[Federal Register Volume 65, Number 240 (Wednesday, December 13, 2000)]
[Rules and Regulations]
[Pages 77993-78020]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30268]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 3, 4, 140, 155 and 166
RIN 3038-AB56
Rules Relating to Intermediaries of Commodity Interest
Transactions
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rules.
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SUMMARY: As part of a comprehensive regulatory reform process, the
Commodity Futures Trading Commission (CFTC or Commission) has revised
its rules relating to intermediation of commodity futures and commodity
options (commodity interest) transactions. These new rules and rule
amendments will provide greater flexibility in several areas. For
example, to ease barriers to entry for persons seeking registration as
futures commission merchants (FCMs) or introducing brokers (IBs), the
Commission has established a simplified registration procedure for
those persons who are regulated by other federal financial regulatory
agencies and who limit their customer base to institutional customers
only, regardless of the type of market involved.
With respect to trading on recognized derivatives transaction
facilities (DTFs), the Commission has determined to permit non-
institutional customers to enter into transactions thereon, provided
that such non-institutional customer business is transacted either
through a registered FCM that is a clearing member of at least one
designated contract market or recognized futures exchange (RFE), and
that has adjusted net capital of at least $20 million or by a
registered commodity trading advisor (CTA) who has discretionary
authority over the non-institutional customer's account, and who has
assets under management of not less than $25 million. The latter
circumstance is an expansion of the proposal.
As proposed, the Commission is expanding the range of instruments
in which FCMs may invest customer funds. In response to various
comments concerning the expansion of permissible investments, the
Commission is making certain adjustments to the proposals relating to,
among other things, concentration limits as applied to securities held
in connection with repurchase transactions, permissible investments in
FCMs and their affiliates by money market mutual funds meeting the
requirements of Rule 2a-7 under the Investment Company Act of 1940
(Investment Company Act), and investment in foreign sovereign debt.
Separately, the Commission also is considering proposing risk-based
capital rules for FCMs. Further, the Commission recently adopted a
revised interpretation concerning the treatment of customer funds on
deposit with
[[Page 77994]]
FCMs for the purpose of trading on foreign markets under Rule 30.7.\1\
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\1\ 65 FR 60558 (Oct. 11, 2000). Unless otherwise noted,
Commission rules referred to herein are found at 17 CFR Ch. I
(2000).
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In addition, the Commission is announcing herein the adoption of
other new rules and rule amendments, concerning the definition of the
term ``principal,'' certified financial reports, ethics training,
disclosure, account opening procedures, trading standards, reporting
requirements, and offsetting positions, as proposed. The Commission has
made additional changes to allow a registrant to notify the Commission
when a new natural person is added as a principal ``promptly'' after
the change occurs. With respect to pre-dispute arbitration agreements
between an institutional customer and a Commission registrant, the
Commission has determined to allow such parties to negotiate any or all
terms of the agreement, provided that the signing of such agreement by
the institutional customer cannot be made a condition of doing business
with the registrant. The Commission has also determined to allow any
counterclaim to be heard as part of an arbitration proceeding between a
non-institutional customer and a registrant where the parties have
agreed in advance that all such claims must be included in the
proceeding, provided that the aggregate value of the counterclaim is
capable of calculation and that the counterclaim arises out of a
transaction subject to Commission jurisdiction.
EFFECTIVE DATE: February 12, 2001.
FOR FURTHER INFORMATION CONTACT: Lawrence B. Patent, Associate Chief
Counsel, Paul H. Bjarnason, Jr., Special Advisor for Accounting Policy
(with respect to Rule 1.25 concerning investment of customer funds), or
Ky Tran-Trong, Attorney-Advisor, Division of Trading and Markets,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street, N.W., Washington, D.C. 20581. Telephone: (202) 418-5450.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Background
B. The Comments Received
II. Responses to the Comments Received
A. General
B. Core Principle One: Registration
1. Definition of the Term ``Principal''
2. Special Procedures Available to Firms Subject to Securities
or Banking Regulation
3. Standard Application Procedures for FCMs and IBs
C. Core Principles Two and Six: Fitness and Supervision
D. Core Principle Three: Financial Requirements
1. Trading by Non-Institutional Customers on DTFs
2. Segregation of Funds
3. Investment of Customer Funds
E. Core Principle Four: Risk Disclosure and Account Statements
F. Core Principle Five: Trading Standards
G. Core Principle Seven: Reporting Requirements
H. Core Principle Eight: Recordkeeping
1. General
2. Customer Account Statements; Close-Out of Offsetting
Positions
III. Section 4(c) Findings
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Introduction
A. Background
In accordance with the recommendations made in a staff task force
report submitted to the Commission's Congressional oversight committees
on February 22, 2000, the Commission on June 22, 2000 published a
proposed new regulatory structure intended to adapt to the changing
needs of the modern marketplace (New Regulatory Framework).\2\ In
reviewing its regulatory structure for intermediaries, the Commission
in its proposal (Proposing Release) identified eight Core Principles
that it believes are fundamental to assuring proper conduct by
intermediaries of commodity interest transactions.\3\ Although the
Commission did not propose these Core Principles as rules, they guided
the Commission in its regulatory reform efforts, as the Commission
reviewed all of its rules related to intermediaries in light of the
Core Principles. The Commission proposed reforms contemplating greater
flexibility for intermediaries and their customers via a regulatory
structure that acknowledges the different levels of safeguards
appropriate to the types of instruments, customers, and markets
involved.
