[Federal Register Volume 59, Number 104 (Wednesday, June 1, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-13213]
[[Page Unknown]]
[Federal Register: June 1, 1994]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release No. IC-20313, 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: Proposed rule and request for comment.
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SUMMARY: The Commission is proposing a new rule under the Investment
Company Act of 1940 to permit registered management investment
companies to use futures commission merchants and commodity clearing
organizations as custodians of their assets in connection with futures
contracts and commodity options regulated under the Commodity Exchange
Act. Currently, investment companies generally must maintain special
accounts with their custodian banks for these transactions. The
proposed rule would enable investment companies to effect their
commodity trades in the same manner as other market participants under
conditions designed to ensure the safekeeping of investment company
assets.
DATES: Comments must be received on or before August 1, 1994.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,
NW., Stop 6-9, Washington, DC 20549. All comment letters should refer
to File No. S7-15-94. All comments received will be available for
public inspection and copying in the Commission's Public Reference
Room, 450 Fifth Street, NW., Washington, DC 20549.
FOR FURTHER INFORMATION CONTACT: Elizabeth R. Kentzman, Special
Counsel, or Diane C. Blizzard, Assistant Director, at (202) 942-0690,
Office of Regulatory Policy, Division of Investment Management, 450
Fifth Street, NW., Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Commission today is requesting public
comment on proposed rule 17f-6 [17 CFR 270.17f-6] under the Investment
Company Act of 1940 [15 U.S.C. 80a] (the ``Act''). The new rule would
permit registered management investment companies to maintain their
assets with certain futures commission merchants (``FCMs'') and
commodity clearing organizations in connection with futures contracts
and commodity options regulated under the Commodity Exchange Act [7
U.S.C. 1-25] (``CEA''). The proposed rule would not affect the extent
to which investment companies may engage in commodity trading.
Table of Contents
I. Introduction and Executive Summary
II. Background
A. Settlement of Futures Contracts and Commodity Options
1. Futures Contracts
2. Commodity Options
3. FCM Insolvency Risks and the Settlement Process
B. FCM and Clearinghouse Custody under the Act
C. Problems with Current Custody Arrangements
III. Discussion
A. Investment Company Margin
1. Initial Margin
2. Margin Gain
B. FCMs Eligible to Hold Investment Company Assets
C. Contract Requirements
D. Responsibilities of the Board of Directors and Delegation
E. Additional FCMs Used for Clearing Purposes
F. Foreign-Related Commodity Transactions
IV. Summary of Initial Regulatory Flexibility Analysis
V. Statutory Authority
VI. Text of Proposed Rule
I. Introduction and Executive Summary
Over the last several years, investment company participation in
the commodity market has increased.\1\ Investment companies, for
example, use commodity investments to hedge their portfolios from
declines in securities prices, changes in interest rates, or foreign
currency fluctuations.\2\ Alternatively, investment companies enter
into commodity transactions to adjust the percentage of their
portfolios held in cash, long-term debt, and stocks without having to
buy or sell the actual assets.\3\
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\1\Section 18 of the Act significantly restricts how investment
companies, particularly open-end funds, may use leverage. 15 U.S.C.
80a-18. Although section 18 does not expressly address commodity
transactions, the Commission has concluded that section 18 governs
trading practices that have the potential for leveraging an
investment company's assets. Securities Trading Practices of
Registered Investment Companies: General Statement of Policy,
Investment Company Act Release No. 10666 (Apr. 18, 1979), 44 FR
25128. These transactions have been interpreted to include commodity
investments. See, e.g., Dreyfus Strategic Investing and Dreyfus
Strategic Income (pub. avail. June 22, 1987). To avoid section 18's
reach, investment companies must fully collateralize their commodity
obligations by establishing a segregated account consisting of high-
grade liquid assets. Id. Proposed rule 17f-6 does not address
section 18 considerations or related restrictions attending
commodity investments, and thus does not affect the extent to which
investment companies may engage in these transactions.
Investment companies and their sponsors also may be subject to
regulation as commodity pool operators under the CEA and Commodity
Futures Trading Commission (``CFTC'') rules, although most seek and
qualify for exemption. See CEA section 1a(4), 7 U.S.C. 1a(4)
(defining commodity pool operator); CFTC regulation 4.5, 17 CFR 4.5
(excluding certain institutional investors, including registered
investment companies, and their principals and employees from the
definition of commodity pool operator, subject to certain
conditions).
\2\Commodity investments 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 Sec. 1.07 (2d ed. Supp. 1991)
[hereinafter Johnson & Hazen].
\3\In this case, the investment would be used as a substitute
for paying cash in the stock and bond markets. Taking a position in
a futures contract, for example, may be quicker and cheaper than
buying and selling the instruments subject to the contract due to
lower brokerage and transaction costs.
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To enter into a futures contract or write a commodity option,
investors deposit a specified amount of assets or cash as initial
margin.\4\ The FCM then clears the transaction by posting margin either
directly with a clearing organization (which matches the opposite side
of the trade) or with one or more other FCMs that will effect the
transaction through the clearing organization. Once a position is
established, 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 payment on the next business day.
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\4\See ``Background--Settlement of Futures Contracts and
Commodity Options.''
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Commodity investors other than investment companies generally
initiate trades by posting margin directly with an FCM. Section 17(f)
of the Act and related rules, however, currently do not permit FCMs to
maintain custody of investment company assets.\5\ FCM custody also
presents certain risks because, in FCM bankruptcy proceedings, margin
entrusted to an FCM's safekeeping may not be returned in full.\6\
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\5\15 U.S.C. 80a-17(f), 17 CFR 270.17f-1 to 270.17f-5. See
``Background--FCM and Clearinghouse Custody under the Act.'' See
also infra note 28 (regarding the Department of Labor's position,
which has not been adopted by the Division of Investment Management,
that margin is not an asset for purposes of the custody requirements
and certain other fiduciary provisions of the Employee Retirement
Income Security Act of 1974 (``ERISA'') [29 U.S.C. 1001-1461]).
\6\See infra notes 65-66 and accompanying text. See also
``Background--Settlement of Futures Contracts and Commodity
Options--FCM Insolvency Risks and the Settlement Process.'' As
indicated infra at note 49, although the potential for loss exists,
actual customer losses from FCM insolvencies are rare.
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Under no-action positions of the Division of Investment Management
(the ``Division''), investment companies must maintain their initial
margin deposits in special accounts with a third party custodian
bank.\7\ Because investment company margin is held by a third party,
FCMs must advance their own funds to cover investment company margin
obligations with the clearinghouse or other FCM that will be used to
effect the transaction.
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\7\See ``Background--FCM and Clearinghouse Custody under the
Act.''
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Some have suggested that third party custodial accounts create
systemic liquidity risks by diverting otherwise available FCM capital
from the marketplace.\8\ In addition, the CFTC staff has stated that
third party accounts would not provide any special protection for
investment company assets in the event of an FCM's bankruptcy.\9\
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\8\See ``Background--Problems with Current Custody
Arrangements.''
\9\Id.
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To address potential liquidity risks and the uncertain status of
third party accounts in FCM bankruptcy proceedings, the Commission is
proposing rule 17f-6. The proposal would permit FCM and clearinghouse
custody of investment company margin, subject to conditions designed to
ensure the safekeeping of investment company assets.
Under proposed rule 17f-6, investment companies could deposit
initial margin with FCMs in amounts necessary to effect their futures
contracts and commodity options.\10\ FCMs also would be permitted to
hold de minimis amounts of gain on commodity transactions; gains
exceeding this threshold would have to be paid to the fund on the day
after receipt by the FCM.\11\
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\10\See ``Discussion--Investment Company Margin--Initial
Margin.''
\11\See ``Discussion--Investment Company Margin--Margin Gain.''
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To protect against the risks of FCM insolvency, rule 17f-6 would
require FCMs holding investment company assets, including any FCMs used
for clearing purposes, to have at least $20 million in adjusted net
capital in excess of the minimum capital requirements established by
the Commodity Futures Trading Commission (``CFTC''). As an additional
measure of financial strength, the ratio of an FCM's adjusted net
capital to the CFTC required minimum would have to equal or exceed 250
percent.\12\
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\12\See ``Discussion--FCMs Eligible to Hold Investment Company
Assets'' and ``--Additional FCMs Used for Clearing Purposes.''
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The proposal also would require a written contract between the
investment company and the FCM to contain certain provisions. Among
other things, FCMs could transfer investment company assets for
clearing purposes only to another FCM that satisfies the requirements
of the rule (other than the requirement of a contract with the
investment company), a bank, or a clearing organization.\13\
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\13\See ``Discussion--Contract Requirements.''
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The board of directors would be responsible for selecting FCMs and
monitoring the custodial arrangements. The board could delegate these
responsibilities to the company's investment adviser or officers under
the board's general oversight and certain procedural requirements.\14\
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\14\See ``Discussion--Responsibilities of the Board of Directors
and Delegation.''
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Finally, FCM custody would be permitted for foreign-related
transactions traded on domestic contract markets, even if the margin is
held overseas. FCM custody would not be allowed for foreign exchange-
traded transactions, since margin for these trades does not enjoy the
full protections of the CEA and CFTC rules.\15\
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\15\See ``Discussion--Foreign-Related Commodity Transactions.''
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II. Background
A. Settlement of Futures Contracts and Commodity Options
Under the CEA and CFTC rules, trading of futures contracts and
commodity options generally must take place on a designated contract
market (an ``exchange'').\16\ An FCM executing trades on an exchange
must be a member of that exchange; nonmembers trade by entering orders
through an exchange member.\17\ All transactions are cleared through a
clearing organization, which matches trades on behalf of the exchange,
and acts as guarantor of the opposite side of each transaction accepted
for settlement.\18\ To clear transactions with a clearing organization,
an FCM must be both an exchange member and a member of the clearing
organization.\19\ Non-clearing member FCMs must execute their
transactions through a clearing member.\20\
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\16\See CFTC regulation 1.3(h), 17 CFR 1.3(h) (defining contract
market).
\17\Fink & Feduniak, supra note 2, at 88.
\18\See CFTC regulation 1.3(d), 17 CFR 1.3(d) (defining clearing
organization). Some clearinghouses are organized as separate
entities from the exchange, while others are departments within the
exchange. Fink & Feduniak, supra note 2, at 154. See generally 1
Thomas A. Russo, Regulation of the Commodities Futures and Options
Markets Sec. 2.01 (1983 & Supp. 1992) [hereinafter Russo] (``Upon
accepting trades for clearance, commodity exchange clearing houses
interpose themselves as principals between the parties, becoming the
`seller to every buyer and the buyer to every seller' and thus `a
party to every trade.''') (citations omitted).
