Alert November 16, 2010

CFTC Proposes Restrictions on Permissible Investments for Customer Segregated Accounts

The CFTC issued proposed amendments (the “Proposed Amendments”) to its regulations regarding the types of permissible investments for customer segregated accounts (“Segregated Accounts”).  In general, the Proposed Amendments would impose certain restrictions on the types and level of investments that futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”) could make with customer assets, as well as revise the general standards associated with these restrictions.  Of particular note, the Proposed Amendments would limit investments in money market funds (“MMFs”) for Segregated Accounts.  The Proposed Amendments also would “harmonize Regulation 30.7 with the investment limitations of Regulation 1.25.”  As a general matter, “Regulation 30.7 governs an FCM’s treatment of customer money, securities, and other property associated with positions in foreign futures and foreign options.”

Statutory and Regulatory Overview.  Section 4d(a)(2) of the Commodity Exchange Act and Regulation 1.25 thereunder limit the types of investments for Segregated Accounts to obligations of the United States and obligations guaranteed as to principal and interest by the United States, general obligations of States or political subdivisions thereof, investments in MMFs, obligations issued by government-sponsored enterprises, bank certificates of deposit, commercial paper, corporate notes and general obligations of sovereign nations.  Regulation 1.25 also sets forth the general standard that such investment limitations are consistent with the goal of ensuring that funds in Segregated Accounts “must be invested in a manner that minimizes their exposure to credit, liquidity, and market risks both to preserve their availability to customers and DCOs and to enable investments to be quickly converted to cash at a predictable value in order to avoid systemic risk.” 

CFTC Review of Segregated Account Investments.  In 2007, the CFTC’s Division of Clearing and Intermediary Oversight launched a review of the nature and extent of investments by Segregated Accounts.  The purpose of the 2007 review was to analyze whether any changes should be proposed to the permissible investments set forth in Regulation 1.25.  While this review was ongoing, the market events of September 2008 occurred, necessitating that the review’s findings be revisited in light of the changed conditions.  In May 2009, the CFTC issued an advance notice of proposed rulemaking regarding revisions to the scope and nature of permitted investments by Segregated Accounts and Regulation 30.7 funds.  The Proposed Amendments discuss the comment letters received and reviewed by the CFTC in connection with the May 2009 request for comment.  In addition, Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act required the CFTC to review its regulations in order to reduce reliance on credit ratings.

Narrowed Scope of Investment Choices and Related Restrictions.  The Proposed Amendments would narrow the scope of investment choices by eliminating the use of certain instruments.  For example, the Proposed Amendments would permit investment “in only those U.S. agency obligations that are fully guaranteed as to principal and interest by the United States,” limit investments in commercial paper and corporate notes or bonds and prohibit investments in foreign sovereign debt.  In addition, the Proposed Amendments would alter the general terms and conditions of Regulation 1.25 to clarify the liquidity standards, remove credit rating requirements and impose stricter concentration limits in an effort to promote greater diversification of Segregated Accounts.

MMF Investment Limitations.  As noted above, the Proposed Amendments would impose heighted restrictions on the use of MMFs by FCMs and DCOs for Segregated Accounts.  In particular, aggregate investments in MMFs would be limited to 10% of the total assets in the Segregated Account and no more than 2% of the total assets in such account could be invested in any single family of MMFs.  The CFTC specifically requests comment on whether to limit investments in MMFs to Treasury MMFs or to those MMFs “that have portfolios consisting only of permitted investments under Regulation 1.25.”  The Proposed Amendments would also clarify the acknowledgement letter requirement in the context of MMFs.  Under Regulation 1.25, FCMs or DCOs that invest customer funds in MMFs must obtain an acknowledgement letter from the “sponsor of the fund and the fund itself” when the MMF shares are held by a shareholder servicing agent.  The Proposed Amendments would clarify that the acknowledgement letter should be obtained “from an entity that has substantial control over the fund’s assets and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds.”  Under most circumstances, entities meeting this standard would include the MMF’s investment adviser or fund sponsor and could also include, for example, the MMF’s administrator.  The Proposed Amendments would also provide certain additional exceptions to Regulation 1.25’s “next day redemption” requirements by accounting for new Rule 22e-3 under the Investment Company Act of 1940, which permits MMFs to suspend redemptions and postpone payment of redemptions in order to facilitate an orderly liquidation of the MMF, provided certain conditions are met.  

The CFTC’s website includes a chart summarizing the impact of the Proposed Amendments. 

Comments on the Proposed Amendments must be submitted by December 3, 2010.