Securities & Exch. Com'n v. Miller
| Decision Date | 14 July 1980 |
| Docket Number | No. 75 Civ. 3391 (JMC).,75 Civ. 3391 (JMC). |
| Citation | 495 F. Supp. 465 |
| Parties | SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. Eldon MILLER, Defendant. |
| Court | U.S. District Court — Southern District of New York |
William D. Moran, Regional Administrator, Securities and Exchange Commission, New York City by Donald N. Malawsky, Douglas P. Jacobs, Andrew E. Goldstein, S. Jane Rose, and Paul Lubetkin, New York City, for plaintiff.
Linde, Thomson, Fairchild, Langworthy & Kohn, Kansas City, Mo. by Albert Thomson, Kansas City, Mo. and Grand & Ostrow, New York City by Frank H. Wright, New York City, for defendant.
After a bench trial, the Court finds that the plaintiff has failed to prove its entitlement to an injunction against the defendant pursuant to 15 U.S.C. § 77t(b), and, accordingly, judgment is entered for the defendant.
Jurisdiction is based upon the federal securities laws. 15 U.S.C. § 77t(b).
This is a Rule 10b-5 case involving allegations of deceptive conduct in connection with a highly specialized type of securities transaction, one which is used exclusively by a relatively small class of sophisticated investors. It is therefore essential to develop an understanding of the nature and purposes of such transactions, the market in which they occur, and the expectations of the persons and institutions that engage in them.1
The transaction is commonly known as a "repurchase agreement," or "repo" for short, although it is sometimes also called a "buy/buy back." It involves two parties, who, for reasons that may become clearer, may be deemed the "borrower" and "lender." Each agreement may also be viewed as comprising two distinguishable transactions, which, although agreed upon simultaneously, are performed at different times: (1) the borrower agrees to sell, and the lender agrees to buy, upon immediate payment and delivery, specified securities at a specified price; and (2) the borrower agrees to buy and the lender agrees to sell, with payment and delivery at a specified future date — or, if the agreement is "open," on demand — the same securities for the same price plus interest on the price. The parties customarily provide that any interest accruing on the securities between the dates of the initial purchase and subsequent "repurchase" remains the borrower's property.
From a purely economic perspective, therefore, a repo is essentially a short-term collateralized loan, and the parties to these transactions tend to perceive them as such.2 The element of the transaction over which the most bargaining usually occurs is the interest rate.3 The parties customarily refer to the underlying securities as "collateral,"4 and the risk of a change in the value of the collateral remains with the borrower, even though the lender "owns" it for the term of the agreement.
Why, then, are these deals structured as sales and repurchases rather than straight loans? The answer appears to be threefold: (1) certain regulations of the Federal Reserve Bank the "Fed", which treat repos differently from ordinary loans;5 (2) a desire to circumvent the U.C.C. requirements and other legal obstacles to using ordinary collateralized loans;6 and (3) market convention.