\19\See CFTC regulation 1.3(c), 17 CFR 1.3(c) (defining clearing
member). Exchange membership is a prerequisite to clearing
membership. See 1 Johnson & Hazen, supra note 2, Sec. 2.49.
\20\Fink & Feduniak, supra note 2, at 154.
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Depending on an FCM's qualifications as an exchange or
clearinghouse member, settlement of a commodity transaction may involve
multiple FCMs. When one FCM acts on behalf of another, its ``customer''
is the FCM on whose behalf the order is effected, not that FCM's
underlying customers. Similarly, clearinghouses consider FCM clearing
members as their customers for purposes of settling trades.
1. Futures Contracts
Investors entering into futures contracts deposit a specified
amount of assets or cash as initial margin.\21\ Initial margin is
intended to secure the obligations of the contracting parties as well
as to protect those involved in the settlement process.\22\ Initial
margin is not considered to be part of the contract purchase price, and
is returned upon the contract's termination unless it is used to cover
a loss in the contract position.\23\ Initial margin in futures
transactions thus differs from securities margin, which represents a
partial payment for securities purchased by the broker on its
customer's behalf.\24\
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\21\See Jerry W. Markham, Federal Regulation of Margin in the
Commodity Futures Industry--History and Theory, 64 Temple L. Rev.
59, n.12 (1991) (initial margin for futures contracts often is five
to ten percent of the value of the commodity subject to delivery
under the contract). See also 1 Johnson & Hazen, supra note 2,
Sec. 2.43 (Supp. 1991) (describing recent developments in the
computation of margin, including ``cross margining'' involving
coordination of margin levels for certain commodity and stock option
positions).
See generally 1 Russo, supra note 18, Sec. 1.20 (``Each of the
exchanges has its own rules as to the types of assets, and as to the
percentage of the fair market value of those assets (sometimes
referred to as a haircut), which may be accepted in satisfaction of
margin requirements.'') (emphasis in original).
\22\See 1 Johnson & Hazen, supra note 2, Sec. 1.10 (``margins
serve not only to protect the parties against default, but the
carrying brokers and clearing house as well'').
\23\Id. Sec. 1.10. See 2 id. Secs. 3.76, 3.79.
\24\1 Id. Sec. 1.10.
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Minimum initial margin requirements are set by the exchange on
which the contract is designated to trade, although FCMs may impose
higher requirements.\25\ Clearing organizations also impose their own
margin requirements for clearing members, which typically are less than
exchange-established initial margin minimums.\26\ Initial margin levels
may be increased or reduced throughout the life of a contract.\27\
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\25\1 Russo, supra note 18, Sec. 2.03. An FCM, for example, may
increase margin requirements based on experience with a customer or
the customer's financial resources. Division of Trading and Markets,
CFTC, Follow-up Report on Financial Oversight of Stock Index Futures
Markets During October 1987 at 28-29 (Jan. 6, 1988) [hereinafter
CFTC October 1987 Follow-up Report].
\26\1 Johnson & Hazen, supra note 2, Sec. 1.10. Margin deposited
to satisfy clearinghouse requirements is known as ``original''
margin. Id. Original margin requirements typically vary for
different clearing members depending, for example, on each member's
trading volume. 1 Russo, supra note 18, Sec. 2.03. Under net
clearing systems in effect at most exchanges, clearing members are
not required to post original margin for offsetting customer
positions. Id. Sec. 2.06.
\27\1 Johnson & Hazen, supra note 2, Sec. 1.10 (``Commodity
margins often vary depending on the stage of the transaction, the
nature of the trading involved, and the volatility of market
prices.''); Markham, supra note 21, at 132 & n.513 (1991) (the
Chicago Board of Trade changed margin levels over 200 times in 1987,
often on a daily basis).
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Customers other than investment companies generally post initial
margin directly with an FCM when they initiate trades.\28\ If the FCM
is a clearing member, it must then satisfy clearinghouse margin
requirements. The FCM typically deposits all or a portion of the
customer's assets directly in a commingled account established by the
clearinghouse for margin deposits and accruals on the FCM's customer
positions.\29\ Any funds remaining in the FCM's possession are
deposited in a commingled customer bank account maintained by the
FCM.\30\ While section 4d(2) of the CEA permits the commingling of
customer funds at both the clearinghouse and FCM levels, it requires
FCMs to segregate customer assets from the FCM's own funds, including
those used for its own trading, and prohibits the use of one customer's
funds to carry another's trades.\31\
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\28\Investment company third party custodial arrangements are
discussed below under ``FCM and Clearinghouse Custody Under the
Act.'' Some pension accounts also may use third party arrangements
for their initial margin deposits, although they are not required to
do so under the ERISA. The Department of Labor has held that, for
purposes of the custody requirements and certain other fiduciary
provisions of ERISA, margin deposited by a pension plan with an FCM
does not constitute an asset of the plan; rather, the plan's assets
are deemed to be the rights embodied in the futures contract. Op.
No. 82-49A (Office of Pension and Welfare Benefits Program, U.S.
Dept. of Labor 1982). The Division has not adopted this approach.
\29\2 Johnson & Hazen, supra note 2, Sec. 3.69 Clearing members
maintain a proprietary account with the clearinghouse for their own
trades, which must be kept separate from customer assets. 1 Russo,
supra note 18, Sec. 2.02. Accounts at the clearinghouse level are
maintained by banks that have been approved by the clearinghouse as
original margin depositories. Id. Sec. 2.03.
An FCM may use its own assets to satisfy a customer's margin
obligations, pending receipt of the required margin from the
customer. CFTC regulation 1.23, 17 CFR 1.23. Exchange rules
generally require FCMs to receive customer margin within a
reasonable time after an order is accepted. See 1 Russo, supra note
18, Sec. 1.20. Under CEA section 4d(2) and the special provisions of
the Bankruptcy Code and CFTC rules that govern FCM liquidations,
margin in the clearinghouse customer account is considered customer
property, whether the margin represents actual customer assets or
the FCM's own funds. 7 U.S.C. 6d(2); 11 U.S.C. 761-766; 17 CFR
190.01 to .10.
\30\1 Johnson & Hazen, supra note 2, Sec. 3.69. See also CFTC
regulations 1.25, 1.29, 17 CFR 1.25, 1.29 (permitting FCMs to invest
customer assets in their possession in certain United States
government obligations and retain the interest thereon, unless the
customer specifically arranges to receive the interest payments).
\31\See also CFTC regulations 1.20-.30, 17 CFR 1.20-.30
(implementing the requirements of section 4d(2)). The FCM at all
times must have sufficient funds in segregation representing
customer margin received or required to be paid. Id.
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If an FCM is not a clearing member, the same procedures and
requirements apply, except that the non-member FCM must post margin
with the clearing member, which in turn must satisfy clearinghouse
requirements.32 FCM custody of customer margin in this case thus
involves both the non-member and clearing member FCM.33
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\3\2See 2 Johnson & Hazen, supra note 2, Sec. 3.76 (``customer
funds routinely travel from the originating FCM to other FCMs, such
as clearing member firms of a contract market, and to the clearing
agencies of the contract market''). If the FCM originating the trade
effects the transaction through an exchange member that is not a
clearing member, the exchange member FCM would be an additional
party in the settlement chain.
\3\3Under CFTC regulation 1.58, clearing member FCMs that carry
customer positions on behalf of non-members must collect margin on a
gross basis (i.e., based on the individual transactions of the non-
member FCM's customers without regard to offsetting positions
between such customers). 17 CFR 1.58. See Gross Margining of Omnibus
Accounts, [1980-1982 Transfer Binder] Comm. Fut. L. Rep. (CCH)
21,296 at 25,507 n.8 (Dec. 29, 1981) (indicating that this approach
transfers customer margin from non-member FCMs to the ``stronger
hands'' of clearing members). Gross margining between clearing and
non-clearing member FCMs contrasts with net margining, discussed
supra note 26, between clearing organizations and their members.
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Once a contract position is established, variation margin is
credited or assessed at least daily to reflect changes in the
contract's value.34 In contrast to initial margin, variation
margin represents the system of marking to market the contract's
value.35 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.36
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\3\4Some exchanges regularly make intraday variation margin
calls and others may do so in response to market volatility. See,
e.g., CFTC October 1987 Follow-up Report, supra note 25, at 26; 1
Johnson & Hazen, supra note 2, Sec. 2.50.
\3\51 Russo, supra note 18, Sec. 2.04. As a result of its
function, variation margin, unlike initial margin, may be satisfied
only in cash. Fink & Feduniak, supra note 2, at 146 (``If losing
positions were permitted to be marked to market with Treasury
securities, letters of credit, and so on, then clearinghouses and
FCMs would face the impossible task of converting various and sundry
types of collateral into the correct amounts of cash for potential
withdrawal by customers with margin excesses.''). See supra note 21.
\3\6See CFTC October 1987 Follow-up Report, supra note 25, at 19
(``The daily settlement of profits and losses through the system of
daily variation collections and payments reflects the `zero sum'
nature of the futures system in which profits and losses are exactly
equivalent.'').
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At the end of each trading day, the clearing organization credits
gains and debits losses on all contract positions in the clearing
member's customer account.37 Before the opening of the exchange on
the next business day, the clearing member FCM must satisfy any
variation margin call reflecting a net loss in contract positions and
similarly is entitled to collect any net gain.38
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\3\71 Russo, supra note 18, Sec. 2.04.
\3\8Id.; CFTC October 1987 Follow-up Report, supra note 25, at
25-26.
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The member FCM must reconcile its customers' positions by crediting
gains and debiting losses on a customer-by-customer basis.39 An
FCM will require the customer to post additional funds to cover any
losses that reduce the customer's margin below a specified
``maintenance'' level set by the exchange. The customer then will make
a margin payment, or meet a ``margin call,'' to restore its account to
the initial margin level.40 Whether gains on contract positions
are collected by the customer immediately or held by the FCM depends on
the customer's arrangements with the FCM.41
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\3\91 Russo, supra note 18, Sec. 2.04. See CFTC regulation 1.32,
17 CFR 1.32 (requiring daily computation of customer accounts).
\4\01 Russo, supra note 18, Sec. 1.20; 1 Johnson & Hazen, supra
note 18, Sec. 1.10.
\4\1See, e.g., CFTC Financial and Segregation Interpretation No.
10, Treatment of Funds Deposited in Safekeeping Accounts, 1 Comm.
Fut. L. Rep. (CCH) 7120 at 7128 n.15 (CFTC Division of Trading and
Markets May 23, 1984) [hereinafter CFTC Interpretation No. 10].
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If a non-member FCM executes trades through a clearing member,
variation margin payments are transferred between the clearing member
and the originating FCM. The originating FCM then reconciles the
individual contract positions of its customers.42
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\4\21 Russo, supra note 18, Sec. 2.04. If a non-exchange member
FCM executes trades through an exchange member that is not a
clearing member, variation margin transfers would occur between
these two FCMs as well.
