TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
Federal Reserve examiners should be aware of recent
targeted examinations and investigations by the Federal Reserve
and the Enforcement Division of the Securities Exchange
Commission (SEC), as well as court actions, that have found banks
in violation of Regulation U (12 CFR 221) (Credit by Banks for
the Purpose of Purchasing or Carrying Margin Stock) in connection
with extensions of credit by bank trust departments, using bank
or other fiduciary funds, to individuals involved in illegal "day
trading" or "free-riding" schemes. These activities also
involved the aiding and abetting of violations of two other
securities credit regulations: Regulation T (12 CFR 220) (Credit
by Brokers and Dealers) and Regulation X (12 CFR 224) (Borrowers
of Securities Credit). Day trading and free-riding schemes
involve the purchase and sale of stock on the same day (or within
a very short period of time) and the funding of the purchases by
the sales' proceeds.
Because of the illegal activities described below,
banking organizations have been exposed to disciplinary
proceedings, as well as to substantial credit risk. To date,
several banks have sustained monetary losses in their trust
departments as a result of their involvement in these schemes.
In the late 1980's, the SEC started to uncover illegal
free-riding schemes and addressed them through injunctive actions
filed against broker-dealers and banks in federal district court.
In one case, SEC v. Hansen, et al., 726 F. Supp. 74 (S.D.N.Y.
1989), a bank was found to have violated Regulation U by
knowingly participating in a free-riding scheme. This was the
first case in which the SEC sued a bank for illegal securities
clearance activities associated with a free-riding scheme. It
appears that over the past several months these illegal schemes
have resurfaced. Investigations and examinations by SEC and
Federal Reserve staffs have detected similar violations by state
member and national banks' trust departments, leading to follow-up enforcement actions. Thus, increased vigilance by
Federal Reserve examiners is called for to ensure that state
member banks' trust departments, as well as bank holding
companies' nonbank subsidiaries and U.S. branches and agencies of
foreign banks that conduct trust-related activities, take all
steps necessary to prevent their customers from involving them in
the customers' attempts at free-riding. Prompt enforcement
action may be necessary to accomplish this in some situations.
Summary of Illegal Activities
The free-riding conduct in question typically involves
individuals trading large amounts of securities without
depositing the necessary money or appropriate collateral in their
customer accounts. The customer seeks to free-ride--that is,
purchase and sell the same securities and pay for the purchase
with the proceeds of the sale. Often, free-riding schemes
involve initial public offerings because broker-dealers are
prohibited from financing these new issues. If the money to pay
for the securities is not in the account when the securities are
delivered in a delivery-versus-payment or receive-versus-payment
(DVP) transaction, a bank or other financial institution that
permits completion of the transaction creates a temporary
overdraft in the customer's account. This overdraft is an
extension of credit that is subject to Regulation U.
The typical device used by the perpetrators of a free-riding scheme is for a new customer to open a custodial agency
account into which a number of broker-dealers will deliver
securities or funds on a DVP basis. Although a deposit may be
made into the custodial agency account, the amount of trading is
greatly in excess of the original deposit causing the bank to
extend its own credit to meet the payment and delivery
obligations of the account. Thus, while the financial
institution may be generating fees based on the activity of these
accounts, it is subjecting itself to substantial losses should
the market prices for the purchased securities fall or failed
transactions otherwise occur. In addition, other liabilities
under federal banking and securities laws may be involved.
Application of Securities Credit Regulations
Regulation U. Because there is no exemption in
Regulation U for trust activities in a bank or other financial
institution,1 any extension of credit in the course of settling
customer securities transactions must comply with all of the
provisions of Regulation U.2 This includes the requirement that
all extensions of credit that are secured by marginable stock be
within the 50 percent margin limit set by Regulation U.
To avoid violations of the Board's securities credit
regulations, the customer's account must hold sufficient funds on
settlement date to pay for each transaction and the funds may not
include the proceeds of their sale. If a financial institution
is relying on the proceeds of the sale of securities as its
source of payment for accepting delivery of the securities, Board
staff, the SEC, and the courts have viewed the institution as
extending credit secured by the securities to the customer.
Because Regulation U limits the amount of credit that can be
extended in these cases to 50 percent of the securities' current
market value if the securities qualify as margin stock and,
generally, in a free-riding scheme a customer's account does not
have funds to pay for all such purchases or a customer instructs
the institution to pay for the purchase of securities with the
proceeds from those securities' sale, a banking organization that
has extended credit in a free-riding scheme has violated
Regulation U.
