4000 - Advisory Opinions
Custodial Holdings of Government Securities Held for Customers by Depository Banks
October 12, 1995
Stephen H. Stiller, Senior Regional Attorney
In essence, you asked whether the failure or inability of an insured State nonmember bank to obtain verification of the safekeeping of its government securities from another bank constitutes: (i) a violation of the Government Securities Act of 1986 ("G.S.A."), 15 U.S.C. § 78o-5, as implemented by the G.S.A. Regulations, 17 C.F.R. Ch. IV; or (ii) noncompliance with the basic external audit procedures for investment securities of the FDIC Statement of Policy entitled, "Statement of Policy Providing Guidance on External Auditing Procedures for State Nonmember Banks," 55 Fed. Reg. 2145 (1990) reprinted in 2 Federal Deposit Insurance Corporation Law, Regulations and Related Acts (FDIC) at 5302.01 (1990). The facts posed in your inquiry are simply too indefinite to draft an appropriate response tailored to those facts. In the alternative, we have summarized the applicable G.S.A. Regulations, consisting principally of requirements in Part 450 and section 403.5 of the G.S.A. Regulations, 17 C.F.R. Part 450 and § 403.5, and commented on the applicability of the referenced FDIC Statement of Policy. We apologize for the very long delay in responding. However, the lengthy legal research and analysis involved as well as the press of other assignments occasioned the delay.
We will limit our discussion of the G.S.A. Regulations to their effect on insured depository institutions, as defined in section 3(c)(2) and (3) of the Federal Deposit Insurance Act ("Act"), 12 U.S.C. § 1813(c) (1) and (2). In fact, the coverage of the G.S.A. Regulations reaches more entities than insured depository institutions and, in so doing, the terms "financial institutions" and "depository institution" used in the G.S.A. Regulations are defined more broadly than insured depository institution is defined in our Act. 17 C.F.R. § § 400.3(j) and 450.2(b). When referring to insured depository institutions hereafter, the terms "depository bank" or "custodian bank" will be used.
Part 450 Overview
Part 450 prescribes the rules with which depository banks must comply when holding government securities for their customers. Part 450 is comprised of five sections. Section 450.1 covers the scope of the Part and describes the capacities in which government securities held by a depository bank trigger the requirements of Part 450. However, Section 450.3 exempts depository banks from Part 450 with respect to government securities held in a fiduciary1 or custodial capacity, provided that: (i) the depository bank has policies and procedures which apply the requirements of its appropriate regulatory agency to its custodial holdings of government securities held in a fiduciary capacity, and (ii) the custodial holdings are subject to examination by such agency for compliance with its fiduciary requirements. The FDIC's requirements for government securities held in a fiduciary capacity by a depository bank for which it is the appropriate regulatory agency are set forth in FDIC Bank Letter No. BL-5-89 (March 2, 1989), Exhibit A, pages 4-6. For all the depository banks which do not come within the exemption, section 450.4 prescribes the specific recordkeeping and handling requirements with which a covered depository bank must comply.
Scope of Part 450
The requirements of Part 450 apply to any depository bank which holds government securities for customers: (1) as a fiduciary or custodian, unless exempt under section 450.3 (17 C.F.R. § § 403.5(a)(1) and 450.1(a)); (2) as a government securities broker or dealer2 for fully paid and excess margin government securities (17 C.F.R. § § 403.5 (a) (2) and 450.1(a)); and (3) as a government securities broker or dealer under repurchase ("repo") agreements, as described in section 403.5(d), which is discussed below at pages 6 and 7.
In addition, there is a fourth category which triggers the application of Part 450. In this category, even though Part 401 of the G.S.A. Regulations exempts certain limited activities by a depository bank from regulation as a government securities broker or dealer, Part 450 is still expressly applicable to such limited activities. Thus, Part 450 applies to the exempt activity under section 401.2, which covers depository banks which limit their transactions in government securities to the tender or subscription for the purchase of original issue U.S. Treasury securities for the account of customers. Similarly, Part 450 applies to the exempt activity under section 401.3, which covers depository banks which effect fewer than 500 government securities brokerage transactions per year or conduct all of their brokerage transactions through arrangements with one or more govenment securities brokers or dealers. Finally, Part 450 applies to the exempt activity under section 401.4, which covers depository banks engaged in government securities dealer activities which are limited to sales or purchases in a fiduciary capacity, or to repo or reverse repo agreements.
Part 450 Custodial Requirements
Section 450.4(a) prescribes the Part 450 custodial requirements for depository banks which hold government securities for customer accounts, unless, as noted above, exempt under section 450.3. Section 450.4(a)(1) provides that a depository bank must maintain possession or control of all government securities held for customer accounts by: (i) segregating them from its own assets and (ii) keeping them free of any lien, charge or third party claim granted or created by the depository bank. Notwithstanding the admonition to maintain the securities free of any lien, charge, or claim, section 450.4(a)(6) permits the bank to lend customer securities, provided there is a written agreement with the customer allowing it and the loan fully complies with the supervisory guidelines of the appropriate regulatory agency.
