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Repos with Affiliates

October 9, 1990

Walter T. Eccard, Esquire
Brown & Wood
815 Connecticut Avenue, N.W.
Washington, D.C. 20006

Dear Mr. Eccard:

This is in response to your letter dated April 24, 1989, and subsequent correspondence,/1/ in which you request an interpretation of the regulations implementing the Government Securities Act of 1986 (“GSA,” 15 U.S.C. 78o-5) concerning repurchase transactions involving Bear Stearns & Co., Inc. (“Bear Stearns”), Custodial Trust Company (“CTC”), and third parties. Your questions have been mainly concerned with whether the fact that Bear Stearns and CTC are affiliated companies necessarily leads to the conclusion that a repurchase transaction in which Bear Stearns is the repurchase seller and CTC is the repurchase custodian is a hold-in-custody repurchase transaction because of that affiliation./2/ More specifically, you have asked us whether the described transaction could be considered to fall outside the definition of a hold-in-custody repurchase transaction as that term has been applied under the GSA regulations.

/1/ Letters from Walter T. Eccard, Brown and Wood, to Kenneth R. Papaj, Director, Government Securities Regulations Staff, dated May 19, 1989; June 7, 1989; October 4, 1989; December 29, 1989; January 10, 1990; April 27, 1990; May 1, 1990; and June 25, 1990.

/2/ The term “hold-in-custody,” while not defined in the GSA regulations, is a commonly-used description of a repurchase transaction in which custody of the security or securities subject to repurchase is retained by the seller. See 17 CFR 403.4(e) and 403.5(d).

Background

CTC and Bear Stearns are both wholly-owned subsidiaries of The Bear Stearns Companies, Inc. CTC is a state-chartered (New Jersey) bank insured by the Federal Deposit Insurance Corporation (FDIC) that provides fiduciary, custody, and agency services for institutions and high net worth individuals. CTC also clears government securities transactions for primary dealers, including Bear Stearns. Bear Stearns is a registered broker-dealer, pursuant to section 15(b) of the Securities Exchange Act of 1934 (“Exchange Act,” 15 U.S.C. 78o(b)), and has filed notice of its status as a government securities broker-dealer pursuant to section 15C(a) of the Exchange Act (15 U.S.C. 78o-5(a)).

The Basic Structure of the Transaction

You have represented that the transactions to which your correspondence relates are structured as follows. Pursuant to written agreements, CTC customers, including in some instances, banks acting on behalf of their customers, enter into both securities lending and repurchase transactions with Bear Stearns. In the lending transactions, the customers, acting through CTC as custodian, lend securities to Bear Stearns and, in return, receive through CTC for their account either Treasury securities, cash, or letters of credit as collateral for the loaned securities. In cases where the customers receive cash for the securities loaned, they also engage in subsequent repurchase transactions with Bear Stearns, again through CTC, using the cash for such purpose. You have stated that some of the cash used to effect the repurchase transactions may be from sources other than through the lending transactions.

You have further represented that the types of eligible securities and the terms and conditions of the repurchase transactions are detailed in master repurchase agreements between the customers and Bear Stearns. In both the repurchase and securities lending transactions, you have represented that CTC, pursuant to agreement, acts as an agent for the customers.

Additional Facts Concerning the Repurchase Transaction and the Affiliate Relationship Between Bear Stearns and CTC

You have provided us with copies of the repurchase agreements which, in your view, contain language that is sufficient to contractually establish CTC as an independent custodian in the repurchase transaction. (In transactions in which banks are involved, CTC acts as a sub-custodian for the banks' customers because the banks are often the principal custodian.) You have represented that the agreements are structured so as to permit CTC to deliver cash or securities to Bear Stearns only upon a simultaneous or prior exchange of collateral or funds, respectively.

Although the relationship and activities conducted by the different parties affect both the securities lending and the repurchase transactions, this letter only focuses upon the questions concerning the repurchase transactions, and accordingly, discussion of relevant facts and regulatory treatment is so limited. According to representations made in your letters, CTC utilizes three different service providers for various aspects of its securities lending and repurchase transaction activities. You have identified the service providers with whom CTC maintains a relationship as being CTC Services, Inc. (CTC Services), Loanet, Inc. (Loanet), and Automatic Data Processing (ADP). These companies provide computer and data processing services for CTC. CTC Services and Loanet are relevant for the purposes of the repurchase transactions.

