Investment Company Act of 1940 — Section 17(f)
LCH.Clearnet Limited

March 16, 2011

RESPONSE OF THE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTMENT MANAGEMENT
Our Ref. No. 201121117

Your letter dated March 15, 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 LCH.Clearnet Limited (“LCH”) or an LCH clearing member that is a futures commission merchant registered with the Commodity Futures Trading Commission (“CFTC”) for purposes of meeting LCH’s or an LCH clearing member’s margin requirements for certain interest rate swap contracts that are cleared by LCH.

Facts

You state the following: LCH is a private company, limited by shares, that is registered and operates in the United Kingdom. LCH clears a broad range of assets classes including: securities, exchange-traded derivatives, energy, freight, interbank interest rate swaps and euro and sterling denominated bonds and repos for U.S. and non-U.S. market participants. LCH is registered as a Derivatives Clearing Organization (“DCO”) with the CFTC.

You state that in 1999, LCH established its SwapClear service, which enables certain financial institutions (“SwapClear Clearing Members,” or “SCMs”) to clear certain “plain vanilla” interest rate swaps (“IRS”) for their own accounts.¹ You further state that in December 2009, LCH began clearing IRS transactions between an SCM and its customers. You state that pursuant to the Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”),² market participants generally will be required to clear IRS and other categories of swaps through regulated clearing houses. You note that the Dodd-Frank Act also requires clearing members that offer to clear swaps from the U.S. or on behalf of U.S. customers to be registered with the CFTC as futures commission merchants (“FCMs”). You state that this requirement is currently scheduled to take effect at the conclusion of a one-year transition period following the effective date of the Dodd-Frank Act (July 16, 2011). You represent that as a result, LCH will require any clearing member located in the United States or providing clearing services to U.S. persons to register as an FCM (a “Clearing Member”), and will clear IRS through FCMs in a manner substantially identical to the manner in which transactions are cleared through FCMs on other DCOs. You represent that LCH commenced FCM clearing in March 2011.

You represent that under the proposed FCM clearing model, LCH clears, settles, and guarantees the performance of all transactions for which LCH provides IRS clearing services. U.S. customers (including Funds) that wish to clear IRS through LCH will be required to maintain a clearing relationship with a Clearing Member. The Clearing Member will serve as the customers’ agent and guarantor in respect of cleared IRS. Customers, including Funds, will execute swaps through executing dealers with which they have swaps trading relationships. You state that the customer’s side of the transaction will then be given up for clearing by the executing dealer to the customer’s Clearing Member, pursuant to “Give-up Agreements” entered into among the Clearing Member, the executing dealer and the customer. You state that LCH will establish initial margin requirements for all cleared IRS, in order to protect against changes in the mark-to-market value of transactions. You further state that each Clearing Member will be required to deposit initial margin with LCH on behalf of its customers, and the Clearing Member will in turn require the customers to deposit the initial margin with the Clearing Member. The Clearing Member will then either pass the customers’ initial margin on to LCH, or deposit its own assets and hold the customers’ initial margin as security for performance of the customers’ obligations.

You represent that LCH rules will require that any Clearing Member that is either located in the United States or clears swaps for U.S. customers (including any Fund) must: (1) be registered with the CFTC as an FCM; (2) effectively provide for the segregation of customer assets in accordance with the Commodity Exchange Act (“CEA”) and CFTC rules; (3) maintain adequate capital and liquidity; and (4) maintain sufficient books and records to establish (a) that the 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 swap positions for customers and any such positions that it holds for its proprietary accounts. You represent that LCH will have the authority to enforce its rules against each Clearing Member and, in the event that LCH discovers or becomes aware of a violation of such rules by a Clearing Member, LCH will take appropriate enforcement action against such Clearing Member, which may include termination of its status as a Clearing Member.

