SEC Approves Proposed Changes to NASD Rule 2520

Amendments to NASD Rules Regarding Margin Requirements

Effective Date: December 1, 2003

Executive Summary

On August 25, 2003, the Securities and Exchange Commission (SEC) approved amendments to NASD Rule 2520.¹ As amended, Rule 2520 (1) reduces the customer maintenance margin requirements for certain non-equity securities; and (2) redefines "exempt account" and permits the extension of good faith margin treatment to certain non-equity securities held in "exempt accounts"; and (3) limits the amount of capital charges a broker/dealer may take in lieu of collecting marked to the market losses.²

The amendments become effective on December 1, 2003. The text of the amendments is provided in Attachment A.

Questions/Further Information

Questions concerning this Notice may be directed to Susan M. DeMando, Director, Financial Operations, Department of Member Regulation, at (202) 728-8411.

Background And Discussion

Regulation T of the Federal Reserve Board establishes initial margin requirements for securities transactions effected in margin accounts. Regulation T also establishes margin requirements for transactions in non-equity securities held in "good faith" accounts. Such transactions are subject to the margin required by the creditor in "good faith" or the percentage set by the regulatory authority where the trade occurs, whichever is greater.³ Consequently, the margin requirements of NASD Rule 2520 apply to non-equity positions maintained in customers' accounts.

The amendments to Rule 2520 provide for margin requirements for non-equity securities that are commensurate with the risk associated with positions in such securities held by customers. In particular, for positions not maintained in "exempt accounts," Rule 2520, as amended, reduces the customer maintenance margin requirement for certain non-equity securities and establishes a customer maintenance margin requirement of 20% of current market value for other marginable non-equity securities. The amended Rule 2520 also permits the extension of good faith margin to certain non-equity securities held in "exempt accounts" and limits the amount of capital charges a broker/dealer may take in lieu of collecting marked to the market losses.

Definitional Changes

Designated Account

The term "designated account" means the account of: a bank (as defined in Section 3(a)(6) of the Securities Exchange Act of 1934 (Act)); a savings association (as defined in Section 3(b) of the Federal Deposit Insurance Act), the deposits of which are insured by the Federal Deposit Insurance Corporation; an insurance company (as defined in Section 2(a)(17) of the Investment Company Act of 1940); an investment company registered with the SEC under the Investment Company Act; a state or political subdivision thereof; or a pension or profit sharing plan subject to Employee Retirement Income Security Act (ERISA) or of an agency of the United States or of a state or a political subdivision thereof.

Highly Rated Foreign Sovereign Debt Securities

The term "highly rated foreign sovereign debt securities" means any debt securities (including major foreign sovereign debt securities) issued or guaranteed by the government of a foreign country, its provinces, state or cities, or a supranational entity, if at the time of the extension of credit the issue, the issuer or guarantor, or any other outstanding obligation of the issuer or guarantor ranked junior to or on a parity with the issue or the guarantee is assigned a rating (implicitly or explicitly) in one of the top two rating categories by at least one nationally recognized statistical rating organization.

Investment Grade Debt Securities

The term "investment grade debt securities" means any debt securities (including those issued by the government of a foreign country, its provinces, states, or cities, or a supranational entity), if at the time of the extension of credit the issue, the issuer, or guarantor, or any other outstanding obligation of the issuer or guarantor ranked junior to or on a parity with the issue or the guarantee is assigned a rating (implicitly or explicitly) in one of the top four rating categories by at least one nationally recognized statistical rating organization.

Major Foreign Sovereign Debt

The term "major foreign sovereign debt" means any debt securities issued or guaranteed by the government of a foreign country or a supranational entity, if, at the time of the extension of credit, the issue, the issuer or guarantor, or any other outstanding obligation of the issuer or guarantor ranked junior to or on a parity with the issue or the guarantee is assigned a rating (implicitly or explicitly) in the top rating category by at least one nationally recognized statistical rating organization.

Mortgage-Related Securities

The term "mortgage-related securities" means securities falling within the definition in Section 3(a)(41) of the Act.

Exempt Account

The term "exempt account" means a member, non-member broker/dealer registered as a broker or dealer under the Act, or "designated account." In addition, an "exempt account" may be any person who has a net worth of at least $45 million and financial assets of at least $40 million for purposes of subparagraphs (e)(2)(F) and (e)(2)(G) and either: (1) has securities registered pursuant to Section 12 of the Act and has been subject to the reporting requirements of Section 13 of the Act for a period of at least 90 days and has filed all the reports required to be filed thereunder during the preceding 12 months (or such shorter period as it was required to file such reports), or (2) has securities registered pursuant to the Securities Act of 1933, has been subject to the reporting requirements of Section 15(d) of the Act for a period of at least 90 days and has filed all the reports required to be filed thereunder during the preceding 12 months (or such shorter period as it was required to file such reports); or (3) if such person is not subject to Section 13 or 15(d) of the Act, it is a person with respect to which there is publicly available the information specified in paragraphs (a)(5)(i) to (xiv), inclusive, of Rule 15c2-11 under the Act; or (4) furnishes information to the SEC as required by Rule 12g3-2(b) of the Act; or (5) makes available to the member such current information regarding such person's ownership, business, operations, and financial condition (including such person's current audited statement of financial condition, statement of income, and statement of changes in stockholder's equity or comparable financial reports), as reasonably believed by the member to be accurate, sufficient for the purposes of performing a risk analysis in respect of such person.

