MEMORANDUM OF LAW FOR THE FUTURES INDUSTRY ASSOCIATION AND THE INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.

Transcription

1 MEMORANDUM OF LAW FOR THE FUTURES INDUSTRY ASSOCIATION AND THE INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC. Enforceability of the Liquidation, Setoff, Netting and Credit Support Provisions of Certain Futures Account Agreements and the FIA-ISDA Cleared Derivatives Addendum upon a Customer s Default or Insolvency, and Enforceability of Certain Offset Provisions Applicable Prior to a Customer s Default or Insolvency August 22, 2013 Cleary Gottlieb Steen & Hamilton LLP One Liberty Plaza New York, New York Phone (212) Fax (212)

2 TABLE OF CONTENTS I. INTRODUCTION...2 II. BACKGROUND...4 A. The Covered Base Agreements...5 B. The Cleared Derivatives Addendum...7 C. Offset Provisions...9 III. ASSUMPTIONS...11 IV. QUESTIONS PRESENTED...15 V. CONCLUSIONS...16 A. Futures Transactions...16 B. Cleared Derivatives Transactions...19 C. Offset Provisions...22 VI. QUALIFICATIONS...22 VII. DISCUSSION...23 A. The FCM s Role as Intermediary and Effect on Commercial Law Analysis The FCM Model Foreign Futures U.S Futures and Foreign Futures...28 B. Covered Customer Not in Insolvency Proceedings Futures Liquidation Rights and Cleared Derivatives Liquidation Rights Futures Netting Rights, Futures Credit Support Rights, Cleared Derivatives Netting Rights and Cleared Derivatives Credit Support Rights Special Considerations Where Covered Customer is a Solvent Insured Institution Affiliate of Clearing Member...32 C. Covered Customer in Proceedings Under the Code Absent Exceptions, the Code Imposes Limitations on the Clearing Member s Rights Applicability of the Safe Harbor for Commodity Contracts to a Clearing Member s Futures Liquidation Rights, Futures Netting Rights, Futures Credit Support Rights, Cleared Derivatives Liquidation Rights, Cleared Derivatives Netting Rights and Cleared Derivatives Credit Support Rights...35 (a) The Futures Transactions and Cleared Derivatives Transactions as Commodity Contracts...38 (b) Each Clearing Member Is a Commodity Broker...39 (c) Futures Liquidation Rights and Cleared Derivatives Liquidation Rights Are Contractual Rights...40 (d) Futures Netting Rights, Futures Credit Support Rights, Cleared Derivatives Netting Rights and Cleared Derivatives Credit

3 Support Rights Are Contractual Rights under a Security Agreement or Arrangement or Other Credit Enhancement Related to a Commodity Contract...41 (e) Summary Specific Provisions Applicable to Cleared Derivatives Transactions and Futures Transactions Where the Covered Customer Is a Commodity Broker Liquidated Under Subchapter IV of Chapter (a) Positive Net Equity Requirement...43 (b) Netting and Customer Obligations Special Considerations Where Covered Customer Is an Affiliate of Clearing Member...45 D. Covered Customer in Proceedings Under SIPA The Automatic Stay and General Enforceability of Contractual Rights Enforcement of Security Interests in Securities Collateral Enforcement of Security Interests in Futures Payment Rights and Cleared Derivatives Payment Rights Special Considerations Where Covered Customer Is a Broker-Dealer Affiliate of Clearing Member Summary...50 E. Covered Customer in Proceedings Under the FDIA Absent Exceptions, the FDIA Imposes Limitations on the Clearing Member s Rights The Qualified Financial Contracts Provisions...51 (a) FDIC Conservatorship Provisions...53 (b) FDIC Receivership Provisions Special Considerations Where Covered Customer Is an Insured Institution Affiliate of Clearing Member...58 F. Covered Customer in Proceedings Under OLA Absent Exceptions, OLA Imposes Limitations on a Clearing Member s Rights The Futures Transactions and Cleared Derivatives Transactions as QFCs Application of Section 561(b)(2) of the Code Where the Covered Customer Is a Commodity Broker Special Considerations Where the Covered Customer Is an Affiliate of Clearing Member...64 G. Covered Insurer in Rehabilitation or Liquidation Proceedings Under the Insurance Law of the Covered Jurisdiction of its Organization Insurers Rehabilitation and Liquidation Model Act ii-

4 (a) Limitations on Creditors Rights in a State Insurance Company Delinquency...66 (b) The QFC Provisions Provide Protections for the Exercise of a Clearing Member s Termination, Liquidation, Netting and Credit Support Rights Insurers Receivership Model Act...74 (a) Limitations on Creditors Rights in a State Insurance Company Delinquency...74 (b) Protections for QFC Counterparties under the Receivership Act Clearing Member s Rights Under New York s and Illinois s Enactments of the Model Acts...81 (a) Clearing Member s Rights Under New York s Enactment of the NAIC Model Acts...82 (b) Clearing Member s Rights Under Illinois s Enactment of the NAIC Model Acts...86 VIII. ENFORCEABILITY OF DCO OFFSET PROVISIONS...89 IX. RELIANCE...92 ATTACHMENT A: FORM OF FIA-ISDA CLEARED DERIVATIVES ADDENDUM... A-1 -iii-

