Federal Register: March 19, 2007 (Volume 72, Number 52)
DOCID: fr19mr07-19 FR Doc E7-4693
SECURITIES AND EXCHANGE COMMISSION
U.S. Citizenship and Immigration Services
CFR Citation: 17 CFR Part 240
RIN ID: RIN 3235-AJ85
DOCUMENT ID: [Release No. 34-55431; File No. S7-08-07]
NOTICE: Part II
DOCUMENT ACTION: Proposed rule.
Amendments to Financial Responsibility Rules for Broker-Dealers
DATES: Comments should be received on or before May 18, 2007.
The Commission is proposing for comment amendments to its net capital, customer protection, books and records, and notification rules for brokerdealers under the Securities Exchange Act of 1934 (``Exchange Act''). The proposed amendments would address several emerging areas of concern regarding the financial requirements for brokerdealers. They also would update the financial responsibility rules and make certain technical amendments.
Securities and Exchange Commission,
We are proposing for comment amendments to the brokerdealer net
capital rule (Rule 15c31),\1\ customer protection rule (Rule 15c3
3),\2\ books and records rules (Rules 17a3 and 17a4),\3\ and notification rule (Rule 17a11).\4\
\1\ 17 CFR 240.15c31.
\2\ 17 CFR 240.15c33.
\3\ 17 CFR 240.17a3 and 17 CFR 240.17a4.
\4\ 17 CFR 240.17a11.
II. Proposed Amendments
A. Amendments to the Customer Protection Rule
The Commission adopted the customer protection rule (Rule 15c33)
in 1972 in response to a congressional directive to strengthen the
financial responsibility requirements for brokerdealers that carry
customer assets.\5\ The rule requires a brokerdealer to take certain
steps to protect the credit balances and securities it holds for
customers. Under the rule, a brokerdealer must, in essence, segregate
customer funds and fully paid and excess margin securities held by the
firm for the accounts of customers.\6\ The intent of the rule is to
require a brokerdealer to hold customer assets in a manner that
enables their prompt return in the event of an insolvency, which, in
turn, increases the ability of the firm to wind down in an orderly
selfliquidation and, thereby avoid the need for a proceeding under the Securities Investor Protection Act of 1970 (``SIPA'').\7\
\5\ See Exchange Act Release No. 9856 (November 10, 1972), 1972 SEC LEXIS 189.
\6\ Subparagraph (a)(3) of Rule 15c33 defines ``fully paid securities'' as securities carried in any type of account for which the customer has made a full payment. Subparagraph (a)(5) defines ``excess margin securities'' as securities having a market value in excess of 140% of the amount the customer owes the brokerdealer and which the brokerdealer has designated as not constituting margin securities.
\7\ 15 U.S.C. 78aaa et seq.
The required amount of customer funds to be segregated is
calculated pursuant to a formula set forth in Exhibit A to Rule 15c3
3.\8\ Under the formula, the brokerdealer adds up various credit and
debit line items. The credit items include cash balances in customer
accounts and funds obtained through the use of customer securities. The
debit items include money owed by customers (e.g., from margin
lending), securities borrowed by the brokerdealer to effectuate
customer short sales, and required margin posted to certain clearing
agencies as a consequence of customer securities transactions. If,
under the formula, customer credit items exceed customer debit items,
the brokerdealer must maintain cash or qualified securities in that
net amount in a ``Special Reserve Bank Account for the Exclusive
Benefit of Customers.'' This account must be segregated from any other
bank account of the brokerdealer. Generally, a brokerdealer with a
deposit requirement of $1 million or more computes its reserve
requirement on a weekly basis as of the close of the last business day
of the week (usually Friday).\9\ The weekly calculation determines the
required minimum balance the brokerdealer must maintain in the reserve account.
\8\ 17 CFR 240.15c33a.
\9\ 17 CFR 240.15c33(e)(3).
As noted, Rule 15c33 also requires a brokerdealer to maintain
physical possession or control of all fully paid and excess margin
securities carried for customers.\10\ This means the brokerdealer
cannot lend or hypothecate these securities and must hold them itself
or, as is more common, in a satisfactory control location. Under the
rule, satisfactory control locations include regulated securities
clearing agencies, U.S. banks, and, with the approval of the
Commission, certain foreign financial institutions.\11\ In order to
meet the possession or control requirement, a brokerdealer must
determine on a daily basis the amount of customer fully paid and excess
margin securities (by issuer and class) it holds for customers.\12\ It
then compares that amount with the amount of securities it holds free
of lien in its own possession or at one of the satisfactory control
locations. If a shortfall exists, the firm must take certain actions
under the rule.\13\ The actions include: removing liens on securities
collateralizing a bank loan; recalling securities loaned to a bank or
clearing corporation; buyingin securities that have been failed to
receive over thirty days; or buyingin securities receivable as a result of dividends, stock splits or similar
distributions that are outstanding over fortyfive days.\14 \ \10\ 17 CFR 240.15c33(b)(1).
\11\ 17 CFR 240.15c33(c).
\12\ 17 CFR 240.15c33(d).
1. Proprietary Accounts of BrokerDealers
We are proposing an amendment to Rule 15c33 that would require
brokerdealers to treat accounts they carry for domestic and foreign
brokerdealers in the same manner generally as ``customer'' accounts
for the purposes of the reserve formula of Rule 15c33.\15\ The
amendment is intended to address an inconsistency between the way these
proprietary accounts of brokerdealers are protected under Rule 15c33 and the SIPA.
\15\ See 17 CFR 240.15c33(a)(1). This paragraph defines ``customer'' for the purposes of Rule 15c33. Brokerdealers, both domestic and foreign, are excluded from the definition and, consequently, are not treated as ``customers'' for the purposes of the rule's reserve and possession and control requirements. Some foreign brokerdealers also operate as banks. These firms are not deemed ``customers'' to the extent that their accounts at the U.S. brokerdealer involve proprietary brokerdealer activities.
Specifically, because brokerdealers are not ``customers'' for purposes of Rule 15c33, a brokerdealer that carries the proprietary accounts of other brokerdealers is not required to include credit and debit items associated with those accounts in the customer reserve formula. Conversely, under SIPA, brokerdealers are considered ``customers'' and, consequently, entitled to certain protections. When a brokerdealer is liquidated under SIPA, an estate of customer property is created.\16\ Customers of the failed brokerdealer, including customers that are brokerdealers, are entitled to a pro rata share of the estate of customer property. Thus, while brokerdealers need not reserve for accounts carried for other brokerdealers under Rule 15c33, in a SIPA liquidation, brokerdealer accountholders may share in the fund of customer property. This disparity increases the risk that, in the event a clearing broker is liquidated under SIPA, customer claims will exceed the amount of customer property. \16\ In particular, under SIPA, the pool of ``customer property'' is established using assets recovered from the failed brokerdealer. The statute determines the assets that become a part of the pool of customer property. 15 U.S.C. 78lll(4). Customer property includes ``cash and securities * * * at any time received, acquired, or held by or for the account of the debtor from or for the securities accounts of a customer, and the proceeds of any such property transferred by the debtor, including property unlawfully converted.'' Therefore, ``customer property'' includes those securities positions that are held for customers and the cash that is owed to customers. After being established, customer property is distributed to customers pro rata based on the amounts of their claims (i.e., their net equity). While brokerdealers are not entitled to advances from the SIPC fund to make up for shortfalls in the fund of customer property (see 15 U.S.C 78fff3(a)(5)), they may be ``customers'' as that term is defined in SIPA and, therefore, entitled to a pro rata distribution from the fund of customer property.
