Iowa Credit Union Division

Transcription

1 Iowa Credit Union Division REGULATORY ADVISORY March 2005 Guidance on the Purchase and Safekeeping of Investments Iowa Administrative Code Chapter (533) prescribes the procedures an Iowa credit union is to follow in the purchase and safekeeping of its investments. It is extremely important that credit union Board of Directors follow these rules as they develop their investment policies and approve the broker-dealer[s] they will use and the safekeeper[s] that will fulfill custodial responsibilities for the credit union. Iowa Administrative Code & 17.9 (533) provide the guidance a credit union must follow in selecting the broker-dealer[s] and safekeeper[s] that will be used in the credit union s investment activity. Section (1) says that a credit union may purchase and sell investments through a broker-dealer as long as the broker-dealer is registered as a broker-dealer with the Securities and Exchange Commission... or is a depository institution whose brokerdealer activities are regulated by a federal or state regulatory agency. Credit unions may be contacted by a person who identifies themselves as a CD finder or rate finder. It is important to understand the difference between a broker-dealer and a CD or rate finder. A broker-dealer is a third party that receives oversight in its functions from a governmental body and/or a tradelicensing body and is registered through the Securities and Exchange Commission (SEC) under the Securities and Exchange Act of Unlike a broker-dealer, a CD finder is not subject to federal or state securities registration laws and typically receives little or no regulatory oversight. A CD finder does not have to register with the SEC through the National Association of Securities Dealers (NASD, a designated self regulatory organization that registers broker-dealers for the SEC]. A broker-dealer brings together a buyer and seller to complete a transaction. The broker-dealer earns a commission by way of: 1) an explicit fee; 2) marking up the purchase price; or 3) from the issuer on a new issue. A CD finder should only collect a fee for its service. However, an unscrupulous CD finder may charge undisclosed (or poorly disclosed) mark-ups in price and may divert part of a CD periodic interest payment by using an associated safekeeper (known as yield stripping). For these reasons, IAC (533) requires state-chartered credit unions to ensure that a CD finder is not involved 1

2 in the transaction from a standpoint of receiving or directing funds, instructing safe-keepers, or otherwise effecting transactions. Direct CD purchases can be a safe way for credit unions to invest. In a direct purchase, a credit union typically wires funds directly to the issuer of the CD. By doing so, clear ownership interest in the CD is established, with the credit union s name recorded directly on the books of the issuing financial institution. Why do direct purchases provide greater safety? First, because the issuer and credit union are the only participants to the transaction, with no outside third-party (e.g., broker-dealer or safekeeper), there is no counter-party risk to worry about. Second, in the unlikely event an insured institution (CD issuer) were to fail, its easier for the FDIC to ascertain ownership interest in the CD for insurance purposes since the credit union is listed as a beneficial owner. A CD has low credit risk to the extent of federal deposit insurance up to $100, However, bad things can happen when investing in a CD, particularly when a credit union hires a third-party to purchase the CD and safe keep it. For example, Bentley Financial Services Inc., a firm charged by the SEC with securities fraud for selling securities misrepresented as insured CDs to unsuspecting credit unions and banks, resulted in losses to nearly 100 credit unions. [see Attachment#1.] An affiliated company of Bentley had acted as the safe-keeper for the fake CDs. For additional information, see NCUA Letter to Credit Unions # 01-CU-23. If a third-party is involved in safekeeping a CD, NCUA Letter to Credit Unions # 04-CU-04 provides valuable information about due diligence procedures that can help avoid becoming a victim to a Bentley type fraud. It is important for credit union management to perform due diligence on counterparties handling funds or investments, such as broker-dealers or safekeepers. Numerous problems can result from a lack of due diligence. Many of these problems can and do cause financial loss to credit unions. The safekeeper used by a credit union must satisfy the custodial responsibility requirements established in rule to fulfill the safekeeper s obligations to the investing credit union. It is usually not a good business practice to have a safekeeper determined by the finder or broker-dealer, unless there is a written custodial agreement that requires the safekeeper to exercise ordinary care in safekeeping the investment for the investing credit union. If a finder or broker-dealer uses its own safekeeper [known as a captured or captive safekeeper], it is possible the finder or broker-dealer has the potential to exert influence or control over the captive safekeeper. Such control is usually considered by regulatory officials as an unsafe and unsound practice. When making an investment, Iowa credit unions are to use an appropriate level of care: 2

3 When an investment appears too good to be true [above market rate of return or below market cost of funding]; When dealing with a person who is unknown or who is infrequently used in making an investment or who is not a broker-dealer approved by the Board; and When participating in an investment that is exotic or unusual in nature or is of a type with unfamiliar terms or specifications. It is expected that a credit union will perform a reasonable level of due diligence to verify the legitimacy and experience of the person offering an investment arrangement prior to engaging in such an investment transaction. To assist in making informed decisions, credit unions are encouraged to pay particular attention to special regulatory alerts issued by federal and state financial regulatory authorities regarding potential concerns the agency has with activities of persons providing products or services to financial institutions. For example, the attached alert issued by the Federal Deposit Insurance Corporation (FDIC) on December 5, 2003 expresses concerns with Rate Quest Investments (RQI), Laguna Hills, California. [see Attachment#2.] This Advisory is not intended to offer an opinion regarding RQI, its officers, employees, practices or product offerings, but to provide an illustration of where a credit union can access information regarding making an informed investment decision. The attached FDIC Special Alert provides the reader an opportunity to obtain information, from a regulatory viewpoint, regarding an investment firm and a product offering, in order to make an intelligent decision prior to making an investment determination. Alerts may be found by visiting the following websites: the NCUA at the FDIC at the Comptroller of the Currency (OCC) at the Office of Thrift Supervision (OTS) at and the Federal Reserve at In addition, Regulatory Advisories are available at the Iowa Credit Union Division website at as well as links to the federal regulatory agencies. 3