Although the proscriptions of Regulation U apply only
to transactions in margin stock, free-riding in nonmargin stocks
in custodial agency accounts could, as described below, result in
aiding and abetting violations by the banking organization of
Regulations T and X, other securities laws, and raise financial
safety and soundness issues.
Regulations T and X. Because the custodial agency
accounts described above are used to settle transactions effected
by the customer at broker-dealers, a banking organization that
opens this type of account should have some general understanding
of how Regulation T restricts the customer's use of the account
at the institution. Regulation T requires the use of a cash
account for customer purchases or sales on a DVP basis.
Section 220.8(a) of Regulation T specifies that cash account
transactions are predicated on the customer's agreement that he
or she will make full cash payment for securities before selling
them and does not intend to sell them before making such payment.
Therefore, free-riding is prohibited in a cash account. A
customer who instructs his or her agent bank or other financial
institution to pay for a security in reliance on the proceeds of
its sale in a DVP transaction is causing, or aiding or abetting,
the broker-dealer to violate the credit restrictions of Regulation T. Regulation X, which generally prohibits borrowers
from willfully causing credit to be extended in contravention of
Regulations T or U, also applies to the customer in such cases.
As described above, banking organizations involved in
free-riding schemes may be aiding and abetting violations of
Regulation T by the broker-dealers delivering securities or funds
to the institutions' customers' accounts. As long as the bank or
other financial institution uses its funds to complete a
customer's transactions, the broker-dealers may not discover that
they are selling securities to the customer in violation of their
obligations under Regulation T. A similar aiding and abetting
violation of Regulation X could occur with respect to violations
by the customers who have used the financial institution to
induce their broker-dealers to violate Regulation T.
New Customer Inquiries and Warning Signals
Trust examiners, as well as commercial examiners,
should make sure that all banking organizations follow
appropriate written policies and procedures concerning the
establishment of custodial agency accounts or any new account
involving customer securities transactions. They should address,
among other things, ways an institution can protect against free-riding schemes. One of the ways financial institutions can
protect themselves is to obtain adequate background and credit
information from new clients, including whether the customer
intends to obtain bank credit to use the account for transactions
as if it were a margin account at a broker-dealer. This type of
activity requires more extensive monitoring than the typical DVP
account in which no credit is extended. It would be prudent to
inquire why a new customer is not utilizing the margin account
services of its broker-dealers. Regulation U Form FR U-1 must be
obtained and constantly updated if the account is to be used as a
margin account.
It also would be advisable for the financial
institution to obtain from the customer a list of broker-dealers
that will be sending securities to or receiving funds from the
account on a DVP basis. If it appears that a number of broker-dealers may be used on a DVP basis, the banking organization
should obtain an undertaking from the customer, as part of the
new account agreement, that all transactions with the broker-dealer will be in conformance with Regulations T and X and that
the customer is aware that a cash account security is not to be
sold until it is paid for. Similarly, in obtaining instructions
for settling DVP transactions for a customer, the institution
should clarify that it will not pay for the purchase of
securities with the proceeds from the sale of those securities.
Examiners should also ensure that banking organizations
monitor such accounts closely for an initial period to detect
patterns typical of free-riding, including intraday overdrafts,
and ensure that sufficient funds or margin collateral are on
deposit at all times. Frequent transactions in securities being
offered in an initial public offering may suggest an avoidance of
Regulations T and X. In the event it appears that a customer is
attempting to free-ride, an institution immediately should alert
the broker-dealers involved and take steps to minimize its own
credit risk and legal liability.
At a minimum, examiners should also evaluate a trust
institution's ability to ensure that it does not extend more
credit on behalf of the banking organization to a customer than
is permitted under Regulation U. Any overdraft related to a
purchase or sale of margin stock is an extension of credit
subject to the regulation, including overdrafts that are
outstanding for less than a day. Board staff has published a
number of opinions discussing the application of Regulation U to
various transactions relating to free-riding in the Federal
Reserve Regulatory Service. See, for example, Federal Reserve
Regulatory Service, at 5-942.2 (1992); 5-942.18 (1990); and 5-942.15 (1989).
SEC and Federal Reserve Sanctions and Enforcement Actions
As noted earlier, the SEC has exercised its broad
authority to enforce the Board's securities credit regulations.
This has included the initiation of several enforcement actions
in federal district court against banks involved in activities
similar to those outlined above, as well as the preparation of
other cases that are pending. In each completed case, the SEC
obtained permanent injunctions against future violations from the
banks involved. The SEC also required the banks to establish
credit compliance committees to formulate written policies and
procedures concerning the extension of purpose credit in their
securities clearance business, establish training programs for
bank personnel responsible for the conduct of their securities
clearance business and submit to outside audits to ascertain
whether the banks met their undertakings under the injunctions.
It should be noted that under recently revised
section 21 of the Securities Exchange Act of 1934, the SEC may,
and has stated an intention to, seek civil money penalties in
addition to federal district court injunctive actions. Civil
penalties and aiding and abetting liability may be assessed by
the SEC against a banking organization if the customer or its
broker-dealer is found in violation of Regulations X or T, and if
the financial institution has knowledge of the facts and assists
the scheme--that is, by extending credit to finance the free-riding.
In addition, the Board may institute enforcement
proceedings against the banking organizations supervised by the
Federal Reserve and their institution-affiliated parties involved
in these activities, including cease and desist, civil money
penalty assessment, and removal and permanent prohibition
actions.
Notification to State Member Banks
Reserve Bank staff should notify the state member
banks, bank holding companies, and the U.S. branches and agencies
of foreign banks in their Districts about the potential for
violations of the Board's Regulation U and other securities
credit regulations. A suggested notification letter is attached.
Please contact Scott Holz, Senior Attorney, or Angela Desmond, Senior Attorney, at (202) 452-2781, with any
questions concerning the Board's margin regulations and free-riding arrangements, and Herbert A. Biern, Deputy Associate
Director, at (202) 452-2620, for enforcement-related matters.
Deputy Director
ATTACHMENT TRANSMITTED ELECTRONICALLY BELOW
Dear ______________________:
State member banks, bank holding companies, and U.S.
branches and agencies of foreign banks should be aware of recent
targeted examinations and investigations by the Federal Reserve
and the Enforcement Division of the Securities Exchange
Commission (SEC), as well as court actions, that have found banks
in violation of Regulation U (12 CFR 221) (Credit by Banks for
the Purpose of Purchasing or Carrying Margin Stock) in connection
with extensions of credit by bank trust departments, using bank
or other fiduciary funds, to individuals involved in illegal "day
trading" or "free-riding" schemes. These activities also
involved the aiding and abetting of violations of two other
securities credit regulations: Regulation T (12 CFR 220) (Credit
by Brokers and Dealers) and Regulation X (12 CFR 224) (Borrowers
of Securities Credit). Day trading and free-riding schemes
involve the purchase and sale of stock on the same day (or within
a very short period of time) and the funding of the purchases by
the sales' proceeds.
Because of the illegal activities described below,
banks have been exposed to disciplinary proceedings, as well as
to substantial credit risk. To date, several banks have
sustained monetary losses in their trust departments as a result
of their involvement in these schemes.
In the late 1980's, the SEC started to uncover illegal
free-riding schemes and addressed them through injunctive actions
filed against broker-dealers and banks in federal district court.
In one case, SEC v. Hansen, et al., 726 F. Supp. 74 (S.D.N.Y.
1989), a bank was found to have violated Regulation U by
knowingly participating in a free-riding scheme. This was the
first case in which the SEC sued a bank for illegal securities
clearance activities associated with a free-riding scheme. It
appears that over the past several months these illegal schemes
have resurfaced. Investigations and examinations by SEC and
Federal Reserve staffs have detected similar violations by state
member and national banks' trust departments, leading to follow-up enforcement actions. Thus, increased vigilance by
banking organizations that conduct trust-related activities is
called for to ensure they take all steps necessary to prevent
their customers from involving them in the customers' attempts at
free-riding.
Summary of Illegal Activities
The free-riding conduct in question typically involves
individuals trading large amounts of securities without
depositing the necessary money or appropriate collateral in their
customer accounts. The customer seeks to free-ride--that is,
purchase and sell the same securities and pay for the purchase
with the proceeds of the sale. Often, free-riding schemes
involve initial public offerings because broker-dealers are
prohibited from financing these new issues. If the money to pay
for the securities is not in the account when the securities are
delivered in a delivery-versus-payment or receive-versus-payment
(DVP) transaction, a bank or other financial institution that
permits completion of the transaction creates a temporary
overdraft in the customer's account. This overdraft is an
extension of credit that is subject to Regulation U.
