New York State Banking Department
|To:||Deputy Superintendent Stone|
|CC:||Assistant Deputy Superintendent Cathcart|
Assistant Counsel Sullivan
|Date:||September 29, 2011|
Securities Lending - Conduit Lender
Whether a New York-chartered bank can function as a conduit lender in securities lending transactions?
Yes. The Bank has the authority to function as a conduit lender in the manner proposed.
Background:[---] ("the Bank") engages in securities lending activities with institutional customers forwhom it acts as securities custodian1 as well as with customers for whom the Bank is not the custodian. Under its securities lending program, the Bank has acted primarily on an agency basis.2 Generally, a customer with securities to lend appoints the Bank as its agent in order to find borrowers for the lending of the customer's securities. The Bank locates borrowers, assists in the delivery of the securities to a borrower, receives and administers the collateral for the customer and provides other administrative services such as marking the trade to market, making collateral calls and general recordkeeping.
The Bank proposes to offer a conduit lending program (the "Conduit Program").3 The Conduit Program would allow a customer to borrow securities from the Bank as its counterparty instead of borrowing such securities from a third party with the Bank only acting as an aqent.4 Under the Conduit Program, the Bank would borrow the desired securities as principal from a third party and then on-lend the same securities as principal to the Bank's borrowing customer. Upon expiration of the loan, the Bank's borrowing customer would return the borrowed securities to the Bank, and the Bank would release any applicable collateral to such customer. The Bank would immediately return the borrowed securities to the third-party lender, who would release the collateral that the Bank had posted.5The Conduit Program, as envisaged by the Bank, would entail the borrowing and lending of both debt and equity securities. When a conduit transaction involved the borrowing and lending of an equity security, the Bank anticipates that its borrower would typically deliver equity securities as collateral to secure its borrowing from the Bank, although cash and cash-equivalents would be acceptable collateral under the Conduit Program. The Bank might use this collateral or other more traditional collateral (e.g., cash or treasury securities) to secure its borrowing from the ultimate lender. Regardless of the type of security borrowed or collateral posted, the Bank would receive a fee based on a spread between the two lending rates. The Bank will not borrow any security from a third party unless the customer that had instigated the transaction had become legally obligated to borrow that security from the Bank.
The Bank will not hold itself out as a dealer or market-maker in securities and will structure its activities as a conduit lender so that the Bank will be excluded from the definition of "dealer" under Rule 3a5-3 under the Exchange Act.6 Therefore, the bank will be exempt from registration as a "dealer" under the Exchange Act. Moreover, the Bank will adopt certain measures to mitigate the risks associated with acting as a conduit lender, which measures are discussed more fully below.
New York Interpretations:
In 1984, the Banking Department issued an interpretive letter that a New York trust company7 could engage in lending securities on an agency basis on behalf of those of its customers for whom it acted as securities custodian.8 In 1991, the Department issued another interpretive letter (the "1991 Letter") to the effect that a limited purpose trust company9 could, under the "incidental powers" clause of Section 96.1 of the Banking Law,10 act as an intermediary principal in a securities lending transaction. The trust company would borrow securities from, and pledge collateral to, a customer for the purpose of obtaining such securities in order to on-lend them to a counterparty.11
This 1991 Letter, however, provides limited precedent for two reasons. First, although it characterized the trust company as acting as a "riskless principal," the 1991 Letter further recited that the agreement between the trust company and its customer would provide that:
"the Trust Company assumes no risk in the transaction other than to act in a traditional role as agent in a securities lending transaction, and the Trust Company will not be liable if the counter-party fails to return the securities."
In the classic riskless principal transaction, however, a bank or broker purchases a security from one counterparty in order to sell the same security to another in a contemporaneous ransaction.12 Accordingly, the bank or broker is fully obligated to each counterparty on the relevant leg of the transaction. The transaction is considered "riskless" to the bank or broker because its obligations to one counterparty are offset or matched by the obligations to the bank from the other.
