The US Securities and Exchange Commission’s proposed Rule 10c-1 would create a sweeping new reporting and disclosure regime for participants in the securities lending markets. Among other things, the proposal increases the Financial Industry Regulatory Authority’s ability to look into the activities of non-broker-dealers, including the potential for near-real-time access to a market participant’s entire portfolio holdings of securities.
Under proposed Rule 10c-1 (Proposed Rule), securities lenders would be required to almost instantly report detailed information about securities lending transactions to the Financial Industry Regulatory Authority (FINRA), and FINRA would in turn disseminate much of this information to the marketplace “as soon as practicable.”
If adopted without change, the Proposed Rule would create new operational reporting burdens and grant FINRA greater insights into the operations and holdings of persons over which it does not have direct statutory jurisdiction. Comments on the Proposed Rule are due by January 7, 2022.
“The securities lending market is opaque,” begins the 184-page regulatory proposal.[1] According to the Proposing Release, industry observers and market participants have requested that the Securities and Exchange Commission (SEC) consider rules addressing this opacity, noting that additional transparency is warranted. In addition, the SEC cites congressional hearings and various reports calling for transparency and a “consolidated tape” for securities lending transactions.
To this end, the Proposed Rule is intended to close data gaps in the market and minimize data asymmetries among market participants by establishing a mechanism of reporting not dissimilar to the TRACE reporting system for fixed-income securities. The Proposed Rule would require any person who lends a security on behalf of itself or another person to provide the specified material terms of the transaction to a registered national securities association (RNSA). Currently, FINRA is the only RNSA.[2]
The SEC believes that the Proposed Rule would provide investors and other market participants with access to pricing and other material information regarding securities lending transactions in a timely manner, increasing price transparency and reducing information asymmetry. The SEC also notes that the information FINRA collects will enable regulators to better surveil the securities markets and inform them of investor behavior in the securities lending market.
Persons Required to Report
The Proposed Rule would have a very broad application and apply to any person who loans any security as defined in Section 3(a)(10) of the Exchange Act on behalf of itself or another person (a Lender), including entities over which neither the SEC nor FINRA have had any direct oversight authority, such as banks, insurance companies, and pension plans. The Proposed Rule’s reporting requirements would apply to every Lender except where a Lender engages a lending agent.[3] In those instances, the lending agent would assume the reporting obligations on behalf of the Lender.
The Proposed Rule would permit Lenders and lending agents to engage a “reporting agent” (i.e., a registered broker-dealer) to transmit required information to FINRA if there is a written agreement requiring the reporting agent to provide the relevant information to FINRA within certain periods outlined in the Proposed Rule (i.e., 15 minutes, as discussed below). The Proposed Rule also sets forth the following specific requirements of broker-dealers acting as “reporting agents”:
Observations: The Proposed Rule has extremely broad application, and the SEC went to great lengths to explain why it has the authority to require that non-FINRA members report information to FINRA, citing to Exchange Act Rule 10b-17. Rule 10b-17, adopted in 1971, requires certain issuers to provide information to FINRA regarding corporate actions, and it is unclear whether it was challenged in the courts at the time. The requirement that information be reported to FINRA by non-members will not be without its controversy and may be subject to challenge by banks, insurance companies, and even clearing agencies. In addition, the requirement that reporting agents be FINRA member broker-dealers is also not without criticism since there are non-broker-dealer private vendors that may be able to fill these requirements just as well or better.
Transaction Data Elements
The Proposed Rule sets forth specific data elements that must be reported to FINRA within 15 minutes after a loan is “effected.” The Proposed Rule also requires that FINRA assign each loan a unique transaction identifier and make such information public “as soon as practicable.” The data elements include the following:
Observations: While many of these data elements seem straightforward, it is unclear whether the SEC gave any consideration to the widely used master securities loan agreement (MSLA) when developing the Proposed Rule and, in particular, the impact that the Proposed Rule would have on legacy and subsequent agreements. This should matter at least with respect to the SEC’s consideration of the Proposed Rule’s economic impact and ultimate cost of compliance.
The Proposing Release alternated between using the terms “effect” and “execute.” Practitioners in this space are well aware that executing a transaction is generally understood to be a much narrower concept that “effecting,” which can include all actions leading up to execution. This is especially true in the broker-dealer context. While this concept may seem esoteric, it can have a ripple effect that leads to more legal uncertainty between these two concepts.
Although required reporters must send these data elements to FINRA within 15 minutes, the SEC gives FINRA more flexibility to disseminate information “as soon as practicable.” Although the SEC expects that FINRA will make the information publicly available on a rolling basis very shortly after receipt, it did not specify a time frame. The SEC, however, was clear in the Proposing Release that it plans to give FINRA more discretion to propose rules that would further elaborate on the required data elements to be reported, and on the types of platforms and venues that have to be identified to FINRA. While the SEC justifies this approach by suggesting that platform/venue identification can give investors insights into liquid platforms, it also provides FINRA with the opportunity to be viewed as implicitly endorsing certain types of platforms over others simply based on how it defines the term.
Loan Modifications
The Proposed Rule also requires reporting of information regarding loan modifications. Specifically, the following information would be required to be provided to FINRA, again within 15 minutes after each loan is modified, if the modification results in a change to information required to be provided to FINRA:
Observations: This requirement has the potential to create significant burdens on Lenders, lending agents, and reporting agents, especially with respect to collateral substitutions, which are not uncommon in this market.
