CONSTITUTIONALITY OF INVESTMENT IN SECURITIES LENDING AGREEMENTS AND REVERSE REPURCHASE AGREEMENTS

FUNDS ‑- INDUSTRIAL INSURANCE ‑- PENSION ‑- SCHOOL FUNDS ‑- TRUSTS ‑- CONSTITUTIONALITY OF INVESTMENT IN SECURITIES LENDING AGREEMENTS AND REVERSE REPURCHASE AGREEMENTS

The permanent common school fund, public pension and retirement funds, and the industrial insurance trust funds may be invested in securities lending agreements and reverse repurchase agreements pursuant to amendments to the Washington Constitution which allow such funds to be invested as authorized by law. 

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                                                                February 25, 1986 

Honorable Robert V. Graham
State Auditor
Legislative Building
Olympia, WA 98504

  Cite as:  AGO 1986 No. 5                                                                                                                 

 Dear Sir:

             By letter previously acknowledged you referenced an agency agreement and a letter addendum thereto which authorize The Chase Manhattan Bank to enter into security lending agreements and reverse repurchase agreements on behalf of certain public funds.  You then asked our opinion on several questions, which we group and paraphrase as follows:

             (1) Does the state, through the State Treasurer or the State Investment Board, have the authority to enter into securities lending agreements or reverse repurchase agreements on behalf of the following:

             a. the school permanent funds,

             b. public pension or retirement funds, or

            c. industrial insurance funds?

             (2) The term "collateral" appears in the agreement and the addendum thereto, and provides that certain collateral held by The Chase Manhattan Bank may be held in the name of the bank.  Does the state have rights to  [[Orig. Op. Page 2]] such "collateral" beyond those of an unsecured creditor of The Chase Manhattan Bank?

             We answer your questions in the affirmative for the reasons stated in the following analysis.

                                                                      ANALYSIS

             The State Investment Board has the statutory authority to invest public trust and retirement funds.  RCW 43.33A.010 provides as follows:

             "The state investment board shall exercise all the powers and perform all duties prescribed by law with respect to the investment of public trust and retirement funds."

             In addition, specific statutes relating to individual funds authorize the State Investment Board to invest and reinvest funds in excess of current requirements.  See RCW 41.32.207 (State Teachers' Retirement Fund), RCW 41.40.072 (Public Employees' Retirement Fund), RCW 43.43.170 (State Patrol Retirement Fund), RCW 43.84.170 (Permanent Common School Fund), and RCW 51.44.100 (Industrial Insurance Funds).

             Pursuant to this authority, the State Investment Board wrote a letter Addendum to an Agency Agreement between the State and The Chase Manhattan Bank, which addendum authorized the bank to loan securities held in the state's account.  You have indicated these include securities held on behalf of the permanent common school fund, public pension or retirement funds, and industrial insurance funds.1/

             The terms of the authorized securities loans are set forth in a "Master Securities Lending Agreement."  Under this agreement, the bank, acting as trustee, would lend securities by delivering them to a borrower who would transfer to the bank collateral required to secure the loan.  Three forms of collateral are acceptable:  (1) cash; (2) securities which are obligations of or guaranteed by the United States Government; or (3) letters of credit.  Compensation  [[Orig. Op. Page 3]] for a securities loan would be paid in an amount to be specified by individual addenda to the "Master Securities Lending Agreement."

            The letter Addendum to the Agency Agreement permits cash held as collateral for securities lending agreements to be invested in reverse repurchase agreements.  "Reverse Repurchase Agreement Guidelines" appended to that letter contain sparse details of the terms of such agreements.  Our understanding of the nature of these transactions and their customary provisions is therefore based upon independent sources.2/

              A repurchase agreement, commonly known as a "repo," typically involves a seller who delivers securities to a buyer in return for cash.  Simultaneously, the seller agrees to repurchase the securities (or securities of the same issue) from the buyer on a set future date for the same price plus interest on the price.3/ If for some reason the seller fails to repurchase the securities, the buyer retains ownership.  The "Reverse Repurchase Agreement Guidelines" specify United States treasury or agency issues as the only securities acceptable for purchase.

