SEC Division of Investment Management staff letter: Seward & Kissel

Investment Company Act of 1940 - Section 3a-6 Seward & Kissel

October 12, 2005

Response of the Office of Chief Counsel Division of Investment Management

Our Ref. No. 2003822141 Seward & Kissel File No. 132-3

Your letter dated October 12, 2005 requests that we concur with your view that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit, and accepting demand and other types of deposits for purposes of rule 3a-6(b) under the Investment Company Act of 1940 (the "1940 Act") if the average of the separate percentages obtained by computing the entity's: (1) credit extension revenues as a percentage of the foreign bank's revenues; (2) receivables from credit activities as a percentage of the foreign bank's assets; and (3) aggregate deposits as a percentage of the foreign bank's liabilities, exceeds ten percent (the "ten percent test"). While not providing guidance specifically with regard to the ten percent test, we do provide other interpretive guidance below, which should be helpful in this regard. In particular, we describe certain factors that generally would indicate that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits.

FACTS

You state that certain of your clients are banks that are incorporated or organized under the laws of a country other than the United States, or a political subdivision of a country other than the United States (each, a "foreign bank"). You state that each foreign bank takes deposits and extends commercial and other types of credit and is regulated as a bank, and with respect to deposit-taking and credit extension, by its country's government or an agency thereof. You represent that the foreign banks are not operated for the purpose of evading the provisions of the 1940 Act and that the foreign banks are not regulated as investment companies in their home jurisdictions.

You state that each foreign bank has issued, or intends to issue, securities in public offerings in the United States. You request guidance concerning whether the foreign banks may engage in public offerings of their securities in the United States, without registering with the Commission as investment companies under the 1940 Act.

ANALYSIS

Section 3(a)(1)(A) of the 1940 Act defines the term "investment company" as any issuer that holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities. Section 3(a)(1)(C) of the 1940 Act defines the term "investment company" as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percent of the issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis. Foreign banks typically meet one or both of these definitions of investment company. 1 Section 7(d) generally prohibits any foreign entity that meets the definition of investment company, including a foreign bank, from making any public offering of its securities in the United States. 2

Rule 3a-6 under the 1940 Act, however, essentially allows certain foreign banks to make public offerings of their securities in the United States without registering as investment companies under the 1940 Act. 3 Specifically, rule 3a-6 provides that a foreign bank shall not be considered to be an investment company under the 1940 Act if the bank is:

[a] banking institution incorporated or organized under the laws of a country other than the United States, or a political subdivision of a country other than the United States, that is:

Regulated as such by that country's or subdivision's government or any agency thereof;

Engaged substantially in commercial banking activity; and

Not operated for the purpose of evading the provisions of the [1940] Act.

Rule 3a-6(b)(2) defines "engaged substantially in commercial banking activity" as:

engaged regularly in, and deriving a substantial portion of its business from, extending commercial and other types of credit, and accepting demand and other types of deposits, that are customary for commercial banks in the country in which the head office of the banking institution is located. [emphasis added].

Rule 3a-6 was designed to "put foreign banks selling securities in the United States on an equal footing under the [1940] Act with banks in like circumstances organized under the laws of the United States" ("U.S. Banks"). 4

You ask us to interpret "substantial" for purposes of determining whether a foreign bank may rely on rule 3a-6 because it derives "a substantial portion of its business from, extending commercial and other types of credit, and accepting demand deposits . . . ." 5 You state that certain members of the securities bar currently interpret the "substantial portion" wording of rule 3a-6(b)(2) as applying to each of two banking functions, extending credit and accepting deposits individually, rather than collectively. You state further that those members of the securities bar generally have been comfortable opining that a 20% or greater activity level is sufficient for each prong. You are concerned that, under this interpretation, foreign banks, unlike U.S. Banks, could, for example be forced to maintain a higher level of deposits than would otherwise be economically warranted by the relative costs of deposits and alternative sources of funding. You contend that, as a result, these foreign banks would find themselves on unequal footing with U.S. Banks due to the need to comply with a rule that was intended to promote equality between U.S. and foreign banks.