Non-Equity Securities

The term "non-equity securities" means any securities other than equity securities as defined in Section 3(a)(11) of the Act.

Listed Non-Equity Securities

The term "listed non-equity securities" means any non-equity securities that are listed on a national securities exchange or have unlisted trading privileges on a national securities exchange.

Other Marginable Non-Equity Securities

The term "other marginable non-equity securities" means any debt securities not traded on a national securities exchange meeting all of the following requirements: (1) at the time of the original issue, a principal amount of not less than $25,000,000 of the issue was outstanding; (2) the issue was registered under Section 5 of the Securities Act of 1933 and the issuer either files periodic reports pursuant to Section 13(a) or 15(d) of the Act or is an insurance company that meets all of the conditions specified in Section 12(g)(2)(G) of the Act; and (3) at the time of the extensions of credit, the creditor has a reasonable basis for believing that the issuer is not in default on interest or principal payments; or, "other marginable non-equity securities" means any private pass-through securities (not guaranteed by any agency of the U.S. government) meeting all of the following requirements: (1) an aggregate principal amount of not less than $25,000,000 (which may be issued in series) was issued pursuant to a registration statement filed with the SEC under Section 5 of the Securities Act of 1933; (2) current reports relating to the issue have been filed with the SEC; and (3) at the time of the credit extension, the creditor has a reasonable basis for believing that mortgage interest, principal payments, and other distributions are being passed through as required and that the servicing agent is meeting its material obligations under the terms of the offering.

Reduced Customer Maintenance Margin Requirements For Non-Equity Securities Held By Other Than Exempt Accounts

Amended Rule 2520 establishes margin requirements for investment-grade debt securities and exempted securities other than U.S. debt securities that are comparable to the highest haircut percentages under the SEC's Net Capital Rule for proprietary positions in similar securities. The margin requirements for retail customers for nonequity securities that are not held in exempt accounts are as follows:

• For investment-grade non-equity securities—reduced from 20% of current market value to 10% of current market value;



 
• For exempted securities other than U.S. government debt—reduced from 15% of the current market value to 7% of current market value;



 
• For highly rated foreign sovereign debt—the amounts specified for U.S. debt securities (1% to 6% of current market value, depending on the time to maturity);



 
• For all other listed non-equity securities and other marginable non-equity securities—the percentage remains at 20% of current market value or 7% of the principal amount, whichever is greater.

Good Faith Margin Treatment For Certain Non-Equity Securities Held By Exempt Accounts

Rule 2520(2)(e)(F), as amended, will permit broker/dealers to effect transactions by persons or entities that qualify as "exempt accounts" without being required to collect either margin or marked to the market losses on exempted securities, mortgagerelated securities, or major foreign sovereign debt securities. However, a broker/dealer must take a capital charge for any uncollected marked to the market losses on exempt account positions in these securities.

Rule 2520(e)(2)(G), as amended, establishes a margin requirement of:

• 0.5% for transactions in exempt accounts involving highly rated foreign sovereign debt; and



 
• 3% for transactions in investment-grade debt.

Although a broker/dealer is not required to collect this margin, it must take a capital charge for any uncollected margin subject to the limitations provided in Rule 2520(e)(2)(H).

Limitation on Capital Charges

Rule 2520(e)(2)(H) limits the amount of capital charges a broker/dealer may take in lieu of collecting marked to the market losses. Specifically, when marked to market losses exceed either: (1) 5% of the broker/dealer's tentative net capital on any one account or group of commonly controlled accounts; or (2) 25% of the broker/dealer's tentative net capital on all accounts combined continue to exist on the fifth business day after they were incurred, the member must provide NASD with written notification and may not enter into any new transactions that would result in an increase in the amount of the excess.

Written Risk Analysis

Rule 2520(e)(2)(H) requires members to establish and maintain a "written risk analysis methodology" when extending margin on "good faith" securities transactions in "exempt accounts." This written risk methodology should include the following:

• Procedures for obtaining and reviewing the appropriate customer account documentation and the customer financial information necessary to determine exempt account status for the extension of credit under the Rule.



 
• Procedures and guidelines for the determination, review, and approval of credit limits to customers and across all customers who qualify as exempt accounts under the Rule.



 
• Procedures and guidelines for monitoring credit risk exposure to the organization relating to exempt account customers.



 
• Procedures and guidelines for the use of stress testing of exempt accounts in order to monitor market risk exposure from exempt accounts individually and in the aggregate.



 
• Procedures providing for the regular review and testing of these risk management procedures by an independent unit such as internal audit, risk management, or other comparable group.

¹ See Release No. 34-48407 (File No. SR-NASD-2000-08 (August 25, 2003), 68 Federal Register 52259 (Sept. 2, 2003).

² The provisions of the proposed rule change are consistent with revisions to New York Stock Exchange (NYSE) Rule 431 that were approved on by the SEC on August 19, 2003 (Exchange Act Rel. No. 34-48365).

³ Regulation T defines "good faith" margin as the amount of margin that a broker/dealer would require in exercising sound credit judgment.

Attachment A

Additions are underlined; deletions are in brackets.

2520.   Margin Requirements