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SEC v. MILLER

June 27, 1980;

SECURITIES AND EXCHANGE COMMISSION, Plaintiff,
v.
Eldon MILLER, Defendant



The opinion of the court was delivered by: CANNELLA

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).

 FACTS

 Background

 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. *fn1"

 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. *fn2" The element of the transaction over which the most bargaining usually occurs is the interest rate. *fn3" The parties customarily refer to the underlying securities as "collateral," *fn4" 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; *fn5" (2) a desire to circumvent the U.C.C. requirements and other legal obstacles to using ordinary collateralized loans; *fn6" 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 balances *fn7" 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, *fn8" 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. *fn9" 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. *fn10"

 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, *fn11" and unlike ordinary deposits, "purchases" of federal funds are exempt from reserve requirements. *fn12" 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. *fn13" 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." *fn14"

 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, *fn15" 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. *fn16" 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. *fn17" Moreover, so long as the collateral consists exclusively of government or agency securities, *fn18" repos are exempt from loan limits *fn19" and reserve requirements. *fn20"

 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. *fn21" 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. *fn22"

 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. *fn23"

 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, *fn24" 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. *fn25"

 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. *fn26" 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. *fn27" 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. *fn28"

 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. *fn29" Even the Federal Reserve Bank participates but only for the purpose of making short-term adjustments to the nation's money supply. *fn30"

 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 the last ten or fifteen years, however, they have grown much more sophisticated about managing their liquid cash positions, and have increasingly turned to short-term instruments such as Treasury bills, commercial paper, negotiable certificates of deposit, and repos as a means of earning profit on them. *fn31"

 Of all of these short-term instruments, repos are by far the most flexible. They can be structured as overnight deals and "rolled over" to whatever extent the money is not needed. Or they can be set up as open agreements. In either case they provide exactly what a money manager needs most: liquidity; security in the form of collateral; and a good return. Consequently, they have come to be viewed by many as "income-generating substitutes for demand deposits at commercial banks." *fn32"

 Among the significant net borrowers in the repo market are government securities dealers, who use repos to finance their holdings. Their activities warrant a somewhat detailed treatment, since the defendant in this case was operating as a dealer in government and agency securities. Most dealers run highly leveraged operations, which means that their investment positions in the securities they hold are significantly larger than their net capital. In other words, the dealers tend to borrow a very high percentage of the money they invest. According to one source, dealers as a whole "borrow 95 cents or more of every dollar used to buy securities, pledging the securities bought as collateral." *fn33" According to another, "(t)he typical dealer is running a highly levered operation in which securities held in position may total 500 or 600 times capital." *fn34"

 Repos are a very convenient way to leverage capital in order to take large positions in a security. And it is easy to see how a repo can be used to borrow against either a long or short position. Simply stated, "long" means taking the risks of owning, *fn35" while "short" means taking the risks of owing. *fn36" When a dealer wants to leverage long, he can buy a large amount of a security and finance nearly all of its purchase price by immediately "hanging it out" on repo in other words, by borrowing the money and using the securities as collateral. Using repos to leverage short is slightly more complicated. The dealer sells securities he does not own, then lends the proceeds of the sale in a repo, receiving as collateral the same type of securities he has sold. *fn37" He then delivers the collateral to the initial purchaser to complete the transaction. Since all the parts of these transactions can be cleared over the federal wire, it is possible to arrange to have everything clear nearly simultaneously, thus enabling the dealer to avoid tying up much of his own money for long.

 Leveraging is nothing untoward or unusual, since it is, in effect, the way even banks make money. *fn38" It is a means of increasing the potential net return on capital. A major source of dealer profits comes from correctly predicting market trends and then taking a highly leveraged position in accordance with that prediction. If the prediction proves accurate, the profits can be huge. If it proves wrong, however, so can the losses. *fn39"

 There are two other significant sources of dealer profit. One is known as "carry," which is the difference between the yield of a security and the interest rate charged on the money borrowed to purchase it. *fn40" Short-term rates are often below long-term rates; consequently, when a dealer purchases government or agency securities and finances them by hanging them out on repo, he can earn the difference between the securities' yield and the repo rate.

 The other source of dealer profit is a trading differential or "mark-up" similar to that of any wholesaler or middleman, which arises from the dealers' ability to buy more cheaply than they sell. The reason dealers can do this is that as they become known, and as they build up the volume of their business, their clients expect them to make a market in repos that is, to be ready to participate as either borrower or lender. Their position as market-makers enables them to command better rates on both sides of the transaction. Thus, a well-established dealer could make a profit by running a "matched book" that is, without taking a position long or short by, in effect, lending at higher rates than he borrows. *fn41"

 Of course, these sources of profit entail risks, an understanding of which is essential to this case. The principal risks to anyone trading in securities are: (1) a "credit risk" that one's trading partner will prove uncreditworthy; *fn42" (2) a "price risk" that the securities involved will change in value against one's expectations; and (3) a "liquidity risk" that one will need cash at a time when it is difficult or disadvantageous to sell the securities or borrow money. These are not rules of law, but of the market.

 As to credit risk, the best way to minimize it is to deal only with persons you know, either through prior experience or good reputation, and by contractual protections such as margin where possible. One protects oneself against liquidity risk by prudently tending one's own garden, and by paying attention to the various indicators of trends in the cost and availability of money.

 Price risk is more difficult to minimize, because it depends entirely on prognostication. As noted above, for government and agency securities, the price risk is essentially the risk that interest rates will change. In general, once a fixed-rate debt security has been issued, its market value will vary inversely to changes in interest rates. *fn43"

 A highly leveraged position is very exposed to price risk. For example, if a dealer is leveraged long at 100 times capital in a particular security, a 1% drop in value will wipe out his equity in that position. To illustrate, if a dealer has used $ 10,000 of his own money and $ 990,000 of borrowed money to purchase $ 1 million of a bond at par 100, he can sustain no more than a one point loss without having to put up additional capital: if the price drops to 99, the bonds will be worth only $ 990,000, precisely what he has borrowed on them, so that his $ 10,000 would be gone. For short positions, the computations are similar, except that losses arise when the securities' value increases.

 "Carry" is also susceptible to the risk of a change in interest rates, but in a different way. As noted above, short-term rates are often below long-term rates. They are also more volatile, however, and often rise above long-term rates. *fn44" When this happens, the carry is said to be negative, and anyone who has hung securities out on repo will suffer a daily net loss, since the yield on them will be below the rate of interest he has to pay for the money borrowed to buy them. There are roughly similar, although inverse risks to anyone who has taken a short position using repos.

 Both of the effects of interest rate fluctuations just described can quickly drain a dealer's operating liquid assets. This is compounded by the likelihood that when interest rates rise, parties that have lent to the dealer will demand additional collateral on their loans, and when interest rates fall, those who have borrowed from him will demand additional money for their collateral.

 Among dealers in government and agency securities are three special categories that are pertinent to this case. Certain dealers are known as "primary dealers," which the Fed describes as "institutions which buy new government securities directly from the Treasury and are ready to buy or sell outstanding U.S. government and agency securities." *fn45" These, then, are the major marketmakers. Approximately thirty of these primary dealers regularly report their trading activities and positions to the Federal Reserve Bank of New York, and are therefore known as "reporting dealers." *fn46" Finally, there is a group whom market participants call "recognized dealers," which are those reporting ...


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