February 2009 Legal Briefs

New FDIC Disclosure for Banks Offering Sweep Accounts

New FDIC Disclosure for Banks Offering Sweep Accounts

Effective July 1, 2009, based on an amended FDIC regulation (12 CFR Section 360.8), all FDIC-insured depository institutions will be required to give notices to sweep account customers, describing (a) the nature of the swept funds (the characteristics of the investment vehicle into which the bank’s program sweeps the funds—either another deposit account, or something else, accurately described), and (b) how those funds would be treated (based on what they are, and how events might end up) if the institution fails. (The issue is, “What might happen to the customer’s money?”)

A majority of the banks in Oklahoma (the smaller ones) probably have no sweep arrangement, and for them this regulation will have no impact.

If a bank’s sweep is “external” in nature (sweeping out of the bank into something that is not held at the same bank), the required “notice” should also mention the possibility that an “external” sweep may not occur at all on a day that a bank fails (because the FDIC will prevent further “external” transactions after the point in time when it takes over the bank).

(If an “external” sweep is blocked by the FDIC, the result may be that funds will stay in the deposit account at the bank, or may come to rest in some intermediary account, part-way along the way between the customer’s deposit account and wherever the swept funds were intended to go. As one possible “unintended consequence” of a failed sweep, a customer’s funds might simply remain in the customer’s original account, in an amount larger than applicable FDIC insurance limits, resulting in partially uninsured deposits on a day that the bank fails.)

The regulation (entitled “Processing of Deposit Accounts in the Event of an Insured Depository Institution Failure”) is issued under FDIC’s general authority as insurer of bank deposits. It applies to national banks and state banks, as well as federally-chartered and state-chartered savings associations.

I will discuss the regulation’s specific notice requirement for sweep accounts, and what a bank must understand to give the notice accurately. It’s necessary to analyze (1) the technical details of how a bank’s own sweep program operates, in context of (2) the procedures that the FDIC will follow for that sweep on a day that the bank fails. The bank needs to describe for its customer what the result may be (where the funds probably or possibly will end up, and what type of investment the customer will hold at that point) if the bank fails.

The regulation’s general principles govern how various types of transactions that are presented or attempted on the day that a bank fails will be handled by the FDIC—what will be posted; what transactions will be stopped if possible (or backed out) before determining end-of-day balances; and what will be posted on the next day’s business (on the books of another bank taking over the failed bank, if there is a buyer). The larger subject is how the FDIC arrives at final “end-of-day” balances for accounts on the day that a bank fails, and who will be the winners and losers in an FDIC liquidation. A subcategory of this subject is what will happen to sweep account customers, and whether they are being given enough information to understand their position.

This is not an especially pleasant subject to consider, and it may seem like an overly “theoretical” exercise to go through—because the scenario will never actually occur unless the bank fails. (Then again, “deposit insurance” is also a purely theoretical issue, examining “what ifs” that hopefully will never occur. Getting to the right answer in the “sweep” area, like in the “deposit insurance” area, is something that matters for the customer’s protection.)

A bank should carefully think through its own sweep procedures, as well as the FDIC’s principles for settlement of transactions on the day that a bank fails, in order to accurately prepare the required “notice” for sweep customers.

1. Types of Sweep Account

In many cases, bank employees opening new accounts (who explain sweep accounts to customers) may lack sufficient understanding of their bank’s own sweep arrangement—exactly how the sweep process occurs, and maybe even what is the specific investment into which the deposits are swept.

(There is a certain need to “simplify the message” for the customer; but something like “This lets you earn interest” gives the customer less than he needs to know. Ideally, the second verse of that song should be, “And here’s how it is done.” The new “notice” requirement at least partially fills the gap. It has to be a prominent disclosure, in writing, given to all sweep customers–so that the same message will be received by all of them, no matter who explains the account.)

