CD Programs and Structured CDs

Teleconference

Thursday, July 14, 2016 12:00PM – 1:00PM EDT

Presenter:

Lloyd S. Harmetz, Partner, Morrison & Foerster LLP

1. Presentation

2. Morrison & Foerster User Guide: “Frequently Asked Questions about Structured Certificates of Deposit”

3. Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, Inc.

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Certificate of Deposit Programs

and Structured CDs

July 14, 2016

Lloyd Harmetz

Morrison & Foerster LLP

2

CDs: Topics to Be Covered

• Types of Programs

• Features of Brokered CDs

• Federal Securities Law Issues

• FDIC Insurance

• Truth in Savings Act Issues

• FINRA Issues

• Use of Third Party Dealers

• Documentation

3

Types of CDs

• Can be “plain vanilla”.

• Fixed rate, floating rate.

• Akin to a traditional CD, but held through brokerage account.

• Can be structured CDs, linked to an underlying asset.

• Can be “lightly structured”.

• Needless to say, not a legal term.

• Fixed to floating rate CDs, step up callables, CMS-linked.

• May have an “embedded derivative.”

4

Structured CDs - Features

• Can link to assets that are similar to those of registered notes:

indices, ETFs, single stocks, currencies, interest rates.

• Technically, possible to link to a broader range of assets, since the

SEC’s “Morgan Stanley” letter doesn’t apply.

• Small cap stocks.

• Non-U.S. stocks that are not registered in the U.S.

• Credit-linked instruments.

• BUT – investor suitability needs to be considered, and issuances of this kind aren’t

frequent, especially in the case of retail investors.

• Interest bearing or non-interest bearing.

• Fixed, floating or indexed interest payments.

• Callable vs. non-callable.

• Participation rate – greater than, equal to, or less than, any increase

in the underlying asset.

5

Structured CDs – Features (con’t)

• Survivor’s Option: upon death (or incompetency) of investor, estate

can obtain deposit amount prior to maturity.

• Feature is associated with some, but not all, structured notes.

• Typically subject to aggregate limits in the course of a year.

• Key difference from structured notes: may not pay less than principal

at maturity. Otherwise, the FDIC would take the position that they are

not “deposits”, and not subject to FDIC insurance.

• But: may sell for less than principal if sold prior to maturity.

• That is, “principal protection” applies only at maturity.

6

New Developments Relating to CDs

• New U.S. Bank Regulatory Capital Issues (TLAC, clean-holding

company): for U.S. banks, offerings of CDs are effected at the bank

subsidiary level.

• Issuances are not limited in the manner that parent company structured notes

would be.

• Department of Labor Fiduciary Rules:

• CDs sales are eligible for the “principal transactions exemption,” potentially

providing more flexibility than other types of structured products.

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Limitations on Brokered Deposits

• Brokered deposits are considered by some to be a risky banking tool.

• Less likely to be rolled over at maturity, since another bank may offer better rates.

• Not as much “brand loyalty.”

• FDIC 337.6 (Under Section 29 of the Federal Deposit Insurance Act):

restricts use of brokered deposits and limits rates paid on interest-

bearing deposits that are solicited by insured institutions that are less

than “well-capitalized”.

• If less than well-capitalized, issuer must seek a waiver to accept or

new brokered deposits.

• FDIC will consider traditional safety and soundness concerns in determining

whether to grant a waiver.

• The rates on these CDs cannot “significantly exceed” the prevailing

rates in the applicable market area.

8

Securities Law Issues

• “Certificates of deposit” are included in the 1933 Act’s definition of a

“security.”

• However, under relevant case law, FDIC insured CDs are typically

not treated as a “security”.

• Guaranteed payment of principal.

• Other regulatory protections provided to holders under applicable banking laws.

• Similar concept of exemption from OCC registration for national banks.

• When is a certificate of deposit a security?

• See “Gary Plastics”, a 1985 Second Circuit decision.

• Bad facts:

• Broker marketed CDs that it had obtained from other banks.

• Broker promised to maintain a secondary market to guarantee liquidity.

• Broker represented to investors that it had reviewed the financial soundness

of the issuing banks.

• Today’s structured CD offering documents are drafted with these concerns in

mind.

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FDIC Insurance

• Current limit is $250,000

• Application may vary, depending upon type of investment account.

• Guidance is available to the public on the FDIC’s website.

• Not all payments are guaranteed:

• Principal and guaranteed interest payments are covered.

• The FDIC has taken the position that contingent payments at maturity, and any

indexed interest payments, are not insured until determined.

• Impact: if bank fails before a “determination date,” that payment will not be

covered by FDIC insurance.

• FDIC insurance will not cover any amount paid in excess of principal, such as the

payment of a premium in a secondary market transaction.

• e.g., investor pays $1,001 for a CD with a face amount of $1,000. That

additional dollar is not insured.

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FDIC Insurance and Recordkeeping

• FDIC has detailed rules relating to account identification, in order to

determine who is entitled to FDIC insurance payments, if needed. (12

C.F.R. 360.9)

• In the case of brokered deposits, the broker is usually obligated by

contract to maintain this information.

• February 2016, the FDIC proposed rules that would apply to banks

with 2 million or more deposit accounts.

• The proposed rules would require the banks to maintain complete data on each

depositor’s ownership interest by right and capacity for all of its deposit accounts.

