SEC Division of Investment Management staff letter: LCH Limited and LCH.Clearnet LLC

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Investment Company Act of 1940- Section 17(f); Rule 17f-6 LCH Limited and LCH.Clearnet LLC

December 19, 2017

RESPONSE OF THE OFFICE OF CHIEF COUNSEL DIVISION OF INVESTMENT MANAGEMENT

File No.: 132-3

In a letter to you dated December 29, 2015, the staff of the Division of Investment Management indicated that we would not recommend enforcement action to the 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 Limited [1] (“LCH Limited”) or LCH.Clearnet LLC (LCH Limited and LCH.Clearnet LLC being referred to herein collectively and individually as “LCH”), each of which is a derivatives clearing organization registered with the Commodity Futures Trading Commission (“CFTC ”) [2] or a clearing member (an “LCH Clearing Member”) that is a futures commission merchant registered with the CFTC (“FCM”), for purposes of meeting LCH’s or the LCH Clearing Member’s margin requirements for certain interest rate swaps (“IRS”) that are cleared by LCH (“Letter”). [3]

We initially provided LCH and LCH Clearing Members with temporary no-action assurances under Section 17(f) of the 1940 Act based on requirements in the Commodity Exchange Act (“CEA”) (added or amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)) [4] that the CFTC adopt rules and issue interpretations with respect to the centralized clearing of swaps transactions. [5] We noted your statement that the Dodd-Frank Act reflected an underlying policy to facilitate the central clearing of swap transactions to reduce systemic risk in the global financial markets, while also minimizing unnecessary disruption and costs to the markets. [6] We concluded that it was appropriate to flexibly apply the custody requirements of the 1940 Act in this instance and extended as necessary temporary no-action assurances while the CFTC was actively working to improve protections for customer assets. [7] Since then the CFTC has adopted rules and regulations implementing the framework for central clearing of swaps, including rules improving customer collateral protections pursuant to its Dodd-Frank Act mandate. [8] We now conclude that it is appropriate to extend these no-action assurances permanently.

In particular, we rely on your representations in the Letter, as updated to reflect rules adopted by the CFTC, that each LCH Clearing Member that holds assets for an unaffiliated Fund customer wishing to clear IRS transactions on LCH will address each of the requirements of Rule 17f-6 under the 1940 Act, as follows: [9]

The manner in which an LCH Clearing Member will maintain such a Fund’s assets will be governed by a written contract between the Fund and the LCH Clearing Member, which provides that: [10]

the LCH Clearing Member will comply with the requirements relating to the separate treatment of customer funds and property of LCH and the CFTC segregation rules for swap collateral ( i.e. , legal segregation with operational commingling), under Part 22 of the CFTC’s Regulations, specifying the substantive requirements for the treatment of cleared over-the-counter derivatives in the Cleared Swaps Customer Account and the cleared swaps account class prior to any bankruptcy; [11]

the LCH 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, to the extent required under CFTC Rules 22.5 and 1.20(a), that such assets are held on behalf of the LCH Clearing Member’s customers in accordance with the provisions of the CEA; [12]

the LCH 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; [13]

any gains on the Fund’s transactions, other than de minimis amounts, may be maintained with the LCH Clearing Member only until the next business day following receipt; [14] and

the Fund has the ability to withdraw its assets from the LCH Clearing Member as soon as reasonably practicable if the custodial arrangement no longer meets the requirements of Rule 17f-6, as applicable. [15]

As the Commission stated in adopting Rule 17f-6 under the 1940 Act, maintaining assets in an FCM’s custody is not without risk. [16] As a result, we encourage Funds to weigh carefully the risks and benefits of maintaining assets to effect transactions in IRS with LCH or an LCH Clearing Member.

Based on your facts and representations, 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 an LCH Clearing Member for purposes of meeting LCH’s or an LCH Clearing Member’s margin requirements for IRS that are cleared by LCH.

Because our position is based on your facts and representations, 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.

Rachel Loko Senior Counsel

[1] Formerly known as LCH.Clearnet Limited.

[2] You have advised us that LCH.Clearnet LLC, an affiliate of LCH Limited, is also registered as a derivatives clearing organization with the CFTC. LCH Limited and LCH LLC are each wholly-owned subsidiaries of LCH.Clearnet Group, Ltd.

[3]

See , e.g. , LCH. Clearnet Limited and LCH. Clearnet LLC, SEC Staff No-Action Letters (Dec. 29, 2015), (Dec. 19, 2014) and (Dec. 26, 2013), LCH.Clearnet Limited, SEC Staff No-Action Letters (Sept. 27, 2012) and (July 29, 2011).

[4] The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[5]

See LCH.Clearnet Limited, SEC Staff No-Action Letters (Sept. 27, 2012) and (July 29, 2011).

[6]

See LCH.Clearnet Limited, SEC Staff No-Action Letters (July 29, 2011).

[7]

See note 2, supra .

[8] In February 2012, the CFTC adopted final rules implementing the segregation requirements for swap collateral, including collateral securing IRS, CDS, CIS and FXS (“Collateral Protection Rules”) and conforming amendments to its Part 190 Bankruptcy Rules. The CFTC had originally adopted amendments to its Part 190 Bankruptcy Rules to create a separate “cleared over-the-counter derivatives” account class (“OTC Derivatives Account Class”) that would apply in the event of a bankruptcy of an FCM that became effective May 6, 2010. See 75 Fed. Reg. 17297 (Apr. 6, 2010). The Collateral Protection Rules and conforming amendments to the CFTC’s Part 190 Bankruptcy Rules replace the OTC Derivatives Account Class with a new cleared swap account class. See 77 Fed. Reg. 6336 (Feb. 7, 2012) (adopting final rules regarding the protection of cleared swaps customer collateral and conforming bankruptcy provisions). In addition, the CFTC has adopted Part 22 of its Rules, governing the treatment of cleared swaps margin by FCMs and derivatives clearing organizations, including FCMs’ custody of Cleared Swaps Customer Accounts, as defined in CFTC Rule 22.1.

[9] These representations were confirmed by Owen Taylor, Director Legal, and Timothy McNamara on behalf of LCH to Rachel Loko of the staff on December 14, 2017.

[10]

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

[11]

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

[12]

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

[13]

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

[14]

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

[15]

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

[16]

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

http://www.sec.gov/divisions/investment/noaction/2016/investment-adviser-association-042516-206(4).htm

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Modified: 04/27/2016