The typical device used by the perpetrators of a free-riding scheme is for a new customer to open a custodial agency
account into which a number of broker-dealers will deliver
securities or funds on a DVP basis. Although a deposit may be
made into the custodial agency account, the amount of trading is
greatly in excess of the original deposit causing the bank to
extend its own credit to meet the payment and delivery
obligations of the account. Thus, while the financial
institution may be generating fees based on the activity of these
accounts, it is subjecting itself to substantial losses should
the market prices for the purchased securities fall or failed
transactions otherwise occur. In addition, other liabilities
under federal banking and securities laws may be involved.
Application of Securities Credit Regulations
Regulation U. Because there is no exemption in
Regulation U for trust activities in a bank or other financial
institution,3 any extension of credit in the course of settling
customer securities transactions must comply with all of the
provisions of Regulation U.4 This includes the requirement that
all extensions of credit that are secured by marginable stock be
within the 50 percent margin limit set by Regulation U.
To avoid violations of the Board's securities credit
regulations, the customer's account must hold sufficient funds on
settlement date to pay for each transaction and the funds may not
include the proceeds of their sale. If a financial institution
is relying on the proceeds of the sale of securities as its
source of payment for accepting delivery of the securities, Board
staff, the SEC, and the courts have viewed the institution as
extending credit secured by the securities to the customer.
Because Regulation U limits the amount of credit that can be
extended in these cases to 50 percent of the securities' current
market value if the securities qualify as margin stock and,
generally, in a free-riding scheme a customer's account does not
have funds to pay for all such purchases or a customer instructs
the institution to pay for the purchase of securities with the
proceeds from those securities' sale, a banking organization that
has extended credit in a free-riding scheme has violated
Regulation U.
Although the proscriptions of Regulation U apply only
to transactions in margin stock, free-riding in nonmargin stocks
in custodial agency accounts could, as described below, result in
aiding and abetting violations by the banking organization of
Regulations T and X, other securities laws, and raise financial
safety and soundness issues.
Regulations T and X. Because the custodial agency
accounts described above are used to settle transactions effected
by the customer at broker-dealers, a banking organization that
opens this type of account should have some general understanding
of how Regulation T restricts the customer's use of the account
at the institution. Regulation T requires the use of a cash
account for customer purchases or sales on a DVP basis. Section
220.8(a) of Regulation T specifies that cash account transactions
are predicated on the customer's agreement that he or she will
make full cash payment for securities before selling them and
does not intend to sell them before making such payment.
Therefore, free-riding is prohibited in a cash account. A
customer who instructs his or her agent bank or other financial
institution to pay for a security in reliance on the proceeds of
its sale in a DVP transaction is causing, or aiding or abetting,
the broker-dealer to violate the credit restrictions of Regulation T. Regulation X, which generally prohibits borrowers
from willfully causing credit to be extended in contravention of
Regulations T or U, also applies to the customer in such cases.
As described above, banking organizations involved in
free-riding schemes may be aiding and abetting violations of
Regulation T by the broker-dealers delivering securities or funds
to the institutions' customers' accounts. As long as the bank
uses its funds to complete a customer's transactions, the broker-dealers may not discover that they are selling securities to the
customer in violation of their obligations under Regulation T. A
similar aiding and abetting violation of Regulation X could occur
with respect to violations by the customers who have used the
financial institution to induce their broker-dealers to violate
Regulation T.
New Customer Inquiries and Warning Signals
Banking organizations that conduct trust-related
activities should make sure that they follow appropriate written
policies and procedures concerning the establishment of custodial
agency accounts or any new account involving customer securities
transactions. They should address, among other things, ways a
bank can protect against free-riding schemes. One of the ways
banks can protect themselves is to obtain adequate background and
credit information from new clients, including whether the
customer intends to obtain bank credit to use the account for
transactions as if it were a margin account at a broker-dealer.
This type of activity requires more extensive monitoring than the
typical DVP account in which no credit is extended. It would be
prudent to inquire why a new customer is not utilizing the margin
account services of its broker-dealers. Regulation U Form FR U-1
must be obtained and constantly updated if the account is to be
used as a margin account.
