Section of Business Law
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April 28, 1998
Securities and Exchange Commission
450 Fifth Street, N.W.
Mail Stop 6-9
Washington, DC 20549 Attention: Mr. Jonathan G. Katz, Secretary

Re: File No. S7-30-97

Ladies and Gentlemen:

The Committee on Federal Regulation of Securities (the "Committee"), Section of Business Law, of the American Bar Association welcomes this opportunity to comment on the release issued by the Securities and Exchange Commission (the "Commission") proposing rules and rule amendments (the "Proposals") under the Securities Exchange Act of 1934 (the "Exchange Act") that would tailor capital, margin and other broker-dealer regulatory requirements to a class of registered dealers, called OTC derivatives dealers, active in over-the-counter derivatives markets, SEC Release No. 34-39454 (December 17, 1997) (the "Release").

A draft of this letter was circulated for comment among members of the Subcommittee on Market Regulation and the Chairs and Vice-Chairs of the other subcommittees and task forces of the Committee, the Advisory Committee of the Committee, the officers of the Committee, and the officers of the Section. A substantial majority of those who responded have indicated their general agreement with the views expressed. This letter, however, does not represent the official position of the American Bar Association, the Section or the Committee, nor does it necessarily reflect the views of all those who have reviewed it.

The Current Proposals. The Proposals are intended to allow securities firms to establish dealer affiliates that would be able to compete more effectively against banks and foreign dealers in global

over-the-counter markets. Registration as an OTC derivatives dealer under the proposed rules would be an alternative to registration as a fully regulated broker-dealer, and would be available only to entities acting primarily as counterparties in privately negotiated 1 over-the-counter derivatives transactions.

The Proposals set forth definitions of the terms "OTC derivatives dealer", "eligible OTC derivatives instrument", "permissible derivatives counterparty", "permissible risk management, arbitrage, and trading transaction", and "hybrid security". 2 They also would include a series of rules establishing a separate scheme of regulation for OTC derivatives dealers that limit their business to the permitted class of transactions and transactional counterparties. Significantly, the Proposals would incorporate the concept of "value at risk" in a new alternative scheme of net capital regulation of OTC derivatives dealers. 3

Insofar as it goes, the proposed new scheme for OTC derivatives dealers seems sensibly designed. 4 As the Commission stated in the Release, the imposition of classical regulation, particularly classical net capital regulation, has resulted in driving offshore the derivatives subsidiaries of the major dealers since they cannot operate economically in the United States in compliance with the applicable rules, particularly the Commission's net capital rule. The Commission's recognition of that long-standing problem and its determination to do something about it are commendable.

The Proposals are aimed at leaving net capital regulation substantially in place while permitting the new class of OTC derivatives dealers to have among their counterparties a broad range of persons, including the following:

Having included such a broad and potentially unsophisticated group of customers, the Proposals then would impose, in lieu of the classical net capital standards, a set of value-at-risk requirements that are even more elaborate and complex than the existing net capital requirements but that do appear to be more finely tuned and more relevant to the assessment of counterparty risk.

Purposes of Net Capital Rule. The Committee does not question whether the numerical tests in the Proposals are sound. 5 Instead, the Committee suggests that there could well be added to the Proposals a separate regime of complete exemption from the net capital rule for an OTC derivatives subsidiary of a registered broker-dealer that does not accept custody of investors' funds or securities and limits its counterparties to large institutional investors and to other dealers. Now, almost a generation after the Commission's net capital rule was first put in place, it would be appropriate to examine the principles employed in the rule to see whether they are still valid and whether the rule continues to serve its intended objectives.

The Commission's uniform net capital rule originally was aimed at protecting customers' funds and securities on deposit with broker-dealers. As the Commission knows, the rule finds its origins in the paperwork crisis of the late 1960s, and the consequent failure of a number of broker-dealers. Following enactment of the Securities Investor Protection Act of 1970, publication of the Commission's Study of Unsafe and Unsound Practices of Brokers and Dealers in 1971, 6 and the addition of authority in Section 15(c) of the Exchange Act as part of the Securities Acts Amendments of 1975, the Commission adopted its uniform net capital rule with a view to protecting investors, and the SIPC treasury, from the results of uneven application of capital standards.

In discussing the need for a uniform Commission rule, however, the Commission noted that the uniform rule would be designed essentially to protect customers' assets, and thus the SIPC treasury, and that the rule would not have any necessary application to broker-dealers that did not accept or hold customer's funds or securities but simply acted as a counterparty in delivery-versus-payment and receipt-versus-payment transactions. The Congress accepted that judgment and adjusted the legislation accordingly:

As originally conceived this section ()section 15(c) as it would have been amended) prohibited the Commission from exempting any broker or dealer from its uniform capital rule. The Commission argued, however, that there were certain types of brokers and dealers with respect to whom the rule should not apply. The Commission . . . noted that certain brokers and dealers do not handle customers' funds and securities, and thus might not need to be subject to the rule. The section as reported by the Committee allows the Commission to grant exemptions to these types of brokers and dealers. 7

The National Securities Market Improvement Act of 1996 ("NSMIA") provides a context in which the Commission today should review its net capital rule. NSMIA mandates the stripping away of regulations that are unneeded and granting exemptions where appropriate. For example, new Section 3(f) of the Exchange Act, added by NSMIA, provides as follows:

Consideration of Promotion of Efficiency, Competition, and Capital Formation—Whenever pursuant to this title the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.

