Separate Entity Doctrine for U.S. Branches of Foreign Banks

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday April 30, 2012 at 9:47 am
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Editor’s Note: The following post comes to us from three law firms: Cleary Gottlieb Steen & Hamilton LLP; Davis Polk & Wardwell LLP; and Sullivan & Cromwell LLP. It is based on a white paper authored jointly by the three firms on the separate entity doctrine as applied to the U.S. branches of foreign headquartered (non-U.S.) banks. The hybrid treatment of the U.S. branches of foreign headquartered banks has become a subject of focus in the wake of the financial crisis and in light of the enactment of the Dodd-Frank Act. The white paper provides a summary of the regulatory treatment of U.S. branches of foreign headquartered banks under various U.S. legal regimes, and highlights the hybrid nature of such branches. The original white paper, including footnotes, is available here.

Although a branch of a bank is not a separate juridical entity from the bank of which it is a component, U.S. law treats branches as separate from the head office and other branches of a bank when such differentiation is appropriate for various purposes. Branches are a hybrid structure, at the same time both an integral part of the banks of which they are merely offices and separate legal entities for a number of U.S. regulatory and commercial law purposes. This feature of bank branches is a central tenet of federal banking statutes, and the law governing U.S. branches of foreign banks in particular.

At times the status of a U.S. branch of a foreign bank under a particular statutory scheme is explicit. Such is the case with the U.S. law treatment of U.S. branches of foreign banks in insolvency. As discussed below, U.S. law treats those branches virtually as separate entities in insolvency.

In other circumstances, a particular statute does not explicitly address the status of U.S. branches of foreign banks, and the treatment has to be arrived at through an analysis of the purpose of the statutory scheme. For example, as discussed below, after a long series of no-action letters, the Securities and Exchange Commission (“SEC”) issued interpretive guidance providing that securities issued or guaranteed by U.S. branches of a foreign bank (but not its non-U.S. branches) could rely on the exemption from registration afforded to securities issued or guaranteed by a bank under Section 3(a)(2) of the Securities Act of 1933 (“Securities Act”). Thus, U.S. branches can rely on the Section 3(a)(2) exemption while the bank itself is required to register to distribute its securities in the United States.

This paper will review the treatment of U.S. branches of foreign banks under a variety of statutory schemes and explore the rationale for that treatment.

I. Background on Branches

(a) Parallel Federal and State Regulatory Regimes

The establishment of a branch is the most prevalent form in which foreign banks operate in the United States. Foreign banks seeking to open U.S. branches face essentially the same regulatory regime as new U.S.-domiciled institutions. As with U.S.-based banks, foreign banks choose whether to seek a federal or state license for their U.S. branches.

Federal branches are authorized and subject to regulation and supervision by the Office of the Comptroller of the Currency (“OCC”). State-chartered branches are authorized and subject to regulation at the state level.

(b) The International Banking Act Provides for National Treatment of U.S. Branches

The International Banking Act of 1978 (“IBA”) establishes a comprehensive framework for the supervision and regulation of non-U.S. banks in the United States. The IBA’s guiding principle of “national treatment”—or parity of treatment between domestic and foreign banks—has informed all subsequent U.S. legislation affecting foreign banks.

Under the IBA framework, a U.S. branch of a non-U.S. bank is treated for most purposes as if it were a U.S. bank. Importantly, despite the fact they are the same juridical entity, it is the U.S. branch—and not the non-U.S. bank as a whole—that is treated as the U.S. bank under the IBA. For example, while the Federal Reserve has authority to examine the foreign bank because it is treated as a bank holding company, the OCC’s examination authority is limited to the federal branch.

(c) Only U.S. Branches Have Been Eligible for Federal Deposit Insurance

The distinction between a foreign bank and its U.S. branch is also reflected in the Federal Deposit Insurance Act (“FDIA”), pursuant to which a U.S. branch, and not the bank as a whole, is eligible to apply for federal deposit insurance for deposits payable at the branch. With the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991(“FDICIA”), no more insured branches may be created. However, the provision of the FDIA that established eligibility was not repealed and the 52 then-insured U.S. branches of foreign banks retained their eligibility pursuant to a grandfathering provision. The FDIC can be appointed as receiver or conservator of the insured branch under the FDIA in the same manner as the FDIC can be appointed as receiver or conservator of an insured U.S. bank. In addition, prior to the enactment of FDICIA, FDIC insurance coverage for U.S. branches of foreign banks was granted on a branch-by-branch basis such that a foreign bank could have a branch in one U.S. state that was insured by the FDIC and another branch in another U.S. state that was not insured by the FDIC.

