Amendments to SEC Rules 15c3-l, 17a-3, and 17a-13 Regarding Treatment of Repurchase and Reverse Repurchase Agreements

TO: All NASD Members and Other Interested Persons

The Securities and Exchange Commission (SEC) has amended its net capital, recordkeeping, and quarterly securities-count rules under the Securities Exchange Act of 1934 regarding the treatment of repurchase (repo) and reverse repurchase (reverse repo) agreements entered into by registered broker-dealers.

The amendments to SEC Rule 15c3-l will become effective on September 10, 1987. The amendments to SEC Rules 17a-3 and 17a-13 became effective on July 25, 1987.

The text of the SEC's amendments, as reprinted in the Federal Register, is attached as Exhibit A.

The significant aspects of the amendments are discussed below.

• Rule 15c3-l—Uniform Net Capital Rule

(Exhibit B shows examples of calculation of charges under Tests 1, 2, and 3.)

• Rule 17a-3—Maintenance of Books and Records

Broker-dealers will, in addition to other provisions of the rule, be required to (1) maintain a separate ledger reflecting the assets and liabilities resulting from repo and reverse repo transactions, (2) record securities subject to repos on the securities position record, and (3) maintain copies of confirmations that it sends out with regard to repo transactions.

• Rule 17a-13—Quarterly Securities Count

Broker-dealers will be required to account for securities that are the subject of repo and reverse repo agreements as they do for other securities for which they are responsible.

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Questions concerning this notice may be directed to I. William Fishkind, Associate Director, NASD Financial Responsibility, at (202) 728-8405.

Sincerely

John E. Pinto, Jr
Senior Vice President
Compliance

Attachments

Exhibt A

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-24553; File No. S7-21-86]

Financial Responsibility Rules

AGENCY: Securities and Exchange Commission.

ACTION: Final rule amendments.

SUMMARY: The Securities and Exchange Commission ("Commission") is amending its net capital, recordkeeping and quarterly securities count rules under the Securities Exchange Act of 1934 ("Act") in connection with the treatment of repurchase and reverse repurchase agreements entered into by registered broker-dealers. The recordkeeping rule is amended to specifically require broker-dealers to maintain certain books and records with respect to their repurchase and reverse repurchase transactions, including securities records and copies of all confirmations. The quarterly securities count rule is amended to clarify that broker-dealers are required to account for securities that are the subjects of repurchase and reverse repurchase agreements, as they do for other securities for which they are responsible. The net capital rule is amended to establish deductions from net worth in arriving at net capital for repurchase and reverse repurchase agreements under certain risk circumstances. The rule is further amended to require additional capital when the broker-dealer has attained a high degree of leverage as a result of those agreements. The rule as amended will also require deductions regarding transactions with affiliates when the affiliate's records are not made available for examination.

EFFECTIVE DATE: Ninety days from publication in the Federal Register, except for amendments to § § 240.17a-3 and 240.17a-13 which will be effective on July 25,1987.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, (202) 272-2904, Julio A. Mojica, (202) 272-2372, or Michael P. Jamroz, (202) 272-2398, Division of Market Regulation, 450 5th Street, NW., Washington. DC 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

In September of 1986, the Commission proposed amendments to its financial responsibility rules relating to repurchase and reverse repurchase agreements ("repos" and "reverse repos").¹ Those proposed amendments were the result of the failures of several government securities dealers which caused substantial harm to public investors and broker-dealers through, fraudulent practices or inadequate accountability.²

In response to those failures, the Congress has enacted the Government Securities Act ("GSA") which, among other things, granted the Department of Treasury ("Treasury") authority to adopt financial responsibility rules for all brokers and dealers in government securities, including those currently registered with the Commission. ³ Subsequently, the Treasury has proposed rules that, to a large extent, incorporate existing Commission financial responsibility regulations. ⁴ With some modification, the Treasury's proposed rules would require all government securities brokers and dealers to comply with Securities Exchange Act Rules 17a-3, 17a-4, 17a-5, 17a-7, 17a-8, 17a-ll, 17a-13 and 15c3-3. The modifications to the Treasury's proposed version of Commission Rules 17a-3 and 17a-13 ⁵ include those amendments proposed by the Commission in September.

