To Our Clients and Friends Memorandum friedfrank.com

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1 To Our Clients and Friends Memorandum friedfrank.com CFTC Update: CFTC Proposes New Position Limits and Aggregation Rules 1 Introduction On November 5, 2013, the Commodity Futures Trading Commission ( Commission or CFTC ) approved proposed new position limits rules ( Position Limits Rules ) and proposed new aggregation standards for determining compliance with position limits ( Aggregation Standards ). 2 The CFTC voted three to one in favor of the Position Limits Rules, with Commissioner Scott O Malia dissenting, and unanimously in favor of the Aggregation Standards. Each proposal has been published in the Federal Register and comments are due 60 days after the respective date of publication of each proposal. 3 However, in response to requests from industry trade associations, the Commission announced on January 9th that it will extend the comment period on the Aggregation Standards to February 10, 2014, the date on which comments are due on the Position Limits Rules, to provide interested parties with an opportunity to comment on both proposals over the same comment period. It remains possible that the Commission may determine to finalize the Aggregation Standards before adopting the Position Limits Rules in final form. These proposals are designed to implement certain amendments added to the Commodity Exchange Act ( CEA ) by the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank Act ), 4 as interpreted by the Commission. Background Pursuant to the CEA, the Commission has long established and enforced position limits for various agricultural commodities under Part 150 of the CFTC regulations. Such position limits regime includes three components: First, the level of limits restricting the speculative positions a person may hold in the spot-month, an individual month, and all months combined; second, exemptions from the speculative position limits; and, third, rules dictating which accounts and positions a person must aggregate for purposes of complying with the speculative position limits This Fried Frank client memorandum supplements our client memorandum published on November 7, See See 78 Fed. Reg. 75,680 (Dec. 12, 2013) ( Position Limits Rules ); 78 Fed. Reg. 68,946 (Nov. 15, 2013) ( Aggregation Standards ). See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 124 Stat (2010). See Aggregation Standards at 68,946. Copyright 2014 Fried, Frank, Harris, Shriver & Jacobson LLP 1/14/14 A Delaware Limited Liability Partnership 1

2 Title VII of the Dodd-Frank Act amended Sections 4a(a)(2) and 4a(a)(5) of the CEA, thereby authorizing the Commission to establish limits for futures and option contracts traded on a designated contract market ( DCM ), as well as swaps that are economically equivalent to such futures or options contracts traded on a DCM [involving physical commodities]. 6 Accordingly, on October 18, 2011, the Commission approved final rules imposing position limits for futures, options, and swaps involving 28 specified physical commodities and codified such rules in a new Part 151 of the CFTC regulations. 7 However, on September 28, 2012, the District Court for the District of Columbia vacated these rules in Part 151, with certain exceptions. 8 The Commission appealed the Court s decision, but ultimately decided to dismiss its appeal and to propose the new Position Limits Rules and Aggregation Standards, which would modify the original Part 150 of the CFTC regulations. In doing so, the Commission has attempted to address the issues relating to its statutory authority under Section 4a(a) of the CEA which are identified in the District Court s opinion. 9 That said, the proposed Position Limits Rules are substantially similar to Part 151. This memorandum is not a comprehensive review or detailed analysis of all the organizational and substantive rules and amendments proposed by the Commission in the Position Limits Rules and Aggregation Standards. Rather, this memorandum is intended to summarize the principal aspects of the Commission s recent proposals. A summary of the proposed rules follows. Summary of Position Limits Rules and Aggregation Standards Proposed Position Limits Rules The Position Limits Rules propose to establish limits on speculative positions in 28 specified exempt (i.e., energy and metals) and agricultural commodity futures and options contracts traded on a DCM (i.e., such contracts are referred to as core referenced futures contracts ) and their economically equivalent futures, options, and swaps (together, Referenced Contracts ). 10 In particular, the Position Limits Rules set forth spot-month and non-spot-month limits. The initial spot-month limits are based on the limits currently in place at DCMs or, in the alternative, on estimates of deliverable supply to be submitted by one or more DCMs and verified by the Commission (i.e., 25% of estimated deliverable supply). 11 The Commission is also considering certain alternatives to setting the initial spot-month limits, including setting them at 25% of the estimates of deliverable supply of the Referenced Contracts provided by the CME Group on July 1, Subsequent spot-month limits will be based on 25% of the estimated spot-month deliverable supply in the relevant core referenced futures contract. The term estimated deliverable supply refers to the amount of a commodity that can Id. 68,947. See 76 Fed. Reg. 71,626 (Nov. 18, 2011). The spot-month position limits rule was an interim final rule subject to further consideration and comment. Id. In May 2012, the Commission proposed amendments to the aggregation provisions of Part 151. See 77 Fed. Reg. 31,767 (May 30, 2012). See International Swaps and Derivatives Ass n v. Commodity Futures Trading Comm n, 887 F. Supp. 2d 259 (D.D.C. 2012). See 78 Fed. Reg. 75,680, 75,682-75,683; 887 F. Supp. 2d 259, See generally Position Limits Rules at 75,725-75,727 (discussing 28 core referenced futures contracts). See id. 75,727-75,728. The initial spot-month limits will become effective 60 days after publication of the final rules in the Federal Register. See id. 75,727. 2

