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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
Release No. IC-22389; File No. S7-15-94
RIN 3235-AF97
Custody of Investment Company Assets with Futures Commission
Merchants and Commodity Clearing Organizations
AGENCY: Securities and Exchange Commission
ACTION: Final Rule
SUMMARY: The Commission is adopting a new rule under the
Investment Company Act of 1940 to permit registered investment
companies to maintain their assets with futures commission
merchants and certain other entities in connection with
futures contracts and commodity options traded on U.S. and
foreign exchanges. Currently, investment companies generally
must maintain assets relating to these transactions in special
accounts with a custodian bank. The new rule will enable
investment companies to effect their commodity trades in the
same manner as other market participants under conditions
designed to provide custodial protections for investment
company assets.
EFFECTIVE DATE: The rule will become effective [insert date
thirty days after publication in the Federal Register].
FOR FURTHER INFORMATION CONTACT: Kenneth J. Berman, Assistant
Director, Office of Regulatory Policy, Division of Investment
Management, at (202) 942-0690, or Elizabeth R. Krentzman,
Assistant Director, Office of Disclosure and Investment
Adviser Regulation, Division of Investment Management, at
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(202) 942-0721, Securities and Exchange Commission, 450 Fifth
Street, N.W., Mail Stop 10-2, Washington, D.C. 20549.
Requests for formal interpretive advice should be
directed to the Office of Chief Counsel at (202) 942-0659,
Division of Investment Management, Securities and Exchange
Commission, 450 Fifth Street, N.W., Mail Stop 10-6,
Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange
Commission ("Commission") today is adopting rule 17f-6 [17 CFR
270.17f-6] under the Investment Company Act of 1940 [15 U.S.C.
80a] (the "Investment Company Act"). The new rule governs the
custody of investment company assets by futures commission
merchants and other entities used for settling commodity
transactions. The rule does not affect the extent to which
investment companies may engage in commodity trading.
TABLE OF CONTENTS
EXECUTIVE SUMMARY
I. BACKGROUND
A. Commodities Trading and Investment Company Act
Custody
B. Custodial Protections for Commodity Assets under
the Commodity Exchange Act
II. RULE 17f-6
A. Role of Fund Board of Directors
B. Eligible FCM Custodians
1. FCM Registration and CFTC Net Capital
Requirements
2. Affiliated FCM Arrangements
C. Domestic and Foreign Commodity Transactions
D. Assets Held in FCM Custody
1. Initial Margin
2. Gains on Commodity Transactions
E. Contract Requirements and Custodians Used to Effect
Commodity Transactions
F. Withdrawal of Assets from FCM Custody
III. COST/BENEFIT ANALYSIS
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IV. SUMMARY OF REGULATORY FLEXIBILITY ANALYSIS
V. STATUTORY AUTHORITY
TEXT OF ADOPTED RULE
EXECUTIVE SUMMARY
The Commission is adopting rule 17f-6 under the
Investment Company Act. Rule 17f-6 permits registered
management investment companies, unit investment trusts
("UITs"), and face-amount certificate companies (collectively,
"funds") to maintain assets (i.e., margin) with futures
commission merchants ("FCMs") in connection with commodity
transactions effected on both domestic and foreign exchanges.
Currently, funds generally must maintain such assets in
special accounts with a custodian bank. The new rule is
designed to eliminate unnecessary regulatory burdens, and to
enable funds to effect their commodity trades in the same
manner as other market participants.
Rule 17f-6 permits funds to maintain their assets with
FCMs that are registered under the Commodity Exchange Act
("CEA") and that are not affiliated with the fund. Rule 17f-6
requires a written contract between the fund and the FCM to
contain certain provisions. Among other things, the FCM must
agree that any other FCMs used to clear the fund's trades meet
the rule's requirements (other than the requirement of a
contract with the fund). To protect fund assets from loss in
the event of an FCM's bankruptcy, any gains on fund
transactions may be maintained with an FCM only in de minimis
amounts.
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Unlike the rule as originally proposed, rule 17f-6 does
not require a fund's board of directors to select and monitor
the fund's FCM arrangements, nor does the rule require an FCM
that holds fund assets to meet capital standards in excess of
those imposed under the CEA.
Rule 17f-6 does not require that assets related to
commodities transactions be maintained with an FCM. Funds may
continue to maintain such assets in a special account with a
custodian bank.
I. BACKGROUND
A. Commodities Trading and Investment Company Act
Custody
The Commission proposed rule 17f-6 under the Investment
Company Act to permit management investment companies to
effect their commodity trades by placing assets relating to
such transactions directly with FCMs.-[1]- Over the last
several years, fund participation in commodity markets has
increased. A fund, for example, may engage in commodity
trades to hedge its portfolio against declines in securities
prices, changes in interest rates, or foreign currency
-[1]- Rule 17f-6 was proposed for public comment on
May 24, 1994. Custody of Investment Company
Assets with Futures Commission Merchants and
Commodity Clearing Organizations, Investment
Company Act Release No. 20313 (May 24, 1994)
[59 FR 28286 (June 1, 1994)] [hereinafter the
Proposing Release].
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fluctuations.-[2]- A fund also may enter into commodity
transactions to adjust the percentage of its portfolio held in
cash, debt, and stocks without having to buy or sell the
actual assets.-[3]-
To enter into a futures contract or write a commodity
option, a customer typically deposits with an FCM, as security
for performance of its obligations, a specified amount of
assets or cash as "initial margin."-[4]- In the case of
-[2]- Commodity transactions include futures
contracts and options on futures contracts and
physical commodities. A futures contract
generally is a bilateral agreement providing
for the purchase or sale of a specified
commodity at a stated time in the future for a
fixed price. ROBERT E. FINK & ROBERT B.