You have further represented that CTC Services is a wholly-owned subsidiary of CTC that performs back office functions for CTC. CTC Services was separately incorporated because CTC had previously been unable to branch into New York State and, as you have stated, still finds it preferable to conduct certain operations from that location. You have also informed us that the New York State Superintendent of Banking has issued a letter that would permit CTC to open an office in New York City for the purposes of conducting the activities currently performed by CTC Services. Currently, CTC Services maintains an office on the same floor as Bear Stearns at 2 Broadway in New York City, but the two offices are physically separated. You have assured us that Bear Stearns employees cannot directly access CTC Services office space or computer terminals, and that there are separate, secured entrances for the two offices. While CTC Services and Bear Stearns do not interact with regard to the repurchase transactions, there is some contact arising from the securities lending transactions. These contacts are specifically circumscribed to prevent Bear Stearns from accessing CTC customer accounts. In addition, according to your representations, there are no common employees of Bear Stearns and CTC Services.

To initiate the repurchase transactions, you have stated that CTC Services determines, on a daily basis, the amount of cash in CTC customer accounts which is the result of both the securities lending and other transactions, and is available for repurchase transactions. CTC Services then communicates this information to CTC on an aggregate basis. At this point, you have represented that CTC Services ends its involvement in the repurchase transactions. A CTC employee then reviews the information on a customer-by-customer basis and transmits to Bear Stearns information detailing the amount of each type of collateral needed to conduct the repurchase transactions. The amount of cash originally calculated by CTC Services as available for repurchase transactions may be independently verified on a real-time basis by a CTC employee located in New Jersey by means of a Loanet terminal.

You have represented that the repurchase collateral is moved from a Bear Stearns account to a segregated CTC account at the Federal Reserve Bank of Philadelphia (FRB Philadelphia) in which only CTC trust customer securities are held. The transfer of cash and collateral between Bear Stearns and CTC is done on a simultaneous (or prior delivery to CTC) basis. More specifically, securities owned by Bear Stearns comprising the repurchase collateral that are cleared by CTC are transferred from the CTC dealer account holding Bear Stearns securities to the above-mentioned CTC trust account at FRB Philadelphia which only contains CTC trust customer securities. You have also represented that government securities in the customer account are held free of any lien, charge, or claim of any third party, including FRB Philadelphia, granted or created by CTC.

During the same day that collateral has been transferred, CTC first verifies, in the aggregate, that the proper amount and type of collateral has been received to conduct the repurchase transactions. The allocation of specific securities to individual CTC customers is performed by Bear Stearns at the Whippany Data Center (Whippany), which performs overnight batch processing for Bear Stearns including the allocation. Upon completion of the allocation, Whippany produces an allocation report which it forwards to CTC. CTC verifies the appropriateness of the allocation the following morning and, if necessary, makes corrections. You have stated that the allocation is verified by CTC on a daily basis for each customer that has entered into a repurchase transaction.

At the completion of the transaction, you have represented that CTC customer repurchase collateral may be moved from CTC back to Bear Stearns only upon the instructions of CTC employees. While Bear Stearns receives information concerning CTC customer portfolios, Bear Stearns may not effect movements of the repurchase collateral.

With regard to the affiliate relationship between Bear Stearns and CTC, you have represented that out of the fourteen directors of CTC, 6 are also officers of Bear Stearns, 6 are outside directors, and 2 are officers of CTC. You have also stated that Bear Stearns and CTC do not share any common officers and that as a state-chartered institution, CTC is subject to regulation and examination by the New Jersey Department of Banking, as well as the FDIC. In addition to FDIC regulations that limit the relationship between Bear Stearns and CTC, you have informed us that the FDIC imposed specific conditions upon CTC as part of its order granting CTC's application for deposit insurance.

Those conditions included: (1) mandatory physical separation of the securities business of Bear Stearns and CTC; (2) a prohibition on common officers between Bear Stearns and CTC; (3) a requirement that a majority of CTC's Board of Directors be comprised of persons that are neither directors nor officers of Bear Stearns; (4) a requirement that any Bear Stearns employee who is also a CTC employee is prohibited from conducting any securities activities that involves customer contact on behalf of Bear Stearns on the premises of CTC; and, (5) a requirement that Bear Stearns must conduct its business pursuant to independent policies and procedures designed to emphasize the separateness of the businesses of Bear Stearns and CTC and to communicate this organizational separateness to customers.

