4000 - Advisory Opinions
Insurance Coverage of Deposits of Futures Commission Merchants and Clearing Organizations in FDIC-Insured Banks
January 28, 1986
Roger A. Hood, Assistant General Counsel
This is in response to your letter of June 5, 1985, in which you inquire about the deposit insurance coverage available to the deposits of futures commission merchants ("FCMs") and clearing organizations in FDIC-insured banks.
Deposit Insurance Coverage of Clearing Organization Margin Accounts
Your first question concerns the coverage available to the "commingled, segregated customer funds that are deposited by an FCM as margin with a clearing organization, and in turn, deposited by a clearing organization in an FDIC-insured bank (clearing organization deposits')." According to your letter, clearing organization deposits consist of the original margin obligations (as altered by variation margin) of the clearing FCM to the clearing organization. Further according to your letter, the clearing FCM uses the initial margin (altered by maintenance margin) received from its customers to meet its original margin obligation to the clearing organization. The FCM and clearing organization maintain margin records on either a "gross" or a "net" basis depending on the rules of the clearing organization. You inform us that in the case of margin records being maintained on a "gross" basis, "the records of the clearing member will permit the reconstruction of the flow of margin funds from each individual customer account to the clearing organization"; in the event margin is recorded on a "net" basis, you state that the FCM's records "would be sufficient to determine the proportionate share of each customer in the amount of commingled segregated funds applied to meet a net margin requirement."
Section 4d(2) of the Commodity Exchange Act, 7 U.S.C. § 6d(2) as you state, "establishes that any customer funds paid by customers to FCMs belong to the respective customers as they may not be offset and must be maintained in segregated accounts (although for purposes of convenience, such accounts may be commingled)." Section 4d(2) also defines the obligations of clearing organizations with respect to customer margin funds as follows:
It shall be unlawful for any person, including but not limited to any clearing agency of a contract market and any depository, that has received any money, securities, or property for deposit in a separate account as provided in paragraph (2) of this section, to hold, dispose of or use any such money, securities, or property as belonging to the depositing futures commission merchant or any person other than the customers of such futures commission merchant.
In an August 12, 1985, interpretative statement, the General Counsel of the Commodity Futures Trading Commission opined that "clearing organization rules and by-laws awarding clearing organizations the right to apply all customer margin funds within their custody to satisfy nonprietary obligations of defaulting clearing firms are not inconsistent with section 4d(2) of the Act or the Commission's regulations." (Interpretative Statement No. 85-3) (emphasis added). In other words, if FCM XYZ defaults on its obligation to the clearing organization because of Customer A's default on his obligation to the FCM, the clearing organization may use all of XYZ's margin deposits, including the margin deposits of nondefaulting customers, in order to discharge XYZ's obligations. The General Counsel's conclusion rests primarily on the view that section 4d(2) "requires only that the clearing organization use such funds as the property of the clearing firm's customers collectively, but does not require the clearing organization to treat such funds as the property of the particular customers who deposited them or to whose positions they have accrued." (Emphasis added).
I understand the original margin payment of an FCM to a clearing organization to be an obligation of the FCM, and not of the FCM's customers. The General Counsel's opinion cited above finds that the funds used to meet the margin obligations of the FCM belong neither to the FCM nor to the FCM's respective customers but to the collective of the FCM's customers, thereby permitting the margin deposits of defaulting and nondefaulting customers alike to be used to meet the margin obligations of a defaulting FCM. Further, the FCM and the clearing organization may maintain margin records on a net basis.
As you know, the deposit insurance coverage afforded by the FDIC is a function of the "rights and capacities" in which funds are held in an FDIC-insured bank. 12 U.S.C. § 1813(m)(1); 12 C.F.R. § 330.1(a). Where funds are owned by a principal and deposited by an agent or a nominee in a deposit account, such deposits are added to any individually-held accounts of the principal and insured up to $100,000. 12 C.F.R. § 330.2(b). The facts you present in your letter show that, up until the moment an FCM defaults on its obligations to the clearing organization, the clearing organization, when it places original margin deposits in an insured bank, is depositing funds that do not belong to it but rather to some principal(s). The question in this case is to whom. If my understanding of the process original margin deposits undergo is correct as recited above, I find that the principals in the relationship are not the respective customers of the various FCMs. In fact, it is unclear who the principals are. FDIC has no regulation recognizing a "collective" of individuals as an insurable entity. I am therefore unable to confirm, as you request, that "the ownership interests of such an FCM's customers (holding open commodity contracts) in clearing organization deposits at an FDIC-insured bank would be determined on a fractional or percentage basis by reference to each customer's proportionate share in commingled funds held by an FCM."
