DIVISION OF TRADING AND MARKETS

FINANCIAL AND SEGREGATION INTERPRETATION NO. 7-1

Investment of Funds Representing an FCM's Residual Financial Interest in Customers' Segregated Funds

The Division of Trading and Markets issued Financial and Segregation Interpretation No. 7 on July 23, 1980. The interpretation addresses the investment of excess segregated commodity customers’ funds in light of the then recently adopted Bankruptcy Reform Act. As originally published, it included explanations of the application of the Commission’s segregation rules which are no longer accurate as a result of the Commission’s adoption on July 28, 1997, of amendments to those rules.1 The Division is, therefore, publishing this amended Interpretation No. 7-1 to make the interpretation conform to the recent rule changes. The interpretation in its amended form follows.

The Division of Trading and Markets has reviewed its policy, in light of the Bankruptcy Reform Act ("BRAct"),2 with respect to the investment of funds added by a futures commission merchant ("FCM") to customers' segregated funds to insure any and all customers' accounts from becoming undermargined at any time.

Section 4d(2)3 of the Commodity Exchange Act ("Act") provides among other things that: (1) customers' funds shall not be commingled with the funds of the FCM; (2) an individual customer's funds may, for convenience, be commingled with the funds of other customers for deposit with a bank, trust company, or clearinghouse; (3) customers' funds may be invested in obligations of the United States, in general obligations of any State or any political subdivision thereof, and in obligations fully guaranteed as to principal and interest by the United States; and (4) the Commission may prescribe by rule, regulation, or order the terms and conditions under which these things may be done.

Rules 1.20(a) and 1.264 describe those conditions, including requirements that: (1) the FCM deposit customers' funds under an account name which clearly shows that they are customers' funds; and (2) an acknowledgment be obtained from each depository that the depository was informed that the deposits represent customers' funds.

Rule 1.235 provides that the prohibition in Section 4d(2) of the Act against commingling customers' funds with the funds of an FCM shall not be construed to prevent such FCM from having a residual financial interest6 in customers' segregated funds or to prevent an FCM from adding its own funds to customers' segregated funds to insure against customers' accounts becoming undermargined, provided that: (1) the FCM's books and records accurately reflect its interest in customers' segregated funds; and (2) withdrawals of funds by the FCM not result in the funds of one customer being used to margin or carry the trades of another person.

On March 6, 1963, the Commodity Exchange Authority ("CEA"), predecessor of the Commission, issued Administrative Determination No. 194 ("AD"). The AD addressed the same question as this interpretation, namely, can funds added by an FCM to customers' segregated funds be invested in the same securities or same types of securities as permitted by Section 4d(2) of the Act and Rule 1.257 for customers' funds. The AD concluded that it was not permissible for the FCM to invest more segregated funds than customers have accruing to them at the time the investments are made because Section 4d(2) of the Act mentions only the investment of funds belonging to customers. However, the AD goes on to state that, if the total of customers' equities should decline to an amount less than the value of securities purchased, the FCM would not be required to reduce the amount invested. It also points out that Rule 1.23 does not limit the residual financial interest an FCM may have in segregated funds.

The question of the treatment of an FCM's residual financial interest in securities purchased with segregated funds in the event of an FCM bankruptcy is not addressed in the AD, although the CEA repeatedly expressed concern with that problem.8 In the absence of specific statutory treatment of the subject and any case law in point, the CEA was concerned that customers' segregated funds at all times be deemed a trust fund, free of funds belonging to anyone else. The BRAct appears to have resolved any questions with respect to the bankruptcy issue. The definition of customer property contained in Section 761(10)9 of the BRAct, together with the special priority of distribution accorded to such property under Section 766(h) thereof, would, in the opinion of the Division, preclude any claim by a non-customer creditor of an FCM against securities in a segregated account until all claims for customers' equities had been satisfied.

The Division has concluded that, particularly in view of the BRAct, the prohibition set forth in the AD, namely, that an FCM cannot invest funds representing its residual financial interest in customer segregated funds, is no longer appropriate. It should be emphasized, however, that such investments can only be made in those obligations enumerated in Section 4d(2) of the Act. The Division wishes to emphasize further that obligations purchased with any segregated funds, whether those of customers, or those representing the FCM’s residual interest, must be treated as the investment of customers’ funds in accordance with the Act and the Commission’s rules.

The Commission amended Rules 1.23, 1.25, and 1.27, effective September 8, 1997, to make direct transfers into segregated accounts of permissible, unencumbered securities ("permissible securities") of the types set forth in Section 4d(2) of the Act and Rule 1.25.10 The amended rules permit an FCM to:

Any such transfer of securities to, or deposit of proceeds into, a nonsegregated account can only be made if the remaining funds in segregated accounts are sufficient to cover the FCM’s obligations to its commodity customers. To assure that there is a clear audit trail of movements of permissible securities between segregated and nonsegregated accounts, the amended rules also require an FCM to record, in the securities ledger required to be maintained to fulfill the recordkeeping requirements of Rule 1.27: (1) the identification number developed by the Committee on Uniform Security Identification Procedures ("CUSIP Number"), and (2) the manner in which the proceeds from the sale or maturity of any segregated securities are disposed of.

This interpretation supersedes Commodity Exchange Authority Administrative Determination No. 194. 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 rules thereunder.

FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Jr., Chief Accountant, Division of Trading and Markets, Commodity Futures Trading Commission, (202) 418-5459.

Issued in Washington, D.C., on September ____, 1997, by the Division of Trading and Markets.

___________________________

Susan C. Ervin

Acting Director

TMINT-71.DOC

¹ 62 Fed. Reg. 42398 (August 7, 1997).

² 11 USC 101 et seq. (1994).

³ 7 USC 6d(2).

⁴ 17 CFR 1.20(a) and 1.26.

⁵ 17 CFR 1.23.

⁶ For purposes of this interpretation, residual financial interest and excess funds in segregation are synonymous.

⁷ 17 CFR 1.25.

⁸ See, for example, ADs 131 and 171.

⁹ Section 761(10) defines customer property as follows:

(10) Customer property means cash, a security, or other property, or proceeds of such cash, security, or property, at any time received, acquired, or held by or for the account of the debtor, from or for the account of a customer --

(i) property received, acquired, or held to margin, guarantee, secure, purchase, or sell a commodity contract;

(ii) profits or contractual or other rights accruing to a customer as a result of a commodity contract;

(iii) an open commodity contract;

(iv) specifically identifiable customer property;

(v) warehouse receipt or other document held by the debtor evidencing ownership of or title to property to be delivered to fulfill a commodity contract from or for the account of a customer;

(vi) cash, a security, or other property received by the debtor as payment for a commodity to be delivered to fulfill a commodity contract from or for the account of a customer;

(vii) a security held as property of the debtor to the extent such security is necessary to meet a net equity claim based on a security of the same class and series of an issuer;

(viii) property that was unlawfully converted and that is property of the state; and

(ix) other property of the debtor that any applicable law, rule, or regulation requires to be set aside or held for the benefit of a customer, unless including such property as customer property would not significantly increase customer property; but

(B) not including property to the extent that a customer does not have a claim against the debtor based on such property[.]

¹⁰ Ibid., fn. 1