                              QBfficeof tip !&tornep @heral
                                             d&ate of Qexag
DAN MORALES
 .Al-rORNEY
         GENERAL                              December 10.1993

      Honorable O.H. “Ike” Harris                        Opinion No. DM-274
      Chair
      Committee on State AtEtim                          Re: Whether, in accordance with section 2
      Texas State Senate                                 of the Public Funds Investment Act,
      P.O. Box 12068                                     V.T.C.S. article 842a-2, a public funds
      Austin, Texas 78711                                investment pool may “purchase. se& or
                                                         invest its funds or funds under its control” in
                                                         wvered call contracts or covered put
                                                         camacts      (RQ-605)
      Dear Senator Harris:

              You have asked us to consider whether, under section 2 of the Public Funds
      Investment Act (the “act”), V.T.C.S. article 842a-2, a public timds investment pool may
      purchase and sell United States government securities through the writing of covered cab
      contracts or covered put contrackt We determine that it may not.

               Section 791.011(a) of the Government Code authorizes a local government to
      contract with another local government to perform certain governmental finctions and
      services. For purposes of the Interlocal Cooperation Act, see Goti Code 5 791.002,
      “Sovemmentrd fbnctions and services” includes public funds investment.                  Id.
      5 791.003(3)(L). The act limits the investment authority of several political subdivisions,
      inchiding a public timds investment pool2 created under chapter 791 of the Government
      Code. See also Tex. Const. art. III, $52(e) (providing that county, city, town, or other
      political corporation or subdivision may invest its funds as authorized by law).

              Section 2(a) of the act provides in pertinent part that
                  any. . public funds investment pool created under Chapter 791,
                  Government Code, acting on behalf of [an incorporated city or town,
                  a county, a, public school district, a district or authority created under
                  Article III, Section 52@)(l) or (2) or Article XVI, Section 59 of the



              ‘Fora descriptionofmvad      call contractsand coveredput mntracts.see in/hap 5.

               %mtion Z(c)(4)of the act de&es “publictbds investmentpool” as “anentity aWed to invest
      plblic fundsjointly on behalf of the entitiesthat participatein the pool and whose investmentcbjectivcsin
      orderof priorityarc: firs&safetyof principal;semnd, liquidity;and third, inmmc.” Acts 1993,73d Leg.,
      ch.!w,~1.


                                                   p.   1431
Honorable O.H. “Ike” Harris - Page 2 (DM-274)




          Texas Constitution, an institution of higher education as defined by
          Section 61.003 of the Education Code, a hospital district, or a fresh
          water supply district] may, in accordance with this Act, purchase,
          sell, and invest its tinds and funds under its control in :

               (I) bbhgatibns of the United States or its agencies and
          instrumentalities;



              (3) other obhgations, the principal of and interest on which are
          unconditionally guaranteed or insured by, or backed by the till faith
          and credit of, . the United States or its agencies and instru-
          mentalities;

                 .


               (9) ti.111~collateral&d repurchase agreements having a defined
          termination date, secured by obligations described by Subdivision (1)
          of this subsection, pledged to the political entity and deposited with a
          third party selected and approved by the political entity, and placed
          through a primary government securities dealer, as defined by the
          Federal Reserve, or a bank domiciled in this state.
Acts 1993, 73d Leg., ch. 946, 5 1, at 4055-56; see also id. at 4057 (adding 5 2(e))
(authorizing any entity listed in subsection (8) to invest its funds and fimds under its
control in eligible public funds investment pool if entity’s governing body resolves to
authorize investment in particular pool). You ask us to determine whether a public funds
investment pool may purchase, sell, or invest its fimds in covered call contracts and
covered put contracts. The act sptcificahy lists the types of investments that a public
tbnds investment pool is authorized to make. The enumerated list does not expressly
include covered call contracts and covered put contracts. See generalZy Attorney General
Opinions JM-1210 (1990); MW-506 (1982); M-607 (1970). We must determine,
therefore, whether any of the explicitly listed permissible investments includes covered call
contracts and covered put contracts. In our opinion, the listed permissible investments do
not include covered call contracts and covered put contracts.

