

[Federal Register: September 8, 2006 (Volume 71, Number 174)]
[Notices]               
[Page 53151-53154]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr08se06-86]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54382; File No. SR-OCC-2005-23]

 
Self-Regulatory Organizations; The Options Clearing Corporation; 
Order Granting Approval of a Proposed Rule Change Relating to the Use 
of Margin Deposit in the Event of a Clearing Member Liquidation

August 29, 2006.

I. Introduction

    On December 16, 2005, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') 
proposed rule change SR-OCC-2005-23 pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'').\1\ Notice of the proposal 
was published in the Federal Register on May 19, 2006.\2\ No comment 
letters were received. For the reasons discussed below, the Commission 
is granting approval of the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 53794, (May 11, 2006), 
71 FR 29206.
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II. Description

    Currently, OCC's By-Laws relating to the potential use of 
securities and other margin assets in the event of a clearing member's 
liquidation restrict the use of such assets in ways not required under 
applicable laws and regulations. In addition, certain provisions of 
OCC's Rules applicable to clearing member liquidations do not fully or 
clearly reflect limitations imposed by the By-Laws. The proposed rule 
change amends Chapter XI of the Rules to more precisely reflect 
appropriate limitations that are imposed by OCC's By-Laws on the use of 
clearing member margin deposits and amends provisions of the By-Laws to 
allow OCC to make use of those margin deposits to the fullest extent 
consistent with (i) applicable customer protection provisions and (ii) 
the ability of OCC and clearing member systems to identify margin 
assets subject to those provisions.
    Article VI, Section 3 of the By-Laws sets out a number of different 
types of accounts that a clearing member may establish and maintain on 
OCC's books. These accounts include firm accounts, separate market-
maker's accounts, combined market-makers' accounts, customers' 
accounts, and others. For each of these account types, Section 3 
provides that OCC shall have a lien on property in the account and 
specifies the extent of the obligations secured by

[[Page 53152]]