It’s not surprising that a bank’s employees have a less-than-complete understanding of the bank’s sweep arrangement. It often is designed (and perhaps operated) by a correspondent bank or other external provider, not by the bank itself. But the bank must “get to the bottom” of how its sweep program operates, to accurately describe the sweep and its possible outcomes, both to answer customers who have questions and to give the “notice” required by the regulation.

There are many variations of sweep account. One bank’s version is probably somewhat different than another bank’s version. And the investment into which the funds are swept could be a variety of things. As only some of the possibilities, money might sweep from a deposit account to another deposit account, either at the same bank or a different bank; to a securities repurchase agreement (repo) that is entered into with the bank; to a money market fund; or to commercial paper.

There also may be substantial differences in how “settlement” occurs for transferred funds. Most sweeps are “same-day,” but some will settle “next-day,” with the funds possibly resting in some kind of holding account overnight. (As discussed below, this holding account may or may not be set up to protect the individual customer’s underlying interest in the pool of funds.)

Some “same-day” sweeps occur around mid-day or earlier, and therefore are very likely to be completed successfully, even on a day that a bank fails. Other sweeps are intended for later in the day, such as a sweep from a fully-posted end-of-day balance in a customer’s transaction account. A later-in-the-day sweep might be cut off by the FDIC, so that it won’t happen on a day that a bank fails; but as explained below, this depends partly on whether the sweep is “internal” or “external,” and partly on whether the FDIC has actually taken control of the institution by the point in the day when the sweep would occur.

Financial institutions should already be providing some level of disclosures concerning when (and in what amount) a customer’s deposits will sweep; what type of account or investment the deposits will sweep to; and whether the customer’s funds will be insured or otherwise protected while “swept out.”

What’s new in the FDIC regulation is a requirement to warn the customer (if true) that a sweep (out or back) may not happen if a bank fails. The bank also must explain where the funds could end up on a day when the bank fails—if it’s something other than the “normal” result on a normal day. A bank should also indicate what rules and limitations will apply to the funds (wherever they are) if the FDIC takes over the bank.

(For example, normal deposit insurance limitations will apply if the funds unexpectedly remain in the customer’s deposit account because the sweep fails; or the customer may end up still owning the securities purchased in an overnight “repo” sweep, and would be entitled to sell them (recovering his money, more or less)–assuming that another bank does not take over the sweep customer’s deposit account and sweep arrangement.)

As discussed later, the FDIC’s regulation classifies some sweeps as “internal” (sweeping from a deposit account at the bank to either another account or some other investment vehicle located within the same depository institution). But other sweeps are classified as“external” (sweeping from a deposit account at the bank to a deposit account or other investment vehicle located outside of the depository institution). The difference between these categories can greatly affect what happens to a sweep customer’s funds on the day that a bank fails.

2. Some Excluded Sweep Accounts

The FDIC regulation’s “notice” requirement applies only to sweep arrangements that are “automated” and are controlled by the terms of a contract between the bank and the customer. (As an example, a bank’s contract might provide that all collected balances above $100 in a corporation’s transaction account–after all other transactions presented on that day are posted–will automatically sweep into some designated overnight investment. This is exactly the kind of situation the regulation covers.)

But if a customer himself decides each day how much money will be moved from one deposit account to another (or another investment), this is not automated and on that basis would not be covered by the regulation. In this example, the customer (not the bank’s computer) controls any transfer.

There are many automated transfers between two deposit accounts of the same customer, in the same bank (for example, to cover overdrafts), that are not considered “sweep” arrangements covered by the regulation. The “notice” requirement does not apply “to sweep accounts where . . . the sweep account involves only deposit-to-deposit sweeps . . . unless the sweep results in a change in the customer’s insurance coverage.” However, a transfer from a customer’s account to a different owner’s account would be a change in whose coverage is used; and a transfer from an account with regular deposit insurance to a “noninterest-bearing transaction account” guaranteed in an unlimited amount at a participating institution would probably also be a change in coverage.