             The component transactions which comprise a repurchase agreement typically are completed in short term, often overnight.  A repurchase agreement is a method which a seller uses to alleviate short-term cash demands or take advantage of favorable market conditions.  The benefit for the buyer is the opportunity to invest large amounts of cash which are available for only a short period of time and therefore would otherwise be idle or invested at a much lower rate.

              [[Orig. Op. Page 4]]

            The Agency Agreement requires The Chase Manhattan Bank to establish a custody account in the name of the State of Washington and to hold in the custody account all securities received by the bank for the state, including securities held as collateral.  Those securities which customarily are held in registered form are registered in the name of the bank's nominee.

 Question (1):

             Your first question asks whether the state, through the State Treasurer or the State Investment Board, has the legal authority to enter into securities lending agreements or reverse repurchase agreements on behalf of the permanent common school fund, public pension or retirement funds, or industrial insurance funds.  As noted above, the State Investment Board exercises all powers with respect to investments of the specified funds.

             Your primary concern, as we understand it, is whether these transactions involving securities held on behalf of the specified public funds are in violation of Wash. Const., Art. VIII, § 5.  Section 5 provides as follows:

             "The credit of the state shall not, in any manner be given or loaned to, or in aid of, any individual, association, company or corporation."

 The more detailed provisions of Article VIII, § 7, which apply to municipal corporations, have been read into Article VIII, § 5 by implication.  See,e.g.,Higher Education Authority v. Gardener, 103 Wn.2d 838, 845, 699 P.2d 1240 (1985); Washington Health Care Facilities Authority v. Ray, 93 Wn.2d 108, 115, 605 P.2d 1260 (1980).  Section 7 provides as follows:

             "No county, city, town or other municipal corporation shall hereafter give any money, or property, or loan its money, or credit to or in aid of any individual, association, company or corporation, except for the necessary support of the poor and infirm, or become directly or indirectly the owner of any stock in or bonds of any association, company or corporation."

             Article VIII, § 5 has been construed by our Supreme Court as prohibiting the state from giving or loaning its money or credit to any private entity, with the express exception of the necessary support of the poor and infirm and the implied exception of  [[Orig. Op. Page 5]] exercising other public governmental functions.  In re Marriage of Johnson, 96 Wn.2d 255, 261-62, 634 P.2d 877 (1981).

             Additional exceptions have been carved out by constitutional amendment.  Wash. Const., Art. XVI, § 5 was amended by 1966 by voter approval of Amendment 44, to provide as follows:

             "The permanent common school fund of this state may be invested as authorized by law."

             Two years later voter approval of Amendment 49 added a new article and section to the Constitution, Wash. Const., Art. XXIX, § 1, to provide as follows:

             "Notwithstanding the provisions of sections 5, and 7 of Article VIII and section 9 of Article XII or any other section or article of the Constitution of the state of Washington, the moneys of any public pension or retirement fund may be invested as authorized by law."

 Article XXIX, § 1 was again amended in our most recent election to include industrial insurance trust funds.  This provision was amended on November 5, 1985 by voter approval of HJR 12 (effective December 5, 1985) to provide as follows:

             "Notwithstanding the provisions of sections 5, and 7 of Article VIII and section 9 of Article XII or any other section or article of the Constitution of the state of Washington, the moneys of any public pension or retirement fund or industrial insurance trust fund may be invested as authorized by law."

             These constitutional amendments allowing the specified funds to be invested prevail over the provisions of Article VIII, § 5.  An amendment to the Constitution will prevail over an original constitutional provision if it either (a) specifically repeals the application of the prior provision or (b) is inconsistent with the prior provision and cannot be harmonized without defeating the clear intent of the latter provision.  Port of Longview v. Taxpayers, 85 Wn.2d 216, 232-3, 533 P.2d 128 (1974).

             By the express terms of Article XXIX, § 1 (as amended by voter approval of HJR 12), any public pension or retirement fund or industrial insurance trust fund may be invested as authorized by law "[n]otwithstanding the provisions of sections 5, and 7 of  [[Orig. Op. Page 6]] Article VIII and section 9 of Article XII. . . ."4/ Although Amendment 44 does not contain a similar express repeal, the changes accomplished by this amendment indicate a clear intent to free the investment of the permanent common school fund from the restrictions of Article VIII, § 5.

             Prior to approval of Amendment 44, Article XVI, § 5 (Amendment 1) read as follows:

             "None of the permanent school fund of this state shall ever be loaned to private persons or corporations, but it may be invested in national, state, county, municipal or school district bonds."

             This language was deletedin toto with passage of Amendment 44 and the following language was adopted:

             "The permanent common school fund of this state may be invested as authorized by law."

             This express authorization would be unnecessary and superfluous unless it was intended to exempt investment of the permanent common school fund from constitutional restrictions.  The Constitution is not a grant, but a limit on the legislature's law-making power.  Public Utility District No. 1 v. Taxpayers of Snohomish County, 78 Wn.2d 724, 728, 479 P.2d 61 (1971).  It is presumed that the legislature does not engage in meaningless acts.  State v. McCullum, 98 Wn.2d 484, 493, 656 P.2d 1064 (1983).  Accordingly, it must be presumed that when the 1965 Legislature passed Senate Joint Resolution No. 22, Part 2 (which, when approved by the voters, became Amendment 44) it intended to repeal the application of constitutional restrictions to investment of the permanent common school fund.

             After passage by the 1965 Legislature, Senate Joint Resolution No. 22, Part 2 was submitted to the voters for their approval.  The official explanatory comments of the Attorney General published in  [[Orig. Op. Page 7]] the 1966 Official Voters' Pamphlet noted the additional authority which would be granted by the amendment.  Those comments were published in the voters' pamphlet as follows:

             "The Law as it now exists:

             "Article XVI, section 5 (Amendment 1) of the state constitution presently restricts the state in investing money in the state permanent school fund (derived from the proceeds of leases or sales of lands granted to the state by the federal government at the time of statehood for the support of public educational institutions) to investments in national, state, county, municipal or school district general obligation bonds.

             "Effect of Senate Joint Resolution No. 22 ‑ Part 2 if approved into Law:

             "The proposed constitutional amendment would eliminate this restriction.  Additionally, it would expressly permit the permanent common school fund to be invested in such manner as may be authorized by act of the legislature."

             In determining the voters' intent when they approved a ballot proposition, one may consider explanatory statements published in the Official Voters' Pamphlet pursuant to RCW 29.81.010, et seq. Port of Longview v. Taxpayers, 85 Wn.2d at 231.  See also State v. Green, 91 Wn.2d 431, 439, 588 P.2d 1370 (1979); State ex rel. PUD No. 1 v. Wylie, 28 Wn.2d 113, 127-28, 182 P.2d 706 (1947).  These explanatory comments indicate the probable intent of the voters was not only to remove existing restrictions, but also to affirmatively permit investment limited only by the extent of legislative authorization.

             The next question which must be resolved, then, is whether securities lending agreements and reverse repurchase agreements are "investments" which may be authorized pursuant to Article XVI, § 5 (Amendment 44) and Article XXIX, § 1 (as amended by voter approval of HJR 12).

             The word "invest" as applied to money comprehends the putting out of funds for income or profit, and is equally inclusive of a loan or a purchase.  Blue River Sawmills, Ltd. v. Gates, 225 Or. 439, 358 P.2d 239, 254 (1960).  This modern usage of the term "invest" is the same as the definition of the term adopted inState ex rel. Hellar v. Young,  [[Orig. Op. Page 8]] 18 Wash. 21 (1897).  In construing an act which authorized the state treasurer to invest certain monies, our Supreme Court quoted State ex rel. Stull v. Bartley, 59 N.W. 907 (Neb. 1894) with approval as follows at p. 25:

             "We are aware of no precise legal definition of the term "investment" as applied to money.  In common speech it means the loaning or putting out of money at interest, so as to produce an income. . . .  It implies the contractual relation of purchaser and seller, or borrower and lender, and in that sense it is employed in the constitution.'" [Citations omitted.]

             The word "loan" imports an advancement of money or other personal property under a contract whereby the person to whom the advancement is made binds himself to repay it at some future time, together with interest for the use of the money or property advanced.  Hafer v. Spaeth, 22 Wn.2d 378, 384, 156 P.2d 408 (1945).

             Under the terms of a securities lending agreement, securities are presently paid out in exchange for the right to receive repayment of the securities, plus interest, at some future date.  Securities lending agreements, as income‑producing loans, are therefore an investment of funds and may be constitutionally entered on behalf of the permanent common school fund, public pension or retirement funds, and industrial insurance funds.

             Reverse repurchase agreements have been characterized in varying contexts both as a purchase/resale and as a short-term collateralized lone.  Compare,e.g., Union Planters Nat. Bank of Memphis v. United States, 426 F.2d 115, 118 (6th Cir. 1970),cert. denied, 400 U.S. 827, 91 S.Ct. 53, 27 L.Ed.2d 56 (1970) withCitizens National Bank of Waco v. United States, 551 F.2d 832, 843 (Ct. Cl. 1977).  For our purposes it is not necessary that we characterize the nature of this transaction as one or the other; the word "invest" encompasses both a loan and a purchase entered for the purpose of realizing income or profit.  State ex rel. Hellar v. Young, 18 Wash. at 25.5/ It also logically includes  [[Orig. Op. Page 9]] the sale of securities to realize the profit contemplated at the time of the purchase.  A reverse repurchase agreement, whether viewed as a loan or a purchase/resale, is an investment and may be entered on behalf of the funds specified above.

             We note that a court in another jurisdiction has similarly found that the authority to "invest and reinvest" funds includes the authority to enter into repurchase agreements.  InBache Halsey Stuart v. University of Houston, 638 S.W.2d 920 (Tex. App. 1982), the court examined the statutory investment authority of a state university and noted as follows at p. 926:

             "The power to 'invest and reinvest' logically encompasses both the power to invest in securities and to sell any securities already owned, reinvesting the funds in other securities, or using them to meet current cash demands.  This is exactly what occurs in a repurchase agreement, except that there is also an agreement to buy back the securities at a certain future date.  Since a repurchase agreement is primarily an investment tool encompassing both an agreement to sell and an agreement to repurchase in the future, rather than simply one or the other, it is consonant with the very general plenary investment powers given to the University. . . ."

             Investment of the specified funds must be "as authorized by law."  The legislature has provided the State Investment Board with broad investment powers.  RCW 43.84.150 provides in pertinent part as follows:

             "Except where otherwise specifically provided by law, the state investment board shall have full power to invest, reinvest, manage, contract, or sell or exchange investments acquired.  Investments shall be made in accordance with RCW 43.33A.140 and investment policy duly established and published by the state investment board. . . ."

              [[Orig. Op. Page 10]]

RCW 43.33A.140 provides as follows:

             "Any investments made by the state investment board shall be made with the exercise of that degree of judgment and care, under circumstances then prevailing, which persons of prudence, discretion, and intelligence exercise in the management of their own affairs, not for speculation but for investment, considering the probable safety of their capital as well as the probable income to be derived."

 Statutes relating to specific funds provide coextensive authority, expressly allowing the State Investment Board to invest the funds "in the manner prescribed by RCW 43.84.150, and not otherwise."  See RCW 41.32.207, RCW 41.40.072, RCW 43.84.170, and RCW 51.44.100.  See also, RCW 43.43.170 incorporating the terms of RCW 41.40.072 by general reference.

             There are no statutory exceptions to this plenary investment authority which would preclude the State Investment Board from entering into securities lending agreements and reverse repurchase agreements on behalf of the specified funds.

 Question (2):

             Your second question, prefaced by the observation that certain collateral held by The Chase Manhattan Bank may be held in the name of the bank, asks as follows:

             Does the state have rights to such "collateral" beyond those of an unsecured creditor of The Chase Manhattan Bank?

