Wall St. and the Law: Customer Fund Protections After the Collapse of MF Global and Peregrine -- What Regulatory Changes Are Taking Place

NYCLA-CLE I n s t i t u t e toward certification inciviltriallaw, criminaltriallaw, workerscompensation lawand/ormatrimonial law. hours oftotalCLE credit.Ofthese,0qualify ashoursofcreditforEthics/Professionalism, and0qualify ashoursofcredit This programhas beenapprovedbytheBoard ofContinuingLegalEducation oftheSupremeCourt NewJerseyfor2 Board foramaximumof2 Transitional &Non-Transitional credithours:.5Ethics;1.5PP This coursehasbeenapproved inaccordancewiththerequirementsofNew C Prof. RonaldH.Filler, W Steven Lofchie, a u Gary DeWaal , G f s hat Prepared inconnectionwithaContinuingLegalEducationcoursepresented W at New York CountyLawyers’ Association, 14 Vesey Street, New York, NY ter tomer 2 TRANSITIONAL &NON-TRANSITIONAL lobal New York Law(NYLS)SchoolFinancialServices Institute all A Cadwalader Wickersham &Taft; Gary DeWaal & Associates (formerGroup GeneralCounselofNewedge)

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Information Regarding CLE Credits and Certification Wall Street and the Law June 18, 2013; 6:00 PM to 8:00 PM

The New York State CLE Board Regulations require all accredited CLE providers to provide documentation that CLE course attendees are, in fact, present during the course. Please review the following NYCLA rules for MCLE credit allocation and certificate distribution.

i. You must sign-in and note the time of arrival to receive your course materials and receive MCLE credit. The time will be verified by the Program Assistant.

ii. You will receive your MCLE certificate as you exit the room at the end of the course. The certificates will bear your name and will be arranged in alphabetical order on the tables directly outside the auditorium.

iii. If you arrive after the course has begun, you must sign-in and note the time of your arrival. The time will be verified by the Program Assistant. If it has been determined that you will still receive educational value by attending a portion of the program, you will receive a pro-rated CLE certificate.

iv. Please note: We can only certify MCLE credit for the actual time you are in attendance. If you leave before the end of the course, you must sign-out and enter the time you are leaving. The time will be verified by the Program Assistant. Again, if it has been determined that you received educational value from attending a portion of the program, your CLE credits will be pro-rated and the certificate will be mailed to you within one week.

v. If you leave early and do not sign out, we will assume that you left at the midpoint of the course. If it has been determined that you received educational value from the portion of the program you attended, we will pro-rate the credits accordingly, unless you can provide verification of course completion. Your certificate will be mailed to you within one week.

Thank you for choosing NYCLA as your CLE provider!

New York County Lawyers’ Association Continuing Legal Education Institute 14 Vesey Street, New York, N.Y. 10007 • (212) 267-6646

Wall St. and the Law: Customer Fund Protections after the Collapse of MF Global and Peregrine -- What Regulatory Changes Are Taking Place

Tuesday, June 18, 2013; 6:00 PM to 8:00 PM

Program Co-Sponsor: New York Law (NYLS) School Financial Services Law Institute

Moderator: Prof. Ronald H. Filler, NYLS Professor of Law and, Director, Financial Services Law Institute, NYLS

Faculty: Steven Lofchie, Cadwalader Wickersham & Taft; Robert L. Sichel, Pacific Global Advisors

AGENDA

5:30 PM – 6:00 PM Registration

6:00 PM – 6:10 PM Introductions and Opening Remarks

6:10 PM – 8:00 PM Discussion

New York County Lawyers’ Association Continuing Legal Education Institute 14 Vesey Street, New York, N.Y. 10007 • (212) 267-6646

Wall St. and the Law: Customer Fund Protections after the Collapse of MF Global and Peregrine -- What Regulatory Changes Are Taking Place

Tuesday, June 18, 2013; 6:00 PM to 8:00 PM

Program Co-Sponsor: New York Law (NYLS) School Financial Services Law Institute

Moderator: Prof. Ronald H. Filler, NYLS Professor of Law and, Director, Financial Services Law Institute, NYLS

Faculty: Steven Lofchie, Cadwalader Wickersham & Taft; Robert L. Sichel, Pacific Global Advisors

Table of Contents

OTC Clearing – What Do Pension Plan Fiduciaries Need to Know?

Ask the Professor: What is the Impact on MF Global From the Recent UK Supreme Court Decision Involving Lehman Brothers International (Europe)?

Ask the Professor: Portfolio Margining– How Will Dodd-Frank Impact its Utilization?

Are Customer Segregated/Secured Amount Funds Properly Protected After Lehman?

OTC CLEARING – WHAT DO PENSION PLAN FIDUCIARIES NEED TO KNOW?

May 21, 2013 S T R I C T L Y P R I V A T E A N D C O N F I D E N T I A L

Disclaimer

This report is provided for informational purposes only. Do not use this report as a primary basis for investment decisions or for decisions pertaining to plan funding, accounting, or related regulatory requirements. In preparing this report, Pacific Global Advisors may have relied upon and assumed, without independent verification, the accuracy and completeness of information provided by various third parties such as investment managers. Pacific Global Advisors is not able to independently verify the accuracy and completeness of such information and makes no representation as to the information’s accuracy or completeness. This report may contain projections, forecasts or estimates. Pacific Global Advisors makes various assumptions in connection with such forward looking information. Actual events or conditions may differ from those assumed and not all relevant events or conditions may have been considered in developing the assumptions. Changes to the assumptions could have a material impact on the information presented herein. No representation is made that the performance presented herein will be achieved. Nothing contained herein should be construed as legal, actuarial or accounting advice. You must retain an actuarial firm which is independent of Pacific Global Advisors to provide all actuarial services with respect to statutory and regulatory requirements.

Pacific Global Advisors and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters included herein (including any attachments) is not intended or written to be used, and cannot be used, (a) in connection with the promotion, marketing or recommendation of any of the matters addressed herein to another person or (b) for the purpose of avoiding U.S. tax- related penalties.

This report summarized certain provisions of Title VII of the Dodd Frank Wall Street Reform and Consumer Protection Act. Pension Plan fiduciaries should discuss the Act’s implications for the plan’s specific situation with the plan’s legal advisors.

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 1

1 Agenda

Background 2

Mechanics of OTC clearing 8

Key risk considerations 18

Portfolio impact, documentation, & next steps 27

Appendix I – Bonds vs. swaps, collateral transformation, fees 33

Appendix II – DOL Advisory Opinion 43

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Foreword

 The Dodd-Frank Wall Street Reform and Consumer Protection Act (Act) was enacted in July 2010

 Title VII of the Act completely overhauls the regulation of derivative transactions

 Users of derivatives, such as pension plans, need to ensure compliance with this new regulatory scheme

 Pension plans widely use derivatives for hedging and other purposes whether it be:  Directly by internal staff at the plan sponsor  Directly by an external investment manager/QPAM in a separate account structure  Indirectly by an external investment manager/QPAM in a commingled vehicle structure, such as a hedge fund

 According to the American Benefits Counsel, “Defined benefit plans use swaps to hedge their asset and liability risks. Without swaps, plan assets and liabilities would be far more volatile, leading to greatly increased funding volatility. Increased funding volatility would, in turn, force plan sponsors to set aside much greater reserves to address possible future funding obligations.” (American Benefits Council letter to the Department of Labor commenting on proposed ERISA regulations, February 3, 2011)

 Mandatory centralized clearing (processing, settling, and guarantying of trades) is one of the centerpieces of the Act’s goal of reducing risk in the derivatives marketplace

 This report summarizes certain provisions of Title VII. Pension Plan fiduciaries should discuss the Act’s implications for the plan’s specific situation with the plan’s legal advisors.

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2 Background

2008 FINANCIAL CRISIS

A series of large financial institution failures triggered a financial and economic crisis that threatened to freeze U.S. and global credit markets. As a result of these failures, unprecedented governmental intervention was required to ensure the stability of the U.S. financial system. The President’s Working Group on Financial Matters noted shortcomings in the OTC derivatives markets during the crisis.

2009 G-20 & INTERNATIONAL COMMITMENTS

The financial crisis brought international attention to strengthening financial regulation through improved transparency. Leaders of the Group of 20 agreed that standardized OTC derivative contracts should be cleared through central counterparties and traded on exchanges or electronic trading platforms.

2010 DODD FRANK ACT

Recognizing the perils the U.S. financial system faced during the financial crisis, Congress passed the Dodd- Frank Act. Title VII of the Act established a comprehensive new regulatory framework for swaps, including the requirement that certain swaps be cleared.

2012 MANDATORY CLEARING REQUIREMENTS

The CFTC finalized a rule establishing a schedule for compliance with the mandatory clearing requirements for swaps under Title VII of the Act.

2013 MANDATORY CLEARING STARTS

G20 countries consist of Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, the Republic of Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United Kingdom, the United States of America plus the European Union

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Phased implementation & OTC derivatives clearable product scope

Mandatory clearing is implemented in phases depending upon (a) the type of derivative product being traded and (b) the type of market participant. The first phase of products subject to mandatory clearing includes certain “plain vanilla” interest rate swaps and credit default swaps. Over the coming years, additional products will be subject to mandatory clearing.

London Clearing House Chicago Mercantile Exchange

 Interest Rate Swaps:  Interest Rate Swaps:

– AUD (30y) – CAD (30y) – CHF (30y) – AUD (30y) – CAD (30y) – CHF (30y) – CZK (10y) – DKK (10y) – EUR (50y) – EUR (50y) – GBP (50y) – JPY (30y) Interest rate – GBP (50y) – HKD (10y) – HUF (10y) – USD (50y) derivatives – JPY (30y) – NOK (10y) – NZD (10y) – PLN (10y) – SEK (30y) – SGD (10y) – USD (50y) – ZAR (10y)  Overnight Index Swaps:

– CHF (2y) – EUR (2y) – GBP (2y) – USD (2y)

Chicago Mercantile Exchange

 Indices: Credit default – CDX IG Series 9 – 11 : 5, 7 & 10 year swaps – CDX IG Series 12 – 19 : 3, 5, 7 & 10 year – CDX HY 11 – 19 : 5 year

 Single names: none

The number in the parenthesis (#) indicates that the trades with tenors up to the # are subject to clearing

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3 Timing for mandatory clearing

Market participants are grouped into 3 categories

CATEGORY CATEGORY DESCRIPTION COMPLIANCE DATE

Swap dealers; security-based dealers; major swap 1 participants; major security-based swap participants and March 11, 2013 active funds

Commodity pools; private funds and persons predominantly 2 engaged in activities that are in the business of banking or June 10, 2013 financial in nature (but not third-party subaccounts)

3 All other market participants, including pension plans September 9, 2013

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Department of Labor (DOL) guidance

 In February 2013, the DOL issued an advisory opinion (2013-01A, attached in the Appendix)

 The opinion analyzed the application of the ERISA fiduciary rules to the categories of swaps subject to mandatory clearing  Clarifications – Clearing members will not be ERISA fiduciaries by reason of exercising their close-out rights under the legal contracts – Margin posted to a clearing member and clearing house will not be treated as ERISA plan assets.  Potential ambiguity – Specifically addresses the QPAM and INHAM exemptions – Does a plan have to hire a QPAM or use an INHAM to trade or may other exemptions such as the “Service provider exception” (Section 408 (b)(17) of ERISA) be relied upon? – Focuses on the guarantee, liquidation and close-out transactions that are “subsidiary” parts of the “primary” swap transaction – Does relief extend to other “subsidiary” transactions?

PGA will monitor the DOL’s initiative to revise the definition of fiduciary which is expected later this year and its potential implications

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4 Agenda

Background 2

Mechanics of OTC clearing 8

Key risk considerations 18

Portfolio impact, documentation, & next steps 27

Appendix I – Bonds vs. swaps, collateral transformation, fees 33

Appendix II – DOL Advisory Opinion 43

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Comparison of OTC market with and without central clearing

OTC market without central clearing

EXECUTING PENSION BROKER TRUST

PGA (as agent)

PGA acts as agent on behalf of the pension trust

 The pension trust faces the executing broker as counterparty

OTC market with central clearing

CM CM

PENSION EXECUTING CLEARING TRUST BROKER HOUSE (CH)

PGA (as agent)

 The contractual obligations between the executing broker and the pension trust are replaced with sets of equivalent obligations (executing broker – clearing house and pension trust – clearing house) with the executing broker and pension trust’s respective clearing members (CM or FCM) acting as agent and guarantor for their cleared positions.

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5 Operational workflow – OTC market with central clearing

1. Trade is executed, EXECUTING PGA selects clearing house PENSION BROKER TRUST Execution PGA (as agent)

2. EB alleges trade 3. PGA affirms trade, allocates among accounts & designates the pension Affirmation AFFIRMATION PLATFORM trust’s CM

4. Trade is matched & sent 7. CH sends confirmation to the clearing house that the trades have cleared

Clearing 5. CH & CM accepts/rejects the trade CLEARING CLEARING HOUSE MEMBER 6. Trade is cleared, if accepted

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Overview of margin

 There are two types of margin that help to mitigate counterparty credit risk (i.e., the risk that the counterparty is not able to make the payments due under the contract)  Variation margin covers the day to day price moves in the underlying position  Initial margin protects the counterparty for adverse price moves when it is faced with closing out the position in a default scenario

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6 Margin – OTC market without central clearing

PENSION EXECUTING Trade is executed TRUST BROKER

PGA (as agent)

Initial Margin

Typically not required

Variation Margin

 Roles and responsibilities are governed by a Collateral Support Agreement (CSA) negotiated between PGA and the executing broker, including  Whether the executing broker holds the margin directly or at a third party custodian  The types of securities that are eligible for posting  The “haircuts” applied to the different securities

The bilateral OTC market is evolving as new regulations that require the posting of IM and VM, subject to certain permissible thresholds, are expected

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Margin – OTC market with central clearing

PENSION Trade is executed EXECUTING TRUST B BROKER PGA (as agent) Summary  Initial margin (IM): CH holds the value of IM from the pension trust and the executing broker  Variation margin (VM): CH and CMs act as conduits for VM between the executing broker and CLEARING CM CM pension trust depending upon HOUSE market movements  The pension trust and executing broker may choose to leave IM IM excess VM in the CM account IM Margin flow 1 Clearing Clearing Clearing A. CH debits CM account to satisfy Member House A Member margin requirement Customer Customer Customer B. If sufficient excess margin is not 2 VM 3 VM 2 Account Account Account held in the CM customer account, CM calls for margin from its client Excess VM Excess VM (pension trust)

1 Illustration of variation margin flow when the position moves against the pension trust (and in favor of the executing broker) 2 Omnibus Account with LSOC Protection 3 Account at a firm unrelated to clearing house with LSOC Protection

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7 Margin – OTC market with central clearing (cont’d)

 Initial margin (IM)  Margin required at the outset of a trade, as calculated by the CH  Value of margin held by the CH for the duration of the trade  Eligible instruments at CH: cash, treasuries, agencies, corporate bonds (CME only), foreign sovereign debt, gold  Methodology: historical V@R using a 5Y look back period, 5-7 day closeout period, and 99.7% loss – USD 10Y swap: 3-4% of notional, 30Y swap: 8-11% of notional

 Variation margin (VM)  Margin posted or collected on a daily basis based on the mark-to-market value of the trade, as calculated by the CH  Eligible instruments at CH: cash only  Methodology: current NPV of the positions settled on a daily basis

 Margin requirements and methodologies vary between CH and CM

 CH and CM have the right to change margin requirements, including CM assessing additional margin above the CH requirement

Note: Please refer to appendix for details on types of eligible collateral and haircuts at LCH and CME

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Background on clearing houses

Relevant information on selected clearing houses

LCH.Clearnet Group Limited Chicago Mercantile Exchange, Inc.

