[Federal Register Volume 67, Number 73 (Tuesday, April 16, 2002)]
[Notices]
[Pages 18661-18664]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-9193]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45721; File No. SR-NASD-2002-12]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment No. 1 Thereto by the National Association of 
Securities Dealers, Inc. Relating to the Establishment of a 
Subordination Agreement Investor Disclosure Document

April 10, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'' or ``Exchange Act''),\1\ and Rule 19b-4 thereunder,\2\ notice 
is hereby given that on January 17, 2002, the National Association of 
Securities Dealers, Inc. (``NASD'' or ``Association'') through its 
wholly owned subsidiary NASD Regulation, Inc. (``NASD Regulation'') 
filed with the Securities and Exchange Commission (``Commission'') the 
proposed rule change as described in Items I, II, and III below, which 
Items have been prepared by NASD Regulation. The Association filed 
Amendment No. 1 to the proposed rule change on March 21, 2002.\3\ The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On March 21, 2002, the Association filed, pursuant to Rule 
19b-4 of the Act, an amendment to its initial Form 19b-4, which made 
certain clarifications to the proposed disclosure document.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation has filed with the Commission a proposed rule 
change that would require, as part of a subordination agreement, the 
execution of a Subordination Agreement Investor Disclosure Document 
(``Disclosure Document''). The proposed form of the Disclocure Document 
is as follows:

SUBORDINATION AGREEMENT

INVESTOR DISCLOSURE DOCUMENT

    PLEASE READ THIS DOCUMENT CAREFULLY BEFORE DECIDING TO ENTER INTO A 
SUBORDINATION AGREEMENT WITH A BROKER/DEALER. SUBORDINATION AGREEMENTS 
ARE AN INVESTMENT. THESE INVESTMENTS CAN BE RISKY AND ARE NOT SUITABLE 
FOR ALL INVESTORS. AN INVESTOR SHOULD NEVER ENTER INTO A SUBORDINATION 
AGREEMENT WITH A BROKER/DEALER UNLESS HE/SHE CAN BEAR THE LOSS OF THE 
TOTAL INVESTMENT.
    Subordination agreements are complicated investments. A 
subordination agreement is a contract between a broker/dealer (the 
borrower) and a lender (the investor), pursuant to which the lender 
lends money and/or securities to the broker/dealer. The proceeds of 
this loan can be used by the broker/dealer almost entirely without 
restriction. The lender agrees that if the broker/dealer does not meet 
its contractual obligations, his/her claim against the broker/dealer 
will be subordinate to the claims of other parties, including claims 
for unpaid wages. Lenders may wish to seek legal advice before entering 
into a subordination agreement.

KEY RISKS

    All investors who enter into Subordination Agreements with broker/
dealers should be aware of the following key risks:
    Money or securities loaned under subordination agreements are not 
customer assets and are not subject to the protection of the Securities 
Investor Protection Corporation (SIPC). In other words, your investment 
in the broker/dealer is not covered by SIPC. Nor are subordination 
agreements generally covered by any private insurance policy held by 
the broker/dealer. Thus, if the broker/dealer defaults on the loan, the 
investor can lose all of his/her investment.
     The funds or securities lent to a broker/dealer under a 
subordination agreement can be used by the broker/dealer almost 
entirely without restriction.
     Subordination agreements cause the lender to be 
subordinate to other parties if the broker/dealer goes out of business. 
In other words, you, as an investor, would be paid after the other 
parties are paid, assuming the broker/dealer has any assets remaining.
     The NASD Regulation approval of subordination agreements 
is a regulatory function.
    It does not include an opinion regarding the viability or 
suitability of the investment. Therefore, NASD Regulation approval of a 
subordination agreement does not mean that NASD Regulation has passed 
judgment on the

[[Page 18662]]

soundness of the investment or its suitability as an investment for a 
particular investor.