If a customer has two interest-bearing accounts subject to regular insurance limits (such as a NOW and a savings account, both in his individual name), a transfer between the two accounts cannot change his insurance coverage. The insured amount is determined by adding the accounts together. The outcome is not affected by a transfer between accounts, regardless of how much ends up in each account separately. On this basis, any sweep between the accounts is not a sweep to which the “notice” requirement applies. (This sweep does not change the type of investment the depositor owns, his risks, or the rules or limitations that would apply to his funds if the bank fails. Disclosure-wise it’s a non-event.)

Other types of sweep, not within the regulation’s exceptions, are a different story, and could cause a very different outcome to the customer.

3. Why Sweep Accounts?

Sweep accounts can be designed in many ways, depending on the bank and the goal to be achieved. (All sweep accounts are somewhat cumbersome to set up and operate. There are always some related administrative expenses. A bank generally would not use such an account unless there is some other advantage to be gained, or some unfavorable limitation to be avoided, by sweeping the funds.)

The most common use of sweep accounts is to provide a way for business customers to earn interest on “swept” funds. (Corporations operated “for profit,” partnerships, and LLCs cannot hold NOW accounts. Sweeping money from a business entity’s noninterest-bearing transaction account to a non-deposit investment product of some type will allow the customer to earn interest.)

A totally different reason for setting up sweep arrangements may be to assist the bank: Sweeping funds daily from noninterest-bearing transaction accounts to related noninterest-bearing savings accounts can result in smaller reserve requirements. If the customer’s funds are always in deposit accounts at the bank (either way), these accounts are a “non-issue” from the FDIC’s standpoint. The transfer is completely “internal,” the FDIC will have no reason to block it even on a day when the bank fails, and there should be no increased risks for the customer.

A third reason for using sweep accounts (in some cases) may be to transfer excess deposit balances (above the FDIC insurance limits at the customer’s own bank) into other investment products. This type of sweep might be (1) into non-deposit investment products at the same bank or a correspondent bank (for example, using a “repo” sweep, which sweeps excess funds to purchase securities on an overnight basis, then later buys them back from the customer, returning funds to the account the next morning, or as needed). Another possibility is a sweep (2) into fully-insured deposit accounts at one or more other insured institutions, to avoid FDIC insurance limits at the sweep customer’s own bank.

Most types of “external” sweep will require a transfer around mid-day if “same-day” settlement is required. (A sweep based on a transaction account’s end-of-day fully-posted balance probably will not be an “external” sweep, because the balance information necessary to perform the sweep becomes available too late in the day. End-of-day balance sweeps are likely to be “internal” sweeps within the same bank.)

Many mid-day “external” sweeps actually rely on a customer’s directions concerning what portion of the account’s full balance is not needed to pay items currently outstanding. As stated above, if the sweep is not automated, but based on the customer’s input, the “notice” requirement does not apply.

For the last several months, customers have had the benefit of (1) a temporary increase in FDIC insurance to at least $250,000 (and more for natural persons who can “structure” accounts jointly or with beneficiaries), and also (2) the FDIC’s temporary unlimited guarantee of noninterest-bearing transaction accounts (at participating banks). These provisions (which both expire on December 31, 2009, unless extended) have certainly reduced the number of customers who need to use a sweep product to deal with uninsured deposit totals.

4. FDIC Cutoff Point

In most respects the FDIC will use a failed bank’s normal procedures in deciding what types of transactions are to be posted (and which ones will not be) to determine end-of-day balances of accounts on the day that a bank fails. (As one example, banks often have different cutoff times for different purposes, and FDIC will generally follow most of this. For example, a bank’s cutoff time for wire transactions is earlier than the cutoff time for accepting deposits on that same day’s business. Also, the cutoff time for deposits at some branches may be earlier than at the main office, to allow for transporting items to the main office for processing. These differences are normally observed by FDIC without change.)

