The Federal Deposit Insurance Corporation (“FDIC”) has recently issued interpretative guidance, including guidance to Seward & Kissel,1 that consolidates its views on the availability of deposit insurance for so-called “brokered deposit” programs offered by financial service firms, such as registered broker-dealers and banks, to their customers. Through such programs the broker or bank may offer certificates of deposit (“CDs”),2 money market deposit accounts (“MMDAs”),3 NOW accounts4 and demand deposit accounts (“DDAs”)5 at FDIC-insured depository institutions (“Insured Institutions”). In some programs that offer MMDAs, NOW accounts and/or DDAs, the broker or bank may offer the deposit accounts as part of an automatic investment, or “sweep,” arrangement for excess cash of its customers.
According to FDIC data, over $560 billion of brokered deposits were outstanding at the end of the 1st quarter of 2011. $472 billion were reported as fully insured. The vast majority of these deposits are assumed to be placed by broker-dealers for their customers. It is generally estimated that an additional $200 billion in deposits are in broker-dealer sweep programs that are exempt from classification as “brokered deposits.”
The deposit programs that are the subject of the FDIC guidance are structured with a broker-dealer or bank acting as an agent for its customers in placing customer funds in deposit accounts at Insured Institutions and as the customer’s custodian in maintaining records that evidence the customer’s deposit accounts. The recent FDIC guidance makes clear that for FDIC insurance to “pass through” the agent or custodian to the customer, thereby permitting the customer to be eligible for insurance to the same extent as if a direct account relationship had been established at the Insured Institutions, the parties must have a bona fide agent or custodial relationship, not a debtor/creditor relationship. Furthermore, the custodian’s customer must own the deposit accounts and not merely have a pro rata interest in a pool of deposits.
This memorandum reviews this recent FDIC guidance, as well as related guidance from the Securities and Exchange Commission (“SEC”) concerning when a broker-dealer or other intermediary6 may have created a separate obligation to its customers that would be a “security” for purposes of the Securities Act of 1933 (“Securities Act”), rather than merely acting as a custodian for customer assets. In our view, failure to comply with the SEC’s guidance concerning the creation of a separate security would pose a significant threat to the availability of “pass-through” deposit insurance.
Because the issuance of a separate security can lead to the creation of an investment company for purposes of the Investment Company Act of 1940 (the “ICA”), we briefly review the factors that could cause a brokered deposit program to be an investment company. FDIC regulations deny “pass-through” deposit insurance to most investment companies.
Lastly, the memorandum reviews common methods that have been used to ensure that a broker is acting as a bona fide custodian for a customer’s deposit accounts at an Insured Institution.
FDIC “Pass-Through” Deposit Insurance
In general, deposit insurance is provided to depositors at an Insured Institution based upon the rights and capacities in which deposits are maintained by the depositor at the Insured Institution. The Federal Deposit Insurance Act (“FDIA”) states that the FDIC “shall aggregate the amounts of all deposits in the insured depository institution which are maintained by a depositor in the same capacity and the same right for the benefit of the depositor either in the name of the depositor or in the name of any other person (emphasis added)….”7
FDIC regulations recognize a number of rights and capacities in which a depositor can be insured. For example, deposits held in an individual capacity are separately insured from deposits held by the same person jointly with one or more other persons. All deposits maintained by a depositor in the same insurable capacity, including deposits held through an agent, are aggregated for purposes of the deposit insurance limit.8
Section 330.5 of the FDIC’s regulations sets forth the deposit insurance coverage for deposits held by a depositor through a fiduciary relationship.9 A “fiduciary” includes, but is not limited to, a trustee, agent, nominee, guardian, executor or custodian.10 Pursuant to the regulations, if the Insured Institution’s deposit account records indicate that the funds are held in a fiduciary capacity, and the fiduciary’s records maintained in the ordinary course of business reflect the ownership interest of the beneficial owner of the account, the FDIC will insure the deposits of the beneficial owner to the same extent, and subject to the same limitations, as deposits held by the beneficial owner directly with the Insured Institution in the same insurable capacity.11
When there are multiple levels of fiduciary relationships, the FDIC regulations state the manner in which deposit insurance can “pass through” those levels of relationships to the beneficial owner. In such case, the deposit account records of the Insured Institution must clearly reflect that there are multiple levels of fiduciary relationships. The existence of additional levels of fiduciary relationships must be disclosed in records at subsequent levels and the names and identities of the persons on whose behalf each fiduciary is acting must be disclosed on the fiduciary’s records.12
FDIC regulations do not permit the “pass-through” of insurance to shareholders in a corporation.13 For purposes of FDIC regulations the holders of interests in an investment arrangement that is registered with the SEC as an investment company under the ICA, or would be required to register but for certain specified exceptions or exemptions, are not eligible for “pass-through” deposit insurance to the holders.14
FDIC Guidance on Fiduciary Relationships
FDIC regulations provide for “pass-through” insurance for deposit accounts held through fiduciary relationships,15 a term that is defined to include agents and custodians.16 The FDIC has recently been explicit about the importance of the underlying characteristics of such relationships in determining whether or not an intermediary is acting as an agent and custodian for purposes of FDIC regulations,17 as opposed to merely maintaining records of amounts on deposit at one or more Insured Institutions.
