Release: July 25, 1996
Responsibilities of Futures Commission Merchants and Relevant
Depositories with Respect to Third Party Custodial Accounts
The Division of Trading and Markets ("Division") is issuing this Advisory to remind futures commission merchants ("FCMs") and relevant depositories of their responsibilities with respect to third party custodial accounts (safekeeping accounts) and to request that FCMs review their custody arrangements with depository institutions to assure that they comply with the requirements of the Commodity Exchange Act ("Act") and Commission regulations, as discussed below. The Division is providing federal banking regulatory authorities with this Advisory for use in their supervisory programs and requesting that they remind banks subject to their jurisdiction that banks acting as custodians for futures and commodity option accounts must maintain such funds in accordance with the segregation requirements of the Act and the criteria set forth in Financial and Segregation Interpretation No. 10.
Applicability of Section 4d(2) Segregation Requirements
The Division has recently received information indicating that certain bank depositories maintaining third party custodial accounts for segregated commodity futures and option customers' funds have engaged in certain practices that appear to be inconsistent with the segregation requirements of the Act, CFTC regulations, and Financial and Segregation Interpretation No. 10 (May 23, 1984). The Division reminds FCMs and depositories of segregated funds that Section 4d(2) of the Act applies expressly to FCMs as well as to "any person, including but not limited to any clearing agency of a contract market and any depository that has received any money, securities and property for deposit in a separate account . . . ." Thus banks acting as custodians for futures accounts are directly subject to Section 4d(2) of the Act, and, as set forth in Financial and Segregation Interpretation No. 10, the segregation requirements of Section 4d(2) of the Act and the regulations thereunder apply fully to third party custodial accounts.
Third party custodial accounts are considered by the Commission to be accounts of the FCM, not accounts of the customer. As such, customer funds deposited in third party custodial accounts are subject to all provisions of the Act, including the requirement that customers using such an account be treated equivalently with other customers in bankruptcy and receive no priority to or preference over other customers by virtue of such accounts. As a consequence, such accounts should be available for bulk transfer on the same basis as other customer accounts in the event of a financial disturbance at the carrying FCM, either prior to insolvency proceedings through the facilities of the relevant self- regulatory organization ("SRO") or thereafter by a trustee in bankruptcy.
Financial and Segregation Interpretation No. 10
Financial and Segregation Interpretation No. 10 sets forth standards that must be followed in order for third party custodial accounts to be deemed properly segregated and for the FCM to avoid taking a charge against net capital for an undermargined customer account. Specifically, Financial and Segregation Interpretation No. 10 requires that: (1) a third party custodial account be maintained under a title such as "[Name of FCM] Customer (Segregated or Secured Amount as the case may be) Funds for the Benefit of X Pension Plan or Y Investment Company;" (2) the FCM carrying an account be able to liquidate open positions in an account which goes into deficit without obtaining permission from a third party who controls the custodianship of the account; (3) the FCM have the right to withdraw funds from a third party custodial account upon demand with no right of the customer, such as a pension plan fiduciary or an investment company, to stop, interrupt or otherwise interfere with such withdrawal; (4) a third party custodial account may not be located in a bank which is an affiliate or fiduciary (e.g., an investment adviser) of the customer, since such an arrangement creates the possibility that control of such funds would rest with the bank and not with the FCM;and (5) in no event may a bank release funds to a customer from a third party custodial account without notice to and consent of the carrying FCM. Where the above guidelines are not met, funds in a third party custodial account would not be considered properly segregated and the customer's commodity trading account would be considered undermargined.
The guidelines set forth in Financial and Segregation Inter- pretation No. 10 are designed to assure, among other things, that the FCM has free and ready access to the funds held in the third party custodial account, with the customer restricted from access to such funds except through the FCM. These requirements are intended to assure that there are no impediments or restrictions that would prevent an FCM from obtaining immediate access to funds needed to satisfy margin requirements, since such restrictions could have market impacts, especially during periods of significant volatility.
