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4000 - Advisory Opinions

Bank Agreement to Be Responsible to Customers and Clearing Broker for Any Loss of Funds Resulting from Misappropriation, Conversion or Errors Made by Bank Affiliated Broker-Dealer


September 11, 1986

Pamela E. F. LeCren, Senior Attorney

The following is in response to your July 11, 1986 letter wherein you request an opinion on whether or not an agreement *** proposes to enter into with its wholly-owned subsidiary *** Discount Brokerage, Inc. would be in violation of section 332.1 of the FDIC rules and regulations. This letter will further confirm the opinion I provided to you over the telephone.

As indicated in your letter, *** has received a copy of a July 1, 1986 letter from the Securities and Exchange Commission ("SEC") to the Director of the National Association of Securities Dealers. The letter sets forth the opinion of the SEC with respect to the applicability of certain SEC rules and regulations to bank affiliated broker-dealers. Among the issues dealt with by the letter is whether or not a bank affiliated broker-dealer need comply with SEC rule 15c3-1 and 15c3-3 in an instance in which the broker-dealer has been given the authority by its customers and its clearing broker to instruct its affiliated bank to transfer funds from the customers' account or clearing broker's account held at the bank for the settlement of securities transactions. The position of the SEC set forth in the letter is that generally a bank affiliated broker-dealer may direct transfers of funds from its customers' or clearing broker's accounts at an affiliated bank for the settlement of securities transactions only if the provisions of rule 15c3-1 and 15c3-3 are met. Among other things, these rules would require the bank affiliated broker-dealer to maintain net capital of not less than $25,000, maintain certain administrative controls, and employ a securities principal that has passed a particular SEC examination.

The letter goes on to indicate, however, that the SEC will raise no question nor recommend any enforcement action if the broker-dealer operates with net capital of not less than $5,000 and considers itself exempt under paragraph (k)(2)(B) of Rule 15c3-3 if the following conditions are met: (1) the bank affiliated broker-dealer obtains and preserves as part of its records a written authorization from its customers and clearing broker authorizing the transfers of funds, (2) the bank affiliated broker-dealer will have access to the customers' or clearing broker's accounts at the affiliated bank solely for the purpose of settling the balance owing from any trades, and (3) the bank affiliated broker-dealer enters into a written agreement with its affiliated bank in which the affiliated bank agrees to be responsible to the customers and clearing broker for any loss of funds resulting from misappropriations, conversions or errors made by the bank affiliated broker-dealer in connection with the settlement of any securities transactions.

Upon carefully reviewing the SEC's July 1, 1986 letter and FDIC's regulations, it is our conclusion that should *** and its subsidiary enter into an agreement as described above, the agreement would violate section 332.1 of the FDIC's regulations. Section 332.1(d) of the FDIC's regulations generally prohibits insured nonmember banks from guaranteeing or acting as surety on the obligations of third parties. On its face, the agreement seems to clearly involve the guarantee of the obligations of another. Over the years the FDIC has recognized two interpretative exceptions to the general prohibition found in section 332.1. The two exceptions which permit a bank to guarantee the obligations of another are: (1) when the bank maintains a segregated deposit fully covering any potential liability, and (2) when the bank is determined to have a substantial interest in the transaction. Of the two, only the latter is potentially applicable here. We have concluded, however, that neither of the exceptions apply in this case.

Historically, the substantial interest exception has been limited to situations in which a bank has a direct economic interest or stake in the particular transaction as well as to situations in which, in addition to such a direct economic interest, the bank is in no worse position than it would have been if it had not entered into the guarantee. My review of the FDIC's legal files reveals that in the past the substantial interest exception has been found to come into play in the following types of situations: (1) the bank is guaranteeing the performance of the bank's co-trustee, (2) the bank is guaranteeing a loan participation, (3) the bank enters into a guarantee of a loan to a third party in an effort to salvage a nonproducing asset, (4) the bank enters into a guarantee of payments on amounts due on bonds issued as part of a financing in conjunction with a lease (the availability of the financing depended upon the guarantee which itself did not materially increase the bank's liability under the lease), (5) the bank enters into a guarantee to facilitate the sale of an asset, (6) the bank guarantees a loan to a service center to be owned by several banks in a holding company system (said service center will provide services to the bank), (7) the bank enters into a guarantee of a loan to bank insiders where the loan is used to buy property on which a bank branch will be built, (8) the bank enters into a guarantee of a portion of a prior debt in exchange for the agreement of a senior creditor to subordinate the senior debt to the bank's subsequent loan to the same debtor, and (9) the bank guarantees a loan to the bank's ESOP to acquire bank's stock for the benefit of the bank's employees.

It is our opinion that the substantial interest exception does not apply in this case as there is no direct economic benefit flowing to the bank as a result of entering into the agreement. On the contrary, by entering into the agreement the bank would increase its potential liability due to the operation of its subsidiary. Although the subsidiary is wholly-owned, it may be considered a legally separate entity from the bank in the event of any litigation arising from its operations. Whether or not a court would pierce the corporate veil between the bank and its subsidiary will depend upon the particular facts. It is clear, however, that should the bank enter into the agreement the bank would be contractually liable for any misappropriations, etc.

Additionally, we do not feel that it is appropriate to opine, as you suggest, that such an agreement would not involve the guarantee of the obligations of another simply because the agreement would extend to a wholly-owned subsidiary of the bank. If the Legal Division were to adopt this position with respect to a subsidiary of a bank without regard to the substance of the guarantee and the overall circumstances of the transaction, the purpose of the regulation would be totally undermined.

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