NASD PROPOSES TO REGULATE INTER-CUSTOMER LENDING

The NASD recently issued Notice to Members 01-06, wherein it seeks comments on its proposals to regulate inter-customer lending. Is this a case of agreeing to an appendectomy because your appendix might one day become infected? Read Bill Singer's comments on the NTM as submitted to the NASD.

January 10, 2001

RE: NASD Notice to Members 01-06--Requests Comment On Member Facilitation Of Lending

Between Customers.

Singer Frumento LLP is a securities industry law firm that represents both industry participants and public customers; accordingly, Regulatory Partner Bill Singer submits the following comments in the public interest and in an effort to provide a disinterested perspective. The NASD’s suggested questions are noted in italic with responses immediately following.

Among the historic difficulties with the proposition posed above is the lack of precision as to the definition of "arranging" or "facilitating." Historically, Regulation T (Reg. T) prohibited broker-dealers (BDs) from arranging for the extension or maintenance of credit to/from customers, except upon the same terms and conditions that a BD extended to its customers. . In the seminal case of Sutro Bros & Co. (SEC Rel. #34-7052, Fed. Sec. L. Rep. {1961-1964 Transfer Binder} ¶76,913, Apr. 10, 1963), arranging a loan occurs when the BD performs some act without which the credit would not be supplied --- the so-called sine qua non. The Sutro test is often described as one of "procuring" or "negotiating." An interesting issue that often surfaces in applying the Sutro test is whether a BD arranges a loan absent a showing that the BD received any compensation.

However in 1996 the Federal Reserve Board (FRB) acknowledged that Wall Street had dramatically changed: the regulatory and legal barriers between BDs and other lenders had been or were being demolished, and that the financial services community was becoming globalized. Accordingly, the FRB promulgated significant amendments to Reg. T., among which were those permitting a BD to arrange any credit for any customer provided such actions do not violate Regulations U and X. As such, much of the jurisprudence pertaining to arranging credit is now of dubious value.

Consequently, I would urge the NASD to include specific definitions of what constitutes prohibitive arranging/facilitating and to offer real-world examples of improper procuring or negotiating of credit so that members are better prepared to critique any proposed guidelines. The FRB’s sensitivity to the changing face of Wall Street should be pragmatically reflected in the NASD’s ultimate rulemaking.

For example, Citigroup includes, inter alia, Citibank and Salomon Smith Barney. Supposing that I opened a bank account at Citibank and obtained an ATM card and a Visa card. Also, suppose that I have a brokerage account with Salomon Smith Barney. This array of accounts challenges traditional notions of arranging credit. If I get a margin call from Salomon Smith Barney (a Citigroup subsidiary) and satisfy it through withdrawing cash from a Citibank ATM or by accessing my Citibank Visa credit card --- how does that transaction comport with traditional notions of facilitating? To add additional facts, what if my registered representative at Salomon Smith Barney provided me with promotional material for the other Citigroup subsidiaries?Furthermore, why should there be a distinction between funds I obtained from credit extended by a bank or credit card company (neither entity of which is a BD) and credit extended by a friend sitting next to me at a trading desk or from a stranger willing to lend me money from half-way around the world? Quite frankly, if the NASD’s professed concern is that

such lending activities allow customers to continue to trade when they would not otherwise be in a financial position to do so, thereby generating more commission income to the member.

Notice to Members 01-06, http://www.nasdr.com/pdf-text/0106ntm.txt, then we are on the horns of a dilemma. Obviously, credit --- whether obtained from an ATM, credit card, or from another public customer --- permits "customers to continue to trade." Further, such trading will certainly generate "more commission income to the member." This then prompts the question as to why it is somehow more in the public’s interest --- more palatable --- that customers allegedly lacking the financial wherewithal to continue trading would be permitted to do so with funds available from credit lines offered by major financial institutions but not from other customers. I found it somewhat odd that the NTM cited to a finding in the Staff Memorandum of Permanent Subcommittee on Investigations of the Committee on Governmental Affairs of the United States Senate, "Day Trading: Everyone Gambles but the House," (February 24, 2000) that "[t]he Memorandum indicated that in many instances, the borrowing customer paid an ‘exorbitant fee’ to the lending customer for the use of the funds." Many consumer advocates argue that the fees charged for consumer credit loans are exorbitant --- yet they continue to be charged.

