Amendments to SEC Rule 15c3-3 Regarding Treatment of Hold-in-Custody Repurchase Agreements

TO: All NASD Members and Other Interested Persons

BACKGROUND

The Securities and Exchange Commission (SEC) has amended its customer protection rule (Rule 15c3-3) under the Securities Exchange Act of 1934, in connection with repurchase (repo) agreements with customers when the broker-dealer retains custody of any securities subject to these agreements.

The amendments become effective January 31, 1988. However, between July 25, 1987, and January 31, 1988 (the "interim period"), all broker-dealers must comply with applicable provisions of the U.S. Treasury Department's rule that was adopted on July 24, 1987. The Treasury's rule applies to all broker-dealers engaged in hold-in-custody repo activities using government securities as the collateral underlying the repo agreements.

The text of the SEC's amendments as reprinted in the Federal Register, dated August 14, 1987, is attached.

SUMMARY OF AMENDMENTS

Highlights of the SEC's amendments include the requirements that broker-dealers:

• Obtain repo agreements in writing. Note: The Treasury's rule for the interim period requires that these agreements be obtained for new customers by October 31, 1987, and for existing customers by January 31, 1988. An "existing customer" is defined as one with whom the broker-dealer has entered into a repo transaction between January 1, 1986, and July 25, 1987.
• Confirm in writing, when a transaction is initiated or when a substitution occurs, the specific securities that are the subject of the repo agreement,
• Disclose that the Securities Investor Protection Corporation (SIPC) has taken the position that coverage for repo agreement participants is not available under the Securities Investor Protection Act of 1970.
  Note: The Treasury's rule for the interim period requires that this disclosure must be a separate document and contain (1) the statement that SIPC coverage for repo participants is not available and (2) the modified disclosure statement regarding substitution of securities. The disclosure statements must be provided by August 31, 1987, for counterparties engaged in repo transactions initiated before August 31, 1987, and ending thereafter. For counterparties initiating repo transactions on or after August 31, 1987, disclosure must be mailed to the counterparties no later than the day the transaction is initiated. The disclosure document may not be printed on the confirmation.
• Maintain possession or control of securities subject to hold-in-custody repo agreements, except that possession or control is not required if certain conditions are met.

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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

Attachment

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-24778; File No. S7-21-86]

Customer Protection Rule

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

SUMMARY: The Securities and Exchange Commission ("Commission") is adopting amendments to its customer protection rule under the Securities Exchange Act ("Act") in connection with repurchase agreements where the broker-dealer agrees to retain custody of the securities that are subject to those agreements ("hold in custody repurchase agreements"). The amendments to the rule will require registered broker-dealers to obtain repurchase agreements in writing, to make specific disclosures regarding certain risks associated with hold in custody repurchase transactions and to disclose that the Securities Investor Protection Corporation ("SIPC") has taken the position that coverage under the Securities Investor Protection Act of 1970 is not available to repurchase agreement participants. The amendments further require registered broker-dealers to maintain possession or control of securities subject to hold in custody repurchase agreements, except that possession or control during the trading day is not required if certain conditions are met.

EFFECTIVE DATE: January 31, 1988.

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: In September of 1988, the Commission proposed amendments to its financial responsibility rules relating to repurchase and reverse repurchase agreements. Those proposed amendments were in response to the failures of several government securities dealers which caused substantial harm to public investors through fraudulent prnctiens.¹ The proposal included amendments to the Commission's net capital rule, securities count and recordkeeping rules and customer protection rule. Securities Exchange Act Rule 15c-3. Subsequently, Congress enacted the Government Securities Act of 1986 ("CSA"). which authorized the Department of the Treasury ('Treasury") to adopt financial responsibility and customer protection rules for all brokers and dealers of U.S. government securities, including those firms currently registered with the Commission. The Treasury has since adopted rules that, in large part, incorporate existing Commission financial responsibility rules. The Treasury's customer protection rule requires compliance with Rule 15c3-3, but modified the provisions that were proposed in the September Release. In Securities Exchange Act Release No. 24554 ("the June Release"), the Commission proposed for comment amendments to Rule 15c3-3 thai would substantially conform to the Treasury's temporary customer protection rule. Today, the Commission adopts those amendments with certain modifications to conform to the Treasury's customer protection rule as adopted in final form on July 24, 1987.²

Unrelated to these changes, the Commission is deleting the word "last" from the wording of Item 9 of the Formula for Determination of Reserve Requirements in Rule 15c3-3a to correct »n error in the Code of Federal Regulations.