(d) Foreign Banks with U.S. Branches Are Subject to Regulation as Bank Holding Companies under the Bank Holding Company Act

The separateness of a foreign bank and its U.S. branch is also reflected in the application of the Bank Holding Company Act (“BHC Act”) to foreign banks with U.S. branches. The BHC Act generally limits the activities of bank holding companies to those of banking or managing and controlling banks, and to those that are closely related thereto or that are financial in nature. By virtue of maintaining a U.S. branch, a foreign bank is deemed a bank holding company, and the BHC Act is applied to the foreign bank and U.S. branch as though they were a holding company and subsidiary bank, respectively. Thus, the foreign bank is subject to the activity restrictions of the BHC Act and to the supervisory and enforcement powers of the Federal Reserve applicable to bank holding companies, including its authority to issue cease-and-desist orders and assess civil money penalties. For purposes of the interstate banking restrictions of the BHC Act, branches were treated as banks, and thus a foreign bank could not acquire a bank in another state, or establish a branch in another state, until the advent of interstate banking with the passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. The separateness of a foreign bank and its U.S. branch is also reflected in the Federal Reserve’s Regulation K, which permits a qualified foreign banking organization to “[e]ngage in activities of any kind outside the United States,” even though a U.S. branch or subsidiary of the same legal entity would generally be subject to the activity restrictions in the BHC Act and the IBA because activities engaged in by such a U.S. branch or subsidiary are considered to be activities engaged in in the United States.

II. Insolvency Laws

(a) State-Chartered Branches Are Liquidated as Separate Legal Entities

State-chartered branches of foreign banks are subject to liquidation at the state level according to state insolvency laws. State laws generally provide a “ring-fence” mechanism, pursuant to which regulators have broad power to liquidate all of the domestic assets of the foreign bank—including those owned by the foreign bank in its own name as opposed to that of the branch—for the benefit of (domestic) claimants against the branch.

The New York bank insolvency law, which is often regarded as a model for state bank insolvency laws, is illustrative. Under this regime, the Superintendent of Financial Services has the authority to seize all the assets of the foreign bank that are located in New York. Upon liquidation, proceeds go first to pay the claims of creditors arising from the transaction of business with the New York branch. The Superintendent is expressly prohibited from honoring claims that would not constitute enforceable legal obligations against the branch if it were a separate and independent legal entity, and claims against other offices, branches and other affiliates of the foreign bank. After claims against the branch are satisfied, any excess proceeds are then paid over to the liquidators, if any, of any of the foreign bank’s other U.S. branches or offices. Only after all such claims are satisfied are any remaining proceeds returned to the principal office of the foreign bank.

(b) Federally Chartered Branches Are Liquidated as Separate Legal Entities

A similar ring-fence regime governs insolvency on the part of a foreign bank that has one or more federally chartered U.S. branches. The IBA empowers the OCC to appoint a receiver to take possession of all U.S. assets of the foreign bank and serve as receiver for all of the foreign bank’s U.S. branches. Only claims arising out of transactions with the foreign bank’s U.S. branches that would be valid obligations against such branch if it were a separate legal entity are honored, and only after all such claims against all U.S. branches are satisfied are excess proceeds returned to the foreign bank’s home office.

(c) Congress Amended the U.S. Bankruptcy Code to Protect the Separateness of Foreign Banks and Their U.S. Branches

In 2003, a district court overturned a bankruptcy court’s ruling that the Bankruptcy Code barred a foreign representative of two failed foreign banks with branches licensed in New York from seeking an injunction to prevent state regulators from giving preference to New York creditors in the liquidation of the U.S. assets of those banks. This decision, which was widely criticized as departing from established authority, effectively disregarded the distinction between the foreign banks and their U.S. branches.

In 2005, Congress responded by amending the Bankruptcy Code to clarify that a foreign bank with a U.S. branch is ineligible to file for bankruptcy in the United States, thereby ensuring the dichotomy between a foreign bank and its U.S. branches will continue to be reflected in U.S. bankruptcy proceedings.

III. Securities Laws

(a) Securities Act Exemption for U.S. Branches of Foreign Banks

Section 3(a)(2) of the Securities Act provides an exemption from the general registration requirements for securities “issued or guaranteed by… any national bank, or any banking institution organized under the laws of any State.” On its face, the statute is unclear as to whether a foreign bank’s compliance with the licensure and related requirements to charter a U.S. branch is akin to the branch’s being “organized under” U.S. law. However, at least as early as 1964, the SEC began issuing no-action letters permitting the U.S. branches of foreign banks to rely on this “bank” exemption to issue various types of securities in specific states.

In 1986, after issuing more than 100 such no-action letters, the SEC issued guidance that it would thereafter take the position that, although U.S. branches of foreign banks are not separate legal entities in a strictly technical sense, they would be deemed banks for purposes of the bank exemption. The release noted the public policy of “national treatment” reflected in the IBA, and the SEC’s conclusion that U.S. branches of foreign banks are subject to domestic supervision sufficient to render them “functionally indistinguishable from their domestic counterparts.” Notably, while U.S. branches of foreign banks qualify for this exemption, foreign banks themselves do not.

The definition of “U.S. person” for purposes of the SEC’s Regulation S, which governs securities offerings and sales outside of the United States that are not registered under the Securities Act, also reflects the separateness of branches and agencies of a legal entity. For example, while the definition of “U.S. person” in Regulation S does not include an entity organized or incorporated under foreign law, it expressly includes “[a]ny agency or branch of a foreign entity located in the United States.” Similarly, while the “U.S. person” definition includes entities incorporated under U.S. law, expressly excluded from such definition is “[a]ny agency or branch of a U.S. person located outside the United States if: (A) The agency or branch operates for valid business reasons; and (B) The agency or branch is engaged in the business of insurance or banking and is subject to substantive insurance or banking regulation, respectively, in the jurisdiction where located.”

(b) Exchange Act Exemption for U.S. Branches of Foreign Banks

Section 3(a)(6) of the Securities Exchange Act of 1934 (“Exchange Act”) defines the term “bank” to include, subject to certain conditions, a “banking institution or savings association, as defined in section 2(4) of the Home Owners’ Loan Act, whether incorporated or not, doing business under the laws of any state or of the United States.” This provision has been construed by the SEC to include a U.S. branch of a non-U.S. bank. This in turn allows a U.S. branch of a non-U.S. bank to engage in certain types of activities that are permissible for banks under the Exchange Act in the absence of broker-dealer registration. This authority is granted only to a U.S. branch of a non-U.S. bank and not to the bank itself.

Moreover, the SEC has construed the broker-dealer “push-out” provisions of the Gramm-Leach-Bliley Act to restrict the ability of a U.S. branch of a non-U.S. bank to engage in certain brokerage and dealing activity, but not to apply to any non-U.S. branches of the same non-U.S. bank.

(c) Investment Company Act Exemption for U.S. Branches of Foreign Banks

Section 3(c)(3) of the Investment Company Act of 1940 (“Investment Company Act”) excludes from the definition of “investment company,” and thus from the Act’s registration requirements, any entity that falls within the definition of “bank,” as set forth in section 2(a)(5) of the Investment Company Act. Before the statute was amended in 1999 to address the issue, practitioners had long taken the view that U.S. branches of foreign banks met the criteria of clause (C) of this definition, which included any “banking institution . . . doing business under the laws of any State or of the United States, a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks . . . and which is supervised and examined by State or Federal authority having supervision over banks.”

In 1990, the SEC issued guidance providing that, for the purpose of issuing securities in the United States, it would deem U.S. branches of foreign banks to be “banks” falling within the exemption, provided their counsel could determine “that the nature and extent of Federal and/or State regulation and supervision of the particular branch [] are substantially equivalent to those applicable to banks chartered under Federal or state law in the same jurisdiction.” This position was based on the SEC’s determination that U.S. branches of foreign banks were “functionally equivalent to their domestic counterparts, as well as similarly regulated.”

In 1999, the definition of “bank” in section 2(a)(5)(A) was amended to expressly include U.S. branches of foreign banks, but not the foreign banks themselves.

IV. Commodity Exchange Act

(a) Foreign Branches of U.S. and Foreign Banks Are Treated as Separate Entities for Introducing Broker and Futures Commission Merchant Registration Purposes

The Commodity Futures Trading Commission (“CFTC”) generally does not require foreign branches of U.S. or foreign banks to register as introducing brokers (“IBs”) or futures commission merchants (“FCMs”) when they transact business only with foreign customers. Based in large part on the treatment of bank branches under banking laws, the CFTC staff has consistently “treated a bank in one country as a separate legal entity from the bank’s branches in another country.”

