The New York Clearing House Association L.L.C.
December 6, 2002
Securities and Exchange Commission
Attention: Mr. Jonathan G. Katz, Secretary
Re: Release No. 34-46745 (File No. S7-41-02) -- Proposed
Ladies and Gentlemen:
The New York Clearing House Association L.L.C. (the "Clearing House")1 is writing to comment on proposals by the Securities and Exchange Commission (the "Commission") to amend Rules 3a5-1 and 3b-18, and to adopt new Rule 15a-11, under the Securities Exchange Act of 1934 (the "Exchange Act"). The proposals interpret the terms of the exceptions for banks from the definitions of broker and dealer in Sections 3(a)(4) and 3(a)(5) of the Exchange Act and provide an additional exemption from the Exchange Act's definition of dealer for banks that engage in non-custodial securities lending.
The Clearing House appreciates the Commission's solicitation of comments in the proposing release2 (the "Release") and the opportunity to provide its comments on the proposals in the Release. We believe the proposed amendments and new rule are constructive and will be helpful to banks in determining how to conduct their operations when the temporary blanket exemptions from the definitions of "broker" and "dealer" are no longer in effect. Our comments on the Release are, accordingly, relatively few and, in several instances, seek clarification of what we believe to be the Commission's intent rather than a substantive change.
As a general matter, we wish to note that the Release includes a discussion of the background of the Gramm-Leach-Bliley Act. The paragraph concerning the overall purposes of the securities and banking laws states that the primary purpose of the federal securities laws is the protection of investors, and that "[i]n contrast, the primary purpose of the federal banking laws is to protect the solvency of banks." While these may be correct statements of important purposes of these laws, the statements are incorrect to the extent that they might suggest that the federal banking laws (or the federal banking agencies that implement those laws) give less than adequate protection to persons who buy or sell securities from, to or through banks. Numerous federal banking laws, regulations and policy statements, such as Part 9 of the regulations of the Office of the Comptroller of the Currency and the Interagency Statement on Retail Sales of Nondeposit Investment Products, implement the banking laws' purpose of protecting investors, and the banking agencies have been vigilant in carrying out this purpose. Thus, the Commission should not conclude that it must interpret bank exceptions from the definitions of "broker" and "dealer" narrowly in order to protect investors. This is simply not the case.
I. Timing of Effectiveness of Rules; Transition Matters
An order issued in conjunction with the Release extends the current blanket exemption for banks from the definition of "dealer" until February 12, 2003, approximately eleven weeks after comments on the Release are due. We do not believe that this schedule will allow sufficient time for banks to develop compliance systems relating to the dealer rules after final rules have been promulgated.
We recognize that the dealer rules, as proposed to be revised in the Release, are intended to permit banks largely to continue their existing dealer activities, and we appreciate the Commission's efforts to learn about those existing activities and to develop workable rules. Compliance with the dealer rules, however, will require certain changes discussed below. Phased implementation of the dealer and broker rules is also likely to create confusion and operating difficulties. For these reasons, we urge the Commission to make the effective date of the dealer rules the same as the effective date of the broker rules, and to delay the effectiveness of both for one year after promulgation of final rules so that banks will have a reasonable period to implement compliance systems.3
At a minimum, if the Commission is unwilling to delay the effectiveness of all the dealer rules, Rule 3a5-1, relating to riskless principal transactions, should be delayed until the same date as the broker rules, and the temporary blanket exemption from the definition of broker should be expanded to exempt riskless principal activities from the definition of "dealer", because from a business and operational perspective riskless principal transactions are more like brokerage than dealing transactions. Rule 3a5-1 in effect adds dealer transactions to permissible transactions under the de minimis brokerage exception in Section 3(a)(4)(B)(xi).
As a separate matter, we also request an extension of the temporary exemption for banks from liability under Section 29 of the Exchange Act provided by Rule 15a-8, which, by its terms, is available only until the end of this year.
