[Federal Register Volume 63, Number 115 (Tuesday, June 16, 1998)]
[Proposed Rules]
[Pages 32768-32770]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-15933]


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FEDERAL RESERVE SYSTEM

12 CFR Part 250

[Miscellaneous Interpretations; Docket R-1015]


Applicability of Section 23A of the Federal Reserve Act to the 
Purchase of Securities From Certain Affiliates

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice of proposed rulemaking.

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SUMMARY: Section 23A of the Federal Reserve Act restricts the ability 
of a member bank to fund its affiliates through asset purchases, loans, 
or certain other transactions (covered transactions). The Board is 
proposing to expand the types of asset purchases that are eligible for 
the exemption in section 23A(d)(6), which permits asset purchases where 
the assets have a readily identifiable and publicly available market 
quotation. This proposal would expand the ability of an insured 
depository institution to purchase securities from its registered 
broker-dealer affiliates, while still ensuring that the transactions 
are conducted in a manner that is consistent with safe and sound 
banking practices.

DATES: Comments must be submitted on or before July 21, 1998.

ADDRESSES: Comments, which should refer to Docket No. R-1015, may be 
mailed to Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, N.W., 
Washington, D.C. 20551. Comments addressed to Ms. Johnson also may be 
delivered to the Board's mail room between 8:45 a.m. and 5:15 p.m. and 
to the security control room outside of those hours. Both the mail room 
and the security control room are accessible from the courtyard 
entrance on 20th Street between Constitution Avenue and C Street, N.W. 
Comments may be inspected in Room MP-500 between 9:00 a.m. and 5:00 
p.m. weekdays, except as provided in Sec. 261.12 of the Board's Rules 
Regarding Availability of Information.

FOR FURTHER INFORMATION CONTACT: Pamela G. Nardolilli, Senior Counsel 
(202/452-3289) or Satish M. Kini, Senior Attorney (202/452-3818), Legal 
Division; or Molly S. Wassom, Deputy Associate Director, Banking 
Supervision and Regulation (202/452-2305), Board of Governors of the 
Federal Reserve System. For the hearing impaired only, 
Telecommunications Device of the Deaf (TDD), Diane Jenkins (202/452-
3254).


[[Page 32769]]



SUPPLEMENTARY INFORMATION:

Background

Restrictions of Section 23A

    Section 23A of the Federal Reserve Act, originally enacted as part 
of the Banking Act of 1933, is designed to prevent the misuse of a 
member bank's resources through ``non-arm's length'' transactions with 
its affiliates.1 Section 23A limits covered transactions 
between a member bank and its subsidiaries and an affiliate to 10 
percent of the institution's capital stock and surplus, and limits the 
aggregate amount of all transactions between a member bank and its 
subsidiaries and all of its affiliates to 20 percent of capital stock 
and surplus. The purchase of assets by a bank from its affiliates, 
including assets subject to repurchase, is included in the definition 
of covered transactions and is subject to the statute's quantitative 
limitation.
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    \1\ By its terms, section 23A only applies to member banks. The 
Federal Deposit Insurance Act extended the coverage of section 23A 
to all FDIC-insured nonmember banks. 12 U.S.C. 1828(j). The 
Financial Institutions Reform, Recovery, and Enforcement Act of 1989 
applies section 23A to FDIC-insured savings associations. 12 U.S.C. 
1468.
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    Section 23A also contains several exemptions from the statute's 
quantitative and collateral limitations. One exemption is contained in 
section 23A(d)(6), which exempts from the statute's quantitative 
limits, a purchase of an asset that has ``a readily identifiable and 
publicly available market quotation'' ((d)(6) exemption).2 
In addition, section 23A gives the Board broad authority to issue 
regulations and orders as may be necessary to administer and carry out 
the purposes of section 23A.3
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    \2\ 12 U.S.C. 371c(d)(6). Although such asset purchases are 
exempt from the quantitative restrictions of section 23A, the (d)(6) 
exemption requires the bank's purchase be consistent with safe and 
sound banking practices. 12 U.S.C. 371c(a)(4).
    \3\ 12 U.S.C. 371c(e)(1).
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    In the past, institutions have been advised that the (d)(6) 
exemption was available for the purchase of assets, the price of which 
were recorded in widely disseminated publications that were readily 
available to the general public. Such assets included obligations of 
the United States, securities traded on exchanges, foreign exchange, 
certain mutual share funds, and precious metals. Other marketable 
assets could not meet this standard, however.