In response to your analysis of the deposit status of a payee of a negotiable certificate of deposit, certified check, certified bank draft, money order, cashier's check or travelers check, the Legal Division agrees with your first conclusion which appears below:
If a bank fails and the person who obtained such a direct bank obligation is still the owner of the instrument (e.g., an FCM which purchased a cashier's check made payable to a clearing house but which did not yet transfer the check), the Division [of Trading of Markets] understands that such person should be able to claim FDIC insurance proceeds in the amount of the instrument up to $100,000, since the failed bank's records almost certainly will disclose the debtor-creditor relationship between the bank and the person who "purchased" the instrument.
You next inquire about the circumstances where the person who originally obtained the bank obligation transfers the instrument to a payee (e.g., a clearing corporation), or where such payee in turn transfers the instrument to a third party. You state that in such cases, "the records of the obligor bank will not disclose the fact of such transfer." In the case of a payee negotiating the instrument to a third party, you are correct that the records of the bank will not disclose the fact of such transfer but that section 330.11 of the FDIC's regulations (12 C.F.R. § 330.11) addresses such a recordkeeping problem by providing as follows:
If any insured deposit obligation of a bank be evidenced by a negotiable certificate of deposit, negotiable draft, negotiable cashier's or officer's check, negotiable certified check, or negotiable traveler's check or letter of credit, the owner of such deposit obligation will be recognized for all purposes of claim for insured deposits to the same extent as if his name and interest were disclosed on the records of the bank provided the instrument was in fact negotiated to such owner prior to the date of the closing of the bank. Affirmative proof of such negotiation must be offered in all cases to substantiate the claim.
The Legal Division does not agree with your next conclusion that the word "negotiation" in section 330.11 "was not intended to be limited to the technical meaning of U.C.C. § 3-202, but was meant to include all transfers.'' This does not mean, however, that payees who are holders of negotiable instruments are not insured. Contrary to your assertion that the payee of a negotiable instrument "would not be able to establish a claim for FDIC insurance proceeds on such records alone," the instrument held by the payee in the payee's name is itself a bank record. The Legal Division also understands that, in most instances, the bank will have a record indicating the identity of the payee. Therefore, where an instrument indicates that a payee clearing organization is holding margin funds, the instrument will be insured as such and not as proprietary funds of the clearing organization.
Checks in the Process of Collection: Failure of Payor Bank
Your next series of questions involves the handling for deposit insurance purposes of items received by an insolvent bank. Assume the following facts:
Bank A receives from Bank B a cash letter containing numerous checks drawn on Bank A by its depositors, which were deposited in Bank B by its customers and are presented to Bank A for payment. Bank A is declared insolvent and put into receivership at the close of business on the day the cash letter is received.
This situation is covered by section 330.12 of the FDIC's regulations (12 C.F.R. § 330.12) which provides that, where a closed bank has become obligated for the payment of items forwarded for collection by a bank acting solely as agent, the owner of such items will be recognized for all purposes of claim for insured deposits to the same extent as if his or her name and interest were disclosed on the records of the bank. The forwarding bank is recognized as agent for the owners for the purpose of making an assignment of the rights of the owners against the closed bank to the FDIC and for receiving payment on behalf of the owners.
This regulation is applicable, by its terms, only when a closed bank has become obligated for payment of the forwarded items. Under section 4-213 of the Uniform Commercial Code (adopted by all the states and the District of Columbia), the payor bank becomes accountable for the amount of an item upon final payment, other than payment in cash. The other forms of final payment are:
1. settlement without the right to revoke the settlement under agreement, clearing house rule, or statute;
2. completing the process of posting the drawer's account; or
3. making provisional settlement and failing to revoke the settlement in a timely manner.
The FDIC does not apply to the example in question your conclusion that the bank becomes "obligated" under section 330.12 when the bank accepts the instrument (see U.C.C. § 3-410) "since that rule also is premised upon the instrument being otherwise payable'." Section 330.12 requires that the claim for insured deposits be otherwise payable, not that the instrument be otherwise payable.