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2. Commodity Options
Initial and variation margin for commodity options serve the same
function as margin for futures contracts.43 Unlike the parties to
a futures contract, however, 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.44 In addition, the writer's
variation margin payments attributable to losses in its position, known
as mark-to-market payments in the options context, are not available
for collection by the option holder.45 During the life of an
option, the writer's mark-to-market payments are transferred to and
held by all FCMs in the settlement chain and, ultimately, the clearing
organization in the same way as initial margin deposits.
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\4\3See supra notes 22 & 35 and accompanying text.
\4\41 Johnson & Hazen, supra note 2, Sec. 1.07. Initial margin
for commodity options may be based on the premium paid for the
option and the initial margin requirements applicable to the
underlying futures contract. See, e.g., Goldman Sachs & Co. (pub.
avail. May 2, 1986). Initial margin also may be determined by
reference to the aggregate risk of the option and underlying futures
contract. See, e.g., 1 Johnson & Hazen, supra note 2, Sec. 2.43
(Supp. 1991). The premium collected from the buyer is passed through
the clearinghouse to the writer's FCM, which credits the writer's
account for the premium received.
\4\5The writer of an option is responsible for changes in the
value of the position only if the option is exercised by the holder
or closed out by the writer through an offsetting position. 1
Johnson & Hazen, supra note 2, Secs. 1.31, 1.07. For this reason,
unlike margin payments on futures contracts (as discussed supra note
35), payments for losses on option positions may be made in cash or
other assets. See, e.g., Goldman Sachs & Co., supra note 44 (option
mark-to-market payments may be made in securities, such as U.S.
Treasury obligations, or letters of credit). In the event of later
gains, the writer would be entitled to collect the gain from
previously made margin payments. See Markham, supra note 21, at 116.
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3. FCM Insolvency Risks and the Settlement Process
FCMs are financially responsible for the trade obligations of their
customers.46 If a clearing member FCM becomes insolvent and cannot
cover the obligations of a defaulting customer, the FCM's non-
defaulting customers may be affected.47 The clearinghouse has the
right to satisfy an outstanding margin call from the assets securing
all of the member's customer trades at the clearinghouse level, which
will create a shortfall in the clearinghouse account.48 Exchanges
and other parties may contribute additional funds to prevent customer
loss.49 Absent this voluntary action, however, a shortfall in the
clearinghouse account will be borne by the member's non-defaulting
customers.50 Because a member's customers may include other FCMs,
losses at the clearinghouse level may affect other FCMs and customer
margin in their safekeeping.
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\4\6See CEA section 4d(2); 1 Johnson & Hazen, supra note 2,
Sec. 1.10.
\4\7An FCM's insolvency may result from its obligation to cover
the trades of a defaulting customer or for other unrelated reasons.
See, e.g., Andrea M. Corcoran & Susan C. Ervin, Maintenance of
Market Strategies in Futures Broker Insolvencies: Futures Position
Transfers From Troubled Firms, Wash. & Lee L. Rev. 852-70 (1987)
[hereinafter Corcoran & Ervin] (the inability of certain customers
to satisfy trade obligations of approximately $14 million caused the
1985 Volume Investors Corporation insolvency, which placed other
customers at risk); CFTC News Release 3663-93 (May 24, 1993) (CFTC
administrative complaints allege that Stotler and Company's
insolvency followed improper conduct by its officers, accountants,
and the Chicago Board of Trade including, among other things,
overstating the firm's net capital).
\4\8See CFTC Interpretative Statement No. 85-3, Use of
Segregated Funds by Clearing Organizations Upon Defaults by Member
Firms, [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) 22,703
at 30,988 (CFTC Office of the General Counsel Aug. 12, 1985). While
the CFTC staff has considered the rights of clearing organizations
in these circumstances, an FCM's right to use another FCM's customer
margin has not been determined. For example, it has not been
established whether a clearing member FCM would be entitled to
customer margin deposited by a non-member FCM in the event the non-
member was unable to satisfy its customers' obligations. See
Corcoran & Ervin, supra note 47, at nn.92, 95.
\4\9See generally National Futures Association, Customer Account
Protection Study 13 (Nov. 20, 1986) [hereinafter NFA Account
Protection Study] (FCM insolvency losses from 1938 through 1985
totalled less than $10 million); Corcoran & Ervin, supra note 47, at
873 (``customer losses have been forestalled * * *, in significant
measure, by the voluntary contributions of futures exchanges to the
compensation of customers of failed clearing members.'').
\5\0See infra notes 65-66 and accompanying text regarding the
treatment of customer margin in FCM bankruptcy proceedings.
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B. FCM and Clearinghouse Custody Under the Act
Section 17(f) of the Act and the rules thereunder govern the
safekeeping of investment company assets.51 Under section 17(f),
investment companies generally may maintain their assets only in the
custody of a bank, a member of a national securities exchange, or a
national securities depository.52 FCMs and commodity clearing
organizations do not fit within one of the statutory categories.53
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\5\1The legislative history of section 17(f) indicates that
Congress intended the assets of investment companies to be kept by a
financially secure entity that has sufficient safeguards against
misappropriation. Investment Trusts and Investment Companies:
Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking
and Currency, 76th Cong., 3d Sess. 264 (1940).
\5\2See also rule 17f-1 (governing custody of investment company
assets by members of a national securities exchange) and rule 17f-4
(governing custody by national securities depositories). Under
section 17(f) and rule 17f-2, investment companies also may maintain
custody of their own assets.
\5\3While certain FCMs also may be members of a national
securities exchange, these FCMs cannot rely on rule 17f-1. This is
because, in accepting margin deposits, the FCM would be acting in
its capacity as a futures broker, and not as a securities broker as
contemplated under rule 17f-1. In any event, rule 17f-1 is rarely
used today because of its segregation and earmarking requirements.
Thomas P. Lemke, Investment Company Act of 1940, in 4 Securities Law
Techniques Transactions Litigation (A.A. Sommer, ed.) Sec. 83.07, at
83-181 (Oct. 1993).
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Under Division no-action positions, investment companies deposit
initial margin in special accounts with their custodian banks.54
Although a third party account may be maintained in the name of an FCM,
the FCM may withdraw funds from the account only if the investment
company does not make a variation margin payment.55 As a
consequence, FCMs must advance their own funds to cover investment
company margin obligations with the clearinghouse or other FCM that is
used to effect the transaction.56
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\5\4See, e.g., Prudential Bache IncomeVertible Plus Fund, Inc.
(pub. avail. Nov. 20, 1985). See also VALIC Timed Opportunity Fund,
Inc., Investment Company Act Release Nos. 13891 (Apr. 17, 1984), 49
FR 17639 (Notice of Application), and 13943 (May 16, 1984), 30 SEC
Docket 845 (Order).
In 1981, the CFTC considered third party arrangements as a way
to address customer losses associated with FCM insolvency. Although
the CFTC rejected this approach, it noted that to make segregation
requirements completely effective, ``access to customer money by the
FCM would have to be totally prohibited. A third party trustee would
have to accept and hold all customer funds and commingling of any
kind would have to be prohibited.'' Gross Margining of Omnibus
Accounts, supra note 33, at 25,504.
\5\5See, e.g., Pension Hedge Fund, Inc. (pub. avail. Jan. 20,
1984). See also CFTC Interpretation No. 10, supra note 41, and CFTC
Interpretative Letter No. 85-6 (Safekeeping Accounts), [1984-1986
Transfer Binder] Comm. Fut. L. Rep. (CCH) 22,579 at 30,495 (CFTC
Division of Trading and Markets Apr. 19, 1985) (both concerning CFTC
staff requirements attending the use of third party custodial
accounts).
\5\6See, e.g., Letter of William J. Brodsky, President and Chief
Executive Officer, Chicago Mercantile Exchange (``CME''), to
Jonathan G. Katz, Secretary, SEC 4 (Oct. 12, 1990), File No. S7-11-
90 (responding to the Commission's request for comments on the
reform of investment company regulation in connection with the
Division's 1992 report, Protecting Investors: A Half Century of
Investment Company Regulation) [hereinafter CME Letter]. The CME
Letter was resubmitted to the Commission last year in connection
with other rule proposals. Letter of Carl A. Royal, Senior Vice
President and General Counsel, CME, to Jonathan G. Katz, Secretary,
SEC (Mar. 16, 1993), File No. S7-41-92.
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No-action letters and exemptive orders permit FCMs to retain
custody of investment company gains on commodity positions in limited
circumstances.57 Under no-action positions, FCMs may hold margin
gain overnight or over a weekend in recognition of the fact that, while
positions are settled at the close of each day's trading, margin gain
is not available to the FCM's customers until the following business
day.58 The Division has reasoned that such custody is incidental
to the commodity investment and not of sufficient duration to trigger
the requirements of section 17(f).59 Exemptive orders permit FCMs
to hold de minimis amounts of margin gain (e.g., $50,000) so that funds
may avoid having to make daily withdrawals when only small amounts of
margin accrue.60
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\5\7Gains on commodity positions are paid directly by an FCM to
the investment company without flowing through or being held in the
third party account. Goldman, Sachs & Company, supra note 44.
Variation margin payments owed by an investment company due to
declines in its position are liabilities of the company, and not
fund assets under section 17(f). Montgomery Street Income
Securities, Inc. (pub. avail. Apr. 11, 1983). Investment companies
satisfy their variation margin obligations by paying the required
amounts directly to FCMs. See id.
\5\8See supra notes 37 & 38 and accompanying text.
\5\9Montgomery Street Income Securities, supra note 57. See also
Putnam Option Income Trust II (pub. avail. Sept. 23, 1985) (futures
contracts); Goldman, Sachs & Company, supra note 44 (written
options).
\6\0See, e.g., Drexel Bond-Debenture Trading Fund, Investment
Company Act Release Nos. 13861 (Apr. 2, 1984), 49 FR 13934 (Notice
of Application), and 13916 (May 1, 1984), 30 SEC Docket 671 (Order).
See also Carnegie Government Securities Trust, Investment Company
Act Release Nos. 15272 (Aug. 22, 1986), 51 FR 30927 (Notice of
Application), and 15317 (Sept. 18, 1986), 36 SEC Docket 1044 (Order)
(permitting up to $50,000 in margin gain to be maintained with any
one FCM and limiting margin gain held by all FCMs to the greater of
$100,000 or 1/8 of one percent of the fund's net assets).
