[Federal Register Volume 63, Number 115 (Tuesday, June 16, 1998)]
[Proposed Rules]
[Pages 32766-32768]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-15934]


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Proposed Rules
                                                Federal Register
________________________________________________________________________

This section of the FEDERAL REGISTER contains notices to the public of 
the proposed issuance of rules and regulations. The purpose of these 
notices is to give interested persons an opportunity to participate in 
the rule making prior to the adoption of the final rules.

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Federal Register / Vol. 63, No. 115 / Tuesday, June 16, 1998 / 
Proposed Rules

[[Page 32766]]


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FEDERAL RESERVE SYSTEM

12 CFR Part 250

[Miscellaneous Interpretations; Docket R-1016]


Applicability of Section 23A of the Federal Reserve Act to Loans 
and Extensions of Credit Made by a Member Bank to a Third Party

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 direct investments, 
loans, or certain other transactions (covered transactions). Section 
23A deems transactions between a member bank and a nonaffiliated third 
party as covered transactions between the bank and its affiliate to the 
extent that proceeds of the transactions are used for the benefit of or 
transferred to the affiliate. The Board is proposing to grant two 
exemptions from section 23A for certain loans and extensions of credit 
made by an insured depository institution to customers that use the 
proceeds to purchase certain securities from or through the depository 
institution's registered broker-dealer affiliate. The first exemption 
would apply when the affiliate is acting solely as a broker or riskless 
principal in the securities transaction. The second exemption would 
apply when the extension of credit is made pursuant to a pre-existing 
line of credit that was not established for the purpose of buying 
securities from or through an affiliate. The Board proposes to grant 
these exemptions from section 23A to permit customers to gain more 
flexible use of the services of insured depository institutions and 
their registered broker-dealer affiliates, while still ensuring that 
the credit 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-1016, 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 section 261.12 of the Board's 
Rules Regarding Availability of Information.

FOR FURTHER INFORMATION CONTACT: Thomas M. Corsi, Senior Counsel (202/
452-3275), 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 for 
the Deaf (TDD), Diane Jenkins (202/452-3254).

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\ To achieve this purpose, section 23A establishes 
both quantitative limits and qualitative restrictions on transactions 
by a member bank with its affiliates. The statute places limits on 
``covered transactions'' between a member bank and any single affiliate 
to no more than 10 percent of the bank's capital and surplus and limits 
aggregate covered transactions with all affiliates to no more than 20 
percent of the bank's capital and surplus.\2\ Covered transactions 
include extensions of credit, investments, and certain other 
transactions that expose the member bank to risk. Section 23A also 
requires that credit exposures to an affiliate be secured by 
collateral, the amount of which is statutorily defined.\3\
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    \1\ 12 U.S.C. 371c. Although section 23A originally applied only 
to member banks, Congress has since applied the section to insured 
nonmember banks and savings associations in the same manner as it 
applies to member banks. See 12 U.S.C. 1828(j); 12 U.S.C. 1468.
    \2\ ``Capital and surplus'' has been defined by the Board as 
tier 1 and tier 2 capital plus the balance of an institution's 
allowance for loan and lease losses not included in tier 2 capital. 
12 CFR 250.242.
    \3\ 12 U.S.C. 371c(c).
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    In addition to regulating direct transactions between a bank and 
its affiliates, section 23A deems any transaction between a member bank 
and any person to be a transaction between a member bank and an 
affiliate to the extent that the proceeds of the transaction are ``used 
for the benefit of, or transferred to,'' that affiliate.\4\ This 
provision of the statute, commonly referred to as the ``attribution 
rule,'' is designed to prevent an evasion of the quantitative limits 
and collateral requirements of section 23A through the use of a third 
party that serves as a conduit for the flow of funds from the bank to 
its affiliates.\5\
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    \4\ 12 U.S.C. 371c(a)(2). Section 23A defines an affiliate to 
include ``any company that controls the member bank and any other 
company that is controlled by the company that controls the member 
bank.'' 12 U.S.C. 371c(b)(1).
    \5\ See A Discussion of Amendments to Section 23A of the Federal 
Reserve Act Proposed by the Board of Governors of the Federal 
Reserve System 36 n.1 (September 1981) (attached as an appendix to 
correspondence from Chairman Paul Volcker to the Chairman and 
Ranking Members of the House and Senate Committees on Banking, 
Housing and Urban Affairs, October 2, 1981).
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    Both the Board and Board staff have taken the position that, by 
means of the attribution rule, section 23A applies to loans made by a 
bank to a third party, where the proceeds of the loans are used to 
purchase various types of assets from the bank's affiliate.\6\ In 
transactions in which a bank provides funds to a borrower to finance 
the purchase of assets from an affiliate of the bank, the Board and its 
staff have been concerned that the affiliate's need for cash or need

