[Federal Register Volume 63, Number 11 (Friday, January 16, 1998)]
[Rules and Regulations]
[Pages 2806-2839]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-871]



[[Page 2805]]

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Part III





Federal Reserve System





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12 CFR Parts 207, 220, 221, 224, and 265



Securities Credit Transactions; Borrowing by Brokers and Dealers; Final 
Rule

12 CFR Parts 207, 220, 221, 224, and 265

Securities Credit Transactions; Proposed Rule

  Federal Register / Vol. 63, No. 11 / Friday, January 16, 1998 / Rules 
and Regulations  

[[Page 2806]]



FEDERAL RESERVE SYSTEM

12 CFR Parts 207, 220, 221, 224 and 265

[Regulations G, T, U and X; Docket Nos. R-0905, R-0923 and R-0944]


Securities Credit Transactions; Borrowing by Brokers and Dealers

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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SUMMARY: The Board is adopting final amendments to Regulations G, T and 
U, the Board's securities credit regulations. These amendments are 
based on proposed amendments issued for comment by the Board in 
December 1995 (Docket R-0905), April 1996 (Docket R-0923) and November 
1996 (Docket R-0944). The final amendments include the extension of 
Regulation U to cover lenders formerly subject to Regulation G and the 
elimination of Regulation G. The amendments reduce regulatory 
distinctions between broker-dealers, banks, and other lenders and 
implement changes to the Board's securities credit regulations to 
reflect changes to the Board's statutory authority under the Securities 
Exchange Act of 1934, as amended by the National Securities Markets 
Improvement Act of 1996. Conforming changes are also made to Regulation 
X, ``Borrowers of Securities Credit'' and the Board's Rules Regarding 
Delegation of Authority.

DATES: Effective date: April 1, 1998.
    Compliance date: Compliance with the revised Regulation T (12 CFR 
part 220) is optional until July 1, 1998.

FOR FURTHER INFORMATION CONTACT: Oliver Ireland, Associate General 
Counsel (202) 452-3625; Scott Holz, Senior Attorney (202) 452-2966, 
Jean Anderson, Staff Attorney, (202) 452-3707, Legal Division; for the 
hearing impaired only, Telecommunications Device for the Deaf (TDD), 
Diane Jenkins (202) 452-3544.

SUPPLEMENTARY INFORMATION: Discussed below are final amendments to the 
Board's securities credit regulations based on three requests for 
comment issued in 1995 and 1996. The December 1995 request (Docket R-
0905; 60 FR 63660, Dec. 12, 1995) covered only Regulation U and dealt 
with mixed collateral loans and the financing of purchases effected on 
a delivery-versus-payment basis. The April 1996 request (Docket R-0923; 
61 FR 20399, May 6, 1996) dealt primarily with credit extended to 
customers by broker-dealers and other lenders, such as loan value for 
securities under Regulations G, T and U and the account structure of 
Regulation T. The November 1996 request (Docket R-0944; 61 FR 60168, 
Nov. 26, 1996) was issued in response to the changes in the Board's 
margin authority contained in the National Securities Markets 
Improvement Act of 1996 (NSMIA) and dealt primarily with borrowing by 
broker-dealers from any lender and the borrowing and lending of 
securities by broker-dealers.
    The statutory changes from NSMIA regarding borrowing by broker-
dealers require parallel amendments to the Board's various margin 
regulations and are discussed first. The second section deals with 
amendments to Regulation T and the third section with amendments to 
Regulations G and U. The final section describes a conforming change to 
Regulation X.
    In a separate document published elsewhere in today's Federal 
Register the Board is issuing an advance notice of proposed rulemaking 
to solicit views on any further amendments to its margin regulations 
that should be proposed to complete the Board's periodic review of 
these regulations.

Table of Contents

I. Borrowing by Broker-Dealers
    A. All Regulations: Implementation of NSMIA
    1. Scope section vs. the definition of customer
    2. Appropriateness of adopting a ``substantial'' test
    3. Test for determining ``substantial'' customer business
    a. Description of test
    b. ``Safe harbor'' status of test
    c. Burden of proof for exempt borrower status
    4. Borrowing exemption for other broker-dealers
    B. Regulations G and U
    1. Need for separate regulations
    2. Special purpose loans to broker-dealers
    3. Board interpretations
    C. Regulation T
    a. Broker-dealer accounts
    b. Borrowing and lending of securities a. Collateral test b. 
Purpose test
    (1) Foreign securities exception
    (2) ``Pre-borrowing''
    (3) Dividend reinvestment and purchase plans
    c. Exempted borrowers
II. Regulation T
    A. Debt Securities and Portfolio Margining
    1. Loan value
    a. Good faith loan value for all non-equity securities
    b. ``Equity-linked'' and preferred securities
    2. Good faith account
    a. Appropriateness
    b. Prohibition on transactions causing a deficit
    c. Money market and other financial instruments
    d. Merging non-equity account into other accounts
    3. Portfolio margining
    a. Portfolio margining as an alternative to Regulation T
    b. Definition of good faith margin
    c. Separation of accounts
    d. Retention of the special memorandum account
    B. Equity Securities and Options
    1. Domestic stocks
    2. Foreign stocks
    3. Options: short sales and arbitrage transactions
    C. Miscellaneous Issues
    1. Foreign Issues
    a. Credit by foreign branches of U.S. broker-dealers
    b. Foreign currency
    2. Technical amendments
    a. Definition of covered option transaction
    b. Definition of margin equity security
    c. Definition of current market value
    3. Cash account: 90-day freeze
    4. Board interpretations
III. Regulations G AND U
    A. Loan Value
    1. Over-the-counter stocks
    2. Options
    3. Money market mutual funds
    B. Financing of Securities Purchased on a DVP Basis
    C. Mixed Collateral Loans
IV. Regulation X
V. Regulatory Flexibility Act
VI. Paperwork Reduction Act

I. Borrowing By Broker-Dealers

A. All Regulations: Implementation of NSMIA

    The National Securities Markets Improvement Act of 1996 (``NSMIA'') 
\1\ repealed section 8(a) of the Securities Exchange Act of 1934 (the 
``'34 Act'') and exempted the extension of credit to certain broker-
dealers from the Board's margin regulations. Section 8(a) of the '34 
Act had required broker-dealers obtaining credit against the collateral 
of exchange-traded equity securities to borrow from only other broker-
dealers, banks that were members of the Federal Reserve System, or 
banks that agreed to abide by certain restrictions applicable to member 
banks. After the enactment of NSMIA, the Board proposed to delete 
Sec. 220.15 of Regulation T and Sec. 221.4 of Regulation U, the 
regulatory sections that implemented section 8(a) of the '34 Act. No 
adverse comments were received, and the Board is deleting the sections 
as proposed. The Board is also deleting the definition of nonmember 
bank from Sec. 220.2 of Regulation T because the term was used only in 
Sec. 220.15 of Regulation T. Finally, the Board is deleting its 
delegation of authority to the Reserve Banks to accept agreements filed 
under section 8(a) of the '34 Act.
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    \1\ Pub. L. 104-290, 110 Stat. 3416.
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    NSMIA amended section 7 of the '34 Act to grant a transactional 
exemption

[[Page 2807]]

for credit extended to a broker-dealer ``to finance its activities as a 
market maker or an underwriter.'' NSMIA also granted a status exemption 
for all borrowing by broker-dealers ``a substantial portion of whose 
business consists of transactions with persons other than brokers or 
dealers.'' These statutory exemptions apply to borrowers, although the 
Board's margin regulations generally apply to lenders. It is therefore 
necessary for the Board to amend Regulations G, T and U to provide 
uniform treatment for broker-dealers whose borrowings are exempted from 
the Board rules under NSMIA.
1. Scope Section vs. the Definition of Customer
    The Board sought comment on whether broker-dealers who qualify for 
an exemption from the Board's margin regulations when borrowing 
(``exempted borrowers'') should be excluded from the scope provisions 
in the first section of each regulation or the definition of customer 
in the second section of each regulation. All but two of the responsive 
commenters preferred the use of the scope section. The Board is 
amending the scope section to exclude loans to an ``exempted borrower'' 
and adding a definition of ``exempted borrower'' to cover those broker-
dealers who have a substantial portion of their business conducted with 
persons other than broker-dealers (when they borrow for any purpose). 
The Board is also excluding an ``exempted borrower'' from the 
definition of ``customer'' in each regulation.
2. Appropriateness of Adopting a ``Substantial'' Test
    The Board sought comment on whether it needs to provide a test to 
identify exempted borrowers. Only one commenter expressed its belief 
that a ``substantial'' test was not needed. The Board is adopting 
several safe harbor tests to provide guidance to lenders as to those 
broker-dealers who qualify under NSMIA for exempted borrower status.
    One commenter stated that once the Board has decided on an 
appropriate test, but before it is implemented, the self regulatory 
organizations (SROs) \2\ should survey their member firms to ascertain 
how many would be qualified. The Board is not adopting this suggestion 
as the Board believes that it would delay unnecessarily the ability of 
some exempted borrowers to take advantage of the Board's implementation 
of the NSMIA.
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    \2\ All SEC-registered broker-dealers belong to one or more SRO, 
such as the New York Stock Exchange, Chicago Board Options Exchange, 
or the National Association of Securities Dealers. If a broker-
dealer belongs to more than one SRO, one of the SROs is designated 
as its examining authority and becomes its primary regulator at the 
SRO level. ``Examining authority'' is defined in Sec. 220.2 of 
Regulation T.
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3. Test for Determining ``Substantial'' Customer Business
    a. Description of test: The Board is adopting three alternative 
tests for broker-dealers to qualify as exempted borrowers. Exempted 
borrowers are being defined to include registered brokers or dealers or 
members of a national securities exchange who have at least: (1) 1000 
active accounts for persons other than brokers, dealers, or persons 
associated with a broker or dealer; or (2) $10 million in annual gross 
revenues from transactions with such persons; or (3) 10 percent of 
their annual gross revenues derived from transactions with such 
persons. These tests will be included in the definition of ``exempted 
borrower'' in Secs. 220.2 of Regulation T and 221.2 of Regulation U. 
The Board believes that these tests should not be excessively onerous 
to satisfy or monitor, but they should exceed the levels that an entity 
is likely to be willing or able to achieve artificially merely to 
obtain exempt credit. The first test provides a straightforward 
mechanism for large, customer-oriented firms to determine that they 
meet the substantial customer business requirement. The second test 
covers large firms that have made a substantial commitment to 
transacting business with persons other than broker-dealers, but do not 
have a large number of customer accounts. The third test compares the 
relative size of a broker-dealer's customer-related securities business 
to its overall securities business.
    The Board believes these tests meet the statutory standard that a 
substantial portion of an exempted borrower's business consist of 
transactions with persons other than brokers or dealers. The Board 
believes that 10 percent of gross revenues is a substantial portion of 
a broker-dealer's business. Similarly, the Board believes that 1000 
customer accounts is a substantial number of accounts, and therefore 
broker-dealers with this many customer accounts have a substantial 
portion of their business with persons other than broker-dealers. 
Finally, the Board believes that having $10 million in gross customer 
revenues is a substantial amount of revenue, and therefore these 
broker-dealers have a substantial portion of their business with 
customers.
    Two of the three tests adopted by the Board today refer to 
``revenue.'' Two commenters suggested that the Board adopt its own 
definition of ``revenue,'' although one of these commenters suggested 
that the Board build upon the definition of ``gross revenues from the 
securities business'' in section 16(9) of the Securities Investor 
Protection Act of 1970. The Board believes it would be more appropriate 
for broker-dealers to determine ``revenue'' in accordance with 
generally accepted accounting principles (GAAP). This should be easier 
than a new standard because broker-dealers are required under SEC rules 
to file annual reports that have been audited by an independent public 
accountant \3\ and these reports are prepared according to GAAP. 
Although the Board is not specifying a methodology for comparing 
customer revenues to gross revenues, it expects that broker-dealers 
will develop appropriate methods for doing so and apply them 
consistently over time.
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    \3\ SEC Rule 17a-5(d); 17 CFR 240.17a-5(d).
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    The Board believes that the statutory requirement that a 
substantial portion of an exempted borrower's business must consist of 
transactions with persons other than ``brokers or dealers'' should be 
interpreted to require that these transactions also be effected with 
persons other than ``persons associated with a broker or dealer'' as 
defined in the '34 Act.\4\ This exclusion is included in the Board's 
definition of ``exempted borrower'' and will prevent a firm from 
qualifying as an exempted borrower by engaging in transactions only 
with related persons and corporate entities.
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    \4\ Section 3(a)(18) of theSec. '34 Act, 15 U.S.C. 78c(a)(18).
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    Several commenters responding to the Board's request for 
appropriate tests to identify exempted borrowers focused on the 
appropriate period of time over which to measure whether a broker-
dealer has a substantial customer business. Some commenters suggested a 
broker-dealer should be deemed to have a substantial customer business 
if it meets one of the Board's tests on an annual basis while others 
suggested using a six month period. The Board believes an annual test 
is appropriate. Therefore, to meet any one of the tests, a broker-
dealer must have met the test on average for a 12 month period. 
However, the Board will permit a newly registered broker-dealer to 
qualify as an exempted borrower if it meets one of the Board's tests 
after six months.\5\
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    \5\ See Section 220.3(j) of the revised Regulation T and 
Sec. 221.3(e) of the revised Regulation U.
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    The Board believes that broker-dealers with exempt borrowing status 
should reevaluate their status on an annual basis. If a broker-dealer 
determines that it is no longer an exempted borrower, it

[[Page 2808]]

should notify its lenders before obtaining additional credit. Once a 
broker-dealer ceases to be an exempted borrower, credit obtained in 
reliance on the exempted borrower exception cannot be rolled over or 
renewed and the lines of credit should be adjusted appropriately as 
positions are liquidated. If the borrowing broker-dealer maintains its 
positions, the lender can continue to maintain the credit extended on 
an exempt basis. Once a borrowing broker-dealer is no longer an 
exempted borrower any new securities transactions requiring financing 
must be effected in conformity with the provisions of the Board's 
margin regulations other than the exempted borrower exception.\6\
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    \6\ See Section 220.3(j) of the revised Regulation T and 
Sec. 221.3(e) of the revised Regulation U.
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    b. ``Safe harbor'' status of test: The term exempted borrower will 
be defined to ``include'' the three tests described above. Each of the 
three alternatives therefore will be a non-exclusive safe harbor. This 
will allow broker-dealers who meet any one of the three tests to borrow 
on an exempt basis, but will not preclude the possibility of 
demonstrating a substantial customer business in other ways.
    c. Burden of proof for exempted borrower status: A commenter stated 
that a lender should be able to rely on a borrowing broker-dealer's 
representation of its exempted status ``irrespective of what additional 
facts are known by the lender.'' Two other commenters recommended that 
lenders be able to use a ``good faith'' standard in accepting a 
borrowing broker-dealer's representation of its exempted status. The 
Board believes lenders should be required to apply a ``good faith'' 
standard in determining whether the Board's margin regulations apply to 
borrowings by specific broker-dealers. Under former Regulations G and 
U, ``good faith'' in accepting a representation required a lender to be 
``alert to the circumstances surrounding the credit, and if in 
possession of information that would cause a prudent person not to 
accept the notice or certification without inquiry, investigates and is 
satisfied that it is truthful.'' \7\ The Board believes that in certain 
situations a lender may be able to determine whether a broker-dealer 
qualifies as an exempted borrower without requiring a statement from 
the borrower. Therefore, the Board is modifying the definition of good 
faith in Sec. 221.2 of Regulation U (which will also cover lenders 
formerly subject to Regulation G) in a way that will allow lenders to 
use their judgment as to whether a statement is necessary. The Board is 
adopting the same definition of good faith in Sec. 220.2 of Regulation 
T so that all lenders will be subject to a uniform standard.
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    \7\ This language was found in the definitional section of each 
regulation (Sec. 207.2 of Regulation G and Sec. 221.2 of Regulation 
U).
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4. Borrowing Exemption for Other Broker-Dealers
    CBOE requested the creation of a borrowing exception in Regulations 
G and U for broker-dealers whose business consists of financing and 
carrying the accounts of registered market makers.\8\ CBOE noted that 
while some broker-dealers that carry the accounts of market makers also 
engage in a general customer business and may qualify for the exempted 
borrower exception created under NSMIA, there are a few clearing firms 
virtually all of whose business consists of carrying the accounts of 
options market makers. CBOE explained that it has encouraged these 
firms to refrain from carrying the accounts of public customers so that 
such firms would not be subject to liquidation proceedings under SIPA, 
which CBOE believes would make the transfer of market maker accounts to 
other clearing firms more difficult. CBOE stated its belief that 
failure of these firms to obtain an exempt borrowing status under 
Regulations G and U will have negative consequences for the safety and 
liquidity of the options markets.
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    \8\ Although CBOE refers to these member firms as ``market 
makers,'' the firms qualify as ``specialists'' under the '34 Act.
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    The Board is adopting an exception from certain of its margin rules 
for broker-dealers whose nonproprietary business is limited to 
transactions with market makers and specialists. This exemption will be 
found in Sec. 221.5(c)(10) of Regulation U (which is being amended to 
cover all lenders other than brokers and dealers) and not in Regulation 
T. This means that broker-dealers who qualify for the exception will 
not be limited by the Board's margin regulations if they borrow from a 
lender other than another broker-dealer, but borrowings from broker-
dealers will be subject to the provisions of Regulation T. CBOE did not 
request an exemption in Regulation T for loans to market maker clearing 
firms and the Board's authority to grant exemptions under Regulations G 
and U is greater than its ability to grant exemptions under Regulation 
T. NSMIA amended section 7(d) of the '34 Act (the section which applies 
to lenders other than broker-dealers and under which the Board has 
adopted Regulations G and U) to allow the Board to exempt such credit 
``as it may deem necessary or appropriate in the public interest or for 
the protection of investors.'' The Board believes that establishing a 
Regulation U borrowing exception for broker-dealers actively engaged in 
clearing and carrying the accounts of market makers is appropriate in 
the public interest by enhancing market liquidity and protecting that 
liquidity in times of market volatility.

B. Regulations G and U

1. Need for Separate Regulations
    The Board noted last year that the current structure of its margin 
regulations is based in part on the requirements of recently repealed 
section 8(a) of the '34 Act. Section 8(a) mandated a distinction 
between bank and nonbank lenders with respect to loans to broker-
dealers. In light of the repeal of section 8(a), the Board sought 
comment on whether it is still appropriate to distinguish between 
Regulation G and Regulation U lenders and whether the regulations 
should be combined. No commenters believed there is a need for 
differing substantive regulation of banks and Regulation G lenders. The 
Board is merging Regulation G into Regulation U. Except as otherwise 
noted, substantive provisions of Regulation G have been incorporated 
into Regulation U.
    On a technical level, the title of Regulation U is being changed to 
reflect its coverage of persons other than banks, brokers and dealers. 
Entities that were known as ``lenders'' under Regulation G will be 
known as ``nonbank lenders'' under Regulation U and the term ``lender'' 
will be used in Regulation U to refer to banks and former Regulation G 
lenders collectively. Similar but not identical provisions, such as the 
definition of ``affiliate'' in Sec. 221.2 and the requirements for 
obtaining a purpose statement in Sec. 221.3(c), have been left with 
their differences intact. The Board is soliciting comment via an 
advance notice of proposed rulemaking published elsewhere in today's 
Federal Register to determine whether and how to harmonize further the 
treatment of bank and nonbank lenders. The Board is also amending its 
rules regarding delegation of authority to eliminate references to 
Regulation G.
2. Special Purpose Loans to Broker-Dealers
    Regulation U has always included an exemption for loans to broker-
dealers in

[[Page 2809]]

specific circumstances.\9\ In response to the Board's request for 
appropriate amendments to Regulation U to reflect the broader exemption 
for broker-dealer borrowing contained in the NSMIA, two commenters 
stated their belief that the following special purpose loans to brokers 
and dealers found in Sec. 221.5(c) of Regulation U no longer need to be 
listed separately: loans to specialists, OTC market makers, third 
market makers, block positioners, and odd-lot dealers; and distribution 
loans.\10\ The Board is deleting these provisions as unnecessarily 
detailed in light of the NSMIA amendments to section 7 of the '34 Act 
and replacing them with a general exclusion for market makers, 
specialists and underwriters in Secs. 221.5(c)(6) and 221.5(c)(7) of 
Regulation U based on the language of NSMIA. Lenders formerly subject 
to Regulation G will also be able to extend special-purpose loans to 
broker-dealers under all of the exemptions contained in Sec. 221.5(c) 
of Regulation U. As proposed, the Board is adding the definition of 
examining authority currently found only in Regulation T to Sec. 221.2 
of Regulation U because the term appears in Sec. 221.5(c)(9) of 
Regulation U.
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    \9\ See Section 221.5(c) of Regulation U.
    \10\ These loans were described in paragraphs (c)(6), (7), (10), 
(11), (12) and (13) of former Sec. 221.5 of Regulation U.
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3. Board Interpretations
    Before its merger into Regulation U, Regulation G contained 14 
Board interpretations codified as 12 CFR 207.101-207.114. Seven of 
these interpretations \11\ were already codified in Regulations T or U 
as well and will be unaffected by the elimination of Regulation G. The 
interpretation concerning credit extended to purchase mutual shares 
before July 8, 1969, which has been codified at 12 CFR 207.107 (and 12 
CFR 221.119), is being deleted as obsolete. The remaining six 
Regulation G interpretations are being moved to Regulation U.
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    \11\ The Regulation G citations for these interpretations were 
12 CFR 207.102, 207.103, 207.106, 207.108, 207.110, 207.113, and 
207.114.
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    The Board has reviewed the 25 interpretations in Regulation U (at 
12 CFR 221.101-125) and decided to delete six of them. As noted in the 
previous paragraph, the interpretation at 12 CFR 221.119 is being 
deleted as obsolete. The same is true of the interpretation at 12 CFR 
221.111, which deals with ``retention requirements'' eliminated by the 
Board the last time the margin regulations were comprehensively 
revised. The interpretations at 12 CFR 221.102 and 221.121 are being 
deleted because they have been superceded by NSMIA. Deletion of the 
interpretation at 12 CFR 221.123 (also codified in Regulation T at 12 
CFR 220.126) is discussed below in the Regulation T section on the use 
of options in short sales and arbitrage transactions (See section II. 
B. 3). The interpretation at 12 CFR 221.124 (``Application of the 
single-credit rule to loan participations'') is being deleted because 
the Board amended the single-credit rule (Sec. 221.3(d) of Regulation 
U) in 1996 to incorporate this interpretation. The six remaining 
Regulation G interpretations will replace the six Regulation U 
interpretations being deleted today.