5 MEMORANDUM OF LAW FOR THE FUTURES INDUSTRY ASSOCIATION AND THE INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC. Enforceability of the Liquidation, Setoff, Netting and Credit Support Provisions of Certain Futures Account Agreements and the FIA-ISDA Cleared Derivatives Addendum upon a Customer s Default or Insolvency, and Enforceability of Certain Offset Provisions Applicable Prior to a Customer s Default or Insolvency This memorandum of law (this Memorandum ) examines the treatment under New York law (including the Uniform Commercial Code in effect in the State of New York (the UCC )), Chapters 7, 9 and 11 of the United States Bankruptcy Code (the Code ), the Securities Investor Protection Act of 1970 ( SIPA ), the Federal Deposit Insurance Act (the FDIA ), the Orderly Liquidation Authority ( OLA ) title of the Dodd-Frank Wall Street Financial Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act ) and the laws of the states of Illinois and New York governing insurer rehabilitation and liquidation of certain provisions of: (A) (B) certain Covered Base Agreements (as defined below), entered into by a futures commission merchant ( FCM ), registered as such with the Commodity Futures Trading Commission (the CFTC ) under the Commodity Exchange Act (the CEA ), that is a clearing member of one or more derivatives clearing organizations (each, a DCO ), registered as such with the CFTC under the CEA (such FCM, a Clearing Member ), and such Clearing Member s Covered Customer (as defined below), setting forth the right of such Clearing Member, upon the occurrence of an event giving rise to any right of such Clearing Member to liquidate all Futures Transactions (as defined below), to liquidate such transactions and to determine amounts owing with respect thereto, to exercise remedies in respect of Futures Payment Rights (as defined below) and rights of netting and setoff with respect to obligations arising from Futures Transactions and to apply Futures Credit Support (as defined below) transferred by a Covered Customer in connection therewith; and the FIA-ISDA Cleared Derivatives Addendum (the CDA ), in the form jointly published by the Futures Industry Association ( FIA ) and the International Swaps and Derivatives Association, Inc. ( ISDA ) and attached hereto as Attachment A, entered into by a Clearing Member and such Clearing Member s Covered Customer, setting forth the right of such Clearing Member, upon the occurrence of an event giving rise to any right of such Clearing Member to liquidate all Cleared Derivatives Transactions (as defined below) under a related Covered Base Agreement, to liquidate such transactions and to determine amounts owing with respect thereto, to exercise remedies in respect of Cleared Derivatives Payment Rights (as defined below) and rights of netting and setoff with respect to obligations arising from Cleared Derivatives Transactions, to apply Cleared Derivatives Credit Support (as defined below) transferred by a Covered Customer in connection therewith and to offset obligations arising from

6 Cleared Derivatives Transactions against Cleared Derivatives Credit Support transferred to the Covered Customer. 1 In addition, this Memorandum addresses the enforceability of certain Offset Provisions (defined in Part II.C below) that may be contained in the rules of clearinghouses clearing U.S. Futures, Options or Cleared Derivatives Transactions (each as defined below). This Memorandum begins with an overview in Part I of the Covered Customers (defined below) analyzed herein, includes a background discussion of the Covered Base Agreements and the Cleared Derivatives Addendum in Part II, sets forth assumptions in Part III and outlines the scope of the questions presented in Part IV. It then summarizes the conclusions in Part V before setting out certain qualifications and the detailed analysis in Parts VI and VIII, respectively. Finally, Part IX discusses reliance on this Memorandum. I. INTRODUCTION A. This Memorandum addresses the following counterparties to a Covered Base Agreement and related CDA (each, a Covered Customer ): 2 1. With respect to Sections II.C, V.C and VIII, and other portions of this Memorandum as they pertain to Offset Provisions, Covered Customer includes all customers of the Clearing Member. 2. With respect to all other portions of this Memorandum: a. Covered Customer includes: i. Certain Debtors Subject to the Code: For purposes of this Memorandum, Debtors Subject to the Code means individuals, municipalities, corporations, limited liability companies, partnerships and business trusts (as defined in Section 101(9)(A)(v) of the Code), including FCMs registered with the CFTC, and including mutual funds that are organized 1 This Memorandum does not address or constitute advice with respect to compliance with, or the effects of (including any unenforceability as a result of a failure to comply with), any other body of law or regulation other than as explicitly set forth herein, including but not limited to (i) any U.S. federal or state commodities, securities or Blue Sky laws, rules or regulations, (ii) the rules and regulations of any self-regulatory organization, exchange or clearing organization of which a Clearing Member may be a member, (iii) U.S. federal or state tax laws, rules or regulations, (iv) the Employee Retirement Income Security Act of 1974 or similar laws, (v) laws applicable to individuals, including but not limited to those related to capacity, competency, marriage, divorce or death or (vi) any non-u.s. laws, regulations, or insolvency proceedings. In addition, this Memorandum does not address or constitute advice with respect to bankruptcy, insolvency or insurance matters other than those expressly addressed herein. We would be happy to discuss such matters separately at your request. 2 The Federal Deposit Insurance Corporation Improvement Act of 1991 ( FDICIA ), 12 U.S.C et seq., may afford additional protections for the exercise of rights by a Clearing Member if both parties to a Covered Base Agreement and CDA are financial institutions, see id. 4402(9), or if the clearing organization netting provisions of FDICIA were to apply. We do not, however, address FDICIA in this Memorandum. 2