             The Agency Agreement provides that securities held by the bank in the state's custody account which customarily are held in registered form shall be registered in the name of the bank's nominee.  The concurrently executed "Schedule B ‑ Securities Loan Agreement" incorporates the provisions of the agency agreement and makes them applicable to the administration of "securities, collateral and their proceeds which are subject to this Agreement."  Accordingly, securities which are held as collateral in securities loans, and securities obtained upon investment of cash collateral in repurchase agreements (as proceeds of the collateral), may be registered in the name of the bank's nominee.

             When securities in which the state holds a beneficial interest are registered in the name of the bank's nominee a trust is  [[Orig. Op. Page 11]] created.  A trust arises whenever the legal and equitable interests in identifiable property are separated, with the legal title passing to a trustee for use of a beneficiary.  National Superlease v. Reliance Ins. Co., 126 Misc.2d 988, 484 N.Y.S.2d 776 (N.Y. Sup. 1985);Smith v. Fitch, 25 Wn.2d 619, 626, 171 P.2d 682 (1946).  The trust property may be absolute ownership or it may be a lesser interest such as a security interest.  G. Bogert,Trusts and Trustees § 112 (2d ed. 1978).

             The state, as beneficiary of a trust and as beneficial owner of the trust property, has rights which are different in nature and superior in enforceability to the rights of an unsecured creditor.  The beneficiary is the equitable owner of the trust property.  76 Am.Jur.2d,Trusts § 101 (1975).  Concommitantly, the trustee holds bare legal title with no entitlement to any benefit or profit from the trust property.  G. Bogert,Trusts and Trustees § 146 (2d ed. 1978).  Since the trustee has no equitable interest in the trust property, that property is not subject to claims by the trustee's private creditors.  76 Am.Jur.2dTrusts § 97 (1975).

             This ownership interest distinguishes a trust beneficiary from an unsecured creditor.  The unsecured creditor holds an intangible legal obligation and has no rights in any identifiable property.  The obligation may be enforced by execution upon the debtor's general assets.  However, such enforcement would be subject to the priorities of competing creditors.

             The relative positions of trust beneficiaries and unsecured creditors may be illustrated by an example from bankruptcy law.  Under the Bankruptcy Code, 11 U.S.C. § 1,et seq., property held by a bankrupt in trust belongs to the beneficiary and will not be considered a part of the bankrupt's estate.  Therefore, the trust property will be preserved for the beneficiary and will not be distributed to the bankrupt's creditors.  Matter of Kennedy and Cohen, Inc., 612 F.2d 963 (5th Cir. 1980), cert. denied 449 U.S. 833, 101 S.Ct. 103, 66 L.Ed.2d 38 (1980);Selby v. Ford Motor Co., 590 F.2d 642 (6th Cir. 1979).  General unsecured creditors, in contrast, will receive payment only after secured creditors and creditors who have priority under the Bankruptcy Code are paid.  11 U.S.C. § 507.

             We do not mean to imply that the beneficiary of a trust is protected from all loss.  The right of a beneficiary to the trust property may be cut off by a bona fide purchaser who acquires interest in the property for value in good faith and without actual or constructive notice of any breach of trust.  Huber v. Coast  [[Orig. Op. Page 12]] Investment Co., Inc., 30 Wn. App. 804, 810, 638 P.2d 609 (1981); Simonds v. Simonds, 45 N.Y.2d 233, 380 N.E.2d 189, 408 N.Y.S.2d 359 (1978).  If a bona fide purchaser acquires the trust property, the beneficiary's remedies are to enforce its ownership rights against proceeds of the sale in the trustee's possession or against the general assets of the trustee.  The beneficiary's rights may also be compromised vis-a-vis creditors of the trustee if the trust property is commingled with the trustee's own property.  See,Aebig v. Commercial Bank of Seattle, 36 Wn.App. 477, 479, 674 P.2d 696 (1984).  The establishment of a custody account in the name of the state apparently avoids such commingling.

             We trust that the foregoing will be of some assistance to you.

 Very truly yours,
KENNETH O. EIKENBERRY
Attorney General

NARDA PIERCE
Assistant Attorney General