[Federal Register Volume 61, Number 243 (Tuesday, December 17, 1996)]
[Rules and Regulations]
[Pages 66207-66212]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-31891]
[[Page 66207]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release No. IC-22389; File No. S7-15-94]
RIN 3235-AF97
Custody of Investment Company Assets With Futures Commission
Merchants and Commodity Clearing Organizations
AGENCY: Securities and Exchange Commission.
ACTION: Final Rule.
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SUMMARY: The Commission is adopting a new rule under the Investment
Company Act of 1940 to permit registered investment companies to
maintain their assets with futures commission merchants and certain
other entities in connection with futures contracts and commodity
options traded on U.S. and foreign exchanges. Currently, investment
companies generally must maintain assets relating to these transactions
in special accounts with a custodian bank. The new rule will enable
investment companies to effect their commodity trades in the same
manner as other market participants under conditions designed to
provide custodial protections for investment company assets.
EFFECTIVE DATE: The rule will become effective January 16, 1997.
FOR FURTHER INFORMATION CONTACT: Kenneth J. Berman, Assistant Director,
Office of Regulatory Policy, Division of Investment Management, at
(202) 942-0690, or Elizabeth R. Krentzman, Assistant Director, Office
of Disclosure and Investment Adviser Regulation, Division of Investment
Management, at (202) 942-0721, Securities and Exchange Commission, 450
Fifth Street, N.W., Mail Stop 10-2, Washington, D.C. 20549.
Requests for formal interpretive advice should be directed to the
Office of Chief Counsel at (202) 942-0659, Division of Investment
Management, Securities and Exchange Commission, 450 Fifth Street, N.W.,
Mail Stop 10-6, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'') today is adopting rule 17f-6 [17 CFR 270.17f-6] under
the Investment Company Act of 1940 [15 U.S.C. 80a] (the ``Investment
Company Act''). The new rule governs the custody of investment company
assets by futures commission merchants and other entities used for
settling commodity transactions. The rule does not affect the extent to
which investment companies may engage in commodity trading.
Table of Contents
Executive Summary
I. Background
A. Commodities Trading and Investment Company Act Custody
B. Custodial Protections for Commodity Assets under the
Commodity Exchange Act
II. Rule 17f-6
A. Role of Fund Board of Directors
B. Eligible FCM Custodians
1. FCM Registration and CFTC Net Capital Requirements
2. Affiliated FCM Arrangements
C. Domestic and Foreign Commodity Transactions
D. Assets Held in FCM Custody
1. Initial Margin
2. Gains on Commodity Transactions
E. Contract Requirements and Custodians Used to Effect Commodity
Transactions
F. Withdrawal of Assets from FCM Custody
III. Cost/Benefit Analysis
IV. Summary of Regulatory Flexibility Analysis
V. Statutory Authority
Text of Adopted Rule
Executive Summary
The Commission is adopting rule 17f-6 under the Investment Company
Act. Rule 17f-6 permits registered management investment companies,
unit investment trusts (``UITs''), and face-amount certificate
companies (collectively, ``funds'') to maintain assets (i.e., margin)
with futures commission merchants (``FCMs'') in connection with
commodity transactions effected on both domestic and foreign exchanges.
Currently, funds generally must maintain such assets in special
accounts with a custodian bank. The new rule is designed to eliminate
unnecessary regulatory burdens, and to enable funds to effect their
commodity trades in the same manner as other market participants.
Rule 17f-6 permits funds to maintain their assets with FCMs that
are registered under the Commodity Exchange Act (``CEA'') and that are
not affiliated with the fund. Rule 17f-6 requires a written contract
between the fund and the FCM to contain certain provisions. Among other
things, the FCM must agree that any other FCMs used to clear the fund's
trades meet the rule's requirements (other than the requirement of a
contract with the fund). To protect fund assets from loss in the event
of an FCM's bankruptcy, any gains on fund transactions may be
maintained with an FCM only in de minimis amounts.
Unlike the rule as originally proposed, rule 17f-6 does not require
a fund's board of directors to select and monitor the fund's FCM
arrangements, nor does the rule require an FCM that holds fund assets
to meet capital standards in excess of those imposed under the CEA.
Rule 17f-6 does not require that assets related to commodities
transactions be maintained with an FCM. Funds may continue to maintain
such assets in a special account with a custodian bank.
I. Background
A. Commodities Trading and Investment Company Act Custody
The Commission proposed rule 17f-6 under the Investment Company Act
to permit management investment companies to effect their commodity
trades by placing assets relating to such transactions directly with
FCMs.1 Over the last several years, fund participation in
commodity markets has increased. A fund, for example, may engage in
commodity trades to hedge its portfolio against declines in securities
prices, changes in interest rates, or foreign currency
fluctuations.2 A fund also may enter into commodity transactions
to adjust the percentage of its portfolio held in cash, debt, and
stocks without having to buy or sell the actual assets.3
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\1\ Rule 17f-6 was proposed for public comment on May 24, 1994.
Custody of Investment Company Assets with Futures Commission
Merchants and Commodity Clearing Organizations, Investment Company
Act Release No. 20313 (May 24, 1994) [59 FR 28286 (June 1, 1994)]
[hereinafter the Proposing Release].