I. Discussion

The proposed amendments to Rule 15c3-3 announced in September were made in response to, among other things, fraudulent practices of both unregistered and registered government securities broker-dealers involving repurchase agreements where the broker-dealers retained possession of the securities underlying the repurchase agreements ("hold in custody repo"). In a repurchase agreement ("repo"), the broker-dealer sells securities and agrees to repurchase the same or similar securities at a later date. In a hold in custody repo, the broker-dealer receives the funds from the sale of the securities but retains control of the securities. Some of the failed broker-dealers allegedly used those securities in their business although they had been sold to the repo counterparties. Those counterparties will be exposed to loss if coverage under the Securities Investor Protection Act of 1970 ("SIPA") is not available.³ The position of the Securities Investor Protection Corporation is that persons engaging in repurchase and reverse repurchase agreements are not customers of the broker-dealer within the meaning of SIPA and are therefore not covered under SIPA.⁴

The amendments to Rule 15c3-3 proposed in September would have required broker-dealers that enter into hold in custody repos to: (i) Disclose the rights and liabilities of the parties to hold in custody repos including a statement that SIPC has taken the position that SIPA coverage it not available to repo counterparties; (ii) disclose to the counterparty which securities are being held on his behalf under the hold in custody repo; and (iii) maintain possession and control of those securities free of lien, except for clearing liens imposed during the trading day for hold in custody renos exceeding $1 million.

Subsequent to the Commission's original proposal, the Treasury, pursuant to authority recently granted to it under the CSA. adopted temporary financial responsibility rules for all brokers and dealers in U.S. government securities in May of 1987. The Treasury's temporary customer protection rule altered the requirements proposed by the Commission. In essence, the Treasury's temporary regulation included the Commission's amendments to Rule 15c3-3 except that: (i) The Treasury rule required broker-dealers to obtain written hold in custody repurchase agreements and to make specific disclosures in those agreements regarding the broker-dealer's use of securities obtained pursuant to hold in custody repos during the trading day; and (ii) the Treasury rule did not require intra-day possession or control of securities that were subject to hold in custody repos of under $1 million on any day on which the broker-dealer obtained the specific prior consent of the counterparty to substitution. The Commission's original proposal would have required registered broker-dealer* to maintain continuous possession or control of securities subject to hold in custody repos under $1 million.

In the June Release, the Commission proposed for comment alternative amendments to Rule 15c3-3 relating to the treatment of hold in custody repos. One version was the same as the Treasury's temporary rule. The other version differed from the Treasury's rule only with respect to hold in custody rcpos under $1 million. The second alternative contained a continuous possession or control requirement for securities obtained under those agreements.

The Commission received one comment letter in response to its proposal.⁵ In its letter, the Public Securities Association ("PSA") objected to the required confirmation of specific securities subject to hold in custody repos and the disclosure of the market value of those securities. The PSA also opposed special restrictions on hold in custody repurchase transactions under $1 million.

In designing its proposed amendments to the customer protection rule, the Commission intended to ameliorate, among other things, two weaknesses observed in the hold in custody repo market. One concern was the duplicative use of securities obtained by broker-dealers under hold in custody repos. The use of securities that were already subject to hold in custody repos was facilitated by the broker-dealers' failure to designate specific securitriea to specific repos. In confirming specific securities, this allocation will have to be performed and the double use of securities will be inhibited.

The other concern was the apparent lack of understanding of hold in custody repo counterparties of their rights and liabilities. To some extent, this misunderstanding was exacerbated by the unsettled legal status of repos. As noted above, SIPC has taken the position that repos are secured loans and not purchases and sales of securities protected under SIPA. If hold in custody repos are secured lending transactions, whether and when a perfected security interest attaches are questions of local law, the answers to which are not always clear. To the extent an interest in securities subject to a hold in custody repo exists, counterparties may be frustrated in submitting claims against those securities because they are not told which securities they purchased under the repo. In many instances, broker-dealers confirm those transactions by submitting a confirmation to the counterparty that states that they have purchased "various" government securities. Because the counterparty never receives the securities, it may never become aware of which securities are subject to the agreement. In some cases, even the broker-dealer is not aware of which securities are subject to the agreement. As mentined above, this may occur when the broker-dealer fails to make the designation necessary to confirm specific securities.

