Proposed Amendments to SEC Rule 15c3-1 Regarding Withdrawals of Net Capital

*These are suggested departments only. Others may be appropriate for your firm.

EXECUTIVE SUMMARY

The Securities and Exchange Commission (SEC) has issued Release No. 34-28347, containing proposed amendments to Rule 15c3-1 (the "Rule") with respect to withdrawals of net capital. The proposal would expand the capital withdrawal limitations in subparagraph (e) of the Rule and would require, in certain instances, notification to the Commission prior to effecting the withdrawal(s) of capital directly or indirectly to benefit certain specified persons or entities related to the broker-dealer. The Commission, by order, could, in exceptional circumstances, prohibit such withdrawals if it determined that the withdrawal(s) could be detrimental to the financial integrity of the broker-dealer or affect the broker-dealer's ability to meet customer obligations. The SEC's comment period expires October 22, 1990. The text of the proposed amendments follows this notice.

BACKGROUND

The Securities and Exchange Commission (SEC) has proposed amendments to its Net Capital Rule designed to address the issues arising from the withdrawal of capital from a broker-dealer by a parent or affiliate. The amendments are intended to improve the Commission's ability to protect the customers and creditors of a broker-dealer in those circumstances where a financial problem in a holding company or other affiliate leads to withdrawals of capital from the broker-dealer.

Subparagraph (e) of the Rule (limitation on withdrawal of equity capital) currently establishes certain prohibitions on the withdrawal of equity capital from a broker-dealer failing to maintain specified levels of net capital. The proposed amendment would expand the scope of this section by prohibiting capital withdrawals, directly or indirectly, by actions of a stockholder, partner, or affiliate of the broker-dealer (insiders) without first notifying the Commission and its designated examining authority at least two business days before the intended withdrawal of capital if:

The notification requirement would apply to aggregate withdrawals in excess of $50,000.

Under the proposal, once notification is given, the Commission could, in exceptional circumstances, prohibit the proposed capital withdrawal to insiders and affiliates by issuing an order that would prevent such withdrawal for a period of twenty (20) business days if the Commission believes the capital withdrawal "... may be detrimental to the financial integrity of the broker-dealer or which may unduly jeopardize its ability to repay its customer claims or other liabilities of the broker-dealer." This 20-day time period would enable the Commission and its staff to further examine the broker-dealer's financial condition so as to determine whether, and under what circumstances, to permit the withdrawal entirely or partially, or prohibit it for additional periods, each with a term no longer than 20 business days.

In addition to the prohibitions currently in subparagraph (e) of the Rule, the Commission is proposing to include a new condition tied to proprietary "haircuts." If a projected capital withdrawal were to cause the firm's net capital to be less than 30 percent of the "haircut" deduction, the withdrawal would be prohibited.

The term "capital withdrawals" is broadly defined to include not only return of capital contributions, but also dividend distributions, stock redemptions, unsecured advances or loans to stockholders, partners, sole proprietors, affiliates, or employees. But withdrawals would not include required tax payments or the payment of reasonable compensation to partners.

In addition to comments on the proposed amendments, the Commission is soliciting comments on whether additional amendments to the financial responsibility rule are appropriate, especially as to larger broker-dealers with affiliated entities. The Commission is asking for alternative approaches regarding capital levels, such as net capital requirements based on haircuts, for large dealer firms that are able to achieve a significant degree of leverage under existing capital rules, particularly firms operating under the alternative method.

NASD members that wish to comment on the proposed rule change should do so by October 22, 1990.

Comment letters in triplicate should be sent to:

Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549.

Comment letters should refer to File No. S7-14-90. All comment letters received will be made available for public inspection and copying in the SEC's Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549.

Members are requested to send copies of their comment letters to:

Lynn Nellius, Corporate Secretary
National Association of Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1506.

Questions concerning this notice may be directed to Walter Robertson, NASD Associate Director, Financial Responsibility, at (202) 728-8236 or Samuel Luque, Associate Director, Financial Responsibility, at (202) 728-8472.

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-28347; File No. S7-14-90]

RIN 3235-AD79

Net Capital Rule; Prohibited Withdrawal by Registered Broker-Dealers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule amendments.