In order to correct the gap between Rule 15c33 and SIPA, we are
proposing amendments to Rules 15c31, 15c33 and 15c33a that would
require carrying brokerdealers to perform a separate reserve
computation for proprietary accounts of other domestic and foreign
brokerdealers in addition to the reserve computation currently
required for ``customer'' accounts, and establish and fund a separate
reserve account for the benefit of these domestic and foreign broker
dealers.\17\ This added protection also would mitigate potential
contagion that might arise in the event of a failure of a brokerdealer with a large number of brokerdealer customers.
\17\ The amendment would exclude from the brokerdealer reserve computation accounts established by a brokerdealer that fully guarantees the obligations of, or whose accounts are fully guaranteed by, the clearing broker. In these circumstances, the guarantor must take deductions under Rule 15c31 for guaranteed obligations of the other firm. In addition, the amendment would exclude deliveryversuspayment and receiptversuspayment accounts. These types of accounts pose little risk of reducing the estate of customer property in a SIPA liquidation since they only hold assets for short periods of time.
The proposed amendments, in many respects, would codify a noaction
letter regarding proprietary accounts of introducing brokers (``PAIB
Letter'') previously issued by Commission staff.\18\ One significant
difference is that the amendments would have a broader scope by
including proprietary accounts of foreign brokersdealers and banks
acting as brokerdealers. In the PAIB Letter, the staff stated it would
not recommend any action to the Commission if an introducing broker
dealer did not take a net capital deduction under Rule 15c31 for cash
held in a securities account at another brokerdealer, provided the
other brokerdealer agreed to (1) perform a reserve computation for
brokerdealer accounts, (2) establish a separate special reserve bank
account, and (3) maintain cash or qualified securities in the reserve account equal to the computed reserve requirement (``PAIB
agreement'').\19\ The PAIB Letter, however, did not completely address the disparity between Rule 15c33 and SIPA, because the procedures set forth in the letter are voluntary and foreign brokerdealers are not subject to Rule 15c31 and, consequently, have no incentive to enter into PAIB agreements. Therefore, carrying firms do not include the accounts of foreign brokerdealers in either the Rule 15c33 or PAIB computations. However, these entities may be customers for the purposes of SIPA.
\18\ See Letter from Michael A. Macchiaroli, Associate Director, Division of Market Regulation, Commission, to Raymond J. Hennessy, Vice President, NYSE, and Thomas Cassella, Vice President, NASD Regulation, Inc. (Nov. 10, 1998).
\19\ Under Rule 15c31, brokerdealers generally are required to deduct unsecured receivables from their net worth when computing their net capital. Paragraph (c) of the rule contains certain exceptions to this requirement. Among the enumerated exceptions are commissions receivable from another brokerdealer outstanding 30 days or less. This exception is limited to receivables from a clearing brokerdealer related to transactions in accounts
introduced by the brokerdealer. Frequently, introducing broker dealers as well as other brokerdealers will have receivables from another brokerdealer arising from proprietary transactions in an account at the other brokerdealer. There is no exception in Rule 15c31 permitting these receivables to be included in a broker dealer's net capital amount. However, under the terms of the PAIB Letter, a brokerdealer could include them.
The proposed amendmentslike the PAIB Letterwould establish
reserve requirements for a carrying broker with respect to proprietary
accounts it carries for other brokerdealers. Paragraph (e) of Rule
15c33 would be amended to require the carrying broker to perform a
reserve computation for a proprietary account of another brokerdealer
(referred to as a ``PAB account'') and to establish and maintain a
reserve account at a bank for these PAB accounts.\20\ A new paragraph
(a)(16) would be added to define ``PAB account,'' paragraph (f) would
be amended to require the carrying brokerdealer to notify the bank
about the status of the PAB reserve account and obtain an agreement and
notification from the bank that the PAB reserve account will be
maintained for the benefit of the PAB accountholders. In addition,
paragraph (g) would be amended to specify when the carrying broker
dealer could make withdrawals from a PAB reserve account. The carrying
broker would have to maintain cash or qualified securities in the PAB
reserve account in an amount equal to the PAB reserve requirement.
Consistent with the noaction relief provided in the PAIB Letter, if the PAB reserve computation results in a deposit
requirement, the proposed amendment would allow the requirement to be offset to the extent there are excess debits in the customer reserve computation of the same date. However, in order to provide greater protection to customers that are not brokerdealers, a deposit requirement resulting from the customer reserve computation would not be able to be offset by excess debits in the PAB reserve computation. This means the carrying brokerdealer could use PAB credits to finance ``customer'' debits, but not the other way around. Thus, ``customers'' (which include retail investors but exclude brokerdealers) would receive greater protection.
\20\ Under paragraph (e), brokerdealers are required to perform the customer reserve computation as of the close of business on the last business day of the week or, in some cases, the month. Broker dealers from time to time may perform a midweek computation if it would permit them to make a withdrawal. Under the proposed amendments, a brokerdealer would need to compute both the customer and PAB reserve requirements simultaneously before making a withdrawal from either account based on a midweek computation. Moreover, a withdrawal could not be made from one account if the midweek computation demonstrated an increased requirement in the other account.
Paragraph (b) of Rule 15c33 would be amended to provide that a brokerdealer carrying PAB accounts would not be required to maintain physical possession or control of fully paid and excess margin securities carried for PAB accounts, provided it obtains the written permission of the PAB accountholder to use such securities in the ordinary course of its securities business. This provision would be consistent with Rule 15c33, which is intended to provide greater protection to customers that are not brokerdealers customers. It also would accommodate industry practice of carrying brokerdealers using the securities of their brokerdealer accountholders, which contributes to the liquidity of the securities markets.
Finally, paragraph (c)(2)(iv)(E) of Rule 15c31 would be amended to require a brokerdealer to deduct from net worth when calculating net capital the amount of its cash in a proprietary account at another brokerdealer where the other brokerdealer is not treating the cash in compliance with the proposed requirements described above. This would prevent brokerdealers from including assets in their net capital amounts that may not be readily available. We would not expect broker dealers to audit or examine their carrying brokerdealers to determine whether the carrying brokerdealer is in compliance with the proposed rules.
