979 D KLD F . H O U S T O N

S E C R E T A R Y O F T H E T R E A S U R Y

C H A I R M A N

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 A D O L P H C . M I L L E R

C H A R L E S S . H A M L I N

H E N R Y A . M O E H L E N P A H

J O H N S K E L T O N W I L L I A M S C O M P T R O L L E R O F T H E C U R R E N C Y

F E D E R A L R E S E R V E B O A R D W . T . C H A P M A N . SECRETARY

» . 8 . E M E R S O N , ASSISTANT SECRETARY

w . M . I H L A Y . FISCAL A « E « T a d d r e s s r e p l y t o ,

F E D E R A L R E S E R V E B O A R D WASHINGTON

October 27,1920.

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Subject : E l i g i b i l i t y of Paper Incident to Cotton Factorage Business.

Dear Sir

On page 10$4 of the Federal Reserve Bul le t in for November, 1919# the Federal Reserve Board published a ru l i ng 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 are used by the cotton f a c t o r to lend to a th i rd pa r ty , i s f inance paper r a the r than commercial or a g r i c u l t u r a l paper and i s , t he re fo re , i n e l i g i b l e for Rediscount, even though the t h i r d par ty to whom such loan i s made may use the proceeds fo r a commercial or a g r i c u l t u r a l purpose. The Federal Reserve Board has recen t ly been requested t o reconsider t h i s ru l i ng .

This r u l i n g has, in e f f e c t , been incorporated in the regu la t ions of the Board, Ser ies of 1920, which have jus t been issued. Section A, paragraph I I of Regulation A provides in par t a s fol lows;

"The Federal Reserve Board, exerc is ing i t s s t a tu to ry r igh t t o def ine the character 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 re t o be used i n the f i r s t ins tance, in procuring, purchasing, carrying, or marketing goods in one or more of the s teps 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 carrying or t rad ing i n bonds or notes of the United S t a t e s . "

The words " in the f i r s t ins tance" did not appear i n the Board's previous regu la t ions and were inser ted in Regulation A of the Ser ies of 1920 for the express purpose of making i t c lear tha t the making of loans to t h i r d p a r t i e s i s a f inance, r a the r than a commercial or a g r i c u l t u r a l purpose even though i t appears tha t the thi rd p a r t i e s are to use the funds f o r commercial or a g r i c u l t u r a l purposes.

Af te r a very f u l l and ca re fu l review of the f a c t s which have been p r e -sented to the Board, and of the quest ions of law involved, the Federal Reserve Board i s of the opinion tha t the ru l ing a s published and a s i n e f f e c t incorporated in the Board's r egu la t ions i s correc t i n p r i n c i p l e and tha t under the terms of the Federal Reserve Act a s i t now stands a contrary ru l i ng i s not poss ib l e . I t i s urged tha t since the loans made by a cotton f a c t o r to h i s customers a r e merely i nc iden t a l t o the main business of the f a c t o r

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which i s the marketing of cot ton, 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 re loaned to the f a c t o r ' s cus-tomers, Under the terms of Section 13 of the Federal Reserve Act, however, the 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 the borrower^ but i s the use of the proceeds of the p a r t i c u l a r ins t rument . Inasmuch a s the loaning of money i s i n i t s e l f a f inance r a the r than a commercial opera-t ion , a note the proceeds of which a r e loaned by the borrower to a t h i r d par ty i s i n e l i g i b l e fo r rediscount i r r e s p e c t i v e of the general character of the borrower 's business .

The Board de s i r e s to ca l l a t t e n t i o n to the f a c t t h a t the r u l i n g does not preclude cot ton f a c t o r ' s notes from being e l i g i b l e under some circum-stances* In the f i r s t paragraph of the ru l i ng i t was sa id :

"* * In view of the f a c t tha t i t i s apparent from a l l the evidence on hand tha t the circumstances and condi t ions under which so-cal led cotton f a c t o r s ' paper i s issued vary so much in d i f f e r e n t cases., i t i s impossible to give any ca tegor ica l answer to the question presented, or to make any general ru l ing 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 red iscount . "

In r e i t e r a t i o n of t h i s statement the Board po in t s out again tha t the f a c t tha 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 the note fo r r ed i scoun 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 regula t ions , and t h i s in tu rn involves the question of the use of the proceeds. In l a s t ana lys i s , t h i s i s a question of fac t and i t i s the funct ion of the Federal Reserve Banks, r a the r than of the Federal Reserve Board, t o determine quest ions of f a c t in the l i g h t of the circumstances of p a r t i c u l a r cases. As was said in the l a s t paragraph of the ru l ing in quest ion;

"In order to a s c e r t a i n the necessary f a c t s i t nay be proper fo r a Federal Reserve Bank t o require statements or a f f i d a v i t s from the maker of the note a s t o the exact na ture of the t r a n s -ac t ion 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 the 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 the request made to the Federal Reserve Board tha t i t reconsider i t s previous ru l ing , the argument was nade t h a t Section 13 of the Federal Reserve Act makes notes of cotton f a c t o r s e l i g i b l e f o r rediscount when secured by cotton, i r r e s p e c t i v e of whether or not the proceeds have been or a re to be, used f o r commercial or a g r i c u l t u r a l purposes. I t was urged tha t t h i s i s the e f f e c t of t h a t pa 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 tha t -

"Nothing i n t h i s Act contained sha l l be construed t o p roh ib i t such notes , d r a f t s and b i l l s of exchange, secured by s taple a g r i c u l t u r a l products , or other goods, wares or mer-chandise from being e l i g i b l e fo r such discount; but such d e f i n i t i o n sha l l not include notes , d r a f t s , or b i l l s covering

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merely investments or issued or drawn f o r the purpose of carrying or t r ad ing in 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 the United S t a t e s , "

The Board i s of the opinion tha t the word "such", qua l i fy ing notes, d r a f t s and b i l l s of exchange, in the clause quoted must necessa r i ly be construed as r e f e r r i n g t o notes , d r a f t s and b i l l s of exchange defined above, t ha t i s , notes, d r a f t s and b i l l s of exchange which a re e l i g i b l e by reason of the fac t tha t the proceeds have been or a re t o be used for 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, the re fore , tha t the provis ion quoted i s merely a dec la ra t ion tha 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 tha t the provis ion cannot be construed, a s the Beard was urged to construe i t , to make e l i g i b l e f o r rediscount paper which i s secured i n the manner spec i f ied 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 as defined i n the preceding pa r t of the Section*

This being so, the prec ise meaning of the phrase "covering merely i n v e s t -ments" i s of no importance in the case under considerat ion. The clause in which t h i s phrase appears provides in e f f e c t tha t "notes, d r a f t s and b i l l s covering merely investments" shal l under no circumstances be e l i g i b l e . This cannot, of course, be construed as an a f f i rma t ive enactment making e l i g i b l e a l l paper other than tha 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 fo r rediscount . Since the Board has determined tha t paper, the proceeds of which have been used to lend to a t h i rd par ty does not meet the requirement a s to the use of the proceeds for 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 spec t ive of whether or not i t i s paper "covering merely investments",

The Federal Reserve Board has f requent ly suggested t h a t if t he cotton f a c t o r s loans to customers were evidenced by the customers1 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 fo 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 pro-ceeds of the loans represented by the notes have been, or a r e to be, used for a g r i c u l t u r a l or commercial purposes. The Board has a l so had occasion to rule recent ly t h a t d r a f t s drawn by cot ton growers, accepted by a cooperative marketing a s soc ia t ion organized f o r the purpose of marketing the cotton de-l ivered 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 fo r rediscount by Federal Reserve Banks when i t i s shown tha t the proceeds of the accepted d r a f t s have been, or a re t o be, used by the growers for 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 ng i s ,o f course, appl icable to cotton f a c t o r s a s well a s to cooperative marketing a s soc i a t i ons , so tha 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 ac to 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 the f ac to r and not the producer would be the borrower i n the f i r s t ins tance 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 the d r a f t s .

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The Board understands that i t has always been the p r a c t i c e i n the co t ton fac torage 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 accounts , and i t has been sa id that i t i s not p o s s i b l e t o change that p r a c t i c e , e s t a b l i s h e d by long custom, so a s t o require customers t o give t h e i r no te s to evidence these l o a n s . The Federal Reserve Board cannot help but f e e l that t h i s d i f f i c u l t y w i l l not prove a s great a s i s f eared , This i s not the f i r s t time that the p l e a has been made that b u s i n e s s usage does not permit of compliance wi th requirements which those admin i s t er ing t h e Federal Reserve System cons ider 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 , notably with respect 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 imposs ib le has proved by experience 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 sugges t ion 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 cot ton f a c t o r s , when the f a c t o r s e l l s cot ton on c r e d i t terms which are customary and which are not u n n e c e s s a r i l y or unreasonably long , i f the purchaser g i v e s a note , or a c c e p t s a draf t drawn on him by the f a c t o r , for the amount of the purchaser ' s o b l i g a t i o n , that note or accepted d r a f t w i l l have been "issued or drawn" for a commercial purpose w i t h i n the meaning of Sect ion 13 of the Federal Reserve Act and w i l l be e l i g i b l e f o r rediscount by Federal Reserve Banks i f i t complies i n other r e s p e c t s wi th the law and the Board's r e g u l a t i o n s .

Very tru ly yours,

Cover cor.

To Governors and Federal Reserve Agents .

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