Investment Company Act of 1940 — Section 17(f) and Rule 17f-6
Chicago Mercantile Exchange

March 24, 2011

RESPONSE OF THE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTMENT MANAGEMENT
Our Ref. No. 20113211340

Your letter dated March 24, 2011 requests our assurance that we would not recommend enforcement action to the Securities and Exchange Commission (“Commission”) under Section 17(f) of the Investment Company Act of 1940 (“1940 Act”) against any registered investment company (a “Fund”) if the Fund or its custodian places and maintains cash and/or certain securities (“assets”) in the custody of the Chicago Mercantile Exchange (“CME”) or a CME clearing member that is a futures commission merchant (“FCM”) registered with the Commodity Futures Trading Commission (“CFTC”) for purposes of meeting CME’s or a CME clearing member’s margin requirements for certain interest rate swap (“IRS”) contracts that are cleared by CME.

Facts

You state the following: CME Group Inc. (“CME Group”), a Delaware stock corporation, is the holding company for CME, as well as certain other exchanges. CME was founded in 1898 as a not-for-profit corporation; in 2000 CME demutualized and became a shareholder-owned corporation. CME is a designated contract market regulated by the CFTC, for the trading of futures contracts and options on futures contracts. In addition, CME Group operates its own clearing house, which is a division of CME. The CME clearing house is a Derivatives Clearing Organization (“DCO”) regulated by the CFTC. The clearing house clears, settles and guarantees the performance of all transactions for which CME Group provides clearing services, including IRS. CME, as part of its clearing services, will be interposed as a central counterparty for transactions in cleared IRS. Customers (including Funds) that wish to clear IRS through CME must maintain an appropriate account relationship with a registered FCM that is a CME clearing member (a “CME Clearing Member”). The CME Clearing Member will clear the transaction and post margin directly with the CME and serve as their agent and guarantor in respect of cleared IRS. In this regard, CME Clearing Members require customers to deposit a specified amount of assets as initial margin as security for performance of their obligations.

You represent that CME’s rules alone or in combination with laws and regulations applicable to CME and its clearing members require that any CME Clearing Member who purchases, sells, or holds IRS positions for other persons (i.e., customers including any Fund): (1) must be registered with the CFTC as an FCM; (2) effectively provide for the separate treatment of funds and securities of other persons (except positions held in proprietary accounts of the clearing member, i.e., positions of the clearing member or affiliates of the clearing member) that it holds in its custody or control for the purpose of purchasing, selling, or holding IRS positions; (3) maintain adequate capital and liquidity; and (4) maintain sufficient books and records to establish (a) that the CME Clearing Member is maintaining adequate capital and liquidity and (b) separate ownership of the funds, securities, and positions it may hold for the purpose of purchasing, selling, or holding IRS positions for other persons and those it holds for its proprietary accounts.

With respect to a CME Clearing Member’s responsibilities to separately treat customer assets from its proprietary positions, you state that the CFTC recently adopted amendments to its Part 190 Bankruptcy Rules to create a separate “cleared over-the-counter derivatives” account class (“OTC Derivatives Account Class”) that would apply in the event of a bankruptcy of an FCM.¹ You state that the OTC Derivatives Account Class is intended to provide customer protection parallel to the existing Section 4d account class, including similar safeguards under CFTC Part 190 Bankruptcy Rules.²

You state that the CFTC presently is relying upon DCOs such as CME to adopt rules specifying the substantive requirements for the treatment of cleared OTC derivatives in the OTC Derivatives Account Class prior to any bankruptcy. You represent that in accordance with the CFTC’s requirements, CME rules for the OTC Derivatives Account Class mirror the provisions of Section 4d of the Commodity Exchange Act (“CEA”) and CFTC regulations with respect to the futures account class (i.e., 17 C.F.R. §§ 1.20, et seq.), including but not limited to the separate treatment of customer positions and property from the CME Clearing Member’s positions and property.³ You represent that all funds and property received from customers in connection with purchasing or holding IRS positions are treated as part of the OTC Derivatives Account Class.

You state that one of the goals of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) ⁴ is to promote price transparency and to minimize exposure to counterparty credit risk and systemic risk in the OTC derivatives market by subjecting as many swaps as possible, including IRS as well as credit default swaps (“CDS”), to central clearing and also requiring such swaps to be traded on exchanges or swap execution facilities.⁵ You state that the Commission and the CFTC generally are required to adopt rules and issue interpretations implementing the Dodd-Frank Act by July 16, 2011 with respect to centralized clearing of swaps.⁶ In particular, you expect that IRS will be subject to mandatory clearing and will be cleared by DCOs, such as CME, subject to CFTC regulation and oversight.

