This interpretation is superseded by revisions to CFTC Regulation 1.25, effective December 28, 2000.
DIVISION OF TRADING AND MARKETS
FINANCIAL AND SEGREGATION INTERPRETATION NO. 2-1
Use Of Customer Funds For The Purchase Of Securities Under Reverse Repurchase Agreements1
On May 9, 1979, the Division of Trading and Markets ("Division") issued Financial and Segregation Interpretation No. 2,2 which outlined seven conditions that must be met by a futures commission merchant ("FCM") or by a contract market clearing organization which invests regulated customer funds3 in permitted government securities subject to instruments known as "repurchase agreements"4 and/or "sale and buy-back agreements"5 in order to remain in compliance with Section 4d(2) of the Commodity Exchange Act ("Act") 7 U.S.C. §6d(2)(1988), and Commission Rule 1.25 promulgated thereunder (17 C.F.R. §1.25 (1993)).6 Interpretation No. 2 incorporated the provisions of Administrative Determination No. 240 ("A.D. 240") which was issued on February 20, 1975, by the Commodity Exchange Authority ("CEA"), the predecessor of the Commodity Futures Trading Commission ("Commission") except that, by eliminating the requirement of physical segregation of securities by a depository bank, for the first time book entry securities were permitted under that Interpretation.
At the time the CEA issued A.D. 240 in 1975, there was disagreement concerning the legal status of repurchase transactions; that is, whether such transactions represented actual purchases of securities (where title passed to the purchaser) or were merely loans collateralized by securities (where title to the securities did not pass to the lender). The CEA and the Commission, therefore, sought to assure that repurchase transactions entered into by FCMs were structured as outright purchases and sales so as to be consistent with the requirements for an investment of customer funds under Section 4d(2) of the Act and Commission Rule 1.25. This is because, although either cash or government securities are themselves permitted investments of customer funds, loan agreements collateralized by such securities are not.7
As a result of the increasing use of book-entry securities and recent developments in the law, some of the conditions specified in Interpretation No. 2 may no longer be essential to assuring customer funds are invested in a manner consistent with the Act. Currently, condition No. 5 requires that an agreement to repurchase transferred securities merely constitutes a unilateral offer by a bank counterparty to repurchase the securities and may not involve any obligation or commitment by the FCM to unwind the transaction with that counterparty.
The statutory requirements for investment of segregated funds are intended both to assure the safety of such investments and their liquidity. An FCM or clearing organization must be able to promptly meet daily variation settlements and obligations to its customers from customer segregated funds and, to that end, must have an unconditional, unstayable right to dispose of any securities received subject to an agreement for their repurchase and to retain the proceeds in the event the counterparty to the transaction fails to perform.
We have been advised that, under new bank capital standards, a sale of securities subject to a repurchase agreement with a unilateral right in the transferee to refuse to return them could be construed to be the granting of a put from the perspective of the original "seller." This would attract a capital charge. For this reason, bank counterparties prefer to have a clear basis to construe the transaction in a manner more consistent with custom and practice where such capital charge would not accrue. In that the legal right to sever the transaction, free of any bankruptcy stay, is now explicitly conferred by law, banks believe that such a treatment would not in any way impair a customer's interest in the securities in the event of counterparty insolvency.
The Division recognizes that repurchase transactions have become widely used, because they represent an attractive cash-management tool for businesses and financial institutions. The Division also believes that, in light of amendments to the bankruptcy laws since the issuance of Interpretation No. 2 8 and recent case law which affords greater protection to participants in repurchase transactions in the event of bankruptcy of one of the parties,9 the conditions relating to the investment of customer funds by FCMs in connection with repurchase agreements can be revised to eliminate Condition 5 of Interpretation 2. The Division is, therefore, issuing this new Interpretation No. 2-1 which supersedes the prior interpretations and includes certain other amendments and clarifications to make the interpretation more consistent with the "book entry" system for transferring government securities.