In 2010, the FDIC issued a Financial Institution Letter (“FIL”) to clarify misunderstandings with respect to insurance coverage of accounts held by agents and custodians. The FIL stated that “pass-through” coverage is available only if “the funds actually are owned by the customer(s) and not the entity performing in a fiduciary capacity.” The FDIC noted that this requirement is likely not satisfied if the terms of the deposit accounts offered to the customers do not match the terms of the deposit accounts at the Insured Institution.18
In interpretive letters issued by the FDIC subsequent to the FIL, the staff has expanded on the fundamental principle set forth in the FIL.
- The parties must be in a bona fide agency relationship – which means that the agent must actually be an agent and the deposit must actually belong to the alleged owners (the customers).19
- The terms of the agreement between the parties may not create independent obligations on behalf of the agent, which would result in a debtor/creditor, not an agent/principal, relationship.20 This could occur when the terms of the deposits offered by the custodian do not match the terms of the deposit accounts at the Insured Institution and the principal must look to the agent, not the Insured Institution, for payment.
- The customer must own an interest in specific deposits, not a pro rata interest in a pool of deposits.21
The FDIC also noted in these letters that FDIC regulations do not permit the “pass-through” of deposit insurance for deposit accounts held through arrangements that have registered, or should register, with the SEC as investment companies pursuant to Section 8 of the ICA,22 or that would be required to do so but for certain limited exceptions or exemptions.23 The SEC has determined that under certain circumstances deposit placement arrangements can be investment companies for purposes of the ICA and must be registered with the SEC.24
In the Seward & Kissel Letter concerning an arrangement maintained by an Insured Institution that automatically invested or “swept” funds from a custodial account at the Insured Institution to deposit accounts at other Insured Institutions, the FDIC staff sought and received, before issuing the interpretive letter, representations from Seward & Kissel that the Insured Institution sponsoring the program had not issued a security for purposes of the Securities Act or created an investment company for purposes of the ICA.
Related Interpretations of the Securities Act
The SEC’s “Rights and Status” Analysis
The SEC has on numerous occasions addressed when a broker is acting in a purely custodial capacity with respect to an obligation issued by a third party, including deposit accounts, and when a broker is issuing a separate security to its customers for purposes of the Securities Act that must be registered with the SEC or offered pursuant to an exemption from registration. Despite the fact that deposit accounts at Insured Institutions are not “securities” for purposes of the Securities Act,25 an interest in deposit accounts at an Insured Institution held by a broker or other intermediary that does not provide the investor with ownership rights that are independently enforceable against the issuer of the deposit accounts can be a security for purposes of the Securities Act. Such security would be deemed issued by the broker and would not be exempt from registration under provisions of the Securities Act that exempt bank-issued securities.26
In determining whether a broker-dealer has issued a separate security, the SEC has considered the nature of the risks assumed by the customer, which includes determining whether the customer holds the “rights and status” of ownership of the underlying asset. The following is a list of factors, developed from SEC no-action letters, that are applied by the SEC in determining whether a separate obligation has been issued by the broker:
- The customer must be the owner of the investment and a real party in interest.27
- The customer has the right upon default to proceed directly against the issuer. In such event, the customer may proceed individually against the issuer and is not required to act in concert with other holders of the investment.28
- The custodian ensures that the customer receives all relevant communications from the issuer that a direct owner would receive.29
- The custodian acts in a purely ministerial capacity and the asset is not considered an asset of the custodian in the event of the custodian’s insolvency.30
- A customer has the benefits or risks that would be present if the customer had chosen to purchase the investment directly from the issuer, as opposed to going through the custodian.31
- Generally, there are no factors present that would require the customer to rely on the custodian to obtain the benefits of the investment.32
In the context of a brokered deposit arrangement, in order to meet the SEC’s standards, the records of the broker must evidence each customer’s individual ownership of a deposit account or deposit accounts at an Insured Institution. Each customer must be entitled to the rights provided to direct depositors and subject to the restrictions imposed on direct depositors holding the same types of deposit accounts, such as early withdrawal restrictions in the case of CDs and limits on transfers and withdrawals in the case of MMDAs.
The Howey Test
Even if a broker-dealer complies with the SEC’s guidance concerning the rights and status of a customer with respect to assets the broker is holding as custodian for the customer, the broker can still be the issuer of a separate security.
The definition of the term “security” in the Securities Act includes “investment contracts.” The U.S. Supreme Court in Howey33 set forth a test for determining whether an investment contract has been created. According to the Court, an investment contract exists when there is (i) an investment of money (ii) in a common enterprise (iii) with an expectation of profits from the efforts of others.
Applying the Howey test to a brokered CD program, the U.S. Court of Appeals for the 2nd Circuit held in Gary Plastic Packaging Corp. v. Merrill Lynch34 that a CD program sponsored by Merrill Lynch would be an investment contract if the facts alleged by the plaintiff were true. The plaintiff alleged that Merrill Lynch had made certain promises in connection with the offering of CDs on which the Plaintiff relied for its profit. These alleged promises included (i) the CDs would have “above-market” rates, (ii) Merrill Lynch would use its financial skills to screen the creditworthiness of the CD issuers and (iii) Merrill Lynch would maintain a secondary market in which the investors could sell their CDs to attain a profit. The Court also cited Merrill Lynch’s alleged failure to disclose the fact that CD issuers paid Merrill Lynch a fee.
According to the Court, the series of promises allegedly made by Merrill Lynch would constitute a security separate from the underlying CDs. The Court concluded that if the alleged facts were proven to be true, Merrill Lynch would be required to register the security with the SEC or offer the security pursuant to an exemption from registration.
While it appears that the issuance of a security under the SEC’s “rights and status” test would prevent the “pass-through” of FDIC insurance because the broker had not entered into a bona fide custodial relationship with its customer, it is not clear whether the issuance of a security under the Howey test would affect “pass-through” insurance absent the creation of an investment company.
Related Interpretations of the ICA
Although the issuance of a separate security by a broker in connection with a brokered deposit program does not by itself create an investment company, it satisfies one of the requirements for the creation of an investment company. In very basic terms, for purposes of the ICA, an investment company is any person, including a “company,” that (i) issues securities and (ii) invests primarily in securities.35 For purposes of the ICA, a “company” includes “a fund or any organized group of persons, whether incorporated or not.”36
In the Kemper No-Action Letter, the SEC staff declined to give no action relief under the ICA to a brokered MMDA program sponsored by a registered broker-dealer.37 The staff concluded that the broker would be the issuer of a security for purposes of the Securities Act because, inter alia, it offered its customers higher rates on the MMDAs than were otherwise available to the public, selected the Insured Institutions after reviewing their financial condition, moved customer funds among Insured Institutions without prior customer knowledge and precluded the customers from directly enforcing their rights in the MMDAs. The staff also concluded that the MMDAs and other deposit accounts would be securities for purposes of the ICA, even though such deposit accounts would generally not be securities for purposes of the Securities Act or the Securities Exchange Act of 1934.
In the Kemper No-Action Letter, the SEC used the Howey test to conclude that an investment company had been created. We believe that the SEC could also use the “rights and status” test to determine that an investment company had been created.
In addition, while banks enjoy exemptions from registration of their securities under the Securities Act, the ICA provides only limited exemptions for banks that have created an investment company.38 If a bank structured a brokered deposit program as an investment company, the bank could be required to register the program under the ICA, and deposit accounts held through the program would not be eligible for “pass-through” insurance.