C. Regulation T

1. Broker-Dealer Accounts
    The former Regulation T required that all financial relations 
between a broker-dealer and its customer (which may include another 
broker-dealer) be recorded in one of the eight accounts described in 
the regulation. The Board requested comment on whether the NSMIA 
eliminated the need for the following Regulation T accounts that were 
generally limited to broker-dealers: omnibus account (former 
Sec. 220.10), broker-dealer credit account (former Sec. 220.11), and 
the market functions account (former Sec. 220.12). Most commenters 
requested retention of the omnibus account, which allows financing of a 
broker-dealer's customers' positions, for broker-dealers who do not 
have a ``substantial'' customer business but nevertheless finance some 
customer transactions. Most commenters also requested retention of the 
broker-dealer credit account, which permits certain extensions of 
credit to SEC-registered broker-dealers and allows certain other 
transactions to be effected without regard to the ``90-day freeze'' 
provision contained in the cash account.\12\ In support of their 
request to retain the broker-dealer credit account, commenters cited 
the provisions of the account that may be used by persons who are not 
SEC-registered broker-dealers (and therefore not affected by the NSMIA) 
and stated their belief that the Board should not eliminate the ability 
of these persons to avail themselves of the account. These provisions 
allow foreign broker-dealers to buy and sell securities on a delivery-
versus-payment (DVP) basis \13\ and allow the use of this account for 
``prime-broker'' customers.\14\ Most commenters recommended repeal of 
the market functions account, which permits good faith credit to be 
extended to broker-dealers who perform a market function such as acting 
as a specialist, as long as the Board indicates that its action is 
based on its belief that the NSMIA exemptions covers all transactions 
previously recorded in this account.
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    \12\ Section 220.8(c) of Regulation T.
    \13\ Former Sec. 220.11(a)(1) of Regulation T.
    \14\ For a description of ``prime-broker'' arrangements, see SEC 
no-action letter of January 25, 1994, reprinted in CCH Fed. Sec. L 
Rptr para. 76,819.
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    The Board is eliminating the market functions account because the 
transactions previously permitted therein have been exempted from Board 
regulation by the NSMIA, with one exception.\15\ The Board is also 
deleting the definitions of in or at the money, in the money, overlying 
option, permitted offset, and specialist joint account from Sec. 220.2 
of Regulation T because the terms were used only in the market 
functions account. Consistent with its action regarding customer 
accounts,\16\ the Board believes that additional flexibility for 
broker-dealers can be achieved by merging the omnibus account into the 
broker-dealer credit account. The different types of credit are 
described in separate paragraphs; the SEC and/or the SROs may require 
that broker-dealers keep separate records within this account, for 
example to segregate omnibus credit (for customers) from other types of 
(proprietary) broker-dealer credit. The provision allowing certain 
``prime broker'' transactions to be effected in the broker-dealer 
credit account will be moved to the new good faith account to reflect 
the fact that these transactions are effected on behalf of non-broker-
dealer customers. Former Sec. 220.11(b), which defined the term 
affiliated corporation, is being moved to the definitional section of 
the regulation (Sec. 220.2).
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    \15\ See 220.12(b)(2)(ii) of former Regulation T provided that 
the margin for the purchase or short sale of a security that does 
not qualify as a specialist or permitted offset position shall be 
the margin required by the Supplement. Purchases on credit and short 
sales of such securities by specialists will henceforth be required 
to be effected in the margin or good faith account.
    \16\ See the discussion in section II. A. 2. d of the 
Supplementary Information.
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    A commenter recommended that the Board allow foreign broker-dealers 
to open omnibus accounts at U.S. broker-dealers. This practice was 
permitted under Regulation T until 1969, as long as the foreign broker-
dealer certified that it made its customers margin their transactions 
in conformity with the requirements of Regulation T. The Board then 
amended Regulation T to require that the broker-dealer obtaining 
omnibus credit be registered with the SEC and therefore subject to the 
jurisdiction of the SEC and SROs to

[[Page 2810]]

ensure Regulation T compliance for customer margin transactions. The 
Board believes that it is extremely difficult to ensure that an 
unregulated entity complies with its regulations and does not believe 
it is appropriate to impose Regulation T on foreign broker-dealers' 
transactions with customers. Therefore, the Board is not amending the 
omnibus account at this time.
    In response to the Board's request for comment on appropriate 
amendments to Regulation T to reflect the changes contained in the 
NSMIA, one commenter recommended incorporation of Sec. 221.5 of 
Regulation U (``Special purpose loans to brokers and dealers'') into 
Regulation T, so that broker-dealers may make loans to other broker-
dealers on the same basis as other lenders. The Board is adding those 
portions of Sec. 221.5 of Regulation U that are not already in 
Regulation T to the broker-dealer credit account. These provisions 
allow the following types of credit without regard to other Regulation 
T requirements: credit to finance the purchase or sale of securities 
for prompt delivery or to finance securities in transit, if the credit 
is to be repaid upon completion of the transaction, and intraday 
credit. The broker-dealer credit account is also being amended to allow 
its use for loans to exempted borrowers, market makers, specialists, 
and underwriters for those broker-dealers who wish to record such 
credit in a Regulation T account.
2. Borrowing and Lending of Securities
    The Board has regulated the borrowing and lending of securities to 
prevent a customer from evading the margin requirements by 
recharacterizing a margin loan from the broker-dealer to the customer 
(which requires a deposit of 50 percent of the stock's value by the 
customer) as the lending of securities by the customer to the broker-
dealer (in return for which the customer can receive 100 percent of the 
stock's value in cash from the broker-dealer). With the exception of 
U.S. government securities,\17\ former Regulation T on its face applied 
to any loan of securities in which a creditor was either borrowing or 
lending. The Regulation T provision that covers borrowing and lending 
securities (formerly Sec. 220.16; now Sec. 220.10) has traditionally 
contained collateral requirements (the ``collateral test'') and limited 
the situations for which securities may be borrowed or lent (the 
``purpose test''). With the adoption of the good faith account, 
Regulation T restrictions on the borrowing and lending of securities 
will only apply to those securities not entitled to good faith loan 
value.
---------------------------------------------------------------------------

    \17\ Borrowing and lending of government (exempted) securities 
has been permitted in the government securities account without 
regard to the borrowing and lending of securities provision of 
Regulation T.
---------------------------------------------------------------------------

    a. Collateral test: Regulation T has reflected industry practice by 
requiring 100 percent collateral against a borrowing of securities, 
with the collateral limited to cash and cash equivalents. Although the 
Board believes requiring 100 percent liquid collateral is consistent 
with prudent securities lending practices, it sought comment on whether 
the existing collateral requirements are necessary for Regulation T 
purposes and proposed three alternatives. Two of the alternatives would 
retain the 100 percent collateral requirement. Of those two 
alternatives, one would allow any security as collateral as long as it 
was valued at its regulatory loan value \18\ and the other would allow 
any collateral without specifying limits as to how the collateral is to 
be valued. The third alternative would eliminate the collateral 
requirements in their entirety.
---------------------------------------------------------------------------

    \18\ The regulatory loan value of a security is the difference 
between 100 percent and the margin required by the Supplement to 
Regulation T (formerly Sec. 220.18, now Sec. 220.12).
---------------------------------------------------------------------------

    No commenter opposed an expansion of the types of collateral 
permitted for borrowing and lending securities. Two commenters 
supported allowing all securities at their regulatory loan value and 
three commenters supported allowing all collateral. Total elimination 
of collateral requirements in connection with the borrowing and lending 
of securities was explicitly supported by four commenters (including 
two who also supported one of the other alternatives) and specifically 
opposed by two commenters. One of the opposing commenters gave no 
reason for its opposition, while the other expressed dissatisfaction 
with the purpose test and suggested that the collateral test was 
necessary to make up this deficiency. Commenters supporting elimination 
of the collateral requirements stated that the purpose test adequately 
limits circumvention of the margin requirements by limiting the 
situations in which securities may be lent. The commenters stated that 
the current collateral requirement of 100 is at odds with the 50 
percent requirement for margin loans on equity securities. Commenters 
also noted that the SEC's customer protection rule specifies acceptable 
collateral for securities lending transactions conducted by broker-
dealers with customers. The Board notes that in addition to the SEC's 
customer protection rules and the reasons cited above, the SROs may 
choose to impose safety and soundness requirements on the borrowing and 
lending of securities by their member firms. The Board is eliminating 
the collateral requirements for borrowing and lending securities.
    b. Purpose test: In addition to the collateral test, Regulation T 
also contains a ``purpose test'' generally limiting the borrowing or 
lending of securities by broker-dealers to situations involving short 
sales or ``fails'' to receive securities needed for delivery. Although 
the Board did not specifically propose to amend the purpose test, 
several commenters recommended modifications to the purpose test. These 
recommendations included: (1) Broadening the exception added last year 
for foreign securities to cover those that trade in the United States, 
(2) broadening the exception added last year to permit borrowing of 
securities before a short sale has occurred to cover fail transactions 
and to allow more time to borrow foreign securities, and (3) expanding 
the purpose test to cover dividend reinvestment plans.
(1) Foreign Securities Exception
    Last year the Board created an exception to its general rule 
regarding the borrowing and lending of securities for certain foreign 
securities. Under former Sec. 220.16(b) of Regulation T, foreign 
securities that are not publicly traded in the United States could be 
lent to foreign persons without regard to the purpose test and on any 
collateral.19 Although several commenters responding to the 
Board's proposal of this exception in 1995 objected to the fact that it 
did not cover foreign securities listed on a U.S. securities exchange 
or the Nasdaq Stock Market, other commenters, including U.S. securities 
exchanges, stressed the importance of equal treatment in this area for 
all securities that are publicly traded in the United States. One 
commenter responding to last year's request for public comment repeated 
its earlier comment requesting that the Board eliminate this limitation 
on the foreign security exception and added an alternative request that 
the Board narrow this limitation to U.S. traded foreign securities 
being lent for short sales effected in the United States. The

[[Page 2811]]

commenter pointed out that (1) the foreign securities exception only 
applies to securities lent to foreign persons and therefore ``equal 
treatment'' for all U.S. traded securities is already assured for 
securities lent to U.S. persons; (2) denying the foreign securities 
exception to U.S. traded foreign securities could create a disincentive 
to foreign companies considering a dual listing arrangement in the 
United States; and (3) U.S. broker-dealers are disadvantaged vis-a-vis 
foreign broker-dealers if their ability to lend foreign securities is 
curtailed once those securities are listed for trading in the United 
States. In light of these considerations, the Board is amending the 
foreign securities exception from the purpose test to cover all foreign 
securities without regard to whether the securities are traded in the 
United States.
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    \19\ When the foreign securities exception was adopted, it 
permitted the use of any legal collateral, but required that the 
collateral's value be at all times at least equal to the value of 
the securities being lent. The requirement for 100 percent 
collateral against a loan of these securities is being eliminated in 
conjunction with the Board's elimination of the collateral test for 
all securities lending transactions.
---------------------------------------------------------------------------

(2) ``Pre-borrowing''
    Last year the Board also amended Regulation T to allow the 
borrowing of a security up to one standard settlement cycle 
20 in advance of the trade date of a short sale. Two 
commenters requested that the Board allow creditors to borrow 
securities three days before the trade date of a transaction they 
reasonably anticipate will result in a fail to deliver. The Board sees 
no reason to maintain a different time frame for borrowings to 
accommodate fails versus short sales, as long as the fail is not 
intended to evade the requirements of Regulation T. The last sentence 
of Sec. 220.10(a) of Regulation T (former Sec. 220.16(a)) is therefore 
being amended to cover fails as well as short sales.
---------------------------------------------------------------------------

    \20\ The phrase ``standard settlement cycle'' refers to SEC Rule 
15c6-1 (17 CFR 240.17c6-1) which currently sets this period at three 
business days.
---------------------------------------------------------------------------

    Three commenters also requested that the Board allow creditors to 
borrow foreign securities with extended settlement periods (i.e., more 
than three business days) up to one foreign settlement period in 
advance of the trade date of a short sale or fail to deliver 
transaction. The Board is not adopting such an amendment. The three day 
period adopted by the Board last year was an attempt to balance the 
need to complete short sales and fail transactions while guarding 
against the potential for manipulative transactions such as squeezes. 
The Board does not believe there is a compelling reason to treat 
foreign securities differently.
(3) Dividend Reinvestment and Purchase Plans
    Last year, the Board declined to adopt a suggestion by commenters 
that the purpose test for borrowing and lending securities be expanded 
to allow creditors to borrow securities in order to take advantage of 
dividend reinvestment programs. Three commenters in this docket 
repeated the suggestion. The Board continues to believe that allowing a 
broker-dealer to borrow customer securities to take advantage of a 
dividend reinvestment and purchase plan could allow customers to obtain 
greater credit than could be obtained via a conventional margin loan 
and unlike borrowing to cover a short sale or fail is not necessary for 
efficient functioning and clearing of transactions in the securities 
market. Therefore, the Board is not amending Regulation T to 
accommodate dividend reinvestment and purchase plans.
    c. Exempted borrowers: In its request for comment on appropriate 
amendments to implement the changes contained in the NSMIA, the Board 
stated that it appeared that Regulation T's requirements for borrowing 
and lending securities no longer applied to the borrowing and lending 
of securities between two exempted borrowers. The Board requested 
comment on how to amend the rules regarding borrowing and lending of 
securities to reflect the NSMIA. Although the SROs that commented 
responded by stating their belief that borrowing and lending of 
securities by brokers and dealers should still be subject to a 
``purpose test,'' all other responsive commenters supported the Board's 
view that Regulation T no longer appears to apply to securities lending 
transactions between exempt broker-dealers. Three commenters suggested 
that Regulation T also should not apply when only one party to the 
securities lending transaction is an exempt broker-dealer; however, the 
commenters were not in agreement as to how this principal should be 
applied. Following the Board's stated logic that Regulation T has 
covered the borrowing and lending of securities to prevent a customer 
from lending securities against 100 percent cash in order to evade the 
50 percent maximum otherwise allowed, the Board is amending Regulation 
T by adding a new paragraph (c) to the section entitled ``Borrowing and 
lending securities'' (Sec. 220.10) to exclude a broker-dealer that is 
an exempted borrower from the restrictions of Regulation T if it is 
lending securities, but not if it is borrowing securities. In order to 
prevent circumvention of the Board's margin rules for nonexempted 
equity securities, a broker-dealer that is an exempted borrower and is 
therefore entitled to lend securities without regard to Regulation T 
will not be permitted to borrow securities from a customer or a broker-
dealer that is not an exempted borrower in order to relend them unless 
the relending is for a permitted purpose such as a short sale or fail 
transaction.

II. Regulation T

A. Debt Securities and Portfolio Margining

1. Loan Value
    Debt securities listed on a national securities exchange have 
always had loan value under Regulation T.21 Beginning in 
1978, the Board created the concept of an ``OTC (over-the-counter) 
margin bond'' to allow loan value for unlisted debt securities that 
meet Board established criteria. These criteria have been expanded over 
the years. Nevertheless, not all OTC debt securities qualify as ``OTC 
margin bonds.'' Debt securities that are neither exchange-listed nor 
OTC margin bonds have no loan value in a margin account.
---------------------------------------------------------------------------

    \21\ From 1934 until 1968, exchange-listed debt securities were 
subject to the same margin requirements as exchange-listed equity 
securities. Since 1968, marginable debt securities have been subject 
to a good faith margin requirement.
---------------------------------------------------------------------------

    a. Good faith loan value for all non-equity securities: Last year, 
the Board amended Regulation T to include all investment-grade debt 
securities under the definition of OTC margin bond and therefore 
ensured good faith loan value for these securities.22 At the 
same time, the Board proposed to grant good faith loan value to all 
non-equity securities.23 The Board noted that banks and 
other lenders are not subject to the Board's margin requirements when 
extending credit on non-equity securities.
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    \22\ Many investment-grade debt securities were already covered 
under the existing definition of ``OTC margin bond.'' However, some 
classes of debt securities, such as domestic debt securities exempt 
from SEC registration, were unable to qualify under the existing 
definition.
    \23\ Formerly, debt securities met the definition of margin 
security and were entitled to good faith loan value only if they 
were registered on a national securities exchange, rated investment-
grade, or otherwise qualified as OTC margin bonds.
---------------------------------------------------------------------------

    The Board's proposal was supported by all responsive commenters 
except for one commenter. This commenter argued that broker-dealers 
have a ``salesman's stake'' not shared by non-broker-dealer lenders and 
this difference justifies the continuation of denying loan value to 
certain non-investment-grade debt securities. On the other hand, 
another commenter stated that there is no policy justification for 
distinguishing between broker-dealers and other U.S. lenders and 
several commenters noted that allowing good faith loan value for non-
equity securities would increase the

[[Page 2812]]

ability of U.S. broker-dealers to compete with other domestic and 
foreign lenders.
    The Board is amending Regulation T as proposed to permit broker-
dealers to extend good faith credit against all non-equity securities. 
Broker-dealers should be no less competent to determine the loan value 
of non-investment-grade debt securities than a bank or other lender 
would be. In addition, self regulatory organizations (SROs) such as the 
New York Stock Exchange will still be able to set margin requirements 
for non-equity security transactions effected by their member brokerage 
firms. To implement this change, the Board is amending Sec. 220.2 of 
Regulation T by deleting the definition of OTC margin bond, replacing 
paragraph (3) of the definition of margin security (currently ``any OTC 
margin bond'') with ``any non-equity security'' and changing the 
Supplement \24\ that provides good faith loan value for these 
securities to refer to any ``non-equity security'' where the regulation 
currently specifies ``registered nonconvertible debt security or OTC 
margin bond.'' The Board is also adding the word ``equity'' to 
paragraph (e) of the Supplement to make clear that the only securities 
that have no loan value under Regulation T are nonmargin nonexempted 
equity securities.
---------------------------------------------------------------------------

    \24\ The Supplement, which contains the margin requirements for 
various securities transactions, is the last section of each of the 
Board's margin regulations. The Supplement was formerly Sec. 220.18; 
the Supplement under the revised Regulation T adopted today is 
Sec. 220.12.
---------------------------------------------------------------------------

    b. ``Equity-linked'' and preferred securities: The Board proposed 
to define non-equity security as ``a security that is not an equity 
security.'' \25\ Under the proposed definition, debt securities that 
are equity-linked securities still would be afforded good faith loan 
value. The Board also sought comment on whether it should modify this 
proposed definition to exclude ``equity-linked securities,'' and if so, 
what securities should be excluded. Modification of the proposed 
definition of non-equity security to exclude ``equity-linked'' 
securities would result in their being treated as equity securities and 
therefore subject to either a 50 percent or 100 percent margin 
requirement.
---------------------------------------------------------------------------

    \25\ The term equity security is defined in section 3(a)(11) of 
the Securities Exchange Act of 1934 (15 U.S.C. 78(c)(a)(11)).
---------------------------------------------------------------------------

    Comment on the appropriate treatment of equity-linked securities 
was mixed. Several commenters stated that equity-linked securities 
trade like equity securities and are often priced in reliance on equity 
securities and therefore should be subject to the same margin 
requirements as equity securities.\26\ Other commenters stated that it 
was unnecessary for the Board to exclude equity-linked securities from 
its proposed definition of non-equity security in light of the SEC's 
authority to elaborate on the definition of ``equity security'' under 
the '34 Act to address questions that may arise regarding novel or 
hybrid products whose status might otherwise be unclear. Staff of the 
SEC commented that equity-linked securities, because they present many 
of the same type of risks as equity securities, should be treated as 
equity securities for purposes of the Board's margin regulations. SEC 
staff further commented that they view a equity-linked security as one 
under which any part of the issuer's obligations is contingent upon, or 
requires the delivery on an optional or forward basis of, an equity 
security or group or index of equity securities. The Board is adopting 
the definition of the term non-equity security that was proposed, with 
the result that equity-linked securities which do not meet the '34 Act 
definition of equity security will be entitled to good faith loan 
value. The Board will defer to the SEC on the appropriate definition of 
equity security.
---------------------------------------------------------------------------

    \26\ Some of these commenters included convertible debt 
securities in their discussion of the types of ``equity-linked'' 
securities they believe should be subject to equity margin 
requirements. The Board has always treated convertible debt 
securities as equity securities because section 3(a)(11) of the 
Securities Exchange Act of 1934 defines ``equity security'' to 
include a security convertible into an equity security.
---------------------------------------------------------------------------

    One commenter suggested that preferred stock be margined at a good 
faith level because its dividend rate is generally tied to current 
interest rates. Another commenter sought confirmation that the term 
non-equity security would include all mortgage and other asset-backed 
securities, including debt instruments, trust certificates, or 
partnership/participation interests. As noted above, the Board is 
deferring to the SEC on the exact parameters of the definition of 
equity security.
2. Good Faith Account
    a. Appropriateness: In addition to proposing good faith loan value 
for all non-equity securities, the Board proposed creating an account 
separate from the margin account described in Sec. 220.4 of Regulation 
T to effect transactions involving these securities. The new account 
would allow purchases and sales of non-equity securities on a credit or 
cash basis, repurchase and reverse repurchase agreements on non-equity 
securities and the purchase or sale of options on non-equity 
securities. All commenters supporting good faith loan value for all 
debt securities supported creation of a new account. The Board is 
adopting its proposal for a non-equity account and, as discussed below, 
is merging it with the government securities account and other accounts 
and naming it the ``good faith account.'' The good faith account 
replaces the government securities account formerly found in Sec. 220.6 
of Regulation T.
    b. Prohibition on transactions causing a deficit: The Board has 
generally viewed section 7 of the '34 Act as prohibiting broker-dealers 
from extending purpose credit \27\ that is either unsecured or secured 
by collateral other than securities. In proposing to create a new non-
equity account, the Board included a prohibition on transactions that 
would cause the account to liquidate to a deficit (i.e., cause the 
market value of the collateral to fall below the customer's debit 
balance). This proposed provision was included to prevent broker-
dealers from extending unsecured purpose credit, which might be an 
evasion of the good faith margin requirement. Commenters generally 
opposed the proposal to prohibit transactions that would cause the 
account to liquidate to a deficit, stating that the restriction would 
seriously undermine the usefulness of the proposed account for 
transactions in fixed-income securities because it would present 
substantial uncertainty with respect to bilateral extensions of credit 
such as reverse repurchase agreements, which may liquidate to a 
deficit, and would continue to place broker-dealers at a disadvantage 
vis-a-vis banks and other lenders.
---------------------------------------------------------------------------

    \27\ ``Purpose credit'' is defined as credit for the purpose of 
buying, carrying, or trading in securities.
---------------------------------------------------------------------------

    Several commenters argued that section 7(c)(1)(B)(ii) of the '34 
Act does not prohibit unsecured credit if the credit is either ``not 
for the purpose of purchasing or carrying securities'' or not extended 
for the purpose of ``evading or circumventing'' the Board's rules 
regarding credit secured by securities. This reading of the statute 
allows broker-dealers to extend unsecured purpose credit if the Board 
concludes that such credit is not for the purpose of evading or 
circumventing its rules regarding secured credit. The Board believes 
that this interpretation is consistent with the statute and therefore 
is eliminating the proposed ``liquidate to a deficit'' prohibition for 
the good faith account. The Board believes that permitting transactions 
in a non-equity securities account to liquidate to a deficit is not 
necessarily an evasion or circumvention of the rules permitting

[[Page 2813]]

good faith loan credit for these securities as a lender extending good 
faith credit may consider factors other than the immediate liquidation 
value of the collateral.
    c. Money market and other financial instruments: In commenting on 
the Board's proposal to grant good faith loan value to non-equity 
securities, many commenters sought good faith loan value for money 
market and other financial instruments such as bankers acceptances, 
certificates of deposit, and commercial paper when used in a margin 
account.\28\ In effect, commenters argued that broker-dealers should be 
able to consider the collateral value of these financial instruments in 
extending good faith credit on non-equity securities. The Board 
believes section 7 of the '34 Act permits the extension of unsecured 
purpose credit if the Board concludes that such credit is not for the 
purpose of evading or circumventing its rules regarding credit 
collateralized by securities. This reasoning also applies to purpose 
credit secured by collateral that may not meet the definition of a 
``security'' in the '34 Act. The Board believes that allowing good 
faith loan value for all assets other than equity securities in the new 
good faith account does not evade or circumvent its rules requiring 
good faith margin for transactions involving non-equity securities. The 
Board therefore is expressly allowing the inclusion of such assets in 
the good faith account described below.
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    \28\ Money market and other financial instruments that may not 
meet the definition of ``security'' in the '34 Act are currently 
valued at good faith when used as collateral for nonpurpose credit 
in the nonsecurities credit account. These instruments currently 
have no loan value when used in a margin account.
---------------------------------------------------------------------------

    d. Merging non-equity account into other accounts: The Board sought 
comment on merging the non-equity account into the government 
securities account (former Sec. 220.6) and/or the nonsecurities credit 
account (former Sec. 220.9). Several commenters supported merging the 
proposed non-equity account into the government securities account. One 
commenter opposed merging the new account into any existing account 
because it believes transactions in the proposed non-equity account 
should be subject to a requirement for timely payment, a requirement 
not imposed for the other two accounts suggested by the Board. A second 
commenter opposed allowing purpose and non-purpose credit in the same 
account, although another commenter noted that purpose and nonpurpose 
credit could be segregated within the account.
    In order to provide maximum flexibility, the Board is merging all 
three accounts for purposes of Regulation T. The new account will be 
called the ``good faith account'' and will be described in Sec. 220.6 
of the revised Regulation T. Creditors may keep separate records for 
each type of credit extended within the account. In addition, the Board 
is amending Regulation T to allow other customer transactions for which 
the Board does not specify margin or payment requirements to be 
effected in the good faith account. These include all transactions 
currently effected in the arbitrage account 29 and those 
transactions effected in the broker-dealer credit account pursuant to a 
``prime brokerage'' arrangement.30 This merger of accounts 
will leave most customers with three possible accounts: a cash account, 
a margin account (with the possibility of a linked special memorandum 
account) and a good faith account.31 The good faith account 
could be used for transactions involving securities entitled to good 
faith margin (including the borrowing and lending thereof), as well as 
nonpurpose credit, bona fide arbitrage,32 and prime broker 
transactions. Rules of the SROs and individual brokerage firms may 
require separation of specific types of credit within the new account 
for their own administrative or regulatory purposes, but this would not 
be required by Regulation T. All credit extended by a broker-dealer to 
a non-broker-dealer customer that is either subject to good faith 
margin or not specifically subject to any Regulation T margin 
requirement could be recorded in the new account. Transactions formerly 
effected in the margin account could continue to be effected there, and 
the restrictions contained in the margin account, such as the 
requirement for timely deposit of payment or margin, would continue to 
apply to transactions conducted in that account.
---------------------------------------------------------------------------

    \29\ The arbitrage account was formerly found in Sec. 220.7 of 
Regulation T.
    \30\ This provision was formerly found in Sec. 220.11(a)(5) of 
Regulation T. ``Prime brokerage'' is an arrangement involving a 
customer and at least two broker-dealers, one of whom is the ``prime 
broker.'' Transactions on behalf of the customer are effected by the 
non-prime broker-dealer (known as an ``executing broker'') and 
immediately sent to the prime broker. The prime broker enforces 
Regulation T vis-a-vis the customer for all transactions, wherever 
executed. The broker-dealer credit account is used by the executing 
broker to record the customers transactions because recordkeeping 
requirements are less onerous than if the transaction were recorded 
in a cash or margin account. The new good faith account will 
eliminate the need to record these customer transactions in the 
broker-dealer credit account.
    \31\ Customers who are broker-dealers will be able to have a 
fourth possible account if they take advantage of the broker-dealer 
credit account.
    \32\ The Board is not modifying the scope of transactions that 
may be effected as ``bona fide arbitrage.'' One commenter suggested 
permitting margin-free arbitrage that is not based on locking in a 
profit from a current disparity in the prices of the two securities, 
and lesser or no margin on transactions that would qualify as 
arbitrage if they had been effected simultaneously. The Board is not 
adopting these two suggestions, as they do not comport with the 
underlying policy of the arbitrage account of allowing special 
credit for transactions that perform a market function by 
eliminating real-time disparities in pricing between identical or 
closely related securities.
---------------------------------------------------------------------------

3. Portfolio Margining
    Regulation T prescribes margin requirements for each security held 
in a margin account. Certain positions involving more than one 
security, such as a long position in a convertible bond coupled with a 
short position in the underlying security, are defined as a single 
position and given lower margin requirements than would be required 
individually. Any combination of securities not specifically identified 
in Regulation T must be margined without regard to any possible 
offsetting positions. The Board noted last year that commenters have 
requested greater flexibility to engage in cross-margining (using 
financial futures to offset securities margin requirements) and more 
broadly ``portfolio'' or ``risk-based'' margining of customer assets. 
The Board identified several provisions in Regulation T that are 
impediments to the possible adoption of a portfolio margining system. 
These include: the definition of good faith margin, the requirement 
that items in one account not be considered in meeting requirements in 
another account (see Sec. 220.3(b), ``Separation of accounts''), and 
the special memorandum account (SMA).
    a. Portfolio margining as an alternative to Regulation T: The Board 
sought comment on any implementation problems that might arise with a 
partial or complete move to portfolio margining, including the need for 
delaying the effective date of any final rule in order to allow the 
SROs time to amend their rules. A commenter suggested an amendment to 
Regulation T that would permit a creditor, in lieu of compliance with 
Regulation T, to comply with any portfolio margining system permitted 
by an SRO under SEC-approved rules. This would not require a delay 
between Board action and SRO implementation. The Board is amending the 
scope provision of Regulation T \33\ to allow portfolio margining to be 
developed by the industry and approved by the SEC as an alternative to

[[Page 2814]]

compliance with Regulation T by broker-dealers.
---------------------------------------------------------------------------

