Jonathan Katz, Secretary
Re: Proposed Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, File No. S7-21-03
To the Commissioners:
I am pleased to submit this comment letter on the above-captioned rule proposal. I was previously the Commission's Assistant General Counsel for Market Regulation during the consideration of several bills which led to the Gramm Leach Bliley Act, and later I was General Counsel for a major national broker-dealer which was part of one of the first financial holding companies under the Gramm Leach Bliley Act. I submit this comment letter solely on my on behalf, and not on behalf of any client, my law firm, or any partners or associates at my law firm.
I write to make a basic point about this proposal: it is not authorized by any statute, and indeed is directly contrary to Congress' expressed intentions in the Gramm Leach Bliley Act. In this proposal, the Commission suggests establishing "voluntary" consolidated supervision over financial holding companies with both broker-dealer subsidiaries and insured depository subsidiaries. There is one and only one federal statute that permits the Commission to exercise consolidated supervision over any financial holding company structure: Section 231 of the Gramm Leach Bliley Act.1 But Section 231(a)(2)(i)(1) could not be more plain: it does not authorize the Commission to exercise consolidated supervision - voluntary or not - over any holding company that includes a federally insured bank, a federally insured savings association, or a foreign bank. The Commission has legislative authorization to establish consolidated supervision only over a holding company that does not have any federally insured depository institutions. The Commission is a creature of statute, and does not have common law authority to establish programs not authorized by federal law. In the absence of a duly enacted statute giving the SEC authority to exercise consolidated supervision over a specific type of entity, it may not do so. Congress has not given the SEC authority to exercise consolidated supervision, as it proposes to do here, over financial holding companies with insured depository subsidiaries.
What the current Commissioners (none of whom were in office during the consideration of the Gramm Leach Bliley Act) may not be aware is that Section 231 was a heavily negotiated provision in the statute. The Commission staff repeatedly sought to convince Congress to loosen the restrictions of what became Section 231. The staff made, and Congress rejected, exactly the policy argument contained in the proposing release here - that the insolvency of Drexel Burnham Lambert demonstrated that risks at the holding company level could affect the integrity of a Commission-regulated broker-dealer. The staff argued that since consolidated supervision in any event would be voluntary, there could be no harm in giving holding companies containing insured depository institutions the choice of having the SEC as a consolidated supervisor. The arguments by the Commission staff were vigorously opposed by the banking industry and the banking regulators. And Congress consciously rejected the arguments of the Commission staff when Congress adopted Section 231.
Congress made a series of related policy decisions in the Gramm Leach Bliley Act. Congress decided that the SEC would serve as a functional regulator with responsibility over broker-dealers, investment advisers and mutual funds. Congress decided that the federal banking regulators similarly would be functional regulators for banking activities. As a result, Congess decided that securities-related activities would be "pushed out" of banks and savings associations into broker-dealers and investment advisers where the SEC could examine them.2 After considering the very different aims and methods of banking examiners and SEC examiners, Congress decided not to allow SEC examiners to have oversight of insured depository institutions. And Congress decided that the Federal Reserve Board, and only the Federal Reserve Board, would have consolidated oversight of holding companies that contain both broker-dealers and insured depository institutions. The Commission was given the opportunity to exercise voluntary consolidated supervision only over investment bank holding companies, a term clearly defined to include only holding companies that contain broker-dealers but not insured depository institution subsidiaries.3 The Commission staff is well aware of this distinction, and this is why the Commission's companion proposal, concerning investment bank holding companies as defined under the Gramm Leach Bliley Act, is careful only to cover holding companies without any insured depository institution subsidiaries.4
In sum, this proposal is an impermissible attempt to use the net capital regulations to evade the carefully considered policy choices made by Congress when it adopted the Gramm Leach Bliley Act. The Commission staff is attempting to achieve indirectly exactly what the statute forbade the Commission from achieving directly - the ability to exercise consolidated supervision of holding companies including insured depository institutions. But the Commission simply does not have legal authority to take this step.5 The net capital provisions of the Exchange Act give the Commission the authority to regulate the net capital of broker-dealers. They do not give the Commission authority to regulate holding companies of broker-dealers or affiliates of broker-dealers. The first day that the Commission sends an examiner into an insured depository institution subsidiary - even of a holding company that has voluntarily consented to SEC consolidated supervision - it will be acting outside the scope of any statutory authorization and indeed directly contrary to Congress' intent. It is a cardinal principle of federal jurisdiction that a party's consent may not create federal jurisdiction in the absence of any statutory authority granting that jurisdiction. The proposed regulation puts financial holding companies to a choice Congress intended they should never have to make: either submit to Commission supervision both at the holding company level and of their insured depository institution subsidiaries, or suffer the competitive harm of having a higher net capital requirement for their broker-dealer subsidiaries. The proposed regulation gives financial holding companies no benefit (and no regulatory incentive) for using even the most state-of-the-art risk management procedures, unless they are willing to be subject to duplicative and possibly inconsistent regulation by both the Commission and functional banking regulators.