In light of these concerns, you propose an alternative interpretation. You assert that a foreign bank should be deemed to derive "a substantial portion of its business from" commercial banking activity if the average of the separate percentages obtained by computing the entity's: (1) credit extension revenues as a percentage of the foreign bank's revenues; (2) receivables from credit activities as a percentage of the foreign bank's assets; and (3) aggregate deposits as a percentage of the foreign bank's liabilities, exceeds ten percent. You contend that the average of deposits and credit extension to the degree described in the ten percent test is consistent with the extent to which U.S. Banks must engage in those activities. Consequently, you argue that this interpretation of "substantial" will put foreign banks selling securities in the United States on an equal footing under the 1940 Act with U.S. Banks. 6

You contend further that the ten percent test is consistent with the plain meaning of the word "substantial": "Belonging to substance; actually existing; real; not seeming or imaginary; not illusive; solid; true; veritable. Something worthwhile as distinguished from something without value or merely nominal." 7 You also contend that foreign banks that meet the ten percent test view their deposit-taking and credit extension activities as substantial due in part to the resources that must be extended to engage in those activities. In addition, you assert that the relevant foreign financial authorities view these activities as substantial, as evidenced by their specific regulation of such activities.

In determining whether a foreign bank derives "a substantial portion of its business from � extending commercial and other types of credit, and accepting demand and other types of deposits," for purposes of rule 3a-6, we are not inclined to provide an interpretation based on particular minimum percentages of either the bank's liabilities (in the case of deposits) or assets or revenues (in the case of credit extensions). This conclusion is based, in part, on the fact that the Commission, when adopting this standard, chose not to define it by reference to minimum percentages. Although we are not willing to set forth such minimum percentages, we recognize that various percentages could demonstrate that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits.

We believe, however, that the banking activities in which a foreign bank engages clearly must be more than nominal to satisfy the "substantial" standard in the rule. In addition, in order to meet this standard, we generally would expect a foreign bank: (1) to be authorized to accept demand and other types of deposits and to extend commercial and other types of credit; (2) to hold itself out as engaging in, and to engage in, each of those activities on a continuous basis, including actively soliciting depositors and borrowers; (3) to engage in both deposit taking and credit extension at a level sufficient to require separate identification of each in publicly disseminated reports and regulatory filings describing the bank's activities; and (4) to engage in either deposit taking or credit extension as one of the bank's principal activities.

When the foregoing factors are present, we will view the foreign bank as deriving a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits. We believe that this position is consistent with the purpose underlying rule 3a-6, which is to put foreign banks selling securities in the United States on an equal footing under the 1940 Act with U.S. Banks. We recognize that there may be other factors that would support a conclusion that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits, and that it may be possible for a foreign bank to satisfy this standard even when fewer than all of the foregoing factors are present.

Sara P. Crovitz Senior Counsel

Endnotes

1 Section 3(c)(3) of the 1940 Act excludes "banks" from the definition of investment company. The definition of "bank" in section 2(a)(5) of the 1940 Act addresses certain U.S. domestic banks, and only certain types of non-U.S. banks (those that are a branch or agency of a foreign bank as such terms are defined in section 1(b) of the International Banking Act of 1978). You state that your clients do not meet the definition of "bank" in section 2(a)(5).

2 Section 7(d) of the 1940 Act states, in part:

No investment company, unless organized or otherwise created under the laws of the United States or of a State shall make use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to offer for sale, sell, or deliver after sale, in connection with a public offering, any security of which such company is the issuer.

3 Rule 3a-6(a) provides that "notwithstanding Section 3(a)(1)(A) or Section 3(a)(1)(C) of the [1940 Act], a foreign bank . . . shall not be considered an investment company for purposes of the [1940 Act]."

4 See Exemption from the Definition of Investment Company for Foreign Banks and Foreign Insurance Companies, Investment Company Act Release No. 18381 (Oct. 29, 1991) (adopting rule 3a-6). See also Safra Republic Holdings, S.A. (pub. avail. Apr. 21, 1998) ("Safra").