3 reasonably be expected to be readily available to short traders to make delivery at the expiration of a futures contract. 12 Note that the spot-month limits will be readjusted no less frequently than every two years and will apply separately for physical-delivery contracts and cash-settled contracts in the same commodity. 13 Thus, a person may hold positions up to the spot-month limit in physical-delivery contracts and positions up to the applicable limit in cash-settled contracts, but a trader may not net across physicaldelivery and cash-settled contracts in the same commodity. The Position Limits Rules include a conditional spot-month limit exemption which would permit a person to hold positions up to five times the spot-month limit for any Referenced Contract, provided that all of such person s positions are only in cash-settled contracts. A person claiming this exemption would be subject to increased reporting obligations and the Commission is seeking comments on a number of alternatives to this conditional spot-month exemption. The non-spot-month limits include single-month and all-months-combined limits. The initial non-spotmonth limits are based on open interest for calendar years 2011 and 2012 in futures, options on futures, and swaps that are significant price discovery contracts. 14 Subsequent non-spot-month limits will be based on 10% of open interest in the first 25,000 contracts and 2.5% of open interest thereafter. 15 The Commission proposes to estimate average open interest based on the largest annual average open interest computed for each of the past two calendar years, using either month-end open contracts or open contracts for each business day in the time period. 16 Note that the non-spot-month limits will be readjusted no less frequently than every two years and apply across physical-delivery contracts and cash-settled contracts in the same commodity. 17 Thus, a person may net all positions in Referenced Contracts (regardless of whether such Referenced Contracts are physical-delivery or cash-settled) when calculating a person s positions for purposes of the proposed non-spot-month limits. Note that the Commission is proposing to conditionally exempt from the non-spot-month limits any preexisting Referenced Contract position acquired in good faith prior to the effective date of such limit, provided that this exemption would not apply if such position in the relevant Referenced Contract is increased after the effective date of such limit. This exemption would not apply to spot-month position limits. In the November 2011 final position limits rules, the Commission adopted position visibility reporting rules which were designed to enhance the reporting regime for traders holding positions in certain energy and metal referenced contracts in excess of a specified visibility level. 18 Note that the Commission is not proposing to adopt similar position visibility reporting rules in connection with the new Position Limits Rules Id. 75,728-75,729. See generally id. 75,727-75,729 (discussing the setting of spot-month limits). See id. 75,729-75,734. See Position Limits Rules at 75,729-75,730, 75,734. Id. 75,730. See generally id. 75,729-75,734 (discussing the setting of non-spot-month limits). See 76 Fed. Reg. 71,626. 3

4 Proposed Exemptions from Position Limits Rules The Position Limits Rules include a number of potential additional exemptions from position limits and also amend the existing exemptions in a number of respects. 19 Currently, the Commission recognizes three types of exemptions. First, a bona fide hedging exemption permits a commercial enterprise to exceed positions limits to the extent the positions are reducing price risks incidental to commercial operations. 20 Second, exemption for spread or arbitrage positions between single months of a futures contract (and/or, on a futures-equivalent basis, options) outside of the spot-month, permits any trader s spread position to exceed the single month limit. 21 Third, the independent account controller ( IAC ) exemption permits the disaggregation of positions carried for an eligible entity in the separate account of an independent account controller... that manages customer positions... [and] the other positions owned or controlled by that eligible entity. 22 The Position Limits Rules expand and amend these exemptions by providing the following exemptions: Exemption from position limits for certain market participants in certain financial distress scenarios, such as a customer default at a futures commission merchant ( FCM ) or in the context of a potential bankruptcy. 23 Exemption from position limits for (1) swaps entered into prior to July 21, 2010 and the terms of which have not expired by such date (i.e., pre-enactment swaps) and (2) swaps entered into before July 22, 2010, the terms of which have not expired by such date, and which end 60 days after publication of such exemption in the Federal Register (i.e., transition swaps). 24 Additionally, pre-enactment swaps and transition swaps may be netted with positions acquired after the effective date of the final position limit rules for the purpose of complying with any non-spot-month position limit. Exemptions for bona fide hedging positions in excluded and exempt commodities based on the Commission s interpretation of the Dodd-Frank Act s new requirements for such positions. 25 These include, among others, exemptions for unfilled anticipated requirements for resale by a utility, royalties and service contracts. 26 Note that a person claiming an exemption for bona fide hedging must meet the following requirements: the position must (i) be taken to offset price risks See Position Limits Rules at 75,735-75,741 (discussing proposed exemptions). Id. 75,735. Id. The Commission proposes to delete the spread exemption as unnecessary. See id. 75,736. Id. 75,735 (footnotes omitted). Note that the IAC exemption is frequently referred to as an aggregation exemption, rather than an exemption from speculative position limits. See id. 75,736. See Position Limits Rules at 75,738. See id. 75,738-75,739 (discussing exemption for non-enumerated bona fide hedging transactions related to riskreducing practices commonly used in the market); id. 75,739-75,741 (discussing previously-granted exemptions for non-enumerated bona fide hedging transactions). See id. 75,713-75,716 (providing an exemption-by-exemption discussion of bona fide hedging), 75,712 (chart), 75,738-75,741. 4