the lien. For example, in the case of the firm lien account, Section 
3(a) of Article VI states that ``the Corporation shall have a lien on 
all positions and on all other securities, margin and other funds in 
such account as security for all of the clearing member's obligations 
to the Corporation.'' This language permits all of the clearing 
member's assets on deposit with OCC with respect to the firm account to 
be applied to any obligation of the clearing member to OCC regardless 
of whether that obligation arises from the firm account or any other 
account. This is appropriate in that, generally speaking, the clearing 
member may deposit with respect to the firm account only those assets 
that it is permitted under applicable law to treat as its own. Such 
assets include all cash not required by Commission Rule 15c3-3\3\ to be 
deposited in a special reserve bank account for the benefit of 
customers and any securities that belong to the clearing member and not 
to its customers as that term is defined in Commission Rules 15c2-1 and 
8c-1 (``hypothecation rules'').\4\
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    \3\ 17 CFR 240.15c3-3.
    \4\ 17 CFR 240.15c2-1 and 240.8c-1. The term customer is defined 
in paragraph (b)(1) of these rules not to include partners, 
officers, or directors of the broker-dealer or a participant in a 
joint account with a broker-dealer. Unlike Rule 15c3-3, however, the 
hypothecation rules do not exclude broker-dealers from the 
definition of customer. Accordingly, market-makers that do not have 
any of these specified relationships with their clearing broker must 
be treated as customers for purposes of the hypothecation rules. 17 
CFR 240.15c2-1(a)(2) and 240.8c-1(a)(2).
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    The lien language applicable to assets in other types of accounts, 
however, restricts the application of margin assets to obligations of 
the clearing member arising from that particular account. For example, 
in the case of a combined market-makers' account other than a 
proprietary combined market-makers' account, Section 3(c) of Article VI 
states that ``the Corporation shall have a lien on all long positions, 
securities, margin and other funds in such combined Market-Maker's 
account with the clearing member as security for the clearing member's 
obligations to the Corporation in respect of all Exchange transactions 
effected through such account, short positions maintained in such 
account, and exercise notices assigned to such account.'' Under this 
language, OCC's lien on margin assets deposited with respect to a 
combined market-makers' account does not secure any obligations of the 
clearing member other than those arising from this account.\5\
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    \5\ In some cases, however, multiple accounts of the same 
account type are treated as a single account as provided in 
Interpretation .02 following Article VI, Section 3 of the By-Laws. 
Thus, for example, if a clearing member maintains more than one 
combined market makers' account for associated market makers, those 
accounts would be treated as a single account for liquidation 
purposes. Similarly, multiple securities customers' accounts would 
be treated as a single securities customers' account for liquidation 
purposes.
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    These limitations on the use of assets in an account to obligations 
arising from the same account were adopted in order to avoid violation 
by clearing members of the hypothecation rules cited above.\6\ The 
rules containing these limitations, which rules are substantially 
identical to one another, provide in pertinent part that a broker or 
dealer may not permit securities carried for the account of any 
customer to be commingled with securities ``carried for any person 
other than a bona fide customer under a lien for a loan made to such 
broker or dealer.'' \7\ Although it is not at all clear that this 
language should apply to OCC's lien, which is not a ``lien for a loan'' 
in the ordinary sense, OCC has historically taken the conservative view 
that it does apply and does not propose now to do otherwise.
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    \6\ The limitation is actually more restrictive than would be 
required under the hypothecation rules because OCC could lawfully 
apply assets in an account to obligations arising from the 
customers' account and any other accounts in which positions of 
securities customers as defined in the hypothecation rules are 
carried. Similarly, assets in the public customers' account could be 
applied to obligations arising from a market-maker account. As a 
matter of policy, however, OCC has maintained the separation 
continued here.
    \7\ The term customer is defined in paragraph (b)(1) of these 
rules not to include partners, officers, or directors of the broker-
dealer or a participant in a joint account with a broker-dealer. 
Unlike Rule 15c3-3, however, the hypothecation rules do not exclude 
broker-dealers from the definition of customer. Accordingly, market-
makers that do not have any of these specified relationships with 
their clearing broker must be treated as customers for purposes of 
the hypothecation rules.
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    Nevertheless, it is clear that the hypothecation rules apply only 
to ``securities carried for the account of any customer.'' Assets other 
than securities are not subject to the rule. Thus, a clearing member is 
not required to segregate cash received by a clearing member from any 
securities customer from other cash deposited by the clearing member 
with OCC as margin. Subject to the requirement to fund its special 
reserve bank account under Rule 15c3-3(e) and to fund a special reserve 
bank account for any proprietary account of an introducing broker 
dealer (``PAIB'') account that the broker-dealer has agreed to 
maintain, a broker-dealer may treat cash received from securities 
customers as its own. Therefore, a clearing member is permitted to 
deposit cash (other than cash received from commodity customers, which 
is required to be segregated under provisions of the Commodity Exchange 
Act [''CEA'']) as margin for any of a broker-dealers' accounts at OCC 
without regard to the source of the cash. Accordingly, the lien 
language applicable to combined market-makers' accounts and certain 
other account types is overly restrictive as applied to cash and any 
other non-securities assets that might be deposited as margin in an 
account.\8\ OCC's lien could lawfully be applied to such non-securities 
assets to secure any obligation of the clearing member to the same 
extent as if the cash had been deposited with respect to the clearing 
member's firm lien account.
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    \8\ At present, the only other non-securities assets that may be 
deposited as margin are letters of credit (``LOCs''). LOCs are 
subject to special OCC rules in that an LOC may be secured by 
customer securities pledged by the broker-dealer to the issuer of 
the LOC. In such a situation, the LOC would be subject to the 
restrictions applicable to the securities. The broker-dealer may 
comply with those restrictions under OCC's Rules by designating the 
LOC as a ``restricted'' LOC and by specifying which account type is 
secured by the LOC.
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    It is also true that when securities other than customer securities 
are deposited with OCC as margin with respect to a customer account 
(other than a commodity customer account where securities must be 
segregated pursuant to provisions of the CEA), those securities would 
not for that reason alone have to be treated as securities carried for 
the account of any customer, and OCC's lien could lawfully apply. 
However, there are no systems in place that allow OCC to distinguish 
between customer and non-customer securities when they are deposited as 
margin for a customer account, including a market-maker account. 
Accordingly, OCC will continue to treat all securities deposited as 
margin for any securities account other than a proprietary account as 
if the securities were customer securities for purposes of the 
hypothecation rules.
    In order to address the discrepancies described above, OCC is 
amending Article I, Section 1 of the By-Laws to define two different 
types of liens: A ``general lien'' and a ``restricted lien.'' Assets 
subject to a general lien will serve as security for all obligations of 
the clearing member to OCC regardless of the origin or nature of those 
obligations. The proposed rule change would also define a ``general 
lien account'' as one in which OCC has a general lien over all assets 
in the account. Thus, the firm account and any other proprietary 
account, such as a proprietary market-maker's account, will be a 
general lien account, and all general lien accounts will be treated as 
a single firm lien account in a

