4000 - Advisory Opinions
Subsidiary Requirements for Broker-Dealer Subsidiary Engaged in Riskless Principal Transactions in U. S. Government Securities, Municipal Bonds and Revenue Bonds
March 28, 1988
Pamela E. F. LeCren, Senior Attorney
You have inquired on behalf of your client, a state chartered nonmember insured bank, whether the bank's registered broker-dealer subsidiary would be subject to the bona fide subsidiary and transaction restrictions of section 337.4 of the FDIC's regulations (12 C.F.R. 337.4) if the subsidiary engages in "riskless principal" transactions in U. S. government securities, municipal bonds, and revenue bonds. According to your letter, the broker's activities will consist of the following. Upon receipt of an order from a customer for the purchase of a government security, municipal bond, or revenue bond, the broker will buy the requested security then immediately resell the security to that customer. Likewise, upon receipt of a sell order from a customer, the broker will purchase the security and immediately resell it to another customer. In either case the broker will not purchase a security until it has an offsetting buy or sell order from another customer.
Section 337.4 of the FDIC's regulations requires that any subsidiary of an insured nonmember bank that engages in activities not authorized to a bank under section 16 of the Glass-Steagall Act (12 U.S.C.24(Seventh)) as made applicable to insured nonmember banks by section 21 of the Glass-Steagall Act (12 U.S.C. 378) must meet the definition of a bona fide subsidiary contained in section 337.4(a)(2) of the FDIC's regulations.* Such a subsidiary is also subject to the provisions of the regulation restricting transactions between the bank and its subsidiary. Furthermore, if a subsidiary of an insured nonmember bank engages in underwriting activities that would not be authorized to a bank under section 16 of the Glass-Steagall Act, that subsidiary is restricted, subject to certain exceptions, in the types of securities it may underwrite to those identified in section 337.4(b)(1)(1), i.e., investment quality debt securities, investment quality equity securities, and certain money market funds and mutual funds. In order to respond to your question we must determine whether section 16 of the Glass-Steagall Act permits a bank to engage in riskless principal transactions.** Inasmuch as the operative language of section 16 permits the buying and selling of securities upon the order, and for the account of a customer, provided that the transaction is without recourse and does not constitute an underwriting, if we determine that in economic substance riskless principal transactions are covered by the language of section 16, the bank's broker-dealer subsidiary will not be required to be a bona fide subsidiary; the transaction restrictions in section 337.4(e) will not apply; and the underwriting limitations contained in section 337.4(b)(1)(1) will not apply. In fact, given such a determination, the bank could itself directly engage in riskless principal transactions if state law so permitted.
Upon the Order of a Customer
It is well established that section 16 of the Glass-Steagall Act does not prohibit retail brokerage activities as such activities fall squarely within the permissive language of section 16, i.e., involve the purchase and sale of securities upon the order and for the account of a customer without recourse. It has been further held that retail brokerage does not involve underwriting or dealing as such transactions do not involve the purchase and sale of particular securities as principal. Securities Industry Association v. Comptroller of the Currency, 577 F. Supp. 252 (D.D.C. 1983), aff'd, 758 F.2d 739 (D.C.Cir. 1985), cert. denied, 106 S.Ct. 790 (1986); Securities Industry Association v. Board of Governors of the Federal Reserve System, 104 S.Ct. 3003 (1984) ("Schwab"). In order to find that riskless principal transactions are permissible under the language of section 16 we must be able to conclude that under the standards announced in applicable case law such transactions, even though effected as principal, qualify as agency transactions that are "upon the order and for the account of customers" within the meaning of section 16.***
The Court of Appeals in Bankers Trust, at 1060, held that the "upon the order of a customer" language in section 16 does not limit a bank to accommodation transactions for existing customers. The Court also found that the transactions at issue there (private placement of commercial paper) met the "upon the order of a customer" language in section 16 as the transactions were initiated by another party, the customer, and not the bank, i.e., the bank played a passive role in the customer's decision to enter into the transaction.
Consider by contrast, a case in which an investment bank decides that the market is favorable to the refinancing of a bond issue or the conversion of debt to equity and initiates discussions with its customer leading up to the eventual transaction. In such a situation, the initiative of the investment banker itself creates the very demand for the particular transaction. Bankers Trust, at 1061.
