ARNOLD & PORTER ADVISORY

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1 ARNOLD & PORTER ADVISORY Implementation of the November 2001 The U.S. Commodity Futures Trading Commission ( CFTC ) and the U.S. Securities and Exchange Commission ( SEC ) have recently adopted a number of new rules and rule amendments implementing the of 2000 ( CFMA ), which was adopted in December 2000 and which significantly revised many aspects of the Commodity Exchange Act ( CEA ) and certain provisions of the federal securities laws. This memorandum summarizes the new rules that have been adopted relating to trading facilities, clearing organizations, security futures products, and intermediaries. 1 I. NEW REGULATORY FRAMEWORK FOR TRADING FACILITIES The CFTC has adopted new rules governing trading facilities, effective October 9, As required by the CFMA, the new rules reduce the level of CFTC regulation of trading facilities generally and relate to three tiers of markets, each with differing levels of regulation depending on the nature of market participants and products traded: designated contract markets, derivatives transaction execution facilities, and exempt markets. The new rules not only establish the administrative procedures necessary to implement these provisions of the CFMA, but also interpret certain statutory provisions, provide guidance on compliance, and grant certain exemptions. WASHINGTON 555 Twelfth Street, NW Washington, DC Fax NORTHERN VIRGINIA Suite Tysons Boulevard McLean, VA Fax NEW YORK 399 Park Avenue New York, NY Fax LOS ANGELES 44 th Floor 777 South Figueroa Street Los Angeles, CA Fax CENTURY CITY 17 th Floor 1900 Avenue of the Stars Los Angeles, CA Fax 1 Many of the new rules merely restate the provisions of the CFMA, which are discussed in our memorandum entitled The of 2000 A Comprehensive Revision of the Commodity Exchange Act, dated January Those rules are not described in detail in this memorandum, and we refer readers to our January 2001 memorandum. LONDON Tower Old Broad Street London EC2N 1HQ Fax DENVER Suite Seventeenth Street Denver, CO Fax arnoldporter.com

2 A. Designated Contract Markets The CFMA continues to authorize the traditional CFTC regulated markets, called designated contract markets, consisting of trading facilities approved by the CFTC which are not limited in the nature of their market participants or the products that they may trade. The CFMA simplified application standards for such markets and substituted core principles for prescriptive provisions in order to lessen the burden of regulation and to promote competitiveness. Part 38 of the new CFTC rules deals with such contract markets. To reduce the level of regulation, Section 38.2 of the new rules exempts contract markets from all of the CFTC s rules except the new Parts 38 and 40 (dealing with market rules and products) and certain specified preexisting CFTC rules, including a number of rules relating to reporting and record-keeping, oversight of market members, and bankruptcy. In Section 38.3(b) of the new rules, the CFTC has provided interpretations of certain of the new statutory requirements for designation as a contract market. In addition, Appendix A to Part 38 provides applicants with guidance on compliance with designation criteria, and Appendix B provides guidance on compliance with the core principles with which a contract market must comply on an on-going basis. Included in Appendix B are acceptable practices for complying with core principles, which provide nonexclusive safe harbors for contract markets that adopt them. Section 38.3 of the new rules establishes a fast-track application process, permitting a trading facility to be deemed designated as a contract market sixty days after the CFTC s receipt of an application for designation as long as the application meets certain standards. The application must, inter alia, demonstrate that the trading facility satisfies the criteria for designation, the core principles for operation of a contract market, and the applicable provisions of the new rules. The CFTC may terminate the running of the sixty-day period for approval if it appears that the application does not provide all of the required information. The rules allow the CFTC to impose conditions on the designation of contract markets. Section 38.5 of the new rules provides that, upon request, a designated contract market must provide the CFTC with information relating to its business or demonstrating its compliance with the core principles. Consistent with the CFMA s goal of preserving the enforceability of contracts even if legal requirements are not met, Section 38.6 provides that contracts executed on a designated contract market are not void merely because CFTC rules applicable to the contract market have been violated. B. Derivatives Transaction Execution Facilities The CFMA creates a new type of regulated trading facility, a derivatives transaction DTF ), which must be approved by the CFTC but is subject to a lower level of regulation than a designated contract market. Such DTFs either must limit the commodities they trade to those found to be not susceptible to manipulation or must limit their market participants to eligible commercial entities as defined in the CFMA. Arnold & Porter 2

