Securities Credit Transactions; Borrowing by Brokers and Dealers

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.

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\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.

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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.

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\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).

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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.

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(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.

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\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.

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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.

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\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.

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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.

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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.

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\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.

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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.

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\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)).

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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.

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\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.

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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.

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\27\ ``Purpose credit'' is defined as credit for the purpose of

buying, carrying, or trading in securities.

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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.

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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.

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\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.

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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.

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

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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.

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\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.''

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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.

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\36\ An exception is provided for maintaining a special

memorandum account (SMA) with a margin account.

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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.

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\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.

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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.

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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.

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\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.

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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.''

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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.

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\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.

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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.

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\48\ 17 CFR 240.15c3-1.

\49\ See, 58 FR 44310; August 20, 1993.

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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

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\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.

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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.

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\51\ 12 CFR 220.126 and 12 CFR 221.123, reprinted in the Federal

Reserve Regulatory Service at 5-488.

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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.

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\52\ American style options are exercisable on any business day

until expiration. European style options may be exercised only at

expiration.

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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

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

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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.

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

Regulation T.

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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.

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

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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.

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\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.

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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.

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\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.

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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.

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\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).

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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

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\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'').

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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

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\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.

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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 w

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