The Commodity Futures Trading Commission (the "CFTC") issued its final rules requiring futures commission merchants ("FCMs") and derivatives clearing organizations ("DCOs") to segregate collateral posted by customers with respect to cleared swaps (the "Collateral Rules") pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act").[1] The CFTC adopted the legal segregation with operational commingling model (the "LSOC Model"), which (1) requires FCMs and DCOs to segregate cleared swap customers' collateral on their books and records, and prohibits them from commingling customer collateral with their own funds, but permits FCMs and DCOs to commingle customer collateral in accounts with other cleared swap customers; and (2) restricts a DCO's ability to use non-defaulting customers' collateral to cover a defaulting customer's obligations in the event that a cleared swap customer defaults on its obligations to an FCM which, in turn, defaults on its obligations to the DCO (a "double default"), thereby reducing "fellow-customer risk" (i.e., the risk that a DCO would need to access the collateral of non-defaulting customers to cure an FCM default).

Private investment fund managers, and the funds that they manage, should be aware of the Collateral Rules because they impact the fellow-customer, operational and investment risks to their collateral. In addition, the Collateral Rules affect the costs of entering into cleared swap transactions. The effective date of the Collateral Rules will be April 9, 2012. All parties, including private fund managers, must comply with the Collateral Rules by Nov. 8, 2012. While implementation may involve considerable operational changes at DCOs and FCMs, it is not expected that most fund managers will have to make significant changes to their current practices in order to comply with the Collateral Rules.

The LSOC Model differs from the existing model that applies to futures (the "Futures Model"). Under the Futures Model, DCOs treat each FCM's customer account on an omnibus basis without differentiating among customers. In the event of a bankruptcy of an FCM due to a double default under the Futures Model, the DCO would be able to access the collateral of non-defaulting customers and defaulting customers posted to the DCO to satisfy any loss in the customer account.[2]

In the case of a bankruptcy of an FCM due to a double default under the LSOC Model, the most significant benefit to customers of the FCM is their protection (assuming that they are a non-defaulting customer) against fellow-customer risk. Where the shortfall is due to a fellow customer’s loss that exceeds both the customer’s collateral and the FCM’s ability to pay, i.e., a double default, the DCO would be able to access only the collateral attributable to defaulting customers to satisfy the loss and not the collateral of non-defaulting customers.[3] In the event of a double default, the adopted model improves on the current Futures Model by not permitting the DCO to access non-defaulting customer collateral in its default "waterfall" of funds to satisfy any losses created from a defaulting customer. In addition, the adopted model improves on the current Futures Model by requiring customer account data to be transmitted to the DCO daily, thereby providing up-to-date information on which to base account transfers and liquidations, and therefore increasing the portability of non-defaulting customers' positions to other FCMs.

The CFTC has acknowledged the limitations of the Collateral Rules in protecting cleared swap customer collateral due to an FCM's bankruptcy with respect to operational risk or investment risk. Under both the LSOC Model and the Futures Model, if the FCM experiences a bankruptcy as a result of corporate financial difficulties unrelated to customer accounts, there will be no shortfall in the customer accounts and each customer's account can be transferred or liquidated in full by the trustee. However, if the shortfall is due to operational risks such as fraud or mismanagement of customer accounts by the FCM, or investment risks resulting from extraordinary losses on permitted investments, customer positions and related collateral at a DCO may be delivered to the trustee of the bankrupt FCM or may be transferred to a solvent FCM, but only to the extent of each customer's pro rata share.

The CFTC may address operational and investment risks in future rulemakings. The CFTC is also considering whether to modify the Futures Model so that futures customers may benefit from protection against fellow-customer risk available to the cleared swap market customers under the LSOC Model.