SUMMARY: The Securities and Exchange Commission proposes to amend its net capital rule under the Securities Exchange Act with respect to withdrawal of net capital. The proposal would, under certain circumstances, prohibit registered broker-dealers from withdrawing capital directly or indirectly to benefit certain described persons related to the broker-dealer, without first notifying the Commission at least two business days before the withdrawal of capital. The proposed amendments would also permit the Commission, by order, to prohibit any of these withdrawals of capital from the registered broker-dealer, if the Commission believed the withdrawal may be detrimental to the financial integrity of the broker-dealer or might affect the broker-dealer's ability to repay its customer claims or other liabilities. Finally, the proposed amendments would prohibit any of these withdrawals of capital if the effect of such withdrawals would cause the broker-dealer's net capital to be less than 30 percent of its deductions required by the net capital rule as to its readily marketable securities.

The proposed amendments are designed to address the issues arising from the withdrawal of capital from a broker-dealer by a parent or affiliate, and they are intended to improve the Commission's ability to protect the customers and creditors of a broker-dealer in those circumstances where a financial problem in a holding company or other affiliate leads to withdrawals of capital from the broker-dealer. The Commission requests comment on the amendments set forth in the proposed rule. In addition, the Commission is requesting comment on whether additional amendments to the Commission's financial responsibility rules are appropriate in order to address the issues arising from the increased complexity of broker-dealer holding company structures and the higher incidence of proprietary risks undertaken by many broker-dealers.

DATES: Comments to be received on or before October 22, 1990.

ADDRESSES: Persons wishing to submit written comments should file three copies with Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549. All comment letters should refer to File No. S7-14-90. All comments received will be available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, (202) 272-2904, Michael P. Jamroz, (202) 272-2372 or Roger G. Coffin, (202) 272-2396. Division of Market Regulation, 450 Fifth Street, NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

The primary purpose of the net capital rule (Securities Exchange Act Rule 15c3-1; 17 CFR 240.15c3-l) is to protect customers and creditors of registered broker-dealers from monetary losses and delays that can occur when a registered broker-dealer fails. In this way, the Rule acts to prevent systemic risk from the failure of a financial intermediary. The Rule requires registered broker-dealers to maintain sufficient liquid assets to enable firms that fall below the minimum net capital requirements to liquidate in an orderly fashion without the need for a formal proceeding. Presently the net capital rule generally requires a registered broker-dealer to maintain net capital in excess of the greater of $25,000 or 6% percent of its liabilities and other obligations ("aggregate indebtedness or basic method"). If the broker-dealer makes an election under paragraph (f) of the Rule, the broker-dealer must maintain net capital in excess of the greater of $100,000 or 2 percent of its so-called aggregate debit items (the "alternative method"). These aggregate debit items generally may be thought of as its customer-related receivables.¹

Generally, the net capital requirement is computed by deducting from net worth, among other things, the book value of illiquid assets and cetain prescribed percentages from the market value of proprietary securities. These letter deductions are referred to as "haircuts". In the case of many firms, these haircuts require the firm to maintain significant amounts of capital (either equity capital or properly subordinated debt) to carry the positions while maintaining net capital compliance.

Paragraph (e) of the Rule generally prohibits withdrawals of equity capital of the registered broker-dealer by action of any stockholder or partner, or the making of unsecured advances or loans to any stockholder, partner or employee if the effect of such withdrawals, advances or loans is to reduce the broker-dealer's net capita! below certain levels. The withdrawals cannot cause the broker-dealer's net capital to be less than, among other things, 120 percent of the applicable minimum dollar amount required under the Rule. If the broken-dealer is computing its requirement under the basic method, the broker-dealer may not allow its net capital to be lowered as the result of equity capital withdrawals and unsecured loans such that its aggregate indebtedness would exceed 1,000 percent of its net capital. If the broker-dealer computes its requirement under the alternative method, it may not allow its net capital to be reduced lower than 5 percent of its aggregate debit items.

These early warning levels in the Rule are set at an amount above the minimum net capital requirement of the broker-dealer. They are designed to provide the Commission and the self-regulatory organizations a margin of safety in which to respond to the potential failure of a firm. These early warning levels restrict the withdrawal of capital below the specified limits, although the Rule does not expressly restrict the broker-dealer from making other distributions of capital to its parent or affiliates. Despite these limitations, the early warning levels of the Rule have generally provide an adequate cushion of net capital before a firm could be considered to be in or approaching financial difficulty. This is particularly true in the case of a large retail firm with a large customer business and little or no dealer business.

