4000 - Advisory Opinions
Insurance Coverage of CDs Purchased by Pension Association
January 12, 1988
Patti C. Fox, Attorney
You requested an opinion regarding the deposit insurance coverage of Development Certificates of Deposit ("CDs") to be purchased by the *** Pension Association *** from *** banks. As we discussed in several telephone conversations there are two primary issues to be resolved: (1) whether the CDs are insured deposits, and (2) the availability of pass-through insurance coverage to each employee-beneficiary of the various benefits plans.
The Insured Deposit Status of Development CDs
The Development CDs are a new product, not yet issued, being created by the Department of Housing and Urban Development, the National Development Council, and the *** Office of Business Development. The purpose of the program is to provide an insured long-term investment instrument to pension funds while creating a source of long- term fixed rate funding for small businesses. As originally proposed, the negotiable CDs will be issued for ten years yielding a rate based on ten year Treasury bills plus 30 basis points. The principal will be amortized based on the amortization schedule of the linked loan, with principal and interest payments made semiannually. The purpose in having a scheduled principal repayment is to avoid a mismatch of the bank's liabilities and assets should interest rates drop during the term of the CD. In addition, the issuing bank will have the right to prepay the Development CD should the borrower of the linked loan default or prepay.
In a recent conversation with ***, he informed me that several significant changes to the Development CD instrument were under consideration, due in part to FDIC concerns regarding the deposit status of the instrument. First, the amortization of principal would be deleted. Second, the instruments would be issued in a series for a period covering the life of the loan; the current proposal is a series of one-year term instruments with a ten year cap. Third, consideration is being given to eliminating the bank's right to prepayment.
I will comment on both proposals in order to clarify the FDIC's major concerns: (1) the status of the instruments as deposits and (2) safety and soundness considerations. The regulatory issues do not, of course, affect the insurability determination.
Under the first program, the Development CD has several features not associated with a typical CD: (1) principal is amortized, (2) the CD is linked to a particular loan, and (3) is callable on demand by the bank in the event of prepayment or default of the linked loan. In effect, state pension funds purchasing Development CDs will be lending to a bank who, in turn, will lend the money to a defined class of borrowers for a specific purpose giving the transaction an appearance of a loan rather than a deposit.
Pursuant to the FDI Act,
a deposit is the unpaid balance of money or its equivalent received or held by a bank in the usual course of business and for which it has given or is obligated to give credit, either conditionally or unconditionally, . . . [and] which is evidenced by its certificate of deposit . . . . 12 U.S.C. § 1813 (l)(1).
It is generally accepted that bank deposits are not loans in the ordinary sense but are transactions peculiar to banking. State v. Northwestern National Bank of Minneapolis, 18 N.W. 2d 569, 579-80 (Minn. 1945) citing 5 Zollman, Banks and Banking § 3154 (perm. ed.)). The issuance of a certificate of deposit is not conclusive proof that the transaction represents a deposit and not a loan. Rather, the substance of a transaction rather than its form determines whether a deposit or loan has been created. Partch v. Krogman, 210 N.W. 612 (1926); 6A Michie on Banks and Banking, §§ 11-1, 11-4 (1987).
Another factor which distinguishes between a deposit and a loan is whether the transaction primarily benefits the bank or the depositor. Shumacher v. Eastern Banking and Trust Co., 52 F.2d 925 (4th Cir. 1931). Here, the *** banks primarily benefit from the easy access to below-market rate funds, i.e,, the blended rate of the cost of state and pension plan funding, as well as the retained option to prepay a Development CD in order to decrease the risk of loss. Moreover, the banks would not make these long-term, fixed rate loans to small business borrowers if this program were not available. In contrast, the pension fund, who are being solicited to provide funding apparently as a part of their civic duty, are acquiring long-term, illiquid instruments with some risk of loss of interest. The amortized principal has a benefit of permitting the reinvestment of the sum into other investments, but has the disadvantage of reducing the amount of return.
Further, the intent of the party making the "deposit" must be considered. Traditionally, the purpose of a loan has been that of an investment while that of a deposit has been one of safekeeping. The purpose behind the insurance of deposits is the protection of earnings entrusted to the bank. See FDIC v. Philadelphia Gear Corp., 106 S.Ct. 1931 (1986). The pension funds appear to be making an investment in small business borrowers under the auspices of the state program. It is unlikely that pension funds would be placed in many of the participating banks without the encouragement of the state.