The Treasury also proposed to apply Rule 15c3-3 to all government securities dealers, with certain modifications. The proposed modifications to Rule 15c3-3 ⁶ relate to hold in custody repos ⁷ and would alter the requirements proposed by the Commission in September. In its release, the Commission proposed to require broker-dealers that enter into hold in custody repurchase agreements to: (i) Disclose the rights and liabilities of the parties, including the fact that the Securities Investor Protection Corporation ("SIPC") has taken the position that coverage under the Securities Investor Protection Act of 1970 may not be available; (ii) confirm the securities that are subject to such agreement; and (iii) maintain possession and control of those securities with certain exceptions. The Commission's proposed amendments would not require possession and control during the trading day for securities subject to hold in custody repurchase agreements of over $1 million. That exemption was provided to facilitate the settlement of government securities transactions during the trading day.

The comments rearding the proposed amendments to Rule 153-3 were favorable in most instances except with respect to the requirement to disclose the rights and liabilities of the parties to repurchase agreements. The Commission has determined, however, to repropose the amendments to Rule 15c3-3 in a manner that will substantially conform Rule 15c3-3 to the Treasury's rule. The Commission's proposal is the subject of a separate release.

Although not every comment is discussed in this release, the comments received with respect to Release No. 34-23602 have been reviewed extensively by the Commission and incorporated, as appropriate, in the amendments that the Commission is adopting today. In addition, a summary of comments has been prepared and placed in Public File No. S7-21-66. The comments received by the Commission regarding the proposed amendments to Rules 17a-3 and 17a-13 were generally favorable. With respect to Rule 15c3-l, the comments suggested that:

II. Accountability for Money and Securities

1. Rule 17a-3

Rule 17a-3 prescribes the books and records that a broker-dealer is required to maintain. The proposed amendments will specifically require a broker-dealer to: (i) Maintain a separate ledger reflecting the assets and liabilities resulting from repo and reverse repo transactions (commonly referred to as the "Repo Book"); (ii) record securities subject to repos and reverse repos on the securities record; and (iii) maintain copies of confirmations that it sends out with regard to repurchase transactions. The commentators generally supported the amendments to Rule 17a-3 and the Commission has determined to adopt the proposed amendments to ensure accountability for the funds and securities involved in repo transactions.

2. Rule 170-13

Rule 17a-13 requires that a broker-dealer physically count, verify and account for securities held in his physical possession or otherwise within his control or direction. Currently, the Rule does not contain a specific reference to securities that are the subjects of repurchase and reverse repurchase agreements. The purpose of the amendment is to make it clear that a broker-dealer is held accountable for repo securities as it is other securities subject to its possession or control. The commentators generally expressed support for the amendment and the Commission is adopting it in the form proposed.⁸

III. Leverage and Risk Control

1. Introduction

Securities Exchange Act Rule 15c3-l requires that a broker-dealer's net capital must exceed the greater of $25,000 or 6% percent of its aggregate indebtedness ⁹ if the broker-dealer does not elect the alternative method. If it elects the alternative method under paragraph (f), the broker-dealer's net capital must exceed the greater of $100,000 or 2 percent of its aggregate debit items as computed in accordance with the Securities Exchange Act Rule 15c3-3a Formula for Determination of Reserve Requirement for Brokers and Dealers ("Reserve Formula"). Net capital, defined in paragraph (c)(2) of Rule 15c3-l, is computed by deducting from net worth, among other things, illiquid assets, unsecured receivables, and certain percentage deductions of the market value of securities and commodities positions of the firm. Those percentages generally take into account market risk, liquidity and volatility of the broker-dealer's holdings.

2. Reverse Repurchase Agreements Deficits

When the uniform net capital rule was adopted in 1975, the Commission required broker-dealers to deduct from net worth in arriving at net capital the amount by which the contract price of a reverse repo exceeded the value of the securities received under the agreement ("reverse repo deficit").¹⁰ The Commission's rule reflected that if a broker-dealer does not receive securities or other property of sufficient worth to cover the counterparty's obligation under a reverse repurchase agreement, the broker-dealer is exposed to risk for the amount of the deficiency.

In 1982, the Commission adopted the current treatment of reverse repo deficits ¹¹ Instead of deducting the entire deficit, the Commission amended the rule such that only a percentage of the deficit, depending on the term of the agreement, would be required to be deducted. Those amendments were in response to the concerns of broker-dealers regarding the application of the rule to the practices of the time. The rule recognized that many repurchase agreements were term, as opposed to overnight agreements, and reverse repo deficits were likely to occur as time passed.