Corporate structure LCH.Clearnet Group Limited is a private company CME Clearing is the clearing house division of registered in the UK. It’s two principal subsidiaries the Chicago Mercantile Exchange Inc. (CME), are LCH.Clearnet Limited and LCH.Clearnet SA. In a Delaware corporation, which is wholly owned August 2012, LCH.Clearnet Group Limited acquired by CME Group, Inc. (CME Group), a publicly IDCC (renamed LCH.Clearnet (US) LLC). traded Delaware corporation. CME Group was LCH.Clearnet. The London Stock Exchange Group formed by the merger of Chicago Mercantile plc (LSEG) recently acquired a majority stake Exchange Holdings, Inc. in 2007 and (57.8%) in LCH.Clearnet Group Limited. subsequently merged with NYMEX Holdings, Inc. in 2008. CME Group is the parent of CME, The Board of Trade of the City of Chicago, New York Mercantile Exchange, Inc and Commodity Exchange, Inc.

Market capitalization $6bn (LSEG) $22bn (CME Group)

Credit rating A+/A1 (S&P) AA-/A1+ (S&P), Aa3/P1 (Moody’s)

Size of default fund1 ~$3bn (cleared IRS) ~$1.1bn (cleared IRS), $0.7bn (cleared CDS)

# of clearing members for IRS 15 23

IRS notional cleared in Q1 2013 $15.3tn $0.9tn

Relevant settlement bank BNY Mellon, Citibank BMO Harris, BNY Mellon, Brown Brothers Harriman, Citibank, J.P. Morgan Bankruptcy regime Currently U.K., the U.S. entity is expected to be U.S. available in early June

1 The size of the default fund is determined based on the default of the two largest clearing members. The clearing house has the power to asses additional contributions for the default fund

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8 Agenda

Background 2

Mechanics of OTC clearing 8

Key risk considerations 18

Portfolio impact, documentation, & next steps 27

Appendix I – Bonds vs. swaps, collateral transformation, fees 33

Appendix II – DOL Advisory Opinion 43

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Lessons from recent history

 Futures  CFTC did not report any loss of customer funds at the FCM, Lehman Brothers Inc. (LBI)  Customers transferred positions & margin to other FCMs even after the parent company filed for bankruptcy

 Swaps clearing  Lehman Brothers had $9tn swap notional (66,000 positions) cleared at LCH LEHMAN (2008) LEHMAN  Within 3 weeks, the default was fully resolved using ~35% of initial margin and with no loss to other participants

 Proprietary investments in European sovereign debt ($7bn, 14% of assets, 4.5x equity) led to a liquidity crisis

 FCM customer property was used to fund the margin calls on the firm’s sovereign debt positions

 Shortfall in customer funds of $1.6bn (domestic $900mm, foreign $700mm) discovered

 Domestic customers recovered ~93% of missing funds

MF GLOBAL MF GLOBAL (2011)  Protection under OTC clearing: LSOC provides greater protection of customer funds

 President defrauded customers by using segregated funds for personal use

 Elaborate fraud achieved through forgery in internal and external financial records

 Shortfall in customer funds of ~$215mm

 Bankruptcy judge approved $123mm interim payout

PEREGRINE (2012)  Protection under OTC clearing: no protection against fraud however greater regulatory transparency

Source: The MF Global Bankruptcy and Missing Customer Funds (Congressional Research Service), Report of the Trustee for MF Global Inc. liquidation, Latham & Watkins, CFTC, NFA, Bloomberg, LCH

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9 Risks under central clearing

Risk factors Mitigating factors

 Investment risk  Regulation 1.25  Pension trust’s CM or CH incurs losses on investments  CMs and CH are restricted in which assets customers’ funds can made using funds posted by its customers as margin be invested in

 Fellow customer risk  LSOC – customers recover the value of their collateral  Customers of the defaulted CM recover their property on a  Pro rata sharing with other customers is only an issue if there is a pro-rata basis with other customers of the defaulted CM shortfall in the pool of customer property  Conservative haircuts on collateral reduce the risk of a shortfall

 Counterparty (CH) credit risk  Waterfall of resources available  Initial margin, default fund, CH capital contribution, assessment power to replenish default fund

 Clearing member credit risk  Ability to port positions and any corresponding margin to a financially stronger CM

 Operational risk and fraud (CH & CM)  Greater regulatory transparency  Losses incurred as a result of negligence, record-keeping  CFTC has the ability to electronically monitor CM customer issues, custodial failures may be shared by customers on a accounts in real-time pro rata basis  Fraud, malfeasance, forgery of financial records and other illegal activities

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Investment risk for client funds

Recent events have impacted regulation

2000 2004 2005 2011 2012

CFTC substantially expanded the scope of permissible investments MF Global declared CFTC amended its to permit the use of repo bankruptcy after using regulations to narrow the agreements, investing in customer funds through repo scope of permitted instruments with embedded arrangements to leverage an investments for clearing derivatives, obligations of investment in European members and clearing government sponsored entities and sovereign debt houses corporate notes CFTC Regulation 1.25

 Objective: Preserve principal and maintain liquidity

 Instrument and issuer based concentration limits

 Permitted investments:  Money market mutual funds  U.S. Agency obligations  U.S. Government securities  Certain CDs  Municipal securities  Certain commercial paper

 Investments no longer permitted:  Corporate obligations not guaranteed by the U.S.  Foreign sovereign securities  Transactions with an affiliate of the clearing member or clearing house

Clearing houses and clearing members may have their own investment policies, which are more restrictive than Regulation 1.25

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10 Fellow customer risk

 Under certain circumstances, clients may be exposed to the risks presented by other clients of the CM (fellow customers). This is because the bankruptcy rules provide that customers of the defaulted CM recover their property on a pro-rata basis with other customers of the defaulted CM.

 Under LSOC, pro rata sharing with other customers is only an issue if there is a shortfall in the pool of customer property. The LSOC framework significantly mitigates the risk that there will be such a shortfall.

Margin protection models

Model Features

Most Physical Segregation  Client funds are segregated from the CM’s account as well as from other clients’ assets Protection – Currently not in the U.S.  Amplifies the number of wires and reconciliations between CM and CH

Legal Segregation with  Preserves CM’s ability to operationally maintain a customer omnibus account Operational Commingling  CM must keep and produce records of individual customer positions and balances (LSOC)  – Required of CH and CM Margin from one customer cannot be used to meet another customer’s margin call by the CM as of November 2012 or the CH (protection from fellow customer risk)  Does not protect customers from operational or investment risk (negligence, theft, etc). So, operating and investment losses can affect a non-defaulting customer

Legal Segregation and  CH collateral and non-defaulting CM contributions applied before non defaulting customers Recourse  Preserves CM’s ability to operationally maintain a customer omnibus collateral account  CM must keep and produce records of individual customer positions and balances  Maintain concepts of clients taking part in risk mutualization process

Futures  Client collateral pooled into an omnibus account but sequestered from the CM’s house account Least  CH permitted to access collateral of non-defaulting customers to satisfy a margin deficiency Protection caused by a defaulting customer

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Counterparty (CH) risk

Resources available in a CM and customer default (waterfall)

Existing futures model (gross omnibus) LSOC model for central clearing

Margin Requirement of the Customer Legally Segregated Collateral of the Customer at the CH

Defaulting CM’s Initial Margin Defaulting CM’s Initial Margin

Defaulting CM’s Default Fund Contribution Defaulting CM’s Default Fund Contribution

Remaining IM of all Customers of Defaulting CM CH’s Capital Contribution (LCH ~$30mm / CME $100mm)

CH’s Capital Contribution Non-defaulting CMs Default Fund Contribution

Remaining Default Fund Replenishment of Default Fund via assessment powers

Replenishment of Default Fund Service Closure

Service Closure

Amounts vary by clearing house per the rules of each clearing house

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11 CM credit risk

CMs and CHs are required to provide clients the capability to transfer their positions (port) to another CM

PORTING  Prior to the default of a CM, a client concerned about its CM’s credit worthiness could engage in self-help measures by IM porting its positions and any corresponding margin to a CLEARING financially stronger CM HOUSE  Central clearing model advantages  Customers have the right to unilaterally port to another CM  Customers can port at any time as long as the customer has clearing documentation in place with a willing transferee CM Transferor  The CH will seek to avoid closing out customer positions CM 1 CM 2 Transferee CM CM by facilitating bulk transfers of non-defaulting customers of defaulted CM to another CM  Important to move quickly  If there is a shortfall of customer funds held at the defaulted CM, the bankruptcy trustee may not permit porting or only permit based on an estimated shortfall risk PENSION TRUST

PGA (as agent)

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View from the CFTC

“The Wall Street reform bill will – for the first time – bring comprehensive regulation to the swaps marketplace. Swap dealers will be subject to robust oversight. Standardized derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties. The Commission looks forward to implementing the Dodd-Frank bill to lower risk, promote transparency and protect the American public.” - CFTC Chairman Gary Gensler

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12 Central clearing mitigates risk

Comparison of risks in OTC market with and without clearing

Considerations: Central clearing OTC without clearing

Collateral: initial margin is required for central clearing 

Collateral segregation: Legally Segregated Operationally Commingled (“LSOC”), which mitigates  fellow customer risk, is required for central clearing

Netting of exposures: the clearing house will be neutral (i.e., it is not making directional bets) 

Risk mutualization: under clearing, losses are shared among the members and owners 

Transparency: CFTC have direct electronic access to bank accounts that hold customer funds 

Exposure to a clearing member: counterparty is typically less well capitalized under clearing  (e.g. JPMorgan Securities LLC in central clearing vs. JPMorgan Chase Bank N.A. in OTC)

Too big to fail: potential for the federal government to bail out an executing broker/ national bank  or a clearing house; arguments for both sides

Portability of trades: easier to port positions that are cleared; portability addressed in clearing  documentation

Term of trade: greater certainty of maintaining trade through maturity under OTC 

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Agenda

Background 2

Mechanics of OTC clearing 8

Key risk considerations 18

Portfolio impact, documentation, & next steps 27

Appendix I – Bonds vs. swaps, collateral transformation, fees 33

Appendix II – DOL Advisory Opinion 43

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13 The incremental cost of clearing is small

Typical bid-offer on swaps vs. bonds (bps) Corporate 6 Govt. <10 Years 10+ Years Related

2 Small increase in cost (0.1 – 0.2 bp) 1

0 Swaps (OTC) Swaps (OTC clearing) Treasury Treasury strips Corporate bonds

Source: PGA, broker-dealers

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 26

Legal documentation for OTC clearing

Between executing broker and pension trust

 Trading agreement currently in place with a number of leading executing brokers ISDA  PGA amended in 2012Q4 per the ISDA protocol to address Dodd-Frank requirements which became effective on May 1st

Clearing Execution Framework  Based on a Futures Industry Association ISDA form of agreement called the “Cleared Derivatives Execution Agreement” Cleared Derivatives  Provides the legal framework for the relationship between pension trust and Execution Agreement the executing broker with which trades are executed and then submitted for clearing

Between pension trust and CM

 Allows for clearing member to be a designated clearing member for the Futures Client pension trust; underlying legal requirement for a CM-based Derivates Clearing Agreement Clearing relationship Clearing Relationship  Based on the Futures Industry Association’s Cleared OTC Derivatives OTC Addendum for Addendum template Cleared Derivatives  Outlines mechanics of clearing service

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 27

14 The clearing market continues to evolve…

 Clearing members

 Clearing houses New Players  Swap Execution Facilities

 Collateral optimization

 Swaps morphing into futures?

 Eris IRS futures New Products  CME deliverable interest rate futures

 Collateral optimization

 CFTC New Regulations  SEC

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 28

Agenda

Background 2

Mechanics of OTC clearing 8

Key risk considerations 18

Portfolio impact, documentation, & next steps 27

Appendix I – Bonds vs. swaps, collateral transformation, fees 33

Appendix II – DOL Advisory Opinion 43

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 29

15 Derivatives allow a plan to retain growth assets while reducing risk

Portfolio without derivatives Portfolio with derivatives

ASSET ALLOCATION Growth Portfolio 60% 60% Liquidity Portfolio 2% 7% Immunizing Portfolio 38% 33%

LIABILITY HEDGE RATIO 30% 60%

PORTFOLIO EXPECTED RETURN 7% 7%

FUNDED STATUS VOLATILITY 15% 12%

Short Growth asset risk Growth 6%interest 6% Growth Other risk Short asset risk, rate risk, interest 6% 1%5% asset risk, 1% Short interest rate risk rate risk, 8%6% 5% 8%

Other Other risk, 1% risk, 1%

Note: example above is an illustration for a pension plan that is 80% funded

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 30

There are insufficient long duration bonds to meet the hedging needs of DB plans

Assets of defined benefit plans ($bn) US IG assets with maturities > 10 years ($bn)

Corporate Other, 638 Govt. <10 Years 10+ Years Related Corporate DB, 1,833

Treasury, 633 Corporate, 838

Govt. related, Govt. DB, 270 3,320

Total assets = $5.8tn Total assets = $1.7tn

 “There's only so much of your liability that you can hedge with physical assets” Ray Kanner, Pension Fund Manager, IBM as reported in AI-CIO.com

 "The longest duration segment of the portfolio comes from derivatives - it is the only way to get the duration we need” Caitlin Long, Retirement Investment Committee Member, Morgan Stanley as reported in AI-CIO.com

Sources: S&P Money Market Directories, Barclays Capital, ai-CIO.com

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 31

16 The Fed is likely to absorb most of the net supply of fixed income in 2013

Demand for fixed income securities ($bn) Net supply of taxable fixed income securities ($bn)

3,000 3,000

2,500 2,500

2,000 2,000 1,300 1,500 1,500 1712 1,000 1,000 920 1,000 906 500 500 343 64 0 0

(500) -500

(1,000) -1,000 2009 2010 2011 2012 2013 (f) 2009 2010 2011 2012 2013 (f) UST Agency MBS Banks Pensions Insurance IG HY ABS Foreigners MF & ETF Fed Other Net supply (Fed)

Source: Credit Suisse, JPMorgan, Federal Reserve flow of funds data

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 32

Swaps are widely utilized to hedge plan liabilities

 The American Benefits Council (“ABC”), a public policy organization which principally represents Fortune 500 companies, included the following in a comment letter to the DOL (http://www.dol.gov/ebsa/pdf/1210-AB32-179.pdf)

“Defined benefit plans use swaps to hedge their asset and liability risks. Without swaps, plan assets and liabilities would be far more volatile, leading to greatly increased funding volatility. Increased funding volatility would, in turn, force plan sponsors to set aside much greater reserves to address possible future funding obligations. Those reserves would directly reduce money available to invest in jobs and in the economic recovery. In short, making swaps far less available would have far reaching adverse effects throughout the economy. In addition, without swaps, the greatly increased volatility with respect to funding adequacy would undermine the security of participants’ benefits.”