You represent that the CEA and the CFTC rules contain provisions designed to safeguard customer assets in connection with cleared over-the-counter derivatives. You state that the CFTC adopted amendments to its Part 190 Bankruptcy Rules to create a separate “cleared over-the-counter derivatives” account class (“OTC Derivatives Account Class”) that apply in the event of a bankruptcy of an FCM.³ 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 Bankruptcy Rules set forth in Part 190 of CFTC rules. You represent that in accordance with the CFTC’s requirements, LCH rules for the OTC Derivatives Account Class will incorporate the relevant provisions of Section 4d of the CEA and CFTC regulations with respect to the futures account class (i.e., 17 C.F.R. §§ 1.20, et seq.), including but not limited to the separate treatment of customer positions and property from the Clearing Member’s positions and property. You state that LCH will treat all funds and property received from customers in connection with purchasing or holding IRS positions as part of the OTC Derivatives Account Class.

You state that the Commission and the CFTC are required to adopt rules and issue interpretations implementing the Dodd-Frank Act by July 16, 2011 with respect to centralized clearing of swaps.⁴ In particular, you note that the CFTC is required under the Dodd-Frank Act to identify the swaps within its jurisdiction that are subject to the mandatory clearing requirement and to adopt regulations regarding the mechanics of clearing, segregation of customers’ margin funds and other matters. You note that the CFTC does not currently have jurisdiction over IRS, although it clearly will have such jurisdiction once the Dodd-Frank Act’s provisions become effective. Notwithstanding the statutory timetable for implementation of the Dodd-Frank Act, you state that LCH and its market participants, for business reasons, wish to implement customer clearing in the U.S. through FCMs as soon as possible. Therefore, you represent that LCH has structured the clearing mechanics, rules and other documents to take into account the statutory requirements under the Dodd-Frank Act and the CEA and the proposals the CFTC has issued to date. While you state that it may be necessary to make some changes in response to regulations ultimately adopted by the CFTC, you believe that no major changes will be required.⁵

You represent that LCH’s clearing of IRS is currently subject to CFTC oversight. You note that even prior to effective date of the Dodd-Frank Act’s provisions, the CFTC oversees all activities of LCH by virtue of its status as a registered DCO. For example, you represent that the CFTC oversees LCH’s risk management functions, capitalization and other features that could potentially impact its ability to provide clearing services. You state that oversight necessarily includes oversight of the IRS clearing business because of its potential effect on LCH generally. Therefore, you represent that the CFTC reviews the clearing systems and mechanics, LCH’s margin requirements and calculations and its compliance procedures. You note that the CFTC’s role with respect to oversight of LCH will become more substantial once the Dodd-Frank Act is fully effective.

With respect to regulation of FCMs, you state that both the CFTC and the National Futures Association, the industry self-regulatory organization, oversee all activities of an FCM that could affect its financial condition, liability to customers and other risk exposures. 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 LCH’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 LCH to clear IRS. You assert that if Funds are unable to participate in the central clearing of IRS, they may be unable to satisfy their obligations under the Dodd-Frank Act and will be exposed to greater risk.

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 Clearing Member who holds assets for an unaffiliated Fund customer wishing to clear IRS transactions on LCH will address each of the requirements of Rule 17f-6, as follows:

(1) the manner in which a Clearing Member will maintain such a Fund’s assets will be governed by a written contract between the Fund and the Clearing Member, which provides that:⁶

(i) the Clearing Member will comply with the requirements relating to the separate treatment of customer funds and property under LCH rules specifying the substantive requirements for the treatment of cleared OTC derivatives in the OTC Derivatives Account Class prior to any bankruptcy;⁷

(ii) the Clearing Member may place and maintain the Fund’s assets as appropriate to effect the Fund’s cleared IRS transactions through LCH 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 Clearing Member’s customers in accordance with the provisions of the CEA;

(iii) the 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;⁸

(iv) any gains on the Fund’s transactions, other than de minimis amounts, may be maintained with the Clearing Member only until the next business day following receipt;⁹ and