• Each bank would be required to:

• collect the information needed to allow the FDIC to determine promptly the deposit

insurance coverage for each owner of funds on deposit at the covered institution;

and

• ensure that its IT system is capable of calculating the deposit insurance available

to each owner of funds on deposit in accordance with the FDIC’s deposit

insurance rules set forth in 12 C.F.R. 330.

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FDIC Insurance and Recordkeeping (con’t)

• A covered institution could apply for:

• an extension of the implementation deadlines;

• an exception from the information collection requirements for certain deposit

accounts under certain limited circumstances;

• an exemption from the proposed rule’s requirements if all the deposits it takes are

fully insured; or

• a release from all of the new requirements when it no longer meets the definition

of a “covered institution.

• Potential impact:

• Issuing banks will need to obtain this information from their brokers, in the format

required under the rules.

• Any sub-distributors used by the brokers will need to furnish this information up

the distribution chain, so that it can reach the issuing bank.

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Truth in Savings Act

• Federal Reserve Regulation DD implements the Truth-in-Savings Act.

• Provisions are applicable to the issuing banks, as well as to deposit

brokers.

• Banks may not advertise deposits in any way that is inaccurate or

misleading, and the regulation provides examples.

• Required disclosures of “annual percentage yield,” “penalty fees” that

may be imposed for early withdrawals, and any other fees.

• In addition, the Federal Trade Commission Act prohibits unfair or

deceptive acts or practices.

• Applies to all aspects of a depository institution's consumer products and services,

including advertisements.

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“Yankee CDs”

• Typically do not have the benefit of FDIC insurance, but designed to have the preferences for deposits that apply under applicable banking laws.

• Are they securities? Answer depends upon, in part, the terms of the instrument and how they are marketed.

• OCC stated in 1994 that it did not intend for the definition of security to cover deposits or other traditional bank products.

• Are the CDs transferable?

• How does the issuer record them on its own books and records?

• However, even if they are securities, an exemption from SEC registration (and OCC registration) can typically be found.

• Federal branches: Part 16.6 – non-convertible debt securities.

• Typically offered in large denominations, in transactions that are privately negotiated with sophisticated investors.

• Consider appropriate level of disclosures about the issuer, the instrument, and the relevant risk factors.

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FINRA Issues

• Because structured CDs are (usually) not “securities,” a variety of

FINRA rules do not technically apply.

• e.g., corporate financing rule, suitability.

• However, most broker-dealers apply a comparable degree of compliance

procedures to these instruments as they do in the case of securities.

• Key areas of FINRA regulation implicated by structured CDs:

• Retail communications – accuracy and completeness.

• FINRA has made substantive comments to broker-dealer marketing materials

for these instruments.

• Training.

• New product approvals.

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Third Party Distribution and KYD

• Many structured CDs are distributed through third party brokers.

• Often subject to a dealer agreement between (a) the dealer that is in

privity with the issuer and (b) downstream distributors.

• A separate form of agreement is typically needed that differs from the type used

for securities.

• Different regulatory regime.

• FDIC record-keeping requirements.

• Market-wide concern that “bad acts” by downstream distributor could

result in liability or reputational risk for issuer or primary distributor.

• Agreements are filled with negotiated representations and warranties, covenants

and indemnification, usually for the benefit of the primary distributor.

• To date, FINRA’s proceedings with respect to structured products have generally

imposed liability on the responsible entity.

• FINRA’s 2013 Report re Conflicts of Interest

• Recommends know-your-dealer diligence procedures.

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Disclosure Documents for CDs

• No specific form requirements. (In contrast, registered securities are

subject to the form requirements of S-3/F-3 and Regulation S-K.)

• Truth-in-Savings Act, FINRA communication rules, and “best

practices” require full and accurate disclosure.

• Often quite similar to the offering documents for registered notes –

similar set of brokers, similar set of investors.

• Estimated Value Disclosures:

• CDs are not subject to the 2012 SEC “sweep letter.”

• However, many regard it as a good disclosure, any many distributors request its

disclosure.

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Additional Documentation for CD Programs

• Program or similar agreement with lead dealers.

• Similar in some respects to agreements used for registered notes, but tailored for

the bank regulatory structure.

• If applicable, paying agency agreement with third party paying agent.

• Forms of master certificates representing the issuances.

• Agreements with hedging counterparties.

F R E Q U E N T L Y A S K E D Q U E S T I O N S

A B O U T S T R U C T U R E D

C E R T I F I C A T E S O F D E P O S I T

Introduction

What are Structured Certificates of Deposit?

Structured Certificates of Deposit (“SCDs”) are financial

instruments representing a deposit of a specified

amount of money for a fixed period of time. Like

traditional certificates of deposit (“CDs”), SCDs entitle

the holder to his or her principal investment, plus

possible additional payments. However, unlike

traditional CDs, which usually pay interest periodically

based on a fixed or

floating rate, SCDs often pay an additional payment at

maturity or periodic interest payments based on the

performance of an underlying asset, such as one or

more equity securities, an index, or one or more

currency exchange rates. SCDs are customizable and

can be tailored to fulfill specific investment objectives.

What are sample terms of a SCD?