In order to understand the repo market, a brief discussion of the "federal funds" market may be helpful, since the development of repos is by and large related to that of federal funds transactions, which they resemble considerably. Since the early days of the Fed, member banks have traded reserve balances7 as a means of allowing those with reserves below their legal requirements to borrow reserves from those with reserves in excess of their legal requirements. This enables the borrowing bank to meet its reserve requirements without having to sell securities from its portfolio, and at relatively lost cost. Since reserve deficits and surpluses can often be brief,8 most member banks prefer to borrow or lend reserves for relatively short periods, usually overnight, which is possible since such loans are effected over the federal wire.9 These transactions also benefit the lending banks, since any reserves in excess of their legal requirements are unnecessarily idle assets. And because of their short duration, they do not significantly impair the lending banks' liquidity. As with repos, such transactions are referred to as sales and purchases rather than loans. A borrowing of reserve balances—which came to be known as "federal funds" or "fed funds" —is usually characterized as a "purchase" with an agreement to resell, and a loan as a "sale" with an agreement to repurchase.10
Apparently because of their purpose, the Fed treats fed funds transactions differently from either ordinary loans or deposits. Unlike ordinary loans, "sales" of federal funds are exempt from loan limits,11 and unlike ordinary deposits, "purchases" of federal funds are exempt from reserve requirements.12 The Fed has also acknowledged that certain borrowings by member banks from other institutions, such as savings banks, are essentially identical, and consequently, it has ruled that these, too, are exempt from reserve requirements.13 The phrase "federal funds transactions," therefore, now generally encompasses all unsecured "loans made in immediately usable funds, against which a commercial bank borrower isn't required to maintain reserves."14
Repos are different from federal funds transactions in essentially only two ways. First, fed funds by definition can be traded only by institutions whose unsecured loans to member banks are exempt from reserve requirements,15 whereas repos can be done by anyone with enough money. Second, a fed funds transaction is essentially an unsecured loan, whereas a repo is essentially a secured loan. In all other respects, however, they are identical. Both are for very short duration, usually overnight. Both are settled in immediately available funds. And since one day's interest is a rather small fraction, both are done only for large amounts of money.16 Nevertheless, because of the speed with which they must be concluded, they are both done on the basis of an oral contract subject to a written confirmation.17 Moreover, so long as the collateral consists exclusively of government or agency securities,18 repos are exempt from loan limits19 and reserve requirements.20
Repos also contain provisions for the treatment of collateral, which, of course, need not be included in fed funds agreements. Repos customarily provide for a right of substitution, which means that the lender need not resell the identical securities purchased, but may substitute different securities of the same issue. Thus, the lender is not required to safekeep the collateral, but may sell, pledge, use or dispose of it in any manner for any purpose, so long as he resells acceptable securities on the repurchase date.21 Repos also customarily give added protection to the lender against fluctuation in the value of the collateral, by providing a "margin," that is, a spread between the value of the collateral and the amount of the loan. In other words, the lender will usually demand as collateral securities that are worth more than the amount of the loan.22
For repos that last longer than a day, the lender may receive even further protection. "Term repos," which are those for a definite period longer than a day, and "open" repos, which are indefinite and may be terminated by either party on demand, customarily give the lender a right to demand additional collateral if the value of the original collateral declines significantly. In the event the borrower fails to honor such a demand, the lender may unilaterally terminate the agreement, sell the collateral on the open market, and hold the borrower liable for any difference between the amount of the loan plus interest and the recovery from the sale.23
As noted above, the types of collateral most commonly used in repos are government and agency securities. One advantage of this is that the risk that the issuer will dishonor them is presumed to be nonexistent,24 and hence their value does not fluctuate significantly in periods of steady interest rates. Of course, like any other fixed-rate security, their value does fluctuate generally in relation to interest rates: when interest rates rise, their value declines; when interest rates decline, their value rises.25
Another advantage of using government and agency securities is their ease of transfer. Most of them are not held in the form of certificates, but rather as bookkeeping entries at the Fed.26 Thus, they can be transferred without any physical deliveries. If a member bank wishes to transfer securities it owns to another bank, it simply wires instructions to the Fed, which debits one account and credits another. No certificates are necessary. Since the regional Federal Reserve Banks are all linked by wire, these transfers can be made almost instantaneously between member banks anywhere in the nation.27 And since immediately available funds may be transferred the same way, repos may be cleared very quickly. Regardless of the parties' locations, therefore, the funds and securities may be exchanged almost simultaneously shortly after they come to an agreement.28
It is worth noting the different participants in the repo market. Most banks participate, both to adjust short-term cash and reserve positions, and as a continuing source of either funds or brief, highly liquid investments.29 Even the Federal Reserve Bank participates—but only for the purpose of making short-term adjustments to the nation's money supply.30
Among the important lenders in the repo market are large corporations and state and local governments. These institutions regularly find themselves with vast amounts of idle cash for brief, often indefinite periods of time. At one time, they would simply have kept such assets in a checking account as demand deposits, which earn no interest. Within...
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