Application of Securities Act Interpretations to Brokered Deposit Programs
In general, broker-dealers offer three types of deposit account programs to their customers:
- CDs that are evidenced by a Master Certificate of Deposit representing individual CDs in $1,000 denominations and held at The Depository Trust Company (“DTC”) or directly by the broker;
- Book-entry time deposits in which the time deposits are maintained in the name of a sub-custodian acting for the broker, evidenced by records maintained by the sub-custodian, and by the broker as custodian for its customers; and
- Book-entry MMDAs, NOW accounts and/or DDAs that are maintained in the name of the broker at each Insured Institution and evidenced by records maintained by the broker as custodian for its customers.
Each of these deposit account programs contains features that reflect the individual nature of the deposit accounts at an Insured Institution that are held by the broker as custodian for its customers.
In the case of CDs evidenced by a Master Certificate and held through DTC or the broker, each CD evidenced by the Master Certificate is an individual obligation of the Insured Institution that is enforceable according to its terms. Each CD can be traded in the secondary market and, when held through DTC, moved between brokers. The CDs are in all respects independent obligations of the Insured Institution.
With respect to book-entry time deposits, such as those offered through Promontory Interfinancial Network’s CDARS® program, the Financial Industry Regulatory Authority and the SEC have required the sub-custodian to separately identify each time deposit on its books and to assign each time deposit a unique identifying number. As a result, each time deposit is a separately identified obligation of the Insured Institution that can be enforced independently of any other time deposit.
The establishment of individual MMDAs and/or NOW accounts in a manner to avoid characterization of a customer’s deposit account as a pro rata interest in a pool has typically been accomplished in the contract between the broker and the Insured Institution. Such contracts specify that the deposit account will be established in the name of the broker, as agent and custodian for its customers, and that this “custodial” or “omnibus” deposit account represents individual deposit accounts evidenced on the books and records of the broker as custodian. In accordance with Federal Reserve Board guidance under Regulation D (Reserves),39 each customer’s MMDA is subject to the transfer and withdrawal limitations imposed on an MMDA held directly with an Insured Institution.
In all of these deposit account programs, it is standard practice to obtain agreement from the Insured Institution that if a customer dismisses the broker as the customer’s custodian the Insured Institution will establish the customer’s deposit accounts directly on its books. Such agreement reflects the fact that the broker is merely an agent of its customer and if the broker is dismissed by the customer the deposit accounts held by the broker for the customer will be separated from the other deposit accounts held through the custodial arrangement and registered in the customer’s name. Further, the provision permits the customer to enforce rights in the deposit account against the Insured Institution in the event of a default by the Insured Institution.
It is also standard practice to obtain agreement from the Insured Institution that it will provide the broker with notices that it provides to its direct depositors when such notices convey material information about the deposit accounts and for the broker to agree to provide this information to its customers. Such agreements comply with the SEC’s position that a broker’s customers should receive the same information as a person holding an investment directly with the issuer.
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1 The FDIC does not publish every letter it issues in response to a request for guidance. The letters cited in this memorandum were not published.
2 A CD is a type of time deposit, which is a deposit that is payable at the expiration of a specified time not less than seven (7) days after the date of deposit. See 12 C.F.R. § 204.2(c)(1)(i).
3 An MMDA is an account in which (i) no more than six (6) transfers and withdrawals can be made per month and (ii) the depository institution reserves the right to take up to seven (7) days to satisfy a request for withdrawal. See 12 C.F.R. §§ 204.2(d)(1) and 204.2(d)(2).
4 A NOW account, which is authorized by 12 U.S.C. § 1832(a), is a transaction account that may bear interest but may be offered only to individuals, non-profit organizations that are operating mainly for religious, philanthropic, charitable, political or similar purposes, or governmental agencies. Also, a NOW account is an account for which the depository institution reserves the right to require at least seven (7) days’ written notice of an intended withdrawal.
5 A DDA is a deposit that is payable on demand or a deposit for which the depository institution does not reserve the right to require at least seven (7) days’ written notice of an intended withdrawal. See 12 C.F.R. § 204.2(b)(1).
6 The terms “broker” and “broker-dealer” are used throughout this memorandum when discussing intermediaries because registered broker-dealers are the largest participants in the brokered deposit market. In general, our analysis applies equally to a bank acting as a placement agent and custodian in a brokered deposit program. However, and as noted later, banks may enjoy certain exemptions from the federal securities laws not available to brokers.
7 12 U.S.C. § 1821(a)(1)(C).
8 12 C.F.R. § 330.3(a).