        We believe that the only permissible investments listed in section 2(a) of the act
that might include covered call contracts and covered put contracts are those described in
subsection (a)(l), (3). and (9). See supra pp.]-2 (quoting V.T.C.S. art. 8428-2, 5 2(a)(l),
(3), (9)). We will consider first whether section 2(a)(l) includes covered call contracts
and covered put contracts, i.e., whether a covered call contract or a covered put contract
is 8n “obhgation[] of the United States or its agencies and instrumentalities.” Attorney
General Opinion IM-I 20 1 ( 1990) is relevant to our inquiry,




                                         p.   1432
Honorable O.H. “Ike” Harris - Page 3 (DM-274)




         In Attorney General Opinion M-1201 this office considered whether the Veterans’
Land Board was authorized to enter into a call option contract. That opinion noted that
article III, sections 49-b and 49-b-l of the Texas Constitution authorize the Veterans’
Land Board to invest “in bonds or obligations of the United States.” Attorney General
Opinion JM-1201 at 2. Thus, the question this office faced was whether a c8ll option
contract is a bond or obligation of the United States. Id. After examining the history of
article III, sections 49-b and 49-b-l of the Texas Constitution, the opinion determined that
the phrase “bonds or obligations of the United States” denotes credit instrumentalities of
the federal government. Id. at 5. According to the opinion, such credit instrumentalities
are characterized by (1) written documents, (2) the bearing of interest, (3) a binding
promise by the United States to pay specified sums at specified dates, and (4) specific
congressional authorization that pledges the faith and credit of the United States in
support ofthe promise to pay. Id. (citing Smith v. Davis, 323 U.S. 111, 114-15 (1944)).

        The opinion described 8 “call option” contract as

                a promise to sell 8 security in the firtIne at a price fixed today.
           The seller agrees to deliver the security for a set price (the “strike
           pricer’) during a limited time. As described by the United States
           Court of Appeals for the Seventh Circuit:

                The buyer pays 8 sum (the “premium”) for the [call option].
                The strike price exceeds the current market price of the
                security. Sellers are betting that the price will not exceed
                the strike price during the duration of the option; buyers are
                betting that it will.

                Board of Trade of City of Chicago v. Securities               &
                Exchange Comm’n, 883 F.2d 525, 527 (7th Cir. 1989).

Id. at 6-7. This office concluded that a call option contract does not satisfy the four
characteristics of credit instrumentalities of the United States because such a contract
represents an instrumentality of a third party, not of the United States. Id. at 5. “[T]he
consideration to flow to the [Veterans’Land Board] from [a call option contract] is merely
a promise from a third party regarding the manner in which the third party will deal with
credit instrumentalities of the United States. Such third parry obligations do not become
oouptlons of the United States, merely because the arsefs which are subject of speculative
transactions with the third party are obligations of the United States.” Id. 8t 6.
Accordingly, the opinion concluded that an investment in a call option contract is not an
investment in an Oblig8tiOII of the United States, and the Veterans’ Land Board therefore is
unauthorized to enter into such transactions3 Id.


       3Yeurquestion appearsto assume that the writing of covered call mntnrcts and mvered pat
mntmets is simply 8 means by which a public funds investmentpool may purchaseor sell United States
governmentobligations. AttorneyGeneralOpinionJhl-I201 refutesthat assamption.


