United States: Monitoring Securities Lending Programs In Today’s Market Environment

The recent instability, and extreme volatility, experienced by the financial markets during these past few weeks has been of some concern to our clients who are fiduciaries and investment advisors of private employee benefit plans subject to the Employee Retirement Income Security Act of 1974 ("ERISA") — as well as to public employee benefit plans, foundations, mutual funds, insurance companies and other institutional owners of securities — which loan their securities. In just the past week alone, several unprecedented events have occurred in the U.S. and worldwide stock and fixed-income securities markets, which have had a severe adverse effect on a number of banks, insurers and other financial services institutions (and, of course, on the value of their securities). These developments, together with the continued extreme turbulence in equity and credit markets around the globe, should prompt plan fiduciaries, and financial services companies that either operate or participate in such programs, to consider whether there now may be unrecognized, heightened risks inherent in their Securities Lending Programs.

Nature Of Securities Lending

For at least the past quarter century, securities lending has been utilized to augment investment income on securities held in security owners' investment portfolios by lending them to borrowers (many of whom typically use the securities to cover positions that are sold "short") on a fully collateralized basis. Where securities loans are secured by cash, the bank, trust company, custodian or other lending agent, on the owner's behalf, invests the cash and the return on the cash (less a negotiated rebate paid to the borrower and the agent's fee) to produce incremental earnings for the lender. Where loans of securities are collateralized by other than cash, such as U.S. Treasury obligations or obligations of agencies or other government-sponsored enterprises, the lender's return is based on a negotiated loan fee collected from the borrower by the lending agent.

Fiduciary Duty To Prudently Monitor Securities Lending Programs

Fiduciaries of all private benefit plans subject to ERISA, and fiduciaries of many (if not most) public plans, are required by the law applicable to their plans to discharge their duties with respect to the plans for the exclusive benefit, and solely in the interest, of the plans' participants (and their beneficiaries) and, for ERISA plans, in accordance with ERISA's "prudent expert" standard of care. This standard of fiduciary prudence governs many actions the fiduciary takes (or omits) on behalf of such plans, and may include decisions involving the lending of plan securities.

As with other plan asset investments, each plan fiduciary should continually monitor its benefit plan's Securities Lending Program in accordance with a prudent procedure. Although all aspects of the program should be carefully reviewed, there are several criteria that may warrant your (or your investment advisor's) immediate attention, especially in the current volatile market environment, in order to ensure that:

  • The collateralization of the loaned securities remains at a sufficiently protective level;
  • The banks, brokers, dealers, and other financial services industry organizations who borrow the securities continue to be financially stable, and fully able to fulfill their obligations under their securities borrowing agreements;
  • The investment vehicles into which the collateral generated by securities lending is placed is safe and remains prudent; and
  • The lending agent(s) indemnifying the plan (or other entity) owning such securities against borrower defaults continue(s) to be financially sound.

Potential Risks Posed By Securities Lending In The Current Market Environment

While securities lending generally has been considered to be a relatively low-risk means of enhancing an institution's securities portfolio investment returns, it is by no means risk-free. Losses can occur both in connection with (i) the investment of cash collateral; and (ii) as a result of a counterparty default at a time when, due to relative overnight pricing movements of collateral vis-à-vis loaned securities, the institution is left in an under-secured position. The recent violent daily swings in the market value of certain stocks – across several market sectors – is precisely the type of environment that can lead to unexpected, and possibly very significant, under-collateralization (which, in turn, can lead to loss scenarios that can – under certain circumstances – be quite substantial).

Thus, among other cautionary measures that may need to be initiated, the investment vehicle into which the collateral generated by securities lending is placed should also be examined in order to determine whether it continues to be appropriate and prudent. In particular, money market funds that were previously regarded as virtually risk-free may no longer warrant that assumption (without conducting further due diligence).

Moreover, while many banks (and other lending agents) indemnify their securities lending customers against borrower defaults, but not reinvestment risk, that indemnity is only as good as the creditworthiness of the guarantor itself. Accordingly, plan fiduciaries should consider whether it is appropriate to undertake a careful evaluation of the creditworthiness of the custodian (or other lending agent) administering their Securities Lending Program and/or consider engaging more than one custodian (or other lending agent) with respect to such program in order to diversify risk.

