BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
FEDERAL DEPOSIT INSURANCE CORPORATION
OFFICE OF THE COMPTROLLER OF THE CURRENCY
December 10, 2002
BY E-MAIL AND HAND DELIVERY
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 5th Street, NW
Washington, D.C. 20549-0609
Re: File No. S7-41-02-Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934 ("Proposed Rules")
Dear Mr. Katz:
The Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency ("Banking Agencies") appreciate the opportunity to comment on the Proposed Rules issued by the Securities and Exchange Commission ("SEC" or "Commission") on October 30, 2002.1 Both the Proposed Rules and the interim final rules they modify2 seek to implement the bank exceptions to the definitions of "broker" and "dealer" in sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934 ("Exchange Act"), as amended by the Gramm-Leach-Bliley Act ("GLB Act").
We appreciate the efforts of the Commission and its staff reflected in the Proposed Rules, as well as the opportunity provided our staffs to discuss how the "dealer" provisions of the Interim Final Rules would disrupt the traditional activities and customer relationships of banks that Congress sought to protect. Although the Proposed Rules address a number of the concerns that our Agencies raised in connection with the "dealer" portions of the Interim Final Rules, we do have several remaining concerns.
We continue to believe that it is important for the Commission to clarify, before any final rules under the GLB Act are adopted, that a bank that has attempted in good faith to comply with the GLB Act's activity-focused exceptions will not be considered a broker-dealer if the bank finds that some of its securities transactions do not comply with an exception due to inadvertent errors or unforeseen circumstances. The Commission recently proposed a similar type of regulatory "safe harbor" in another rulemaking under the Exchange Act, and we believe such an approach is particularly appropriate in this area given the potential serious disruptions that minor and inadvertent infractions may have on banks and their customers.
In addition, we believe that the Act's "broker" and "dealer" exceptions and any rules implementing these exceptions should become effective at the same time. Simultaneous implementation of the Act's "broker" and "dealer" provisions will significantly reduce the disruptions that banks and their customers will face as the industry transitions to the Act's activity-focused exceptions.
Our views on these matters, as well as our concerns with the Proposed Rules' provisions relating to the securities lending and asset-backed securities activities of banks, are discussed in greater detail below.
I. Need for An Effective "Cure" or Leeway Period for Banks that Attempt in Good Faith to Comply with the GLB Act's Requirements
The Banking Agencies continue to believe that the Commission should clarify that a bank that has attempted in good faith to comply with the GLB Act's activity-focused exceptions will not be considered a "broker" or "dealer" if the bank finds that some of its securities transactions do not comply with an exception due to inadvertent errors or unforeseen circumstances. We expressed our views on this matter in our comment letter on the Interim Final Rules,3 and this issue remains a substantial concern. We believe it is important for the Commission to clarify this matter before any rules implementing the GLB Act's "broker" or "dealer" exceptions for banks become effective. Otherwise, banks that take reasonable steps and attempt in good faith to comply with the exceptions may incur substantial, unnecessary costs and suffer unduly harsh and inappropriate consequences from minor infractions.
In this regard, the Commission's rules appear to contemplate that a bank would be considered a broker-dealer if it engaged in a single securities transaction that did not comply with the bank exceptions in the GLB Act. It is to be expected, however, that banks that are attempting to conform their securities activities to the Act's exceptions will identify some transactions that do not meet the terms of an exception due to the complexity of the rules or an inadvertent error. For example, it is entirely conceivable that a bank actively engaged in selling equity derivative products may find that, despite the existence of strong internal controls and compliance procedures, a single purchaser of such products did not, in fact, meet the qualified investor requirements of the Act.4 The Rules also require banks to calculate their compliance with some exceptions or exemptions based on the bank's activities throughout an entire year. In these cases, the bank may not be able to confirm that a transaction is exempt at the time it occurs and an inadvertent error at year-end would appear to cause the bank to lose its exception for the entire year.5
Without a regulatory "safe harbor," such inadvertent and minor infractions could have significant adverse consequences for the bank and its customers. For example, a single nonconforming transaction would appear to require a bank to immediately restructure its operations and customer relationships and register with the SEC as a broker-dealer. Moreover, the minor infraction would subject the bank to SEC enforcement action and, after January 1, 2003, private suits for rescission of any securities contracts entered into by the bank after the infraction occurred. These potential disruptions and liabilities may be particularly severe in cases where a single nonconforming transaction late in a year (e.g. a riskless principal transaction) would appear to cause the bank to lose its exception retroactive to the beginning of the year.
