Opinion ID: 2307607
Heading Depth: 1
Heading Rank: 3

Heading: Brokerage Account Customer Agreements

Text: RCM Customers held securities and other assets in non-discretionary securities brokerage accounts with RCM pursuant to a standard form Securities Account Customer Agreement with RCM and RSL (the Customer Agreement). RCM Customers' securities and other property deposited in their accounts were not segregated but were commingled in a fungible pool. As a result, no particular security or securities could be identified as being held for any particular customer. Such a practice is common in the brokerage industry. See Levitin v. PaineWebber, Inc., 159 F.3d 698, 701 (2d Cir.1998) (Customer accounts with brokers are generally not segregated, e.g. in trust accounts. Rather, they are part of the general cash reserves of the broker.); U.C.C. § 8-503 cmt. 1 ([S]ecurities intermediaries generally do not segregate securities in such fashion that one could identify particular securities as the ones held for customers.); Adoption of Rule 15c3-2 Under the Securities Exchange Act of 1934, Exchange Act Release No. 34-7325, 1964 WL 68010, at  (1964) ([W]hen [customers of broker-dealers] leave free credit balances with a broker-dealer the funds generally are not segregated and held for the customer, but are commingled with other assets of the broker-dealer and used in the operation of the business.). [3] The Customer Agreement included a margin provision that permitted RCM Customers to finance their investment transactions by posting securities and other acceptable property held in their accounts as collateral for margin loans extended by RCM. Under the margin provision, RCM, upon extending a margin loan to a customer, had the right to use or rehypothecate [4] the customer's account securities and other property for RCM's own financing purposes. For example, RCM might pledge customers' securities as collateral for its own bank loans or sell the securities pursuant to repurchase agreements (repos). [5] The parties dispute whether the rehypothecation rights were limited to securities serving as collateral or whether they also included securities that were excess collateral. We discuss this dispute, infra. We briefly provide a generic background. From an ex ante perspective, such margin provisions provide distinct, but related, economic benefits to both the brokerage and its customers. For the customers, the margin provision provides the ability to invest on a leveraged basis and thereby earn amplified returns on their investment capital. As for the brokerage, the ability to rehypothecate its customers' securities presents, among other things, an additional and inexpensive source of secured financing. See Michelle Price, Picking over the Lehman CarcassAsset Recovery, Banker, Dec. 1, 2008, available at 2008 WLNR 24064913 ([Without rehypothecation rights] the prime broker would have to use its unsecured credit facilities, the cost of which is currently in the region of 225 to 300 basis points above that of secured credit.). While these types of margin provisions provide economic benefits to both parties, like any creditor-debtor arrangement they also create counterparty risks. The brokerage bears the risk that its customers default on margin loans that could become under-secured due, for example, to a precipitous decline in the value of the posted collateral. Likewise, of course, the customers face the possibility that the brokerage, having rehypothecated its customers' securities, fails, making it unable to return customer securities after those customers meet their margin debt obligations. Counterparty risks associated with margin financing have long been recognized by industry participants and regulators alike. In the United States, for example, margin financing has been subject to federal [6] and state [7] regulation, and, even longer still, to self-imposed limitations by brokers and self-regulating organizations. [8] In general, margin restrictions attempt to reduce the counterparty risk associated with margin financing by limiting the types of securities that can be posted by an investor as collateral for a margin loan and limiting the amounts that can be borrowed against that collateral. [9] Similarly, at least in the United States, brokers' rehypothecation activities have long been restricted by federal [10] and state law, [11] and by rules promulgated by the principal stock exchanges. [12] These restrictions generally limit a broker's ability to commingle its customers' securities without their consent, and limit a broker's rehypothecation rights with respect to a customer's excess margin securities i.e., securities not deemed collateral to secure a customer's outstanding margin debt, and fully-paid securities, i.e., securities in a cash account for which full payment has been made. [13] The upshot of these restrictions is that in the United States, brokers and investors alike are limited in the amount of leverage that is available to amplify returns. However, since the development of globalized capital and credit markets, investors have sought to avoid these limitations by seeking unrestricted margin financing through, among other sources, unregulated offshore entities. See, e.g., Metro-Goldwyn-Mayer, Inc. v. Transamerica Corp., 303 F.Supp. 1354 (S.D.N.Y.1969) (leveraged buyout of Metro-Goldwyn-Mayer financed through the Eurodollar market, thus avoiding U.S. margin restrictions); Martin Lipton, Some Recent Innovations to Avoid the Margin Regulations, 46 N.Y.U. L.Rev. 1 (1971). In recent years, U.S.-based broker-dealers have satisfied investor demand for unrestricted margin financing by providing financing to institutional investors, e.g., hedge fundsthrough, inter alia, unregulated foreign affiliates that are not subject to U.S. margin or rehypothecation restrictions. See Noah Melnick et al., Prime Broker Insolvency Risk, Hedge Fund J., Nov. 2008 (US prime brokers commonly rely on [foreign] unregulated affiliates for margin lending or securities lending and/or to act as custodians in non-US jurisdictions.); Sherri Venokur & Richard Bernstein, Protecting Collateral against Bank Insolvency RiskPart I, Sept. 8, 2008, at 1 (U.S. registered broker-dealers enter into derivatives transactions through their unregulated affiliates in order to reduce capital reserve requirements but also to be able to use counterparty collateral.); Roel C. Campos, SEC Comm'r, Remarks before the SIA Hedge Funds & Alternative Investments Conference (June 14, 2006) (noting that certain hedge fund financing is generally booked through foreign, unregulated affiliates). In the instant case, RCM held itself out as, and the record indicates that at least some of the RCM Customers understood it to be, an unregulated offshore broker.