5 While rule 3a-6 does not define "substantial," that term requires something less than "primary." Rule 3a-6 is based on former rule 6c-9 under the 1940 Act, which codified prior exemptive orders that the Commission had issued to foreign banks. As originally proposed, rule 6c-9 would have required a foreign bank to be "primarily engaged in accepting demand deposits and making commercial loans." Exemption from the Investment Company Act of 1940 for the Offer or Sale of Debt Securities and Non-voting Preferred Stock by Foreign Banks or Foreign Bank Finance Subsidiaries, Investment Company Act Release No. 15314 (Sept. 17, 1986). In adopting rule 6c-9, the Commission revised the definition to impose "no requirements as to the primary activities engaged in by the entity seeking to the use the rule" in response to criticism by commentators that this definition was so restrictive as to render the rule inapplicable to many entities legitimately seeking exemption. Exemption from the Investment Company Act of 1940 for the Offer or Sale of Debt Securities and Non-voting Preferred Stock by Foreign Banks or Foreign Bank Finance Subsidiaries, Investment Company Act Release No. 16093 (Oct. 29, 1987).

In a prior letter, we concluded that certain foreign banks were "engaged substantially in commercial banking activity" for purposes of rule 3a 6, relying, in part, on the representation that time deposits were considered to be "other types of deposits" and interbank deposits were considered to be extensions of "commercial and other types of credit," both by the banking regulators in the countries in which the banks operate and under U.S. law. Safra, supra note 4. In the letter, we also cited to the fact that the banks' liabilities represented by deposits ranged from 90 to 96%, the banks' assets attributable to "interbank deposits" ranged from 59% to 84%, and the banks' assets attributable to conventional loans ranged from 12% to 2%. Id. You contend that this staff position does not represent the exclusive means by which a foreign bank can be substantially engaged in commercial banking activity. We agree.

6 In further support of this interpretation, you note that in certain instances in the securities laws, a ten percent or lower threshold is used to define substantial. See Securities Exchange Act Release No. 39098 (Sept. 19, 1997) (approval of New York Stock Exchange proposal that cash sales of stock to a "substantial" security holder be exempt from its shareholder approval policy; a five percent threshold used in the definition of "substantial"); Stampede Int'l Resources Ltd, Northwest Ventures (pub. avail. Jan. 4, 1982) (for purposes of reorganizations relying on section 3(a)(10) of the Securities Act of 1933, "substantial" amount of securities considered to be greater than one percent). But see rule 3-16 of Regulation S-X (definition of "substantial portion of collateral" includes 20% threshold); Rule 902 of Regulation S (definition of "substantial U.S. market interest" includes 20% threshold).

A ten percent threshold while not identified as "substantial" is of considerable importance in other areas of the securities laws. See, e.g., Regulation S-X (definitions of "principal holder of equity securities" and "significant subsidiary" include a ten percent threshold).

7 Black's Law Dictionary 1428 (6th ed. 1990).

Incoming Letter

The Incoming Letter is in Acrobat format.

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INCOMING LETTER:
Anthony C.J. Nuland
Partner
(202) 737-8833
October 12, 2005
VIA HAND DELIVERY
Douglas J. Scheidt
Associate Director and Chief Counsel
Office of the Chief Counsel
Division of Investment Management
U.S. Securities and Exchange Commission
100 F Street, N.E.
Washington, D.C. 20549-0506
Re: Request for interpretation of “substantial portion” as used in Investment Company Act Rule 3a-6 Dear Mr. Scheidt:
We are writing to you to follow up on our correspondence and telephone conversations with the Staff regarding the Staff’s willingness to entertain a request for an interpretation of the term “substantial portion” as used in subsection (b)(2) of Rule 3a-6 (“Rule 3a-6” or the “Rule”) under the Investment Company Act of 1940 (the “1940 Act”). As discussed further herein, foreign banks we represent are concerned that it may become increasingly uneconomical for them to comport with current interpretations of what constitutes being engaged substantially in commercial banking activities for purposes of reliance on Rule 3a-6. We believe that this concern is not unique to our clients and applies to foreign banks generally. Rule 3a-6 excludes a “foreign bank,” as defined in the Rule, from the definition of investment company within the meaning of the 1940 Act, and was designed to put