We request comment on all aspects of these proposed amendments, including whether the accounts of other noncustomers under Rule 15c33 (e.g., principal officers of the brokerdealer) should be included in the PAB computation.
2. Banks Where Special Reserve Deposits May Be Held
Brokerdealers must deposit cash or ``qualified securities'' into
the customer reserve account maintained at a ``bank'' under Rule 15c3
3(e).\21\ Rule 15c33(f) further requires the brokerdealer to obtain a
written contract from the bank in which the bank agrees not to relend
or hypothecate securities deposited into the reserve account.\22\
Consequently, the securities should be readily available to the broker
dealer. Cash deposits, however, are fungible with other deposits
carried by the bank and may be freely used in the course of the bank's
commercial lending activities. Therefore, to the extent a brokerdealer
deposits cash in a reserve bank account, there is a risk the cash could
be lost or inaccessible for a period if the bank experiences financial
difficulties. This could adversely impact the brokerdealer and its
customers if the balance of the reserve deposit is concentrated at one bank in the form of cash.
\21\ The term ``qualified securities'' is defined in paragraph (a)(6) of Rule 15c33 to mean a securities issued by the United States or guaranteed by the United States with respect to principal and interest. 17 CFR 240.15c33(a)(6). The term ``bank'' is defined in paragraph (a)(7) of Rule 15c33.
\22\ See 17 CFR 240.15c33(f).
This risk may be heightened when the deposit is held at an affiliated bank in that the brokerdealer may not exercise due diligence with the same degree of impartiality when assessing the financial soundness of an affiliate bank as it would with a non affiliate bank. Moreover, the brokerdealer's customers may not derive any significant protection from the reserve requirement in the event of the parent's insolvency.
To address these risks, we are proposing an amendment to Rule 15c3
3 that would exclude cash deposits at affiliate banks for the purposes
of meeting customer or PAB reserve requirements and place limitations
on the amount of cash a brokerdealer could maintain in a customer or
PAB special reserve bank account at one unaffiliated bank. The
exclusion and limitations would not apply to deposits of securities
since these assets do not become a part of a bank's working capital. As
discussed below, the limitations would prevent a brokerdealer from
maintaining a reserve deposit in the form of cash at a single
unaffiliated bank that exceeds a percentage of the brokerdealer's or
the bank's capital. This is designed to mitigate the risk that an
impairment of the reserve deposit at an unaffiliated single bank will
have a material negative impact on the brokerdealer's ability to meet its obligations to customers and PAB accountholders.\23\
\23\ These amendments are not intended to affect the practice whereby customer free credit balances are swept into a bank deposit account and the customer receives Federal Deposit Insurance Protection.
Under the proposal, a paragraph (e)(5) would be added to Rule 15c3
3. This new paragraph would provide thatin determining whether the
brokerdealer maintains the minimum reserve deposits required (customer
and PAB)the brokerdealer would be required to exclude a cash deposit
at an affiliated bank. With respect to unaffiliated banks, the broker
dealer would be required to exclude the deposit to the extent that it
exceeded (1) 50% of the brokerdealer's excess net capital (based on
the most recently filed FOCUS Report),\24\ or (2) 10% of the bank's
equity capital (based on the bank's most recently filed Call Report or
Thrift Financial Report).\25\ The goal is to limit cash reserve account
deposits to reasonably safe amounts as measured against the
capitalization of the brokerdealer and the bank. Excess net capital is
the amount that a brokerdealer's net capital exceeds its minimum
requirement and, therefore, constitutes a cushion to absorb unexpected
losses. We believe limiting a cash deposit in one bank to 50% of excess
net capital means the brokerdealer has a reserve to absorb the loss or
impairment of the deposit plus an additional amount to absorb other
losses. The amount of a bank's equity capital is a measure of its
financial solvency. We believe limiting the cash deposit to 10% of the
bank's equity capital means the brokerdealer would not commit customer
cash to an institution in an amount that is out of proportion to the bank's capital base.
\24\ Under Rule 17a5 (17 CFR 240.17a5) brokerdealers must file periodic reports on Form X17a5 (Financial and Operational Combined Uniform Single Reports (``FOCUS Reports'')). The FOCUS Report form requires, among other financial information, a balance sheet, income statement, and net capital and customer reserve computations.
\25\ Commercial banks insured by the Federal Deposit Insurance Corporation (``FDIC''), savings banks supervised by the FDIC, and noninsurance trust companies supervised by the Office of the Comptroller of the Currency file quarterly Call Reports. Savings Associations and noninsured trust companies supervised by the Office of Thrift Supervision file Thrift Financial Reports (TFRs). These reports include a line item for equity capital. A report for a specific institution can be obtained by accessing the following Web site: http://www2.fdic.gov/call_tfr_rpts/search.asp.
We request comment on all aspects of these proposed amendments,
including whether the proposed reserve deposit limitations of 50% of
excess net capital or 10% of the bank's equity capital adequately
address the risks of concentrating cash deposits at any one bank or whether other thresholds should apply.
3. Expansion of the Definition of Qualified Securities To Include Certain Money Market Funds
As noted above, a brokerdealer is limited to depositing cash or
``qualified securities'' into the bank account it maintains to meet the
customer reserve deposit requirements under Rule 15c33. Paragraph
(a)(6) of Rule 15c33 defines ``qualified securities'' as securities
issued by the United States or guaranteed by the United States with
respect to principal and interest (``US Treasury securities'').\26\
These strict limitations on the types of assets that can be used to
fund a brokerdealer's customer reserve account are designed to further
the purpose of Rule 15c33; namely, that customer assets be segregated
and held in a manner that makes them readily available to be returned
to the customer. For example, paragraph (e)(2) of Rule 15c33 makes it
unlawful for a brokerdealer to use customer credits (generally, cash
balances in securities accounts) for any purpose other than financing
customer debits (fully secured margin loans).\27\ Under the rule, the
amount of excess credits (i.e., credits net of debits) must be held in
the customer reserve account and, as noted, the account must be funded with either cash or U.S. Treasury securities.\28\
\26\ 17 CFR 240.15c33(a)(6).
\27\ 17 CFR 240.15c33(e)(2).
Federated Investors, Inc. (``Federated'') has filed a petition with
the Commission requesting that Rule 15c33 be amended to include
certain types of money market funds in the definition of qualified
securities.\29\ We believe expanding the definition to include money
market funds that only invest in securities meeting the definition of
``qualified security'' in Rule 15c33 would be appropriate. The assets
held by such a money market fund would be same as those a brokerdealer
can hold directly in its customer reserve account. Consequently, a
brokerdealer might choose to deposit qualifying money market fund
shares into the customer reserve account based on operational
considerations such as avoiding the need to actively manage a portfolio
of U.S. Treasury securities. This operational benefit also could
decrease burdens on those brokerdealers that would be impacted by our
proposed amendments discussed above with respect to customer reserve
account cash deposits into affiliate and nonaffiliate banks. A broker
dealer that deposits cash into the customer reserve account to avoid
the operational aspects of holding and managing U.S. Treasury
securities would have the option of depositing a qualifying money market fund to replace the cash deposit.