Section 450.4(a)(2)(i) describes how a depository bank, including a correspondent bank or trust company, may comply with section 450.4(a)(1) when it maintains a customer's government securities at another bank ("custodian bank"), as follows: (i) by notifying the custodian bank that the securities are customer securities, (ii) by instructing the custodian bank to maintain the securities free of any lien, charge, or claim of any kind in favor of the custodian bank or any persons claiming through it, and (iii) by the custodian bank maintaining the securities in an account designated for customers of the depository bank which has no securities belonging to the depository bank.
Section 450.4(a)(2)(ii) provides that, once the depository bank identifies government securities held by the custodian bank as customer securities of the depository bank, the custodian bank must treat the securities as customer securities separate from any other securities held for the account of the depository bank.
Part 450 Documentation Requirements
Except for securities which are subject to repo agreements, under section 450.4(b)(1), a depository bank must issue a confirmation or safekeeping receipt for each government security held for a customer, which identifies the issuer, maturity date, par amount, and coupon rate of the security. Corresponding confirmation requirements for securities which are the subject of repo agreements are governed by section 403.5(d), which is discussed on pages 6 and 7.
Section 450.4(c) requires a depository bank to maintain records of government securities held for customers separately from other records and prescribes that the records:
(1) Provide a system for identifying each customer, and each government security (or the amount of each issue of a government security in book-entry form) held for the customer;
(2) Describe the customer's interest in the government security;
(3) Indicate all receipts and deliveries of government securities and all receipts and disbursements of cash by the depository institution in connection with such securities;
(4) Include a copy of the safekeeping receipt or a confirmation issued for each government security held; and
(5) Provide an adequate basis for audit of the above information.
Under section 450.4(d), government securities held for customers must be counted at least annually and reconciled with customer account records. Subdivisions (1), (2), and (3) of section 450.4(d) elaborate on how the count must be made and verified, including where the securities are held outside the possession, but not the control, of the depository bank. Thus, section 450.4(d)(1) covers where government securities are held outside the possession of the depository bank and mandates reconciliation of the depository bank's records with those of the entity with which the depository bank has securities accounts, including any Federal Reserve bank. Section 450.4(d)(2) requires the depository bank conducting the count to verify any government securities held for customers which are subject to its control but not in its physical possession and which have been "in transfer, in transit, pledged, loaned, borrowed, deposited, failed to receive, failed to deliver, subject to repurchase or reverse repurchase agreements or otherwise subject to the depository institution's control or direction" for more than 30 days. Finally, under section 450.4(d)(3), the dates and results of the counts and reconciliations must be documented and, within seven business days after each required count and reconciliation, any differences must be noted "in a security count difference account."
Under section 450.4(e), a depository bank must treat a government securities broker or dealer as a customer with respect to: (i) securities maintained by the broker or dealer in a Segregated Account3 established by written agreement between the broker or dealer and the depository bank whereby (A) securities under the control of a broker or dealer that belong to the broker's or dealer's customers are segregated from those belonging to the broker or dealer and (B) the bank agrees not to assert any claim or lien against the securities maintained in the account or grant any third party an interest in such securities, and (ii) securities otherwise identified to the depository bank as customer securities for purposes of possession or control. Subdivision (e) also provides that, under the recordkeeping requirements of section 450.4(c), the depository bank must treat such securities as customer securities separate from any other securities held for the account of the government securities broker or dealer, but does not have to identify individual customers of the broker or dealer.4 Section 450.4(f) provides that the records required by sections 450.4(c) and 450.4(d)(3) must be maintained for at least six years and for the first two years "in an easily accessible place."
Section 403.5 Custodial, Documentation and Disclosure Requirements
In addition to the foregoing Part 450 requirements, depository banks when serving as government securities brokers or dealers which hold for customer accounts (i) fully paid and excess margin government securities and/or (ii) government securities subject to hold-in-custody repo agreements, as described in section 403.5(d), are subject to the custodial, documentation, and disclosure requirements of sections 403.5(b), (c) and (d).
Section 403.5(c) Custodial Requirements
Under section 403.5(c)(1), depository banks must determine on each business day the quantity and issue of government securities, including repo securities, that are required to be, but are not, in the bank's possession or control and promptly take any of the following steps necessary to bring such securities into its possession or control: (i) obtain the release of any lien, charge, or other encumbrance against the securities; (ii) obtain the return of any securities loaned; (iii) obtain possession or control of securities it has not received for more than 30 days, or in the case of mortgage-backed securities, for more than 60 days; or (iv) buy securities as necessary to cover any shortage which cannot be resolved by any of the other enumerated steps. Section 403.5(c)(2) requires a depository bank to prepare and maintain a current and detailed description of procedures and internal controls used to comply with section 403.5(c)(1) and to make them available to the bank's appropriate regulatory agency upon request.