\2\ Commodity transactions include futures contracts and options
on futures contracts and physical commodities. A futures contract
generally is a bilateral agreement providing for the purchase or
sale of a specified commodity at a stated time in the future for a
fixed price. Robert E. Fink & Robert B. Feduniak, Futures Trading 10
(1988) [hereinafter Fink & Feduniak]. A commodity option gives its
holder the right, for a specified period of time, to either buy (in
the case of a call option) or sell (in the case of a put option) the
subject of the option at a predetermined price. The writer (seller)
of an option is obligated to sell or buy the specified commodity at
the election of the option holder. 1 Philip M. Johnson & Thomas L.
Hazen, Commodities Regulation section 1.07 (2d ed. Supp. 1991)
[hereinafter Johnson & Hazen].
\3\ Taking a position in a futures contract with respect to
stocks that comprise the Standard & Poor's 500 Index, for example,
may be more efficient than buying and selling all of the stocks that
comprise that index due to lower brokerage and transaction costs.
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To enter into a futures contract or write a commodity option, a
customer typically deposits with an FCM, as security for performance of
its obligations, a specified amount of assets or cash as ``initial
margin.'' 4 In the case
[[Page 66208]]
of a fund, placing initial margin with an FCM could be viewed as
placing fund assets in the custody of the FCM.5 The FCM then
clears the transaction by posting margin either directly with a
clearing organization or with one or more other FCMs that will effect
the transaction through the clearing organization.6
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\4\ Unlike the parties to a futures contract, only the writer
(seller) of an option is subject to margin requirements; the option
holder (purchaser) pays the writer a one-time premium as
compensation in full for its right to compel the writer's
performance. See Proposing Release, supra note, at n.44 and
accompanying text.
\5\ Initial margin is not considered part of the contract or
option price, and is returned upon termination of the position,
unless used to cover a loss. Initial margin in commodity
transactions thus differs from securities margin, which represents a
partial payment for securities purchased by a broker on its
customer's behalf. Initial margin can also be contrasted with
variation margin, which is credited or assessed at least daily to
reflect any gains or losses in the contract's value. In contrast to
initial margin, variation margin represents the system of marking to
market the contract's value. Through this system, losses on one side
of a contract position are matched with and paid as profits to the
other side of the transaction. See Proposing Release, supra note at
nn.34-38 and accompanying text, and infra note.
\6\ The clearing organization matches the trade on behalf of the
exchange, and acts as guarantor of the opposite side of the
transaction. An FCM executing trades on an exchange must be a member
of that exchange; nonmembers trade by entering orders through an
exchange member. To clear transactions with a clearing organization,
an FCM must be both an exchange member and a member of the clearing
organization. Non-clearing member FCMs must execute their
transactions through a clearing member. A commodity transaction,
therefore, may be effected through several FCMs.
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Section 17(f) generally permits a fund to maintain its assets only
in the custody of a bank, a member of a national securities exchange,
the fund itself, or a national securities depository.7 Under no-
action positions of the Division of Investment Management, a fund may,
consistent with the requirements of section 17(f), place assets
relating to commodity transactions in a special account with a third
party custodian bank (``third party accounts'').8 As a
consequence, an FCM must use its own assets to effect fund commodity
trades.
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\7\ 15 U.S.C. 80a-17(f). See also Investment Company Act rules
17f-1 [17 CFR 270.17f-1] (custody with members of national
securities exchanges); 17f-2 [17 CFR 270.17f-2] (custody by funds
themselves); 17f-4 [17 CFR 270.17f-4] (custody with securities
depositories); 17f-5 [17 CFR 270.17f-5] (custody of fund securities
outside the United States).
\8\ See, e.g., Prudential Bache IncomeVertible Plus Fund, Inc.
(pub. avail. Nov. 20, 1985). The third party account may be
maintained in the name of the FCM, but the FCM's ability to withdraw
these funds is limited. See Proposing Release, supra note, at n.55
and accompanying text.
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The Commission proposed rule 17f-6 to respond to certain criticisms
associated with third party accounts.9 Commenters have indicated
that third party accounts create systemic liquidity risks by diverting
FCM capital, which would otherwise be available for use in the
marketplace, to effect fund transactions.10 Commenters also have
stated that third party arrangements are unnecessary because they are
unlikely to provide any special protection to fund assets in FCM
bankruptcy proceedings. The U.S. Bankruptcy Code and rules of the
Commodity Futures Trading Commission (``CFTC'') provide that customer
assets relating to commodity transactions generally have priority over
other creditors' claims, and are subject to distribution based on each
customer's pro rata share of the available customer property.11
Although the issue has not been judicially determined, the CFTC staff
has stated that assets in a third party account will be subject to the
same pro rata treatment as all other assets in the FCM's
custody.12 Finally, third party accounts may be redundant in view
of the safeguards for customer assets afforded by the CEA and CFTC
rules.
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\9\ See Proposing Release, supra note, at nn.61-70 and
accompanying text.
\10\ According to a 1988 report, third party accounts may have
been a source of liquidity stress in the clearing and credit systems
during the October 1987 market break. Report of the Presidential
Task Force on Market Mechanisms (1988) VI-73 to -74 (discussing
statements of members of the Chicago Mercantile Exchange).
\11\ 11 U.S.C. 766; CFTC rule 190.08 [17 CFR 190.08].