Section 4d(2) of the Act permits the investment of customer funds in government securities. Based on changes in the law, which provide the absolute right for an FCM to retain securities subject to a reverse repurchase agreement in the event of a counterparty bankruptcy, the Division of Trading and Markets takes the position that the use of customer funds for the purchase of securities under reverse repurchase agreements, in accordance with the conditions set forth below, will be treated as sales and buy-backs for these purposes and therefore deemed permissible investments under Section 4d(2) of the Act and Commission Rule 1.25 (this discussion is phrased in terms of an FCM's investment of customer funds, but also would apply to a clearing organization's investment of such funds):
1. The securities transferred by reverse repurchase agreement are limited to the securities enumerated in Commission Rule 1.25 (17 C.F.R. §1.25), and are specifically identified by coupon rate, par amount, market value, maturity date and CUSIP number.
2. Counterparties are limited to a bank as defined in Section 3a(6) of the Securities Exchange Act of 1934,10 or a domestic branch of a foreign bank insured by the Federal Deposit Insurance Corporation, a registered securities broker or dealer, or a government securities broker or government securities dealer which is registered with the Securities and Exchange Commission ("SEC") or which has filed notice pursuant to Section 15C(a) of the Government Securities Act of 1986.
3. The transaction is made pursuant to a written repurchase agreement signed by the parties to the agreement, which is consistent with these conditions,11 which states that the parties thereto intend the transaction to be treated as a purchase and sale of securities.12
4. The term of the agreement is no more than one business day, or reversal of the transaction is possible on demand.
5. The securities transferred under the reverse repurchase agreement are held in or irrevocably credited to a safekeeping account with a bank as referred to in Condition 2, or a clearing organization13 in an account which is titled to identify it as containing securities segregated for the benefit of the FCM's commodity customers, and which is covered by a written acknowledgment from the bank or clearing organization (which must be maintained by the FCM in accordance with Commission Rule 1.31, 17 C.F.R. §1.31 (1993)) that it: understands the nature of the account; understands the segregation provisions of Section 4d(2) of the Act and the rules promulgated thereunder; will treat the securities in the account as belonging to the customers of the FCM and not as belonging to the FCM; will not claim such securities or inhibit their prompt, authorized removal and sale; will not offset such securities against obligations which the FCM may have owing to the custodian; and will not dispose of the securities, except as directed by the FCM, or encumber the securities in any respect.
6. The FCM may not use securities received under a reverse repurchase agreement in another repurchase transaction and may not otherwise hypothecate or pledge such securities, except as provided in footnote 13. No right to substitute other securities for the securities subject to a reverse repurchase agreement shall be granted.
7. The transfer of securities is made on a delivery-vs.-payment basis in immediately available funds. The transfer is not recognized as accomplished until the funds and/or securities are actually received by the custodian of the FCM's customer funds or securities purchased on behalf of customers. The transfer or credit of securities covered by the reverse repurchase agreement to the FCM's customer segregated custodial account is made simultaneously with the disbursement of funds from the FCM's customer segregated cash account at the custodian bank. On the resale, the FCM's customer segregated cash account at the custodian bank must receive same-day funds credited to such segregated account simultaneously with the delivery or transfer of securities from the customer segregated custodial account.
8. A written confirmation to the FCM on behalf of customer funds specifying the terms of the reverse repurchase agreement and/or a safekeeping receipt are issued immediately upon entering into the transaction and a confirmation to the FCM is issued once the transaction is reversed.
9. The reverse repurchase transactions are recorded in the record required to be maintained under Commission Rule 1.27 (17 C.F.R. §1.27 (1993)) of investments of customer funds, and the securities subject to such transactions are specifically identified in such record as described in condition 1 above and further identified in such record as being subject to a reverse repurchase agreement.
10. An actual transfer of securities by book entry is made consistent with Federal or State commercial law, as applicable. At all times, securities received subject to a reverse repurchase agreement are reflected as "customer property."