[[Page 53153]]

liquidation of the clearing member. This is precisely the same result 
as under the present rules.
    The definition of a restricted lien will provide that assets in an 
account that are specified as subject to a restricted lien serve as 
security only for obligations arising from that particular account or 
from a specified group of accounts to which that account belongs.\9\ A 
restricted lien account will be defined as an account in which 
specified assets are subject to a restricted lien. All accounts other 
than the various types of proprietary accounts will be restricted lien 
accounts. However, not all assets in those accounts would be subject to 
a restricted lien. Cash and any other non-securities assets in a 
restricted lien account, because they are not subject to the 
restrictions of the hypothecation rules, would be subject to a general 
lien. However, an exception will be made for the securities customers' 
account and the customer lien account where all assets, including cash, 
would be subject only to a restricted lien. The reason for this 
exception is that although these non-securities assets are not subject 
to the hypothecation rules, the provisions of Rule 15c3-3(e) and in 
particular the reserve formula used in calculating the amount of funds 
a clearing member is required to deposit in the special reserve bank 
account for the exclusive benefit of customers provide a debit (i.e., a 
reduction in the required deposit) for ``[m]argin required and on 
deposit with [OCC] for all option contracts written or purchased in 
customer accounts.'' Given this debit in the reserve formula, it would 
appear to be inconsistent to use funds in the account as collateral for 
obligations other than those arising in such accounts. This limitation 
is reflected in the proposed rule change.
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    \9\ The reference to groups of accounts is necessary because, 
for example, a clearing member may have multiple combined market 
makers' accounts that would be liquidated as if they were a single 
account. The same would be true if a clearing member had more than 
one securities customers' account. These account groupings are 
addressed in existing Interpretation .02 following Article VI, 
Section 3 of the By-Laws.
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    In order to eliminate unnecessary restrictions on the use of non-
securities assets in certain accounts as described above, OCC is 
modifying the lien language appearing in the following paragraphs of 
Article VI, Section 3: Paragraph (a) to the extent applicable to firm 
non-lien accounts; paragraph (b) to the extent applicable to separate 
market-maker accounts other than proprietary market-maker accounts; 
paragraph (c) to the extent applicable to combined market-makers' 
accounts other than proprietary combined market-makers' accounts; and 
paragraph (h) applicable to JBO Participants' accounts. The 
modification necessary in each case is to provide that margin assets 
deposited with respect to the applicable account and consisting of cash 
and other non-securities collateral may be applied to any obligation of 
the clearing member rather than only to obligations arising from that 
account. This is accomplished by subjecting securities assets in the 
accounts to a restricted lien while subjecting non-securities assets in 
certain of the account to a general lien. Other changes in Article VI, 
Section 3 are non-substantive changes intended to make use of the newly 
defined terms, to improve consistency, to eliminate repetition, and to 
clarify ambiguities.\10\
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    \10\ No changes of substance are being made with respect to 
futures accounts subject to segregation requirements under the CEA.
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    In order to conform its Rules to the changes made in provisions of 
Article VI, Section 3(a) of the By-Laws relating to firm non-lien 
accounts and in Section 3(e) relating to the securities customers' 
account, OCC is deleting the specific lien language applicable to 
unsegregated long positions currently set forth in Rule 611. The extent 
of these liens would be set forth in the cited provisions of Article 
VI, Section 3.
    Notwithstanding the limitations of the existing lien language 
described above applicable to accounts other than proprietary accounts, 
the limitations of the use of margin are not fully reflected in the 
provisions of OCC's Rule 1104(a), which governs the creation of a 
liquidating settlement account and payments from that account in a 
clearing member liquidation. Rule 1104(a) presently provides, in 
effect, that proceeds from restricted letters of credit,\11\ 
unsegregated long positions, and variation payments resulting from 
positions in security futures in a public customers' account, may not 
be applied to obligations other than those arising from the public 
customers' account. It does not similarly restrict the use of proceeds 
of securities deposited directly as margin for that account even though 
the application of such securities to obligations arising out of other 
accounts would arguably be in violation of the hypothecation rules and 
even though such use would be inconsistent with OCC's restricted lien 
on those securities. In the event of a clearing member liquidation 
prior to the approval of this rule change, OCC would observe the 
limitations of the hypothecation rules and the lien language as it 
presently exists in OCC's By-Laws notwithstanding that those 
limitations are not fully reflected in Rule 1104(a). Those limitations 
are fully consistent with OCC's risk management system in that OCC has 
never set margin or clearing fund requirements with the expectation 
that it would have excess collateral in one account that could be 
applied against obligations arising in other accounts. OCC determines 
its risk margin requirements on each clearing member account 
independently.
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    \11\ OCC is amending the definition of restricted letter of 
credit in Rule 101 in order to make it more generic. In current 
practice, restricted letters of credit are used not only for the 
securities customers' account but may also be used in a segregated 
futures account. Under OCC's Rules, he letter of credit must 
indicate on its face the purpose or purposes to which it may be 
applied.
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    Nevertheless, if in liquidating any clearing member account a 
shortfall occurred, it would obviously be in the interest of OCC, its 
clearing members, and the integrity of the clearing system if OCC were 
able to apply the margin assets that it holds to the fullest extent 
practicable under applicable law. In addition, the intended 
restrictions on the use of proceeds of positions and securities in the 
securities customers' account as well as in market-maker accounts and 
other restricted lien accounts as OCC is now proposing to refer to them 
generically should be clearly stated. By making use of the newly 
defined terms general lien and restricted lien and by relying on the 
provisions of Article VI, Section 3 as proposed to be amended, only 
relatively minor amendments to the provisions of Rule 1104(a) are 
required to effectuate the dual purposes of the rule change. Other 
changes to Rule 1104 are intended for clarification only and are not 
substantive.

