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Interpretive Guidance - Interpretive Notices
Publication date:
Confirmation, Delivery and Reclamation of Interchangeable Securities

In March 1988, the Securities and Exchange Commission approved amendments to rules G-12 and G-15 concerning municipal securities that may be issued in bearer or registered form (interchangeable securities).[1] These amendments will become effective for transactions executed on or after September 18, 1988. The amendments revise rules G-12(e) and G-15(c) to allow inter-dealer and customer deliveries of interchangeable securities to be either in bearer or registered form, ending the presumption in favor of bearer certificates for such deliveries. The amendments also delete the provision in rule G-12(g) that allows an inter-dealer delivery of interchangeable securities to be reclaimed within one day if the delivery is in registered form. In addition, the amendments remove the provisions in rules G-12(c) and G-15(a) that require dealers to disclose on inter-dealer and customer confirmations that securities are in registered form.

The Board has received inquiries on several matters concerning the amendments and is providing the following clarifications and interpretive guidance.

Deliveries of Interchangeable Securities

Several dealers have asked whether the amendments apply to securities that can be converted from bearer to registered form, but that cannot then be converted back to bearer form. These securities are "interchangeable securities" because they originally were issuable in either bearer or registered form. Therefore, under the amendments, physical deliveries of these certificates may be made in either bearer or registered form, unless a contrary agreement has been made by the parties to the transaction.[2]

The Board also has been asked whether a mixed delivery of bearer and registered certificates is permissible under the amendments. Since the amendments provide that either bearer or registered certificates are acceptable for physical deliveries, a delivery consisting of bearer and registered certificates also is an acceptable delivery under the amendments.

Fees for Conversion

Transfer agents for some interchangeable securities charge fees for conversion of registered certificates to bearer form. Dealers should be aware that these fees can be substantial and, in some cases, may be prohibitively expensive. Dealers, therefore, should ascertain the amount of the fee prior to agreeing to deliver bearer certificates. A dealer may pass on the costs of converting registered securities to bearer form to its customer. In such a case, the dealer must disclose the amount of the conversion fee to the customer at or prior to the time of trade, and the customer must agree to pay it.[3] In addition, rule G-15(a)(iii)(J)[*] requires that the dealer note such an agreement (including the amount of the conversion fee) on the confirmation.[4] The conversion fee, however, should not be included in the price when calculating the yield shown on the confirmation.[5] In collecting this fee, the dealer merely would be passing on the costs imposed by a third party, voluntarily assumed by the customer, relating to the form in which the securities are held. The conversion fee thus is not a necessary or intrinsic cost of the transaction for purposes of yield calculation.[6]

Continued Application of the Board's Automated Clearance Rules

The Board's automated clearance rules, rules G-12(f) and G-15(d), require book-entry settlements of certain inter-dealer and customer transactions.[7] The amendments on interchangeable securities address only physical deliveries of certificates and, therefore, apply solely to transactions that are not required to be settled by book-entry under the automated clearance rules.

When a physical delivery is permitted under Board rules (e.g., because the securities are not depository eligible), dealers may agree at the time of trade on the form of certificates to be delivered. When such an agreement is made, this special condition must be included on the confirmation, as required by rules G-12(c)(vi)(I) and G-15(a)(iii)(J).[8][*]Dealers, however, may not enter into an agreement providing for a physical delivery when book-entry settlement is required under the automated clearance rules, as this would result in a violation of the automated clearance rules.[9]

Need for Education of Customers on Benefits of Registered Securities

Dealers should begin planning as soon as possible any internal or operational changes that may be needed to comply with the amendments. The Depository Trust Company (DTC) has announced plans for a full-scale program of converting interchangeable securities now held in bearer form to registered form beginning on September 18, 1988.[10] When possible, DTC plans to retain a small supply of bearer certificates in interchangeable issues to accommodate withdrawal requests for bearer certificates.[11] The general effect of the amendments and DTC's policy, however, will make it difficult for dealers, in certain cases, to ensure that their customers will receive bearer certificates. Dealers should educate customers who now prefer bearer certificates on the call notification and interest payment benefits offered by registered certificates and dealer safekeeping and advise them when it is unlikely that bearer certificates can be obtained in a particular transaction. Dealers safekeeping municipal securities through DTC on behalf of such customers also may wish to review with those customers DTC's new arrangements for interchangeable securities.