    \33\ Section 220.1(b) of Regulation T.
---------------------------------------------------------------------------

    b. Definition of good faith margin: The Board stated that a revised 
definition of good faith margin \34\ is a necessary prerequisite to 
eventual implementation of a portfolio margining system. The Board 
requested comment on a proposed amendment that would modify the 
definition of good faith margin by deleting references to a specific 
security and eliminating the requirement that the credit be extended 
without regard to the customer's other assets.\35\ This change would 
facilitate portfolio margining on good faith basis. Almost all of the 
responsive commenters supported this proposal. One commenter suggested 
that the Board determine what type of portfolio margining systems 
should be adopted before modifying the definition of good faith. The 
Board believes that broker-dealers will be afforded greater flexibility 
by changing the definition of good faith at this time while permitting 
portfolio margining to be developed and implemented at a later date 
when agreed upon by the SEC and SROs. The Board therefore is adopting a 
definition of ``good faith with respect to margin'' in Sec. 220.2 of 
Regulation T that substantially follows the proposal.
---------------------------------------------------------------------------

    \34\ Margin is the amount of equity a customer must have against 
a given position and the complement of the security's loan value. A 
margin requirement of 60 percent for a security is the same as 
assigning it a loan value of 40 percent. In determining good faith 
margin, a broker-dealer is assigning a ``good faith'' loan value to 
a specific non-equity security.
    \35\ The Board proposed to modify the current definition to read 
as follows: ``good faith margin means the amount of margin which a 
creditor would require in exercising sound credit judgment.''
---------------------------------------------------------------------------

    The Board also sought comment on whether an amended definition of 
good faith should be limited to the proposed non-equity account or made 
applicable for all accounts. All of the commenters expressing an 
opinion supported modifying the definition of good faith for all 
accounts. The new definition of ``good faith with respect to margin'' 
in Sec. 220.2 of Regulation T will cover transactions recorded in the 
good faith account. The Board is retaining the requirements of the 
former definition of good faith margin for transactions recorded in the 
margin account by adding a new paragraph, ``sound credit judgment'' 
(Sec. 220.4(b)(8)), to the provisions concerning the margin account. 
Allowing a broker-dealer to determine margin requirements by taking 
into account the customer's other unrelated assets or securities 
positions is inconsistent with limiting the loan value of equity 
securities to 50 percent of its current market value. Therefore, 
securities entitled to ``good faith'' margin treatment, if used in a 
margin account, must be valued without regard to the customer's other 
assets and securities positions held in connection with unrelated 
transactions.
    c. Separation of accounts: Section 220.3(b) of Regulation T, 
``Separation of accounts,'' generally provides that requirements for an 
account may not be met by considering items in any other account.\36\ 
Consistent with its action last year to allow financial futures to 
serve in lieu of margin for securities options pursuant to SRO rules, 
the Board proposed to modify the separation of accounts provision to 
allow commodities and foreign exchange positions in the nonsecurities 
credit account to be considered in calculating margin for any 
securities transaction in the proposed good faith account for non-
equity securities transactions or the margin account for any securities 
transaction. Responsive commenters supported the Board's proposal. The 
Board is adopting the amendment to Sec. 220.3(b) of Regulation T as 
proposed.
---------------------------------------------------------------------------

    \36\ An exception is provided for maintaining a special 
memorandum account (SMA) with a margin account.
---------------------------------------------------------------------------

    The Board also invited comment on whether it should modify further 
the separation of accounts provision in Sec. 220.3(b) of Regulation T 
to facilitate portfolio margining. Several commenters pointed out that 
the separation of accounts provision will have to be relaxed if 
portfolio margining is made part of Regulation T. One commenter 
supported complete elimination of the separation of accounts provision, 
while two other commenters did not believe broker-dealers should be 
required to link accounts, but should be permitted to do so if they 
wish. The Board is not taking any additional action with respect to 
Sec. 220.3(b) of Regulation T at this time, as the development of 
portfolio margining systems can be accommodated as an alternative to 
compliance with the account-based system contained within Regulation T, 
as is provided in Sec. 220.1(b)(3)(i) of the revised regulation. 
Further, the Board notes that the reduction in the number of customer 
accounts resulting from combining the proposed good faith account with 
the arbitrage, government securities, nonsecurities credit and prime 
brokerage portion of the broker-dealer credit account will result in 
fewer situations in which the separation of accounts provision of 
Regulation T will apply.
    d. Retention of the special memorandum account: Section 220.5 of 
Regulation T provides that a broker-dealer may maintain a special 
memorandum account (SMA) for a customer in conjunction with the 
customer's margin account and use the SMA to hold customer moneys not 
required to be maintained in the margin account. The Board sought 
comment on eliminating the SMA in conjunction with adoption of a 
portfolio margining system. Several commenters expressed support for 
retaining the SMA and one commenter noted that the SMA could be 
recreated by use of the cash account, which it believes would be less 
efficient. This commenter also pointed out that the concept of the SMA 
would not be necessary under a portfolio margining system because 
initial and maintenance margin requirements would be the same. Another 
commenter wanted broker-dealers to be able to establish multiple margin 
accounts for the same person in cases other than those identified in 
Regulation T 37 and operate separate SMAs for each account.
---------------------------------------------------------------------------

    \37\ The Board allows multiple margin accounts for a single 
customer under conditions found in Sec. 220.4(a)(2) of Regulation T. 
These margin accounts may be operated with separate SMAs.
---------------------------------------------------------------------------

    The Board is not making any changes to the SMA at this time. The 
SMA will continue to be available for use in conjunction with a margin 
account, but will not be available for use in conjunction with a good 
faith account. The concept of locking in ``buying power'' from the 
appreciated value of securities held in an account or monies not 
required by Regulation T is inconsistent with the revised definition of 
``good faith with respect to margin'' which is based on the creditor's 
judgment of the customer's creditworthiness and collateral at a given 
time. The issue of using an SMA in connection with adoption of 
portfolio margining systems may be addressed by the SEC, SROs and 
securities industry.

B. Equity Securities and Options

1. Domestic Stocks
    Prior to the adoption of today's amendments, the following United 
States traded stocks 38 were subject to the Board's 50 
percent margin requirement: 39 (1) Stocks traded on a

[[Page 2815]]

national securities exchange, (2) stocks in the National Market tier of 
the Nasdaq Stock Market (``NMS'' securities), and (3) stocks in the 
Small Capitalization (``SmallCap'' securities) tier of the Nasdaq Stock 
Market that are identified by the Board as ``OTC margin stocks.'' These 
stocks were subject to the same margin requirements regardless of 
whether the lender is a broker-dealer, bank, or other 
lender.40
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    \38\ Stocks that are not traded in the United States are subject 
to Regulation T (although they are not covered by Regulations G and 
U) and their margin status is discussed in section II.B.2 of the 
Supplementary Information.
    \39\ Although section 7 of the '34 Act instructs the Board to 
limit the amount of credit that can be extended against nonexempted 
securities, it does not require the Board to make individualized 
determinations for every security.
    Section 7 originally mandated that the Board prescribe rules 
with respect to the amount of credit that may be extended on ``any 
security (other than an exempted security) registered on a national 
securities exchange.'' The Board originally subjected all securities 
registered on a national securities exchange to the same margin 
requirement. It later established different margin requirements for 
convertible and nonconvertible debt securities, but at no time 
denied loan value (i.e., required 100 percent margin) to exchange-
listed securities (with the exception of options).
    In 1968, Congress amended section 7 of the '34 Act to delete the 
reference to exchange listed securities so that the Board is now 
instructed to prescribe rules with respect to the amount of credit 
that may be extended on ``any security (other than an exempted 
security).'' The Board chose to implement this authority to 
establish margin requirements for securities not traded on a 
national securities exchange by subjecting every over-the-counter 
stock to a set of Board-established criteria and publishing a list 
of those OTC securities which meet these criteria. However, in 1983 
the Board deferred to the listing requirements of Nasdaq's National 
Market tier as an additional method of qualifying as a margin 
security. Thereafter, domestic stocks that were not listed on a 
national securities exchange qualified for margin treatment either 
by being listed on Nasdaq's National Market tier or by appearing on 
the Board's List of Marginable OTC Stocks after meeting the Board's 
criteria formerly found in Sec. 220.17 of Regulation T.
    \40\ Lenders other than broker-dealers and banks are responsible 
for applying Federal Reserve margin requirements only after they 
have extended margin stock secured credit in an amount that 
surpasses one of two dollar thresholds: $200,000 in credit extended 
in one calendar quarter or $500,000 in credit outstanding at any 
time.
---------------------------------------------------------------------------

    In its request for comment issued last year, the Board noted that 
although the definition and treatment of domestic margin stocks is 
currently the same in Regulations G, T and U, nonmargin stocks are 
treated differently at broker-dealers (where they have no loan value) 
than at banks and other lenders (where the Board's margin rules do not 
limit their value). The Board sought comment on the possibility of 
expanding the types of securities with loan value at broker-dealers by 
amending the definition of margin security in Sec. 220.2 of Regulation 
T to cover all domestic equity securities that have a ``ready market'' 
for purposes of the SEC's net capital rule.41 This would 
cover all Nasdaq SmallCap stocks 42 and thousands of 
additional over-the-counter (``OTC'') stocks not traded on Nasdaq. In 
light of the disparate treatment of nonmargin stock at broker-dealers 
versus other lenders, the Board also sought comment on the appropriate 
definition of margin stock under Regulations G and U and on possible 
solutions to the current structure of its margin regulations that 
results in an increase in burden for lenders other than broker-dealers 
whenever burden is reduced for broker-dealers. The Board suggested its 
regulations might be amended to cover more securities for broker-
dealers and fewer securities for banks and other lenders.
---------------------------------------------------------------------------

    \41\ 17 CFR 240.15c3-1, ``Net capital requirements for brokers 
or dealers.''
    \42\ The SmallCap tier of the Nasdaq Stock Market contains over 
1800 stocks, of which approximately 442 are currently marginable at 
broker-dealers.
---------------------------------------------------------------------------

    The proposal to make all domestic ``ready market'' stocks 
marginable under Regulation T was supported by four commenters and 
opposed by four commenters, while another commenter stated its belief 
that further clarification is needed before such an amendment could be 
adopted. Three commenters suggested expanding the definition of OTC 
margin stock at least to cover all stocks listed on the Nasdaq Stock 
Market.
    Regulation T has always included all securities (other than 
options) registered on any national securities exchange as margin 
securities.43 In allowing loan value for certain over-the-
counter securities, the Board has attempted through its criteria to 
ensure similar levels of liquidity and transparency.44 The 
NASD has recently raised listing requirements for both the National 
Market and SmallCap tiers of the Nasdaq Stock Market.45 The 
minimum standards for listing on Nasdaq (i.e., the SmallCap tier) 
generally equal or exceed those of the American, Boston, Chicago, 
Pacific, and Philadelphia Stock Exchanges. The Board believes that 
Nasdaq SmallCap issues, which meet or exceed many national securities 
exchange requirements, should not be denied margin status solely 
because they are not traded on an ``exchange.'' Therefore the Board is 
including all Nasdaq listed issues in its definition of margin 
security.46 The Board's quarterly OTC List will no longer be 
necessary for broker-dealers because the Board will no longer choose 
which Nasdaq stocks are marginable, but will instead rely on Nasdaq 
listing standards to the same extent it relies on the listing standards 
of U.S. securities exchanges.
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    \43\ Although the term ``national securities exchange'' is not 
defined in the Board's margin regulations or section 3(a) of the '34 
Act (whence terms are incorporated by reference into the Board's 
margin regulations), the Board has always understood the term to 
mean a securities exchange registered with the SEC under section 6 
of the '34 Act (``National securities exchanges,'' 15 U.S.C. 78f). 
In a separate document published elsewhere in today's Federal 
Register, the Board is requesting comment on whether it should 
propose to incorporate this definition into its margin regulations.
    \44\ The Board definition of OTC margin stock in the second 
(definitional) section of Regulations G, T and U referred to stock 
``that the Board has determined has the degree of national investor 
interest, the depth and breadth of market, the availability of 
information respecting the security and its issuer, and the 
character and permanence of the issuer to warrant being treated like 
an equity security traded on a national securities exchange.''
    \45\ SEC approval was received on August 22, 1997.
    \46\ The definition of margin security formerly included ``any 
OTC security designated as qualified for trading in the national 
market system under a designation plan approved by the Securities 
and Exchange Commission (NMS security)'' as well as ``any OTC margin 
stock.'' The former referred to Nasdaq listed stocks trading in the 
National Market tier, while the latter referred to those Nasdaq 
listed stocks trading in the SmallCap tier that the Board identified 
on a quarterly basis as meeting the requirements found in Sec. 207.6 
of Regulation G, Sec. 220.17 of Regulation T, and Sec. 221.7 of 
Regulation U. These two paragraphs have been replaced with a 
reference to ``any security listed on the Nasdaq Stock Market.''
---------------------------------------------------------------------------

    SEC staff have asked for a delay in the effective date of the 
amendment giving 50 percent loan value to all Nasdaq securities to 
address possible sales practice issues. The Board is delaying the 
effectiveness of this provision until January 1, 1999 and will cease 
publication of its quarterly OTC List for U.S. traded securities after 
publication of the November 1998 list.47 The Board may 
revisit the issue of allowing credit on other equity securities at a 
later date.
---------------------------------------------------------------------------

    \47\ For a discussion of the effect of the elimination of the 
OTC List for lenders other than broker-dealers, see section III. A. 
1. In the Supplementary Information.
---------------------------------------------------------------------------

2. Foreign Stocks
    The Board has been identifying those foreign equity securities that 
are eligible for margin at broker-dealers since 1990 by publishing a 
List of Foreign Margin Stocks (``Foreign List'') on a quarterly basis. 
As in the case of OTC margin stocks, the Board has based its decisions 
on criteria aimed at ensuring liquidity and price transparency for all 
margin securities. Last year, the Board amended its criteria for 
foreign margin stocks to encompass foreign stocks deemed to have a 
``ready market'' under the SEC's net capital rule.48 This 
action allowed the inclusion of hundreds of additional foreign stocks 
on the Foreign List, based on a ``no action'' position from the SEC 
that effectively treats all stocks on the Financial Times/Standard & 
Poor's World Actuaries Indices (``FT/S&P Indices'') as having a ``ready 
market'' for capital purposes.49 Although there was 
considerable overlap between stocks on the FT/S&P Indices and the 
Board's Foreign List, there were also a significant number of foreign 
stocks that appeared on the Foreign List but not the FT/S&P Indices. 
The Board sought comment on whether it should phase

[[Page 2816]]

out its original criteria and Foreign List and rely exclusively on the 
SEC's ``ready market'' test.
---------------------------------------------------------------------------

    \48\ 17 CFR 240.15c3-1.
    \49\ See, 58 FR 44310; August 20, 1993.
---------------------------------------------------------------------------

    Most commenters opposed the idea of phasing out the Board's 
original eligibility requirements for foreign margin stocks in favor of 
reliance on the FT/S&P Indices or the SEC's ``ready market'' concept 
because they did not want to eliminate the marginability of stocks that 
appear on the Board's Foreign List but that may not meet the other 
tests. The Board therefore is retaining its Foreign List to identify 
those foreign stocks that have been found to meet the Board's original 
eligibility and continued listing requirements and amending the 
definition of foreign margin stock in Sec. 220.2 of Regulation T to 
include both securities on the Board's Foreign List and those deemed to 
have a ``ready market'' for capital purposes, as determined by the SEC. 
This will allow a stock appearing on the FT/S&P Indices to qualify as a 
margin security without the need to be included on the Board's Foreign 
List, a request made by several commenters. Several other commenters 
also requested the ability to have broker-dealers make their own 
determination that a specific foreign stock has a ``ready market'' and 
should therefore be a margin security. The Board views the process of 
increasing the coverage of its definition of margin security as an 
incremental one and believes it is appropriate at this time to limit 
the margin status of foreign stocks to those that either meet the 
Board's original criteria for foreign margin stock and therefore appear 
on the Board's Foreign List or are deemed by the SEC to have a ``ready 
market'' for purposes of their net capital rule.50
---------------------------------------------------------------------------

    \50\ In this regard, the Board is confirming that broker-dealers 
may rely on written ``no action'' or interpretative letters issued 
by the SEC or its staff regarding its ``ready market'' criteria.
---------------------------------------------------------------------------

3. Options: Short Sales and Arbitrage Transactions
    When options first began trading on a national securities exchange 
in 1973, the Board issued an interpretation concluding that options may 
not be considered securities ``exchangeable or convertible into other 
securities, within 90 calendar days, without restriction other than the 
payment of money.'' 51 The quoted language appears in the 
bona fide arbitrage provision of the good faith account (Sec. 220.6(b) 
of Regulation T, formerly the arbitrage account in Sec. 220.7) and in 
the Supplement (Sec. 220.12 of Regulation T, formerly Sec. 220.18) 
under the margin required for short sales. The effect of the 
interpretation was to preclude the possibility of effecting ``bona fide 
arbitrage'' (which requires no margin under Regulation T) between 
options and their underlying securities and to preclude the use of an 
option in lieu of the 50 percent margin required for short sales in 
addition to the short sale proceeds. Last year, the Board proposed to 
rescind the 1973 interpretation. A majority of commenters supported 
this proposal, although the Treasury Department commented that this may 
have merit for certain options but is premature until an approach is 
more fully developed.
---------------------------------------------------------------------------

    \51\ 12 CFR 220.126 and 12 CFR 221.123, reprinted in the Federal 
Reserve Regulatory Service at 5-488.
---------------------------------------------------------------------------

    The Board is rescinding its interpretation that options are not 
convertible securities and amending the Supplement of Regulation T to 
allow a listed call option to serve as partial margin for short sales 
of the underlying security. To ensure that a call option adequately 
covers a customer's obligation in a short sale, the Supplement of 
Regulation T requires that a call option serving in lieu of part of the 
required margin is an American style option 52 issued by a 
registered clearing corporation and traded on a national securities 
exchange with an exercise (strike) price that is not greater than the 
price at which the underlying security was sold short. This will ensure 
that the short sale proceeds and option can be used to cover the short 
position in the underlying security if necessary. In addition, 
rescission of the Board interpretation will allow ``bona fide'' 
arbitrage between options and their underlying securities to be 
effected without further regulatory changes in the good faith account 
on the same basis as other convertible securities such as convertible 
bonds.
---------------------------------------------------------------------------

    \52\ American style options are exercisable on any business day 
until expiration. European style options may be exercised only at 
expiration.
---------------------------------------------------------------------------

    In response to the Board's request for comment on using long calls 
to offset some of the required margin for a short sale, several 
commenters also suggested that the Board should not require margin for 
the long purchase of a security if the customer has a long put on that 
security. The Board believes the use of a put option in lieu of margin 
for the purchase of a security may be appropriate in the context of a 
future portfolio margining system, which is permitted as an alternative 
to Regulation T.53
---------------------------------------------------------------------------

    \53\ See Section 220.1(b)(3)(i) of the revised Regulation T.
---------------------------------------------------------------------------

    When the Board adopted amendments to Regulation T in 1996, it made 
several provisions of the regulation concerning options effective only 
until June 1, 1997.54 These provisions have been replaced 
with SRO rules and the Board is deleting the provisions from the 
revised Regulation T.
---------------------------------------------------------------------------

    \54\ See e.g., Secs. 220.4(b)(9) and 220.12(b)(6) of the former 
Regulation T.
---------------------------------------------------------------------------

C. Miscellaneous Issues

1. Foreign Issues
    a. Credit by foreign branches of U.S. broker-dealers: The Board 
proposed to amend Regulation T to exempt credit extended by foreign 
branches of U.S. broker-dealers if the credit is extended to foreign 
persons against foreign securities. This proposal was supported by all 
responsive commenters, although one commenter expressed concern about 
foreign securities whose principal trading market is in the United 
States and another commenter suggested exempting all credit extended by 
U.S. broker-dealers outside the United States. The Board is adopting 
its proposal and amending the scope section of Regulation T to exclude 
financial relations between a foreign branch of a U.S. broker-dealer 
and a foreign person involving foreign securities. 55 This 
will remove restrictions from foreign branches of U.S. broker-dealers 
that are not imposed on foreign branches of U.S. banks or foreign 
affiliates of U.S. lenders.
---------------------------------------------------------------------------

    \55\ See Section 220.1(b)(3)(iv) of the revised Regulation T.
---------------------------------------------------------------------------

    b. Foreign currency: The Board is moving former Sec. 220.4(b)(8) of 
Regulation T, which permits a creditor to extend credit in a margin 
account denominated in any freely convertible foreign currency, to the 
general provisions section of the regulation (specifically, 
Sec. 220.3(i)). This will make clear that creditors may also extend 
credit denominated in any freely convertible currency in the good faith 
account and the broker-dealer credit account.
2. Technical Amendments
    There were no negative comments on the first two technical 
amendments described below, which were proposed by the Board in April 
1996. The third amendment is also technical in nature and was suggested 
by a commenter.
    a. Definition of covered option transaction: The Board proposed to 
amend the definition of covered option transaction in Sec. 220.2 of 
Regulation T to shorten the list of permissible options transactions in 
the cash account by referring to SRO rules generically. These rules 
were most recently amended in June of this year and the Board's action 
should result in a shorter and simpler

[[Page 2817]]

Regulation T without having a substantive effect for broker-dealers. 
The Board is adopting the amendment as proposed.
    b. Definition of margin equity security: The Board proposed to add 
a definition of the term margin equity security, which appears in the 
Supplement to Regulation T. No adverse comments were received. The 
definition, which is being adopted as proposed, states that a margin 
equity security means a margin security (as defined in Regulation T) 
that is an equity security (as defined in section 3(a) of the '34 Act, 
whence definitions are incorporated into the Board's margin regulations 
if not otherwise defined by the Board).
    c. Definition of current market value: Regulations G and U each 
contained a definition of the phrase ``current market value'' used to 
determine the loan value of margin securities. Regulation T did not 
contain a definition of current market value but addressed the same 
issue in former Sec. 220.3(g), ``Valuing securities.'' One commenter 
noted that while Regulation T contains several references to a 
security's ``current market value,'' it does not contain a definition 
of this term as do Regulations G and U. The Board is adding a 
definition of current market value to Sec. 220.2 of Regulation T that 
is the equivalent of former Sec. 220.3(g) and is deleting former 
Sec. 220.3(g) from Regulation T. This action will have no substantive 
effect, but will make the structure of the Board's margin regulations 
more consistent.
3. Cash Account: 90-Day Freeze
    Customers who do not have sufficient funds in their cash account to 
pay for a security on trade date must agree to pay for the security 
before selling it. According to Sec. 220.8(c)(1) of Regulation T, if a 
nonexempted security ``is sold or delivered to another broker or dealer 
without having been previously paid for in full by the customer, the 
privilege of delaying payment beyond the trade date shall be withdrawn 
for 90 calendar days.'' This is known as a ``90-day freeze.'' However, 
Sec. 220.8(c)(2) says the freeze ``shall not apply'' if full payment is 
received within the required payment period and the proceeds from the 
sale are not withdrawn before payment is received. In response to 
requests for clarification from commenters, the Board is of the view 
that when a customer sells or delivers out securities that have not 
been paid for, the 90-day freeze contained in Sec. 220.8(c) of 
Regulation T need not be applied until the permissible payment period 
has passed.
4. Board Interpretations
    The Board is reviewing its interpretations of Regulation T as part 
of its periodic review. In 1996, the Board deleted eleven 
interpretations that had either been incorporated directly into the 
regulation or had become moot due to subsequent amendments. As 
discussed above in section II.B.3, the Board is deleting an additional 
interpretation today that prevented the use of options as margin for 
short sales of the underlying security and prevented the use of the 
bona fide arbitrage provision for transactions involving options and 
their underlying securities.
    In an advance notice of proposed rulemaking published elsewhere in 
today's Federal Register, the Board is also specifically soliciting 
comment on whether it should propose amendments to incorporate and 
broaden two additional interpretations: a 1962 interpretation 
56 regarding the retirement of stock by an issuer and a 1990 
interpretation 57 regarding the application of the arranging 
provision 58 to broker-dealer activities under SEC Rule 
144A.
---------------------------------------------------------------------------

    \56\ 12 CFR 220.119, reprinted in the FRRS at 5-490.
    \57\ 12 CFR 220.131, reprinted in the FRRS at 5-470.1.
    \58\ As proposed in 1996, the Board is moving the arranging 
provision from former Sec. 220.13 of Regulation T to the general 
provisions found in Sec. 220.3.
---------------------------------------------------------------------------

III. Regulations G and U

A. Loan Value

1. Over-the-Counter Stocks
    Prior to the adoption of today's amendments, all of the Board's 
securities credit regulations permitted 50 percent loan value for: (1) 
Stocks traded on a national securities exchange, (2) stocks in the 
National Market tier of the Nasdaq Stock Market (``NMS'' securities), 
and (3) stocks in the Small Capitalization (``SmallCap'' securities) 
tier of the Nasdaq Stock Market that are identified by the Board as 
``OTC margin stocks.''
    In its request for comment issued last year, the Board noted that 
although the definition and treatment of domestic margin stocks is 
currently the same in Regulations G, T and U, nonmargin stocks are 
treated differently at broker-dealers (where they have no loan value) 
than at banks and other lenders (where the Board's margin rules do not 
limit their value). In light of the disparate treatment of nonmargin 
stock at broker-dealers versus other lenders, the Board sought comment 
on the appropriate definition of margin stock under Regulations G and U 
and on possible solutions to the current structure of its margin 
regulations. This structure results in an increase in burden for 
lenders other than broker-dealers whenever burden is reduced for 
broker-dealers if the definition of margin stock in Regulations G and U 
is expanded whenever the definition of margin security is expanded in 
Regulation T. The Board suggested its regulations might be amended to 
cover more securities for broker-dealers and fewer securities for banks 
and other lenders.
    Although three commenters argued for uniform coverage of equity 
securities under the Board's margin regulations, most commenters 
opposed increasing the coverage of Regulations G and U if Regulation T 
is amended to permit broker-dealers to extend credit against more 
securities. Because banks and other lenders already have experience in 
valuing smaller issues, the Board believes that definition of margin 
stock in Regulation U (which incorporates Regulation G) can be amended 
to exclude stocks trading in the SmallCap tier of the Nasdaq Stock 
Market.59 The Board's quarterly OTC List will no longer be 
required for banks and other nonbroker lenders because the Board will 
no longer choose which Nasdaq stocks qualify as a margin stock for 
purposes of Regulation U. These lenders can determine whether an OTC 
stock is in Nasdaq's National Market tier by consulting a newspaper, 
contacting the NASD or SEC, or checking the NASD's web site at http://
www.nasdaq.com. The Board is therefore deleting the requirements for 
inclusion on the OTC List formerly found in Sec. 221.7 of Regulation U, 
the definition of OTC margin stock in Sec. 221.2 of Regulation U, and 
the provision concerning ``lack of notice of NMS security designation'' 
formerly found in Sec. 221.3(j) of Regulation U.
---------------------------------------------------------------------------