7 as one of the foregoing, that are eligible for and become subject to proceedings under the Code; 3 ii. Broker-Dealers Subject to SIPA (a Broker-Dealer ): For the purposes of this Memorandum, Broker-Dealers Subject to SIPA means registered broker-dealers that are members of the Securities Investor Protection Corporation ( SIPC ) and whose liquidation proceedings are governed by SIPA, including broker-dealers that are also FCMs registered with the CFTC; 4 iii. Certain U.S. Banking Institutions: For purposes of this Memorandum, U.S. Banking Institutions means state- and nationally-chartered banking and savings institutions that take deposits insured by the Federal Deposit Insurance Corporation (the FDIC ) (each, an Insured Institution ); and iv. Insurance Companies Organized Under the Laws of Covered Jurisdictions: For the purposes of this Memorandum, Insurance Companies Organized Under the Laws of Covered Jurisdictions means life or property and casualty insurance companies organized under the laws of Illinois or New York, (each such jurisdiction, a Covered Jurisdiction ), 5 but only to the extent such an insurance company is subject to liquidation or rehabilitation proceedings under the laws of the Covered Jurisdiction of its organization (such an insurance company, a Covered Insurer ). b. Covered Customer specifically excludes: i. insurance companies other than Insurance Companies Organized Under the Laws of Covered Jurisdictions ; ii. pension funds, including those subject to the insolvency regime administered by the Pension Benefit Guaranty Corporation; 3 We analyze an FCM as a Covered Customer only to the extent it acts in a proprietary capacity and not for a customer. 4 We analyze a Broker-Dealer as a Covered Customer only to the extent it acts in a proprietary capacity and not for a customer. 5 We do not practice law in the state of Illinois, and we have not consulted attorneys practicing in Illinois in preparing this Memorandum. Our analysis of the laws of Illinois is based entirely on a review of Illinois s enactment of the NAIC Model Acts related to qualified financial contracts (defined below in Part VII.F.4), and the commentary surrounding the Model Acts. In rendering the analysis with respect to the state of Illinois, we have assumed that Illinois s adoption of the Model Acts provisions would be interpreted in accordance with the plain meaning of those provisions. We have further assumed that, to the extent the adoption of the model provisions related to qualified financial contracts by the state of Illinois varies from the language set forth in the NAIC Model Acts, such modifications would be interpreted by the courts in the state of Illinois as a New York court would interpret such modifications if adopted in the New York statute. We have not reviewed any legislative history or case law from the state of Illinois. We would, of course, be pleased to make further inquiries with counsel practicing in the state of Illinois at your request. 3

8 iii. ordinary private trusts governed by an insolvency regime other than the Code; iv. credit unions; v. political subdivisions, public agencies, governmental entities, or instrumentalities of any U.S. state, except for municipalities subject to proceedings under the Code; vi. government-sponsored enterprises; vii. state and federally licensed branches or agencies of foreign banks; and viii. Covered Customers in proceedings that are not under the Code, SIPA, the FDIA, OLA or the insurance insolvency laws of the relevant Covered Jurisdictions addressed in this Memorandum. II. BACKGROUND We assume in this Memorandum that (i) each Clearing Member is an FCM and that it performs certain services for Covered Customers, including the execution, carrying and clearing of certain contracts for the accounts of such Covered Customers; (ii) with respect to U.S. Futures and Cleared Derivatives Transactions (defined below), the Clearing Member acts in its capacity as a futures commission merchant as defined in Section 761(8) of the Code; (iii) with respect to Options (defined below), the Clearing Member acts in its capacity as a commodity options dealer as defined in Section 761(6) of the Code and (iv) with respect to Foreign Futures (defined below) the Clearing Member acts in its capacity as a foreign futures commission merchant within the meaning of Section 761(12) of the Code. In addition, we assume, except with respect to Foreign Futures, that the Clearing Member is a direct clearing member of the relevant DCO for each Futures Transaction and Cleared Derivatives Transaction and that no intermediary exists between the Clearing Member and the DCO. With respect to Foreign Futures, we assume that the Clearing Member acts as an agent for (and guarantor of) the Covered Customer by carrying Foreign Futures on the Covered Customer s behalf with clearing members ( Foreign Clearing Members ) of the relevant foreign clearinghouses, which Foreign Clearing Members may frequently be affiliates of the Clearing Member, and that the Foreign Clearing Members will, in turn, enter into back-to-back futures transactions cleared by foreign clearinghouses. 6 In this Memorandum, we use the term Clearing Entity to refer, as the context requires, to (i) with respect to Foreign Futures, an applicable Foreign Clearing Member, and (ii) with respect to all other Futures Transactions and Cleared Derivatives Transactions, an applicable DCO. 6 We assume for purposes of this Memorandum that Foreign Clearing Members transact with non-u.s. clearinghouses on a principal-to-principal basis, as is common in most non-u.s. jurisdictions. 4

