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4000 - Advisory Opinions
Interpretation of the Department of Treasury Regulations
Implementing the Government Securities Act
FDIC--96--1
March 23, 1995
John J. Oldenburg, Jr., Regional Attorney
By memorandum of December 1, 1994, you requested our review of the
draft of three apparent violations of law to be included in the FDIC's
Report of Examination of the Bank as of November 1, 1994. We note, in
passing, that the issues raised entailed a considerable amount of
original legal research which necessarily was time consuming.
Nevertheless, we apologize for the delay in responding.
The Bank has a sweep account program for which customer demand
deposits in excess of a certain amount are "swept" on a daily
basis into a repurchase transaction pursuant to a repurchase agreement
(paragraph 5). The violations at issue pertain to certain disclosures
and confirmations under the Bank's repurchase agreement transactions.
Under the relevant terms of the Bank's repurchase agreements: the Term
of the repurchase agreement is for one day, and is automatically
renewable each subsequent day (paragraph
7); 1
the customers
{{10-31-96 p.4967}}are to receive a statement of their
repurchase agreement account at least monthly (paragraph 6); the
customer's interest in a given security under the repurchase agreement
may be a fractional interest (paragraph 7); and the securities which
are the subject of the repurchase agreement are held by another
institution as custodian, but the Bank reserves the right to substitute
different but similar securities for those originally subject to the
repurchase agreement (paragraph 8). The cited violations under review
are of the Government Securities Act Regulations ("G.S.A.
Regulations") issued by the Department of the Treasury, 17 C.F.R.
Parts 400--450. Even though the securities subject to the Bank's
repurchase agreements are held by another institution as custodian, the
Bank retains exclusive control over them as well as the customer funds
paid under its repurchase agreements. Thus, the Bank's repurchase
agreements are considered "hold-in-custody" repurchase agreement
transactions and, therefore, are subject to section 403.5(d) of the
G.S.A. Regulations, 17 C.F.R.
§ 403.5(d). 2
The first violation cited by the examiners is of section
403.5(d)(1)(i) of the G.S.A. Regulations, 17 C.F.R. § 403.5(d)(1)(i),
which requires that the institution obtain a written repurchase
agreement for each repurchase transaction. During their examination of
the Bank, the examiners found that for 14 repurchase transactions the
Bank had no written repurchase agreement. Assuming there is valid
evidence supporting the examiners' conclusion, the Bank is in violation
of the regulation cited.
The second violation cited by the examiners is of section
403.5(d)(1)(iv) of the G.S.A. Regulations, 17 C.F.R.
§ 403.5(d)(1)(iv). It appears that the examiners have inadvertently
cited subparagraph (iv) of this regulation when they meant to cite
subparagraph (v). Subparagraph (iv) requires that, if the seller under
a repurchase agreement retains the right to substitute securities for
those originally subject to the agreement, such right must be included
in the written repurchase agreement. As discussed above, paragraph 8 of
the Bank's repurchase agreement states that the Bank reserves the right
to substitute different but similar securities for those originally
subject to the repurchase transaction. Thus, the Bank's repurchase
agreement complies with subparagraph (iv). However, subsection (v) of
the regulation requires a very specific disclosure "which must be
prominently displayed in the written repurchase agreement immediately
preceding the provision governing the right to
substitution . . . ." The required specific disclosure is not
included in the Bank's repurchase agreement. Accordingly, the Bank
should be cited for a violation of section 403.5(d)(1)(v) of the G.S.A.
Regulations, 17 C.F.R. § 403.5(d)(1)(v), instead of section
403.5(d)(1)(iv) of the G.S.A. Regulations, 17 C.F.R.
§ 403.5(d)(1)(iv).
The last apparent violation cited by the examiners pertains to the
frequency and content of customer confirmations. The Bank provides a
confirmation of the securities involved in the transaction to a
customer when the repurchase agreement is initially entered into and on
at least a monthly basis thereafter. Section 403.5(d)(1)(ii) of the
G.S.A. Regulations, 17 C.F.R. § 403.5(d)(1)(ii), requires written
confirmation of the specific securities involved in the repurchase
transaction at the end of the day each transaction was initiated.
Because the Bank's repurchase agreements mature and automatically renew
on a daily basis, they are considered a newly initiated transaction
each day they are renewed and must be accompanied by a daily written
confirmation to the customer of the securities
involved. 3
{{10-31-96 p.4968}}The Bank's failure to provide daily
written confirmations constitutes a violation of section
403.5(d)(1)(ii).
The Bank is also cited for a violation of
section 403.5(d)(2)(i) of the
G.S.A. Regulations, 17 C.F.R. § 403.5(d)(2)(i), which pertains to the
type of information required in a confirmation given in accordance with
the above-described requirements. 4
The examiner's discussion of this violation fails to identify what
information is currently not provided, simply stating "[t]he bank
does not now provide these customer disclosures." We recommend that,
if this violation is based solely on the fact that no daily
confirmations are provided, that should be made clear. Otherwise, the
apparent violation should be revised to provide a specific description
of the missing information.
