Investment Company Act of 1940 — Section 17(f) and Rule 17f-6
RESPONSE OF THE OFFICE OF CHIEF COUNSEL
Our Ref. No. 20103121347
Your letter dated July 16, 2010 requests our assurance that we would not recommend enforcement action to the Securities and Exchange Commission (the “Commission”) under Section 17(f) of the Investment Company Act of 1940 (the “1940 Act”) against any registered investment company (a “Fund”) if the Fund or its custodian places and maintains cash and/or certain securities (“assets”) in the custody of the Chicago Mercantile Exchange (“CME”) or a CME clearing member (a “CME Clearing Member”) that is a futures commission merchant registered with the Commodity Futures Trading Commission (“CFTC”) for purposes of meeting CME’s or a CME Clearing Member’s margin requirements for certain credit default swap contracts (“CDS”) that are cleared by CME.
You state the following: CME Group Inc. (“CME Group”), a Delaware stock corporation, is the holding company for CME, as well as certain other exchanges. CME is a Designated Contract Market regulated by the CFTC for the trading of futures contracts and options on futures contracts. In addition, CME Group operates its own clearing house, which is a division of CME. The CME clearing house is a Derivatives Clearing Organization (“DCO”) regulated by the CFTC. The clearing house clears, settles and guarantees the performance of all transactions for which CME Group provides clearing services, including CDS. CME as part of its clearing services will be interposed as a central counterparty for transactions in cleared CDS. Customers (including Funds) that wish to clear CDS through CME are required to maintain a clearing relationship with a CME Clearing Member, which will serve as their agent and guarantor in respect of cleared CDS. CME Clearing Members require customers to deposit a specified amount of assets as initial margin as security for performance of their obligations. The CME Clearing Member then clears the transaction and posts margin either directly with the CME, or the CME Clearing Member will clear the transaction by posting margin with another CME Clearing Member with which it has a clearing relationship, and this CME Clearing Member will then clear the transaction and post margin with CME.
CME’s rules alone or in combination with laws and regulations applicable to CME and CME Clearing Members require that any CME Clearing Member who purchases, sells, or holds CDS positions for other persons (i.e., customers including any Fund) must: (1) be registered with the CFTC as a futures commission merchant (“FCM”); (2) effectively provide for the separate treatment of assets of other persons (except positions held in proprietary accounts of the clearing member, i.e., positions of the clearing member or affiliates of the clearing member) that it holds in its custody or control for the purpose of purchasing, selling, or holding CDS positions; (3) maintain adequate capital and liquidity; and (4) maintain sufficient books and records to establish (a) that the CME Clearing Member is maintaining adequate capital and liquidity and (b) separate ownership of the funds, securities, and positions it may hold for the purpose of purchasing, selling, or holding CDS positions for other persons and those it holds for its proprietary accounts.
With respect to a CME Clearing Member’s responsibilities to separately treat customer assets from its proprietary positions, you state that the CFTC recently adopted amendments to its Part 190 Bankruptcy Rules to create a separate “cleared over-the-counter derivatives” account class (the “OTC Derivatives Account Class”) that would apply in the event of a bankruptcy of an FCM.1 You state that these provisions became effective May 6, 2010. You state that the OTC Derivatives Account Class is intended to provide customer protection parallel to the existing Section 4d account class, including similar safeguards under CFTC Part 190 Bankruptcy Rules.2
You state that the CFTC presently is relying upon DCOs such as CME to adopt rules specifying the substantive requirements for the treatment of cleared OTC derivatives in the OTC Derivatives Account Class prior to any bankruptcy. You represent that in accordance with the CFTC’s requirements, CME rules for the OTC Derivatives Account Class will mirror the provisions of Section 4d of the CEA and CFTC regulations with respect to the futures account class (i.e., 17 C.F.R. §§ 1.20, et seq.), including but not limited to the separate treatment of customer positions and property from the CME Clearing Member’s positions and property. CME anticipates that its rules for the OTC Derivatives Account Class will be implemented on September 13, 2010. You represent that once CME rules are implemented and the OTC Derivatives Account Class is operational on September 13, 2010, all funds and property received from customers in connection with purchasing or holding CDS positions will be treated as part of the OTC Derivatives Account Class.