 In addition, on January 19, 2012, ABC sent an email to its members that included the following:

“ERISA plans commonly use swaps to hedge or mitigate risks endemic to plan liabilities and investments. In numerous meetings with the regulatory agencies, the Council has consistently argued that without the use of swaps, defined benefit pension funding obligations would become more volatile and force employers to find other less efficient ways to manage that risk – including setting aside large sums of cash to cover potential funding obligations.”

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 33

17 Collateral transformation and optimization

Collateral transformation

 Converting ineligible collateral, such as corporate bonds and equities, into eligible collateral to meet clearing house requirements

 Different service providers  Clearing members  Custody banks  Securities lending agents  Prime broker

 Different programs  Repo  Securities lending  Prime brokerage financing

 Important considerations  Which program is most beneficial economically considering fees, haircuts, types of securities that can be used and operational efficiencies?  Will participation in the program cause the plan to have adverse tax consequences (i.e. Will participation in a program cause the plan to have UBTI?)  Which statutory or administrative prohibited transaction exemptions are available (e.g. QPAM, INHAM, 408(b)(17) or ERISA)

Collateral optimization

 In connection with trading decisions, analyzing the impact of the collateral requirements looking across  Existing trades and collateral with the plan’s clearing members  The pool of securities that is available for posting  Collateral requirements and restrictions for all of the plan’s clearing members and clearing houses

 Perform in-house or hire a service provider?

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 34

Fees charged by clearing house

Summary of fees by each clearing house

LCH.Clearnet Chicago Mercantile Exchange

Booking fees for new trades Maturity Fee ($/million Notional) Maturity Fee ($/million Notional) 0 to 1 0.90 0 to 1 1.00 1+ to 3 2.25 1+ to 3 2.50 3+ to 5 4.05 3+ to 5 4.50 5+ to 7 5.40 5+ to 7 6.00 7+ to 10 7.20 7+ to 10 8.00 10+ to 12 8.10 10+ to 12 10.00 12+ to 15 9.00 12+ to 15 12.50 15+ to 20 13.50 15+ to 20 15.00 20+ to 25 16.20 20+ to 25 17.50 25+ to 30 18.00 25+ to 30 24.00 Maintenance fees $3/million of notional $2/million of notional Assessed annually on anniversary date of each Assessed annually on anniversary date of each trade; not charged if trade is terminated before trade; not charged if trade is terminated before the anniversary date the anniversary date Volume discounts are available based on total fees paid

There are minor differences between the fee schedules for the two Clearing Houses. Over time, we expect this divergence to get even smaller. The clearing members pass these fees onto the pension trust. The fee schedules are subject to change without notice.

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 35

18 Default fund

LCH.Clearnet1 Chicago Mercantile Exchange2

Number of default funds  Fund for IRS  Fund for IRS  Fund for CDS

Default protection Cover defaults by the two largest CMs plus 10%, Cover defaults by the two largest CMs (or other method defined as “Fund amount” determined by the CME’s Risk Committee)

Size of contribution Clearing members contribute: Clearing members contribute greater of:  “Fund amount” multiplied by the amount calculated  $50mm by dividing the average daily IM requirement for  CM’s proportional share of funds based on: prior 20 business day by the total of the average  30-day trailing average of its potential residual daily requirements applied to all non-defaulting loss (95% weighting for CDS, 90% for IRS) CMs  30-day trailing average of its gross notional (5% weighting for CDS, 10% for IRS)

Contribution calculation Monthly; more frequently if risk profile of the two largest Monthly; more frequently if risk profile of the two largest frequency CMs change by more than 25% from prior period CMs change by more than 10% from prior period calculation calculation

Collateral  Cash only  Cash  U.S. Treasury securities  U.S. Agency securities (capped at 50%)  Money market mutual funds approved by the CH

Size of default fund Data as of May 1, 2013: Data as of March 31, 2013:  Current size: $3.0bln  $1.1bln for IRS  Max size: $5.0bln  $0.7bln for CDS  Min size: $15mm per CM

1 Chapter 3 of the LCH Rulebook 2 All information provided for CDS and IRS default funds . Refer to Section 8G07 and 8G02 of the CME Rulebook. The CH does not rehypothecate collateral for the default fund.

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 36

Collateral type and haircut

Summary of types of collateral accepted and haircuts applied by each clearing house

LCH.Clearnet1 Chicago Mercantile Exchange2

 Cash (USD, GBP, EUR, CAD, CHF, JPY, SEK, NOK)  Category 1  Cash (USD, or 5% haircut on AUD / GBP / CAD / EUR /  Government securities of Australia, Austria, Belgium, Canada, JPY / CHF) Denmark, Finland, France, Germany, Italy, Japan, Luxembourg,  US Treasury bills / notes / bonds (0.5 – 6% haircut) Netherlands, Norway, Spain, Sweden, U.K. and U.S. (0.1 –  Strips (11% haircut) 13% haircut)  Category 2 (max 40% of core requirement)  US MBS (GNMA) (2 – 14% haircut)  U.S. Government Agencies (3.5 – 7% haircut)  FNMA, FHLMC and GNMA MBS (11% haircut)  FNMA, FHLMC, FHLB (0.4% - 4.9% haircut)  TLGP securities (10% haircut)

 Euro Agencies (0.6 – 6.3% haircut)  Category 3 (max if 40% of core requirement of USD 3bb)  Gold (15% haircut)  Government guaranteed bonds / CDs of Australia, Austria,  Foreign sovereign debt of Canada, France, Germany France, Germany, Netherlands, Norway, Spain, Sweden, U.K. Japan, Sweden and the U.K. (5 – 10.5% haircut) and U.S. (0.1 – 2.9% haircut)  Corporate Bonds (CME-approved, min A- rating, >USD 300mm outstanding, 20% haircut)  Gold (14% haircut)

1 Source: LCH 2 Source: CME

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 37

19 Agenda

Background 2

Mechanics of OTC clearing 8

Key risk considerations 18

Portfolio impact, documentation, & next steps 27

Appendix I – Bonds vs. swaps, collateral transformation, fees 33

Appendix II – DOL Advisory Opinion 43

STRICTLY PRIVATE AND CONFIDENTIAL O T C D E R I V A T I V E S C L E A R I N G 38

20 ARTICLE REPRINT The Journal on the Law of Investment & Risk Management Products Futures & Derivatives LawREPORT LBIE in a segregated client account. byactualclient heldmoneyofpool the in ent asset protection and, thus, should share clireceivecontractualto righta had not, the protected client money fund account or in heldactually were funds theirwhether LBIE, of clients all that held and edents SupremeUKCourtreversed existing prec Clarke,DysonCollins.andessence, In the Walker,Hope, Lordsbefore 2011, 3, and 2 1, November and 31 October on days U.K. Regulatory Background–U.S. vs. R y B LEHMAN BROTHERS INTERNATIONAL (EUROPE)? RECENT UK SUPREME COURT DECISION INVOLVING WHAT IS THE IMPACT ON MF GLOBAL FROM THEASK THE PROFESSOR: one of the most important customer pro customerimportant most the of one is determined. is fund margin initial how money and U.K., the in rules client similar from differ rules U.S. the commission how futures (“FCM”), amerchant by held be must funds customer futures how on recently Lehmregardingbyclientheldfunds how issuedthelong-awaited landmark decision Court”),Supreme “UK the as to referred (hereinaftercourtUK’shighest the Court, ofLBIE. insolvency the following distributed and afterreferred to as “LBIE”) will be treated an Brothers International (Europe) (herein hs uhr a witn ay articles many written has author This Supreme the 2012, 29, February On A N O 2 Arguments were heard over four l d 3 F As noted in these articles,these in noted As i l l R E 1 - - - - - CONTINUED ONPAGE 3 bankruptcy. for files FCM their if proceedsinsurance turescustomersreceivenot specialdoany fu Insurance),SIPC and InsuranceFDIC governmentindustry the(e.g.,firms or by insuranceprograms fundedthatareeither andstock brokerage accounts, which have savings checking, U.S. Unlikesacrosanct. derlyingfuturescontracts.arerules These customer’stheun margin to FCM an by held collateral and cash assets, customer protectionof(“CFTC”)the regulations is TradingFuturesCommodityCommission applicableExchange(“CEA”)andityAct Commod the underlying themes tection also applies to cleared swap accounts. important restriction is included in CFTCimportant includedrestrictionin is vestthe customer funds. For example, one in may FCMs how restrict significantly and swaps cleared and futures both accounts for segregated customer the fund properly must FCMs how governstrictly regulations and laws applicable the tion, hs ulcto pes vst www.west. thomson.com visit about please publication information this more For Reuters. Law Report. Copyright © 2011 Thomson Reprinted from the Futures & Derivatives Topromotesuchcustomer assetprotec Article

4 REPRINT hs bec o insurance of absence This April 2012 n Volume 32 n Issue4 - - - - - April 2012 n Volume 32 n Issue 4 Futures & Derivatives Law Report

Newsletter ad 2.8772 x 4.5.qxp 2/1/2010 1:38 PM Page 1

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Editorial Board Stephen W. Seemer Rhett Campbell Donald L. Horwitz Glen A. Rae Publisher, West Legal Ed Center Thompson & Knight LLP One Chicago Banc of America Securities LLC Houston, TX Chicago, IL New York, NY JANNA M. PULVER Publication Editor, Thomson Reuters/West ANDREA M. CORCORAN Philip McBride Johnson Kenneth M. Raisler Align International, LLC Skadden Arps Slate Meagher & Flom Sullivan & Cromwell Richard A. Miller Washington, D.C. Washington, D.C. New York, NY Editor-in-Chief, Prudential Financial Two Gateway Center, 5th Floor, Newark, NJ 07102 W. Iain Cullen Dennis Klejna Richard A. Rosen Phone: 973-802-5901 Fax: 973-367-5135 Simmons & Simmons MF Global Paul, Weiss, Rifkind, Wharton & Garrison LLP E-mail: [email protected] London, England New York, NY New York, NY Michael S. Sackheim Warren N. Davis Robert M. McLaughlin Kenneth M. Rosenzweig Managing Editor, Sidley Austin LLP Sutherland Asbill & Brennan Katten Muchin Rosenman Katten Muchin Rosenman 787 Seventh Ave., New York, NY 10019 Washington, D.C. New York, NY Chicago, IL Phone: (212) 839-5503 Fax: (212) 839-5599 Susan C. Ervin Charles R. Mills Thomas A. Russo E-mail: [email protected] Dechert LLP K&L Gates, LLP New York, NY Washington, D.C. Washington, D.C. PAUL ARCHITZEL Howard Schneider Alston & Bird Ronald H. Filler David S. Mitchell MF Global Washington, D.C. New York Law School Fried, Frank, Harris, Shriver & Jacobson LLP New York, NY New York, NY Geoffrey Aronow Edward H. Fleischman Stephen F. Selig Bingham McCutchen LLP Linklaters Richard E. Nathan Brown Raysman Millstein Felder & Steiner LLP Washington, D.C. New York, NY Los Angeles New York, NY Conrad G. Bahlke Denis M. Forster Paul J. Pantano Paul Uhlenhop OTC Derivatives Editor New York, NY McDermott Will and Emery Lawrence, Kamin, Saunders & Uhlenhop Washington, D.C. Chicago, IL Weil, Gotshal & Manges Thomas Lee Hazen New York, NY University of North Carolina at Chapel Hill Frank Partnoy Emily M. Zeigler University of San Diego Willkie Farr & Gallagher School of Law New York, NY

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Regulation 1.25, which provides that an FCM addressed in prior U.K. cases involves what pro- may invest customer property in only certain per- tections, if any, do U.K. customers receive in the missible investments.5 Industry practices hold the event their investment firm does not properly FCM liable for any losses that may result from hold their property in compliance with Chapter 7 such investments. of the Client Asset Sourcebook rules, commonly Equally as important, upon deposit in a pro- referred to as CASS 7.11 In LBIE’s case, not all of tected customer segregated account, customer the customer funds were properly forwarded to funds must remain in such protected accounts the CASS 7 protected account. Therefore, the key until returned back to the customer. This concept issue before the UK Supreme Court was whether of customer segregation, in essence, forms a pro- client money funds that were not deposited in the tective ring around the customer assets held by an CASS 7 account by LBIE should receive the same FCM at a custodian bank and protects the cus- customer asset protection that LBIE’s customers tomer assets from being held subject to the claims received whose client money funds were actu- of the FCM’s creditors. Applicable CFTC regula- ally deposited in the CASS 7 segregated account. tions provide an important protective barrier and This same issue arises with the insolvency of MF require each FCM to maintain customer assets Global UK Limited (“MF Global UK”), the UK in accordance with these regulations. Therefore, affiliate of MF Global Inc., as most of the funds once a customer trades futures (and now cleared transferred to MF Global UK were not held in its swaps), its FCM must transfer funds held in the CASS 7 account.12 customer segregated account in the name of the FCM to another segregated account held at an- Background of LBIE Casesfrom MF other custodian bank in the name of the derivatives clearing organization (“DCO”).6 Customer Global Inc. funds held by a DCO must also comply with these Lehman Brothers Inc. (“LBI”), the U.S. regis- same applicable CFTC regulations. Similarly, if a tered broker-dealer and futures commission mer- U.S. customer wants to trade futures on a non- chant, had opened a customer omnibus account U.S. futures exchange, the funds used to margin on the books of LBIE to permit LBI’s futures the non-U.S. futures positions must be held in an- customers to trade on the various European ex- other protected account, called a secured amount changes. LBIE itself had several direct client con- account under CFTC Regulation 30.7.7 Thus, at tractual arrangements. Moreover, LBIE either was all times, customer funds used to margin futures a direct general clearing member firm (“GCM”) contracts are held in these protective accounts, on certain European clearing houses, such as solely for the benefit of the customers.8 EUREX Clearing AG or LCH Clearnet SA, or In the U.K., investment firms are similarly required to maintain client property in a “client had established its own customer omnibus clear- money” account pursuant to the UK’s Financial ing accounts with other third party clearing firms Services Authority (“FSA”) Rules.9 Unlike the acting as a GCM on other European exchanges. U.S., where customers directly deposit their ini- Similarly, LBIE opened a customer omnibus ac- tial margin amounts into the FCM’s customer count with LBI to allow its own direct customers 13 segregated account, in the U.K., investment firms to trade on U.S. exchanges. typically use an alternative approach in which In two judgments handed down on December customer property are first directly sent to the 15, 2009 and on January 10, 2010, Justice Briggs house account of the U.K. investment firm which of the High Court held that LBIE’s customers, then deposits the client money in the client money with client money not segregated in accordance fund account.10 The investment firm must identify with the CASS 7 rules at the time of administra- customer assets held in the firm’s house account, tion (e.g., on September 15, 2008), had no claim must reconcile the funds and then segregate the against the client money pool (“CMP”) and thus client monies. The one main issue that has been would be treated as unsecured customers. This

