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SECURITIES INVESTOR PROTECTION CORPORATION MODERNIZATION TASK FORCE Audit Responsibilities of Broker-Dealers, Related Actions, and Proposed Rule Change June 2010 This paper provides an overview of (i) the audit responsibilities of securities broker-dealers pursuant to federal law and rules; (ii) causes of action related thereto in liquidation proceedings under the Securities Investor Protection Act, 15 U.S.C. §78aaa et seq. (“SIPA”); and (iii) a proposal to change a related Rule of the Securities and Exchange Commission (“SEC” or “Commission”) I. Broker-Dealer Audit Responsibilities For more than sixty years, by means of its Rule 17a-5, 17 C.F.R. §240.17a-5, the SEC has required the independent public accountant to make written representations in its audit report 1designed to safeguard customers’ securities. Toward that end, the accountant must perform an “examination of accountabilities and responsibilities of a firm resulting in a report to regulatory 2bodies concerning that firm’s fiduciary obligations to customers.” The information is filed with the Commission and the securities self-regulatory organizations. The information provides these authorities “with a sufficiently early warning to enable them to take appropriate action to protect 3investors before the financial collapse of the particular broker-dealer involved.” 1 See Exchange Act Release No. 3338, 7 Fed. Reg. 9917 (Dec. 1, ...
Voir
SECURITIES INVESTOR PROTECTION CORPORATION
MODERNIZATION TASK FORCE
Audit Responsibilities of Broker-Dealers, Related Actions, and Proposed Rule Change
June 2010
This paper provides an overview of (i) the audit responsibilities of securities broker-
dealers pursuant to federal law and rules; (ii) causes of action related thereto in liquidation
proceedings under the Securities Investor Protection Act, 15 U.S.C. §78aaa
et seq.
(“SIPA”); and
(iii) a proposal to change a related Rule of the Securities and Exchange Commission (“SEC” or
“Commission”)
I.
Broker-Dealer Audit Responsibilities
For more than sixty years, by means of its Rule 17a-5, 17 C.F.R. §240.17a-5, the SEC
has required the independent public accountant to make written representations in its audit report
designed to safeguard customers’ securities.
1
Toward that end, the accountant must perform an
“examination of accountabilities and responsibilities of a firm resulting in a report to regulatory
bodies concerning that firm’s fiduciary obligations to customers.”
2
The information is filed with
the Commission and the securities self-regulatory organizations.
The information provides these
authorities “with a sufficiently early warning to enable them to take appropriate action to protect
investors before the financial collapse of the particular broker-dealer involved.”
3
1
See
Exchange Act Release No. 3338, 7 Fed. Reg. 9917 (Dec. 1, 1942)
2
See
SEC,
Study of Unsafe and Unsound Practices of Broker-Dealers
(“SEC Study”), H.R. Doc.
No. 92-231, at 152 (1971).
3
Touche Ross & Co. v. Redington,
442 U.S. 560, 570 (1979) (footnote omitted)
The written reporting responsibilities of accountants auditing brokerage firms have
continually been refined in order to provide better protection for the investing public.
In the
1960s, the Commission began to require accountants to identify any material inadequacies
discovered in broker-dealers’ accounting systems, internal accounting controls and procedures
for safekeeping of customer property, and to report corrective action.
4
The 1969-1970 crisis in the brokerage industry, intensified, in part, by auditing and
reporting deficiencies, signaled a need for heightened financial responsibility requirements.
5
In
1970, SIPA was enacted, among other things, to “restore investor confidence in the capital
markets, and upgrade the financial responsibility requirements for registered brokers and
dealers.”
6
One purpose of SIPA was “to protect the public customer of securities dealers from
suffering the consequences of financial instability in the brokerage industry.”
7
In addition to
providing for a specialized liquidation proceeding to facilitate the prompt return of funds and
securities to customers of financially troubled broker-dealers, SIPA required the Commission to
identify and eliminate unsafe and unsound practices of broker-dealers.
8
4
Exchange Act Release No. 34-8172, 32 Fed. Reg. 14018 (Oct. 10, 1967); Rules 17a-5(g)(3) and
(h)(2), 17 C.F.R. §§240.17a-5(g)(3) and (h)(2)
5
SEC Study,
supra
at 25
6
SIPC v. Barbour,
421 U.S. 412, 415 (1975) (
citing
S. Rep. No. 91-1218 at 2-4 (1970); H. R.
Rep. No. 91-1613, at 2-4 (1970),
reprinted in
1970 U.S.C.C.A.N. 5254) (hereinafter “SIPA’s
Legislative History”)
7
SEC v. F.O. Baroff Co.,
497 F.2d 280, 281 (2d Cir. 1974).
See also SEC v. Packer, Wilbur &
Co.,
498 F.2d 978, 980 (2d Cir. 1974) (SIPA “was a legislative effort to reinforce the flagging
confidence in the securities market by providing an extra margin of protection for the small
investor).