9 12 C.F.R. § 330.5.
10 12 C.F.R. § 330.5(b)(1).
11 12 C.F.R. §§ 330.5(b)(1) and 330.5(b)(2).
12 12 C.F.R. § 330.5(b)(3); see, e.g., letter to Anthony C.J. Nuland, Esq., from Roger A. Hood, Assistant General Counsel (May 24, 1996) and letter to Seward & Kissel LLP from Daniel G. Lonergan, Counsel, FDIC (Feb. 8, 2011) (“Seward & Kissel Letter”).
13 12 C.F.R. § 330.11(a).
14 12 C.F.R. § 330.11(a)(2). The specified exceptions and exemptions relate to government agencies, issuers whose securities are owned by 100 or fewer persons and are not publicly offered, and investment companies organized under the laws of Puerto Rico or other U.S. possessions.
15 12 C.F.R. § 330.5(b).
16 12 C.F.R. § 330.5(b)(1).
17 See Financial Institution Letter: Guidance on Deposit Placement and Collection Activities, FIL-29-2010 (June 7, 2010) (“2010 FIL”) (“the funds actually are owned by the customer(s) and not the entity performing in a fiduciary capacity”); Seward & Kissel Letter; and letter to William Burdette, CEO, Institutional Deposits Corp., from Christopher L. Hencke, Counsel, FDIC (Sept. 23, 2010).
18 2010 FIL.
20 See Seward & Kissel Letter.
22 See 12 C.F.R. § 330.11(a)(2).
23 See note 14, supra.
24 See Kemper Financial Services, Inc., SEC No-Action Letter (avail. Nov. 29, 1985) (“Kemper No-Action Letter”).
25 See Marine Bank v. Weaver, 455 U.S. 551 (1982).
26 Securities issued by banks and savings associations are exempt from registration pursuant to Sections 3(a)(2) and 3(a)(5), respectively, of the Securities Act (15 U.S.C. §§ 77c(a)(2) and 77c(a)(5), respectively).
27 See Apfel & Co., Inc., SEC No-Action Letter (July 18, 1991) (“Apfel No-Action Letter”); Merrill Lynch, Pierce, Fenner & Smith Inc., SEC No-Action Letter (Sept. 26, 1990) (“Merrill No-Action Letter”); E.F. Hutton & Co. Inc., SEC No-Action Letter (Mar. 28, 1985) (“E.F. Hutton No-Action Letter”).
28 See Apfel No-Action Letter, supra note 27; Merrill No-Action Letter, supra note 27; E.F. Hutton No-Action Letter, supra note 27; M.L. Stern & Co., SEC No-Action Letter (May 21, 1984) (“M.L. Stern No-Action Letter”).
29 See Apfel No-Action Letter, supra note 27; Merrill No-Action Letter, supra note 27.
30 See Apfel No-Action Letter, supra note 27; Merrill No-Action Letter, supra note 27; Pension Administrators, Inc., SEC No-Action Letter (Oct. 18, 1989) (“Pension No-Action Letter”); E.F. Hutton No-Action Letter, supra note 27; M.L. Stern No-Action Letter, supra note 28.
31 See Pension No-Action Letter, supra note 30; Rappaport and Segal, SEC No-Action Letter (May 24, 1988) (denying no-action relief in connection with the custody of deposits where an unregulated entity played a role in handling customer funds, which exposed the customers to the “risk of loss separate from and in addition to that presented by the underlying investment itself”).
32 See Apfel No-Action Letter, supra note 27; Merrill No-Action Letter, supra note 27.
33 SEC v. W.J. Howey Co., 328 U.S. 293, reh’g denied, 329 U.S. 819 (1946).
34 Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985).
35 15 U.S.C. § 80a-3(a)(1); see also related definitions at 15 U.S.C. § 80a-2(a).
36 15 U.S.C. § 80a-2(a)(8).
37 Kemper No-Action Letter, supra note 24; see also Merrill Lynch, Pierce, Fenner & Smith, Inc., SEC No-Action Letter (Oct. 28, 1982).
38 There is an exemption for banks from the definition of investment company under Section 3(c)(3) of the ICA. However, this exemption only applies to banks acting in certain trust capacities. Furthermore, the program created by the bank would be the investment company and the issuer of the security, not the bank itself. (15 U.S.C. § 80a-3(c)(3).)
39 12 C.F.R. Part 204.