You represent that prior to CME’s implementation of its rules for the OTC Derivatives Account Class, all CDS contracts submitted to CME for clearing for the account of a CME Clearing Member customer will be assigned and held in an account subject to CFTC Rule 30.7. You state that CFTC Rule 30.7 accounts contain funds of U.S. customers trading futures and options contracts on foreign exchanges, and may include funds of non-U.S. customers trading these products, and the funds of customers engaged in “non-regulated” transactions, including cleared over-the-counter transactions. CFTC Rule 30.7 requires that customer positions and property be separately held and accounted for from the positions and property of the FCM, and that customer property be deposited under an account name that clearly identifies it as customer property.3 You state that it is unclear whether customers with cleared OTC derivatives in a Rule 30.7 account would receive the same protections as foreign futures and options customers in the event of an FCM’s bankruptcy under the Bankruptcy Code and the Part 190 Rules.4
You state that CME and CME Clearing Members received from the Commission temporary conditional exemptions until November 30, 2010. As set forth in the Commission Order, they exempt temporarily (i) CME Clearing Members from certain requirements under the Securities Exchange Act of 1934 (“Exchange Act”) with respect to certain CDS transactions and (ii) CME from clearing agency registration under Section 17A of the Exchange Act to perform the functions of a clearing agency for certain CDS transactions (the “Commission Order”).5 The Commission Order contained a series of conditions designed to require CME Clearing Members to protect customer assets.6
With respect to CME Clearing Members holding customer assets, the Commission Order requires that a CME Clearing Member must use one of three types of accounts: (i) an account established pursuant to Section 4d of the Commodity Exchange Act (“CEA”) pursuant to an order of the CFTC (“Section 4d Order”);7 or (ii) in the absence of a Section 4d Order, in an account that is part of a separate account class, specified by CFTC Bankruptcy Rules, established for an FCM to hold its customers’ positions in cleared OTC derivatives (and funds and securities posted to margin, guarantee, or secure such positions);8 or (iii) if both of those other two alternatives are not available, in an account established in accordance with CFTC Rule 30.7 (with additional disclosures to be made to the customer, as stated below). You represent that, in accordance with the conditions imposed by the Commission Order, once CME rules are implemented and the OTC Derivatives Account Class is operational on or about September 13, 2010, all Fund assets received in connection with purchasing or holding CDS positions will be treated as part of the OTC Derivatives Account Class. Until such time, you represent that (i) all CDS contracts submitted to CME for clearing for the account of a CME Clearing Member customer will be assigned and held in an account subject to CFTC Rule 30.7 and (ii) CME will require CME Clearing Members to make certain written disclosures to their customers to highlight certain risks, including the absence of regulation as a broker-dealer by the Commission, inapplicability of protections available under the Securities Investor Protection Act, and uncertainty as to bankruptcy treatment that may affect such customers’ ability to recover funds and securities, or the speed of any such recovery, in an insolvency proceeding.
You represent that absent our assurances that we will not recommend to the Commission that it take enforcement action, Funds likely will continue to access the CDS marketplace only through direct, bilateral trading with individual CDS counterparties, forgoing the benefits of central clearing. You state that Rule 17f-6 under the 1940 Act provides that Funds may place and maintain assets with an FCM to effect a Fund’s transactions in exchange-traded futures contracts or commodity options, but the Rule does not permit Funds to place and maintain assets with an FCM to effect CDS transactions. You represent that each CME Clearing Member who holds assets for an unaffiliated Fund customer wishing to clear CDS transactions on the CME will address each of the requirements of Rule 17f-6, as follows:
(1) the manner in which a CME Clearing Member will maintain such a Fund’s assets will be governed by a written contract between the Fund and the CME Clearing Member, which provides that:9
(i) the CME Clearing Member will comply with the secured amount requirements of CFTC Rule 30.7, and once operational, the requirements relating to the separate treatment of customer funds and property of CME rules specifying the substantive requirements for the treatment of cleared OTC derivatives in the OTC Derivatives Account Class prior to any bankruptcy;10
(ii) the CME Clearing Member may place and maintain the Fund’s assets as appropriate to clearing the Fund’s CDS transactions on the CME and in accordance with the CEA and the CFTC’s rules thereunder, and will obtain an acknowledgement, as required under CFTC Rule 30.7(c) or Rule 1.20(a), as applicable, that such assets are held on behalf of the CME Clearing Member’s customers in accordance with the provisions of the CEA;11 and