[[Page 32767]]

to sell assets may improperly influence the bank's decision to extend 
credit.
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    \6\ See, e.g., Letter from J. Virgil Mattingly, General Counsel 
of the Board, to Ms. Charla Jackson (August 26, 1996) (crop-
production loan to farmer who leases farm land from a bank's 
affiliate is covered by section 23A); F.R.R.S. para. 3-1146.5 (bank 
loan to finance a prospective purchaser's acquisition of an 
affiliate covered by section 23A); F.R.R.S. para. 3-1167.3 (bank 
loan to finance the purchase of shares issued by an affiliate deemed 
a covered transaction subject to section 23A).
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    Section 23A also gives the Board broad authority to grant 
exemptions from the statute's restrictions. Specifically, the statute 
permits the Board to exempt transactions or relationships, by 
regulation or by order, if such exemptions are ``in the public interest 
and consistent with the purposes of this section.'' \7\
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    \7\ 12 U.S.C. 371c(e)(2).
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Section 20  Operating Standards and Application of Section 23A

    In August 1997, the Board revised the prudential limitations 
governing the activities of section 20 subsidiaries of bank holding 
companies and adopted Operating Standards to replace the existing 
firewalls.\8\ One of the firewalls had prohibited a bank holding 
company and its subsidiaries (other than the underwriting subsidiary) 
from knowingly extending credit to customers to purchase (a) a bank-
ineligible security underwritten by a section 20 subsidiary during the 
period of the underwriting or for 30 days thereafter, or (b) a bank-
ineligible security in which the section 20 subsidiary makes a market.
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    \8\ See 62 FR 45295, 45307 (1997) (codified at 12 CFR 225.200). 
Section 20 subsidiaries are companies that underwrite and deal in, 
to a limited extent, bank-ineligible securities. A bank-ineligible 
security is a security in which a member bank may not underwrite or 
deal.
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    In place of this firewall, the Board adopted Operating Standard # 
6, which prohibits a bank from knowingly extending credit to a customer 
to purchase bank-ineligible securities that a section 20 subsidiary is 
underwriting or has underwritten within the past 30 days. The Operating 
Standard, however, allows an extension of credit to be made by a bank 
to a customer to purchase securities from a section 20 affiliate during 
the underwriting period, pursuant to a pre-existing line of credit not 
entered into in contemplation of the purchase of affiliate-underwritten 
securities. Operating Standard #6 does not otherwise prohibit a bank 
from lending to a customer to purchase securities from a section 20 
affiliate.
    At the same time that it adopted the Operating Standards, the Board 
affirmed that section 23A would apply to the types of credit 
transactions that Operating Standard #6 does not prohibit to the extent 
that the proceeds of the transactions would be used for the benefit of, 
or transferred to, an affiliate. Several commenters on the Board's 
proposal to adopt the Operating Standards raised concerns about the 
compliance and economic burdens associated with applying section 23A to 
the extensions of credit now permitted under Operating Standard #6.\9\ 
The commenters argued that these burdens would cause banks to avoid 
making the types of loans permitted by the new Operating Standard, 
thereby minimizing the practical effect of eliminating the firewall. In 
response, the Board stated that it would consider whether an exemption 
from section 23A for those transactions to which the Operating Standard 
does not apply would be appropriate.
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    \9\ For example, commenters noted that a bank making a loan for 
the purchase of securities from its section 20 affiliate would need 
to monitor (1) whether the stocks being purchased by its customers 
were issues in which its section 20 affiliate was making a market, 
(2) the appropriate amount of collateral, (3) the length of time the 
collateral would need to be posted, and (4) whether there was room 
for the loan under the bank's section 23A quantitative limit on 
covered transactions.
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Proposal