Second, the 1991 Letter specified that U.S. government securities would be the subject of the securities lending transactions. Accordingly, the letter would not necessarily provide a precedent if the securities lent included securities in which a bank could not invest.
In 1992, the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") determined that "acting as 'conduit' or 'intermediary' in securities borrowing and lending" was an activity "closely related to banking," and therefore, permissible for a bank holding company or a non-bank subsidiary thereof.13
As the barriers between the securities and banking industries eroded, Congress enacted the Gramm-Leach-Bliley Act of 1999 (the "GLB Act")14 which repealed most of the separations that had been mandated by the Glass-Steagall Act.15 The GLB Act replaced the blanket exclusion for banks from the definitions of "broker" and "dealer" in the Exchange Act with a number of functional exceptions.
One of these exceptions permits a bank, without being considered a broker, to effect securities lending or borrowing transactions with or on behalf of customers as part of the bank's customary custodial, safekeeping and clearing activities.16 This exception technically applies only to a bank acting as a broker (i.e., as agent). Nevertheless, in 2002, the Securities and Exchange Commission (the "SEC") issued a proposed rule that would exclude a bank that was conducting securities lending transactions as a conduit lender (i.e., as principal) from the definition of dealer under the Exchange Act.17In a joint letter, the general counsels of the Federal banking agencies (the "Joint Letter") not only supported the proposed exception but urged that it be broadened.18 That letter asserted that the exceptions had been enacted in the GLB Act to protect "the traditional activities and customer relationships of banks." The Joint Letter stated:
"Congress recognized that custodial and safekeeping activities, including providing securities borrowing and lending services as agent, are part of the core business of banking. Securities lending activities are a natural outgrowth of, and are integrally related to, the traditional custody businesses of banks and banks historically have served as the primary intermediary between securities lenders and securities borrowers."
Moreover, the Joint Letter stated that the exemption is appropriate when a bank is acting as a conduit lender (i.e., as principal) and should apply whether or not the bank is acting as custodian when engaging in securities lending activities. In this regard, the Joint Letter was expressing the unanimous view of the Federal banking agencies.The SEC issued a final rule that excludes from the definition of "dealer" a bank that is acting as a conduit lender in securities lending transactions subject to certain conditions.19 Some of these conditions restrict the counterparties of a bank acting as a conduit lender to certain institutional investors. Those particular conditions address the issue of whether a bank should be exempt from registering as a dealer. They do not call into question a bank's power to act as conduit lender.20
In Interpretive Letter 1026 (April 27, 2005), the OCC determined that a national bank's acting as a conduit lender in a securities lending transaction was permissible under the "incidental powers" clause of 12 U.S.C. § 24 (Seventh).21 The OCC noted that acting as conduit lender was analogous to acting as a riskless principal.22 In the facts described in Interpretive Letter 1026, the national bank had represented that in a securities lending transaction that was initiated by a lender of securities, the bank would not borrow the securities from such lender until it had "a commitment from the ultimate borrower." This is consistent with the analogy to a bank's acting as a riskless principal. In a riskless principal transaction, a bank may not assume an obligation to sell a security to, or purchase a security from, one unless the bank has an offsetting order for the identical security from another party.
In Interpretive Letter 1026, the national bank proposed to serve those of its customers that wished to lend their securities but did not wish to lend such securities to the potential borrowers that had been identified by the bank. In such a case, the bank would offer to act as a conduit lender. If the lending customer were willing to lend securities to the bank, the bank would borrow the securities as principal from such lending customer. The bank would on-lend those securities as principal to a borrower to whom the lending customer did not want to lend directly.
In contrast, the Bank proposes to serve prospective borrowers. When the Bank receives a commitment from a customer to borrow securities, it would seek out prospective lenders. Then, the Bank would act as principal both to borrow the securities from the lender and to on-lend such securities to its customer.This distinction should not be determinative. The conduit lender's position as a lender/borrower is the same whether the transaction is initiated by a prospective borrower or prospective lender. Moreover, Interpretive Letter 1026 cited with approval Saban, the Joint Letter and the exemption from the definition of "dealer" in then Rule 15a-11. In Saban, the non-bank subsidiary was acting at the instigation of a borrower of securities. The Joint Letter did not distinguish between a bank's acting on behalf of the borrower or the lender. Similarly, the definition of "conduit lender" in Rule 3a5-3 does not make such a distinction.
