Customer Securities at a Custodial Bank
May 11, 1989
Mr. Robert Plotkin
Division of Banking, Supervision and Regulation
Federal Reserve Board
Washington, D.C. 20551
Dear Mr. Plotkin:
The Department has received inquiries concerning situations in which a depository institution instructs another financial institution (“custodian institution”) to receive securities for the account of the depository institution's customers. The circumstances involve depository institutions that, under the Government Securities Act regulations, 17 C.F.R. Chap. IV, are eligible for exemption from the requirement to give notice of being a government securities broker or dealer (“exempt institution”). Such exempt institutions remain subject to 17 C.F.R. Part 450, including section 450.4(a)(2), which requires that fully paid customer securities be maintained free of lien. Section 450.4(a)(2) specifically requires an exempt institution, which is maintaining fully paid customer securities through a custodian institution, to instruct the custodian institution that the securities are fully paid customer securities to be maintained in a separate customer account free from lien, charge, or claim of the custodian institution. In the context of that prohibition, questions have been raised about the possibility of an exempt institution granting a lien on securities to a custodian institution until such time that the custodian institution receives payment for the securities from the exempt institution, even though the customer has paid the exempt institution for the securities.
It is our understanding that situations involving delays in receipt of payments by the custodian institution arise infrequently, but may occur, for example, if the exempt institution has misdirected the funds for payment of the securities or has missed the cut-off time for wire payments. As a result of these situations, the custodian institutions have raised questions concerning our rules with respect to securities for which they have not yet received payment, but which are fully paid customer securities from the perspective of the exempt institution. To obtain protection for an extension of credit in such situations, some custodian institutions have informally been seeking an interpretation of section 450.4(a)(2) that would permit the exempt institution to grant a temporary lien on its customers' fully paid securities until payment has been received by the custodian institution.
Although a custodian institution may be concerned that it is bearing the risk of exposure for clearing securities for other parties, the custodial rules, specifically, the “no lien” provision contained in section 450.4(a)(2) does not permit an exempt institution to grant a lien, even on a temporary basis, to the custodian institution, nor does it permit the custodian institution to take one. The Department views this treatment of fully paid customer securities to be an essential element of customer protection. It is the Department's view that the custodian institution must look toward the exempt institution to provide a remedy, and that alternative arrangements can be made, other than a lien on customer securities.
While the subject of this letter specifically addresses questions that are being raised about clearing for exempt institutions, it is noted that the requirements of section 450.4(a)(2) are applicable to all depository institutions, whether or not exempt. In discussions of these requirements, the provision of section 450.4(a)(4)(ii) was referenced to support arguments for permitting exempt institutions to grant liens on customer securities. This provision addresses situations of banks that are clearing for government securities broker-dealers, not exempt institutions, and states that the clearing bank is not required to segregate securities upon the instruction of the broker-dealer if the clearing bank determines that the securities continue to be required as collateral for the extension of clearing credit. The provision was expressly intended to be limited to situations involving financial institutions that are performing clearing functions for government securities broker-dealers.
Those clearing operations are conducted differently than the custody and clearing performed by the custodian institutions in the instant case. In the situation described in section 450.4(a)(4)(ii), on any given day, a clearing bank would be conducting a large number of transactions for a broker-dealer and would retain an intra-day lien until it could segregate customer securities at the end of the trading day. This is a different operation than custodial functions performed on behalf of exempt institutions. The exception was intended to be a narrow one of infrequent occurrence and limited application and it should not be interpreted as authorizing the broker-dealer to grant a lien on customers' securities. When a clearing bank invokes this provision, the broker-dealer is in violation of the possession or control requirements for customer securities. Further, the clearing bank is required to send notification of the violation to the broker-dealer's appropriate regulatory agency.
Therefore, pursuant to 15 U.S.C. 78o-5(b), it is our interpretation of 17 C.F.R. 450.4(a)(2) that financial institutions performing clearing and custody functions for exempt depository institutions may not take, nor may exempt depository institutions grant, a lien against fully paid customer securities.
This interpretation will be immediately available to the public and is being issued to each appropriate regulatory agency for depository institutions.
Richard L. Gregg