FEDUNIAK, FUTURES TRADING 10 (1988)
[hereinafter FINK & FEDUNIAK]. A commodity
option gives its holder the right, for a
specified period of time, to either buy (in the
case of a call option) or sell (in the case of
a put option) the subject of the option at a
predetermined price. The writer (seller) of an
option is obligated to sell or buy the
specified commodity at the election of the
option holder. 1 PHILIP M. JOHNSON & THOMAS L.
HAZEN, COMMODITIES REGULATION section 1.07 (2d
ed. Supp. 1991) [hereinafter JOHNSON & HAZEN].
-[3]- Taking a position in a futures contract with
respect to stocks that comprise the Standard &
Poor's 500 Index, for example, may be more
efficient than buying and selling all of the
stocks that comprise that index due to lower
brokerage and transaction costs.
-[4]- Unlike the parties to a futures contract, only
the writer (seller) of an option is subject to
margin requirements; the option holder
(purchaser) pays the writer a one-time premium
as compensation in full for its right to compel
the writer's performance. See Proposing
Release, supra note 1, at n.44 and accompanying
text.
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a fund, placing initial margin with an FCM could be viewed as
placing fund assets in the custody of the FCM.-[5]- The
FCM then clears the transaction by posting margin either
directly with a clearing organization or with one or more
other FCMs that will effect the transaction through the
clearing organization.-[6]-
Section 17(f) generally permits a fund to maintain its
assets only in the custody of a bank, a member of a national
securities exchange, the fund itself, or a national securities
-[5]- Initial margin is not considered part of the
contract or option price, and is returned upon
termination of the position, unless used to
cover a loss. Initial margin in commodity
transactions thus differs from securities
margin, which represents a partial payment for
securities purchased by a broker on its
customer's behalf. Initial margin can also be
contrasted with variation margin, which is
credited or assessed at least daily to reflect
any gains or losses in the contract's value.
In contrast to initial margin, variation margin
represents the system of marking to market the
contract's value. Through this system, losses
on one side of a contract position are matched
with and paid as profits to the other side of
the transaction. See Proposing Release, supra
note 1 at nn.34-38 and accompanying text, and
infra note 37.
-[6]- The clearing organization matches the trade on
behalf of the exchange, and acts as guarantor
of the opposite side of the transaction. An
FCM executing trades on an exchange must be a
member of that exchange; nonmembers trade by
entering orders through an exchange member. To
clear transactions with a clearing
organization, an FCM must be both an exchange
member and a member of the clearing
organization. Non-clearing member FCMs must
execute their transactions through a clearing
member. A commodity transaction, therefore,
may be effected through several FCMs.
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depository.-[7]- Under no-action positions of the
Division of Investment Management, a fund may, consistent with
the requirements of section 17(f), place assets relating to
commodity transactions in a special account with a third party
custodian bank ("third party accounts").-[8]- As a
consequence, an FCM must use its own assets to effect fund
commodity trades.
The Commission proposed rule 17f-6 to respond to certain
criticisms associated with third party accounts.-[9]-
Commenters have indicated that third party accounts create
systemic liquidity risks by diverting FCM capital, which would
otherwise be available for use in the marketplace, to effect
fund transactions.-[10]- Commenters also have stated
-[7]- 15 U.S.C. 80a-17(f). See also Investment
Company Act rules 17f-1 [17 CFR 270.17f-1]
(custody with members of national securities
exchanges); 17f-2 [17 CFR 270.17f-2] (custody
by funds themselves); 17f-4 [17 CFR 270.17f-4]
(custody with securities depositories); 17f-5
[17 CFR 270.17f-5] (custody of fund securities
outside the United States).
-[8]- See, e.g., Prudential Bache IncomeVertible Plus
Fund, Inc. (pub. avail. Nov. 20, 1985). The
third party account may be maintained in the
name of the FCM, but the FCM's ability to
withdraw these funds is limited. See Proposing
Release, supra note 1, at n.55 and accompanying
text.
-[9]- See Proposing Release, supra note 1, at nn.61-
70 and accompanying text.
-[10]- According to a 1988 report, third party
accounts may have been a source of liquidity
stress in the clearing and credit systems
during the October 1987 market break. REPORT
(continued...)
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that third party arrangements are unnecessary because they are
unlikely to provide any special protection to fund assets in
FCM bankruptcy proceedings. The U.S. Bankruptcy Code and
rules of the Commodity Futures Trading Commission ("CFTC")
provide that customer assets relating to commodity
transactions generally have priority over other creditors'
claims, and are subject to distribution based on each
customer's pro rata share of the available customer
property.-[11]- Although the issue has not been
judicially determined, the CFTC staff has stated that assets
in a third party account will be subject to the same pro rata
treatment as all other assets in the FCM's
custody.-[12]- Finally, third party accounts may be
-[10]-(...continued)
OF THE PRESIDENTIAL TASK FORCE ON MARKET
MECHANISMS (1988) VI-73 to -74 (discussing
statements of members of the Chicago Mercantile
Exchange).
-[11]- 11 U.S.C. 766; CFTC rule 190.08 [17 CFR
190.08].
-[12]- CFTC Financial and Segregation Interpretation
No. 10, Treatment of Funds Deposited in
Safekeeping Accounts, 1 Comm. Fut. L. Rep.