SIPC COVERAGE

    Q. In general, what is SIPC coverage?
    A. SIPC is a non-profit, non-government, membership corporation 
created to protect customer funds and securities held by a broker/
dealer if the broker/dealer closes because of bankruptcy or other 
financial difficulties. SIPC defines customers as persons who have 
securities or cash on deposit with a SIPC member for the purpose of, or 
as a result of, securities transactions.
    Q. Is an investor who enters into a subordination agreement covered 
by SIPC?
    A. No. SIPC considers these agreements to be investments in the 
broker/dealer. Once a customer signs a Subordinated Loan Agreement 
(SLA) or Secured Demand Note Agreement (SDN), he or she is no longer 
considered a customer of the broker/dealer relative to this investment. 
(These agreements are explained in further detail below.) For example, 
Mr. Jones has an IRA rollover account and a separate investment account 
with a broker/dealer. Mr. Jones enters into a subordination agreement 
with the broker/dealer and uses the investment account as collateral. 
This action would cause Mr. Jones to lose SIPC coverage for the 
investment account but not for his IRA account. If Mr. Jones pledges 
physical shares (i.e., certificates) as collateral for his 
subordination agreement, as opposed to pledging an account, he will 
lose SIPC coverage for the shares pledged.

OTHER INSURANCE COVERAGE

    Q. If my broker/dealer tells me that the firm has Fidelity Bond 
Coverage, will this coverage insure my investment?
    A. Fidelity Bond Coverage provides limited protection that 
generally would not benefit a subordinated lender (investor) under an 
SLA or SDN. In addition, NASD Regulation is not aware of any other 
insurance product that will protect an investor in this situation. If a 
broker/dealer claims that an SLA or SDN is covered by any type of 
insurance, the investor should insist on receiving that representation 
in writing from the insurance company.

GENERAL INFORMATION ABOUT SUBORDINATION AGREEMENTS

    Q. Why would a broker/dealer ask an investor to enter into a 
subordination agreement?
    A. Subordination agreements add to the firm's capital and thereby 
strengthen the broker/dealer's financial condition.
    Q. What are the advantages and disadvantages for an investor to 
enter into a subordination agreement with a broker/dealer?
    A. An investor may be able to obtain a higher interest rate than 
from other investments. There are, however, key disadvantages. If the 
broker/dealer goes out of business, the investor's claims are 
subordinated to the claims of other parties, i.e., customer and 
creditor claims will be paid before investors' claims. Thus, the 
subordinated investor may or may not get his/her funds or securities 
back, depending on the financial condition of the broker/dealer. 
FINALLY, MONEY OR SECURITIES LOANED UNDER SUBORDINATION AGREEMENTS ARE 
NOT CUSTOMER ASSETS AND ARE NOT COVERED BY SIPC, OR IN GENERAL, ANY 
OTHER PRIVATE INSURANCE.
    Q. Per the Lender's Attestation, the broker/dealer is required to 
give the prospective lender copies of various financial documents, 
including a certified audit. Why is this necessary?
    A. A subordination agreement is an investment in the broker/dealer. 
Therefore, the investor, as a prospective lender, should assess the 
firm's financial condition to determine whether the loan makes good 
business sense. Financial documents can be complicated and the investor 
should consider consulting with an attorney or accountant.
    Q. Outside counsel can be expensive. What if my broker/dealer 
provides an attorney for me at its expense?
    A. It may not be desirable to use a broker/dealer's attorney to 
assist you in the transaction. To ensure independent, objective 
representation, an investor should retain his/her own attorney.
    Q. How many types of subordination agreements are there?
    A. In general, there are only two, the Subordinated Loan Agreement 
and the Secured Demand Note Agreement.

SUBORDINATED LOAN AGREEMENTS (SLA)

    Q. What is an SLA?
    A. If an investor lends cash to a broker/dealer, the investor will 
usually do this as part of an SLA. The SLA discloses the terms of the 
loan, including the identities of the broker/dealer and investor, the 
amount of the loan, the interest rate, and the date on which the loan 
is to be repaid.
    Q. Can the lender restrict the broker/dealer's use of the loan?
    A. No. Language in the SLA precludes the lender from placing 
restrictions on how the broker/dealer may use the funds. Therefore, 
lenders should not rely on side agreements with a broker/dealer that 
purport to limit the use of the loan proceeds. These agreements are 
inconsistent with the SLA and may not be enforceable.