Bank X issues a certificate of deposit with a two-year

term, a 100% participation rate, and a minimum

investment of $1,000. In lieu of a fixed interest rate,

Bank X has offered to pay an amount equal to the

appreciation of the Dow Jones Industrial Average Index

(the “DJIA”) over that two-year term. If the DJIA

increases by 20% in the two-year time period, Bank X

will pay $200 for each $1,000 invested plus the $1,000 in

principal, or $1,200 in total. However, if the DJIA

declines, Bank X will only pay out at maturity the

principal amount.

What are some examples of underlying assets to which

SCDs can be linked?

As discussed above, an investor is entitled to the

principal amount invested plus a return based on the

performance of an underlying asset. Examples of

reference assets include equity indices (e.g., the Dow

Jones Industrial Average and S&P 500 Index), foreign

currency exchange rates (e.g., the BRIC Currency

Basket), commodities (e.g., oil and gas or gold prices), or

some combination of any of these.

How do SCDs differ from traditional CDs?

SCDs possess a number of characteristics not generally

associated with traditional CDs.

First, unlike traditional CDs, SCDs do not generally

pay interest at a fixed or floating rate; instead, they

generally pay an additional payment at maturity or

periodic interest payments based on the performance of

the underlying reference asset.

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Second, SCDs are customizable. This allows investors

access to a number of investment strategies, as well as

the opportunity to gain upside exposure to a variety of

markets.

Third, SCDs may or may not be interest-bearing, and

may offer a wide variety of payment calculations. For

example, payments may be calculated using the

percentage increase of the reference asset based on the

starting level (determined on the pricing date) and the

ending level (determined before the date of maturity),

or may be calculated using the average of the levels of

the reference asset, based on a series of observation

dates throughout the term of the SCDs. In the

alternative, the payments may be subject to a cap, or

ceiling, representing a maximum appreciation in the

level of the reference asset. Depending on the terms, the

particular SCDs may also have a participation rate,

which represents the exposure of the SCDs to

movements in the underlying reference asset. For

example, an investor in an SCD with a 90% participation

rate will only receive 90% of the gains in the

performance of the reference asset.

What are some benefits to investors associated with

investing in SCDs?

SCDs can be a relatively low-risk alternative to other

investment vehicles because they provide “principal

protection” for the deposit amount. Regardless of how

poorly the underlying reference asset performs, at

maturity, a holder will still receive the original

investment amount (provided that the issuing bank

remains solvent).

However, it is important to note that this protection

feature is only available if the investment is held to

maturity.

As an added layer of protection, the deposit amounts

of SCDs are insured by the Federal Deposit Insurance

Corporation (“FDIC”) and backed by the full faith and

credit of the U.S. government. Currently, the FDIC

insures up to $250,000 of an investor’s deposits at the

relevant bank. However, the determination of how the

$250,000 limit applies to different types of accounts can

be somewhat complex. The FDIC’s website sets forth a

variety of examples at the following page:

http://www.fdic.gov/deposit/deposits/.

Another notable aspect of many SCDs is the “estate

feature” (otherwise commonly known as a “death put”

or “Survivor’s Option”). To the extent provided in the

terms of the particular SCD, if at any time the depositor

of an SCD passes away (or, in some cases, becomes

legally incapacitated), the estate or legal representative

has the right, but not the obligation, to redeem the SCD

for the full deposit amount before the date of maturity,

without being subject to any penalty provisions. In the

alternative, the estate or representative may choose not

to exercise the estate feature and instead hold the SCD

to maturity. This term is often offered by an issuing

bank as an extra purchase incentive; an investor need

not worry that his or her descendants will end up

holding a long-term instrument that they don’t wish to

sell at a discount to face value.

FDIC Insurance

How much of an investor’s deposit is insured by the

FDIC?

FDIC insurance coverage applies to bank products that

are classified as “deposits.” Following the passage of

the Dodd-Frank Wall Street Reform and Consumer

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Protection Act, the FDIC now covers up to $250,000 of

an investor’s deposits with the relevant bank.

Are there any limitations to the FDIC coverage?

The guarantee by the FDIC is limited to the principal

invested and any guaranteed interest rate, but does not

extend to the amount of any “contingent” interest. For

example, in the hypothetical scenario outlined above, if

the issuing bank were to fail prior to maturity of the

SCD, the FDIC insurance would only cover the $1,000

investment, but not the $200 of earnings based on the

performance of the DJIA. In addition, if an investor

pays a purchase price for the SCDs that exceeds the par

amount of the deposit, for example, paying $1,005 for a

$1,000 SCD in the secondary market, the premium paid

by the investor would not be covered by FDIC

insurance.

Further, investors are still subject to the direct credit

risk of the issuing bank for any dollar amount over the

maximum applicable deposit insurance coverage. This

would occur, for example, if the investor holds other

deposits with the applicable bank that together exceed

$250,000.

Other Banking Laws and SCDs

Can a SCD be non-principal-protected?

Not if the SCD is intended to be covered by FDIC

insurance. FDIC insurance extends only to those bank

products that are regarded as deposits. The FDIC has

taken the position that an instrument must guarantee

the repayment of principal in order to be treated as a

deposit. (See: “How much of an investor’s deposit is insured

by the FDIC?”)

How does the Truth-in-Savings Act apply to SCDs?

Under Regulation DD of the Consumer Financial

Protection Bureau (which implements the Truth-in-

Savings Act), issuing banks are required to make certain

disclosures with regard to deposit accounts “held by or

offered to” consumers in order to enable consumers to

make informed decisions about accounts such as SCDs.