    \59\ Approximately 442 SmallCap issues qualify as ``OTC margin 
stock'' under the Board's criteria formerly found in Sec. 221.7 of 
Regulation U. If today's amendments were adopted with an immediate 
effective date, these stocks would no longer be subject to a 50 
percent loan value limitation when used as collateral for purpose 
loans. The number of stocks that will actually be affected when the 
new regulation goes into effect is likely to be somewhat smaller 
once the new Nasdaq listing requirements are fully phased in.
---------------------------------------------------------------------------

2. Options
    Options, whether traded on an exchange (also known as listed 
options) or over-the-counter (also known as unlisted options), have 
traditionally had no loan value under the Board's margin

[[Page 2818]]

regulations. 60 In 1995, the Board proposed giving listed 
options 50 percent loan value at broker-dealers (under Regulation T) 
and banks (under Regulation U).61 Based on comments received 
in connection with the proposed amendments to Regulation T, the Board 
decided in 1996 to incorporate rules of the options exchanges (also 
known as self-regulatory organizations or SROs) regarding options loan 
value into Regulation T instead of the 50 percent requirement it had 
proposed. At the same time, the Board proposed to amend Regulations G 
and U to allow these lenders to extend credit against listed options to 
the extent permitted by the rules of the options exchanges. The Board 
sought comment on the practicality of requiring banks and others to 
comply with rules of SROs of which they are not members.62 
Five commenters supported uniform margin requirements for all lenders, 
while four other commenters opposed making lenders who are not broker-
dealers, and therefore not members of a securities SRO, comply with SRO 
rules. The SRO margin rules for options are complex and the Board does 
not believe it is practical to require banks to comply with the rules 
of national securities exchanges of which they are not members, nor to 
expect bank examiners to be familiar with these rules in verifying 
compliance with Regulation U. The Board is therefore adopting the 
original 1995 Regulation U proposal and amending the Supplement to 
Regulation U to allow lenders other than broker-dealers to extend 50 
percent loan value against listed options. Unlisted options continue to 
have no loan value when used as part of a mixed-collateral loan. 
However, banks and other lenders can extend credit against unlisted 
options if the loan is not subject to Regulation U. The Board is 
requesting comment on the future status of unlisted options under 
Regulation U in an advance notice of proposed rulemaking published 
elsewhere in today's Federal Register.
---------------------------------------------------------------------------

    \60\ Listed options were the only securities denied loan value 
by the Board under all of its securities credit regulations, in 
spite of the fact that they qualify as margin stock because they are 
listed on a national securities exchange. Although unlisted options 
do not qualify as margin stock and most nonmargin stock has good 
faith loan value under Regulation U, unlisted options have no loan 
value if the loan is a purpose credit secured at least in part by 
margin stock. Of course, Regulations G and U by their terms would 
not cover a loan that was solely secured by an unlisted option.
    \61\ The Regulation T proposal for broker-dealers was part of 
Docket No. R-0772 and appeared at 60 FR 33763 (June 29, 1995). The 
Regulation U proposal for banks was part of Docket No. R-0905 and 
appeared at 60 FR 63660 (December 12, 1995).
    \62\ The final action on Regulation T and revised proposal for 
Regulations G and U appeared at 61 FR 20385 (May 6, 1996).
---------------------------------------------------------------------------

3. Money Market Mutual Funds
    Although Regulation U treats most mutual funds as margin stock 
subject to 50 percent loan value, it has always allowed good faith loan 
value for mutual funds whose portfolios consist of exempted 
securities.63 In 1995, the Board proposed to extend this 
treatment to all money market mutual funds under both Regulations T and 
U. All responsive commenters supported this proposal, which was adopted 
for Regulation T purposes in 1996. The Board is therefore amending the 
definition of margin stock in Regulation U to exclude money market 
mutual funds. This will have the effect of permitting good faith loan 
value for these securities when they are used as collateral for a 
purpose loan that is secured in part by margin stock.64
---------------------------------------------------------------------------

    \63\ Section 221.2 of Regulation U excludes from the definition 
of ``margin stock'' any security issued by an investment company 
registered under section 8 of the Investment Company Act of 1940 
``which has at least 95 percent of its assets continuously invested 
in exempted securities.''
    \64\ Regulation T was amended last year to provide similar 
treatment for money market mutual funds. The Board is using the same 
definition used at that time, i.e., a security issued by a 
registered investment company that is considered a money market fund 
under SEC Rule 2a-7 (17 CFR 270.2a-7, ``Money market funds'').
---------------------------------------------------------------------------

B. Financing of Securities Purchased on a DVP Basis

    Banks may act as custodians for their customers' securities. These 
securities are often purchased at registered broker-dealers and 
delivered to the bank on a delivery-versus-payment (DVP) basis. In the 
late 1980s and early 1990s, Federal Reserve System examiners and staff 
of the SEC alleged that certain banks were accepting the delivery of 
customer margin securities without having the customer's full payment 
on hand, thereby extending purpose credit in excess of the Regulation U 
margin requirements. In many cases, payment for the customer's purchase 
was made in reliance on the proceeds of the sale of the same 
security.65
---------------------------------------------------------------------------

    \65\ In response to banks who argued that they were relying on 
the sale proceeds of the unpaid-for security, Board staff opined 
that reliance on sale proceeds is tantamount to reliance on the 
security itself.
---------------------------------------------------------------------------

    The purchase and same-day sale of a security without independent 
funds to pay for the purchase is prohibited at a broker-dealer if 
effected in a cash account (where it is known as ``free-riding''), 
because the customer is obtaining intraday credit from the broker-
dealer to pay for the security so it can own the security in order to 
sell it. This practice, however, is not prohibited at a broker-dealer 
if effected in a margin account, because the broker-dealer has entered 
into a credit relationship with the customer before extending credit to 
cover the purchase. In order to allow banks to extend credit in a 
manner similar to broker-dealers using a margin account, the Board 
proposed to amend the existing provision in Sec. 221.3(c) of Regulation 
U for revolving credit agreements to include such credit. The Board 
stated its belief that applying the revolving credit provision would 
ensure that banks financing customer securities transactions establish 
credit limits for their customers, including limits on intraday 
trading.
    Ten commenters, including five Reserve Banks, supported the Board's 
proposal. Two bank trade associations opposed the proposal. The trade 
associations made similar arguments. Each acknowledged that in 
providing custodial services banks sometimes extend credit to pay for 
customer securities and this credit may be intraday or extend for a 
longer period of time. The trade associations stated that this credit 
is extended by a bank in its own discretion and not pursuant to an 
agreement with their customer. The trade associations stated banks do 
not have written agreements with their customers because they do not 
want to be required to extend this type of credit. The trade 
associations stated that custodial banks generally have a lien only on 
the assets in a customer's account, and they believed it would be 
inconsistent for a bank to demand that a customer post additional 
assets to cover overdraft extensions of credit. The trade associations 
were also concerned that the Board's proposal might be seen as 
superseding staff opinions in this area permitting some overdrafts when 
banks carefully monitor their customer's transactions.
    As an alternative to the Board's proposal to cover extensions of 
credit used to finance a customer's purchase of securities on a DVP 
basis under the provision for revolving lines of credit, the trade 
associations suggested exempting these transactions by amending 
Sec. 221.6(f) of Regulation U. Section 221.6(f) provides that a bank 
may extend and maintain purpose credit without regard to the 
requirements of Regulation U if the credit is to ``temporarily finance 
the purchase or sale of securities for prompt delivery, if the credit 
is to be repaid in the ordinary course of business upon completion of 
the transaction.'' The Board proposed to amend this section to restore 
language inadvertently deleted in 1983 that

[[Page 2819]]

makes clear the exception cannot be used to finance the purchase of 
securities at a broker-dealer (see, e.g. staff opinions at FRRS 5-
884.68 and 5-942.2). The trade associations suggested that if the 
Board's primary concern in this area is preventing banks from aiding 
and abetting free-riding violations by their customers, Sec. 221.6(f) 
of Regulation U should be amended not by restating that it cannot be 
used to finance transactions effected at a broker-dealer, but by 
stating that the exception is not available if the bank ``knowingly'' 
relies on the proceeds of a security's sale as a source of payment for 
the security.
    The Board is amending the revolving credit agreement provision in 
Sec. 221.3(c)(2)(iii)(B) of Regulation U as proposed to require a 
lender to call for additional collateral when the lender is relying on 
margin stock which is insufficient to cover an extension of purpose 
credit. This will clarify that a lender who has an agreement with its 
customer covering credit extended in connection with custodial or 
clearing services is properly secured or truly unsecured and should 
therefore be free from allegations of aiding and abetting customer 
free-riding violations. The Board is also readopting the language 
inadvertently dropped from Sec. 221.6(f) of Regulation U, as proposed. 
The exemption in Sec. 221.6(f) of Regulation U has never been available 
to cover the same-day purchase and sale of a security bought in a cash 
account at a broker-dealer, and the restoration of the former language 
will eliminate any ambiguity. Finally, the Board notes that its action 
is not intended to supersede the staff opinions in this area.
    In the advance notice of proposed rulemaking published elsewhere in 
today's Federal Register, the Board is soliciting comment on proposals 
to address the supervisory and credit implications of free-riding.

C. Mixed Collateral Loans

    Regulation U does not apply to extensions of securities credit that 
are not secured at least in part by margin stock. Purpose loans secured 
in part by margin stock and in part by other collateral are known as 
``mixed-collateral'' loans and Regulation U has always required some 
kind of separation for these types of loans.\66\ Section 221.3(e) of 
Regulation U provided that mixed collateral loans ``shall be treated as 
two separate loans.'' This was intended to prevent a bank from 
inflating the value of nonmargin stock collateral to make up for the 50 
percent limitation for purpose loans secured by margin stock.
---------------------------------------------------------------------------

    \66\ The mixed-collateral loan provision does not apply to 
nonpurpose loans.
---------------------------------------------------------------------------

    The provision for mixed collateral loans did not present a problem 
when applied at the time the loan commitment is made, as it merely 
required a bank to determine the loan value of margin stock collateral 
and then verify that the other collateral has a good faith loan value 
sufficient to make up the difference between the loan value of the 
margin stock and the amount of credit being extended and allocate the 
credit secured by each tranche.
    The Board has received a number of inquiries about the interplay of 
the provision for mixed-collateral loans and Sec. 221.3(f) of 
Regulation U, which covers withdrawals and substitution of collateral. 
For example, if the value of a customer's nonmargin stock collateral 
has increased since a mixed collateral loan was made, but the value of 
the margin stock has stayed the same, the customer cannot withdraw 
margin stock even though the overall value of the collateral has 
increased, because the ``separate'' loan secured by margin stock does 
not have excess value that would permit its withdrawal. In other words, 
changes in collateral value in one tranche have no effect on the other.
    Noting that the separation requirement for mixed collateral loans 
makes collateral management extremely difficult, the Board proposed to 
modify the provision on mixed-collateral loans so that instead of 
separating margin stock from all other collateral, a bank would 
separate margin stock and other financial instruments such as nonmargin 
stock, bonds, and cash equivalents. This collateral would secure one 
loan and nonfinancial instruments (such as real estate), if any, would 
be treated as securing a ``separate'' loan. The Board noted that 
financial instruments generally have readily available prices and are 
therefore less susceptible to being assigned an inflated value to 
offset the 50 percent loan value limitation for margin stock. The Board 
also invited comment on the continuing need for separation of financial 
and nonfinancial collateral.
    Ten commenters supported the Board's proposal and no commenter 
expressed a preference for maintaining the status quo. One commenter 
suggested providing additional flexibility by amending the regulation 
to provide that margin stock and other financial instruments may be 
treated as a single loan. Three commenters supported complete 
elimination of any separation requirements.
    The Board is deleting the mixed collateral loan provision in former 
Sec. 221.3(e) of Regulation U. Banks will still be required to make a 
good faith determination that nonmargin stock collateral, if any, has 
sufficient good faith loan value to make up the difference between the 
regulatory loan value of margin stock and the amount of credit extended 
for a purpose loan. Although nonfinancial instruments are often more 
difficult to value than securities, the Board believes the requirement 
of good faith on the part of the lender is sufficient to guard against 
circumvention of the Board's margin requirements for equity securities. 
With the elimination of the requirement to separate purpose loans 
secured by margin stock from other purpose loans will allow a bank to 
release any type of collateral if the overall loan value of the pool of 
collateral is greater than the amount required under Regulation U.

IV. Regulation X

    Regulation X (``Borrowers of securities credit'') applies the 
Board's margin regulations to United States persons and related parties 
who obtain credit outside the United States to purchase or carry United 
States securities. Borrowers must conform the credit they receive with 
one of the Board's other margin regulations, according to the lender 
involved. The regulation also applies to borrowers who obtain credit 
within the United States to purchase or carry any security if the 
borrower willfully causes the credit to be extended in contravention of 
the Board's other margin regulations. Both of these provisions refer to 
Regulation G. The Board is amending Regulation X to remove the 
references to Regulation G. Borrowers obtaining credit outside the 
United States who were formerly required to conform their credit to 
Regulation G will now be required to conform their credit to Regulation 
U as it applies to nonbank lenders.

V. Regulatory Flexibility Act

    The amendments being adopted are intended to accomplish two goals. 
As discussed in the preamble, some of the amendments have been 
developed to implement the National Securities Markets Improvement Act 
(Pub. L. 104-290), which reduced the scope of the Board's statutory 
authority for margin regulation. The others are intended to simplify 
regulatory requirements and eliminate restrictions currently imposed on 
broker-dealers, other lenders of securities credit, and their 
customers. For example, smaller companies whose stock is listed on 
Nasdaq's Small Capitalization market will no longer be

[[Page 2820]]

subject to Regulation G registration and reporting requirements if they 
extend credit to employees secured by company stock. The Board believes 
the amendments will not have a substantial adverse effect on a 
significant number of small lenders.

VI. Paperwork Reduction Act

    In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3506; 5 CFR 1320 Appendix A.1), the Board reviewed the rule under the 
authority delegated to the Board by the Office of Management and 
Budget. The Federal Reserve may not conduct or sponsor, and an 
organization is not required to respond to, an information collection 
unless it displays a currently valid OMB control number. The OMB 
control numbers are listed below.
    The collections of information that may be affected by this 
rulemaking are found in 12 CFR 207 and 12 CFR 221. These information 
collections are mandatory (15 U.S.C. 78g and 78w). The respondents and 
recordkeepers are for-profit financial institutions, including banks 
and nonbank lenders. The Federal Reserve collects the information in 
order to identify lenders subject to Regulation G, to verify compliance 
with Regulation G, and to monitor the size of the market for margin 
credit. The purpose statements collect information on the amount and 
purpose of the loans secured by margin stock. The burden associated 
with the FR U-1 and the FR G-3 is recordkeeping burden. Because the 
records would be maintained by respondents and are not provided to the 
Federal Reserve, no issue of confidentiality under the Freedom of 
Information Act arises. The FR G-2 does not contain confidential 
information. The information in the FR G-1 and the FR G-4 are given 
confidential treatment under the Freedom of Information Act (5 U.S.C. 
Sec. 552 (b)(4)).
    In a separate document published elsewhere in today's Federal 
Register, the Board is soliciting comment on the disposition of certain 
reporting forms currently used by Regulation G lenders, the FR G-1, FR 
G-2, and FR G-4, and on further amendments to Regulation U that would 
affect the margin credit ``purpose statements,'' the FR G-3 and the FR 
U-1. Accordingly, until the Board has collected and analyzed such 
comments as may be forthcoming, it will extend for three years, without 
revision, under delegated authority by the Office of Management and 
Budget, the following collections of information: FR G-1 (OMB No. 7100-
0011), FR G-2 (OMB No. 7100-0011), FR G-3 (OMB No. 7100-0018), FR G-4 
(OMB No. 7100-0011), and FR U-1 (OMB No. 7100-0115). The Board 
anticipates that these information collections will be revised before 
the full three-year period has ended.
    In proposed amendments issued for comment by the Board in December 
1995 (Docket R-0905), April 1996 (Docket R-0923), and November 1996 
(Docket R-0944), no comments specifically addressing the burden 
estimates for these information collections were received.
    The estimated annual burden for these information collections is 
summarized in the table below.

----------------------------------------------------------------------------------------------------------------
                                                     Estimated                       Estimated       Estimated  
                                                     number of        Annual       average hours   annual burden
                                                    respondents      frequency     per response        hours    
----------------------------------------------------------------------------------------------------------------
FR G-1..........................................              81               1            2.50             203
FR G-2..........................................              68               1            0.25              17
FR G-3..........................................             700              20            0.16           2,240
FR G-4..........................................             629               1            2.00           1,258
FR U-1..........................................          10,637             212            0.07         157,853
                                                 ---------------------------------------------------------------
      Total.....................................  ..............  ..............  ..............         161,571
----------------------------------------------------------------------------------------------------------------

    The Federal Reserve has a continuing interest in the public's 
opinions of our collections of information. At any time, comments 
regarding the burden estimate, or any other aspect of this collection 
of information, including suggestions for reducing the burden, may be 
sent to: Secretary, Board of Governors of the Federal Reserve System, 
20th and C Streets, N.W., Washington, DC 20551; and to the Office of 
Management and Budget, Paperwork Reduction Projects (7100-0011, 7100-
0018, and 7100-0115), Washington, DC 20503.

List of Subjects

12 CFR Part 207

    Banks, banking, Credit, Federal Reserve System, Reporting and 
recordkeeping requirements, Securities.

12 CFR Part 220

    Banks, banking, Brokers, Credit, Federal Reserve System, Reporting 
and recordkeeping requirements, Securities.

12 CFR Part 221

    Banks, banking, Brokers, Credit, Federal Reserve System, Reporting 
and recordkeeping requirements, Securities.

12 CFR Part 224

    Banks, banking, Brokers, Credit, Federal Reserve System, Reporting 
and recordkeeping requirements, Securities.

12 CFR Part 265

    Authority delegations (Government agencies), Banks, banking, 
Federal Reserve System.

    For the reasons set out in the preamble, and under the authority of 
12 U.S.C. 78c, 78g, 78q, and 78w, 12 CFR chapter II is amended as 
follows:

PART 207--[REMOVED]

    1. Part 207 is removed.

PART 220--CREDIT BY BROKERS AND DEALERS (REGULATION T)

    2. The authority citation for part 220 continues to read as 
follows:

    Authority: 15 U.S.C. 78c, 78g, 78q, and 78w.

    3. Sections 220.1 through 220.12 are revised to read as follows:


Sec. 220.1  Authority, purpose, and scope.

    (a) Authority and purpose. Regulation T (this part) is issued by 
the Board of Governors of the Federal Reserve System (the Board) 
pursuant to the Securities Exchange Act of 1934 (the Act) (15 U.S.C.78a 
et seq.). Its principal purpose is to regulate extensions of credit by 
brokers and dealers; it also covers related transactions within the 
Board's authority under the Act. It imposes, among other obligations, 
initial margin requirements and payment rules on certain securities 
transactions.
    (b) Scope. (1) This part provides a margin account and four special 
purpose accounts in which to record all financial relations between a 
customer and a creditor. Any transaction not specifically permitted in 
a special

[[Page 2821]]

purpose account shall be recorded in a margin account.
    (2) This part does not preclude any exchange, national securities 
association, or creditor from imposing additional requirements or 
taking action for its own protection.
    (3) This part does not apply to:
    (i) Financial relations between a customer and a creditor to the 
extent that they comply with a portfolio margining system under rules 
approved or amended by the SEC;
    (ii) Credit extended by a creditor based on a good faith 
determination that the borrower is an exempted borrower;
    (iii) Financial relations between a customer and a broker or dealer 
registered only under section 15C of the Act; and
    (iv) Financial relations between a foreign branch of a creditor and 
a foreign person involving foreign securities.


Sec. 220.2  Definitions.

    The terms used in this part have the meanings given them in section 
3(a) of the Act or as defined in this section as follows:
    Affiliated corporation means a corporation of which all the common 
stock is owned directly or indirectly by the firm or general partners 
and employees of the firm, or by the corporation or holders of the 
controlling stock and employees of the corporation, and the affiliation 
has been approved by the creditor's examining authority.
    Cash equivalent means securities issued or guaranteed by the United 
States or its agencies, negotiable bank certificates of deposit, 
bankers acceptances issued by banking institutions in the United States 
and payable in the United States, or money market mutual funds.
    Covered option transaction means any transaction involving options 
or warrants in which the customer's risk is limited and all elements of 
the transaction are subject to contemporaneous exercise if:
    (1) The amount at risk is held in the account in cash, cash 
equivalents, or via an escrow receipt; and
    (2) The transaction is eligible for the cash account by the rules 
of the registered national securities exchange authorized to trade the 
option or warrant or by the rules of the creditor's examining authority 
in the case of an unregistered option, provided that all such rules 
have been approved or amended by the SEC.
    Credit balance means the cash amount due the customer in a margin 
account after debiting amounts transferred to the special memorandum 
account.
    Creditor means any broker or dealer (as defined in sections 3(a)(4) 
and 3(a)(5) of the Act), any member of a national securities exchange, 
or any person associated with a broker or dealer (as defined in section 
3(a)(18) of the Act), except for business entities controlling or under 
common control with the creditor.
    Current market value of:
    (1) A security means:
    (i) Throughout the day of the purchase or sale of a security, the 
security's total cost of purchase or the net proceeds of its sale 
including any commissions charged; or
    (ii) At any other time, the closing sale price of the security on 
the preceding business day, as shown by any regularly published 
reporting or quotation service. If there is no closing sale price, the 
creditor may use any reasonable estimate of the market value of the 
security as of the close of business on the preceding business day.
    (2) Any other collateral means a value determined by any reasonable 
method.
    Customer excludes an exempted borrower and includes:
    (1) Any person or persons acting jointly:
    (i) To or for whom a creditor extends, arranges, or maintains any 
credit; or
    (ii) Who would be considered a customer of the creditor according 
to the ordinary usage of the trade;
    (2) Any partner in a firm who would be considered a customer of the 
firm absent the partnership relationship; and
    (3) Any joint venture in which a creditor participates and which 
would be considered a customer of the creditor if the creditor were not 
a participant.
    Debit balance means the cash amount owed to the creditor in a 
margin account after debiting amounts transferred to the special 
memorandum account.
    Delivery against payment, Payment against delivery, or a C.O.D. 
transaction refers to an arrangement under which a creditor and a 
customer agree that the creditor will deliver to, or accept from, the 
customer, or the customer's agent, a security against full payment of 
the purchase price.
    Equity means the total current market value of security positions 
held in the margin account plus any credit balance less the debit 
balance in the margin account.
    Escrow agreement means any agreement issued in connection with a 
call or put option under which a bank or any person designated as a 
control location under paragraph (c) of SEC Rule 15c3-3 (17 CFR 
240.15c3-3(c)), holding the underlying asset or required cash or cash 
equivalents, is obligated to deliver to the creditor (in the case of a 
call option) or accept from the creditor (in the case of a put option) 
the underlying asset or required cash or cash equivalent against 
payment of the exercise price upon exercise of the call or put.
    Examining authority means:
    (1) The national securities exchange or national securities 
association of which a creditor is a member; or
    (2) If a member of more than one self-regulatory organization, the 
organization designated by the SEC as the examining authority for the 
creditor.
    Exempted borrower means a member of a national securities exchange 
or a registered broker or dealer, a substantial portion of whose 
business consists of transactions with persons other than brokers or 
dealers, and includes a borrower who:
    (1) Maintains at least 1000 active accounts on an annual basis for 
persons other than brokers, dealers, and persons associated with a 
broker or dealer;
    (2) Earns at least $10 million in gross revenues on an annual basis 
from transactions with persons other than brokers, dealers, and persons 
associated with a broker or dealer; or
    (3) Earns at least 10 percent of its gross revenues on an annual 
basis from transactions with persons other than brokers, dealers, and 
persons associated with a broker or dealer.
    Exempted securities mutual fund means any security issued by an 
investment company registered under section 8 of the Investment Company 
Act of 1940 (15 U.S.C. 80a-8), provided the company has at least 95 
percent of its assets continuously invested in exempted securities (as 
defined in section 3(a)(12) of the Act).
    Foreign margin stock means a foreign security that is an equity 
security that:
    (1) Appears on the Board's periodically published List of Foreign 
Margin Stocks; or
    (2) Is deemed to have a ``ready market'' under SEC Rule 15c3-1 (17 
CFR 240.15c3-1) or a ``no-action'' position issued thereunder.
    Foreign person means a person other than a United States person as 
defined in section 7(f) of the Act.
    Foreign security means a security issued in a jurisdiction other 
than the United States.
    Good faith with respect to:
    (1) Margin means the amount of margin which a creditor would 
require in exercising sound credit judgment;
    (2) Making a determination or accepting a statement concerning a 
borrower means that the creditor is alert to the circumstances 
surrounding the credit, and if in possession of information that would 
cause a prudent

[[Page 2822]]

person not to make the determination or accept the notice or 
certification without inquiry, investigates and is satisfied that it is 
correct.
    Margin call means a demand by a creditor to a customer for a 
deposit of additional cash or securities to eliminate or reduce a 
margin deficiency as required under this part.
    Margin deficiency means the amount by which the required margin 
exceeds the equity in the margin account.
    Margin equity security means a margin security that is an equity 
security (as defined in section 3(a)(11) of the Act).
    Margin excess means the amount by which the equity in the margin 
account exceeds the required margin. When the margin excess is 
represented by securities, the current value of the securities is 
subject to the percentages set forth in Sec. 220.12 (the Supplement).
    Margin security means:
    (1) Any security registered or having unlisted trading privileges 
on a national securities exchange;
    (2) After January 1, 1999, any security listed on the Nasdaq Stock 
Market;
    (3) Any non-equity security;
    (4) Any security issued by either an open-end investment company or 
unit investment trust which is registered under section 8 of the 
Investment Company Act of 1940 (15 U.S.C. 80a-8);
    (5) Any foreign margin stock;
    (6 ) Any debt security convertible into a margin security;
    (7) Until January 1, 1999, any OTC margin stock; or
    (8) Until January 1, 1999, any OTC security designated as qualified 
for trading in the national market system under a designation plan 
approved by the Securities and Exchange Commission (NMS security).
    Money market mutual fund means any security issued by an investment 
company registered under section 8 of the Investment Company Act of 
1940 (15 U.S.C. 80a-8) that is considered a money market fund under SEC 
Rule 2a-7 (17 CFR 270.2a-7).
    Non-equity security means a security that is not an equity security 
(as defined in section 3(a)(11) of the Act).
    Nonexempted security means any security other than an exempted 
security (as defined in section 3(a)(12) of the Act).
    OTC margin stock means any equity security traded over the counter 
that the Board has determined has the degree of national investor 
interest, the depth and breadth of market, the availability of 
information respecting the security and its issuer, and the character 
and permanence of the issuer to warrant being treated like an equity 
security treaded on a national securities exchange. An OTC stock is not 
considered to be an OTC margin stock unless it appears on the Board's 
periodically published list of OTC margin stocks.
    Payment period means the number of business days in the standard 
securities settlement cycle in the United States, as defined in 
paragraph (a) of SEC Rule 15c6-1 (17 CFR 240.15c6-1(a)), plus two 
business days.
    Purpose credit means credit for the purpose of:
    (1) Buying, carrying, or trading in securities; or
    (2) Buying or carrying any part of an investment contract security 
which shall be deemed credit for the purpose of buying or carrying the 
entire security.
    Short call or short put means a call option or a put option that is 
issued, endorsed, or guaranteed in or for an account.
    (1) A short call that is not cash-settled obligates the customer to 
sell the underlying asset at the exercise price upon receipt of a valid 
exercise notice or as otherwise required by the option contract.
    (2) A short put that is not cash-settled obligates the customer to 
purchase the underlying asset at the exercise price upon receipt of a 
valid exercise notice or as otherwise required by the option contract.
    (3) A short call or a short put that is cash-settled obligates the 
customer to pay the holder of an in the money long put or long call who 
has, or has been deemed to have, exercised the option the cash 
difference between the exercise price and the current assigned value of 
the option as established by the option contract.
    Underlying asset means:
    (1) The security or other asset that will be delivered upon 
exercise of an option; or
    (2) In the case of a cash-settled option, the securities or other 
assets which comprise the index or other measure from which the 
option's value is derived.