ruling was similar to the decision issued in the 3. Whether a client’s right to participate in distri- Global Trader case noted above. butions from the client money pool (“CMP”) On August 2, 2010, the UK Court of Appeals is only available to clients whose funds were reversed the High Court decisions and held that actually placed in the CASS 7 account (e.g., client money property should be treated equita- Segregated Customers) or also available to bly, whether the client monies were actually held customers whose funds were not so placed in accordance with the CASS 7 rules or not. The (e.g., Unsegregated Customers)? UK Court of Appeals, in essence held: Both Justice Briggs of the High Court and the 1. The statutory trust over client money takes UK Court of Appeals held that, as to the first issue effect immediately upon receipt of the client above, the statutory trust of client money occurs monies by the UK investment firm. upon its receipt, and not whether the client funds are deposited in the segregated CASS 7 account. 2. CASS 7 requires client money pooling of all The UK Supreme Court was unanimous on this identifiable customer property wherever it first issue and agreed with Justice Briggs and the may be found, and not just the amount of cli- UK Court of Appeals. CASS 7.7.2R states that “a ent money actually held in the protected cli- firm receives and holds client money as trustee.” ent money account. The UK Supreme Court stated that these words clearly mean that the trust over client money aris- 3. All clients have a contractual right to partici- es when that client money is received by the firm. pate in distributions from the CMP, not just When an investment firm, such as LBIE, utilizes those customers whose property happened to the alternative approach noted above, then there be properly segregated. must be a presumption that customer funds held This decision was appealed to the UK Supreme in the firm’s house account must be client monies Court. The UK Supreme Court decision affirmed and thus are entitled to be deemed property held the UK Court of Appeals ruling. in trust.14 On this first issue, Lord Walker stated: The U.K. Supreme Court Judgment “Where money is received from a client, on LBIE or from a third party on behalf of a client, The CASS 7 rules thus require investment firms, it would be unnatural, and contrary to the such as LBIE, to segregate client money received primary purpose of client protection, for the money to cease to be the client’s prop- from clients. These rules create, in essence, a stat- erty on receipt, and for it (or its utory trust over client funds and provide impor- substitute) to become property again on tant priority treatment over such client funds held segregation.”15 in trust. The UK Supreme Court decision was based on three key issues, namely: He then stated: 1. Whether the statutory trust created by the “The absence of express restrictions, un- CASS 7 rules arise when the money is actu- der the alternative approach, on use of cli- ally placed in the CASS 7 account or as soon ents’ money while held in a house account as the firm receives the client funds? does not mean that the firm is free to use it for its own purposes.”16 2. Do the primary FSA client money pooling (“CMP”) arrangements apply to client mon- He then concluded: ey held in house accounts (e.g., not placed in the segregated account) or only to client mon- “To allow a limited defect of the alterna- ey held in the segregated CASS 7 accounts? tive approach to dictate the interpretation

of the essential provisions of Section 7.2 scheme (as required by the Directives) is would be to let the tail wag the dog.”17 to provide a high level of protection to all clients and in respect of client money held The other two questions noted above received in each money account of the firm.”21 the greatest attention and debate. As to the second issue, Justice Briggs in the High Court held As to the third issue, Justice Briggs held that that the CMP shall only apply to funds actually only client money held in the CMP, that is, client held in the segregated client accounts whereas the money actually segregated, should participate in Court of Appeals held that the CMP applies to any distributions from the CMP. The UK Court all identifiable client money, wherever held, and of Appeals held that all clients with a contractual thus should be pooled. The UK Supreme Court entitlement to CMP are entitled to such distri- confirmed the UK Court of Appeals ruling. It butions, regardless of whether their client funds stated that the pooling requirements apply to all were actually segregated. client money, even identifiable client assets held in The majority of the Supreme Court (Lords a house account and not deposited in the CASS7 Clarke, Dyson and Collins) agreed with the UK account. In essence, the UK Supreme Court held Court of Appeals on Issue #3. Lords Hope and that the true purpose of the CASS 7 protective Walker issued very strong dissenting judgments scheme was to provide a high level of protection and held that the findings of Justice Briggs should for all clients, including client funds held in the prevail on this third issue. house account (e.g., the unsegregated account).18 The views of the majority appear to apply a Lord Dyson stated: theory of equitable fairness, that is, that all clients should be treated equitably. The majority clearly “The phrase ‘client money account of the believed that the CASS 7 rules were intended to firm’ is not defined. As a matter of ordinary protect and provide a safeguard for all clients, language, the phrase ‘client money ac- regardless of whether LBIE treated their assets count’ is capable of meaning (i) an account properly. In essence, clients have a contractual en- which contains or is intended to contain titlement to client money protection. The major- exclusively client money or (ii) an account ity held that the term “each client” in the CASS 7 of the firm which contains client money. rules must refer to each and every client for whom Even when a firm is fully compliant, CASS client money is identified, and that any and all 7 contemplates that client money will be funds remain fiduciary in character until all of the held in the firm’s own account.”19 obligations arising from the fiduciary relationship are discharged.22 Lord Dyson then confirms his position and states that the Lord Walker, on the other hand, took a more correct interpretation of the phrase “each client money practical business approach. In his strong dissent, account of the firm” is “the one which best promotes the purpose of CASS 7 as a whole.”20 He then states: Lord Walker fully agreed with Justice Briggs. As to issue #3, relating to the basis of sharing the CMP, “To exclude identifiable client money he acknowledged that Justice Briggs approached in house accounts from the distribution that issue as “a contest between what he called the regime runs counter to this policy. It cre- contributions theory and the claims theory.”23 In ates what was referred to in argument other words, do the protections provided by the as a ‘bifurcated’ scheme which provides CASS 7 rules refer to contractual or proprietary clients with different levels of protection, entitlement. He agreed that the contributions the- namely a right to claim in the CMP under ory should apply. the CASS 7 rules for those whose money Lord Walker then reasoned regarding the is held in segregated client accounts but court’s responsibility:: no right (other than a right to trace in equity) to those whose money is held in the “The court has to give directions to the firm’s house accounts. The purpose of the administrators on the basis of the as-

sumed facts set out in the SAF. Those as- gated basis, and had made other claims for other sumed facts are stated for the most part amounts owed back to the U.S. SIPA Trustee for at a high level of generality, and with an the benefit of MF Global Inc.27 The Administrator almost clinical detachment from what the further stated that none of the amounts sought by judge referred to as LBIE’s ‘shocking un- the U.S. SIPA Trustee had been held by MF Glob- derperformance’. We simply do not know al UK in a segregated account in accordance with how it came about that so much clients’ the CASS 7 rules as of the date of the appoint- money was paid into house accounts when ment of the Administrator.28 If the LBIE decision 24 it should have been segregated.” had reversed the decision issued by the UK Court of Appeals and ruled in favor of Justice Briggs, as Lord Walker goes on to state: the two dissenting justices concluded, then prob- “Moreover client money held temporar- ably none of these amounts being sought by the ily in a house account does not, in the U.S. SIPA Trustee would be returned back to the eyes of trust law, ‘swill around’ but sinks U.S. Now, in light of the UK Supreme Court hold- to the bottom in the sense that when the ing, it would appear that all of these amounts will firm is using money for its own purpose it be grouped with those client funds actually held is treated as withdrawing its own money in accordance with the CASS 7 rules by MF Glob- from a mixed fund before it touches trust al UK, and thus receive a pro rata distribution of money.”25 the total client funds held by MF Global UK. The big issue now is how much of these assets will In summary, the UK Supreme Court decision now be returned back to the U.S. and when. on LBIE expands the CMP, which affords priority treatment to customer funds, to include client Conclusion money that LBIE should have, but failed to, prop- The UK Supreme Court judgment now requires erly segregate as CASS 7 funds. This landmark the Administrator to go back to the drawing decision will have a major impact on new cases, board to determine the amounts to be distributed in particular the recent MF Global UK insolvency, to all LBIE clients. This could take several months, and may even result in new legislative and regula- and maybe even more litigation, to determine the tory reforms. As just decided, mis-directed cus- accounting required and the pro rata customer tomer funds by a UK investment firm can and distributions to the entire LBIE client base. LBIE will be returned, and included with well-directed filed for bankruptcy on September 15, 2008. customer funds in determining the pro rata dis- Certain LBIE creditors were anticipating receiv- tribution. In other words, trust law prevails over ing their funds back even 3+ years later. Now, the location. timing for such distributions is not known. Lord MF Global’s Bankruptcy Walker even acknowledged that the distributions of client money by the LBIE Administrator would MF Global Inc., which was registered as both take a very long time. The amount of any such a broker-dealer and as a futures commission mer- distribution to the Segregated Customers will chant, filed for bankruptcy on Monday, October likewise be diluted. Query, how long may it be be- 31, 2011.26 Similarly, a liquidation proceeding fore any client funds are returned back to custom- was initiated in the U.K. on behalf of MF Global ers of MF Global UK, including assets transferred UK on the same day. KMPG LLP was appointed by MF Global Inc. to MF Global UK during those as the Administrator for MF Global UK. In its re- last days in October or will those funds be held port, dated February 3, 2012, the Administrator indefinitely before any distribution may occur. A stated that the U.S. SIPA Trustee appointed for new special administration procedure for invest- MF Global Inc. has made a claim for an aggregate ment firms was created by FSA regulations issued amount of $742,151,834, which the U.S. SIPA on February 8, 2011, to expedite distributions in Trustee claimed should have been held on a segre- new insolvency matters.29 These new procedures

should apply to MF Global UK and should thus Taxation and Regulation of Financial Institutions help to further expedite the distribution of client (May/June 2011). funds. However, in light of the new UK Supreme 4 An interesting comparison involves the recent bankruptcies of Lehman Brothers Inc. Court judgment on LBIE, the FSA and the UK in september 2008, which left no shortfall Parliament may now need to assess whether new in the customer segregated fund account, legislative or regulatory changes are still needed and that of mF Global Inc. in october 2011, to provide certain and prompt distributions of which apparently has resulted in a shortfall in client funds after an investment firm fails. These customer funds, estimated to be approximately changes, in my opinion, are drastically needed in $1.6 billion. order to maintain and further enhance London as 5 17 C.F.R. 1.25. Please note that the CFTC has recently adopted changes to CFTC Rule 1.25 a great financial center in today’s global market. which further restrict the types and usage of Copyright RONALD H. FILLER permissible investments and the amount of investment in such permissible investments. NOTES 6 A DCO is commonly referred to as a “clearing 1 Ronald Filler is a Professor of Law and the house” or “central counterparty” (“CCP”). Director of the Center on Financial Services Law 7 17 C.F. R. 30.7 at new York Law school (“NYLS”). he is also 8 CFTC Regulation 1.20 also requires an FCM to the Program Director of the LLM in Financial receive an acknowledgement letter from the Services Law Graduate Program at NYLS which custodian bank or other depository that may offers more than 40 courses involving various hold futures customer assets which confirms aspects of the global financial services industry, that the custodian bank or depository may not including several courses on derivatives law and apply any of the assets held in the protected customer account to satisfy any obligations products. Go to www.nyls.edu/financellm to owed by the FCM to the custodian bank. learn more about this very unique LLM program. 9 See section 139 of the Financial services and Before joining the NYLS faculty in 2008, he was Markets Act of 2000. The U.K. client money rules a managing Director in the Capital markets are reflected in Chapter 7 of the Client Assets Prime Services Division at Lehman Brothers Inc. Sourcebook (“CASS 7”), and are commonly in its new York headquarters. Prof. Filler also referred to as the CASS7 rules. acts as a senior Consultant for Allen & overy, 10 Note that, under FSA rules, a customer may “opt a major international law firm. You can reach out” of the protections provided by the client Prof. Filler via email at: [email protected] money fund rules. When a customer makes such 2 In the matter of Lehman Brothers International an election, then, in theory, it is not entitled to (Europe) (In Administration) and In the matter of any such client money protections. the Insolvency Act 1986, Hilary Term, 2012 UKSC 11 See In the matter of Global Trader Europe 6 (February 29, 2102). (hereinafter referred to Limited (in liquidation) (2009), EWCH 602 (Ch). as the “Judgment”). A copy of the Judgment is 12 According to a recent Report of the uK available at: http://www.supremecourt.gov.uk/ Administrator for MF Global UK, approximately docs/UKSC_2010_0194_Judgment.pdf $742 million transferred by MF Global Inc., the 3 See Are Customer Funds Segregated/Secured U.S. FCM, were not deposited in the CASS7 Amount Funds Properly Protected after account opened by MF Global UK. Lehman?, Journal on the Law of Investment 13 For a more detailed explanation of what took & Risk management Products, The Futures place during the week of september 15-19, & Derivatives Law Report (November 2008); 2008, please read the articles published by this Ask the Professor—What is Margin and How author as listed in Note iii, supra. Is It (Or Should be) Determined?, Journal on 14 See “eAlert of Allen & overy, entitled “The the Investment & Risk management Products, client money lottery: you don’t have to be in it The Futures & Derivatives Law Report (March to win it”, 29 February 2012. 2009); and Consumer protection: How U.K. 15 See Paragraph 63 of the Judgment. Client Money Rules Differ From U.S. Customer 16 Ibid. Segregated Rules When a Custodian Firm Fails 17 Ibid. to Treat Customer Funds Properly, Journal of 18 See Paragraph 165 of the Judgment.