3 Part 37 of the new CFTC rules relates to DTFs. Section 37.2 exempts DTFs from a number of preexisting Commission regulations and specifies the CFTC rules applicable to DTFs. Section 37.1 of the new rules expands those qualifying as eligible commercial entities to include registered floor traders and floor brokers trading for their own accounts. In adopting this rule, the CFTC stated that it was broadening the entities permitted to trade on DTFs by adding floor traders and floor brokers in order to increase liquidity in the trading on DTFs. Section 37.3 deals with commodities eligible to be traded on those DTFs restricted to products not susceptible to manipulation. Financial products defined as excluded commodities under the CFMA are expressly eligible under the new rules to be traded on a DTF, as are security futures products as long as the DTF trading them has also qualified as a national securities exchange under the federal securities laws. The rules spell out procedures for DTFs to apply for a determination by the CFTC that other commodities are eligible to be traded. Such a determination is to be based on a finding that trading in the commodity is highly unlikely to be susceptible to the threat of manipulation in light of the commodity s market characteristics and surveillance history and the self-regulatory record and capacity of the particular DTF. Section 37.5 of the new rules specifies the procedures for registration of DTFs with the CFTC. It provides that the CFTC may register a DTF subject to conditions and creates a thirty-day fast track period in which certain DTFs may be deemed approved. The rules indicate that a DTF need not demonstrate a capacity at the time its application is submitted to comply with the core principles applicable to DTFs, but rather may instead certify that it has the capacity to operate and will operate in compliance with the core principles when its application is approved and it commences operations. The new rules also state that existing designated contract markets may qualify immediately as DTFs through notification to the CFTC along with filing their proposed rules and a certification that the trading facility will meet the requirements for DTFs. General guidance for registration applications is provided in Appendix A of Part 37, and general guidance for compliance with the core principles applicable to DTFs is provided in Section 37.6 and Appendix B of Part 37. Unlike the rules relating to designated contract markets, the rules relating to DTFs do not specify any acceptable practices constituting safe harbors. The new rules also include certain special call provisions permitting the CFTC to request information from DTFs, FCMs acting for customers on DTFs and DTF market participants. As with designated contract markets, the rules state that contracts traded on a DTF are enforceable even if the DTF has violated provisions of the CEA or the CFTC s rules. C. Rules and Products of Registered Entities Part 40 of the new rules deals with CFTC approval of market rules and/or products. Section 40.6 provides that a designated contract market or registered derivatives clearing organization (discussed in Part II of this memorandum, below) may implement a new rule or amended rule simply by filing the text of the rule with the CFTC, along with a certification that the rule complies with the CEA and the CFTC s regulations, on the day Arnold & Porter 3

4 before the rule goes into effect. However, any rule that would make a material change in the terms of a contract on certain enumerated agricultural products in a delivery month with open interest may not be implemented without submission to the CFTC for prior approval. Section 40.5 provides for a forty-five-day review period by the CFTC as to such rules. Moreover, it provides that any registered entity a designated contract market, a DTF or a registered derivatives clearing organization may voluntarily request CFTC rule approval pursuant to such forty-five-day review. The CFTC may extend the forty-five-day review period for an additional thirty days. Similarly, a designated contract market, DTF or registered derivatives clearing organization may list a new product for trading or clearing merely by providing the CFTC with notice by no later than the preceding day. The notice must include, inter alia, a copy of the product s rules and a certification that trading or clearing the product complies with the CEA and the CFTC s regulations. Voluntary submission of a new product listing by a designated contract market or DTF to the CFTC for prior approval is also permitted for all products except security futures products. Section 40.3 permits a forty-five-day review period for such products, which the CFTC may extend for forty-five additional days. D. Exempt Markets The CFMA exempts certain markets from most provisions of the CEA as long as they notify the CFTC of their intention to trade. Certain fraud and manipulation prohibitions of the CEA do apply to such markets. The new CFTC rules deal with two types of exempt markets: exempt boards of trade and exempt commercial markets. Exempt boards of trade under the CFMA are restricted to market participants who are eligible contract participants, as defined in the CFMA, and to futures and options on commodities with a nearly inexhaustible deliverable supply or its equivalent. Section 36.2 of the new rules specifies that commodities eligible to be traded on such exempt boards of trade include all excluded commodities as defined in the CFMA other than securities products and may include other commodities as determined by the CFTC. The new rules specify how exempt boards of trade are to notify the CFTC of their intention to trade. Section 36.3 of the new rules deals with exempt commercial markets created under the CFMA. Such markets consist of electronic trading facilities on which eligible commercial entities trade exempt commodities (such as metals or energy products) on a principal-toprincipal basis. The new rules provide for the manner in which such markets must notify the CFTC of their intention to trade and provide for certain reporting by the markets to the CFTC. They also specify that an exempt commercial market must provide the CFTC with its trading protocols and either electronic access to transactions on the market or information concerning large traders. Arnold & Porter 4

