohibit a broker-dealer from obtaining a temporary subordinated loan if it has given notice under Rule 17a-11 within the preceding thirty calendar days. This amendment will enable the DEAs to prevent a broker-dealer from obtaining temporary subordinated loans during periods in which the broker-dealer may be experiencing financial or operational difficulties.
III. Summary of Final Regulatory Flexibility Analysis

The Commission has prepared a Final Regulatory Flexibility Analysis (FRFA") in accordance with 5 U.S.C. 604 concerning the final rule amendments. The FRFA states that the Commission did not receive any comments concerning the Initial Regulatory Flexibility Analysis. A copy of the FRFA may be obtained by contacting Elizabeth K. King, Division of Market Regulation, U.S. Securities and Exchange Commission. 450 Fifth Street. NW., Washington. DC, 20549, (202) 272-3881.
IV. Statutory Analysis

Pursuant to the Securities Exchange Act of 1934 and particularly section 15 thereof, 15 U.S.C. 78o, the Commission is amending §§ 240.17a-11, 240.17a-5, and 15c3-1d of Title 17 of the Code of Federal Regulations in the manner set forth below.

List of Subjects in 17 CFR Part 240

Brokers, Confidential business information. Reporting and recordkeeping requirements. Securities.

Text of the Amendments

In accordance with the foregoing. Title 17, Chapter II of the Code of Federal Regulations is amended as follows:

PART 240-GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934

1. The authority citation for Part 240 continues to read in part as follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78l, 78m, 78n, 78o, 78p, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, and 80b-11, unless otherwise noted.

* * * * *
2. § 240.15c3-1d is amended by revising the second sentence of the introductory text of paragraph (c)(5)(i) to read as follows:

§ 240.15c3-1d Satisfactory Subordination Agreements (Appendix D to 17 CFR 240.15c3-1).

* * * * *
(c) * * *
(5) * * *
(i) * * * This temporary relief shall not apply to a broker or dealer if, within the preceding thirty calendar days, it has given notice pursuant to § 240.17a-11. or if immediately prior to entering into such subordination agreement, either:
* * * * *
2. § 240.17a-5 is amended by revising paragraph (c)(2)(iii) and revising the first three sentences of paragraph (h)(2) to read as follows:

§ 240.17a-5 Reports to be made by certain brokers and dealers.

* * * * *
(c) * * *
(2)* * *
(iii) If in connection with the most recent annual audit report pursuant to § 240.17a-5, the independent accountant commented on any material inadequacies in accordance with paragraphs (g) and (h) of this section, and § 240.17a-11(e), there shall be a statement by the broker or dealer that a copy of such report and comments is currently available for the customer's inspection at the principal office of the Commission in Washington, DC, and the regional office of the Commission for the region in which the broker or dealer has its principal place of business; and
* * * * *
(h) * * *
(2) If, during the course of the audit or interim work, the independent public accountant determines that any material inadequacies exist in the accounting system, internal accounting control, procedures for safeguarding securities, or as otherwise defined in paragraph (g)(3) of this section, then the independent public accountant shall call it to the attention of the chief financial officer of the broker or denier, who shall have a responsibility to inform the Commission and the designated examining authority by telegraphic or facsimile notice within 24 hours thereafter as set forth in § 240.17a-11 (e) and (g). The broker or dealer shall also furnish the accountant with a copy of said notice to the Commission by telegram or facsimile within said 24 hour period. If the accountant fails to receive such notice from the broker or dealer within said 24 hour period, or if the accountant disagrees with the statements contained in the notice of the broker or dealer, the accountant shall have a responsibility to inform the Commission and the designated examining authority by report of material inadequacy within 24 hours thereafter as set forth in §240.17a-11(g). * * *
* * * * *
4. By revising § 240.17a-11 to read as follows:

§240.17a-11 Notification provisions for brokers and dealers.
(a) This section shall apply to every broker or dealer registered with the Commission pursuant to section 15 of the Act.
(b) Every broker or dealer whose net capital declines below the minimum amount required pursuant to § 240.15c3-1 shall give notice of such deficiency that same day in accordance, with paragraph (g) of this section. The notice shall specify the broker or dealer's net capital requirement and its current amount of net capital. If a broker or dealer is informed by its designated examining authority or the Commission that it is, or has been, in violation of § 240.15c3-1 and the broker or dealer has not given notice of the capital deficiency under this § 240.17a-11, the broker or dealer, even if it does not agree that it is, or has been, in violation of § 240.15C3-1, shall give notice of the claimed deficiency, which notice may specify the broker's or dealer's reasons for its disagreement.
(c) Every broker or dealer shall send notice promptly (but within 24 hours) after the occurrence of the events specified in paragraphs (c)(l), (c)(2) or (c)(3) of this section in accordance with paragraph (g) of this section:
(1) If a computation made by a broker or dealer subject to the aggregate indebtedness standard of § 240.15c3-1 shows that its aggregate indebtedness is in excess of 1,200 percent of its net capital; or
(2) If a computation made by a broker or dealer, which has elected the alternative standard of § 240.15c3-1, shows that its net capital is less than 5 percent of aggregate debit items computed in accordance with § 240.15c3-3a Exhibit A: Formula for Determination Reserve Requirement of Brokers and Dealers under § 240.15c3-3; or
(3) If a computation made by a broker or dealer pursuant to § 240.15c3-1 shows that its total net capital is less than 120 percent of the broker or dealer's required minimum net capital.
(d) Every broker or dealer who fails to make and keep currant the books and records required by § 240.17a-3, shall give notice of this fact that same day in accordance with paragraph (g) of this section, specifying the books and records which have not been made or which are not current. The broker or dealer shall also transmit a report in accordance with paragraph (g) of this section within 48 hours of the notice stating what the broker or dealer has done or is doing to correct the situation.
(e) Whenever any broker or dealer discovers, or is notified by an independent public accountant, pursuant to § 240.17a-5(h)(2) of the existence of any material inadequacy as defined in § 240.17a-5(g), the broker or dealer shall:
(1) Give notice, in accordance with paragraph (g) of this section, of the material inadequacy within 24 hours of such discovery or notification; and
(2) Transmit a report in accordance with paragraph (g) of this section within 48 hours of the notice stating what the broker or dealer has done or is doing to correct the situation.
(f) Every national securities exchange or national securities association that learns that a member broker or dealer has failed to send notice or transmit a report as required by paragraphs (b), (c), (d), or (e) of this section, even after being advised by the securities exchange or the national securities association to send notice or transmit a report, shall immediately give notice of such failure in accordance with paragraph (g) of this section.
(g) Every notice or report required to be given or transmitted by this section shall be given or transmitted to the principal office of the Commission in Washington, D.C., the regional office of the Commission for the region in which the broker or dealer has its principal place of business, the designated examining authority of which such broker or dealer is a member, and the Commodity Futures Trading Commission if the broker or dealer is registered as a futures commission merchant with such Commission. For the purposes of this section, "notice" shall be given or transmitted by telegraphic notice or facsimile transmission. The report required by paragraphs (d) or (e)(2) of this section may be transmitted by overnight delivery.
(h) Other notice provisions relating to the Commission's financial responsibility or reporting rules are contained in § 240.15c3-1(a)(6)(iv)(B), §240.15c3-1(a)(6)(v), §240.15c3-1(a)(7)(iv), § 240.15c3-1(c)(2)(x)(B)(J), § 240.15c3-1(c)(2)(x)(F)(3), § 240.15c3-1(e), §240.15c3-1d(c)(2), §240.15c3-3(i) and § 240.17a-5(h)(2).

Dated: July 7, 1993.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 93-16480 Filed 7-12-93; 8:45 am)

BILLING CODE 8010-01-M


1 Securities Exchange Act Release No. 9268 (July 30, 1971), 38 FR 14725 (Aug. 11, 1971).

2 Securities Exchange Act Release No. 31155 (Oct. 26, 1992), 57 FR 49156 (Oct. 30, 1992).

3 FOCUS Reports contain schedules including the broker-dealer's: net capital: assets and liabilities; and income and expenses. Generally. Part IIA is filed by broker-dealers that do not clear or carry customer accounts, and those broker-dealers that are subject to the requirements of paragraphs (a)(2) and (a)(3) of Rule 15C3-1. Part II is filed by all other broker-dealers engaged in a general securities business and subject to paragraph (a)(l) of Rule 15c3-1.

4 Many of the notices received by the Commission already contain this information. The Commission believes it would be appropriate, however, to specify the contents of the notice in the Rule to standardize the notices received.

5 There are three early warning levels. First, a broker-dealer that has elected to compute its net capital under the basic method must give notice if its aggregate indebtedness, as defined in Rule 15c3-1, exceeds 1,200 percent of its net capital. Second, a broker-dealer that computes its net capital under the alternative standard is required to give notice if its net capital falls below 5 percent of its aggregate debit items computed in accordance with the Formula for Determination of Reserve Requirement for Brokers and Dealers under Rule 15c3-3. Third, a broker-dealer that computes its net capital under either standard is required to give notice if its total net capital declines below 120 percent of its minimum requirement. If a broker-dealer falls out of net capital compliance, it must comply with both paragraphs (a) and (b) of Rule 17a-11.

6 Rule 15c3-1 (17 CFR 240.15c3-1).

7 17 CFR 240.15c3-3.

8 17 CFR 240.15c3-1d(c)(5)(i).


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