Section 3(a)(2) of the Securities Act of 1933 (the “Securities Act”) exempts from registration under the Securities Act any security issued or guaranteed by a bank. This exemption is based on the notion that, whether state or federal, banks are highly and relatively uniformly regulated, and as a result will provide adequate disclosure to investors about their finances in the absence of federal securities registration requirements. In addition, banks are also subject to various capital requirements that may increase the likelihood that holders of their debt securities will receive timely payments of principal and interest. This article provides an overview of how this exemption applies to a bank’s offering of securities, including structured notes.
What Is a Bank?
Under Section 3(a)(2), a “bank” is defined broadly to mean any national bank, or any banking institution organized under the law of any state, territory, or the District of Columbia, the business of which is substantially confined to banking and is supervised by the state or territorial banking commission or similar official. To qualify as a bank under Section 3(a)(2), the institution must meet both of the following requirements: (i) it must be a national bank or any institution supervised by a state banking commission or similar authority and (ii) its business must be substantially confined to banking. Therefore, securities issued by bank holding companies, finance companies, investment banks, and loan companies are not exempt from registration under Section 3(a)(2); even though many investors may think of these institutions as “banks,” their businesses are not substantially confined to banking. An offering of securities by any of these institutions must be registered under the Securities Act unless the offering comes within another exemption from registration.
Securities Guaranteed by a Bank
As noted above, the Section 3(a)(2) exemption is also available for securities “guaranteed” by a bank. Whether an offering is guaranteed by a bank is interpreted broadly by the Securities and Exchange Commission (the “SEC”). The staff of the SEC has taken the position in no-action letters that the term “guarantee” is not limited to a guaranty in a legal sense, but also includes arrangements in which the bank agrees to ensure the payment of a security. However, in a typical guaranteed offering, a bank’s affiliate will serve as issuer of the relevant securities, and the entity that is a bank will execute a written guarantee of the payment obligations on those securities.
U.S. branches of foreign banks are entitled to rely on the Section 3(a)(2) exemption. In 1986, the SEC announced its decision to cease granting no-action letters regarding securities issued or guaranteed by foreign bank branches and agencies, and formalized its position that a foreign branch will be deemed to be a “national bank” or a “banking institution organized under the laws of any state” if “the nature and extent of federal and/or state regulation and supervision of that particular branch or agency is substantially equivalent to that applicable to federal or state chartered domestic banks doing business in the same jurisdiction.”1 As a result, several U.S. branches of non-U.S. banks are currently frequent issuers of structured products and other debt securities in the U.S.
Types of Securities
The exemption under Section 3(a)(2) applies not only to securities issued or guaranteed by a bank but also, to the extent they are considered securities (instead of bank deposits), certificates of deposit issued or guaranteed by a bank. Additionally, structured notes linked to the performance of an index or another underlying asset are also commonly issued by banks in reliance on the Section 3(a)(2) exemption.2 In these instances, even though the return of the note is linked to an underlying asset, the investor is buying debt of the issuer and must rely on the credit of the issuer for repayment of the note, no matter how the underlying asset performs. This strengthens the argument that the structured instrument is covered under the Section 3(a)(2) exemption.
Because bank notes are not subject to the SEC’s registration requirements, structured bank notes sometimes are linked to different types of assets than registered structured notes, particularly when the investor is sufficiently sophisticated to understand the relevant risks. For example, because bank notes are not subject to the “strict liability” provisions of Sections 11 and 12 of the Securities Act, an issuer may be more comfortable linking the bank note to a complex underlying asset or investment strategy, which may be difficult to describe adequately in the context of a registered offering. In addition, registered offerings of equity-linked structured notes are typically linked only to large-cap U.S. stocks due to the “Morgan Stanley no-action letter.”3 However, some bank notes may be linked to debt securities (credit-linked notes), small-cap stocks, or securities that are traded only on non-U.S. exchanges. Of course, due to the liability and other concerns described in this article, issuers and underwriters must carefully craft the offering documents for these types of offerings, and broker-dealers must carefully determine the suitability of the relevant investors.
Even though securities offerings under Section 3(a)(2) are exempt from registration under the Securities Act, public securities offerings conducted by banks must be filed with the Financial Industry Regulatory Authority (“FINRA”) for review under Rule 5110(b)(9), unless an exemption is available. Additionally, transactions under Section 3(a)(2) must be reported through the Trade Reporting and Compliance Engine (“TRACE”).4 All brokers and dealers who are FINRA members have an obligation to report Section 3(a)(2) transactions to TRACE.
For national banks or federally licensed U.S. branches of foreign banks regulated by the Office of the Comptroller of the Currency (the “OCC”), an additional layer of federal regulation applies to securities offerings. Part 16 of OCC regulations provides that these banks may not offer and sell their securities until a registration statement has been filed and declared effective with the OCC, unless an exemption applies. An OCC registration statement has a detailed scope that is comparable to an SEC registration statement; as a result, most bank issuers prefer to rely upon an exemption from the OCC’s registration requirements. Section 16.5 provides a list of exemptions, which includes:
- Regulation D offerings to accredited investors
- Rule 144A offerings to qualified institutional buyers
- Securities guaranteed by the federal government, such as the 2008 “Temporary Liquidity Guarantee Program”
- Regulation S offerings effected outside of the U.S.