5 E. Foreign Currency Sales The new rules contain a provision broadly prohibiting fraud in connection with over-thecounter foreign currency sales by unregulated entities to retail customers. The CFMA eliminated an ambiguity in the CEA by explicitly granting broad jurisdiction over such transactions to the CFTC. This provision of the new rules is an attempt by the CFTC to close a possible loophole in the CEA s basic fraud prohibition, which may be interpreted to apply only when a principal-agent relationship exists. II. NEW REGULATORY FRAMEWORK FOR CLEARING ORGANIZATIONS The CFTC has adopted new rules for derivatives clearing organizations, effective October 29, The CFMA created a regulatory regime relating to derivatives clearing organizations, providing that futures and commodity options may generally be cleared only by a derivatives clearing organization registered with the CFTC and that such clearing organizations must comply with certain core principles. 2 Part 39 of the CFTC s new rules implements these provisions of the CFMA. Section 39.2 of the rules exempts derivatives clearing organizations from most existing CFTC rules with some specified exceptions including certain CFTC reporting requirements. Section 39.3 describes the procedures for registration of derivatives clearing organizations. A clearing organization is deemed registered sixty days after receipt by the CFTC of its application unless the CFTC notifies it otherwise. The application must include, inter alia, the clearing organization s rules, a demonstration of how it will satisfy the core principles applicable to clearing organizations and copies of agreements and system tests demonstrating its ability to comply with the core principles. Appendix A to Part 39 provides guidance on compliance with the core principles applicable to clearing organizations, but does not set out any safe harbors. Under Section 39.5 of the new rules, the CFTC may request information concerning a clearing organization s business or its compliance with the core principles. The rule also requires that FCMs, clearing members and foreign brokers must file large trader reports concerning transactions cleared on the clearing organization and that, if such reports are unavailable, the clearing organization itself must provide the information. The CFTC may also request additional information concerning customers from FCMs, clearing members or foreign brokers by special call. Continuing the CFMA s theme of protecting the enforceability of contracts without regard to compliance issues, Section 39.6 of the new rules provides that a transaction cleared by a clearing organization shall not be unenforceable because of a violation of the CEA or the CFTC 2 A derivatives clearing organization need not register if it clears only transactions exempted or excluded from the CEA or if it is a clearing agency registered under the Securities Exchange Act of 1934 and is clearing only transactions in security futures products. Arnold & Porter 5