(CCH) 7120 at 7130 (CFTC Division of Trading
and Markets, May 23, 1984) [hereinafter
Interpretation No. 10]. See also CFTC Advisory
No. 37-96, Responsibilities of Futures
Commission Merchants and Relevant Depositories
with Respect to Third Party Custodial Accounts
(July 25, 1996) (discussing Interpretation No.
10 and requesting that FCMs review their
custody arrangements with depository
institutions to assure that they fully accord
with the requirements of the CEA and CFTC
regulations).
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redundant in view of the safeguards for customer assets
afforded by the CEA and CFTC rules.
B. Custodial Protections for Customer Assets under the
Commodity Exchange Act
The CEA and CFTC rules contain provisions designed to
safeguard customer assets held by an FCM.-[13]- For
transactions traded on domestic exchanges, extensive
regulations, known as the "segregation requirements," are
designed to protect customer funds in an FCM's
possession.-[14]- Under these requirements, an FCM may
maintain customer assets in a single commingled bank account
established for those assets. The FCM must segregate customer
-[13]- Maintaining assets in an FCM's custody is not
without risk. An FCM is financially
responsible for the trade obligations of its
customers. JOHNSON & HAZEN, supra note 2, at
section 1.10. If an FCM becomes insolvent and
cannot cover the obligations of a defaulting
customer, the FCM's non-defaulting customers
may be affected. The clearing organization has
the right to use customer assets held at the
clearing organization level to satisfy a
commodity loss on behalf of the FCM's
customers. The resulting shortfall in the
customer assets may be borne by the FCM's non-
defaulting customers. See supra note 11 and
infra note 17, and accompanying text (regarding
FCM bankruptcy provisions). To date, however,
losses of customer funds have been rare. See
Andrea M. Corcoran & Susan C. Ervin,
Maintenance of Market Strategies in Futures
Broker Insolvencies: Futures Position
Transfers From Troubled Firms, 44 WASH. & LEE
L. REV. 849, 863-64 (1987) ("customer losses
have been forestalled . . . , in significant
measure, by the voluntary contributions of
futures exchanges").
-[14]- CEA section 4d(2) [7 U.S.C. 6d(2)]; CFTC rules
1.20 to .30 [17 CFR 1.20 to .30].
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funds from the FCM's own assets, and may not use one
customer's assets to carry another customer's
trades.-[15]- Special provisions, which parallel the
segregation requirements for domestic transactions, govern the
safekeeping of margin relating to foreign exchange-traded
transactions.-[16]- CFTC rules require an FCM engaging
in foreign commodity transactions to maintain a "secured
amount," which generally represents the assets required to
margin the foreign commodity trades of its U.S. customers.-
[17]-
-[15]- Customer funds also may be maintained in a
commingled bank account established by the
clearing organization for the FCM's customers.
-[16]- CFTC rule 30.7 [17 CFR 30.7].
-[17]- Id. In the event of an FCM's bankruptcy, CFTC
rules provide for the allocation of property
among different types of customer accounts,
which include customer assets underlying U.S.
and foreign trades that are subject to the
segregation and secured amount requirements,
respectively. While customer assets relating
to U.S. and foreign-based trades are subject to
the same pro rata treatment in FCM bankruptcy
proceedings (see supra note 11 and accompanying
text), customers of U.S. and foreign trades may
receive different proportional amounts based on
the assets attributed to the respective account
classes. For example, a shortfall in the
secured amount (e.g., due to a customer default
or currency fluctuations during bankruptcy
proceedings) will result in customers of
foreign trades receiving a smaller percentage
of their margin deposits than customers of the
segregated account class underlying U.S.
trades. Although the maintenance of separate
customer accounts for U.S. and foreign-based
trading may result in different pro rata
distributions in FCM bankruptcy proceedings,
these differences generally are attributable to
the investment risks associated with U.S. and
(continued...)
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As proposed, rule 17f-6 would have permitted funds to
post commodity margin with FCMs registered under the CEA,
subject to certain conditions. Nineteen commenters commented
on proposed rule 17f-6. Commenters generally supported the
rule's adoption, while recommending certain changes to the
proposed rule.
II. RULE 17f-6
The Commission is adopting rule 17f-6 with a number of
changes based on commenters' suggestions. Rule 17f-6, as
adopted, extends to registered investment
companies.-[18]- The adopted rule incorporates the
safeguards that are provided for fund assets under the CEA and
-[17]-(...continued)
foreign-based commodity transactions rather
than differences in custodial protections.
-[18]- See rule 17f-6(b)(3) [17 CFR 270.17f-6(b)(3)]
(defining "Fund"). The Commission notes that
trading in futures contracts and commodity
options ordinarily requires a significant
degree of management. Since unit investment
trust ("UIT") portfolios are generally
unmanaged, it is unclear at present to the
Commission how an investment company that
engages is commodity trading could meet the
requirements imposed on a UIT by the Investment
Company Act, including section 4(2) thereof [15
U.S.C. 80a-4(2)].
Rule 17f-6 also is available to face-amount certificate
companies that are governed by section 28 of the
Investment Company Act [15 U.S.C. 80a-28]. See IDS
Certificate Company, Investment Company Act Release Nos.
21098 (May 26, 1995) [60 FR 28818 (June 2, 1995)] (Notice
of Application) and 21155 (June 21, 1995) [59 SEC Docket
1918] (Order) (regarding, among other things, a face-
amount certificate company's participation in commodity
markets and the use of third party accounts).
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CFTC rules and, in so doing, generally permits funds to effect
domestic and foreign commodity transactions in the same manner
as other market participants.