B. Effectiveness of the Dealer Rules Should
We recognize that in the Release the Commission has attempted to address issues that have arisen under the dealer rules. It does not follow, however, that no implementation issues will arise from the lifting of the dealer exemption.
The Release asserts that "the question of whether a bank acts as a dealer under the securities laws is entirely separate from the question of whether it acts as a dealer under the banking laws", and it acknowledges that
The Release also recognizes the customary distinction under the securities laws between a "dealer" and a "trader", observing that "banks may have a legitimate need to, on occasion, lend or borrow securities on their own behalf for hedging or for other reasons" and that, in such circumstances, "they should be subject to the same dealer/trader distinction that applies to all other market participants". We agree wholeheartedly with all these statements. These statements also demonstrate, however, the need for a longer transition period under the dealer rules. Lifting the exemption of the definition of dealer in February and from the definition of broker at a later date will require banks to go through a thorough analysis twice and then to develop new systems and procedures, and to train personnel, to recognize the distinctions made under the securities laws, twice. It will also require banks to engage in partial, incomplete analysis without the necessary knowledge of the interrelated impact of the final broker rules. Indeed, the final formulation of the broker rules might require changes to the analysis previously made under the dealer rules. This will impose an unnecessary burden on banks, and we see no policy reason to impose such a burden.
C. The Riskless Principal Rule
In the case of riskless principal transactions, banks must have systems to identify such transactions as dealer rather than agency transactions and additional systems to ensure that such transactions are counted against the 500 transaction de minimis limit if no other exemption is available. Moreover, it is not clear to us how the 500 transaction limit will be applied before the broker rules are implemented. For these reasons we believe that the case is particularly strong for maintaining a blanket exemption for banks' riskless principal transactions until implementation of the broker rules.
D. Related Issues, Including NASD Rule 3040
It is likely that some degree of restructuring and/or reorganization within the affected institutions (both banks and broker-dealers) will be necessary with the adoption of each individual rule or set of rules -- the dealer exemptions, the broker exemptions, and any new interpretation of NASD Rule 3040. We believe it is unlikely that the impact of each individual rule or set of rules will be fully understood, however, until all of the rules and interpretations are finalized. Only at that time will banks and broker-dealers be able to understand and evaluate all available exceptions and exemptions and their supervisory ramifications. The interplay among the rules and interpretations may be critical to determinations related to restructuring. In addition, the NASD may find it useful to delay implementation of any new interpretation of Rule 3040 with its changes in supervisory policies and procedures until it, too, understands the full scope of the bank broker and dealer exceptions going forward.
E. Rule 15a-8
We note that Rule 15a-8 under the Exchange Act, which was adopted in 2001 along with the interim final push-out rules, applies only to contracts entered into before January 1, 2003. Rule 15a-8 forbids the voiding of a contract on the grounds that a bank has violated the broker-dealer registration requirements of the Exchange Act. The original purpose of Rule 15a-8 was to provide banks with a safe harbor from certain civil liability prior to, and for approximately one year after, the date on which they became subject to push-out. Consistent with this purpose, we believe that Rule 15a-8 should be amended to apply to contracts entered into prior to the first anniversary of the date on which banks are required to comply with the push-out rules. At a minimum, the rule should be amended to apply to any contracts entered into before the date on which banks are required to comply with the push-out rules.
F. Consequences of Inadvertent Non-Compliance
In our comment letter on the Interim Rules dated August 1, 2001, we expressed concern that no provision was made in the Interim Rules (other than Rule 15a-8) for failures to comply with the push-out provisions, despite good faith efforts to do so. We continue to believe that, due to the complexity of the push-out requirements, the statutory exceptions and the rules thereunder, banks should not be penalized if they have appropriate procedures in place and fall out of compliance due to inadvertence or unforeseen circumstances. This is especially true in light of the potentially severe penalties for noncompliance, which may include criminal liability and the voiding of contracts.