6 rules by the clearing organization. Finally, Section 39.7 creates a broad fraud prohibition directed specifically at fraud in connection with the clearing of derivatives transactions. III. RULES ON SECURITY FUTURES PRODUCTS The CFMA overturned a ban on trading futures on single stocks and narrow-based security indices and provides a regulatory regime for trading such futures. 3 The regulatory regime allows trading of these security futures products on either securities or futures exchanges and provides for coordinated regulatory oversight by both the CFTC and the SEC. The CFTC and the SEC have adopted a number of new rules implementing these provisions of the CFMA. A. Markets The CFMA provides that designated contract markets, DTFs, and certain markets regulated by the SEC national securities exchanges, national securities associations, and alternative trading systems may trade security futures products. However, markets regulated by the CFTC must register with the SEC and vice versa. The CFTC and SEC have adopted rules implementing these provisions of the CFMA which allow markets regulated by one agency to register by filing notice with the other. CFTC rules. The CFTC adopted rules on this subject new Part 41 effective August 21, They provide that SEC regulated markets may automatically become designated contract markets for security futures products by filing a written notice with the CFTC. Section specifies the procedures for filing notice with the CFTC and the contents of such notice. Such notice must include, inter alia, a description of the security futures products to be traded and certifications that the market is regulated by the SEC and meets certain other criteria specified in the CFMA. Designation as a contract market is effective upon receipt of the notice by the CFTC. A contract market designated in this manner may not trade futures contracts other than security futures products. Section of the new rules requires certain reporting by contract markets designated by these notice procedures and requires that they provide information about their business as a designated contract market and information demonstrating their compliance with the CEA and the CFTC regulations upon request by the CFTC. Section of the new rules explicitly exempts notice-designated contract markets from certain provisions of the CEA and the CFTC regulations. Furthermore, Section provides that a notice-designated market may apply for exemption from other provisions of the CEA or CFTC regulations by filing an application with the CFTC 3 While the CFMA authorized trading in security futures products between eligible contract participants, as defined in the CFMA, on a principal-to-principal basis to begin no earlier than August 21, 2001, trading generally may not begin until December 21, 2001, at the earliest. Moreover, a joint letter from the Future Industry Association and the Securities Industry Association to Congress suggested that general trading in security futures products is unlikely to begin before the end of March Arnold & Porter 6

7 explaining its need for relief. The CFTC will review such an application within ninety days, subject to the power to stay the running of the period or to decline to review the application. SEC rules. The SEC adopted complementary rules relating to notice registration of designated contract markets and DTFs as national securities exchanges for the limited purpose of trading security futures products as required by the CFMA. These rules became effective on August 20, Because of a requirement of the CFMA that such notice-registered national securities exchanges must file information with the SEC comparable to that filed by regular national securities exchanges, the amount of information required in the notice to the SEC is significantly more extensive than that required by the CFTC. New SEC Form 1-N requires the filing of nine exhibits covering such matters as exchange structure, ownership, rules, trading system and membership. Moreover, notice-registered exchanges must provide the SEC with certain updated and supplemental information and with monthly trading reports and must maintain certain records subject to SEC inspection. Rule changes on margin (except those increasing margin) must be submitted to the SEC for prior approval after publication and public comment. Certain other rule changes by notice-registered national securities exchanges must be submitted to both the SEC and CFTC, but become effective upon approval by the CFTC, upon a determination by the CFTC that review is unnecessary or in some circumstances upon the filing of a written certification with the CFTC. After such rule changes become effective, they are subject to summary abrogation by the SEC (after consultation with the CFTC) on grounds that they unduly burden competition or efficiency, conflict with the securities laws or are inconsistent with the public interest or the protection of investors. A rule change that has been summarily abrogated by the SEC may be submitted again by the exchange to the SEC for an in-depth review. After publication and public comment on such a rule change, the SEC may approve it or (after consultation with the CFTC) institute disapproval proceedings. B. Intermediaries The CFMA allows FCMs and introducing brokers ( IBs ) registered with the CFTC and brokers and dealers registered with the SEC to enter transactions in security futures products on behalf of customers as long as they are cross-registered with the other agency. CFTC rules. To implement this provision, the CFTC adopted rules effective September 17, 2001, to provide that a broker or dealer registered with the SEC may become registered as an FCM or IB by filing a notice registration with the National Futures Association ( NFA ). Registration becomes effective immediately upon filing of the notice with the NFA. Such notice-registered FCMs and IBs must limit their activities as intermediaries on designated contract markets or DTFs to security futures products. The new rules exempt notice-registered FCMs from the general requirement that FCMs Arnold & Porter 7

