CFTC Issues CPO Relief for Insurance-linked Securities | Practical Law

CFTC Issues CPO Relief for Insurance-linked Securities | Practical Law

The CFTC granted general no-action relief from commodity pool operator (CPO) registration for entities engaging in insurance-linked securities (ILS) transactions.

CFTC Issues CPO Relief for Insurance-linked Securities

Practical Law Legal Update 2-593-9346 (Approx. 4 pages)

CFTC Issues CPO Relief for Insurance-linked Securities

by Practical Law Finance
Published on 08 Jan 2015 • USA (National/Federal)
The CFTC granted general no-action relief from commodity pool operator (CPO) registration for entities engaging in insurance-linked securities (ILS) transactions.
On December 18, 2014, the CFTC issued No-action Letter 14-152 (No-action 14-152), which provides no-action relief from registration as a commodity pool operator (CPO) for entities engaging in insurance-linked securities (ILS) transactions.
ILS transactions were first developed in the 1990s to generate additional capital to support the insurance industry in the wake of Hurricane Andrew, which forced several insurers to enter into receivership. ILS transactions allow insurance companies to obtain collateralized protection against insurance-related risks from the capital markets under a risk transfer contract with the ILS seller (ILS Issuer), which is a special purpose vehicle (SPV) formed by the insurance company.
In a typical ILS transaction, the insurance company (the transaction's protection buyer) causes an SPV to be created to act as the ILS Issuer. The protection buyer enters into a risk transfer contract with the ILS Issuer (ILS CPO) under which the protection buyer obtains protection against specified and clearly defined trigger events to which the protection buyer has exposure during the life of the ILS transaction. The protection payments from the protection buyer to the ILS Issuer are then used to make payments on securities issued to third-party investors (bondholders).
Under No-action 14-152, the CFTC's Division of Swap Dealer and Intermediary Oversight (DSIO) states that it will not recommend that the CFTC take enforcement action against any entity characterized as the operator of an ILS CPO, for failure to register as a CPO under Commodity Exchange Act (CEA) Section 4m(1) (17 CFR 4m(1)), provided that:
  • The ILS CPO meets the conditions for an exemption from CPO registration in CFTC Regulations 4.13(a)(3)(i), (ii) and (iii) (17 CFR 4.13(a)(3)) regarding an ILS Issuer.
  • The ILS CPO files a notice of eligibility for an exemption from CPO registration with the National Futures Association (NFA) under Regulation 4.13(b) (17 CFR 4.13(b)) and meets the other terms of Regulation 4.13 (17 CFR 4.13).
  • The ILS CPO does not actively manage assets and liabilities over the lifetime of the ILS Issuer.
  • The collateral held by the ILS Issuer must, at all times:
    • be in the form of cash or cash-equivalent, "highly liquid" (as that term is defined in CFTC Regulation 1.25 (17 CFR 1.25)) assets; and
    • either have a maturity date that is on or before the termination date of the risk transfer contract or be convertible to cash by the issuer/obligor of the collateral upon demand by the ILS Issuer.
  • Upon becoming aware that the value of the collateral held by the ILS Issuer is less than the notional amount of the risk transfer contract, the ILS Issuer:
    • promptly notifies the DSIO in writing and provides copies of the notice to the protection buyer and the bondholders under the notice procedures in the applicable transaction documentation; and
    • neither issues any additional bonds nor enters into any commodity interest transactions for so long as the deficiency exists.
  • The payment obligations of the ILS Issuer to the protection buyer and to the bondholders are secured by eligible collateral, and the security arrangements provide that the ILS Issuer's obligations to the protection buyer are to be satisfied from the eligible collateral prior to any proceeds of the eligible collateral being used to repay principal under the ILS to the bondholders.
  • The ILS Issuer maintains the eligible collateral 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.
  • The eligible collateral held by the ILS Issuer is subject to arrangements that protect the protection buyer in the event the ILS Issuer becomes subject to an insolvency proceeding, to the extent possible under the applicable law. This condition is satisfied if the ILS Issuer satisfies the following criteria, consistent with ABS SPV-issuer separateness covenants and substantive nonconsolidation analysis:
    • the powers of the ILS Issuer are 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 is restricted from incurring additional debt, except as may be necessary or appropriate for entering into additional ILS offerings in the case of a multi-use issuer, in which case the obligation to repay the additional debt must be secured solely by additional eligible collateral obtained in connection with the additional ILS offering;
    • the ILS Issuer is 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 issuer, the ILS Issuer may enter into additional swap transactions to the extent it is necessary or appropriate in order to enter into additional ILS offerings;
    • the ILS Issuer is governed by a board of directors or other similar body comprised of individuals independent of the protection buyer;
    • corporate formalities are observed between the ILS Issuer, on the one hand, and the protection buyer and affiliates of the protection buyer, on the other hand, such that each entity maintains its separate corporate status and identity;
    • as a condition to any agreement imposing obligations on the ILS Issuer, bondholders, the protection buyer and any other potential creditors of the ILS Issuer are 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 regarding the ILS Issuer; and
    • the ILS Issuer is prohibited from filing a voluntary petition for bankruptcy and from engaging in a merger, asset sale (other than for collateral management purposes), consolidation, liquidation, dissolution or other action having substantially similar effect.
The relief remains effective until the effective date of any superseding CFTC action on ILS transactions.