(iii) the CME Clearing Member will promptly furnish copies of or extracts from its records or such other information pertaining to the Fund’s assets as the Commission through its employees or agents may request;12
(iv) any gains on the Fund’s transactions, other than de minimis amounts, may be maintained with the CME Clearing Member only until the next business day following receipt;13 and
(v) the Fund has the ability to withdraw its assets from the CME Clearing Member as soon as reasonably practicable if the custodial arrangement no longer meets the requirements of Rule 17f-6, as applicable.14
Section 17(f) of the 1940 Act and the rules thereunder govern the safekeeping of Fund assets, and generally provide that a Fund must place and maintain its securities and similar instruments only with certain qualified custodians. As stated above, Rule 17f-6 under the 1940 Act permits a Fund to place and maintain assets with an FCM that is registered under the CEA and that is not affiliated with the Fund in amounts necessary to effect the Fund’s transactions in exchange-traded futures contracts and commodity options, subject to certain conditions. Among other things, the FCM must comply with the segregation requirements of Section 4d of the CEA and the rules thereunder or, if applicable, the secured amount requirements of CFTC Rule 30.7. Rule 17f-6 was intended to provide Funds with the ability to effect commodity trades in the same manner as other market participants under conditions designed to provide custodial protections for Fund assets.15
As discussed above, in March 2010, the Commission Order issued temporary exemptions until November 30, 2010 to CME and CME Clearing Members to facilitate central clearing of certain CDS. In the Commission Order, the Commission stated:
The Commission has taken multiple actions designed to address concerns related to the market in CDS. The over-the-counter (“OTC”) market for CDS has been a source of particular concern to us and other financial regulators, and we have recognized that facilitating the establishment of central counterparties for CDS can play an important role in reducing the counterparty risks inherent in the CDS market, and thus can help mitigate potential systemic impact. We have therefore found that taking action to help foster the prompt development of central counterparties, including granting temporary conditional exemptions from certain provisions of the federal securities laws, is in the public interest.16
We conclude that the factors highlighted in the Commission Order, along with certain representations provided by CME, argue in favor of flexibly applying the custody requirements of the 1940 Act in this instance. In particular, we rely on your representations and the conditions in the Commission Order that:
In taking this position, we note that, as the Commission stated in adopting Rule 17f-6 and as you acknowledge, maintaining assets in an FCM’s custody is not without risk.17 Therefore, we strongly encourage Funds to weigh carefully the risks and the benefits of maintaining assets to effect transactions in CDS with a CME Clearing Member and CME.18
Based on the facts and representations in your letter, we would not recommend enforcement action to the Commission under Section 17(f) of the 1940 Act against a Fund if the Fund or its custodian places and maintains assets in the custody of CME or a CME Clearing Member for purposes of meeting CME’s or a CME Clearing Member’s margin requirements for CDS that are cleared by CME.
Our position herein is temporary, and will expire when the Commission Order is no longer effective or it is rescinded, whichever is earlier. Because our position is based on the facts and representations made in your letter, you should note that any different facts or circumstances might require a different conclusion. This letter represents only the Division’s position on enforcement action and does not purport to express any legal conclusion on the questions presented.
1 See 75 Fed. Reg. 17297 (Apr. 6, 2010) (adopting final rules establishing a sixth and separate account class applicable for cleared over-the-counter derivatives only). See also 74 Fed. Reg. 40794 (Aug. 13, 2009) (proposing final rules establishing a sixth and separate account class applicable for cleared over-the-counter derivatives only).
2 You state that a Section 4d account contains funds of customers trading futures and options on futures on U.S. exchanges, separate from the FCM’s own funds.
3 You state that futures accounts (governed by Section 4d of the Commodity Exchange Act and foreign futures accounts (governed by CFTC Rule 30.7) are each a recognized “account class” under the CFTC’s Part 190 Rules, which would be applicable in the event of an FCM’s bankruptcy. Similarly, pursuant to the CFTC’s recent rule amendments, the OTC Derivatives Account Class is a recognized “account class” under the CFTC’s Part 190 Rules, which would be applicable in the event of an FCM’s bankruptcy. Under the Part 190 Rules, each account class is a separate pool of funds for claims of customers in that class. The claims of customers whose funds are held in defined account classes will have priority over proprietary claims and the claims of general creditors in an FCM’s bankruptcy.