You have specifically represented that all of the employees of CTC Services are CTC employees, not Bear Stearns employees, and that no Bear Stearns employees have access to or control of the cash or securities that are subject to the repurchase transactions described in your request and that are held by CTC in a custodial capacity. Finally, you have noted that Bear Stearns and CTC each employs its own internal auditors, although the two entities now employ the same outside accountant, Deloitte & Touche, as the result of a merger between Touche Ross and Company and Deloitte, Haskins, and Sells. Different managing partners working out of separate offices are responsible for the CTC and Bear Stearns work. According to your representations, CTC's outside accountants report directly to an Audit Committee of the Board of Directors of CTC that is exclusively comprised of outside directors.

Analysis

In light of the above-described repurchase transaction, you have asked us to interpret the term “hold-in-custody repurchase transaction” as that term is applied to the GSA regulations. Specifically, you request that we address the question of whether a repurchase transaction is necessarily a hold-in-custody repurchase transaction (and therefore subject to the relevant regulatory treatment contained in 17 CFR 403.1, 403.4, or 403.5, as applicable) by virtue of the fact that the repo custodian is an affiliate of the government securities broker or dealer that is the seller in the repurchase transaction. Treasury has previously addressed this issue and has stated its views in the preamble to the temporary regulations implementing the GSA (52 FR 19642, 19660). At that time, Treasury stated that a major purpose of the provisions governing hold-in-custody repurchase transactions is to assure, to the extent possible, that the securities are handled in a manner that recognizes and preserves the interest of the counterparty to the broker or dealer in the securities subject to repurchase.

Accordingly, the Department was of the view that delivery of the securities subject to repurchase to an affiliate could fall outside the parameters of a hold-in-custody repurchase transaction only if the counterparty was a direct customer of the affiliated custodian and the custodian was subject to the requirements of Securities and Exchange Commission Rule 15c3-3 (17 CFR 240.15c3-3) or the provisions of Part 450 of the GSA regulations (17 CFR Part 450) with respect to the securities subject to repurchase. We differentiated this treatment of the securities subject to repurchase from a situation where the securities would be subject to disposition solely on the instruction of the government securities broker or dealer that is the seller of a repurchase agreement. In that case, the transaction would be considered to be a hold-in-custody repurchase transaction.

Treasury is still of the view that an affiliate relationship between a government securities broker or dealer and the custodian of the securities subject to repurchase is not dispositive of the issue of whether a repurchase transaction is characterized as hold-in-custody. The preamble explanation cited above sets out the basic measure of independence of the affiliated custodian with respect to its responsibilities to the repo counterparty -- that there is a clear manifestation of the counterparty's interest registered with the custodian, and that the securities are held subject to the custodial rules. For your information, in addition to the specific questions addressed in this letter, Treasury has evaluated on a general basis, repurchase transactions involving third party custodians and issued an interpretation of the regulations dated May 7, 1990, which discusses different types of transactions in light of the regulations applicable to hold-in-custody repurchase agreements.

In response to your request, to the extent that the set of facts you have presented describes a transaction, which, in this case, is being conducted by Bear Stearns and CTC, and has been represented as establishing independent obligations of the custodian to the counterparty (and conversely, independence of the custodian from the control of the repo seller), a transaction so constructed, would appear to fall outside the definition of a hold-in-custody repurchase transaction. Thus, it would not be subject to GSA rules applicable to hold-in-custody transactions solely because the government securities broker or dealer that is the seller in the repurchase transaction and the custodian of the securities subject to repurchase are affiliated entities. This interpretation of the regulatory treatment afforded such a transaction is premised upon the fact that the counterparty to the repurchase transaction is (1) an independent customer of the custodian and, (2) that the custodian holds the securities subject to repurchase in accordance with the requirements of 17 CFR 240.15c3-3 or 17 CFR Part 450, as applicable.

Accordingly, pursuant to 15 U.S.C. 78o-5(b) the term “hold-in-custody” as it is used in the GSA regulations is interpreted to exclude certain repurchase transactions, subject to specified limitations, in which the government securities broker or dealer acting as the seller in the repurchase transaction is an affiliate of the custodian of the securities subject to repurchase, provided that certain aforementioned indicia of independence are established.

This interpretation is issued subject to the two conditions mentioned above and is premised upon the specific facts and representations concerning the transactions and the relationships between the parties as you have described them, that no material facts have been omitted, and that no facts exist to the contrary. Any change in facts or circumstances could cause the resulting transaction to differ from the transaction contemplated in issuing this interpretation and accordingly, could fall outside the scope of this interpretation of the GSA regulations and could lead to a different result.

Pursuant to 17 CFR 400.2(c)(7), this letter and your incoming correspondence will be made immediately available to the public.

Sincerely,
Richard L. Gregg
Commissioner