Sec. 220.3  General provisions.

    (a) Records. The creditor shall maintain a record for each account 
showing the full details of all transactions.
    (b) Separation of accounts--(1) In general. The requirements of one 
account may not be met by considering items in any other account. If 
withdrawals of cash or securities are permitted under this part, 
written entries shall be made when cash or securities are used for 
purposes of meeting requirements in another account.
    (2) Exceptions. Notwithstanding paragraph (b)(1) of this section:
    (i) For purposes of calculating the required margin for a security 
in a margin account, assets held in the good faith account pursuant to 
Sec. 220.6(e)(1)(i) or (ii) may serve in lieu of margin;
    (ii) Transfers may be effected between the margin account and the 
special memorandum account pursuant to Secs. 220.4 and 220.5.
    (c) Maintenance of credit. Except as prohibited by this part, any 
credit initially extended in compliance with this part may be 
maintained regardless of:
    (1) Reductions in the customer's equity resulting from changes in 
market prices;
    (2) Any security in an account ceasing to be margin or exempted; or
    (3) Any change in the margin requirements prescribed under this 
part.
    (d) Guarantee of accounts. No guarantee of a customer's account 
shall be given any effect for purposes of this part.
    (e) Receipt of funds or securities. (1) A creditor, acting in good 
faith, may accept as immediate payment:
    (i) Cash or any check, draft, or order payable on presentation; or
    (ii) Any security with sight draft attached.
    (2) A creditor may treat a security, check or draft as received 
upon written notification from another creditor that the specified 
security, check, or draft has been sent.
    (3) Upon notification that a check, draft, or order has been 
dishonored or when securities have not been received within a 
reasonable time, the creditor shall take the action required by this 
part when payment or securities are not received on time.
    (4) To temporarily finance a customer's receipt of securities 
pursuant to an employee benefit plan registered on SEC Form S-8 or the 
withholding taxes for an employee stock award plan, a creditor may 
accept, in lieu of the securities, a properly executed exercise notice, 
where applicable, and instructions to the issuer to deliver the stock 
to the creditor. Prior to acceptance, the creditor must verify that the 
issuer will deliver the securities promptly and the customer must 
designate the account into which the securities are to be deposited.
    (f) Exchange of securities. (1) To enable a customer to participate 
in an offer to exchange securities which is made to all holders of an 
issue of securities, a creditor may submit for exchange any securities 
held in a margin account, without regard to the other provisions of 
this part, provided

[[Page 2823]]

the consideration received is deposited into the account.
    (2) If a nonmargin, nonexempted security is acquired in exchange 
for a margin security, its retention, withdrawal, or sale within 60 
days following its acquisition shall be treated as if the security is a 
margin security.
    (g) Arranging for loans by others. A creditor may arrange for the 
extension or maintenance of credit to or for any customer by any 
person, provided the creditor does not willfully arrange credit that 
violates parts 221 or 224 of this chapter.
    (h) Innocent mistakes. If any failure to comply with this part 
results from a mistake made in good faith in executing a transaction or 
calculating the amount of margin, the creditor shall not be deemed in 
violation of this part if, promptly after the discovery of the mistake, 
the creditor takes appropriate corrective action.
    (i) Foreign currency. (1) Freely convertible foreign currency may 
be treated at its U.S. dollar equivalent, provided the currency is 
marked-to-market daily.
    (2) A creditor may extend credit denominated in any freely 
convertible foreign currency.
    (j) Exempted borrowers. (1) A member of a national securities 
exchange or a registered broker or dealer that has been in existence 
for less than one year may meet the definition of exempted borrower 
based on a six-month period.
    (2) Once a member of a national securities exchange or registered 
broker or dealer ceases to qualify as an exempted borrower, it shall 
notify its lender of this fact before obtaining additional credit. Any 
new extensions of credit to such a borrower, including rollovers, 
renewals, and additional draws on existing lines of credit, are subject 
to the provisions of this part.


Sec. 220.4  Margin account.

    (a) Margin transactions. (1) All transactions not specifically 
authorized for inclusion in another account shall be recorded in the 
margin account.
    (2) A creditor may establish separate margin accounts for the same 
person to:
    (i) Clear transactions for other creditors where the transactions 
are introduced to the clearing creditor by separate creditors; or
    (ii) Clear transactions through other creditors if the transactions 
are cleared by separate creditors; or
    (iii) Provide one or more accounts over which the creditor or a 
third party investment adviser has investment discretion.
    (b) Required margin--(1) Applicability. The required margin for 
each long or short position in securities is set forth in Sec. 220.12 
(the Supplement) and is subject to the following exceptions and special 
provisions.
    (2) Short sale against the box. A short sale ``against the box'' 
shall be treated as a long sale for the purpose of computing the equity 
and the required margin.
    (3) When-issued securities. The required margin on a net long or 
net short commitment in a when-issued security is the margin that would 
be required if the security were an issued margin security, plus any 
unrealized loss on the commitment or less any unrealized gain.
    (4) Stock used as cover. (i) When a short position held in the 
account serves in lieu of the required margin for a short put, the 
amount prescribed by paragraph (b)(1) of this section as the amount to 
be added to the required margin in respect of short sales shall be 
increased by any unrealized loss on the position.
    (ii) When a security held in the account serves in lieu of the 
required margin for a short call, the security shall be valued at no 
greater than the exercise price of the short call.
    (5) Accounts of partners. If a partner of the creditor has a margin 
account with the creditor, the creditor shall disregard the partner's 
financial relations with the firm (as shown in the partner's capital 
and ordinary drawing accounts) in calculating the margin or equity of 
the partner's margin account.
    (6) Contribution to joint venture. If a margin account is the 
account of a joint venture in which the creditor participates, any 
interest of the creditor in the joint account in excess of the interest 
which the creditor would have on the basis of its right to share in the 
profits shall be treated as an extension of credit to the joint account 
and shall be margined as such.
    (7) Transfer of accounts. (i) A margin account that is transferred 
from one creditor to another may be treated as if it had been 
maintained by the transferee from the date of its origin, if the 
transferee accepts, in good faith, a signed statement of the transferor 
(or, if that is not practicable, of the customer), that any margin call 
issued under this part has been satisfied.
    (ii) A margin account that is transferred from one customer to 
another as part of a transaction, not undertaken to avoid the 
requirements of this part, may be treated as if it had been maintained 
for the transferee from the date of its origin, if the creditor accepts 
in good faith and keeps with the transferee account a signed statement 
of the transferor describing the circumstances for the transfer.
    (8) Sound credit judgment. In exercising sound credit judgment to 
determine the margin required in good faith pursuant to Sec. 220.12 
(the Supplement), the creditor shall make its determination for a 
specified security position without regard to the customer's other 
assets or securities positions held in connection with unrelated 
transactions.
    (c) When additional margin is required--(1) Computing deficiency. 
All transactions on the same day shall be combined to determine whether 
additional margin is required by the creditor. For the purpose of 
computing equity in an account, security positions are established or 
eliminated and a credit or debit created on the trade date of a 
security transaction. Additional margin is required on any day when the 
day's transactions create or increase a margin deficiency in the 
account and shall be for the amount of the margin deficiency so created 
or increased.
    (2) Satisfaction of deficiency. The additional required margin may 
be satisfied by a transfer from the special memorandum account or by a 
deposit of cash, margin securities, exempted securities, or any 
combination thereof.
    (3) Time limits. (i) A margin call shall be satisfied within one 
payment period after the margin deficiency was created or increased.
    (ii) The payment period may be extended for one or more limited 
periods upon application by the creditor to its examining authority 
unless the examining authority believes that the creditor is not acting 
in good faith or that the creditor has not sufficiently determined that 
exceptional circumstances warrant such action. Applications shall be 
filed and acted upon prior to the end of the payment period or the 
expiration of any subsequent extension.
    (4) Satisfaction restriction. Any transaction, position, or deposit 
that is used to satisfy one requirement under this part shall be 
unavailable to satisfy any other requirement.
    (d) Liquidation in lieu of deposit. If any margin call is not met 
in full within the required time, the creditor shall liquidate 
securities sufficient to meet the margin call or to eliminate any 
margin deficiency existing on the day such liquidation is required, 
whichever is less. If the margin deficiency created or increased is 
$1000 or less, no action need be taken by the creditor.
    (e) Withdrawals of cash or securities. (1) Cash or securities may 
be withdrawn from an account, except if:
    (i) Additional cash or securities are required to be deposited into 
the

[[Page 2824]]

account for a transaction on the same or a previous day; or
    (ii) The withdrawal, together with other transactions, deposits, 
and withdrawals on the same day, would create or increase a margin 
deficiency.
    (2) Margin excess may be withdrawn or may be transferred to the 
special memorandum account (Sec. 220.5) by making a single entry to 
that account which will represent a debit to the margin account and a 
credit to the special memorandum account.
    (3) If a creditor does not receive a distribution of cash or 
securities which is payable with respect to any security in a margin 
account on the day it is payable and withdrawal would not be permitted 
under this paragraph (e), a withdrawal transaction shall be deemed to 
have occurred on the day the distribution is payable.
    (f) Interest, service charges, etc. (1) Without regard to the other 
provisions of this section, the creditor, in its usual practice, may 
debit the following items to a margin account if they are considered in 
calculating the balance of such account:
    (i) Interest charged on credit maintained in the margin account;
    (ii) Premiums on securities borrowed in connection with short sales 
or to effect delivery;
    (iii) Dividends, interest, or other distributions due on borrowed 
securities;
    (iv) Communication or shipping charges with respect to transactions 
in the margin account; and
    (v) Any other service charges which the creditor may impose.
    (2) A creditor may permit interest, dividends, or other 
distributions credited to a margin account to be withdrawn from the 
account if:
    (i) The withdrawal does not create or increase a margin deficiency 
in the account; or
    (ii) The current market value of any securities withdrawn does not 
exceed 10 percent of the current market value of the security with 
respect to which they were distributed.


Sec. 220.5  Special memorandum account.

    (a) A special memorandum account (SMA) may be maintained in 
conjunction with a margin account. A single entry amount may be used to 
represent both a credit to the SMA and a debit to the margin account. A 
transfer between the two accounts may be effected by an increase or 
reduction in the entry. When computing the equity in a margin account, 
the single entry amount shall be considered as a debit in the margin 
account. A payment to the customer or on the customer's behalf or a 
transfer to any of the customer's other accounts from the SMA reduces 
the single entry amount.
    (b) The SMA may contain the following entries:
    (1) Dividend and interest payments;
    (2) Cash not required by this part, including cash deposited to 
meet a maintenance margin call or to meet any requirement of a self-
regulatory organization that is not imposed by this part;
    (3) Proceeds of a sale of securities or cash no longer required on 
any expired or liquidated security position that may be withdrawn under 
Sec. 220.4(e); and
    (4) Margin excess transferred from the margin account under 
Sec. 220.4(e)(2).


Sec. 220.6  Good faith account.

    In a good faith account, a creditor may effect or finance customer 
transactions in accordance with the following provisions:
    (a) Securities entitled to good faith margin--(1) Permissible 
transactions. A creditor may effect and finance transactions involving 
the buying, carrying, or trading of any security entitled to ``good 
faith'' margin as set forth in Sec. 220.12 (the Supplement).
    (2) Required margin. The required margin is set forth in 
Sec. 220.12 (the Supplement).
    (3) Satisfaction of margin. Required margin may be satisfied by a 
transfer from the special memorandum account or by a deposit of cash, 
securities entitled to ``good faith'' margin as set forth in 
Sec. 220.12 (the Supplement), any other asset that is not a security, 
or any combination thereof. An asset that is not a security shall have 
a margin value determined by the creditor in good faith.
    (b) Arbitrage. A creditor may effect and finance for any customer 
bona fide arbitrage transactions. For the purpose of this section, the 
term ``bona fide arbitrage'' means:
    (1) A purchase or sale of a security in one market together with an 
offsetting sale or purchase of the same security in a different market 
at as nearly the same time as practicable for the purpose of taking 
advantage of a difference in prices in the two markets; or
    (2) A purchase of a security which is, without restriction other 
than the payment of money, exchangeable or convertible within 90 
calendar days of the purchase into a second security together with an 
offsetting sale of the second security at or about the same time, for 
the purpose of taking advantage of a concurrent disparity in the prices 
of the two securities.
    (c) ``Prime broker'' transactions. A creditor may effect 
transactions for a customer as part of a ``prime broker'' arrangement 
in conformity with SEC guidelines.
    (d) Credit to ESOPs. A creditor may extend and maintain credit to 
employee stock ownership plans without regard to the other provisions 
of this part.
    (e) Nonpurpose credit. (1) A creditor may:
    (i) Effect and carry transactions in commodities;
    (ii) Effect and carry transactions in foreign exchange;
    (iii) Extend and maintain secured or unsecured nonpurpose credit, 
subject to the requirements of paragraph (e)(2) of this section.
    (2) Every extension of credit, except as provided in paragraphs 
(e)(1)(i) and (e)(1)(ii) of this section, shall be deemed to be purpose 
credit unless, prior to extending the credit, the creditor accepts in 
good faith from the customer a written statement that it is not purpose 
credit. The statement shall conform to the requirements established by 
the Board.


Sec. 220.7  Broker-dealer credit account.

    (a) Requirements. In a broker-dealer credit account, a creditor may 
effect or finance transactions in accordance with the following 
provisions.
    (b) Purchase or sale of security against full payment. A creditor 
may purchase any security from or sell any security to another creditor 
or person regulated by a foreign securities authority under a good 
faith agreement to promptly deliver the security against full payment 
of the purchase price.
    (c) Joint back office. A creditor may effect or finance 
transactions of any of its owners if the creditor is a clearing and 
servicing broker or dealer owned jointly or individually by other 
creditors.
    (d) Capital contribution. A creditor may extend and maintain credit 
to any partner or stockholder of the creditor for the purpose of making 
a capital contribution to, or purchasing stock of, the creditor, 
affiliated corporation or another creditor.
    (e) Emergency and subordinated credit. A creditor may extend and 
maintain, with the approval of the appropriate examining authority:
    (1) Credit to meet the emergency needs of any creditor; or
    (2) Subordinated credit to another creditor for capital purposes, 
if the other creditor:
    (i) Is an affiliated corporation or would not be considered a 
customer of the lender apart from the subordinated loan; or
    (ii) Will not use the proceeds of the loan to increase the amount 
of dealing in securities for the account of the

[[Page 2825]]

creditor, its firm or corporation or an affiliated corporation.
    (f) Omnibus credit (1) A creditor may effect and finance 
transactions for a broker or dealer who is registered with the SEC 
under section 15 of the Act and who gives the creditor written notice 
that:
    (i) All securities will be for the account of customers of the 
broker or dealer; and
    (ii) Any short sales effected will be short sales made on behalf of 
the customers of the broker or dealer other than partners.
    (2) The written notice required by paragraph (f)(1) of this section 
shall conform to any SEC rule on the hypothecation of customers' 
securities by brokers or dealers.
    (g) Special purpose credit. A creditor may extend the following 
types of credit with good faith margin:
    (1) Credit to finance the purchase or sale of securities for prompt 
delivery, if the credit is to be repaid upon completion of the 
transaction.
    (2) Credit to finance securities in transit or surrendered for 
transfer, if the credit is to be repaid upon completion of the 
transaction.
    (3) Credit to enable a broker or dealer to pay for securities, if 
the credit is to be repaid on the same day it is extended.
    (4) Credit to an exempted borrower.
    (5) Credit to a member of a national securities exchange or 
registered broker or dealer to finance its activities as a market maker 
or specialist.
    (6) Credit to a member of a national securities exchange or 
registered broker or dealer to finance its activities as an 
underwriter.


Sec. 220.8  Cash account.

    (a) Permissible transactions. In a cash account, a creditor, may:
    (1) Buy for or sell to any customer any security or other asset if:
    (i) There are sufficient funds in the account; or
    (ii) The creditor accepts in good faith the customer's agreement 
that the customer will promptly make full cash payment for the security 
or asset before selling it and does not contemplate selling it prior to 
making such payment;
    (2) Buy from or sell for any customer any security or other asset 
if:
    (i) The security is held in the account; or
    (ii) The creditor accepts in good faith the customer's statement 
that the security is owned by the customer or the customer's principal, 
and that it will be promptly deposited in the account;
    (3) Issue, endorse, or guarantee, or sell an option for any 
customer as part of a covered option transaction; and
    (4) Use an escrow agreement in lieu of the cash, cash equivalents 
or underlying asset position if:
    (i) In the case of a short call or a short put, the creditor is 
advised by the customer that the required securities, assets or cash 
are held by a person authorized to issue an escrow agreement and the 
creditor independently verifies that the appropriate escrow agreement 
will be delivered by the person promptly; or
    (ii) In the case of a call issued, endorsed, guaranteed, or sold on 
the same day the underlying asset is purchased in the account and the 
underlying asset is to be delivered to a person authorized to issue an 
escrow agreement, the creditor verifies that the appropriate escrow 
agreement will be delivered by the person promptly.
    (b) Time periods for payment; cancellation or liquidation. (1) Full 
cash payment. A creditor shall obtain full cash payment for customer 
purchases:
    (i) Within one payment period of the date:
    (A) Any nonexempted security was purchased;
    (B) Any when-issued security was made available by the issuer for 
delivery to purchasers;
    (C) Any ``when distributed'' security was distributed under a 
published plan;
    (D) A security owned by the customer has matured or has been 
redeemed and a new refunding security of the same issuer has been 
purchased by the customer, provided:
    (1) The customer purchased the new security no more than 35 
calendar days prior to the date of maturity or redemption of the old 
security;
    (2) The customer is entitled to the proceeds of the redemption; and
    (3) The delayed payment does not exceed 103 percent of the proceeds 
of the old security.
    (ii) In the case of the purchase of a foreign security, within one 
payment period of the trade date or within one day after the date on 
which settlement is required to occur by the rules of the foreign 
securities market, provided this period does not exceed the maximum 
time permitted by this part for delivery against payment transactions.
    (2) Delivery against payment. If a creditor purchases for or sells 
to a customer a security in a delivery against payment transaction, the 
creditor shall have up to 35 calendar days to obtain payment if 
delivery of the security is delayed due to the mechanics of the 
transaction and is not related to the customer's willingness or ability 
to pay.
    (3) Shipment of securities, extension. If any shipment of 
securities is incidental to consummation of a transaction, a creditor 
may extend the payment period by the number of days required for 
shipment, but not by more than one additional payment period.
    (4) Cancellation; liquidation; minimum amount. A creditor shall 
promptly cancel or otherwise liquidate a transaction or any part of a 
transaction for which the customer has not made full cash payment 
within the required time. A creditor may, at its option, disregard any 
sum due from the customer not exceeding $1000.
    (c) 90 day freeze. (1) If a nonexempted security in the account is 
sold or delivered to another broker or dealer without having been 
previously paid for in full by the customer, the privilege of delaying 
payment beyond the trade date shall be withdrawn for 90 calendar days 
following the date of sale of the security. Cancellation of the 
transaction other than to correct an error shall constitute a sale.
    (2) The 90 day freeze shall not apply if:
    (i) Within the period specified in paragraph (b)(1) of this 
section, full payment is received or any check or draft in payment has 
cleared and the proceeds from the sale are not withdrawn prior to such 
payment or check clearance; or
    (ii) The purchased security was delivered to another broker or 
dealer for deposit in a cash account which holds sufficient funds to 
pay for the security. The creditor may rely on a written statement 
accepted in good faith from the other broker or dealer that sufficient 
funds are held in the other cash account.
    (d) Extension of time periods; transfers. (1) Unless the creditor's 
examining authority believes that the creditor is not acting in good 
faith or that the creditor has not sufficiently determined that 
exceptional circumstances warrant such action, it may upon application 
by the creditor:
    (i) Extend any period specified in paragraph (b) of this section;
    (ii) Authorize transfer to another account of any transaction 
involving the purchase of a margin or exempted security; or
    (iii) Grant a waiver from the 90 day freeze.
    (2) Applications shall be filed and acted upon prior to the end of 
the payment period, or in the case of the purchase of a foreign 
security within the period specified in paragraph (b)(1)(ii) of this 
section, or the expiration of any subsequent extension.

[[Page 2826]]

Sec. 220.9  Clearance of securities, options, and futures.

    (a) Credit for clearance of securities. The provisions of this part 
shall not apply to the extension or maintenance of any credit that is 
not for more than one day if it is incidental to the clearance of 
transactions in securities directly between members of a national 
securities exchange or association or through any clearing agency 
registered with the SEC.
    (b) Deposit of securities with a clearing agency. The provisions of 
this part shall not apply to the deposit of securities with an option 
or futures clearing agency for the purpose of meeting the deposit 
requirements of the agency if:
    (1) The clearing agency:
    (i) Issues, guarantees performance on, or clears transactions in, 
any security (including options on any security, certificate of 
deposit, securities index or foreign currency); or
    (ii) Guarantees performance of contracts for the purchase or sale 
of a commodity for future delivery or options on such contracts;
    (2) The clearing agency is registered with the Securities and 
Exchange Commission or is the clearing agency for a contract market 
regulated by the Commodity Futures Trading Commission; and
    (3) The deposit consists of any margin security and complies with 
the rules of the clearing agency that have been approved by the 
Securities and Exchange Commission or the Commodity Futures Trading 
Commission.


Sec. 220.10  Borrowing and lending securities.

    (a) Without regard to the other provisions of this part, a creditor 
may borrow or lend securities for the purpose of making delivery of the 
securities in the case of short sales, failure to receive securities 
required to be delivered, or other similar situations. If a creditor 
reasonably anticipates a short sale or fail transaction, such borrowing 
may be made up to one standard settlement cycle in advance of trade 
date.
    (b) A creditor may lend foreign securities to a foreign person (or 
borrow such securities for the purpose of relending them to a foreign 
person) for any purpose lawful in the country in which they are to be 
used.
    (c) A creditor that is an exempted borrower may lend securities 
without regard to the other provisions of this part and a creditor may 
borrow securities from an exempted borrower without regard to the other 
provisions of this part.


Sec. 220.11  Requirements for the list of marginable OTC stocks and the 
list of foreign margin stocks.