Some commentators suggested that the reverse repo deficit deduction should be similar to the proposed charges for repo deficits. ¹² Under the proposal, the broker-dealer would not deduct the entire repo deficit as it would a reverse repo deficit. The proposal would only require a deduction when the repo deficit exceeded certain specified constraints. The Commission designed the repo deficit deductions in this manner to recognize that broker-dealers normally provide excess securities under a repo as a "cushion" or margin. Conversely, the Commission understands that when broker-dealers engage in reverse repos, they normally receive excess securities. Therefore, the deduction for reverse repo deficits not only more accurately reflects risk, but also the current industry practice. Accordingly, the Commission has adopted the proposed amendment.

3. Repurchase Agreement Deficits

For repo deficits, the proposed amendments required broker-dealers to deduct the largest amount computed under three separate tests. Under the first test, the broker-dealer deducts the amount by which the value of U.S. Treasury securities subject to repurchase agreements with a counterparty exceeds 105 percent of the funds received by the broker-dealer under those agreements. This charge takes into account the risk that the broker-dealer is exposed to when it delivers securities under a repurchase agreement that are valued in excess of the amount the broker-dealer receives from the counterparty.

Under the second test, the broker-dealer deducts the excess of the difference between the market value of securities subject to repurchase agreements with a counterparty and the funds received (if less than the market value of the securities) over 25 percent of the broker-dealer's tentative net capital. The second charge takes into account the exposure to risk incurred by the broker-dealer in delivering a concentration of excess securities under repurchase agreements to one counterparty.

Under the third test, the broker-dealer compares the aggregate market value of securities subject to repurchase agreements to the total amount of funds it has received under such agreements. If the aggregate market value of the securities exceeds the funds received by an amount greater than 300 percent of the broker-dealer's tentative net capital, the broker-dealer is required to deduct the amount equal to the excess over 300 percent of the broker-dealer's tentative net capital. The third computation compares the aggregate repurchase agreement exposure with all counterparties to the broker-dealer's tentative net capital.

The Commission continues to believe that the three alternative tests accurately measure the risks entailed in repurchase transactions. Accordingly, the Commission has adopted the proposed amendments with two modifications. As in the case of reverse repo deficits, the commentators requested that margin calls be taken. into account. In recognition of the industry practice of requesting margin when exposure exceeds certain limits, the Commission has modified the amendments to reduce the repo deficit for purposes of the rule by margin calls outstanding one business day or less. In computing the deductions, the broker-dealer is allowed to net repurchase and reverse repurchase agreements into with the same party.¹³

The commentators also pointed out that the 105% parameter under the first test should be increased where the securities subject to the repo are not United States Treasury securities. These commentators noted that it was common industry practice to require Government Agency Securities valued in excess of 105 percent of the funds received in the repo. For this reason, the factor has been increased to 110 percent for mortgage-backed securities and to 120 percent for other securities.

4. Excess Margin on Reverse Repos

While most broker-dealers properly protect themselves against credit risk related to reverse repos by receiving securities that are valued in excess of the funds they have extended under the agreement, some broker-dealers create leverage by obtaining the use of funds through matched repurchase agreements. Those broker-dealers enter into reverse repurchase agreements, receive securities that are valued substantially in excess of the amount advanced, then sell the securities pursuant to repurchase agreements for an amount of cash greater than the amount advanced under the reverse repurchase agreements. The net funds obtained are then used in the business of the broker-dealer.

Under the amendments, the broker-dealer is required to increase its required net capital by ten percent of the excess market value of U.S. Treasury securities subject to reverse repos agreements with one counterparty over 105 percent of the funds paid pursuant to such agreements. Commentators reported that this amendment would inhibit the credit function of the broker-dealer because it would require capital when the broker-dealer is protecting itself against credit risk.

The Commission does not wish to interfere in the normal credit policies of a broker-dealer. The Commission, however, believes that the leverage obtainable in repurchase transactions is of such magnitude that some restraint is necessary. Restraint in the use of "customer" property usually occurs through Rule 15c3-3, which prevents use of customer funds and securities to finance the broker-dealer's inventory. If Rule 15c3-3 were applicable to repurchase transactions, there would be no need for this amendment. However, the Commission, relying to some degree on the determination of the Securities Investor Protection Corporation that for purposes of the Securities Investor Protection Act ^l4 repo participants are not customers, has not taken the position that repo participants are "customers" for purposes of Rule 15c3-3. Such a determination would in effect result in a 100 percent capital charge as to the excess margin because the broker-dealer would likely fund the additional Reserve Account deposit with its own capital

In sum, the Commission believes that the use of excess repb margin does raise concerns. Indeed, the misappropriation of excess margin accounted for a large percentage of total losses hvboth the E.S.M. and Bevill, Bresler failures. Accordingly, the Commission believes that because the broker-dealer has obtained leverage through the use of third party funds, an additional capital requirement is appropriate. Therefore, the Commission adopts the proposed amendments, but with one modification as suggested by the commentators.¹⁵ The 105% parameter will apply only to reverse repos using U.S. Treasury securities. As in the repo deficit area, the appropriate parameter for mortgage-backed securities will be 110%. The parameter for securities other than U.S. Treasury and mortgaged-backed securities will be 120 percent. With this modification, the Commission believes that the amendment provide assurance that firms will be able to meet customer obligations without unduly revising current industry practices.