8 must become members of the NFA. The CFTC has delegated responsibility to perform notice-registration functions to the NFA and has approved new NFA rules for doing so. 4 Under the CFMA, notice-registered FCMs and IBs are exempt from certain provisions of the CEA, and the CFMA authorizes the CFTC to grant additional exemptions. The CFTC implemented this provision by adopting rules effective October 9, 2001, establishing procedures for notice-registered FCMs and IBs to apply for additional exemptions. A self-regulatory organization may apply for such an exemption on behalf of its members. The new rules provide that the CFTC may grant or deny the exemption application, decline to entertain the application, or grant the application subject to conditions. SEC rules. Effective August 27, 2001, the SEC adopted complementary rules permitting FCMs and IBs to register as broker-dealers for purposes of trading security futures products through notice registration. Notice is to be filed with the NFA on a new Form BD-N that includes identification information and information confirming that the applicant is eligible for notice registration under the provisions of the CFMA. Registration is effective upon filing of the notice. 5 Notice-registered broker-dealers may trade security futures products on any authorized market for such products. They may become members of a national securities exchange or a national securities association for the purpose of trading such products as long as the exchange or association has rules permitting such membership. The SEC expects that such an exchange or association will have developed an appropriate regulatory structure for such members and will monitor a compliance system for them. Notice-registered broker-dealers who trade security futures products on a national securities exchange must also comply with certain provisions of the Securities Exchange Act of 1934 restricting trading for their own or related accounts. C. Other Provisions Narrow-based security indices. The CFTC and the SEC have taken additional steps to implement the security futures products provisions of the CFMA. For example, the CFMA for the first time permitted futures on narrow-based security indices subject to joint regulation by the CFTC and SEC and provided that futures on broad-based security indices are subject to the exclusive jurisdiction of the CFTC. The CFTC and the SEC adopted rules effective August 21, 2001, consisting of a detailed definition of narrowbased security indices involving a method for determining market capitalization and dollar value of average daily trading volume. 4 The new NFA rules became effective on August 20, The SEC published the new NFA rules for public comment as to whether the SEC should exercise its power summarily to abrogate the rules. The comment period closed on October 18, Under the SEC s new rules, FCMs and IBs are exempt from the requirement to register as broker-dealers until October 21, This provision is designed to permit them temporarily to engage in limited trading in security futures products if such trading begins prior to October 21 and if they are unable to complete notice registration before that time. Arnold & Porter 8

9 Dual trading; listing standards. The CFTC adopted rules implementing the CFMA s provisions concerning listing standards and conditions for trading of security futures products, effective November 1, On July 5, 2001, the CFTC proposed regulations restricting dual trading by floor brokers on security futures products on designated contract markets or DTFs, as required by the CFMA. Those rules have not yet been adopted. Customer funds protection. More recently, the CFTC and SEC proposed rules dealing with the applicability of customer protection, recordkeeping, reporting and bankruptcy rules and the Securities Investor Protection Act of 1970 to accounts holding security futures products. Public comments on the proposed rules are due to the agencies on or before December 5, The CEA protects customer funds by requiring segregation of those funds by the FCM and by granting customers priority in bankruptcy with respect to the segregated funds. On the other hand, customers of a broker-dealer are entitled to the protections of the Securities Investor Protection Act of As to security futures products, the customers of notice-registered broker-dealers (entities primarily subject to CFTC oversight) will be entitled to the CEA protections, while the customers of noticeregistered FCMs (entities primarily subject to SEC oversight) will be entitled to the protections of the federal securities laws. The proposed rules deal primarily with the issue of intermediaries which are both fully registered FCMs and fully registered broker-dealers and which therefore, under current rules, would be subject to both schemes for protecting customer funds. Since the schemes are duplicative and inconsistent, some accommodation is necessary. The proposed rules would allow such entities to elect whether to hold security futures products for a customer in a futures type of account or a securities type of account. Depending upon the type of account selected, the futures or securities regime for protection of customer funds would be applicable. The proposed rules also would permit those entities to allow their customers to elect whether their security futures products should be held in a futures type of account or a securities type of account. Other provisions of the proposed rules relate to disclosure to customers of the differences between the two types of accounts and the way in which the intermediary will treat the customer s particular account. The intermediary must obtain a signed acknowledgement by the customer of receipt of this information. Different recordkeeping and reporting requirements would be applicable depending on the type of account used. Margin requirements. The CFTC and the SEC have also jointly proposed customer margin rules relating to securities futures. The proposed rules establish minimum initial and maintenance margin levels for long or short security futures positions at twenty percent of the current market value of the position. Comments on these proposed rules must be received by the agencies on or before December 5, Arnold & Porter 9