    (a) Requirements for inclusion on the list of marginable OTC 
stocks. Except as provided in paragraph (f) of this section, OTC margin 
stock shall meet the following requirements:
    (1) Four or more dealers stand willing to, and do in fact, make a 
market in such stock and regularly submit bona fide bids and offers to 
an automated quotations system for their own accounts;
    (2) The minimum average bid price of such stock, as determined by 
the Board, is at least $5 per share;
    (3) The stock is registered under section 12 of the Act, is issued 
by an insurance company subject to section 12(g)(2)(G) of the Act, is 
issued by a closed-end investment management company subject to 
registration pursuant to section 8 of the Investment Company Act of 
1940 (15 U.S.C. 80a-8), is an American Depository Receipt (ADR) of a 
foreign issuer whose securities are registered under section 12 of the 
Act, or is a stock of an issuer required to file reports under section 
15(d) of the Act;
    (4) Daily quotations for both bid and asked prices for the stock 
are continously available to the general public;
    (5) The stock has been publicly traded for at least six months;
    (6) The issuer has at least $4 million of capital, surplus, and 
undivided profits;
    (7) There are 400,000 or more shares of such stock outstanding in 
addition to shares held beneficially by officers, directors or 
beneficial owners of more than 10 percent of the stock;
    (8) There are 1,200 or more holders of record, as defined in SEC 
Rule 12g5-1 (17 CFR 240.12g5-1), of the stock who are not officers, 
directors or beneficial owners of 10 percent or more of the stock, or 
the average daily trading volume of such stock as determined by the 
Board, is at least 500 shares; and
    (9) The issuer or a predecessor in interest has been in existence 
for at least three years.
    (b) Requirements for continued inclusion on the list of marginable 
OTC stocks. Except as provided in paragraph (f) of this section, OTC 
margin stock shall meet the following requirements:
    (1) Three or more dealers stand willing to, and do in fact, make a 
market in such stock and regularly submit bona fide bids and offers to 
an automated quotations system for their own accounts;
    (2) The minimum average bid price of such stocks, as determined by 
the Board, is at least $2 per share;
    (3) The stock is registered as specified in paragraph (a)(3) of 
this section;
    (4) Daily quotations for both bid and asked prices for the stock 
are continuously available to the general public; ;
    (5) The issuer has at least $1 million of capital, surplus, and 
undivided profits;
    (6) There are 300,000 or more shares of such stock outstanding in 
addition to shares held beneficially by officers, directors, or 
beneficial owners of more than 10 percent of the stock; and
    (7) There continue to be 800 or more holders of record, as defined 
in SEC Rule 12g5-1 (17 CFR 240.12g5-1), of the stock who are not 
officers, directors, or beneficial owners of 10 percent or more of the 
stock, or the average daily trading volume of such stock, as determined 
by the Board, is at least 300 shares.
    (c) Requirements for inclusion on the list of foreign margin 
stocks. Except as provided in paragraph (f) of this section, a foreign 
security shall meet the following requirements before being placed on 
the List of Foreign Margin Stocks:
    (1) The security is an equity security that is listed for trading 
on or through the facilities of a foreign securities exchange or a 
recognized foreign securities market and has been trading on such 
exchange or market for at least six months;
    (2) Daily quotations for both bid and asked or last sale prices for 
the security provided by the foreign securities exchange or foreign 
securities market on which the security is traded are continuously 
available to creditors in the United States pursuant to an electronic 
quotation system;
    (3) The aggregate market value of shares, the ownership of which is 
unrestricted, is not less than $1 billion;
    (4) The average weekly trading volume of such security during the 
preceding six months is either at least 200,000 shares or $1 million; 
and
    (5) The issuer or a predecessor in interest has been in existence 
for at least five years.
    (d) Requirements for continued inclusion on the list of foreign 
margin stocks. Except as provided in paragraph (f) of this section, a 
foreign security shall meet the following requirements to remain on the 
List of Foreign Margin Stocks:
    (1) The security continues to meet the requirements specified in 
paragraphs (c) (1) and (2) of this section;
    (2) The aggregate market value of shares, the ownership of which is

[[Page 2827]]

unrestricted, is not less than $500 million; and
    (3) The average weekly trading volume of such security during the 
preceding six months is either at least 100,000 shares or $500,000.
    (e) Removal from the list. The Board shall periodically remove from 
the lists any stock that:
    (1) Ceases to exist or of which the issuer ceases to exist; or
    (2) No longer substantially meets the provisions of paragraphs (b) 
or (d) of this section or the definition of OTC margin stock.
    (f) Discretionary authority of Board. Without regard to other 
paragraphs of this section, the Board may add to, or omit or remove 
from the list of marginable OTC stocks and the list of foreign margin 
stocks an equity security, if in the judgment of the Board, such action 
is necessary or appropriate in the public interest.
    (g) Unlawful representations. It shall be unlawful for any creditor 
to make, or cause to be made, any representation to the effect that the 
inclusion of a security on the list of marginable OTC stocks or the 
list of foreign margin stocks is evidence that the Board or the SEC has 
in any way passed upon the merits of, or given approval to, such 
security or any transactions therein. Any statement in an advertisement 
or other similar communication containing a reference to the Board in 
connection with the lists or stocks on those lists shall be an unlawful 
representation.


Sec. 220.12  Supplement: Margin requirements.

    The required margin for each security position held in a margin 
account shall be as follows:
    (a) Margin equity security, except for an exempted security, money 
market mutual fund or exempted securities mutual fund, warrant on a 
securities index or foreign currency or a long position in an option: 
50 percent of the current market value of the security or the 
percentage set by the regulatory authority where the trade occurs, 
whichever is greater.
    (b) Exempted security, non-equity security, money market mutual 
fund or exempted securities mutual fund: The margin required by the 
creditor in good faith or the percentage set by the regulatory 
authority where the trade occurs, whichever is greater.
    (c) Short sale of a nonexempted security, except for a non-equity 
security:
    (1) 150 percent of the current market value of the security; or
    (2) 100 percent of the current market value if a security 
exchangeable or convertible within 90 calendar days without restriction 
other than the payment of money into the security sold short is held in 
the account, provided that any long call to be used as margin in 
connection with a short sale of the underlying security is an American-
style option issued by a registered clearing corporation and listed or 
traded on a registered national securities exchange with an exercise 
price that does not exceed the price at which the underlying security 
was sold short.
    (d) Short sale of an exempted security or non-equity security: 100 
percent of the current market value of the security plus the margin 
required by the creditor in good faith.
    (e) Nonmargin, nonexempted equity security: 100 percent of the 
current market value.
    (f) Put or call on a security, certificate of deposit, securities 
index or foreign currency or a warrant on a securities index or foreign 
currency:
    (1) In the case of puts and calls issued by a registered clearing 
corporation and listed or traded on a registered national securities 
exchange or a registered securities association and registered warrants 
on a securities index or foreign currency, the amount, or other 
position specified by the rules of the registered national securities 
exchange or the registered securities association authorized to trade 
the option or warrant, provided that all such rules have been approved 
or amended by the SEC; or
    (2) In the case of all other puts and calls, the amount, or other 
position, specified by the maintenance rules of the creditor's 
examining authority.


Secs. 220.13--220.18  [Removed]

    4. Sections 220.13 through 220.18 are removed.


Sec. 220.126  [Removed and Reserved]

    5. Section 220.126 is removed and reserved.
    6. Part 221 is revised to read as follows:

PART 221--CREDIT BY BANKS AND PERSONS OTHER THAN BROKERS OR DEALERS 
FOR THE PURPOSE OF PURCHASING OR CARRYING MARGIN STOCK (REGULATION 
U)

Sec.
221.1  Authority, purpose, and scope.
221.2  Definitions.
221.3  General requirements.
221.4  Employee stock option, purchase, and ownership plans.
221.5  Special purpose loans to brokers and dealers.
221.6  Exempted transactions.
221.7  Supplement: Maximum loan value of margin stock and other 
collateral.

Interpretations

221.101  Determination and effect of purpose of loan.
221.102  Application to committed credit where funds are disbursed 
thereafter.
221.103  Loans to brokers or dealers.
221.104  Federal credit unions.
221.105  Arranging for extensions of credit to be made by a bank.
221.106  Reliance in ``good faith'' on statement of purpose of loan.
221.107  Arranging loan to purchase open-end investment company 
shares.
221.108  Effect of registration of stock subsequent to making of 
loan.
221.109  Loan to open-end investment company.
221.110  Questions arising under this part.
221.111  Contribution to joint venture as extension of credit when 
the contribution is disproportionate to the contributor's share in 
the venture's profits or losses.
221.112  Loans by bank in capacity as trustee.
221.113  Loan which is secured indirectly by stock.
221.114  Bank loans to purchase stock of American Telephone and 
Telegraph Company under Employees' Stock Plan.
221.115  Accepting a purpose statement through the mail without 
benefit of face-to-face interview.
221.116  Bank loans to replenish working capital used to purchase 
mutual fund shares.
221.117  When bank in ``good faith'' has not relied on stock as 
collateral.
221.118  Bank arranging for extension of credit by corporation.
221.119  Applicability of plan-lender provisions to financing of 
stock options and stock purchase rights qualified or restricted 
under Internal Revenue Code.
221.120  Allocation of stock collateral to purpose and nonpurpose 
credits to same customer.
221.121  Extension of credit in certain stock option and stock 
purchase plans.
221.122  Applicability of margin requirements to credit in 
connection with Insurance Premium Funding Programs.
221.123  Combined credit for exercising employee stock options and 
paying income taxes incurred as a result of such exercise.
221.124  Purchase of debt securities to finance corporate takeovers.
221.125  Credit to brokers and dealers.

    Authority: 15 U.S.C. 78c, 78g, 78q, and 78w.


Sec. 221.1  Authority, purpose, and scope.

    (a) Authority. Regulation U (this part) is issued by the Board of 
Governors of the Federal Reserve System (the Board) pursuant to the 
Securities Exchange Act of 1934 (the Act) (15 U.S.C. 78a et seq.).
    (b) Purpose and scope. (1) This part imposes credit restrictions 
upon persons other than brokers or dealers (hereinafter lenders) that 
extend credit for the purpose of buying or carrying

[[Page 2828]]

margin stock if the credit is secured directly or indirectly by margin 
stock. Lenders include ``banks'' (as defined in Sec. 221.2) and other 
persons who are required to register with the Board under 
Sec. 221.3(b). Lenders may not extend more than the maximum loan value 
of the collateral securing such credit, as set by the Board in 
Sec. 221.7 (the Supplement).
    (2) This part does not apply to clearing agencies regulated by the 
Securities and Exchange Commission or the Commodity Futures Trading 
Commission that accept deposits of margin stock in connection with:
    (i) The issuance of, or guarantee of, or the clearance of 
transactions in, any security (including options on any security, 
certificate of deposit, securities index or foreign currency); or
    (ii) The guarantee of contracts for the purchase or sale of a 
commodity for future delivery or options on such contracts.
    (3) This part does not apply to credit extended to an exempted 
borrower.
    (c) Availability of forms. The forms referenced in this part are 
available from the Federal Reserve Banks.


Sec. 221.2  Definitions.

    The terms used in this part have the meanings given them in section 
3(a) of the Act or as defined in this section as follows:
    Affiliate means:
    (1) For banks:
    (i) Any bank holding company of which a bank is a subsidiary within 
the meaning of the Bank Holding Company Act of 1956, as amended (12 
U.S.C. 1841(d));
    (ii) Any other subsidiary of such bank holding company; and
    (iii) Any other corporation, business trust, association, or other 
similar organization that is an affiliate as defined in section 2(b) of 
the Banking Act of 1933 (12 U.S.C. 221a(c));
    (2) For nonbank lenders, affiliate means any person who, directly 
or indirectly, through one or more intermediaries, controls, or is 
controlled by, or is under common control with the lender.
    Bank. (1) Bank. Has the meaning given to it in section 3(a)(6) of 
the Act (15 U.S.C. 78c(a)(6)) and includes:
    (i) Any subsidiary of a bank;
    (ii) Any corporation organized under section 25(a) of the Federal 
Reserve Act (12 U.S.C. 611); and
    (iii) Any agency or branch of a foreign bank located within the 
United States.
    (2) Bank does not include:
    (i) Any savings and loan association;
    (ii) Any credit union;
    (iii) Any lending institution that is an instrumentality or agency 
of the United States; or
    (iv) Any member of a national securities exchange.
    Carrying credit is credit that enables a customer to maintain, 
reduce, or retire indebtedness originally incurred to purchase a 
security that is currently a margin stock.
    Current market value of:
    (1) A security means:
    (i) If quotations are available, the closing sale price of the 
security on the preceding business day, as appearing on any regularly 
published reporting or quotation service; or
    (ii) If there is no closing sale price, the lender may use any 
reasonable estimate of the market value of the security as of the close 
of business on the preceding business day; or
    (iii) If the credit is used to finance the purchase of the 
security, the total cost of purchase, which may include any commissions 
charged.
    (2) Any other collateral means a value determined by any reasonable 
method.
    Customer excludes an exempted borrower and includes any person or 
persons acting jointly, to or for whom a lender extends or maintains 
credit.
    Examining authority means:
    (1) The national securities exchange or national securities 
association of which a broker or dealer is a member; or
    (2) If a member of more than one self-regulatory organization, the 
organization designated by the Securities and Exchange Commission as 
the examining authority for the broker or dealer.
    Exempted borrower means a member of a national securities exchange 
or a registered broker or dealer, a substantial portion of whose 
business consists of transactions with persons other than brokers or 
dealers, and includes a borrower who:
    (1) Maintains at least 1000 active accounts on an annual basis for 
persons other than brokers, dealers, and persons associated with a 
broker or dealer;
    (2) Earns at least $10 million in gross revenues on an annual basis 
from transactions with persons other than brokers, dealers, and persons 
associated with a broker or dealer; or
    (3) Earns at least 10 percent of its gross revenues on an annual 
basis from transactions with persons other than brokers, dealers, and 
persons associated with a broker-dealer.
    Good faith with respect to:
    (1) The loan value of collateral means that amount (not exceeding 
100 per cent of the current market value of the collateral) which a 
lender, exercising sound credit judgment, would lend, without regard to 
the customer's other assets held as collateral in connection with 
unrelated transactions.
    (2) Making a determination or accepting a statement concerning a 
borrower means that the lender or its duly authorized representative is 
alert to the circumstances surrounding the credit, and if in possession 
of information that would cause a prudent person not to make the 
determination or accept the notice or certification without inquiry, 
investigates and is satisfied that it is correct;
    In the ordinary course of business means occurring or reasonably 
expected to occur in carrying out or furthering any business purpose, 
or in the case of an individual, in the course of any activity for 
profit or the management or preservation of property.
    Indirectly secured. (1) Includes any arrangement with the customer 
under which:
    (i) The customer's right or ability to sell, pledge, or otherwise 
dispose of margin stock owned by the customer is in any way restricted 
while the credit remains outstanding; or
    (ii) The exercise of such right is or may be cause for accelerating 
the maturity of the credit.
    (2) Does not include such an arrangement if:
    (i) After applying the proceeds of the credit, not more than 25 
percent of the value (as determined by any reasonable method) of the 
assets subject to the arrangement is represented by margin stock;
    (ii) It is a lending arrangement that permits accelerating the 
maturity of the credit as a result of a default or renegotiation of 
another credit to the customer by another lender that is not an 
affiliate of the lender;
    (iii) The lender holds the margin stock only in the capacity of 
custodian, depositary, or trustee, or under similar circumstances, and, 
in good faith, has not relied upon the margin stock as collateral; or
    (iv) The lender, in good faith, has not relied upon the margin 
stock as collateral in extending or maintaining the particular credit.
    Lender means:
    (1) Any bank; or
    (2) Any person subject to the registration requirements of this 
part.
    Margin stock means:
    (1) Any equity security registered or having unlisted trading 
privileges on a national securities exchange;
    (2) Any OTC security designated as qualified for trading in the 
National Market System under a designation plan approved by the 
Securities and Exchange Commission (NMS security);

[[Page 2829]]

    (3) Any debt security convertible into a margin stock or carrying a 
warrant or right to subscribe to or purchase a margin stock;
    (4) Any warrant or right to subscribe to or purchase a margin 
stock; or
    (5) Any security issued by an investment company registered under 
section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), 
other than:
    (i) A company licensed under the Small Business Investment Company 
Act of 1958, as amended (15 U.S.C. 661); or
    (ii) A company which has at least 95 percent of its assets 
continuously invested in exempted securities (as defined in 15 U.S.C. 
78c(a)(12)); or
    (iii) A company which issues face-amount certificates as defined in 
15 U.S.C. 80a-2(a)(15), but only with respect of such securities; or
    (iv) A company which is considered a money market fund under SEC 
Rule 2a-7 (17 CFR 270.2a-7).
    Maximum loan value is the percentage of current market value 
assigned by the Board under Sec. 221.7 (the Supplement) to specified 
types of collateral. The maximum loan value of margin stock is stated 
as a percentage of its current market value. Puts, calls and 
combinations thereof that do not qualify as margin stock have no loan 
value. All other collateral has good faith loan value.
    Nonbank lender means any person subject to the registration 
requirements of this part.
    Purpose credit is any credit for the purpose, whether immediate, 
incidental, or ultimate, of buying or carrying margin stock.


Sec. 221.3  General requirements.

    (a) Extending, maintaining, and arranging credit--(1) Extending 
credit. No lender, except a plan-lender, as defined in Sec. 221.4(a), 
shall extend any purpose credit, secured directly or indirectly by 
margin stock, in an amount that exceeds the maximum loan value of the 
collateral securing the credit.
    (2) Maintaining credit. A lender may continue to maintain any 
credit initially extended in compliance with this part, regardless of:
    (i) Reduction in the customer's equity resulting from change in 
market prices;
    (ii) Change in the maximum loan value prescribed by this part; or
    (iii) Change in the status of the security (from nonmargin to 
margin) securing an existing purpose credit.
    (3) Arranging credit. No lender may arrange for the extension or 
maintenance of any purpose credit, except upon the same terms and 
conditions under which the lender itself may extend or maintain purpose 
credit under this part.
    (b) Registration of nonbank lenders; termination of registration; 
annual report--(1) Registration. Every person other than a person 
subject to part 220 of this chapter or a bank who, in the ordinary 
course of business, extends or maintains credit secured, directly or 
indirectly, by any margin stock shall register on Federal Reserve Form 
FR G-1 (OMB control number 7100-0011) within 30 days after the end of 
any calendar quarter during which:
    (i) The amount of credit extended equals $200,000 or more; or
    (ii) The amount of credit outstanding at any time during that 
calendar quarter equals $500,000 or more.
    (2) Deregistration. A registered nonbank lender may apply to 
terminate its registration, by filing Federal Reserve Form FR G-2 (OMB 
control number 7100-0011), if the lender has not, during the preceding 
six calendar months, had more than $200,000 of such credit outstanding. 
Registration shall be deemed terminated when the application is 
approved by the Board.
    (3) Annual report. Every registered nonbank lender shall, within 30 
days following June 30 of every year, file Form FR G-4 (OMB control 
number 7100-0011).
    (4) Where to register and file applications and reports. 
Registration statements, applications to terminate registration, and 
annual reports shall be filed with the Federal Reserve Bank of the 
district in which the principal office of the lender is located.
    (c) Purpose statement--(1) General rule--(i) Banks. Except for 
credit extended under paragraph (c)(2) of this section, whenever a bank 
extends credit secured directly or indirectly by any margin stock, in 
an amount exceeding $100,000, the bank shall require its customer to 
execute Form FR U-1 (OMB No. 7100-0115), which shall be signed and 
accepted by a duly authorized officer of the bank acting in good faith.
    (ii) Nonbank lenders. Except for credit extended under paragraph 
(c)(2) of this section or Sec. 221.4, whenever a nonbank lender extends 
credit secured directly or indirectly by any margin stock, the nonbank 
lender shall require its customer to execute Form FR G-3 (OMB control 
number 7100-0018), which shall be signed and accepted by a duly 
authorized representative of the nonbank lender acting in good faith.
    (2) Purpose statement for revolving-credit or multiple-draw 
agreements or financing of securities purchases on a payment-against-
delivery basis--(i) Banks. If a bank extends credit, secured directly 
or indirectly by any margin stock, in an amount exceeding $100,000, 
under a revolving-credit or other multiple-draw agreement, Form FR U-1 
must be executed at the time the credit arrangement is originally 
established and must be amended as described in paragraph (c)(2)(iv) of 
this section for each disbursement if all of the collateral for the 
agreement is not pledged at the time the agreement is originally 
established.
    (ii) Nonbank lenders. If a nonbank lender extends credit, secured 
directly or indirectly by any margin stock, under a revolving-credit or 
other multiple-draw agreement, Form FR G-3 must be executed at the time 
the credit arrangement is originally established and must be amended as 
described in paragraph (c)(2)(iv) of this section for each disbursement 
if all of the collateral for the agreement is not pledged at the time 
the agreement is originally established.
    (iii) Collateral. If a purpose statement executed at the time the 
credit arrangement is initially made indicates that the purpose is to 
purchase or carry margin stock, the credit will be deemed in compliance 
with this part if:
    (A) The maximum loan value of the collateral at least equals the 
aggregate amount of funds actually disbursed; or
    (B) At the end of any day on which credit is extended under the 
agreement, the lender calls for additional collateral sufficient to 
bring the credit into compliance with Sec. 221.7 (the Supplement).
    (iv) Amendment of purpose statement. For any purpose credit 
disbursed under the agreement, the lender shall obtain and attach to 
the executed Form FR U-1 or FR G-3 a current list of collateral which 
adequately supports all credit extended under the agreement.
    (d) Single credit rule. (1) All purpose credit extended to a 
customer shall be treated as a single credit, and all the collateral 
securing such credit shall be considered in determining whether or not 
the credit complies with this part, except that syndicated loans need 
not be aggregated with other unrelated purpose credit extended by the 
same lender.
    (2) A lender that has extended purpose credit secured by margin 
stock may not subsequently extend unsecured purpose credit to the same 
customer unless the combined credit does not exceed the maximum loan 
value of the collateral securing the prior credit.
    (3) If a lender extended unsecured purpose credit to a customer 
prior to the extension of purpose credit secured by margin stock, the 
credits shall be

[[Page 2830]]

combined and treated as a single credit solely for the purposes of the 
withdrawal and substitution provision of paragraph (f) of this section.
    (4) If a lender extends purpose credit secured by any margin stock 
and non-purpose credit to the same customer, the lender shall treat the 
credits as two separate loans and may not rely upon the required 
collateral securing the purpose credit for the nonpurpose credit.
    (e) Exempted borrowers. (1) An exempted borrower that has been in 
existence for less than one year may meet the definition of exempted 
borrower based on a six-month period.
    (2) Once a member of a national securities exchange or registered 
broker or dealer ceases to qualify as an exempted borrower, it shall 
notify its lenders of this fact. Any new extensions of credit to such a 
borrower, including rollovers, renewals, and additional draws on 
existing lines of credit, are subject to the provisions of this part.
    (f) Withdrawals and substitutions. (1) A lender may permit any 
withdrawal or substitution of cash or collateral by the customer if the 
withdrawal or substitution would not:
    (i) Cause the credit to exceed the maximum loan value of the 
collateral; or
    (ii) Increase the amount by which the credit exceeds the maximum 
loan value of the collateral.
    (2) For purposes of this section, the maximum loan value of the 
collateral on the day of the withdrawal or substitution shall be used.
    (g) Exchange offers. To enable a customer to participate in a 
reorganization, recapitalization or exchange offer that is made to 
holders of an issue of margin stock, a lender may permit substitution 
of the securities received. A nonmargin, nonexempted security acquired 
in exchange for a margin stock shall be treated as if it is margin 
stock for a period of 60 days following the exchange.
    (h) Renewals and extensions of maturity. A renewal or extension of 
maturity of a credit need not be considered a new extension of credit 
if the amount of the credit is increased only by the addition of 
interest, service charges, or taxes with respect to the credit.
    (i) Transfers of credit. (1) A transfer of a credit between 
customers or between lenders shall not be considered a new extension of 
credit if:
    (i) The original credit was extended by a lender in compliance with 
this part or by a lender subject to part 207 of this chapter in effect 
prior to April 1, 1998, (See part 207 appearing in the 12 CFR parts 200 
to 219 edition revised as of January 1, 1997), in a manner that would 
have complied with this part;
    (ii) The transfer is not made to evade this part;
    (iii) The amount of credit is not increased; and
    (iv) The collateral for the credit is not changed.
    (2) Any transfer between customers at the same lender shall be 
accompanied by a statement by the transferor customer describing the 
circumstances giving rise to the transfer and shall be accepted and 
signed by a representative of the lender acting in good faith. The 
lender shall keep such statement with its records of the transferee 
account.
    (3) When a transfer is made between lenders, the transferee shall 
obtain a copy of the Form FR U-1 or Form FR G-3 originally filed with 
the transferor and retain the copy with its records of the transferee 
account. If no form was originally filed with the transferor, the 
transferee may accept in good faith a statement from the transferor 
describing the purpose of the loan and the collateral securing it.
    (j) Action for lender's protection. Nothing in this part shall 
require a bank to waive or forego any lien or prevent a bank from 
taking any action it deems necessary in good faith for its protection.
    (k) Mistakes in good faith. A mistake in good faith in connection 
with the extension or maintenance of credit shall not be a violation of 
this part.


Sec. 221.4  Employee stock option, purchase, and ownership plans.

    (a) Plan-lender; eligible plan. (1) Plan-lender means any 
corporation, (including a wholly-owned subsidiary, or a lender that is 
a thrift organization whose membership is limited to employees and 
former employees of the corporation, its subsidiaries or affiliates) 
that extends or maintains credit to finance the acquisition of margin 
stock of the corporation, its subsidiaries or affiliates under an 
eligible plan.
    (2) Eligible plan. An eligible plan means any employee stock 
option, purchase, or ownership plan adopted by a corporation and 
approved by its stockholders that provides for the purchase of margin 
stock of the corporation, its subsidiaries, or affiliates.
    (b) Credit to exercise rights under or finance an eligible plan. 
(1) If a plan-lender extends or maintains credit under an eligible 
plan, any margin stock that directly or indirectly secured that credit 
shall have good faith loan value.
    (2) Credit extended under this section shall be treated separately 
from credit extended under any other section of this part except 
Sec. 221.3(b)(1) and (b)(3).
    (c) Credit to ESOPs. A nonbank lender may extend and maintain 
purpose credit without regard to the provisions of this part, except 
for Sec. 221.3(b)(1) and (b)(3), if such credit is extended to an 
employee stock ownership plan (ESOP) qualified under section 401 of the 
Internal Revenue Code, as amended (26 U.S.C. 401).


Sec. 221.5  Special purpose loans to brokers and dealers.

    (a) Special purpose loans. A lender may extend and maintain purpose 
credit to brokers and dealers without regard to the limitations set 
forth in Secs. 221.3 and 221.7, if the credit is for any of the 
specific purposes and meets the conditions set forth in paragraph (c) 
of this section.
    (b) Written notice. Prior to extending credit for more than a day 
under this section, the lender shall obtain and accept in good faith a 
written notice or certification from the borrower as to the purposes of 
the loan. The written notice or certification shall be evidence of 
continued eligibility for the special credit provisions until the 
borrower notifies the lender that it is no longer eligible or the 
lender has information that would cause a reasonable person to question 
whether the credit is being used for the purpose specified.
    (c) Types of special purpose credit. The types of credit that may 
be extended and maintained on a good faith basis are as follows:
    (1) Hypothecation loans. Credit secured by hypothecated customer 
securities that, according to written notice received from the broker 
or dealer, may be hypothecated by the broker or dealer under Securities 
and Exchange Commission (SEC) rules.
    (2) Temporary advances in payment-against-delivery transactions. 
Credit to finance the purchase or sale of securities for prompt 
delivery, if the credit is to be repaid upon completion of the 
transaction.
    (3) Loans for securities in transit or transfer. Credit to finance 
securities in transit or surrendered for transfer, if the credit is to 
be repaid upon completion of the transaction.
    (4) Intra-day loans. Credit to enable a broker or dealer to pay for 
securities, if the credit is to be repaid on the same day it is 
extended.
    (5) Arbitrage loans. Credit to finance proprietary or customer bona 
fide arbitrage transactions. For the purpose of this section bona fide 
arbitrage means:
    (i) Purchase or sale of a security in one market, together with an 
offsetting

[[Page 2831]]

sale or purchase of the same security in a different market at nearly 
the same time as practicable, for the purpose of taking advantage of a 
difference in prices in the two markets; or
    (ii) Purchase of a security that is, without restriction other than 
the payment of money, exchangeable or convertible within 90 calendar 
days of the purchase into a second security, together with an 
offsetting sale of the second security at or about the same time, for 
the purpose of taking advantage of a concurrent disparity in the price 
of the two securities.
    (6) Market maker and specialist loans. Credit to a member of a 
national securities exchange or registered broker or dealer to finance 
its activities as a market maker or specialist.
    (7) Underwriter loans. Credit to a member of a national securities 
exchange or registered broker or dealer to finance its activities as an 
underwriter.
    (8) Emergency loans. Credit that is essential to meet emergency 
needs of the broker-dealer business arising from exceptional 
circumstances.
    (9) Capital contribution loans. Capital contribution loans include:
    (i) Credit that Board has exempted by order upon a finding that the 
exemption is necessary or appropriate in the public interest or for the 
protection of investors, provided the Securities Investor Protection 
Corporation certifies to the Board that the exemption is appropriate; 
or
    (ii) Credit to a customer for the purpose of making a subordinated 
loan or capital contribution to a broker or dealer in conformity with 
the SEC's net capital rules and the rules of the broker's or dealer's 
examining authority, provided:
    (A) The customer reduces the credit by the amount of any reduction 
in the loan or contribution to the broker or dealer; and
    (B) The credit is not used to purchase securities issued by the 
broker or dealer in a public distribution.
    (10) Credit to clearing brokers or dealers. Credit to a member of a 
national securities exchange or registered broker or dealer whose 
nonproprietary business is limited to financing and carrying the 
accounts of registered market makers.


