|
[Main Tabs]
[Table of Contents - 4000]
[Index]
[Previous Page]
[Next Page]
[Search]
4000 - Advisory Opinions
Subsidiary Requirements for Broker-Dealer Subsidiary
Engaged in Riskless Principal Transactions in U. S. Government
Securities, Municipal Bonds and Revenue Bonds
FDIC-88-31
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
{{4-28-89 p.4327}}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.
Analysis
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
{{4-28-89 p.4328}}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.
Without Recourse
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
{{4-28-89 p.4329}}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.
Underwriting
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,
{{4-28-89 p.4330}}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.
Conclusion
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 business of dealing in securities and stock by [a
bank] shall be limited to the purchasing and selling. . .of
securities and stock without recourse, solely upon the order, and for
the account of customers, and in no case for its own account, and the
[bank] shall not underwrite any issue of securities or stock.
Section 21 of the Glass-Steagall Act which prohibits any company
that engages in the issuance, public sale, distribution or underwriting
of securities from also taking deposits and which applies to all banks
whether or not a member of the federal reserve system excepts from its
coverage securities activities otherwise permissible to national banks
under section 16. (Securities Industry Association v. Board of
Governors of the Federal Reserve System, 807 F.2d 1052 (1986),
cert. denied. 107 S.Ct. 3228 (1987) ("Bankers Trust"), securities activities permissible
under section 16 are not prohibited under section 21). Go Back to Text
** 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
[Main Tabs]
[Table of Contents - 4000]
[Index]
[Previous Page]
[Next Page]
[Search]
|