\12\ CFTC Financial and Segregation Interpretation No. 10,
Treatment of Funds Deposited in Safekeeping Accounts, 1 Comm. Fut.
L. Rep. (CCH) Sec. 7120 at 7130 (CFTC Division of Trading and
Markets, May 23, 1984) [hereinafter Interpretation No. 10]. See also
CFTC Advisory No. 37-96, Responsibilities of Futures Commission
Merchants and Relevant Depositories with Respect to Third Party
Custodial Accounts (July 25, 1996) (discussing Interpretation No. 10
and requesting that FCMs review their custody arrangements with
depository institutions to assure that they fully accord with the
requirements of the CEA and CFTC regulations).
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B. Custodial Protections for Customer Assets Under the Commodity
Exchange Act
The CEA and CFTC rules contain provisions designed to safeguard
customer assets held by an FCM.13 For transactions traded on
domestic exchanges, extensive regulations, known as the ``segregation
requirements,'' are designed to protect customer funds in an FCM's
possession.14 Under these requirements, an FCM may maintain
customer assets in a single commingled bank account established for
those assets. The FCM must segregate customer funds from the FCM's own
assets, and may not use one customer's assets to carry another
customer's trades.15 Special provisions, which parallel the
segregation requirements for domestic transactions, govern the
safekeeping of margin relating to foreign exchange-traded
transactions.16 CFTC rules require an FCM engaging in foreign
commodity transactions to maintain a ``secured amount,'' which
generally represents the assets required to margin the foreign
commodity trades of its U.S. customers.17
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\13\ Maintaining assets in an FCM's custody is not without risk.
An FCM is financially responsible for the trade obligations of its
customers. Johnson & Hazen, supra note 2, at section 1.10. If an FCM
becomes insolvent and cannot cover the obligations of a defaulting
customer, the FCM's non-defaulting customers may be affected. The
clearing organization has the right to use customer assets held at
the clearing organization level to satisfy a commodity loss on
behalf of the FCM's customers. The resulting shortfall in the
customer assets may be borne by the FCM's non-defaulting customers.
See supra note 11 and infra note 17, and accompanying text
(regarding FCM bankruptcy provisions). To date, however, losses of
customer funds have been rare. See Andrea M. Corcoran & Susan C.
Ervin, Maintenance of Market Strategies in Futures Broker
Insolvencies: Futures Position Transfers From Troubled Firms, 44
Wash. & Lee L. Rev. 849, 863-64 (1987) (``customer losses have been
forestalled * * *, in significant measure, by the voluntary
contributions of futures exchanges'').
\14\ CEA section 4d(2) [7 U.S.C. 6d(2)]; CFTC rules 1.20 to .30
[17 CFR 1.20 to .30].
\15\ Customer funds also may be maintained in a commingled bank
account established by the clearing organization for the FCM's
customers.
\16\ CFTC rule 30.7 [17 CFR 30.7].
\17\ Id. In the event of an FCM's bankruptcy, CFTC rules provide
for the allocation of property among different types of customer
accounts, which include customer assets underlying U.S. and foreign
trades that are subject to the segregation and secured amount
requirements, respectively. While customer assets relating to U.S.
and foreign-based trades are subject to the same pro rata treatment
in FCM bankruptcy proceedings (see supra note 11 and accompanying
text), customers of U.S. and foreign trades may receive different
proportional amounts based on the assets attributed to the
respective account classes. For example, a shortfall in the secured
amount (e.g., due to a customer default or currency fluctuations
during bankruptcy proceedings) will result in customers of foreign
trades receiving a smaller percentage of their margin deposits than
customers of the segregated account class underlying U.S. trades.
Although the maintenance of separate customer accounts for U.S. and
foreign-based trading may result in different pro rata distributions
in FCM bankruptcy proceedings, these differences generally are
attributable to the investment risks associated with U.S. and
foreign-based commodity transactions rather than differences in
custodial protections.
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As proposed, rule 17f-6 would have permitted funds to post
commodity margin with FCMs registered under the CEA, subject to certain
conditions. Nineteen commenters commented on proposed rule 17f-6.
Commenters generally supported the rule's adoption, while recommending
certain changes to the proposed rule.
II. Rule 17f-6
The Commission is adopting rule 17f-6 with a number of changes
based on commenters' suggestions. Rule 17f-6, as adopted, extends to
registered investment companies.18 The adopted
rule incorporates the safeguards that are provided for fund assets
under the CEA and CFTC rules and, in so doing, generally permits funds
to effect domestic and foreign commodity transactions in the same
manner as other market participants.
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\18\ See rule 17f-6(b)(3) [17 CFR 270.17f-6(b)(3)] (defining
``Fund''). The Commission notes that trading in futures contracts
and commodity options ordinarily requires a significant degree of
management. Since unit investment trust (``UIT'')
[[Page 66209]]
portfolios are generally unmanaged, it is unclear at present to the
Commission how an investment company that engages is commodity
trading could meet the requirements imposed on a UIT by the
Investment Company Act, including section 4(2) thereof [15 U.S.C.
80a-4(2)].
Rule 17f-6 also is available to face-amount certificate
companies that are governed by section 28 of the Investment Company
Act [15 U.S.C. 80a-28]. See IDS Certificate Company, Investment
Company Act Release Nos. 21098 (May 26, 1995) [60 FR 28818 (June 2,
1995)] (Notice of Application) and 21155 (June 21, 1995) [59 SEC
Docket 1918] (Order) (regarding, among other things, a face-amount
certificate company's participation in commodity markets and the use
of third party accounts).
