Free of payment

What Is Free of Payment?

"Free of payment" (FOP) refers to a securities transaction where the transfer of ownership of securities occurs without a corresponding exchange of money. In the realm of securities settlement, FOP transfers are distinct from "delivery versus payment" (DVP) transactions, where cash and securities are exchanged simultaneously. This method of transfer is typically used for specific purposes, such as gifts, inheritances, internal account transfers, or movements of collateral, rather than for standard market trades involving a purchase or sale.

History and Origin

The concept of transferring assets without immediate monetary exchange is as old as asset ownership itself. However, within the structured financial markets, "free of payment" transfers became formally recognized as electronic settlement systems evolved. These systems were designed to handle not only commercial trades but also other legitimate changes in ownership. For instance, the Federal Reserve's Fedwire Securities Service, established to facilitate the electronic transfer of U.S. Treasury and other government securities, specifically accommodates both delivery-versus-payment and free-of-payment transfers, emphasizing the finality and irrevocability of the transfer of securities and funds.¹², ¹³ This service plays a crucial role in modern securities settlement infrastructure, allowing for efficient movement of assets for various purposes beyond typical buy-sell transactions.¹⁰, ¹¹

Key Takeaways

• Free of payment (FOP) involves the transfer of securities without a simultaneous cash exchange.
• FOP transfers are common for non-commercial purposes, such as gifts, inheritances, or movements of collateral.
• These transfers are processed by entities like transfer agents or through electronic systems designed for securities settlement.
• Understanding the proper procedures for FOP transfers is crucial for maintaining accurate share ownership records and ensuring regulatory compliance.

Formula and Calculation

The term "free of payment" does not involve a specific financial formula or calculation, as it describes the method of transfer rather than a quantifiable financial metric. There is no monetary value derived or calculated from the FOP status itself; instead, it indicates the absence of a cash component in the exchange.

Interpreting the Free of Payment

When a transfer is designated as "free of payment," it signifies that the underlying reason for the transfer is not a commercial trade where one party is buying and the other is selling for cash. Instead, it indicates a change in ownership that stems from other circumstances. For example, a parent might transfer shares to their child as a gift, or a corporation might move securities between its internal custody accounts. In such cases, the absence of a payment leg in the transaction is the defining characteristic of "free of payment." Financial professionals interpret an FOP instruction as a directive to re-register ownership of a security from one party to another without debiting or crediting cash accounts. This understanding is critical for accurate record-keeping and avoiding errors in brokerage accounts.

Hypothetical Example

Consider an individual, Alice, who wishes to gift 100 shares of XYZ Corp. stock to her niece, Beth. Alice holds these shares in her brokerage account. To facilitate this, Alice would instruct her broker-dealer to transfer the shares to Beth's brokerage account as a "free of payment" transaction.

1. Initiation: Alice contacts her brokerage firm and completes the necessary paperwork for an FOP transfer, providing her account details, Beth's account details, and the specifics of the XYZ Corp. shares to be transferred.
2. Processing: Alice's brokerage firm, acting as the delivering firm, initiates the transfer request. They communicate with the transfer agent for XYZ Corp. and Beth's receiving brokerage firm.
3. Settlement: The shares are moved electronically from Alice's account to Beth's account. No cash changes hands between Alice and Beth, nor between their respective brokerage firms for this specific transfer instruction. The ownership record of the 100 XYZ Corp. shares is updated to reflect Beth as the new legal owner.

This scenario clearly demonstrates a free of payment transfer, as the objective is to change ownership without a sale.

Practical Applications

"Free of payment" transfers have several practical applications across various facets of finance and investing:

• Gifts and Inheritances: Securities can be transferred as gifts between individuals, often subject to gift tax regulations, or as part of an estate planning strategy following a death. The Internal Revenue Service (IRS) provides detailed guidance on what constitutes a taxable gift and the applicable reporting requirements for such transfers.⁸, ⁹
• Internal Account Transfers: Investors may move securities between different accounts they own at the same or different broker-dealer firms (e.g., from a taxable account to a trust account, or between individual and joint accounts). This can often be facilitated through services like the Automated Customer Account Transfer Service (ACATS).
• Collateral Transfers: In financial agreements such as repurchase agreements (repos) or securities lending, securities are often transferred as collateral without a direct sale. These are typically FOP movements, with the understanding that the securities will be returned.
• Corporate Actions: Companies may issue new shares to existing shareholders as part of a stock split, stock dividend, or corporate reorganization, which are FOP transfers to reflect the adjusted ownership.
• Private Securities Transfers: The transfer of restricted or unregistered private placement securities between parties, where the intent is not a public market sale, is often conducted on a free of payment basis, adhering to specific regulations like SEC Rule 144.⁶, ⁷ The SEC has provided guidance on such private transfers.⁵

Limitations and Criticisms

While "free of payment" transfers are necessary for certain transactions, they also carry inherent risks, particularly settlement risk, due to the lack of simultaneous exchange of value. Unlike a DVP transaction, where the delivery of securities and payment occur concurrently, an FOP transfer introduces a temporal risk if one leg of an intended two-part transaction (e.g., a non-cash transfer followed by a later cash payment outside of the FOP instruction) fails.

Another limitation is the potential for misuse or errors if proper procedures are not followed. Inaccurate instructions can lead to delays, incorrect account postings, or even unintended tax consequences.⁴ For instance, the Securities and Exchange Commission (SEC) has taken enforcement actions against transfer agents for failing to safeguard funds and securities and for not taking reasonable steps to find "lost securityholders," highlighting the importance of robust internal controls and due diligence in all types of transfers, including FOP.¹, ², ³ Operational errors in FOP transfers can contribute to operational risk within financial institutions.

It's also crucial to distinguish between a legitimate FOP transfer and a transaction that should involve payment but is incorrectly executed without it, which could have significant market risk implications or even suggest fraudulent activity.

Free of Payment vs. Delivery Versus Payment (DVP)

The primary distinction between "free of payment" (FOP) and delivery versus payment (DVP) lies in the presence of a monetary exchange.

DVP is the standard settlement method for most securities trades, as it significantly reduces counterparty risk by ensuring that the buyer receives the securities only when the seller receives payment, and vice versa. FOP, conversely, is reserved for situations where the transfer of ownership is not contingent on a cash transaction. For example, moving shares from a cash account to a margin account at the same brokerage firm would typically be an FOP transfer, whereas buying new shares would always be a DVP transaction.

FAQs

What does "free of payment" mean in stocks?

In stocks, "free of payment" means shares are transferred from one owner or account to another without any money being exchanged as part of that specific transfer. This is common for gifts, inheritances, or moving shares between accounts owned by the same person.

When would you use a free of payment transfer?

You would typically use a free of payment transfer for non-commercial reasons, such as gifting shares to a family member, transferring securities as part of an estate planning strategy, or moving collateral in a lending arrangement. It's also used when consolidating accounts or transferring shares between different account types (e.g., cash to margin account) under the same ownership.

Who handles free of payment transfers?

"Free of payment" transfers are typically handled by broker-dealers and transfer agents. Brokerage firms initiate the transfers based on client instructions, and transfer agents are responsible for recording changes in share ownership and maintaining the official shareholder records for a company. Electronic settlement systems, like the Fedwire Securities Service, also facilitate these transfers.

Is free of payment subject to taxes?

While the transfer itself is "free of payment," the underlying event, such as a gift or inheritance, may be subject to taxes like the gift tax or estate tax, depending on the value and applicable tax laws. The recipient of the FOP transfer usually does not pay income tax on the receipt of the gift itself, but they will be responsible for taxes on any future income or capital gains generated from those securities.