Proposal

    The Board has received several requests from organizations 
(Petitioners) regarding the interpretation of the (d)(6) exemption. 
These requests were prompted, in part, by the Board's removal of the 
section 20 firewalls, which had prohibited many transactions between an 
insured depository institution and its affiliated section 20 
subsidiary. Several Petitioners have stated that, although the removal 
of the firewall was welcomed, section 23A continues to limit certain 
transactions with their section 20 subsidiaries. Petitioners argue that 
certain prohibited transactions do not raise significant safety and 
soundness issues and impedes the efficient operations of the insured 
depository institution and the section 20 affiliate. In particular, 
Petitioners were concerned about the ability of the insured depository 
institution to purchase securities under the (d)(6) exemption because 
of the narrow reading that had been imposed on the exemption, which 
prevented the purchase of otherwise marketable assets.
    In light of technological and market changes and to address 
concerns of the Petitioners, the Board is proposing to expand the kind 
of assets that may be eligible for the (d)(6) exemption to include 
other securities that, although not so widely traded as to warrant 
publication of their activity in publications of general circulation, 
are actively traded and whose price can be obtained from independent 
reliable sources, if the securities are purchased from a registered 
broker-dealer. The Board is proposing that this test can be met for 
certain assets that are treated as having a ``ready market,'' as 
defined by the Securities and Exchange Commission (SEC), and where such 
assets are purchased at publicly available market quotations from a 
registered broker-dealer.4
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    \4\ 17 CFR 240.15c3-1(c)(11)(i). The SEC defines a ready market 
as including a recognized established securities market in which 
there exists independent bona fide offers to buy and sell so that a 
price reasonably related to the last sales price or current bona 
fide competitive bid and offer quotations can be determined for a 
particular security almost instantaneously and where payment will be 
received in settlement of a sale at such price within a relatively 
short time conforming to trade custom.
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    This ``ready market'' definition ensures that a ready, competitive 
market exists for that asset. In addition, the marketability of the 
asset meets a standard already used by registered broker-dealers and 
that is monitored by the SEC. Under the SEC net capital requirements, a 
registered broker-dealer must deduct 100 percent of the carrying value 
of securities and certain other assets if there is not a ``ready 
market'' for the asset. The purpose of the ready market test is to 
identify securities with a liquid market to ensure that a broker-dealer 
can liquidate a security and receive its value. The type of securities 
that meet this definition include obligations of the United States, 
including agency-issued securities, as well as many asset-backed, 
corporate debt, and sovereign debt securities.
    In addition to meeting the ``ready market'' standard, the Board 
proposes that any security that is purchased as exempt under (d)(6) 
receive an investment grade rating from a nationally recognized 
statistical rating organization (NRSRO). Ratings that are stated by an 
NRSRO to be ``under review'' for a possible downgrade to below 
investment grade would not be viewed as ``investment grade for meeting 
this requirement.''
    In addition to requiring that a security have a ready market, the 
Board believes that the price of each security must be established from 
sources other than the purchasing bank and its affiliates. Thus, in 
addition to demonstrating that the security has a ready market and is 
rated by an NRSRO, the Board believes that the bank must be able to 
demonstrate that the price paid by the bank for the security was a 
competitive price that examiners can verify.
    Securities that meet the ``ready market'' standard may not always 
be verifiable through a widely disseminated news source, however. 
Accordingly, the Board proposes to allow alternative reliable pricing 
sources, such as electronic services from real-time financial networks 
that provide indicative data to determine that the price that the bank 
pays is on market terms. Such pricing services could be used to qualify 
a bank's purchase from a registered broker-dealer under the (d)(6) 
exemption so long as the bank is able to obtain a quote on the exact 
security it wishes to purchase. In the alternative, if a security was 
so thinly traded that a quote from a ``screen'' or other similar source 
was not available, the Board is proposing to adopt a standard that an 
insured depository institution could purchase the security as an exempt 
transaction if the insured depository institution obtained at least two 
actual independent dealer quotes for the particular security from 
unaffiliated registered broker-dealers, which must be based, in part, 
on the amount of the security that the bank proposes to purchase. The 
insured depository institution could purchase the security from the 
registered broker-dealer at a price no higher than the average of the 
prices obtained from the unaffiliated broker-dealers. To assist 
examiners in verifying the price paid, documentation for (d)(6) 
transactions must be maintained in the insured depository institution's 
file for five years.
    The Board's proposal would not allow, however, an insured 
depository

[[Page 32770]]