These are the standards the Commission now must use in all its rulemaking under the Exchange Act, including the creation of a regulatory scheme for OTC derivatives dealers. To the extent the existing regulation of broker-dealers restrains the operations of OTC derivatives dealers in ways that are dysfunctional or that go beyond the bounds of appropriate regulation, the Commission has a legal duty to make appropriate revisions. In the words of Representative Jack Fields, the sponsor of NSMIA, that legislation was designed to empower the Commission to "eliminate rules and regulations that no longer serve a legitimate purpose." 8

Current circumstances. It is currently the case, as the Commission knows, that the major dealers all have subsidiaries, organized in London or Zurich or other off-shore locations, and that major U.S. institutional investors that are seeking to transact in derivatives currently find it acceptable to deal with those offshore entities. That result, however, shows that the Commission's net capital rule has distorted capital flows by causing OTC derivatives creation to be expatriated to countries that have been more flexible than the United States. The costs of operating under the Commission's net capital rule exceed the benefits that institutional investors perceive they would obtain from dealing with a U.S.-registered broker-dealer as their derivatives counterparty.

It accordingly appears that the net capital rule, in its application to derivatives dealings, does not in fact achieve its purposes and that a solution should be found to cure its competitive burdens and dysfunctional impact on the OTC derivatives market. It might well not be wise at this juncture to exempt entirely from the net capital rule all derivatives dealers that do not hold customers' funds or securities; unregulated dealers having retail counterparties, for example, could fail and leave their counterparties with market exposure on uncompleted transactions. It would make sense, however, to exempt OTC derivatives dealers that, in addition to not holding customers' funds or securities, are affiliated with a registered broker-dealer and limit their counterparties to large institutions.

In view of the purposes of the net capital rule, the Committee recommends, therefore, that the Commission consider using the authority it has told the Congress it needs, the authority to exempt absolutely from the net capital rule, to exempt OTC derivatives dealers that (i) are affiliated with registered broker-dealers, (ii) do not take possession of customers' funds and securities and (iii) deal only with large institutions, such as the "major institutional investors" that are described in Rule 15a-6 under the Exchange Act, 9 that is, entities that own or manage $100 million or more in securities, or possibly a category of even larger institutions, as well as other dealers. To be sure, that would involve taking a bolder approach to net capital regulation than is taken in the Proposals, but it would both accord with the congressional authority granted to the Commission in Section 15(c) and meet the competitive and practical demands of the marketplace.

Today, major dealers and institutional investors in the derivatives marketplace evaluate the financial soundness of a counterparty on bases other than the Commission's net capital rule. The net capital rule is premised on a liquidity-based notion that there should be an equity cushion of cash and assets that can be readily converted into cash to support a broker-dealer's liability to customers for their cash and securities left with the broker-dealer. It is of course the case that financial soundness of counterparties is an important element in the derivatives markets, particularly given the extended period of time unsecured derivatives obligations can be outstanding, but financial soundness of a counterparty is not synonymous with the liquidity-based concept that underlies the net capital rule.

Obligations owed by derivatives counterparties to one another are not much different in substance from other financial obligations that reside in loan documents, debentures, other obligations for borrowed money and other commitments that contemplate future performance. They are, however, different from the relationship between a broker-dealer and its customer where the broker-dealer has accepted funds or securities on deposit. The relationship between derivatives counterparties is that of debtor and creditor, not fiduciary custodian and client.

In the case of OTC derivatives, where there is not the credit of a registered clearing corporation to rely on, the creditworthiness of the counterparty, at the time the relationship is created and at the time the transaction is concluded, are essential to the success of the transaction. As a result, financial institutions and other sophisticated market participants continually evaluate the financial wherewithal of the counterparties with which they deal, whether their relationship is one of creditor to lender, swap counterparty, options counterparty or some other obligor/obligee relationship. For many years, U.S. institutions have dealt, apparently successfully, with the unregistered and unregulated offshore affiliates of the major U.S. broker-dealers and banks without being particularly concerned about the absence of regulation under the net capital rule.

At some level of wealth and sophistication, institutional investors are able to fend for themselves. In cash-and-carry transactions, and in their ultimate reliance on a counterparty to perform in future its contractual obligations under derivatives contracts, they do not need or want to rely on the SEC's net capital rule to protect them from dealing with insolvent or potentially insolvent counterparties.

The basic thrust of the net capital rule, to protect customers, and the SIPC treasury, from cash and securities left on deposit with a broker, is not particularly suitable where there is not a custodial relationship. Also, the Commission's current approach under the Proposals would not achieve any greater protection of the markets at large than would be achieved by having the currently unregistered affiliates operate out of the United States.