2 foreign banks on an equal footing with their counterparts organized in the United States when issuing securities in the United States.1 Our foreign bank clients are concerned that in order to continue to meet the definition of “foreign bank” in Rule 3a-6 and be able to issue securities in the United States without registering under the 1940 Act as an investment company they, unlike domestic banks, could be forced to maintain a higher level of deposits than would otherwise be economically warranted by the relative costs of deposits and alternative sources of funding. As a result, these foreign banks could find themselves on an unequal footing with domestic banks due to the need to comply with the Rule that was intended to promote equality between domestic and foreign banks. Rule 3a-6 Rule 3a-6 provides that “notwithstanding Section 3(a)(1) or Section 3(a)(3) of the [1940] Act, a foreign bank ... shall not be considered an investment company for purposes of the [1940] Act.” For purposes of Rule 3a-6, the term “foreign bank” is defined to mean:
“[a] banking institution incorporated or organized under the laws of a country other than the United States, or a political subdivision of a country other than the United States, that is:
(a) regulated as such by that country’s or subdivision’s government or any agency thereof; (b) engaged substantially in commercial banking activity; and (c) not operated for the purpose of evading the provisions of the [1940] Act.”2 “Engaged substantially in commercial banking activity” is defined to mean “engaged regularly in, and deriving a substantial portion of its business from, extending commercial and other types of credit, and accepting demand and other types of deposits, that are customary for commercial banks in the country in which the head office of the banking institution is located.”3

1
Investment Company Act Release No. 17682 (August 17, 1990).
2
Rule 3a-6(b)(1).
3
Rule 3a-6(b)(2).

3
The Securities and Exchange Commission (the “Commission”) stated in the release proposing Rule 3a-6 that the intent behind the Rule was to put foreign banks on an equal footing with banks organized in the United States.4 Banks organized under the laws of the United States are exempt from the definition of investment company by section 3(c)(3) of the 1940 Act. A bank is defined, in relevant part, in section 2(a)(5) of the 1940 Act as “(A) a depository institution (as defined in section 3 of the Federal Deposit Insurance Act [12 USCS § 1813]) or a branch or agency of a foreign bank (as such terms are defined in section 1(b) of the International Banking Act of 1978 [12 USCS § 3101]), (B) a member bank of the Federal Reserve System, [and] (C) any other banking institution or trust company, whether incorporated or not, doing business under the laws of any State or of the United States, a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks under the authority of the Comptroller of the Currency, and which is supervised and examined by State or Federal authority having supervision over banks, and which is not operated for the purpose of evading the provisions of this title.” Domestic banks, as defined by the 1940 Act, were exempted from the definition of investment company because they were already subject to significant regulation and therefore it was not necessary to subject them to the registration requirements of the 1940 Act. Foreign banks that meet the definition of such in Rule 3a-6 are required to be organized under the laws of a country, or political subdivision of a country, other than the United States, are required to derive a substantial portion of their business from accepting deposits and extending commercial and other types of credit, and are required to be regulated as a bank by that country’s or political subdivision’s government or an agency thereof.5 The deposit-taking and credit extension aspects of the Rule’s requirements

4
Investment Company Act Release No. 17682, supra note 1.
5
Rule 3a-6(b)(1)(i).

4 insure that through regulation of a foreign bank by its country’s government or an agency thereof, the foreign bank would be subject to significant regulation similar to the regulation that applied to banks organized in the United States. Unlike foreign banks, however, only certain banks organized in the United States are subject under the definition of “bank” in the 1940 Act to a “substantial portion” test applicable to specified activities, including taking deposits, and even those banks need not satisfy the deposit￾taking part of the definition if a substantial portion of their business consists of exercising certain fiduciary powers.6 As a result, unlike a foreign bank, any bank organized under the laws of the United States is able to satisfy the definition of “bank” under the 1940 Act without being subject to a “substantial portion” test applicable to deposit-taking. Changes in the Nature of Banking Activities Our foreign banking clients currently meet all the requirements of the definition of “foreign bank” in Rule 3a-6. Each is a bank that takes deposits and extends credit and is regulated as a deposit-taking institution by its country’s government or an agency thereof. They are all “engaged substantially in commercial banking activity” and regularly derive a substantial portion of their business from extending commercial and other types of credit and accepting demand and other types of deposits. Our foreign banking clients are not regulated as investment companies in their home jurisdictions. When Rule 3a-6 was adopted in 1991, the nature of the banking industry was different than it is today, and accepting deposits was a larger source of bank funding than it is now. Today, banks rely more heavily than they did previously on such other sources of funding as, commercial paper, certificates of deposit, medium term notes, bankers acceptances, promissory notes and interbank borrowing. In the United States, the shift in sources of bank funding has

