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979 W . P . G . H A R D I N G , GOVERNOR E D M U N D P L A T T , V I C E GOVERNOR ADOLPH C. MILLER D KLD F . H O U S T O N SECRETARY C H A R L E S S . HAMLIN OF THE TREASURY FEDERAL RESERVE BOARD CHAIRMAN JOHN SKELTON WILLIAMS COMPTROLLER OF THE CURRENCY H E N R Y A. MOEHLENPAH W . T . C H A P M A N . SECRETARY » . 8 . E M E R S O N , ASSISTANT SECRETARY a d d r e s s r e p l y F E D E R A L t o , R E S E R V E B O A R D w . M . I H L A Y . FISCAL A « E « T WASHINGTON October 27,1920. X-2040 Subject: E l i g i b i l i t y of Paper Incident t o Cotton Factorage Business. Dear Sir On page 10$4 of the Federal Reserve B u l l e t i n f o r November, 1919# the Federal Reserve Board published a r u l i n g t o the e f f e c t t h a t the note of a cotton f a c t o r , the proceeds of which a r e used by the cotton f a c t o r t o lend t o a t h i r d p a r t y , i s f i n a n c e paper r a t h e r than commercial or a g r i c u l t u r a l paper and i s , t h e r e f o r e , i n e l i g i b l e f o r Rediscount, even though the t h i r d p a r t y t o whom such loan i s made may use the proceeds f o r a commercial or a g r i c u l t u r a l purpose. The Federal Reserve Board has r e c e n t l y been requested t o reconsider t h i s r u l i n g . This r u l i n g has, i n e f f e c t , been incorporated i n t h e r e g u l a t i o n s of the Board, S e r i e s of 1920, which have j u s t been issued. Section A, paragraph I I of Regulation A provides i n p a r t a s follows; "The Federal Reserve Board, e x e r c i s i n g i t s s t a t u t o r y r i g h t t o d e f i n e the c h a r a c t e r of a note, d r a f t , or b i l l of exchange e l i g i b l e f o r rediscount a t a Federal Reserve Bank, has determined t h a t (a) I t must be a note, d r a f t , or b i l l of exchange which has been issued or drawn, or the proceeds of which have been used or a r e t o be used i n the f i r s t i n s t a n c e , i n procuring, purchasing, carrying, or marketing goods i n one or more of t h e s t e p s of the process of production, manufacture, or d i s t r i b u t i o n , or f o r the purpose of c a r r y i n g or t r a d i n g i n bonds or notes of t h e United S t a t e s . " The words " i n the f i r s t i n s t a n c e " did not appear i n t h e Board's previous r e g u l a t i o n s and were i n s e r t e d i n Regulation A of t h e S e r i e s of 1920 for the express purpose of making i t c l e a r t h a t t h e making of l o a n s t o t h i r d p a r t i e s i s a f i n a n c e , r a t h e r than a commercial or a g r i c u l t u r a l purpose even though i t appears t h a t the t h i r d p a r t i e s a r e to use the funds f o r commercial or a g r i c u l t u r a l purposes. A f t e r a very f u l l and c a r e f u l review of t h e f a c t s which have been p r e sented to t h e Board, and of t h e questions of law involved, t h e Federal Reserve Board i s of t h e opinion t h a t the r u l i n g a s published and a s i n e f f e c t incorporated i n t h e Board's r e g u l a t i o n s i s c o r r e c t i n p r i n c i p l e and t h a t under t h e terms of the Federal Reserve Act a s i t now stands a contrary r u l i n g i s not p o s s i b l e . I t i s urged t h a t since the l o a n s made by a cotton f a c t o r t o h i s customers a r e merely i n c i d e n t a l t o t h e main b u s i n e s s of the f a c t o r -2- X-2C40 which i s the marketing of cotton, and since the marketing of cotton i s a commercial business, a cotton factory's note should be considered e l i g i b l e commercial paper even though the proceeds a r e loaned t o t h e f a c t o r ' s customers, Under the terms of Section 13 of the Federal Reserve Act, however, t h e t e s t of e l i g i b i l i t y i s not the character of the business of t h e borrower^ but i s the use of the proceeds of the p a r t i c u l a r i n s t r u m e n t . Inasmuch a s t h e loaning of money i s i n i t s e l f a finance r a t h e r than a commercial operat i o n , a note the proceeds of which a r e loaned by the borrower t o a t h i r d p a r t y i s i n e l i g i b l e f o r rediscount i r r e s p e c t i v e of the general c h a r a c t e r of the b o r r o w e r ' s b u s i n e s s . The Board d e s i r e s t o c a l l a t t e n t i o n t o the f a c t t h a t t h e r u l i n g does not preclude cotton f a c t o r ' s notes from being e l i g i b l e under some circumstances* In the f i r s t paragraph of the r u l i n g i t was s a i d : " * * In view of t h e f a c t t h a t i t i s apparent from