Court Rules That TBA Contract Investors Are Not SIPA Customers
- A federal bankruptcy judge has ruled that investors in TBA contracts do not have customer claims under the Securities Investor Protection Act of 1970. In re Lehman Brothers, Case No. 08-01420 (Bankr. S.D.N.Y. Dec. 8, 2011). The court's decision confirms the determination of the trustee for the SIPA liquidation of Lehman Brothers Inc., which was supported by the Securities Investor Protection Corporation. The ruling leaves the claimants with only unsecured contract claims against the Lehman Brothers estate. The claimants are expected to appeal.
For those who are unfamiliar with TBA contracts, the import of the decision is greater than it might immediately appear: The vast majority of trading in mortgage-backed securities occurs in the TBA market, and the trading volume of the TBA market is second only to the market for United States Treasury securities. A TBA contract is a bilateral agreement to buy or sell, on a delivery-versus-payment basis, "to-be-announced" mortgage-backed securities that are issued or guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. Typically, there is an interval of several weeks between the trade date and the settlement date, and although the contract is binding and the key terms of the underlying securities are specified, the mortgage-backed securities to be conveyed are not identified until 48 hours before the settlement date. During the interval between trade and settlement, TBA contracts trade much like securities, albeit securities that can have either positive or negative value: The TBA contracts are assigned CUSIP numbers based on their parameters, and investors can realize gain or loss by pairing off TBA contracts with offsetting transactions, resulting in a net payable or receivable that is due on the settlement date.
In the Lehman Brothers case, hundreds of claimants filed thousands of claims for TBA contracts, based upon market appreciation between their respective trade dates and the filing date for the SIPA case. In a decision based upon the claims made by representative claimants, the court ruled that the trustee was correct in his determination that claims based on TBA contracts are not properly classified as customer claims for purposes of SIPA. The key factor was that, because TBA contracts are entered into on a delivery-versus-payment basis, the claimants did not meet the SIPA requirement of having "entrusted" cash or securities to a broker-dealer. The court also ruled that the TBA contracts themselves are not "securities" for purposes of SIPA. The court's ruling does not conclusively bind parties other than the representative claimants. However, the court intends the ruling to be the law of the case, so other claimants would need to identify distinguishing facts or circumstances applicable to their own claims.
The ruling places mutual funds that invest in mortgage-backed securities in an odd position. In general, mutual funds are subject to rigorous custody requirements for their portfolio holdings. Under the court's ruling, however, the value of a TBA contract is entirely dependent on the solvency of the counterparty broker-dealer. The court's ruling can also be expected to place additional pressure on broker-dealers that are active in the TBA market, since the slightest hint of doubt will cause their customers instantly to be unwilling to deal with them.
The court's opinion does not seem to be available yet online, but I have placed a copy on the FundLaw web page (free registration with Yahoo Groups may be required), and it is available at
John M. Baker <JMB@...>
Stradley Ronon Stevens & Young, LLP http://www.stradley.com
1250 Connecticut Avenue, NW, Suite 500
Washington, DC 20036
FundLaw Listowner http://groups.yahoo.com/group/fundlaw
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