9 A. The Covered Base Agreements Pursuant to a futures customer account agreement (a Covered Base Agreement ) entered into between a Clearing Member and a Covered Customer, the Clearing Member agrees to carry one or more accounts on behalf of that Covered Customer (each, an Account ) and to execute, carry and clear transactions for the purchase or sale of commodities for future delivery on, or subject to the rules of a DCO registered as such under the Commodity Exchange Act (the CEA ) or traded on, or subject to the rules of, a board of trade outside the United States (such contracts executed on a contract market designated pursuant to Section 5 of the CEA and cleared by a U.S.-registered DCO, U.S. Futures, such contracts traded on or subject to the rules of, a board of trade outside the United States, and options thereon, Foreign Futures and, collectively Futures ) and/or options on U.S. Futures subject to Part 33 of the rules of the CFTC (such contracts, Options, and collectively with Futures, Futures Transactions ). 7 We assume that: 1. Each Covered Base Agreement is governed by New York law. 2. Pursuant to a Covered Base Agreement, the Covered Customer agrees to transfer, as applicable, initial margin and variation margin payments as the Clearing Member may require in respect of the Covered Customer s Futures Transactions. Also, pursuant to the Covered Base Agreement, the Covered Customer grants a security interest to the Clearing Member in all of the Covered Customer s rights in the following property, whether at the time of the grant or thereafter existing: a. Futures Credit Support, including: i. with respect to U.S. Futures and Options, its Account and all assets (including security entitlements, commodity contracts, financial assets and investment property (each as defined in the UCC)) credited thereto, including assets held by a DCO, as well as other property of the Covered Customer (including any securities accounts, commodity accounts, security entitlements, commodity contracts, financial assets and investment property (each as defined in the UCC)) held in respect of Futures Transactions by or for the Clearing Member, the DCO or any agent acting for the Clearing Member, the DCO or the Covered Customer; ii. with respect to Foreign Futures, its Account and all assets (including security entitlements, commodity contracts, financial assets and investment property (each as defined in the UCC)) credited thereto, including assets held by a Foreign Clearing Member or foreign clearinghouse, as well as other property of the Covered Customer (including any securities accounts, commodity accounts, security entitlements, commodity contracts, financial assets and investment property (each as defined in the UCC)) held in respect of Futures Transactions by or for, or for the Account and due from, the Clearing 7 Futures Transactions do not include transactions effected in furtherance of a Clearing Member s Futures Liquidation Rights (defined below). 5

10 Member, any Foreign Clearing Member, any foreign clearinghouse or others, or any agent acting for the Clearing Member, any Foreign Clearing Member, any foreign clearinghouse or others; and b. Futures Payment Rights, including: i. with respect to U.S. Futures and Options, its Futures Transactions and all rights to payment thereunder (whether constituting obligations of the Clearing Member or a DCO); ii. with respect to Foreign Futures, its Futures Transactions and all rights to payment thereunder (whether constituting obligations of the Clearing Member, a Foreign Clearing Member or a foreign clearinghouse). The security interest secures all obligations of the Covered Customer to the Clearing Member under the Covered Base Agreement A Covered Base Agreement contains one or more events of default (whether or not described therein as events of default ) (each, an Event of Default ) the effect of which is to give the Clearing Member the right to liquidate the Futures Transactions held in the Covered Customer s Account ( Futures Liquidation Rights ). 9 Among such Events of Default are defaults predicated on (a) a Covered Customer s filing under applicable bankruptcy or similar insolvency laws, (b) the filing of a petition for the commencement of involuntary proceedings in respect of the Covered Customer under applicable bankruptcy or similar insolvency laws which filing results in a judgment of insolvency or bankruptcy or an order for relief and (c) the appointment in respect of the Covered Customer or substantially all of its assets of an administrator, conservator, receiver or similar official, including the possession and control of the property of the Covered Insurer of a state official pursuant to seizure orders. The terms of the Covered Base Agreement provide the Clearing Member with the right as a secured party to exercise remedies in respect of Futures Payment Rights and to net amounts owing under Futures Transactions on account of their liquidation and termination (collectively, Futures Netting Rights ). 4. The Covered Base Agreement includes a provision the effect of which is to permit the Clearing Member, upon the occurrence of an Event of Default in respect of a Covered Customer, to dispose of or realize on all Futures Credit Support posted by the Covered 8 The Covered Customer may also grant a security interest in the same assets to other entities (e.g., the Clearing Member s affiliates), subject to the prior rights therein of the Clearing Member and applicable Clearing Entity. We express no opinion with respect to such security interests. The CDA integrates into the foregoing grant a Covered Customer s Cleared Derivatives Transactions and the Covered Customer s rights to payment thereunder by designating Cleared Derivatives Transactions as Contracts, which term encompasses Futures Transactions. 9 In this Memorandum, we do not address the effect of any grace periods for Events of Default, in particular grace periods related to involuntary filings, on our analysis. 6

11 Customer to the Clearing Member in respect of Futures Transactions and set off or apply the foregoing or the liquidation value thereof to any obligations the Covered Customer owes to Clearing Member under the Covered Base Agreement. We refer to the foregoing collectively as Futures Credit Support Rights. B. The Cleared Derivatives Addendum In addition to entering into a Covered Base Agreement with the Covered Customer, the Clearing Member and the Covered Customer may execute the CDA. The CDA supplements a Covered Base Agreement with respect to, among other things, the liquidation and netting of Cleared Derivatives Transactions carried in the Covered Customer s account holding Cleared Derivatives Transactions (the Cleared Derivatives Account ) 10, as well as the application of collateral related to those Cleared Derivatives Transactions. For the purposes of this Memorandum, Cleared Derivatives Transactions 11 are swaps, forwards, options, or similar transactions (but excluding Futures Transactions executed on or subject to the rules of a U.S. designated contract market or on a foreign board of trade and subject to regulation in that jurisdiction) that are (i) entered into by a Covered Customer in the over-the-counter market, or (ii) executed or traded by such Covered Customer on or subject to the rules or protocols of any multilateral or other trading facility, system or platform, including any communication network or auction facility permitted under applicable law or any designated contract market and, in either case, subsequently submitted to and accepted for clearing by a DCO and subject to the CFTC s Part 22 rules. 12 To the extent that a security-based swap 13 is, in accordance with applicable law, carried by an FCM in a cleared swaps customer account (as defined in the CFTC s Part 22 rules), such security-based swap constitutes a Cleared Derivatives Transaction for purposes of this Memorandum. We assume that: 1. The CDA is governed by New York law. 2. Pursuant to the CDA, Cleared Derivatives Transactions become incorporated into the related Covered Base Agreement, which incorporation is accomplished by considering references to Contracts, Futures, Futures Contracts and similar terms in such Covered Base Agreement to include references to the Cleared Derivatives Transactions. 10 The parties may elect to use the term Account from a Covered Base Agreement rather than use the narrower term Cleared Derivatives Account. So long as the defined term Account is sufficiently broad to include accounts holding Cleared Derivatives Transactions, the election of either term does not affect our analysis in this Memorandum. 11 Cleared Derivatives Transactions do not include transactions effected in furtherance of Clearing Member s Cleared Derivatives Liquidation Rights (defined below). 12 While the CDA includes within the definition of Cleared Derivatives Transactions contracts cleared by derivatives clearing organizations not registered under the CEA, we do not address such contracts in this Memorandum. 13 See CEA 1a(42); 15 U.S.C. 78c(a)(68). 7