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C. Problems With Current Custody Arrangements
Commenters have criticized third party custodial accounts on
several grounds. Some have asserted that current arrangements create
systemic liquidity risks by diverting otherwise available FCM capital
from the marketplace.61 These risks may become acute in times of
market volatility when liquidity may be most critical. Initial margin
requirements typically rise during these periods, resulting in
additional drains on FCM resources.62 According to the 1988 Brady
Report, third party custodial accounts may have been a source of
liquidity stress in the clearing and credit systems during the October
1987 market break.63
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\6\1See, e.g., Letter from Peter Karpen, First Boston
Corporation, Steven Keltz, Shearson Lehman Brothers Inc., Anthony J.
Leitner, Goldman, Sachs & Co., and John T. Shinkle, Saloman Brothers
Inc., to Marianne K. Smythe, Director, Division of Investment
Management, SEC 1-4 (Sept. 17, 1991) [hereinafter Joint FCM Letter]
(observing that a survey of 12 FCMs revealed that as much as $2
billion may be maintained in third party custodial accounts, and
suggesting by way of a conservative estimate that FCMs advance as
much as 50% of initial margin deposited by investment companies).
Commenters also point out that FCMs incur financing and
potential opportunity costs as a result of using their own assets to
meet investment company margin requirements. See, e.g., Letter from
Barbara Wierzynski, General Counsel, Futures Industry Association
Inc., to Elizabeth Krentzman, Division of Investment Management, SEC
(Oct. 11, 1993) (securities deposited by FCMs on behalf of
investment companies may not be pledged by the FCM to raise cash for
other purposes). See also Letter from Thomas A. Russo, Cadwalader,
Wickersham & Taft, to Mary Podesta, Chief Counsel, Division of
Investment Management, SEC 13 (Sept. 23, 1988) [hereinafter Russo
Letter II] (financing costs may cause FCMs to increase commission
rates or limit the number and size of investment company accounts,
forcing funds to trade through less well-capitalized FCMs).
\6\2CFTC October 1987 Follow-up Report, supra note 25, at 65.
\6\3Report of the Presidential Task Force on Market Mechanisms
(1988) VI-73 to -74 (discussing statements of certain CME members).
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Commenters also have contended that third party arrangements are
unnecessary because they are unlikely to provide any special protection
to investment company assets in FCM bankruptcy proceedings.64
Special provisions of the Bankruptcy Code and related CFTC rules govern
FCM liquidations.65 Under these provisions, FCM customers
generally have priority over other creditors' claims. All customer
assets, even if specifically identifiable to one customer, are subject
to disposition based on each customer's pro rata share of the available
customer property.66 The CFTC staff has stated that funds in a
third party custodial account will be subject to the same pro rata
treatment as all other customer assets.67
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\6\4See, e.g., Joint FCM Letter, supra note, at 4-6.
\6\511 U.S.C. 761-766; 17 CFR 190.01 to .10. The CFTC bankruptcy
regulations were adopted pursuant to CEA section 20, 7 U.S.C. 24.
\6\6See United States Bankruptcy Code sections 766(d), (h). The
claims of customers engaging in certain foreign-related commodity
transactions may be subordinated in bankruptcy to the claims of
other customers. See infra notes 148-151 and accompanying text.
\6\7CFTC Interpretation No. 10, supra note 41, at 7129. The CFTC
staff reasons that the Bankruptcy Code provisions were intended ``to
promote equitable treatment of customers and to provide for an
across-the-board application of pro rata distribution to all
customer commodity accounts whether or not the funds related to such
accounts were maintained with separate depositories or otherwise
were specifically identifiable.'' Id. See also Interpretative Letter
No. 90-1 (Safekeeping and Third-Party Custodial Accounts) [1987-1990
Transfer Binder] Comm. Fut. L. Rep. (CCH) 24,579 at 36,505 (CFTC
Division of Trading and Markets Jan. 19, 1990) (reaffirming this
position).
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No court has examined the status of these accounts in bankruptcy.
Commenters maintain that the issue inevitably will be litigated, which
may carry its own adverse consequences.68 In addition to freezing
investment company assets during the pendency of the action, third
party accounts may impede the transfer of investment company accounts
to a financially strong FCM, subjecting the fund to possible
losses.69
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\6\8See, e.g., Letter from Thomas A. Russo, Cadwalader,
Wickersham & Taft, to Mary Podesta, Chief Counsel, Division of
Investment Management, SEC 3-4 (Apr. 8, 1988) [hereinafter Russo
Letter I]. See also CFTC Interpretation No. 10, supra note 41, at
7129 (if presented with the issue, the CFTC staff intends to
strongly recommend that the CFTC take appropriate action ``to ensure
that all customers, including institutional customers, are treated
equally'' in FCM bankruptcy proceedings).
\6\9Russo Letter I, supra note 68, at 4; Joint FCM Letter, supra
note 61, at 5 (``even if such customers ultimately recover the
entire equity in their account following liquidation, they will lose
money as the result of prices realized on forced liquidations or
they will lose the protection of hedges until they can replace the
positions at a new firm.''). See generally Corcoran & Ervin, supra
note 47, at 872 (discussing the Bankruptcy Code's strong preference
for immediate transfer of customer accounts to ensure daily payment
of margin obligations and to minimize the possibility of margin
default).
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The Commission believes liquidity concerns and the absence of clear
bankruptcy protection for third party accounts warrant proposing new
rule 17f-6. The Commission, however, requests comment on these and any
other factors concerning current investment company
arrangements.70
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\7\0Some commenters, for example, have identified certain
operational difficulties associated with third party arrangements.
See, e.g., CME Letter, supra note 56, at 4 (third party accounts may
take up to several weeks to establish and are expensive and complex
to maintain). Other commenters have suggested certain benefits
associated with their use. See, e.g., Leslie L. Ogg, Remarks at the
Meeting of the Financial Products Advisory Committee, CFTC 54 (July
23, 1992) (noting that tax-exempt funds avoid earning taxable income
(excluding any gains realized on contract positions) by maintaining
their tax-exempt securities in third party custodial accounts).
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III. Discussion
Proposed rule 17f-6 would allow FCM and clearinghouse custody of
investment company margin, subject to conditions designed to ensure the
safekeeping of investment company assets.71 The proposal would
govern initial margin deposits and FCM custody of margin gain,
establish certain objective qualifications for FCMs that hold
investment company assets, and require a written contract between the
FCM and investment company to contain certain provisions. The board of
directors would be responsible for selecting FCMs and monitoring the
custodial arrangements, although the board could delegate its
responsibilities to the investment company's investment adviser or
officers. The rule's provisions (other than the requirement of a
contract with the investment company) would apply to any FCM used to
clear the fund's commodity transactions. FCM custody would be permitted
in connection with foreign-related commodity transactions traded on
domestic exchanges. It could not be used, however, for foreign-exchange
traded transactions since margin for those trades does not enjoy the
full protections of the CEA and CFTC rules.
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\7\1The Commission is not proposing to amend rule 7d-1 with
respect to the use of proposed rule 17f-6 by investment companies
organized under Canadian law and other foreign jurisdictions. 17 CFR
270.7d-1. Rule 7d-1 governs applications by Canadian funds seeking
to obtain exemptive orders under section 7(d). 15 U.S.C. 7(d).
Although rule 7d-1 by its terms only applies to Canadian investment
companies, funds organized in other jurisdictions have agreed to
comply with its conditions as a prerequisite to receiving a section
7(d) order. See Division of Investment Management, SEC, Protecting
Investors: A Half Century of Investment Company Regulation 193 n.23
(1992) [hereinafter Protecting Investors report]. Considerable time
has passed since rule 7d-1 was last used. Id. Should an investment
company seek relief pursuant to rule 7d-1 in the future, the
Commission would consider any request to rely on proposed rule 17f-
6, as it may be adopted, at that time.
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Proposed rule 17f-6 would not be mandatory, and investment
companies could use third party custodial accounts for their margin
deposits.72 Because of the uncertain status of third party
accounts in FCM bankruptcy proceedings, investment companies using
these accounts should satisfy themselves of the financial strength of
the FCMs that carry their trades.73 The Commission requests
comment on whether investment companies should be permitted to continue
to use third party arrangements if the proposed rule is adopted.
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\7\2Investment companies also could continue to initiate their
trades through introducing brokers, which do not take custody of
customer margin. See CEA section 1(a)(14), 7 U.S.C. 1(a)(14)
(defining introducing broker). When, however, an introducing broker
is used and margin is placed in the custody of an FCM, the proposed
rule would apply with respect to the FCM holding investment company
assets.
\7\3See supra notes 65-69 and accompanying text.
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A. Investment Company Margin
Rule 17f-6 would permit investment companies to maintain margin
with FCMs in connection with futures contracts and commodity options
traded on a designated contract market.74 This provision is
intended to establish the parameters of fund transactions involving FCM
custody and to ensure that margin underlying those transactions has the
full protections of the CEA and CFTC rules.75 Because only United
States commodity exchanges may be designated contract markets,
investment company margin deposits involving FCM custody would be
limited to domestically traded transactions.76
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\7\4See proposed subparagraph (d)(2) (defining exchange-traded
futures contracts and commodity options). Fund investments for which
FCM custody would be permitted include futures contracts, options on
futures contracts, and options on physical commodities. Id. The
Commission understands that options on physical commodities
currently are not traded on any exchange, although CFTC rules would
permit their trading. See CFTC regulation 33.7, 17 CFR 33.7. As
discussed supra at note 57, since margin payments resulting from
losses on commodity positions are not fund assets subject to section
17(f), the proposed rule would not govern these payments.
\7\5See, e.g., CEA section 4 (requiring the keeping of books and
records); CEA section 4b (prohibiting fraudulent transactions); CEA
section 4d (requiring segregation of customer funds and other
safekeeping measures); CFTC regulation 1.10, 17 CFR 1.10 (financial
reporting obligations); CFTC regulations 1.20 to .30 (safekeeping of
customer funds); CFTC regulation 3.10, 17 CFR 3.10 (registration of
FCMs).
\7\6See CEA sections 4(a) and (b). Margin deposits in connection
with foreign-related investments are discussed under ``Foreign-
Related Commodity Transactions'' below.
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1. Initial Margin
Under proposed paragraph (a), investment companies may place and
maintain initial margin with FCMs in amounts necessary to effect their
commodity trades.77 This provision is intended to tie FCM custody
of investment company assets to margin levels associated with specific
transactions. Investment companies would be permitted to use FCM
custody for margins established by exchanges as well as any additional
requirements imposed by FCMs.
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\7\7References to initial margin include maintenance margin
deposited throughout the life of the transaction. Rule 17f-6 would
not limit the types of assets that investment companies may use to
satisfy margin requirements. In addition, in accordance with
exchange rules, discounts may be applied to investment company
securities posted as margin. See supra note 21.