Section 1030.8 of Regulation DD (“Section 1030.8”)

prohibits an issuing bank from advertising its deposit

accounts in any way that is inaccurate or misleading.

The regulation contains a variety of specific disclosure

rules with which issuers of CDs must comply. For

instance, banks are prohibited from using the word

“profit” in referring to interest payments, or using the

words “free” or “no cost” if a maintenance or activity

fee is imposed on the account. Banks are also obligated

to comply with Section 1030.8’s advertising rules

regarding rates of return. For example, an issuing bank

must state certain types of interest payments as an

“annual percentage yield,” and disclose any and all fees

associated with the deposit, such as ladder rates on

various CDs, as well as any penalty fees that may be

imposed for early withdrawal.

Structured CDs and the Securities Laws

Are SCDs subject to the registration requirements of the

federal securities laws?

Usually no. Section 2(a)(1) of the Securities Act of 1933

(the “Securities Act”) includes “certificates of deposit”

in the definition of the term “security.” However,

under relevant federal judicial and regulatory

proceedings, FDIC-insured CDs are generally exempt

from the definition of “security” under the federal

securities laws. The Supreme Court, in its analysis of

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CDs, found that since holders of CDs are guaranteed

payment of principal by the FDIC, and a variety of other

protections are provided to depositors under applicable

banking laws, it was not necessary to provide to CD

holders the added protections afforded under the

federal securities laws.

Under what circumstances can an SCD be deemed to be

a security under the federal securities laws?

While CDs, including SCDs, are not generally

considered securities under the Securities Act, there are

limited instances when the courts have been willing to

characterize CDs as securities.

In Gary Plastics Packaging v. Merrill Lynch, Pierce,

Fenner, & Smith Inc., 756 F.2d 230 (2d Cir. 1985), Merrill

Lynch marketed insured CDs that it obtained from

various banks. Merrill Lynch purportedly promised to

maintain a secondary market to guarantee purchasers

liquidity for their deposits, and represented to

purchasers that it had reviewed the financial soundness

of the issuing banks. Due to the fact that the broker’s

creation and maintenance of a secondary market was a

critical part of its marketing efforts, and permitted

investors to make a profit from these investments, the

additional protection of the Securities Act was deemed

appropriate. In its analysis, the Second Circuit Court of

Appeals analogized CDs to “investment contracts.” An

instrument is an “investment contract” if it evidences:

(1) an investment; (2) in a common enterprise; (3) with a

reasonable expectation of profits; and (4) to be derived

from the entrepreneurial or managerial efforts of others.

Due to the fact that the broker’s creation and

maintenance of a secondary market was a critical part of

its marketing efforts, and permitted investors to profit

from these investments, the additional protection of the

Securities Act was deemed appropriate.

As one result of this case, while brokers who offer

these products indicate that they may make a secondary

market in them (and in fact many do), these issuances

do not involve a commitment or an agreement on the

part of any broker to do so.

Are SCDs subject to other registration requirements?

Issuing banks that are engaged in the offer and sale of

securities may still need to comply with the registration

requirements of the Office of the Comptroller of the

Currency (the “OCC”). The OCC’s securities offering

rules apply to U.S. national banks and federal branches

and agencies of non-U.S. banks. The OCC’s securities

offering disclosure regulations provide that, absent an

available exemption, no bank may offer or sell securities

without meeting the registration requirements of

12 C.F.R. 16 (“Part 16”). Like the registration

requirements under the Securities Act, Part 16 aims to

provide the investing public with full disclosure of the

material facts and circumstances regarding the offer and

sale of securities by national banks. In fact, Part 16

incorporates by reference a variety of the definitions,

registration, and prospectus delivery requirements of

the Securities Act, as well as the implementing rules of

the Securities and Exchange Commission (the “SEC”),

including the definition of “security.” As a result, most

FDIC-insured SCDs issued by these banks are exempt

from registration under the OCC’s rules, for the same

reasons that result in their exemption from registration

under the Securities Act. (See “Are SCDs subject to the

registration requirements of the federal securities laws?”)

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Are there any differences in the underlying assets to

which SCDs can be linked as compared to registered

debt securities?

Registered offerings of equity-linked structured debt

securities are typically linked only to large-cap U.S.

stocks due to the “Morgan Stanley” SEC no-action

letter.1 Some SCDs may be linked to debt securities

(credit-linked notes), small-cap stocks, or securities that

are traded only on non-U.S. exchanges, in addition to

the underlying assets mentioned in “What are some

examples of underlying assets to which SCDs can be linked?”

above.

Do “Blue Sky Laws” apply to SCDs?

No. Since they are usually not considered securities

under federal securities law, SCDs fall outside of the

registration requirements imposed by each state’s Blue

Sky Laws. Further, under the National Securities

Markets Improvement Act of 1996, federal law

preempts the application of Blue Sky Laws to certain

categories of securities, known as “covered securities.”

Included in the definition of “covered securities” are

certain securities exempt under Section 3(a) of the

Securities Act. These include any security issued or

guaranteed by any bank. Because SCDs are issued by

banks, even if they were securities, they would be

“covered securities” and fall outside of the Blue Sky

Laws.

