[Federal Register: January 16, 1998 (Volume 63, Number 11)]
[Rules and Regulations]               
[Page 2805-2839]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr16ja98-17]


[[Page 2805]]

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Part III





Federal Reserve System





_______________________________________________________________________



12 CFR Parts 207, 220, 221, 224, and 265



Securities Credit Transactions; Borrowing by Brokers and Dealers; Final 
Rule

12 CFR Parts 207, 220, 221, 224, and 265

Securities Credit Transactions; Proposed Rule


[[Page 2806]]



FEDERAL RESERVE SYSTEM

12 CFR Parts 207, 220, 221, 224 and 265

[Regulations G, T, U and X; Docket Nos. R-0905, R-0923 and R-0944]

 
Securities Credit Transactions; Borrowing by Brokers and Dealers

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.<SUP>19</SUP> 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 
<SUP>20</SUP> 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.<SUP>21</SUP> 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.<SUP>22</SUP> At the 
same time, the Board proposed to grant good faith loan value to all 
non-equity securities.<SUP>23</SUP> 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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)).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \27\ ``Purpose credit'' is defined as credit for the purpose of 
buying, carrying, or trading in securities.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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 <SUP>29</SUP> and those 
transactions effected in the broker-dealer credit account pursuant to a 
``prime brokerage'' arrangement.<SUP>30</SUP> 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.<SUP>31</SUP> 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,<SUP>32</SUP> 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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

    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.
---------------------------------------------------------------------------

    \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.''
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \36\ An exception is provided for maintaining a special 
memorandum account (SMA) with a margin account.
---------------------------------------------------------------------------

    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 <SUP>37</SUP> and operate separate SMAs for each account.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 <SUP>38</SUP> were subject to the Board's 50 
percent margin requirement: <SUP>39</SUP> (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.<SUP>40</SUP>
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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.
---------------------------------------------------------------------------

    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.<SUP>41</SUP> This would 
cover all Nasdaq SmallCap stocks <SUP>42</SUP> 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.<SUP>43</SUP> 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.<SUP>44</SUP> The 
NASD has recently raised listing requirements for both the National 
Market and SmallCap tiers of the Nasdaq Stock Market.<SUP>45</SUP> 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.<SUP>46</SUP> 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.
---------------------------------------------------------------------------

    \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.''
---------------------------------------------------------------------------

    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.<SUP>47</SUP> The Board may 
revisit the issue of allowing credit on other equity securities at a 
later date.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.<SUP>48</SUP> 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.<SUP>49</SUP> 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.
---------------------------------------------------------------------------

    \48\ 17 CFR 240.15c3-1.
    \49\ See, 58 FR 44310; August 20, 1993.
---------------------------------------------------------------------------

    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.<SUP>50</SUP>
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.'' <SUP>51</SUP> 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.
---------------------------------------------------------------------------

    \51\ 12 CFR 220.126 and 12 CFR 221.123, reprinted in the Federal 
Reserve Regulatory Service at 5-488.
---------------------------------------------------------------------------

    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 <SUP>52</SUP> 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.
---------------------------------------------------------------------------

    \52\ American style options are exercisable on any business day 
until expiration. European style options may be exercised only at 
expiration.
---------------------------------------------------------------------------

    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.<SUP>53</SUP>
---------------------------------------------------------------------------

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

    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.<SUP>54</SUP> These provisions have been replaced 
with SRO rules and the Board is deleting the provisions from the 
revised Regulation T.
---------------------------------------------------------------------------

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

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. <SUP>55</SUP> 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.
---------------------------------------------------------------------------

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

    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 
<SUP>56</SUP> regarding the retirement of stock by an issuer and a 1990 
interpretation <SUP>57</SUP> regarding the application of the arranging 
provision <SUP>58</SUP> to broker-dealer activities under SEC Rule 
144A.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.<SUP>59</SUP> 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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. <SUP>60</SUP> In 1995, the Board proposed giving listed 
options 50 percent loan value at broker-dealers (under Regulation T) 
and banks (under Regulation U).<SUP>61</SUP> 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.<SUP>62</SUP> 
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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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.<SUP>63</SUP> 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.<SUP>64</SUP>
---------------------------------------------------------------------------

    \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'').
---------------------------------------------------------------------------

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.<SUP>65</SUP>
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.