Beyond the general concerns raised above, fiduciaries should consider, in consultation with their investment advisors, whether to analyze the following specific issues:

  • Nature of Counterparty. Borrowers of securities are typically financial services institutions, either acting on their own behalf in connection with their proprietary trading or as agent on behalf of customers (through prime brokerage arrangements or otherwise). Given the unprecedented weakening of the creditworthiness of several major banks and broker-dealers within the past two weeks alone, you may want to consider an immediate re-evaluation of your Securities Lending Program's list of authorized borrowers in conjunction with both the plan's custodian that administers the program and the plan's investment consultant.
  • Permitted Collateral. Generally, collateral posted by a borrower in respect of a securities lending transaction consists of cash, U.S. Treasury obligations, Government National Mortgage Association issues and, occasionally, government-sponsored enterprises such as Fannie Mae and Freddie Mac. In light of the recent severe economic stress experienced by both Fannie Mae and Freddie Mac, and despite the fact that the U.S. Government is now more strongly standing behind each of these entities, fiduciaries should consider requesting the opinion of their investment advisor as to whether the advisor believes that it might be prudent, under the circumstances, to limit non-cash collateral (at least temporarily) to short-term direct obligations of the U.S. Government.
  • Required Collateralization. Generally, loans of U.S. Government securities are collateralized at 102% of the value of the loaned securities, and certain other securities are collateralized at between 103% and 105% of their fair market value. Given the recent extreme volatility in securities trading and price movements within the market, reconsideration of the adequacy of the collateral cushion (i.e., the degree of required over-collateralization) should be considered in consultation with your plan's investment advisors.
  • Mark-to-Market Policies. Security loans are "marked-to-market" daily to maintain required collateralization levels. However, some lending agents employ an informal (or formal) procedure whereby they do not require the borrower to post collateral unless and until the value of the collateral actually falls below 100% of the value of the loaned securities, rather than falling below the initial prescribed collateralization level of between 102% and 105%. Fiduciaries should consider whether their agent employs such a practice and, if so, whether adherence to it in the current market environment may be exposing their investment portfolios to an inappropriate level of risk.
  • Cash Collateral Reinvestment. The profit expected to be generated from cash collateralized securities loans obviously is dependent upon the income generated by the investment of cash collateral and the nature (and relative safety) of the investment vehicles into which it is placed. The permitted vehicles generally utilized for such investment should also be reviewed carefully to ensure that they continue to be prudent and are not subject to undue market risk or loss of principal. Typically, cash collateral is invested in one of the following short-term investment vehicles:
    • Some type of group or commingled short-term investment fund ("STIF") established by the plan's custodial bank or an affiliate;
    • A money market fund;
    • Specific transactions, such as repurchase agreements (collateralized by U.S. Government obligations, with a counterparty meeting certain credit or risk parameters);
    • Commercial paper having a specified rating; or
    • Short-term bank deposits.

Given the recent disclosures in the marketplace concerning money market funds that heretofore have almost always maintained a share value of one dollar (i) that have either imposed unexpected moratoriums on customer withdrawals; and/or (ii) whose share value has fallen below one dollar, and amidst growing concern as to the obligors in respect of the underlying investments of such funds, a careful review of the investment criteria for securities lending cash collateral (including as to obligor, type of instrument, concentration, diversification, weighted average maturity, liquidity, volatility, and all other relevant criteria) should be undertaken by fiduciaries in conjunction with their professional advisors.

  • Short Sales. As noted above, entities generally borrow securities to avoid failures-to-deliver or pursuant to permitted arbitrage or hedging activities. A significant portion of borrowings are by short-sellers—those who sell the security before they own it, borrow the security to settle the sale trade, and eventually hope to purchase the security in the marketplace to satisfy the borrowing (hopefully at a price less than that at which the security was initially sold). Many commentators have concluded that short-selling skews market volatility and exacerbates downward movements of the prices of targeted securities, akin to manipulation. The SEC has recently imposed a ban on the short-selling of financial services entities (very broadly defined). The extent to which specific securities available for loan should be restricted or withheld from lending in this environment should be considered by a securities lender (in conjunction with the lender's advisors and the custodian).

www.proskauer.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions