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
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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
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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.”
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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.
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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.
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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.
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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
TH,%20INC#