(b) The Dodd-Frank Act Contemplates Separate Designation of U.S. Branches of Foreign Banks as Swap Dealers

Consistent with the historical distinction between a foreign bank and its U.S. branches, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), in defining the term “prudential regulator,” expressly contemplates that a “federally chartered branch . . . of a foreign bank” or a “State-chartered branch . . . of a foreign bank” could itself be a swap dealer. In addition, the Dodd-Frank Act’s “swap dealer” definition specifically provides that a “person may be designated as a swap dealer for a single type or single class or category of . . . activities and considered not to be a swap dealer for other types, classes, or categories of . . . activities.”

V. Other Banking Law Provisions

(a) Only U.S. Branches Access the Federal Reserve Discount Window and Comply with Reserve Requirements

Pursuant to the statutory framework and implementing regulations governing access to the Federal Reserve’s discount window, a U.S. branch of a foreign bank is treated as if it were a member bank, separate and apart from the foreign bank of which it is a component.

In 1978, the IBA applied reserve requirements to “every Federal branch and Federal agency of a foreign bank in the same manner and to the same extent as if the Federal branch or Federal agency were a member bank,” subject to certain exceptions. Pursuant to authority in the IBA, the Federal Reserve applied these requirements to state branches and agencies, and made Federal Reserve bank discount window access available “to any branch or agency of a foreign bank in the same manner and to the same extent that [the Federal Reserve bank] may exercise such powers with respect to a member bank if such branch or agency is maintaining reserves with such Reserve Bank . . . .”

Subsequently, the Monetary Control Act of 1980 amended the Federal Reserve Act to provide that “any depository institution in which transaction accounts or nonpersonal time deposits are held shall be entitled to the same discount and borrowing privileges as member banks.”

The Federal Reserve’s Regulation D, which implements the reserve requirement provisions of the Federal Reserve Act, provides that a foreign bank’s branch or agency located in the United States is required to comply with the reserve requirements “in the same manner and to the same extent” as if the branch or agency were a member bank. Under the Federal Reserve Act, the U.S. branch or agency is required to maintain reserves only with respect to its own reservable deposits—not those of the non-U.S. bank. Similarly, the Federal Reserve’s Regulation A, which governs extensions of credit by a Federal Reserve bank, applies to U.S. branches and agencies of non-U.S. banks that are subject to reserve requirements under Regulation D “in the same manner and to the same extent as this part applies to depository institutions.”

Thus, the U.S. branch is required to maintain reserves with a Federal Reserve bank with respect to its transaction accounts and nonpersonal time deposits, but neither the U.S. branch nor the foreign bank is required to maintain reserves against deposits of the foreign bank. As a consequence, the branch—but not the foreign bank—is entitled to the same discount and borrowing privileges as a member bank.

(b) Affiliate Transaction Restrictions Only Apply to U.S. Branches

Transactions between a U.S. branch and certain of its U.S. insurance, broker-dealer and merchant banking affiliates are subject to the restrictions of Sections 23A and 23B of the Federal Reserve Act, even though these restrictions do not apply to transactions between the foreign bank and these same U.S. affiliates.

(c) Anti-Tying Provisions Apply Only to U.S. Branches

Anti-tying provisions of the U.S. banking laws and regulations apply to the activities of the U.S. branches and agencies of a foreign bank, but do not apply to activities of the foreign bank generally.

(d) The Depository Institution Management Interlocks Act Applies Only to U.S. Branches

The Federal Reserve’s application of the interlock restrictions in the Depository Institution Management Interlocks Act respects the distinction between a foreign bank and its U.S. branch by applying the act’s restrictions to the officers of U.S. branches, but not those of the foreign bank itself.

(e) Federal and State Laws Require Maintenance of Assets or Capital Equivalency Deposits for a U.S. Branch of a Foreign Bank Notwithstanding the Overall Capital Adequacy of the Foreign Bank

The IBA requires that a foreign bank maintain a deposit in a member bank located in the state in which each of its Federal branches and agencies is located in an amount “not less than the greater of (1) that amount of capital (but not surplus) which would be required of a national bank being organized at this location, or (2) 5 per centum of the total liabilities of such branch or agency . . .” The underlying purpose of the IBA provision is to ensure that branches and agencies of a foreign bank maintain a minimum level of unencumbered assets in the United States that would be available in a liquidation of the branch or agency. Many states impose similar requirements on state-licensed branches of foreign banks.

(f) Before Its Repeal, the Prohibition Against the Payment of Interest on Demand Deposits Applied Only to U.S. Branches

The prohibition against payment of interest on demand deposits was applied only to those deposits maintained at U.S. branches of foreign banks and not to any deposits “payable only at an office located outside of the United States.” This prohibition was repealed for both U.S. banks and U.S. branches of foreign banks, effective July 21, 2011.

