Legal Alert: CFTC Grants No-Action Relief to Commodity Pool Operators with Respect to Certain Insurance-Linked Securitization Vehicles

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1 Action Relief to Commodity to Certain Insurance-Linked Securitization Vehicles Toward the end of 2014, the staff of the Commodity Futures Trading Commission s (CFTC) Division of Swap Dealer and Intermediary Oversight (DSIO) issued two letters affecting insurance-linked securitization vehicles: CFTC Letter No and CFTC Letter No EXECUTIVE SUMMARY CFTC Letter affords industry-wide relief from commodity pool operator (CPO) registration to entities operating certain insurancelinked securities (ILS) issuers by permitting them to avail themselves of an exemption available under CFTC Rule 4.13(a)(3). CFTC Letter generally will not affect the majority of the widelydistributed catastrophe bond transactions that are currently being executed. The type of risk transfer agreement that catastrophe bond issuers have entered into in connection with Rule 144A/Regulation S offerings has, in recent years, usually been an indemnity reinsurance agreement. In 2014, indemnity-based catastrophe bond transactions accounted for about 70% of such transactions by outstanding notional. This type of ILS transaction is structured to mitigate any material concern that the ILS issuer could be a commodity pool, subjecting its operator(s) to regulation under the U.S. Commodity Exchange Act (CEA). Accordingly, CFTC Letter will not have a significant impact on a majority of the Rule 144A/Regulation S catastrophe bond offerings currently being executed. CFTC Letter will, however, affect ILS transactions involving risk transfer agreements that could be swaps under the CEA, 1 where the ILS are offered or sold to U.S. investors (Derivatives-based ILS Transactions). CFTC Letter will reduce the compliance obligations of operators of ILS issuers in connection with Derivativesbased ILS Transactions, and may affect the disclosure used in connection with some Derivatives-based ILS Transactions. Issuers of ILS in Derivatives-based ILS Transactions should ensure that Letter s conditions for relief are complied with. These conditions (described in greater detail below) include: The type of collateral that such issuers may hold. The filing of a notice of eligibility for an exemption from CPO registration with the National Futures Association (NFA), which notice must be reaffirmed annually. Notification of the DSIO if the value of the collateral held by the ILS Contacts If you have any questions about this Legal Alert, please feel free to contact any of the attorneys listed or the Sutherland attorney with whom you regularly work. Brian Barrett Partner brian.barrett@sutherland.com James M. Cain Partner james.cain@sutherland.com Eric R. Fenichel Partner eric.fenichel@sutherland.com Daphne G. Frydman Partner daphne.frydman@sutherland.com Nicole S. Lim Associate nicole.lim@sutherland.com Raymond A. Ramirez Associate ray.ramirez@sutherland.com Related People/Contributors Brian Barrett James M. Cain Daphne G. Frydman Catherine M. Krupka David T. McIndoe Mark D. Sherrill

2 issuer is less than the notional amount of the relevant risk transfer contract, and may not issue any additional bonds or enter into any commodity interest transactions while such deficiency exists. It is also worth noting that an ILS issuer would only be permitted to hold certain Eligible Collateral, as described below. CFTC Letter affords relief, to an anonymous, registered CPO for an ILS issuer, from certain disclosure and periodic reporting requirements. The basis for affording relief from the requirements is the unique structure of ILS transactions. Although the letter cannot be relied on by all market participants, because it is tailored to the CPO in question s particular facts and circumstances, it nevertheless provides insight into the CFTC staff s view of ILS transactions within the context of the CPO regulatory regime. R. Michael Sweeney, Jr. Warren N. Davis Meltem F. Kodaman Cheryl I. Aaron Doyle Campbell Lillian A. Forero Meghan R. Gruebner Alexander S. Holtan Nicole S. Lim Raymond A. Ramirez Both CFTC Letters and , which are summarized below, afford relief from certain CPO compliance obligations. Although Letter preceded Letter , our summary begins with Letter because Letter is a no-action letter that was issued to a specific (and anonymous) market participant and cannot be relied on by other market participants. In contrast, Letter was addressed to the Securities Industry and Financial Markets Association (SIFMA) and affords industry-wide relief from CPO registration to certain entities that engage in insurance-linked securities transactions. CFTC Letter Letter , which was issued on December 18, 2014, permits certain entities that engage in ILS transactions to avail themselves of the exemption from CPO registration afforded by CFTC Rule 4.13(a)(3), so long as certain conditions, described below, are met. 2 The relief afforded by Letter is not selfexecuting and must be claimed with the NFA, as is generally the case with regard to the CFTC Rule 4.13(a)(3) exemption. The relief afforded by Letter is not time limited and, therefore, so long as such relief is not amended or revoked, it can be relied on indefinitely. Rule 4.13(a)(3) and Why Relief is Necessary Under the CEA, as interpreted by the CFTC, any collective investment vehicle that engages in even one commodity interest transaction (i.e., a futures, option or swap) could be a commodity pool. 3 The operator of a commodity pool is required to register as a commodity pool operator with the CFTC, unless it is eligible for an exemption from CPO registration or an exclusion from CPO status. To the extent that an entity is eligible for an exemption from CPO registration or an exclusion from CPO status, such entity is not required to satisfy the compliance obligations applicable to CPOs.