\29\ See Public Petition for Rulemaking No. 4478 (April 3, 2003), as amended (April 4, 2005), available at http://www.sec.gov/rules/petitions/petn4478.htm .
We believe, however, that there should be safeguards in place designed to ensure that qualifying money market fund shares could be redeemed quickly. A brokerdealer in financial difficulty must be able to liquidate quickly the assets in its customer reserve account so that customer credit balances can be returned without delay. Consequently, in addition to the limitations on holdings discussed above, our proposal to expand the definition of ``qualified securities'' to include money market funds includes the following safeguards. First, the money market fund could not be a company affiliated with the brokerdealer. The brokerdealer may experience financial difficulty caused by liquidity problems at the holding company level that are adversely impacting an affiliated money market fund as well in terms of the fund's ability to promptly redeem shares. Second, our proposal would require the brokerdealer to use a fund that agrees to redeem fund shares in cash on the next business day. There should be no ability of the fund to delay redemption beyond one day or to require a multiday redemption notification period.
Finally, our proposal would require that the money market fund have an amount of net assets (assets net of liabilities) that is at least 10 times the value of the fund's shares held by the brokerdealer in its customer reserve account. This is designed to prevent a brokerdealer from holding too concentrated a position in a single fund. It also limits a potential redemption request by the brokerdealer to 10% or less of the fund's assets. While a redemption request that equaled 10% of a fund's net assets would be very substantial, we believe it is a reasonable threshold between a request that could be handled promptly and one that could have the potential to cause the fund some degree of difficulty in meeting the request within one business day. We seek comment on this threshold, particularly with respect to whether it should be smaller (e.g., 5% or 2%) or higher (e.g., 15% or 25%).
For the foregoing reasons, we propose amending the definition of ``qualified security'' in paragraph (a)(6) of Rule 15c33 to include an unaffiliated money market fund that: (1) Is described in Rule 2a7 of the Investment Company Act of 1940; (2) invests solely in securities issued by the United States or guaranteed by the United States as to interest and principal; (3) agrees to redeem fund shares in cash no later than the business day following a redemption request by a shareholder; and (4) has an amount of net assets equal to at least 10 times the value of the shares deposited by the brokerdealer in its customer reserve account.
We solicit comment on all aspects of this proposal, including
whether these types of money market funds are appropriate for the
customer reserve account in terms of liquidity and safety and whether
the 10% net asset limitation would be an adequate safeguard in terms of ensuring a brokerdealer could quickly redeem its shares.
4. Allocation of Customers' Fully Paid and Excess Margin Securities to Short Positions
Paragraph (d) of Rule 15c33 sets forth steps a brokerdealer must take to retrieve securities from noncontrol locations if there is a shortfall in the fully paid or excess margin securities it is required to hold. The rule does not require the brokerdealer to act when a short position on the brokerdealer's stock record allocates to a customer long position; for example, if the brokerdealer sells short a security to its customer. In such a circumstance, the brokerdealer would not be required to have possession or control of the security its customer has paid for in full. Instead, the brokerdealer would put the marktomarket value of the security as a credit item in the reserve formula. The cash paid by the customer to purchase the security could be used by the brokerdealer to make any increased deposit requirement caused by the credit item. If the increase is less than the cash paid, the brokerdealer could use the excess funds in its own business operations. Moreover, if the value of the security decreases, the brokerdealer could withdraw funds out of the reserve account and use them as well. In effect, this permits the brokerdealer to monetize the customer's security. This is contrary to the customer protection goals of Rule 15c33, which seeks to ensure that brokerdealers do not use customer assets for proprietary purposes.
Accordingly, we are proposing to add a new paragraph (d)(4) to Rule
15c33, which would add an additional action with respect to retrieving
securities from noncontrol positions when the brokerdealer needs to
obtain possession or control over a specific issue and class of [[Page 12866]]
securities.\30\ Specifically, under the proposal, the brokerdealer would be required to take prompt steps to obtain physical possession or control over securities of the same issue and class as those included on the brokerdealer's books as a proprietary short position or as a short position for another person. By requiring the brokerdealer to obtain physical possession or control over the security, it would no longer be able to monetize the value of the security and use the cash for proprietary activities.
\30\ Current paragraph (d)(4) of Rule 15c33 would be re designated as paragraph (d)(5).
Under the proposal, the action would not be required until the short position had aged more than 10 business days (or more than 30 calendar days if the broker or dealer is a market maker in the securities).\31\ Allowing brokerdealers 10 business days before they must take action is consistent with paragraph (m) of Rule 15c33, which similarly allows a brokerdealer up to 10 business days after settlement date to purchase securities that a customer has sold through the brokerdealer but failed to deliver. As with the requirement in paragraph (m), the proposal's objective is to require a brokerdealer to close an open transaction but within a timeframe that permits a degree of flexibility. The longer 30 calendar day period for securities in which the brokerdealer makes a market is intended to accommodate the shortselling that is integral to marketmaking activities. \31\ The proposed amendment would not apply to securities that are sold for a customer but not obtained from the customer within 10 days after the settlement date. This circumstance is addressed by paragraph (m) of Rule 15c33, which requires the brokerdealer to close the transaction by purchasing securities of like kind and quantity. 17 CFR 240.15c33(m).
We request comment on all aspects of this proposed amendment,
including whether the proposed time periods should be longer or shorter.
5. Treatment of Free Credit Balances and Importation of Rule 15c32 Requirements Into Rule 15c33
i. Treatment of Free Credit Balances
Free credit balances are funds payable by a brokerdealer to its customers on demand.\32\ They may result from cash deposited by the customer to purchase securities, proceeds from the sale of securities or other assets held in the customer's account, or earnings from dividends and interest on securities and other assets held in the customer's account. Brokerdealers may, among other things, pay interest to customers on their free credit balances, or offer to transfer (sweep) them into a specific money market fund or interest bearing bank account. The customer earns dividends on the money market fund or interest on the bank account until such time as the customer chooses to liquidate the position in order to use the cash, for example, to purchase securities.
\32\ See 17 CFR 240.15c33(a)(8).
In recent years, brokerdealers have on occasion changed the
product to which a customer's free credit balances are sweptmost
frequently from a money market fund product to an interest bearing bank
account. There are differences in these two types of products,
including the type of protection afforded the customer in the event of
an insolvency. The money market sharesas securitieswould receive up
to $500,000 in SIPA protection in the event the brokerdealer failed.