A. Role of Fund Board of Directors
Proposed rule 17f-6 would have required a fund's board of
directors (or the board's delegate) to find that maintaining
the fund's assets with an FCM is consistent with the best
interests of the fund and its shareholders. The proposed rule
also would have required the board or its delegate to
establish a monitoring system to ensure compliance with the
requirements of the rule. Several commenters opposed this
approach, stating that the level of board involvement was
burdensome and unnecessary in light of the regulatory
safeguards under the CEA and CFTC rules.
Upon further consideration of the issue, the Commission
believes that the rule's objective standards (in particular,
the requirement of FCM registration and the related CFTC
segregation and secured amount requirements) make specific
provisions concerning board oversight unnecessary.-[19]-
-[19]- Eliminating the requirement in rule 17f-6 for
the board or its delegate to select and monitor
FCM arrangements differs from the approach
under rule 17f-5, which governs the custody of
fund assets outside the United States. Custody
arrangements for assets maintained outside the
United States and related safeguards vary
widely from one country to another. As such,
it appears to be appropriate for such rule to
require case-by-case evaluations. See Custody
of Investment Company Assets Outside the United
States, Investment Company Act Release No.
(continued...)
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As adopted, rule 17f-6 does not require a fund's board to
select or monitor the FCMs with which the fund places margin.
Like other aspects of fund operations, however, FCM
arrangements will remain subject to the board's general
oversight.-[20]- In this regard, 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.
B. Eligible FCM Custodians
1. FCM Registration and CFTC Net Capital
Requirements
Like the proposed rule, rule 17f-6 permits a fund to
place and maintain assets with an FCM that is registered under
the CEA.-[21]- Registered FCMs are subject to the
-[19]-(...continued)
21259 (July 27, 1995) [60 FR 39592 (Aug. 2,
1995)]. In contrast, domestic and foreign FCM
arrangements are subject to a regulatory
framework under the CEA designed to provide
consistent safeguards.
-[20]- The Investment Company Act and state law impose
oversight responsibilities on a fund's board of
directors to protect the interests of fund
shareholders. See, e.g., Burks v. Lasker, 441
U.S. 471, 484 (1979).
-[21]- See rule 17f-6(b)(4) [17 CFR 270.17f-6(b)(4)]
(defining "Futures Commission Merchant"). The
FCM may, in turn, place the initial margin with
(continued...)
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requirements of the CEA and CFTC rules thereunder, which,
among other things, address the safekeeping of assets in FCM
custody.-[22]- Rule 17f-6 does not require that the FCM
be a member of a commodity exchange or clearing organization.
Such a requirement would not appear necessary for the
protection of fund assets and would unnecessarily limit the
number of FCMs that could be used as fund
custodians.-[23]- A registered FCM, regardless of its
membership status, is subject to the CEA and CFTC safekeeping
requirements.
Under CFTC rules, a registered FCM must maintain adjusted
net capital equal to or exceeding the greatest of (i)
$250,000, (ii) 4% of customer funds maintained in safekeeping,
or (iii) for an FCM that also is a registered securities
broker-dealer, the net capital required by rule 15c3-1(a)
under the Securities Exchange Act of 1934.-[24]- An FCM
generally must notify the CFTC of potential capital impairment
if the ratio of its total adjusted net capital to CFTC
-[21]-(...continued)
certain other market participants, such as a
clearing organization, to effect the fund's
transactions. See rule 17f-6(a)(1)(ii) [17 CFR
270.17f-6(a)(1)(ii)].
-[22]- See supra notes 13-17 and infra note 33, and
accompanying text.
-[23]- See supra note 6 and accompanying text.
-[24]- CFTC rule 1.17 [17 CFR 1.17]; 17 CFR 240.15c3-
1(a).
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required minimums falls below 150%.-[25]- Rule 17f-6,
as proposed, would have required an FCM holding fund assets to
have at least $20 million in adjusted net capital in excess of
the CFTC's net capital requirements. In addition, the FCM's
adjusted net capital would have had to equal or exceed 250% of
the CFTC's required minimum.-[26]-
Commenters were divided on the proposed approach.
Commenters opposing the additional capital requirements
suggested that, because the CFTC net capital requirements
serve to protect assets in an FCM's custody from loss due to
misappropriation or the FCM's insolvency, additional capital
standards are not necessary. The Commission agrees that the
CFTC net capital requirements are designed to safeguard fund
assets in an FCM's custody.-[27]- Therefore, rule
17f-6, as adopted, does not require FCM custodians to meet
additional capital standards.
-[25]- CFTC rule 1.12 [17 CFR 1.12]. The CFTC
recently amended rule 1.12 to strengthen its
provisions concerning early warning to the CFTC
in the event of FCM capital impairment. Early
Warning Reporting Requirements, Minimum
Financial Requirements, Prepayment of
Subordinated Debt, Gross Collection of
Exchange-Set Margin for Omnibus Accounts and
Capital Charge on Receivables from Foreign
Brokers (Apr. 25, 1996) [61 FR 19177 (May 1,
1996)] [hereinafter the CFTC Early Warning
Release].
-[26]- See Proposing Release, supra note 1, at nn.97-
98 and accompanying text.
-[27]- See, e.g., CFTC Early Warning Release, supra
note 25.