12 Through this incorporation, the Covered Customer grants a security interest to the Clearing Member in all of the Covered Customer s rights in the following property, whether at the time of the grant or thereafter existing: a. (i) its Cleared Derivatives Account and all assets (including security entitlements, commodity contracts, financial assets and investment property (each as defined in the UCC)) credited thereto, including assets held by a DCO, and (ii) other property of the Covered Customer (including any securities accounts, commodity accounts, security entitlements, commodity contracts, financial assets and investment property (each as defined in the UCC)) held in respect of Cleared Derivatives Transactions by or for the Clearing Member, the DCO and any agent acting for the Clearing Member, the DCO or the Covered Customer (collectively, Cleared Derivatives Credit Support ); and b. its Cleared Derivatives Transactions and all rights to payment thereunder (whether constituting obligations of the Clearing Member or a DCO) (collectively, Cleared Derivatives Payment Rights ). 3. Pursuant to the CDA, following the occurrence of an Event of Default, the Clearing Member is entitled to set off or apply any margin transferred to the Covered Customer under Cleared Derivatives Transactions ( Customer Received Margin ) against obligations to the Covered Customer under the CDA The Clearing Member is entitled to, upon the occurrence of an Event of Default, designate a date and thereupon cause the liquidation 15 of a Covered Customer s Cleared 14 The CDA includes within the concept of credit support payments made or received by a Covered Customer as security or to provide setoff or netting rights with respect to one or more Cleared Derivatives Transactions. We express no opinion as to whether variation margin payments are collateral, a loan with a right of netting or a payment. To the extent variation margin payments are treated as collateral or a loan with a right to net, we consider them to be Cleared Derivatives Credit Support (in addition to the assets contained within the definition above) for purposes of this Memorandum and, accordingly, the exercise of rights against such Cleared Derivatives Credit Support would be encompassed by Cleared Derivatives Credit Support Rights (defined below). To the extent such payments are treated as payment or settlement, they would change the value of the related Cleared Derivatives Transactions that would then be subject to closeout. 15 The liquidation of Cleared Derivatives Transactions may be effected in several manners. The Clearing Member may: (1) Effect transactions in the Covered Customer s Account to offset all or part of a Cleared Derivatives Transaction, which result in a proportional liquidation of the Cleared Derivatives Transaction on the DCO on which such transaction is cleared; (2) Sell or novate one or more Cleared Derivatives Transactions; or (3) Value all or part of one or more Cleared Derivatives Transactions by determining any losses, costs or gains with respect thereto. In addition to the foregoing, the CDA entitles a Clearing Member, following an Event of Default, to enter into and liquidate transactions to hedge the risk of one or more Cleared Derivatives Transactions in the Covered Customer s 8

13 Derivatives Transactions (such rights, the Cleared Derivatives Liquidation Rights ). 16 The Clearing Member is entitled to exercise its remedies as a secured party in respect of Cleared Derivatives Payment Rights and to net amounts owing in respect of liquidated Cleared Derivatives Transactions (such rights, the Cleared Derivatives Netting Rights ) Upon the liquidation of a Covered Customer s Cleared Derivatives Transactions, the CDA provides the Clearing Member with rights to (a) dispose of or realize on all Cleared Derivatives Credit Support posted by the Covered Customer to the Clearing Member in respect of Cleared Derivatives Transactions and set off or apply the foregoing or the liquidation value thereof to any obligations the Covered Customer owes to Clearing Member under the CDA and (b) set off or apply the value of any Customer Received Margin against any obligations owed to the Covered Customer under the CDA (such rights, the Cleared Derivatives Credit Support Rights ). 18 C. Offset Provisions When a Covered Customer enters into a U.S. Future, Option or Cleared Derivatives Transaction and that U.S. Future, Option or Cleared Derivatives Transaction is accepted for clearing, a position of the Covered Customer is created consisting of the Covered Customer s rights and obligations with respect to the U.S. Future, Option or Cleared Derivatives Transaction (an Open Position ). Open Positions may be long or short e.g., a Covered Customer could be long or short delivery of a commodity for the same month, the buyer or seller of an option, the buyer or seller of credit protection on a broad-based index or a fixed- or floating-rate payer on an interest rate swap. The rules of DCOs may contain provisions that provide, on an ongoing basis, for the offset of Open Positions that consist of exactly offsetting long and short positions in the same underlying contract. 19 We assume that such provisions ( Offset Provisions ) generally provide for the following: Account ( Risk-reducing Transactions ) and to enter into and liquidate transactions to hedge the risk of one or more Cleared Derivatives Transactions in the Clearing Member s house account ( Mitigation Transactions ). 16 We express no opinion with respect to Risk-Reducing Transactions and Mitigation Transactions to the extent they are not liquidations or terminations of one or more Cleared Derivatives Transactions or portions thereof. 17 These amounts might include: (i) trading gains and losses incurred by the Clearing Member (or, in the case of Mitigation Transactions, the Clearing Member or its affiliates) in entering into or closing out Cleared Derivatives Transactions, Risk-reducing Transactions and Mitigation Transactions, as well as any upfront payments made or received in connection therewith; (ii) valuations associated with Cleared Derivatives Transactions, Risk-reducing Transactions and Mitigation Transactions not closed out through entry into offsetting transactions; (iii) amounts due on account of Cleared Derivatives Transactions, Risk-reducing Transactions and Mitigation Transactions prior to the date on which such transactions are liquidated; and (iv) costs and expenses, including costs of funding and attorneys fees, incurred in connection with the exercise of remedies under the CDA. 18 See Note 14 above. 19 See 17 C.F.R (requiring certain offsets of positions in futures, retail forex transactions and options). 9

