Re: Regulation as a Commodity Pool

Dear :

This is in response to your letter dated June 20, 1997, to the Division of Trading and Markets ("Division") of the Commodity Futures Trading Commission ("Commission"), as supplemented by your letters dated September 23, 1997 and December 14, 1998, facsimile transmissions dated November 18, 1997, July 28, 1998, August 6, 1998, August 7, 1998 and September 18, 1998 and telephone conversations with Division staff. By your correspondence you request that the Division confirm your views that: (1) "M" may be treated as an entity that need not be operated by a person registered as a commodity pool operator ("CPO") under Section 4m(1) of the Commodity Exchange Act (the "Act");¹ and (2) "M's" Common Members, "N" and "O", need not register as a commodity trading advisor ("CTA") pursuant to Section 4m(1) of the Act.²

Background

Based upon the representations made in your correspondence, we understand the pertinent facts to be as follows.³ "M" is a special purpose limited liability company organized under the laws of the State of New York.⁴ The primary business of "M" is acting as a broker of guaranteed investment contracts ("GICs"),⁵ a business in which banks and insurance companies also engage. "M" acts as a GIC broker in connection with trust funds and similar accounts in municipal finance transactions involving municipalities or other issuers ("Municipalities") and related nongovernmental entities.⁶ Under the terms of each GIC, "M" pays each GIC holder a guaranteed fixed or variable rate of return determined through a bidding process or through negotiation. The rate is not in any way determined by or dependent upon any commodity interest trading in which "M" may engage. "M's" GICs are rated "Aaa" by Moody's Investors Services, Inc. and "AAA" by Standard & Poor's Rating Services, which are the highest ratings issued by these rating services. There is no minimum or maximum GIC value.⁷

"M" has two Common Members: "N" and "O". "N" is the Non-Controlling Common Member. It is a wholly-owned subsidiary of "T", which is a wholly-owned subsidiary of "Q", the parent company of several companies engaged in the insurance of debt securities and the investment and financial services businesses. ⁸ "O" is the Controlling Common Member. All of its capital stock is owned by the "U", a charitable trust.⁹ Although "O" has the sole discretion to control the agreements entered into on behalf of "M", "O" has delegated to "N" the authority to determine "M's" investments and to select and retain "M's" futures commission merchants. Additional Common Members will not be added, and Common Member interests are non-assignable, non-transferable and may not be encumbered. Under New York law, no member of a limited liability company (i.e., "N", "O" and the Preferred Members discussed below) is liable for any debts, obligations or liabilities of the limited liability company or each other. Neither "M", "N", "O", nor any of their principals or officers is subject to a statutory disqualification under Section 8a(2) or 8a(3) of the Act.¹⁰

"M" also has Preferred Members. These are persons who purchase preferred membership interests ("Preferred Interests"), which represent equity interests, in "M".¹¹ None of the Preferred Members is or will be an entity formed for the purpose of purchasing Preferred Interests in "M" or otherwise participating in a pool whose operator is not subject to registration as a CPO. A maximum of five hundred Preferred Interests may be issued at a purchase price of $100,000 each.¹² "M's" placement agent anticipates offering and selling Preferred Interests in minimum blocks of $1 million, subject to market conditions and future business judgments.¹³ Preferred Members will receive a return composed of a fixed-rate monthly distribution, the rate of which is subject to change, and the return of their principal investment at maturity or redemption. Neither the monthly distribution rate nor the return of principal is in any way determined by or dependent upon any commodity interest trading in which "M" may engage. To date, five persons have purchased Preferred Interests in the aggregate amount of $30 million.

GICs are securities subject to regulation (or exemption from regulation) under the federal securities laws.¹⁴ In this regard, "M" will issue GICs and Preferred Interests in a manner complying with the exemption from registration of securities provided by Section 4(2) of the Securities Act of 1933. Thus, the offers and sales of these securities are subject to the antifraud provisions of the federal securities laws. In this regard, "M's" offering memoranda contains all material disclosures (e.g., concerning "M's" intended trading of commodity interests) sufficient to enable a GIC or a Preferred Interest offeree to make an informed and knowledgeable investment decision. "M" also will be operated so as to qualify for exemption from registration as an investment company pursuant to Section 3(c)(7) of the Investment Company Act of 1940 (the "ICA").¹⁵