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A. Role of Fund Board of Directors
Proposed rule 17f-6 would have required a fund's board of directors
(or the board's delegate) to find that maintaining the fund's assets
with an FCM is consistent with the best interests of the fund and its
shareholders. The proposed rule also would have required the board or
its delegate to establish a monitoring system to ensure compliance with
the requirements of the rule. Several commenters opposed this approach,
stating that the level of board involvement was burdensome and
unnecessary in light of the regulatory safeguards under the CEA and
CFTC rules.
Upon further consideration of the issue, the Commission believes
that the rule's objective standards (in particular, the requirement of
FCM registration and the related CFTC segregation and secured amount
requirements) make specific provisions concerning board oversight
unnecessary.19 As adopted, rule 17f-6 does not require a fund's
board to select or monitor the FCMs with which the fund places margin.
Like other aspects of fund operations, however, FCM arrangements will
remain subject to the board's general oversight.20 In this regard,
fund boards have a particular responsibility to ask questions
concerning why and how the fund uses futures and other derivative
instruments, the risks of using such instruments, and the effectiveness
of internal controls designed to monitor risk and assure compliance
with investment guidelines regarding the use of such instruments.
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\19\ Eliminating the requirement in rule 17f-6 for the board or
its delegate to select and monitor FCM arrangements differs from the
approach under rule 17f-5, which governs the custody of fund assets
outside the United States. Custody arrangements for assets
maintained outside the United States and related safeguards vary
widely from one country to another. As such, it appears to be
appropriate for such rule to require case-by-case evaluations. See
Custody of Investment Company Assets Outside the United States,
Investment Company Act Release No. 21259 (July 27, 1995) [60 FR
39592 (Aug. 2, 1995)]. In contrast, domestic and foreign FCM
arrangements are subject to a regulatory framework under the CEA
designed to provide consistent safeguards.
\20\ The Investment Company Act and state law impose oversight
responsibilities on a fund's board of directors to protect the
interests of fund shareholders. See, e.g., Burks v. Lasker, 441 U.S.
471, 484 (1979).
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B. Eligible FCM Custodians
1. FCM Registration and CFTC Net Capital Requirements
Like the proposed rule, rule 17f-6 permits a fund to place and
maintain assets with an FCM that is registered under the CEA.21
Registered FCMs are subject to the requirements of the CEA and CFTC
rules thereunder, which, among other things, address the safekeeping of
assets in FCM custody.22 Rule 17f-6 does not require that the FCM
be a member of a commodity exchange or clearing organization. Such a
requirement would not appear necessary for the protection of fund
assets and would unnecessarily limit the number of FCMs that could be
used as fund custodians.23 A registered FCM, regardless of its
membership status, is subject to the CEA and CFTC safekeeping
requirements.
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\21\ See rule 17f-6(b)(4) [17 CFR 270.17f-6(b)(4)] (defining
``Futures Commission Merchant''). The FCM may, in turn, place the
initial margin with certain other market participants, such as a
clearing organization, to effect the fund's transactions. See rule
17f-6(a)(1)(ii) [17 CFR 270.17f-6(a)(1)(ii)].
\22\ See supra notes 13-17 and infra note 33, and accompanying
text.
\23\ See supra note 6 and accompanying text.
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Under CFTC rules, a registered FCM must maintain adjusted net
capital equal to or exceeding the greatest of (i) $250,000, (ii) 4% of
customer funds maintained in safekeeping, or (iii) for an FCM that also
is a registered securities broker-dealer, the net capital required by
rule 15c3-1(a) under the Securities Exchange Act of 1934.24 An FCM
generally must notify the CFTC of potential capital impairment if the
ratio of its total adjusted net capital to CFTC required minimums falls
below 150%.25 Rule 17f-6, as proposed, would have required an FCM
holding fund assets to have at least $20 million in adjusted net
capital in excess of the CFTC's net capital requirements. In addition,
the FCM's adjusted net capital would have had to equal or exceed 250%
of the CFTC's required minimum.26
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\24\ CFTC rule 1.17 [17 CFR 1.17]; 17 CFR 240.15c3-1(a).
\25\ CFTC rule 1.12 [17 CFR 1.12]. The CFTC recently amended
rule 1.12 to strengthen its provisions concerning early warning to
the CFTC in the event of FCM capital impairment. Early Warning
Reporting Requirements, Minimum Financial Requirements, Prepayment
of Subordinated Debt, Gross Collection of Exchange-Set Margin for
Omnibus Accounts and Capital Charge on Receivables from Foreign
Brokers (Apr. 25, 1996) [61 FR 19177 (May 1, 1996)] [hereinafter the
CFTC Early Warning Release].
\26\ See Proposing Release, supra note, at nn.97-98 and
accompanying text.
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Commenters were divided on the proposed approach. Commenters
opposing the additional capital requirements suggested that, because
the CFTC net capital requirements serve to protect assets in an FCM's
custody from loss due to misappropriation or the FCM's insolvency,
additional capital standards are not necessary. The Commission agrees
that the CFTC net capital requirements are designed to safeguard fund
assets in an FCM's custody.27 Therefore, rule 17f-6, as adopted,
does not require FCM custodians to meet additional capital standards.
