Investment Company Act of 1940 — Section 17(f) and Rule 17f-6
ICE Trust U.S. LLC

March 1, 2011

Response of the Office of Chief Counsel
Division of Investment Management
Our Ref. No. 2010411617

Your letter dated March 1, 2011 requests our assurance that we would not recommend enforcement action to the Securities and Exchange Commission (the “Commission”) under Section 17(f) of the Investment Company Act of 1940 (the “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 ICE Trust U.S. LLC (“ICE”) or a U.S. ICE clearing member (“ICE Clearing Member”) for purposes of meeting ICE’s or an ICE Clearing Member’s margin requirements for credit default swap contracts (“CDS”) that are cleared by ICE.

Facts

You state the following: ICE is a New York-chartered limited purpose trust company and member of the Federal Reserve System that acts as a central counterparty for bilateral CDS. ICE is directly supervised by the New York State Banking Department and as a member bank by the Board of Governors of the Federal Reserve System. You represent, therefore, that ICE meets the definition of a “bank” as defined by Section 2(a)(5) of the 1940 Act, one of which is “a member bank of the Federal Reserve System.”

ICE currently acts as a central clearing party by accepting the rights and obligations under eligible CDS transactions entered into with ICE Clearing Members and submitted to ICE in accordance with its rules (“ICE Rules”). Following acceptance of a CDS transaction for clearing, ICE becomes the seller of credit protection with respect to the CDS purchaser, and the purchaser of credit protection with respect to the CDS seller.

You state that ICE has developed a framework (the “Non-Member Framework”) to provide access to ICE’s clearing services to clients (including Funds) of ICE Clearing Members (“Third-Party Clients”). You state that only ICE Clearing Members can directly access ICE. Under the Non-Member Framework, ICE has no direct relationship with a Third-Party Client. Rather, a Third-Party Client enters into CDS transactions with an ICE Clearing Member, as described below.

You represent that ICE Clearing Members are regulated financial institutions (or affiliates thereof subject to consolidated supervision). In addition, you represent that ICE Clearing Members are subject to specific requirements and conditions under the ICE Rules and an order of the Commission as discussed below.¹ You state that ICE Clearing Members are required to be regulated by a “competent authority” for capital adequacy (such as the Federal Reserve Board, the Office of the Comptroller of the Currency, or the Commission), and are not registered as futures commission merchants (“FCMs”) with the Commodity Futures Trading Commission (“CFTC”) under the Commodity Exchange Act (“CEA”).²

As described more fully in the Commission’s orders providing temporary conditional exemptions to ICE and ICE Clearing Members (collectively, the “Commission Orders”),³ you state the Non-Member Framework is intended to protect Third-Party Clients from the adverse effects of default by ICE Clearing Members. You state that ICE Clearing Members must post all of the margin they collect from Third-Party Clients pursuant to ICE requirements to the custodial client omnibus margin account (“Custodial Client Omnibus Margin Account”) that is maintained at ICE or a subcustodian. The Custodial Client Omnibus Margin Account will be held for the benefit of all Third-Party Clients of the relevant ICE Clearing Member (or for the ICE Clearing Member as agent or custodian on behalf of such Third-Party Clients), subject to the rights of ICE under ICE Rules to apply such margin, and will be segregated from the other assets of the ICE Clearing Member (including assets in the ICE Clearing Member’s proprietary account). ICE Rules require ICE Clearing Members to maintain records of the identity of the Third-Party Clients, the margin they post, the transfer of those assets to the Custodial Client Omnibus Margin Account and the use of that margin.

You also state that in the event of an ICE Clearing Member default, ICE will have the right to close out the positions of the defaulting ICE Clearing Member with ICE under ICE Rules. ICE is required to run this closing-out process separately for transactions between the ICE Clearing Member and ICE related to transactions of Third-Party Clients (“Client-Related Transactions”) and proprietary transactions, such that a separate net gain or loss will be determined for the Client-Related Transactions and for the proprietary transactions of the defaulting ICE Clearing Member. ICE Rules provide that net gains on Client-Related Transactions may not be applied to net losses on proprietary transactions. Losses on closed-out transactions may only be satisfied from certain sources as specified under ICE Rules.

