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4000 - Advisory Opinions

Interpretation of the Department of Treasury Regulations Implementing the Government Securities Act


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 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 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"

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 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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