United States: SEC Issues Order Implementing Expanded Categories of Permissible Collateral That A Broker-Dealer May Pledge to Customers Under Rule 15c3-3, Paragraph (b)(3)

The SEC issued an order (the "Order") expanding the categories of collateral that a broker-dealer may pledge when borrowing fully-paid and excess margin securities from customers beyond those currently permitted under Rule 15c3-3 of the Securities Exchange Act of 1934 ("Rule 15c3-3"). Rule 15c3-3, the broker-dealer customer protection rule, required a broker-dealer that borrows fully-paid or excess margin securities from a customer for its own use to provide the customer with at least 100% collateral consisting exclusively of cash, U.S. Treasury bills or notes, or irrevocable letters of credit issued by a bank. Rule 15c3-3, however, was recently amended to allow the SEC to expand the categories of permissible collateral by order based on a variety of factors, including the collateral’s liquidity, volatility, market depth and location and the issuer’s creditworthiness. The Order permits a broker-dealer to pledge certain government and mortgage-backed securities, securities issued by or guaranteed as to principal and interest by certain Multilateral Development Banks, certain negotiable certificates of deposits and bankers acceptances, and certain non-governmental debt securities denominated in U.S. dollars. The Order also permits a broker-dealer to pledge foreign currency, foreign sovereign debt and certain non-governmental debt not denominated in U.S. dollars, each subject to certain conditions and restrictions including over-collateralization when the securities borrowed and the collateral pledged are denominated in different currencies. The Order does not, however, permit a broker-dealer to pledge any security that (1) has no principal component, or (2) accrues interest at the time of the pledge at a stated rate equal to or greater than 100% per annum (expressed as a percentage of the actual principal amount of the security).

The Order requires, in addition to Rule 15c3-3’s collateralization and notice requirements, that the written agreement with the customer include notice that some of the securities provided by the borrower may not be guaranteed by the U.S. The Order was issued and became effective on April 16, 2003 and supersedes all prior interpretations and no-action positions issued by the staff of the SEC concerning the types of collateral that may be pledged under paragraph (b)(3) of Rule 15c3-3.

The OCC issued an interpretive letter ("Letter #961") that clarifies that a national bank, which acquires stock of a company in connection with satisfaction of debts previously contracted ("DPC Shares") has the authority (subject to establishing, and perhaps obtaining OCC approval of, the process set forth below) to hedge the market risk associated with changes in the value of the DPC Shares. The OCC states that since both lending and hedging risks arising from such lending are powers incidental to the business of banking and permissible under 12 U.S.C. § 24 (Seventh) ("Section 24 (Seventh")) a national bank may buy and sell options as a technique to hedge the market risks associated with DPC Shares, provided that the national bank "establishes an appropriate risk measurement and management and compliance process to conduct such hedging activities." The OCC also concludes in Letter #961 that the use of options to hedge the lending risk does not constitute prohibited underwriting or dealing under Section 24 (Seventh).

The Financial Crimes Enforcement Network of the Department of the Treasury ("FinCEN") issued an Advanced Notice of Proposed Rulemaking ("ANPR") concerning the requirement of the USA PATRIOT Act that a person "involved in real estate closings and settlements" be deemed a "financial institution" and accordingly be subject to the requirement under Section 352 of the USA PATRIOT Act to implement an anti-money laundering ("AML") program. FinCEN’s’s ANPR requests comments that address the issues of: (1) what money laundering risks are associated with real estate closings; (2) how should "persons involved in real estate closings and settlements" be defined; (3) should any such persons be exempted from the AML program requirement; and (4) how should the AML program requirement be structured. FinCEN notes in the ANPR that because the statute covers persons involved in real estate closings and settlements the definition of "financial institution" could cover participants other than those who actually conduct the closing. Moreover, FinCEN observes that such closings may involve the acquisition or sale of real estate by various types of real estate investment vehicles, including real estate investment trusts and real estate "syndicates." In defining persons involved in real estate closings and settlements, FinCEN points out that it wants to include persons whose services rendered or products offered are susceptible to abuse by money launderers. FinCEN also wants to include persons well positioned to identify the purpose and nature of the transaction and those who are important to the success and to the completion of the transaction and, accordingly, well positioned to identify suspicious conduct. Furthermore, FinCEN states, "involvement with the actual flow of funds used to purchase the [real estate] is a significant factor." Comments on the ANPR are due to FinCEN on or before June 9, 2003.

In a series of recent speeches, members of the Board of Governors of the Federal Reserve System have provided further guidance on the development of the contemplated international risk capital rules more commonly referred to as "Basel II," as well as their likely application to US banking institutions. As discussed in detail in the October 23, 2001 Alert, Basel II is intended to create a more risk sensitive approach to capital than the "four bucket" approach in the current rule.

Timing. The third and last consultation paper (called "CP3") setting forth Basel II for comment is due out in early May 2003. The US federal banking agencies then plan on publishing an advance notice of public rulemaking ("ANPR") seeking industry comment as to how to apply Basel II in the US in the summer, with a target of the end of June. However, it will likely be 2007 before Basel II is implemented in the US.

US Applicability. For the vast majority of US banking institutions, the implementation of Basel II will essentially be a non-event from a capital perspective (although there may be competitive issues, as discussed below). The bank regulators have determined that, in light of the prompt corrective action rules, the strong capital position of community and regional banks, and the US focus of their operations, the cost to most US banks of developing the necessary risk management tools to satisfy the requirements of Basel II will outweigh the benefit. Therefore, the vast majority of institutions will continue to apply the current capital framework.

However, about ten US banks, which generally are the largest and most complex internationally active organizations, would be required to conform with Basel II as implemented in the US. Moreover, the regulators anticipate that approximately another ten large institutions would voluntarily choose to comply with Basel II relatively quickly, for competitive reasons. Finally, some large regional banks (approximately the 25th to 100th largest US banks) have indicated that market pressures or the rating agencies ultimately may compel them to comply with Basel II. The regulators, however, do not currently believe the rating agencies are seeking such a change.

Manner of Application. Basel II itself provides for three levels of capital frameworks, the Standardized Approach, the Foundation Internal Ratings Based Approach and the Advanced Internal Ratings Based Approach (the "A-IRB Approach"), with the Standardized representing the simplest risk capital calculation approach and the A -IRB being the most complex. Given that Basel II only will apply to the most complex US banks, the US regulators only intend to make the A -IRB Approach available. In other words, those who are compelled to apply Basel II standards in the US, as well as those who voluntarily wish to comply with them, will have to satisfy the most sophisticated criteria for capital calculation. In addition, banks using the A -IRB Approach to capital also will have to use the most sophisticated approach to measuring operational risk, the advanced measurement approach.

Other Significant Issues. The ANPR will seek comment on a number of significant issues. For example, how implementation of Basel II in the US will affect competitive equality between large banks that have adopted the A-IRB approach and smaller banks and nonbank entities, as well as between US banks and their foreign competitors. Moreover, the ANPR will discuss the extent to which banks using the A -IRB approach are anticipated to also incur a charge for operational risk (with the expectation that processing banks will experience an increase in their regulatory capital requirements for those activities).