3 An ILS issuer is a vehicle of pooled assets through which investors (i.e., bondholders) obtain exposure to specified trigger events. The mechanism by which this is accomplished is the risk transfer contract between the ILS issuer and the Protection Buyer. To the extent that such risk transfer contract could be considered a swap, then the ILS issuer would be a commodity pool, and the ILS issuer s operator could be required to register as a CPO. 4 There are numerous exclusions and exemptions from CPO status and CPO registration, respectively. Among them is CFTC Rule 4.13(a)(3). Rule 4.13(a)(3) exempts persons from registration if four criteria are met: 1. Interests in the relevant commodity pool are exempt from registration under the Securities Act of 1933, and such interests are offered and sold without marketing to the public in the United States; 2. The commodity pool must at all times meet a de minimis commodity interest trading activity threshold. Namely, either (a) the margins, premiums and required minimum security deposit for retail forex transactions cannot exceed 5% of the liquidation value of the commodity pool s assets after giving effect to unrealized profits or losses, or (b) the aggregate net notional value of the commodity pool s commodity interest positions, determined at the time the most recent position was established, cannot not exceed 100% of the liquidation value of the commodity pool s portfolio, after taking into account unrealized profits and unrealized losses; 3. The operator of the commodity pool believes, at the time of investment, that each investor in the pool meets one of certain enumerated tests relating to the financial sophistication of the investor (e.g., accredited investor or qualified eligible person); and 4. Participations in the commodity pool are not marketed as or in a vehicle for trading in commodity interests. 5 SIFMA, in its representations to the CFTC staff, indicated that ILS transactions typically satisfy the first three of Rule 4.13(a)(3) s four criteria for relief: According to Letter , ILS issuers offer their bonds in private placements and such bonds are exempt from registration under the Securities Act of 1933, and the bonds are not offered or sold through marketing to the public in the United States. Thus, such ILS transactions meet Rule 4.13(a)(3) s first condition for relief. Moreover, ILS issuers can, and according to SIFMA will, comply with Rule 4.13(a)(3) s de minimis threshold.

4 Last, ILS transactions are typically only sold to sophisticated institutional investors meeting the qualified eligible purchaser standard, in compliance with Rule 4.13(a)(3) s third condition for relief. However, because the risk transfer contract is the mechanism by which bondholders obtain exposure to insurance-linked risk, according to the CFTC, it is difficult to argue that ILS transactions are not the primary source of investment gains and losses to the bondholders. Therefore, ILS transactions, whose underlying risk transfer agreement is a swap, could, according to the CFTC, involve the marketing of ILS Issuers and their Bonds as vehicles for investing interests in violation of the fourth prong of Regulation 4.13(a)(3). According to Letter , ILS transactions are typically offered via an offering circular that includes a risk analysis report, prepared by an independent company, that uses models widely employed by insurers and reinsurers in their own risk evaluations. The risk analysis forms much of the basis on which bonds are evaluated, rated and priced. Following numerous representations from SIFMA, the CFTC staff deemed it appropriate to characterize (1) the marketing efforts associated with ILS transactions as focused on the analysis and statistical modeling of insurance risks to and for which the Protection Buyer is actually exposed, and (2) the risk transfer contract as merely a conduit to transmit the insurance-related risks of the Protection Buyer through the ILS issuer to the bondholders. Relief Granted Based on SIFMA s representations and the CFTC staff s conclusions resulting therefrom, Letter permits ILS issuers to avail themselves of the CFTC Rule 4.13(a)(3) exemption provided that they meet the following requirements: The operator of the ILS issuer meets the first three conditions for exemption of CFTC Rule 4.13(a)(3). The operator of the ILS issuer files a notice of eligibility for exemption from CPO registration with the NFA in accordance with the requirements of CFTC Rule 4.13(b) (which also requires an annual reaffirmation of the exemption). The ILS issuer is operated in the following manner: There is no active management of assets and liabilities over the lifetime of the ILS issuer. The collateral (Eligible Collateral) held by the ILS issuer must at all times:

5 Be in the form of cash or cash-equivalent, highly-liquid assets, i.e., assets that can be converted into cash within one business day without a material discount in value, limited to: Puttable debt issued by the International Bank for Reconstruction and Development, the European Bank for Reconstruction and Development, or the Kreditanstalt für Wiederaufbau; Any U.S. or European Union-regulated money market fund that invests solely in debt issued by the U.S. Treasury or U.S. sponsored agencies, or repurchase and reverse repurchase agreements collateralized by debt issued by the U.S. Treasury or U.S. sponsored agencies; Other assets that are highly liquid under CFTC Rule 1.25; or Any other CFTC- or DSIO-approved collateral; and Either have a maturity date that falls on or before the termination date of the risk transfer contract entered into by the ILS issuer, or be convertible to cash upon demand by the ILS issuer. Upon becoming aware that the value of collateral held by the ILS issuer is less than the notional amount of the relevant risk transfer contract, the ILS issuer (a) shall promptly notify the DSIO of the same in writing, and copies of such notice must be provided to the Protection Buyer and the bondholders pursuant to the notice procedures in the applicable transaction documentation, and (b) shall neither issue any additional bonds nor enter into any commodity interest transactions for so long as such deficiency exists. The payment obligations of the ILS issuer to the Protection Buyer and to the bondholders must be secured by Eligible Collateral, and the security arrangements must provide that obligations to the Protection Buyer under the relevant risk transfer contract will be satisfied from the Eligible Collateral prior to any proceeds of the Eligible Collateral being used to repay principal to the bondholders. The Eligible Collateral shall be maintained by the ILS issuer so that it is available to be distributed in the form of cash or in kind to the Protection Buyer at the time a payment becomes due under the risk transfer contract.

6 The Eligible Collateral held by the ILS issuer shall be subject to arrangements that protect the Protection Buyer in the event that the ILS issuer becomes subject to an insolvency proceeding. This condition will be satisfied if the ILS issuer satisfies the following criteria: The powers of the ILS issuer shall be limited so that the ILS issuer may not engage in business or activity other than as necessary or appropriate for serving as an ILS vehicle; The ILS issuer can be restricted from incurring additional debt, except as may be necessary or appropriate for entering into additional ILS offerings in the case of a multi-user issuer, in which case the obligation to repay such additional debt shall be secured solely by additional Eligible Collateral obtained in connection with such additional ILS offering; The ILS issuer shall be restricted from entering into any additional commodity interest transactions beyond the swap transaction necessary for the ILS offering, except that in the case of a multi-use ILS issuer, the ILS issuer may enter into additional swaps to the extent it is necessary or appropriate in order to enter into additional ILS offerings; The ILS issuer shall be governed by a board of directors (or other similar body) comprised of individuals independent of the Protection Buyer; Corporate formalities shall be observed between the ILS issuer, on the one hand, and the Protection Buyer and affiliates of the Protection Buyer; As a condition to any agreement imposing obligations on the ILS issuer, the interest holders, the Protection Buyer and any potential creditors of the ILS issuer shall be required to waive any right to file an involuntary bankruptcy petition for the ILS issuer or otherwise initiate a solvency, liquidation, dissolution, or other action having a substantially similar effect with respect to the ILS issuer; and The ILS issuer shall be prohibited from filing a voluntary petition for bankruptcy and from engaging in a merger, asset sale, consolidation, liquidation, dissolution, or other action having a substantially similar effect.

7 CFTC Letter Letter , which was issued on November 12, 2014, relieves an anonymous registered CPO, A, from having to satisfy the CPO financial statement delivery requirements under CFTC Rule 4.22 and the disclosure requirements of CFTC Rule 4.24(s), in each case with respect to an ILS issuer. 6 Because Letter is a no-action letter that is addressed to a specific market participant, it cannot be relied on by market participants generally. However, it is nevertheless useful because it provides insight into the CFTC staff s view of ILS transactions within the context of the CPO regulatory regime. Background As described in Letter , the ILS issuer in question entered into a risk transfer agreement to transfer excess mortality life insurance risk from an insurance company, C, and certain of its affiliates (the Protection Buyer), to investors in insurance-linked notes issued by the ILS issuer and pursuant to which the Protection Buyer agreed to make quarterly payments to the ILS issuer in exchange for the ILS issuer s commitment to make payments to the Protection Buyer upon the occurrence of certain excess mortality events. The quarterly payments made by the Protection Buyer, together with investment returns on collateral held by the ILS issuer resulting from the sale of the insurance-linked notes, fund the interest payments to the holders of the ILS issuer s insurancelinked notes. Such returns were generated from investment in a pool of highquality instruments, including AAA rated bonds and U.S. Treasury-only money market funds. Relief Granted from CFTC Rules 4.22 and 4.24(s) CFTC Rule 4.22 CFTC Rule 4.22 requires a registered CPO to distribute periodic account statements and annual reports to each pool participant and to submit copies of such statements and reports to the NFA. 7 The purpose of CFTC Rule 4.22 is to ensure that commodity pool participants receive accurate, fair and timely information on the overall trading performance and financial condition of the pool. As argued, the provision of periodic account statements and annual reports to the holders of the ILS issuer s notes, in accordance with CFTC Rule 4.22, would not provide relevant information to the holders of the ILS issuer s notes. This is because the ILS issuer in question has predefined assets and liabilities and its activities largely consist of holding eligible investments, receiving quarterly payments from the Protection Buyer, and using such investments and payments, as applicable, to pay its obligations under the risk transfer agreement or to investors in accordance with the terms of the ILS issuer s notes. Thus, there is no management of assets and liabilities over the lifetime of the ILS issuer. As a result of A s representations concerning the ILS issuer, the staff of the DSIO deemed it appropriate to replace the requirements of CFTC Rule 4.22 with the

8 disclosures required as conditions for relief, described below, certain of which are already made by the ILS issuer in an Offering Circular Supplement provided by the ILS issuer to the holders of its notes. CFTC Rule 4.24(s) CFTC Rule 4.24 requires a registered CPO to make certain general disclosures, in a disclosure document, to each prospective participant in a pool that it operates. 8 Among such disclosures are those required by subsection (s) of Rule 4.24, which relate to the inception of trading of a commodity pool. Specifically, CFTC Rule 4.24(s) requires the disclosure of (1) the minimum aggregate subscriptions that are necessary for a commodity pool to commence trading, (2) the minimum and maximum aggregate subscriptions that may be contributed to a commodity pool, (3) the maximum period of time that a pool will hold funds prior to the commencement of trading, (4) the disposition of funds received if a commodity pool does not receive the necessary amount to commence trading, including the period of time within which the disposition will be made, and (5) where a CPO will deposit funds received prior to the commencement of trading by a pool. The principal purpose of these disclosures is to ensure that commodity pool participants are informed about the material facts regarding a commodity pool before they commit their funds. In its request for relief, A argued that CFTC Rule 4.24(s) is not applicable to the ILS issuer in question due to the structure of ILS transactions. According to A, the information about subscriptions is known ahead of closing and disclosed in the offering prospectus supplement and pricing settlement, because a predefined principal amount of the notes is to be issued. In addition, the other disclosures required by CFTC Rule 4.24(s) are irrelevant because the risk transfer agreement between the ILS issuer and the Protection Buyer is entered into concurrently with the issuance of notes to investors by the ILS issuer. Based on these representations, the staff of the DSIO deemed it appropriate to afford relief from the Rule 4.24(s) disclosure requirements, subject to the conditions for relief described below. The Conditions for Relief The CFTC granted relief to A from the requirements of CFTC Rules 4.22 and 4.24(s) on the following conditions: That A provide the holders of the ILS issuer s notes with the following information on at least a monthly basis: All payments that have been made during the month prior pursuant to the risk transfer agreement, and all payments that have at least a reasonable possibility of being payable pursuant to the risk transfer agreement.