The bank depositsas cashwould receive $100,000 in protection from
the Federal Deposit Insurance Corporation (``FDIC'') in the event the
bank failed. On the other hand, the money market fund as a security
theoretically could lose its principal; whereas the bank deposit would
be guaranteed up to the FDIC's $100,000 limit. There also may be
differences in the amount of interest earned from the two products. In
short, while not judging the appropriateness of either option, we note
there may be consequences to changing options and believe that
customers should have a sufficient opportunity to make an informed decision.\33\
\33\ In 2005, The New York Stock Exchange LLC (``NYSE'') addressed the issue of disclosure. Specifically, the NYSE issued an information memo to its members discussing, among other things, the disclosure responsibilities of a brokerdealer offering a bank sweep program to its customers. See Information Memo 0511 (February 15, 2005). The Memo stated that brokerdealers should disclose material differences in interest rates between the different products and, with respect to the bank sweep program, the terms and conditions, risks and features, conflicts of interest, current interest rates, the manner by which future interest rates will be determined, and the nature and extent of FDIC and SIPC protection. See id.
For these reasons, we are proposing to amend Rule 15c33 by adding
a new paragraph (j) that would make it unlawful for a brokerdealer to
convert, invest or otherwise transfer free credit balances except under
three circumstances. The first circumstance, set forth in proposed
paragraph (j)(2)(i) of Rule 15c33, would permit a brokerdealer to
convert, invest, or otherwise transfer the free credit balances to any
type of investment or other product, or to a different account within
the brokerdealer or at another institution, or otherwise dispose of the free credit balances, but only upon a specific order,
authorization, or draft from the customer, and only under the terms and conditions specified by the customer in the order, authorization or draft. This proposal is not addressing free credit balance sweeps to money market funds and bank deposit accounts, but rather the use of customer free credit balances for other purposes (e.g., to purchase securities other than money market funds, or to transfer to a different account or financial institution). In these circumstances, the proposed paragraph would prohibit any investment, conversion, or other transfer of the free credit balances except on the customer's specific order, authorization, or draft.
The second and third circumstances, set forth in proposed paragraphs (j)(2)(ii) and (iii) of Rule 15c33, address the sweeping of free credit balances to either a money market fund or a bank deposit account. The former applies to new customers and the latter to existing customers as of the date the proposed amendments would become effective.
Proposed paragraph (j)(2)(ii) of Rule 15c33 would permit a broker
dealer to have the ability to change the sweep option of a new customer
from a money market fund to a bank deposit account (and vice versa),
provided certain specific conditions are met. First, the customer would
need to agree prior to the change (e.g., in the account opening
agreement) that the brokerdealer could switch the sweep option between
those two types of products. Second, the brokerdealer would need to
provide the customer with all notices and disclosures regarding the
investment and deposit of free credit balances required by the self
regulatory organizations for which the brokerdealer is a member.\34\
Third, the brokerdealer would need to provide the customer with notice
in the customer's quarterly statement that the money market fund or
bank deposit account can be liquidated on the customer's demand and
converted back into free credit balances held in the customer's
securities account. Fourth, the brokerdealer would need to provide the
customer with notice at least 30 calendar days before changing the
product (e.g., from one money market fund to another), the product type
(e.g., from a money market fund to a bank account), or the terms and
conditions under which the free credit balances are swept. The notice
would need to describe the change and explain how the customer could opt out of it.
\34\ See NYSE Information Memo 0511 (February 15, 2005).
The third circumstance, set forth in proposed paragraph (j)(2)(iii) of Rule
15c33, would apply to existing customers as of the effective date of the proposed rule. It would permit a brokerdealer to have the option to change an existing customer's sweep option from a money market fund to a bank deposit account (and vice versa), provided the second, third, and fourth conditions set forth in proposed paragraph (j)(2)(ii) discussed above were met. To minimize the burden on the brokerdealer, proposed paragraph (j)(2)(iii) would not require the brokerdealer to obtain the customer's previous agreement to permit the brokerdealer to switch the sweep option between money market fund products and bank deposit account products. This would avoid the necessity of having to amend each existing customer account agreement. Because all the other conditions in proposed paragraph (j)(2)(ii) would apply, the broker dealer would be required to provide existing customers with the various notices and disclosures that must be made to new customers, including giving notice at least 30 calendar days before the sweep option was changed and in that notice explain the change and how the customer could opt out of it.
We request comment on all aspects of this proposed amendment, including: (1) Whether it would provide adequate protection to customers with respect to changes in the treatment of their free credit balances, (2) on the cost burdens (quantified to the extent possible) that would result if the condition in proposed paragraph (j)(2)(ii)(A) of Rule 15c33 to obtain a new customer's prior agreement were to be applied to existing customers, (3) whether there are other sweep products in addition to money market mutual funds and bank deposit accounts that could be contemplated in proposed paragraphs (j)(2)(ii) and (iii) of Rule 15c33, and (4) whether the treatment of free credit balances has already been adequately addressed by the selfregulatory organizations.
ii. Importation of Rule 15c32
Rule 15c32 requires a brokerdealer holding free credit balances to provide its customers (defined as any person other than a broker dealer) at least once every three months with a statement of the amount due the customer and a notice that (1) the funds are not being segregated, but rather are being used in the brokerdealer's business, and (2) that the funds are payable on demand. The rule was adopted in 1964 before the adoption of Rule 15c33.\35\ Since the adoption of Rule 15c33, a brokerdealer, as noted above, has been limited in how it may use customer free credit balances. While the reserve account required under Rule 15c33 is in the name of the brokerdealer and the assets therein remain a part of its capital, the assets in the account are held for the exclusive benefit of the brokerdealer's customers. In a liquidation of the brokerdealer, the assets in the account will be available to satisfy customer claims ahead of all other creditors. \35\ See Exchange Act Release No. 7266 (March 12, 1964).
We believe the adoption of Rule 15c33 has eliminated the need to
have a separate Rule 15c32. At the same time, we believe certain of
the requirements in Rule 15c32 should be imported into Rule 15c33;
namely, the requirements that brokerdealers inform customers of the
amounts due to them and that such amounts are payable on demand.\36\
Accordingly, we are proposing to eliminate Rule 15c32 and amend Rule 15c33 to include these latter requirements.
\36\ Rule 15c32 contains an exemption for brokerdealers that also are banking institutions supervised by a Federal authority. This exemption would not be imported into Rule 15c33 because there are no brokerdealers left that fit within the exemption. Further, under the proposed amendment, the definition of ``customer'' for purposes of the imported 15c32 requirements would be the definition of ``customer'' in Rule 15c33, which is somewhat narrower than the definition in Rule 15c32.