In the case of losses to ICE, ICE may apply the following assets to those losses, in order, (i) margin provided by a defaulting Third-Party Client, (ii) amounts received from Third-Party Clients on close-out of their transactions, (iii) margin posted by the defaulting ICE Clearing Member with respect to its proprietary positions (to the extent not otherwise used for losses on those positions), (iv) the defaulting ICE Clearing Member’s contribution to the ICE guaranty fund, (v) the initial margin posted by Third-Party Clients, up to a specified cap (the “ICE Trust Net Customer Margin Requirement”), and (vi) contributions of other ICE Clearing Members to the ICE guaranty fund.

You state that ICE may use the margin posted by non-defaulting Third-Party Clients on a pro rata basis in an aggregate amount up to the ICE Trust Net Customer Margin Requirement.⁴ You represent that ICE will not be able use a non-defaulting Third-Party Client’s margin beyond this amount, even if there are additional losses. You also represent that Third-Party Client initial margin held with ICE cannot be used to cover losses on proprietary positions. You also represent that margin posted by a Third-Party Client and held with ICE with respect to transactions through a particular ICE Clearing Member will not be used to satisfy losses (client or proprietary) from the default of a different ICE Clearing Member. You note that, as a result of the ICE Rules, Funds, like other Third-Party Clients of an ICE Clearing Member, are subject to the risk of loss resulting from the default of another Third-Party Client of that ICE Clearing Member, up to the amount of the ICE Clearing Member’s Net Margin Requirement.

You state that with respect to portability of Third-Party Client positions in the event of an ICE Clearing Member default, ICE Rules permit ICE (i) to transfer, or arrange the transfer of, the defaulting ICE Clearing Member’s Third-Party Client positions and related transactions and margin to a new ICE Clearing Member, (ii) close out the existing transactions and establish new positions with the new ICE Clearing Member, or (iii) take into account Third-Party Client prearrangements for the use of one or more “backup” ICE Clearing Members to which their transactions would be transferred in the event their primary ICE Clearing Member defaults. You state that in the event that ICE is unable to transfer or terminate and replace Third-Party Client-member transactions during the transfer period, the Third-Party Client may close out the client-member transactions as provided by the terms of the agreement. ICE then would determine the close-out price for the Third-Party Client positions and the Third-Party Client-member transactions.

You state that ICE and ICE Clearing Members received from the Commission temporary conditional exemptions until July 16, 2011.⁵ As set forth in the Commission Orders, they exempt temporarily (i) ICE Clearing Members from certain requirements of the Securities Exchange Act of 1934 (“Exchange Act”) with respect to certain CDS transactions and (ii) ICE from clearing agency registration under Section 17A of the Exchange Act to perform the functions of a clearing agency for certain CDS.⁶ The Commission Orders contain a series of conditions designed to require ICE Clearing Members to protect Third-Party Client assets.⁷ The conditions also are designed to enable Commission staff to monitor ICE’s clearance and settlement of CDS transactions and help reduce risk in the CDS market.⁸

You state that the Commission and the CFTC are required to adopt rules and issue interpretations implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) by July 16, 2011 with respect to centralized clearing of swaps.⁹ You also note that upon the July 16, 2011 implementation date of the Dodd-Frank Act, ICE will automatically become a derivatives clearing organization registered with the CFTC and a securities clearing agency registered with the Commission. You state that the laws and regulations then applicable to ICE and ICE Clearing Members will require that any ICE Clearing Member that purchases, sells or holds CDS positions for others (including for Funds) must be registered as a FCM with the CFTC for CDS that are swaps and/or a broker-dealer or security-based swap dealer registered with the Commission for CDS that are security-based swaps. You note that therefore certain aspects of the Non-Member Framework are expected to change to reflect the use of FCM and broker-dealer clearing members for customer business rather than the existing financial institution clearing members. Notwithstanding the statutory timetable for implementation of Dodd-Frank, you state that ICE, for business reasons, wishes to offer CDS clearing to Funds.

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

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. Section 17(f)(1)(A) of the 1940 Act permits certain banks to maintain custody of Fund assets subject to Commission rules. You represent that ICE is a “bank” as defined by Section 2(a)(5) of the 1940 Act, but acknowledge that ICE would be holding a Fund’s assets at least partially for the benefit of its central clearing operations, rather than in the more pure custody context of a Fund custodian under Section 17(f)(1) of the 1940 Act.

