This Interpretation is superseded by Financial and Segregation Interpretation No. 10-1 (May 5, 2005).
DIVISION OF TRADING AND MARKETS
FINANCIAL AND SEGREGATION INTERPRETATION No. 10
Treatment of Funds Deposited in Safekeeping Accounts
The Division of Trading and Markets ("Division") is aware of the increasing use of the commodity futures and commodity option markets by various institutions, such as pension plans and investment companies registered with the Securities and Exchange Commission ("SEC") under the Investment Company Act of 1940 ("ICA") (15 U.S.C. §80a-1 et seq. (1982)). The Division has become aware that certain of these institutions have sought to control margin funds by establishing so-called "safekeeping accounts" (sometimes also referred to as "third-party custodial accounts") at banks in connection with their commodity trading. The Division has received several inquiries as to its views on the treatment of funds deposited in safekeeping accounts. The Division believes that it is appropriate to issue a formal interpretation on this subject at this time because of the increasing participation in the futures and option markets by institutions which are subject to other regulatory frameworks and the need to avoid inconsistent regulatory actions being taken by the Commission, the SEC and the United States Department of Labor ("DOL") with respect to certain hybrid investment vehicles.1 The Division believes that the use of safekeeping accounts raises questions with respect to the following areas: (1) segregation of customer funds by an FCM; (2) computation of an FCM's adjusted net capital; and (3) disposition of the bankrupt estate in the event of an FCM bankruptcy.
The use of safekeeping accounts originally was a corollary of the law regarding the custodianship of assets applicable to pension plans and investment companies. The regulatory frameworks applicable to those institutions each raised the question of whether funds used to margin futures or option transactions were to be considered as assets of the institution and thus subject to those provisions relating to the safeguarding and segregation of such assets.2 However, the DOL has issued an advisory opinion under ERISA concerning pension plan participation in commodity futures transactions.3 That advisory opinion letter stated, among other things, that funds deposited by a pension plan fiduciary with a futures commission merchant ("FCM") to margin, secure or guarantee commodity trades made for the pension plan (consisting of initial and maintenance margin payments in connection with a futures transaction) are not considered to be pension plan assets.4 The advisory opinion letter further stated that "[w]hen a [pension] plan engages in a futures transaction, its assets are the rights embodied in the futures contract as evidenced by a written confirmation and outlined in its agreement with its FCM." In assessing the responsibilities of the pension plan fiduciary and the FCM to treat and deal with funds used to margin, guarantee or secure commodity trades of the pension plan, the advisory opinion concluded that such funds need not be held in a separate safekeeping account by either the pension plan fiduciary or the FCM and that such funds may be treated like those of any other customer and may, for convenience, be held by the FCM in a single commingled account segregated from the funds of the FCM.5
With respect to registered investment companies, the SEC and its staff have recently considered whether such companies may engage in commodity transactions in light of the provisions of Section 17(f) of the ICA relating to the custody of securities and similar investments of such companies. The Office of Chief Counsel of the SEC's Division of Investment Management has stated that it will not recommend enforcement action under Section 17(f) of the ICA against a registered investment company which engages in certain permitted commodity transactions, provided the company: (1) maintains, with its custodian for ICA purposes,6 initial margin for its commodity transactions in a separate account in the name of the FCM, under an agreement whereby the securities, commodities and other property in the account are at all times maintained with the custodian unless released to the company or sold or disposed of as permitted under the company's agreement with the FCM, and whereby prior to directing any disposition of the securities, commodities or property in the account, the FCM states that all conditions precedent to its right to direct disposition have been satisfied; and (2) demands payment promptly upon notification by the FCM that funds are due the company as a variation margin payment (variation collects). (The FCM's retention overnight of variation funds due the company would not be deemed to be in conflict with the requirements of Section 17(f) of the ICA).7 The SEC also has granted an exemption from the provisions of Section 17(f) of the ICA to a registered investment company which engages in certain permitted commodity transactions under conditions similar to those set forth above.8 That application for exemption specifically stated that the company's initial margin, deposited with its custodian for ICA purposes in a separate account in the name of the FCM, may be retained by the FCM if, among other things, the company defaults in making payment upon termination of a commodity position or in making a variation margin payment.