1Morgan Stanley & Co. Incorporated, June 24, 2006. Under the

terms of this no-action letter, if a linked stock does not satisfy

the specified requirements, the issuer of the structured note

must include in the prospectus for the structured notes detailed

information about the issuer of the underlying stock (the

“underlying stock issuer”). Issuers are reluctant to include this

type of information, as they would face the possibility of

securities law liability for their own documents if the relevant

information about the underlying stock issuer was incorrect.

Documentation for SCDs

What disclosure requirements must issuing banks

comply with in connection with their SCDs?

While they are generally excluded from the registration

requirements under the Securities Act, SCDs may not be

excluded from certain disclosure requirements by the

self-regulating organizations. For instance, in 2006, the

New York Stock Exchange, or “NYSE,” published

Information Memo 06-12 addressing the disclosure and

sale practices concerning SCDs. A key concern of the

NYSE was the adequacy of the disclosure materials

used in connection with the sale of SCDs and whether

an investor would fully understand how these differ

from conventional CDs. The NYSE required that its

member organizations be able to identify the customer

criteria that define the appropriate market for a

particular SCD, and provide training to their registered

representatives to assure that they can identify investors

for whom the SCD may be suitable. From a disclosure

standpoint, the NYSE required its member

organizations to make appropriate disclosures to

investors prior to, or at the time of, the sale. In addition,

member organizations must clearly explain the risks

associated with SCDs. Such risks include, but are not

limited to, market risks, liquidity risks, tax implications,

and any potential call features (if applicable).

The SEC has also indicated some of the concerns that

it has had as to the disclosures made in connection with

sales of SCDs. For example, the SEC added a page to its

website, “Equity Linked CDs”

(http://www.sec.gov/answers/equitylinkedcds.htm),

which serves as a reminder to issuers and brokers of

SCDs of certain key disclosure issues.

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In addition, Regulation DD (which implements the

Truth in Savings Act) sets forth additional disclosure

requirements. (See: “How does the Truth-in-Savings Act

apply to SCDs?”).

What are some advantages of mirroring the types of

disclosures traditionally found in medium-term note

programs?

Mirroring the types of disclosures traditionally found in

medium-term note programs can allow an issuing bank

to accomplish a number of objectives. First, the

disclosures allow issuing banks to address potential

disclosure concerns raised by the NYSE, FINRA, and

Regulation DD. Second, the disclosures provide

investors with the level and quality of information that

regulators have traditionally deemed adequate for

investors to make an investment decision. Last, since

many issuing banks that offer SCDs also offer

structured securities programs, providing similar types

of documentation for SCDs provides some level of

familiarity to investors (as well as the brokers that

market SCDs).

What other offering documentation is used in a SCD

program?

While SCDs are not generally considered securities,

many issuing banks treat, document, and market them

in a manner that is similar to offerings under medium-

term note programs. For the SCDs that are marketed by

larger, more frequent issuers, the related documents

that are prepared and distributed to investors often look

and feel similar to those used in structured note

offerings. For example, an issuer may provide its SCD

investors with a “pricing supplement” which sets forth

the specific terms of a particular SCD (including the

terms of the SCD, a comprehensive discussion of the

economic terms of the offering, a discussion of the

underlying asset, specific risk factors, fees, and

expenses), a “product supplement,” and a base

disclosure statement.

What types of documents and agreements are used to

establish a SCD program?

Establishing a SCD program typically requires a variety

of additional agreements and documents, including:

A brokerage or purchase agreement between

the issuing bank and the brokers that will

market the SCDs.

A paying agency agreement with a paying

agent (if necessary).

Forms of master certificates that represent the

SCDs.

Documentation providing for the clearance of

the SCDs through the facilities of the

Depository Trust Company.

Agreements with hedging counterparties, in

the event the issuing bank is engaged in

hedging activities (see “Are SCDs subject to

hedging transactions?”).

Many brokers will often on-sell SCDs to third-party

broker-dealers, who in turn sell them to retail accounts.

A CD-specific selling group agreement will typically be

used to document the relationship between the brokers.

Marketing of SCDs

How are SCDs marketed?

The marketing process for SCDs is similar to the process

employed in offering structured notes that are issued

under a medium-term note program. Banks that are

frequent issuers of SCDs will market SCDs with specific

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structures, linked to different reference assets. Further,

as with medium-term notes, an issuing bank can tailor a

SCD offering with characteristics that are unique to the

market, in order to meet the needs of specific investors

(also known as a “reverse inquiry”).

Are SCDs subject to hedging transactions?

As with medium-term note offerings, the issuing bank

or any of its affiliates may engage in hedging

transactions. An issuing bank will typically hedge to

offset its payment obligations at maturity. This hedge

transaction is typically arranged by the investment bank

that is acting as broker for the SCDs.

Other Terms of SCDs

Can SCDs be withdrawn prior to maturity?

Usually not. However, depending on the terms of the

particular SCD, an issuing bank may offer an “estate

feature” (otherwise commonly known as a “death put”

or “Survivor’s Option”). In the event the depositor of

an SCD passes away (or, in some cases, becomes legally

incapacitated), the estate or legal representative has the

right, but not the obligation, to redeem the SCD for the

full deposit amount before the date of maturity, without

being subject to any penalty provisions.

Can an SCD underperform a traditional CD?