The loan characteristics of the Development CD and the active solicitation of funding from a specific source to be used for a particular purpose take the transaction out of the usual course of business of taking deposits within the meaning of the FDI Act. Based on consideration of the above factors, the Development CD as originally proposed is not an insured deposit. The second proposal, which eliminates two of the three objectionable features, is troublesome due to the solicitation of funds for specific bank loans. Admittedly, this is little different from the solicitation of brokered deposits by banks. Although eliminating the direct tie-in of pension deposits to a particular loan would be preferable, the second proposal would appear to create an insured deposit.
Apart from the insurability issue, the linked financing arrangement presents safety and soundness from the regulatory standpoint. The easy access to below market rate funds invites poorly managed banks to fail to perform thorough credit evaluations of borrowers, as well as become unduly dependent upon this type of lending. The FDIC would, therefore, encourage a pension fund investing in this program to perform its usual analysis of the institution's performance.
Deposit Insurance Coverage
Assuming that there is an insured deposit, insurance coverage is discussed below. The *** is a political subdivision of *** charged with administering, as trustee, the pension plans for *** within the state. The funds from the various pension plans are commingled for investment purposes; however, the *** maintains separate accounting for each pension plan. Funds from other types of plans, i.e., death and disability benefits, are not commingled with the pension plan funds in the same deposit accounts. In its trustee capacity, the *** will purchase Development CDs from *** banks participating in the state-sponsored program. At this time, the CDs are to be offered in $100,000 increments or less; however, this is subject to change.
Notwithstanding the *** status as a public unit, funds held pursuant to an employee welfare and benefit plan are insured as trust funds under Section 330.10 of FDIC regulations. Each participant-beneficiary is insured to $100,000 for his or her interest in the plan separately from the accounts owned by that participant in the same bank. Although Section 330.1(c)(1) requires the value of the trust interest of each beneficiary to be capable of determination without the evaluation of contingencies, unless covered by the present worth tables set forth in Federal Estate Tax regulations, an exception is made for pension and other trusteed employee benefit plans. In that instance, the trust interest of each beneficiary is treated as though fully vested as of the date the bank closed. If any one plan consists of funds which required the evaluation of contingencies, e.g., death and disability benefits, insurance coverage would not pass through to the individual beneficiaries, unless the individual's claim had accrued. Instead, the funds attributable to that plan would be insured to $100,000.
In order to obtain pass-through insurance coverage, the recordkeeping requirements must be met. Section 330.1(b)(1) of FDIC regulations provides that the deposit account records of a bank "are conclusive as to the existence of any relationship pursuant to which the funds in the account are deposited and on which a claim for insurance coverage is founded." When deposit account records disclose the existence of such a relationship, "the details of the relationship and the interests of other parties in the account must be ascertainable either from the records of the bank or the records of the depositor maintained in good faith and in the regular course of business." 12 C.F.R. § 330.1(b)(2).
Therefore, the CDs should reflect that *** is acting in a trustee capacity for others. In the event of a bank failure, the *** would have to indicate the pension plans and amount of interest attributable to each, and the interest of each participant under the plan. Normally, an actuarial calculation is made for a pension plan using the beneficiaries with the largest interests. If an interest exceeds $100,000, then further calculations must be made as to the interest of the remaining beneficiaries. If the largest interest is less than $100,000, then the entire plan is treated as fully insured. A check for the insured deposits of all the plans would be given to the *** as trustee.
Although the insurance coverage cannot be limited to the pension plans rather than each employee-participant, as you requested, except in the case of plans with contingent beneficial interests, the actuarial determination of the beneficial interests described above could be reduced. If the *** limits its total investment in any one bank to a $100,000 interest for each pension plan, there would be no need for a separate actuarial determination of each beneficial interest.
The interpretation of federal deposit insurance coverage given in this letter is dependent upon the facts as previously stated. Because details of the second Development CD proposal have not been finalized, this opinion should not be construed as an assurance that the final instrument will constitute an insured deposit. Moreover, the FDIC is not bound by the staff opinion expressed herein, and reserves the right to examine deposit insurance claims on a case-by-case basis. Please let me know if I can be of further assistance.