11. The agreement makes clear that, in the event of FCM bankruptcy, any securities purchased with customer funds that are subject to a reverse repurchase agreement may be transferred, notwithstanding the reverse repurchase agreement. The agreement also makes clear that in the event of FCM bankruptcy, the counterparty has no right to compel liquidation of securities subject to a reverse repurchase agreement or to make a priority claim for the difference between current market value of the securities and the price agreed upon for resale of the securities to the counterparty, if the former exceeds the latter.
In preparing its daily segregation record, an FCM must reflect the securities involved in a reverse repurchase transaction at no more than the lesser of the current market value of the securities subject to the reverse repurchase agreement, or the net amount to be realized by the FCM upon resale of the securities.
For purposes of computing regulatory capital, the charge on reverse repurchase agreements and sales and buy-backs should be computed in accordance with SEC Rule 240.15c3-1(c)(2)(iv)(F), 17 C.F.R. §15c3-1(c)(2)(iv)(F) (1993), which generally requires a capital charge equal to the difference between the contract price for resale of the securities and the market value of those securities (if less than the contract price). This charge can be reduced based on certain factors set forth in the rule.
The statements made in this Interpretation are not rules or interpretations of the Commodity Futures Trading Commission, nor are they published as bearing the Commission's approval; they represent interpretations and practices followed by the Division of Trading and Markets in administering the Commodity Exchange Act and the regulations thereunder.
FOR FURTHER INFORMATION, CONTACT: Paul H. Bjarnason, Jr., Chief Accountant, or Lawrence B. Patent, Associate Chief Counsel, Division of Trading and Markets, Commodity Futures Trading Commission, 2033 K Street, N.W., Washington, D.C. 20581. Telephone (202) 254-8955.
Issued in Washington, D.C., on ________________, by the Division of Trading and Markets.
Andrea M. Corcoran
1 This interpretation relates only to reverse repurchase agreements using customer funds. The Division has separately issued Interpretative Letter No. 84-24 regarding a customer-authorized bank Treasury bill repurchase program. Where a customer deposits his own securities with an FCM, the proceeds or interest thereon is payable to the customer. [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶22,449 (Dec. 5, 1984).
2 Comm. Fut. L. Rep. (CCH) ¶7112 (May 9, 1979).
3 The term "customer funds" is defined in Commission Rule 1.3(gg), 17 C.F.R. §1.3(gg) (1993).
4 For purposes of this Interpretation, a repurchase agreement is defined as follows:
an agreement which provides for the transfer of securities that are direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or any agency of the United States in exchange for the transfer of funds or other securities by the transferee with a simultaneous agreement by the parties to reverse the transaction at a specified future date and price. See also Section 101(41) of the Bankruptcy Code, 11 U.S.C. §101(41)(1988).
In effect, a repurchase agreement and a reverse repurchase agreement are two sides of the same transaction. In arrangements where the FCM is disbursing cash and receiving securities, an FCM is considered to be effecting a reverse repurchase transaction.
5 Sale and buy-back agreements and simultaneous buy/sell agreements generally refer to agreements in which the title and ownership of a security passes between two parties along with an agreement to re-transfer the title and ownership at a subsequent date.
6 Section 4d(2) of the Act provides, in part:
[Customer] money may be invested in obligations of the United States, in general obligations of any State or of any political subdivision thereof, and in obligations fully guaranteed as to principal and interest by the United States, such investments to be made in accordance with such rules and regulations and subject to such conditions as the Commission may prescribe.
Commission Rule 1.25 states:
No futures commission merchant and no clearing organization shall invest customer funds except in obligations of the United States, in general obligations of any State or of any political subdivision thereof, or in obligations fully guaranteed as to principal and interest by the United States. Such investments shall be made through an account or accounts used for the deposit of customer funds and proceeds from any sale of such obligations shall be redeposited in such account or accounts.