14 1. When a Covered Customer has entered into a U.S. Future, Option or Cleared Derivatives Transaction with an Open Position exactly opposite that of another U.S. Future, Option or Cleared Derivatives Transaction carried by the Clearing Member, the Covered Customer s Clearing Member may initiate the offset of those Open Positions. To initiate the offset, the Clearing Member may submit new position data to the DCO 20 or make a request to the DCO to initiate a compression mechanic On the completion of the offset process, the first U.S. Future, Option or Cleared Derivatives Transaction is cancelled by the subsequent U.S. Future, Option or Cleared Derivatives Transaction and the total Open Positions with respect thereto reduced to a net position, which may, depending on the magnitude of the Open Positions, be zero. Thereupon, rights or obligations in respect of such U.S. Futures, Options or Cleared Derivatives Transactions remain only for the resultant net Open Position. 20 The Rulebook of the Chicago Mercantile Exchange Inc. (the CME ) contains a provision regarding the offset process for futures. CME Rule 805 states that [a]ll contracts for the purchase or sale of any product for future delivery shall remain open and in force, and shall continue to be binding upon the original parties until liquidated by offset as provided in Rule 806 or by delivery or failure to perform as provided in Chapter 7. CME Rule 806, in turn, provides that long and short contracts cleared through CME for the same commodity and delivery month (or in the case of options, with the same strike price and expiration month) may be offset by complying with CME Rule 811. Pursuant to CME Rule 811, a Clearing Member must provide position change data to the CME each trading day. Under CME Rule 854, concurrent long and short positions of a clearing member s customer may be held open at the direction of the customer. 21 The rules of ICE Clear Credit LLC provide that where... a Participant has entered into Trades that are... Client-Related Positions with ICE Clear Credit that constitute opposite positions which are identical in all material respects (other than notional or other reference amount and the application of Rule 613[relating to taxes]) in a single Contract, then at the applicable time and in the manner to be specified in the Ice Clear Credit Procedures, the second such Trade shall be deemed pro tanto a settlement or adjustment of the prior transaction and, therefore, a reduction in the relevant Open Position. Thereupon, such Participant shall possess no further rights and be under no further liability with respect thereto only to the extent of such settlement or adjustment. ICE Clear Credit LLC Rule 304(a). Similarly, the rules of LCH.Clearnet LLC provide in relevant part for customer positions: Notwithstanding any other provision of these Regulations, if one or more SwapClear Contracts registered by a Clearing Member in accordance with the Rulebook has substantially the same Economic Terms as one or more other SwapClear Contracts previously registered for the account of such Clearing Member, and all such SwapClear Contracts are either registered on the Clearing Member s own behalf or registered on behalf of the same Client then, to the extent permitted in the Procedures, the Clearing Member may request that the Clearing House compress and combine all such SwapClear Contracts by terminating the relevant existing SwapClear Contracts and compressing them into one SwapClear Contract reflecting the aggregate economic terms, or the net economic terms, as the case may be, of the original SwapClear Contracts.... The Clearing House shall determine (in its sole discretion) whether SwapClear Contracts that are the subject of a request for compression from the Clearing Member may be compressed and, if such SwapClear Contracts are compressed, the Clearing House shall determine the resulting notional amount of the SwapClear Contract(s) (if any) that replaces the compressed SwapClear Contracts, and such determination shall be binding on the Clearing Member, absent manifest error. LCH.Clearnet LLC Rule 401(l). 10