(v) the Fund has the ability to withdraw its assets from the Clearing Member as soon as reasonably practicable if the custodial arrangement no longer meets the requirements of Rule 17f-6, as applicable.¹⁰

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.¹¹

You state that the passage of the Dodd-Frank Act reflects Congress’s policy determination that the centralized clearing of swaps is in the best interests of market participants and the markets generally and that such clearing will reduce counterparty credit and systemic risks. You note that we recently issued a letter with respect to the custody issues for Funds raised by the central clearing of credit default swaps.¹² You represent that with the exception of the fact that LCH will be clearing IRS, and not credit default swaps, your facts and representations are substantially identical to those in that letter. You assert that LCH’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:

• LCH and Clearing Members will address each of the requirements of Rule 17f-6 under the 1940 Act as described above;
   
• LCH and Clearing Members, as applicable, will comply with the following representations, as applicable:
   
  
  • Each Clearing Member will hold Fund assets as part of the OTC Derivatives Account Class;
     
  • Each Clearing Member carrying accounts on behalf of Funds will be required to provide LCH, on an annual basis, with a self-assessment that it is in compliance with the representations set forth herein along with a report by the Clearing Member’s independent third-party auditor that attests to that assessment;
     
  • Each Clearing Member will be required to segregate customer funds and securities from the Clearing Member’s own assets;
     
  • Each Clearing Member carrying accounts on behalf of Funds will be required to provide LCH on an annual basis with a self-assessment that it is in material compliance with LCH rules; and
     
  • Each Clearing Member carrying accounts on behalf of Funds will be required to represent to LCH, on an annual basis, that it is 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 LCH.

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.¹³ Therefore, we strongly encourage Funds to weigh carefully the risks and the benefits of maintaining assets to effect transactions in IRS with a Clearing Member and LCH.¹⁴

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 LCH or a Clearing Member for purposes of meeting LCH’s or a Clearing Member’s margin requirements for IRS that are cleared by LCH.

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.¹⁵ 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 You state that SwapClear Clearing Members are highly regulated financial institutions, required to meet certain criteria under LCH’s rules, including but not limited to: (a) minimum levels of net capital; (b) appropriate banking arrangements; (c) staff with sufficient experience and knowledge of interest rate swaps; (d) appropriate systems to cope with clearing activities; and (e) ratings requirements.

² See Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1375 (2010).

³ 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).

⁴ You note that it is possible that the actual effective date of some of these rules may be delayed beyond July 16, 2011.

⁵ You state that one potential change is that the CFTC has proposed permitting DCOs to establish individual segregated sub-accounts on behalf of customers of the FCMs clearing transactions through such DCOs, rather than requiring that all DCOs operate under the model currently in effect, which involves full mutualization of risk across all customers of an FCM. You state that if the CFTC adopts regulations permitting individual segregated sub-accounts, LCH expects to modify its clearing structure and rules to facilitate such sub-accounts, but that you cannot predict at this point whether the CFTC will adopt such regulations or the specific requirements that will be imposed under any such regulations.

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

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

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

⁹ See Rule 17f-6(a)(2) under the 1940 Act.

¹⁰ See Rule 17f-6(a)(3) under the 1940 Act.

¹¹ 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.

¹² 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 Letter”).

¹³ See the Rule 17f-6 Adopting Release, supra note 11, 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.”).

¹⁴ See also Rule 17f-6 Adopting Release, supra note 11, 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).

¹⁵ The grant of temporary relief expiring on July 16, 2010 is consistent with relief that the Commission and we have provided in similar contexts. Seei, ie.g., Order Extending Temporary Conditional Exemptions under the Securities Exchange Act of 1934 in Connection with Request of Chicago Mercantile Exchange Inc. Related to Central Clearing of Credit Default Swaps and Request for Comment, Securities Exchange Act Release No. (Nov. 29, 2010) and CME Letter, supra note 12, respectively.

Incoming Letter

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