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The Commission considered limiting FCM custody to exchange-
established margin requirements.78 While this approach would
address concerns that FCMs might hold more investment company assets
than are technically necessary to enter into commodity transactions, it
also could interfere with normal commodity settlement
procedures.79 In addition, investment companies should be able to
bargain effectively with FCMs so that custody of fund assets is
appropriately circumscribed. The Commission, however, requests comment
on the proposed approach and whether any restrictions are necessary to
address an FCM's discretion to increase exchange-established margin
levels.
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\7\8See Russo Letter II, supra note 61, at 4 (recommending such
a limitation).
\7\9See supra notes 25 & 27 and accompanying text.
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In addition, exchange rules and FCMs may restrict the types of
assets that may be used to satisfy margin requirements.\80\ When an
investor does not have the assets required, the FCM may loan the
investor cash or other acceptable assets to meet margin requirements
upon taking possession of other assets as collateral for the loan.\81\
The Commission requests comment on whether investment companies should
be permitted to engage in these transactions and what, if any,
additional protections should apply.\82\
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\80\1 Russo, supra note 18, Secs. 1.20, 4.28.
\81\Id. Sec. 4.28. See CFTC regulation 1.30 (regarding FCM
loans).
\82\See, e.g., Inv. Co. Act Rel. 10666, supra note 1, 82
(requiring, among other things, the use of segregated accounts to
fully collateralize investment company reverse repurchase
agreements).
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2. Margin Gain
Paragraph (b) of proposed rule 17f-6 would permit FCMs to hold de
minimis amounts of investment company margin gain. The Commission
generally would expect that margin gain maintained with any one FCM
would not exceed $50,000.\83\ Consistent with current no-action
positions and the commodity settlement process, margin gain exceeding
de minimis amounts could be held by the FCM until the next business day
following receipt.
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\83\The de minimis limitation would apply on a per FCM basis.
This contrasts with certain exemptive orders which also limited the
amount of margin gain held by all FCMs through which trades are
effected. See, e.g., Carnegie Government Securities Trust, supra
note 60.
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The CFTC staff has suggested that margin gain should be collected
daily to avoid possible losses resulting from the pro rata treatment
accorded customer assets in FCM bankruptcy proceedings.\84\ Exemptive
applications, however, suggest funds may benefit from leaving small
amounts of margin gain in FCM custody.\85\ The Commission requests
comment on whether FCMs should be permitted to hold margin gain beyond
the next business day following receipt and, if so, whether the holding
of such gain should be subject to a $50,000 or other de minimis
limitation.\86\ The Commission also requests comment on whether it
would be appropriate for the rule to include, for example, a specific
dollar limitation instead of the proposed de minimis standard.
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\84\CFTC Interpretation No. 10, supra note 41, at 7128 n.15. The
risk of loss should be minimized by the proposed de minimis margin
gain limitation and FCM capitalization requirements. See
subparagraph (a)(1)(i) of the proposed rule (regarding the proposed
FCM capitalization requirements), discussed under ``FCMs Eligible to
Hold Investment Company Assets'' below.
\85\See, e.g., Carnegie Government Securities Trust, supra note
60 (indicating that the fund's custodian imposed a $25 charge for
each transfer of margin gain to the fund's account).
\86\The Commission, for example, considered whether to interpret
the de minimis limitation based on the facts and circumstances of
the fund involved. For example, $100,000 in margin gain could be
considered de minimis for funds that are more actively engaged in
commodity trading. The Commission also considered using a percentage
limitation, which would take into account the size of the fund.
Given the CFTC staff's position regarding daily collections of
margin gain, however, the $50,000 level seems prudent.
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B. FCMs Eligible to Hold Investment Company Assets\87\
FCMs maintaining custody of investment company margin would have to
be registered under the CEA, and thus would be subject to CEA and CFTC
regulation.\88\ The proposal would not require FCMs to be members of a
commodity exchange or clearing organization.
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\87\In addition to the objective requirements discussed in this
section, the board of directors (or its delegate) would be required
to determine that maintaining the fund's assets with a particular
FCM is in the best interests of the investment company and its
shareholders. See proposed subparagraph (a)(2), discussed under
``Responsibilities of the Board of Directors and Delegation'' below.
As discussed below under ``Additional FCMs Used for Clearing
Purposes,'' where the FCM accepting the investment company's trade
orders uses one or more FCMs to clear the fund's transactions, each
other FCM would be subject to the rule's requirements (other than
the requirement of a contract with the investment company).
\88\Proposed subparagraph (d)(1) (defining futures commission
merchant). See CFTC regulation 1.3(p), 17 CFR 1.3(p) (FCMs include
any entity that solicits or accepts trade orders and also accepts
customer assets to margin trades); CEA section 4d(1) (requiring FCM
registration).
The CFTC has delegated its responsibility for processing FCM
registrations to the National Futures Association (``NFA''). CFTC
regulation 3.10. The NFA currently is the only futures association
registered under the CEA and has its own rules governing FCM
operations. See CFTC regulation 170.15, 17 CFR 170.15 (requiring
FCMs to be members of at least one registered futures association);
NFA Manual, Registration Rules, Part 400 (providing for FCM training
and proficiency testing); NFA Manual, Compliance Rules, Part 3 (FCM
disciplinary actions). Subject to the minimum financial requirements
established by the CFTC (discussed in the text below), the NFA and
the individual exchanges share responsibility for imposing financial
standards and auditing FCMs; the NFA is responsible for FCMs that
are not members of an exchange, while the exchanges are responsible
for their members. CFTC regulation 1.52, 17 CFR 1.52.
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An exchange or clearing membership requirement might provide
additional investor protections.\89\ It also could reduce risks by
limiting the number of FCMs involved in the settlement of investment
company transactions.\90\ Imposing either requirement, however, might
restrict unnecessarily the number of FCMs eligible to hold investment
company margin and force investment companies to use different FCMs for
the various exchanges on which trading is conducted.\91\ The Commission
requests comment on the appropriateness of an exchange or clearing
membership requirement.\92\
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\89\Members of an exchange are subject to the rules of that
exchange and clearing members typically are subject to additional
clearing organization requirements. 1 Johnson & Hazen, supra note 2,
Secs. 2.53, 3.49 (exchange rules); 1 Russo, supra note 18,
Secs. 2.08, 4.33 (clearing organization requirements).
Prior to 1981, a number of failures occurred among non-member
FCMs that were not subject to the additional regulation and
oversight of an exchange. See Division of Trading and Markets, CFTC,
Commodity Account Protection Study 30 (Nov. 20, 1988) [hereinafter
CFTC Account Protection Study]. In 1981, the NFA was given
additional powers to regulate non-member FCMs to fill this
regulatory gap. 1 Johnson & Hazen, supra note 2, Sec. 1.89.
\90\See ``Background--FCM Insolvency Risks and the Settlement
Process'' above.
\91\Based on information provided by the CFTC staff, of 265 FCMs
registered under the CEA as of December 31, 1993, 184 FCMs, or
69.4%, are members of at least one exchange; 134 FCMs, or 50.5%, are
members of at least one clearing organization. 117 FCMs, or 44.2%,
are members of more than one exchange, and 90 FCMs, or 34%, are
members of more than one clearing organization.
\92\As discussed infra at note 144 and accompanying text, a
clearing membership requirement would eliminate the need to evaluate
additional FCMs in the settlement process, as currently required
under the proposed rule.
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Under CFTC regulations, FCMs generally must maintain adjusted net
capital equal to or exceeding the greatest of (i) $50,000,\93\ (ii)
four percent of customer funds maintained in safekeeping,\94\ or (iii)
for FCMs that are also registered securities broker-dealers, the net
capital required by rule 15c3-1(a) under the Securities Exchange Act of
1934 [17 CFR 15c3-1(a)].\95\ FCMs generally must notify the CFTC of
potential capital impairment if the ratio of their total adjusted net
capital to CFTC required minimums falls below 150%.\96\
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\93\Under NFA rules, FCMs are required to maintain adjusted net
capital of at least $250,000. NFA Manual, Financial Requirements,
section 1.
\94\This requirement is based on the amount of customer funds
required to be segregated under CEA section 4d(2) and CFTC rules
thereunder.
\95\CFTC regulation 1.17, 17 CFR 1.17. An FCM whose adjusted net
capital falls below the required minimum generally must cease doing
business as an FCM and transfer all customer accounts to an FCM that
meets CFTC requirements. CFTC regulation 1.17(a)(4).
After the 1985 insolvency of Volume Investors Corporation, the
CFTC proposed, but never adopted, a risk-based approach to FCM
capital requirements. See, e.g., Minimum Financial and Related
Requirements for FCMs, [1986-1987 Transfer Binder] Comm. Fut. L.
Rep. (CCH) 23,738 at 33,911 (CFTC July 29, 1987).
\96\CFTC regulation 1.12(b), 17 CFR 1.12(b).
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Proposed subparagraph (a)(1)(i) would require an FCM to have at
least $20 million in adjusted net capital in excess of the applicable
CFTC minimum requirement.\97\ In addition, the ratio of the FCM's
adjusted net capital to the CFTC required minimum would have to equal
or exceed 250%. These provisions seek to address FCM insolvency risks
by establishing a cushion between the FCM's actual capital and minimum
regulatory requirements.\98\
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\97\See proposed subparagraph (d)(3) (an FCM's adjusted net
capital and required minimum adjusted net capital would be
determined under CFTC regulation 1.17, which governs FCM minimum
capital requirements). See also rule 17f-5 (generally requiring
foreign banks holding investment company assets to have at least
$200 million in shareholders' equity). Rule 17f-1, which governs
custody of investment company assets by registered securities
brokers, does not contain specific minimum capital requirements. As
indicated supra at note 53, however, rule 17f-1 is rarely used,
because it requires investment company assets to be individually
segregated and marked as belonging to the fund.
\98\See, e.g., Division of Trading and Markets, CFTC, Volume
Investors Corporation 10 (July 1985) (Volume Investors Corporation
reported excess adjusted net capital of $1.6 million and a ratio of
266% prior to its failure in March 1985); CFTC News Release No.
3663-93, supra note 47, at 2 (Stotler and Company claimed $9.5
million in excess capital on the eve of its failure in August 1990,
but the CFTC later charged that its capital had fallen below the
150% ratio without the required notification more than six months
before).
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Because FCMs must compute their adjusted net capital to facilitate
regulatory oversight, investment companies should be able to evaluate
and monitor an FCM's compliance with the proposed requirements.\99\ If
the FCM's capital at any time falls below the proposed thresholds, the
FCM no longer would be eligible to hold investment company assets, and
the fund would be required to withdraw its assets from the FCM's
safekeeping.\100\
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\99\FCMs, for example, must compute their adjusted net capital
regularly to ensure compliance with the CFTC's notification
requirement discussed supra at the text accompanying note 96. See
also CFTC regulation 1.18, 17 CFR 1.18 (requiring FCMs to calculate
their adjusted net capital as of the end of each month); CFTC
regulation 1.10 (requiring FCMs to prepare and file periodic reports
concerning their financial strength and operations). See generally
infra note 128 (regarding the monitoring of FCM arrangements).