4 See Letter from Ann K. Shuman, Managing Director and Deputy General Counsel, CME, to Elizabeth Murphy, Secretary, Commission, Dec. 14, 2009, stating that “[n]either the CFTC nor the courts have issued an interpretation with regard to the bankruptcy protections that would be afforded to customers clearing OTC positions in 30.7 accounts, and it is therefore unclear whether they would receive the same protections as foreign futures customers.”
5 Securities Exchange Act Rel. No. 61803 (Mar. 30, 2010) (the “Commission Order”). See also Securities Exchange Act Rel. Nos. 61164 (Dec. 14, 2009) and 59578 (Mar. 13, 2009) (issuing temporary exemptions in connection with CDS clearing by CME that were extended in the Commission Order).
6 See the Commission Order, id. at pages 34-39. For example, the Commission Order requires that the CME Clearing Member annually provide CME with a self-assessment that it is in compliance with applicable laws and regulations relating to the segregation of customer funds and secured amount requirements in connection with clearing CDS transactions on CME, as well as a report by the clearing member’s independent third-party auditor attesting to the assessment.
7 You state that CME previously petitioned the CFTC for an order pursuant to Section 4d of the CEA with respect to cleared CDS contracts (“Section 4d Order”). See Letter from Lisa A. Dunsky, Director and Associate General Counsel, CME Group, to David Stawick, Secretary to the CFTC, dated June 15, 2009. If granted, the Section 4d Order would have permitted funds margining cleared CDS transactions on CME to be held by clearing FCMs and clearing houses in Section 4d accounts. However, you represent that the CFTC’s adoption of rules establishing the OTC Derivatives Account Class obviates the need for CME to petition the CFTC for a Section 4d Order, given that the OTC Derivatives Account Class, together with CME’s forthcoming rules for the OTC Derivatives Account Class, will provide safeguards for customer funds and property comparable to those provided in customer accounts segregated pursuant to Section 4d and CFTC regulations thereunder. Therefore, you state that CME has withdrawn its petition for a Section 4d Order.
8 See note 1, supra, and accompanying text discussing the CFTC’s recent amendments to its rules establishing the OTC Derivatives Account Class.
9 See Rule 17f-6(a)(1) under the 1940 Act.
10 See Rule 17f-6(a)(1)(i) under the 1940 Act.
11 See Rule 17f-6(a)(1)(ii) under the 1940 Act. You state that under CFTC Rule 1.20(a), an acknowledgement need not be obtained from a DCO such as the CME that has adopted and submitted to the CFTC rules that provide for the segregation as customer funds, in accordance with relevant provisions of the CEA and the rules thereunder, of all funds held on behalf of customers.
12 See Rule 17f-6(a)(1)(iii) under the 1940 Act.
13 See Rule 17f-6(a)(2) under the 1940 Act.
14 See Rule 17f-6(a)(3) under the 1940 Act.
15 Investment Company Act Rel. No. 22389 (Dec. 11, 1996) (“Rule 17f-6 Adopting Release”). In particular, Rule 17f-6 under the 1940 Act incorporates the safeguards that are provided for Fund assets under the CEA and CFTC rules.
16 See the Commission Order, supra note 5 at pages 1-2.
17 See the Rule 17f-6 Adopting Release, supra note 15, at n. 13 (“If an FCM becomes insolvent and cannot cover the obligations of a defaulting customer, the FCM’s non-defaulting customers may be affected.”). See also the Commission Order, supra note 5 at page 26 (“We understand that the protections associated with using CFTC Rule 30.7 to segregate collateral associated with over-the-counter derivatives is untested, and thus less certain than the protections that would be afforded to collateral protected by Section 4d.”) See also the Report to the Supervisors of the Major OTC Derivatives Dealers on the Proposals of Centralized CDS Clearing Solutions for the Segregation and Portability of Customer CDS Positions and Related Margin (June 30, 2009), available at http://www.newyorkfed.org/markets/Full_Report.pdf (the ISDA buy-side/sell-side committee report analyzing the legal issues associated with segregating the collateral that customers post with members).
18 See also Rule 17f-6 Adopting Release, supra note 15, at page 13 (stating that Fund boards have a particular responsibility to ask questions concerning why and how the Fund uses futures and other derivative instruments, the risks of using such instruments, and the effectiveness of internal controls designed to monitor risk and assure compliance with investment guidelines regarding the use of such instruments).
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