It also would be advisable for the bank or bank holding
company subsidiary to obtain from the customer a list of broker-dealers that will be sending securities to or receiving funds
from the account on a DVP basis. If it appears that a number of
broker-dealers may be used on a DVP basis, the bank should obtain
an undertaking from the customer, as part of the new account
agreement, that all transactions with the broker-dealer will be
in conformance with Regulations T and X and that the customer is
aware that a cash account security is not to be sold until it is
paid for. Similarly, in obtaining instructions for settling DVP
transactions for a customer, the bank should clarify that it will
not pay for the purchase of securities with the proceeds from the
sale of those securities.
State member banks, bank holding companies, and U.S.
branches and agencies of foreign banks exercising trust powers
should also ensure that they monitor such accounts closely for an
initial period to detect patterns typical of free-riding,
including intraday overdrafts, and ensure that sufficient funds
or margin collateral are on deposit at all times. Frequent
transactions in securities being offered in an initial public
offering may suggest an avoidance of Regulations T and X. In the
event it appears that a customer is attempting to free-ride, a
banking organization immediately should alert the broker-dealers
involved and take steps to minimize its own credit risk and legal
liability.
At a minimum, you should also evaluate a trust
institution's ability to ensure that it does not extend more
credit on behalf of the banking organization to a customer than
is permitted under Regulation U. Any overdraft related to a
purchase or sale of margin stock is an extension of credit
subject to the regulation, including overdrafts that are
outstanding for less than a day. Board staff has published a
number of opinions discussing the application of Regulation U to
various transactions relating to free-riding in the Federal
Reserve Regulatory Service. See, for example, Federal Reserve
Regulatory Service, at 5-942.2 (1992); 5-942.18 (1990); and 5-942.15 (1989).
SEC and Federal Reserve Sanctions and Enforcement Actions
As noted earlier, the SEC has exercised its broad
authority to enforce the Board's securities credit regulations.
This has included the initiation of several enforcement actions
in federal district court against banks involved in activities
similar to those outlined above. In each case, the SEC obtained
permanent injunctions against future violations from the banks
involved. The SEC also required the banks to establish credit
compliance committees to formulate written policies and
procedures concerning the extension of purpose credit in their
securities clearance business, establish training programs for
bank personnel responsible for the conduct of their securities
clearance business and submit to outside audits to ascertain
whether the banks met their undertakings under the injunctions. It should be noted that under recently revised section 21 of the Securities Exchange Act of 1934, the SEC may, and has stated an intention to, seek civil money penalties in addition to federal district court injunctive actions. Civil penalties and aiding and abetting liability may be assessed by the SEC against a banking organization if the customer or its broker-dealer is found in violation of Regulations X or T, if the financial institution has knowledge of the facts and assists the scheme--that is, by extending credit to finance the free-riding.
In addition, we may institute enforcement proceedings
against banking organizations supervised by the Federal Reserve
and their institution-affiliated parties involved in these
activities, including cease and desist, civil money penalty
assessment, and removal and permanent prohibition actions.
In the event you have any questions concerning this
matter, please contact Scott Holz, Senior Attorney, or
Angela Desmond, Senior Attorney, at (202) 452-2781, at the Board
of Governors of the Federal Reserve System in Washington, D.C.,
or ________________________, at the Federal Reserve Bank of
_____________, at ________________.
Footnotes 1. The definition of the term "bank" for purposes of the regulation specifically includes institutions "exercising fiduciary powers." See 12 CFR 221.2(b), 15 U.S.C. 78(c)(a)(6), and Federal Reserve Regulatory Service at 5-795 (1946). Return to text 2. When used in discussing a bank's trust department, or any other type of financial institution exercising fiduciary powers, the term "extension of credit" includes overdrafts in settling customer's accounts that may be covered by advances from the banking organization, from other fiduciary customers, or from a combination of both. Return to text 3. The definition of the term "bank" for purposes of the regulation specifically includes institutions "exercising fiduciary powers." See 12 CFR 221.2(b), 15 U.S.C. 78(c)(a)(6), and Federal Reserve Regulatory Service at 5-795 (1946). Return to text 4. When used in discussing a bank's trust department, or any other type of financial institution exercising fiduciary powers, the term "extension of credit" includes overdrafts in settling customer's accounts that may be covered by advances from the banking organization, from other fiduciary customers, or from a combination of both. Return to text |
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