In addition, Part 16.6 of the OCC regulations provides an exemption for offerings of “non-convertible debt” to accredited investors in denominations of $250,000 or more. Due to these rules, banks subject to OCC regulation will need to tailor their offerings to meet the Part 16 requirements if they intend to seek an exemption from the requirement to file a registration statement with the OCC. However, in light of these limitations, banks regulated by the OCC tend to have somewhat less flexibility in selling structured products and other types of securities compared to bank holding companies that have an SEC shelf registration statement, particularly with respect to sales to retail investors.
Additionally, for federally-insured state banks and state-licensed branches of foreign banks, the Federal Deposit Insurance Corporation (the “FDIC”) adopted a Statement of Policy Regarding the Use of Offering Circulars in Connection with Public Distribution of Bank Securities for state non-member banks.5 This policy requires that an offering circular include prominent statements that the securities are not deposits, are not insured by the FDIC or any other agency, and are subject to investment risk. The policy states that the offering circular should include detailed prospectus-like disclosure, similar to the type contemplated by Regulation A or 12 CFR 563g. The policy further states that the goals of the policy will be met if the securities are offered and sold in a transaction that, among other options, satisfied (i) the requirements of Regulation D of the Securities Act relating to private offers and/or sales to accredited investors or (ii) the information and disclosure requirements of the Office of Thrift Supervision’s (“OTS”) regulations regarding securities offerings, which require that debt securities be issued in denominations of $100,000 or more. To the extent an offering meets these requirements, it will be deemed to satisfy the FDIC requirements. Nonetheless, an issuer may still want to include more detailed disclosure, as the policy emphasizes the applicability of the anti-fraud provisions of the Securities Act and Exchange Act to offerings by banks.
Blue Sky Laws
Securities issued under Section 3(a)(2) are considered “covered securities” under Section 18 of the Securities Act; as a result, blue sky filings are not need in any state in which the securities are offered. Additionally, for intrastate offerings made by state banks, many states have their own exemptions.
Exchange Act Reporting
Securities issued by banks under Section 3(a)(2) are also not subject to the reporting requirements under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Section 12(g)(2)(C) and 12(i) of the Exchange Act provide that the enforcement of Sections 12, 13, 14(a), 14(c), 14(d), 14(f), and 16 of the Exchange Act is vested in the Comptroller of the Currency with respect to national banks, the Federal Reserve Board as to member banks of the Federal Reserve System, the FDIC as to all other insured banks, and the OTS as to savings associations. Therefore, a bank which would be subject to the Exchange Act reporting requirements would submit its financial reports to the appropriate banking authority, and not to the SEC.
Securities offerings by a bank or guaranteed by a bank under Section 3(a)(2) are not subject to the civil liability provisions under Section 11 and Section 12(a)(2) of the Securities Act. However, the anti-fraud provisions of Section 17 of the Securities Act are applicable to offerings under Section 3(a)(2). Additionally, offerings under Section 3(a)(2) are also subject to Section 10(b) of the Exchange Act and the anti-fraud provisions of Rule 10b-5 of the Exchange Act. Therefore, when considering an offering under Section 3(a)(2), a bank must take into consideration what disclosure is necessary to avoid liability under the anti-fraud provisions, even if the document does not need to comply with the specific form requirements of the SEC or another regulator. As a result, the form and content of structured note offering documents issued under Section 3(a)(2) are similar in many respects to that used for a registered offering.
As a result of these various rules and regulations, the offering documentation for structured bank notes is somewhat similar to that of a registered offering. An issuer typically has a base offering document, usually called an “offering memorandum” or an “offering circular” (instead of a “prospectus”). That base document is supplemented for a particular offering by one or more “pricing supplements” and/or “product supplements.” The form of these documents is not subject to the relevant SEC form rules, and may vary somewhat from those used in a registered offering. However, the content (as well as the types of documents incorporated by reference) tends to be somewhat similar.
These offering documents may be supplemented by additional offering materials, including term sheets and brochures. Because these offerings are not registered with the SEC, these additional documents are not subject to the SEC’s “free writing prospectus” rules that apply to registered offerings. However, in order to ensure that the disclosure is adequate, the issuers and underwriters that use these documents are careful about their content.
Section 3(a)(2) provides bank issuers with the ability to issue securities, including structured notes, without registering the offering with the SEC. When relying on Section 3(a)(2), an issuer must carefully consider the disclosure included in its offering document, so as not to subject itself to liability under the anti-fraud provisions of the securities laws and to comply with the regulations and other guidance adopted by the various banking regulators. Banks and underwriters seeking to employ industry best practices typically utilize disclosures and suitability determinations that are very similar to those used in the context of registered offerings.