Clarification of Member Obligations Regarding Brokered Certificates of Deposit
Certificates of Deposit
Effective Date: October 8, 2002
Certificates of Deposit
NASD is issuing this Notice to supersede NASD Notice to Members 02-28 (Notice or Notice 02-28) and replace the guidance offered in Notice to Members 02-28, which addressed issues applicable to members offering "brokered" certificates of deposit (CDs). Accordingly, this Notice repeats pertinent information from Notice to Members 02-28. However, it also provides additional guidance not included in Notice to Members 02-28. First, the Notice gives a more detailed description of the characteristics of brokered CDs, the mechanics of the brokered CD market, and the circumstances in which brokered CDs may be considered securities. Second, the Notice harmonizes NASD's disclosure and sales practice requirements with the New York Stock Exchange's (NYSE's) disclosure and sales practice obligations applicable to its members offering brokered CDs. Finally, the Notice recommends the appropriate pricing that members should use in reporting the value of brokered CDs on customers' account statements and the appropriate disclosures that should appear in customers' account statements.
Members may direct questions about this Notice to Patricia Albrecht, Assistant General Counsel, Office of General Counsel, NASD Regulatory Policy and Oversight, at (202) 728-8206.
Characteristics of Brokered CD and Brokered CD Market
CDs that typically are issued by a bank directly to a customer carry a fixed interest rate over a fixed duration of time and are insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000 against insolvency by the depository institution. As such, they are generally considered by the investing public to be simple, conservative products that carry few risks.
However, some members have been soliciting customers with "brokered" CDs. As explained below, brokered CDs may have a longer holding period until maturity date, be more complex, and carry more risk than "traditional" CDs. Brokered CDs are CDs issued by banks via a "master CD" to deposit brokers, which in turn sell interests in the master certificate to individual retail investors. Any broker/dealer that sells brokered CDs is a deposit broker.
The master CD is a negotiable instrument that represents a certain number of individual CDs, each with the same denomination. FDIC insurance attaches to the individual CDs represented in the master CD.1 The master CDs are held by a deposit broker as a custodian or by a sub-custodian appointed by the deposit broker. Either the deposit broker or the sub-custodian keeps the records of its customers' ownership interests in the CDs.2
In general, brokered CDs have longer maturity dates (in some cases, 20 years from the date of issuance), than traditional CDs. The interest rate terms of brokered CDs can also differ significantly from the simple interest rate terms usually used by traditional CDs. For example, some brokered CDs have their interest rates tied to a market index, such as the S&P 500. Brokered CDs also may have special call features that allow the issuing bank to terminate the CD after a specified period of time if interest rates drop. In this respect, the CD is similar to a callable, fixed-rate bond. To compensate for these additional features, brokered CDs frequently pay a higher interest rate than traditional CDs.
Because issuing banks may impose penalties on investors for withdrawing their funds before the maturity date of the CD or may not allow withdrawal prior to the maturity date, some deposit brokers (usually broker/dealers) may maintain a limited secondary market for customers who have purchased brokered CDs by buying back the CDs to resell to other customers. The deposit brokers maintain these markets to create some liquidity for the investment. However, the market conditions do not always favor the customer. For instance, if interest rates are high and a customer wants to trade in a low interest brokered CD for another CD with a higher interest rate, the customer might have to realize a loss on the principal of the CD in order to sell the CD. In addition, deposit brokers are not obligated to maintain a secondary market for brokered CDs sold to customers.
Circumstances that May Make a Brokered CD a Security
Although brokered CDs may have certain features that traditional CDs do not have, it is important to remember that, as long as a banking institution issues the brokered CDs, sets all of their features, and FDIC insurance applies to them, brokered CDs are generally considered bank products, not securities. However, there are several circumstances under which a brokered CD may be considered a security. For example, if a deposit broker materially alters the terms and features of a brokered CD (e.g., offering a different interest rate than the interest rate set by the issuing depository institution), the brokered CD is arguably a different investment vehicle that could be considered a security. Additionally, if a deposit broker buys for itself a largedenomination CD, fractionalizes it, and sells the fractions to investors, these actions could make the fractionalized CDs securities. Also, if a deposit broker affirmatively offers to customers certain expertise and skills that go beyond the sale of brokered CDs as incentives to purchase the brokered CDs, such as marketing and the ability to identify attractive CDs, these features may make the brokered CDs securities.3 As noted above, some deposit brokers maintain a limited secondary market for customers who have bought brokered CDs. If a deposit broker, as an incentive to purchase brokered CDs, offers and/or maintains a secondary market for customers to rely upon to provide additional liquidity to their brokered CDs, this feature may make brokered CDs securities.