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\27\ See, e.g., CFTC Early Warning Release, supra note 25.
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2. Affiliated FCM Arrangements
As proposed, rule 17f-6 would have broadly prohibited a fund from
placing assets with any FCM that is an affiliated person of the fund or
an affiliated person of such person.28 This provision is being
adopted substantially as proposed.29 While some commenters viewed
the scope of this provision as too restrictive, custody by fund
affiliates raises additional investor protection concerns.30
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\28\ See Proposing Release, supra note, at nn.104-106 and
accompanying text; Investment Company Act section 2(a)(3) [15 U.S.C.
80a-2(a)(3)] (defining affiliated person).
\29\ Rule 17f-6(b)(4) [17 CFR 270.17f-6(b)(4)]. The prohibition
has been incorporated into the definition of ``Futures Commission
Merchant.''
\30\ For example, to guard against potential abuses resulting
from control over fund assets by related persons in other contexts,
rule 17f-2, the Commission's rule governing self-custody
arrangements, has been read to require fund affiliates to comply
with its provisions or establish other appropriate safeguards. See,
e.g., Pegasus Income and Capital Fund, Inc. (pub. avail. Dec. 31,
1977) (custody by adviser-bank). One commenter acknowledged the
risks that could be presented by affiliated custody and suggested
that safeguards similar to those in rule 17f-2 could be required for
affiliated FCM arrangements.
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C. Domestic and Foreign Commodity Transactions
As proposed, rule 17f-6 would have permitted a fund to place assets
with an FCM only in connection with domestic commodity transactions.
The proposed rule would not have permitted a fund to place assets with
an FCM in connection
[[Page 66210]]
with commodity transactions traded on a foreign exchange. Commenters
strongly urged the Commission to expand rule 17f-6 to permit FCM
custody in connection with foreign exchange-traded transactions. In
support of this approach, commenters cited the custodial protections
under the CEA applicable to these transactions and noted the importance
of international commodity trading in achieving fund management and
hedging objectives.
Upon further consideration of the issue, the Commission has decided
to permit a fund to place assets with a registered FCM in connection
with commodity trades effected on both domestic and foreign
exchanges.31 As in the case of domestic transactions, an FCM
holding the assets of U.S. customers in connection with foreign
commodity transactions is subject to CFTC regulations designed to
protect those assets.32 These regulations require the FCM to be
registered under the CEA, and thus subject to, among other things, the
secured amount and CFTC net capital requirements.33 Consistent
with commodity trading practices, the rule permits FCMs to place fund
assets with a clearing organization and certain other market
participants as appropriate to effect foreign commodity
transactions.34
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\31\ See rule 17f-6(b)(2)(i) and (ii) [17 CFR 270.17f-6(b)(2)(i)
and (ii)] (defining ``Exchange-Traded Futures Contracts and
Commodity Options'' for purposes of domestic and foreign
transactions, respectively). Certain foreign-related commodity
transactions trade on U.S. exchanges. These transactions, which may
involve placing fund margin outside the United States, include
futures contracts and commodity options involving foreign currencies
and those effected through electronic links between U.S. and foreign
exchanges. Consistent with CFTC rules and commodity settlement
practices, a fund engaging in foreign currency transactions on
domestic exchanges or placing margin overseas in connection with
domestic trades may enter into subordination agreements. In these
agreements, commodity customers agree that, if their FCM becomes
insolvent and there is a margin shortfall, claims to margin securing
their trades will be subordinated to the claims of customers whose
accounts are denominated in U.S. dollars or held in the United
States. See CFTC Financial and Segregation Interpretation No. 12 [53
FR 46911 (Nov. 21, 1988)] (the subordination requirement seeks to
tie the risks of a particular jurisdiction or currency to customers
engaging in commodity transactions relative to that jurisdiction or
currency). See also Proposing Release, supra note , at nn.148-152
and accompanying text. In the case of commodity transactions
effected on foreign exchanges, a subordination agreement is not
required. In FCM bankruptcy proceedings, when a fund's assets
relating to foreign exchange-traded transactions are held in one or
more foreign currencies, the fund may be subject to the risks of
foreign currency fluctuations of assets held on behalf of other
customers in other foreign currencies.
\32\ CFTC rules 30.1 to .11 [17 CFR 30.1 to .11]; see supra
notes--and accompanying text. In early 1995, Barings PLC, a British
investment bank, failed after suffering losses of approximately $1
billion from commodity transactions effected on the Singapore
Monetary Exchange. Following Barings' collapse, commodity regulators
from sixteen countries agreed in the ``Windsor Declaration'' on
principles aimed at improving communications among commodity
regulators and enhancing surveillance of risks taken by commodity
market participants. Among the issues addressed was the protection
of customer assets. See Suzanne McGee, Futures Regulators Agree to
Cooperate Globally, Wall St. J. C18 (May 18, 1995); Brett D.
Fromson, Regulators Adopt Crisis Measures, Wash. Post D15 (May 18,
1995). Earlier this year, commodity exchanges and regulators from
various countries agreed on specific information-sharing measures.
Suzanne McGee, Two Information-Sharing Pacts Signed By 50 Exchanges
and 13 Regulators, Wall St. J. A7B (Mar. 18, 1996).