The concept in the proposing release of being "primarily in the insured depository institutions business" illustrates many of the problems of the proposed rule. For a holding company that is "primarily in the insured depository institutions business", the Commission would defer to the banking agency's regulation of its insured depository institutions; but for a holding company that is not "primarily in the insured depository institutions business", the Commission would examine the depository institution subsidiaries as part of its consolidated supervision of the holding company. First, the concept of "primarily in the insured depository institutions business" is not contained in or authorized by any federal statute; it is completely divorced from any statutory text. This fact underscores the fact that the Commission is pursuing this proposed regulation without any legal authority to do so. Second, the significance of the distinction is that it contemplates having the Commission do something that Congress explicitly decided in the Gramm Leach Bliley Act that it should never do: examine federally insured depository institutions. Third, it puts holding companies that are not "primarily in the insured depository institutions business" at a competitive disadvantage, because (unlike holding companies that are "primarily in the insured depository institutions business,") their insured depository institutions will be subject to expensive, duplicative and potentially inconsistent examinations by both the Commission and their functional banking regulator. Finally, the critical term "primarily in the insured depository institutions business" is not defined at all in the proposed regulation. How is "primarily in the insured depository institutions business" to be determined? By assets? By revenues? By net income? By intuition? By divining rod? The proposing release gives no indication. The definition of such a critical term should be determined after public notice and comment, not by the administrative fiat of agency staff.
Even apart from the legal objections to the proposed regulation, there is also a substantial policy problem with the proposal. If there is any lesson for the Commission in the current mutual fund scandal, it is that the Commission (even with the increase in staff after the Sarbanes-Oxley Act) has insufficient examination staff for its current mission of overseeing all registered broker-dealers, SROs, investment advisers, mutual funds, transfer agents and related regulated entities. We have very recently seen the harm of having the Commission staff examine mutual funds and investment advisers only every five to seven years. Even if it were legally authorized to do so, the Commission should not dilute its examination program at this time by taking on the examination of insured depository subsidiaries of financial holding companies - especially where those financial holding companies already have consolidated supervision by the Federal Reserve Board, and the insured depository institutions are examined by their functional banking regulator. The Commission should prioritize its mission and focus on the tasks actually assigned by Congress before taking on the substantial new burdens envisioned in this proposed rule.
The SEC rightly insists that regulated entities adhere strictly to all the laws and regulations to which they are subject. However, the same principle applies with at least equal weight to the Commission itself. Congress made a considered judgment in the Gramm Leach Bliley Act that the SEC should exercise voluntary consolidated supervision only over a specific subset of holding companies - those without insured depository institutions as subsidiaries. If the Commission believes it is important that it should be able to exercise consolidated supervision over financial holding companies with both broker-dealers and insured depository institutions, it should do what it could not do at the time of the Gramm Leach Bliley Act - convince Congress to give it that authority. The Commission cannot and should not attempt to end-run the Gramm Leach Bliley Act and exercise authority it has never been given, and therefore the Commission should not adopt this proposed rule.
W. Hardy Callcott