19 See Paragraph 162 of the Judgment. 20 See Paragraph 164 of the Judgment. 21 See Paragraph 165 of the Judgment. 22 See Paragraph 16 of the Judgment. 23 See Paragraph 68 of the Judgment. 24 See Paragraph 81 of the Judgment. 25 See Paragraph 65 of the Judgment. 26 See article written by this author on “Ask the Professor: ‘OMG. What did MF Global Do?’ “, Futures and Derivatives Law Report (November 2011 Issue, Vol. 31, No. 10). 27 See Paragraph 42 of the “Report for the Hearing on 3 February 2012” issued In the Matter of MF Global UK Limited (No. 9527 of 2011) filed with the High Court of Justice, Chancery Division of the Companies Court (hereafter referred to as the “UK Administrator’s Report”). 28 See Paragraph 44 of the uK Administrator’s Report. 29 These special administration proceedings apply to any investment firm, as defined in section 232 of the Banking Act 2009 which have permission under Part 4 of the Financial services and markets Act 2000 to carry on certain customer business

8 © 2012 Thomson Reuters REPRINT ARTICLE The Journal on the Law of Investment & Risk Management Products Futures & Derivatives LawREPORT futures assets are now subject to the pro the to subject now are assetsfutures specificallythat provides Dodd-FrankAct the of particular,983 SectionIn purpose. allowtoportfolio margining achieveto its needed were that laws bankruptcy the to July 21, 2010, made on important corrections Obama President by law into signed tion Act (“SIPA”).Act tion Protec Investor Securities the of visions over the past developed several years. has margining portfolio how to back look let’s be, might regulations provisions. customeraddresssegregationthewillthat regulations new promulgate must CFTC the thatprovidesfurther Dodd-FrankAct r P y B Impact its Utilization? How Will Dodd-Frank Portfolio Margining– Ask the Professor: properly determine its true impact. regulatorylandscapewill the as detailthe in is devil with thelegislative change,new any as However, lot”. a “by is: above sumer Protection Act CFTC Regulation 1.20. thatsecurities futuresheldamaybein ac provides specifically Act Dodd-Frank of omdt Ecag At (“CEA”) Act ExchangeCommodity segregationprovisions ofSection 4dof the customerthesubject to be thus and count Beforethesenewspeculatingwhat to as h Dd-rn Wl Sre ad Con and Street Wall Dodd-Frank The questionraisedthe toanswer shortThe o f e s s o r 3 Similarly,713 Section A N O r 2 (“Dodd-Frank Act”) 5 Section 713 of the l d

I f l l e 4 r and 1 - - - - CONTINUED ONPAGE 3 Background eurd nta mri rqieet for requirements margin initial required the establishes agency, government any held bythebroker-dealer. account securities its from collateral or buys customer cash withdraws or short stock sells stock, a when occur may lending that margin of amount the governs securities transactions. other and stock to relating requirements margin the establishes T”), (“Reg. T tion Regula- its to pursuant System, Reserve tomer’s securities account. securities tomer’s of any non-cash collateral held in the cus- value of the account into taking 50% value, such than more on based credit ing extend- from or purchased securities the more than 50% of the underlying value of lending from broker-dealer a prohibits T hs ulcto pes vst www.west. thomson.com visit about please publication information this more For Reuters. Law Report. Copyright © 2010 Thomson Reprinted from the Futures & Derivatives n uue, h ecags rte than rather exchanges, the futures, In The Board of Governors of the Federal the of Governors of Board The Article November 2010

REPRINT 6 In particular, Reg. n Volume 30 7 Thus, Reg. T Reg. Thus, n Issue10 November 2010 n Volume 30 n Issue 10 Futures & Derivatives Law Report

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Editorial Board Stephen W. Seemer Rhett Campbell Donald L. Horwitz Glen A. Rae Publisher, West Legal Ed Center Thompson & Knight LLP One Chicago Banc of America Securities LLC Houston, TX Chicago, IL New York, NY JANNA M. PULVER Publication Editor, Thomson Reuters/West ANDREA M. CORCORAN Philip McBride Johnson Kenneth M. Raisler Align International, LLC Skadden Arps Slate Meagher & Flom Sullivan & Cromwell Richard A. Miller Washington, D.C. Washington, D.C. New York, NY Editor-in-Chief, Prudential Financial Two Gateway Center, 5th Floor, Newark, NJ 07102 W. Iain Cullen Dennis Klejna Richard A. Rosen Phone: 973-802-5901 Fax: 973-367-5135 Simmons & Simmons MF Global Paul, Weiss, Rifkind, Wharton & Garrison LLP E-mail: [email protected] London, England New York, NY New York, NY Michael S. Sackheim Warren N. Davis Robert M. McLaughlin Kenneth M. Rosenzweig Managing Editor, Sidley Austin LLP Sutherland Asbill & Brennan Katten Muchin Rosenman Katten Muchin Rosenman 787 Seventh Ave., New York, NY 10019 Washington, D.C. New York, NY Chicago, IL Phone: (212) 839-5503 Fax: (212) 839-5599 Susan C. Ervin Charles R. Mills Thomas A. Russo E-mail: [email protected] Dechert LLP Kirkpatrick & Lockhart New York, NY Washington, D.C. Washington, D.C. PAUL ARCHITZEL Howard Schneider Alston & Bird Ronald H. Filler David S. Mitchell MF Global Washington, D.C. New York Law School Fried, Frank, Harris, Shriver & Jacobson LLP New York, NY New York, NY Geoffrey Aronow Edward H. Fleischman Stephen F. Selig Bingham McCutchen LLP Linklaters Richard E. Nathan Brown Raysman Millstein Felder & Steiner LLP Washington, D.C. New York, NY Los Angeles New York, NY Conrad G. Bahlke Denis M. Forster Paul J. Pantano Paul Uhlenhop OTC Derivatives Editor New York, NY McDermott Will and Emery Lawrence, Kamin, Saunders & Uhlenhop Washington, D.C. Chicago, IL Weil, Gotshal & Manges Thomas Lee Hazen New York, NY University of North Carolina at Chapel Hill Frank Partnoy Emily M. Zeigler University of San Diego Willkie Farr & Gallagher School of Law New York, NY

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each respective futures contract traded on that Portfolio Margining Today exchange. Unlike stock margin, which is related to the value of the securities purchased, initial NYSE Rule 431 specifically states that a mem- futures margin is determined based on histori- ber firm may aggregate various products, includ- cal risk parameters, known commonly as SPAN, ing stocks, stock options, securities swaps and which applies, in essence, a two standard devia- stock index futures in determining the applicable tion, one day analytical risk model. Futures mar- risk margin requirements.13 Remember, NYSE gin, which generally looks at recent historical fu- Rule 431 was approved by the SEC. However, tures price changes over the past 60 or 90 days, is since broad-based stock index futures, such as 14 designed to provide the minimum amount needed the CME’s S&P 500 Stock Index Contract, are such that a one-day trading loss would not nor- subject to the exclusive jurisdiction of the Com- mally exceed the amount of the initial margin re- modity Futures Trading Commission (“CFTC”), quirement for that futures contract. pursuant to Section 2(c) of the CEA, portfolio These differences, between securities and fu- margining, to date, has not achieved its ultimate tures, reflect some of the major hurdles that have goal. Before the Dodd-Frank Act made changes faced portfolio margining and its effectiveness to relating to portfolio margining, as described in date. more detail below, the CFTC took the position and, rightfully so, that customer futures margin Introduction to Portfolio Margining8 must be held in a customer segregated account in accordance with Section 4d of the CEA and As noted above, Reg. T establishes the amount CFTC Rule 1.20.15 Thus, before the Dodd-Frank that can be financed by a broker-dealer in con- Act, any customer, such as a long-short hedge nection with stock purchases. Reg. T also permits fund, that traded a variety of equity products a securities self-regulatory organization (“SRO”), and related stock index futures contracts, had such as a securities exchange, to adopt rules gov- to maintain two accounts with its broker-dealer/ erning the amount that must be maintained for FCM, one for its stock transactions, in compli- open securities positions held by the broker-deal- ance with Reg. T, and one for its futures transac- er on behalf of its customers.9 Thus, New York tions in compliance with the CEA. This so-called Stock Exchange Rule 431 provides that a NYSE “two-pot” approach prevented the full effective- member firm must collect additional margin from ness of a portfolio margining scheme. a customer whenever the value in the customer’s For example, let’s assume that ABC Hedge account falls below a specified level (e.g., 25% for Fund traded a basket of large cap stocks that long positions, 30% for short positions). were highly correlated to the S&P 500 Index, and In 1998, Reg. T was amended to permit, for the shorted an appropriate amount of S&P 500 Stock first time, an exchanged-approved portfolio mar- Index futures contracts to be effectively hedged. gining regime to allow broker-dealers to compute With respect to its margin requirements, if ABC the initial and maintenance margin requirements Hedge Fund bought the underlying stocks on in a different way.10 Specifically, this change per- margin, it would be required to pay the appropri- mits margin requirements to be determined on a ate margin amount, as required by Reg. T in its risk-based model, more similar to futures, and securities account at the broker-dealer, and would required that any such exchange risk analytical be required to post the appropriate amount of ini- model be approved by the Securities and Ex- tial futures margin requirements, as required by change Commission (“SEC”).11 the CME, in its futures account held at the FCM, NYSE Rule 431 was then amended to initiate even though, from a risk-based analytical model, this portfolio margining concept for its member there would be very little, if any, risk to the un- firms. It first sought approval from the SEC in derlying accounts, given the high correlation of 2002, which was initiated in July 2005 under a the stocks to the respective index futures position. two-year pilot program.12 This two-pot approach has thus raised serious is-

sues as both accounts must be properly margined merchant pursuant to section 4f(a)(1) of the under different regulatory schemes. For example, Commodity Exchange Act, in a portfolio mar- if the equity positions made $1,000 and the fu- gining account as a futures account subject to tures account, being highly correlated, would thus section 4d of the Commodity Exchange Act and lose $1,000 that same day, the increased amount the rules and regulations promulgated thereun- of $1,000 in the securities account must be moved der, pursuant to a portfolio margining program to the futures account to cover the variation loss approved by the Commodity Futures Trading in that account. For portfolio margining to be Commission …” successful as a proper risk-based model, the un- Section 983(a) of the Dodd-Frank Act states: derlying products must be held in one pot. “Section 9(a)(1) of the Securities Investor Protec- Dodd-Frank Act tion Act of 1970 (15 U.S.C. 78fff3(a)(1)) is amend- The new law provides some important changes ed by inserting “or options on commodity futures contracts” after “claim for securities”. that will ultimately enhance the use and effectiveness of a portfolio margin system. In particular, Section 983(b)(1) of the Dodd-Frank Act amended the Dodd-Frank Act amends the 1934 Act and the definition of an “included person” for purposes the CEA to authorize joint broker-dealers/futures of SIPA. The term ‘customer’ for purposes of Sec- commission merchants to hold securities that are tion 9(a) of SIPA now includes “any person who part of a portfolio margining program in a futures has a claim against the debtor for cash, securities, account. Securities products held in a futures ac- futures contracts or options on futures contracts count will be treated as futures contracts for pur- …”. Debtor for this section of the Dodd-Frank Act poses of the U.S. Bankruptcy Code. The CEA means a broker-dealer. and applicable CFTC regulations have always al- Thus, the stage has been set to implement more lowed securities to be held in a futures account. fully an effective portfolio margining system. In fact, most U.S. futures exchanges and DCOs However, the exact impact of these legislative accept listed equities as satisfying most initial changes rests with new CFTC and SEC regula- margin requirements. The key legislative change tions which will prescribe the requisite require- is that futures contracts can now be held in a se- ments to be imposed on a joint BD/FCM which curities account. While, as noted above, NYSE wants to provide portfolio margining to its key Rule 431(g) included stock index futures as an customers. acceptable product to be included in determining the applicable risks of such an account, the CFTC Its True Impact has never accepted this position, arguing that Sec- tion 4d of the CEA and CFTC Rule 1.20 requires While the Dodd-Frank Act has provided the necessary tools to enhance the effectiveness of futures customer assets to be held in a customer portfolio margining, with the to-be-adopted segregated account which does not include a se- regulations providing important guidelines, a curities account. portfolio margining scheme will not necessarily Section 713(C) of the Dodd-Frank Act states: achieve its ultimate purpose of applying a true “Notwithstanding any provision of sections risk-based portfolio analysis until the clearing 2(a)(1(C)(i) or 4d(a)2) of the Commodity Ex- houses accept a reduced margin amount when change Act and the rules and regulations pro- only part, but not all, of the products comprising mulgated thereunder, and pursuant to an the portfolio, are cleared by that DCO. Let’s take exemption granted by the Commission under the following example: section 36 of this title or pursuant to a rule or ABC Hedge Fund has a large growth stock regulation, cash and securities may be held by a portfolio that is highly correlated to the S&P 500 broker-dealer registered pursuant to section (b) Stock Index Contract traded on the CME. From (1) and also registered as a futures commission a pure risk-based perspective, if ABC bought the

stock portfolio on margin via a stock lending relating to financial firms. For more information program at its prime broker, it is still required on this LLM program, go to: www.nyls.edu/ to post the full amount of the initial margin re- financellm. Also, for a great new website that quired by the CME Clearing House with respect offers direct links to several governmental agencies and other important resources, all on to the S&P 500 futures contracts held in its ac- one page, go to: www.finlawupdates.org count at the FCM. © Ronald H. Filler. Reprinted with permission. Thus, while the overall margin required by NYSE Rule 431 would be significantly reduced, 2 Pub L 111-203, HR 4173 (111th Congress, 2010). cash or acceptable non-cash collateral must still 3 since its enactment in 1975, futures contracts be deposited with the CME Clearing House. It and assets used to margin futures contracts is thus critical to the success of portfolio margin- were specifically excluded fromS IPA’s provisions. ing that U.S. clearing houses establish a means of Accordingly, any customer trading both equities margining that recognizes the offsetting risks and and futures were required to maintain two separate and distinct accounts, commonly permits a reduced amount of the initial margin referred to as the “two-pot approach”, one for to be posted. This may require that the clearing securities transactions and one for futures. house establish a lien on the stock portfolio held 4 7 U.S.C §6d. by the joint BD/FCM or require the joint BD/FCM 5 17 C.F.R. §1.20. to open an account with the clearing house so it 6 see 12 C.F.R. §220. has a direct security interest in the stock portfolio, 7 Ibid. but until such an approach is adopted, portfolio 8 The SEC defines a “portfolio margining system” margining will not achieve its ultimate risk-based as: “Portfolio margining establishes margin levels margin goal. by assessing the market risk of a ‘portfolio’ of Also, keep in mind that the Dodd-Frank Act positions in securities or commodities. Under only applies to a joint BD/FCM. If a firm, such a portfolio margining system, the amount of as a bank, has separate affiliates registered as required margin is determined by analyzing a BD and as a FCM, then that bank may be the risk of each component position in a placed at a competitive disadvantage versus customer account …” See Exchange Act investments banks which have registered joint Release No,. 34-46292 (July 31, 2002). BD/FCMs. A legislative fix may be needed to 9 Supra, Note v. 10 Ibid. correct this situation. 11 Ibid. 12 cite. NOTES 13 nYSE Rule 431(b)(1) requires that a customer 1 Ronald Filler is a Professor of Law, the Director deposit “initial margin” greater to the amount of the Center on Financial Services Law and the specified in Regulation T of the Federal Reserve Program Director of the LLM in Financial Services System or Rules 400 through 406 of the Securities Law at New York Law School. Before joining the Exchange Act of 1934 or Rules 41.42 through NYLS faculty in June 2008, he was a Managing 41.48 of the Commodity Exchange Act, or (2) the Director in the Capital Markets Prime Services amount specified inN YSE Rule 431(c), which is the Division at Lehman Brothers.This unique LLM maintenance margin amounts. NYSE Rule 431(f) program offers more than 40 courses involving (10) defines the margin requirements relating all aspects of the global financial services to security futures. NYSE Rule 431(g), the NYSE industry, including five courses on derivatives Portfolio Margining Rule, applies to all margin law and products, four courses on hedge funds for equity securities, listed options, unlisted and private equity, four courses on banking derivatives and securities futures products. NYSE issues, three courses involving litigation matters, Rule 431(g) then goes on to state: two courses on clearing issues and courses on “In addition, a member organization, such topics as AML; Global Compliance Issues; provided it is a Futures Commission Merchant Insolvency Issues: EU Regulation; Executive (“FCM”) and is a clearing member of a futures Compensation Issues; Audits and Examinations; clearing organization, or has an affiliate that Prime Brokerage, and many other great topics is a clearing member of a futures clearing

organization, is permitted under section (g) index futures covering the same underlying to combine an eligible participant’s “related instruments” instruments’ as defined in section (g)(2)(E) 14 Go to CME web site for the contract specifications with listed index options on exchange traded for this futures contract. http://www.cme. funds (ETF), index warrants and underlying com/trading/equity-index/us-index/sandp- instruments.” (emphasis added) 500-citigroup-growth_contract_specifications. section 431(g)(2)(E) defines the term html#prodType=undefined “related instruments” to mean “broad-based 15 Supra, Note iv.

