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4000 - Advisory Opinions


Obligations Under the "Interagency Policy Statement on Retail Sales of Nondeposit Products" and the FDIC's Recordkeeping and Disclosure Requirements

FDIC--99--6

August 18, 1999

Michael B. Phillips, Counsel

This letter responds to the issues presented in your letter of January 6, 1999, to Russell Marshall and William Tullis of the Atlanta Regional Office of the Federal Deposit Insurance Corporation (the "FDIC") regarding certain securities activities of your client,            (the "Bank"). Your letter responded to a letter dated August 25, 1998, from the Federal Deposit Insurance Corporation (the "FDIC") with respect to the Bank's obligations under (i) the Interagency Policy Statement on Retail Sales of Nondeposit Products ("Interagency Statement"), and (ii) the FDIC's recordkeeping and disclosure requirements in 12 C.F.R. Part 344. In particular, your letter requested that the FDIC consider certain interpretative guidance by the Office of the Comptroller of the Currency (the "OCC") and other federal regulators regarding compensation disclosure obligations arising from riskless principal transactions that involve debt securities. Your letter was forwarded to the FDIC's Legal Division in Washington, D.C. for response. We apologize for the delay in responding to your letter.

In your letter, you cited the Bank's internal procedures that conform with the Interagency Statement and provided information supporting your position that because the majority of the Bank's securities transactions constitute "riskless principal" transactions involving primarily debt securities, the compensation disclosure requirements of Part 344 should not be applied to the Bank's securities transactions. In addition, you provided data with respect to the Bank's qualification for an exemption under 12 C.F.R. § 344.2(a)(1) (i.e., that the Bank conducted an average of less than 200 securities transactions over a three-year period) for the period of 1995--97 and thereby qualified for an exemption from the recordkeeping and other requirements in 12 C.F.R. §§ 344.4(a)(2) through (4) and 344.8(a)(1) through (3). This letter addresses the aforementioned matters and provides guidance concerning further information that we need from the Bank for purposes of reviewing compliance with the Interagency Statement and the applicability of the exemption in 12 C.F.R. § 344.2(a)(1).

I. Interagency Policy Statement on Retail Sales of Nondeposit Products

In your letter, you stated that the Bank acknowledges that it is subject to the Interagency Statement for purposes of its securities transactions. In this regard, you asserted that the Bank is implementing the various requirements in the Interagency Statement and is adopting "more formalized procedures with respect to its nondeposit activities to strengthen its compliance with the Interagency Statement." We are interested in whether the Bank has completed implementation of those procedures. If so, we request you transmit to the FDIC (to the attention of Counsel Michael B. Phillips at the above address) a copy of those procedures so that we can confirm whether the procedures comply with the Interagency Statement's requirements.

II. Applicability of Part 344

We agree with the statement in your letter that the Bank's transactions involving certificates of deposit ("CDs") with maturities of less than 9 months are not subject to Part 344. Such transactions are exempted from Part 344 because such short-term CDs do not constitute "securities" under the definition in 12 C.F.R. § 344.3(m)(5). However, we have determined that the operative period for purposes of the exemption category in 12 C.F.R. § 344.2(a)(1) is 1996--98, not the period 1995--97, which was discussed in your letter. We recognize that the earlier period was the focus of the FDIC examination of the Bank to which your letter of April 7, 1998 responded.

In response to the FDIC's letter of August 25, 1998, you provided statistics with respect to the Bank's securities transactions during the period 1995--97. In your letter, you stated that this information supports the Bank's exemption from the FDIC's record keeping requirements in 12 C.F.R. § 344.3(a)(2) through (4) and the securities trading procedures in § 344.8(a)(1) through (3). The relevant calculations for purposes of the exemption in § 344.2(a)(1) involve several provisions of Part 344:

• Section 344.2(a)(2), which states that the record keeping requirements of Section 344.4 do not apply to banks effecting less than 500 government securities transactions per year;

• Section 344.3(m), which excludes from the definition of the term "security" deposit accounts (§ 344.3(m)(1)) and certificates of deposit that qualify as "any note, draft, bill of exchange, or bankers acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace or any renewal thereof" (§ 344.3(m)(5)); and

• Section 344.2(a)(1), which states that the requirements of §§ 344.4(a)(2) through (4) and 344.8(a)(1) through (3) do not apply to a bank effecting an average of fewer than 200 securities transactions per year for customers over the prior three calendar years.

For purposes of your response to the FDIC examination of the Bank in 1998, we concur with your determination that the Bank has satisfied exemption category § 344.2(a)(1) for the period 1995--97--i.e., the Bank has engaged in an average of fewer than 200 securities transactions per year. However, we have determined that the period 1996--98 is the relevant period for purposes of the FDIC's current review of whether the Bank meets that exemption category. Note that § 344.2(a)(1) requires data "over the prior three calendar year period." Regarding the Bank's request, that period currently would be 1996--98, not 1995--97.

According to your letter, in 1997, the amount of nonexempted securities transactions significantly increased from the two prior years. In 1997, the Bank engaged in 424 nonexempt securities transactions. However, in 1995 and 1996, nonexempt securities transactions totaled 77 and 58, respectively. Given this trend, it is anticipated that the three-year average for the period 1996--98 likely exceeded the average for the period of 1995--97 (i.e., 184.6 transactions per year).

Note that even if the results for the period of 1996--98 establish that the 200 transaction threshold for the exemption category in § 344.2(a)(1) is met, only the recordkeeping and securities trading policy requirements in Part 344 would be exempted. The notification/reporting requirements (§§ 344.5 and 344.6), the settlement requirements (§ 344.7), and the insider trading policy requirements (§ 344.9) still would apply to the Bank's securities transactions.

III. Disclosure of Bank Compensation on Riskless Principal Transactions Effected on Behalf of the Bank's Customers

According to your letter, the Bank's "riskless principal" transactions involving debt securities should not be subject to Part 344's disclosure requirements regarding markups or markdowns. Your rationale is based on the treatment by the U.S. Securities and Exchange Commission (the "SEC") of such transactions in its Rule 10b--10,1 in addition to Interpretive Letter No. 626 issued by the OCC. That Letter concerns an OCC regulation that is substantially similar to the FDIC's Part 344 and is patterned after the SEC's Rule 10b--10.2 In addition, you informed us that the Bank has redesigned its confirmations to customers to (i) disclose that the customer's securities transactions is being conducted on a "riskless principal" basis, (ii) explain what constitutes a "riskless principal" transaction, (iii) describe the markup or markdown involved in the transaction and (if applicable) other fees imposed by the Bank, and (iv) indicate that if specific inquiry is directed by the customer, more detailed disclosure concerning the markup will be provided.

With respect to the SEC's Rule 10b--10, you noted that for riskless principal transactions, the SEC requires that a broker-dealer disclose to the customer the amount of the markup, markdown or other compensation charged by the broker-dealer only if the securities traded are equity securities, not "debt securities."3 You also note that OCC Interpretive Letter No. 626 indicates that compensation need not be disclosed in the case of riskless principal transactions involving debt securities provided that certain conditions are met.4

In evaluating your request, we are using the term "riskless principal" securities transactions to refer to those securities transactions in which a broker-dealer, after receiving an order to buy (or sell) a security from a customer, purchases (or sells) the security for its own account to offset a contemporaneous sale to (or purchase from) the customer. In 1989, the Board of Governors of the Federal Reserve System (the "FRB") determined that riskless principal transactions by bank holding companies and their bank subsidiaries do not violate the Glass-Steagall Act.5 In that 1989 order, the FRB described such transactions as follows:

If the firm elects to act as a riskless principal in executing the transaction, it will purchase the securities from a third party dealer at that dealer's "inside" price and then, acting as a principal, resell them to the customer, adding a mark up over its cost. However, the broker-dealer does not confirm the transaction with its customer until the securities have been purchased from the third party dealer.
6

For purposes of the FRB's determination that riskless principal transactions subject to certain restrictions
7 are closely related to banking for purposes of Section 4(c)(8) of the Bank Holding Company Act, the FRB has commented:

In acting as a riskless principal . . . Company would not obligated to its customer to buy or sell securities until after an offsetting purchase or sell securities until after an offsetting purchase or sale of the securities has already been executed. If the market price of the securities ordered by the customer suddenly were to change significantly, before Company is able to arrange an offsetting open market transaction on terms that would protect it from loss, Company can decline to execute the order.
8

We concur that the compensation disclosure requirements of Part 344 as applied to riskless principal transactions involving debt securities should be construed in a manner that is consistent with the SEC's Rule 10b--10. Part 344 was revised, in part, to better conform with the SEC's regulations governing broker-dealer confirmations, and thereby provide better regulatory parity between (1) banks and bank customers, and (2) broker-dealers and their customers. Thus, the FDIC will not require disclosure of the compensation at issue, as the SEC does not require such disclosure.

However, consistent with OCC Interpretive Letter No. 626, we will require that two categories of conditions must be met by the Bank in order that the compensation disclosure requirements in Part 344 will be found not to apply to such transactions. Under its Interpretive Letter, the OCC has imposed certain conditions to ensure compliance with the Glass-Steagall Act. In addition, the OCC has required certain conditions with respect to disclosures to customers.

With respect to compliance with the Glass-Steagall Act, for purposes of the Bank's riskless principal transactions involving debt securities, the FDIC will require the Bank's compliance with the following conditions:

• The Bank will limit its riskless principal activities to securities transactions with institutional customers concerning investment grade, debt securities.

• The Bank will not execute riskless principal transactions on behalf of any of its foreign subsidiaries or its affiliates.

• The Bank will not represent itself as a market maker or dealer for the debt securities.

• The Bank will not enter quotes for specific securities in the National Association of Securities Dealers automated quotation system ("NASDAQ") or any other dealer quotation system in connection with riskless principal transactions.

• The Bank will not make any general solicitation or advertisement for any security being bought or sold.

With respect to disclosure requirements and related confirmation and recordkeeping requirements, for purposes of the Bank's riskless principal transactions involving debt securities, the FDIC will require the Bank's compliance with the following conditions:

• Confirmations will (i) refer to the transactions as "riskless principal" transactions; (ii) explain what constitutes a "riskless principal" transaction; (iii) describe the markup or markdown involved in such transactions and (if applicable) other fees imposed by the Bank; and (iv) indicate that if specific inquiry is directed by the customer, more detailed disclosure concerning the markups will be provided.

• The Bank will disclose its capacity in each customer trade to be that of a "riskless principal."

• Except for the compensation reporting requirements in Part 344 (12 C.F.R. § 344.5(b)(5) and (6)), the other reporting requirements in 12 C.F.R. § 344.5 will continue to apply.

• The Bank will adopt procedures that fully conform with Part 344 to code and identify all riskless principal transactions and maintain appropriate records, including original order tickets with time sampling of both receipt and execution of orders.

• The Bank will disclose whether it is being compensated by means of a spread, and the Bank will adhere to internal policy under which spreads will approximate a typical commission and will be within the limits required under the Federal securities laws.

The conditions set forth in OCC Interpretive Letter No. 626 with respect to compliance with the Glass-Steagall Act are similar to commitments obtained by the FRB in connection with its orders approving certain riskless principal transactions by subsidiaries of bank holding companies.9 The FDIC agrees with the FRB's view in those orders that certain conditions are necessary for riskless principal securities transactions to ensure that those transactions will not constitute securities underwriting or brokerage activities in violation of the Glass-Steagall Act.10 To date, the FRB has not issued interpretive guidance with respect to the compensation disclosure issues that are presented in your letter.11

Note that this interpretation of Part 344 specifically involves the compensation disclosure requirements in 12 C.F.R. § 344.5(b)(5) and (6). The other disclosure requirements in Part 344 would apply to all transactions involving a "security" as defined in 12 C.F.R. § 344.3(m), including riskless principal transactions involving debt securities. Disclosure requirements specific to debt securities are set forth in 12 C.F.R. § 344.5(b)(8) through (12).

If you have any questions regarding this letter, please contact me at (202) 898--3581.

117 C.F.R. § 240.10b--10. The rationale for the SEC's treatment of riskless principal transactions involving debt securities is stated in the preamble to its 1994 revision of Rule 10b--10. See 59 Fed. Reg. 59612, 59615--616 (1995). According to the preamble, the SEC will defer mandating markup disclosure for riskless principal transactions involving debt securities until it determines whether there is sufficient "transparency" in the debt securities markets. Go back to Text

2See 12 C.F.R. Part 12 (OCC). The FRB also has promulgated regulations substantially similar to the FDIC's Part 344. See 12 C.F.R. § 208.34. Go back to Text

3The definition of "debt securities" in § 344.3(h) of the FDIC's regulations is substantially identical to the SEC's definition of that term in Rule 10b--10(d)(4). See 17 C.F.R. § 240.10b--10(d)(4). Go back to Text

4OCC Interpretive Letter No. 626 (July 7, 1993). Go back to Text

575 Fed. Res. Bull. 829 (1989). Go back to Text

6Id. at 831. Go back to Text

7For a listing of conditions required by the FRB in its latest order involving riskless principal activities, see 82 Fed. Res. Bull. 748 (1996). Go back to Text

875 Fed. Res. Bull. 829, 832 (1989). Go back to Text

9See the FRB's Order Revising the Limitations Applicable to Riskless Principal Activities, 82 Fed. Res. Bull. 759, 760--61 (1996). The FRB also has issued orders regarding riskless principal transactions by specific bank holding companies. See 82 Fed. Res. Bull. 748 (1996) (The Bank of New York); 75 Fed. Res. Bull. 829 (1989) (Bankers Trust). Go back to Text

10In 1997, the FRB revised its regulations governing bank holding companies at 12 C.F.R. Part 225 (Part Y) with respect to riskless principal transactions as permissible activities for purposes of Section 4(c)(8) of the Bank Holding Company Act. See 12 C.F.R. § 225.28(b)(7)(ii). Go back to Text

11The FRB's securities transaction confirmation regulations for state-member banks, which are substantially equivalent to the FDIC's Part 344, are set forth in 12 C.F.R. § 208.34. The FRB's compensation disclosure requirements are provided in § 208.34(d)(2)(v) and (vi). Go back to Text


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