FCM Right of Immediate Access
Consequently, as Financial and Segregation Interpretation No. 10 states, no depository may release funds from a third party custodial account without first providing notice to and obtaining the consent of the carrying FCM. This requirement applies continuously and thus would, for example, prohibit a bank from allowing intra-month transfers from a third party custodial account without first obtaining adequate authorization from the FCM, even if all transferred funds were returned by month-end. Further, unrestricted access to third party custodial accounts would encompass a right on the part of the carrying FCM to obtain on demand information concerning the assets held in such accounts to assure that adequate funds are available at all times to meet margin requirements. This would include, but not be limited to, the right of the carrying FCM to receive a monthly, or more frequent, statement from the depository institution concerning activity in the custodial account.
The Division has reviewed a number of customer agreements governing third party custodial accounts and noted that these agreements include procedural provisions establishing a schedule for the FCM's routine collection of variation margin, facilitating funding by the customer. However, in addition to such provisions, agreements governing third party custodial accounts also specifically acknowledge that such accounts are customer funds that are segregated and held in accordance with the Commodity Exchange Act and the regulations and interpretations thereunder and that the provisions of the agreement are controlling only "to the extent not inconsistent therewith."
The Division is of the view that customer account agreements providing a pre-established timeframe for collection of customer margin, while not objectionable in the ordinary course of business in which immediate access to funds is unnecessary, cannot be construed to prevent or impede an FCM's immediate access to customer segregated funds in circumstances in which such access is necessary in order for the FCM to satisfy regulatory or self- regulatory requirements. Consequently, the Division believes that provisions establishing a timeframe for variation margin collection may not operate, in the event that such funds are needed to satisfy margin requirements due to a market disruption or other exigency, to impede an FCM's immediate access to a safekeeping account, to prevent, or otherwise interfere with an SRO's or trustee in bankruptcy's ability to require, the immediate bulk transfer of funds held in the safekeeping account, or to confer in bankruptcy any other special preference upon a customer using a third party custodial account relative to any other customer of the carrying FCM.
If such provisions were to be construed to prevent an FCM from obtaining access to margin funds during a period of market disruption or to result in preferential treatment in bankruptcy for a customer using a third party custodial account, the Division would consider them to be inconsistent with the segregation requirements of the Act and the Commission's regulations. Therefore, the Division construes third party agreements' administrative provisions to be subject to the authority of the carrying FCM, relevant SRO, and trustee in any relevant bankruptcy proceeding to make an immediate claim on such funds to address a market emergency.
Prohibited Commingling of Segregated Funds and Secured Amount
The Division has also been advised that certain bank depositories maintaining third party custodial accounts for segregated commodity futures and option customers' funds accounts may have improperly commingled such segregated funds with funds held pursuant to Rule 30.7as the secured amount for foreign futures and foreign options contracts. This appears to have been the case notwithstanding that such depositories had provided the depositing FCM with the acknowledgement required pursuant to Rule 1.20(a)that all such funds are segregated and accounted for in accordance with the provisions of Section 4d(2) of the Act and Commission regulations. Commission Rule 30.7(d)states that "[i]n no event may money, securities or property representing the . . . secured amount be held or commingled and deposited with customer funds in the same account or accounts required to be separately accounted for and segregated pursuant to Section 4d of the Act and the regulations thereunder." The Division wishes to remind FCMs and depository institutions that, under Section 4d of the Act, both the FCM and any depository institution which holds customer funds on its behalf are responsible for maintaining such funds in accordance with all applicable Commission requirements, including those set forth in Rule 30.7.
Request for Review of Custodial Arrangements
By this Advisory, the Division is requesting that FCMs review their custody arrangements with depository institutions to assure that they fully accord with the requirements of the Act and the Commission's regulations. In this regard, FCMs should review their custodial account agreements to assure that they comply with the guidelines of Financial and Segregation Interpretation No. 10 and adequately address the separation of segregated funds and the secured amount and all other Commission requirements. The Division is attaching Financial and Segregation Interpretation No. 10 to this Advisory.