The Securities and Exchange Commission has proposed to shorten the settlement cycle for securities trades in which broker-dealers are participants from the current T+3 to T+2. Settlement times for bank loan trades are considerably longer, but the Loan Syndications and Trading Association (LSTA) has also recently taken action to financially incentivize parties toward shorter settlement times.
From T+3 to T+2
On September 28, 2016, the SEC proposed an amendment to Rule 15c6-1(a) under the Securities Exchange Act of 1934 to shorten the standard settlement cycle for most broker-dealer transactions from three business days after the trade date (T+3) to two business days after the trade date (T+2). The proposed amendment builds on previous industry proposals and initiatives and, depending on the contours of any final rule adopted, could raise some challenges for broker-dealers, including determining the settlement date of sales in connection with firm commitment underwritten offerings, determining whether a sale can be marked “long” under Regulation SHO, the time frame for compliance with multiple requirements related to lending customer securities and protecting customer funds under Rule 15c3 under the Exchange Act, and whether or not broker-dealers will have to address their credit policies with respect to smaller retail investors. The proposed amendment should not affect the U.S. syndicated corporate loan trading market and trades made under form LSTA documentation. (See below.)
Comments on the proposed amendment are due on or before December 5, 2016. Although the proposed amendment does not target an exact date of implementation, the SEC has acknowledged that the industry had previously identified September 5, 2017, as a target transition date and that it would consider that date (as well as other dates) in setting a compliance date under any final adopted amendment.
Since the adoption of Rule 15c6-1 in 1993, broker-dealers have been prohibited from effecting or entering into a contract for the purchase or sale of a security that provides for payment of funds and delivery of securities later than the third business day after the date of the contract. Previously, a five-day settlement cycle (T+5) had been the rule. Rule 15c6-1(a), which is the operative provision, generally covers all securities, including equities, corporate bonds, mutual funds, exchange-traded funds, American Depositary Receipts (ADRs) and securities-based swaps and options. Rule 15c6-1(a) does not apply to a contract for an exempted security, a government security, a municipal security, commercial paper, bankers’ acceptances or commercial bills, or to transactions in unlisted limited partnership interests. Rule 15c6-1(c) also provides an exception to the general T+3 rule that allows broker-dealers in a firm commitment underwriting to enter into contracts for the sale for cash of securities that are priced after 4:30 p.m. Eastern time on the date the securities are priced and sold by an underwriter. Such a transaction may settle on the fourth business day after the date of the contract (T+4). Finally, parties may contract out of Rule 15c6-1(a).
In light of technology advances since 1993, various market participants have considered the possibility of shortening the settlement cycle. In 2012, the Depository Trust & Clearing Corporation commissioned a study to examine the benefits of shortening the settlement cycle and explore the investments that would be necessary to implement a shortened cycle. In 2014, securities industry participants formed an industry steering group to facilitate the migration to T+2 for certain securities. In 2015, PricewaterhouseCoopers LLP and Deloitte & Touche LLP, in conjunction with the steering group, released publications addressing necessary requirements to implementing T+2, setting the third quarter of 2017 as the target completion date and listing the milestones that would be required in order to meet the target date. Also in 2015, the Investor Advisory Committee of the SEC (consisting of industry participants, current and former regulators, and academics) issued a public statement recommending that market participants move forward with the implementation of a shorter settlement period for all securities as soon as possible and recommending that the SEC take a “lead role” in the process of migrating to a shorter settlement cycle. Against this backdrop, the SEC proposed amending Rule 15c6-1(a).
The proposed amendment to Rule 15c6-1(a) will prohibit a broker-dealer from effecting or entering into a contract for the purchase or sale of a security (other than certain exempted securities) that provides for payment of funds and delivery of securities later than T+2, unless otherwise expressly agreed to by the parties at the time of the transaction.
The SEC believes, based on the various publications issued by the market participants, that the shortened settlement cycle will reduce credit, market, liquidity and systemic risk. Assuming trading activity levels remain unchanged, the shorter settlement cycle will result in fewer unsettled trades. Fewer unsettled trades and a shorter exposure period will expose market participants to less counterparty credit risk, less market risk when one counterparty to a transaction is required to liquidate an open position as a result of an unsettled trade in the open market, and less liquidity risk by requiring market participants to dedicate fewer financial resources to their respective central clearing counterparties.
The SEC also acknowledged that shortening the settlement cycle to T+2 will involve initial fixed costs to update systems and processes of market participants and may inconvenience some retail investors if their broker-dealers are unwilling to extend additional credit and require the retail investors to pre-fund their transactions to ensure that funds are available on settlement day. However, given the industry initiatives already put in place to facilitate migration to a T+2 standard, the SEC believes that the risk-reduction benefits justify the anticipated costs. The SEC is requesting comments on all aspects of the proposed amendment generally and is also soliciting comments on certain specific questions, including with respect to the T+4 exception for firm commitment underwritten offerings, the impact of the rule change on retail investors, operational changes that might arise if broker-dealers were obligated to recall loaned securities one day earlier, the impact of the proposed amendment on compliance by broker-dealers with applicable financial responsibility rules, and an appropriate compliance date for the proposed amendment.
Settlement of Bank Loan Trades
Rule 15c6-1(a) does not apply to the settlement of trades of bank debt, which is generally not deemed to be a security for purposes of the federal securities laws. Settlement periods for these trades are considerably longer than those for trades of public securities.
Market observers believe that there are many reasons why the settlement of bank loan trades are delayed. Assignments typically require the consent and approval of the administrative agent and the borrower (unless the borrower is in default). Furthermore, the administrative agent may require the parties to complete indefinite know-your-customer procedures. These consents and approvals tend to cause delays in the settlement process. Distressed trades are private transactions involving customized negotiation, documentation and due diligence which may involve as many as four parties: a buyer, a seller, a dealer firm acting as a “riskless principal” and the administrative agent. Unregulated shorting of trades in the distressed loan market also may contribute to gaps in timely settlements.
Under standardized LSTA legal documents governing loan trades, the parties agree to close as soon as practical on or after the trade date. However, to encourage timely settlement, the rules apply delayed compensation for par trades – performing loans that are expected to be paid in full and on a timely basis – that close on or after T+7, and for distressed trades – loans that are perceived to be at risk for full and timely payment – that are expected to close prior to T+20. According to a representative of the LSTA, currently, par trades are settling on an average of T+11 and distressed trades are settling on an average of T+44. In response to the market delays, the LSTA recently revised trading rules for par trades affecting delayed compensation.
Delayed compensation is a component of pricing in the settlement of par and distressed loan trades to ensure that neither party receives an economic benefit from delaying settlement. Delayed compensation places the parties in the approximate economic position on the closing or settlement date that they would have been in if they had settled their trade by T+7 or T+20, as the case may be.
Effective September 1, 2016, the LSTA revised par trading rules because settlement times were too long, and market participants desired to free up capital and reduce counterparty risk. The delayed compensation rules for par trades were changed from a no-fault model to a requirements-based model. Under the prior no-fault model, both buyer and seller paid delayed compensation, regardless of who was to blame for the delay. The buyer paid the seller LIBOR interest for the period of delay, calculated on the purchase price the seller would have received if the trade had closed timely, and the seller paid the buyer the amount of interest and accruing fees attributable to the loans for the period of delay that the buyer would have earned if the trade had closed timely. Under the new requirements-based model, if the buyer or seller does not take certain actions, which may include the delivery of forms, signatures and trade confirmations by specified dates, then the defaulting party may lose rights to receive delayed compensation.