In view of the embryonic state of the law and regulatory requirements which may affect the ability of other institutions to participate in the commodity markets, the Division does not now wish to ban altogether the use of safekeeping accounts. However, in order for an FCM to avoid a charge against net capital for an undermargined customer account (see Commission Rule 1.17(c)(5)(viii)9 in the case of a customer using a third-party custodial arrangement, the safekeeping account must meet the standards set forth below with respect to the following matters: (1) account name; (2) liquidation of open positions; (3) withdrawal power; and (4) account location. These standards must also be met to assure compliance with the Commodity Exchange Act, as amended ("Act") (7 U.S.C. §1 et seq. (1982)), and the regulations promulgated thereunder relating to the segregation of customer funds.
A third-party custodial account must be maintained under a title such as "[Name of FCM] Customer Funds for the Benefit of X Pension Plan" or "[Name of FCM] Customer Funds for the Benefit of Y Investment Company." If a third-party custodial account is simply maintained in the name of the pension plan fiduciary as trustee for the pension plan, or in the name of the registered investment company, it could not be demonstrated that funds maintained in such an account would be subject to such control as to qualify for immediate access by the FCM. Accordingly, any funds maintained in an account so named could not be considered to be proper margin funds for the trading of the pension plan or the registered investment company, and this could result in the commodity trading account of such an institution being undermargined. The Division also notes that Commission Rule 1.20(a) provides in pertinent part that "customer funds ... shall be deposited under an account name which clearly identifies them as such and shows that they are segregated as required by the Act and these regulations."10 Customer funds are all treated as a single trust fund."11
An FCM carrying a commodity trading account for any customer, including an institutional account, must be able to liquidate open positions in an account which goes into deficit without getting clearance from a third party which controls the custodianship of the account.12 If the pension plan fiduciary or registered investment company fails to maintain proper margin for the trades in its account or to make any other required deposits, the FCM must have the right to liquidate open positions within a reasonable time, just as would be the case for any other customer. An FCM which is forced to await pre-clearance for margin withdrawals has neither possession nor control of the funds which may be needed for margin purposes. The FCM must have the right to act within any exchange or Commission time limits, and to take emergency action if necessary to pay margin due the clearinghouse to protect its own solvency and hence the security of its other customers, as well as the marketplace itself.13
In addition to the right to liquidate open positions, the FCM must have the right to withdraw funds from the safekeeping account on demand with no right for the pension plan fiduciary or registered investment company to stop, interrupt or otherwise interfere with such a withdrawal. The pension plan fiduciary or registered investment company also cannot withdraw or otherwise have access to the funds in a safekeeping account except through the FCM. Although a provision in a safekeeping agreement for notice to the pension plan fiduciary or registered investment company would not necessarily make the FCM subject to a capital charge for an undermargined account, a requirement that a pension plan fiduciary or registered investment company preapprove margin withdrawals by the FCM would require an FCM to treat such a customer's account as undermargined.14 Also, the FCM could agree in a safekeeping agreement that before it directs the custodian of a safekeeping account to dispose of customer funds held therein, the FCM will state that all conditions precedent to its right to direct disposition of customer funds in the account have been met, provided that the only condition which an FCM must satisfy in order to have access to the funds in a safekeeping account is to state that there has been a default by the customer in making a margin payment or any other required deposit. The free flow of required margin payments and other required deposits is absolutely essential to the proper functioning of the commodity exchanges. No customer, especially one who may maintain relatively large positions, can be permitted to interrupt that flow, or there will be the potential for serious adverse consequences to other market participants and the marketplace itself. In addition, those who use a safekeeping account should be aware that such an account will be considered subject to the customary provision in a commodity customer account agreement to the effect that all money, securities or property in the customer's account, or field for the customer by the FCM or by anv clearing organization for a contract market upon which trades of the customer are executed, are pledged with the FCM and are subject to a security interest in the FCM's favor to secure any indebtedness at any time owed by the customer to the FCM.15
The third-party custodial account cannot be located at an affiliate of the pension plan or registered investment company or a fiduciary thereof. For example, a pension plan for bank employees may not post margin in a safekeeping account maintained at the same bank where the bank itself is the pension plan fiduciary and the safekeeping account is maintained in-house at that bank. The likelihood that real control of funds would be in the bank rather than the FCM is obvious in such a case. Similarly, although a bank may find it administratively convenient to maintain a safekeeping account in-house for a pension plan for which it is a fiduciary, to do so would also require an FCM to treat such a pension plan's commodity trading account as undermargined. The Division takes the position that in such a case the pension plan or a banking regulator could exert pressure on the bank not to allow withdrawals by the FCM, notwithstanding any agreement to allow such withdrawals.