8
SIPA §78kkk(g)
2
From SIPA there followed two measures to upgrade broker-dealers’ financial
responsibility requirements: (1) a tightening of the Commission’s net capital requirements;
9
and
(2) the adoption by the Commission of a customer reserve requirement.
10
Taken together, these
rules are “necessary to a comprehensive program of investor protection consistent not only with
the express congressional intent but with the high standards of financial responsibility which
must prevail in the brokerage community.”
11
The rules serve the objective of SIPA “that
customer funds and securities not be exposed to risk of loss through broker-dealer insolvency.”
12
SIPA specifies that a broker-dealer’s lack of compliance with either requirement, or the mere
inability to make such computations as may be necessary to show compliance, is grounds to
liquidate the broker-dealer.
13
The certified audit of a broker-dealer by the independent public accountant includes, as a
primary purpose, compliance with these upgraded financial responsibility requirements.
Following the brokerage industry crisis that led to enactment of SIPA, the Committee on Stock
Brokerage Accounting and Auditing of the American Institute of Certified Public Accountants
(“AICPA”) revised the booklet that guides accountants in their audits of broker-dealers (the
9
17 C.F.R. §240.15c3-1.
This “Net Capital Rule” has consistently been recognized as “one of
the most important weapons in the Commission’s arsenal to protect investors.”
See, e.g., Blaise
D’Antoni & Assocs., Inc. v. SEC
, 289 F.2d 276, 277 (5
th
Cir. 1961),
cert. den
., 368 U.S. 899.
10
17 C.F.R. §240.15c3-3.
This “Customer Protection Rule” is considered to be “the most
comprehensive protection of customers’ funds and securities.”
Exchange Act Release No. 34-
9622, 37 Fed. Reg. 11,687 (June 10, 1972).
See also
Exchange Act Release No. 34-9856, 37
Fed. Reg. 25,224 (Nov. 29, 1972).
11
37 Fed. Reg. at 25,225
12
Id.,
37 Fed. Reg
.
at 25,225
13
SIPA §78eee(b)(1)(C) and (D)
3
“Audit Guide”).
14
The Audit Guide describes the regulatory context in which accountants
perform their audits of broker-dealers and alerts accountants to the losses that customers may
suffer in the event the financial responsibility rules are violated.
15
As the Commission has noted,
this “extensive and detailed” audit, combined with the accountant’s report on the broker-dealer’s
system of internal controls, is intended to enhance the safeguards for customers who entrust
property to broker-dealers.
16
Thus, the purpose of the accountant’s audit report is closely linked to the purposes of
SIPA.
Both are intended to enhance a broker-dealer’s financial responsibilities and to provide
greater protection to customers.
The accountant’s audit report includes detailed information
regarding the Net Capital Rule and Customer Protection Rule.
Non-compliance with these Rules
requires the Commission to inform SIPC for the benefit of customers.
17
II.
Related Litigation in SIPA Liquidation Proceedings
Since 1996, SIPC and/or SIPA trustees, have taken action against accounting firms based
on the firms’ audit responsibilities in six liquidation proceedings.
Settlements were reached
14
The booklet, then entitled “Audits of Brokers and Dealers in Securities,” was first published in
1956.
15
See
AICPA, Audit & Accounting Guide – Brokers & Dealers in Securities §§1.41-1.44, 3.01-
3.118
16
SEC Study,
supra
at 152
17
The Commission and the broker-dealer’s self-regulatory organization are obligated under
SIPA to alert the Securities Investor Protection Corporation (“SIPC”) if they learn from an
accountant, or otherwise, that a broker-dealer is in, or approaching, financial difficulty.
See
SIPA §78eee(a)(1) (“If the Commission or any self-regulatory organization is aware of facts
which lead it to believe that any broker or dealer subject to its regulation is in or is approaching
financial difficulty, it shall immediately notify SIPC …”) (emphasis added).
4
regarding the actions in three of those liquidation proceedings.
18
A brief description of the
litigation in the other three matters follows.
In
SIPC v. BDO Seidman (In re A.R. Baron & Co., Inc.)
, 245 F.3d 174 (2d Cir. 2001), on
an appeal from the U.S. District Court for the Southern District of New York, the Second Circuit
certified two questions to New York’s highest court, the New York Court of Appeals, to
determine liability under New York law for fraudulent misrepresentation, and negligent
misrepresentation.
The Court of Appeals held that the defendant accountants could not be held
liable to SIPC under New York law.
Regarding the fraudulent misrepresentation claim, the Court held that SIPC could not
“sustain a cause of action for fraud if Defendant’s misrepresentation did not form the basis of
reliance,” and “SIPC relied to its detriment on the implication of the NASD’s silence, not on
representations from BDO.”
245 F.3d at 180.
As the Court explained, “[t]he inescapable
conclusion from the complaint’s reference to the reporting rules and the regulatory ‘early
warning system’ is that the NASD had a significant role in choosing what information it wanted
to receive and, in addition, what it deemed worthy of communicating.”
Id
.