III. Discussion

    Section 17A(b)(3)(F) of the Act requires, among other things, that 
the rules of a clearing agency be designed to assure the safeguarding 
of securities and funds which are in its custody or control or for 
which it is responsible.\12\ OCC Rule 1104 provides that following the 
suspension of a clearing member OCC will create a liquidating 
settlement account for the purpose of making settlement payments for 
the clearing member's obligations to OCC. Under Rule 1104, all margin 
deposited by the suspended member in all of the member's accounts, as 
well as its contribution to OCC's clearing fund, will be converted to 
cash and will be deposited in the liquidating settlement account. To 
the extent such funds are insufficient for settlement and the clearing 
member is otherwise unable to

[[Page 53154]]

satisfy its obligations, OCC may have to use its clearing fund, which 
is made up from contributions from all clearing members, to make up the 
loss.
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    \12\ 15 U.S.C. 78q-1(b)(3)(F).
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    Under the current version of Article VI, Section 3, of OCC's By-
Laws, OCC has a lien on cash and non-securities assets in a non-
proprietary account for purposes of the obligations of such account 
only, thus limiting OCC's ability to use these assets in the 
liquidating settlement procedures provided for in Rule 1104. Although 
OCC is entitled under Rule 1108 to recover any amounts owed to it by 
the suspended Clearing member and OCC's members are entitled under 
Article VIII of the By-Laws to share in a recovery of charges against 
the clearing fund, the restriction on the use of the assets in non-
proprietary accounts unnecessarily complicates the liquidating 
settlement process.
    The rule change gives OCC a general lien over the cash and non-
securities assets in non-proprietary accounts at OCC, other than 
securities customers' accounts and customer lien accounts, so that 
those assets may be used to meet any of the member's obligations to OCC 
for purposes of creating a liquidating settlement account under Rule 
1104. Accordingly, by revising its By-Laws and Rules to give OCC 
broader access to collateral in the event of a clearing member 
liquidation while still complying with the Commission's hypothecation 
rules and customer protection rule, OCC has designed the proposed rule 
change to improve its ability to protect itself and its clearing 
members from the potential losses associated with a clearing member 
liquidation without affecting the protection of customers' securities 
under the Commission's rules. As a result, the Commission finds that 
the proposed rule change is designed to assure the safeguarding of 
securities and funds which are in OCC's custody or control or for which 
OCC is responsible.

IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
in particular Section 17A of the Act and the rules and regulations 
thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-OCC-2005-23) be and hereby 
is approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
[FR Doc. E6-14857 Filed 9-7-06; 8:45 am]

BILLING CODE 8010-01-P