\100\See proposed subparagraph (a)(4), discussed under
``Responsibilities of the Board of Directors and Delegation'' below.
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The Commission requests comment on the proposed approach and the
appropriateness of the proposed $20 million and 250% thresholds.\101\
Specific comment is requested on the circumstances under which FCM
capital may fluctuate below these levels and whether the proposed rule
should incorporate a grace period or other mechanism to address such
fluctuations. The Commission also requests comment on whether both
requirements are necessary,\102\ and on alternative capital
requirements that would promote the safekeeping of investment company
assets.\103\
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\101\Based on information provided by the CFTC staff, of 265
FCMs registered under the CEA as of December 31, 1993, 79 FCMs, or
29.8%, would satisfy the proposed excess capital and ratio
requirements.
\102\Either requirement, standing alone, may not provide a
complete picture of an FCM's financial strength. For example,
without the proposed 250% ratio requirement, an FCM's capital may be
sufficient to satisfy the proposed $20 million excess capital
standard, but may fall below the CFTC 150% ratio signalling
potential vulnerability.
\103\One commenter, for example, recommended a $10 million total
(as opposed to excess) adjusted net capital requirement. Russo
Letter II, supra note 61, at 2-3. This approach, however, may not
reflect an FCM's financial strength. For example, depending of the
amount of customer funds in safekeeping or the FCM's status as a
registered broker-dealer, an FCM with $10 million in adjusted net
capital may not satisfy applicable CFTC requirements.
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Under proposed subparagraph (a)(2)(ii), FCMs holding investment
company margin could not be affiliated persons of the company or
affiliated persons of such persons.\104\
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\104\See section 2(a)(3) of the Act, 15 U.S.C. 80a-2(a)(3)
(defining affiliated person).
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Although some investment companies may use affiliated FCMs to
execute their trades,105 custody by FCM affiliates raises
additional investor protection concerns.106 Investment companies
wishing to execute their trades through affiliated FCMs may use third
party custodial accounts for their margin deposits.
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\1\05Several no-action letters concern commission payments to
affiliated FCMs. See, e.g., Prudential-Bache Government Plus Fund,
Inc. (pub. avail. Sept. 3, 1985); Kidder, Peabody Government Income
Fund, Inc. (pub. avail. Sept. 15, 1986).
\1\06To guard against potential abuses resulting from control
over fund assets by related persons, in other contexts rule 17f-2
has been read to require investment company affiliates to comply
with its provisions or establish other appropriate safeguards. See,
e.g., Pegasus Income and Capital Fund, Inc. (pub. avail. Dec. 1,
1977) (custody by adviser-bank).
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The Commission requests comment on whether the proposed approach
would be unduly restrictive and whether there are alternative
safeguards that would address investor protection concerns associated
with these arrangements. For example, should the board of directors
retain all responsibility for affiliated FCM custody arrangements,
without being able to delegate FCM selection and monitoring
responsibilities to the fund's adviser or officers?107
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\1\07See ``Responsibilities of the Board of Directors and
Delegation'' below.
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C. Contract Requirements
Subparagraph (a)(3) would require a written contract between the
investment company and the FCM to contain certain provisions.108
The contract would require the FCM to comply with the segregation
requirements of section 4d(2) of the CEA and CFTC rules
thereunder.109 In addition, to facilitate the inspection of
investment company assets, the FCM contract would have to provide that
the FCM would furnish the Commission or its staff upon request with
information concerning the FCM's custody of investment company
margin.110 The Commission requests comment on whether investment
company contracts also should require FCMs to furnish information at
the request of investment company accountants.111
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\1\08The Commission understands that FCMs use standardized
customer agreements, and that proposed subparagraph (a)(3) would
require additional contract provisions for investment company
clients.
\1\09Proposed subparagraph (a)(3)(i). This provision is intended
to ensure that investment company assets are not commingled with the
FCM's own funds, and that the FCM could not assign, hypothecate,
pledge or otherwise dispose of investment company margin except in
connection with the fund's commodity transactions and as required by
the exchanges and clearing organizations. See supra text
accompanying note 31. See also Russo Letter II, supra note 61, at 2,
5-6.
Certain exchanges have applied to the CFTC for exemptions from
section 4d(2) and other provisions of the CEA with respect to the
trading of futures contracts and commodity options among
institutional investors, including registered investment companies.
Exemptions for Certain Exchange-Traded Futures and Options
Contracts, 58 FR 43414 (Aug. 16, 1993). The Commission has urged the
CFTC to disapprove these requests. Letter of Jonathan G. Katz,
Secretary, SEC, to Jean A. Webb, Secretary, CFTC (Dec. 28, 1993).
\1\10Proposed subparagraph (a)(3)(ii). See Russo Letter II,
supra note 61, at 3 (recommending that the fund's commodity account
and related assets be subject to Division inspection).
\1\11See rule 17f-5(a)(1)(iii)(F) (imposing this requirement in
connection with investment company foreign custody arrangements).
The proposed rule also would not require the investment company's
independent accountants to verify or otherwise examine the fund's
margin held by the FCM. See, e.g., rule 17f-2(f) (imposing such a
requirement for self-custody arrangements).
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The FCM would be permitted to transfer the investment company's
assets for clearing purposes, consistent with the commodity settlement
process.112 The FCM may deposit and maintain investment company
margin with another FCM that meets the requirements of the rule (other
than the requirement of a contract with the investment
company),113 a bank that satisfies section 26(a)(1),114 or a
clearing organization.115 This provision is intended to
accommodate the legitimate needs of the participants in the commodity
settlement process, consistent with the safekeeping of investment
company assets.
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\1\12Proposed subparagraph (a)(3)(iii). As discussed supra at
note 29, if an FCM advances its own funds to satisfy margin
requirements, those funds are considered under the CEA to be
customer property. Proposed subparagraph (a)(3)(iii) thus would
apply without regard to whether an FCM advances its own funds or
transfers investment company assets to effect the company's
commodity transactions.
\1\13In addition, proposed subparagraph (a)(3)(iii) would
require the FCM to obtain the agreement of each FCM used for
clearing purposes to comply with the segregation requirements of the
CEA. See ``Additional FCMs Used for Clearing Purposes'' below.
\1\1415 U.S.C. 80a-26(a)(1). Section 26(a)(1) requires a bank to
have at all times at least $500,000 in capital, surplus, and
undivided profits. See also sections 17(f)(1) (investment company
assets may be held by a bank meeting the requirements of section
26(a)(1)) and 2(a)(5), 15 U.S.C. 80a-2(a)(5) (defining bank).
\1\15See proposed subparagraph (d)(4) (defining clearing
organization in accordance with CFTC rule 1.3(q)).
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The proposed contract provisions would not require that FCMs
maintain specific records or furnish investment companies with specific
reports concerning their commodity accounts. Under CFTC rules, FCMs
must maintain daily financial ledger records of all customer
transactions.116 In addition, FCMs must supply customers with
prompt confirmations of their trades and monthly statements concerning
their accounts.117 The Commission requests comment on whether the
proposed rule should impose any additional recordkeeping or reporting
requirements.118 For example, would the transmission of daily
account reports facilitate an investment company's compliance with the
proposed limitations on FCM custody of margin gain?119
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\1\16CFTC regulation 1.35, 17 CFR 1.35.
\1\17CFTC regulation 1.33, 17 CFR 1.33.
\1\18See Russo Letter II, supra note 61, at 4 (recommending that
FCMs transmit daily transaction reports); rule 17f-5(a)(1)(iii)(D)
and (F) (requiring records and periodic reports in connection with
investment company foreign custody arrangements).
\1\19See proposed paragraph (b), discussed under ``Background--
Investment Company Margin--Margin Gain'' above.
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Subparagraph (a)(3) also would not require FCMs to indemnify
investment companies or insure their assets against non-trading margin
losses.120 It appears that indemnification provisions in favor of
FCM customers are not included in customary FCM account
agreements.121 Private insurance may not be available or may be
unduly expensive.122 Comment is requested on the feasibility of an
indemnification or insurance requirement and whether such a requirement
would be appropriate.123
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\1\20Indemnification could protect against the loss of
investment company assets as a result of negligence or malfeasance.
Third party insurance could protect against both impropriety and
insolvency risks.
\1\21The CFTC has established a customer reparations program
that generally permits persons to seek redress with the CFTC for
alleged violations of the CEA and CFTC regulations by registered
FCMs. CEA section 14, 7 U.S.C. 18. Under this program, the CFTC may
award damages without dollar limitation if it finds that a violation
has occurred involving monetary injury. Damage awards are paid by
the FCM against whom reparation is sought. See id.; CFTC regulations
12.1 [-.408], 17 CFR 12.1 [-.408].
\1\22See CFTC Account Protection Study, supra note 89, at 63-66
(describing the experience of one commodity insurer organized in
1981, sold a year later, and no longer offering commodity coverage).
Unlike securities accounts of almost all broker-dealers
registered with the Commission, FCM commodity accounts are not
protected by the Securities Investor Protection Corporation
(``SIPC'') or mandatory insurance requirements. See Securities
Investor Protection Act, 15 U.S.C. 78aaa-78lll (in the event of a
member's financial failure, SIPC protects each securities customer
for claims of up to $500,000 for cash and securities losses, with a
$100,000 limit for cash losses); National Association of Securities
Dealers, Inc. Rules of Fair Practice, Art. III, sec. 32 and Appendix
C thereto (broker-dealer fidelity bonds). At the request of Congress
and the CFTC, the CFTC staff and the NFA have studied these and
other insurance mechanisms, and generally have concluded that
insurance protection is neither necessary nor cost effective in the
commodity context. See, e.g., CFTC Account Protection Study, supra
note 89; NFA Account Protection Study, supra note 49. Certain
exchanges maintain trusts that could be used in the exchange's
discretion to reimburse customer losses. Corcoran & Ervin, supra
note 47, at nn.87 & 208.
\1\23See rule 17f-5(a)(1)(iii)(A) (regarding indemnification and
insurance for investment company foreign custody arrangements).
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D. Responsibilities of the Board of Directors and Delegation124
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\1\24As discussed below under ``Additional FCMs Used for
Clearing Purposes,'' where the FCM originating the trade uses one or
more FCMs to clear the transaction, each other FCM would be subject
to the rule's requirements (other than the requirement of a contract
with the investment company).