\33\ CEA section 4d(1) [7 U.S.C. 6d(1)]; CFTC rules 3.10, 30.4
[17 CFR 3.10, 30.4]. The CFTC grants to certain foreign commodity
brokers exemptions from requirements under the CFTC's rules relating
to transactions effected on foreign exchanges, including FCM
registration. CFTC rule 30.10 [17 CFR 30.10]. The CFTC grants the
exemption based on a determination that the foreign broker is
subject to comparable regulation in its home country. Because of
uncertainties arising from differing regulatory schemes among
various jurisdictions, especially those involving the bankruptcies
of commodities brokers, rule 17f-6 permits funds to use only
registered FCMs.
\34\ See infra note and accompanying text (discussing provisions
of rule 17f-6 that permit an FCM to transfer fund margin to another
registered FCM, a clearing organization, a member of a foreign board
of trade, or a U.S. or foreign bank).
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D. Assets Held in FCM Custody
1. Initial Margin
As proposed, rule 17f-6 would have permitted a fund to place and
maintain assets with an FCM in amounts necessary to effect its
commodity trades. Consistent with commodity settlement practices, the
proposed rule would have allowed a fund to maintain assets with an FCM
to meet exchange-imposed minimum margin requirements, as well as any
additional requirements imposed by the FCM. Three commenters supported
the proposed approach. One commenter recommended that the rule limit
FCM custody of fund margin to the minimum requirements established by
an exchange.
The Commission is adopting this provision of the rule as proposed.
Rule 17f-6 permits funds to meet FCM margin requirements that exceed
those of an exchange.35 Limiting FCM custody of initial fund
margin to exchange requirements is not necessary to safeguard fund
assets. Such a limitation also would be inconsistent with commodity
settlement practices, since FCMs typically impose higher margin
requirements than the margin requirements established by
exchanges.36
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\35\ Rule 17f-6(a) [17 CFR 270.17f-6(a)]. Currently, only the
writer of a commodity option is required to post margin with an FCM.
Rule 17f-6, therefore, does not apply to funds that purchase
commodity options through payment of an option premium. See supra
note and accompanying text.
\36\ Fink & Feduniak, supra note, at 137. An FCM, for example,
may impose higher initial margin requirements based on market
volatility or to retain a cushion in the event an exchange
subsequently raises its margin requirements. Id. at 137-138.
Exchange rules or the procedures of the FCM also may restrict
the types of assets that may be used to satisfy margin requirements.
A fund may borrow assets from an FCM to meet margin requirements so
long as the arrangement is consistent with section 18 of the
Investment Company Act [15 U.S.C. 80a-18]. Section 18 restricts the
circumstances under which funds may borrow from other persons.
Borrowing assets from an FCM will not be deemed to violate section
18, in the case of an open-end fund, or be subject to that section's
asset coverage requirements, in the case of a closed-end fund, if
the fund sets aside or provides the FCM with liquid assets that
collateralize 100% of the market value of the loan. See, e.g.,
Merrill Lynch Asset Management, L.P. (pub. avail. July 2, 1996). See
also 1 Thomas P. Lemke et al., Regulation of Investment Companies,
section 8.06[1][a][ii] (1996) (by setting aside fund assets or
otherwise covering its exposure, a fund avoids the restrictions of
section 18(f)); 1 Thomas A. Russo, Regulation of the Commodities
Futures and Options Markets section 1.20 (1983 & Supp. 1993) (FCM
asset lending arrangements typically are fully collateralized).
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2. Gains on Commodity Transactions
Once a customer establishes a position with an FCM, it is marked to
market at least daily to reflect gains and losses in the position's
value. Gains on commodity transactions are available for collection by
commodity customers on the next business day following the crediting of
the gain by the clearing organization.37 In the event of an FCM's
bankruptcy, if there are insufficient assets to cover all customer
claims, commodity gains in the FCM's possession may be distributed on a
pro rata basis to all of the FCM's customers. Allowing unlimited
amounts of commodity gains to be maintained in an FCM's custody would
subject fund assets to unnecessary risks.38
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\37\ A party to a futures contract suffering a loss on its
position makes a payment (variation margin) in the amount of the
loss, which is available for collection by the other party to the
contract on the next business day. See supra note 5. While an option
writer suffering a loss on its position similarly makes a payment
covering the loss, the payment is held by the clearing organization
on behalf of the option holder until the option is exercised; in the
event of subsequent gains in the writer's position, the writer would
be entitled to collect the gains from its previous payments held by
the clearing organization.
\38\ See Interpretation No. 10, supra note 12, at 7133 n.15
(indicating that gains on commodity transactions should be collected
daily). See also supra note 11 and accompanying text. For funds that
use third party accounts, gains on commodity positions are paid
directly by an FCM to the fund without flowing through or being held
in the third party account. Goldman Sachs & Co. (pub. avail. May 2,
1986). Consequently, the rule's de minimis limitation on the amount
of gains in an FCM's custody effectively is required for third party
arrangements.
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As proposed, rule 17f-6 would have permitted a fund to maintain
with the
[[Page 66211]]
FCM de minimis amounts of gains on fund commodity transactions; gains
exceeding the de minimis threshold could be held by an FCM only until
the next business day. One commenter supported the proposed approach.
Four other commenters indicated that the amount of commodity gains held
by an FCM should be determined by the FCM and the fund on an individual
basis.