SECURED DEMAND NOTE AGREEMENTS (SDN)

    Q. What is an SDN?
    A. An SDN is a promissory note, in which the lender agrees to give 
cash to the broker/dealer on demand during the term of the SDN. This 
``promissory note'' must be backed by collateral, generally the 
lender's securities. The lender retains his/her status as beneficial 
owner of the collateral, but the securities must be in the possession 
of the broker/dealer and registered in its name. As securities can 
fluctuate in value, the lender must give sufficient securities to the 
broker/dealer so that when the securities are discounted, the net value 
of the securities will be equal to or greater than the amount of the 
SDN. This ``discounting'' is required by regulation. The rate of the 
discount varies and can be as high as 30 percent in the event common 
stock is used as collateral.
    For example, assuming common stock is used as collateral, for every 
$1,000 of face amount of the SDN, the investor must give the broker/
dealer collateral that has a market value of at least $1,429. 
Therefore, collateral for a $15,000 SDN would require common stock that 
has a current market value of at least $21,435.
    Q. What happens to the securities that I pledge as collateral under 
an SDN?
    A. The investor gives up the right to sell or otherwise use 
the securities that have been pledged to the broker/dealer under an 
SDN. Once securities are pledged as collateral for an SDN, the broker/
dealer has exclusive use of the securities.
     The investor may exchange or substitute the securities 
that have been pledged to the broker/dealer with different securities, 
but the value of the new securities (after applying the appropriate 
discount) must be sufficient to collateralize the SDN.
     The broker/dealer may use them as collateral, i.e., the 
broker/dealer may borrow money from another party using the securities 
the investor has pledged as collateral under the SDN as collateral for 
the new loan.
     If the securities pledged as collateral decline in value 
so that their discounted value is less than the face amount of the SDN, 
the investor must deposit additional securities with the broker/dealer 
to keep the SDN at the

[[Page 18663]]

proper collateral level. If the investor does not give the broker/
dealer additional collateral, the broker/dealer may sell some or all of 
the investor's securities.
     If the broker/dealer makes a demand for cash under an SDN, 
and the investor does not provide the broker/dealer with the cash, the 
broker/dealer has discretion to sell some or all of the investor's 
collateral (or securities). The SDN gives the broker/dealer the 
discretion to choose which of the investor's collateral to sell.
     All securities pledged as collateral for the SDN, 
including excess collateral, are subordinated to the claims of the 
broker/dealer's customers and creditors. Thus, if the firm becomes 
insolvent, the investor's ability to retrieve his/her collateral may be 
at risk.

THE NASD REGULATION APPROVAL PROCESS

    Q. What is involved in the NASD Regulation approval process?
    A. NASD Regulation will review the subordination agreement to 
ensure that it meets all technical requirements of Appendix D of SEC 
Rule 15c3-1 and to verify and that the broker/dealer has actually 
received the investor's funds or securities. This review is done to 
enable the borrower broker/dealer to use the subordination agreement as 
part of its regulatory capital. As previously stated, NASD Regulation 
does not review subordination agreements to determine whether the 
investment is viable or suitable for the investor (lender). The 
investor must make this determination.
    By signing below, the investor attests to the fact that he/she has 
read this Subordination Agreement Investor Disclosure Document.
----------------------------------------------------------------------
Investor Name
----------------------------------------------------------------------
Investor Signature            Date

FOR NASD USE ONLY

Effective Date:
LOAN Number:
NASD ID Number:
Date Filed:

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD Regulation included 
statements concerning the purpose of and basis for the proposed rule 
change, as amended, and discussed any comments it received on the 
proposed rule change. The text of these statements may be examined at 
the places specified in Item IV below. NASD Regulation has prepared 
summaries, set forth in sections A, B, and C below, of the most 
significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