In addition to the above, you indicate that the examiners have asked
whether the Bank can enter into a repurchase agreement with a customer
for a "fractional interest" in a particular security, or whether
such a transaction constitutes "pooling of
collateral." 5
Also, by a subsequent memorandum of February 3, 1995, Review Examiner Y
notes that Bank counsel, X, has inquired whether the Bank can retain
possession and be the custodian of the securities which are subject to
its repurchase agreements. With respect to the latter question
regarding whether the Bank can retain possession of the securities,
section 403.5(d)(1)(vi) of the G.S.A. Regulations, 17 C.F.R.
§ 403.5(d)(1)(iv), indicates that the Bank may do so but it must
comply with section 450.4(a) 6
of the regulations, "except when exercising its right of
substitution in accordance with the provisions of the agreement and
paragraph (d)(1)(iv) of this
section." 7
Thus, nothing in the G.S.A. Regulations precludes the Bank from
retaining custody of the securities involved in its repurchase
agreements but it must do so in accordance with the applicable
regulations. 8
Whether the Bank may enter into repurchase agreements involving
fractional interests in government securities is not specifically
addressed by the G.S.A. Regulations or any published interpretation of
those regulations. To answer the examiner's question regarding
"pooling of collateral," it is necessary to understand what
"pool repurchase transactions"
{{2-29-00 p.4969}}
are and how the G.S.A. Regulations are designed to respond to
concerns over such transactions. The Department of Treasury described
the nature of "pool repurchase transactions" in the preamble to
temporary regulations on this subject as follows:
The Department's understanding is that, under
["Pool Repurchase Transactions"], a dealer will set aside a
pool of securities with an aggregate value at least equal to the amount
of its outstanding repurchase transactions. The dealer does not
identify specific securities as belonging to specific counterparties,
and confirmations for these repurchase transactions do not include a
description of specific collateral. Instead, the confirmation would
only refer to "various securities."
The Department has serious questions whether any type
of property interest in securities is conveyed to a counterparty when
specific securities are not allocated to that counterparty's repurchase
transactions. . . . [W]hether a repurchase transaction is
characterized as a secured loan, as an outright sale of a security
accompanied by the obligation to later repurchase that security, or as
a transaction conveying some other type of limited interest in the
underlying securities . . . it does not appear that the described
practice of segregating collateral for repurchase transactions in
pooled or bulk form is effective to transfer an interest in securities.
Furthermore, it is not clear that interests would be
conveyed under the existing Treasury and other agency regulations
governing transactions in book-entry securities applicable to
government securities . . . . If this is the case, then it appears
that a counterparty to a pool repurchase transaction would have no
greater rights than a general creditor in the event of a failure of its
dealer counterparty with respect to a hold-in-custody repurchase
transaction.
Given these concerns, the Department has concluded
that bulk segregation or pooling of repurchase collateral without
identification of specific securities should not be permitted and that
the practice of confirming only "various securities" in
connection with repurchase transactions is not sufficient to comply
with the requirements of § . . . 403.5(d).
52 Fed. Reg. 19,642, 19,659 (1987). The focus of the Department of
the Treasury's concern is to ensure that a buyer under a repurchase
agreement receives an identified interest in specifically identified
government securities. That concern is satisfied where the customer
receives a specific fractional interest in a specifically identified
government security, e.g., "repurchase agreements to A
and B in the amount of $200,000 each, giving A and B each an undivided
50 percent interest in U.S. Government Bond XYZ with a par value of
$450,000 with a coupon interest rate of 3--1/2 percent, and a market
value of $500,000." 9
{{2-29-00 p.4970}}Accordingly, although we have found no
published opinion addressing the question, we believe repurchase
agreements with appropriate confirmations which specifically identify
the security involved and the fractional interest of the customer would
not constitute a "pooled transaction" and would not run afoul of
the G.S.A. Regulations.
1The Bank's repurchase agreement in paragraph 7 describes these
transactions as "Retail Repurchase Agreements." However, a
"retail" repurchase agreement is an agreement for government
securities in aggregate denominations of less than $100,000, for a term
less than 90 days which is not automatically renewable. FDIC Statement
of Policy on Retail Repurchase Agreements, 46 Fed. Reg. 49,197 (1981),
reprinted in 2 FDIC Law, Regulations, Related Acts (FDIC)
5,217 (Sep. 28, 1981).Repurchase agreements that are not "retail" repurchase
agreements are commonly referred to as "wholesale repurchase
agreements." In the Matter of Mt. Pleasant Bank & Trust Co.,
426 N.W.2d 126, 130 n.3 (Ia. 1988) citing, Comment, 36
Am.U.L.Rev. at 669 n.3 (1987). Thus, as the Bank's repurchase
agreements are automatically renewable, they are not "retail
repurchase agreements." Go Back to Text
2See "Distinctions Between Tri-Party' and
Hold-In-Custody' Repurchase Agreement Transactions,"
Department of Treasury Letter No.