The amendments to Rule 15c3-3 require broker-dealers to make basic disclosures to hold in custody repo counterparties regarding their rights and liabilities under the agreement. The amendments require that the broker-dealer inform the counterparty of SIPC's position and state to the counterparty that its securities may be subject to clearing liens during the trading day.

The amendments also require the broker-dealer to disclose the identity of the specific securities that are the subject of the agreement so the counterparty will be able to pursue any legal interest it may have in those securities in the event that the broker-dealer defaults. The broker-dealer will also be required to include the market value of those securities on the confirmation so the conterparty can more easily determine if sufficient securities have been allocated to it under the agreement. The disclosure of market value is particularly important because it is evident that in some sectors of the repo market, counterparties are measuring credit exposure by comparing the amount of funds invested in the repurchase transaction to the face value of government securities involved. The disclosure of market value of the securities subject to the repo emphasizes to those counterparties that market value, not face value, is the appropriate measure for determining credit exposure.

With respect to hold in custody repo transactions under $1 million, the Commission believes that special treatment for those transactions is not appropriate at this time. When the amendments to Rule 15c3-3 were proposed for comment in September 1986, the Commission sought to achieve its regulatory objectives with a minimum burden on the repo marketplace. The Commission learned that, in order to maximize the efficiency of the settlement process for U.S. government securities, broker-dealers needed to be able to substitute securities subject to hold in custody repos. In order for those substitutions to be performed, broker-dealers had to combine securities subject to hold in custody repos with other government securities in their clearance accounts and submit all of those securities to clearing liens during the day. However, the Commission was also aware of instances where securities subject to hold in custody repos were misappropriated. The Commission therefore proposed that broker-dealers obtain possession and control of securities that were the subject of hold in custody repo agreements exceeding $1 million at the end of each trading day. Because the Commission was concerned that smaller investors might not fully appreciate the risks involved with hold in custody repo transactions, the Commission propsed that small hold in custody repo transactions be subject to a continuous possession or control requirement.

When the Commission reproposed its amendments in the alternative in June 1987, the amendments included significant modifications to the Commission's original proposal that were included in the recently adopted Treasury's temporary rule. Both alternatives required that hold in custody repo agreements be written and include specific disclosures regarding SIPC coverage and the effects of consent to substitution by the counterparty. The alternatives differed in that one would have required continuous possession or control of securities subject to hold in custody repos under $1 million while the other proposed, in a manner identical to that required under the Treasury's temporary rule, that those securities could be used by the broker-dealer provided that prior written or oral consent of the counterparty had been received on the day of use.

The release requested comment on the enforceability of an oral consent provision but, at the tame time, the Commission was uncertain of whether the benefit obtained by a continuous possession or control requirement was worth the cost to the industry of treating smaller hold in custody repos differently. The Commission was aware that broker-dealers may incur a significant recordkeeping cost in identifying those transactions. Furthermore, a continuous possession or control requirement may hinder the settlement process if the broker-dealer is unable to effect substitutions. The Commission also understands that many small hold in custody repos are entered into by large, sophisticated investors. Since hold in custody repos often represent temporary investments of available cash balances, the size of the repo is often more a function of available funds than the net worth of the investor. Finally, the Commission was concerned that the stricter segregation requirements might result in many firms refusing to effect small hold in custody repo transactions.

Some of the Commission's concerns have been addressed by modifications to its original proposal. The amendments, as adopted, require explicit disclosures regarding the risks of entering into hold in custody repos to be made in a written agreement. The counterparty will be informed of the ramifications of his consent to substitution and the exposure of his securities to clearing liens. Moreover, the Commission believes that the requirement that firms segregate hold in custody securities every night and confirm the specific securities employed in hold in custody repos should serve to protect against the double use of those securities. In light of all of the considerations, the Commission has determined that a separate standard for hold in custody repos under $1 million is not appropriate.