5 incidental to commercial cash operations (the incidental test ), (ii) be established and liquidated in an orderly manner and (iii) be economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise. The Position Limits Rules also include different requirements for a position to qualify as a bona fide hedge, depending on whether the position is in an agricultural or exempt commodity (energy and metals) or in an excluded commodity. Any person claiming a bona fide hedge exemption must make a filing with the Commission, and be subject to significant recordkeeping and reporting requirements. A pass through swap exemption for a trader when it enters into a swap for a counterparty for whom the swap qualifies as a bona fide hedge, provided that the trader offsets the trade subsequently and subject to certain conditions. 27 As noted in our prior memorandum, we expect that commenters will object to the narrowing of many of these exemptions, in particular the bona fide hedging exemption. It is true that market participants engaging in risk reducing practices commonly used in the market, which they believe may not be specifically enumerated in the definition of bona fide hedging, may request an interpretative letter from the CFTC staff or exemptive relief from the Commission under CEA Section 4a(a)(7). 28 However, this process is likely to be difficult, time-consuming, and uncertain. The Commission also is proposing various other organizational and substantive amendments to its existing and proposed exemptions from position limits. 29 Proposed Aggregation Standards The Aggregation Standards are quite similar in most respects to the amendments proposed by the Commission in May 2012, although the new version reflects certain comments received in response to the May 2012 proposal and also includes certain other revisions. 30 As proposed, the Aggregation Standards generally require that, absent a specific exemption, a person must treat as its own any positions in any account in which it has (directly or indirectly) a 10% or greater ownership or equity interest, even if the person does not control the trading in such account. 31 Also, a person must treat as its own the positions in any account on the basis of control over the trading decisions in the account, or on the basis of trading pursuant to an express or implied agreement or understanding with another person, both of which are consistent with longstanding CFTC policy. 32 However, the Commission is proposing to See id. 75,710-75,711, 75,712 (chart), 75,788. See id. at 75,828. See, e.g., Position Limits Rules at 75,735-75,736 (proposing new cross-references), 75,736 (proposing deletion of the existing exemption for calendar spread and arbitrage positions); 75,736 (proposing relocation of IAC exemption); 75,741 (proposing recordkeeping requirements for persons claiming an exemption). See note 7, supra. For example, the Commission is soliciting comments on whether to permit entities that must aggregate the positions of an owned entity to aggregate positions pro rata based on the percentage of their ownership interest and, if so, whether to provide for aggregation of an owned entity s positions to its owners based on ownership tiers. See Aggregation Standards at 68,958-68,959. See id. 68,958. See also id. 68,956 ( The Commission also believes that aggregation of positions across accounts based upon ownership is a necessary part of the Commission s position limit regime. ). However, contingent ownership such as an equity call option does not constitute am ownership or equity interest for this purpose. 77 Fed. Reg. 68,958 at n.108. See Aggregation Standards at 68,976. 5

