Banking Interpretations

May 20, 2003

Robert E. Hand, Esq.
General Counsel
The Bank of Tokyo-Mitsubishi, Ltd.
New York Branch
1251 Avenue of the Americas
New York, NY 10020-1104 

Dear Mr. Hand: 

Thank you for your letter of November 27, 2002 (“Incoming Letter”), clarified by additional details contained in the February 5, 2003 letter to the Bank of Tokyo-Mitsubishi Trust Company from [                ] (“[      ]Letter”) that you provided to us, wherein you seek the Banking Department’s concurrence that fully secured securities lending transactions, as typically entered into by The Bank of Tokyo-Mitsubishi, Ltd., New York Branch (“Branch”) should be considered “qualified financial contracts” (“QFCs”) under Section 618-a(2)(d) of the New York Banking Law, and thus may be excluded from the Branch’s “total liabilities” calculation for purposes of calculating the Branch’s asset pledge requirement under Superintendent’s regulation Part 322.  Your question arises in light of a recent amendment to Part 322 permitting foreign branches and agencies to exclude from their calculation of “total liabilities” under that Part “liabilities arising from QFCs to the extent such liabilities are secured by collateral within the meaning of Section 618-a(2)(d).” 

We agree that securities lending transactions that meet collateral and other requirements of Banking Law Section 618-a(2) should be treated as QFCs and thus should be exempt from the calculation of liabilities for purposes of Part 322.  I hope you do not mind that I have quoted from your Incoming Letter in my response for the benefit of future readers.

I.  Securities Contract

Section 322.1(c) of Part 322 exempts liabilities arising from QFCs to the extent such liabilities are secured by collateral within the meaning of Section 618-a(2)(d).  Section 618-a(2)(e) defines a QFC as: 

“any securities contract, commodity contract, forward contract (including spot and forward foreign exchange), repurchase agreement, swap agreement, and any similar agreement, any option to enter into any such agreement, including any combination of the foregoing, and any master agreement for such agreements (such master agreement, together with all supplements thereto, shall be treated as one qualified financial contract), provided that such contract, option or agreement is reflected in the books, accounts or records of the banking organization or a party provides documentary evidence of such agreement;…”

Such a contract is secured under Section 618-a(2)(d) if a party has a perfected security interest in collateral or other valid lien or security interest in collateral enforceable against third parties pursuant to a security arrangement.

The Banking Law does not define the term “securities contract.”  However, as you point out, Section 11(e) of the Federal Deposit Insurance Act (the “FDI Act”), in providing special rules for the treatment of QFCs of an insured depository institution for which the FDIC is appointed as conservator or receiver, refers for the meaning of “securities contract” to Section 741 of the U.S. Bankruptcy Code.  Section 741(7) of the Bankruptcy Code provides that a “securities contract” means, among other things, a contract for the purchase, sale or loan of a security, including an option for the purchase of a sale of security. (Incoming Letter, pp. 1-2). 

II.  Secured QFCs Exempt from Automatic Stay or Repudiation 

Section 618-a(2)(e) was added in 1993 in order to codify the special treatment to be given to certain fully secured QFCs in a foreign branch or agency liquidation scenario, in the event such QFCs are repudiated or terminated in accordance with their terms.  As a result, parties to QFCs that have a security interest in collateral enforceable against third parties are allowed to retain and apply that collateral in the event of a liquidation of a banking organization in accordance with the terms of the QFC.

Likewise, under the FDI Act and the Bankruptcy Code, parties to securities contracts that qualify as collateralized QFCs are permitted to liquidate those QFCs in accordance with their terms despite the automatic stay and avoidance provisions.  Section 11(e) of the FDI Act provides that no person shall be stayed or prohibited from exercising any right to cause the termination or liquidation of any QFCs with an insured depository institution.  Furthermore, Section 362 of the Bankruptcy Code specifically provides that the filing of a petition does not operate as a stay to securities contracts against cash, securities, or other property held by or due from financial institutions to guarantee or secure securities contracts. (“Incoming Letter”, p.2).

To further quote your letter, Section 741 of the Bankruptcy Code was amended out of fear that: 

“The avoidance provisions of the Code, as originally enacted, could be construed as invalidating margin, settlement, and similar type payments made by a broker or clearing agency that becomes insolvent. The resulting uncertainty about the legal status of these payments threatened serious repercussions in the commodities and securities markets and could have forced drastic and costly changes in the manner in which obligations were collateralized in these industries.”  (Citing Collier Bankruptcy Manual ¶ 741.07).

As such, both federal and state laws had the same objective of excluding QFCs from the general automatic stay and repudiation rules because the potential negative impact on the market would be significantly reduced if these contracts were allowed to self-liquidate in accordance with their terms. (Incoming Letter, p.2).

III.  Securities Lending Transactions and Repurchase Transactions

You state that you believe that a securities lending transaction is a securities contract, because it is a loan of a security and is conceptually comparable to a repurchase transaction (“repo”).  In a typical securities lending transaction, the owner of a security (the “lender”) transfers securities temporarily to another party (the “borrower”) so that the borrower can use the security lent to satisfy its settlement obligations.  The borrower secures its obligation to return the security to the lender with collateral of equal or greater value than the security lent, typically with securities of a similar type.  The collateral securing a securities lending transaction could also be cash.[1]  

In the event of the insolvency of the borrower, the lender would liquidate the collateral to satisfy its claim against the borrower.  Likewise, the lender grants a security interest in the security lent to the borrower.  In the event of the insolvency of the lender, the borrower is permitted to liquidate the security lent to satisfy its claim against the lender.  While it may be possible that these securities lending transactions are entered into on a non-secured basis, market practice is to fully-secure any such transactions.  Accordingly, your request for concurrence that such transactions constitute QFCs for purposes of Banking Law Section 618-a(2)(d) and Part 322 relates only to fully-secured securities lending transactions. 

In a typical repo, a seller transfers a security to a buyer in exchange for cash and undertakes the obligation to repurchase the security at a future date for an amount equal to the cash exchanged plus a stipulated “interest factor.”  As in a securities lending transaction, both parties grant security interests in a security and collateral.  In the event of insolvency of the seller, the buyer would liquidate the security in its possession.  In the event of an insolvency of the buyer, the seller would retain the cash. 

You also note that in 1999, the Department revised Part 322 to exclude securities repos from the calculation of total liabilities for the purposes of the asset pledge requirement due to the self liquidating, collateralized nature of those transactions, and you suggest that, as the functional equivalent of repos, securities lending transactions should also be excluded as QFCs.  (Incoming Letter, p.3).

You point out, by way of background, that certain accounting rule changes set forth in FAS 140, which governs transfers of assets, and which treats repos and securities lending transactions similarly, motivated your inquiry.[2] 

V.  Conclusion

We agree that securities lending transactions that meet collateral and other requirements of Banking Law Section 618-a(2) should be treated as QFCs and thus should be exempt from the calculation of liabilities for purposes of Part 322.  Securities lending transactions entered into in the market place are, like repos, fully secured and self-liquidating.  As such, liabilities of a banking organization arising out of such securities lending transactions would be settled by the parties to the transaction outside of a liquidation, as creditors of the banking organization could apply collateral to satisfy an obligation owed by the banking organization under the QFC.  For this reason, it is appropriate to exclude such liabilities from the calculation of “total liabilities” for purposes of the asset pledge requirement in Part 322. 

I trust that this is helpful. 

Very truly yours, 

Rosanne Notaro
Assistant Counsel

Cc:  Deputies Lesser and Abballe
        -- Foreign Financial Services Division