Rule 17f-6 permits a Fund to place and maintain assets with futures commission merchants in connection with futures contracts and commodity options traded on U.S. and foreign exchanges. You contend that ICE’s structure closely approximates arrangements for FCMs and derivatives clearing organizations that may custody Fund assets in compliance with Rule 17f-6 under the 1940 Act to effect the Fund’s transactions in exchange-traded futures and commodity options,¹⁰ but acknowledge that ICE’s clearing structure does not meet all of the Rule’s requirements. For example, ICE Clearing Members are not currently registered as FCMs under the CEA, and the Rule does not address transactions in CDS.

You argue, however, that a Fund’s deposit of assets with ICE or an ICE Clearing Members is consistent with the principles of custody established by Congress and the Commission in Section 17(f) of the 1940 Act and the rules thereunder. In particular, you assert that the Non-Member Framework, which requires that ICE Clearing Members segregate assets held on behalf of Third-Party Clients from proprietary assets, the maintenance of adequate capital and liquidity, and adequate books and records, provides protection to Third-Party Client assets. You also note that the Commission stated:

… [the] Commission has taken multiple actions designed to address concerns related to the market in CDS. The over-the-counter market for CDS has been a source of particular concern to us and other financial regulators, and we have recognized that facilitating the establishment of central counterparties for CDS can play an important role in reducing the counterparty risks inherent in the CDS market, and thus can help mitigate potential systemic impact. We have therefore found that taking action to help foster the prompt development of central counterparties, including granting temporary conditional exemptions from certain provisions of the federal securities laws, is in the public interest.¹¹

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

• ICE and ICE Clearing Members, as applicable, will comply with all of the representations made in the Commission Order, including, but not limited to:
   
  
  • ICE will keep and preserve at least one copy of all documents, including all correspondence, memoranda, papers, books, notices, accounts and other such records as shall be made or received by it relating to its cleared CDS clearance and settlement services. These records shall be kept for at least five years and for the first two years shall be held in an easily accessible place;
     
  • ICE will supply information and periodic reports relating to its cleared CDS clearance and settlement services as may be reasonably requested by the Commission, and will provide access to the Commission to conduct on-site inspections of all facilities (including automated systems and systems environment), records, and personnel related to ICE’s cleared CDS clearance and settlement services;
     
  • each ICE Clearing Member will be in material compliance with the ICE Rules;
     
  • each ICE Clearing Member will be in material compliance with applicable laws and regulations relating to capital, liquidity, and segregation of Third-Party Client assets (and related books and records provisions) with respect to CDS cleared by ICE;
     
  • each ICE Clearing Member will provide disclosure that, among other things, applicable insolvency law may affect a Fund’s ability to recover assets, or the speed of any such recovery, in any insolvency proceeding involving the ICE Clearing Member;
     
  • each ICE Clearing Member will transfer Fund assets as promptly as practicable after receipt to the Custodial Client Omnibus Margin Account, and to the extent that there is any delay in such transfer, the ICE Clearing Member will effectively segregate Fund assets in a way that is reasonably expected to effectively protect such assets from the ICE Clearing Member’s creditors;
     
  • each ICE Clearing Member annually will provide ICE with a self-assessment that it is in compliance with the representations in the Commission Order along with a report by the ICE Clearing Member’s independent third-party auditor that attests to that assessment; and
     
  • each ICE Clearing Member will provide the Commission upon request with any information or documents within the possession, custody, or control of the ICE Clearing Member, any testimony of personnel of the ICE Clearing Member, and any assistance in taking the evidence of such persons, that the Commission requests and that relates to certain CDS transactions;

In taking this position, we note that in the Commission Order, the Commission stated:

[the Commission is] … mindful that [ICE’s representations] cannot provide legal certainty that customer collateral in fact would be protected in the event an ICE [Clearing Member] were to be become insolvent. The Commission believes that the segregation framework … represents a reasonable step to help protect the collateral posted by customers of ICE [Clearing Members] from threat of loss in the event of [an ICE] clearing member insolvency.¹²

As stated above, the Commission also recognized the benefits of central clearing of CDS, including the ability for customers to reduce their counterparty risk. Therefore, we strongly encourage Funds to weigh carefully the risks and the benefits of maintaining assets to effect transactions in CDS with an ICE Clearing Member and ICE.¹³

Conclusion

Based on the facts and representations in your letter, and without necessarily agreeing with your legal analysis, 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 ICE or an ICE Clearing Member for purposes of meeting ICE’s or an ICE Clearing Member’s margin requirements for CDS that are cleared by ICE.