II. The Drexel Burnham Bankruptcy

Recent events have indicated that the existing early warning restrictions may not be sufficient to address the problems that have arisen in connection with the development by many broker-dealers of large, complex holding companies. The Division of Market Regulation in its October 1987 Market Break Report anticipated to some degree the problems that might arise:²

The large investment banking firms generally are owned by holding companies that have other subsidiaries engaging in unregulated securities-related or banking related activities. These unregulated entities attain a degree of leverage and take credit risks regulated broker-dealers cannot. In some cases, the registered broker-dealer's parent (without the broker-dealer's capital) or sister affiliates have significantly less capital than the broker-dealer. Moreover, the Division believes that in many cases the creditors of those entities are indirectly relying on the credit of the broker-dealer and (he ability of the holding company to shift capital from broker-dealer to the unregulated entity. * * *

A broker-dealer may be indirectly affected, however, by an insolvency of an affiliate or a parent. Broker-dealers often need short-term financing. The failure of a related entity could have substantial effects on the broker-dealer. In addition, management might seek ways to divert capital from the broker-dealer to the extent permitted by the net capital rule. While this shift of assets would not, by itself, place a firm in net capital violation, it could leave the firm more exposed to failure during volatile market conditions.

The recent bankruptcy of Drexel Burnham Lambert Group" Inc. ("Drexel"), the holding company parent of the broker-dealer Drexel Burnham Lambert, Inc. ("DBL"), underscores the need for amendments to the net capital rule that will enable the Commission to control diversions of a broker-dealer's capital within an interlocking financial services structure. In that case, Drexel had over $1 billion in commercial paper and other unsecured short term borrowings. Unsecured borrowing, particularly through the commercial paper market, is a common financing technique used by many large broker-dealer holding companies. As a result of significant losses and a decline in the rating of its commercial paper, Drexel found it more difficult to renew its short-term borrowings. Drexel was then forced to look to the only liquid sources of capital in its assetsâ€"the excess net capital of DBL and an affiliate government securities dealer.

In a period of approximately three weeks, and without the knowledge of the Commission or the New York Stock Exchange Inc., (the "NYSE") DBL's designated examining authority, approximately $220 million was transferred to the holding company in the form of short term loans. This action occurred during a period in which the default or financial problems of a number of issuers³ had adversely impacted the liquidity and pricing reliability in the high-yield securities market and raised difficulties in valuing a substantial portion of the firm's portfolio of securities for purposes of determining capital compliance. Moreover, at the time the Commission became aware of Drexel's financial dilemma, Drexel or its affiliates had more than $400 million in short-term liabilities coming due in the next two weeks and an additional $330 million scheduled to mature in the next month.

Prior to the chapter 11 bankruptcy filing by Drexel, the Commission advised Drexel and DBL of its concerns regarding the substantial withdrawals of capital by Drexel from DBL and an affiliate government securities dealer. In addition, the Division of Market Regulation sent a letter to DBL confirming its understanding that DBL would not make any further loans to Drexel or its affiliates without prior consultation with the Commission. This letter was followed by two letters from the NYSE which: Prohibited DBL from making any loans or advances to any related entity without NYSE approval; increased DBL's haircuts on its high yield inventory position; and prescribed a minimum net capital requirement for DBL of $150,000,000.⁴

Had the Commission and the NYSE not intervened when they did, Drexel would have continued to withdraw funds out of DBL and probably would have continued until the broker-dealer's early warning level was reached. Especially in light of Drexel's precarious financial position and the uncertainty with respect to DBL's valuation of its high yield portfolio, this would have created the risk that the broker-dealer's customers and its counterparties would have been subjected to a liquidation under the Securities Investor Protection Act.

III. The Proposed Rule Amendments

The Commission proposes to address the potential for a holding company parent in financial difficulty from withdrawing a substantial percentage of a broker-dealer's net capital in three different ways. First, the Commission is concerned that the present early warning levels may not be sufficient for firms that primarily do a dealer business. Because such a firm may have relatively few customer debits, the capital level required under the alternative method may be relatively low, and it may not be related to the size or risk of its dealer business. Haircuts provide an approximation of the risk in a dealer's proprietary securities positions. Accordingly, the proposed amendments would establish a new early warning level for a dealer based on the firm's proprietary positions, as represented by the haircuts on those positions. If a firm triggers the proposed new early warning level, that event will indicate to the Commission that the firm's net capital is low in relation to the amount of the firm's securities positions. In such cases, no capital should be removed from the firm to benefit insiders.