Notwithstanding the statutory timetable for implementation of the Dodd-Frank Act, you state that CME and its market participants, for business reasons, wish to implement client clearing through FCMs as soon as possible. Therefore, you represent that CME has already been subject to extensive regulation and oversight under the CEA and pursuant to the Dodd-Frank Act, the CFTC has proposed additional requirements, including, but not limited to, additional core principles related to risk management requirements and product eligibility. You also represent that CME is currently engaged in dialogue with the CFTC and its staff regarding these proposals and will comply with the final rules upon enactment. While you state that it may be necessary to make some changes in response to regulations ultimately adopted by the CFTC, you do not anticipate that the proposed regulations will materially affect CME’s ability to clear IRS because, as noted above, CME is already subject to extensive regulation and oversight by the CFTC.

You represent that the only difference in oversight of an FCM that clears futures and an FCM that clears IRS, therefore, is the fact that the CFTC doesn’t, in the latter case, regulate the instruments themselves, but it does regulate the clearing of such instruments by FCMs and their carrying of the resulting positions. In sum, you represent that CME’s clearing of IRS is currently subject to substantial CFTC oversight and will be subject to substantially greater oversight and regulation as the Dodd-Frank Act is implemented in the near future.

You believe that the requested relief would provide Funds equal access to the benefits and protections afforded to other market participants using CME to clear IRS. You assert that preventing Funds from participating in the clearing of IRS will expose Funds to greater risk, and will also prevent them from realizing the benefits of clearing recognized by Congress by the passage of the Dodd-Frank Act and by market participants.

You state that Rule 17f-6 under the 1940 Act provides that Funds may place and maintain assets with an FCM to effect a Fund’s transactions in exchange-traded futures contracts or commodity options, but the Rule does not permit Funds to place and maintain assets with an FCM to effect IRS transactions. You represent that each CME Clearing Member who holds assets for an unaffiliated Fund customer wishing to clear IRS transactions on CME will address each of the requirements of Rule 17f-6, as follows:

(1) the manner in which a CME Clearing Member will maintain such a Fund’s assets will be governed by a written contract between the Fund and the CME Clearing Member, which provides that:⁷

(i) the CME Clearing Member will comply with the requirements relating to the separate treatment of customer funds and property under CME rules specifying the substantive requirements for the treatment of cleared OTC derivatives in the OTC Derivatives Account Class prior to any bankruptcy;⁸

(ii) the CME Clearing Member may place and maintain the Fund’s assets as appropriate to effect the Fund’s cleared IRS transactions through CME and in accordance with the CEA and the CFTC’s rules thereunder, and will obtain an acknowledgement, as required under CFTC Rule 1.20(a), as applicable, that such assets are held on behalf of the CME Clearing Member’s customers in accordance with the provisions of the CEA;⁹

(iii) the CME Clearing Member will promptly furnish copies of or extracts from its records or such other information pertaining to the Fund’s assets as the Commission through its employees or agents may request;¹⁰

(iv) any gains on the Fund’s transactions, other than de minimis amounts, may be maintained with the CME Clearing Member only until the next business day following receipt;¹¹ and

(v) the Fund has the ability to withdraw its assets from the CME Clearing Member as soon as reasonably practicable if the custodial arrangement no longer meets the requirements of Rule 17f-6, as applicable.¹²

Analysis

Section 17(f) of the 1940 Act and the rules thereunder govern the safekeeping of Fund assets, and generally provide that a Fund must place and maintain its securities and similar instruments only with certain qualified custodians. As stated above, Rule 17f-6 under the 1940 Act permits a Fund to place and maintain assets with an FCM that is registered under the CEA and that is not affiliated with the Fund in amounts necessary to effect the Fund’s transactions in exchange-traded futures contracts and commodity options, subject to certain conditions. Among other things, the FCM must comply with the segregation requirements of Section 4d of the CEA and the rules thereunder or, if applicable, the secured amount requirements of CFTC Rule 30.7. Rule 17f-6 was intended to provide Funds with the ability to effect commodity trades in the same manner as other market participants under conditions designed to provide custodial protections for Fund assets.¹³

You state that the passage of the Dodd-Frank Act reflects Congress’s policy determination that the centralized clearing of swaps, including IRS, will promote price transparency and minimize exposure to counterparty credit risk and systemic risk in the OTC derivatives market. You note that we recently issued a letter with respect to the custody issues for Funds raised by the central clearing of CDS.¹⁴ You represent that with the exception of the fact that CME will be clearing IRS, and not CDS, your facts and representations are substantially identical to those in the CME CDS Letter. You assert that CME’s clearing of IRS incorporates the safeguards that are provided for Fund assets under the CEA and CFTC rules.

