
[Federal Register Volume 79, Number 73 (Wednesday, April 16, 2014)]
[Notices]
[Pages 21494-21496]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-08585]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-71927; File No. SR-FINRA-2013-039]


Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Granting Approval of a Proposed Rule Change, as 
Modified by Amendment No. 1, To Clarify How Certain Securities Are 
Classified and Reported to FINRA

April 10, 2014.

I. Introduction

    On September 16, 2013, the Financial Industry Regulatory Authority, 
Inc. (``FINRA'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a 
proposed rule change to clarify how certain securities are classified 
and reported to FINRA. The proposed rule change was published for 
comment in the Federal Register on September 30, 2013.\3\ The 
Commission received two comments on the Original Proposal.\4\ On 
November 12, 2013, FINRA granted the Commission an extension of time to 
act on the proposal until December 29, 2013.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 70482 (September 23, 
2013), 78 FR 59995 (September 30, 2013) (``Original Proposal'').
    \4\ See Letters to the Commission from Sean Davy, Managing 
Director, Capital Markets, SIFMA, dated October 21, 2013 (``SIFMA 
Letter''); and Manisha Kimmel, Executive Director, Financial 
Information Forum, dated October 31, 2013 (``FIF Letter'').
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    On December 24, 2013, the Commission instituted proceedings to 
determine whether to disapprove the proposed rule change.\5\ On 
February 12, 2014, FINRA submitted Amendment No. 1 to respond to the 
comments and amend the proposed rule change, which the Commission 
published for comment in the Federal Register on March 5, 2014.\6\ In 
response to the Order Instituting Proceedings and the Notice of 
Amendment No. 1, the Commission received one additional comment letter 
on the proposal.\7\ On March 27, 2014, the Commission extended to May 
28, 2014, the period for Commission action to determine whether to 
disapprove the proposed rule change, as modified by Amendment No. 1.\8\
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    \5\ See Securities Exchange Act Release No. 71180 (December 24, 
2013), 78 FR 79716 (December 31, 2013) (``Order Instituting 
Proceedings'').
    \6\ See Securities Exchange Act Release No. 71629 (February 27, 
2014), 79 FR 12541 (March 5, 2014) (``Notice of Amendment No. 1'').
    \7\ See Letter to the Commission from Sean Davy, Managing 
Director, Capital Markets, SIFMA, dated March 14, 2014 (``SIFMA 
Letter II'').
    \8\ See Securities Exchange Act Release No. 71819 (March 27, 
2014), 79 FR 18591 (April 2, 2014).
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    This order approves the proposed rule change, as modified by 
Amendment No. 1.

II. Description of the Original Proposal

    FINRA's rules generally require that members report over-the-
counter (``OTC'') transactions in eligible debt and equity securities 
to a trade reporting system operated by FINRA. FINRA Rule 6622 requires 
that members report transactions in OTC Equity Securities \9\ to the 
OTC Reporting Facility (``ORF''), and the Rule 6700 Series requires 
members to report transactions in

[[Page 21495]]

TRACE-Eligible Securities \10\ to the Trade Reporting and Compliance 
Engine (``TRACE'').
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    \9\ FINRA Rule 6420(f) defines ``OTC Equity Security'' to 
include ``any equity security that is not an `NMS stock' as that 
term is defined in Rule 600(b)(47) of SEC Regulation NMS; provided, 
however, that the term `OTC Equity Security' shall not include any 
Restricted Equity Security.'' FINRA Rule 6420(k) defines 
``Restricted Equity Security'' to mean ``any equity security that 
meets the definition of `restricted security' as contained in 
Securities Act Rule 144(a)(3).''
    \10\ FINRA Rule 6710(a) defines ``TRACE-Eligible Security'' to 
include ``a debt security that is United States (`U.S.') dollar-
denominated and issued by a U.S. or foreign private issuer, and, if 
a `restricted security' as defined in Securities Act Rule 144(a)(3), 
sold pursuant to Securities Act Rule 144A.''
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    The Original Proposal was designed to clarify how members are 
required to report two classes of securities--``depositary shares'' and 
``capital trust'' (or ``trust preferred'') securities--under these 
rules. Both classes are ``hybrid'' securities, in that each has debt- 
and equity-like features. According to FINRA, such hybrid securities 
are frequently designed to straddle both classifications for a variety 
of purposes, including the tax treatment applicable to issuers and 
recipients when distributions are made (or not made) to holders of the 
security, and the treatment of the principal as capital for issuers 
subject to capital requirements.\11\ In the Original Proposal, FINRA 
stated that it had received requests for guidance whether such hybrid 
securities should appropriately be classified as equities, and thus 
reported to ORF, or debt securities, and thus reported to TRACE.
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    \11\ See Original Proposal, 78 FR 59996.
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    FINRA thus proposed to classify depositary shares, when not listed 
on an equity facility of a national securities exchange,\12\ as OTC 
Equity Securities under FINRA Rule 6420(f). As such, depositary shares 
would be reportable to ORF in accordance with ORF requirements. FINRA 
took the view that depositary shares generally are securities that 
represent a fractional interest in a share of preferred stock, and 
preferred stocks are considered equity securities. FINRA noted further 
that depositary shares generally entitle the holder, through the 
depositary, to a proportional fractional interest in the rights, 
powers, and preferences of the preferred stock represented by the 
depositary share.\13\
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    \12\ For purposes of the proposed rule change, the term ``listed 
on an equity facility of a national securities exchange'' would mean 
a security that qualifies as an NMS stock (as defined in Rule 
600(b)(47) of Regulation NMS) as distinguished from a security that 
is listed on a bond facility of a national securities exchange.
    \13\ See Original Proposal, 78 FR 59996.
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    With respect to capital trust (or trust preferred) securities, 
FINRA proposed to include such securities within the definition of 
``TRACE-Eligible Security'' under FINRA Rule 6710(a). Thus, members 
would be required to report transactions in such securities to TRACE 
according to applicable TRACE reporting requirements. For example, 
members would be required to report price as a percentage of par value, 
and volume as the total par value of the transaction (not the number of 
bonds traded).\14\
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    \14\ See FINRA Rule 6730.
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    FINRA stated that the proposed interpretation would apply only on a 
prospective basis. It would not require FINRA members to review old 
trades and cancel and re-report those trades if they had been reported 
contrary to the terms of the proposal. If the proposal became 
effective, FINRA members would be required to cancel and re-report 
trades that occurred after the date of the proposal's effectiveness 
only if those trades had been reported incorrectly.\15\
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    \15\ See Original Proposal, 78 FR 59996-97.
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III. Comments on the Original Proposal, FINRA's Response, and Amendment 
No. 1

