SHEARMAN & STERLING LLPSecurities and Exchange Commission
File No. S 7-15-0
We appreciate the opportunity to comment on some aspects of proposed Rule 13k-1 (the "Rule") promulgated under Section 13(k) of the Securities Exchange Act of 1934, as amended (the "Securities Exchange Act"). 1. Definition of Foreign Bank, Rule 13k-1(a) (a) We accept the basic proposition that the group of foreign banks exempted from Section 402 of the Sarbanes-Oxley Act of 2002 ("SO Act") must be comparable to the group of U.S. banks exempted from the prohibition of Section 402 of the SO Act. (b) It appears to us, however, that foreign bank is defined more restrictively than is necessary to create comparability with insured depository institutions as defined in Section 3(c)(1) & (2) of the Federal Deposit Insurance Act ("FDIC Act"), § 12 U.S.C. 1813(c)(1) & (2), which are excepted from the prohibition of Section 402 of the SO Act (Section 13(k)(1) of the Securities Exchange Act). It seems to us that it is sufficient to require that the foreign bank be regulated as a bank in its home jurisdiction and be engaged in the business of banking. See Rule 13k-1(a)(1). We do not see any justification for the additional requirements under Rule 13k-1(a)(3) as to the type of business in which such foreign bank is engaged. There are many foreign banks that are licensed and regulated as banks but that do not receive deposits or take deposits only to a minor extent as a convenience for their corporate customers.1 In many foreign bank regulatory systems, the power to take deposits and the actual taking of deposits are not of significance for the application of banking laws and regulations or for the scope of supervision by bank regulatory agencies.2 As you know, deposit-taking has become a far less important source of funding than it used to be. There is no reason why a bank that finances itself (mainly or exclusively) in the capital market should not have the benefits of Rule 13k-1. Furthermore, the deposit requirement adds many interpretative issues that will take up much time and effort of the foreign banks and the SEC's staff, although they have little relevance to the purpose of Section 402 of the SO Act. For instance: are interbank deposits deposits for purposes of Rule 13k-1(a)(3)? Which law determines whether a deposit is a deposit in the meaning of Rule 13k-1(a)(3): the law of the home country of the foreign bank or U.S. law (federal or state)? What is a substantial extent? Is "substantially" determined in absolute amounts or in relative amounts? If an absolute amount is determinative, small banks are disadvantaged. If it is a relative concept - what does it relate to? It could, for instance, relate to the balance sheet total or to liabilities or other balance sheet items? Why is it relevant that deposits are taken in the regular course of business? Is the taking of a few large deposits or of interbank deposits for funding purposes deposit-taking in the regular course of business? Why is it relevant for purposes of Section 402 of the SO Act that the bank has the power to accept demand deposits? At any rate, how could a bank take deposits without that power? Does Rule 13k-1(a)(3)(ii) imply that a foreign bank must take time deposits (to a substantial extent) but need not actually take demand deposits as long as it has the power to do so? Rule 13k-1(3)(iii) requires that the foreign bank extend commercial or other types of credit. Does "commercial or other types of credit" cover the universe of possible credit? If so, why does the Rule not simply require that the bank extends credit? (c) The requirement and definition of being engaged substantially in the business of banking will create in many cases serious interpretative issues. Furthermore, this requirement has not been imposed by Section 402 of the SO Act on U.S. banks. An insured depository institution under Section 3(c)(2) of the Federal Deposit Insurance Corporation Act ("FDIC Act"), 12 U.S.C. § 1813(c)(2), is not limited to institutions that take demand deposits and extend credit. Depository institutions is defined in Section 3(c)(1) of the FDIC Act, 12 U.S.C. § 1813(c)(1), as a bank or a savings association. A bank is defined in Section 3(a) of the FDIC Act, 12 U.S.C. § 1813(a), as a national bank or a State bank, a Federal branch and an insured branch. State banks must be in the business of receiving deposits, Section 3(a)(2)(A) of the FDIC Act, 12 U.S.C. § 1813(a)(2)(A), but the deposits need not be substantial, and a state bank need not be engaged in the extension of credit. A national bank is not at all defined in terms of deposit taking and extending credit although clearly national banks have the power to take deposits (see Eastern Townships Bank v. Vermont Nat'l Bank, 22 F.186 (Cir. Ct. D.Vt. 1884); see also 12 U.S.C. § 24, Seventh) and to make loans (see First Nat'l Bank v. Harris, 27 F.2d 117 (8th Cir. 1928)). Obviously, in most cases insured depository institutions under the FDIC Act presumably have deposits, but there is no such requirement and in particular there is no requirement as to the size or nature of deposits or that deposits must be taken in the regular course of business. Certain special-purpose banks, such as those engaged solely in the business of issuing credit cards, have only one depositor solely for the purpose of qualifying for deposit insurance. Bank, for purposes of the Bank Holding Company Act of 1956 ("BHC Act"), is defined as an insured bank as defined in Section 3(h) of the FDIC Act, 12 U.S.C. § 1813(h), or as an institution which both accepts demand deposits and is engaged in the business of making commercial loans. 