6 © 2010 Thomson Reuters REPRINT ARTICLE The Journal on the Law of Investment & Risk Management Products Futures & Derivatives LawREPORT committees, andisamemberoftheBoardEditorsFDLR. man Brothers Inc., has served on several DCO, governmental, exchange and industry boards and advisory Leh- at Division Services Prime Markets Capital the in Director Managing a formerly was He School. Law Ronald H. Filler is a Professor of Law and the Director of the Center for Financial Services Law at New York By: Rona ld H.Filler Protected After Amount FundsProperly Segregated/Secured Are Customer 30.7 Regulation CFTC in States United the side especially in connection with assets held out- vide greater customer protection safeguards, and policies now in place are needed to pro- procedures the to changes major but States a customer segregated account in the United in held assets customer to respect with part and clearing houses. Some clearing houses, houses, clearing Some houses. clearing and exchanges global various the by differently interpreted all were bankruptcy FCM’s an of event the in applied be to rules the were believed all we October.What of most and the period of the last two weeks in through September slept have must they then lenging, chal- and mysterious not is markets futures secured amount funds play in today’s global and segregated that role the that believe not do who those for And horror. and themes story even if it’s filled with mystery suspense, exciting different a however, is, This tery. themys- solve and clues final the provide to chapter last the of pages few last the til trading onnon-U.S.futuresexchanges. The short answer is “yes” for the most most the for “yes” is answer short The Most mystery authors normally wait un- wait normally authors mystery Most 1 secured amount accounts, regarding regarding accounts, amount secured CONTINUED ONPAGE 3 global approach. product base,anyfuturesolutionmustbea and customer their in global truly are day to- consider.firms now brokerage should the Since industry global this that practices best of recommendations several then and provide 11 protection Chapter for filed (“LBI”), Inc. Brothers Lehman of company parent the Inc., Holdings Brothers Lehman after occurred what explain then accounts, of customer segregated and secured amount role the be to understand industry futures the in us of many what explain will article et neet o ftrs customers. futures of interests best the in necessarily not was that manner a in acted others while professionally and rably and The Clearing Corporation, acted admi- SA, the CME Clearing House, ICE Clearnet Clear US LCH AG, Clearing EUREX like thomson.com www.west. visit please publication this Reuters/West. For more information about Law Report. Copyright © 2008 Thomson Reprinted from the Futures & Derivatives Article November 2008 Lehman

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Editorial Board Rhett Campbell Donald L. Horwitz Glen A. Rae Thompson & Knight LLP One Chicago Banc of America Securities LLC Stephen W. Seemer Houston, TX Chicago, IL New York, NY Publisher, Thomson/Legalworks ANDREA M. CORCORAN Philip McBride Johnson Kenneth M. Raisler Carrie A. Petersen Promontory Financial Group Skadden Arps Slate Meagher & Flom Sullivan & Cromwell Publication Editor, Thomson/West Washington, D.C. Washington, D.C. New York, NY Richard A. Miller W. Iain Cullen Dennis Klejna Richard A. Rosen Editor-in-Chief, Prudential Financial st Simmons & Simmons MF Global Paul, Weiss, Rifkind, Wharton & Garrison LLP 751 Broad Street, 21 Floor, Newark, NJ 07102 London, England New York, NY New York, NY Phone: (973) 802-5901 Fax: (973) 802-2393 E-mail: [email protected] Warren N. Davis Robert M. McLaughlin Kenneth M. Rosenzweig Sutherland Asbill & Brennan Katten Muchin Rosenman Katten Muchin Rosenman Michael S. Sackheim Washington, D.C. New York, NY Chicago, IL Managing Editor, Sidley Austin LLP 787 Seventh Ave., New York, NY 10019 Susan C. Ervin Charles R. Mills Thomas A. Russo Phone: (212) 839-5503 Dechert LLP Kirkpatrick & Lockhart Lehman Brothers Fax: (212) 839-5599 Washington, D.C. Washington, D.C. New York, NY E-mail: [email protected] Ronald H. Filler David S. Mitchell Howard Schneider PAUL ARCHITZEL Lehman Brothers Fried, Frank, Harris, Shriver & Jacobson LLP MF Global Alston & Bird New York, NY New York, NY New York, NY Washington, D.C. Edward H. Fleischman Richard E. Nathan Stephen F. Selig Geoffrey Aronow Linklaters Los Angeles Brown Raysman Millstein Felder & Steiner LLP Heller Ehrman LLP New York, NY New York, NY Washington, D.C. Paul J. Pantano Denis M. Forster McDermott Will and Emery Paul Uhlenhop Conrad G. Bahlke New York, NY Washington, D.C. Lawrence, Kamin, Saunders & Uhlenhop OTC Derivatives Editor Chicago, IL Weil, Gotshal & Manges Thomas Lee Hazen Frank Partnoy New York, NY University of North Carolina at Chapel Hill University of San Diego Emily M. Zeigler School of Law Willkie Farr & Gallagher New York, NY

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Introduction account”. It holds the assets of all customers (U.S. and non-U.S.) deposited in conjunc- With the demise of Bear Stearns Securities tion with transactions on all U.S. futures (“Bear”) in March 2008 and now the bankruptcy markets. All customer assets are required of LBI, many futures customers have raised seri- to be held only in accounts maintained at ous questions and concerns regarding how and custodial banks and other permitted finan- whether their funds held by a futures commis- cial institutions, including other FCMs and sion merchant (“FCM”) are protected under such clearing houses that are registered with the 3 circumstances. Similarly, given the recent credit CFTC as “derivatives clearing organiza- crisis, the government loans provided to Ameri- tions” (DCOs). All customer segregated ac- can International Group (“AIG”), the acquisition counts are required to be clearly identified of Merrill Lynch by Bank of America, the $700 as segregated pursuant to CFTC Rule 1.20. billion bailout approved by Congress and numer- These segregated funds are not permitted to ous other financial-related matters, customers of be commingled with the FCM’s proprietary broker-dealers (“BD”), insurance companies and funds or used to finance its futures or bro- banks have raised similar concerns. Not to under- ker-dealer businesses. The amounts held in estimate the importance of insolvencies involv- the segregated funds accounts are calculated ing these other financial institutions, this article daily as required by CFTC Rule 1.32, and will only address the laws, regulations and poli- the FCM must take immediate action in the cies that impact futures customers globally under unlikely event that there is ever a shortfall in 4 such circumstances. its segregated funds accounts. This daily calculation must be completed by each FCM by Rules Governing Futures Accounts not later than noon on the next business day. at an FCM However, the customer segregated required amount needs to be in a good control loca- Substantial financial safeguards and customer 8 protections exist within the futures industry that tion the night before. Otherwise, the FCM are designed to protect customer funds in the is deemed to be “under segregated”, and, if event of an FCM bankruptcy. Assets held in a fu- the FCM is “under-segregated”, this must be tures account at an FCM are protected and gov- reported promptly to the CFTC and its re- 9 erned specifically by applicable laws and CFTC spective DSRO. Given this same-day deposit regulations that require the segregation of cash requirement, most large FCMs will deposit a and collateral deposited by customers in conjunc- large amount of their own capital in the cus- tion with their futures trading. Pursuant to the tomer segregated account to ensure that such Commodity Exchange Act (“CEA”)5 and appli- accounts are never “under-segregated”. This cable CFTC regulations6, an FCM, must maintain capital infusion can amount to several hun- its futures customer assets in at least two different dred million dollars, depending on the total types of customer fund accounts (e.g., segregated amount held in the segregation pool. and secured amount accounts) and may use a 2. SECURED AMOUNT FUNDS: The second third type (e.g., a non-regulated account), each of type of account, governed by CFTC Rule which have different priority rights in the event of 30.7, is known as the “customer secured the FCM’s insolvency. amount account” and holds the assets of U.S. The three types of customer fund accounts used residents deposited in conjunction with their by an FCM are: transactions on non-U.S. futures markets. 1. SEGREGATED FUNDS: The first such ac- These funds are also required to be held in count, established pursuant to Section 4d(a) accounts at banks and other permitted finan- (2) of the CEA7 and CFTC Rule 1.20, is re- cial institutions, including non-U.S. clearing ferred to as the “customer segregated funds houses and members of non-U.S. exchanges,

provided such non-U.S. clearing houses and products, with the difference being whether the non-U.S. member firms are deemed to be a futures products are traded on U.S. or non-U.S. “good secured” location. Like segregated futures markets and, for non-US markets only, funds, secured amount funds are not permit- whether the customer is a U.S. or a non-U.S. en- ted to be commingled with the FCM’s pro- tity. prietary assets and are calculated daily and In addition to the segregation and secured represent 100% of that day’s customer re- amount requirements, CFTC regulations restrict quirements.10 FCMs are permitted to secure where client funds may be placed. CFTC Rule more than the minimum requirement stated 1.20 requires the FCM to maintain customer above and can elect to deposit all funds used segregated funds, whether in the form of cash or to trade on non-U.S. markets by all of its cli- collateral, either with a clearinghouse of a U.S. ents, including foreign domiciled clients. Like futures exchange registered with the CFTC as a segregated funds as noted above, the calcu- DCO, in a customer segregated account with a lation for the secured amount requirements bank or with another FCM. In connection with must be completed by the following morning its custodial arrangement, the FCM must obtain but the secured amount requirement must be what is known as a “segregation acknowledge- deposited in a good secured location the night ment letter”, commonly known as a “seg. waiver before or the FCM will be deemed to be in letter”, in which the respective custodial bank or 11 default. As noted above with customer seg- FCM acknowledges and agrees that all assets de- regated accounts, most large FCMs will also posited in this segregated account are for the sole deposit their own capital in a secured amount benefit of the FCM’s futures customers and are account to prevent any under-funding from not subject to the claims of any of the FCM’s cred- occurring itors, including that bank or FCM, respectively. 3. NON-REGULATED FUNDS: The third Similar letters must also be obtained for the Rule type of account, called the “Non-Regulated 30.7 secured amount account and the Rule 15c3-3 Customer Credit” calculation, contains the non-regulated account at the respective custodial assets (cash and open trade equity) of non- bank. All customer assets are therefore held at all U.S. customers deposited in conjunction with times in these accounts at the respective custodial transactions on non-U.S. futures markets if bank or FCM, in accounts at the various clearing such amounts are not included in the secured houses or with other clearing brokers that act as amount account as noted above.12 An FCM, clearing brokers on the various exchanges around also registered as a broker-dealer, may use the globe on behalf of the FCM. this third account type, which is governed RECOMMENDATION #1: While the by Securities and Exchange Commission CFTC does not specifically require the use of (“SEC”) Rule 15c3-3. The amounts held in non-regulated accounts, as this is primarily an this account reflect the total of the credit bal- SEC requirement for broker-dealers, the CFTC ances calculated for each individual account should now prohibit the use of non-regulated owed by the FCM to its non-U.S. customers accounts by an FCM, that is also registered as a for transactions on non-U.S. futures markets broker-dealer, and require that all funds held by less any deposits of cash or securities held an FCM to margin non-U.S. futures, whether they with a clearing organization or correspon- be for the benefit of a U.S. customer or a non-U.S. dent clearing broker.13 Any amounts held in a customer, be held in a 30.7 Customer Secured non-regulated account are not covered by the Amount Account. This prohibition will prevent provisions of the Securities Investor Protec- any misappropriation of futures customer funds tion Act (“SIPA”). held in a 15c3-3 account as such accounts could Each “bucket”, noted above, contains funds arguably be deemed to fall outside the protections used by customers to margin the relevant futures afforded by CFTC regulations 1.20 and 30.7.

An FCM is also required by CFTC regulations the shareholder equity of the FCM, then each of to properly account for and calculate on a daily the three accounts held at the custodian bank (or basis both the amount that it is required to hold in an FCM) would be treated independently of each segregation and the amount that actually is in its other. Customers’ assets held in one of these three customer segregated accounts.14 Any deficiencies accounts may not be used to satisfy any shortfalls in the amounts required must be remedied and re- in another account (e.g., the amounts held in the ported immediately to the appropriate regulators. segregated account at the respective custodial bank Most large FCMs deposit a substantial amount or at a DCO may not be used to cover a shortfall of their own capital in the customer segregated held in the non-regulated account). However, as account to provide excess funds in the event a fu- noted in greater detail below, a clearing house, tures customer does not timely meet its margin including a DCO, may apply a clearing member requirements. This capital infusion may also be firm’s customer assets that are on deposit with used to satisfy customer claims in the event of that respective clearing house to satisfy margin the FCM’s insolvency. Similarly, to provide ad- amounts owed to the clearing house by that clear- ditional protections to its customers, the FCM ing member firm (and that clearing member firm must report, in accordance with applicable CFTC only) for its customer accounts. In other words, regulations, to the appropriate regulators within customer assets held by a clearing house may not 24 hours if its net capital falls below the “early be used to cover a shortfall in the FCM’s “house” warning” level and must promptly add additional account nor may assets held at one clearing house capital to bring its net capital above this level.15 be applied to cover a shortfall at another clearing In the event of the FCM’s bankruptcy,16 futures house unless a cross-margining arrangement ex- customer assets are normally protected except as ists with respect to the two clearing houses. described below. First, assuming no material fu- The assets of an FCM’s futures customers, tures customer-related default exists or was the which trade on the U.S. futures markets, are nor- cause of the FCM’s bankruptcy (e.g., the insol- mally wired directly by those customers into the vency was the direct result of a non-futures cus- customer segregated account at the respective tomer or transaction), a bankruptcy filing should custodial bank. The custodian bank would typi- have no material impact on customers’ assets cally maintain different segregated accounts to held in the three aforementioned accounts. Under hold cash and any non-cash collateral, such as such circumstances, each account should contain U.S. Treasury bills, respectively. This firewall be- 100% of the required amounts and should be tween the bank and the FCM provides important transferred back to customers in an orderly fash- protections to the FCM’s futures customers. As ion. An FCM bankruptcy would be administered noted above, the assets held in these accounts at under Chapter 7 of the U.S. Bankruptcy Code, the bank do not fall within the bankrupt estate which contains specific provisions for the protec- and are reserved for payment to customers if the tion of customers in the event of an FCM’s insol- FCM files for bankruptcy. If the bank mishandles vency. Under Part 190 of the CFTC’s rules, the futures customers’ assets held with the FCM, its bankruptcy trustee would have the responsibility full shareholder capital should stand behind the of returning the custodied assets back to each fu- accounts. tures customer. Creditors of the FCM’s bankrupt If the FCM is required by an exchange to send estate would have no claim to any of the assets cash or collateral to a DCO to meet its custom- held in these three accounts. The assets would be ers’ initial or variation margin requirements, the held solely for the benefit of the FCM’s futures required amounts are typically sent via wire trans- customers. fer from the customer segregated account at the If, on the other hand, the FCM’s bankruptcy respective custodial bank or FCM to another cus- resulted from a futures customer’s failure to de- tomer segregated account held in the name of the liver the required margin for its futures trading DCO for the benefit of the FCM’s futures custom- positions, and the default was greater than all of ers. Therefore, at all times, assets of the FCM’s fu-