We request comment on all aspects of this proposed amendment. Commenters are encouraged to provide data to support their views. 6. Aggregate Debit Items Charge
Note E(3) to the customer reserve formula (Rule 15c33a) requires a
brokerdealer using the ``basic method'' of computing net capital under
Rule 15c31 to reduce by 1% the total debits in Item 10 of the formula
(i.e., debit balances in customer's cash and margin accounts).\37\ This
1% reduction in Item 10 debits lowers the amount of total debit items
in the formula. Because the debits offset aggregate credits in
determining customer reserve requirements, the reduction has the
potential to increase the amount a brokerdealer must maintain in the
reserve account. Under paragraph (a)(1)(ii)(A) of Rule 15c31 however,
brokerdealers using the ``alternative standard'' \38\ to compute their
minimum net capital requirement must reduce aggregate debit items by 3%
in lieu of the 1% reduction required by Note E(3).\39\ Thus, the
deduction applicable to alternative standard firms can result in an even larger reserve deposit requirement.
\37\ Under the ``basic method,'' a brokerdealer cannot permit its aggregate indebtedness (generally total money liabilities) to exceed 1500% of its net capital. 17 CFR 15c31(a)(1)(i).
\38\ Under the ``alternative standard,'' a brokerdealer's minimum net capital requirement is equal to 2% of the firm's aggregate debit items. 17 CFR 240.15c31(a)(1)(ii).
\39\ 17 CFR 240.15c31(a)(1)(ii)(A).
The Commission adopted the alternative standard as part of the 1975
amendments to Rule 15c31, which expanded the rule's scope to apply to
all brokerdealers.\40\ The alternative standard constituted a new way
of providing for the capital adequacy of a brokerdealer in that it
diverged from the traditional notion of limiting a firm's leverage.\41\
The alternative standard instead imposes a capital requirement based on
the size of the brokerdealer's commitments to its customers through
margin lending and other transactions. Thus, it requires a broker
dealer to hold net capital equal to a percentage of its customer
commitments. The alternative standard was designed to integrate a
brokerdealer's capital requirement under Rule 15c31 with the customer
protection requirements in Rule 15c33; hence it uses the aggregate
debit computation required by Rule 15c33 to determine a broker dealer's net capital requirement under Rule 15c31.\42\
\40\ See Exchange Act Release No. 11497 (June 26, 1975). Prior to 1975, the rule only applied to brokerdealers that were not a member of a securities exchange, since exchange members were subject to capital rules promulgated by the exchanges. Id.
\41\ See id.
As part of the amendments adopting the alternative standard, the
Commission lowered the haircut on equity securities from 30% to 15% for
a brokerdealer using the standard.\43\ At the same time, it amended
Rule 15c31 to require alternative standard firms to employ the greater
3% reduction of debit items.\44\ The Commission explained the greater
requirement as providing, ``in the event of a liquidation [of the
brokerdealer], an additional cushion of secured debit items which will
be available to satisfy customers with whom the broker or dealer effects transactions.'' \45\
Originally, the alternative standard required a brokerdealer to
hold net capital equal to 4% of its customer debits.\46\ The Commission
lowered this requirement to 2% in 1982.\47\ It explained its decision
as being based on brokerdealers' improved backoffice systems and increased use of clearing
agencies.\48\ These developments made it possible for the firms to handle large volumes of trading without experiencing operational and bookkeeping problems.\49\ The Commission also noted that the SROs had upgraded their surveillance programs and that the early warning rules of both the Commission and the SROs remained significantly higher than the 2% minimum requirement.\50\
\47\ Exchange Act Release 18417 (January 13, 1982), 47 FR 3512 (January 25, 1982).
In recent years, the amount of debit items carried by broker dealers has increased substantially. Consequently, the 3% reduction in debit items has required many brokerdealers using the alternative standard to increase their reserve deposits by additional amounts that are far in excess of the additional cushion envisioned when the amendment was adopted in 1975. Furthermore, the level of risk assumed by brokerdealers does not increase proportionately as the aggregate amount of debits increases; due, in part, to an increase in diversity among the debits. The proportional 3% reduction of debit items does not recognize this diversification benefit.
Moreover, in 1992, the Commission amended Rule 15c31 to lower the
haircut for brokerdealers using the basic method to 15%, which brought
their requirement in line with the alternative standard firms.\51\ The
15% haircut for equity securities has proven sufficient to cover most
market moves and, therefore, we believe the increased level of
protection derived from the greater 3% debit item reduction likely would not provide a benefit justified by the costs.
\51\ Exchange Act Release No. 31511 (November 24, 1992), 57 FR 56973 (December 2, 1992).
For these reasons, we believe it is now appropriate to treat brokerdealers using the alternative standard on a par with firms using the basic method and, therefore, propose lowering the debit reduction applicable to alternative standard firms. We would apply a 1% reduction, rather than a 3% reduction, for alternative standard firms. The 1% reduction should provide an adequate cushion, given these firms' current levels of debit items, whichas notedare far greater than existed when the rule was adopted in 1975 or amended in 1982. Our proposal would amend paragraph (a)(1)(ii)(A) of Rule 15c31 by removing the provision requiring the 3% reduction. This would make alternative standard firms subject to the 1% reduction in debit items as required in Note E(3) of Rule 15c33a.
We request comment on all aspects of this proposed amendment, including whether the benefits of the 3% reduction outweigh any costs that might arise from the proposal. Commenters are requested to identify potential costs and provide data to support their views. 7. ``Proprietary Accounts'' Under the Commodity Exchange Act
Certain brokerdealers also are registered as futures commission
merchants under the Commodity Exchange Act (``CEA''). These firms carry
both securities and commodities accounts for customers. The definition
of ``free credit balances'' in paragraph (a)(8) of Rule 15c33 excludes
funds that are carried in commodities accounts that are segregated in
accordance with the requirements of the CEA.\52\ However, regulations
promulgated under the CEA exclude certain types of accounts
(``proprietary accounts'') from the segregation requirement.\53\ The
question has arisen as to whether a brokerdealer holding these types
of accounts must include funds in them as ``free credit balances'' when performing a customer reserve computation.
\52\ 17 CFR 240.15c33(a)(8).
\53\ Rule 1.20 (17 CFR 1.20) requires a futures commission merchant to segregate ``customer'' funds. Rule 1.3(k) (17 CFR 1.3(k)) defines the term ``customer'' for this purpose. The definition of ``customer'' excludes persons who own or hold a ``proprietary account'' as that term is defined in Rule 1.3(y) (17 CFR 1.3(y)). Generally, the definition of ``proprietary account'' refers to persons who have an ownership interest in the futures commission merchant. See 17 CFR 1.3(y).
These funds likely would not be protected in a SIPA proceeding
because they are related to commodities transactions.\54\ The purpose
behind the cash reserve requirements in Rule 15c33 is to require
brokerdealers to hold sufficient funds with which to satisfy customer
claims arising from securities (not commodities) transactions and,
thereby, to minimize the need for a SIPA liquidation. This purpose
would not be served by treating funds held in commodities accounts
(that are not segregated under CEA regulations) as ``free credit
balances.'' Accordingly, we are proposing an amendment to paragraph
(a)(8) of Rule 15c33, which would clarify that funds held in a
commodity account meeting the definition of a ``proprietary account''
under CEA regulations are not to be included as ``free credit balances'' in the customer reserve formula.