[1] See SEC Release No. 34-25489 (March 18, 1988); MSRB Reports Vol. 8, no. 2 (March 1988), at 3.

[2] The amendments should substantially reduce delays in physical deliveries that result because of dealer questions about whether specific certificates should be in bearer form. This efficiency would be impossible if these "one-way" interchangeable securities were excluded from the amendments since dealers would be required to determine, for each physical delivery of registered securities, whether the securities are "one-way" interchangeable securities.

[3] Rule G-17, on fair dealing, requires dealers to disclose all material facts about a transaction to a customer at or before the time of trade. In many cases, the conversion fee is as much as $15 for each bearer certificate. The Board also has been made aware of some cases in which the transfer agent must obtain new printing plates or print new bearer certificates to effect a conversion. The conversion costs then may be in excess of several hundred or a thousand dollars. Therefore, it is important that the customer be aware of the amount of the conversion costs prior to agreeing to pay for them.

[4] This rule requires that, in addition to any other information required on the confirmation, the dealer must include "such other information as may be necessary to ensure that the parties agree on the details of the transaction."

[5] Rule G-15(a)(i)(I) [currently codified at rule G-15(a)(i)(A)(5)] requires the yield of a customer transaction to be shown on the confirmation.

[6] Some customers, for example, may ask dealers to convert registered securities to bearer form even though the customers also may be willing to accept registered certificates if this is more economical.

[7] Rule G-12(f)(ii) requires book-entry settlement of an inter-dealer municipal securities transaction if both dealers (or their clearing agents for the transaction) are members of a depository making the securities eligible and the transaction is compared through a registered securities clearing agency. Rule G-15(d)(iii) requires book-entry settlement of a customer transaction if the dealer grants delivery versus payment or receipt versus payment privileges on the transaction and both the dealer and the customer (or the clearing agents for the transaction) are members of a depository making the securities eligible.

[8] These rules require that, in addition to the other information required on inter-dealer and customer confirmation, confirmations must include "such other information as may be necessary to ensure that the parties agree to the details of the transaction."

[9] Of course, dealers may withdraw physical certificates from a depository once a book-entry delivery is accepted.

[10] DTC expects this conversion process to take approximately two years. Midwest Securities Trust Company and The Philadelphia Depository Trust Company have not yet announced their plans with regard to interchangeable securities.

[11] DTC Notice to Participants on Plans for Comprehensive Conversion of Interchangeable Municipal Bonds to the Registered Form (August 10, 1988).

[*] [Currently codified at rule G-15(a)(i)(A)(8)]

Interpretive Guidance - Interpretive Notices
Publication date:
Determining Whether Transactions Are Inter-Dealer or Customer Transactions: Rules G-12 and G-15
Rule Number:

Rule G-12, Rule G-15

In December 1984, the Board published a notice providing guidance to dealers in determining whether certain transactions are inter-dealer or customer transactions for purposes of Board rules. Since the publication of this notice, the Board has continued to receive reports that inter-dealer transactions sometimes are erroneously submitted to automated confirmation/affirmation systems for customer transactions. This practice reduces the efficiencies of automated clearance since these transactions fail to compare in the initial comparison cycle. The Board is re-publishing the notice to remind dealers of the need to submit inter-dealer and customer transactions to the correct automated clearance systems.

The Board recently has been advised that some members of the municipal securities industry are experiencing difficulties in determining the proper classification of a contra-party as a dealer or customer for purposes of automated comparison and confirmation. In particular, questions have arisen about the status of banks purchasing for their trust departments and dealers buying securities to be deposited in accumulation accounts for unit investment trusts. Because a misclassification of a contra-party can cause significant difficulty to persons seeking to comply with the automated clearance requirements of rules G-12, and G-15, the Board believes that guidance concerning the appropriate classification of contra-parties in certain transactions would be helpful to the municipal securities industry.

Background

Rule G-12(f)(i) requires dealers to submit an inter-dealer transaction for automated comparison if the transaction is eligible for automated comparison .... Rule G-15(d)(ii) requires dealers to use an automated confirmation/affirmation service for delivery versus payment or receipt versus payment (DVP/RVP) customer transactions if the [transactions are eligible for automated confirmation and acknowledgement].