A source of real concern to the Commission, however, should be the fact that the current regulatory pattern, in a global economy, causes institutional investors to have to take legal risks many of them might well prefer not to have to take. In dealing with offshore entities, including offshore affiliates of the major U.S. dealers, institutional investors often have to forego the protections of U.S. bankruptcy law, U.S. law on offsetting of obligations, and possibly also the advantages afforded by access to the U.S. judicial system. While that has not led to any notorious financial problems to date, the Commission's approach effectively leaves institutional investors shouldering the risks. It is unclear what public policy or investor protection purpose is served by this result.

It might be argued that, under today's circumstances, the net capital rule also serves to limit systemic risk to the markets. That goal, the argument would hold, is fostered by subjecting even the largest broker-dealer counterparties to value-at-risk or other regulation under the net capital rule. While superficially appealing, however, that argument ignores the reality that there is, today, a global marketplace and that the banished counterparties simply form offshore and present the same systemic risks without the benefit to their trading partners of U.S. bankruptcy law, substantive contract law and U.S. judicial and arbitral enforcement of contracts.

Another argument that might be advanced in opposition to providing the large counterparty exemption we recommend could be described as the "medallion" argument. This argument would hold that the Commission, by registering a broker-dealer, permits the registrant to hold itself out as having some measure of governmental financial regulation, if not approval. It would be inconsistent with that representation, the argument would conclude, not to require net capital compliance.

One answer to that argument is that the Commission rejected it almost 25 years ago when it appealed to the Congress to change the proposed net capital legislation to give the Commission exemptive authority. More importantly, the medallion argument should have little if any persuasive force in the case of OTC derivatives dealers that deal only with large institutional investors. Whatever misperception that might otherwise arise could be fully cured with disclosure.

In this instance, the Exchange Act goal of investor protection would be better served by affording to the large institutional investor a legal regime, in addition to that set forth in the Proposals, in which it could knowingly forego whatever economic protections might be afforded by the net capital rule in return for the legal protection afforded by being able to deal with a class of OTC derivatives dealers that are affiliated with registered broker-dealers and, being organized under U.S. law, are subject to predictable results under U.S. substantive law, including U.S. bankruptcy law. This would avoid their having instead to take their chances with an uncertain mosaic of foreign laws and legal remedies should it become necessary to seek judicial enforcement of derivatives agreements and structures.

Adding that approach to the approaches set forth in the Proposals would both serve the interests of the investors and advance the deregulatory goals of NSMIA. The Commission's goals of protecting investors and preventing systemic disruption would be better served, moreover, by ensuring that derivatives entities of all sorts could operate effectively under U.S. law rather than by trying to force them into a regulatory regime that neither they nor their large customers need.

If members of the Committee may be of further service to the Commission or its staff in their evaluation of these matters, please let us know.

Respectfully submitted,

  /s/ John M. Liftin by RDB  

John M. Liftin
Chair, Committee on Federal
Regulation of Securities

  /s/ Roger D. Blanc  

Roger D. Blanc
Chair, Subcommittee on Market Regulation

cc: The Hon. Arthur Levitt, Chairman
The Hon. Norman S. Johnson, Commissioner
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Richard H. Walker, Esq., General Counsel
Dr. Richard R. Lindsey, Director,
Robert L. D. Colby, Esq., Deputy Director
Michael A. Macchiaroli, Esq., Associate Director
Catherine McGuire, Esq., Chief Counsel,
Division of Market Regulation



1 The Committee recommends that the Commission clarify that the use of screen-based systems would not be inconsistent with the concept of private negotiation.
2 Proposed Rules 3b-12 through -16.
3 The Committee is not commenting on certain matters that are principally economic in nature, such as the numerical tests for qualification for the relief offered under the proposed rules, since those issues go beyond the Committee's expertise on legal matters.
4 The Committee notes that the U.S. Commodity Futures Trading Commission (the "CFTC"), in its letter dated February 28, 1998, objects to the Commission's proposals on the ground that they would "create the potential for conflict with the ()commodities laws) and would create gaps and inconsistencies in the regulatory treatment of instruments traded by OTC derivatives dealers." Id. at 1. The Committee is not commenting substantively on the CFTC's views, but notes that the Commission and the CFTC have worked together in the past to prevent such problems and the Committee hopes that the two agencies will be able to work together to address the CFTC's concerns.
5 See note 3, supra .
6 H.R. Rep. No. 231, 92d Cong., 1st Sess. (1971).
7 Securities Reform Act of 1975, Report of the House Comm. on Interstate and Foreign Commerce to Accompany H.R. 4111 , 94th Cong., 1st Sess. 76-77 (1975). The Senate bill that preceded the 1975 legislation did not have any counterpart on net capital regulation and the Senate acceded to the House in conference. Securities Acts Amendments of 1975; Joint Explanatory Statement of the Comm. of Conference , H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 104 (1975).
8 142 Cong. Rec. H6446 (daily ed. June 18, 1996).
9 See also letter from Dr. Richard R. Lindsey to Giovanni P. Prezioso, Esq. (April 9, 1997), 1997 SEC No - Act. LEXIS 525..