NASD expects registered persons to understand the characteristics and risk factors associated with all investment products, including each type of brokered CD offered by the member with which the registered persons are associated, before soliciting customers. NASD recommends that firms review their compliance programs, supervisory procedures, and continuing education offerings to ensure that registered persons are properly trained and educated about these products. Audits, compliance meetings, and continuing education programs should include a discussion of these products.
Appropriate Disclosures and Sales Practices
The NYSE has also provided guidance on the appropriate disclosures and sales practices for members selling brokered CDs to customers.4 As noted above, this Notice serves in part to harmonize NASD's disclosure and sales practice requirements applicable to members offering brokered CDs with those of the NYSE. Accordingly, the Notice recommends amended disclosure and sales practice requirements in the following areas: (1) loss of principal; (2) secondary market; (3) call features; and (4) "step-rate" CDs. The following disclosures should be provided sufficiently in advance of the transaction date in any brokered CD in order to provide customers with meaningful notice of the terms, conditions, and risks in connection with such a transaction.
Members should provide customers with written materials that describe the characteristics and risks of purchasing brokered CDs or prepare such material for distribution if not made available by the issuer. Any such written materials must also comply with Rule 2210 ("Communications With The Public").
NASD has observed that some members continue to price brokered CDs at par value on account statements. Carrying CDs at par value could be materially misleading if values have significantly eroded, and members are advised to diligently endeavor to price accurately the brokered CDs on customer account statements.
There is no single method to determine the market value of brokered CDs. Members can obtain estimated values from several sources, including commercial pricing services. Some members rely on their fixed-income trading desks to determine a market value, while others have developed computerized valuation models or matrices to ascertain a theoretical market price. NASD recommends that when disclosing in account statements the more accurate values of brokered CDs held by customers, members should also disclose to customers that the value of brokered CDs on account statements are estimated and that their actual value may differ if customers elect to sell their brokered CDs in the secondary market. In addition, NASD recommends that members disclose the pricing method used to determine the market value of the brokered CDs. If market value is not provided as described above, NASD recommends that brokered CDs be reflected on customer statements as unpriced.
The Notice also recommends including other disclosures on the account statement, covering the following points:
1 Federal deposit insurance generally covers deposits of up to $100,000 in the aggregate for each depositor in each bank, thrift, or credit union. A customer should ensure that purchasing any insured CD will not bring his or her aggregate deposit over the $100,000 FDIC insurance limit.
2 For FDIC insurance protection to apply to the owner of the brokered CD, it is important that deposit brokers keep accurate records of the ownership interest in the brokered CD. However, the FDIC does not have to rely solely upon the records of the bank and/or the deposit broker to establish ownership. Under the FDIC's rules, if the brokered CDs are being held by a custodian, which is usually the case in sales by broker/dealers, the FDIC may also look to the records of a custodian to establish a relationship that permits deposit insurance to pass through the custodian to the purchaser. In addition, if the FDIC has reason to believe that the insured depository institution's deposit account records misrepresent the actual ownership of deposited funds and such misrepresentation would increase deposit insurance coverage, the FDIC may consider other available evidence of ownership and pay claims for insured deposits on the basis of the actual rather than the misrepresented ownership. See 12 C.F.R. ÃÂ§ 330.5. Accordingly, firms should suggest to their customers that the customers keep records of their brokered CDs in the event the FDIC needs to look beyond the custodian's or deposit institution's records to establish ownership.
3See Gary Plastic v. Merrill Lynch, Pierce, Fenner & Smith, 756 F.2d 230 (2d Cir. 1985).
4See NYSE Information Memo No. 01-5 (March 7, 2001) and NYSE Information Memo No. 01-19 (July 20, 2001).