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Under subparagraph (a)(2), the investment company's board of
directors would be required to find that maintaining the investment
company's assets with the FCM is in the best interests of the company
and its shareholders.125 The board would consider the FCM's
financial strength and its general reputation and standing in the
financial community, the FCM's internal procedures and safeguards
regarding custody of the fund's assets, and such other factors as the
board deems relevant.126 This requirement is intended to
complement the objective criteria set forth in proposed subparagraph
(a)(1) to ensure that all considerations pertinent to the safekeeping
of investment company assets are evaluated prior to depositing margin
with a particular FCM.
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\1\25The rule would not require the investment company's
contract with an FCM to be approved by the board. The board
nonetheless may choose to review and approve the FCM contract in
light of its fiduciary duties under state law. As discussed above,
proposed subparagraph (a)(3) would mandate specific contract
requirements.
\1\26Proposed subparagraphs (a)(2)(i)-(iii). See generally Russo
Letter II, supra note 61, at 4 (recommending similar factors to be
considered by the board in selecting FCMs); Note 2 to rule 17f-5
(enumerating factors investment company boards should consider in
selecting foreign custodians).
Under proposed subparagraph (a)(2)(i), the board would be
required to consider the FCM's financial strength apart from the
proposed capitalization requirements of subparagraph (a)(1)(i). The
board, for example, may consider the FCM's financial history and any
other lines of business undertaken by the FCM and its potential
impact on the FCM's operations. See also Risk Assessment for Holding
Company Systems, 59 FR 9689 (CFTC Mar. 1, 1993) (proposing rules to
require FCM recordkeeping and reporting in connection with financial
and operational risks presented by FCM affiliates).
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Factors not enumerated in the proposed rule that the board may deem
relevant would depend on the facts and circumstances. The board, for
example, may want to consider the FCM's status as an exchange or
clearing member.127
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\1\27See supra ``Background--Settlement of Futures Contracts and
Commodity Options--FCM Insolvency Risks and the Settlement Process''
and infra note 144.
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Subparagraph (a)(4) would require the board to establish a
monitoring system to ensure compliance with the requirements of the
proposed rule. This provision would require the board to create a means
of receiving sufficient and timely information to alert it to any
material change in circumstance.128 If the custodial arrangement
no longer complies with the proposed rule, the investment company would
be required to withdraw its assets promptly. The Commission generally
would expect such a withdrawal to be made within five business days.
The Commission requests comment on the appropriateness of this time
period.129
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\1\28An investment company, for example, may arrange to receive
regular reports of the FCM's financial condition. A fund also could
require the FCM to notify it of changes, such as a drop in the FCM's
adjusted net capital, that may affect the FCM's continued ability to
meet the requirements of the rule. External sources, such as
newspaper reports and other publications, may provide additional
information.
\1\29The Commission believes that five business days should be
sufficient to withdraw margin deposits either by closing out
existing positions or by transferring margin to an FCM that meets
the requirements of the proposed rule. Cf. CFTC regulation 190.02(e)
(requiring a trustee in FCM bankruptcy proceedings to transfer open
customer positions within four business days). Investment companies
may wish to maintain alternative FCM arrangements to facilitate
transfers of existing positions in the event of changed
circumstances.
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Under paragraph (c), the board could delegate its responsibilities
for selecting and monitoring FCM arrangements to the investment
company's adviser or officers, subject to the board's general oversight
and certain conditions.\130\ This approach is consistent with
recommendations of the Division and rule amendments approved by the
Commission to eliminate regulatory requirements that involve directors
in detailed findings of fact that do not present serious conflicts of
interest.\131\
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\130\The board would not be permitted to delegate certain
responsibilities (e.g., FCM selection), while retaining others
(e.g., monitoring).
\131\Protecting Investors report, supra note, 71 at 251-289;
Exemption of Acquisitions of Securities Issued by Persons Engaged in
Securities Related Businesses, Investment Company Act Release No.
19716 (Sept. 16, 1993) (eliminating the requirement in rule 12d3-1
[17 CFR 270.12d3-1] that directors determine the credit quality of
debt securities of certain issuers involved in securities related
activities). See also Letter from Matthew P. Fink, President,
Investment Company Institute, to Marianne K. Smythe, Director,
Division of Investment Management, SEC (Jan. 18, 1993) (recommending
delegation of the board's responsibilities with respect to foreign
custodian arrangements under rule 17f-5).
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Under proposed rule 17f-6, the board would be required to find that
the delegation is in the best interests of the investment company and
its shareholders.\132\ In addition, the board would be required to
adopt written guidelines and procedures governing the delegate's
responsibilities, and make and approve changes to the guidelines and
procedures as the board deems necessary.\133\ The guidelines and
procedures would require the delegate to notify the board of its
selection of an FCM at or before the next regularly scheduled board
meeting following the selection.\134\ The delegate also would report
any material changes in the investment company's custodial arrangements
and the actions taken by the delegate with respect thereto.\135\
Reports of material changes would be given to the board as soon as
reasonably practicable, but in no event later than the next regularly
scheduled meeting after the event triggering the board's
involvement.\136\
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\132\Proposed subparagraph (c)(1).
\133\Proposed subparagraphs (c)(2) and (c)(3). The proposed
approach is consistent with Investment Company Act rules 10f-3, 17a-
7, and 17e-1. 17 CFR 270.10f-3, 17a-7, 17e-1. See Revision of
Certain Annual Review Requirements of Investment Company Boards of
Directors, Securities Act Release No. 7013 (Sept. 17, 1993), 58 FR
49919.
\134\The proposed notification of FCM selection also would
extend to any other FCMs used for clearing purposes. See
``additional FCMs Used for Clearing Purposes'' below.
\135\A material change would include, but not be limited to,
discontinuing the use of a particular FCM or an FCM's loss of
exchange or clearinghouse membership. A material change also would
include circumstances that may adversely affect the FCM's financial
strength, such as a change in control as a result of the FCM's sale.
If appropriate, the delegate would report its reasons for continuing
to use the FCM.
\136\Proposed subparagraph (c)(2)(ii).
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Delegation would not relieve the board of ultimate responsibility
for the fund's custodial arrangements. Notification of an FCM's
selection and reports of material changes would keep the board
generally apprised of the investment company's custodial arrangements
and facilitate the board's oversight of the delegate's performance.
Based on this information, the board may determine to make adjustments
in the written guidelines and procedures governing the delegate's
responsibilities or overrule the delegate's decision to use a
particular FCM. In some instances, the board may determine to rescind
the delegation.
The Commission requests comment on the role and responsibilities of
investment company boards and their delegates under proposed rule 17f-
6. The Commission also requests comment on whether the board should be
permitted to delegate its responsibilities to any other party, such as
the investment company's primary bank custodian or a fund
administrator, and what, if any, additional protections would be
necessary or appropriate.\137\
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\137\Because FCM selection also would involve brokerage
considerations (e.g., prompt execution and commission rates),
investment company officers and advisers may be in a better position
to make these determinations. In addition, officers and advisers
have fiduciary duties to investment companies under section 36. 15
U.S.C. 80a-35.
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E. Additional FCMs Used for Clearing Purposes
When the FCM that executes the investment company's trades is not
an exchange or clearinghouse member, investment company margin will be
transferred to one or more FCMs for clearing purposes.\138\ The
proposed rule would apply to each subsequent FCM in the settlement
chain, although a contract with the investment company would not be
required.\139\
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\138\See supra notes 17-20 and 32-33 and accompanying text. See
also supra note .
\139\Commodity customers enter into contracts only with the FCM
with which orders are placed; as discussed above under
``background--Settlement of Futures Contracts and Commodity
Options,'' when one FCM acts on behalf of another, its ``customer''
is the FCM on whose behalf the order is effected, not that FCM's
underlying customer. Thus, requiring a contract between the
investment company and other FCMs in the settlement process would
not be consistent with normal FCM/customer relationships.
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When a non-clearing member FCM, for example, transfers investment
company margin to a clearing member, the member FCM also would have to
satisfy the objective requirements of proposed subparagraph
(a)(1),\140\ and be selected by the board (or its delegate) in
accordance with proposed subparagraph (a)(2).\141\ Under its contract
with the investment company, the non-member could place and maintain
the company's assets only with a clearing member that meets these
requirements.\142\ The non-member FCM also would be contractually
responsible for securing the clearing member's agreement to comply with
the segregation requirements of the CEA. Although the proposed approach
would place certain contractual responsibilities on the non-member FCM,
the board of directors and its delegate (if any) would remain
responsible for the continuing appropriateness of the custodial
arrangement.\143\
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\140\See ``FCMs Eligible to Hold Investment Company Assets''
above.
\141\See ``Responsibilities of the Board of Directors and
Delegation'' above. Under most circumstances, the board or its
delegate would evaluate the use of one or more clearing members at
the same time it selects the non-member FCM. Under proposed
subparagraph (c)(2)(i), if the board has delegated its
responsibilities, the delegate would be required to notify the board
of the selection of each FCM used for clearing purposes at or before
the next regularly scheduled board meeting.
\142\Proposed subparagraph (a)(3)(iv).
\143\See ``Responsibilities of the Board of Directors and
Delegation'' above, discussing proposed subparagraph (a)(4).
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The Commission believes the proposed approach is appropriate to
protect investment company assets when more than one FCM is involved in
the settlement process. The Commission requests comment on the proposed
approach and any alternatives that would ensure the safekeeping of
investment company margin.\144\ Specific comment is requested on
whether an FCM to which assets are transferred should be required to
satisfy only the objective requirements of proposed subparagraph
(a)(1).\145\
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\144\For example, the transfer of investment company assets from
one FCM to another could be eliminated by restricting FCM custody to
FCM clearing members. Such a requirement, however, would limit the
number of FCMs eligible to hold investment company assets. See supra
note 91 and accompanying text. Under the proposed rule, investment
companies would have the option of determining whether to execute
their trades directly through a clearing member FCM.
\145\For example, the rule could require the FCM originating the
fund's trades to determine whether an FCM used for clearing purposes
satisfies the objective requirements of proposed subparagraph
(a)(1). While such an approach would be less burdensome for
investment companies, it would eliminate consideration of subjective
factors relevant to the safekeeping of investment company margin.
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F. Foreign-Related Commodity Transactions
Certain futures contracts and options involving foreign commodities
or linked to foreign markets are traded on domestic exchanges. These
transactions include commodity contracts and options involving foreign
currencies and certain commodity investments that are effected through
electronic links between United States and foreign exchanges.\146\
Proposed rule 17f-6 would permit FCM custody of investment company
margin for these domestically traded transactions, even if the margin
is held overseas.\147\ Because the transactions are traded on or linked
to United States contract markets, margin underlying the transactions
enjoys the full protections of the CEA and CFTC rules.