Rule 17f-6, as adopted, retains the proposed requirement governing
commodity gains in FCM custody.39 This approach gives funds the
flexibility of not having to withdraw de minimis amounts of gains from
FCM custody, while limiting the potential for fund assets to be used to
satisfy the claims of other customers in the event of the FCM's
bankruptcy.
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\39\ Rule 17f-6(a)(2) [17 CFR 270.17f-6(a)(2)]. Losses paid to
an FCM due to declines in a fund's commodity positions represent
discharged liabilities and not fund assets under section 17(f).
Montgomery Street Income Securities, Inc. (pub. avail. Apr. 11,
1983). Losses paid to an FCM, therefore, are not subject to rule
17f-6.
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E. Contract Requirements and Custodians Used To Effect Commodity
Transactions
As proposed, rule 17f-6 would have required a fund to enter into a
written contract with an FCM custodian, in which the FCM would agree to
adhere to the CEA and CFTC segregation requirements and to furnish the
Commission with information concerning the FCM's custody of fund
margin. The proposed rule also would have required certain contract
provisions relating to the transfer of fund assets for clearing
purposes.40
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\40\ The proposal would have required the FCM to agree that any
transfer of fund assets for clearing purposes would be to another
FCM that met the requirements of the rule (other than the
requirement of a contract with the fund). The FCM also would have
been permitted to place fund margin with a clearing organization or
a bank.
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The adopted rule retains these requirements, modified to reflect
the use of FCM custodians in connection with foreign exchange-traded
transactions.41 Thus, in addition to requiring compliance with the
segregation requirements for domestic trades, the contract must require
the FCM to comply with the secured amount requirements in connection
with any foreign transactions.42 The FCM also must agree that any
other FCM used to effect transactions will be registered with the CFTC,
comply with the CFTC segregation or secured amount requirements, and
not be affiliated with the fund. Consistent with commodity settlement
practices, rule 17f-6 permits an FCM to place fund margin with a
clearing organization, a member of a foreign board of trade, or a U.S.
or foreign bank. The FCM must agree to obtain from each entity used for
clearing purposes, including any other FCM, an acknowledgment that the
fund's assets are held on behalf of the FCM's customers in accordance
with provisions under the CEA.43
\41\ Rule 17f-6(a)(1)(i) to (iii) [17 CFR 270.17f-6(a)(1)(i) to
(iii)].
\42\ Last year, the CFTC adopted rules creating a new market for
eligible professional investors. Section 4(c) Contract Market
Transactions; Swap Agreements, 60 FR 51323 (Oct. 2, 1995); CFTC
rules 36.1 et seq. [17 CFR 36.1 et seq.] Transactions in the new
market by eligible investors, which include funds with total assets
exceeding $5 million, are exempt from many of the requirements under
the CEA and related CFTC rules. The CFTC rules applicable to the new
professional trading market, however, do not affect requirements
relating to, among other things, segregation and FCM net capital.
Consequently, funds may participate in the new professional trading
market and use FCM custodians under rule 17f-6.
\43\ Rule 17f-6(a)(1)(ii) [17 CFR 270.17f-6(a)(1)(ii)]. See CFTC
rules 1.20, 30.7(c) [17 CFR 1.20, 30.7(c)] (requiring this
acknowledgment). See also rule 17f-6(b)(1) [17 CFR 270.17f-6(b)(1)]
(defining ``Clearing Organization''); rule 17f-6(b)(5) [17 CFR
270.17f-6(b)(5)] (defining ``U.S. or Foreign Bank''). Proposed rule
17f-6 would have required that any bank used to hold fund assets
have a minimum capitalization of $500,000. The adopted rule does not
impose this requirement because the CFTC addresses the credit-
worthiness of these depositories. See, e.g., CFTC Advisory 87-5
(Dec. 17, 1987). The Proposing Release requested comment on
requiring a number of other contract provisions. In particular, the
Proposing Release requested comment whether fund contracts should
require FCMs: (i) to provide information at the request of the
fund's accountants, (ii) to maintain specific records or furnish
funds with specific reports concerning their margin accounts, and
(iii) to indemnify funds or insure fund assets against non-trading
margin losses. While one commenter favored these additional
requirements, most commenters indicated that they are unnecessary.
Rule 17f-6 does not include these requirements, since either CFTC
regulations address these issues (such as recordkeeping) or these
matters (such as accountants' access and indemnification) can be
negotiated between the fund and the FCM.
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F. Withdrawal of Assets From FCM Custody
As proposed, rule 17f-6 would have required a fund to withdraw its
assets from an FCM promptly in the event the fund's FCM arrangements no
longer complied with the requirements of the rule. The Proposing
Release suggested that asset withdrawals would be expected to be made
within five days of the event triggering the withdrawal.44 Rule
17f-6, as adopted, requires asset withdrawals to be made as soon as
reasonably practicable.45 Although a five-day standard appears to
be a generally appropriate length of time,46 any asset withdrawals
under the rule would be subject to circumstances (such as the size or
number of a fund's positions) that indicate a longer period of time
would be reasonable.
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\44\ Proposing Release, supra note 1, at n. 129 and accompanying
text.