Therefore, the Court
further explained, “the reporting system on which SIPC relied put too much discretion in the
hands of the NASD for SIPC to be able to claim any significant direct reliance on BDO.”
Id
.
As for the negligent misrepresentation claim, the Court held that “there was no ‘linking
conduct’ that put SIPC and BDO in a relationship approaching privity.”
Thus, the complaint
failed to satisfy the third prong of the professional liability test set forth in
Credit Alliance Corp.
v. Arthur Andersen & Co.
, 65 N.Y.2d 536, 493 N.Y.S.2d 435 (1985).
18
The three liquidation proceedings were (1)
R.D. Kushnir & Co.
; (2)
Rocky Mountain Securities
and Investments, Inc.
; and (3)
NEBS Financial Services, Inc.
5
In
SIPC v. Munninghoff Lange & Co. (In re Donahue Securities, Inc.)
, Adv. No. 02-1179,
2004 WL 3152763 (Bankr. S.D. Ohio Nov. 23, 2004), the Bankruptcy Court granted the
defendant accounting firm’s motion to dismiss, finding that SIPC could not prove that it relied on
the defendants’ audit.
The court essentially followed the decision in
SIPC v. BDO Seidman
,
finding that decision to be “thorough and well-reasoned,”
id.
at *8, and held that “[t]he intended
effect of a federal regulatory scheme is completely irrelevant to the issue of whether a party to
that scheme can sustain its burden of proof on the reliance element of a state law action.”
Id
. at
*4.
In
SIPC v. Cheshier & Fuller (In re Sunpoint Sec., Inc.)
, 377 B.R. 513 (Bankr. E.D. Tex.
2007),
aff’d
, 2008 WL 5122122 (E.D. Tex. 2008), the Bankruptcy Court also concluded that
SIPC could not sustain on its own behalf a cause of action against accountants for the brokerage
firm.
Regarding the cause of action for professional negligence (malpractice), the court held that
“[Cheshier & Fuller (“C&F”)] did not owe a duty to SIPC or the Sunpoint customers to exercise
that degree of care, skill and diligence required to be exercised by reasonably prudent certified
public accountants and auditors ....”
377 B.R. at 557.
Regarding the cause of action for negligent misrepresentation, the court held that “SIPC
is not within the limited group entitled to rely on C&F statements, because C&F was not aware
that SIPC would receive such statements.”
377 B.R. at 559.
“SIPC cannot recover without proof
that it actually relied on the misstatements of C&F.”
377 B.R. at 560.
The court further held: “Neither may SIPC substitute the reliance of the NASD for its
own.
The existence of a regulatory structure is not a surrogate for actual reliance in the context
of a state law action for negligent misrepresentation.”
377 B.R. at 561, citing
SIPC v. BDO
Seidman
.
“Because SIPC was never aware of the contents of the audit reports, it cannot
6
demonstrate that it justifiably relied on any statement made by the auditors in those reports, and
it cannot recover against C&F upon a theory of negligent misrepresentation.”
377 B.R. at 561.
III.
Proposal to Change Applicable SEC Rule
Presently, SEC Rule 17a-5(d)(6), 17 C.F.R. §240.17a-5(d)(6), provides that the audit
report is to be filed with the Commission in Washington, D.C., the Commission’s office in the
broker-dealer’s region, and the principal office of the broker-dealer’s designated examining
authority.
While the report is thus available for regulators’ use in monitoring the broker-dealer’s
financial health,
19
the report is not provided to SIPC even though it ultimately may trigger the
start of a liquidation proceeding.
Against this background, SIPC has proposed changing SEC Rule 17a-5(d)(6) to require
that the audit reports also be filed with SIPC.
20
Including SIPC as a designated recipient would
further the goal of investor protection by providing another layer of review of the report by the
organization directly affected by its contents.
In addition, including SIPC as a recipient would
help to address the persistent concern that any signs of “financial weakness, as by non-
compliance with net capital requirements or otherwise, [be] watched very carefully and followed
19
See
Rule 17a-5(e)(3)
20
The proposed rule change would revise SEC Rule 17a-5(d)(6) to add SIPC as a designated
entity to receive a copy of the annual audit report filed with the Commission.
The rule is set
forth below, and the proposed revision is italicized.
The annual audit report shall be filed at the regional office of the
Commission for the region in which the broker or dealer has its principal
place of business, the Commission's principal office in Washington, D.C.,
and the principal office of the designated examining authority for said
broker or dealer.
Copies thereof shall be provided to all self-regulatory
organizations of which said broker or dealer is a member,
and to the
Securities Investor Protection Corporation ("SIPC")
.
The addition of SIPC to Rule 17a-5(d)(6) would require a technical amendment to SEC
Rule 17a-5(e)(4), 17 C.F.R. §240.17a-5(e)(4), striking the reference to the "Securities Investor
Protection Corporation," and substituting "SIPC" in its place.
7
8
up” in order to augment the financial responsibility requirements SIPA was intended to enhance,
and to provide greater investor protection.
21
21
SEC Study,
supra
at 25