Confidential Data Elements
In addition to the above data, which will be made publicly available, the Proposed Rule would require certain information be submitted to FINRA on a confidential basis (subject to applicable law):
Observations: These reporting elements may exceed the authority under which the SEC is proposing to adopt the Proposed Rule. Specifically, Section 984(b) of the Dodd-Frank Act directs the SEC to “promulgate rules that are designed to increase the transparency of information available to brokers, dealers, and investors with respect to loaned or borrowing securities.” These data elements would not be disseminated because, as noted by the SEC, revealing this information to the market would be detrimental because it reveals a specific market participant’s investment decisions. As a result, it is not clear how this confidential reporting would meet the requirements of Section 984(b): “[T]o increase the transparency of information available to brokers, dealers, and investors with respect to loan or borrowing securities.”
Securities Available to Loan
In addition to the transaction-level reporting obligations described above, the Proposed Rule would require Lenders/lending agents to report certain data about “securities available to loan” and “securities on loan” to FINRA at the end of each business day that the Lender lends securities or has outstanding securities loans. Specifically, each Lender/lending agent would have to report the following:
The calculations of securities “available to lend” for lending agents vary depending on whether the lending agent is a broker-dealer. Where the lending agent is a broker-dealer, the total amount available to lend must include those securities in the broker-dealer’s inventory, securities of customers who agreed to participate in a fully paid lending program, and the securities in its margin customers’ accounts.
If the lending agent is not a broker-dealer, the amounts must include all securities available to lend. In addition, the Proposed Rule would require that FINRA receive the total amount of each specific security on loan and require that FINRA publicly disseminate aggregate information about the security, exclusive of identifying information regarding the Lenders, lender agents, reporting agents, or person using reporting agents.
Observations: On its terms, the Proposed Rule would seem to require that any time a Lender lends a security or has a security outstanding on loan, the Lender must report all securities that are not subject to legal or other restrictions that would prevent the Lender from lending them. If read in this way, the Proposed Rule would effectively require Lenders (including private funds, endowments, foundations, registered investments companies, and others) to report substantially all of their portfolio holdings to FINRA.
FINRA Rules
The Proposed Rule also includes a direction to the RNSA (i.e., FINRA) to implement rules regarding the format and manner to administer the collection of information required under the Proposed Rule and distribute such information.
Observations: Although this provision takes up the least shelf space in the Proposed Rule, it can ultimately prove to be the most consequential given the considerable leeway that FINRA would have to develop its own companion rule set. While the SEC would review any proposed FINRA rules, and such rules would be subject to a notice and public comment period, the industry would have to be cognizant of any proposals that can adversely impact their securities lending activities and that go beyond what any final rule (if adopted) intended.
FINRA Data Retention and Availability
The Proposed Rule also sets forth data-retention and availability requirements applicable to the RNSA (i.e., FINRA), including the requirement that FINRA establish, maintain, and enforce reasonably designed written policies and procedures to maintain the security and confidentiality of confidential information. Of note, it requires that FINRA disseminate the required information under the Proposed Rule on its website or similar electronic means of delivery, without charge or use restrictions, for at least five years.
Observations: This provision could potentially create the opportunity for FINRA to have a new revenue stream, as there is no prohibition on FINRA otherwise charging fees related to the data as long as it makes a form of the data available without restriction on its website. For example, FINRA could choose to make a version of the data available for free that meets the requirements of the Proposed Rule while charging for a modified version of the data that includes elements not required under the Proposed Rule. It may behoove the SEC to clarify that free means free and that FINRA cannot otherwise use the data it collects to develop a new profit center.
FINRA Fees
Finally, the Proposed Rule provides that FINRA can establish and collect reasonable fees from each person who provides any required information directly to FINRA.
Observations: The substantive portion of the Proposal ended much like it started—with the SEC justifying why it can require non-FINRA members to report and pay fees to FINRA. Again, the SEC heavily relies on one rule that was adopted in the 1970s, perhaps without industry pushback, to justify imposing a requirement on market participants that arguably can be viewed as outside the SEC’s authority.
It is unclear whether the Proposed Rule will ever be formally adopted, but it does represent a wholly new reporting mechanism for the securities lending market. The SEC acknowledges this scope when it notes that compliance with the provisions of the Proposed Rule would be expected to cost the industry $375 million in the first year and $140 million annually thereafter.
We also note that there are several provisions where the Proposed Rule appears to be susceptible to challenge, whether because the SEC is exceeding its regulatory authority or, despite the hefty, acknowledged price tag, not fully appreciative of the costs and burden associated with implementing these requirements. What is clear, however, is that FINRA is poised to exert much more influence on non-broker-dealers if the Proposed Rule is adopted as is.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
David C. Boch
Katherine Dobson Buckley
New York
Thomas V. D’Ambrosio
Joseph D. Zargari
Philadelphia
John J. O’Brien
Christine M. Lombardo
Washington, DC
Laura E. Flores
Amy Natterson Kroll
W. John McGuire
Christopher D. Menconi
Ignacio A. Sandoval
Steven W. Stone
Kyle D. Whitehead
[1] Reporting of Securities Loans, Exchange Act Release No. 93613 (Nov. 18, 2021) (the Proposing Release).
[2] The Proposing Release notes that “[c]urrently, FINRA is the only RNSA and has experience establishing and maintaining systems that are designed to capture transaction reporting.”
[3] A lending agent generally means third-party intermediaries such as banks, clearing agencies, or broker-dealers that intermediate the loan of securities on behalf of beneficial owners.