                                           p.   1433
Honorable O.H. “Ike” Harris - Page 4 (DM-274)




        We found no legislative history indicating that the legislature intended to include
covered call contracts and covered put contracts within the ambit of section 2(a)(l) of the
act, “obligations of the United States or its agencies.” Additionally, based on the similarity
between a call option contract, as described in Attorney General Opinion Jh4-1201, and
your description of-a covered call contract and a wvered put contract, we believe that
neither a covered call wntract nor a covered put contract is an obligation of the United
States or its agencies and instrumentalities. Similarly, section 2(a)(3), which authorizes
investments in obligations that the United States or its agencies and instrumentalities
unwnditionally guarantee, insure, or back with the full faith and credit of the United
States, does not encompass covered call contracts and wvered put contracts. As this
office determined in Attorney General Opinion JM-1201, a call option contract “is merely
II promise from a third party regarding the manner in which the third party will deal with
credit instrumentalities of the United States.” Attorney General Opinion JM-1201 8t 6.
The United States or its agencies and instrumentalities do not guarantee, insure, or back
the promise of the third party.

        Finally, we must consider whether covered call contracts and covered put
contracts are repurchase agreements within the scope of section 2(a)(9) of the act. In the
context of the act, 8 “repurchase agreement” is
          a simultaneous agreement to buy, hold for a specified time, and then
          sell back at a future date, obligations [of the United States or its
          agencies and instrumentalities], the principal and interest ofwhich are
          gwr8ntee.d by the United States or any of its agencies, in market
          value of not less than the principal amount of the funds disbursed.
          The term includes direct security repurchase agreements and reverse
          security repurchase agreements.

V.T.C.S. art. 842a-2, $2(c)(3).

        You explain that 8 direct security repurchase agreement is a contract between a
seller and a buyer, in which the seller agrees to sell obligations of the United States or its
agencies and instrumentalities, then to buy them back at an agreed upon price and a
specified date. On the other hand, a reverse security repurchase agreement is a contract
between a dealer in government securities and an investor, in which the dealer agrees to
r-.-Z .___ C,u:; the investor United States government securities and the investor agrees to
repurchase the securities at a later date. This office previously has described a repurchase
agreement as “essentially a short-term collateralized loan.” Anomey General Opinion
JM-23 (1983) 8t 1.

        The act thus authorizes a public t%nds investment pool to purchase, sell, or invest
its funds and funds under its control in United States government securities. You indicate
that settlement on the outright purchase or sale of United States government securities




                                         p. 1434
Honorable O.H. “Ike” Harris - Page 5 W-274)




occurs within one to five business days. 4 In addition, as you note, the act expressly
authorizes a public funds investment pool to purchase, sell, and invest its fbnds and tinds
under its control in repurchase agreements that meet certain standards. You point out that,
in contrast to an “outright” purchase or sale of securities, under a repurchase agreement
@oth a direct security repurchase agreement and a reverse secu~rity repurchase
agreement), the United States securities are delivered to the buyer at 8 date beyond the
usual settlement time, which, as stated above, generally is five business days.

        You state that such “forward delivery” also is a characteristic of covered call
contracts and covered put contracts. You explain such contracts as follows:

                An investor who writes a covered call receives an income
           premium, a sum of money, and agrees to sell a vnited States]
           Government security, already owned by the investor, at a future date
           and at an agreed price. The call writer is considered covered when
           the investor already owns the underlying [United States] Government
           security agreed to be sold under the covered call contract.

                On the other hand, an investor who writes a covered put
           receives an income premium, a sum of money, agrees to buy a
           [United States] Government security at a future date and at an
           agreed price. The put writer is considered covered when the investor
           has a sufficient cash reserve equal to the total purchase price agreed
           to under the covered put contract.

Thus, under a covered call contract, an investor agrees to sell certain specified United
States government securities in the future; under a covered put contract, an investor
agrees to buy certain specified United States government securities in the future. Neither
transaction includes a subsequent buy-back of the securities. In contrast, under either a
direct security repurchase agreement or a reverse security repurchase agreement, one
party to the transaction agrees to sell United States government securities now and to buy
the securities back at a later specified date.