The Commission remains concerneu about the use of free credit balances by means of hold in custody repurchase agreements. In some instances, broker-dealers have characterized free credit balances as repurchase agreements in an apparent attempt to avoid depositing those free credit balances in tne Special Reserve Bank Account for the Exclusive Benefit of Customers ("Reserve Account") under Rule 15c3-3(e).⁶ The Commission believes that the written agreement requirement will inhibit this practice and make smaller repo participants more conscious of the risks involved in the transaction. However, the Commission's view is thai if the broker or dealer enters into a hold in custody repurchase agreement with a retail customer who has a preexisting free credit balance with the broker or dealer, the liability of the broker or dealer will ordinarily be considered to be a free credit balance for purposes of Rule 15c3-3. Customers that conduct their business with the broker-dealer on a delivery versus payment basis would not be considered retail customers for purposes of this interpretation. The Commission will continue to monitor this area and may consider imposing separate restrictions on smaller hold in custody repos in the future. The Commission has selected an effective date of January 31, 1988, to coincide with the effective date of the Treasury rule adopted in final form July 24,1987. Between July 25, 1987 and January 31, I960 registered broker-dealers must comply with applicable provisions of the Treasury rule.

II. Summary of Final Regulatory Flexibility Analysis

The Commission has prepared a Final Regulatory Flexibility Analysis in accordance with 5 U.S.C. section 604 regarding the amendments to Rule 15c3-3. The Analysis notes that the objective of the amendments is to further the purposes of the various financial responsibility rules, which are designed 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 recordkeeping and disclosure 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.

III. Statutory Authority

Pursuant to the Securities Exchange Act of 1834 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 24O.15c3-3 of Title 17 of the Code of Federal Regulations in the manner set forth below.

List of Subjects in 17 CFR Part 240

Securities.

Text of Amendments

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

PART 240-OEWERAL RULES AND REGULATIONS SECURITIES EXCHANGE ACT OF 1S34

§ 240.15C3-3 Customer protection reserves and custody of securities

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Required Disclosure

The [seller] is not permitted to substitute other securities for those subject to this agreement and therefore must keep the [buyers] securities segregated at all times, unless in this agreement the [buyer] grants the [seller] the right to substitute other securities. If the [buyer] grants the right to substitute, this means that the [buyer's] securities will likely be commingled with the [seller's] own securities during the trading day. The [buyer] is advised that, during any trading day that the [buyer's] securities are commingled with the [seller's| securities, they will be subject to liens grantt-d by the [seller] to its clearing bank and m;iy be used by the [seller] for deliveries on other securities transactions Whenever the securities are commingled, the [seller's] ability to resegregate substitute securities for the [buyer] will be subject to the [seller's] ability to satisfy the clearing lien or to obtain substitute securities.

$240.15c3-3a Exhibit A—formula for determination of reserve requirement of brokers and dealers under § 240.15c3-3.

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By the Commission.

August 6, 1987.

Jonathan G. Katz,
Secretary.

[IFR Doc. 87-18478 Filed 8-1J-87; 8:45 am]

BILLING CODE 8010-O1-M

¹See Security Exchange Act Release No. 23602 (September 4, 1986). 51 FR 3T8M (September 15, 1-1986) ("September Release").

²52 FR 27910 (July 24, 1987).

³Under section 9(a) of SIPA. advances for cuf tomer claims are limited to $100,000 for cash claims and $500,000 for claim« for securities. To the extern the claims of repo counterparties exceed those limits, those counterparties will be exposed to loss even if SIPC coverage is extended.

⁴The United States District Court for the District of New Jersey decided in Cohen v. Army Moral Support Fund (in re Bevill. Bresler and Schulmon). Adv. Proc No. 85-21-3 (slip op.) (D N ) Oct 23. 1966). that repo transaction* 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. A final order in that case, however, has not yet been entered and. therefor*, no appeal has been possible from the Court's determination.

⁵The Department of Treasury received 21 comiaent letten which the Commission oonsidered in evaluating this proposal. The Treasury comment letters have been placed in lh« CoaaMssion's public files.

⁶Rule 15c3-3(e) require! broker-dealers to deposit in the Reserve Account an amount at computed en a periodic bant under the Rule 15c3-3a Formula for Determination of He»er»e Requirement ("Reserve Formula**). Under the Reserve Formula, the amount of the required deposit is determined by comparing the free credit balances and other funds obtained from customers to the amount by which the broker-dealer finances customer activities through the use of its own funds. Because the Commission has not taken the position that repo participants are "customers" for purposes of Rule 15c3-3. funds obtained in a repo wouid not be included in toe Reserve Formula unless customer securities were used in the repo.