00-59

Section 4d(2) of the Act provides, in relevant part, that an FCM: (1) must segregate from its own assets all money, securities and other property contributed by customers to margin commodity futures and option contracts as well as any gains accruing to such customers from open futures and option positions; and (2) may not use money, securities, or property of one customer to margin or secure futures or option positions of another customer. Regulation 1.32 requires each FCM to compute daily the amount of customer funds that it holds in segregated accounts and the amount of funds that it is required to segregate under Section 4d(2) (the "segregation computation") to assure compliance with the segregation requirement.³

The Commodity Exchange Authority ("CEA"), predecessor of the Commission, issued Administrative Determination ("AD") No. 171 that provided that an FCM must have in segregation sufficient money (or securities purchased with customer funds) to cover the net liquidating equity of all customers to preclude the FCM from being "undersegregated".⁴ AD No. 171 further provided that any net liquidating deficit in the account of a customer who deposited securities as margin was required to be covered by a deposit in segregation of an equivalent amount of the FCM's own money. The CEA reasoned that while money was fungible, securities were not. Therefore, if an FCM became insolvent, a customer whose securities could be identified to that customer might be in a position to reclaim those securities free of any pro rata distribution. If the customer who deposited these "specifically identifiable" securities had been allowed to build up a deficit in his account and the FCM had not deposited enough of its own money in segregation to cover the deficit, the amount of money needed to pay other customers would be insufficient.

The prevailing concept of the right to reclaim "specifically identifiable property" from a bankrupt estate, which motivated the issuance of AD No. 171, was changed with the enactment of the Bankruptcy Reform Act of 1978, which became effective on October 1, 1979.⁵ In recognition of this change, in November 1980 the Division issued an advisory whereby it set forth a no-action position applicable to FCMs with respect to the segregation computation when customers' accounts incur net liquidating deficits. ⁶ In the advisory, the Division stated that it would not recommend that the Commission commence enforcement action against an FCM based solely upon the FCM's use of customer-owned U.S. Treasury Bills, U.S. Treasury Notes, or U.S. Treasury Bonds (collectively "Treasuries") in connection with the segregation computation provided that certain conditions were met, including the following.

Analysis

Based upon the representations made in your letter and subsequent conversations, we understand the facts to be as follows. To the extent permitted by contract market rules, "X" accepts debt securities issued by Fannie Mae and Freddie Mac and deposited by customers to margin futures and option positions.⁷ "X", in computing its segregation requirement under Section 4d(2) of the Act and Regulation 1.32, does not offset a net liquidating deficit in a customer's account by the value of any Fannie Mae or Freddie Mac debt securities deposited by such customer. In such situations, "X" contributes a sufficient amount of its own cash or other permissible assets into the segregation account to cover the net liquidating deficit in the customer's account.

You represent that the debt securities issued by Fannie Mae and Freddie Mac have the characteristics of liquidity, marketability, and high credit quality that should ensure that "X" can liquidate the securities quickly and realize the market value to cover the related customer deficit. You further represent that "X" will use Fannie Mae or Freddie Mac debt securities to offset a net liquidating deficit in a customer's account provided that the following conditions are met.

1. The Fannie Mae and Freddie Mac debt securities are segregated from any securities belonging to the FCM or any other person not within the meaning of the term "commodity customer" as defined by Regulation 1.3(k). The Fannie Mae and Freddie Mac debt securities are segregated with a bank, trust company, clearing organization of a contract market, or another FCM, in an account which is titled in a manner to clearly identify the account as containing regulated commodity customers' funds and which is covered by an acknowledgment from the depository, as required by Regulation 1.20;

2. "X" retains a security interest in the Fannie Mae and/or Freddie Mac debt securities which includes written authorization from the customer to liquidate the debt securities at "X"'s discretion in order to protect "X" and cover any deficit in the customer's account; and

3. The amount of the net liquidating deficit to be offset will be limited to the current market value of the Fannie Mae and Freddie Mac debt securities less applicable haircuts as set forth in Rule 240.15c3-1(c)(2)(vi) of the Securities and Exchange Commission (17 C.F.R. ї 240.15c3-1(c)(2)(vi)).

In light of the foregoing, the Division will not recommend that the Commission initiate an enforcement action against "X" based solely upon Section 4d(2) of the Act and/or Commission Regulation 1.32 if, in computing its segregation requirement, "X" offsets a net liquidating deficit in a customer account with Fannie Mae or Freddie Mac debt securities deposited by such customer. ⁸ Furthermore, "X" must comply with the reporting and recordkeeping requirements set forth in Interpretative Letter No. 86-16 in offsetting a customer net liquidating deficit with Fannie Mae or Freddie Mac debt securities.⁹ In this regard, with respect to balance sheet presentation, "X" must report the deficit as a secured receivable (as a current asset only to the extent of market value of the securities less applicable haircuts) rather than offsetting the deficit against the securities. In addition, "X" must maintain a reconciliation of deficits reflected on its daily segregation statement to that shown in its supporting records, such as daily customer equity printouts.

Because this position is based upon facts and representations contained in your letter and subsequent conversations with Division staff, it should be noted that any different, omitted or changed facts or conditions might require a different conclusion. This letter represents the views of the Division only and does not necessarily represent the views of the Commission or any other office or division of the Commission. If you have any questions concerning this correspondence, please contact Thomas J. Smith, Special Counsel, at (202) 418-5495, or Henry J. Matecki, Chicago Branch Chief, at (312) 886-3217.