Risk Mitigation:Matched Transactions:
The most salient risk mitigant devolves from the structure of the conduit lending transaction, itself. Each borrowing of securities by the Bank will be matched by its lending the same securities. The Bank's obligation to return the securities to the lender will be offset by the obligation of the borrower to return the securities. Each borrowing of securities will be matched by a lending of identical securities. The transactions will not be hedged on a "portfolio basis."
The Bank will not acquire an "equity" interest the securities. If the securities appreciate, the Bank will realize no gain. Instead, the dollar value of its obligation to the lender will increase, but this increase will be offset by an identical increase in the dollar value of the obligation of the borrower to the Bank. Conversely, if the securities depreciate, the dollar value of the Bank's obligation to the lender will decrease, but such decrease will be offset by an identical decrease in the obligation of the borrower to the Bank.
The obligations to return the securities (i.e., of the borrower to the Bank and of the Bank to the lender) will each be secured by collateral. Accordingly, if the borrower defaults the exposure of the Bank can be measured as the amount by which the value of the unreturned securities exceeds that of the collateral. To mitigate this risk, the collateral will be marked to market on a daily basis, and the Bank will be able to require additional collateral whenever the value of the collateral falls below that of the securities borrowed plus a margin of safety.
Conversely, the lender may fail to return the collateral posted by the Bank. To mitigate this risk, all transactions in the Conduit Program will be subject to a "delivery versus payment requirement" i.e., the borrowed securities will be returned in exchange for the collateral in a simultaneous transaction. Still if the transaction fails, the exposure of the Bank will be the amount by which the value of the collateral exceeds that of the borrowed securities. The Bank will address this exposure, which is essentially a credit exposure, by requiring that all prospective lenders be previously approved as participants in the Bank's agency lending program.One unusual aspect of the Conduit Program is that in many cases the Bank will accept equity securities as collateral from the borrower instead of requiring the more traditional cash or treasury securities. Apparently assuming a higher volatility in the price of equities, the Bank will impose a 150% collateral requirement when equity securities serve as collateral.23 This means that the Bank will require additional collateral whenever the value the collateral falls below 150% of the value of the securities lent.24
Other:The Bank will take a number of additional steps to manage risk in the Conduit Program. In this regard, the Bank will:
- Provide a price quote to each securities borrower prior to engaging in the lending transaction.
- Disclaim in its agreements that it is acting in a fiduciary capacity with respect to any party.
- Take appropriate steps to avoid entering transactions that exceed the Bank's capacity to process.
As noted above, Interpretive Letter 1026 relied on the "incidental powers" clause in the National Bank Act whose wording is identical to the "incidental powers" clause in Section 96.1 of the Banking Law. That portion of Section 96 was the basis for the Banking Department's determination in the 1991 Letter that a bank may act as an intermediary principal in a securities lending transaction.
There is no reason to read the 1991 Letter narrowly. A New York-chartered bank's authority is not limited to acting as a conduit lender with respect to only those securities in which such a bank may invest ("bank eligible" securities). The bank would not be investing in, or taking a speculative position in, the securities that it is borrowing and on-lending. Instead, it would be incurring credit exposure with respect to each counterparty.25 Therefore, the limitations applicable to a bank's investments are not relevant.
Moreover, the risk incurred by a bank as conduit lender is similar to that incurred when the bank is acting is agent. The obligation that the conduit lender owes to the lending counterparty is the same as that which a bank that is acting is agent owes when it provides an indemnity against the borrower's default." Further, a bank's obligation to return collateral to the borrower would give rise to an analogous risk. Accordingly, a bank acting as conduit lender may incur the obligation to return the borrowed securities to the lender and the relevant collateral to the borrower not Withstanding the possible default of the counterparty on the opposite side of the transaction.
This memorandum covers the legal capacity of the Bank to engage in conduit lending as proposed. It does not address whether the Bank has proposed sufficient measures from a standpoint of safety and soundness.
For example, the Bank has indicated that it will demand an unusually high margin requirement when the collateral posted is composed of equity securities. However, the adequacy of collateral is generally a business and not a legal issue. Similarly, while the Bank's disclaimer of fiduciary responsibility should be protective of the Bank, it is only one of a number of contractual provisions that the Bank might require.
- As custodian, the Bank provides safekeeping for the securities owned by its customers, as well as other administrative services related to the securities held.
- A New York-chartered bank has the ability to lend its own proprietary securities as principal. Memorandum dated October 15, 2009 from Assistant Counsel Sullivan to Deputy Counsel Notaro.
- Even when a bank conducts securities lending activities as agent, it may provide indemnities to its customers. Typically, the bank indemnifies the lender against a borrower's default -i.e., the borrower's failure to return the securities. Office of the Comptroller of the Currency (the "OCC") Handbook - Custody Services, p. 31 (January 2002).
- A bank that is acting as a "conduit lender," as defined by the SEC, is permitted at the termination of either the borrowing or lending leg of a conduit securities lending transaction to take up to one business day to replace the terminated leg. Rule 3a5-3(d)(1) under the Securities Exchange Act ("Exchange Act"), 17 C.F.R. § 240.3a5-3(d)(1), quoted at note 19, infra. A bank acting in this manner would incur an unmatched intra-day exposure. The Bank has not proposed to so act, and this memorandum does not address its ability to do so.
- 17 C.F.R. §240.3a5-3. The text of Rule 3a5-3 is set forth at note 19, infra.
- The Bank has been granted fiduciary powers, and therefore, is a trust company under the New York Banking Law. However, a bank without fiduciary powers may conduct securities lending activities as agent unless the bank is exercising investment discretion. Letter dated November 25, 1991 from Associate Attorney Salvatore A. Fiorella of the Banking Department to Peter Figdor of Marks, Murase & White.
- Letter dated September 17, 1984 from Deputy Superintendent and Counsel Derrick D. Cephas to Otto H. Chu, Senior Attorney, Mellon National Corporation. In the facts as stated in that letter, the lending customers would not only "determine to whom and on what terms they wished to lend ... securities" but also would directly arrange the transaction with the third-party borrower.
- Under the Banking Law, a limited purpose trust company has all the powers of a bank or trust company except that it may not take deposits or make loans.
- Section 96.1 of the Banking Law empowers a New York bank to "exercise all such incidental powers as shall be necessary to carry on the business of banking."
- Letter dated November 25, 1991, note 7, supra.
- The concept of riskless principal is defined at Rule 3a5-1 (b) under the Exchange Act, 17 C.F.R § 240.3a5-1 (b), which reads:
- Saban, S.A., 78 Fed. Res. Bull, 955 (Dec. 1992) ("Saban"). In Saban, a non-bank broker subsidiary of a bank holding company would act as a conduit lender. At the request of a third-party broker/dealer who wanted to borrow securities they were not available in the accounts of either the subsidiary or its customers, the subsidiary would seek out, and borrow the particular securities from, third-party non-customer lenders.
- Pub. L. 106-102, 113 Stat. 1338 (1999).
- Pub. L. 73-66, ch. 89, 48 Stat. 162 (1933).
- 16 Section 3(a)(4)(B)(viii)(I)(aa), (bb) and (cc) of the Exchange Act, 15 U.S.C. §78cla)(4)(B)(viii)(l)(aa), (bb) and (cc). as added by Section 201 of the GLB Act.
- Prop. Rule 15a-11, 67 Fed. Reg. 67496, 67507 (November 2, 2002).
