On July 6, 2009, the FDIC published a set of Frequently Asked Questions relating to the Sweep Account Disclosure Requirements which recently went into effect. One of the issues addressed was what does the FDIC consider to be a perfected interest in a security. This issue first came up earlier this year when the FDIC took the position that many repurchase agreements were defective and that in a failed bank situation the FDIC would take the position that the funds subject to such an agreement never left the deposit account. One of the primary defects which the FDIC pointed out was the right of substitution found in many such agreements. This announcement caused many banks to modify their master repurchase agreements to delete that right.
The FAQ clarifies the FDIC’s position in several respects. It first addresses the basic question of when is a security interest perfected in a security. The FDIC generally considers three elements in determining whether the customer has a perfected security interest in a security subject to a repo sweep: (1) the particular security in which the customer has an interest has been identified, and this identity is indicated in a daily confirmation statement; (2) the customer has “control” of the particular security; and (3) there is no substitution of the security during the term of the repurchase agreement even if the agreement allows for substitution with the customer/buyer’s consent.
Identification of Securities
The element of identification is met by a confirmation identifying the security (i.e., CUSIP or mortgage-backed security pool number) and also specifying the issuer, maturity date, coupon rate, par amount and market value. Fractional interests in a specific security must be identified, if relevant. Importantly, the FDIC takes the position that an arrangement where bulk segregation or pooling of repurchase collateral without identification of specific securities does not result in the buyer receiving an identified interest in specifically identifies securities.
Earlier this year the FDIC published its Final Rule on Processing Deposit Accounts in the Event of an Insured Depository Institution Failure. One of the requirements of the Rule is that financial institutions are required to provide sweep account customers with information about what would happen to the customer’s funds in the event the institution failed. As a byproduct of the attention being paid to the new sweep account disclosure rules, the FDIC has also focused on the terms of the Master Repurchase Agreement used in certain sweep arrangements where the institution serves as the customer’s custodial agent for securities held at another financial intermediary.
The standard industry Repurchase Agreement contains a provision which allows the financial institution to substitute the originally purchased securities with different securities of the same type. The FDIC has recently taken the position that the right of substitution renders a Repurchase Agreement used in connection with such a sweep account defective based on the fact that the institution retains excessive control over the securities. The result of this is that the customer’s funds will be treated as if they never left the deposit account from which they originated. This could be devastating to a customer in the event of the failure of the institution.
In addition to the risk which a customer runs of having significant uninsured deposits, the financial institution runs the risk that the funds should have been reported on a Call or Thrift Financial Report as deposits for purposes of reserves and assessments. This then in turn raises issues of whether the financial institution has been in violation of Reg Q which prohibits the payment of interest on demand deposits.