But on the day that a bank fails, the FDIC has authority to make certain changes to the failed bank’s otherwise normal cutoff times. The FDIC can establish its own “FDIC Cutoff Point,” if it chooses to do so—and normally it will do so, simultaneously with its takeover of the bank, in any case where the bank’s own daily cutoff time has not yet been reached. The designated FDIC Cutoff Point can be any time after the bank is taken over on the day that it fails. (Establishing a separate FDIC Cutoff Point is unnecessary, and will not happen, if the bank’s own normal cutoff time has already passed by the time of day when the FDIC takes over.)

The regulation notes that most institutions are closed by FDIC after 4 p.m. anyway. Many banks (particularly in rural areas) do not have a normal cutoff time later than that. (Some metro-area banks have lobby hours as late as 5:00 p.m., but in that situation the FDIC would probably close the bank only at the end of normal lobby hours, to cause less disruption.)

I assume that a large majority of banks in Oklahoma have a regular cutoff time no later than their regular lobby-closing time—and in some cases their normal cutoff time is earlier. But almost every bank has a drive-through that stays open later than the lobby. Some banks do allow transactions at a bank’s drive-through (after normal lobby hours) that can still be credited on the same day’s business—during at least part of the additional time that the drive-through is open. This depends greatly on a bank’s own processing capabilities, time required to transport items, and competition.

Using an illustration that may not be typical, let’s assume that the FDIC takes over a bank at 4 p.m., which is the regular lobby-closing time. The bank’s drive-through (in a metro area) does not regularly close until 6:00 p.m., and all transactions before 6:00 p.m. are regularly posted on the same day’s business.

Two things will probably happen in this situation: (1) The FDIC will usually immediately shut down the bank’s drive-throughs, because a bank isn’t “closed” unless it is really closed. (2) The FDIC will impose an FDIC Cutoff Point of 4:00 p.m., which in this case is earlier than the bank’ s normal cutoff time of 6:00 p.m.

The second step (choosing an earlier FDIC Cutoff Point) will affect transactions that otherwise might have occurred on the same day’s business between 4:00 p.m. and 6:00 p.m. You may say, “That’s obvious, if the lobby and drive-through are both closed.” But all other transactions are affected too.

The FDIC Cutoff Point of 4:00 p.m. would be a “hard” cutoff of all external transactions that are going either into or out of the institution. This is true although a bank’s normal practice might have been to allow a somewhat later cutoff time for special categories, such as all electronic transactions, or remote-deposit-capture deposits for the bank’s most important customers.

After the FDIC Cutoff Point, no additional “external” transactions of any kind will be allowed to change the amount of the FDIC’s end-of-day account balances, in determining final deposit insurance status of accounts. (Once an FDIC Cutoff Point of (say) 4:00 p.m. has passed, it should be assumed that the FDIC will not allow any additional “externally generated” auto-debits or automatic deposits, nor any online balance transfers, or online bill-pay transactions, on that day’s business.)

Establishing an FDIC Cutoff Point (an earlier-than-normal cutoff time) may cause some disruptions, from a customer’s standpoint. Although a business normally would make its daily deposit at the drive-through (or an electronic deposit of remote-capture items) just before the bank’s normal cutoff time, it will not be able to do so after an FDIC Cutoff Point is set.

(Deposits received by a bank after its normal internal cutoff or FDIC Cutoff Point on the day that a bank closes are not “lost dollars,” regardless of account balances, any more than deposits made at a drive-through or night-drop after the daily cutoff time on a normal day would be: They are just not treated as received on that day’s business. Either they will be returned to the customer (for example, if no bank takes over the failed bank’s deposit accounts), or they will be credited on the next day’s business, if another bank takes over the account.)