\54\ To receive protection under SIPA, a claimant must first qualify as a ``customer'' as that term is defined in the statute. Generally, a ``customer'' is any person who has (1) ``a claim on account of securities received, acquired, or held by the [broker dealer],'' (2) ``a claim against the [brokerdealer] arising out of sales or conversions of such securities'' or (3) ``deposited cash with the debtor for the purposes of purchasing securities.'' 15 U.S.C. 78lll(2). The definition of ``security'' in SIPA specifically excludes commodities and nonsecurities futures contracts (see 15 U.S.C. 78lll(14)) and, thus, a person with a claim for such assets would not meet the definition of ``customer.''
We request comment on all aspects of this proposed amendment. Commenters are encouraged to provide data to support their views. B. Holding Futures Positions in a Securities Portfolio Margin Account
The Chicago Board of Options Exchange, Incorporated (``CBOE'') and
the NYSE have amended their margin rules to permit brokerdealer
members to compute customer margin requirements using a portfolio
margin methodology (``Portfolio Margin Rules'').\55\ A portfolio
margining methodology computes margin requirements based on the net
market risk of all positions in an account assuming certain potential
market movements. Under the Portfolio Margin Rules, a brokerdealer can
combine securities and futures positions into the portfolio margin
account. SIPA, however, only protects customer claims for securities
and cash and specifically excludes from protection futures contracts
that are not also securities.\56\ This raises a question as to how
futures positions in a portfolio margin account would be treated in a
SIPA liquidation. Consequently, we are proposing amendments to Rules
15c33 and 15c33a that are designed to provide the protections of Rule
15c33 and SIPA to futures positions in a securities account under the Portfolio Margin Rules.
\55\ Exchange Act Release No. 54918 (December 12, 2006), 72 FR 1044 (January 9, 2007) (SRNYSE200613); Exchange Act Release No. 54919 (December 12, 2006), (SRCBOE 200614); Exchange Act Release No. 52031 (July 14, 2005), 70 FR 42130 (July 21, 2005) (SRNYSE 200219); Exchange Act Release No. 52032 (July 14, 2005), 70 FR 42118 (July 21, 2005) (SRCBOE200203).
\56\ The definition of ``security'' in SIPA includes a futures contract that also is a security; namely, a ``security future'' as defined in section 3(a)(55)(A) of the Exchange Act. See 15 U.S.C. 78lll(14).
First, we propose amending the definition of ``free credit
balances'' in paragraph (a)(8) of Rule 15c33 to include funds
resulting from margin deposits and daily marks to market related to,
and proceeds from the liquidation of, futures on stock indices and
options thereon carried in a securities account pursuant to a portfolio
margining rule of an SRO. Under this amendment, a brokerdealer holding
such funds would have to treat them as ``credit items'' for purposes of
the customer reserve computation. Consequently, the futuresrelated funds
in a portfolio margin account would need to be included with all other credit items when a brokerdealer computed its customer reserve requirement under Rule 15c33. Further, because free credit balances constitute ``cash'' in a customer's account, they are ``cash'' for purposes of determining a customer's ``net equity'' in a SIPA liquidation.\57\
\57\ If a person qualifies as a ``customer'' under SIPA, the next inquiry is to value the amount of the customer's claim. This step is accomplished by reference to the definition of ``net equity'' in SIPA. 15 U.S.C 78lll(11). Generally, ``net equity'' is the ``dollar amount of the [customer's] account'' as determined by calculating the sum that would have been owed the customer had the securities in the customer's account been liquidated on the date the SIPA proceeding was commenced minus any amounts owed by the customer to the brokerdealer.
Our proposed amendment to the definition of ``free credit
balances'' also would bring within the definition's scope the market
value of futures options in a portfolio margin account as of the SIPA
``filing date.'' \58\ Unlike futures contracts, futures options do not
take the form of cash balances in the account (i.e., they have market
value at the end of a trading day). Since the brokerdealer is not
holding cash for the customer there is not the need to treat the
futures options as a ``free credit balance'' and require a credit in
the reserve formula. However, if the brokerdealer is liquidated under
SIPA, the unrealized gains or losses of the futures options should be
included in calculating the customer's net equity in the account (along
with the cash balances related to the futures contracts and the
securities positions and related cash balances). The proposed amendment
is designed to provide for this outcome by defining the market value of
the futures options as a free credit balance in the event the broker
dealer becomes subject to a SIPA proceeding. As ``free credit
balances,'' funds resulting from margin deposits and daily marks to
market related to futures and the market value of futures options as of
the SIPA filing date would constitute claims for cash in a SIPA
proceeding and, therefore, become a part of a customer's ``net equity''
claim and be entitled to up to $100,000 in advances to make up for shortfalls.\59\
\58\ The term ``filing date'' is defined in SIPA as, generally, being the date a SIPA proceeding is commenced. See 15 U.S.C. 78lll(7).
\59\ Generally, futures and futures options in a portfolio margin account would be transferred to a solvent brokerdealer or liquidated before the initiation of a SIPA proceeding. Consequently, these proposals are highly cautionary as it is unlikely that a brokerdealer would be placed in a SIPA liquidation while still holding these types of positions in customer accounts.
On the debit side of the customer reserve formula, we are proposing
an amendment to Rule 15c33a Item 14 that would permit the broker
dealer to include as a debit item the amount of customer margin
required and on deposit at a futures clearing organization related to
futures positions carried in a securities account pursuant to an SRO
portfolio margin rule. Under SIPA, the term ``customer property''
includes ``resources provided through the use or realization of
customers'' debit cash balances and other customerrelated debit items
as the Commission defines by rule.'' \60\ Under this provision of SIPA,
this proposed amendment to Rule 15c33a would make the margin required
and on deposit at a futures clearing organization part of the
``customer property'' in the event the brokerdealer is placed in a
SIPA liquidation.\61\ Thus, it would be available to the liquidation trustee for distribution to the failed firm's customers.
\60\ 15 U.S.C. 78lll(4)(B).
\61\ Margin posted at a futures clearing organization for securities futures products currently is treated in this manner. See 17 CFR 240.15c33a.
We believe our proposed amendments designed to provide the protections of Rule 15c33 and SIPA to all positions in a securities account established under an SRO portfolio margin rule are warranted given that the futures positions in the account serve as hedges for the securities positions and, therefore, reduce the risk of the securities positions. The intermingled nature of the positions, margin or deposit, and the fact that the futures positions reduce the amount of margin necessary to carry the securities positions makes it highly practical to treat all the positions in accordance with the requirements of Rule 15c33 and, as part of the customer's ``net equity'' in a SIPA liquidation.