All of the standards for a proper safekeeping account discussed in this interpretation relate to control of such an account. If the guidelines set forth are followed, a third-party custodial account will be deemed to be a separate segregated account of the FCM. The FCM must credit the customer's commodity account for the amount of funds deposited in the safekeeping account, and since those funds constitute funds required to be segregated under the Act and the regulations promulgated thereunder, the FCM's minimum adjusted net capital requirement will increase by four per cent of the amount of such funds (unless the FCM is operating pursuant to the minimum dollar amount of adjusted net capital or pursuant to a higher requirement of the SEC, if the firm is also a broker-dealer). On the other hand, if the guidelines are not followed and control over the safekeeping account is retained by the pension plan fiduciary or registered investment company or by an affiliate of such a firm, the funds in such an account would not be considered to be properly segregated, and such a customer's commodity trading account will be considered undermargined for purposes of computing the FCM's adjusted net capital. For example, a "collateral and pledge" arrangement, where the pension plan fiduciary or registered investment company essentially maintains its own bank account and pledges the funds therein as collateral for its commodity trading obligations, would clearly violate the segregation provisions of Section 4d(2) of the Act and the regulations promulgated thereunder and would have an adverse impact on an FCM's adjusted net capital as well. If the FCM uses any money, securities or property of another customer to cover the margin requirements not collected from the pension plan or registered investment company, that would be a clear violation of Section 4d(2) of the Act, which states that customer funds may not "be used to margin or guarantee the trades or contracts, or to secure or extend the credit, of any customer or person other than the one for whom the same are held." See also Commission Rules 1.20(a) and 1.22. If the FCM were to use its own money to cover the margin requirements of the pension plan or registered investment company, and in effect to make a loan of the required margin amount, secured only by a collateral and pledge bank account, the Division would consider the resulting receivable to be an unsecured receivable of the FCM, which must be excluded from current assets for net capital purposes. See Commission Rule 1.17(c)(2)(ii). In addition, if margin for the trades of a pension plan or registered investment company is not collected by the FCM and remains in a collateral and pledge account, the pension plan or registered investment company trading account would be considered undermargined and appropriate charges against net capital would have to be taken by the FCM. See Commission Rule 1.17(c)(5)(viii). Further, pursuant to Commission Rule 1.17(c)(2)(i), if the pension plan or registered investment company commodity trading account went into deficit and it remained in deficit beyond the one-day grace period, the FCM would have to exclude that account from current assets unless the FCM actually drew on the collateral and pledge account an amount sufficient to cover the deficit.