In order to assess the impact of the proposed early warning level on large broker-dealer subsidiaries of holding companies, the Commission staff examined data provided by the staff of the NYSE which refelcted NYSE member financial data as of December 31,1989. The proposed amendments would raise the early warning level of twelve of the twenty largest NYSE member firms. These firms would have a total of approximately $911 million in capital restricted from withdrawal by the proposed amendments, or an average of $76 million per firm.

Additionally, twelve of the twenty NYSE member firms with the largest dollar amount of haircuts would be affected by the proposed amendments. These firms would have approximately $940 million in additional capital restricted from withdrawal. On average, each of these firms would have approximately $78 million in capital per firm that would be subject to restrictions on withdrawal. The twenty NYSE firms that would be most impacted by the proposed early warning level would have approximately $1 billion in additional capital restricted from withdrawal, for an average of approximately $50 million per firm.

Based on this data, the Commission has preliminarily concluded that 30 percent of a firm's haircuts will provide an adequate cushion of net capital to liquidate a firm's positions. If a firm reaches this early warning level, regulatory authorities will be alerted to the need for increased surveillance of the firm and will be able to take appropriate action. This action may include requiring a firm to reduce its securities positions.

Second, the proposed amendments would require a broker-dealer to notify the Commission and its designated examining authority at least two business days before it intends to withdraw capital in certain instances. This notification would be required only where the projected withdrawal, along with other withdrawals over the preceding 30 days, would equal or exceed 20 percent of the firm's excess net capital, or where 30 percent of the firm's excess net caiptal was withdrawn over the preceding 90 days. In order to provide smaller broker-dealers flexibility to transfer funds in the ordinary course of business, the notification requirement would not be triggered by aggregate withdrawals of less than $50,000. This exception would not apply to limitation on withdrawals imposed by the other early warning levels.

Finally, the proposed amendments would also allow the Commission in extraordinary circumstances to restrict any withdrawal of capital by insiders of the firm for a period of up to twnety business days at a time. This discretionary authority could be used where the Commission believes that any withdrawal of capital may be detrimental to the finacial integrity of the broker-dealer or might unduly jeopardize the broker-dealer's ability to pay its liabilities to customers or other creditors.

The twenty business day period would enable the Commission and its staff to further examine the broker-dealer's financial condition, net capital position and the risk exposure to the customers and creditors of the broker-dealer. During this period the Commission, after considering the above and other factors, could determine whether, under what circumstances, or in what amounts, withdrawals of net capital from the broker-dealer should be allowed. To continue to restrict withdrawals, however, additoinal orders will have to be issued by the Commission, each with a term of no more than twenty business days.

The Commission does not expect that this authority will be exercised except in those exceptional circumstances where the Commission is concerned that the concentration or lack of liquidity of the assets held by the dealer raise concerns about the firm's ability to liquidate, if necessary, in an orderly fashion.

IV. Request for Comment

The Commission requests comments on the proposed amendments. In particular, commentators are requested to address the issue of whether the proposed amendments will improve the Commission's ability to respond to serious financial and liquidity problems occurring in the holding company of a borker-dealer. Comment is also invited on any potential adverse impact the proposed amendments may have on the willingness of other corporate entities to invest in and to maintain substantial excess net capital in a broker-dealer. Comment is also requested on the adequacy of the specific standards proposed, including, but not limited to, the use of a 30 percent of haircuts test for limiting capital withdrawals and the provision that exempts notification when the anticipated withdrawal is $50,000 or less.

With respect to the provision that would enable the Commission to restrict withdrawals of capital from any particular broker-dealer, the Commission preliminarily believes that the execution of an order under paragraph (e}(4) would fall within section 23(c) of the Securities Exchange Act and, in particular, 17 CFR 201.27 adopted thereunder. More specifically, Rule 201.27 would require the Commission to give prompt notice to the broker-dealer in th event an order restricting a withdrawal of capital is issued. The Commission requests comment on whether proposed paragraph (e](4l raises issues under either section 23(a) of the Securities Exchange Act or the Administrative Procedure Act.