How does all of this relate to sweep accounts? If a customer’s sweep arrangement is “external” and might normally occur after 4:00 p.m. on a regular banking day (but on the same day’s business), a bank failure and establishment of an earlier FDIC Cutoff Point (such as 4:00 p.m.) will very likely cause the expected “external” sweep to be blocked by FDIC on that day. (This applies equally to sweeps moving “into” or “out” of the bank after that time.) The bank must disclose in its “notice” the possibility that a sweep will not occur if the bank fails, and that in such circumstances the customer’s funds may end up in an unintended status. The bank should indicate where the funds would probably or possibly come to rest if the bank fails, and what type of funds the customer then would have an interest in (for example, deposits, or some specific type of investment product, or a general creditor’s claim against the failed bank). The rules or limits affecting those funds (if the sweep fails) should be disclosed—for example, deposit insurance limits, if the funds end up as deposits that simply never left the sweep account.

5. Will A Better Scenario Occur?

Let me stop for a moment to observe that a bank closing may involve a “better scenario” than what is described here. In particular, there may be a situation where an acquiring bank successfully bids for all of the deposits of a failing bank, not just the insured deposits. Where the FDIC will not have the responsibility to determine accurately the amount of loss that should fall on “uninsured” depositors (because a purchaser is going to assume even the uninsured deposits), there may be no need to use an FDIC Cutoff Point to impose an “absolute cutoff” on new transactions or “external” transactions occurring after the point in the day when the FDIC takes over the bank (earlier than the bank’s normal cutoff time). It may be acceptable in such circumstances simply to use the bank’s usual cutoff time and a “business as normal” approach—in which case all transactions initiated on the day that the bank fails could flow pretty much like on any normal day.

In recent failed-bank situations the FDIC has tried in various ways to avoid disruptions–for example. by making the transition for deposit customers appear “seamless” between the old bank and the purchasing bank. But there are a lot of technical issues “behind the scenes” in a failed-bank situation—and the very nature of a liquidation is that somewhere there will be “losers” because of a bank failure, just as in any “bankruptcy.” Swept-out balances (not in a deposit account at the end of the day when a bank fails) are a category for which it is unrealistic to assume that there will be a “nice and neat” resolution in every bank failure.

It’s quite possible that a “worst case” scenario will not occur with respect to sweep arrangements, when a particular bank fails. My discussion here is to emphasize that the worst is at least possible. The “notice” a bank gives to its sweep customers should also consider the “worst” possibility, even though events in a bank failure may not go down as disruptively as that.

6. No More “External” Transactions

When the FDIC establishes an FDIC Cutoff Point with respect to a failed bank (earlier than the regular cutoff time), this step does not stop automated transactions within the bank’s own accounts, if they are of a type that normally would occur as part of the bank’s regular end-of-day posting process. This is true although these “internal” transactions do change the end-of-day balance in certain accounts. As one example, the automatic transfer of funds from one account to another, to cover an overdraft that results from posting checks at the end of the day, is allowed to occur normally.

The posting of an “auto-debit” by the bank to pay a loan payment owed to that bank on that date will still be carried out, even if it happens after the FDIC Cutoff Point. Similarly, an “automated” sweep of funds set up between two accounts at the same bank will normally be allowed to go forward. An FDIC Cutoff Point also does not affect the bank’s end-of-day processing of items in “batch mode” (for example, deposits of checks received earlier in the day.) But “external” transactions will no longer be allowed after the FDIC Cutoff Point.

The regulation states that “the FDIC will use its best efforts to take all steps necessary to stop the generation, via transactions or transfers coming from or going outside the institution, of new liabilities or extinguishing existing liabilities for the depository institution.” (This covers all “external” transactions, but especially electronic transactions, which may be most likely to occur on their own after the FDIC Cutoff Point if nothing were done to stop them.)

The same section states, “End-of-day ledger balances are subject to corrections for posted transactions that are inconsistent with the above principles.” In other words, if a new “external” transaction somehow manages to post after the FDIC Cutoff Point (in spite of best efforts), the FDIC will back out that transaction in determining the end-of-day balance for an account on the day that the bank fails.