Sec. 221.6  Exempted transactions.

    A bank may extend and maintain purpose credit without regard to the 
provisions of this part if such credit is extended:
    (a) To any bank;
    (b) To any foreign banking institution;
    (c) Outside the United States;
    (d) To an employee stock ownership plan (ESOP) qualified under 
section 401 of the Internal Revenue Code (26 U.S.C. 401);
    (e) To any plan lender as defined in Sec. 221.4(a) to finance an 
eligible plan as defined in Sec. 221.4(b), provided the bank has no 
recourse to any securities purchased pursuant to the plan;
    (f) To any customer, other than a broker or dealer, to temporarily 
finance the purchase or sale of securities for prompt delivery, if the 
credit is to be repaid in the ordinary course of business upon 
completion of the transaction and is not extended to enable the 
customer to pay for securities purchased in an account subject to part 
220 of this chapter;
    (g) Against securities in transit, if the credit is not extended to 
enable the customer to pay for securities purchased in an account 
subject to part 220 of this chapter; or
    (h) To enable a customer to meet emergency expenses not reasonably 
foreseeable, and if the extension of credit is supported by a statement 
executed by the customer and accepted and signed by an officer of the 
bank acting in good faith. For this purpose, emergency expenses include 
expenses arising from circumstances such as the death or disability of 
the customer, or some other change in circumstances involving extreme 
hardship, not reasonably foreseeable at the time the credit was 
extended. The opportunity to realize monetary gain or to avoid loss is 
not a ``change in circumstances'' for this purpose.


Sec. 221.7  Supplement: Maximum loan value of margin stock and other 
collateral.

    (a) Maximum loan value of margin stock. The maximum loan value of 
any margin stock is fifty per cent of its current market value.
    (b) Maximum loan value of nonmargin stock and all other collateral. 
 The maximum loan value of nonmargin stock and all other collateral 
except puts, calls, or combinations thereof is their good faith loan 
value.
    (c) Maximum loan value of options. Except for options that qualify 
as margin stock, puts, calls, and combinations thereof have no loan 
value.

Interpretations


Sec. 221.101  Determination and effect of purpose of loan.

    (a) Under this part the original purpose of a loan is controlling. 
In other words, if a loan originally is not for the purpose of 
purchasing or carrying margin stock, changes in the collateral for the 
loan do not change its exempted character.
    (b) However, a so-called increase in the loan is necessarily on an 
entirely different basis. So far as the purpose of the credit is 
concerned, it is a new loan, and the question of whether or not it is 
subject to this part must be determined accordingly.
    (c) Certain facts should also be mentioned regarding the 
determination of the purpose of a loan. Section 221.3(c) provides in 
that whenever a lender is required to have its customer execute a 
``Statement of Purpose for an Extension of Credit Secured by Margin 
Stock,'' the statement must be accepted by the lender ``acting in good 
faith.'' The requirement of ``good faith'' is of vital importance here. 
Its application will necessarily vary with the facts of the particular 
case, but it is clear that the bank must be alert to the circumstances 
surrounding the loan. For example, if the loan is to be made to a 
customer who is not a broker or dealer in securities, but such a broker 
or dealer is to deliver margin stock to secure the loan or is to 
receive the proceeds of the loan, the bank would be put on notice that 
the loan would probably be subject to this part. It could not accept in 
good faith a statement to the contrary without obtaining a reliable and 
satisfactory explanation of the situation.
    (d) Furthermore, the purpose of a loan means just that. It cannot 
be altered by some temporary application of the proceeds. For example, 
if a borrower is to purchase Government securities with the proceeds of 
a loan, but is soon thereafter to sell such securities and replace them 
with margin stock, the loan is clearly for the purpose of purchasing or 
carrying margin stock.


Sec. 221.102  Application to committed credit where funds are disbursed 
thereafter.

    The Board has concluded that the date a commitment to extend credit 
becomes binding should be regarded as the date when the credit is 
extended, since:
    (a) On that date the parties should be aware of law and facts 
surrounding the transaction; and
    (b) Generally, the date of contract is controlling for purposes of 
margin regulations and Federal securities law, regardless of the 
delivery of cash or securities.


Sec. 221.103  Loans to brokers or dealers.

    Questions have arisen as to the adequacy of statements received by 
lending banks under Sec. 221.3(c), ``Purpose Statement,'' in the case 
of loans to brokers or dealers secured by margin stock where the 
proceeds of the loans are to be used to finance customer transactions 
involving the purchasing or

[[Page 2832]]

carrying of margin stock. While some such loans may qualify for 
exemption under Secs. 221.1(b)(2), 221.4, 221.5 or 221.6, unless they 
do qualify for such an exemption they are subject to this part. For 
example, if a loan so secured is made to a broker to furnish cash 
working capital for the conduct of his brokerage business (i.e., for 
purchasing and carrying securities for the account of customers), the 
maximum loan value prescribed in Sec. 221.7 (the Supplement) would be 
applicable unless the loan should be of a kind exempted under this 
part. This result would not be affected by the fact that the margin 
stock given as security for the loan was or included margin stock owned 
by the brokerage firm. In view of the foregoing, the statement referred 
to in Sec. 221.3(c) which the lending bank must accept in good faith in 
determining the purpose of the loan would be inadequate if the form of 
statement accepted or used by the bank failed to call for answers which 
would indicate whether or not the loan was of the kind discussed 
elsewhere in this section.


Sec. 221.104  Federal credit unions.

    For text of the interpretation on Federal credit unions, see 12 CFR 
220.110.


Sec. 221.105  Arranging for extensions of credit to be made by a bank.

    For text of the interpretation on Arranging for extensions of 
credit to be made by a bank, see 12 CFR 220.111.


Sec. 221.106  Reliance in ``good faith'' on statement of purpose of 
loan.

    (a) Certain situations have arisen from time to time under this 
part wherein it appeared doubtful that, in the circumstances, the 
lending banks may have been entitled to rely upon the statements 
accepted by them in determining whether the purposes of certain loans 
were such as to cause the loans to be not subject to the part.
    (b) The use by a lending bank of a statement in determining the 
purpose of a particular loan is, of course, provided for by 
Sec. 221.3(c). However, under that paragraph a lending bank may accept 
such statement only if it is ``acting in good faith.'' As the Board 
stated in the interpretation contained in Sec. 221.101, the 
``requirement of `good faith' is of vital importance''; and, to fulfill 
such requirement, ``it is clear that the bank must be alert to the 
circumstances surrounding the loan.''
    (c) Obviously, such a statement would not be accepted by the bank 
in ``good faith'' if at the time the loan was made the bank had 
knowledge, from any source, of facts or circumstances which were 
contrary to the natural purport of the statement, or which were 
sufficient reasonably to put the bank on notice of the questionable 
reliability or completeness of the statement.
    (d) Furthermore, the same requirement of ``good faith'' is to be 
applied whether the statement accepted by the bank is signed by the 
borrower or by an officer of the bank. In either case, ``good faith'' 
requires the exercise of special diligence in any instance in which the 
borrower is not personally known to the bank or to the officer who 
processes the loan.
    (e) The interpretation set forth in Sec. 221.101 contains an 
example of the application of the ``good faith'' test. There it was 
stated that ``if the loan is to be made to a customer who is not a 
broker or dealer in securities, but such a broker or dealer is to 
deliver margin stock to secure the loan or is to receive the proceeds 
of the loan, the bank would be put on notice that the loan would 
probably be subject to this part. It could not accept in good faith a 
statement to the contrary without obtaining a reliable and satisfactory 
explanation of the situation''.
    (f) Moreover, and as also stated by the interpretation contained in 
Sec. 221.101, the purpose of a loan, of course, ``cannot be altered by 
some temporary application of the proceeds. For example, if a borrower 
is to purchase Government securities with the proceeds of a loan, but 
is soon thereafter to sell such securities and replace them with margin 
stock, the loan is clearly for the purpose of purchasing or carrying 
margin stock''. The purpose of a loan therefore, should not be 
determined upon a narrow analysis of the immediate use to which the 
proceeds of the loan are put. Accordingly, a bank acting in ``good 
faith'' should carefully scrutinize cases in which there is any 
indication that the borrower is concealing the true purpose of the 
loan, and there would be reason for special vigilance if margin stock 
is substituted for bonds or nonmargin stock soon after the loan is 
made, or on more than one occasion.
    (g) Similarly, the fact that a loan made on the borrower's 
signature only, for example, becomes secured by margin stock shortly 
after the disbursement of the loan usually would afford reasonable 
grounds for questioning the bank's apparent reliance upon merely a 
statement that the purpose of the loan was not to purchase or carry 
margin stock.
    (h) The examples in this section are, of course, by no means 
exhaustive. They simply illustrate the fundamental fact that no 
statement accepted by a lender is of any value for the purposes of this 
part unless the lender accepting the statement is ``acting in good 
faith'', and that ``good faith'' requires, among other things, 
reasonable diligence to learn the truth.


Sec. 221.107  Arranging loan to purchase open-end investment company 
shares.

    For text of the interpretation on Arranging loan to purchase open-
end investment company shares, see 12 CFR 220.112.


Sec. 221.108  Effect of registration of stock subsequent to making of 
loan.

    (a) The Board recently was asked whether a loan by a bank to enable 
the borrower to purchase a newly issued nonmargin stock during the 
initial over-the-counter trading period prior to the stock becoming 
registered (listed) on a national securities exchange would be subject 
to this part. The Board replied that, until such stock qualifies as 
margin stock, this would not be applicable to such a loan.
    (b) The Board has now been asked what the position of the lending 
bank would be under this part if, after the date on which the stock 
should become registered, such bank continued to hold a loan of the 
kind just described. It is assumed that the loan was in an amount 
greater than the maximum loan value for the collateral specified in 
this part.
    (c) If the stock should become registered, the loan would then be 
for the purpose of purchasing or carrying a margin stock, and, if 
secured directly or indirectly by any margin stock, would be subject to 
this part as from the date the stock was registered. Under this part, 
this does not mean that the bank would have to obtain reduction of the 
loan in order to reduce it to an amount no more than the specified 
maximum loan value. It does mean, however, that so long as the loan 
balance exceeded the specified maximum loan value, the bank could not 
permit any withdrawals or substitutions of collateral that would 
increase such excess; nor could the bank increase the amount of the 
loan balance unless there was provided additional collateral having a 
maximum loan value at least equal to the amount of the increase. In 
other words, as from the date the stock should become a margin stock, 
the loan would be subject to this part in exactly the same way, for 
example, as a loan subject to this part that became under-margined 
because of a decline in the current market value of the loan collateral 
or because of a decrease by the Board in the maximum loan value of the 
loan collateral.

[[Page 2833]]

Sec. 221.109  Loan to open-end investment company.

    In response to a question regarding a possible loan by a bank to an 
open-end investment company that customarily purchases stocks 
registered on a national securities exchange, the Board stated that in 
view of the general nature and operations of such a company, any loan 
by a bank to such a company should be presumed to be subject to this 
part as a loan for the purpose of purchasing or carrying margin stock. 
This would not be altered by the fact that the open-end company had 
used, or proposed to use, its own funds or proceeds of the loan to 
redeem some of its own shares, since mere application of the proceeds 
of a loan to some other use cannot prevent the ultimate purpose of a 
loan from being to purchase or carry registered stocks.


Sec. 221.110  Questions arising under this part.

    (a) This part governs ``any purpose credit'' extended by a lender 
``secured directly or indirectly by margin stock'' and defines 
``purpose credit'' as ``any credit for the purpose, whether immediate, 
incidental, or ultimate, of buying or carrying margin stock, `` with 
certain exceptions, and provides that the maximum loan value of such 
margin stock shall be a fixed percentage ``of its current market 
value.''
    (b) The Board of Governors has had occasion to consider the 
application of the language in paragraph (a) of this section to the two 
following questions:
    (1) Loan secured by stock. First, is a loan to purchase or carry 
margin stock subject to this part where made in unsecured form, if 
margin stock is subsequently deposited as security with the lender, and 
surrounding circumstances indicate that the parties originally 
contemplated that the loan should be so secured? The Board answered 
that in a case of this kind, the loan would be subject to this part, 
for the following reasons:
    (i) The Board has long held, in the closely related purpose area, 
that the original purpose of a loan should not be determined upon a 
narrow analysis of the technical circumstances under which a loan is 
made. Instead, the fundamental purpose of the loan is considered to be 
controlling. Indeed, ``the fact that a loan made on the borrower's 
signature only, for example, becomes secured by registered stock 
shortly after the disbursement of the loan'' affords reasonable grounds 
for questioning whether the bank was entitled to rely upon the 
borrower's statement as to the purpose of the loan. 1953 Fed. Res. 
Bull. 951 (See, Sec. 221.106).
    (ii) Where security is involved, standards of interpretation should 
be equally searching. If, for example, the original agreement between 
borrower and lender contemplated that the loan should be secured by 
margin stock, and such stock is in fact delivered to the bank when 
available, the transaction must be regarded as fundamentally a secured 
loan. This view is strengthened by the fact that this part applies to a 
loan ``secured directly or indirectly by margin stock.''
    (2) Loan to acquire controlling shares. (i) The second question is 
whether this part governs a margin stock-secured loan made for the 
business purpose of purchasing a controlling interest in a corporation, 
or whether such a loan would be exempt on the ground that this part is 
directed solely toward purchases of stock for speculative or investment 
purposes. The Board answered that a margin stock-secured loan for the 
purpose of purchasing or carrying margin stock is subject to this part, 
regardless of the reason for which the purchase is made.
    (ii) The answer is required, in the Board's view, since the 
language of this part is explicitly inclusive, covering ``any purpose 
credit, secured directly or indirectly by margin stock.'' Moreover, the 
withdrawal in 1945 of the original section 2(e) of this part, which 
exempted ``any loan for the purpose of purchasing a stock from or 
through a person who is not a member of a national securities exchange 
. . .'' plainly implies that transactions of the sort described are now 
subject to the general prohibition of Sec. 221.3(a).


Sec. 221.111  Contribution to joint venture as extension of credit when 
the contribution is disproportionate to the contributor's share in the 
venture's profits or losses.

    (a) The Board considered the question whether a joint venture, 
structured so that the amount of capital contribution to the venture 
would be disproportionate to the right of participation in profits or 
losses, constitutes an ``extension of credit'' for the purpose of this 
part.
    (b) An individual and a corporation plan to establish a joint 
venture to engage in the business of buying and selling securities, 
including margin stock. The individual would contribute 20 percent of 
the capital and receive 80 percent of the profits or losses; the 
corporate share would be the reverse. In computing profits or losses, 
each participant would first receive interest at the rate of 8 percent 
on his respective capital contribution. Although purchases and sales 
would be mutually agreed upon, the corporation could liquidate the 
joint portfolio if the individual's share of the losses equaled or 
exceeded his 20 percent contribution to the venture. The corporation 
would hold the securities, and upon termination of the venture, the 
assets would first be applied to repayment of capital contributions.
    (c) In general, the relationship of joint venture is created when 
two or more persons combine their money, property, or time in the 
conduct of some particular line of trade or some particular business 
and agree to share jointly, or in proportion to capital contributed, 
the profits and losses of the undertaking.
    (d) The incidents of the joint venture described in paragraph (b) 
of this section, however, closely parallel those of an extension of 
margin credit, with the corporation as lender and the individual as 
borrower. The corporation supplies 80 percent of the purchase price of 
securities in exchange for a net return of 8 percent of the amount 
advanced plus 20 percent of any gain. Like a lender of securities 
credit, the corporation is insulated against loss by retaining the 
right to liquidate the collateral before the securities decline in 
price below the amount of its contribution. Conversely, the 
individual--like a customer who borrows to purchase securities--puts up 
only 20 percent of their cost, is entitled to the principal portion of 
any appreciation in their value, bears the principal risk of loss 
should that value decline, and does not stand to gain or lose except 
through a change in value of the securities purchased.
    (e) The Board is of the opinion that where the right of an 
individual to share in profits and losses of such a joint venture is 
disproportionate to his contribution to the venture:
    (1) The joint venture involves an extension of credit by the 
corporation to the individual;
    (2) The extension of credit is to purchase or carry margin stock, 
and is collateralized by such margin stock; and
    (3) If the corporation is not a broker or dealer subject to 
Regulation T (12 CFR part 220), the credit is of the kind described by 
Sec. 221.3(a).


Sec. 221.112  Loans by bank in capacity as trustee.

    (a) The Board's advice has been requested whether a bank's 
activities in connection with the administration of an employees' 
savings plan are subject to this part.
    (b) Under the plan, any regular, full-time employee may participate 
by

[[Page 2834]]

authorizing the sponsoring company to deduct a percentage of his salary 
and wages and transmit the same to the bank as trustee. Voluntary 
contributions by the company are allocated among the participants. A 
participant may direct that funds held for him be invested by the 
trustee in insurance, annuity contracts, Series E Bonds, or in one or 
more of three specified securities which are listed on a stock 
exchange. Loans to purchase the stocks may be made to participants from 
funds of the trust, subject to approval of the administrative 
committee, which is composed of five participants, and of the trustee. 
The bank's right to approve is said to be restricted to the mechanics 
of making the loan, the purpose being to avoid cumbersome procedures.
    (c) Loans are secured by the credit balance of the borrowing 
participants in the savings fund, including stock, but excluding (in 
practice) insurance and annuity contracts and government securities. 
Additional stocks may be, but, in practice, have not been pledged as 
collateral for loans. Loans are not made, under the plan, from bank 
funds, and participants do not borrow from the bank upon assignment of 
the participants' accounts in the trust.
    (d) It is urged that loans under the plan are not subject to this 
part because a loan should not be considered as having been made by a 
bank where the bank acts solely in its capacity of trustee, without 
exercise of any discretion.
    (e) The Board reviewed this question upon at least one other 
occasion, and full consideration has again been given to the matter. 
After considering the arguments on both sides, the Board has reaffirmed 
its earlier view that, in conformity with an interpretation not 
published in the Code of Federal Regulations which was published at 
page 874 of the 1946 Federal Reserve Bulletin (See 12 CFR 261.10(f) for 
information on how to obtain Board publications.), this part applies to 
the activities of a bank when it is acting in its capacity as trustee. 
Although the bank in that case had at best a limited discretion with 
respect to loans made by it in its capacity as trustee, the Board 
concluded that this fact did not affect the application of the 
regulation to such loans.


Sec. 221.113  Loan which is secured indirectly by stock.

    (a) A question has been presented to the Board as to whether a loan 
by a bank to a mutual investment fund is ``secured * * * indirectly by 
margin stock'' within the meaning of Sec. 221.(3)(a), so that the loan 
should be treated as subject to this part.
    (b) Briefly, the facts are as follows. Fund X, an open-end 
investment company, entered into a loan agreement with Bank Y, which 
was (and still is) custodian of the securities which comprise the 
portfolio of Fund X. The agreement includes the following terms, which 
are material to the question before the Board:
    (1) Fund X agrees to have an ``asset coverage'' (as defined in the 
agreements) of 400 percent of all its borrowings, including the 
proposed borrowing, at the time when it takes down any part of the 
loan.
    (2) Fund X agrees to maintain an ``asset coverage'' of at least 300 
percent of its borrowings at all times.
    (3) Fund X agrees not to amend its custody agreement with Bank Y, 
or to substitute another custodian without Bank Y's consent.
    (4) Fund X agrees not to mortgage, pledge, or otherwise encumber 
any of its assets elsewhere than with Bank Y.
    (c) In Sec. 221.109 the Board stated that because of ``the general 
nature and operations of such a company'', any ``loan by a bank to an 
open-end investment company that customarily purchases margin stock * * 
* should be presumed to be subject to this part as a loan for the 
purpose of purchasing or carrying margin stock'' (purpose credit). The 
Board's interpretation went on to say that: ``this would not be altered 
by the fact that the open-end company had used, or proposed to use, its 
own funds or proceeds of the loan to redeem some of its own shares * * 
*.''
    (d) Accordingly, the loan by Bank Y to Fund X was and is a 
``purpose credit''. However, a loan by a bank is not subject to this 
part unless: it is a purpose credit; and it is ``secured directly or 
indirectly by margin stock''. In the present case, the loan is not 
``secured directly'' by stock in the ordinary sense, since the 
portfolio of Fund X is not pledged to secure the credit from Bank Y. 
But the word ``indirectly'' must signify some form of security 
arrangement other than the ``direct'' security which arises from the 
ordinary ``transaction that gives recourse against a particular chattel 
or land or against a third party on an obligation'' described in the 
American Law Institute's Restatement of the Law of Security, page 1. 
Otherwise the word ``indirectly'' would be superfluous, and a 
regulation, like a statute, must be construed if possible to give 
meaning to every word.
    (e) The Board has indicated its view that any arrangement under 
which margin stock is more readily available as security to the lending 
bank than to other creditors of the borrower may amount to indirect 
security within the meaning of this part. In an interpretation 
published at Sec. 221.110 it stated: ``The Board has long held, in the 
* * * purpose area, that the original purpose of a loan should not be 
determined upon a narrow analysis of the technical circumstances under 
which a loan is made * * * . Where security is involved, standards of 
interpretation should be equally searching.'' In its pamphlet issued 
for the benefit and guidance of banks and bank examiners, entitled 
``Questions and Answers Illustrating Application of Regulation U'', the 
Board said: ``In determining whether a loan is ``indirectly'' secured, 
it should be borne in mind that the reason the Board has thus far 
refrained * * * from regulating loans not secured by stock has been to 
simplify operations under the regulation. This objective of simplifying 
operations does not apply to loans in which arrangements are made to 
retain the substance of stock collateral while sacrificing only the 
form''.
    (f) A wide variety of arrangements as to collateral can be made 
between bank and borrower which will serve, to some extent, to protect 
the interest of the bank in seeing that the loan is repaid, without 
giving the bank a conventional direct ``security'' interest in the 
collateral. Among such arrangements which have come to the Board's 
attention are the following:
    (1) The borrower may deposit margin stock in the custody of the 
bank. An arrangement of this kind may not, it is true, place the bank 
in the position of a secured creditor in case of bankruptcy, or even of 
conflicting claims, but it is likely effectively to strengthen the 
bank's position. The definition of indirectly secured in Sec. 221.2, 
which provides that a loan is not indirectly secured if the lender 
``holds the margin stock only in the capacity of custodian, depositary 
or trustee, or under similar circumstances, and, in good faith has not 
relied upon the margin stock as collateral,'' does not exempt a deposit 
of this kind from the impact of the regulation unless it is clear that 
the bank ``has not relied'' upon the margin stock deposited with it.
    (2) A borrower may not deposit his margin stock with the bank, but 
agree not to pledge or encumber his assets elsewhere while the loan is 
outstanding. Such an agreement may be difficult to police, yet it 
serves to some extent to protect the interest of the bank if only 
because the future credit standing and business reputation of the 
borrower will depend upon his keeping his word. If

[[Page 2835]]

the assets covered by such an agreement include margin stock, then, the 
credit is ``indirectly secured'' by the margin stock within the meaning 
of this part.
    (3) The borrower may deposit margin stock with a third party who 
agrees to hold the stock until the loan has been paid off. Here, even 
though the parties may purport to provide that the stock is not 
``security'' for the loan (for example, by agreeing that the stock may 
not be sold and the proceeds applied to the debt if the borrower fails 
to pay), the mere fact that the stock is out of the borrower's control 
for the duration of the loan serves to some extent to protect the bank.
    (g) The three instances described in paragraph (f) of this section 
are merely illustrative. Other methods, or combinations of methods, may 
serve a similar purpose. The conclusion that any given arrangement 
makes a credit ``indirectly secured'' by margin stock may, but need 
not, be reinforced by facts such as that the stock in question was 
purchased with proceeds of the loan, that the lender suggests or 
insists upon the arrangement, or that the loan would probably be 
subject to criticism by supervisory authorities were it not for the 
protective arrangement.
    (h) Accordingly, the Board concludes that the loan by Bank Y to 
Fund X is indirectly secured by the portfolio of the fund and must be 
treated by the bank as a regulated loan.


Sec. 221.114  Bank loans to purchase stock of American Telephone and 
Telegraph Company under Employees' Stock Plan.