institution to purchase certain securities under the (d)(6) exemption 
even if the proposed criteria are met. The proposed interpretations 
would prohibit the purchase under the (d)(6) exemption of any 
securities issued by an affiliate, which would include the capital 
stock of an affiliate, asset-backed securities issued by an affiliate, 
of shares of mutual funds advised by the bank or an affiliate, unless 
those instruments are obligations of the United States or fully 
guaranteed by the United States or its agencies as to principal and 
interest. The Board believes that safety and soundness requires 
restrictions on an insured depository institution's ability to purchase 
an affiliate's securities to help prevent the unlimited funding of its 
affiliates, and the restriction is consistent with other provisions of 
section 23A, which limit the insured depository institution's ability 
to lend to an affiliate or accept the affiliate's securities as 
collateral.5
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    \5\ For example, if the restriction on the purchase of an 
affiliate's securities is not imposed, an insured depository 
institution could purchase the debt securities of an affiliate 
without limit, but a collateralized loan to the affiliate would be 
limited to 10 percent of the institution's capital and surplus.
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    In addition, bank-ineligible securities that are underwritten by an 
affiliate would not qualify for the (d)(6) exemption during the period 
of the underwriting or for 30 days thereafter. This restriction is 
similar to Operating Standard 6 that the Board has imposed on section 
20 subsidiaries, which prohibits an insured depository institution from 
extending credit to a customer secured by, or for the purpose of 
purchasing, any bank-ineligible security that a section 20 affiliate is 
underwriting or has underwritten within the past 30 days.6 
The Board believes that the market value of securities may be uncertain 
during the underwriting period and that the conflicts of interest that 
may arise during the underwriting period cause enough concern to 
require this limitation. Banks, of course, could continue to buy 
nonexempt securities from an affiliate subject to the quantitative 
limits of section 23A and could buy such securities from unaffiliated 
parties without any section 23A limit, so long as the purchase was 
otherwise authorized by law. In addition, this interpretation of (d)(6) 
does not interfere with the ability of an insured depository 
institution to purchase assets from affiliates other than the 
registered broker-dealer so long as the price of such assets are 
recorded in widely disseminated publications that are readily available 
to the general public.
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    \6 \Amendments to Restrictions in the Board's Section 20 Orders 
number 6, 62 F.R. 45295, 45307 (1997) (to be codified at 12 CFR 
225.200). A bank-ineligible security is a security that a member 
bank may not deal in or underwrite.
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    The Board understands that these criteria are more restrictive than 
the criteria proposed by some Petitioners in their request for the 
Board's review of the (d)(6) exemption. For example, it has been 
proposed that if the bank cannot obtain a quote on the exact security, 
the bank should be able to rely on quotes for ``comparable 
securities''--securities with the same rating and other similar 
characteristics--to determine the correct price and to permit the bank 
to exclude the purchase from its quantitative limits. The purchase of 
such securities, which would be without any type of quantitative limit 
if purchased as a (d)(6) exempt asset, would raise significant safety 
and soundness concerns, however, because it would be difficult for 
examiners to verify compliance with the (d)(6) exemption requirement 
that the price paid was determined by reference to a competitive market 
for the security.
    Although the Board believes that the expansion of the types of 
assets that are eligible for the (d)(6) exemption is warranted, the 
Board believes it is prudent to limit expansion at this time. The 
Board, as part of its review of the public comments on this proposal, 
will consider other suggested pricing mechanisms if such mechanisms can 
meet the statutory standards.

Regulatory Flexibility Act Analysis

    The Board certifies that adoption of this proposal is not expected 
to have a significant economic impact on a substantial number of small 
business entities within the meaning of the Regulatory Flexibility Act 
(5 U.S.C. 601 et seq.) because most small bank holding companies and 
insured depository institutions do not have registered broker-dealer 
affiliates. For this reason, small bank holding companies would not be 
affected by the proposed rule.
    In addition, the proposed rule would expand the type of 
transactions that an insured depository institution may engage in with 
its affiliate. Accordingly, the proposal does not impose more 
burdensome requirements on depository institutions, their holding 
companies, and their affiliates than are currently applicable.

Paperwork Reduction Act

    The Board has determined that the proposal does not involve the 
collection of information pursuant to the provisions of the Paperwork 
Reduction Act of 1995, 44 U.S.C. 3501 et seq.

List of Subjects in 12 CFR Part 250

    Federal Reserve System.

    For the reasons set forth in the preamble, the Board proposes to 
amend 12 CFR part 250 as follows:

PART 250--MISCELLANEOUS INTERPRETATIONS

    1. The authority citation for part 250 continues to read as 
follows:

    Authority: 12 U.S.C. 78, 248(i) and 371c(e).

    2. Section 250.246 is added to read as follows:


Sec. 250.246  Applicability of section 23A of the Federal Reserve Act 
to the purchase of securities by an insured depository institution.

    The purchase of securities by an insured depository institution 
from an affiliate that is a broker-dealer is exempt under section 
23A(d)(6) of the Federal Reserve Act (12 U.S.C. 317 c(d)(6)) if:
    (a) The broker-dealer is registered with the Securities and 
Exchange Commission;
    (b) The securities have a ``ready market,'' as defined by 17 CFR 
240.15c3-1(c)(11)(i);
    (c) The securities have received an investment grade rating from a 
nationally recognized statistical rating organization (NRSRO), and a 
NRSRO has not stated that the rating is under review for a possible 
downgrade to below investment grade;
    (d) The securities are not purchased during an underwriting or 
within 30 days of an underwriting if an affiliate is an underwriter of 
the security;
    (e) The price paid for the security can be verified by
    (1) A widely disseminated news source;
    (2) An electronic service that provides indicative data from real-
time financial networks; or
    (3) Two or more actual independent dealer quotes on the exact 
security to be purchased, where the price paid is no higher than the 
average of the price quotes obtained from the unaffiliated broker-
dealers;
    (f) The securities are not issued by an affiliate, unless the 
securities are obligations of the United States or fully guaranteed by 
the United States or its agencies as to principal and interest.

    By order of the Board of Governors of the Federal Reserve 
System, June 10, 1998.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 98-15933 Filed 6-15-98; 8:45 am]
BILLING CODE 6210-01-P