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\146\See Laurie Morse, CME to Relaunch Derivatives in French
Francs, Financial Times, Sept. 16, 1993, at 23 (CME commodity
trading based on the French franc, Deutsche mark, British sterling,
Swiss franc, Japanese yen, and Canadian dollar); Futures Exchanges--
Open all hours, The Economist, Nov. 6, 1993, at 107 (describing the
``Globe'' and ``Access'' computer systems). Additional transactions
include those that are cleared on domestic exchanges pursuant to
CFTC-approved linkage agreements between United States and foreign
exchanges. Current arrangements involve the Singapore Monetary
Exchange and the Sidney Futures Exchange Limited, although the
Commission understands that no trading presently is conducted under
the Australian agreement. See CFTC Interpretative Letter No. 84-19,
Mutual Offset System's Customer Funds Treatment, [1984-1986 Transfer
Binder] Comm. Fut. L. Rep. (CCH) 22,389 at 29,795 (CFTC Division of
Trading and Markets Aug. 9, 1984); CFTC Interpretative Letter No.
86-26, Treatment of Customer Funds Under Linkage Agreement Between
Commodity Exchange, Inc. and the Sidney Future Exchange Limited,
[1986-1987 Transfer Binder] Comm. Fut. L. Rep. (CCH) 23,359 at
32,989 (CFTC Division of Trading and Markets Nov. 17, 1986).
\147\As discussed above under ``Investment Company Margin,''
although FCM custody would be limited to domestically traded
transactions, the proposal would not require investment company
assets to be held in the United States. By virtue of proposed
paragraph (a)(3)(iii), however, margin posted overseas would have to
be maintained by a foreign branch of a United States bank to meet
the definition of bank in section 2(a)(5). See International
Resources Fund, Inc., Investment Company Act Release No. 2866 (Apr.
17, 1959). The Commission understands that this requirement
generally would be consistent with current practices. Margin held by
foreign subsidiaries of United States banks or other foreign
entities would raise additional issues. See rule 17f-5 (governing
custody of investment company assets by foreign entities in
connection with foreign securities investments).
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The CFTC has identified certain risks associated with domestically
traded transactions margined in foreign currencies or overseas.\148\
The CFTC requires customers with these accounts to enter into
subordination agreements.\149\ For example, customers trading in the
currency of one jurisdiction or posting margin in the same jurisdiction
must 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 other customers.\150\ The subordination requirement is
intended to tie the risks of a particular jurisdiction and currency to
investors engaging in commodity transactions relative to that
jurisdiction and currency.\151\ Investment companies depositing margin
for foreign-related transactions would be subject to this
requirement.\152\
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\148\See, e.g., CFTC Financial and Segregation Interpretation
No. 12, Deposit of Customer Funds in Foreign Depositories, 1 Comm.
Fut. L. Rep. (CCH) 7122 at 7129, 7130-31 (Nov. 16, 1988)
[hereinafter CFTC Interpretation No. 12]. These risks include
various ``location'' risks, such as the freezing and expropriation
of margin deposits, and the risk of foreign currency fluctuations
pending FCM insolvency proceedings. Id.
\149\Id. The CFTC currently is reviewing Interpretation No. 12
with a view toward possible refinements.
\150\Id., at 7132-33. See supra notes 65-66--and accompanying
text (regarding the treatment of margin funds in FCM bankruptcy
proceedings).
\151\See CFTC Interpretation No. 12, supra note 148, at 1730.
\152\The fund's investment adviser would be expected to evaluate
the risks associated with a particular foreign-related commodity
transaction, such as the likelihood of expropriation or difficulties
in converting foreign currencies to United States dollars, in
connection with the adviser's decision to engage in that transaction
on the fund's behalf. But cf. rule 17f-5, Note 1(d) & (e)
(suggesting directors consider these risks in selecting foreign
custodians). Foreign investment-related risks also would be
disclosed, if material, in the fund's prospectus.
---------------------------------------------------------------------------
The Commission requests comment on the proposed approach and
whether any additional safeguards are necessary to address margin
underlying foreign-related transactions. For example, should these
margin deposits be required to be held in the United States? The
Commission also requests specific comment on the appropriateness of
investment companies entering into the required subordination
agreements.\153\
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\153\Subordination would come into play only upon an FCM's
insolvency, which other provisions of the proposed rule are intended
to address.
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Proposed rule 17f-6 would not allow FCM custody in connection with
commodity investments effected on foreign exchanges.\154\ These
transactions are governed by special regulations, which do not provide
customer funds with the full protections of the CEA and CFTC
rules.\155\ Although the proposed approach should not affect
significantly investment company participation in foreign futures and
options transactions,\156\ the Commission requests comment on the
proposed approach and alternatives that would address safekeeping
considerations. For example, would risks be diminished if FCMs
maintained custody of investment company margin in the United States
and advanced their own funds for foreign exchange-traded transactions?
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\154\Proposed subparagraph (d)(2) (defining exchange-traded
futures contracts and commodity options to include investments
traded on or subject to the rules of any contract market designated
under the CEA and CFTC rules). See supra note 76 and accompanying
text (only United States exchanges may be designated as contract
markets). Although comment is requested on this approach, investment
companies may use third party custodial accounts for foreign
exchange-traded investments. See Koenig Tax-Advantaged Liquidity
Fund, Inc. (pub. avail. Mar. 21, 1985).
\155\See Foreign Futures and Foreign Options, 52 FR 28985 (Aug.
5, 1987) (recognizing ``inherent limitations on [the CFTC's] ability
to provide U.S. residents trading on foreign exchanges the identical
protections available to U.S. residents trading on U.S. contract
markets''). See also CFTC regulations 30.1 through 30.10, 17 CFR
30.1-.10 (governing the sale of foreign exchange-traded futures
contracts and commodity options to United States investors).
\156\See supra notes 146-147 and accompanying text. It appears
that most investment company foreign transactions are effected in
the over-the-counter market where the posting of collateral
generally is not required.
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IV. Summary of Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis in accordance with 5 U.S.C. 603 regarding proposed rule 17f-6.
The analysis states that the proposed rule would permit registered
management investment companies to use FCMs and commodity clearing
organizations as custodians in connection with CEA-regulated commodity
transactions under conditions designed to ensure the safekeeping of
investment company assets. The analysis explains that the proposed rule
would provide flexibility and investor protection in a way that should
minimize any impact on, or cost to, small business. To obtain a copy of
the Initial Regulatory Flexibility Analysis, write to Elizabeth
Krentzman, Division of Investment Management, Mail Stop 10-6,
Securities and Exchange Commission, 450 Fifth Street, NW., Washington,
DC 20549.
V. Statutory Authority
The Commission is proposing rule 17f-6 pursuant to sections 6(c)
and 38(a) of the Investment Company Act of 1940 [15 U.S.C. 6(c),
37(a)].
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Proposed Rule
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is proposed to be 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;
* * * * *
2. By adding Sec. 270.17f-6 to read as follows:
Sec. 270.17f-6 Custody of investment company assets with futures
commission merchants and commodity clearing organizations.
(a) A registered management investment company may place and
maintain cash, securities, and similar investments with a futures
commission merchant in amounts necessary to effect the company's
transactions in exchange-traded futures contracts and commodity
options, provided that:
(1) The futures commission merchant and each other futures
commission merchant the futures commission merchant uses for purposes
of clearing the company's transactions:
(i) Has adjusted net capital that is:
(A) At least $20,000,000 in excess of the futures commission
merchant's required minimum adjusted net capital; and
(B) Equal to at least 250% of such required minimum adjusted net
capital; and
(ii) Is not an affiliated person of the company or an affiliated
person of such person.
(2) The board of directors of the company shall have determined
that placing and maintaining the company's assets with the futures
commission merchant and each other futures commission merchant used for
clearing purposes is consistent with the best interests of the company
and its shareholders, after considering:
(i) The financial strength of the futures commission merchant and
its general reputation and standing within the financial community;
(ii) The futures commission merchant's internal procedures and
safeguards regarding custody of the assets; and
(iii) Such other factors as the board deems relevant.
(3) The manner in which the futures commission merchant maintains
the company'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);
(ii) 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 company's assets as the Commission
through its employees or agents may request; and
(iii) The futures commission merchant may place and maintain the
company's assets for clearing purposes only with another futures
commission merchant that meets the requirements of paragraphs (a)(1)
and (2) of this section, a bank that meets the requirements of section
26(a)(1) of the Act (15 U.S.C. 26(a)(1)), or a clearing organization.
Each futures commission merchant used for clearing purposes shall agree
to comply with the segregation requirements of section 4d(2) of the
Commodity Exchange Act and rules thereunder.
(4) The board of directors shall establish a system to monitor the
custodial arrangement to ensure it meets the requirements of this
section. If the custodial arrangement no longer meets the requirements
of this section, the company shall promptly withdraw its assets from
the futures commission merchant.
(b) Subject to the requirements of paragraph (a) of this section,
any gains of the company on exchange-traded futures contracts and
commodity options may be maintained with the futures commission
merchant in de minimis amounts. Gains in excess of such amounts may be
maintained by the futures commission merchant until the next business
day following receipt.
(c) The board of directors may delegate to the company's investment
adviser or officers its responsibilities under this section, provided
that:
(1) The board determines that the delegation is consistent with the
best interests of the company and its shareholders.
(2) The board adopts written guidelines and procedures under which
the delegate shall act under this section, which shall include:
(i) Notifying the board of the selection of a futures commission
merchant, including each other futures commission merchant used for
clearing purposes, no later than the next regularly scheduled board
meeting following such action; and
(ii) Reporting to the board any material change in the custodial
arrangement and any action taken by the delegate with respect thereto
as soon as is reasonably practicable under the circumstances, but not
later than the next regularly scheduled board meeting.
(3) The board makes and approves such changes to the written
guidelines and procedures required by paragraph (c)(2) of this section
as the board deems necessary.
(d) For purposes of this section:
(1) Futures commission merchant is any person who is registered as
a futures commission merchant under the Commodity Exchange Act (7
U.S.C. 1-25).
(2) Exchange-traded futures contracts and commodity options are
commodity futures contracts, options on commodity futures contracts,
and options on physical commodities conducted on or subject to the
rules of any contract market designated for trading such transactions
under the Commodity Exchange Act and the rules and regulations
thereunder.
(3) Adjusted net capital and required minimum adjusted net capital
shall be determined under rule 1.17 under the Commodity Exchange Act
(17 CFR 1.17).
(4) Clearing organization has the meaning set forth in rule 1.3(d)
under the Commodity Exchange Act (17 CFR 1.3(d)).
By the Commission.
Dated: May 24, 1994.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-13213 Filed 5-31-94; 8:45 am]
BILLING CODE 8010-01-P