Our position herein is temporary, and will expire when the Commission Orders are no longer effective or are rescinded, whichever is earlier. Our position applies only to ICE Clearing Members as described in this letter and not to non-U.S. clearing members of ICE. 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 each ICE Clearing Member must have at least $5 billion in tangible net worth, as computed in accordance with the Federal Reserve Board’s definition of Tier 1 capital. As part of the application process, ICE Clearing Members also must demonstrate operational and risk management competence in CDS transactions. ICE Clearing Members are required to notify ICE in the event of certain material adverse changes in financial condition or adverse regulatory actions. ICE may terminate an ICE Clearing Member’s status, or impose limitations on its activities, if it fails to satisfy ongoing membership requirements.

² Your request does not relate to non-U.S. clearing members of ICE.

³ See Order Extending and Modifying Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection with Request of ICE Trust U.S. LLC Related to Central Clearing of Credit Default Swaps and Request for Comment, Exchange Act Release No. 63387 (Nov. 29, 2010) (“November Order”). See also Order Granting Temporary Exemptions under the Securities Exchange Act of 1934 in Connection with Request from ICE Trust U.S. LLC Related to Central Clearing of Credit Default Swaps, and Request for Comments, Exchange Act Release No. 61662 (Mar. 5, 2010); Order Extending and Modifying Temporary Exemptions under the Securities Exchange Act of 1934 in Connection with Request from ICE Trust U.S. LLC Related to Central Clearing of Credit Default Swaps, and Request for Comments, Exchange Act Release No. 61119 (Dec. 4, 2009) (“December Order”); and Order Granting Temporary Exemptions Under the Exchange Act on Behalf of ICE Trust LLC, Exchange Act Release No. 59527 (March 6, 2009).

⁴ You state that the ICE Net Margin Requirement is determined by ICE to reflect the net risk to ICE from all Third-Party Client-related transactions of an ICE Clearing Member.

⁵ See November Order, supra note 3.

⁶ Id.

⁷ See November Order, supra note 3 at pages 34-53. For example, ICE Clearing Members are required to annually provide ICE with a self-assessment that they are in compliance with applicable laws and regulations relating to the segregation of customers’ assets in connection with cleared CDS, as well as a report by the ICE Clearing Member’s independent third-party auditor attesting to the assessment.

⁸ For example, the conditions require, among other things, ICE to provide certain information to the Commission, including reports relating to its CDS clearance and settlement services, and to any material disciplinary actions taken against ICE Clearing Members. ICE also is required to make available to the public (i) all end-of-day settlement prices and any other prices with respect to cleared CDS that ICE may establish to calculate settlement variation or margin requirements for ICE Clearing Members, and (ii) any other pricing or valuation information with respect to cleared CDS as is published or distributed by ICE. See the November Order, id.

⁹ You note that it is possible that the actual effective date of some of these rules may be delayed beyond July 16, 2011.

¹⁰ For example, Rule 17f-6 prohibits an FCM from being an affiliated person of a Fund or an affiliated person of such person. You understand that, for purposes of this relief, a Fund similarly may not be affiliated with any ICE Clearing Member through which the Fund chooses to access the ICE central clearing operations.

¹¹ See the December Order, supra note 3 at pages 1-2.

¹² See November Order, supra note 3, at page 20. See also the Report to the Supervisors of the Major OTC Derivatives Dealers on the Proposals of Centralized CDS Clearing Solutions for the Segregation and Portability of Customer CDS Positions and Related Margin (June 30, 2009) available at http://www.newyorkfed.org/markets/Full_Report.pdf (the ISDA buy-side/sell-side committee report analyzing the legal issues associated with segregating the collateral that customers post with members).

¹³ See also Custody of Investment Company Assets with Futures Commission Merchants, Investment Company Act Release No. 22389 (Dec. 11, 1996) 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).

Incoming Letter

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The Incoming Letter is in Acrobat format.