Yes. Unlike traditional CDs, which provide for a fixed

rate of return, the rate of return for an SCD is contingent

on the performance of the underlying asset. There may

be no assurance of any return above the deposit

amount. While an investor is guaranteed his or her

principal amount, in the end, if the reference asset

performs unfavorably, the investor will still experience

an “opportunity cost,” compared to having invested in a

traditional, interest-paying CD.

What is a “participation rate”?

The “participation rate” is the exposure of a product to

movements in the price or level of the underlying asset.

A participation rate of 100% would generate a return

equal to any increase in the value of the underlying

asset. Conversely, if the participation rate is 80%, an

investor will receive 80% of the increase in the value of

the underlying reference asset. In such a case, the SCD

will underperform the underlying asset if the value of

the underlying asset increases.

What are some other features that could limit an

investor’s return at maturity?

Even if the asset performs favorably, depending on the

terms of an SCD, the return on the investment may be

limited by a predetermined return (a “cap”) or some

other term specific to a particular SCD. These types of

features could cause the SCD to perform less well than

the relevant underlying asset. Further, because SCDs

are FDIC-insured, the premiums and assessments paid

by the bank issuer to the FDIC are usually passed on to

the investor in the form of a lower participation rate or a

lower maximum payment, as compared to non-FDIC-

insured investments.

What is a “call feature” and how does it apply to

SDCs?

A “call feature” allows an issuing bank, at its discretion,

to redeem a SCD at a call price on a specified call date or

dates, prior to maturity. By agreeing to a specified call

price, the investor effectively forgoes any possible

returns that could be realized had the SCD not been

called, or had the SCD been called on a later date. In

8

addition, if an SCD is called, the investor may not be

able to reinvest the proceeds in a similar instrument,

since interest rates and the level of the underlying asset

may have changed since the SCD was initially

purchased.

How are investments in SCDs taxed?

The specific U.S. federal tax consequences to an investor

depend upon a variety of factors, particularly the

structure of the SCD. These tax consequences are

typically discussed in the SCD’s offering documents.

Because many SCDs are typically subject to contingent

payments during the term of the instrument or at

maturity, they often require the holder to include in

income “original issue discount,” even though the

holder may or may not actually receive a cash payment

prior to maturity.

Is there a secondary trading market for SCDs?

Not always. Because they are not typically traded on

any exchanges, SCDs are generally not liquid

investments. Further, issuing banks rarely create a

secondary market for SCDs, and even if a secondary

market is created, such banks are under no obligation to

maintain it. Market-making activities with respect to

the SCDs are typically limited to the broker-dealers that

originally offered them. As a result, if an investor

decides to sell his or her SCD prior to maturity, the

amount he or she receives could potentially be lower

than the initial principal amount.

____________________

By Lloyd S. Harmetz, Partner,

Morrison & Foerster LLP

© Morrison & Foerster LLP, 2016

1

GARY PLASTIC PACKAGING CORP. v.

MERRILL LYNCH, PIERCE, FENNER &

SMITH, INC. No. 116, Docket 89-7295.

903 F.2d 176 (1990)

GARY PLASTIC PACKAGING CORPORATION, a New York corporation, for itself and others similarly

situated, Plaintiff-Appellant, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., a Delaware

corporation, and Merrill Lynch Money Markets, Inc., a Delaware corporation, Defendants-Appellees.

United States Court of Appeals, Second Circuit.

Argued November 3, 1989.

Decided May 14, 1990.

View Case Cited Cases Citing Case

Guy B. Bailey, Jr., Miami, Fla. (Bailey & Hunt, Miami, Fla., of counsel), for plaintiff-appellant.

William R. Glendon, New York City (Christopher W. O'Neill, Rogers & Wells, New York City, E. Michael

Bradley, Paul Windels III, Brown & Wood, New York City, of counsel), for defendants-appellees.

Before VAN GRAAFEILAND, PIERCE, and PRATT, Circuit Judges.

PIERCE, Senior Circuit Judge:

Gary Plastic Packaging Corp. ("Gary Plastic") appeals from a judgment of the United States

District Court for the Southern District of New York, Haight, Judge, dismissing its complaint,

with prejudice, for failure to prosecute, pursuant to Rule 41(b), Fed.R.Civ.P. On appeal, Gary

Plastic seeks review of an order denying its motion for class certification and disqualifying its

2

counsel. See Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 119

F.R.D. 344 (S.D.N.Y.1988).

I .

While we assume familiarity with both Judge Haight's reported decision and our prior opinion in

this case, Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d

230 (2d Cir.1985), we briefly restate the relevant facts.

Gary Plastic is a closely-held corporation. Its four shareholders are Marilyn Schur Hellinger

("Marilyn"); her husband, Gary Hellinger; and her brothers, Kenneth and Robert Schur. Gary

Hellinger is Gary Plastic's president and Robert Schur is its general counsel, vice-president and

assistant secretary. Robert Schur is also affiliated with the Miami law firm of Bailey & Dawes

(currently, Bailey & Hunt).

Since approximately 1973, Howard Schur, Marilyn's first cousin, has been a stockbroker

responsible for accounts for Gary Plastic and various members of the Schur family. From 1978

until 1983, Howard Schur was a broker with appellee Merrill Lynch, Pierce, Fenner & Smith,

Inc. ("Merrill").