The ultimate issue is not whether a fee is exorbitant but whether it is illegal, usurious to be more exact. Certainly a fair extension of this logic would be to examine why discount BDs charge under $20 per trade but major, national firms are often charging two to three times that amount to buy/sell the exact same stock. Within such a comparison are not the higher transaction charges exorbitant? Is the NASD now proposing to require the disclosure to all retail accounts of the availability of discount commissions? Will non-discounting BDs be required to direct their customers to more affordable competitors?

As such, the issue of whether arranging/facilitating should be permitted will largely depend on the working definition of those terms, and no reliable indicia were included with the NTM. I would support a prohibition against BD’s becoming involved in customer-to-customer credit transactions where the BD receives any fee (percentage or flat) for its role. I would also support a prohibition against the BD suggesting/initiating the process whereby a customer seeking to borrow money is directed to a customer seeking to lend. I would support the development of a web page resident at the BD wherein customers could post their interest in borrowing/lending and any resulting communications are solely initiated by the customers through clicks to displayed e-mails of the contra-customer or to posted telephone numbers.

2. If such lending activities were not prohibited, are there limitations or restrictions that should be imposed on specific types of loans, such as loans that are used to meet a margin call or minimum equity requirements?

This proposal smacks of paternalism. The NASD has not set forth a compelling statistical case that supports its contention that inter-customer lending requires regulation. Quite frankly, one of the prominent citations in the NTM is to the Staff Memorandum of Permanent Subcommittee on Investigations of the Committee on Governmental Affairs of the United States Senate, "Day Trading: Everyone Gambles but the House," (February 24, 2000), which was not favorably received in all quarters and the Subcommittee’s methodology and tactics is not above reproach. As one of the few attorneys representing witnesses during those hearings, I can attest to the fact that the sessions were poorly attended by the Subcommittee members, a strong indication of the lack of public interest in the inquiry and its results. Further, as evidenced by the somewhat flip title of the report, the undertaking smacked of an effort to garner press for the politicians pushing the investigation and underscored the foregone conclusion that was likely reached prior to the receipt of any evidence.

Notably, the testimony and documentation before the Subcommittee confirmed what was fairly evident to knowledgeable industry insiders: there were not overwhelming numbers of public customer complaints arising from either the day trading industry’s practices nor from the specific inter-customer lending policies. "[T]he examinations did not reveal widespread fraud . . ." Testimony of Lori A. Richards, Director, Office of Compliance, Inspections and Examinations, SEC, February 25, 2000, Hearings before the Permanent Subcommittee on Investigations of the Committee on Governmental Affairs of the United States Senate, "Day Trading: Everyone Gambles but the House, page 71.

As such, NASD has not necessarily advanced a statistically relevant case in support of the need to implement the credit regulations. At best, the evidence is anecdotal and isolated. Before agreeing to impose credit restrictions, even in limited areas, the NASD needs to set forth a persuasive argument as to why such limitations are necessary.

Again, this is a loaded question --- what does "adequate" mean? When is "enough" enough? How "regular" is regular? A better approach would be to compare the customer-to-customer lending disclosures with those mundane situations we all typically experience. Returning to the ATM machine, do we all receive adequate disclosure of the credit terms associated with each withdrawal? Do we all receive adequate disclosure of credit terms every time we use our Visa cards? Do most customers even understand the credit terms associated with using margin?

Ultimately, NASD must ask whether it is serving to merely anesthetize the public by requiring more and more disclosure --- given that there is so much already out there --- perhaps too much. "Adequate disclosure" is an interesting term. If it means yet another feat of advanced origami, by which we supply each customer with a huge legalese document folded into a small pamphlet akin to those found inside every box of aspirin --- then we don’t need adequate disclosure. If, on the other hand, the NASD would simply sit down with several pro-consumer organizations, most notably something like the Public Investors Arbitration Bar Association (PIABA), and ask them to draft an adequate disclosure document--- I suspect that we could get proper disclosure. Now, I am certain that the industry might object to a PIABA drafted disclosure document, but that’s fine with me too. If it’s good enough for the attorneys usually representing public customers against the industry, I would expect that such a signed form would be a strong defense that adequate disclosure was provided.