Thus the Clearing House again urges that a new rule be adopted providing that a bank that attempts in good faith to conduct its securities activities in conformance with the push out requirements, and that has in place policies and procedures reasonably designed to result in compliance therewith, will not be considered a broker-dealer merely because some of its securities transactions do not satisfy all the conditions for an exception.
In addition, we continue to be deeply concerned about the potential extent of the civil liability of a bank that falls out of compliance due to inadvertence or unforeseen circumstances. As we noted in our earlier letter, if a bank inadvertently fails any one of the enumerated exceptions in Section 3(a)(4)(B) or Section 3(a)(5)(C), it potentially could be exposed to liability for its activities under all such exemptions. We again strongly urge the Commission to adopt rules that limit a bank's civil liability for noncompliance with the final rules to the customer or group of customers that received the services, or were parties to the transactions, that resulted in noncompliance. These are the only parties in respect of which the bank acted as a broker-dealer, and they are thus the only parties that should be entitled to assert a claim for violation of the broker-dealer registration requirements.
That the Commission has not proposed rules addressing these issues is another reason that the effectiveness of the dealer rules should be postponed.
II. Proposed Rule 15a-11: Securities Lending Activity
Proposed Rule 15a-11 acknowledges that securities lending is a customary bank activity that should not be subject to "push-out", even when the bank is not also acting in a custodial capacity or providing clearance and settlement services to customers as contemplated by Section 3(a)(4)(b)(viii)(I)(cc) of the Exchange Act (the "Custodial Lending Exception"). We fully support this view, along with the exemption for securities lending by banks acting as principal ("conduit lender") as well as those acting as agent.
A. Comments on the Proposed Rule
We have a number of comments on this proposal, as discussed below.
In paragraph (a), the positioning of the word "solely" is potentially confusing because it might be interpreted as attempting to narrow in certain respects the statutory Custodial Lending Exception. In particular, the Custodial Lending Exception does not contain the requirement that customers to whom such services are provided be "qualified investors", but paragraph (a) in its present form might be interpreted to suggest the imposition of such a requirement. We do not believe that to have been the Commission's intent, nor do we believe that such a narrowing would be within the Commission's interpretive authority. We recommend that the phrase "solely to engage in or effect" in paragraph (a) be replaced with "to the extent that it engages in or effects". This would clarify that the rule is permissive and does not limit other existing exceptions or exemptions. We also recommend that the words "or on behalf of" be added prior to the words "qualified investor" (in both instances) in order that the language of paragraph (a) track the statutory language more closely.
We also do not understand the purpose of the introductory phrase in paragraph (a) ("Except as otherwise provided in paragraph (d) of this section"). Paragraph (d) does not appear to impose any limitations or contrary provisions, and we recommend that the introductory phrase be deleted from paragraph (a).
Paragraphs (b) and (c) might be interpreted to require two separate agreements in order for the securities lending exemption to be available: a "securities lending agreement" and a "agreement to provide securities lending services." While it is frequently the case that securities lending arrangements are documented with two agreements as contemplated by the draft rule, it is by no means always the case. For example, a conduit lender might have an arrangement with a qualified investor involving only a securities lending agreement. We believe that the substance of a securities lending transaction is more important than the specific manner in which it is documented. We therefore request that the Commission revise proposed Rule 15a-11 to require that the necessary substantive terms be set forth in one or more written agreements, without the specific bifurcation of agreements that is implied by the draft rule.
In paragraph (c), we again recommend that the words "with or" be added before "on behalf of" for consistency.
In paragraph (c)(5), it is not clear to us whether the use of the terms "reinvest" and "reinvestment" used in respect of cash collateral are intended to signify something different from the term "invests" used in the Custodial Lending Exception ("invests cash collateral pledged in connection with such transactions"). For the avoidance of ambiguity, we recommend that paragraph (c)(5) follow the statutory formulation and read "Invest, or direct the investment of, cash collateral; or".