Section 403.5(d) Hold-in-Custody Repo Requirements
The repo agreement described in section 403.5(d), which is referenced in the third category under "Scope of Part 450" above, is where the depository bank ("repo seller") retains control of the government securities it sold subject to the repo agreement ("repo securities"). This type of repo agreement is called a "hold-in-custody" repo agreement, which is distinguished from both "deliver out" and "tri-party" repo agreements. In the "deliver out" repo agreement, the repo securities are delivered to the repo purchaser or a depository bank designated by the repo purchaser. Under a "tri-party" repo agreement, a custodian bank enters into an agreement with both the repo seller and repo purchaser and has custodial responsibilities to each.
The documentation and disclosure requirements for government securities held by depository banks under hold-in-custody repo agreements are found in sections 403.5(d)(1) and (2). Section 403.5(d)(1)(i) requires that the repo seller obtain the repo agreement in writing. Section 403.5(d)(1)(ii) requires that the repo seller confirm in writing: (1) by the close of business of the day the repo transaction is initiated, the specific securities subject to the repo agreement and (2) any day thereafter, when the repo securities have been replaced with securities having a different issuer, maturity date, par amount, or coupon rate from the government securities specified in the previous confirmation. The requirements in Sections 403.5(d)(1)(iv) and (v) provide that, where the repo purchaser grants the repo seller a right to substitute repo securities, the repo agreement must include the right of substitution and, immediately preceding the provision containing the right of substitution, the disclosure statement5 set forth in the regulation. Under section 403.5(d)(2), any confirmation must contain specified information about the repo securities, including the issuer, maturity date, coupon rate, par amount, and market value.
Additionally, section 403.5(d) contains a custodial requirement. Under section 403. 5(d)(1)(vi), the repo seller is required to maintain possession or control of the repo securities in accordance with section 450.4(a), discussed on pages 3 and 4 above, except when exercising a right to substitute securities expressly agreed to by the repo purchaser in the repo agreement.
Section 403.5(b) Exception to Sections 403.5(c) and (d) Requirements
Under section 403.5(b), a depository bank is determined not to be in violation of sections 403.5(c) and (d) when, by reason of "temporary lags" in its normal business operations, the bank fails to have possession or control of a security in accordance with the requirements of sections 403.5(c) or (d), provided that the bank acts promptly and in good faith to establish possession or control. Nevertheless, with respect to overnight repo transactions, the normal business lags exception is not applicable to a depository bank which is not in possession or control of the repo securities by the close of the business day it engaged in the repo transaction.
FDIC Statement of Policy
The purpose of the FDIC Statement of Policy Providing Guidance on External Auditing Procedures for State Nonmember Banks, cited above, is to provide guidance and encouragement to state nonmember banks to have the external auditing procedures listed therein performed and reported on annually by an independent auditor. These enumerated auditing procedures involve testing and evaluation consistent with generally accepted auditing standards of high risk areas of a bank's business. One of the enumerated auditing procedures pertains to the ability to confirm the existence of the securities belonging to a bank, including their safekeeping if held by another institution, through the examination of a sample number of the bank's securities.
From the foregoing, determination of a bank's compliance with the referenced FDIC Statement of Policy would not be based on the results of the auditing procedures performed, which are included in the independent auditor's report to the bank's board of directors, but rather would depend upon whether the enumerated auditing procedures were performed and, if performed, whether they were performed timely and properly, i.e., consistent with generally accepted auditing standards.
1"Fiduciary capacity" is defined in the G.S.A. Regulations to include a trustee, executor, administrator, registrar, transfer agent, guardian, assignee, receiver, managing agent, and any other similar capacity involving the sole or shared exercise of discretion by a depository bank having fiduciary powers that is supervised by a federal or state financial institution regulatory agency. 17 C.F.R. § 450.2 (d). Go back to Text
2A "government securities broker" is defined in the G.S.A. Regulations as "any person regularly engaged in the business of effecting transactions in government securities for the account of others. . . ." 17 C.F.R. § 400.3(k). A "government securities dealer'' is defined in the G.S.A. Regulations as "any person engaged in the business of buying and selling government securities for his own account, through a broker or otherwise. . . ." Banks are excluded from this dealer definition unless engaged in buying and selling for their own account "other than in a fiduciary capacity." 17 C.F.R. § 400.3(1). Go back to Text
3"Segregated Account" is defined in 17 C.F.R. § 403.4 (f)(1). Go back to Text
4The FDIC has noted that a depository bank may be entrusted with the safekeeping of customer securities of another depository bank ("customer bank") which is also a government securities broker or dealer. Consistent with the requirements of section 450.4(e), the depository bank entrusted with safekeeping would not have to maintain records identifying individual customers of the customer bank. FDIC Bank Letter No. BL-5-89 (March 2, 1989), Exhibit A, page 6. Go back to Text
5This disclosure statement reads, as follows: