On July 6, 2009, the FDIC published a set of Frequently Asked Questions relating to the Sweep Account Disclosure Requirements which recently went into effect.   One of the issues addressed was what does the FDIC consider to be a perfected interest in a security.   This issue first came up earlier this year when the FDIC took the position that many repurchase agreements were defective and that in a failed bank situation the FDIC would take the position that the funds subject to such an agreement never left the deposit account.   One of the primary defects which the FDIC pointed out was the right of substitution found in many such agreements.  This announcement caused many banks to modify their master repurchase agreements to delete that right.

The FAQ clarifies the FDIC’s position in several respects.  It first addresses the basic question of when is a security interest perfected in a security.  The FDIC generally considers three elements in determining whether the customer has a perfected security interest in a security subject to a repo sweep: (1) the particular security in which the customer has an interest has been identified, and this identity is indicated in a daily confirmation statement; (2) the customer has “control” of the particular security; and (3) there is no substitution of the security during the term of the repurchase agreement even if the agreement allows for substitution with the customer/buyer’s consent.

Identification of Securities

The element of identification is met by a confirmation identifying the security (i.e., CUSIP or mortgage-backed security pool number) and also specifying the issuer, maturity date, coupon rate, par amount and market value. Fractional interests in a specific security must be identified, if relevant.  Importantly, the FDIC takes the position that an arrangement where bulk segregation or pooling of repurchase collateral without identification of specific securities does not result in the buyer receiving an identified interest in specifically identifies securities.

Control of Securities

The control requirement is met if the customer is able to direct the disposition of the security in the event of default.  The two arrangements recognized by the FDIC as being used to establish control are tri-party and hold-in-custody (HIC).

In a tri-party arrangement, the securities are held by an independent third party acting as a custodian.  As custodian, the third party has possession over the securities and performs certain functions including effecting the buyer’s orders regarding the securities.  It should be noted that solely transferring the securities to a third party custodian does not transfer control.  Rather, the customer/buyer must be able to direct the custodian as to the disposition of the securities in the event of a default by the seller.  If the seller is the sole party who can direct the custodian to act with respect to the securities, control has not been transferred.  All of the parties should execute a tri-party control agreement to evidence this arrangement.

In a HIC arrangement: (1) the depository institution maintains physical possession of the securities or (2) a third party maintains physical possession of the securities but the third party accepts direction regarding the securities solely from the depository institution.  In the eyes of the FDIC, a HIC arrangement may result in a transfer of control of the security to the customer/buyer if the repurchase agreement allows the depository institution, acting as agent for the customer, to effect the customer’s orders regarding the securities, such as transferring the securities to the customer in the event of failure.

From a UCC standpoint, the FDIC’s position on HIC arrangements is really “control lite.” Articles 8 and 9 of the UCC really look to the tri-party control agreement arrangement as the preferred method of perfecting a party’s security interest.  To the extent that the FDIC has taken the position that it will honor the HIC arrangements, we believe that banks and customers should be able to rely upon that guidance and be assured that in a failed bank situation the FDIC will honor the customer’s claims to the securities.  To satisfy this test, any master repurchase agreements should be modified to provide that the bank is acting as agent for the customer with respect to the securities being purchased and will act on the customer’s orders in the event of a default by the bank.

Right of Substitution

Finally, banks should address the right of substitution issue.   As noted above, the right of substitution was one of the primary defects identified by the FDIC.  This can be handled in several different ways.  First, the bank can modify its master repurchase agreements to delete the right of substitution.  Second, the bank could unilaterally inform the customer that it will not exercise that right.  Finally, it can simply note on any confirmations going forward that the bank does not have that right.

As a practical matter, substitution generally is not exercised.  Repo sweeps typically are overnight investments where the customer may own the security, or an interest in a security, for only a few hours, i.e., late evening to early morning.  During such a short time period, it is unlikely that there would be any need to substitute securities.  This issue only really comes up when there are longer term arrangements where securities could mature during the term of the repurchase period.