Accordingly, we believe the Commission should clarify that a bank that attempts in good faith to conduct its securities activities in conformance with the bank exceptions, and that has in place policies and procedures reasonably designed to ensure compliance with the exceptions, will-
- Not be considered a broker-dealer if some of its securities transactions do not meet the terms of an exception due to an inadvertent error or unforeseen circumstances; and
- Have a reasonable period of time to address any inadvertent or unforeseen violation, such as by "curing" the violation (if possible) or appropriately strengthening its internal controls.
The Commission recently approved a similar type of safe harbor in a separate rulemaking,6 and we believe adoption of such an approach is particularly appropriate in this area given Congress' desire to protect traditional bank activities.
II. Effective Date of the Proposed Rules and the Act's Dealer Exceptions
The Commission has requested comment on when the Proposed Rules and the GLB Act's "dealer" exceptions for banks should become effective. Our Agencies believe that the GLB Act's "broker" and "dealer" exceptions for banks, as well as any rules implementing those exceptions, should become effective on the same date.
Banks, like other market participants, operate and manage their securities activities on an integrated basis to the extent consistent with applicable law and prudent business practices. Our supervisory experience indicates that banks often use the same systems, personnel, policies and procedures in connection with their broker and dealer activities. The lines between a bank's "broker" and "dealer" activities are further blurred because certain transactions that are viewed as a "dealer" activity under the Federal securities laws (e.g. riskless principal transactions) have traditionally been viewed as agency or "broker" transactions for purposes of the Federal banking laws.
The significant inter-relationship between the broker and dealer activities of banks is reflected in the Commission's proposed rules themselves. For example, Proposed Rule 3a5-1 requires a bank to aggregate its riskless principal transactions (a "dealer" activity) with any brokerage transactions effected by the bank under the "de minimis" broker exception for purposes of determining whether the bank complies with the rule's 500 transaction limit. Likewise, Proposed Rule 15a-11 combines a "broker" exemption for the non-custodial securities lending activities of banks with a "dealer" exemption for those securities lending transactions conducted by a bank as a conduit lender.
In light of the significant integration of the broker and dealer activities of banks, and the substantial interplay between the "broker" and "dealer" exceptions for bank activities, we believe any rules implementing the "broker" and "dealer" exceptions in the GLB Act should become effective at the same time-that is, after final "broker" rules are adopted and a reasonable transition period has expired.7 Simultaneous implementation of the Act's "broker" and "dealer" exceptions would allow banks to modify their securities-related systems, policies and procedures in a coordinated fashion and, thus, significantly reduce any costs and disruptions that banks and their customers may incur in transitioning to the requirements of the GLB Act. Furthermore, such an approach would facilitate the adoption by our Agencies of a single recordkeeping rule for banks conducting securities transactions under the "broker" and "dealer" exceptions for banks in the GLB Act.8 Adoption of a single recordkeeping rule (rather than separate rules for "broker" and "dealer" activities) would further reduce the disruptions that banks and their customers will face during any transition period.
Importantly, we do not believe that delaying the effective date of the Act's "dealer" provisions until the implementation date of the Act's "broker" provisions would adversely affect investors. Our Agencies have effectively supervised and regulated the securities activities of banks for many years and we will continue to do so while the SEC's rulemaking process continues.
III. Proposed Exemption for Securities Lending Transactions
The GLB Act permits a bank, without being considered a broker, to engage in a variety of custodial and safekeeping activities "as part of customary banking activities." The activities permitted by the Act include effecting securities lending or borrowing transactions with or on behalf of customers as part of the bank's customary custodial, safekeeping and clearing activities.9 In enacting this exception, Congress recognized that custodial and safekeeping activities, including providing securities borrowing and lending services as agent, are part of the core business of banking. Securities lending activities are a natural outgrowth of, and are integrally related to, the traditional custody businesses of banks and banks historically have served as the primary intermediary between securities lenders and securities borrowers.10
The Proposed Rules include an SEC-granted exemption that would allow banks, subject to certain restrictions, to act as: (1) a non-custodial agent in securities lending transactions without being considered a "broker"; and (2) a conduit lender in securities lending transactions without being considered a "dealer." Although the proposed exemption is designed to accommodate the existing securities lending practices of banks, we believe that an SEC-granted exemption for non-custodial agency activities is unnecessary. In addition, while we agree that an exemption is appropriate for the conduit lending activities of banks, we do not believe any exemption in this area should be limited to transactions with "qualified investors."
A. Exemption for Non-Custodial Securities Lending Services
As noted above, the GLB Act expressly permits a bank, without being considered a broker, to effect "securities lending or borrowing transactions with or on behalf of customers as part of" the bank's customary securities custodial, safekeeping and clearing services.11 We believe this statutory language is sufficiently broad to encompass situations where a bank acts as a non-custodial agent in securities lending transactions.
In this regard, the language of the GLB Act does not require that a bank have custody of the securities that it borrows or lends on behalf of its customers. Rather, the statute protects the securities lending services that a bank provides as agent and "as part of" the bank's custodial and safekeeping activities. Both the custodial and non-custodial securities lending services offered by banks have grown out of, and remain integrally related to, the custody businesses of banks and, thus, are offered "as part of" customary custody services. Our supervisory experience, for example, indicates that banks use many of the same systems and personnel when providing custodial and non-custodial lending services, and both forms of securities lending require a bank to perform many of the same services.12
In our view, interpreting the statutory exception in this manner also is consistent with the purposes and intent of the exception. The custody and safekeeping exception in the GLB Act was designed to protect the custody, safekeeping and securities lending services that banks traditionally have provided their customers as agents. Banks today provide their customers both custodial and non-custodial securities lending services and, accordingly, interpreting the statutory exception to allow banks to provide both forms of these customary banking services would be in accord with Congress' intent.
For these reasons, we believe the Commission should clarify that the GLB Act permits a bank to act as a non-custodial agent in securities lending transactions without being considered a "broker" under the Exchange Act. We also believe that the portion of Proposed Rule 15a-11 that relates to the non-custodial agency activities of banks should be deleted.
B. Qualified Investor Restriction
The Proposed Rules would allow a bank to act as a non-custodial agent or conduit lender in securities lending transactions only if both the lending and borrowing customers of the bank are "qualified investors."13 Although the securities lending market is institutional in nature, we believe the proposed "qualified investor" restriction is inconsistent with the statutory framework and should be deleted. Congress did not place any limit on the type of customers to whom banks may provide securities lending services under the statutory exception set forth in section 3(a)(4)(B)(viii) of the Exchange Act and we see no reason to restrict the type of customers that may receive securities lending services from banks under any SEC-granted exemption. This is particularly true because a bank acting as a non-custodial agent, unlike a custodial bank, does not have custody of the customer's securities being lent. We note, moreover, that the Commission does not prohibit broker-dealers from providing non-custodial and conduit securities lending services to non-qualified investors.
C. Request for Comment on Risks Associated with Securities Lending Activities and Appropriateness of Additional Restrictions
The Commission has asked the Banking Agencies whether the exemption for securities lending activities included in the Proposed Rules would pose any risks that the Commission should address. The Proposed Rules also ask for public comment on whether the Commission should place additional conditions on banks that engage in securities lending transactions under the proposed exemption.
We believe it would be unnecessary and inappropriate for the Commission to impose any additional restrictions on the securities lending activities of banks. These activities are, and have been, supervised and regulated extensively and effectively by the Banking Agencies for many years. For example, our Agencies have adopted detailed interagency guidelines that are designed to ensure that banks conduct their securities lending activities in a safe and sound manner and consistent with sound business practices, investor protection considerations and applicable law.14 These Interagency Guidelines direct banks to establish written policies and procedures to ensure that the bank-
- Provides securities lending services only pursuant to written agreements that set forth the rights and obligations of each party and detail the fees to be charged;
- Maintains adequate records concerning all securities lending transactions, including sufficient records to ensure that all outstanding loans are fully accounted for and that adequate collateral for all loans is received;
- Fairly allocates securities loans among all accounts participating in a securities lending program;
- Performs an adequate and timely credit review of all securities borrowers and establishes appropriate credit limits for each borrower; and
- Receives the proper amount and type of collateral for all securities lending transactions, appropriately values any non-cash collateral received and marks the collateral to market at least daily.15
Our Interagency Guidelines require banks to adhere to standards that are comparable to those imposed by the Commission on the securities lending activities of broker-dealers,16 and bank activities in this area have not given rise to significant concerns. Our Agencies also have full supervisory authority to take action if a bank were to conduct its securities lending activities in an unsafe or unsound manner or in violation of applicable law. Accordingly, we do not believe there are any risks related to the securities lending activities of banks that the Commission needs to address in this rulemaking.
IV. Dealer Exception for Asset-Backed Activities
One of the statutory "dealer" exceptions permits banks to issue or sell asset-backed securities through a grantor trust or other separate entity if the obligations backing the securities were predominantly "originated" by the bank or certain other entities specified in the statute. Proposed Rule 3b-18(e) provides that a loan will be considered "originated" by a bank for these purposes if the bank (1) funds the obligation at the time it is created, or (2) initially approves and underwrites the obligation or initially agrees to purchase the obligation and certain other conditions are satisfied.17 We are concerned that the word "initially" in paragraph (e)(2) could be interpreted as requiring that a bank have a contractual commitment in place to purchase an obligation before it is funded by a third party with whom the bank has an ongoing correspondent relationship. Interpreting the term in this manner would be inconsistent with the usual business practices of banks in this area. We therefore urge the Commission to clarify the definition to address this issue.