The Division is also concerned that persons making use of a safekeeping account may mistakenly expect special treatment in the event of the bankruptcy of the FCM. One of the principal purposes of the Bankruptcy Reform Act of 1978 (11 U.S.C. §101 et seq. (1982)) with respect to the bankruptcy of an FCM was 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. The Division's position is that a safekeeping account or any separate segregated customer funds account could not be used to give a preference to a pension plan, a registered investment company or any other customer in a bankruptcy distribution, and if the issue were to arise in the course of an FCM bankruptcy proceeding, the Division would recommend strongly to the Commission that appropriate actions be taken to ensure that all customers, including institutional customers, are treated equally. The Division recognizes, however, that certain third-party custodial arrangements may create unnecessary confusion on the part of the institution on whose behalf it was established or a reviewing court in the event of an FCM bankruptcy and assuredly would cause additional administrative expenses to be incurred.
Although it is permissible under Section 4d(2) of the Act to deposit customer funds in a bank, it has always been the Division's position that customer funds deposited in a bank cannot be restricted in any way, that such funds must be held for the benefit of customers and must be available to the customer and the FCM immediately upon demand.16 The essential elements of the system for segregation of customer funds established under Section 4d(2) of the Act and the regulations promulgated thereunder are that customer funds must be separately accounted for by the FCM, that customer funds must not be commingled with the FCM's own funds, and, as stated above, that customer funds must be held for the benefit of customers and must be available to the customer and to the FCM immediately upon demand. The Division is concerned that if there are any impediments or restrictions upon an FCM's ability to obtain immediate access to funds needed to satisfy margin requirements, the FCM's inability to obtain immediate access to such funds at a time when they are most needed, such as when there is a significant market disruption, could magnify the impact of any market disruption and cause additional repercussions. The system of segregation of commodity customer funds has proved to be an adequate safeguard for such funds, and administratively the most efficient way to treat such funds is to have a single segregated customer funds account. An FCM may earn interest on customer funds for its own benefit under certain conditions.17 If a customer is concerned about earning interest on its funds, separate arrangements can be made with the FCM.
The Division's position is that the DOL advisory opinion dated September 21, 1982, resolves whatever uncertainty may have existed as to whether a pension plan fiduciary was required to establish a safekeeping account in connection with commodity trading on behalf of a pension plan. Therefore, there is no need under ERISA to maintain a safekeeping account and there is nothing to prevent an FCM from treating the funds of a pension plan like those of any other customer. The Division's staff has discussed with the staff of the SEC's Division of Investment Management the approach taken by DOL with respect to commodity trading by pension plans, and particularly the position enunciated by DOL in its September 21, 1982, advisory opinion, referred to above, that funds deposited by a pension plan fiduciary with an FCM in connection with commodity trading are not considered to be pension plan assets for ERISA purposes. The staff of the SEC's Division of Investment Management has indicated to the Division's staff that they are not at this time prepared to take a similar position with respect to commodity trading by a registered investment company, and that assets of such a company must be held by the company or by the company's custodian.
In conclusion, the Division wishes to reiterate that a proper safekeeping account in accordance with the guidelines set forth in this interpretation is simply a separate customer segregated account for a single customer which does not change that customer's rights as against any other customer.
Any third-party custodial agreement entered into after the date of this interpretation must conform to the guidelines set forth herein or the parties to the agreement will be subject to the adverse consequences described above. Parties to any third-party custodial agreement entered into prior to the date of this interpretation shall have a reasonable time, not to exceed three months, during which to amend any agreement which does not conform to the guidelines set forth herein before being subject to the adverse consequences described above.
The statements made in this interpretation are not rules or interpretations of the Commodity Futures Trading Commission, nor are they published as bearing the Commission's approval; they represent interpretations and practices followed by the Division of Trading and Markets in administering the Commodity Exchange Act and the regulations thereunder.
FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Jr., Chief Accountant, or Lawrence B. Patent, Special Counsel, Division of Trading and Markets, Commodity Futures Trading Commission, 2033 K Street, N.W., Washington, D.C. 20581. Telephone (202) 254-8955.