a l l the evidence on hand t h a t the circumstances and c o n d i t i o n s under which s o - c a l l e d cotton f a c t o r s ' paper i s issued vary so much i n d i f f e r e n t cases., i t i s impossible t o give any c a t e g o r i c a l answer t o the question presented, or to make any general r u l i n g t h a t cotton f a c t o r s ' paper a s such, i e e l i g i b l e or i n e l i g i b l e for rediscount." In r e i t e r a t i o n of t h i s statement the Board p o i n t s out a g a i n t h a t the f a c t t h a t a cotton f a c t o r i s the maker of a note, does not of i t s e l f determine the e l i g i b i l i t y or i n e l i g i b i l i t y of t h e note f o r r e d i s c o u n t . The t e s t of the e l i g i b i l i t y of paper i s whether i t complies with the terms of the Federal Reserve Act and the Board's r e g u l a t i o n s , and t h i s i n t u r n involves the question of the use of the proceeds. In l a s t a n a l y s i s , t h i s i s a question of f a c t and i t i s t h e f u n c t i o n of the Federal Reserve Banks, r a t h e r than of the Federal Reserve Board, t o determine questions of f a c t i n the l i g h t of the circumstances of p a r t i c u l a r cases. As was said i n the l a s t paragraph of the r u l i n g i n q u e s t i o n ; "In order t o a s c e r t a i n t h e necessary f a c t s i t nay be proper f o r a Federal Reserve Bank t o r e q u i r e statements or a f f i d a v i t s from t h e maker of the note a s t o the exact n a t u r e of the t r a n s a c t i o n out of which i t a r i s e s . With these p r i n c i p l e s a s a guide, the Federal Reserve Bank must determine the e l i g i b i l i t y of any p a r t i c u l a r paper i n t h e l i g h t of the circumstances i n which i t was issued, and i t s proceeds disposed o f . " In connection with t h e r e q u e s t made t o t h e Federal Reserve Board t h a t i t reconsider i t s previous r u l i n g , the argument was nade t h a t Section 13 of the Federal Reserve Act makes n o t e s of cotton f a c t o r s e l i g i b l e f o r r e d i s c o u n t when secured by cotton, i r r e s p e c t i v e of whether or not t h e proceeds have been or a r e t o be, used f o r commercial or a g r i c u l t u r a l purposes. I t was urged t h a t t h i s i s the e f f e c t of t h a t p a r t of Section 13 which immediately follows the d e f i n i t i o n of e l i g i b l e commercial and a g r i c u l t u r a l paper and which provides that "Nothing i n t h i s Act contained s h a l l be construed t o p r o h i b i t such n o t e s , d r a f t s and b i l l s of exchange, secured by s t a p l e a g r i c u l t u r a l products, or other goods, wares or merchandise from being e l i g i b l e f o r such discount; but such d e f i n i t i o n s h a l l not include notes, d r a f t s , or b i l l s covering 981 -3- X-2040 merely investments or issued or drawn f o r the purpose of c a r r y i n g or t r a d i n g i n stocks, bonds or other i n v e s t ment s e c u r i t i e s , except bends and notes of the Government of t h e United S t a t e s , " The Board i s of the opinion t h a t the word "such", q u a l i f y i n g notes, d r a f t s and b i l l s of exchange, i n the clause quoted must n e c e s s a r i l y be construed a s r e f e r r i n g t o n o t e s , d r a f t s and b i l l s of exchange defined above, t h a t i s , notes, d r a f t s and b i l l s of exchange which a r e e l i g i b l e by reason of the f a c t t h a t the proceeds have been or a r e t o be used f o r a g r i c u l t u r a l , i n d u s t r i a l or commercial purposes, The Board i s of the opinion, t h e r e f o r e , t h a t the p r o v i s i o n quoted i s merely a d e c l a r a t i o n t h a t paper which i s e l i g i b l e f o r rediscount by reason of the use of the proceeds i s not made i n e l i g i b l e by reason of being secured, and t h a t the p r o v i s i o n cannot be construed, a s t h e Beard was urged t o construe i t , t o make e l i g i b l e f o r rediscount paper which i s secured i n the manner s p e c i f i e d but which i s not e l i g i b l e commercial ot a g r i c u l t u r a l paper a s defined i n t h e preceding p a r t of the Section* This being so, the p r e c i s e meaning of the phrase "covering merely i n v e s t ments" i s of no importance i n the case under consideration. The clause i n which t h i s phrase appears provides i n e f f e c t t h a t "notes, d r a f t s and b i l l s covering merely investments" shall under no circumstances be e l i g i b l e . This cannot, of course, be construed