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04-75 NASD Seeks Comment on Enhanced Disclosure for Subordination Agreements
REQUEST FOR COMMENT
Comment Period Expires November 26, 2004
Legal & Compliance
Appendix D to the Net Capital Rule
In 2002, NASD adopted a requirement that firms submitting subordination agreements to NASD staff for approval provide each investor with a Subordination Agreement Investor Disclosure Document (Disclosure Document), a signed copy of which must be provided to NASD staff before the agreement will be approved.1 The purpose of the Disclosure Document is to help investors understand what a subordination agreement is and what risks investors assume when they enter into such agreements.
While NASD continues to believe that the disclosures contained in the Disclosure Document help investors assess the general risks of subordination agreements, NASD is concerned that investors may still be entering into subordination agreements with firms without fully appreciating the specific risks that may be involved. Accordingly, NASD is seeking comment on a proposal to require firms to provide investors with detailed, specific disclosure focused on the firm and the particular loan before entering into a subordination agreement with an investor. These disclosures would augment the existing risk disclosures currently required to be provided by the firm to investors.
NASD encourages all interested parties to comment on the proposal. Comments must be received by November 26, 2004. Members and other interested persons can submit their comments using the following methods:
- Mailing comments in hard copy to the address below; or
- E-mailing comments to firstname.lastname@example.org.
To help NASD process and review comments more efficiently, persons commenting on this proposal should use only one method. Comments sent by hard copy should be mailed to:
Barbara Z. Sweeney
Office of the Corporate Secretary
1735 K Street, NW
Washington, DC 20006-1500
The only comments that will be considered are those submitted pursuant to the methods described above. All comments received in response to this Notice will be made available to the public on the NASD Web site. Generally, comments will be posted on the NASD Web site one week after the end of the comment period.2
Before becoming effective, a proposed rule change must be authorized for filing with the Securities and Exchange Commission (SEC) by the NASD Board, and then must be approved by the SEC, following publication for public comment in the Federal Register.3
Questions concerning this Notice may be directed to Gary L. Goldsholle, Associate Vice President and Associate General Counsel, Office of General Counsel, Regulatory Policy and Oversight (RPO), at (202) 728-8104; or Brant K. Brown, Counsel, Office of General Counsel, RPO, at (202) 728-6927.
Background and Discussion
At times, a broker-dealer may borrow funds or securities from investors to enhance the firm's net capital position. To receive benefit under the SEC's net capital rule (Rule 15c3-1), funds or securities loaned by an investor to a broker-dealer must be the subject of a satisfactory subordination agreement. The subordination agreement sets forth the rights and obligations of the lender (i.e., the investor) and the borrower (i.e., the broker-dealer), and it provides that any claims by the lender must be subordinate to claims by other parties, including customers and employees of the firm. Before a subordination agreement becomes effective for net capital purposes, it must be reviewed and approved by the broker-dealer's designated examining authority (DEA).4
SEC Rule 15c3-1d(a)(1) provides that NASD, as a DEA, may require that subordination agreements "include such other provisions as deemed necessary or appropriate to the extent such provisions do not cause the subordination agreement to fail to meet the requirements of [Appendix D to Rule 15c3-1]." In 2002, the SEC approved an NASD rule change that requires firms, before entering into any subordination agreement with an investor, to deliver the Disclosure Document to the investor and receive a signed copy affirming that the investor has read it.5 This rule became effective on July 15, 2002.
The Disclosure Document is intended to help investors understand what a subordination agreement is and what risks they assume when they enter into a subordination agreement. The Disclosure Document covers such topics as:
NASD is concerned that the general disclosures in the Disclosure Document alone may be insufficient to convey the specific risks of a particular subordination agreement and that, without some degree of detail about the specific subordination agreement and the broker-dealer firm, an investor is not able to assess accurately the appropriateness of the investment. Consequently, NASD is proposing that, in addition to the Disclosure Document, firms be required to provide an investor entering into a subordination agreement with specific, written disclosure concerning the proposed investment. Specifically, NASD is proposing to require firms to:
provide the investor with a detailed statement concerning the intended use of proceeds;
provide the investor with a detailed statement concerning the intended plan of financing;
disclose the amounts, types, interest rates, and scheduled maturity dates of debt to which the intended loan will be subordinate;
for any subordinated loans6 with outstanding balances, disclose the outstanding balances, interest rates, and scheduled maturity dates of such loans and the number of investors involved; and
provide the investor with a copy of the broker-dealer's most recent audited financial statement.
Firms would be required to provide these disclosures to the investor in writing before entering into any subordination agreement.7 To the extent that the information does not appear in the subordination agreement itself, the firm would be required to provide the investor with a separate, stand-alone document containing the required information. NASD believes that these firm-specific and loan-specific disclosures will provide investors with useful information that will aid them in determining whether subordination agreements are appropriate investments.8
NASD proposes to require each firm to include in its disclosure a detailed statement concerning the firm's intended use of the proceeds from the subordinated loans. NASD recognizes that lenders are precluded from placing restrictions on how the brokerdealer may use the proceeds from a subordinated loan, and the Disclosure Document includes disclosure to this effect. Nevertheless, at the time a firm solicits or receives a subordination agreement, it is likely to have an intended use for those proceeds, and that use should be disclosed. For example, the broker-dealer would be required to disclose whether it is pursuing the funds to satisfy an arbitration award (and, if so, a description of such award) or to pay salaries (and, if so, a description of the persons receiving the salaries and the amounts). In short, the firm would be required to disclose the reason it is pursuing the loan.
NASD also proposes to require firms to include in its disclosure a detailed plan of financing. This plan would include
NASD also proposes to require firms to disclose the amounts, types, interest rates, and scheduled maturity dates of debt to which the intended loan will be subordinate. NASD believes that this information is important for investors in determining whether a subordination agreement is an appropriate investment and that without this information it is difficult for investors to assess the merits and risks of the investment.
NASD also proposes to require firms to disclose, with respect to any subordinated loans with outstanding balances, the outstanding balances, interest rates, and scheduled maturity dates of those loans and the number of investors involved. NASD believes that it is important for investors to know about the broker-dealer's other outstanding subordinated loans and the current status of those loans to aid the investor in its determination of whether to loan funds or securities to the firm. Firms would be required to include only subordinated loans with outstanding balances at the time the investor enters into the subordination agreement.
NASD believes that firms should be required to provide an investor with a copy of the firm's most recent audited financial statement before entering into a subordination agreement with that investor.9 Because a subordination agreement is an investment in the broker-dealer firm, this requirement would provide the investor with a minimum amount of financial information about the firm before deciding whether to invest.
Request for Comment
NASD requests comment on the following questions:
In addition to the questions listed above, NASD is interested in any other issues that commenters may wish to address relating to the proposal.