The definition of "conduit lender" in paragraph (d) states that a bank's status as such will continue "as long as the original securities lending transaction remains outstanding", even if there are substitutions of collateral on the borrowing side of the transaction. We recognize that this definition was intended to provide a degree of latitude to banks in determining their status as conduit lenders. We believe, however, that there are other circumstances under which a bank should be able to continue to qualify as a conduit lender. First, when either side of a conduit lending transaction terminates, a bank should continue to qualify as a conduit lender as long as it promptly enters into a new transaction that replaces the terminated transaction. Otherwise, the bank would have no exemption for the transaction and would be required to unwind or push out the side of the transaction that did not terminate. Permitting a replacement transaction would maintain the bank's matched loan and borrow of securities, and it would avoid the need for the bank to unwind or push out the remaining side of the transaction. Second, the definition contemplates substitution of collateral only on the borrowing side of a transaction. Substitutions of collateral may also occur on the lending side of a transaction, and we see no reason why such substitutions should in any way impair a bank's status as a conduit lender. We request that the definition of "conduit lender" be revised to clarify that replacement transactions and substitutions of collateral are permissible on both sides of a transaction.
B. Requests for Comments
We agree with the Commission's decision not to impose broker-dealer-type financial risk precaution conditions on banks seeking to rely on Rule 15a-11. First, such conditions are unnecessary. As the Release notes, banks are subject to comprehensive regulation to ensure their soundness. There is no need for Commission regulation of the same subject. Second, any such Commission regulations would be inconsistent with the concept of functional regulation. Third, imposing existing broker-dealer regulations on banks would be burdensome at best and at worst would make the exemption unavailable as a practical matter.
We also believe that the exemption should not contain requirements that banks verify that counterparties are borrowing securities for a proper purpose or that participants have been evaluated for their suitability to participate in the transaction. Nor should there be a requirement that the exemption not be used to avoid U.S. margin requirements or to avoid other restrictions on alienability of securities. Such conditions would require banks to police the activities of third parties, creating an unfair burden on banks. Nor are such requirements necessary, especially in view of the exemption's limitation to transactions with qualified investors. Moreover, there is no reason to believe that this exemption for certain types of securities lending transactions would somehow permit or encourage activities that would violate the existing margin rules, or that the existing margin rules do not adequately address the potential for abuse.
III. Definition of "Qualified Investor"
In the Release,4 the Commission adopts a broad interpretation of the term "company" as used in paragraph (A)(xi) of the definition of "qualified investor" in Section 3(a)(54) of the Exchange Act. We agree with the Commission's approach, primarily because we see no reason to draw distinctions among forms of organization for purposes of the push-out provisions (including, as noted in the comment letter cited at note 67 of the Release, entities organized under non-U.S. law), and also because the interpretation will provide flexibility in the event that new forms of business organization evolve in the future (as limited liability companies did in the 1990s). We also agree that the expanded definition should apply whenever the term "qualified investor" is used. In the interests of clarity, we recommend that the Commission adopt a rule under Section 3(a)(54) setting forth this interpretation. Authority to adopt such a rule is provided in Section 3(a)(54)(C). Such a rule could read as follows: "As used in paragraph (A)(xi) of Section 3(a)(54) of the Exchange Act, the term `company' shall include any type of entity not otherwise specifically listed in Section 3(a)(54)."
We note that neither the definition of "qualified investor" in Section 3(a)(54) nor the uses of that term in the Exchange Act includes a "reasonable belief" standard of the sort found in the safe harbor for sales to "qualified institutional buyers" in Rule 144A under the Securities Act of 1933. Because of the potential harshness of the consequences to a bank of engaging in certain transactions with counterparties that are not qualified investors, and the inefficiencies of requiring banks to seek to verify on a case-by-case basis each counterparty's status as a qualified investor, we urge the Commission to include in the rules under Section 3(a)(54) an interpretation to the effect that banks may rely upon representations from prospective counterparties that they are qualified investors unless such reliance would be unreasonable under the circumstances.
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