6 add a new aggregation provision applicable to positions in accounts or pools with so-called substantially identical trading strategies, even if a person does not control the trading in such accounts and has less than a 10% interest in such accounts and notwithstanding the availability of an exemption from aggregation which otherwise would be applicable. 33 We expect that commenters will object to this provision and will also request guidance as to its intended application and scope. Proposed Exemptions From Aggregation Standards The Aggregation Standards provide for certain exemptions from aggregation including, but not limited to, situations in which: A limited partner, limited member, shareholder or other similar type of pool participant that directly or indirectly holds a 10% or greater ownership or equity interest in the pool need not aggregate the positions of the pool with any other accounts or positions such person is required to aggregate, unless such person: o o o Is the commodity pool operator of the pool ( CPO ); Is a principal or affiliate of the pool, unless the CPO meets certain requirements to ensure that each entity s trading is independent and, if a principal, maintains only such minimum control over the CPO as is consistent with its responsibilities as a principal and necessary to fulfill its duty to supervise the trading activities of the pool; Has a 25% or greater ownership or equity interest in a pool and the CPO is exempt from registration under CFTC Rule The sharing of information would violate or create reasonable risk of violating federal, state, or foreign laws or regulations. 34 An ownership interest is no greater than 50% in any other entity whose trading is independently controlled. 35 An ownership interest is greater than 50% in another non-consolidated entity whose trading is independently controlled and an applicant certifies that the owned entity is not required under U.S. generally accepted accounting principles to be consolidated on such person s financial statement; and such entity s positions qualify as bona fide hedging or do not exceed 20% of any position limit and each representative of the person on the owned entity s board certifies that he or she does not control the trading decisions of the owned entity See id. 68,976; see also id. 68,958 n.109. See id. at 68,949-68,950. See id. 68,958. The Commission is proposing five criteria that are the conditions that would have to be met in order for a person to rebut the presumption that an ownership or equity interest of between 10 and 50 percent (inclusive) requires aggregation of the positions of the owned entity. Id. 68,961; see Aggregation Standards at 68,961-68,962 (discussing the proposed five criteria). See id. 68,959-68,960. The demonstration that a person must make to be eligible for this exemption is set forth below. 6

7 Ownership in another entity results from broker-dealer activities in the normal course of business as a dealer, but not greater than 50%. 37 Ownership is in an entity based on the ownership of securities constituting the whole or part of an unsold allotment to or subscription by such person as a participant in the distribution of such securities by the issuer or by or through an underwriter. The Commission also is retaining the longstanding exemptions for positions in discretionary accounts or in customer trading programs held by an FCM or its affiliates and accounts carried by an IAC, subject to certain conditions designed to ensure independence of trading between the eligible entity (as defined therein) and the IAC. Under the Aggregation Standards, the exemptions are generally not self-executing as is the case today with respect to existing disaggregation exemptions and require a notice filing with the Commission, except for the exemptions for underwriting and for broker-dealer activity. A notice filing must provide a description of the relevant circumstances that warrant an exemption and a statement of a senior officer of the entity certifying that conditions set forth in the applicable aggregation exemption provision have been met. 38 Such a notice filing must be amended in the event of any material change. 39 The Commission, however, is proposing to permit a parent company to rely on an owned entity exemption (without having to file for its own exemption), provided that the parent company complies with the conditions of its subsidiary s exemption. 40 In addition, a person with a greater than 50% ownership or equity interest in an owned entity seeking an aggregation exemption must apply to the Commission for relief on a case-by-case basis and the relief is not effective upon filing the notice. 41 Among other things, such an applicant must demonstrate that (i) the owned entity is not required to be, and is not, consolidated on the financial statement of the person; (ii) the person does not control the trading of the owned entity, with evidence that it and the owned entity have procedures in place that are reasonably effective to prevent coordinated trading notwithstanding majority ownership; (iii) each representative of the person (if any) on the owned entity s board of directors (or equivalent governing body) attests that he or she does not control trading of the owned entity; and (iv) the person certifies that either (a) all of the owned entity s positions qualify as bona fide hedging transactions or (b) the owned entity s positions that do not so qualify do not exceed 20% of any position limit currently in effect. 42 Furthermore, this relief is not automatic and is available only if the Commission finds, in its discretion, that these conditions are met See id. 68,964. See id. 68,978. See id. 68,958, 68,962. See id. 68,947; Aggregation Standards at 68,953. See id. 68,959-68,960. See id. See id. 68,960. 7

8 A person with a greater than 50% ownership or equity interest in an owned entity who could not meet these conditions could apply to the Commission for aggregation relief under CEA Section 4a(a)(7). 44 The Commission is requesting comments as to whether relief from aggregation should be available in such a case and as to the facts and circumstances that should be evaluated in considering such relief. Conclusion The Position Limits Rules and Aggregation Standards have substantial implications for the futures, options and swaps markets and market participants and raise a host of interpretative questions, issues and other concerns. We will continue to monitor and report on developments in this area. * * * 44 Id. 8

9 Authors: Robert M. McLaughlin David S. Mitchell William J. Breslin Victoria T. Mazgalev J. Peter Ripley This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions about the contents of this memorandum, or wish to discuss any specific aspects of the ruling, please call your regular Fried Frank contact or the attorneys listed below: Contacts: Robert M. McLaughlin David S. Mitchell Daniel A. Mullen New York Washington, DC London Paris Frankfurt Hong Kong Shanghai friedfrank.com 9