         The legislature enacted the Public Funds Investment Act in 1987 to enable certain
political subdivisions to make investments that previously had been prohibited. See Acts
19X7 70th i,eg., ch. 889, at 2985; see also Tex. Const. art. III, $ 52(e); Attorney General
Opinion DM-202 (1993) at 3. Since its origin81 enactment, the act has authorized political
subdivisions to which the act applies to invest in “fidly cdllateralized direct repurchase

        ‘When 8 aemrilicstransactionis “settled,”the deliveryof mrtificatesfrom seller10buyeractually
is effected
          and the bayer has    paid for the semrilies. See H. MCCAWLEY,TRANSACTIONS          IN STOCK,
SEcuRllTEsANOOther FNWCIAL~NST8LIhfENTS           A-4 (1990). The “seulementdate”generallyis on th$
iifth busine.ssday afterthe buyerand seller have enteredinto a binding mnuacl to buy and sell the stock.
Id.




                                            p. 1435
Honorable O.H. “Ike” Harris - Page 6 (DM-274)




agreements.“5 Acts 1985, 70th Leg., ch. 889, 4 2(a)(6), at 2985, umended and
renumbered by Acts 1993, 73d Leg., ch. 946, 5 1. In public hearings on the 1987 bill,
Represent8tive Hammond, the author of the bill, stated that the bill “sets out certain
specilic areas that [the listed political subdivisions] are allowed to invest in.” Hearings on
H.B. 1488 Before the House Comm. on Financial Institutions, 76th Leg. (Apr. 1, 1987)
(statement of Representative Hammond, author) (tape available from House Committee
Services Office). During the hearings on the bill before the House Committee on Financial
Institutions, legislators expressed concern that the investments listed in the bill be safe and
prudent. See id. (statements of Representative Hammond and repeated questions from
Representative Larry).

         In our opinion, the legislature intended the list of permissible investments in section
2(a) of the act to be specifically delineated and exclusive. Additionally, the legislature
specifically has considered and approved the riskiness of each of the listed permissible
investments. We therefore decline to construe “repurchase agreements” in section 2 of the
act to include covered call contracts and covered put wntracts.              Consequently, we
conclude that section 2(a)(9) of the act does not include covered call contracts and
wvered put contracts. Because covered call contracts and covered put contracts do not
fall within any of the investments in section 2(a) of the act that a public timds investment
pool is permitted to purchase, sell, or invest in, a public timds investment pool may not
write such contracts.




         51n1989the legislatureamendedthe languageof what is now section 2(a)(9) to delete the word
“direct”fromthe phrase“follymllateralizcddirectrepurchasea’grecmenu.”See Acts 1989,‘Ilst Leg., ch.
628, 0 1, 81 2099, 2100. Unfortunately,the legislatureenactedthree other bills in 1989 that amended
section 2(a), none of which deleted the word “direct”from “folly mllateralized direct repurchase
agreements’in what is now subsection(9). See Acts 1989,71st Leg., ch. 39.5 1, at 325,326; id. ch. 693,
0 4,8l3199,3200; id. ch. 750,@ 1, at 3333.3333. In 1993 the legislatoreclearlyamendedsection2(a)(9)
to deletethe word “direct.”See Acts 1993,73d Leg., ch. 946.8 1.



                                             p.   1436
Honorable O.H. “Ike” Harris - Page 7 (DM-274)




                                   SUMMARY

                A covered call contract and a covered put contract are not, for
          purposes of section 2 of the Public Funds Investment Act, V.T.C.S.
          article 842a-1, lobligations of the United States or its agencies and
          instrumentalities,” ”obligations, the principal of and interest on which
          are unconditionally guaranteed. . by. . . the United States or its
          agencies and instrumentalities.” or “titlly collateralized repurchase
          agreements having a defined termination date.” Thus, section 2 does
          not authorize a public funds investment pool to “purchase, sell, or
          invest its funds and funds under its control” in covered call contracts
          or covered put contracts.




                                                     DAN      MORALES
                                                     Attorney General of Texas

WILL PRYOR
First Assistant Attorney General

MARYKELLER
Deputy Attorney General for Litigation

RENEA HICKS
State Solicitor

MADELEINE B. JOHNSON
Chair, Opinion Committee

Prepared by Kymberly K. Oltrogge
Assistant Attorney General