- Letter of J. Virgil Mattingly, Jr., General Counsel, Federal Reserve Board; William F. Kroener, III, General Counsel, Federal Deposit Insurance Corporation; and Julie L. Williams, First Senior Deputy Comptroller and Chief Counsel, Office of the Comptroller of the Currency (the "OCC"), dated December 10, 2002 to Jonathan G, Katz, Secretary, SEC.
- The rule was issued as Rule 15a-11 under the Exchange Act, 17 C.F.R. § 240.15a-11. 68 Fed. Reg. 8686, 8701 (February 24, 2003). Subsequently, it was re-codified as Rule 3a5-3 under the Exchange Act, 17 C.F.R. § 240.3a5-3. 72 Fed. Reg. 56562, 56568 (October 3, 2007). The rule currently reads as follows:
"(a) A bank is exempt from the definition of the term "dealer" under section 3(a)(5) of the Act (15 U.S.C. 78c(a)(5)), to the extent that, as a conduit lender, it engages in or effects securities lending transactions, and any securities lending services in connection with such transactions, with or on behalf of a person the bank reasonably believes to be:
- A qualified investor as defined in section 3Ia)(54)(A) of the Act (15 U.S.C. 78c(a)(54)(A)); or
- Any employee benefit plan that owns and invests, on a discretionary basis, not less than $25,000,000 in investments.
(b) Securities lending transaction means a transaction in which the owner of a security lends the security temporarily to another party pursuant to a written securities lending agreement under which the lender retains the economic interests of an owner of such securities, and has the right to terminate the transaction and to recall the loaned securities on terms agreed by the parties.
- Although the Joint Letter had objected to such conditions, the SEC continues to assert "that the parameters of the exemption reflect banks' existing securities business." 72 Fed. Reg. at 56565.
- This portion of the National Bank Act grants national banks the power to exercise "all such incidental powers as shall be necessary to carryon the business of banking."
- The OCC did point out that a conduit lending transaction is of longer duration than the classic riskless principal transaction which entails a straight purchase and sale. On the hand, the OCC noted that risk to the conduit lender is mitigated because its exposure is collateralized. The SEC has also noted a difference in that "a conduit lender may on occasion substitute collateral on the securities borrowing side of the transaction while the original securities lending transaction remains outstanding." 67 Fed. Reg. at 67503 n. 55.
- The equity securities used as collateral under the Conduit Program will have to:
- In most cases, however, the Bank intends to post cash collateral for its own borrowings and anticipates that its own margin requirement will usually be a more customary 102%.
- Interpretive Letter 1026 n. 35.
- Note 4, supra.
(b) For purposes of this section, the term riskless principal transaction means a transaction in which, after having received an order to buy from a customer, the bank purchased the security from another person to offset a contemporaneous sale to such customer or, after having received an order to sell from a customer, the bank sold the security to another person to offset a contemporaneous purchase from such customer.
(c) Securities lending services means:
(1) Selecting and negotiating with a borrower and executing, or directing the execution of the loan with the borrower;
(2) Receiving, delivering, or directing the receipt or delivery of loaned securities;
(3) Receiving, delivering, or directing the receipt or delivery of collateral;(4) Providing mark-to-market, corporate action, recordkeeping or other services incidental to the administration of the securities lending transaction;
(5) Investing, or directing the investment of, cash collateral; or(6) Indemnifying the lender of securities with respect to various matters.
(d) For the purposes of this section, the term conduit lender means a bank that borrows or loans securities, as principal, for its own account, and contemporaneously loans or borrows the same securities, as principal, for its own account. A bank that qualifies under this definition as a conduit lender at the commencement of a transaction will continue to qualify, notwithstanding whether:
(1) The lending or borrowing transaction terminates and so long as the transaction is replaced within one business day by another lending or borrowing transaction involving the same securities; and
(2) Any substitutions of collateral occur."
1. Be components of the S&P 500 index;
2. Have a value of at least $5.00 per share;3. Be less than 10% of the daily trading volume of the issuer, and
4. Be subject to a concentration limit of less than a 25% per industry group.