9 Material performance information concerning the assets supporting the ILS issuer s notes or the obligations under the risk transfer agreement, including without limitation, any swaps held in the issuer s portfolio. That A provide the holders of the ILS issuer s notes with basic, material information concerning all of the following, to the extent an existing investor has not received such information, at the same time or before the information required above is first provided: The terms and conditions of the risk transfer agreement, including the risks agreed to be borne by the ILS issuer; The structure of the securities and distributions thereon; The nature and servicing of the assets supporting the ILS issuer s notes and the obligations under the risk transfer agreement including, without limitation, a discussion of any swaps held in the ILS issuer s portfolio, including the function of such swaps; and The ILS issuer s counterparties. To prospective holders of the ILS issuer s notes, A must provide the most recent copy of the information required to be provided to the existing holders of notes of the ILS issuer that are described immediately above. If A knows or should know that the above information is materially inaccurate or incomplete in any respect, it must correct the defect and distribute the correction consistent with the CFTC s rules concerning the correction of disclosure documents, which are found in CFTC Rule 4.26(c). There is to be no management of assets or liabilities over the lifetime of the ILS issuer. A must calculate net asset value with respect to the ILS issuer in the following manner: Fixed income securities rated BB and higher should be treated as debt. All other fixed income securities and equity tranches should be treated as equity. Finally, Letter does not excuse A from complying with other applicable requirements under the CEA or CFTC regulations promulgated thereunder.

10 APPENDIX A ILS Transaction Summary The relief afforded in Letter is premised on the following ILS transaction structure, which market participants will note is consistent with the typical structure used in the market. Thus, Letter should have some general applicability. ILS transactions allow insurance companies (Protection Buyers) to obtain collateralized protection against insurance-related risks from the capital markets, pursuant to a risk transfer contract with an ILS issuer, which is a special purpose vehicle formed by the Protection Buyer. In an ILS transaction, a Protection Buyer will form an ILS issuer. The Protection Buyer and the ILS issuer subsequently enter into a risk transfer contract, pursuant to which the ILS issuer agrees to make payments to the Protection Buyer if certain trigger events occur. The example used in Letter is that of an insurance company that has historically had exposure to California earthquakes. Such an insurance company could create an ILS issuer and contract with such issuer to receive payments if a California earthquake occurs, and the Protection Buyer must pay claims to earthquake insurance policyholders. To support its obligations under the risk transfer contract, an ILS issuer sells bonds, notes, certificates or other instruments (Bonds) in an amount equal to its maximum exposure under the risk transfer contract. Bonds are only sold to persons who are qualified institutional buyers that, with respect to U.S. persons, are also qualified purchasers. All proceeds of the Bonds are deposited into a collateral account. Upon the occurrence of a specified trigger event (e.g., an earthquake in California, in the above example), the ILS issuer pays the contractual payment amount to the Protection Buyer from the collateral account. Coverage provided by the ILS issuer cannot exceed the collateralized amount. When amounts are transferred from the collateral account to cover a specified trigger event under a risk transfer contract, the aggregate principal amount of the Bonds is written down in the amount of such transfer. As part of the risk transfer contract, the Protection Buyer makes payments to the ILS issuer to cover the ILS issuer s expenses and to pay interest to the holders of the Bonds (Bondholders). The Bondholders interest rate payments consist of a portion of the Protection Buyer s payments plus the earnings on investments of the proceeds from the Bond issuance. At maturity and upon satisfaction of the risk transfer contract obligations to the Protection Buyer, funds from the collateral account are used for repayment of the remaining principal balance of the Bonds to the Bondholders.

11 The diagram below reflects the ILS transaction structure described above. ILS Transaction Structure 1 For a summary of the swap definition in the insurance context, please see Sutherland s Legal Alert: Insurance Safe Harbor Affords Little Certainty for Non-US Insurers, dated January 3, See Appendix A, below, for a description of the ILS transaction structure for which Letter affords relief. 3 See 77 Fed. Reg. 11,252 (Feb. 24, 2012) at 11,258. See also 7 U.S.C. 1a(10). 4 The term swap is broadly defined. See Section 1a(47) of the CEA and the joint CFTC and Securities and Exchange Commission regulations adopted to further define the term, 77 Fed. Reg. 48,207 (Aug. 13, 2012). 5 See 17 C.F.R. 4.13(a)(3) (2014). 6 The directors of the ILS issuer in question delegated their CPO obligations with respect to the ILS issuer to A, and such delegation satisfied the CPO-delegation requirements outlined in CFTC Letter No C.F.R (2014) C.F.R. 4.24(s). 9 Qualified purchasers are qualified eligible persons as defined in CFTC Regulation 4.7(a), 17 C.F.R. 4.7(a) (2014). If you have any questions about this Legal Alert, please feel free to contact any of the attorneys listed under 'Related People/Contributors' or the Sutherland attorney with whom you regularly work.