    Summary of Comments. As noted above, the Commission received two 
comment letters on the Original Proposal.\16\ Both comments expressed 
concern with FINRA's proposed guidance regarding trade reporting of 
hybrid securities, and argued that hybrid securities currently being 
reported to TRACE should continue to be reported to TRACE. One of the 
commenters stated, in particular, that investors evaluate hybrid 
securities, including depositary shares, based upon their fixed income 
attributes. According to this commenter, depositary shares with a par 
value of $1,000 have historically been traded and settled with a debt 
convention, meaning on the basis of yield and credit quality rather 
than on the potential for capital appreciation.\17\ This commenter 
supported the current market practice of treating depositary shares 
with $1,000 par value or greater as debt securities. The commenter 
believed that the proposed interpretation could dampen the secondary 
market by creating investor confusion or rendering the securities 
ineligible for inclusion in fixed income indices.\18\
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    \16\ See supra note 4.
    \17\ See SIFMA Letter at 6. See also FIF Letter at 1 (stating 
generally that the depositary shares ``are traded as fixed income 
securities'').
    \18\ See SIFMA Letter at 5.
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    Both commenters argued that it would be difficult for market 
participants to adapt their systems to comply with the proposed 
reclassification of depositary shares as ORF-eligible. One commenter 
noted that the data fields captured by FINRA's ORF are different than 
those captured by TRACE.\19\ The second commenter stated that many 
firms have separate trading, operations, and technology architecture 
for equities and debt that is tailored to the order lifecycle of each 
type of instrument,\20\ and argued that the costs of implementing the 
new guidance may not justify the benefits.\21\
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    \19\ For example, ORF collects for each transaction the price 
per share and number of shares traded. It does not have a data field 
for an accrued coupon or dividend, information captured as part of 
debt transactions reported to TRACE. See id. at 7.
    \20\ See FIF Letter at 1-2. This commenter also listed a number 
of other potential effects of the proposed interpretation. See id. 
at 2-3.
    \21\ See id. at 3.
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    One of the commenters also believed that the proposed guidance 
``fail[ed] to capture the entire hybrid preferred universe,'' \22\ and 
therefore offered a formulation of the guidance that it believed would 
more thoroughly define the criteria by which a security would be 
classified as reportable to ORF or TRACE.\23\
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    \22\ SIFMA Letter at 11.
    \23\ See id. at 12.
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    FINRA's Response to Commenters and Amendment No. 1. FINRA 
acknowledged that the appropriate classification of hybrid securities 
is a complex analysis and agreed with the commenters that hybrid 
securities--in particular, securities with a liquidation preference of 
$1,000 or more--have significant debt-like characteristics. FINRA 
stated that it had further discussions about the proposal with several 
institutional investors who, in general, agreed with the concerns 
raised by the commenters.\24\
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    \24\ See Notice of Amendment No. 1, 79 FR 12543.
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    Therefore, in Amendment No. 1, FINRA modified the proposed 
interpretation to provide that, in addition to capital trust and trust 
preferred securities, the term ``TRACE-Eligible Security'' would 
include: (1) A depositary share having a liquidation preference of 
$1,000 or more (or a cash redemption price of $1,000 or more) that is a 
fractional interest in a non-convertible,\25\ preferred security and is 
not listed on an equity facility of a national securities exchange 
(``hybrid $1,000 depositary share''); and (2) a non-convertible, 
preferred security having a liquidation preference of $1,000 or more 
(or a cash redemption price of $1,000 or more) that is not listed on an 
equity facility of a national securities exchange (``hybrid $1,000 
preferred security''), such as a hybrid $1,000 preferred security that 
is offered directly to an investor or a preferred security underlying 
multiple hybrid $1,000 depositary shares. Any such