10 IV. RULES ON INTERMEDIARIES Apart from the provisions relating to security futures products, the CFMA made few changes to the CEA s treatment of intermediaries. The CFMA mandates that the CFTC conduct a study of the CEA provisions and the CFTC s rules relating to registrants and present a report to Congress. That study is ongoing and will likely lead to regulatory changes. However, the spirit of regulatory reform embodied in the CFMA has led the CFTC to adopt new rules and rule amendments streamlining regulation of intermediaries even before the completion of the study. The rules became effective on October 23, Registration. The new rules streamline registration by intermediaries by narrowing the definition of the principals of intermediaries who are required to register with the NFA. Rather than requiring all officers to register, the rules provide that the only officers that need to register are those in certain specified positions, those with management authority over the intermediary and those with the power to exercise a controlling influence over the intermediary s regulated activities. The rules also clarify and broaden the definition of those who must register as principals because they have at least a ten percent interest in an intermediary. With respect to registration by IBs, the new rules for the first time permit an applicant to file an unaudited financial report, but require a review of such an IB by its designated self-regulatory organization within six months of the IB s registration. Ethics training. The new rules eliminate the current CFTC rule requiring ethics training of intermediaries and their associated persons and replace it with a Statement of Acceptable Practices With Respect to Ethics Training, which leaves the format, frequency and provider of ethics training to the discretion of the individual intermediary. DTF trading. Under the CFMA, retail customers trading on a DTF must trade through an FCM that is a clearing member of the DTF and that has net capital of at least twenty million dollars. The new rules authorize registered commodity trading advisors ( CTAs ) to direct trading of accounts of their retail customers on a DTF as long as they direct accounts with total assets of not less than twenty-five million dollars and disclose to the customers that they may trade on the customers behalf on a DTF. Such accounts must be carried by an FCM, but the FCM need not meet the higher standards of being a clearing member of the DTF with a net capital of at least twenty million dollars. Risk disclosure and reporting. The new rules eliminate the requirement to provide eligible contract participants with general risk disclosure statements and permit FCMs and IBs to obtain 6 Effective December 28, 2000, the CFTC adopted rules broadening the kinds of instruments in which FCMs and clearing organizations may permissibly invest customer funds. The CFTC also adopted rules implementing a provision of the CFMA permitting FCMs to allow certain customers to opt out of segregation of their funds and to waive separate accounting of them. The rules provide that an FCM may ask a customer to do so as long as (i) the customer is an eligible contract participant, (ii) the funds have been deposited with the FCM for trading on a registered DTF, (iii) the DTF has authorized the FCM to permit customers to opt out of segregation, and (iv) the customer has signed an agreement electing to opt out and acknowledging the consequences of doing so. These rules became effective on June 19, Arnold & Porter 10

11 certain required customer acknowledgements through a single signature of the customer. The rules also codify an earlier CFTC Advisory permitting electronic transmission of account statements by FCMs with the consent of the customer after certain disclosures. Trading abuses. The new rules extend the prohibitions of Sections 155.1, and of the CFTC s rules applicable to an intermediary s use of knowledge of its customer s orders to the customer s disadvantage on a contract market to protect retail customers trading on DTFs as well. With respect to eligible contract participants, intermediaries are prohibited generally from misusing customer information in trading on their behalf on DTFs. Offsetting. The new rules permit customers to authorize intermediaries to deviate from a first in-first out approach in closing out offsetting positions. * * * For additional information concerning these new CFTC and SEC rules, please contact one of the following attorneys: Brooksley Born Brooksley_Born@aporter.com Geoffrey Aronow Geoffrey_Aronow@aporter.com Daniel Waldman Daniel_Waldman@aporter.com Susan Lee Susan_Lee@aporter.com Arnold & Porter 11