Opinion ID: 411108
Heading Depth: 2
Heading Rank: 5

Heading: Functional Analysis of Commercial Paper

Text: 34 The language and the legislative history of the Glass-Steagall Act strongly suggest that commercial paper should be viewed as a loan rather than as a security for the purposes of the Act. However, as we have seen, neither the language nor direct evidence from the legislative history is decisive of the question before us. There is no foolproof formula by which we can decide whether the commercial paper marketed by Bankers Trust constitutes a security. Rather, as the Board observed, 35 a broad generic or literal reading of the term security would likely encompass a number of instruments that banks routinely deal with in the course of their business and would, consequently, be contrary to the basic purpose of the Act. On the other hand, a highly technical or formalistic approach might permit evasions of the mandate of Congress. 71 36 Because neither the literal language of the statute nor other expressions of congressional intent available to us directly indicate whether commercial paper is a security, it is necessary to conduct a functional analysis of Bankers Trust's commercial paper to resolve this question. The problem becomes whether classifying commercial paper as a security would further the policies of the Act. As the Board phrased this inquiry:[I]f a particular kind of financial instrument evidences a transaction that is more functionally similar to a traditional commercial banking operation than to an investment transaction, then fidelity to the purposes of the Act would dictate that the instrument should not be viewed as a security. 72 37 In adopting this functional analysis, the Board followed the Supreme Court's reasoning in its recent cases construing the Glass-Steagall Act. In Investment Company Institute v. Camp (ICI I) the Court noted that 38 Congress was concerned that commercial banks in general and member banks of the Federal Reserve System in particular had both aggravated and been damaged by stock market decline partly because of their direct and indirect involvement in the trading and ownership of speculative securities. The Glass-Steagall Act reflected a determination that policies ... which might otherwise support the entry of commercial banks into the investment banking business were outweighed by the hazards and financial dangers that arise when commercial banks engage in the activities proscribed by the Act. 73 39 Thus, if confronted with a banking practice which involves the sale of securities and for that reason threatens the hazards at which the Act is aimed, neither the Federal Reserve Board nor this court is free to balance these hazards against the perceived benefits of the proposed practice. If the practice does not threaten to cause these hazards, however, we need undertake no such balancing. Rather, we effectuate the will of Congress by concluding that the proposed banking practice is not within the scope of the statutory proscription. 40 For example, in ICI I the Court found that the bank's sale of participations in a bank-sponsored mutual fund posed the dangers that the Glass-Steagall Act was designed to prevent; the Court concluded that these participations were securities within the meaning of the Act. 74 Once these participations were found under this functional analysis to be securities, the literal language of the Act prohibited sale by the bank. 75 41 The Federal Reserve Board, in resolving the present case, therefore correctly focused on whether the commercial paper marketed by Bankers Trust functioned economically as a loan or as a security. Only if commercial paper displayed the economic characteristics of a security would the marketing of commercial paper by Bankers Trust cause the hazards the Act was designed to prevent. The Board concluded that, in all relevant respects, the commercial paper had the economic characteristics of a loan. 76 We agree. 42 It is useful to review the traditional lending functions of commercial banks. The commercial lender extends short-term credit to businesses to finance immediate needs for working capital. 77 To assure itself of timely repayment, the commercial bank carefully evaluates the credit-worthiness of the borrower and the borrower's representations as to the use of funds. In recent years, the lender has characteristically been either a bank or a syndicate of lenders, which may include banks and lending institutions such as credit or mortgage companies. 78 43 We find that the commercial paper at issue here has the economic characteristics of a traditional loan. Purchase of commercial paper, like lending by a commercial bank, represents a very reliable means by which the lender may earn a return on excess cash over a short period of time. Several features of the commercial paper market are salient in this respect. 44 First, the default rate on commercial paper is extremely low: only highly solvent corporations, with the best possible bond ratings, are able to market commercial paper. Indeed, the default rate on commercial paper is much lower than that on ordinary commercial loans made to high-grade commercial customers. 