Our Agencies appreciate the opportunity to comment on the Proposed Rules and remain committed to working with the Commission and its staff to ensure that the bank exceptions adopted by Congress in the GLB Act are implemented in a manner consistent with the purposes of those exceptions.
J. Virgil Mattingly, Jr.
Board of Governors of the
Federal Reserve System
William F. Kroener, III
Federal Deposit Insurance Corporation
Julie L. Williams
First Senior Deputy Comptroller and Chief Counsel
Office of the Comptroller of the Currency
cc: Annette Nazareth
|1|| Exchange Act Release No. 34-46745, 67 Federal Register 67,496 (Nov. 5, 2002).
|2|| Exchange Act Release No. 34-44291, 66 Federal Register 27,760 (May 18, 2001) ("Interim Final Rules").
|3|| See Letter dated June 29, 2001, to the Commission from Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Donna Tanoue, Chairman, Federal Deposit Insurance Corporation, and John D. Hawke, Comptroller of the Currency ("Initial Comment Letter"), at p. 6 and Appendix at 43-44. Other commenters on the Interim Final Rules also requested that the Commission provide banks a cure or leeway period to address inadvertent infractions. See Comment Letters on the Interim Final Rules submitted on behalf of the Financial Services Roundtable, Bank Securities Association, Bankers Trust, and New York Clearing House Association, L.L.C., each dated July 17, 2001.
|4|| See 15 U.S.C. §§ 78c(a)(5)(C)(iv) and (a)(54), and section 206 of the GLB Act (15 U.S.C. § 78c note).
|5|| For example, Proposed Rule 3a5-1 would allow a bank to conduct "riskless principal" transactions for customers so long as the total number of riskless principal transactions effected by the bank during a calendar year, combined with any brokerage transactions effected by the bank during the calendar year under the "de minimis" exception in section 3(a)(4)(B)(xi) of the Exchange Act, does not exceed 500. Accordingly, a bank that effects a riskless principal transaction for a customer in January may not know until December 31st of that year whether the transaction complied with the terms of the proposed exemption.
|6|| The Commission recently adopted proposed rules that would expand the list of events that require a public company to file a Form 8-K with the Commission and shorten the deadline for such filings. See Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, Exchange Act Release No. 34-46084, 67 Federal Register 42,914 (June 25, 2002). The proposal provides that a company that inadvertently fails to file a Form 8-K within the new deadlines will not be liable under sections 13 and 15(d) of the Exchange Act if: (A) the company maintains sufficient procedures to provide reasonable assurances that the company is able to collect, process and disclose information required to be disclosed by Form 8-K in a timely manner; and (B) no officer, employee or agent of the company knew, or was reckless in not knowing, that a report on Form 8-K was required to be filed and the company promptly files the report once an executive officer of the company became aware that a filing was required. See id. at 42,929-30 and 42,937-38.
|7|| The Commission previously has acknowledged that banks may need up to one year after final rules are adopted to bring their systems into compliance with the rules' new requirements. See Exchange Act Release No. 34-45897 (May 8, 2002).
|8|| Section 204 of the GLB Act requires the Banking Agencies, in consultation with the SEC, to adopt recordkeeping requirements for banks that rely on the broker and dealer exceptions established by the Act. See 12 U.S.C. § 1828(t).
|9|| See 15 U.S.C. § 78c(a)(4)(B)(viii)(I)(aa), (bb) and (cc).
|10|| See Securities Lending Transactions: Market Development and Implications, report prepared by the Technical Committee of the International Organization of Securities Commissioners and the Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries at 14 (July 1999).
|11|| See 15 U.S.C. § 78c(a)(4)(B)(viii)(cc).
|12|| For example, a bank, whether acting as a custodial or non-custodial lending agent, generally arranges the terms of the transaction, monitors the value of the securities lent and collateral received, tracks corporate actions relating to the securities lent and maintains records relating to the transaction.
|13|| Proposed Rule 15a-11(a). The Proposed Rules define a qualified investor for these purposes to include only those corporations, companies, partnerships and natural persons that have at least $25 million in discretionary investments. See Proposed Rule 15a-11(e).
|14|| See Revised Policy Statement on Securities Lending, 62 Federal Register 38,991 (July 21, 1997) ("Interagency Guidelines").
|15|| These Interagency Guidelines are supplemented by a variety of additional supervisory and examination guidance relating to the securities lending activities of banks. See, e.g. The Comptroller's Handbook: Custody Services at 28-36 (Jan. 2002); Banking Circular 196 (OCC); Commercial Bank Examination Manual at § 2030.1 (Board); Trust Examination Manual at §§ 3.N and 5.H (2001) (FDIC).
|16|| See 17 C.F.R. § 240.15c3-3(b)(3).
|17|| Proposed Rule 3b-18(e)(2).