In 1980, appellee Merrill Lynch Money Markets, Inc. ("Money Markets") initiated a program

which enabled investors to purchase fully-insured $100,000 certificates of deposit ("CDs")

issued by banks around the country.

Between May and July 1982, Gary Plastic purchased twelve short-term CDs through Merrill. In

July 1982, Robert Schur also purchased a short-term CD

[903 F.2d 178]

through Merrill for his own account. Howard Schur was the broker on all of these transactions.

In late July 1982, Gary Hellinger discovered that the CDs which Gary Plastic had bought through

Merrill paid less interest than CDs which could be bought directly from the banks which issued

them. Hellinger asked Robert Schur to investigate the situation.

Subsequently, Gary Plastic and Robert Schur each purchased CDs directly from an issuing bank.

Gary Plastic, however, continued investing in Merrill's CD program: in August 1982 and in

October 1982, it "rolled over" a total of four CDs which it had purchased through Merrill.

3

In 1983, Gary Plastic retained Bailey & Dawes and filed a complaint asserting claims, on behalf

of itself and a class which it sought to represent, against Merrill and Money Markets alleging

securities fraud. The action was filed in the Southern District of Florida and, in November 1983,

it was transferred to the Southern District of New York. In July 1985, after we reversed a grant

of summary judgment in favor of the defendants, Gary Plastic Packaging Corp. v. Merrill

Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir.1985), Gary Plastic moved for class

certification.

On February 10, 1988, Judge Haight denied this motion and, pursuant to DR 5-102(A) of New

York's Code of Professional Responsibility, disqualified Bailey & Dawes from pursuing Gary

Plastic's individual claims. Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner &

Smith, Inc., 119 F.R.D. 344 (S.D.N.Y.1988).

Judge Haight scheduled a pre-trial conference for April 22, 1988. Gary Plastic failed to appear at

this conference, whereupon Judge Haight informed its local counsel of his continuing obligations

and scheduled another conference for June 17, 1988. Plaintiff's local counsel appeared at this

conference and applied for leave to withdraw. Also on June 17, 1988, Gary Plastic moved to

reargue the certification and disqualification issues.

By order dated June 22, 1988, Judge Haight rejected the motion to reargue as untimely, relieved

local counsel, and dismissed Gary Plastic's individual claims, with prejudice, for failure to

prosecute. This order, however, gave Gary Plastic thirty days to find acceptable counsel and to

move to vacate the order of dismissal. Three months elapsed, and on September 23, 1988, noting

that Gary Plastic had not applied to have the action reopened, Judge Haight directed that

judgment be entered. This appeal followed and initially raises questions of appealability.

I I .

The denial of a class certification motion and the disqualification of counsel are interlocutory

orders which are not immediately appealable under 28 U.S.C. § 1291. See Coopers & Lybrand v.

Livesay, 437 U.S. 463, 98 S.Ct. 2454, 57 L.Ed.2d 351 (1978) (class certification); Richardson-

Merrell Inc. v. Koller, 472 U.S. 424, 105 S.Ct. 2757, 86 L.Ed.2d 340 (1985) (disqualification of

counsel); cf. Deposit Guar. Nat'l Bank v. Roper, 445 U.S. 326, 336, 100 S.Ct. 1166, 1173, 63

L.Ed.2d 427 (1980) (denial of class certification appealable after entry of final judgment).

Appellees assert that since Gary Plastic could not appeal the denial of its class certification

4

motion directly, it should not be permitted to obtain appellate review by refusing to prosecute its

individual claims.

In Coopers & Lybrand, the Court rejected the "death knell" doctrine which had treated as final,

for purposes of 28 U.S.C. § 1291, orders denying class certification which, as a practical matter,

made it unlikely that the disappointed class representative would pursue its individual claims.

437 U.S. at 469-77, 98 S.Ct. at 2458-62. In so holding, the Court identified several flaws relating

to the "death knell" doctrine: (1) the impropriety of courts, as opposed to the legislature,

formulating an appealability rule which turns upon the value of the plaintiff's individual

claim, id. at 472-73, 98 S.Ct. at 2459-60; (2) the potential waste of judicial resources involved in

determining whether the denial of class

[903 F.2d 179]

certification was, in fact, the "death knell" of the action, id. at 473-74, 98 S.Ct. at 2460-61; (3) the

discretion which the doctrine accorded to district judges, id. at 474-75, 98 S.Ct. at 2460-61; (4) the fact

that the doctrine operates only to the advantage of plaintiffs, id. at 476, 98 S.Ct. at 2462; and (5) the

intrusion of appellate courts in the trial process, id.

In Huey v. Teledyne, Inc., 608 F.2d 1234 (9th Cir.1979), relied upon by appellees, the district

court declined to certify a class and subsequently dismissed the individual claims when the

putative class representative refused to proceed. The Ninth Circuit held that a putative class

representative may not evade the policy against piecemeal review by waiving his individual

claims: "[w]here the record shows that the denial of class certification caused the failure to

prosecute, that ruling does not merge in the final judgment for purposes of appellate

review...." Id. at 1240; accord Bowe v. First of Denver Mortgage Investors, 613 F.2d 798 (10th

Cir.), cert. denied, 447 U.S. 906, 100 S.Ct. 2989, 64 L.Ed.2d 855 (1980); cf. Sere v. Board of

Trustees, 852 F.2d 285, 288 (7th Cir.1988) (interlocutory order does not merge into final

judgment where merger would reward party for bad faith and dilatory tactics).