5. Transactions with Affiliates

The amendments announced today also include a deduction from net worth in arriving at net capital for intercompany transactions with affiliates where the registered broker-dealer is potentially exposed to loss unless the books and records of the affiliate are available for examination. The amendment covers all intercompany receivables (not otherwise deducted) and liabilities to affiliates where collateral given to the affiliate exceeds the amount of the liability. The comment letters stated that the scope of the examination of the affiliate should be limited to verification of the location and control of the collateral. The Commission believes, however, that it is difficult, if not impossible, to determine which entity has control over collateral without the ability to conduct a broad examination, the Commission has clarified the language of the amendment, however, to indicate that the purpose of the examination is to demonstrate the validity of the receivable or payable.

The Commission emphasizes that a broad review of the books and records of the affiliate will be necessary in some cases because the assets pledged as collateral by the affiliate in the intercompany loan may be fungible, for example securities or commodities positions. If the assets are fungible, and examiner will need to determine, by review of the firm's use of all of the assets of that group, if the assets pledged by the affiliate are being used for another purpose.

The Commission's concerns extend beyond the question of control over collateral. In past examinations and investigations, the Commission has noted that some registered broker-dealers have used unregistered affiliates to embezzle customer funds or conduct fraudulent transactions. Those transactions have, in some cases, been initiated in the registered broker-dealer and transfered, via an intercompany account, to an unregistered affiliate upon regulatory investigation.

The Commission does, however, adopt this amendment with the understanding that examiners will use discretion in applying the rule. The Commission expects any examination to be limited to demonstrating the validity of the receivable or payable. Moreover, no examination would be necessary if the examiner believes that the capital of the registered broker-dealer is not at risk as a result of the transactions. For example, under most circumstances examiners should not find it necessary to question transactions with affiliated publicly held companies that are subject to the independent annual audit requirements under the Securities Exchange Act Rules.

Some commentators have suggested that futures commission merchants be exempt from this provision. The amendments announced today include that modification. The Commission has also decided to exempt registered government securities brokers or dealers from the provision.

IV. Summary of Final Regulatory Flexibility Analysis

The Commission has prepared a final Regulatory Flexibility Analysis in accordance with 5 U.S.C. 604 regarding the amendments to Rules 17a-3, 17a-13 and 15c3-l. The Analysis notes that the objective of the amendments is to further the purposes of the various financial responsibility rules which are to provide safeguards with respect to the financial responsibility and related practices of brokers and dealers and to require broker-dealers to maintain such records as necessary or appropriate in the public interest or for the protection of investors. The analysis states that the amendments would subject small broker-dealers to additional record-keeping, disclosure, capital and accountability requirements. The Analysis states that the Commission did not receive any comments concerning the Initial Regulatory Flexibility Analysis. A copy of the Final Regulatory Flexibility Analysis may be obtained by contacting Michael P. Jamroz, Division of Market Regulation, Securities and Exchange Commission, Washington, DC 20549 (202) 272-2398.

V. Statutory Authority

Pursuant to the Securities Exchange Act of 1934 and particularly sections 15(c)(3), 17 and 23 thereof, 15 U.S.C. 78o(c)(3), 78q, and 78w, the Commission is adopting amendments to §§ 240.15c3-1, 240.17a-3, and 240.17a-13 of Title 17 of the Code of Federal Regulations in the manner set forth below.

List of Subjects in 17 CFR Part 240

Brokers, Reporting and recordkeeping requirements, Securities.

VI. Text of Amendments

In accordance with the foregoing, 17 CFR Part 240 is amended as follows:

PART 240—GENERAL RULES AND REGULATIONS SECURITIES EXCHANGE ACT OF 1934

§ 240.15C3-1 Net capital requirements for brokers and dealers.

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§ 240.17a-3 Records to be made by certain exchange members, brokers and dealers.

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§ 240.17a-13 Quarterly security counts to be made by certain exchange members, brokers and dealers.