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2. Affiliated FCM Arrangements
As proposed, rule 17f-6 would have broadly prohibited a
fund from placing assets with any FCM that is an affiliated
person of the fund or an affiliated person of such
person.-[28]- This provision is being adopted
substantially as proposed.-[29]- While some commenters
viewed the scope of this provision as too restrictive, custody
by fund affiliates raises additional investor protection
concerns.-[30]-
C. Domestic and Foreign Commodity Transactions
As proposed, rule 17f-6 would have permitted a fund to
place assets with an FCM only in connection with domestic
commodity transactions. The proposed rule would not have
permitted a fund to place assets with an FCM in connection
-[28]- See Proposing Release, supra note 1, at nn.104-
106 and accompanying text; Investment Company
Act section 2(a)(3) [15 U.S.C. 80a-2(a)(3)]
(defining affiliated person).
-[29]- Rule 17f-6(b)(4) [17 CFR 270.17f-6(b)(4)]. The
prohibition has been incorporated into the
definition of "Futures Commission Merchant."
-[30]- For example, to guard against potential abuses
resulting from control over fund assets by
related persons in other contexts, rule 17f-2,
the Commission's rule governing self-custody
arrangements, has been read to require fund
affiliates to comply with its provisions or
establish other appropriate safeguards. See,
e.g., Pegasus Income and Capital Fund, Inc.
(pub. avail. Dec. 31, 1977) (custody by
adviser-bank). One commenter acknowledged the
risks that could be presented by affiliated
custody and suggested that safeguards similar
to those in rule 17f-2 could be required for
affiliated FCM arrangements.
==========================================START OF PAGE 17======
with commodity transactions traded on a foreign exchange.
Commenters strongly urged the Commission to expand rule 17f-6
to permit FCM custody in connection with foreign exchange-
traded transactions. In support of this approach, commenters
cited the custodial protections under the CEA applicable to
these transactions and noted the importance of international
commodity trading in achieving fund management and hedging
objectives.
Upon further consideration of the issue, the Commission
has decided to permit a fund to place assets with a registered
FCM in connection with commodity trades effected on both
domestic and foreign exchanges.-[31]- As in the case of
-[31]- See rule 17f-6(b)(2)(i) and (ii) [17 CFR
270.17f-6(b)(2)(i) and (ii)] (defining
"Exchange-Traded Futures Contracts and
Commodity Options" for purposes of domestic and
foreign transactions, respectively). Certain
foreign-related commodity transactions trade on
U.S. exchanges. These transactions, which may
involve placing fund margin outside the United
States, include futures contracts and commodity
options involving foreign currencies and those
effected through electronic links between U.S.
and foreign exchanges. Consistent with CFTC
rules and commodity settlement practices, a
fund engaging in foreign currency transactions
on domestic exchanges or placing margin
overseas in connection with domestic trades may
enter into subordination agreements. In these
agreements, commodity customers agree that, if
their FCM becomes insolvent and there is a
margin shortfall, claims to margin securing
their trades will be subordinated to the claims
of customers whose accounts are denominated in
U.S. dollars or held in the United States. See
CFTC Financial and Segregation Interpretation
No. 12 [53 FR 46911 (Nov. 21, 1988)] (the
subordination requirement seeks to tie the
(continued...)
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domestic transactions, an FCM holding the assets of U.S.
customers in connection with foreign commodity transactions is
subject to CFTC regulations designed to protect those
assets.-[32]- These regulations require the FCM to be
registered under the CEA, and thus subject to, among other
-[31]-(...continued)
risks of a particular jurisdiction or currency
to customers engaging in commodity transactions
relative to that jurisdiction or currency).
See also Proposing Release, supra note 1, at
nn.148-152 and accompanying text. In the case
of commodity transactions effected on foreign
exchanges, a subordination agreement is not
required. In FCM bankruptcy proceedings, when
a fund's assets relating to foreign
exchange-traded transactions are held in one or
more foreign currencies, the fund may be
subject to the risks of foreign currency
fluctuations of assets held on behalf of other
customers in other foreign currencies.
-[32]- CFTC rules 30.1 to .11 [17 CFR 30.1 to .11];
see supra notes 13-17 and accompanying text.
In early 1995, Barings PLC, a British
investment bank, failed after suffering losses
of approximately $1 billion from commodity
transactions effected on the Singapore Monetary
Exchange. Following Barings' collapse,
commodity regulators from sixteen countries
agreed in the "Windsor Declaration" on
principles aimed at improving communications
among commodity regulators and enhancing
surveillance of risks taken by commodity market
participants. Among the issues addressed was
the protection of customer assets. See Suzanne
McGee, Futures Regulators Agree to Cooperate
Globally, Wall St. J. C18 (May 18, 1995); Brett
D. Fromson, Regulators Adopt Crisis Measures,
Wash. Post D15 (May 18, 1995). Earlier this
year, commodity exchanges and regulators from
various countries agreed on specific
information-sharing measures. Suzanne McGee,
Two Information-Sharing Pacts Signed By 50
Exchanges and 13 Regulators, Wall St. J. A7B
(Mar. 18, 1996).
==========================================START OF PAGE 19======
things, the secured amount and CFTC net capital
requirements.-[33]- Consistent with commodity trading
practices, the rule permits FCMs to place fund assets with a
clearing organization and certain other market participants as
appropriate to effect foreign commodity
transactions.-[34]-
D. Assets Held in FCM Custody
1. Initial Margin
As proposed, rule 17f-6 would have permitted a fund to
place and maintain assets with an FCM in amounts necessary to
effect its commodity trades. Consistent with commodity
settlement practices, the proposed rule would have allowed a
fund to maintain assets with an FCM to meet exchange-imposed
minimum margin requirements, as well as any additional
-[33]- CEA section 4d(1) [7 U.S.C. 6d(1)]; CFTC rules
3.10, 30.4 [17 CFR 3.10, 30.4]. The CFTC
grants to certain foreign commodity brokers
exemptions from requirements under the CFTC's
rules relating to transactions effected on
foreign exchanges, including FCM registration.