Issued in Washington, D.C. on May 23, 1984, by the Division of Trading and Markets.
ANDREA M. CORCORAN
DIVISION OF TRADING AND MARKETS
1 The views expressed in this interpretation are specifically directed to safekeeping accounts of pension plans and registered investment companies, but the same reasoning would apply to a safekeeping account of any customer of an FCM (e.g., an insurance company).
2 Section 403(a) of the Employee Retirement Income Security Act of 1974 ("ERISA") (29 U.S.C. §1103(a)(1982)) and Section 17(f) of the ICA (15 U.S.C. §80a-17(f)(1982)).
3 DOL Advisory Opinion #82-49A was issued in the form of a letter dated September 21, 1982, from Jeffrey N. Clayton, Administrator, Pension and Welfare Benefits Programs, Labor Management Services Administration, DOL, to Howard Pianko, Esq., of the law firm of Baer Marks & Upham, which is counsel for the Futures Industry Association. 9 Pens. Rep. (BNA) 1394. The DOL's advisory opinion procedure, and the effect of its advisory opinions, is set forth in ERISA Procedure 76-1 (41 Fed. Reg. 36281 (August 27, 1976)).
4 The DOL expressed no opinion regarding funds in a commodity trading account in excess of the amounts needed for initial and maintenance margin, which could accrue due to favorable price movements of the account's futures contracts, or whether the failure of the pension plan fiduciary to withdraw such amounts would violate the prudent investment requirements of ERISA, or constitute a prohibited transaction under ERISA. The Division will discuss this aspect of commodity trading more fully below.
5 The advisory opinion is dated September 21, 1982, which predates the commencement of trading under the Commission's exchange-traded commodity option pilot program. The advisory opinion addresses specifically only the trading of commodity futures contracts: we assume for purposes of this interpretation that the reasoning and conclusions set forth in that advisory opinion would apply to exchange-traded commodity options as well.
6 There is no prohibition on this custodian being the FCM's usual bank.
7 Montgomery Street Income Securities, Inc. (pub. avail. date April 11, 1983): see also Claremont Capital Corp. (pub. avail. date September 16, 1979), which pertains to short sales of securities and which was relied upon in the letter pertaining to commodity trading.
8 Prudential-Bache Option Growth Fund, Inc., SEC Investment Company Act Release Nos. 13194 and 13272 (April 26 and May 25, 1983). For purposes of this interpretation, there is no distinction intended between a closed-end and an open-end registered investment company.
9 All Commission rules cited in this interpretation can be found in Volume 17 of the Code of Federal Regulations according to the number of the regulation.
10 Rule 1.20(a) also provides that:
Each registrant shall obtain and retain in his files for the period provided in §1.31 an acknowledgment from [the depository] that it was informed that the customer funds deposited therein are those of commodity or Option customers and are being held in accordance with the provisions of the Act and these regulations.
If the custodial agreement with the depository holding the safekeeping account contains the acknowledgment cited above, a separate acknowledgment letter would not be necessary.
11 Section 4d(2) of the Commodity Exchange Act (7 U.S.C. §6d(2)(1982)) was amended in 1978 to give Lhe Commission express authority to prescribe regulations which permit the commingling by an FCM of funds received from futures and option customers in a single segregated account, and to climate any confusion as to whether the preexisting Section 4d(2) of the Act required separate segregated accounts for futures customer funds and option customer funds. Futures Trading Act of the 1978. Pub. L. No. 95-405, §4, 92 Stat. 865, 869 (1978). See also Commission Rules 1.3(gg), 1.20-1.30, 1.32 and 1.36.