VI. U.S. Law Recognizes Certain Distinctions Between U.S. Banks and Their Branches

(a) U.S. Law Recognizes the Distinction Between U.S. Banks and Their Foreign Branches

U.S. law also recognizes analogous distinctions between foreign branches of U.S. banks, and the banks of which they are components. For example, deposits payable only at foreign branches are non-reservable, non-insured, and in fact subordinated in right of payment to domestic deposits. In addition, although the credit of the whole bank is normally engaged when a foreign branch contracts, the Federal Reserve Act shields the bank from liability for deposits made at a foreign branch if the branch is unable to repay the deposit on account of war, civil strife or insurrection in, or expropriation by, the foreign country in which the branch is located.

Finally, in order to ensure foreign branches of U.S. banks are competitive in their local markets, such branches are authorized to engage a number of activities that are prohibited for U.S. banks, including offering insurance as agent or broker and underwriting and dealing in obligations of foreign governments.

(b) U.S. Law Recognizes the Distinction Between Different U.S. Branches of the Same U.S. Bank

U.S. commercial law recognizes the distinction between different U.S. branches of the same U.S. bank where the distinction is consistent with certain bank functions. For example, the Uniform Commercial Code provides that a branch or other separate office of a U.S. bank is a “separate bank” for the purpose of calculating certain timeframes with respect to negotiable instruments, bank deposits and collections, and wire transfers.

(c) Separate Entity Doctrine in New York Judicial Proceedings

The separate entity doctrine under New York judge-made law provides, in essence, that “each branch of a bank is a separate entity, [and is] in no way concerned with accounts maintained by depositors in other branches or at a home office.” This doctrine has long been an important facet of New York attachment and execution law and stands for the proposition that the “mere fact that a bank may have a branch within New York is insufficient to render accounts outside of New York subject to attachment merely by serving a New York branch.” The purpose of the separate entity doctrine is clear—service of process on one branch should not be permitted to accomplish a restraint on accounts in other branches because of the substantial interference with banking business, and the exposure of banks doing business in multiple jurisdictions to inconsistent determinations being rendered by the courts sitting in those jurisdictions. Section 138 of the New York Banking Law represents a statutory articulation of the separate entity doctrine for New York banks.

* * *

In conclusion, U.S. law has long recognized in a variety of contexts that bank branches are not merely offices of the bank. Instead, they enjoy a hybrid status that results in their treatment as separate entities for numerous purposes. Although that separate treatment is sometimes explicitly provided by statute, it is frequently the result of interpreting the relevant statutory scheme and its purpose in light of the nature and regulation of the branch.

  1. First, as a matter of honesty and full disclosure, both the Harvard Law School and the three law firms have neglected to mention that the firms represent banking clients, and specifically foreign banking clients that undoubtedly benefit from the positions taken in their “white paper.”

    One might think that instead of portraying their views as being unbiased and examples of objectivity and altruism, they would have disclosed such interests that seemingly have shaped their views and have motivated the preparation and submission of their paper.

    Second, since its enactment into law, the banking industry and its lawyers have attempted to limit the scope of the Anti-Tying Provision of the Bank Holding Company Act— which I wrote as a young attorney with the U.S. Senate Banking Committee—and to “gut” its provisions entirely. Fortunately, their efforts have failed entirely or been largely unsuccessful.

    See, e.g., http://www.federalreserve.gov/SECRS/2005/March/20050329/OP-1158/OP-1158_56_1.pdf

    Third, the Anti-Tying Provision must be applied to the activities of the U.S. branches and agencies of a foreign bank, and to activities of the foreign bank generally, at least under certain circumstances. To apply the law as the three law firms have suggested would be tantamount to allowing foreign banks to circumvent and evade the Anti-Tying Provision.

    While the law firms might like to see this happen, as being in the best interests of their foreign bank clients, it would not be consistent with sound U.S. banking policies or the legislative intent undergirding the Anti-Tying Provision.

    See, e.g., http://www.naegele.com/documents/antitying_3.pdf

    Comment by Timothy D. Naegele — April 30, 2012 @ 3:33 pm

  2. Is there ever a case where a branch of a bank can have a difference in its ownerships structure? I know we can’t have this in the USA, but is it at all possible globally?
    Please advise
    Maria F Cicinelli

    Comment by Maria F Cicinelli — July 1, 2013 @ 1:57 pm

 

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