Let’s assume a depositor has $260,000 in an individual account (with $250,000 of deposit insurance) as of the FDIC Cutoff Point on the day that the bank fails. The depositor, perhaps not even be aware that the bank has failed, attempts after 4:00 p.m. to authorize an online bill-pay transfer of $20,000. This transaction is after the FDIC Cutoff Point but before the bank’s normal cutoff time. If the FDIC allowed this transaction to post on that day’s business, the effect would be to reduce the customer’s end-of-day account balance from $260,000 (when the FDIC took over the bank) to $240,000. This would change the customer’s deposit account status from partially uninsured to fully insured. And every depositor would try to do the same thing, if FDIC allowed it. This shows why FDIC must cut off “external” transactions after it takes control of a bank, to prevent evasion of its insurance rules.

In an opposite example, let’s assume that the individual has a $249,000 balance at the FDIC Cutoff Point. After that time, but before the bank’s normal cutoff time for that day’s business, an automatic deposit to the account is received in the amount of $20,000. If the FDIC allowed this deposit to post before the bank’s end-of-day balance is finalized, the total would be $269,000. Here is a customer who potentially would sustain a partial loss (on uninsured deposits) due to a transaction after the bank failed—even though the account was in a fully insured status at the point when the bank was closed. This doesn’t seem right either, so FDIC’s policy will prevent that item from posting on the current day’s business. If such a transaction manages to post anyway, the FDIC will back it out.

These two examples also help to illustrate why the FDIC does not allow any “external” sweep to occur (either into the institution or out of the institution) after the FDIC Cutoff Point.

7. External Sweep Accounts

If an “external” sweep has already occurred on a certain day, before the FDIC Cutoff Point or the bank’s normal cutoff time (whichever occurs first), that transaction will not be affected by FDIC’s procedures. The actual risk, instead, on the day a bank fails, is that the FDIC will cut off an “external” sweep that sometimes or normally will occur later in the day than what turns out to be the FDIC Cutoff Point (4:00 p.m. or later). (Most banks using “external” sweeps probably do not have one occurring so late in the day, but each bank should think through its own process to verify this.)

If a bank with an “external” sweep reads the regulation and realistically concludes that its own sweep is likely to occur earlier in the day and is not likely to be blocked by FDIC on a day that the bank fails, I think it could state its reasoning on this issue in the notice—but the bank is still required to disclose to the sweep customer the “technical” possibility that a “external” sweep will not occur (and the effect that would have).

8. Internal Sweep Accounts

Banks can have many types of fund-transfer arrangements (consumer or commercial) between accounts in the same bank. “Internal” sweep arrangements are just one subcategory within the broader range of internal transfers that a bank’s normal procedures regularly allow—and the FDIC generally permits all of these to be carried out, even on the day when a bank fails.

One common example of an automated “internal” funds transfer occurs when the current balance in a transaction account is not adequate to pay all of the items presented on that account for the particular day. Some other account is “linked,” allowing a pre-authorized transfer, as necessary. Such transfers occur at the end of the banking day, after all other transactions on an account have posted, so that the amount of funds needed will be known with certainty. FDIC’s policy allows such “internal” transfers to go forward, as part of the bank’s standard procedures, even after the FDIC Cutoff Point has passed on a day when the bank fails. In that light, it’s not unusual that the FDIC also allows all “internal” sweeps to go forward.

The FDIC’s discussion accompanying the regulation states, “The FDIC’s intention is to complete internal postings of transactions presented or authorized prior to the institution’s normal cutoff procedures . . . . Any transaction—including sweep arrangements—would be completed for that day according to normal procedures if it involves only the movement of funds between accounts within the confines of the depository institution.”

Apparently this allows all types of automated “internal” sweep transfers within the same depository institution. (The transfer does not have to be between two deposit accounts. A pre-authorized transfer from a deposit account to a non-deposit investment account maintained at the same bank will also be carried out, even after the FDIC Cutoff Point.)