[[Page 21496]]

security deemed as a TRACE-Eligible Security would be excluded from the 
term ``OTC Equity Security.'' \26\
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    \25\ ``Non-convertible'' means not convertible into or 
exchangeable for property or shares of any other series or class of 
the issuer's capital stock. See Notice of Amendment No. 1, 79 FR 
12543, n. 17.
    \26\ See Notice of Amendment No. 1, 79 FR 12543.
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    FINRA did not modify the proposed interpretation regarding the 
treatment of capital trust securities and trust preferred securities. 
Thus, the term ``TRACE-Eligible Security'' would include a capital 
trust security and a trust preferred security (other than a capital 
trust security or a trust preferred security that is listed on an 
equity facility of a national securities exchange), and transactions in 
such securities must be reported to TRACE (and not to ORF) in 
compliance with the applicable reporting requirements. This 
interpretation would apply even if the capital trust security (or a 
trust preferred security) was previously listed on an equity facility 
of a national securities exchange but has since been delisted. Once 
delisted, the security must be reported to TRACE.\27\ All other 
preferred securities and depositary shares representing fractional 
interests in such securities--except the hybrid securities identified 
above: hybrid $1,000 preferred securities and hybrid $1,000 depositary 
shares--would continue to be included in the term ``OTC Equity 
Security,'' and members must report transactions in such securities to 
ORF.\28\
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    \27\ See id. at n. 18.
    \28\ For example, a non-convertible preferred security having a 
par value or liquidation preference of $25 that is not listed on an 
equity facility of a national securities exchange would be an OTC 
Equity Security under the interpretation and would be required to be 
reported to ORF. See 79 FR 12543.
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    In light of the amended interpretation, FINRA determined not to 
extend the implementation date beyond the originally proposed maximum 
of 150 days following Commission approval. FINRA believes that members 
will be able to comply within such timeframe because the amended 
interpretation largely follows current market practice.\29\ Therefore, 
as of the date of implementation, affected securities will be 
transferred, if necessary, for reporting to the appropriate trade 
reporting facility, and after this transfer members must report all 
transactions in such securities to the appropriate trade reporting 
facility.
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    \29\ See id.
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    Comment on Amendment No. 1. The Commission received one comment 
letter in response to Amendment No. 1.\30\ The commenter supported the 
proposed revisions and believed that the amended interpretation would 
prevent investor confusion by allowing hybrid $1,000 depositary shares 
and hybrid $1,000 preferred securities to be reported to TRACE. The 
commenter stated that the amended interpretation ``appropriately 
preserves the established market practice for these securities and 
achieves investor protection goals consistent with the debt-like nature 
of the security, without being unduly burdensome.'' \31\
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    \30\ See supra note 7.
    \31\ SIFMA Letter II at 2.
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V. Discussion

    After carefully considering the proposed rule change, as modified 
by Amendment No. 1, the comments submitted, and FINRA's response to the 
comments, the Commission finds that the proposed rule change, as 
modified by Amendment No. 1, is consistent with the requirements of the 
Act and the rules and regulations thereunder applicable to a national 
securities association.\32\ In particular, the Commission finds that 
the proposed rule change, as modified by Amendment No. 1, is consistent 
with Section 15A(b)(6) of the Act,\33\ which requires, among other 
things, that FINRA rules be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest.
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    \32\ In approving this proposed rule change, the Commission has 
considered the proposed rule change's impact on efficiency, 
competition, and capital formation. See 15 U.S.C. 78c(f).
    \33\ 15 U.S.C. 78o-3(b)(6).
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    The Commission believes that it is reasonable and consistent with 
the Act for FINRA to provide guidance as to whether particular hybrid 
securities should, for purposes of FINRA's trade reporting rules, be 
deemed debt securities, and thus TRACE-eligible, or equity securities, 
and thus reportable to an equity trade reporting facility. Although 
such securities may have both debt and equity features, the Commission 
believes that it is appropriate for FINRA to seek to address the 
confusion about how to report such securities by having all 
transactions in a particular type of hybrid security reported to the 
same facility. This approach is reasonably designed to promote 
transparency, as all trade reports of the same hybrid security 
discussed in the proposal should now be reported to and disseminated by 
the same trade reporting facility, instead of appearing on different 
facilities in different formats. Furthermore, the Commission believes 
that, in the absence of a compelling regulatory reason to require 
hybrid securities to be reported to an equity trade reporting facility 
such as the ORF, it is consistent with the Act for FINRA to permit its 
members to continue using existing infrastructure to report the hybrid 
securities in question to TRACE.

VII. Conclusion

    It is therefore ordered pursuant to Section 19(b)(2) of the Act 
\34\ that the proposed rule change (SR-FINRA-2013-039), as modified by 
Amendment No. 1, be and hereby is approved.
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    \34\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\35\
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    \35\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2014-08585 Filed 4-15-14; 8:45 am]
BILLING CODE 8011-01-P