The systems available for the automated comparison of inter-dealer transactions and automated confirmation/affirmation of customer transactions are separate and distinct. As a result, misclassification of a contra-party may frustrate efficient use of the systems. For example, a selling dealer in an inter-dealer transaction may misclassify the contra-party as a customer, and submit the trade for confirmation/affirmation through the automated system for customer transactions while the purchaser (correctly considering itself to be a dealer) seeks to compare the transaction through the inter-dealer comparison system. Since, the automated systems for inter-dealer and customer transactions are entirely separate, the transaction will not be successfully compared or acknowledged through either automated system.

Transactions Effected by Banks

The Board has received certain questions about the proper classification of contra-parties in the context of transactions effected by banks. A bank may be the purchaser or seller of municipal securities either as a dealer or as a customer. For example, a dealer may sell municipal securities to a bank's trust department for various trust accounts. Such purchases by a bank in a fiduciary capacity would not constitute "municipal securities dealer activities" under the Board's rules[1] and are properly classified and confirmed as customer transactions. A second type of transaction by a bank is the purchase or sale of securities for the dealer trading account of a dealer bank. The bank in this instance clearly is acting in its capacity as a municipal securities dealer and the transaction should be compared as an inter-dealer transaction.

A dealer effecting a transaction with a dealer bank may not know whether the bank is acting in its capacity as a dealer or as a customer. The Board is of the view that, in such a case, the dealer should ascertain the appropriate classification of the bank at the time of trade to ensure that the transaction can be compared or confirmed appropriately. The Board anticipates that dealer banks will assist in this process by informing contra-parties whether the bank is acting as a dealer or customer in transactions in which the bank's role may be unclear to the contra-party.

Transactions by Dealer Purchasing Municipal Securities for UIT Accumulation Accounts

The Board has also received several inquiries concerning the appropriate classification of a dealer who purchases municipal securities to be deposited into an accumulation account for ultimate transfer to a unit investment trust (UIT). The dealer buying securities for a UIT accumulation account may purchase and hold the securities over a period of several days before depositing them with the trustee of the UIT in exchange for all of the units of the trust; during this time the dealer is exposed to potential market risk on these securities positions. The subsequent deposit of the securities with the trustee of the UIT in exchange for the units of the trust may be viewed as a separate, customer transaction between the dealer buying the accumulation account and the trust. The original purchase of the securities by the dealer for the account then must be considered an inter-dealer transaction since the dealer is purchasing for its own account ultimately to execute a customer transaction. The Board notes that the SEC has taken this approach in applying its net capital and customer protection rules to such transactions.

The Board is of the view that, for purposes of its automated comparison requirements, transactions involving dealers purchasing for UIT accumulation accounts should be considered inter-dealer transactions. The Board also notes the distinction between this situation, in which a dealer purchases for ultimate transfer to a trust or fund, and situations where purchases or sales of municipal securities are made directly by the fund, as is the case with purchases or sales by some open-end mutual funds. These latter transactions should be considered as customer transactions and confirmed accordingly.

Other Inter-Dealer Transactions

In addition to questions on the status of a dealer bank and dealers purchasing for accumulation accounts, the Board has received information that a few large firms are sometimes subtracting trades with regional securities dealers into the customer confirmation system. The Board is aware that these firms may classify transactions with regional dealers or bank dealers as "customer" transactions for purposes of internal accounting and compensation systems. The Board reminds industry members that transactions with other municipal securities dealers will always be inter-dealer transactions and should be compared in the inter-dealer automated comparison system without regard to how the transactions are classified internally within a dealer's accounting systems. The Board believes it is incumbent upon those firms who misclassify transactions in this fashion to promptly make the necessary alterations to their internal systems to ensure that this practice of misclassifying transactions is corrected.


[1] Section 3(a)(30) of the Securities Exchange Act of 1934 defines a bank to be a municipal securities dealers if it "is engaged in the business of buying and selling municipal securities for its own account other than in a fiduciary capacity." For purposes of the Board's rule G-1, defining a separately identifiable department or division of a bank dealer, the purchase and sale of municipal securities by a trust department would not be considered to be "municipal securities dealer activities."

NOTE: Revised to reflect subsequent amendments.