When a bank has an “internal” sweep, with no risk that it will be cut off by FDIC, the regulation does not require the bank to describe what might happen if the sweep fails.

For an “internal” sweep (outbound from an account), the “notice” requires a description of what investment or fund the customer will actually hold, and what rights and limits will apply, if the bank fails, the sweep arrangement does not sweep back after that point, and the customer’s funds become “stuck” in whatever the “other” account or investment may be. (As one example, the funds cannot sweep back into the deposit account on the next day if the bank is liquidated. It’s impossible to know in advance, but a more usual outcome is for another bank to take over both the sweep account and related contracts, so that the funds will sweep back on the next day, with the arrangement continuing normally thereafter.)

The “notice” provision requires (for both “internal” and “external” sweep arrangements) that “institutions must prominently disclose in writing to sweep account customers whether their swept funds [after they are swept out] are deposits . . . .” It also states, “If the [swept] funds are not deposits, the institution must further disclose the status such funds would have if the institution failed—for example, general creditor or secured creditor status.”

Here’s where things can get “sticky”: If the sweep is “internal,” we must assume a failed bank will be “holding” (in one way or another) whatever it is that the customer’s funds have been swept into. At that point, the sweep customer’s position needs to be adequately protected against the failed bank itself, so that the customer will not have a loss. The “notice” (beginning July 1) must inform the sweep customer in advance how he is protected (or not) in the “swept” non-deposit investment, or in a deposit that might be styled in the name of someone other than that customer.

In a securities repurchase (“repo”) sweep account, the daily sweep of funds from the customer’s deposit account will result (by pre-authorized contract) in the customer’s actual “same-day” purchase of securities (or a specific interest therein) from the bank, before the final close of the bank’s books on the day that the funds come out of the customer’s sweep account. With respect to repo sweep agreements the regulation notes, in a situation where “the customer becomes either the legal owner of identified assets subject to repurchase or obtains a perfected security interest in those assets, [that] the FDIC will recognize, for receivership purposes, the customer’s ownership interest or security interest in those assets.” In this situation, if funds are swept out of the deposit account and the bank fails, the customer will become the continuing owner of the securities that he thought he was purchasing only overnight. He will not own deposits, but he will also not be a general creditor of the failed bank. Assuming that the value of the securities has not declined suddenly, he will probably come out even, or nearly so, by selling the securities that he then owns. He doesn’t have complete protection from loss, but nearly so, if the documents and transactional steps are all in order.

The FDIC warns that “some institutions’ repo arrangements are not properly executed. In those situations, the sweep customer obtains neither an ownership interest nor a perfected security interest in the applicable deposits.” (A bank should be careful that its “notice” does not merely describe how sweeps of this type are supposed to work, without understanding how its own sweep will actually work. The bank should carefully review its own contract, and understand the effect on its own customer’s funds, so it can describe accurately what its own customer’s position will be if the bank fails while funds are swept out of a deposit account.)

The FDIC further notes that some sweeps to a money market mutual fund result in a “same-day” purchase of funds, but others involve a “next-day” purchase. Where the funds are used for a “next-day” investment purchase, they may be swept on the first day into a “holding account” within the same bank, which may be a deposit, or a general account of the bank, but is not a “mutual fund” investment yet.

This type of arrangement could raise a further problem–accurately describing (in the notice) what type of funds the customer will have if the bank fails on the first day, while funds are in this pooled account or holding account, and whether these funds at this stage are protected. Let’s assume that the “holding account” is maintained in the same bank as the sweep account. On the first day, funds may transfer on an automated basis from the customer’s sweep account to the holding account, awaiting purchase of some “external” investment the next morning (the second day). What does the customer actually own, if the bank fails on the first day?