a s an a f f i r m a t i v e enactment making e l i g i b l e a l l paper other than t h a t "covering merely investments." The clause merely adds another condition with which paper must comply i n order to be e l i g i b l e f o r r e d i s c o u n t . Since the Board has determined t h a t paper, the proceeds of which have been used t o lend to a t h i r d party does not meet the requirement a s to the use of the proceeds f o r a commercial or a g r i c u l t u r a l purpose, such paper i s i n e l i g i b l e i r r e s p e c t i v e of whether or not i t i s paper "covering merely investments", The Federal Reserve Board has f r e q u e n t l y suggested t h a t if t h e cotton f a c t o r s loans to customers were evidenced by the customers 1 notes these notes could be endorsed and discounted by the f a c t o r and might then be e l i g i b l e f o r rediscount by Federal Reserve Banks upon s a t i s f a c t o r y evidence t h a t the p r o ceeds of the l o a n s represented by t h e n o t e s have been, or a r e t o be, used for a g r i c u l t u r a l or commercial purposes. The Board has a l s o had occasion t o rule r e c e n t l y t h a t d r a f t s drawn by cotton growers, accepted by a cooperative marketing a s s o c i a t i o n organized f o r the purpose of marketing the cotton del i v e r e d by the growers, and discounted by the growers a t t h e i r banks, tray be e l i g i b l e f o r rediscount by Federal Reserve Banks when i t i s shown t h a t the proceeds of the accepted d r a f t s have been, or a r e t o be, used by the growers f o r a g r i c u l t u r a l purposes. The p r i n c i p l e of t h i s r u l i n g i s , o f course, a p p l i c a b l e to cotton f a c t o r s a s well a s t o cooperative marketing a s s o c i a t i o n s , so t h a t under i t d r a f t s of cotton producers or owners drawn upon and accepted by the cotton f a c t o r s may be e l i g i b l e f o r rediscount by Federal Reserve Banks when discounted by the drawers. This would not be t r u e , however, if the f a c t o r should r e t a i n the d r a f t s a f t e r acceptance and should discount them a t h i s bank. In t h a t case t h e f a c t o r and not the producer would be the borrower i n t h e f i r s t i n s t a n c e and the use of the proceeds by the f a c t o r would deter-*mine the e l i g i b i l i t y of t h e d r a f t s . \ 9 4 * -4- X-2C40 The Board understands t h a t i t has always been the p r a c t i c e i n the c o t t o n f a c t o r a g e b u s i n e s s f o r the f a c t o r 1 s l o a n s t o h i s customers t o be evidenced merely by open a c c o u n t s , and i t has been s a i d t h a t i t i s not p o s s i b l e t o change t h a t p r a c t i c e , e s t a b l i s h e d by l o n g custom, so a s t o r e q u i r e customers t o g i v e t h e i r n o t e s t o e v i d e n c e t h e s e l o a n s . The Federal Reserve Board cannot help but f e e l t h a t t h i s d i f f i c u l t y w i l l not prove a s g r e a t a s i s f e a r e d , This i s not t h e f i r s t time t h a t the p l e a h a s been made t h a t b u s i n e s s usage does not permit of compliance w i t h requirements which t h o s e a d m i n i s t e r i n g t h e Federal Reserve System c o n s i d e r mandatory a s a matter of law or e s s e n t i a l a s a n a t t e r of banking prudence, and i n many i n s t a n c e s , n o t a b l y w i t h r e s p e c t t o the requirement of borrower's s t a t e m e n t s , what has a t f i r s t seemed i m p o s s i b l e has proved by e x p e r i e n c e t o be both p r a c t i c a b l e and b e n e f i c i a l . Another s u g g e s t i o n has been made by one of the Federal Reserve Banks which may be of a s s i s t a n c e t o c o t t o n f a c t o r s , when the f a c t o r s e l l s c o t t o n on c r e d i t terms which a r e customary and which a r e not u n n e c e s s a r i l y or unreasonably l o n g , i f t h e purchaser g i v e s a n o t e , or a c c e p t s a d r a f t drawn on him by t h e f a c t o r , f o r the amount of the p u r c h a s e r ' s o b l i g a t i o n , t h a t n o t e or a c c e p t e d d r a f t w i l l have been "issued or drawn" f o r a commercial purpose w i t h i n t h e meaning of S e c t i o n 13 of the Federal Reserve Act and w i l l be e l i g i b l e f o r r e d i s c o u n t by Federal Reserve Banks i f i t complies i n other r e s p e c t s w i t h the law and the Board's r e g u l a t i o n s . Very t r u l y yours, Cover cor. To Governors and Federal Reserve A g e n t s .
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