We solicit comment on whether this approach represents a workable solution to providing SIPA protection to portfolio margin
accountholders. In particular, we request comment as to whether there are other approaches the Commission may pursue that are designed to provide SIPA protection to futures related cash and futures options in portfolio margin accounts.
C. Amendments With Respect to Securities Lending and Borrowing and Repurchase/Reverse Repurchase Transactions
Securities lending and repurchase transactions by institutions are
an important element of the financial markets. In a typical securities
lending transaction, the parties agree that the owner of the securities
(e.g., a pension fund, institutional investor, bank, or brokerdealer)
will lend securities to a borrower, and the borrower will be required
to return securities of like kind and quantity to the lender. To
protect the lender's interest, the borrower typically will provide cash
or other securities as collateral in excess of the market value of the
securities loaned.\62\ In the typical securities repurchase/reverse
repurchase transaction (``repo transactions''), a buyer agrees to
purchase securities from a seller and the seller agrees to repurchase
them at some time in the future at the sale price plus some additional
consideration. Thus, if the securities increase in value, the seller is
at risk that the buyer will default on its obligation to resell them at
the original contract price. Conversely, if the securities decrease in
value, the buyer is at risk that the seller will default on its
obligation to repurchase them at the original contract price. To
address these risks, the securities underlying the agreement are marked
to market daily and, if their value rises above the contract price, the
buyer provides margin to the seller to secure the buyer's obligation to resell the securities at a price lower than market value.
Alternatively, if the value of the securities falls below the contract price, the seller provides margin to the buyer to secure the seller's obligation to repurchase the securities at a price above the market value.
\62\ In computing net capital under Rule 15c31, a brokerdealer generally must make a deduction in the amount that the market value of securities loaned exceeds the value of collateral received. 17 CFR 240.15c31(c)(2)(iv)(B). Likewise, a brokerdealer must make a deduction in the amount the value of collateral posted exceeds the value of securities borrowed to the extent the excess is greater than certain percentages. This permits the brokerdealer to provide excess collateral in conformance with industry standards without taking the deduction. In either case, the brokerdealer is not required to take the deduction, provided it issues a marktomarket call and collects payment the same day.
In addition to participating in securities lending transactions, brokerdealers provide a variety of services to other borrowers and lenders, including counterparty credit evaluation, collateral management, and administration of distributions and corporate actions. Moreover, a brokerdealer may negotiate the loan as agent for both parties (divulging their identities just prior to the transaction) or by interposing itself as principal between two undisclosed counterparties as a conduit lender.
The failure of MJK Clearing, Inc. (``MJK'')the largest SIPA
liquidation to dateraised several concerns regarding securities lending transactions. The
Commission, in two civil complaints,\63\ alleged that MJK engaged in conduit securities lending transactions involving shares of a company called GenesisIntermedia, Inc. According to the complaints, MJK borrowed shares of GenesisIntermedia from one brokerdealer, providing cash collateral equal to the market value of the borrowed shares. MJK then relent the GenesisIntermedia shares to other brokerdealers that provided cash collateral in return. As indicated in the complaints, after the transactions, the market value of the GenesisIntermedia shares declined dramatically. The complaints also describe how MJK returned cash collateral to the borrowing brokerdealers as the shares declined in value but did not collect excess cash collateral provided to the brokerdealer that lent the shares to MJK. Eventually, MJK went out of business. At the time of its failure, MJK still owed cash collateral to several of the borrowing brokerdealers.\64\
\63\ See SEC Litigation Release No. 18641, 2004 LEXIS 706 (March 26, 2004); SEC Complaint, SEC v. Thomas G. Brooks, Civil Action No. CV 033319 ADM/AJB, United States District Court (D. Minn. June 2, 2003); SEC v. Thomas G. Brooks, SEC Litigation Release No. 18168, 2003 SEC LEXIS 1321 (June 3, 2003); SEC Complaint, SEC v. Kenneth P. D'Angelo et al., Case No. LACV 036499 CAS (VBKx), United States District Court (C.D.Cal. September 11, 2003); SEC Litigation Release No. 18344, 2003 SEC LEXIS 2173 (September 11, 2003).
\64\ Id.; See also, In re MJK Clearing, Inc., 2003 U.S. Dist. LEXIS 5954 (D.Minn. 2003).
MJK's failure caused losses to the borrowing brokerdealers and to
other firms to whom those brokerdealers relent the borrowed
securities.\65\ In subsequent litigation, disputes have arisen as to
whether certain of these brokerdealers were acting as principals or
agents.\66\ Uncertainty as to whether brokerdealers are acting as
principal or agent in a securities loan transaction raises concerns as
to whether firms are taking required net capital charges related to
their securities lending activities.\67\ A brokerdealer might not take
the required charges on the theory that it was arranging the loans as
agent, rather than principal, notwithstanding the fact that there was no express disclaimer of principal liability.
\65\ See, e.g., Nomura v. E*Trade, 280 F.Supp. 2d 184 (S.D.N.Y. 2003).
\66\ See id.
\67\ Under paragraph (c)(2)(iv)(B) of Rule 15c31, broker dealers are required to deduct from net worth most unsecured receivables, including the amount that the market value of a securities loan exceeds the value of collateral obtained for the loan. Similarly, with respect to repo transactions, a brokerdealer obligated to resell securities must, in computing net capital, deduct the amount that the market value of the securities is less than the resale price. 17 CFR 240.15c31(c)(2)(iv)(F). A broker dealer obligated to repurchase securities must, in computing net capital, deduct the amount that the market value of the securities is greater than the repurchase price to the extent the excess is greater than certain percentages. 17 CFR 240.15c31(c)(2)(iv)(F).
We are proposing two amendments designed to improve regulatory
oversight of securities lending and repo transactions. The first
proposal would amend subparagraph (c)(2)(iv)(B) to Rule 15c31 to
clarify that brokerdealers providing securities lending and borrowing
settlement services are assumed, for purposes of the rule, to be acting
as principals and are subject to applicable capital deductions. Under
the proposed amendment, these deductions could be avoided if a broker
dealer takes certain steps to disclaim principal liability. Namely, the
brokerdealer would be required to disclose the identities of the
borrower and lender to each other and obtain written agreements from
the borrower and lender stating that the brokerdealer is acting
exclusively as agent and assumes no principal liability in connection with the transaction.\68\
\68\ Standard master securities loan agreements (including the annexes thereto) commonly used by the parties to a secu
FOR FURTHER INFORMATION CONTACT
Michael A. Macchiaroli, Associate Director, at (202) 5515525; Thomas K. McGowan, Assistant Director, at (202) 5515521; Randall Roy, Branch Chief, at (202) 5515522; or Bonnie Gauch, Attorney, (202) 5515524; Division of Market Regulation, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 205496628.