(1) Purpose
    In order to receive benefit under the Commission's net capital 
rule,\4\ funds or securities loaned by an investor to a broker-dealer 
must be the subject of a satisfactory subordination agreement. Rule 
15c3-1d under the Act \5\ sets forth the minimum and non-exclusive 
requirements for satisfactory subordination agreements. Rule 15c3-
1d(a)(1) \6\ also provides that the ``Examining Authority'' may require 
``such other provisions as deemed necessary or appropriate to the 
extent such provisions do not cause the subordination agreement to fail 
to meet the minimum requirements of [Exchange Act Rule 15c3-1d].'' 
Under Rule 15c3-1d(c)(6)(i),\7\ ``[n]o proposed agreement shall be a 
satisfactory subordination agreement for the purposes of this section 
unless and until the Examining Authority has found the agreement 
acceptable and such agreement has become effective in the form found 
acceptable.'' As an Examining Authority,\8\ NASD Regulation proposes a 
rule change that would require each of its members that is a ``lender'' 
under Rule 15c3-1d \9\ to execute a Disclosure Document as part of 
every subordination agreement. NASD Regulation states that the purpose 
of the Disclosure Document is to help lenders understand the risks 
associated with subordination agreements.
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    \4\ Rule 15c3-1 under the Act, 17 CFR 240.15c3-1.
    \5\ 17 CFR. 240.15c3-1d.
    \6\ 17 CFR. 240.15c3-1d(a)(1).
    \7\ 17 CFR. 240.15c3-1d(c)(6)(i).
    \8\ The term ``Examining Authority'' is defined in Rule 15c3-
1(d) under the Act. 17 CFR 240.15c3-1(d).
    \9\ The term ``lender'' is defined in Rule 15c3-1d(a)(2)(v)(f) 
under the Act. 17 CFR 240.15c3-1d(a)(2)(v)(f).
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    NASD Regulation states that it is concerned that an increasing 
number of retail investors may be entering into subordination 
agreements with broker-dealers without fully appreciating the risks or 
implications of such arrangements. For example, NASD Regulation notes 
that a number of investors in two recently failed firms found that 
entering into subordination agreements affected their rights to the 
protection of the Securities Investor Protection Corporation 
(``SIPC''). The proposed rule change would require members to make the 
Disclosure Document a part of the subordination agreement, and NASD 
Regulation staff would not consider a subordination agreement to be 
satisfactory under Rule 15c3-1d unless it includes a signed copy of the 
Disclosure Document.\10\ NASD Regulation states that it would advise 
Members of this requirement in the instructions for subordination 
agreements.
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    \10\ The NASD states that it issued a Notice to Members 
announcing this proposed rule change and urged its members that 
enter into subordination agreements to adopt immediately, as a 
``best practice,'' procedures to deliver the Disclosure Document to, 
and obtain a signed copy from, all lenders.
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    NASD Regulation believes that the proposed Disclosure Document 
outlines in ``plain English'' the risks to an investor of entering into 
a subordination agreement. The Disclosure Document first reviews the 
``key risks'' associated with subordination agreements and then, in 
question and answer form, provides the prospective investor with 
additional information to heighten his or her understanding of what it 
means to enter into a subordination agreement.
    NASD Regulation states that, among other things, the Disclosure 
Document explains that money or securities loaned under subordination 
agreements are no longer customer assets that are subject to the 
protection of SIPC or, generally, any other insurance. The Disclosure 
Document would also advise investors that once they invest in a broker-
dealer, they would have no say in how the broker-dealer uses the funds. 
In addition, it would advise investors that if they enter into a 
secured demand note agreement, the broker-dealer may borrow against any 
securities that are used to collateralize the note. It would further 
explain that if the broker-dealer closes because of bankruptcy or other 
financial difficulties, the claims of investors who have entered into 
subordination agreements are subordinate to the claims of other 
parties, including customers, creditors, and employees of the firm. 
Because NASD Regulation staff review of subordination agreements is 
merely to ensure that the terms of such agreements are consistent with 
the requirements of Rule 15c3-1d, the Disclosure Document would also 
advise prospective investors that they may wish to seek legal advice 
before entering into subordination agreements.
(2) Statutory Basis
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of sections 15A(b)(6) of

[[Page 18664]]

the Act,\11\ which requires, among other things, that the Association's 
rules must be designed to prevent fraudulent and manipulative acts and 
practices, to promote just and equitable principles of trade, and, in 
general, to protect investors and the public interest. NASD Regulation 
believes that the proposed rule change is designed to accomplish these 
ends by disclosing to investors certain key risks associated with 
subordination agreements.
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    \11\ 15 U.S.C. 78o-3(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received. The proposed 
rule change was not noticed for comment by the NASD through its Notice 
to Members process.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding, or (ii) as to 
which the Exchange consents, the Commission will:
    (A) by order approve such proposed rule change; or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609. Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Room. Copies of such 
filings will also be available for inspection and copying at the 
principal office of the Association. All submissions should refer to 
File No. SR-NASD-2002-12 and should be submitted by May 7, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\12\
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    \12\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Secretary.
[FR Doc. 02-9193 Filed 4-15-02; 8:45 am]
BILLING CODE 8010-01-P