12 U.S.C. § 1841(c)(1). However, the BHC Act does not address the supervision and regulation of banks as such and therefore its definition of bank should have no relevance for purposes of Rule 13k-1. (d) Rule 13k-1(a)(iii) would require that the foreign bank must be engaged substantially in the business of banking. It is not clear what the word "substantially" is intended to express. Are only large banks covered? Does this word intend to distinguish between banking and nonbanking business? This could be very troublesome in countries in which banks are permitted to invest in nonbanking enterprises. Once a foreign bank is licensed and supervised as a bank in its home jurisdiction, it is neither appropriate nor useful to second-guess the foreign law and regulators by excluding from the definition foreign banks that under application of U.S. concepts of banking law are partially engaged in nonbanking activities. (e) It seems to us that foreign bank should be defined as an institution: (i) the home jurisdiction of which is other than the United States; (ii) that is regulated as a bank in its home jurisdiction; and (iii) that is engaged in the business of banking. This definition would be very close to the definition of bank in Regulation K, 12 C.F.R. § 211.21(n), a result that makes sense because a proliferation of definitions of foreign bank is confusing. 2. Requirement of deposit insurance Rule 13k-1(b)(1)(i) requires that the laws or regulations of the foreign bank's home jurisdiction require the bank to insure its deposits. We appreciate that this requirement is necessary in light of Section 402 of the SO Act. However, we propose not to use the term deposit insurance. This is a term of art of U.S. bank regulation, and thoughtful observers have convincingly argued that the U.S. deposit insurance is not insurance in any meaning of the term and that the term was chosen for purposes of political expediency. See Carter Golembe in Golembe Report No. 8 of 2000. European Union Directive 94/19/EC of the European Parliament and Council of 30 May 1994, O.J. Eur. Comm. No. L 135/5 (1994) very appropriately calls the directive a directive on deposit-guarantee schemes. Many deposit protection schemes of European countries are better described by that term. See, e.g., Gruson, Banking Regulation in Germany, supra, § 8.17, discussing the German deposit protection schemes. In order to avoid doubt and the need for unnecessary legal analysis, we propose to rephrase Rule 13k-1(b)(1) as follows:
It seems that a bank that under local law is permitted to voluntarily join a deposit insurance/deposit guarantee scheme should have the same benefit as a bank that is required to do so. The perceived advantages of the membership, namely increased supervision, apply equally in both cases. The Release accompanying final Rule 13k-1 should recognize that countries have adopted a wide variety of deposit-guarantee or protection schemes and that it is not the intention of Rule 13k-1 to evaluate the merits and demerits of such schemes. For instance, German public sector banks (such as Landesbanken) and co-operative banks are exempted from the statutory deposit-guarantee scheme as long as they are members of a mutual deposit protection system that has the purpose of protecting the solvency and liquidity of the participating institutions rather than the protection of their customers. It stands to reason that the customer is better protected by a system that protects the solvency and liquidity of his bank rather than by a system that pays him a minimal amount in case of insolvency of the bank. 3. Comprehensive Supervision on a Consolidated Basis Rule 13k-1(b)(1)(ii) requires a determination that the bank in question has been determined to be comprehensively supervised on a consolidated basis ("CSCB"). Under U.S. federal banking law, a finding of CSCB is required if a foreign bank wishes to establish an office in the United States, Section 7(d)(2)(A) of the International Banking Act of 1978, 12 U.S.C. § 3105(d)(2)(A) and 12 C.F.R. § 211.24(c)(1)(i)(A) (Regulation K), or where a foreign bank elects to be a financial holding company under Section 4(l)(1)(C) of the BHC Act, 12 U.S.C. § 1843(l)(1)(C) and 12 C.F.R. § 225.92(e) (Regulation Y), or where a foreign bank applies to become a bank holding company, Section 3(c)(3)(B), BHC Act, 12 U.S.C. § 1842(c)(3)(B) and 12 C.F.R. § 225.13(a)(4) (Regulation Y). In all these instances specific applications by specific foreign banks are required and it stands to reason that the applicant must demonstrate in this application that it is subject to CSCB. Rule 13k-1, however, deals with the general applicability to foreign banks of an exception from the prohibition of Section 402 of the SO Act and it does not seem appropriate to make the applicability of the exception dependent on whether a particular bank has in the past filed an individual application quite unrelated to the prohibition of Section 402 of the SO Act. Furthermore, in our experience, it is highly unlikely that once the Board of Governors of the Federal Reserve System has determined the existence of CSCB in a country in connection with an individual application, it could reach a different result in connection with an application by another bank of the same country. CSCB requires an analysis of the banking law, regulations and administrative practices in a country and these do not change with respect to different banks, unless, of course, the second bank belongs to a different category of banks that is subject to a different regulatory scheme, which is a determination that banking lawyers can readily make. 4. Alternative Reliance on Deposit Insurance and CSCB We very much support the proposal to permit foreign banks to rely in the alternative on deposit insurance/guarantee schemes and comprehensive supervision on a consolidated basis. Section 402 of the SO Act mentions specifically insured banks. The rationale of this provision is not that the deposit insurance as such has any relevance to the soundness of loans to directors and officers. The rationale of Section 402 of the SO Act is that FDIC insurance provides a common set of prudential supervisory rules for substantially all banks in the United States. Section 402 of the SO Act refers to deposit insurance as a convenient reference to a common comprehensive supervisory system. Since the existence