15 We assume that each Covered Customer agrees in its Covered Base Agreement that its U.S. Futures, Options and Cleared Derivatives Transactions are subject to the constitution, bylaws, rules, interpretations and customer of the relevant DCO, including any Offset Provision that such DCO s rules may contain. Further, we assume that each Clearing Member has agreed to be bound by the constitution, bylaws, rules, interpretations and customs of each DCO of which it is a member. 22 III. ASSUMPTIONS 23 Unless otherwise indicated, and in addition to any other assumptions specifically stated elsewhere in this Memorandum, we assume throughout this Memorandum that, with respect to each Futures Transaction and Cleared Derivatives Transaction and each Covered Base Agreement and CDA: 1. The Clearing Member has: a. a security interest granted by the Covered Customer in the Futures Payment Rights, Futures Credit Support, Cleared Derivatives Payment Rights and Cleared Derivatives Credit Support described in Part II above which has attached and is perfected under applicable law, and the Clearing Member s rights in such collateral as secured party rank senior in priority to those of any other person or entity, with the exception of security interests in such collateral in favor of related Clearing Entities, 24 and/or b. a mutual right of setoff in respect of the Futures Payment Rights, Futures Credit Support, Cleared Derivatives Payment Rights and Cleared Derivatives Credit Support described in Part II above. 2. Each Foreign Clearing Member has the right to reuse Futures Credit Support in accordance with applicable law Each Futures Transaction and Cleared Derivatives Transaction is the valid, binding and enforceable agreement of each of the parties thereto, and, except with regard to the provisions analyzed in this Memorandum, each of the Covered Base Agreement and CDA is the valid, binding and enforceable agreement of each of the parties thereto. 22 See Assumption 17 below. 23 We have included additional assumptions specific to Covered Jurisdictions in the subsections of Part VII.G.3 of this Memorandum that discuss the laws of those specific Covered Jurisdictions. 24 See Note 8 above. 25 The commercial law analysis of attachment and perfection of security interests in Futures Payment Rights, Futures Credit Support, Cleared Derivatives Payment Rights and Cleared Derivatives Credit Support involves complicated legal and factual analysis, potentially involving the laws of multiple jurisdictions. 11

16 4. Each of the Clearing Member and the Covered Customer is duly organized and validly existing in good standing under the laws of its jurisdiction of organization and continues to be duly organized and validly existing upon the occurrence of any Event of Default. 5. The Clearing Member has duly executed and delivered, with all requisite capacity and authority (having obtained any required governmental or other consents, approvals, authorizations, registrations or qualifications, provided any required governmental or other notices or filings and taken any other actions necessary for this purpose), and for bona fide commercial reasons and on arm s-length terms as principal and not as agent for any third party other than the Covered Customer, each Covered Base Agreement, each CDA and any respective amendments of such documents. 6. The Covered Customer has duly executed and delivered, with all requisite capacity and authority (having obtained any required governmental or other consents, approvals, authorizations, registrations or qualifications, provided any required governmental or other notices or filings and taken any other actions necessary for this purpose), and for bona fide commercial reasons and on arm s-length terms, its Covered Base Agreement, CDA, Futures Transactions and Cleared Derivatives Transactions and any respective amendments thereto. To the extent that the Covered Customer acts through an agent, (a) the agent has been validly appointed and duly authorized by the Covered Customer to enter into a Covered Base Agreement and CDA with the Clearing Member and to enter into Futures Transactions and Cleared Derivatives Transactions; (b) all of the agent s activities in connection with a Covered Base Agreement, the CDA, any amendments thereto and any Futures Transactions and Cleared Derivatives Transactions are within the scope of its agency; (c) Futures Transactions and Cleared Derivatives Transactions entered into by the agent in its capacity as agent for the Covered Customer are allocated to a unique account or sub-account at the Clearing Member separate from all other accounts or subaccounts to which Futures Transactions and Cleared Derivatives Transactions entered into by the agent on behalf of other principals, or by the Covered Customer as principal, are allocated; (d) the agent of the Covered Customer has no proprietary interest in the Covered Customer s Covered Base Agreement, Account, Futures Transactions, CDA, Cleared Derivatives Account or Cleared Derivatives Transactions, in each case, by virtue of subrogation or otherwise; and (e) the agent is solvent and not subject to any bankruptcy, insolvency, reorganization, moratorium, conservatorship or similar proceedings. 7. At the time each Covered Base Agreement, the CDA and each Futures Transaction and Cleared Derivatives Transaction is entered into, no party thereto is subject to an insolvency proceeding or has actual notice of the insolvency of the other party. In respect of the Covered Base Agreement, the CDA and each Futures Transaction and Cleared Derivatives Transaction, at the time each is entered into, neither party thereto has any intent to hinder, delay or defraud creditors of itself or the other party. 8. The Covered Base Agreement and CDA, and any Futures Transactions and Cleared Derivatives Transactions entered into in connection therewith, have not been varied, waived or discharged in any material respect in respect of any defaults specified therein, close-out, netting, setoff and other rights and remedies, the scope and nature of any 12