Prior to the payor bank's becoming obligated to the owner of the item, its obligation to its depositor continues. In such cases, the items would be returned to the collecting bank for return ultimately to the payees.
A depositor who draws a check on his account does not thereby assign the funds in that account to the payee of the check. (See U.C.C. § 3-409). Until the check is presented for payment and the bank becomes obligated for payment to the owner of the item, the deposit obligation is owed by the bank to its depositor. As such, it represents a proper insurance claim on the part of the depositor, together with any other deposits owned by that same depositor in the bank.
If the closed bank has, however, become obligated for payment of the items, the owners of the items are recognized as depositors, and the forwarding bank is recognized as the owner's agent to present the claims and receive the insurance payments.
In the event the payor bank fails prior to its becoming obligated to pay an instrument, the FDIC, as receiver, as a general rule, returns all instruments upon which final payment has not been made to the appropriate clearing house the day following its appointment as receiver. With respect to the time for payment of deposit insurance claims, we note that, while 12 U.S.C. § 1821(f) simply requires FDIC to pay such claims "as soon as possible,'' the payment of insured deposits has historically commenced no later than three to five days after the date of the bank's failure.
Checks in the Process of Collection: Failure of Collecting Bank
In response to the first in your series of questions about the deposit insurance consequences that follow the failure of collecting and depositary banks during the collection process, this will confirm that, in the event of the failure of a depositary bank and provided the deposit account records at the depositary bank adequately disclose the depositor status of the commodity clearing organization pursuant to 12 C.F.R. § 330.1(b), then the clearing organization would be able successfully to claim FDIC insurance. The same rule is applicable in the event the failed depositary bank had provided provisional credit without receiving final payment from the drawee prior to its closing because, as you observe, the definition of deposit includes the conditional obligation of a bank to give credit.
In the event of the failure of an intermediary bank prior to final payment by the drawee, the deposit insurance consequences are illustrated by the following examples. First, assume the following facts:
Customers of Bank B deposit in Bank B checks drawn on Banks C, D, and E. Bank B (Depositary Bank) forwards the items to its correspondent, Bank A (Intermediary Bank) to be forwarded directly or indirectly to Banks C, D and E (Payor Banks) for payment. Bank A is declared insolvent and is closed.
The deposit insurance consequences are dependent on the status of the collection process at the time Bank A is closed, and on the instructions given to Bank A by Bank B or the understanding or custom existing between the banks. The various situations are described below.
1. Bank A has received the items from Bank B, but has not forwarded them to the payor banks.
Section 4-214(1) of the Uniform Commercial Code provides that any item in or coming into the possession of a collecting bank (including an intermediary bank) which suspends payment and which item is not finally paid shall be returned by the receiver, trustee or agent to the presenting bank or the closed bank's customer. In this situation, the items would be returned to Bank B which could present them to Banks C, D, and E though alternate channels.
2. Bank A has forwarded the items to Banks C, D, and E which have not settled for the items at the time Bank A is declared insolvent.
Section 4-201 of the UCC provides that unless a contrary intent clearly appears, and prior to the time that a settlement given by a collecting bank becomes final, the bank is an agent or sub-agent of the owner of the item. Under this theory, Bank A is the sub-agent of Bank B which, in turn, is the agent of the owner. Funds (whether cash or other form of settlement) coming into the hands of the agent bank, or its receiver after closing, would not constitute assets of that bank available for its general creditors, but belong to the owners of the items and would properly be passed along by the receiver to Bank B for ultimate payment to the owners of the items.
3.a. Bank A has received funds from Banks C, D and E, but has failed to remit to Bank B as required by instructions or practice.
Section 4-214(4) of the UCC provides that if a collecting bank receives from subsequent parties settlement for an item which settlement becomes final and suspends payments without making final settlement for the item with its customer, the owner of the item has a preferred claim against the collecting bank. This rule would give the owner of the item (acting through its agent, Bank B) a preferred claim against Bank A's assets.
The official comment to this section of the UCC notes that Federal Deposit Insurance affects materially the result of bank failures or holders of items and banks, but states that no attempt is made to vary the rules of the section by reason of such insurance. Section 330.12 would also be applicable to this situation in that, at the time of closing, Bank A would have become obligated for the payment of items forwarded for collection. Under section 330.12, the owner of the item is recognized for all purposes of claim and forwarding bank (Bank B) would be recognized as the agent of the owners for purposes of making an assignment of rights and receiving payment.