6
See Section 3(c)(3)(C) of the 1940 Act, which states that the definition of bank includes “any other banking institution or trust company … a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks organized under the authority of the Comptroller of the Currency ….”

5 been accelerated by the adoption of the Gramm-Leach-Bliley Act in 1999, the resulting repeal of many of the Glass-Steagall Act restrictions and the consolidation of banks and other financial services firms. History of the Use of “Substantial” in Rule 3a-6 Rule 3a-6 does not define “substantial.” However, it plainly means something less than “principal” or “primary.”7

“Rule 3a-6 is descended, largely without change, from former Investment Company Act Rule 6c-9. As originally proposed in 1986, Rule 6c-9 would have defined ‘foreign bank’ as an entity ‘primarily engaged in accepting demand deposits and making commercial loans.’ In response to criticism by commentators that this definition was too restrictive, the Commission determined to revise the definition ‘so that it imposes no requirements as to the primary activities engaged in by the entity seeking to use the rule.’”8

Currently foreign banks relying on Rule 3a-6 to issue securities in the United States without registering as an investment company do so based on opinions of counsel that they are “engaged substantially in banking activity.” The securities bar has interpreted the “substantial portion” language in Rule 3a-6(b)(2) as applying to each of its prongs individually (extending credit and accepting deposits) rather than collectively and generally has been comfortable opining that a 20 percent or greater activity level for each prong is sufficient. Other Interpretations of “Substantial” Under the Federal Securities Laws There is some guidance in other areas of the securities laws on what percentage might be considered “substantial,” but that guidance is inconsistent. For example, substantial is defined in two regulations under the Securities Act of 1933 (the “1933 Act”). Rule 3-16 of Regulation S-X uses a 20 percent threshold in its definition of “substantial portion of

7
Safra Republic Holdings, S.A., SEC No-Action Letter (pub. avail. April 21, 1998). 8 Id.

6 collateral.”9
Rule 902 of Regulation S also uses the 20 percent threshold in its definition of “substantial U.S. market interest.”10 In a line of no-action letters concerning reorganizations relying on the exemption in
Section 3(a)(10) of the 1933 Act, the Commission permitted resales of the securities
issued pursuant to the exemption without compliance with the registration provisions of the 1933 Act when the sellers of the securities did not receive a substantial amount of the securities. In these letters, substantial amount was generally considered to be greater than one percent.11 In a pair of earlier 3(a)(10) letters, the Commission declined to define what constituted a “substantial amount of debentures,” but it agreed not to recommend enforcement action based on an opinion of counsel that “10 percent or less of the debentures would not represent an amount which is substantial in relation to the amount of debentures issued.”12 In Guides for Preparation and Filing of Registration Statements, the Commission used the 10 percent threshold when it defined a “substantial amount of securities to be offered in relation to the securities of the class outstanding.”13 In the