CFTC rule 30.10 [17 CFR 30.10]. The CFTC
grants the exemption based on a determination
that the foreign broker is subject to
comparable regulation in its home country.
Because of uncertainties arising from differing
regulatory schemes among various jurisdictions,
especially those involving the bankruptcies of
commodities brokers, rule 17f-6 permits funds
to use only registered FCMs.
-[34]- See infra note 43 and accompanying text
(discussing provisions of rule 17f-6 that
permit an FCM to transfer fund margin to
another registered FCM, a clearing
organization, a member of a foreign board of
trade, or a U.S. or foreign bank).
==========================================START OF PAGE 20======
requirements imposed by the FCM. Three commenters supported
the proposed approach. One commenter recommended that the
rule limit FCM custody of fund margin to the minimum
requirements established by an exchange.
The Commission is adopting this provision of the rule as
proposed. Rule 17f-6 permits funds to meet FCM margin
requirements that exceed those of an exchange.-[35]-
Limiting FCM custody of initial fund margin to exchange
requirements is not necessary to safeguard fund assets. Such
a limitation also would be inconsistent with commodity
settlement practices, since FCMs typically impose higher
margin requirements than the margin requirements established
by exchanges.-[36]-
-[35]- Rule 17f-6(a) [17 CFR 270.17f-6(a)].
Currently, only the writer of a commodity
option is required to post margin with an FCM.
Rule 17f-6, therefore, does not apply to funds
that purchase commodity options through payment
of an option premium. See supra note 4 and
accompanying text.
-[36]- FINK & FEDUNIAK, supra note 2, at 137. An FCM,
for example, may impose higher initial margin
requirements based on market volatility or to
retain a cushion in the event an exchange
subsequently raises its margin requirements.
Id. at 137-138.
Exchange rules or the procedures of the FCM also may
restrict the types of assets that may be used to satisfy
margin requirements. A fund may borrow assets from an
FCM to meet margin requirements so long as the
arrangement is consistent with section 18 of the
Investment Company Act [15 U.S.C. 80a-18]. Section 18
restricts the circumstances under which funds may borrow
from other persons. Borrowing assets from an FCM will
not be deemed to violate section 18, in the case of an
(continued...)
==========================================START OF PAGE 21======
2. Gains on Commodity Transactions
Once a customer establishes a position with an FCM, it is
marked to market at least daily to reflect gains and losses in
the position's value. Gains on commodity transactions are
available for collection by commodity customers on the next
business day following the crediting of the gain by the
clearing organization.-[37]- In the event of an FCM's
bankruptcy, if there are insufficient assets to cover all
customer claims, commodity gains in the FCM's possession may
be distributed on a pro rata basis to all of the FCM's
customers. Allowing unlimited amounts of commodity gains to
-[36]-(...continued)
open-end fund, or be subject to that section's asset
coverage requirements, in the case of a closed-end fund,
if the fund sets aside or provides the FCM with liquid
assets that collateralize 100% of the market value of the
loan. See, e.g., Merrill Lynch Asset Management, L.P.
(pub. avail. July 2, 1996). See also 1 Thomas P. Lemke
et al., REGULATION OF INVESTMENT COMPANIES, section
8.06[1][a][ii] (1996) (by setting aside fund assets or
otherwise covering its exposure, a fund avoids the
restrictions of section 18(f)); 1 Thomas A. Russo,
REGULATION OF THE COMMODITIES FUTURES AND OPTIONS MARKETS
section 1.20 (1983 & Supp. 1993) (FCM asset lending
arrangements typically are fully collateralized).
-[37]- A party to a futures contract suffering a loss
on its position makes a payment (variation
margin) in the amount of the loss, which is
available for collection by the other party to
the contract on the next business day. See
supra note 5. While an option writer suffering
a loss on its position similarly makes a
payment covering the loss, the payment is held
by the clearing organization on behalf of the
option holder until the option is exercised; in
the event of subsequent gains in the writer's
position, the writer would be entitled to
collect the gains from its previous payments
held by the clearing organization.
==========================================START OF PAGE 22======
be maintained in an FCM's custody would subject fund assets to
unnecessary risks.-[38]-
As proposed, rule 17f-6 would have permitted a fund to
maintain with the FCM de minimis amounts of gains on fund
commodity transactions; gains exceeding the de minimis
threshold could be held by an FCM only until the next business
day. One commenter supported the proposed approach. Four
other commenters indicated that the amount of commodity gains
held by an FCM should be determined by the FCM and the fund on
an individual basis.
Rule 17f-6, as adopted, retains the proposed requirement
governing commodity gains in FCM custody.-[39]- This
approach gives funds the flexibility of not having to withdraw
de minimis amounts of gains from FCM custody, while limiting
-[38]- See Interpretation No. 10, supra note 12, at
7133 n.15 (indicating that gains on commodity
transactions should be collected daily). See
also supra note 11 and accompanying text. For
funds that use third party accounts, gains on
commodity positions are paid directly by an FCM
to the fund without flowing through or being
held in the third party account. Goldman Sachs
& Co. (pub. avail. May 2, 1986). Consequently,
the rule's de minimis limitation on the amount
of gains in an FCM's custody effectively is
required for third party arrangements.
-[39]- Rule 17f-6(a)(2) [17 CFR 270.17f-6(a)(2)].