By contrast, in Allied Air Freight, Inc. v. Pan American World Airways, Inc., 393 F.2d 441 (2d

Cir.), cert. denied, 393 U.S. 846, 89 S.Ct. 131, 21 L.Ed.2d 117 (1968), the district court had

stayed an action until the plaintiff exhausted its administrative remedies. When the plaintiff

refused to pursue these remedies, the court dismissed the action. While the appellant did not

deny that it had intentionally defaulted in order to obtain review of the interlocutory order

staying the action, this court held that the stay was reviewable since all interlocutory orders

merge into a final order. Id. at 444; cf. Drake v. Southwestern Bell Tel. Co., 553 F.2d 1185,

1186-87 (8th Cir.1977). Significantly, we expressly rejected the argument that permitting an

5

appeal through this mechanism "would encourage all would-be appellants from interlocutory

orders to do nothing [and] procure a dismissal ... which could then be appealed." Allied Air

Freight, 393 F.2d at 444.

We decline to follow Huey and Bowe and we reject appellees' assertion that Allied Air is no

longer valid in light of Coopers & Lybrand. We note that the concerns identified by the Court

in Coopers & Lybrand, supra at 178-179, are inapplicable where, as here, the putative class

representative's individual claims have been dismissed for failure to prosecute. Moreover, since

immediate appellate review will only be available to disappointed class representatives who risk

forfeiting their potentially meritorious individual claims, 7B C. Wright, A. Miller & M.

Kane, Federal Practice and Procedure § 1802, at 483 (2d ed. 1986), reviewing the merits of the

class certification order will not substantially undermine the policy against piecemeal review.

Thus, we hold that for purposes of appellate review, an order denying a motion for class

certification merges into a final judgment which results from the class representative's failure to

prosecute its individual claim. Cf. Nichols v. Mobile Bd. of Realtors, Inc., 675 F.2d 671, 675 (5th

Cir. Unit B 1982) (stating that Fifth Circuit has sub silentio refused to follow Hueyand Bowe).

I I I.

In evaluating whether class certification is appropriate, the district court is required to consider

the factors set forth in Rule 23, Fed.R.Civ.P. In light of the importance of the class action device

in securities fraud suits, these factors are to be construed liberally. Green v. Wolf Corp., 406 F.2d

291, 295, 298 (2d Cir.1968), cert. denied, 395 U.S. 977, 89 S.Ct. 2131, 23 L.Ed.2d 766 (1969).

In the present case, Judge Haight found that Gary Plastic was an inappropriate class

representative since its claim is subject to several unique defenses including its continued

purchases of CDs through Merrill despite having notice of, and having investigated, the alleged

fraud.

[903 F.2d 180]

While it is settled that the mere existence of individualized factual questions with respect to the class

representative's claim will not bar class certification, see, e.g., Green, 406 F.2d at 301; Dura-Bilt Corp. v.

Chase Manhattan Corp., 89 F.R.D. 87, 98-99 (S.D.N.Y.1981), class certification is inappropriate where a

putative class representative is subject to unique defenses which threaten to become the focus of the

litigation, see, e.g., Kline v. Wolf, 88 F.R.D. 696, 700 (S.D.N.Y.1981) (Weinfeld, J.), aff'd in relevant

part, 702 F.2d 400, 403 (2d Cir.1983); J.H. Cohn & Co. v. American Appraisal Assoc., Inc.,628 F.2d 994,

6

998-99 (7th Cir.1980). Regardless of whether the issue is framed in terms of the typicality of the

representative's claims, Rule 23(a)(3), Fed.R.Civ.P., or the adequacy of its representation, Rule 23(a)(4),

Fed.R.Civ.P., there is a danger that absent class members will suffer if their representative is preoccupied

with defenses unique to it. 7A C. Wright, A. Miller & M. Kane, Federal Practice and Procedure § 1764,

at 259-60 (2d ed.1986) (typicality); 3B J. Moore & J. Kennedy, Moore's Federal Practice ¶ 23.07[1], at

23-192 (2d ed. 1987) (adequacy of representation).

While the fact that Gary Plastic was the only plaintiff to come forward and seek to represent the

class weighs in favor of certification, see Green, 406 F.2d at 298; Dura-Bilt, 89 F.R.D. at 101, a

class "may only be certified if the trial court is satisfied, after a rigorous analysis, that the

prerequisites of Rule 23(a) have been satisfied," General Tel. Co. v. Falcon, 457 U.S. 147, 161,

102 S.Ct. 2364, 2372, 72 L.Ed.2d 740 (1982). In the factual context presented, we see no abuse

of discretion in the district court's refusal to certify a class action.

We need not consider whether the district court erred either in disqualifying Bailey & Dawes or

in dismissing Gary Plastic's individual claim with prejudice since, at oral argument, Gary Plastic

conceded that it does not intend to pursue its individual claims.

IV.

The judgment of the district court is affirmed. Each party shall bear its own costs.

http://www.leagle.com/decision/19901079903F2d176_11059/GARY%20PLASTIC%20PACKA

GING%20CORP.%20v.%20MERRILL%20LYNCH,%20PIERCE,%20FENNER%20&%20SMI

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