It would appear that the owner of the item may have a choice of claiming a preference against the receivership assets or claiming FDIC insurance if Bank A was a state bank. Because preferences are not recognized in national bank receiverships, only the insurance remedy would be available if Bank A was a national bank.
3.b. Bank A has received funds from Banks C, D and E, and has credited those funds to Bank B's correspondent account with Bank A in accordance with Bank B's instructions or their general practice.
The agency status created by section 4-201 of the UCC continues until a settlement given by a collecting bank for an item is or becomes final. Section 4-213(3) of the UCC continues until a settlement given by a collecting bank for an item is or becomes final. Section 4-213(3) provides that if a collecting bank receives a settlement for an item which is or becomes final, the bank is accountable to its customer for the amount of the item and any provisional credit given for the item in an account with its customer becomes final. Under these rules, Bank A's agency status would have terminated upon receipt of funds or settlement prior to its closing. The collection process would have been concluded and Bank A's deposit liability would run only to Bank B for the balance of the correspondent account. Bank B is insured to the maximum amount of $100,000 for its deposit in Bank A.
With respect to your question about an insured bank holding United States Government securities representing margin for a clearing organization, we confirm your conclusions that such securities are not deposits of the bank, are not available to satisfy claims of the bank's general creditors, and that the bank's receiver (usually FDIC) would either return the securities to the owner or transfer than to the designee of the owner, who, in turn, would continue to hold those assets in safekeeping for the owner. In the event of a purchase and assumption agreement whereby the assets of the closed bank are sold by FDIC as receiver to another bank which assumes the liabilities of the closed bank, the agreement would transfer safekeeping items to the assuming bank which would carry out the safekeeping duties of the closed bank or transfer the items to the owner or the owner's designee if so directed.
Standby Letters of Credit
I regret that I cannot answer your first three questions about standby letters of credit relating to the deposit insurance thereof. The FDIC has taken the position in pending litigation that standby letters of credit are not deposits. It would therefore be speculative to consider the deposit insurance coverage of bank obligations that may turn out not to be deposits. For your information, the Supreme Court has granted the FDIC's petition for certiorari in the case of Philadelphia Gear Corp. v. FDIC. FDIC's appeal of the decision in Allen v. FDIC is pending before the United States Court of Appeals for the Sixth Circuit. As you note, both cases held standby letters of credit backed by promissory notes to be deposits.
In response to your fourth question, I would note that it is more appropriately directed to the Comptroller of the Currency in the case of national banks and the appropriate state authority in the case of state-chartered banks since it is they, not the FDIC, who make the determination of when a bank has become insolvent.
In answer to your next question, 12 U.S.C. § 1818 provides the federal bank regulatory agencies cease-and-desist authority to deal with unsafe or unsound banking practices. The same section gives the FDIC the authority to terminate the insured status of an insured bank operating in an unsafe or unsound condition.
Lastly, section 337.2 of the FDIC's regulations (12 C.F.R. § 337.2) authorizes insured State nonmember banks to issue standby letters of credit. The Comptroller of the Currency and the Federal Reserve Board have similar regulations applicable to national banks and state member banks, respectively. With respect to any state-chartered bank, it would be necessary to find authority to issue standby letters of credit in its state law.
Your final question concerns the extent to which FDIC insurance applies to wire transfers of funds handled by FDIC-insured banks. As you point out, there is no unified law governing the rights and liabilities of the parties to wire transfer. This fact is exemplified by the decision in FDIC v. European American Bank & Trust Co., 576 F. Supp. 950 (S.D.N.Y. 1983), where the characterization of funds in the process of wire transfer hinged upon the application of the definition of "deposit" in 12 U.S.C. § 1813(l) to the rules of the Clearing House Interpayment System, a voluntary association of New York banks formed in 1970 to process an increasing volume of international and domestic fund transfers, and the practices of the European American Bank. Therefore, without a specific scenario, I cannot set forth a rule on what funds in the process of wire transfers would constitute deposits. I can tell you, however, that sections 330.11 and 330.12 are inapplicable to wire transfers by their very terms. Furthermore, those two sections remain virtually unchanged from the form in which they were adopted 50 years ago, long before the advent of wire transfers.