Losses paid to an FCM due to declines in a
fund's commodity positions represent discharged
liabilities and not fund assets under section
17(f). Montgomery Street Income Securities,
Inc. (pub. avail. Apr. 11, 1983). Losses paid
to an FCM, therefore, are not subject to rule
17f-6.
==========================================START OF PAGE 23======
the potential for fund assets to be used to satisfy the claims
of other customers in the event of the FCM's bankruptcy.
E. Contract Requirements and Custodians Used to Effect
Commodity Transactions
As proposed, rule 17f-6 would have required a fund to
enter into a written contract with an FCM custodian, in which
the FCM would agree to adhere to the CEA and CFTC segregation
requirements and to furnish the Commission with information
concerning the FCM's custody of fund margin. The proposed
rule also would have required certain contract provisions
relating to the transfer of fund assets for clearing
purposes.-[40]-
The adopted rule retains these requirements, modified to
reflect the use of FCM custodians in connection with foreign
exchange-traded transactions.-[41]- Thus, in addition
to requiring compliance with the segregation requirements for
domestic trades, the contract must require the FCM to comply
with the secured amount requirements in connection with any
-[40]- The proposal would have required the FCM to
agree that any transfer of fund assets for
clearing purposes would be to another FCM that
met the requirements of the rule (other than
the requirement of a contract with the fund).
The FCM also would have been permitted to place
fund margin with a clearing organization or a
bank.
-[41]- Rule 17f-6(a)(1)(i) to (iii) [17 CFR 270.17f-
6(a)(1)(i) to (iii)].
==========================================START OF PAGE 24======
foreign transactions.-[42]- The FCM also must agree
that any other FCM used to effect transactions will be
registered with the CFTC, comply with the CFTC segregation or
secured amount requirements, and not be affiliated with the
fund. Consistent with commodity settlement practices, rule
17f-6 permits an FCM to place fund margin with a clearing
organization, a member of a foreign board of trade, or a U.S.
or foreign bank. The FCM must agree to obtain from each
entity used for clearing purposes, including any other FCM, an
acknowledgment that the fund's assets are held on behalf of
the FCM's customers in accordance with provisions under the
CEA.-[43]-
-[42]- Last year, the CFTC adopted rules creating a
new market for eligible professional investors.
Section 4(c) Contract Market Transactions; Swap
Agreements, 60 FR 51323 (Oct. 2, 1995); CFTC
rules 36.1 et seq. [17 CFR 36.1 et seq.]
Transactions in the new market by eligible
investors, which include funds with total
assets exceeding $5 million, are exempt from
many of the requirements under the CEA and
related CFTC rules. The CFTC rules applicable
to the new professional trading market,
however, do not affect requirements relating
to, among other things, segregation and FCM net
capital. Consequently, funds may participate
in the new professional trading market and use
FCM custodians under rule 17f-6.
-[43]- Rule 17f-6(a)(1)(ii) [17 CFR 270.17f-
6(a)(1)(ii)]. See CFTC rules 1.20, 30.7(c) [17
CFR 1.20, 30.7(c)] (requiring this
acknowledgment). See also rule 17f-6(b)(1) [17
CFR 270.17f-6(b)(1)] (defining "Clearing
Organization"); rule 17f-6(b)(5) [17 CFR
270.17f-6(b)(5)] (defining "U.S. or Foreign
Bank"). Proposed rule 17f-6 would have
required that any bank used to hold fund assets
(continued...)
==========================================START OF PAGE 25======
F. Withdrawal of Assets from FCM Custody
As proposed, rule 17f-6 would have required a fund to
withdraw its assets from an FCM promptly in the event the
fund's FCM arrangements no longer complied with the
requirements of the rule. The Proposing Release suggested
that asset withdrawals would be expected to be made within
five days of the event triggering the withdrawal.-[44]-
Rule 17f-6, as adopted, requires asset withdrawals to be made
as soon as reasonably practicable.-[45]- Although a
five-day standard appears to be a generally appropriate length
-[43]-(...continued)
have a minimum capitalization of $500,000. The
adopted rule does not impose this requirement
because the CFTC addresses the
credit-worthiness of these depositories. See,
e.g., CFTC Advisory 87-5 (Dec. 17, 1987).
The Proposing Release requested comment on requiring a
number of other contract provisions. In particular, the
Proposing Release requested comment whether fund
contracts should require FCMs: (i) to provide
information at the request of the fund's accountants,
(ii) to maintain specific records or furnish funds with
specific reports concerning their margin accounts, and
(iii) to indemnify funds or insure fund assets against
non-trading margin losses. While one commenter favored
these additional requirements, most commenters indicated
that they are unnecessary. Rule 17f-6 does not include
these requirements, since either CFTC regulations address
these issues (such as recordkeeping) or these matters
(such as accountants' access and indemnification) can be
negotiated between the fund and the FCM.
-[44]- Proposing Release, supra note 1, at n.129 and
accompanying text.
-[45]- Rule 17f-6(a)(3) [17 CFR 270.17f-6(a)(3)]. See
Custody of Investment Company Assets Outside
the United States, supra note 19 (proposing a
similar approach for custody arrangements
involving foreign securities).
==========================================START OF PAGE 26======
of time,-[46]- any asset withdrawals under the rule
would be subject to circumstances (such as the size or number
of a fund's positions) that indicate a longer period of time
would be reasonable.
III. COST/BENEFIT ANALYSIS
Rule 17f-6 should not impose any burdens on funds.
Rather, the rule should benefit funds by permitting, but not
requiring, fund margin to be maintained directly with FCMs
instead of in third party accounts. The requirements of rule
17f-6 are consistent with those of the CEA and CFTC rules.