DT--7, reprinted in 3 Federal Deposit Insurance
Corporation Law, Regulations and Related Acts (FDIC) 8280.05 (May 7,
1990). Go Back to Text
3The issue of daily confirmations was expressly raised in
comments to these regulations when they were proposed, and was
addressed by the Department of the Treasury in the preamble to the
regulations when they were finalized. In essence, the Department of the
Treasury found that the need for customer confirmations was for the
protection of the customer, and thus, in the case of daily sweep
repurchase programs, daily confirmations of such transactions is
required. 53 Fed. Reg. 28,981--28,982 (1988). Go Back to Text
4Section 403.5(d)(2)(i) of the G.S.A. Regulations, 17 C.F.R.
§ 403.5(d)(2)(i), requires that customer confirmations "specify
the issuer, maturity date, coupon rate, par amount and market value of
the security and . . . further identify a CUSIP or mortgage-backed
security pool number, as appropriate . . . ." Go Back to Text
5The repurchase agreement provided does not specify either the
fractional interest or the specific securities covered by the
transaction. Paragraph 7 of the Bank's repurchase agreement indicates
that, at the time of entering into the agreement, the customer will
receive a "statement of the government securities that will act as
collateral." We have not received a copy of any such statement and
have no way of knowing whether a fractional interest in a particular
security is specified in the statement. Go Back to Text
6Section 450.4(a)(1) of the G.S.A. Regulations,
17 C.F.R. § 450.4(a)(1),
pertains to when the depository institution maintains possession of the
government securities subject to a repurchase agreement while
subsection (a)(2) of that regulation pertains to when such customer
securities are maintained by a depository institution at another
depository institution. Generally, under each section, the requirements
are that the securities must be held for the account of the customers
by segregating such securities from the assets of the depository
institution writing the repurchase agreement, and they must be kept
free of any lien, charge or claim of any third party. Go Back to Text
7As is apparent from the required disclosure under
section 403.5(d)(1)(v) of the
G.S.A. Regulations, the Department of the Treasury has concluded that
liens from third parties may attach during any substitution of
securities due to a commingling of assets that may occur during such
substitution. Go Back to Text
8The Bank's repurchase agreement states that the covered
securities are held by a custodian in order to "perfect" the
customers' security interests in those securities. The GSA Regulations
do not require that customers have a "perfected" security
interest and this memorandum is not intended to address issues of
whether "perfection" of any security interest was in fact
accomplished by the Bank. However, as the Bank is now retaining custody
of such securities, whether the customers have perfected security
interests should be reevaluated and properly disclosed. While the law
is unclear as to whether the antifraud provisions of the federal
securities laws apply to repurchase agreements secured by government
securities, a misrepresentation or omission of a material fact in
connection with such a transaction may heighten the risk to the
institution concerned. Thus, we believe it is important that the Bank
accurately determine and disclose the extent of any "perfected"
security interest given to its customers. Go Back to Text
9As noted above, the custodial requirements of section 450.4(a)
of the G.S.A. Regulations, 17 C.F.R. § 450.4(a), require an
institution to segregate customers securities and maintain them free of
any lien or claim of any third party. This requirement raises a
question of whether A and B above constitute "third parties" to
each other regarding their respective security interests in "U.S.
Government Bond XYZ" securing their respective repurchase
agreements. In a recent interpretation by the Department of the
Treasury regarding the proper timing and allocation of securities to
customer accounts in compliance with section 450.4(a), the Commissioner
stated:
One of the fundamental objectives that gave rise to the
enactment of the GSA, and the subsequent issuance of regulations
thereunder, was to strengthen customer protection in hold-in-custody
repo transactions. The requirement that financial institutions maintain
and allocate specific securities to specific customers is aimed at
protecting customer securities in the event of the failure of a
financial institution. Without timely and proper allocation, it may not
be clear if an interest in the securities has been conveyed to the
counterparty. The allocation requirement focuses on eliminating
duplicative use of securities as well as precluding pooling of
securities (i.e., failing to identify and record specific securities on
the books and records of the institution).
Department of
the Treasury Interpretation No. DT--9, reprinted in
3 FDIC Law, Regulations and Related Acts (FDIC) 8,280.13 (June 21,
1993). Having fractional interests in a single identified security is
not a "duplicative" use of the security so long as the total
fractional interests do not exceed 100 percent of the subject security.
There is no discernable difference in either the legal effect or extent
of customer protection if A and B are co-tenants, each with an
undivided 50 percent interest in
the security under a single repurchase agreement, or
have that identified interest under separate repurchase agreements.
Thus, A and B would not be "third parties" with a claim or lien
on each other's respective interests in the security for purposes of
compliance with section 450.4(a). Go Back to Text
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