We conclude that the factors highlighted above argue in favor of flexibly applying the custody requirements of the 1940 Act in this instance. In particular, in reaching this conclusion, we also rely on your representations that:

• CME and CME Clearing Members will address each of the requirements of Rule 17f-6 under the 1940 Act as described above;
   
• CME and CME Clearing Members, as applicable, will comply with the following representations, as applicable:
   
  
  • Each CME Clearing Member will hold Fund assets as part of the OTC Derivatives Account Class;
     
    
  • Each CME Clearing Member annually will provide CME with a self-assessment that it is in compliance with the representations set forth herein and with CME rules along with a report by the clearing member’s independent third-party auditor that attests to that assessment;
     
    
  • Each CME Clearing Member will segregate customer funds and securities from the CME Clearing Member’s own assets;
     
    
  • Each CME Clearing Member will be in material compliance with the CME rules; and
     
    
  • Each Clearing Member will be in material compliance with applicable laws and regulations relating to capital, liquidity, and segregation of customer assets (and related books and records provisions) with respect to IRS that are cleared by CME.

In taking this position, we note that, as the Commission stated in adopting Rule 17f-6 and as you acknowledge, maintaining assets in an FCM’s custody is not without risk.¹⁵ Therefore, we strongly encourage Funds to weigh carefully the risks and the benefits of maintaining assets to effect transactions in IRS with a CME Clearing Member and CME.¹⁶

Conclusion

Based on the facts and representations in your letter, we would not recommend enforcement action to the Commission under Section 17(f) of the 1940 Act against a Fund if the Fund or its custodian places and maintains assets in the custody of CME or a CME Clearing Member for purposes of meeting CME’s or a CME Clearing Member’s margin requirements for IRS that are cleared by CME.

Our position herein is temporary, and will expire July 16, 2011, upon the conclusion of a one-year transition period following the effective date of the Dodd-Frank Act.¹⁷ Because our position is based on the facts and representations made in your letter, you should note that any different facts or circumstances might require a different conclusion. This letter represents only the Division’s position on enforcement action and does not purport to express any legal conclusion on the questions presented.

¹ See 75 Fed. Reg. 17297 (Apr. 6, 2010) (adopting final rules establishing a sixth and separate account class applicable for cleared over-the-counter derivatives only).

² You state that a Section 4d account contains funds of customers trading futures and options on futures on U.S. exchanges, separate from the FCM’s own funds.

³ See Letter from Lisa A. Dunsky, Director and Associate General Counsel, CME Group, to David Stawick, Secretary to the CFTC, dated September 30, 2010 (submitting amendments to CME’s rules to implement the substantive requirements for the treatment of cleared OTC derivatives in the OTC Derivatives Account Class prior to any FCM bankruptcy).

⁴ See Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L., No. 111-203, 124 Stat. 1375 (2010).

⁵ See id. at §723, 1675 – 1682. See also, id. at 1762-69.

⁶ You note that it is possible that the actual effective date of some of these rules may be delayed beyond July 16, 2011.

⁷ See Rule 17f-6(a)(1) under the 1940 Act.

⁸ See Rule 17f-6(a)(1)(i) under the 1940 Act.

⁹ See Rule 17f-6(a)(1)(ii) under the 1940 Act. You state that under CFTC Rule 1.20(a), an acknowledgement need not be obtained from a DCO such as the CME that has adopted and submitted to the CFTC rules that provide for the segregation as customer funds, in accordance with relevant provisions of the CEA and the rules thereunder, of all funds held on behalf of customers.

¹⁰ See Rule 17f-6(a)(1)(iii) under the 1940 Act.

¹¹ See Rule 17f-6(a)(2) under the 1940 Act.

¹² See Rule 17f-6(a)(3) under the 1940 Act.

¹³ Custody of Investment Company Assets with Futures Commission Merchants, Investment Company Act Release No. 22389 (Dec. 11, 1996) (“Rule 17f-6 Adopting Release”). In particular, Rule 17f-6 under the 1940 Act incorporates the safeguards that are provided for Fund assets under the CEA and CFTC rules.

¹⁴ See CME Group Inc., SEC Staff No-Action Letter (July 16, 2010) and CME Group Inc., SEC Staff No-Action Letter (Dec. 3, 2010) (collectively, the “CME CDS Letter”).

¹⁵ See the Rule 17f-6 Adopting Release, supra note 13, at n. 13 (“If an FCM becomes insolvent and cannot cover the obligations of a defaulting customer, the FCM’s non-defaulting customers may be affected.”).

¹⁶ See also Rule 17f-6 Adopting Release, supra note 13, at page 13 (stating that Fund boards have a particular responsibility to ask questions concerning why and how the Fund uses futures and other derivative instruments, the risks of using such instruments, and the effectiveness of internal controls designed to monitor risk and assure compliance with investment guidelines regarding the use of such instruments).

¹⁷ The grant of temporary relief expiring on July 16, 2010 is consistent with relief that the Commission and we have provided in similar contexts. See, e.g., Securities Exchange Act Release No. 63388 (Nov. 29, 2010) and CME CDS Letter, supra note 14, respectively.

Incoming Letter

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The Incoming Letter is in Acrobat format.