In addition to requesting comment on the amendments proposed today, the Commission also requests comment on whether additional amendments to the Commission's financial responsibility rules are appropriate in light of the increased complexity of broker-dealer holding company structures and the higher incidence of proprietary risks now taken by many broker-dealers. Specifically, the Commission requests comment on the adequacy of the existing minimum capital levels for broker-dealers, in particular larger broker-dealers that conduct a broad range of activities, both in the broker-dealer and in affiliated enterprises. The Commission asks for alternative aproaches to determining the appropriate required capital for large firms in view of the large degree of leverage that those firms, particularly those that operate under the alternative method, can attain.⁵ Insofar as the deductions taken on the firm's securities positions represent the Rule's general measurement of risk related to those positions, the Commission asks for comment regarding whether the net capital Rule should provide for a required level of capital that is based on the haircuts incurred by the firm on its positions.

V. Summary of Initial Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility Analysis ("IRFA") in accordance with 5 U.S.C. 630 regarding the proposed amendments. The Analysis notes that the objective of the proposed amendments is to further the purposes of the various financial responsibility rules which provided safeguards with respect to financial responsibility and related practices of brokers and dealers. Smaller broker-dealers will generally not be affected because the new early warning level will generally not be in excess of their present early warning levels. Additionally, a firm may withdraw capital of up to $50,000 without notice if this withdrawal would not pull the firm below other early warning levels. In sum, the Analysis states that the proposed amendments would affect the ability of broker-dealers to distribute capital to related parties. The amendments are designed to prevent insiders from withdrawing capital from the registered broker-dealer to benefit the parent or its ultimate owners to the detriment of the creditors of the broker-dealer. A copy of the IRFA may be obtained by contacting Roger G. Coffin, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC, 20549, (202] 272-2396.

VI. Statutory Analysis

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 proposes to amend § 240.15c3-l, of title 17 of the Code of Federal Regulations in the manner set forth below.

VII. List of Subjects in 17 CFR Part 240

Reporting and recordkeeping requirements; Securities.

VIII. Text of the Proposed Amendments

In accordance with the foregoing, title 17, chapter II of the Code of Federal Regulations is proposed to be amended as follows:

PART 240â€"GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934

Authority: Sec. 23, 48 Stat. 901. as amended (15 U.S.C. 78w), * * *. § 240.15C3-1 is also issued under sees. 15(c){3). 15 U.S.C. 78o{c)(3).

§ 240.15c3-1 Net capital requirements for brokers or dealers.

* * * * *

* * * * *

By the Commission.

Dated: August 15, 1990.

Jonathan C. Katz,

Secretary.

[FR Doc. 90-19606 Filed 8-20-90; 8:45 am]

BILLING CODE 8010-01-M

¹More specifically, the broker-dealer must maintain net capital in excess of 2 percent of its aggregate debit items as computed in accordance with the Formula for Determination of Reserve Requirement for Brokers and Dealers contained in Securities Exchange Act Rule 15c3-3 (17 CFR 240.15C3-3).

²See The October 1987 Market Break. A Report by the Division of Market Regulation of the U.S. Securities and Exchange Commission. February 1988, pp 5-17, 5-18.

³During 1989. 47 issuers defaulted or were involved in distressed exchange offers [i.e., an exchange of an outstanding debt security for a security with a lower principal amount or a lower interest rate) on approximately $7.3 billion in registered high-yield securities. For example, in June of 1989. Integrated Resources, a major issuer of high-yield securities, defaulted on $1 billion in commercial paper. In July of 1989, the Southmark Corporation filed for bankruptcy, and in September of that year, the Campeau Corporation announced that it lacked sufficient cash to satisfy its debt obligations. In January of 1990. the Campeau Corporation filed for protection from creditors under the federal bankruptcy laws. These failures adversely impacted the high-yield market in two ways. First secondary trading in high-yield securities fell off sharply. Second, new transactions involving the issuance of high-yield securities began to slow down, with a resultant decline in underwriting and related income.

⁴The NYSE letters were predicated on NYSE Rules 325 and 326. which authorize the NYSE to require a member firm to maintain net capital in an amount necessary to meet a firm's financial obligations, and authorize the NYSE to prohibit a firm from advancing funds to its owners.

⁵For example, immediately before Drexel declared bankruptcy, DBL's net capital requirement was approximately $16 million, in addition to aggregate haircuts of approximately $900 million.