12 In the Claremont Capital Corp. letter referred to above, the Office of Chief Counsel of the SEC's Division of Investment Management stated that it would not recommend enforcement action under Section 17(f) of the ICA if all securities, commodities and other property of Claremont Capital Corporation ("Claremont") in a margin account with a broker are held, in negotiable form, 'in the possession of the custodian of Claremont's other assets, but in a separate account in the name of the broker who has agreed that (1) the securities, commodities and other property in the account will at all times be maintained with the custodian unless released back to Claremont or sold or disposed of as permitted under Claremont's agreement with the broker and (2) in directing any disposition of the securities, commodities or property in the account, the broker must state that all conditions precedent to its right to direct disposition have been satisifed.
Claremont negotiated this limitation on the right to obtain custody of its assets with Merrill Lynch, Pierce, Fenner & Smith, Inc. ("ML"). ML's standard customer agreement form provides in pertinent part that:
[ML] shall have the right to transfer securities, commodites and other property so held by [ML] from or to any other of the accounts of the undersigned whenever in [ML's] judgment [ML] consider[s] such a transfer necessary for [its] protection. In enforcing [its] lien, [ML] shall have the discretion to determine which securities and property are to be sold and which contracts are to be closed.
The standard customer agreement of Merrill Lynch Futures Inc. is to the same effect.
13 The following example is illustrative of why this is necessary:
Between January 2, 1980, and January 21, 1980 (14 trading days) a member firm of Comex Clearing Association, Inc. ("Association") which traded for its own account made net variation payments to the Association totalling $754,680,000. Similarly, between March 3, 1980, and March 31, 1980 (21 trading days) a large FCM member firm of the Association made net variation margin payments to the Association totalling $408,830,000.
The clearing association, thus, was collecting margin payments of as much as $50,000,000 per day on behalf of a single firm. Letter of Stephen F. Selig, Esq. to the Subcommittee on Monopolies and Commercial Law of the House Committee on the Judiciary, July 29, 1981, cited in the Commission's letter to the same Subcommittee, October 6, 1981.
Although we have not independently verified Mr. Selig's figures, they conform with our understanding of the situation at the time. Nor was the cited case an isolated occurrence. During the period between July 1979 and March 1980, a period of substantial price fluctuations in the precious metals markets, there were a number of customers for which the payment of daily margin calls in excess of $10,000,000 was commonplace. Report of the Commodity Futures Trading Commission on Recent Developments in the Silver Futures Markets, April 25, 1980, printed for the use of the Senate Committee on Agriculture, Nutrition, and Forestry, 96th Cong., 2d Sess. 83 (1980). Moreover, although the described period was a period of unusual volatility, as Mr. Selig states "there could be variation payments of like magnitude whenever there is an extended price movement in one direction in an active futures contract with a large open interest."
14 A safekeeping agreement also cannot require the pension plan fiduciary or registered investment company to acknowledge receipt of a notice from the FCM before the FCM can have access to the funds in a safekeeping account, because such a provision could prevent FCM access to those funds simply by a refusal to acknowledge receipt of the notice.
15 This is another reason, in addition to the items discussed in Footnote 4 of this Interpretation, for the pension plan fiduciary or registered investment company to arrange daily withdrawals of excess funds from the commodity trading account.
16 Cf. Administrative Determination No. 29 of the Commodity Exchange Authority ("CEA"), the Commission's predecessor agency, dated September 28, 1937, which stated in pertinent part that "the deposit, by a futures commission merchant, of customers' funds ... under conditions whereby such funds would not be subject to withdrawal upon demand would be repugnant to the spirit and purpose of the Commodity Exchange Act. All funds deposited in a bank should in all cases be subject to withdrawal on demand." See also Division of Trading and Markets Financial and Segregation Interpretation No. 9 - Money Market Deposit Accounts and NOW Accounts, 1 Comm. Fut.L. Rep. (CCH) ¶ 7119 (November 23, 1983).
17 The types of investments which FCMs can make with customer funds are limited to those permitted by Section 4d(2) of the Act and Regulation 1.25 promulgated thereunder; Regulation 1.29 permits an FCM to receive and retain as its own any increment or interest resulting from a permissible investment.