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By the Commission.

June 4,1987.

Shirley E. Hollis,

Assistant Secretary.

[FR Doc. 87-13390 Filed 6-10-87; 8:45 am]

BILLING CODE 8010-01-M

Exhibt B

EXAMPLES OF CALCULATIONS OF CHARGES

Assumed Tentative Net Capital (TNC): $50 Million

Test 1

Test 2

Test 3

The charge shall be the greater of the amounts computed under Tests 1 and 2 combined, or Test 3.

¹ See Securities Exchange Act Release No. 23602 (September 4,1986) 51 FR 32858 (September 15. 1986). A repurchase agreement involving a security is the sale of that security at a specified price with a simultaneous agreement to repurchase the security at a specified price on a specified future date. A reverse repurchase agreement involving a security is the purchase of that security at a specified price with a simultaneous agreement to resell the security at a specified price on a specified future date.

² See The Regulation of the Government Securities Market, Report by the Securities and Exchange Commission to the Subcommittee on Telecommunications, Consumer Protection and Finance of the Committee on Energy and Commerce of the U.S. House of Representatives (June 20 1985).

³ See section 15C(b) of the Securities Exchange Act as amended by the GSA.

⁴ See 52 FR 5680 (February 25.1867).

⁵ See 17 CFR 240.17a-3 and 17 CFR 24O.17a-13.

⁶ See 17 CFR 24O.15C3-3.

⁷ A hold in custody repurchase agreement is a repurchase agreement where the broker-dealer retains custody of the counterparty's securities.

⁸ One commentator asked if substitution of securities subject to a repurchase agreement would cause the thirty day period under the rule to start again. Paragraph (b)(3) to Rule 17a-13 requires verification of securities "* * * subject to his control or direction but not in his physical possession, where such securities have been in said status for longer than thirty days". The Commission takes the position that the substitution of securities subject to a repurchase agreement changes the status of those securities for purposes of Rule 17a- 13. Consequently, any substitution would cause the thirty day period to start again.

⁹ The term aggregage indebtedness is defined in paragraph Rule 15c3-l(c)(l).

¹⁰ See Securities Exchange Act Release No. 11497 (June 26, 1975). 40 FR 29729 (July 18, 1975).

¹¹ See Securities Exchange Act Release No. 18737 (Mar. 13, 1982). 47 FR 21759 (May 20.1982). Subparagraph (c)(2)(iv)(F) of Rule 15c3-l prescribes a schedule of deductions ranging from zero to 100 percent for deficits resulting from reverse repurchase agreements [i.e., the difference between the contract price and the market value of the security). The amount of the charge depends on the maturity of the repo agreement.

¹² A repurchase agreement deficit occurs when the market value of securities subject to a repurchase agreement exceeds the contract price of the repurchase agreement.

¹³ The Commission recognizes that when a broker-dealer enters into repurchase agreements using proprietary securities, the firm may incur a deduction because of a repo deficit and a deduction, or haircut, related to the securities. The Commission also understands that it is difficult for broker-dealers that engage in a significant amount of repurchase transactions to identify the specific securities that were used in a particular repurchase agreement. For those broker-dealers that believe they have a program which can specifically indentify those proprietary securities which are used in a particular repurchase agreement, the Commission will entertain requests for no-action positions that would allow any repurchase agreement deficit deduction to be reduced by the haircut already incurred with respect to the repurchase agreement securities.

¹⁴ The status of repo participants for SIPA purposes has become more uncertain, however, as the United States District Court for the District of New Jersey has decided that repo participants are customers for purposes of the Securities Investor Protection Act of 1970 ("S1PA"). The United States District Court for the District of New Jersey decided in Cohen v. Army Moral Support Fund (in re Bevill, Bresler and Schulman). Adv. Proc. No. 85-2103 (slip op.) (D.N.J. Oct. 23,1966 that repo transactions were purchases and sales rather than secured loans. The practical effect of this decision was to extend coverage under the Securities Investor Protection Act to repo participants within that Jurisdiction.

¹⁵ The Commission understands that it is difficult for broker-dealers that engage in significant repurchase agreement activity to identify whether specific securities obtained under a reverse repurchase agreement were used by the firm to obtain the use of funds. The Commission is willing to entertain no-action requests from those broker-dealers that can show that specific securities received under a reverse repurchase agreement were not used to obtain funds.

* Collateral assumed to be U.S. Treasury Bills, Notes, and Bonds.

** As to the same counterparty, the charge will be the greater of the amount computed under either Test 1 or Test 2.