of a comprehensive system of supervision is the basis of the bank exception from the prohibition of Section 402 of the SO Act, it stands to reason that foreign banks that are subject (in the view of the Board of Governors) to a comprehensive system of supervision should be equally exempt from the prohibition of Section 402 of the SO Act. Consequently, it makes eminent sense and reflects the policy of Section 402 of the SO Act that Rule 13k-1 relies in the alternative on a home jurisdiction deposit insurance requirement or CSCB. We do not support the sole reliance on CSCB. If, as Rule 13k-1 presently suggests, CSCB must have been found for the bank in question, the exemption from Section 402 of the SO Act would only apply to a relatively small group of foreign banks that have opened a branch or agency after 1991, the year in which the Foreign Bank Supervision Enhancement Act of 1991, Pub. L. No. 102-242, 102d Cong., 1st Sess. (Dec. 19, 1991), 105 Stat. 2286 (1991), introduced the CSCB requirement or that have acquired a U.S. bank after that date or have obtained financial holding company status (as of April 18, 2003, only 29 foreign banks have elected to be a financial holding company). Even if, as proposed in this letter, the finding of CSCB for one bank of a country is sufficient to all banks subject to the same regulatory scheme from that country, sole reliance on CSCB would exclude banks from all countries whose banks have not (after 1991) entered the U.S. banking market by establishing a new office or bank subsidiary. This would create a distinction that is not based on a rationale that is relevant for Section 402 of the SO Act. In our view, the proposal to rely on the foreign deposit protection or CSCB is sound. It would be very difficult for the SEC to establish detailed requirements which the foreign deposit protection scheme or foreign supervision must meet in order to give banks the benefit of an exemption from the prohibition of Section 402 of the SO Act. The SEC would have to embark on a qualitative evaluation of foreign bank regulatory systems. 5. Foreign Rules Comparable to Regulation O Rule 13k-1(b)(2) proposes two conditions which insider loans must meet. It appears to us that these two conditions meet the rationale of Section 402 of the SO Act. To add a requirement that foreign insider lending restrictions must be substantially similar to Regulation O, 12 C.F.R. § 215, seems to be an unnecessary and psychologically unwise imposition of U.S. regulations on foreign countries. The essential restrictions on insider lending are captured by Rule 13k-1(b)(2)(i) & (ii). What purpose would it serve to make foreign banks go through the very difficult analysis of comparing their rules with Regulation O and to reach the extremely difficult conclusion of "substantial similarity"? Few lawyers would be able to give an opinion that two pieces of legislation or regulation are "similar", in particular if the legislation or regulation is embedded in different legal systems. As to the definition of parent, it appears sound to adopt the BHC Act approach of ownership of 25 percent of the voting securities, Section 2(a)(2) and (d), BHC Act, 12 U.S.C. § 1841(a)(2) and (d). First of all, Regulation O is based on that ownership percentage, 12 C.F.R. § 215.2(c), and it is difficult to justify a less favorable treatment for foreign bank holding companies. Foreign bank holding companies that control U.S. banks and foreign banks that are treated as bank holding companies because they operate a branch or agency in the United States, are familiar with the 25 percent threshold. A different threshold for purposes of insider loans would be confusing and appears not to be justified. Once a foreign bank regulator has approved an insider loan, it would be seen as a violation of international comity if a U.S. regulator would second-guess the foreign bank regulator. 6. Interpretative Issue Regarding Schedule B Issuers We would like to bring to your attention an interpretation issue under the Sarbanes-Oxley Act that is related to the matters covered by Rule 13k-1. German state development banks are typically wholly or majority-owned by German state(s) they support, and their debt securities are guaranteed by such state(s). They, therefore, register their debt securities under Schedule B of the Securities Act of 1933, as amended (the "Securities Act"). As Schedule B filers, such banks are not subject to the reporting requirements of Section 15(d) of the Securities Exchange Act, which means that one of the alternative triggers of issuer status under Section 2(a)(7) of the SO Act, which is a requirement for the applicability of the insider lending prohibition of Section 13(k) of the Securities Exchange Act, is not met. Of course, state development banks may become subject to the insider lending prohibition if they list their debt securities on a U.S. national securities exchange, since issuer status under Section 2(a)(7) of the SO Act also applies to entities registered pursuant to Section 12 of the Securities Exchange Act. A development bank that issues securities under Schedule B but does not list the securities on a U.S. national securities exchange would under a literal reading of Section 2(a)(7) of the SO Act be an issuer and hence be subject to Section 13(k) of the Securities Exchange Act only for the brief period from the filing of the registration statement until effectiveness.3 After effectiveness, it would cease to be an issuer and cease to be subject to Section 13(k) of the Securities Exchange Act. This interpretative issue is further discussed in the memorandum attached to this letter as Exhibit A. This result, of course, makes no sense and cannot have been intended by Congress. We respectfully request that the release accompanying the final Rule 13k-1 set forth an explanation that this result is not intended. If you have any questions regarding this letter, please feel free to contact Michael Gruson, Tel. (212) 848-8060, e-mail: mgruson@shearman.com.