9
Rule 3-16 of Regulation S-X defines “substantial portion of collateral” to be where “the aggregate principal amount, par value, or book value of the securities as carried by the registrant, or the market value of such securities, whichever is the greatest, equals 20 percent or more of the principal amount of the secured class of securities.” 10 “Substantial U.S. market interest” for a class of foreign equity securities is defined, in relevant
part, to be where “20 percent or more of all trading in the class of securities took place in, on or through the
facilities of securities exchanges and inter-dealer quotation systems in the United States and less than 55 percent of such trading took place in, on or through the facilities of securities markets of a single foreign country in the shorter of the issuer’s prior fiscal year or the period since the issuer’s incorporation.” Regulation S, Rule 902(j)(1). In the adopting release, the Commission responded to commentators’ concerns that defining substantial U.S. market interest using percentages would present difficulties where records of trading in an issuer’s equity securities were inaccessible or incomplete by stating that in such cases “the issuer may reasonably believe there is not a substantial U.S. market interest in that class of securities where less than 20 percent of the class is held by persons for whom a U.S. address appears on the records. …” Investment Company Act Release No. 17458 (April 24, 1990). Rule 902 also uses the 20 percent test in defining “substantial U.S. market interest” in debt securities. Regulation S, Rule 902(j)(2). 11 See e.g. Stampede Int’l Resources Ltd, Northwest Ventures (pub. avail. January 4, 1982), HRS Ind. Inc. (pub. avail. April 1, 1982), International H.R.S. Ind., Inc. (pub. avail. April 16, 1984) and Dreco Energy Services Ltd. & Dreco, Inc. (pub. avail. December 31, 1984). 12 April Industries, Inc. (pub. avail. April 14, 1977 and March 18, 1977). 13 Securities Act Release No. 4936 (December 9, 1968).

7 proposing release for Rule 203A-3 under the Investment Advisers Act of 1940, “investment adviser representative” was proposed to include “only those supervised persons a ‘substantial portion’ of whose business is providing advice to natural persons.” Here, a 10 percent threshold was used in the definition of “substantial portion.”14 In a concept release on takeovers and contests for corporate control in which the Commission outlined a possible approach to applying the protections of the Williams Act to substantial acquisitions undertaken during or shortly after tender offers, the Commission suggested that a “substantial amount of target company securities” might be 10 percent.15 Certain of the self-regulatory organizations have used a five percent threshold in their interpretations of “substantial.” For example, the New York Stock Exchange defines a “substantial security holder” to be one who holds five percent of either a company’s stock or voting power.16 In a proposed rule on hot equity offerings, NASD Regulation, Inc. selected a five percent threshold premium in its definition of hot issue, stating that it preliminarily believed (subject to comment) that “a 5 percent premium effectively

14 Investment Advisers Act Release No. 1601 (December 20, 1996). The Commission proposed that “a substantial portion of a supervised person’s business would be providing advice to natural persons if, during the preceding twelve months, more than ten percent of the supervised person’s clients consisted of natural persons, or more than ten percent of the assets under management by the adviser attributable to the supervised person were assets of clients who are natural persons “ (the 10 percent allowance). Id. The rule as adopted did not reference “substantial portion”; however, the 10 percent allowance was adopted substantially as proposed. Investment Advisers Act Release No. 1632 (May 9, 1997). 15 Securities Exchange Act Release No. 23486 (July 31, 1986). The Commission specifically requested comment on the need for and appropriate level of the threshold. Id. The Commission subsequently proposed Rule 13e-2 with the 10 percent threshold. Securities Exchange Act Release No. 24976 (October 1, 1987). The proposal was later withdrawn. 16 See, Securities Act Release No. 39098 (September 19, 1997) (“Issuers sometimes seek cash financing from one or more of their “substantial” security holders (which the Exchange defines as a person holding either five percent of the company’s stock or five percent of the company’s voting power”)). See also, Section 312.04 of the New York Stock Exchange Listed Company Manual (“[A]n interest consisting of less than either five percent of the number of shares of common stock or five percent of the voting power outstanding of a company or entity shall not be considered a substantial interest or cause the holder of such an interest to be regarded as a substantial security holder”).

8 distinguishes between offerings for which there is substantial excess investor demand and those that are generally satiated by the market supply.”17 Interpretation of “Substantial” Under the Federal Reserve Act Since the purpose of Rule 3a-6 is to put foreign banks on an equal footing with banks organized in the United States, the federal banking laws also may provide some guidance on an interpretation of “substantial.” An interpretation of “substantial” can be found in Federal Reserve Board Rulings regarding Section 20 of the Glass-Steagall Act (“Section 20”). Section 20, which was repealed by the Gramm-Leach-Bliley Act, provided that a member bank of the Federal Reserve System could not be affiliated with a company that was “engaged principally” in underwriting and dealing in securities.18 In 1987, the Federal Reserve Board (the “Board”) first interpreted the term “engaged principally.” At that time the Board determined that “principal” included definitions such as “primary,” “substantial,” “leading,” “important,” or “outstanding” and translated into a stricter limitation on underwriting and dealing than “main” or “largest” (therefore somewhat lower than 49 percent).19 The Board then translated this interpretation into a quantitative limit on the amount of gross revenue allowable from underwriting and dealing.20 The Board determined that “underwriting and dealing in bank-ineligible securities (the only securities that counted toward the Section 20 limit) would not be a ‘substantial’ activity for a Section 20 subsidiary if the gross revenue derived from that activity did not exceed 5 to 10 percent of the total gross revenue of the subsidiary.”21

17 Securities Exchange Act Release No. 42325 (January 10, 2000). NASD Regulation, Inc. subsequently decided against any threshold for a blanket prohibition and revoked the threshold in an amended proposal. Securities Exchange Act Release No. 43627 (November 28, 2000). 18 Revenue Limit on Bank-Ineligible Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing in Securities, 61 Fed. Reg. 68750 (December 30, 1996), citing 12 U.S.C. 377. 19 Id. 20 Id. 21 Id. The Board initially limited ineligible revenue to five percent of total revenue in order to gain experience supervising such subsidiaries. In 1989, the Board increased the limit to 10 percent. Id.

9
In 1996, the Board proposed to increase the limit on gross revenue derived from underwriting and dealing in bank-ineligible securities to 25 percent. The Board stated its belief that the 10 percent limitation unduly restricted the underwriting and dealing activity of Section 20 subsidiaries, especially since changes in the product mix that they were permitted to offer and developments in the securities markets had changed the relationship between gross revenue and underwriting and dealing activity from the relationship that prevailed in 1987.22 The Board concluded that 10 percent was an unduly restrictive limit for defining the level of activities that would not amount to a “principal engagement” for purposes of Section 20. The Board based this conclusion on its experience supervising and examining Section 20 subsidiaries and on “identifiable changes in the relationship between gross revenue and underwriting and dealing” since
1987.23 Finally, the Board agreed with commentators who “stressed that an increase in
the revenue limit would allow Section 20 subsidiaries to operate more efficiently and compete more effectively domestically and globally and would benefit both institutional and individual customers by increasing customer choice and lowering prices.”24 Suggested Interpretations of “Substantial Portion” While the Commission did not suggest what a “substantial portion” of deposits might be, in the release adopting Rule 3a-6, the Commission was clear that it intended to require a foreign bank to accept some amount of deposits in the definition of “foreign bank.”25 The Commission rejected comments urging the Commission to adopt a broader definition

22 Id. The Board believed that this change resulted, in part, from the circumstance that in 1989 the levels of gross revenue and underwriting and dealing included activity involving corporate debt and other securities first approved by the Board in 1989 as bank-eligible securities, whereas in 1987 bank-eligible securities, and therefore underwriting and dealing activities, were limited to commercial paper, municipal revenue bonds, mortgage-backed securities, and consumer-receivable-related securities. 23 Id. 24 Id. 25 Investment Company Act Release No. 18381 (October 29, 1991).

10 in the Rule that would include banks that “provided many traditional banking services, but [did] not accept deposits.”26 The Commission believed that such a broad definition of “foreign bank” would “bring within the scope of the rule entities that would not be banks under the 1940 Act if those entities were organized under the laws of the United States, and thus would not accord with the principal purpose of Rule 3a-6, which is to put foreign banks selling securities in the United States on an equal footing under the [1940] Act with banks organized under the laws of the United States.”27 While there is a question of what amount of deposits is “substantial” for purposes of Rule 3a-6, we believe there is no question about the need for foreign banks to take deposits and be regulated as deposit-taking institutions. We believe that requiring foreign banks to be subject to the regulatory oversight applicable to deposit-taking institutions is important. However, we believe also that it is not necessary to separately quantify for a foreign bank the amount of deposits being taken as long as some deposits are taken and the bank extends commercial and other types of credit at a level that makes the combination of these two activities a substantial portion of the foreign bank’s business. A foreign bank should be able to determine the appropriate mix of credit extensions and deposits based on what is the most economically sound approach to obtaining capital. That the foreign bank is authorized to and engages in deposit-taking and extending credit at whatever level the bank chooses insures that the foreign bank is subject to the type of regulation the Commission seeks, regardless of the level of either activity separately. Reliance on the type or quality of regulatorily significant activity rather than the quantity of that activity is supported by the decision of the Supreme Court in Marine Bank v. Weaver.28 There, the Supreme Court refused to subject an issuer of a bank certificate of

26 Id.
27 Id.
28 455 U.S. 551 (1982).

11 deposit insured by the Federal Deposit Insurance Corporation (the “FDIC”) to liability under the federal securities laws because holders of bank certificates of deposit are protected by a comprehensive set of regulations governing the banking industry and are abundantly protected under those laws in ways that make application of the federal securities laws unnecessary.29 In Brockton Sav. Bank v. Peat, Marwick, Mitchell & Co., 30 a case in which the plaintiff brought suit seeking to recover loss on an FDIC insured certificate of deposit under the federal securities laws arguing, among other things, that the certificate of deposit was only partially FDIC insured and that the issuer lent the depositor’s funds to risky outside ventures. Interpreting the Supreme Court’s decision in Weaver, the Brockton Court stated that the certificate of deposit was not a security under any test, and even though the certificate of deposit was not fully covered by FDIC insurance and the issuer lent the depositor’s funds to risky outside ventures, this did not transform the deposit into an investment protected by the federal securities laws.31 The Court emphasized that the deposit was “abundantly protected” by the banking laws and remedy must be sought through those laws.32 The Court in Brockton clearly concluded that it was not important how much of the certificate of deposit was covered by the FDIC insurance, rather it was only important that the issuing bank was thoroughly regulated. We believe that this rationale is applicable here. Although arguments can be made for having no thresholds in order to provide parity of treatment between domestic and foreign banks, we believe it is appropriate to use either a numeric threshold requirement to establish a meaningful basis for regulation-invoking activities or non-numeric qualitative indicia of those activities.

29 Id. at 558.
30 577 F. Supp. 1281 (1983).
31 Id.
32 Id.

12
In our view, the appropriate numeric threshold for purposes of Rule 3a-6 should be 10 percent and should relate to deposit-taking and credit extension in the aggregate in order to provide foreign banks maximum economic flexibility.33 To provide this flexibility we suggest requiring that the average of the separate percentages obtained by computing (i) credit extension revenues as a percentage of the foreign bank’s revenues, (ii) receivables from credit activities as a percentage of the foreign bank’s assets and (iii) deposits as a percentage of the foreign bank’s liabilities be required to exceed 10 percent. A non-numeric, qualitative approach would be to require a foreign bank (i) to be authorized to accept demand and other types of deposits and to extend commercial and other types of credit, (ii) to hold itself out as engaging in, and to engage in, each of those activities on a regular and continuous basis, including actively soliciting depositors and borrowers, and (iii) to engage in either deposit taking or credit extension as one of the bank’s principal activities requiring separate identification in publicly disseminated reports and regulatory filings describing the bank’s activities. Either of the foregoing approaches would ensure that a foreign bank, like its competitor banks organized in the United States, is able to use the most economically advantageous methods for funding itself through the liability side of its balance sheet and that the banking activities in which the foreign bank engages are more than nominal.

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33 We believe that, as described above, 10 percent has been widely used as a measure of “substantial” under the federal securities laws. We believe also that the Board’s determination to increase the threshold on gross revenue derived from underwriting and dealing in bank-ineligible securities from 10 to 25 percent was a regulatory decision regarding the appropriate maximum allowed for activities that had become increasingly significant and not an effort to define “substantial.”

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Please contact us at (202) 737-8833 if you have any questions about the information that we have provided to you. cc: Sara P. Crovitz, Senior Counsel Very truly yours, Anthony C.J. Nuland Nora L. Sheehan

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