    The Board is proposing to grant two exemptions from the 
quantitative limitations and collateral restrictions of section 23A for 
certain loans and extensions of credit made by an insured depository 
institution, the proceeds of which are used to buy securities from a 
registered broker-dealer affiliate of the depository institution. The 
first proposed exemption from section 23A would apply when an insured 
depository institution lends to its customers for the purpose of 
purchasing third-party securities through a registered broker-dealer 
affiliate that is acting solely as broker (but not as principal) in the 
securities transaction with the customer or as riskless principal in 
the transaction with the customer.\10\ In such circumstances, the 
customer would be purchasing securities through the depository 
institution's affiliated broker-dealer, which would be acting only on 
an agency or agency-equivalent basis, and the seller of the securities 
would be required to be a nonaffiliated third-party. The exemption 
would be applicable even if the broker-dealer affiliate of the insured 
depository institution retained part of the loan proceeds as a 
brokerage commission or, in the case of a riskless principal 
transaction, a mark-up for effecting the securities transaction.
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    \10\ ``Riskless principal'' is the term used in the securities 
business to refer to a transaction in which a broker-dealer, after 
receiving an order to buy (or sell) a security for a customer, 
purchases (or sells) the security for its own account to offset a 
contemporaneous sale to (or purchase from) the customer. A broker-
dealer acting as a riskless principal is not obligated to buy (or 
sell) a security for its customer until after the broker-dealer 
executes the offsetting purchase (or sale) for its own account. See, 
e.g., 12 CFR 225.28(b)(7)(ii); The Bank of New York Company, Inc., 
82 Fed. Res. Bull. 748 (1996). Accordingly, riskless principal 
transaction are an alternative means for executing buy or sell 
orders on behalf of customers in a manner equivalent to an agency 
transaction.
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    The second proposed exemption would apply to extensions of credit 
that are made pursuant to a pre-existing line of credit, the proceeds 
of which are used to purchase securities from or through an affiliate 
that is a registered-broker dealer. Under the proposed exemption, the 
extensions of credit must be made by an insured depository institution 
pursuant to a pre-existing line of credit that (1) was not entered into 
in contemplation of the purchase of securities from or through an 
affiliate, and (2) is either unrestricted or the extension of credit is 
clearly consistent with any restrictions imposed. (For example, if the 
customer had a pre-existing line of credit limited to purchases of 
rated securities from an unaffiliated party, then the exemption would 
not apply to an extension of credit used to purchase unrated securities 
from or through an affiliate.) In determining whether the line of 
credit is truly pre-existing, examiners will consider the timing of the 
line of credit, the conditions imposed on the line of credit, and 
whether the line of credit has been used for purposes other than the 
purchase of securities from an affiliate.
    The Board believes that the two proposed exemptions from the 
restrictions of section 23A are consistent with the purposes of the 
Federal Reserve Act. The exemptions would pose minimal risk to insured 
depository institutions. Under the first exemption, there is negligible 
risk that loans made would be used as a source of funding from an 
insured depository institution to its affiliates. The exemption may be 
used only when the depository institution's broker-dealer affiliate 
acts as a broker or riskless principal in a securities transaction. 
Accordingly, the securities being sold through the registered broker-
dealer would not be carried in the inventory of the broker-dealer or an 
affiliate, and the loan proceeds, which would be initially transferred 
to the affiliate to purchase the securities, would be transferred in 
turn to the seller of the securities, which also would not be an 
affiliate of the insured depository institution.
    The second exemption also presents little opportunity for a 
depository institution to benefit its affiliates. In circumstances in 
which there is a pre-existing line of credit that has been established 
for a purpose other than buying securities from or through an 
affiliate, there is little risk that the

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depository institution either will be using a credit transaction to 
direct money to its affiliates in violation of section 23A or will ease 
its credit standards to benefit its affiliate.
    The Board also believes that the proposed exemptions from section 
23A are consistent with the public interest. The two exemptions would 
provide greater convenience to customers to gain more flexible use of 
the services of insured depository institutions and their registered 
broker-dealer affiliates, while still ensuring that the safety and 
soundness concerns of section 23A are met. In addition, the exemption 
that applies to pre-existing lines of credit would alleviate the 
compliance burdens associated with applying section 23A to extensions 
of credit that were not made in contemplation of a purchase of 
securities from a depository institution's section 20 affiliate.

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.). Many small bank holding companies do not have 
registered broker-dealer affiliates. Many small banking organizations, 
therefore, would not be affected by the proposed rule.
    In addition, the proposed rule would create an exemption from 
section 23A of the Federal Reserve Act for bank holding companies and 
insured depository institutions that have registered broker-dealer 
affiliates. Accordingly, the proposal may be expected to alleviate 
(rather than increase) compliance for affected small bank holding 
companies and their affiliates.

Paperwork Reduction Act

    The Board has determined that the proposed rules do 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 250.244 is added to read as follows:


Sec. 250.244  Exemption from section 23A of the Federal Reserve Act for 
certain loans and extensions of credit made by an insured depository 
institution to a third party to purchase securities from an affiliate.

    (a) Section 23A of the Federal Reserve Act (12 U.S.C. 371c) shall 
not apply to a loan or extension of credit by an insured depository 
institution to any person other than an affiliate if--
    (1) The terms of the loan or extension of credit are consistent 
with safe and sound banking practices; and
    (2) The proceeds of the loan or extension of credit are used to 
purchase securities through an affiliate that is a broker-dealer 
registered with the Securities and Exchange Commission, where
    (i) The affiliate is acting solely as broker (but not as principal) 
in the securities transaction or as riskless principal in the 
securities transaction; and
    (ii) The securities are not issued or sold by companies that are 
affiliates of the insured depository institution.
    (b) This grant of exemption is applicable to a loan or extension of 
credit even if a portion of the proceeds are used by a borrower to pay 
brokerage commissions or, in the case of riskless principal 
transactions, mark-ups to the affiliate.
    3. Section 250.245 is added to read as follows:


Sec. 250.245  Exemption from section 23A of the Federal Reserve Act for 
certain extensions of credit by an insured depository institution to a 
third party made pursuant to a pre-existing line of credit.

    Section 23A of the Federal Reserve Act (12 U.S.C. 371c) shall not 
apply to an extension of credit by an insured depository institution to 
any person other than an affiliate if--
    (a) The proceeds of the extension of credit are used to purchase 
securities from or through an affiliate that is a registered broker-
dealer; and
    (b) The extension of credit is made pursuant to, and consistent 
with any conditions imposed in, a pre-existing line of credit that was 
not established in contemplation of the purchase of securities from or 
through an affiliate.

    By order of the Board of Governors of the Federal Reserve 
System, June 10, 1998.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 98-15934 Filed 6-15-98; 8:45 am]
BILLING CODE 6210-01-P