Monday, October 31, 2011

PCAOB Chair Examines Board Broker-Dealer Audit Oversight, Hints that Introducing Brokers May Be Exempted

The PCAOB will use an open and transparent process to develop professional standards and inspection programs to implement Dodd-Frank provisions authorizing Board oversight of firms performing the audits of brokers and dealers registered with the SEC, said PCAOB Chair James Doty. In remarks at the AICPA/SIFMA national conference on the securities industry, the Chair said the Board’s goal is to create programs with real value for investors and customer of broker-dealers, and that reinforce the integrity of the capital markets.

He said that the Board intends to gather information from industry professionals and their auditors so as to act with intelligence and knowledge, not simply on instinct. The information will be obtained through the Board’s temporary inspection program and broker-dealer small business forums, as well as by meetings with representatives of various organizations representing broker-dealers and their auditors, meetings with other regulators, and participation in conferences.

While Dodd-Frank charged the PCAOB with creating an inspection program for the audits of brokers and dealers, the legislation did not mandate a specific program of inspection for these audits, thus giving the PCAOB discretion to determine the specific elements of an inspection program. Recently, the Board adopted and the SEC approved a temporary rule establishing an interim inspection program for auditors of brokers and dealers. Chairman Doty noted that the Board's interim program will be used to learn about the auditors conducting audits of differing types of brokers and dealers.

More specifically, the Board's goal in the interim inspection program will be to gather information that will be used as the basis to inform the Board's consideration of a permanent inspection program. The Board will focus on gaining a greater understanding of the potential benefits to investors and potential cost and regulatory burdens. He stressed that providing programs that add value for investors and account holders means that the benefits of Board programs should exceed the regulatory costs. With this information, the Board will put itself in the best position to determine how to structure the scope of a permanent inspection regime, including whether to differentiate between different classes of brokers and dealers and how frequently auditors should be inspected.

Acknowledging concerns about the scope of the interim program, the PCAOB Chair cautioned the industry not to assume that the inclusive nature of the interim inspection program translates to the likely scope of the permanent program. The Board is not suggesting that every broker or dealer auditor will be inspected as part of the interim program. Indeed, the Board expects to be able to gather most of the information without having to inspect the majority of firms during the interim program.

The Board will consider whether there should be exemptions to the permanent program. While Congress made a deliberate decision not to exempt any class of broker-dealer auditor from Board oversight, noted the Chair, the Board, armed with information gained through the interim inspection program, may be able to focus on areas where oversight would provide the greatest investor protection. In particular, the Board will consider whether to exclude introducing brokers and dealers, which do not generally maintain customer cash and securities, from the permanent inspection program.

The Chair added that, while the risks presented to account holders by the activities of introducing brokers and dealers may be lower than those presented by carrying or clearing brokers and dealers, risks do exist. The interim program, outreach efforts and research have already confirmed that introducing brokers and dealers are not a uniform population. They have a wide variety of business lines and practices, he said, representing varying degrees of risk to their underlying account holders and investors.

Thus, Chairman Doty said that the Board will carefully consider these risks in determining the scope of the permanent inspection program. The PCAOB will also continue to consult with the SEC, FINRA, and the Securities Investor Protection Corporation in order to consider the role of auditor regulation against the backdrop of direct regulation over brokers and dealers.
The interim inspection program will be a key part of gaining understanding of he risks presented by all classes of brokers and dealers against the effectiveness and costs of PCAOB oversight. More broadly, the interim inspection program will provide transparency into what the Board is finding in its interim inspections.

However, unlike the inspection reports of auditors of public companies, the interim inspection program for auditors of brokers and dealers will not initially include firm-specific inspection reports. Instead, the Board will annually publish reports on the interim program and what its inspectors are finding. The Board will not issue firm-specific reports until inspection work is performed under the permanent program, which is not imminent. In fact, Chairman Doty said that decisions about the permanent inspection program are at least a year away. Meanwhile, there will be ample opportunity for the public to learn what the Board is finding in the interim program and to participate in the decision process.

However, the PCAOB Chair emphasized that any significant audit issues identified in the interim program should be promptly addressed by the inspected brokerage firm. In egregious cases, he continued, the Board may initiate disciplinary actions or refer information about potential broker-dealer violations to the SEC or FINRA.
He also noted that PCAOB staff is working on "Day 1 Guidance" to assist auditors in the transition from AICPA to PCAOB standards. This guidance will summarize the requirements of the new attestation and review standards, provide practical implementation guidance, and help auditors gain a greater understanding of the expectations for handling audit and other issues common to brokers and dealers.

On a separate issue, he reminded that the Board's oversight and standards generally do not cover the audit work performed in connection with the client-asset-custody arrangements of investment advisers. These arrangements are governed by SEC rules. While certain investment advisers are required to have reports prepared by auditors registered with the Board, he noted, neither Sarbanes-Oxley nor Dodd-Frank authorizes the Board to exercise oversight over those audits.

In some cases brokers and dealers are also investment advisers, he pointed out, and in some cases investment advisers use particular broker-dealers to maintain custody of their customer assets. In those situations, the Board's oversight responsibilities would extend to the audits of the respective broker-dealer functions. However, the Chair emphasized that the Board is not authorized to directly oversee the audits of investment advisers or their investor protection procedures.

Finally, turning to funding, the Chair said that the largest source of funding for the PCAOB's broker oversight regime comes from the companies whose financial statements must be audited by PCAOB-registered firms. Section 109 of the Sarbanes-Oxley Act, as originally enacted, provided that funds to cover the PCAOB annual budget, less registration and annual fees paid by registered public accounting firms, would be collected from issuers based on each issuer's relative average monthly equity market capitalization. The amount due from issuers is referred to as the accounting support fee.

As amended by the Dodd-Frank Act, Section 109 now requires the Board to allocate respective portions of its accounting support fee among issuers and broker-dealers and allows for differentiation among classes of issuers and brokers and dealers. In establishing rules on the allocation of the accounting support fee between issuers and broker-dealers, the Board was guided by two overarching principles. First, the fee must be allocated in a manner reflecting the proportionate sizes of issuers, brokers and dealers. Second, the fee must be allocated in an equitable manner.

Under the Board's funding rules, brokers and dealers will be allocated a portion of the broker-dealer accounting support fee based on their average, quarterly tentative net capital. Generally, brokers and dealers with average, quarterly tentative net capital of greater than $5 million may be assessed a share of the fee. According to the PCAOB head, this means that the vast majority of broker-dealers will not be assessed any portion of the accounting support fee whatsoever. He added that the Board expects that the initial allocation and assessment of the accounting support fee for brokers and dealers will take place by the end of 2011.

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