7 Bevill, Bresler & Schulman Asset Management Corp. v. Spencer Savings & Loan Association, 878 F.2d 742 (3d Cir. 1989). The Bresler court said two things: (1) the court accepted the view that repurchase transactions are properly characterized as purchases and sales of securities but did not reach the question of what constitutes transfer of ownership; (2) in 1984, Congress provided not only that a party to a transaction structured as a repurchase agreement could liquidate its securities or cash position, but also that it could keep the proceeds of liquidation to the extent of the contract price. See also S.E.C. v. Drysdale Securities Corp., 785 F.2d 38 (2d Cir.), cert. denied sub nom. Essner v. S.E.C., 476 U.S. 1171 (1986) (repurchase agreement held to constitute purchase and sale of securities for purposes of antifraud provisions of the federal securities laws); In re Comark, 145 B.R. 47 (9th Cir. BAP 1992). In other circumstances, a court has viewed the fundamentals of the transaction differently. In re Lombard-Wall, Inc., No. 82-B-11556, bench op. (S.D.N.Y. Sept. 16, 1982) (repurchase transaction in that case held to be a secured loan for bankruptcy purposes), cited in In the Matter of Bevill, Bresler & Schulman Asset Management Corp., 67 B.R. 557 at 595 (D.N.J. 1986). It should be noted, however, that the repurchase agreement at issue in that case differed from traditional repurchase agreements in certain critical respects: (1) the purchaser was not entitled to possession of the underlying securities; (2) the purchaser had no right to deal with such securities in any way during the term of the agreement; and (3) the purchased securities were to be held in trust by a bank trustee until repurchased. See also Resolution Trust Corporation, as Conservator for Great American Federal Savings and Loan Association v. Aetna Casualty & Surety Company of Illinois, 1993 U.S. Dist. LEXIS 11632 (N.D. Ill. August 19, 1993).
8 The 1984 amendments to the bankruptcy laws added Section 546(f)(11 U.S.C. §546(f)(1988)), which provides that:
Notwithstanding 544, 545, 547, 548(a)(2), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in 741(5) or 761(15) of this title, or settlement payment, as defined in 741(8) of this title, made by or to a repo participant in connection with a repurchase agreement and that is made before the commencement of the case, except under 548(a)(1) of this title.
Section 559 of the Code (11 U.S.C. §559(1988)) was also amended in 1984. It provides in pertinent part that:
The exercise of a contractual right of a repo participant to cause the liquidation of a repurchase agreement because of a condition of the kind specified in section 365(e)(1) of this title shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title. . . .
9 The Bresler court stated:
Congress determined to correct these uncertainties by amending the Code to ensure there is no question that repo participants are afforded the same treatment with respect to the stay and avoidance provisions of the Code in connection with repurchase agreements as is afforded other market participants under the 1982 amendments. 878 F.2d 742, at 748.
See also 1984 amendments to Sections 546(f) and 559 of the Bankruptcy Code, and Sections 101(41), 362(b)(7) and 548(d)(2)(C) of the Bankruptcy Code.
10 15 U.S.C. §78c(a)(6) (1988).
11 The Public Securities Association ("pSA") Master Repurchase Agreement could be used so long as the counterparty does not retain custody of the purchased securities and the FCM does not permit the counterparty to substitute securities. Such a right to substitute would lead to commingling of securities with the counterparty's own securities and could subject securities purchased with customer funds to liens granted by the counterparty to third parties, in contravention of Section 4d(2) of the Act. In addition, the PSA Master Repurchase Agreement must be modified to preclude the FCM from engaging in repurchase transactions with the purchased securities or otherwise hypothecating or pledging the purchased securities, except as provided in footnote 13.
12 As the SEC persuasively argued in the Drysdale case:
That the parties to [repurchase] transactions have expressly chosen to treat them as purchases and sales of securities is a fact entitled to substantial weight and should not be casually discounted merely because these transactions may be viewed from 'an economic perspective' as a secured loan.
This passage is cited in In the Matter of Bevill, Bresler & Schulman Asset Management Corp., 67 B.R. 557, at 598 (D.N.J. 1986).
13 Securities obtained by an FCM through reverse repurchase transactions involving customer funds can be pledged to a clearing organization to satisfy customer margin requirements provided such securities have a maturity of 180 days or less.