17 security interest granted or delivery mechanics for collateral. There are no agreements or understandings between the Clearing Member and the Covered Customer or any other party that would modify or otherwise affect the terms of the Covered Base Agreement and CDA, and any Futures Transactions and Cleared Derivatives Transactions entered into in connection therewith, or the respective rights or obligations of the parties thereunder in a manner that would prejudice the Clearing Member s ability to exercise the rights and remedies analyzed herein. 9. From the time a Covered Customer becomes the subject of insolvency proceedings and until its Futures Transactions and Cleared Derivatives Transactions are closed out, the Clearing Member is not itself the subject of insolvency proceedings. With respect to a Covered Customer that is a Covered Insurer, the Covered Insurer and its Clearing Member are not affiliates or insiders of one another. 10. Each Covered Customer subject to the Code or SIPA is a customer, within the meaning of Section 761(9) of the Code, with respect to its Futures Transactions or Cleared Derivatives Transactions carried by a Clearing Member. 11. With regard to the FDIA, the written agreement requirements of Sections 1821(n)(4)(I) and 1823(e) of Title 12 of the United States Code are satisfied in respect of the Covered Base Agreement, the CDA and all Futures Transactions and Cleared Derivatives Transactions. 26 With regard to OLA, the written agreement requirements of Sections 210(a)(6) and 210(h)(7) of the Dodd-Frank Act are satisfied in respect of the Cleared Base Agreement, the CDA and all Futures Transactions and Cleared Derivatives Transactions In respect of each Futures Transaction and Cleared Derivatives Transaction, neither party thereto has entered into any related transaction or agreement that could affect the 26 The Board of Directors of the FDIC issued a Statement of Policy on Qualified Financial Contracts (the Statement of Policy ) on December 12, 1989 that interprets, inter alia, the written agreement requirements of Sections 1821(n)(4)(I) and 1823(e) of Title 12 of the United States Code. The Statement of Policy provides that any qualified financial contract that complies with the following three criteria will be deemed to satisfy the written agreement requirements of Sections 1821(n)(4)(I) and 1823(e) of Title 12: (i) the qualified financial contract is evidenced by a writing sent by one of the parties and such writing is sent reasonably contemporaneously with the parties agreement to enter the specific qualified financial contract transaction; (ii) the insured depository institution had the corporate authority to enter into the qualified financial contract (and the insured depository institution s counterparty may rely on a resolution or written representation to determine whether it is so authorized); and (iii) the insured depository institution must maintain in its official books and records the writing evidencing the qualified financial contract and evidence of the requisite corporate authority, although the counterparty may, by appropriate evidence, establish the existence of the writing and the evidence of authority. The Statement of Policy by its terms, however, does not apply to qualified financial contracts between an insured depository institution and that institution s affiliate. 27 Sections 210(a)(6) and 201(h)(7) require that the agreement must (i) be in writing; (ii) have been executed by an authorized officer or representative of the covered financial company or confirmed in the ordinary course of business by the covered financial company; and (iii) have been, since the time of its execution, an official record of the company, or the party claiming under the agreement must provide documentation, acceptable to the receiver, of such agreement and its authorized execution or confirmation by the covered financial company. 13

18 characterization of such Futures Transaction or Cleared Derivatives Transaction (or any related security arrangements) as a swap agreement and/or a commodity contract within the meaning of the Code, SIPA, the FDIA, OLA or the insurance law of a Covered Jurisdiction, as applicable. 13. With respect to proceedings under the Code and SIPA, each Foreign Future is a commodity contract as defined in Section 761(4) of the Code. With respect to proceedings under the FDIA, each Futures Transaction is a commodity contract as defined in 12 U.S.C. 1821(e)(8)(D)(iii) and each Cleared Derivatives Transaction is a swap agreement as defined in 12 U.S.C. 1821(e)(8)(D)(vi). With respect to proceedings under OLA, each Futures Transaction is a commodity contract as defined in Section 210(c)(8)(D)(ii) of the Dodd-Frank Act and each Cleared Derivatives Transaction is a swap agreement as defined in Section 210(c)(8)(D)(vi) of the Dodd- Frank Act. With respect to proceedings under the insurance laws of a Covered Jurisdiction, each Futures Transaction is a commodity contract as defined under the law of such Covered Jurisdiction, each Cleared Derivatives Transaction is a swap agreement as defined under the insurance insolvency law of such Covered Jurisdiction and each Covered Base Agreement and each CDA is a netting agreement as defined under the insurance insolvency law of such Covered Jurisdiction None of the parties rights under a Futures Transaction, Cleared Derivatives Transaction, Covered Base Agreement or CDA is subject, voluntarily or involuntarily, to any assignment, pledge, lien, security interest or other encumbrance in favor of any person other than the parties or the Clearing Entity, unless such assignment, pledge, lien, security interest or other encumbrance is subject to the netting or offset rights and security interest of the Clearing Member under such Covered Base Agreement and such CDA. 28 The Dodd-Frank Act amended the definition of commodity contract in the Code (which definition also applies in proceedings under SIPA) to include with respect to a futures commission merchant or a clearing organization, any other contract, option, agreement, or transaction, in each case, that is cleared by a clearing organization. 11 U.S.C. 761(4)(F)(ii). Because of this expanded definition, we analyze each Cleared Derivatives Transaction as a commodity contract under the Code and do not need to assume that each Cleared Derivatives Transaction is a commodity contract or a swap agreement. See Part VII.C.2(a). In addition, we do not assume, for purposes of the Code and SIPA, that U.S. Futures and Options are commodity contracts within the meaning of the Code and SIPA. The Code definition of commodity contract includes, among other things, (i) with respect to an FCM, a contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade and (ii) an option to enter such a contract. See 11 U.S.C. 761(4). It is quite likely that U.S. Futures and Options will fall within these definitions. However, if they do not, we believe that they would be captured by Section 761(4)(F)(ii), which includes other contracts cleared by a DCO. The Dodd-Frank Act did not expand the definition of commodity contract in the FDIA and did not include the expanded definition in OLA. Further, the Model Acts do not include provisions similar to those included in the Dodd-Frank Act amendments to the Code. As a result, whether a Futures Transaction or Cleared Derivatives Transaction is a Qualified Financial Contract under the FDIA or OLA or a protected contract under the insurance laws of a Covered Jurisdiction depends on the substantive terms of that Futures Transaction or Cleared Derivatives Transaction. 14