"M's" Operating Agreement provides that, for capital appreciation purposes, "M" is permitted solely to: (1) invest its funds in a portfolio of securities, debt obligations and money market investments within certain credit quality parameters ("Permitted Investments"); (2) enter into repurchase agreements and reverse repurchase agreements; and (3) enter into, among other transactions, interest rate futures contracts and options on interest rate futures contracts ("commodity interest transactions") for the sole purpose of hedging any or all of its investment risk exposure in connection with its issuance of GICs and investing in Permitted Investments. Further, in connection with "M's" operations "R"¹⁶ has issued to "M": (1) a $600 million Liquidity Facility which, among other things, is intended to enable "M" to pay all amounts owing on the GICs and to pay distributions and redemptions on the Preferred Interests in each case where funds may not be available from the Permitted Investments; and (2) an irrevocable $240 million Letter of Credit, which is intended to assure that "M" can make distributions to Preferred Members consistent with applicable law.¹⁷

"M" deposits all amounts received from the sale of GICs, Preferred Securities, the Liquidity Facility and the Letter of Credit into a segregated trust account (the "Facility Account").¹⁸ The source of "M's" distributions to its Common Members, made on an annual basis, is from any excess assets in the Facility Account remaining after all other payments are made by "M", including payments on its GICs and Preferred Interests, based upon an annual financial audit.

Specifically with respect to "M's" contemplated commodity interest transactions, "M" intends to trade interest rate futures contracts and options thereon for the purpose of hedging its GICs and Permitted Investments through bona fide hedging transactions and positions as defined in Commission Rule 1.3(z)(1).¹⁹ "M" will not deposit as initial margin or premiums for its commodity interest transactions an aggregate amount of funds greater than three percent of the liquidation value of "M's" outstanding GIC contracts (which should be equal to the aggregate principal dollar amount of "M's'" obligations to holders of its GIC contracts), computed in accordance with generally accepted accounting principles, after taking into account unrealized profits and unrealized losses on such transactions. The purpose of "M's" commodity interest trading will be to hedge against "M's" obligations (income and return of principal payments) to the GIC holders and Preferred Members. Thus, you claim that the results of "M's" commodity interest trading will not affect the amount of "M's" payments to the GIC holders and Preferred Members and specifically, that these payments will not be increased or decreased as a result of "M's" commodity interest trading. Rather, and as is stated more fully above, payments to GIC holders and Preferred Members are based upon previously-agreed upon rates (and are supported by the $600 million Liquidity Facility and the $240 million irrevocable Letter of Credit).

"M" understands that the Commission, or its representatives, may exercise its regulatory authority to examine "M's" relevant books and records or exercise other authority, at such time as the Commission deems necessary, to assure compliance with those provisions of the Act, and the regulations promulgated thereunder, applicable to "M's" activities.

Analysis

Section 1a(4) of the Act^20- defines the term "commodity pool operator" as "any person engaged in a business which is in the nature of an investment trust, syndicate, or similar form of enterprise and who, in connection therewith, solicits, accepts, or receives from others . . . property for the purpose of trading in [commodity interests]." Rule 4.10(d)(1) similarly defines the term commodity "pool" to mean "any investment trust, syndicate or similar form of enterprise operated for the purpose of trading commodity interests." Section 1a(5) of the Act²¹ defines the term "commodity trading advisor" to mean "any person who, for compensation or profit, engages in the business of advising others . . . as to the value of or the advisability of trading in commodity interests." Section 4m(1) of the Act generally requires each person who comes within the CPO or CTA definition to register as such with the Commission.

You have asked the Division to find that: (1) "M" is not a commodity "pool" within the meaning and intent of Rule 4.10(d); (2) "N" and "O" are not CPOs as defined in Section 1a(4) of the Act; and (3) "N" and "O" are not CTAs as defined in Section 1a(5) of the Act in providing commodity interest trading advice to "M".²² In support of your request you note that the Division previously has taken the position that "N" and "O" need not register as CPOs and CTAs in connection with their operation of "P".²³ You further note that: (1) "M" is an operating business entity, whose business is the issuance of GICs (i.e., it is a GIC broker); (2) like any operating business entity, "M" has persons who own the entity (the Common and Preferred Members); and (3) like many operating business entities, "M" will hedge its obligations through the trading of commodity interests. The Division additionally notes that: (1) neither the periodic income nor return of principal payments that "M" will make to the GIC holders and Preferred Members is in any way determined by or dependent upon any commodity interest trading in which "M" may engage; and (2) the results of "M's" commodity interest trading will not affect the amount of "M's" payments to the GIC holders and Preferred Members and specifically, that these payments will not be increased or decreased by "M's" commodity interest trading.

In light of the foregoing representations and analysis, the Division believes your request has merit. Specifically, the Division believes that: (1) as a GIC broker, "M" is not within the meaning and intent of the term commodity "pool"; (2) "N" and "O" are not CPOs of "M"; and (3) "N" and "O" are not CTAs of "M".²⁴

You should be aware that the positions taken in this letter do not excuse "O" or "N" from compliance with any otherwise applicable requirements contained in the Act or in the Commission's regulations issued thereunder. For example, each remains subject to all applicable antifraud provisions of the Act and to the reporting requirements for traders set forth in Parts 15, 18 and 19 of the Commission's regulations.

This letter, and the interpretations provided herein, are based upon the representations you have made to us. Any different, changed or omitted material facts or circumstances might render these views void. You must notify us immediately in the event the operations of "M", including the restrictions on its commodity interest trading, change in any way from those as represented.

The interpretations provided herein are those of the Division only and do not necessarily represent the views of the Commission or of any other office or division of the Commission. If you have any questions concerning this correspondence, please contact me or Barbara Stern Gold, Assistant Chief Counsel, at (202) 418-5450.

Very truly yours,

Michael Greenberger

Director

¹ 7 U.S.C. § 6m(1) (1994).

² Your June 20, 1997 letter further requested that the Division not recommend that the Commission commence any enforcement action against: (1) "M", "N", "O" or their principals or officers, or any other persons or entities, based on "M's" not being operated by a registered CPO; and (2) "N" or "O" or their principals or officers based solely on "N's" furnishing commodity interest trading advice to "M" without being registered as a CTA. In light of the interpretations we are providing below, however, it has been unnecessary for us separately to consider your further request.

³ The Division also notes your representation that the material facts concerning "M" are substantially similar to those concerning the operation of "P", with respect to which the Division previously granted CPO and CTA registration relief. CFTC Interpretative Letter No. 95-98, [1994-1996 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 26,500 (October 31, 1995).

⁴ A special purpose limited liability company typically is a collective investment entity formed for limited and specified purposes, many of which are subject to ratings of their creditworthiness. "M's" purpose and the rating of its obligations are discussed below.

⁵ GICs are a form of investment vehicle introduced in the early 1970's. The most basic form of a GIC is a contract characterized by a single deposit, earning interest at a guaranteed rate of return until maturity, at which time the principal is returned.

⁶ Typically, a GIC is purchased in connection with a bond offering by the Municipality and serves as a source of security for the Municipality's bonds or an investment of bond proceeds.

⁷ The average initial investment in "M's" GICs has been, and is expected to continue to be, similar to the "P" experience. To date, the average initial investment in a "P" GIC has been in excess of $25 million.

⁸ "Q" is a wholly-owned subsidiary of "R". "R", an indirect wholly-owned subsidiary of "S', is a diversified financial services company. Subsidiaries of "Q" include "V", a company whose principal business is the issuance of insurance coverage for municipal bonds. For its 1996 fiscal year, "N" maintained a statutory capital base, as determined pursuant to New York State insurance law, of over $1.5 billion. The volume of insurance written in 1996 by "V" for municipal bonds in the primary market was $16 billion and in the secondary market was $471 million. Other wholly-owned companies of "Q" are "T" and "X". In 1996, "X" had outstanding municipal investment contracts (similar to the GICs issued by "M") with more than 275 state and local governments and agencies with a total value of $3.3 billion. "X" committed more than $2.5 billion in liquidity facilities to municipal issuers of variable-rate obligations, all guaranteed by "R", also in 1996. "P", which also has as a Common Member "N", has obtained municipal investment contracts (similar to the GICs to be issued by "M") with a total value of $2.9 billion.

⁹ More specifically, "O" is a Delaware special purpose corporation organized for the purpose of owning an interest in and acting as a Common Member of "M". Its initial capital contribution to "M" was $20,000. For the year ending December 31, 1997, $17,000 in net income had been distributed to "O" from "M" and it is expected that $23,000 will be distributed for the year ending December 31, 1998. "O" must in turn distribute this net income to one or more organizations described in Section 170(c) of the Internal Revenue Code -- e.g., religious, charitable, scientific, literary or educational organizations created under United States law. "O" serves as the Controlling Common Member of "M" for "accounting purposes," so that financial information on "M's" operations is not required to be included on the balance sheet or tax returns of "R", the ultimate parent of "N". In this regard, you represent that this practice (i.e., serving as a Controlling Common Member for accounting purposes) is permissible under accounting standards and tax law.

¹⁰ 7 U.S.C. § 12a(2) or 12a(3) (1994).

¹¹ Thus, "M" effectively derives funds from two sources: GICs and Preferred Interests.

¹² Preferred Members may acquire, sell or redeem Preferred Interests on the fourth Wednesday of each 28 day period through an auction process whereby: (1) the purchase price of the Preferred Interests is determined through an auction by selling and buying investors, with bids and offers subject to a set price range; and (2) the fixed distribution rate for Preferred Interests is reset every 28 days by the Auction Agent (here, "Y") based on the sale prices of the Preferred Interests at the auctions. Preferred Members may redeem their Preferred Interests every 28 days at the auction and are not otherwise required to own the Preferred Interests for any minimum period. This auction process is a customary and frequent offer and sale mechanism for preferred securities such as the Preferred Interests and is done in compliance with applicable federal securities laws and guidelines of the Securities and Exchange Commission.

¹³ While $1 million is not required as a minimum unit of sale, it is expected that prospective Preferred Members would not be interested in purchasing a lesser amount of Preferred Interests.

The minimum unit of sale is, as noted above, $100,000.

¹⁴ However, GIC brokers themselves (i.e., companies such as banks, insurance companies and other operating companies) are not subject to regulation under the federal securities laws (e.g., they are not subject to regulation as a broker or dealer of securities) in connection with their issuance of GICs.

¹⁵ Section 3(c)(7) of the ICA provides an exclusion from the definition of an investment company for "[a]ny issuer, the outstanding securities of which are owned exclusively by persons who, at the time of the acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities."

Section 2(51)(A) of the ICA defines the term "qualified purchaser" to mean:

(i) any natural person (including any person who holds a joint, community property, or other similar shared ownership interest in an issuer that is excepted under section 3(c)(7) with that person's qualified purchaser spouse) who owns not less than $5,000,000 in investments, as defined by the [Securities and Exchange] Commission;

(ii) any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons;

(iii) any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in clause (i), (ii), or (iv); or

(iv) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.

Although to purchase a GIC or Preferred Interest a person may satisfy any of the foregoing qualified purchaser criteria, persons who have purchased these securities have been, and it is expected that persons who will purchase these securities will be, qualified purchasers because they will meet the criteria of Section 2(51)(A)(iv). In this regard, the Division notes that at the time it issued its response to the "P" request Congress had not yet enacted Section 3(c)(7) of the ICA. Accordingly, "P" did not (and could not) represent that the purchasers of its GICs and Preferred Interests would be qualified purchasers.

¹⁶ As stated above, "N", "M's" Non-Controlling Member, is, through several intermediary companies, a wholly-owned subsidiary of "R".

¹⁷ The terms and conditions of the Liquidity Facility and the Letter of Credit are set forth more fully in "M's" Private Placement Memorandum (Series A) dated June 18, 1997, the relevant pages of which you transmitted with your November 18, 1997 facsimile. The terms and conditions of the Liquidity Facility provide that the Facility may be increased or decreased as appropriate.

¹⁸ Inasmuch as the Facility Account is in the name of "M", the funds in the Facility Account cannot be used to satisfy the assets of any other person.

¹⁹ Commission rules referred to herein are found at 17 C.F.R. Ch. I (1998).

²⁰ 7 U.S.C. § 1 (1994).

²¹ Id.

²² Alternatively, you asked the Division to consider "M" as the "functional equivalent" of a registered investment company for the purpose of the availability of the exclusion from the CPO definition in Rule 4.5. However, as stated above, "M" is not a registered investment company.

²³ Interpretative Letter No. 95-98, supra n.3.

²⁴ While the Division previously took CPO and CTA registration no-action positions in connection with the operation of "P", we are now finding that "M" is not a commodity pool in light of the additional background information and analysis you have provided us in connection with the instant, "M" request (e.g., how the periodic income payment rates of the Preferred Interests are determined).