79 45 Second, Bankers Trust commercial paper, like most commercial loans, is of very short maturity: it is generally redeemable at face value within 30 to 90 days. 80 Short maturity not only makes commercial paper a very liquid investment; it also reduces risk, because the financially strong corporations which can issue commercial paper are unlikely to deteriorate over the short period during which purchasers must hold the paper. 46 Third, because commercial paper is sold by Bankers Trust in denominations averaging one million dollars or more, 81 this paper is placed only with sophisticated purchasers--large institutions such as pension funds, money market mutual funds, insurance companies and nonfinancial corporations with large amounts of idle cash. 82 These purchasers, like commercial banks, are well able to evaluate the riskiness of the investments by verifying representations about the issuers. Three independent rating services also conduct thorough periodic investigations of issuers' financial condition. 83 47 For all these reasons, investment in commercial paper, far from resembling securities speculation, is less risky even than banks' ordinary commercial lending. 84 The key difference between the commercial paper sold by Bankers Trust and the traditional lending of commercial banks is that capital is lent by other investors rather than by the bank. 85 In the traditional loan transaction, the commercial bank purchases commercial paper; in the present case, the bank acts as agent in the sale of commercial paper. The bank is simply on the other side of the transaction. The question which faced the Board is whether commercial paper should be considered a security merely because the bank acts as the seller rather than the purchaser of the commercial paper--i.e., whether the role of the bank in and of itself makes the transaction one prohibited by the Glass-Steagall Act. 86 48 We agree with the Board that Bankers Trust may sell as well as purchase commercial paper. The bank's role as seller does not threaten the bank with those dangers which the Glass-Steagall Act was designed to prevent. Because commercial paper is like a loan rather than a security, marketing of commercial paper by the bank does not have the same economic impact on the bank as would marketing of securities. 49 This is confirmed by an analysis of the dangers which the Glass-Steagall Act was designed to prevent. 87 One such danger was that bank underwriting of securities may tie up depositors' funds in speculative securities. Bankers Trust's sale of commercial paper does not create this danger because of the features of commercial paper already noted. First, the bank acts simply as an agent in the sale of commercial paper; it does not agree to purchase the paper on its own account--i.e., with the funds of depositors. 88 Second, commercial paper is of prime quality, sold only by corporations with well-established credit ratings: commercial paper is not a speculative holding. 89 Third, commercial paper is held by the lender only for 30 to 90 days: 90 the lender may readily convert his holdings to cash and does not bear the risk of long-term fluctuations in the value of the enterprise. 50 The other set of dangers addressed by the Glass-Steagall Act comprises the conflicts of interest that arise when a commercial bank underwrites securities. 91 Again, Bankers Trust does not face these conflicts. 51 First, the bank cannot use its credit facilities in order to facilitate sale of its commercial paper. Because the interest on a commercial loan is higher than that paid out on commercial paper, a purchaser of commercial paper would not use a commercial loan to finance its purchases. 92 Conversely, the bank is under no incentive to advance unsound loans to shore up its issuers of commercial paper, because these issuers must be, by the nature of the commercial paper market, financially sound. 93 52 Second, Bankers Trust is not in a position to abuse its reputation for prudence, or give unreliable financial advice to its depositors, in order to promote the sale of commercial paper. Commercial paper is purchased only by large sophisticated buyers who are capable themselves of evaluating the wisdom of their investment. 94 Moreover, commercial paper is very low-risk, and is issued only by very solvent corporations about whose financial prospects information is widely available. 95 It is inconceivable that a commercial bank such as Bankers Trust could, under these conditions, seek improperly to influence potential purchasers of commercial paper. 96 53 Finally, the bank's reputation for prudence will not suffer by its association with the issue of commercial paper. Commercial paper is a highly sound short-term investment. And even if a commercial paper issuer were to default, the sophisticated purchasers of commercial paper will understand that this paper is not backed by the guarantees on commercial bank deposits. 54 The Board's functional analysis leads inexorably to the conclusion that Bankers Trust's commercial paper is not a security within the meaning of the Glass-Steagall Act. Transactions in commercial paper display the key economic characteristics of a commercial bank loan; and, because of these characteristics, Bankers Trust's dealings in commercial paper pose none of the hazards the Glass-Steagall Act was designed to prevent.