\45\ Rule 17f-6(a)(3) [17 CFR 270.17f-6(a)(3)]. See Custody of
Investment Company Assets Outside the United States, supra note 19
(proposing a similar approach for custody arrangements involving
foreign securities).
\46\ Cf. CFTC rule 190.02(e) [17 CFR 190.02(e)] (giving a
trustee in FCM bankruptcy proceedings four days to transfer open
commodity positions).
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III. Cost/Benefit Analysis
Rule 17f-6 should not impose any burdens on funds. Rather, the rule
should benefit funds by permitting, but not requiring, fund margin to
be maintained directly with FCMs instead of in third party accounts.
The requirements of rule 17f-6 are consistent with those of the CEA and
CFTC rules. The rule gives funds the option of placing with FCMs margin
in the same manner as other participants in the commodity markets.
IV. Summary of Regulatory Flexibility Analysis
A summary of the Initial Regulatory Flexibility Analysis, which was
prepared in accordance with 5 U.S.C. 603, was published in Investment
Company Act Release No. 20313. No comments were received on this
analysis. The Commission has prepared a Final Regulatory Flexibility
Analysis in accordance with 5 U.S.C. 604. The Analysis states that the
new rule will permit funds to maintain their assets with FCMs and other
entities used for settlement purposes in connection with futures
contracts and commodity options traded on a U.S. or foreign exchange.
The Analysis explains that the rule provides flexibility and custodial
protections in a way that should minimize any impact on, or cost to,
small business. Cost-benefit information reflected in the ``Cost/
Benefit Analysis'' section of this Release also is reflected in the
Analysis. A copy of the Final Regulatory Flexibility Analysis may be
obtained by contacting Nadya B. Roytblat, Mail Stop 10-2, Securities
and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C.
20549.
V. Statutory Authority
The Commission is adopting rule 17f-6 under sections 6(c) and 38(a)
of the Investment Company Act [15 U.S.C. 80a-6(c), -37(a)].
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Adopted Rule
For the reasons set out in the preamble, Title 17, Chapter II of
the
[[Page 66212]]
Code of Federal Regulations is amended as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
1. The authority citation for Part 270 continues to read, in part,
as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless
otherwise noted;
* * * * *
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 Fund may place and maintain cash, securities, and similar
investments with a Futures Commission Merchant in amounts necessary to
effect the Fund's transactions in Exchange-Traded Futures Contracts and
Commodity Options, Provided that:
(1) The manner in which the Futures Commission Merchant maintains
the Fund's assets shall be governed by a written contract, which
provides that:
(i) The Futures Commission Merchant shall comply with the
segregation requirements of section 4d(2) of the Commodity Exchange Act
(7 U.S.C. 6d(2)) and the rules thereunder (17 CFR Chapter I) or, if
applicable, the secured amount requirements of rule 30.7 under the
Commodity Exchange Act (17 CFR 30.7);
(ii) The Futures Commission Merchant, as appropriate to the Fund's
transactions and in accordance with the Commodity Exchange Act (7
U.S.C. 1 through 25) and the rules and regulations thereunder
(including 17 CFR part 30), may place and maintain the Fund's assets to
effect the Fund's transactions with another Futures Commission
Merchant, a Clearing Organization, a U.S. or Foreign Bank, or a member
of a foreign board of trade, and shall obtain an acknowledgment, as
required under rules 1.20(a) or 30.7(c) under the Commodity Exchange
Act [17 CFR 1.20(a) or 30.7(c)], as applicable, that such assets are
held on behalf of the Futures Commission Merchant's customers in
accordance with the provisions of the Commodity Exchange Act; and
(iii) The Futures Commission Merchant shall promptly furnish copies
of or extracts from the Futures Commission Merchant's records or such
other information pertaining to the Fund's assets as the Commission
through its employees or agents may request.
(2) Any gains on the Fund's transactions, other than de minimis
amounts, may be maintained with the Futures Commission Merchant only
until the next business day following receipt.
(3) If the custodial arrangement no longer meets the requirements
of this section, the Fund shall withdraw its assets from the Futures
Commission Merchant as soon as reasonably practicable.
(b) For purposes of this section:
(1) Clearing Organization means a clearing organization as defined
in rule 1.3(d) under the Commodity Exchange Act (17 CFR 1.3(d)) and
includes a clearing organization for a foreign board of trade.
(2) Exchange-Traded Futures Contracts and Commodity Options means
commodity futures contracts, options on commodity futures contracts,
and options on physical commodities traded on or subject to the rules
of:
(i) Any contract market designated for trading such transactions
under the Commodity Exchange Act and the rules thereunder; or
(ii) Any board of trade or exchange outside the United States, as
contemplated in Part 30 under the Commodity Exchange Act.
(3) Fund means an investment company registered under the Act (15
U.S.C. 80a-1 et seq.).
(4) Futures Commission Merchant means any person that is registered
as a futures commission merchant under the Commodity Exchange Act and
that is not an affiliated person of the Fund or an affiliated person of
such person.
(5) U.S. or Foreign Bank means a bank, as defined in section
2(a)(5) of the Act (15 U.S.C. 80a-2(a)(5)), or a banking institution or
trust company that is incorporated or organized under the laws of a
country other than the United States and that is regulated as such by
the country's government or an agency thereof.
Dated: December 11, 1996.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-31891 Filed 12-16-96; 8:45 am]
BILLING CODE 8010-01-P