In my professional experience the lenders tend to be more sophisticated than the borrowers and I am aware of very few complaints as to inadequate disclosure of the lending risk. Most individuals who have attained adulthood --- and particularly those individuals who are prepared to extend credit to other customers --- understand that there is significant risk in lending money within the context of the securities markets. I have not seen any proof indicating that those lenders at day trading firms --- or those likely to engage in such loans at the retail level --- are complaining about inadequate disclosure in numbers warranting regulatory intervention.

c. Should members be required to provide disclosures to both parties to the loan regarding the terms and risks involved in such lending activities? For example, should disclosure requirements similar to that of SEC Rule 15c2-5 apply to these types of lending activities?

This presupposes that members know or should be required to know when customers are lending money to each other. First, there is a significant concern as to the invasion of privacy aspect of this issue. What business is it of the BD if I want to lend money to another customer --- or if I want to borrow? Again, it is not the BD that is extending the credit. Why should the BD become exposed to even greater legal liability?

Second, where does the line get drawn? Supposing John Doe and Jane Smith are both customers at XYZ BD. Jane wants to open a florist shop. She asks John to lend her $5,000. Is XYZ BD required to ensure that there is adequate disclosure concerning the terms of that loan? Supposing Jane asks John to lend her $5,000 but doesn’t explain why. And for argument’s sake, let’s suppose that John lends Jane the "unexplained" $5,000. Should those facts impose a disclosure obligation upon the BD? Finally, if the disclosure is going to hinge on the "use of funds" aspect of such customer-to-customer loans, then isn’t it likely to expect that lenders will limit such loans to general-purpose-personal-use and claim that there was no understanding that the loan would be solely applied to brokerage account credit issues?

Again, there is a flaw in the rationale behind the question. Rule 15c2-5 addresses issues in which the BD is lending or extending credit (directly or indirectly) or is substantively involved in the lending process. But within the inter-customer lending context, the lending is between customers and the BD should not be involved. On what basis should we apply to public customers an SEC rule whose subject is an SEC registered BD? Doesn’t this smack of if my aunt were a man she’d be my uncle ? Public customers are not registered BDs. The ’34 Act was meant to regulate the conduct of registered entities, not the private lending practices of public citizens.

4. Are there other approaches to addressing the concerns associated with such lending practices? For example, what types of additional supervisory mechanisms or requirements should be in place to monitor and/or approve these types of loans?

The more supervisory obligations the NASD imposes upon the limited staffing and financial capacities of BDs, the less vigilant overall member supervision becomes. BDs are not like gas, which simply expands to fill whatever size container it is placed in. There comes a point at which there are too few people and too few dollars to profitably permit a business to operate. We must stop piling on regulations simply because they merely seem like a good idea. As recently appointed NASD President Glauber stated:

Remarks by Robert R. Glauber at NASD Regulation Fall Securities Conference, San Francisco, California, November 17, 2000, http://www.nasdr.com/1420/glauber_01.htm. I submit that the proposals contained within NTM 01-06 do not pass the Glauber cost-benefits test.

In conclusion, there are many matters of concern on Wall Street, but promulgating more rules is not always the best response. NTM 01-06 does not present compelling evidence that the practice of inter-customer loans is

·in violation of any rule,

·widespread,

·abusive, or

·requiring specific rulemaking.

I would urge the NASD to prepare a suggested disclosure document detailing the risks of inter-customer lending. I would recommend that such a document be prominently posted on the NASD’s website and made a part of the standard new account materials provided to retail accounts. Further, the NASD should publish an Interpretive Letter stating that if such a disclosure document is provided to a retail customer, that it would satisfy the disclosure obligations for such lending. This concession would prove of inestimable value when BDs are required to demonstrate a standard of care during civil litigation or arbitration, thus providing BDs with an incentive to distribute the document. Beyond that I would not support further rulemaking.

Under the title of "Background", the NTM sets forth the basis for its proposed rulemaking with the sentence "Certain firms may arrange for and/or facilitate loans between customers that are used to finance securities trading and/or meet margin requirements." That is troublesome. Certain firms may arrange . . . I strongly oppose regulation premised upon what may happen, as opposed to what is happening. Many things in life may occur --- I am five-foot six-inches in height and hope springs eternal that I may wake up one morning and be six feet tall. But I would hardly go out and purchase longer pants in anticipation of that remote likelihood. I suggest that the NASD better consider its own language. Self regulation simply cannot support excessive regulation premised upon what may happen.

Sincerely,

Bill Singer