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Exhibit A to Shearman & Sterling LLP
Memorandum on the Application of Section 13(k) of the Securities Exchange Act of 1934 to Schedule B Issuers The insider lending prohibition, like most other provisions of the Sarbanes-Oxley Act of 2002 ("SO Act"), applies to "issuers" within the meaning of Section 2(a)(7) of the SO Act. Section 2(a)(7) of the SO Act provides that the term "issuer" means an issuer (as defined in Section 3 of the Securities Exchange Act of 1934 ("Securities Exchange Act")):
This "issuer" definition leads to the absurd result that the insider lending prohibition under Section 13(k) of the Securities Exchange Act technically applies to foreign governments and certain other entities eligible to register securities under Schedule B of the Securities Act (collectively referred to herein as "Schedule B Issuers"),1 which are generally not subject to the reporting requirements of Section 15(d) of the Securities Exchange Act, on a temporary basis each time they file a registration statement under the Securities Act until such registration statement is declared effective.2 We believe that Congress did not intend such a temporary applicability of the insider lending prohibition to Schedule B Issuers. The "issuer" definition of Section 2(a)(7) of the SO Act was drafted to subject two types of reporting companies to the provisions of the SO Act: (i) those that are traded on a national securities exchange or are otherwise widely held and therefore required to register their securities under Section 12 of the Securities Exchange Act, and (ii) those that are subject to the periodic reporting requirements of Section 15(d) of the Securities Exchange Act, because they have filed a registration statement under the Securities Act that has become effective. The third trigger of "issuer" status under the SO Act - the period from the filing of a registration statement until its effective date - was meant to capture the latter type of issuers even before their reporting obligations under the Securities Exchange Act begin, so that they are subject to the insider lending prohibition and the other provisions of the SO Act throughout their life as public companies. In our view, the filing of a registration statement and the existence of reporting obligations under Section 15(d) must, therefore, be read together, so that the filing of a registration statement under the Securities Act subjects a registrant to the provisions of the SO Act only if after the effective date of the registration statement the registrant will be subject to the reporting obligations of the Securities Exchange Act. This view is supported by the legislative history of Section 2(a)(7) of the SO Act. A Senate bill of July 15, 2002 defined the term "issuer" as:
The difference between the final wording of Section 2(a)(7) and the Senate bill's definition of the term "issuer" should be understood as Congress's intent to ensure that the term "issuer" would include all future reporting companies that are in the process of registration under the Securities Act. The earlier definition would have failed to cover some public companies whose registration, solely by chance, had not yet become effective by the end of the fiscal year in which they had filed. In other words, the change in wording was not meant to include a new class of non-15(d) reporting companies (such as Schedule B Issuers), but rather to ensure that the term "issuer" comprehensively include all those registrants that are soon to fall under Section 15(d). Had Congress intended to include Schedule B Issuers within the ambit of the SO Act, it would have ensured that the obligations under the Act would apply to them throughout their entire lives as public entities, and not only during the waiting period. While a temporary applicability of the insider lending prohibition would impose a substantial burden on Schedule B Issuers, or even entirely prevent their access to the public capital markets in the United States, it would not further the SO Act's stated purpose - the protection of investors.4 Since Schedule B Issuers would be deemed to be "issuers" under Section 2(a)(7) of the SO Act only prior to the effective date of their registration statement, that is before any securities covered by the registration statement could have been publicly sold in the United States, Schedule B Issuers would be subject to the insider lending prohibition at a time when investors do not hold any stake in them. On the other hand, absent the filing of additional registration statements, the Schedule B Issuer would not be subject to any restrictions (other than home country law) on the granting of personal loans during the entire term of the securities issued.
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