New York State Seal
STATE OF NEW YORK
INSURANCE DEPARTMENT
25 BEAVER STREET
NEW YORK, NEW YORK 10004

David A. Paterson
Governor

Eric R. Dinallo
Superintendent

OGC Op. No. 08-10-07

The Office of General Counsel issued the following opinion on November 25, 2008 representing the position of the New York Insurance Department.

Re: Proposed Capital Markets Securities Transaction

Questions Presented:

1. Will the proposed securities constitute insurance contracts or policies under the New York Insurance Law?

2. Would holders of the securities be required to be licensed by the state of New York as insurers or reinsurers?

3. Would any provision of the New York Insurance Law preclude the securities from being enforceable in accordance with their terms?

4. Will placement or selling agents of the securities be considered insurance agents, insurance brokers, reinsurance intermediaries, or insurance consultants within the meaning of the New York Insurance Law?

5. Will the issuer of the securities be considered to be doing an insurance business under the New York Insurance Law?

Conclusions:

1. No. The proposed securities will not constitute insurance contracts or policies under the New York Insurance Law.

2. No. Holders of the securities will not be required to be licensed by the state of New York as insurers or reinsurers.

3. No. There are no provisions of the New York Insurance Law that would preclude the securities from being enforceable in accordance with their terms.

4. No. Placement or selling agents of the securities will not be considered insurance agents, insurance brokers, reinsurance intermediaries, or insurance consultants within the meaning of the New York Insurance Law.

5. No. The issuer of the securities will not be considered to be doing an insurance business under the New York Insurance Law.

Facts:

Issuer is a wholly-owned subsidiary of ABC Limited, a public company. Issuer’s shares are listed for trading on the licensed financial market operated by ABC Limited. Together with its wholly-owned subsidiaries, ABC Limited operates a vertically integrated multi-asset class exchange business, including trading, clearing and settlement platforms, under the business name “Securities Exchange”. The Issuer also is the parent company of the X Clearing House (“XCH”) and the SFE Clearing Corporation (“SFECC,”and, together with XCH, the “Clearing Companies”), which act as the clearing companies for the licensed financial markets operated by ABC Limited and S Futures Exchange Limited (“SFE”), respectively. Both XCH and SFECC are required to maintain specified levels of regulatory capital as a condition of their licenses.1 Neither the issuer nor the Clearing Companies conduct any business in the United States.

At present, the Clearing Companies maintain capital in amounts required in the form of margins and commitments from clearing participants,2 equity, restricted capital reserves and subordinated loans. In general, the purpose of the regulatory capital requirement is to maximize the likelihood that, in the event of extreme volatility in the relevant markets, the Clearing Company will be able to settle all of its obligations in a timely manner.

The Transaction is intended to refinance the layer of regulatory capital currently represented by subordinated loans owed by the Clearing Companies directly to other members of the ABC Limited group with debt securities that will be issued by the Issuer to capital market investors (the “Institutional Investors”) in the form of the Securities. The Issuer will lend the proceeds of the Securities to the Clearing Companies in the form of subordinated loans (the “Subordinated Loans”).3 Through the terms and the principal reduction mechanism of the Securities and the Subordinated Loans described below, the proceeds raised by the offering of the Securities and thereupon loaned to the Clearing Companies will act as a layer of regulatory capital maintained by the Clearing Companies.

In addition to raising external finance as described above, the Issuer will perform a treasury investment function by investing on behalf of the Clearing Companies their cash assets, including the Clearing Companies’ capital and the margins and commitments received from clearing participants.

As a result of the regulatory capital function of the Securities described above, the Securities will include a principal reduction feature in which the principal amount of the Securities payable at their maturity4 will be reduced in the event that:

1. Either of the Clearing Companies recognizes any losses from defaults by any of its clearing participants in the settlement of trades (Clearing Participant Default Loss”); or

2. The Issuer recognizes any losses on investments held on behalf of the Clearing Companies (“Investment Loss”).

The amount by which principal would be reduced in the event of such losses will be:

1. In the case of a Clearing Participant Default Loss, the amount of such losses to the extent they exceed (x) the combined amount of any margin, together with any commitments and contributions, held by the relevant Clearing Company in respect of the defaulting participant and (y) certain specified levels of capital;5 and

2. In the case of an Investment Loss, the amount of such losses to the extent they exceed the equity of ABC Limited in the Issuer, which is US$28 million.

If the principal amount of the Securities is reduced, it can also later be increased in the event of certain recoveries of defaulted amounts. Interest and prepayment amounts payable in respect of the Securities will be payable on the adjusted principal amount of the Securities outstanding from time to time after all adjustments. At maturity, the Issuer will repay the adjusted principal amount of the Securities to the holder of the Securities at that time.

Clearing Participant Default Losses can occur if the clearing participant lacks sufficient funds to settle a trade or does not complete settlement for any other reason. The inquirer asserts that such defaults have been extremely rare historically.

The Transaction would involve the offer and sale of approximately US$129 million aggregate principal amount of Securities by the Issuer to Institutional Investors located in the United States, including the State of New York, and potentially outside the United States. The Institutional Investors are expected to include pension funds, insurance companies, mutual funds and other investors that regularly purchase debt securities in the institutional debt private placement market. Each Institutional Investor will be required to meet the criteria for both an institutional accredited investor within the meaning of Rule 501(a) (1), (2), (3) or (7) under the federal Securities Act of 1933, as amended (the “Securities Act”), and a “qualified purchaser” under Section 2(a) (51) under the federal Investment Company Act of 1940, as amended (the “Investment Company Act”). The Securities will be offered and sold in transactions exempt from registration under the Securities Act and will be issued and held by each Institutional Investor in certificated form, subject to the terms of a note purchase agreement. The Securities will be transferable to other Institutional Investors, subject to compliance with the transfer restrictions set forth in the note purchase agreement, which implement the restrictions necessary to comply with applicable federal and state securities laws.

Since the only activity that may occur in New York is the sale of securities, this opinion is limited to addressing those sales alone.

Analysis:

Central to the inquiry is the definition of an insurance contract. If the Securities do not satisfy the elements of that definition, then their issuance will not constitute the making of an insurance contract or policy, and any parties engaged in the marketing of the Securities will not require licensing by the New York Insurance Department. New York Insurance Law § 1101 (McKinney 2006) defines an insurance contract, in relevant part, as follows:

(1) "Insurance contract" means any agreement or other transaction whereby one party, the "insurer", is obligated to confer benefit of pecuniary value upon another party, the "insured" or "beneficiary", dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event.

(2) "Fortuitous event" means any occurrence or failure to occur which is, or is assumed by the parties to be, to a substantial extent beyond the control of either party.

The issuance of the Securities described in the inquiry does not constitute the making of an insurance contract under New York Insurance Law.6 As described, the transaction essentially consists of an entity using an alternative method to fund a portion of the regulatory capital requirements of two of its subsidiaries, by establishing a third subsidiary (Issuer) for the purpose of issuing the Securities. The proceeds from the sale of the Securities then will be used to replace a portion of the regulatory capital, as described above.

The purchasers of the Securities will be exposed to risks of loss from possible investment losses or as a result of defaults by clearing participants. This risk exposure, however, does not mean that the purchasers of the Securities are acting as insurers. The mere assumption of a possible risk of loss in connection with the making of an investment does not constitute the conduct of the business of insurance. The investors are not obligating themselves to provide a pecuniary benefit to anyone upon the happening of a fortuitous event. Rather, they are investing their funds in the anticipation of deriving a return on their capital. In the course of so doing, they are assuming certain risks of loss, as do all investors.