    (a) The Board of Governors interpreted this part in connection with 
proposed loans by a bank to persons who are purchasing shares of stock 
of American Telephone and Telegraph Company pursuant to its Employees' 
Stock Plan.
    (b) According to the current offering under the Plan, an employee 
of the AT&T system may purchase shares through regular deductions from 
his pay over a period of 24 months. At the end of that period, a 
certificate for the appropriate number of shares will be issued to the 
participating employee by AT&T. Each employee is entitled to purchase, 
as a maximum, shares that will cost him approximately three-fourths of 
his annual base pay. Since the program extends over two years, it 
follows that the payroll deductions for this purpose may be in the 
neighborhood of 38 percent of base pay and a larger percentage of 
``take-home pay.'' Deductions of this magnitude are in excess of the 
saving rate of many employees.
    (c) Certain AT&T employees, who wish to take advantage of the 
current offering under the Plan, are the owners of shares of AT&T stock 
that they purchased under previous offerings. A bank proposed to 
receive such stock as collateral for a ``living expenses'' loan that 
will be advanced to the employee in monthly installments over the 24-
month period, each installment being in the amount of the employee's 
monthly payroll deduction under the Plan. The aggregate amount of the 
advances over the 24-month period would be substantially greater than 
the maximum loan value of the collateral as prescribed in Sec. 221.7 
(the Supplement).
    (d) In the opinion of the Board of Governors, a loan of the kind 
described would violate this part if it exceeded the maximum loan value 
of the collateral. The regulation applies to any margin stock-secured 
loan for the purpose of purchasing or carrying margin stock 
(Sec. 221.3(a)). Although the proposed loan would purport to be for 
living expenses, it seems quite clear, in view of the relationship of 
the loan to the Employees' Stock Plan, that its actual purpose would be 
to enable the borrower to purchase AT&T stock, which is margin stock. 
At the end of the 24-month period the borrower would acquire a certain 
number of shares of that stock and would be indebted to the lending 
bank in an amount approximately equal to the amount he would pay for 
such shares. In these circumstances, the loan by the bank must be 
regarded as a loan ``for the purpose of purchasing'' the stock, and 
therefore it is subject to the limitations prescribed by this part. 
This conclusion follows from the provisions of this part, and it may 
also be observed that a contrary conclusion could largely defeat the 
basic purpose of the margin regulations.
    (e) Accordingly, the Board concluded that a loan of the kind 
described may not be made in an amount exceeding the maximum loan value 
of the collateral, as prescribed by the current Sec. 221.7 (the 
Supplement).


Sec. 221.115  Accepting a purpose statement through the mail without 
benefit of face-to-face interview.

    (a) The Board has been asked whether the acceptance of a purpose 
statement submitted through the mail by a lender subject to the 
provisions of this part will meet the good faith requirement of 
Sec. 221.3(c). Section 221.3(c) states that in connection with any 
credit secured by collateral which includes any margin stock, a nonbank 
lender must obtain a purpose statement executed by the borrower and 
accepted by the lender in good faith. Such acceptance requires that the 
lender be alert to the circumstances surrounding the credit and if 
further information suggests inquiry, he must investigate and be 
satisfied that the statement is truthful.
    (b) The lender is a subsidiary of a holding company which also has 
another subsidiary which serves as underwriter and investment advisor 
to various mutual funds. The sole business of the lender will be to 
make ``non-purpose'' consumer loans to shareholders of the mutual 
funds, such loans to be collateralized by the fund shares. Most mutual 
funds shares are margin stock for purposes of this part. Solicitation 
and acceptance of these consumer loans will be done principally through 
the mail and the lender wishes to obtain the required purpose statement 
by mail rather than by a face-to-face interview. Personal interviews 
are not practicable for the lender because shareholders of the funds 
are scattered throughout the country. In order to provide the same 
safeguards inherent in face-to-face interviews, the lender has 
developed certain procedures designed to satisfy the good faith 
acceptance requirement of this part.
    (c) The purpose statement will be supplemented with several 
additional questions relevant to the prospective borrower's investment 
activities such as purchases of any security within the last 6 months, 
dollar amount, and obligations to purchase or pay for previous 
purchases; present plans to purchase securities in the near future, 
participations in securities purchase plans, list of unpaid debts, and 
present income level. Some questions have been modified to facilitate 
understanding but no questions have been deleted. If additional inquiry 
is indicated by the answers on the form, a loan officer of the lender 
will interview the borrower by telephone to make sure the loan is 
``non-purpose''. Whenever the loan exceeds the ``maximum loan value'' 
of the collateral for a regulated loan, a telephone interview will be 
done as a matter of course.
    (d) One of the stated purposes of Regulation X (12 CFR part 224) 
was to prevent the infusion of unregulated credit into the securities 
markets by borrowers falsely certifying the purpose of a loan. The 
Board is of the view that the existence of Regulation X (12 CFR part 
224), which makes the borrower liable for willful violations of the 
margin regulations, will allow a lender subject to this part to meet 
the good faith acceptance requirement of Sec. 221.3(c) without a face-
to-face interview if the lender adopts a program, such as the one 
described in

[[Page 2836]]

paragraph (c) of this section, which requires additional detailed 
information from the borrower and proper procedures are instituted to 
verify the truth of the information received. Lenders intending to 
embark on a similar program should discuss proposed plans with their 
district Federal Reserve Bank. Lenders may have existing or future 
loans with the prospective customers which could complicate the efforts 
to determine the true purpose of the loan.


Sec. 221.116  Bank loans to replenish working capital used to purchase 
mutual fund shares.

    (a) In a situation considered by the Board of Governors, a business 
concern (X) proposed to purchase mutual fund shares, from time to time, 
with proceeds from its accounts receivable, then pledge the shares with 
a bank in order to secure working capital. The bank was prepared to 
lend amounts equal to 70 percent of the current value of the shares as 
they were purchased by X. If the loans were subject to this part, only 
50 percent of the current market value of the shares could be lent.
    (b) The immediate purpose of the loans would be to replenish X's 
working capital. However, as time went on, X would be acquiring mutual 
fund shares at a cost that would exceed the net earnings it would 
normally have accumulated, and would become indebted to the lending 
bank in an amount approximately 70 percent of the prices of said 
shares.
    (c) The Board held that the loans were for the purpose of 
purchasing the shares, and therefore subject to the limitations 
prescribed by this part. As pointed out in Sec. 221.114 with respect to 
a similar program for putting a high proportion of cash income into 
stock, the borrowing against the margin stock to meet needs for which 
the cash would otherwise have been required, a contrary conclusion 
could largely defeat the basic purpose of the margin regulations.
    (d) Also considered was an alternative proposal under which X would 
deposit proceeds from accounts receivable in a time account for 1 year, 
before using those funds to purchase mutual fund shares. The Board held 
that this procedure would not change the situation in any significant 
way. Once the arrangement was established, the proceeds would be 
flowing into the time account at the same time that similar amounts 
were released to purchase the shares, and over any extended period of 
time the result would be the same. Accordingly, the Board concluded 
that bank loans made under the alternative proposal would similarly be 
subject to this part.


Sec. 221.117  When bank in ``good faith'' has not relied on stock as 
collateral.

    (a) The Board has received questions regarding the circumstances in 
which an extension or maintenance of credit will not be deemed to be 
``indirectly secured'' by stock as indicated by the phrase, ``if the 
lender, in good faith, has not relied upon the margin stock as 
collateral,'' contained in paragraph (2)(iv) of the definition of 
indirectly secured in Sec. 221.2.
    (b) In response, the Board noted that in amending this portion of 
the regulation in 1968 it was indicated that one of the purposes of the 
change was to make clear that the definition of indirectly secured does 
not apply to certain routine negative covenants in loan agreements. 
Also, while the question of whether or not a bank has relied upon 
particular stock as collateral is necessarily a question of fact to be 
determined in each case in the light of all relevant circumstances, 
some indication that the bank had not relied upon stock as collateral 
would seem to be afforded by such circumstances as the fact that:
    (1) The bank had obtained a reasonably current financial statement 
of the borrower and this statement could reasonably support the loan; 
and
    (2) The loan was not payable on demand or because of fluctuations 
in market value of the stock, but instead was payable on one or more 
fixed maturities which were typical of maturities applied by the bank 
to loans otherwise similar except for not involving any possible 
question of stock collateral.


Sec. 221.118  Bank arranging for extension of credit by corporation.

    (a) The Board considered the questions whether:
    (1) The guaranty by a corporation of an ``unsecured'' bank loan to 
exercise an option to purchase stock of the corporation is an 
``extension of credit'' for the purpose of this part;
    (2) Such a guaranty is given ``in the ordinary course of business'' 
of the corporation, as defined in Sec. 221.2; and
    (3) The bank involved took part in arranging for such credit on 
better terms than it could extend under the provisions of this part.
    (b) The Board understood that any officer or employee included 
under the corporation's stock option plan who wished to exercise his 
option could obtain a loan for the purchase price of the stock by 
executing an unsecured note to the bank. The corporation would issue to 
the bank a guaranty of the loan and hold the purchased shares as 
collateral to secure it against loss on the guaranty. Stock of the 
corporation is registered on a national securities exchange and 
therefore qualifies as ``margin stock'' under this part.
    (c) A nonbank lender is subject to the registration and other 
requirements of this part if, in the ordinary course of his business, 
he extends credit on collateral that includes any margin stock in the 
amount of $200,000 or more in any calendar quarter, or has such credit 
outstanding in any calendar quarter in the amount of $500,000 or more. 
The Board understood that the corporation in question had sufficient 
guaranties outstanding during the applicable calendar quarter to meet 
the dollar thresholds for registration.
    (d) In the Board's judgment a person who guarantees a loan, and 
thereby becomes liable for the amount of the loan in the event the 
borrower should default, is lending his credit to the borrower. In the 
circumstances described, such a lending of credit must be considered an 
``extension of credit'' under this part in order to prevent 
circumvention of the regulation's limitation on the amount of credit 
that can be extended on the security of margin stock.
    (e) Under Sec. 221.2, the term in the ordinary course of business 
means ``occurring or reasonably expected to occur in carrying out or 
furthering any business purpose. * * *'' In general, stock option plans 
are designed to provide a company's employees with a proprietary 
interest in the company in the form of ownership of the company's 
stock. Such plans increase the company's ability to attract and retain 
able personnel and, accordingly, promote the interest of the company 
and its stockholders, while at the same time providing the company's 
employees with additional incentive to work toward the company's future 
success. An arrangement whereby participating employees may finance the 
exercise of their options through an unsecured bank loan guaranteed by 
the company, thereby facilitating the employees' acquisition of company 
stock, is likewise designed to promote the company's interest and is, 
therefore, in furtherance of a business purpose.
    (f) For the reasons indicated, the Board concluded that under the 
circumstances described a guaranty by the corporation constitutes 
credit extended in the ordinary course of business under this part, 
that the corporation is required to register pursuant to Sec. 221.3(b), 
and that such guaranties may not be given in excess of

[[Page 2837]]

the maximum loan value of the collateral pledged to secure the 
guaranty.
    (g) Section 221.3(a)(3) provides that ``no lender may arrange for 
the extension or maintenance of any purpose credit, except upon the 
same terms and conditions on which the lender itself may extend or 
maintain purpose credit under this part''. Since the Board concluded 
that the giving of a guaranty by the corporation to secure the loan 
described above constitutes an extension of credit, and since the use 
of a guaranty in the manner described could not be effectuated without 
the concurrence of the bank involved, the Board further concluded that 
the bank took part in ``arranging'' for the extension of credit in 
excess of the maximum loan value of the margin stock pledged to secure 
the guaranties.


Sec. 221.119  Applicability of plan-lender provisions to financing of 
stock options and stock purchase rights qualified or restricted under 
Internal Revenue Code.

    (a) The Board has been asked whether the plan-lender provisions of 
Sec. 221.4(a) and (b) were intended to apply to the financing of stock 
options restricted or qualified under the Internal Revenue Code where 
such options or the option plan do not provide for such financing.
    (b) It is the Board's experience that in some nonqualified plans, 
particularly stock purchase plans, the credit arrangement is distinct 
from the plan. So long as the credit extended, and particularly, the 
character of the plan-lender, conforms with the requirements of the 
regulation, the fact that option and credit are provided for in 
separate documents is immaterial. It should be emphasized that the 
Board does not express any view on the preferability of qualified as 
opposed to nonqualified options; its role is merely to prevent 
excessive credit in this area.
    (c) Section 221.4(a) provides that a plan-lender may include a 
wholly-owned subsidiary of the issuer of the collateral (taking as a 
whole, corporate groups including subsidiaries and affiliates). This 
clarifies the Board's intent that, to qualify for special treatment 
under that section, the lender must stand in a special employer-
employee relationship with the borrower, and a special relationship of 
issuer with regard to the collateral. The fact that the Board, for 
convenience and practical reasons, permitted the employing corporation 
to act through a subsidiary or other entity should not be interpreted 
to mean the Board intended the lender to be other than an entity whose 
overriding interests were coextensive with the issuer. An independent 
corporation, with independent interests was never intended, regardless 
of form, to be at the base of exempt stock-plan lending.


Sec. 221.120  Allocation of stock collateral to purpose and nonpurpose 
credits to same customer.

    (a) A bank proposes to extend two credits (Credits A and B) to its 
customer. Although the two credits are proposed to be extended at the 
same time, each would be evidenced by a separate agreement. Credit A 
would be extended for the purpose of providing the customer with 
working capital (nonpurpose credit), collateralized by margin stock. 
Credit B would be extended for the purpose of purchasing or carrying 
margin stock (purpose credit), without collateral or on collateral 
other than stock.
    (b) This part allows a bank to extend purpose and nonpurpose 
credits simultaneously or successively to the same customer. This rule 
is expressed in Sec. 221.3(d)(4) which provides in substance that for 
any nonpurpose credit to the same customer, the lender shall in good 
faith require as much collateral not already identified to the 
customer's purpose credit as the lender would require if it held 
neither the purpose loan nor the identified collateral. This rule in 
Sec. 221.3(d)(4) also takes into account that the lender would not 
necessarily be required to hold collateral for the nonpurpose credit 
if, consistent with good faith banking practices, it would normally 
make this kind of nonpurpose loan without collateral.
    (c) The Board views Sec. 221.3(d)(4), when read in conjunction with 
Sec. 221.3(c) and (f), as requiring that whenever a lender extends two 
credits to the same customer, one a purpose credit and the other 
nonpurpose, any margin stock collateral must first be identified with 
and attributed to the purpose loan by taking into account the maximum 
loan value of such collateral as prescribed in Sec. 221.7 (the 
Supplement).
    (d) The Board is further of the opinion that under the foregoing 
circumstances Credit B would be indirectly secured by stock, despite 
the fact that there would be separate loan agreements for both credits. 
This conclusion flows from the circumstance that the lender would hold 
in its possession stock collateral to which it would have access with 
respect to Credit B, despite any ostensible allocation of such 
collateral to Credit A.


Sec. 221.121  Extension of credit in certain stock option and stock 
purchase plans.

    Questions have been raised as to whether certain stock option and 
stock purchase plans involve extensions of credit subject to this part 
when the participant is free to cancel his participation at any time 
prior to full payment, but in the event of cancellation the participant 
remains liable for damages. It thus appears that the participant has 
the opportunity to gain and bears the risk of loss from the time the 
transaction is executed and payment is deferred. In some cases brought 
to the Board's attention damages are related to the market price of the 
stock, but in others, there may be no such relationship. In either of 
these circumstances, it is the Board's view that such plans involve 
extensions of credit. Accordingly, where the security being purchased 
is a margin security and the credit is secured, directly or indirectly, 
by any margin security, the creditor must register and the credit must 
conform with either the regular margin requirements of Sec. 221.3(a) or 
the special ``plan-lender'' provisions set forth in Sec. 221.4, 
whichever is applicable. This assumes, of course, that the amount of 
credit extended is such that the creditor is subject to the 
registration requirements of Sec. 221.3(b).


Sec. 221.122  Applicability of margin requirements to credit in 
connection with Insurance Premium Funding Programs.

    (a) The Board has been asked numerous questions regarding purpose 
credit in connection with insurance premium funding programs. The 
inquiries are included in a set of guidelines in the format of 
questions and answers. (The guidelines are available pursuant to the 
Board's Rules Regarding Availability of Information, 12 CFR part 261.) 
A glossary of terms customarily used in connection with insurance 
premium funding credit activities is included in the guidelines. Under 
a typical insurance premium funding program, a borrower acquires mutual 
fund shares for cash, or takes fund shares which he already owns, and 
then uses the loan value (currently 50 percent as set by the Board) to 
buy insurance. Usually, a funding company (the issuer) will sell both 
the fund shares and the insurance through either independent broker/
dealers or subsidiaries or affiliates of the issuer. A typical plan may 
run for 10 or 15 years with annual insurance premiums due. To 
illustrate, assuming an annual insurance premium of $300, the 
participant is required to put up mutual fund shares equivalent to 250 
percent of the premium or $600 ($600 x 50 percent

[[Page 2838]]

loan value equals $300 the amount of the insurance premium which is 
also the amount of the credit extended).
    (b) The guidelines referenced in paragraph (a) of this section 
also:
    (1) Clarify an earlier 1969 Board interpretation to show that the 
public offering price of mutual fund shares (which includes the front 
load, or sales commission) may be used as a measure of their current 
market value when the shares serve as collateral on a purpose credit 
throughout the day of the purchase of the fund shares; and
    (2) Relax a 1965 Board position in connection with accepting 
purpose statements by mail.
    (c) It is the Board's view that when it is clearly established that 
a purpose statement supports a purpose credit then such statement 
executed by the borrower may be accepted by mail, provided it is 
received and also executed by the lender before the credit is extended.


Sec. 221.123  Combined credit for exercising employee stock options and 
paying income taxes incurred as a result of such exercise.

    (a) Section 221.4(a) and (b), which provides special treatment for 
credit extended under employee stock option plans, was designed to 
encourage their use in recognition of their value in giving an employee 
a proprietary interest in the business. Taking a position that might 
discourage the exercise of options because of tax complications would 
conflict with the purpose of Sec. 221.4(a) and (b).
    (b) Accordingly, the Board has concluded that the combined loans 
for the exercise of the option and the payment of the taxes in 
connection therewith under plans complying with Sec. 221.4(a)(2) may be 
regarded as purpose credit within the meaning of Sec. 221.2.


Sec. 221.124  Purchase of debt securities to finance corporate 
takeovers.

    (a) Petitions have been filed with the Board raising questions as 
to whether the margin requirements in this part apply to two types of 
corporate acquisitions in which debt securities are issued to finance 
the acquisition of margin stock of a target company.
    (b) In the first situation, the acquiring company, Company A, 
controls a shell corporation that would make a tender offer for the 
stock of Company B, which is margin stock (as defined in Sec. 221.2). 
The shell corporation has virtually no operations, has no significant 
business function other than to acquire and hold the stock of Company 
B, and has substantially no assets other than the margin stock to be 
acquired. To finance the tender offer, the shell corporation would 
issue debt securities which, by their terms, would be unsecured. If the 
tender offer is successful, the shell corporation would seek to merge 
with Company B. However, the tender offer seeks to acquire fewer shares 
of Company B than is necessary under state law to effect a short form 
merger with Company B, which could be consummated without the approval 
of shareholders or the board of directors of Company B.
    (c) The purchase of the debt securities issued by the shell 
corporation to finance the acquisition clearly involves purpose credit 
(as defined in Sec. 221.2). In addition, such debt securities would be 
purchased only by sophisticated investors in very large minimum 
denominations, so that the purchasers may be lenders for purposes of 
this part. See Sec. 221.3(b). Since the debt securities contain no 
direct security agreement involving the margin stock, applicability of 
the lending restrictions of this part turns on whether the arrangement 
constitutes an extension of credit that is secured indirectly by margin 
stock.
    (d) As the Board has recognized, indirect security can encompass a 
wide variety of arrangements between lenders and borrowers with respect 
to margin stock collateral that serve to protect the lenders' interest 
in assuring that a credit is repaid where the lenders do not have a 
conventional direct security interest in the collateral. See 
Sec. 221.124. However, credit is not ``indirectly secured'' by margin 
stock if the lender in good faith has not relied on the margin stock as 
collateral extending or maintaining credit. See Sec. 221.2.
    (e) The Board is of the view that, in the situation described in 
paragraph (b) of this section, the debt securities would be presumed to 
be indirectly secured by the margin stock to be acquired by the shell 
acquisition vehicle. The staff has previously expressed the view that 
nominally unsecured credit extended to an investment company, a 
substantial portion of whose assets consist of margin stock, is 
indirectly secured by the margin stock. See Federal Reserve Regulatory 
Service 5-917.12. (See 12 CFR 261.10(f) for information on how to 
obtain Board publications.) This opinion notes that the investment 
company has substantially no assets other than margin stock to support 
indebtedness and thus credit could not be extended to such a company in 
good faith without reliance on the margin stock as collateral.
    (f) The Board believes that this rationale applies to the debt 
securities issued by the shell corporation described in paragraph (b) 
of this section. At the time the debt securities are issued, the shell 
corporation has substantially no assets to support the credit other 
than the margin stock that it has acquired or intends to acquire and 
has no significant business function other than to hold the stock of 
the target company in order to facilitate the acquisition. Moreover, it 
is possible that the shell may hold the margin stock for a significant 
and indefinite period of time, if defensive measures by the target 
prevent consummation of the acquisition. Because of the difficulty in 
predicting the outcome of a contested takeover at the time that credit 
is committed to the shell corporation, the Board believes that the 
purchasers of the debt securities could not, in good faith, lend 
without reliance on the margin stock as collateral. The presumption 
that the debt securities are indirectly secured by margin stock would 
not apply if there is specific evidence that lenders could in good 
faith rely on assets other than margin stock as collateral, such as a 
guaranty of the debt securities by the shell corporation's parent 
company or another company that has substantial non-margin stock assets 
or cash flow. This presumption would also not apply if there is a 
merger agreement between the acquiring and target companies entered 
into at the time the commitment is made to purchase the debt securities 
or in any event before loan funds are advanced. In addition, the 
presumption would not apply if the obligation of the purchasers of the 
debt securities to advance funds to the shell corporation is contingent 
on the shell's acquisition of the minimum number of shares necessary 
under applicable state law to effect a merger between the acquiring and 
target companies without the approval of either the shareholders or 
directors of the target company. In these two situations where the 
merger will take place promptly, the Board believes the lenders could 
reasonably be presumed to be relying on the assets of the target for 
repayment.
    (g) In addition, the Board is of the view that the debt securities 
described in paragraph (b) of this section are indirectly secured by 
margin stock because there is a practical restriction on the ability of 
the shell corporation to dispose of the margin stock of the target 
company. Indirectly secured is defined in Sec. 221.2 to include any 
arrangement under which the customer's right or ability to sell, 
pledge, or otherwise dispose of margin stock owned by the customer is 
in any way restricted while the credit remains outstanding. The 
purchasers of the debt securities issued by a shell corporation to 
finance a

[[Page 2839]]

takeover attempt clearly understand that the shell corporation intends 
to acquire the margin stock of the target company in order to effect 
the acquisition of that company. This understanding represents a 
practical restriction on the ability of the shell corporation to 
dispose of the target's margin stock and to acquire other assets with 
the proceeds of the credit.
    (h) In the second situation, Company C, an operating company with 
substantial assets or cash flow, seeks to acquire Company D, which is 
significantly larger than Company C. Company C establishes a shell 
corporation that together with Company C makes a tender offer for the 
shares of Company D, which is margin stock. To finance the tender 
offer, the shell corporation would obtain a bank loan that complies 
with the margin lending restrictions of this part and Company C would 
issue debt securities that would not be directly secured by any margin 
stock. The Board is of the opinion that these debt securities should 
not be presumed to be indirectly secured by the margin stock of Company 
D, since, as an operating business, Company C has substantial assets or 
cash flow without regard to the margin stock of Company D. Any 
presumption would not be appropriate because the purchasers of the debt 
securities may be relying on assets other than margin stock of Company 
D for repayment of the credit.


Sec. 221.125  Credit to brokers and dealers.

    (a) The National Securities Markets Improvement Act of 1996 (Pub. 
L. 104-290, 110 Stat. 3416) restricts the Board's margin authority by 
repealing section 8(a) of the Securities Exchange Act of 1934 (the 
Exchange Act) and amending section 7 of the Exchange Act (15 U.S.C. 
78g) to exclude the borrowing by a member of a national securities 
exchange or a registered broker or dealer ``a substantial portion of 
whose business consists of transactions with persons other than brokers 
or dealers'' and borrowing by a member of a national securities 
exchange or a registered broker or dealer to finance its activities as 
a market maker or an underwriter. Notwithstanding this exclusion, the 
Board may impose such rules and regulations if it determines they are 
``necessary or appropriate in the public interest or for the protection 
of investors.''
    (b) The Board has not found that it is necessary or appropriate in 
the public interest or for the protection of investors to impose rules 
and regulations regarding loans to brokers and dealers covered by the 
National Securities Markets Improvement Act of 1996.

PART 224--BORROWERS OF SECURITIES CREDIT (REGULATION X)

    7. The authority citation for part 224 is revised to read as 
follows:

    Authority: 15 U.S.C. 78g.


Sec. 224.1  [Amended]

    8. Section 224.1 is amended as follows:
    a. Remove ``G,'' and ``207,'' from the last sentence in paragraph 
(a).
    b. Remove ``G,'' from paragraph (b)(1).


Sec. 224.2  [Amended]

    9. Section 224.2 is amended by removing ``G,'' from the 
introductory text.
    10. Section 224.3 is revised to read as follows:


Sec. 224.3  Margin regulations to be applied by nonexempted borrowers.

    (a) Credit transactions outside the United States. No borrower 
shall obtain purpose credit from outside the United States unless it 
conforms to the following margin regulations:
    (1) Regulation T (12 CFR part 220) if the credit is obtained from a 
foreign branch of a broker-dealer;
    (2) Regulation U (12 CFR part 221), as it applies to banks, if the 
credit is obtained from a foreign branch of a bank, except for the 
requirement of a purpose statement (12 CFR 221.3(c)(1)(i) and 
(c)(2)(i)); and
    (3) Regulation U (12 CFR part 221), as it applies to nonbank 
lenders, if the credit is obtained from any other lender outside the 
United States, except for the requirement of a purpose statement (12 
CFR 221.3(c)(1)(ii) and (c)(2)(ii)).
    (b) Credit transactions within the United States. Any borrower who 
willfully causes credit to be extended in contravention of Regulations 
T and U (12 CFR parts 220 and 221), and who, therefore, is not exempted 
by Sec. 224.1(b)(1), must conform the credit to the margin regulation 
that applies to the lender.

PART 265--RULES REGARDING DELEGATION OF AUTHORITY

    11. The authority citation for part 265 continues to read as 
follows:

    Authority: 12 U.S.C. 248(i) and (k).

    12. Section 265.11(f) is revised to read as follows:


Sec. 265.11  Functions delegated to Federal Reserve Banks.

* * * * *
    (f) Securities. To approve applications by a registered lender for 
termination of the registration under Sec. 221.3(b)(2) of Regulation U 
(12 CFR 221.3(b)(2)).
* * * * *
    By order of the Board of Governors of the Federal Reserve 
System, January 8, 1998.
William W. Wiles,
Secretary of the Board.
[FR Doc. 98-871 Filed 1-15-98; 8:45 am]
BILLING CODE 6210-01-P