Riskless principal transactions seem to qualify as upon the order of a customer in this regard. A broker which engages in riskless principal transactions assumes a passive role, i.e., does not seek to generate the demand for the transaction in question. It is initiated by the customer who decides whether to purchase or sell a security, the timing of the sale or purchase and which security to buy or sell. Absent the customer's placement of a buy or sell order, the broker has no interest in the transaction taking place. He therefore conclude that such transactions are upon the order of a customer.
For the Account of a Customer
As to the transactions being effected for the account of a customer, it is clear that a broker which engages in riskless principal transactions has no intention of taking securities into its own account either for the purposes of investment or to hold in its inventory for later resale hopefully when the market goes up. The broker does not incur market risk with respect to the securities inasmuch as the broker has received offsetting buy and sell orders before it makes any purchase. Furthermore, as the offsetting orders are placed before the broker makes any purchases, the acquisition of title is merely incidental to the underlying transaction and the broker is acting more in the way of an agent than in the way of a principal.
If the bank had a service designed to provide buyers, for a fee, with the securities desired, the bank would obviously be purchasing the securities for those buyers. . .the bank might be precluded [however] from soliciting any particular order from them. Bankers Trust, at 1062 n.2.
The riskless principal broker is providing buyers for a fee (the mark up on the securities) with the securities desired and is therefore, in the words of Bankers Trust, "obviously purchasing the securities for those buyers," i.e. acting as agent. We conclude based on the above that riskless principal transactions are agency transactions for the purposes of section 16 of the Glass-Steagall Act.
The ordinary commercial meaning of "without recourse" means that a party does not assume the liability of endorser or maker with respect to an instrument. See G. Munn & F. Garcia, Encyclopedia of Banking and Finance 943 (7th Ed. 1973); UCC § 3-424(1). The Supreme Court has said of the term "without recourse'' that "the evil aimed at is concededly a consequence of either an endorsement or guarantee by the bank of the paper which it sells. . .whether it ensues from technical endorsements. . .or from some other form of contract." Awotin v. Atlas Exchange National Bank of Chicago, 295 U. S. 211 (1934). The bank in that instance "undertook to save petitioner [the purchaser] harmless for all risk of loss on his purchase, as effectively as it had endorsed the bonds without restriction or had guaranteed their payment at maturity." Awotin, at 212. Thus, in the context of securities dealing, the "without recourse" language of section 16 prohibits a bank from: (1) assuming liability for the securities that it sells in the event that payment is not made by the issuer at maturity, (2) insuring a purchaser against loss, or (3) assuming the risk of loss that would otherwise fall on a buyer of securities (i.e., the risk that the value of a purchased security will decline during the period in which it is held as an investment or held in inventory). A transaction is also without recourse if "the bank makes no warranty as to the quality of the investment." New York Stock Exchange v. Smith, 404 F. Supp. 1091, 1097 (D.D.C. 1975), vacated on other grounds, sub. nom. New York Stock Exchange v. Bloom, 562 F.2d 736 (D.C. Cir. 1977), cert. denied, 435 U.S. 942 (1978).
The liability a bank may assume to complete a transaction when a third party to the transaction "walks away" from the deal is not the type of liability prohibited by section 16 as described above. This liability is incidental and the bank can bring an action for breach of contract to recover its damages if any. The Second Circuit rejected the proposition that Charles Schwab, a retail broker, trades with recourse "simply because it faces the kind of incidental liability to which SIA refers. [Liability of broker to complete a transaction even if other party does not]. Schwab can maintain actions for breach of contract against customers who fail to pay for or deliver securities and thus, giving the words their ordinary meaning, is not without recourse' against such customers." Securities Industry Association v. Board of Governors of the Federal Reserve System, 716 F.2d 92, 100 n.4 (2d Cir. 1983), aff'd, Schwab, 104 S.Ct. 3003 (1984).
Riskless principal transactions appear to be "without recourse" under the standard set forth above. The broker does not endorse or guarantee the securities nor make any warranty as to the quality of the securities. Although the broker does incur the risk that one of the parties will fail to complete the transaction, that is not the risk referred to by the "without recourse" language. Furthermore, it can be said that the broker does not assume the risk of a buyer ( i.e., market risk) inasmuch as the broker only makes a purchase after it has an offsetting buy or sell order from a customer. Like Schwab, the broker has recourse against its customer for breach of contract if the customer fails to perform.