In evaluating whether an agreement is an insurance contract, the Insurance Department ignores the label attached to the agreement and focuses instead on the actual terms of the agreement. In general, securities are unlike insurance contracts because the purchasers of securities commit their resources in order to achieve investment returns. The purchaser of a security makes no ongoing undertaking or promise to make an additional payment in the future to any party. The investment transaction is complete upon purchase, payment by the security holder and the delivery of the security to the security holder by the issuer. An insurance contract, by contrast, involves an ongoing undertaking, usually in the form of a promise, to deliver a benefit of some kind in the future upon the happening of an event, which is uncertain as to its happening, and which can be expected to have an adverse affect upon another's interest.

Accordingly, based upon the provided description of the transaction, the Securities will not constitute insurance contracts or policies under New York law; holders of the Securities will not be required to be licensed by the state of New York as insurers or reinsurers; there are no provisions of the New York Insurance Law that would preclude the Securities from being enforceable in accordance with their terms; the placement or selling agents of the Securities will not be considered insurance agents, insurance brokers, reinsurance intermediaries, insurance consultants within the meaning of the New York Insurance law; and the issuer of the Securities will not be considered to be doing an insurance business under New York law. Please be advised, however, that if the facts as described above were to change, the Department’s conclusions might be different.

For further information, you may contact Supervising Attorney Michael Campanelli at the New York City office.

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1 When a trade is made across the ABC Limited market or the SFE market, a buy order and a sell order are originated by participants in the relevant exchange that are also participants, or have appointed clearing agents who are participants, in the clearing system operated by the relevant Clearing Company. Upon execution of a securities trade, the Clearing Company for that exchange novates the securities sale contract and stands as the counterparty for both the sell side of that transaction and the buy side of that transaction. Upon settlement of the transaction and delivery of the purchase money and securities, respectively, the Clearing Company fulfills the contract to each counterparty. If a counterparty defaults, the transaction is not disrupted, as the Clearing Company performed each side of the contract regardless of whether the other side to the contract has defaulted, thereby maintaining certainty of the settlement of the securities that are the subject of that contract through the relevant exchange. As a result, the Clearing Company bears the risk of default by a participant in the relevant clearing system. Each Clearing Company is, therefore, required by law to maintain capital in order to meet its obligations in the event of defaults by one or more clearing participants.

2 Margins represent deposits by the clearing participants with the applicable Clearing Company to secure the participants’ performance of securities transactions through the Clearing Company. Commitments (or contributions) are amounts paid by the clearing participants to the applicants to the applicable Clearing Company to provide a source of funds out of which the Clearing Company may meet the obligations of any defaulting participant to settle trades in the event that the defaulting participant’s margins are insufficient for that purpose.

3 The Issuer will make a Subordinated Loan of approximately US$62 million (at current exchange rates) to ABC and a Subordinated Loan of approximately US$58 million to SFECC. The principal reduction feature of the Securities described below will also be reflected in the Subordinated Loans.

4 It is expected that the Securities will mature in either 5, 7 and/or 10 years from the date of issuance

5 In the case of ABC, the relevant level of capital is US$3 million in equity plus US$59 million in “restricted capital”; in the case of SFECC, US$25 million in equity.

6 Section 1101 further defines the “business of insurance” to include the following:

(A) making, or proposing to make, as insurer, any insurance contract, including either issuance or delivery of a policy or contract of insurance to a resident of this state or to any firm, association, or corporation authorized to do business herein, or solicitation of applications for any such policies or contracts;
(B) making, or proposing to make, as warrantor, guarantor or surety, any contract of warranty, guaranty or suretyship as a vocation and not as merely incidental to any other legitimate business or activity of the warrantor, guarantor or surety;
(C) collecting any premium, membership fee, assessment or other consideration for any policy or contract of insurance;
(D) doing any kind of business, including a reinsurance business, specifically recognized as constituting the doing of an insurance business within the meaning of this chapter;
(E) doing or proposing to do any business in substance equivalent to any of the foregoing in a manner designed to evade the provisions of this chapter.

None of the above, however, is relevant to the situation presented by the instant inquiry.