tures customers, who trade on U.S. futures mar- es, if any, are now needed to these regulations and kets, are held in a customer segregated account programs. In particular, they should codify that at the FCM’s or the DCO’s custodial bank. Simi- any FCM or clearing member firm that invests in larly, assets that need to be transferred to clearing money market funds or other permissible invest- brokers or clearing houses outside the U.S. are ments under CFTC Regulation 1.25 on behalf of also sent directly from the 30.7 Secured Amount their futures customers will be held liable for any Account at the bank to the required good secured losses that may occur from such investments and location. should consider setting guidelines relating to such investments. For example, one such guideline, a Investments of Futures Customer portfolio diversification guideline, may state that Assets no FCM should invest more than a particular percentage of its customer assets in any one money There are also customer protections relating market fund or other permissible investment. to the types of permissible investments that an Also, the money market funds that can be used FCM may make with customer assets held by the for such investments by FCMs should be required FCM. Pursuant to CFTC Rule 1.25, the FCM is to accept redemptions on a daily basis and pay permitted to invest its futures customers’ assets in such redemption proceeds within a certain time 17 a limited number of permissible investments. In frame, e.g., 24 hours, with only one exception today’s marketplace, the most commonly used in- permitted, that is, to do so would cause the fund vestment product are money market mutual funds to “break the buck”. that meet the requirements of CFTC Rule 1.25 and SEC Rule 2a-7 under the Investment Compa- Good Risk Management Practices ny Act of 1940 (the “1940 Act”). However, any investment loss that may be incurred as a result The risk management disciplines applied by of such investment must be borne solely by the FCMs and other participants in the futures in- FCM; its futures customers assume no such industry are another significant source of customer vestment risk.18 This concern has been heightened protection. To provide the greatest protection to recently by The Reserve Fund which lost a sub- its futures customers, the FCM must exercise a stantial amount of its investment assets through strong risk management practice. This requires its purchase of commercial paper held in the name establishing a proper trade or credit risk amount of Lehman Brothers and AIG, causing the fund to for each of its client futures accounts, monitor- “break the buck”.19 Also, the FCM must receive ing such levels frequently and receiving current an acknowledgement from each money market on-going financial information from each futures fund that the amounts invested by the FCM on customer. This is especially true for those custom- behalf of its customers with the respective money ers who trade an account (or a combination of ac- market fund may not be applied to any creditor counts pursuant to an aggregation concept) that of the FCM. This is similar to the segregation results in a large percentage of the open interest acknowledgement letter received by FCMs from of any single commodity being owned or con- their custodial banks, as noted above. trolled by a client. Also, while a DCO normally RECOMMENDATION #2: Given the recent sets adequate and proper initial margin levels, issues that have arisen with respect to money typically involving a one day, two standard devia- market funds as well as other investments that tion test, an FCM should also analyze each of its are permissible under CFTC Regulation 1.25, the large futures customers, especially those, as noted CFTC should review CFTC Regulation 1.25 and above, who hold positions that represent a large U.S. clearing houses should review their respec- percentage of the open interest, and apply a more tive rules regarding deposits made by their clear- conservative variation risk (“VAR”) or standard ing member firms, such as the IEF2 Program at the deviation (“SD”) analysis, such as a five day, two CME Clearing House, to determine what chang- SD test, on a daily basis.

If one of the FCM’s customers were to fail to requires its clearing members to make deposits to meet its margin requirements in a timely manner, the clearing house’s Guaranty Fund, also known which is typically a T+1 standard,20 that FCM as a Surety Fund, to provide additional, back-up would be required to step in and use its own capi- capital protections to the clearing house in the tal to ensure that other customers are not affected event of a customer default. The amount deposit- and to satisfy that FCM’s obligations as a clearing ed by each clearing member firm typically is based broker. As noted above, most large FCMs main- on a formula based on the volume and overnight tain a significant amount of their own capital in margin requirements maintained by that clearing the customer segregated and secured amount ac- member firm. At the CME Clearing House, the counts to provide a first line of protection in the Guaranty Fund currently totals approximately event a customer fails to meet its daily margin re- US$1,800,000,000. Third, in the unlikely event quirements. Applicable laws and regulations pro- that a clearing member were to default and the hibit that FCM from using the assets of its other, proceeds held in the Guaranty Fund were used non-defaulting futures customers to meet the ob- to cover a shortfall, the DCO will immediately ligations of a defaulting client. However, as not- take steps to restore its Guaranty Fund to pre- ed above, this does not prevent a clearing house default levels. (For example, the CME Clearing House can require other, non-defaulting clearing from applying assets held in a clearing member’s member firms to increase their Guaranty Fund customer segregated fund account to cover any deposits by as much as 2.75 times the amount deficit that may result from a shortfall in the cus- of their security deposits to restore the Fund to tomer segregated account held on the books of pre-default levels.) In its history, no CME clear- that clearing house. ing member firm has ever defaulted but these Role of a DCO safeguards are designed to provide financial protections even in times of significant stress in the DCOs also impose important financial safe- financial markets. These protections are further guards that are intended to ensure financial safety buttressed by the customer margin requirements to the markets. Let’s assume, for purposes of this that are established by the futures exchanges and article, that the FCM and its foreign affiliates are by the exchanges’ own market surveillance and a clearing member of most of the major global financial surveillance programs, all of which pro- futures exchanges. The exchange clearing house vide important customer protections to futures (referred to in the U.S. as a DCO) stands as the customers. guarantor between its clearing members and represents the buyer and seller of every futures con- Net Capital Requirements tract (“the buyer to every seller and the seller to Another customer protection are the financial every buyer”). As such, the clearing houses estab- net capital requirements imposed on all broker- lish and enforce strict financial requirements for age firms, including FCMs. The minimum “ad- their clearing members to minimize the likelihood justed net capital” requirement, from an account- of, and the consequences of, a default by one of ing perspective, reflects an amount that equals the parties to a futures transaction. the total of the current liquid assets on the books In the event of a default by a clearing member, of the FCM in excess of the total amount of its the following resources are typically available to liabilities. Most large brokerage firms today are a DCO. First, the exchange memberships and registered as both an FCM and as a BD.21 shares held by a defaulting clearing member and Pursuant to CFTC Rule 1.17, the firm must all the margin supporting the positions held in its maintain “adjusted net capital” that is equal to or “house” account at the clearing house may be greater than the sum of customer (8%) and non- used to cover any shortfall in that clearing mem- customer (4%) required margin requirements. In ber firm’s “customer segregated funds” account the event that the net capital amount determined at the clearing house. Second, each clearing house pursuant to CFTC Rule 1.17 is greater than the

amount required under SEC Rule 15c3-1, the International (Europe) (“LBIE”), also submitted firm must meet the greater of these two amounts. its filing on Septemberth 15 . The U.K. Financial In determining its minimum net capital require- Services Authority (“FSA”) appointed Price Wa- ments pursuant to the applicable regulations terhouse Coopers (“PWC”) as the Administrator noted above, the firm’s assets must be valued con- for LBIE. This is similar to the role of a trustee in servatively, with most financial assets having their bankruptcy had LBI made such a filing. value discounted, using value at risk or scenario LBI had opened a Customer Omnibus Ac- analysis, to provide a conservative assessment of count on the books of LBIE to permit LBI fu- their market value. tures customers to trade on the various European exchanges. LBIE was either directly a general Reporting Requirements clearing member firm (“GCM”) on the clearing houses in Europe, such as LCH Clearnet SA and Under applicable rules, a broker-dealer/FCM EUREX Clearing AG, or had established their must provide the SEC, the CFTC, FINRA, the Na- own customer omnibus accounts on the books of tional Futures Association (“NFA”) and its desig- a third party clearing firm on other European ex- nated examining authority and its designated self- changes. LBI was the clearing member firm on the regulatory organization (DSRO) (for most large U.S. futures exchanges and had opened a futures U.S. brokerage firms, this would be FINRA in customer omnibus account with other Lehman their broker-dealer capacity and the CME in their Brothers affiliates or third party clearing firms in FCM capacity) with same-day notice if its regu- Canada and Asia. LBIE had opened a customer latory capital drops below the “early warning” omnibus account on the books of LBI to allow its level (a multiple of the net capital requirements futures customers to trade on the U.S., Canadian mandated by SEC Rule 15c3-1 and CFTC Rule and Asian markets. All futures customer accounts 1.17). Similarly, if at any time the firm’s regula- were opened with either LBI or LBIE.23 Note that tory tentative net capital declines by 20% or more LBIE had many direct futures accounts opened from the last month-end, that firm must, in accor- on its books, including some accounts, especially dance with applicable SEC and CFTC regulations, hedge fund accounts, that involved a prime bro- immediately notify these regulators regarding this kerage and cross margin netting arrangement. change. The “early warning” requirements effec- LBI had similar arrangements with hedge funds tively provide an advance indication of potential on its books but also had a large number of fu- financial stress that a broker-dealer/FCM may tures-only accounts that were managed by large incur and are set significantly above the level at investment advisory firms. which a broker-dealer/FCM must maintain its As noted above, the concept of segregated minimum net capital requirements. funds is designed to protect the cash and collat- The Lehman Events eral deposited by futures customers to margin their futures positions. These regulations do not On September 15, 2008, Lehman Brothers directly address the actual futures positions them- Holdings Inc. (“LB Holdings”), the holding com- selves. Given the uncertainty of the situation and pany of all Lehman Brothers entities and the pub- the volatility in the marketplace, senior Lehman licly-traded company (NYSE symbol: LEH) filed futures officials worked closely with their futures a petition for bankruptcy under Chapter 11 of Ti- clients and governmental and exchange officials tle 11 of the U.S. Bankruptcy Code with the U.S. to transfer the client futures positions to other Bankruptcy Court for the Southern District of clearing firms in order to provide these customers New York.22 Its principal U.S. subsidiary, Lehman with a new home that was properly capitalized. Brothers Inc. (“LBI”), a registered broker-dealer This process started immediately after LB Hold- and FCM, did not file its petition (a Chapter 7 ings filed its petition for bankruptcy in the U.S. filing) until the following weekend. The principal but not so outside the U.S. PWC, as the newly-ap- U.K. affiliate of LB Holdings, Lehman Brothers pointed Administrator, did not permit the trans-

fer of the open futures positions until late in the appointees, even if they are only granted certain day on Wednesday, September 17th, with the vast limited powers over futures accounts, must have majority of the futures positions being transferred a thorough knowledge of the global futures mar- on Thursday, September 18th or Friday, Septem- kets. Customer protection is the most important ber 19th. goal, and futures positions need to be moved in Most of the futures positions held by Lehman’s a very timely manner, especially during a volatile customers, whether they were held on the books marketplace. of LBI or LBIE, were either moved to other clear- Sadly, some European and Asian exchanges ing member firms per the instructions of such took a different path to resolving the issue before customers by the close of business on Friday, Sep- them. Even though the accounts were labeled as tember 19th, or they became futures customers of customer omnibus accounts on their books, they Barclays Capital Inc. (“BCI”), the U.S. affiliate of chose to simply liquidate the open futures posi- Barclays Bank PLC. BCI acquired all of the re- tions and not participate in any position trans- maining futures customer accounts on the books fers. Such liquidations came with little or no prior of LBI after the close of business on September notice to Lehman officials. This should never be 19th. Therefore, the system worked for the most allowed again. part although, as noted above, quicker action was RECOMMENDATION #4: It is very important needed. Through the tremendous efforts of many that every global exchange recognize the concept governmental agencies, SROs, firms, exchanges, of a customer omnibus account or create a special clearing houses and clients, the goal of transfer- coding on their exchange operational system that ring the open futures positions was effectively can easily identify which positions belong to cus- achieved within five days. This reflects the strong tomers and which positions belong to the clearing working relationships that exist within the global member’s proprietary traders. Once positions are futures community. No other product area or in- identified as belonging to a customer of a clearing dustry can make a similar claim. member or their carrying brokers, these customer RECOMMENDATION #3: In the future, it is positions should not be liquidated but should be imperative that any trustee in bankruptcy or ad- allowed to be moved to another firm unless, of ministrator that is selected should have a strong course, the client seeks such liquidation. The ex- futures product knowledge and expertise to al- change is protected financially as it can liquidate low prompt and immediate transfers of futures the clearing firm’s proprietary positions and can positions. Granted, in today’s marketplace, prime thus hold these proceeds to protect against a mar- brokerage accounts and corresponding Cross ket move in the positions held by the customers or Margin Netting Agreements (“CMNA”) play a can even issue an increased margin call. To mere- critical role relating to the required funding of the ly liquidate open customer positions promptly risk margin amounts that control multiple prod- without providing alternative approaches to the ucts, including futures accounts, but many futures solution is not an acceptable practice and should accounts are stand alone accounts without any not be allowed. This is especially troublesome in prime brokerage (“PB”) or CMNA agreements today’s marketplace as a large number of futures in place. Accordingly, the margin amounts held positions are used to hedge against some stock or in such stand alone accounts will not have been bond portfolios. By liquidating one leg of these used to finance other related financial transac- positions, given the market volatility that oc- tions and products, such as via a PB or portfolio curred, some clients incurred even greater damage margining arrangement. All customer omnibus to their portfolio. Actions taken by an exchange accounts fall within this parameter and must be or clearing house to liquidate all customer open treated differently than other futures accounts positions without first providing an opportunity that are highly correlated with other products and to have these positions transferred, even if permit- PB arrangements. The product expertise for such ted by their rules, should be guarded and not used appointees related to futures is critical, and such without greater forethought.

RECOMMENDATION #5: The CFTC and is not needed, commonality of elements and their the FSA should consider and establish policies, corresponding interpretations are. A global set and perhaps regulations, that require any global of bankruptcy laws and regulations that relate futures exchange that holds positions for custom- specifically to the insolvency of global brokerage ers of FCMs in the U.S. or registered investment firms and banks are now needed. entities (“RIEs”) in the U.K. to contact the CFTC While open futures positions were, for the most and the FSA, respectively, before the exchange part, transferred within the first five days, the cash takes actions to liquidate all customer positions. and collateral used to margin those positions were The CFTC and the FSA could require, via a not timely transferred. While part of the delay re- Memorandum of Understanding (“MOU”), that sulted from some difficulty in the accounting and such exchanges notify them in the event an ex- trade confirmation processes, some banks simply change elects to take actions to liquidate all open refused to transfer the amounts held in customer customer positions. protected accounts in a timely manner. For ex- RECOMMENDATION #6: Regulations need ample, JP Morgan Chase Bank NA, the U.S. bank to be established to provide better customer pro- that held all of the cash and collateral in the LBI tections for the actual positions held by futures Customer Segregated Account, stopped releasing customers globally. As noted above, current regu- customer funds on Thursday, September 18th and lations only address the cash and collateral used continued this “hold” for many more days. Even- to margin these positions. However, when major tually, it agreed to transfer the cash and collateral events occur, like they did over the weekend of held in the Customer Segregated Account. September 12-14, the resulting market volatility RECOMMENDATION #8: Actions taken by caused significant harm to end users who were banks that did not release funds in a timely man- not able to liquidate their open positions. Regu- ner were unacceptable.24 There is no probable lations need to establish proper guidelines and cause to place a “hold” by such banks on segre- procedures that an administrator or trustee in gated funds. Such banks have signed a “segregat- bankruptcy must follow to permit the prompt re- ed acknowledgement” letter, which clearly states lease of open futures positions that are not part that the bank acknowledges and agrees that the of any PB or other risk-based financing arrange- amounts held in a Customer Segregated Account ment, and to require the exchanges to act accord- belong solely to the futures customers of the re- ingly, all in the best interests of the end users of spective FCM and do not belong to any creditors the global futures markets. of that FCM or custodial bank. By taking such RECOMMENDATION #7: The global futures actions, banks required the end users, in essence, industry is just one small part of the total invest- to “double segregate” by depositing new margin ment landscape. Many products in today’s mar- amounts at their new clearing firms. The addi- ketplace are intertwined within a total risk port- tional funding requirement adversely impacted folio. This reflects the significant growth of prime their liquidity performance and return and should brokerage globally and the growing concept of not have occurred. portfolio margining. Because different products RECOMMENDATION #9: The CFTC, NFA, are so correlated to each other, especially from a FSA and the respective clearing houses should risk margin and financing perspective, it is very carefully review the entire process of account important that all of these products be treated movement during stressed situations, establish in a similar manner under new bankruptcy laws proper guidelines and procedures to require cus- and regulations that are clearly now needed. Such todial banks, that act in this capacity on behalf laws and regulations must be adopted globally. of futures customers on a global basis, to trans- This requires all of the major countries to meet fer customer protected funds in a very timely together to address this global problem. A future manner and take enforcement actions against with 15 or 20 different sets of laws and regula- banks that refuse to act in the best interests of tions is not a very bright one. While uniformity the customers.