If this “holding account” (wherever funds are held awaiting transfer out of the bank on the following day) is a general account of the bank, the funds held in that account might be just an ordinary liability of the bank (not a deposit and not an investment product)—possibly leaving the sweep account customer as an unsecured general creditor of the failed bank, as to any customer funds held in that account on a day when the bank fails.

Alternatively, if the “holding account” at the bank is a deposit styled in the name of the brokerage that will carry out the next-day mutual fund purchase, without any “agency” or “trust” relationship in the styling to indicate the existence of underlying owners, the “holding account” (now held at a failed bank) might be treated by FDIC as insured only up to the brokerage’s own separate FDIC insurance limit. With this inadequate styling of the account, not reflecting any agency for others, the holding account could be partially uninsured when the bank fails, and a sweep account customer’s funds temporarily held in that account may be inadequately protected.

But as a different possibility, the “holding account” of the brokerage (held at the failed bank) might indicate clearly in the styling that it is an agency or trust account for others—in which case the sweep account customer’s share of the deposit account maintained by the brokerage should receive “pass-through” insurance coverage. In this situation, what the customer “owns” if the bank fails would be an underlying share in that deposit account, which (depending on the size) could be fully insured within the customer’s FDIC insurance limits.

As these fairly complicated examples demonstrate, the bank must understand the steps in how the funds will flow, who will own what at each stage in the transfer process, and what will happen to the customer’s funds if they get frozen at an “in-between” stage in the process. Then the bank is in a position to accurately describe (as the “notice” requires) what the likely status of a sweep account customer’s “swept out” funds will be if the bank fails.

9. Contents & Timing of Notice

For all sweep customers, 12 CFR Section 360.8(e) requires a bank to “prominently disclose in writing” (by notice) the following points, discussed above: (1) whether the funds, while swept out of the account, are deposits; and (2) if not deposits, what the status of those funds will be if the bank fails.

Will the customer have an investment of some kind that is directly owned (such as securities purchased overnight from the bank, in the case of a “repo” sweep; or ownership in a money fund that is “external” to the bank)? Instead, would the customer become either a general creditor of the bank (not in an insured deposit status) or a secured creditor of the bank, if the bank should fail?

Each bank should review its sweep agreement to be sure it gives the customer the protection that everyone assumes to exist. (If the bank sees “technical gaps” in the way the bank is operating its sweep, compared to how it is designed to work, these should be corrected.) After understanding how the FDIC Cutoff Point functions, a bank should consider what the customer likely will own if an “external” sweep (normally occurring) is attempted on a particular day that the bank fails, but that “external” sweep is blocked by FDIC’s procedures.

I would strongly caution a bank against simply obtaining and adopting the same sweep account “notice” that another bank has developed. (This may be a useful starting point but should not be the end of the process. Sweep arrangements vary at least slightly from bank to bank. Each bank’s “notice” needs to describe where that bank’s customer will stand under that bank’s own sweep arrangement. )

When a bank sets up an arrangement to sweep its customers’ money from insured deposit accounts into a non-deposit investment, it needs to be especially careful that the temporary “other investment” will be appropriate and reasonably protected. The true nature of the “other investment,” and the risks involved, should be accurately described to the customer. Failure to describe accurately any pitfalls within the bank’s own sweep process could result in liability.

After July 1, 2009, this sweep account “notice” must be given at several points in the ongoing relationship between a sweep customer and the bank, as follows: (1) “in all new sweep account contracts,” as those are entered into; (2) “in renewals of existing sweep account contracts”; (3) in any event, “within sixty days after July 1, 2009” (in other words, on a one-time basis for all pre-existing sweep customers as of that date); and also (4) “no less than annually thereafter” (for example, as a regular annual notice if renewal contracts are entered into less frequently than annually).

To summarize, all existing sweep customers should receive an appropriate “notice” at least by August 30, 2009. Going forward, all new sweep customers will get a notice, and all renewals will get a notice, and if those two approaches don’t already accomplish it, the bank must provide “in between” notices so that the customer gets a notice at least once a year.