The rule gives funds the option of placing with FCMs margin in
the same manner as other participants in the commodity
markets.
IV. SUMMARY OF REGULATORY FLEXIBILITY ANALYSIS
A summary of the Initial Regulatory Flexibility Analysis,
which was prepared in accordance with 5 U.S.C. 603, was
published in Investment Company Act Release No. 20313. No
comments were received on this analysis. The Commission has
prepared a Final Regulatory Flexibility Analysis in accordance
with 5 U.S.C. 604. The Analysis states that the new rule will
permit funds to maintain their assets with FCMs and other
entities used for settlement purposes in connection with
futures contracts and commodity options traded on a U.S. or
-[46]- Cf. CFTC rule 190.02(e) [17 CFR 190.02(e)]
(giving a trustee in FCM bankruptcy proceedings
four days to transfer open commodity
positions).
==========================================START OF PAGE 27======
foreign exchange. The Analysis explains that the rule
provides flexibility and custodial protections in a way that
should minimize any impact on, or cost to, small business.
Cost-benefit information reflected in the "Cost/Benefit
Analysis" section of this Release also is reflected in the
Analysis. A copy of the Final Regulatory Flexibility Analysis
may be obtained by contacting Nadya B. Roytblat, Mail Stop 10-
2, Securities and Exchange Commission, 450 Fifth Street, N.W.,
Washington, D.C. 20549.
V. STATUTORY AUTHORITY
The Commission is adopting rule 17f-6 under sections 6(c)
and 38(a) of the Investment Company Act [15 U.S.C. 80a-6(c),
-37(a)].
LIST OF SUBJECTS IN 17 CFR PART 270
Investment companies, Reporting and recordkeeping
requirements, Securities.
TEXT OF ADOPTED RULE
For the reasons set out in the preamble, Title 17,
Chapter II of the Code of Federal Regulations is amended as
follows:
PART 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF
1940
1. The authority citation for Part 270 continues to
read, in part, as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless
otherwise noted;
==========================================START OF PAGE 28======
* * * * *
2. By adding 270.17f-6 to read as follows:
270.17f-6 Custody of Investment Company Assets with Futures
Commission Merchants and Commodity Clearing Organizations.
(a) A Fund may place and maintain cash, securities, and
similar investments with a Futures Commission Merchant in
amounts necessary to effect the Fund's transactions in
Exchange-Traded Futures Contracts and Commodity Options,
Provided that:
(1) The manner in which the Futures Commission Merchant
maintains the Fund's assets shall be governed by a written
contract, which provides that:
(i) The Futures Commission Merchant shall comply with
the segregation requirements of section 4d(2) of the Commodity
Exchange Act [7 U.S.C. 6d(2)] and the rules thereunder [17 CFR
Chapter I] or, if applicable, the secured amount requirements
of rule 30.7 under the Commodity Exchange Act [17 CFR 30.7];
(ii) The Futures Commission Merchant, as appropriate to
the Fund's transactions and in accordance with the Commodity
Exchange Act [7 U.S.C. 1 through 25] and the rules and
regulations thereunder (including 17 CFR Part 30), may place
and maintain the Fund's assets to effect the Fund's
transactions with another Futures Commission Merchant, a
Clearing Organization, a U.S. or Foreign Bank, or a member of
a foreign board of trade, and shall obtain an acknowledgment,
as required under rules 1.20(a) or 30.7(c) under the Commodity
Exchange Act [17 CFR 1.20(a) or 30.7(c)], as applicable, that
==========================================START OF PAGE 29======
such assets are held on behalf of the Futures Commission
Merchant's customers in accordance with the provisions of the
Commodity Exchange Act; and
(iii) The Futures Commission Merchant shall promptly
furnish copies of or extracts from the Futures Commission
Merchant's records or such other information pertaining to the
Fund's assets as the Commission through its employees or
agents may request.
(2) Any gains on the Fund's transactions, other than de
minimis amounts, may be maintained with the Futures Commission
Merchant only until the next business day following receipt.
(3) If the custodial arrangement no longer meets the
requirements of this section, the Fund shall withdraw its
assets from the Futures Commission Merchant as soon as
reasonably practicable.
(b) For purposes of this section:
(1) Clearing Organization means a clearing organization
as defined in rule 1.3(d) under the Commodity Exchange Act [17
CFR 1.3(d)] and includes a clearing organization for a foreign
board of trade.
(2) Exchange-Traded Futures Contracts and Commodity
Options means commodity futures contracts, options on
commodity futures contracts, and options on physical
commodities traded on or subject to the rules of:
==========================================START OF PAGE 30======
(i) any contract market designated for trading such
transactions under the Commodity Exchange Act and the rules
thereunder; or
(ii) any board of trade or exchange outside the United
States, as contemplated in Part 30 under the Commodity
Exchange Act.
(3) Fund means an investment company registered under
the Act [15 U.S.C. 80a-1 et seq.].
(4) Futures Commission Merchant means any person that is
registered as a futures commission merchant under the
Commodity Exchange Act and that is not an affiliated person of
the Fund or an affiliated person of such person.
(5) U.S. or Foreign Bank means a bank, as defined in
section 2(a)(5) of the Act [15 U.S.C. 80a-2(a)(5)], or a
banking institution or trust company that is incorporated or
organized under the laws of a country other than the United
States and that is regulated as such by the country's
government or an agency thereof.
By the Commission.
Jonathan G. Katz
Secretary
December 11, 1996