4 Attachment 1 U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. Litigation Release No / October 23, 2001 SEC v. Robert L. Bentley, Entrust Group and Bentley Financial Services, Inc., Civ. Action No (Eastern District of Pennsylvania) Today, the Securities and Exchange Commission filed suit in the United States District Court for the Eastern District of Pennsylvania against Robert L. Bentley, his d/b/a, Entrust Group, and Bentley Financial Services, Inc., all of Paoli, Pennsylvania. The Commission alleged that the defendants are committing fraud in the sales of securities to hundreds of financial institutions, including banks and credit unions, and to individual investors nationwide. Specifically, the Commission alleged that the defendants are representing to investors that they are selling bank-issued, federally insured certificates of deposit ("CDs"). In fact, unbeknownst to these investors, they are buying uninsured securities issued by the defendants rather than insured CDs issued by banks. Although the defendants are using at least some investor funds to buy CDs, the terms of the CDs often vary substantially from those of the securities defendants are selling. Moreover, the Commission alleged that in many cases, investors must rely on the defendants' ability to attract new investors in order for previous investors to receive repayment of their principal. Accordingly, investors are not buying the low-risk, federally-insured CDs that they were promised. Rather, they are buying higher risk securities issued by defendants, whose business is uninsured, unaudited and unregulated. Investors currently have over $300 million invested with the defendants. The Commission also alleged that the defendants are defrauding investors by leading them to believe that their investments are being made through a brokerage firm registered with the Commission and insured by the Securities Investor Protection Corporation. In fact, none of the defendants' sales of purported CDs to investors is made through such a firm. The Commission alleged that the defendants are violating the broker-dealer registration and the antifraud provisions of the federal securities laws set forth in Section 17(a) of the Securities Act of 1933 and Sections 10(b) and 15(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission's action seeks permanent injunctions prohibiting future violations of these provisions and others, disgorgement of the defendants' ill-gotten gains plus prejudgment interest, and civil penalties against each defendant. Additionally, the Commission's action seeks emergency injunctive and equitable relief consisting principally of a temporary restraining order, an order freezing each defendant's assets and an order appointing a receiver. The Commission gratefully acknowledges the assistance of the National Association of Securities Dealers-Regulation, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the National Credit Union Administration, the Office of Comptroller of the Currency and the Board of Governors of the Federal Reserve System in bringing this action. 4

5 Attachment 2 Special Alerts DEPOSIT BROKER ALERT SA December 5, 2003 TO: SUBJECT: Summary: CHIEF EXECUTIVE OFFICER Zero-Coupon Investments, Rate Quest Investments, Laguna Hills, California Deposit broker links purchase of zero-coupon investments with brokered deposits. The Federal Deposit Insurance Corporation (FDIC) has identified potential concerns with brokered deposit arrangements that federally insured financial institutions have entered into with Rate Quest Investments (RQI), Laguna Hills, California. RQI is an unregistered financial services broker that places brokered deposits with financial institutions. RQI was incorporated by primary principal Bruce Carter, who was also an executive of Prime Yield, Inc., San Clemente, California. Prime Yield Inc., and Bruce Carter, individually, stipulated and consented to a Cease and Desist Order and Order to Pay a Civil Money Penalty, with the National Credit Union Administration, dated July 10, The Order addresses oral and written misrepresentations made to federally insured credit unions. Mr. Carter was also an account executive of San Clemente Financial Group, Inc., San Clemente, California, which was the subject of a prior Deposit Broker Alert issued by the FDIC on June 29, 2000 (FIL ). RQI has been known to conduct transactions with insured financial institutions that are seeking funding. As part of the transaction, RQI has required the purchase of long-term, zero-coupon certificates. RQI conducts these transactions through several custodial banking arrangements. If your institution has any deposit or securities transactions with RQI or any other financial services broker, comprehensive due diligence should be conducted to ensure a full understanding of all the costs associated with the transactions. Your analysis should determine whether the zerocoupon investment price is at the market and how the cost and yield of the investment compare to other investments of similar maturity. The level of exposure to interest rate and liquidity risks involved with the funding agreement should also be assessed. Furthermore, the financial capacity of RQI or any other financial services broker should be reviewed prior to engaging in any transaction to ensure the broker's ability to fulfill its obligations. The FDIC has identified a number of concerns in connection with an institution's participation in a funding agreement requiring the purchase of long-term, zero-coupon certificates of deposit. Although the brokered deposits are generally offered at a below-market rate, the funds are shortterm and the total cost of the zero-coupon certificates of deposit appears to be priced above the market and is considerable in comparison with a U.S. Treasury security of comparable maturity. The below-market yield on the investment ultimately eliminates any economic benefit achieved through the below-market cost of funding. 5

6 Attachment 2 Financial institutions should be cautious when participating in unusual financial arrangements and should be particularly thorough when assessing investments that offer an above-market rate of return or a below-market cost of funding. Additionally, it is imperative that an appropriate level of due diligence is performed to verify the legitimacy and experience of the entity offering any such arrangement prior to engaging in any transaction. Inquiries may be directed to the FDIC's Special Activities Section, th Street, NW, F-4044, Washington, D.C For your reference, FDIC Special Alerts may be accessed from the FDIC's Web site at To learn how to automatically receive FDIC Special Alerts through , please visit Michael J. Zamorski Director Distribution: FDIC-Supervised Banks (Commercial and Savings) 6