We are of the opinion that a broker does not become an underwriter solely as a result of engaging in riskless principal transactions. However, a broker could be involved in an underwriting if it engaged in a public offering of securities (Bankers Trust, at 1062-1064, underwriting only occurs in the context of a public offering) or purchased a block of securities for resale on its own behalf as principal or entered into an agreement as agent on behalf of an issuer to sell securities (i.e., best efforts underwriting). Under such circumstances, even if the broker could characterize its activities as riskless principal transactions, such activities would not be permissible under the Glass-Steagall Act and would have to be conducted in the arms length affiliate required by the FDIC's regulation. The riskless principal transactions contemplated by our letter that would be permissible avoid the underwriting pitfalls. The broker does not have a salesman's stake in any particular security and its assets are not subject to the vagaries of the securities markets. Its profits depend on the volume of securities traded and not the value of particular securities which are purchased and sold. See Schwab, at 3011. The broker is merely matching buy and sell orders for customers something characteristic of retail brokerage which has been clearly held not to constitute underwriting.
Subtle Hazards Analysis
A review of the subtle hazards sought to be addressed by the Glass-Steagall Act reinforces our conclusion, set forth above, that riskless principal transactions fall within the literal language of section 16 and are therefore permissible for banks. As the broker does not recommend investments or warrant the quality of any investment, there is little risk that customers will blame the broker (or its affiliated bank) if their investment goes sour. As the broker does not purchase any security to be held in its own account nor look to the value of any particular security from which to derive its profits, the broker does not have a salesman's stake in any particular security. Thus, the broker's affiliated bank has no incentive to make loans to any particular issuer of securities in order to improve or maintain the value of the issuer's securities. Although a broker could use the affiliated bank's trust department as a means of disposing securities when its customer fails to buy as agreed, the presence of some but not all of the hazards addressed by the Glass-Steagall Act does not render an activity in violation of the Act. Bankers Trust, at 1069. What is more, general principles of fiduciary obligation would prevent self-dealing of this sort. Lastly, while the broker's affiliated bank may have an incentive to lend to the broker's customers so that the broker will have an endless supply of purchasers, the same incentive is present in any retail brokerage operation and the Supreme Court was apparently untroubled thereby. Schwab, at 3011.
Based on all of the above, we conclude that a broker-dealer subsidiary of an insured nonmember bank which engages in riskless principal transactions need not as a result of so doing, comply with the bona fide subsidiary requirements of section 337.4 nor is such a broker rendered subject to the underwriting limitations of section 337.4(b)(1)(1). Please note, however, that this opinion is limited to circumstances in which the broker has offsetting buy and sell orders prior to purchasing a security; the broker does not solicit buy or sell orders from customers; the broker has not entered into any agreement with an issuer or underwriter to buy an agreed upon amount of securities which the broker then seeks to resell; and the broker does not guarantee, warrant, or otherwise endorse securities which it sells. Furthermore, this opinion does not cover market making, block positioning activities, or other activities which may be similar to riskless principal trades in that buy and sell orders are matched within the same day through active marketing on the part of the broker. Finally, we are not expressing any opinion on whether it would be permissible under section 16 for the broker, in addition to acting as riskless principal, to also advise customers as to the purchase of any particular security.
* Section 16 provides that:
** The prohibition on underwriting in section 16 does not extend to U.S. government obligations and certain municipal bonds. It is clear, therefore, that transactions with respect to such securities, whether or not done as riskless principal, do not trigger section 337.4 of the FDIC's regulations. Underwriting and dealing in revenue bonds is not permitted, however, under section 16. Our analysis is therefore confined to whether such transactions will trigger the application of section 337.4 of the FDIC's regulations. Go back to Text
*** A riskless principal transaction, sometimes referred to as a simultaneous trade, has been defined by the Securities and Exchange Commission as one in which the broker, after having received an order to buy from a customer, purchases the security from another person to offset the broker's contemporaneous sale to the customer or, one in which the broker, after receiving an order to sell from a customer, sells the security to another person to offset the broker's contemporaneous purchase from the customer. SEC Release No. 15220 October 6, 1978, CCH ¶ 81,746. The Securities and Exchange Commission has characterized riskless principal transactions as being in many respects equivalent to transactions effected on an agency basis and further has said that such transactions are, in economic substance, agency transactions. SEC Release No. 15219 October 6, 1978, CCH ¶ 81,746. The Securities and Exchange Commission has characterized riskless principal transactions as being in many respects equivalent to transactions effected on an agency basis and further has said that such transactions are, in economic substance, agency transactions. SEC Release No. 15219 October 6, 1978, CCH ¶ 81,746. Go back to Text