PWC, the Administrator for LBIE, issued a RECOMMENDATION #12: The CFTC and statement on October 7, 2008, stating it was still the NFA, together with other governments and reviewing how to deal with requests for transfer industry associations, should establish a task of client monies and assets. PWC gave no indica- force that includes members from the industry tion as to when such client assets would be dis- and the end user community to determine what tributed. Other firms appointed to serve as the new best practices are now needed in the event trustee in bankruptcy in other jurisdictions have such a global bankruptcy event ever occurs again. also not released any of the funds held in the LBI The last such industry task force was established Customer Omnibus Account on the books of after the Barings collapse in the mid-1990s. LBIE and other non-U.S. Lehman affiliates. In Ja- There has been considerable change in the way pan, for example, the bankruptcy-appointed firm the industry operates since then, in particular the indicated that it would not announce any deci- wide-spread use of PB arrangements and new risk sion regarding releasing the funds held in LBI’s management analyses for funding a wide array of customer segregated account until after Novem- financial products. The new task force should ber 17, 2008. consist of a global committee that creates several RECOMMENDATION #10: As noted above, sub-committees, each having jurisdiction and re- the customer omnibus account of a U.S. FCM sponsibility over a specific issue or concern. should receive prompt payment of any amounts RECOMMENDATION #13: The current caps held in such accounts in those countries that the on FDIC insurance (currently, $100,000)25 and CFTC deem to be a good control location over SIPC ($500,000) are being reviewed for possible customer funds, once the open positions have increases. The futures industry and the CFTC been transferred to another clearing member. The should meet to determine whether an insurance CFTC, together with the industry and other for- program is now needed for futures accounts. eign governmental agencies, need to review these SIPA specifically excludes futures accounts. How- procedures and establish new guidelines on how ever, in light of the actions taken by some of the such omnibus accounts should be treated. Once global exchanges in connection with Lehman’s the open positions held in a customer omnibus bankruptcy, there is a need to determine whether account have been transferred away, then the such an insurance program is now viable and can funds held to margin those positions should be be properly funded. promptly transferred back to such customers or their new clearing member firms. Conclusion RECOMMENDATION #11: Customer funds held by a brokerage firm or exchange in a coun- As noted above, the process and procedures try that is deemed to be a good secured location that followed the filing of Lehman’s bankruptcy pursuant to CFTC regulations should not be did not always flow as well as many believed it deemed to be subject to the claims of a creditor should have. The industry and government need of the brokerage firm that has filed for bankrupt- to establish a task force that addresses these issues cy and should be protected against such claims. and determine what changes and best practices, if The CFTC should consider whether a non-US any, are now needed to minimize the impact on exchange, that permits a U.S. FCM to open a cus- customers in the event another such bankruptcy tomer omnibus account on the books of a clear- ever occurs. ing member firm of that exchange, should be required to open special bank accounts with a U.S. NOTES bank or DCO to hold such initial margin within 1. 2008, Ronald H. Filler. Printed with permission. the U.S. and be subject to the U.S. Bankruptcy “CFTC” stands for the U.S. Commodity Futures Code and Part 190 of the CFTC Regulations in Trading Commission, the U.S. governmental order to facilitate the transfer of such customer agency in charge of regulating the U.S. futures funds in a timely manner. markets and U.S. industry professionals.

2. special recognition goes to Acting CFTC 10. For those jurisdictions (e.g., Germany, Hong Chairman Walt Lukken, NFA President Dan Kong, Korea) that do not provide the standard Roth and many other senior CFTC and NFA staff customer asset protection that requires the members who provided tremendous assistance separation of a Firm’s proprietary assets from to help the futures customers of Lehman its customer assets, the FCM may deposit a Brothers Inc. throughout this period. corresponding amount of its own capital in a 3. Another FCM has recently been the subject good control location, typically in the accounts of bankruptcy proceedings. See Sentinel at its respective custodial bank, to reflect the Management Group, Inc. (U.S. Bankruptcy amounts as determined in its 30.7 daily secured Court for the Northern District of Illinois, amount calculation (based on the amount for Eastern Division (Case No. 07 B 14987) but this that trade date), in its UK FSA segregation daily proceeding involved a different set of issues and calculation (based on the amount as determined did not involve transactions in futures contracts. on the trade date plus one day) and in its weekly Bear was taken over by J.P. Morgan Bank, with 15c3-3 weekly calculation. This form of “double the assistance of the Federal Reserve Bank, in segregation” provides significant protections to March 2008. an FCM’s futures customers. 4. A broker-dealer must maintain its securities 11. note that, pursuant to applicable CFTC customer assets in compliance with the SEC’s regulations, an FCM is required to deposit “customer protection rule” (Rule 15c3-3), all customer cash and securities in a customer segregated fund account but, in reality, is not including maintaining cash in a special reserve required to place customer assets in a secured account and maintaining fully paid and excess amount account. It can elect to use its own margin securities in a segregated account. In capital to meet the minimum secured amount general, the securities accounts maintained requirements. at a BD will receive the benefit of expedited 12. If the FCM is also registered as a broker- administration and the right to recover up to dealer, then these non-regulated accounts are US$100,000 in cash or US$500,000 in securities maintained in accordance with SEC Rule 15c3- if its broker-dealer were to become insolvent. 3. The Customer Reserve Formula calculation Under such a scenario, customer assets held required by SEC Rule 15c3-3 is performed in a securities account would be administered weekly, typically on each Monday reflecting pursuant to a proceeding brought by the the amounts as of the previous Friday’s close Securities Investor Protection Corporation (SIPC) of business. The assets held in this account can pursuant to the Securities Investor Protection not be commingled with the FCM’s proprietary Act (SIPA). If the BD were also registered as funds and are maintained in a designated Special an FCM, futures customers should understand, Custody Account for the “Exclusive Benefit of however, that SIPA rules specifically exclude Customers” (EBOC Account) at a designated futures customer accounts and their assets from custodial bank. its provisions. Most BDs have purchased a surety 13. see Note 4, supra. bond that provides protection in excess of the 14. see CFTC Regulation 1.20 which states in amounts provided under SIPC. However, this essence: “All customer funds shall be separately surety bond would, like SIPA, be limited to only accounted for and segregated as belonging the broker-dealer securities accounts and would to commodity or option customers. Such not apply to the futures customer assets held by customer funds when deposited with any a joint BD-FCM. bank, trust company, clearing organization or 5. 7 U.S.C. § 1 et seq. another futures commission merchant shall be 6. see CFTC Regulations 1.20 and 30.7 deposited under an account name which clearly 7. 7 U.S.C. § 6d(a)(2) identifies them as such and shows that they are 8. “Good control location” is mainly a term used by segregated as required by the Act and this part.” broker-dealers pursuant to SEC regulations but CFTC Regulation 30.7 contains similar language its meaning here implies an account established regarding the treatment of foreign futures and in accordance with CFTC regulations. options secured amount accounts. 9. see Interpretative Statement issued by the CFTC 15. see CFTC Regulation 1.17. on September 26, 2008, regarding funds related 16. For a more detailed explanation of applicable to cleared-only contracts. laws and regulations affecting the bankruptcy

of an FCM, see Subchapter IV of Chapter 7 of remain in compliance with the SEC and CFTC the U.S. Bankruptcy Code and Part 190 of the net capital requirements. The CSE net capital CFTC Regulations. rules effectively require that the CSE firm must 17. Pursuant to CFTC Rule 1.25, an FCM may re- maintain at least US $500 million in “adjusted hypothecate customer funds provided that, at net capital” and US$1 billion in “tentative net all times, an equivalent amount of the funds capital” in order to continue operations. This being re-hypothecated are maintained in the calculation does not include customer-owned customer segregated account. securities. 18. This view has been expressed by many industry 22. Case No. 08-13555. The petition was filed observers but is not directly covered by any CFTC following a special meeting of the Board of regulation. Directors of Holdings on September 14, 2008. 19. The Reserve Fund “broke the buck” in September On September 19, 2008, LBI filed a proceeding 2008, and many other such funds halted under the Securities Investor Protection Act of redemptions for a 7-day period as permitted by 1970 (Case No. 08-01420). See also Statement their prospectus. On September 22, 2008, the issued by SIPC on September 15, 2008. SEC, pursuant to Section 22(e) of the Investment 23. over this same weekend, Merrill Lynch was Company Act of 1940 (the ‘40 Act”) issued an acquired by the Bank of America and American order temporarily suspending redemptions and International Group (“AIG”) received a $85 postponing payment of shares of two series billion loan from the U.S. Treasury. All of these of The Reserve Fund -- The Primary Fund and events and other similar concerns created huge The U.S. Government Fund. On September 29, volatility in the global markets all at once. During 2008, the Board of Trustees of The Reserve this same period, many banks refused to issue Fund announced that it would liquidate the credit to other financial institutions, including assets of The Primary Fund. (See Release No. other banks. Over the weekend of September 28386). See also CFTC Staff Interpretative 19-21, 2008, the U.S. Treasury announced its $700 Letter issued on September 24, 2008, to Debra billion bailout which received Congressional Kokal, Chairman of the Joint Audit Committee. approval on October 3, 2008. Also, on September 29th, the U.S. Treasury 24. section 4d(b) of the CEA states in essence: “It Department announced that it was opening shall be unlawful for any person, including but its Temporary Guarantee Program for Money not limited to any clearing agency of a contract Market Funds (Press Release hp-1161). In the market or derivatives transaction execution release, the Treasury Department stated that it facility and any depository, that has received will guarantee the share price of any publicly any money, securities, or property for deposit in offered eligible public money market fund that a separate account as provided in paragraph 2 is regulated under SEC Rule 2a-7 under the 1940 of this section, to hold, dispose of, or use any Act for amounts held by shareholders as of such money, securities, or property as belonging September 19th. to the depositing futures commission merchant 20. After T+3 days, a capital charge is assessed or any person other than customers of such against the FCM for failing to collect the futures commission merchant.” 7 U.S.C. § 6d(b). required margin amount. 25. FDIC insurance was increased to $250,000.00 21. A few, including Goldman Sachs, Morgan Stanley on a temporary basis through December 2009 pursuant to the Economic Stabilization Act of and Merrill Lynch, were also once licensed as a 2008 passed on October 3, 2008. consolidated supervisory entity (“CSE”). The SEC suspended the CSE program on September 26, 2008. See SEC Release 2008-230. A key protection to customers is the special regime applicable to CSEs under the SEC’s and CFTC’s respective “net capital” rules (SEC Rule 15c3-1 and CFTC Rule 1.17). As a CSE, the firm would calculate its net capital requirement pursuant to Appendix E to SEC Rule 15c3-1, which establishes alternative net capital requirements and allows the CSE firm to use SEC-approved value at risk or scenario analysis models to calculate and

Ronald H. Filler is an expert in the area of financial services law. He joins New York Law School as Professor of Law and Director of the School’s newest academic center, the Center on Financial Services Law. He will teach Derivatives Market Regulation, Special Topics in Corporate Law: Financial Services Seminar and Workshop, and Special Topics in Corporate Law: Regulation of Brokers/Dealers and Futures Commissions Merchants. Professor Filler was previously the Managing Director in the Capital Markets Prime Services Division at Lehman Brothers. He has spoken at hundreds of industry conferences and seminars during his more than 30 years in the futures and derivatives legal fields and has taught several different courses as an adjunct professor of law at four U.S. law schools, including New York Law School, the University of Illinois, Chicago-Kent College of Law, and Brooklyn Law School. He founded the Commodities Law Institute at Chicago-Kent College of Law in 1978, and this institute became the futures industry’s leading academic law program through 1995. Professor Filler has served on numerous industry boards and advisory committees during his career and, most recently, as a member of NYSE LIFFE US, the National Futures Association, CFTC Global Markets Advisory Committee, the CME Clearing House Risk Operating Committee, The Clearing Corporation Board of Directors, the FIA Board of Directors, and the FIA Law and Compliance Division Executive Committee. He received a BA from University of Illinois, a JD with honors From George Washington University law School and an LLM in Taxation from Georgetown University Law Center.

Steven Lofchie, Co-Chairman of the Financial Services Department at Cadwalader, concentrates his practice in advising financial institutions on regulatory issues and on derivatives and other financial instruments. He is the author of Lofchie's Guide to Broker-Dealer Regulation and Lofchie's Guide to CPO/CTA Regulation, both available at www.cadwalader.com/thecabinet. Chambers USA ranks Steven in its first band for both financial services regulation and derivatives, making him the only lawyer in the country to be top-ranked in both these categories. Steven counsels broker-dealers, banks, securities exchanges, private funds and registered investment companies regarding regulatory and transactional issues. His regulatory practice addresses virtually all the securities-law related statutory and regulatory requirements applicable to broker-dealers, other regulated institutions and their affiliates. He advises on registration requirements and exemptions, employee issues; cash market, sales, and trading; the development of compliance and supervisory procedures; satisfaction of margin, capital and recordkeeping requirements; the rules of the financial industry self-regulatory organizations; anti- money laundering; privacy; procedures for cross-border transactions; and insider trading issues. His transactional practice focuses on over-the-counter derivatives, securities financing, and trading agreements (from prime brokerage to the use of asset-backed structures for the financing of investments in hedge funds), and various types of licensing and membership agreements.

The securities industry associations and organizations for which Steven does work include the Securities Industry and Financial Markets Association, the Managed Funds Association, and the International Swaps and Derivatives Association. Steven has been very active in developing web-based compliance tools, including acting as the creator of the Cadwalader Cabinet on which he publishes The Guide to Broker Dealer Regulation, The Guide to CPO-CTA Regulation, online compliance manuals, research tools and document analysis systems ad from which he generates a daily newsletter of regulatory developments.

Steven received his B.A. from Sarah Lawrence College and his M.B.A. from Columbia Business School, where he was a General Motors Fellow. He received his J.D. from Yale Law School, where he was a member of the Yale Law Journal.

Robert L. Sichel, PGA’s General Counsel and Chief Compliance Officer, has over 17 years of experience in ERISA matters. Prior to joining PGA, Robert was an Executive Director in the legal department at J.P. Morgan, where he was responsible for handling ERISA-related matters within the investment bank. Before his time at J.P. Morgan, Robert served as ERISA counsel for Bear Stearns. Robert holds a J.D. from Villanova University School of Law, and an LL.M in Taxation from New York University School of Law.