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\2\ See A New Regulatory Framework for Multilateral Transaction
Execution Facilities, Intermediaries and Clearing Organizations, 65
FR 38986; Rules Relating to Intermediaries of Commodity Interest
Transactions, 65 FR 39008; A New Regulatory Framework for Clearing
Organizations, 65 FR 39027; Exemption for Bilateral Transactions, 65
FR 39033.
\3\ 65 FR 39008.
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To the extent that an existing rule was not addressed in the
Proposing Release, and no amendment thereto has been adopted, the rule
will apply to intermediaries transacting business on behalf of
customers on contract markets, RFEs and DTFs. When an intermediary
transacts business on an exempt multilateral transaction execution
facility (exempt MTEF), these transactions are subject only to the
Commission's antifraud and antimanipulation authority to the extent
applicable.\4\ Similarly, where a DTF permits trading only on a
principal-to-principal basis, CFTC rules related only to intermediaries
will not be applicable to such a market structure.\5\
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\4\ See id. at 39009 nn.1-3.
\5\ See id. A more complete description of the various new
market structures can be found in ``A New Regulatory Framework for
Multilateral Transaction Execution Facilities, Intermediaries and
Clearing Organizations,'' published elsewhere in today's edition of
the Federal Register..
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The Core Principles that guided the Commission in its review of
rules applicable to intermediaries, which relate to registration,
fitness of registrants, financial requirements, risk disclosure,
trading standards, supervision of personnel, large position reporting
requirements, and recordkeeping, are as follows:
1. Registration Required
Any person or entity intermediating a transaction on an RFE, or on
a DTF that permits intermediation of trading, must be registered in the
appropriate capacity with the Commission as an FCM, IB, CTA, commodity
pool operator (CPO), associated person (AP) of any of the foregoing, or
floor broker (FB). In addition, a person trading solely for his or her
own account on an RFE or DTF with a trading floor must register as a
floor trader (FT).
2. Fitness of Registrants
Intermediaries and FTs in all markets recognized by the CFTC must
be and remain fit.
3. Financial
FCMs must keep and safeguard customer money and FCMs and IBs must
have sufficient capital to ensure their capacity to meet their
obligations to customers.
4. Risk Disclosure
Intermediaries must provide to customers risk disclosure
appropriate to the particular instrument or transaction and the
customer.
5. Trading Standards
Intermediaries and their affiliated persons are prohibited from
misusing knowledge of their customers' orders.
6. Supervision
All intermediaries, including APs having supervisory
responsibilities, must diligently supervise all commodity interest
accounts that they carry,
[[Page 77995]]
operate, advise, introduce, handle, or trade, as well as all of the
other activities that arise in their business as intermediaries. All
intermediaries must establish, maintain, and enforce supervisory
procedures.
7. Reporting of Positions
All intermediaries must report to the Commission, RFE or DTF
information that permits the Commission, RFE, or DTF to identify
concentrations of positions and market composition. Reports of
transactions on RFEs are required on a routine and non-routine basis,
as is the case for transactions on contract markets. Reports of
transactions on an institutional-participant DTF are required only on a
non-routine basis.\6\
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\6\ As discussed in a companion release in today's edition of
the Federal Register, large trader reports will not be required from
participants trading on a DTF restricted to commercial participants,
except where the Commission specifically orders otherwise.
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8. Recordkeeping
All intermediaries (and FTs) must keep full books and records of
all activities related to their business as an FCM, IB, CPO, CTA, FB,
or FT, in a form and manner acceptable to the Commission for a period
of five years. Such information must be readily available during the
first two years and be produced to the Commission at the expense of the
person required to keep the books or records. All such books and
records shall be open to inspection by any representative of the
Commission or the U.S. Department of Justice.
Certain of the Commission's rule amendments, such as those
concerning ethics training and the definition of the term
``principal,'' will affect all registered firms. The other new rules
and rule amendments will affect mainly FCMs and IBs, and are not
applicable to CPOs and CTAs. The Commission intends to consider further
rulemaking proposals at a subsequent date that will focus more directly
upon Part 4 of the Commission's rules, which governs the operations and
activities of CPOs and CTAs.\7\
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\7\ The Commission wishes to make clear that its regulatory
reform efforts are an ongoing process. Thus, for example, as a part
of the regulatory reform process, the Division of Trading and
Markets recently permitted designated self-regulatory organizations
(DSROs) to conduct ``risk-based'' auditing and thereby take into
account a firm's business practices in establishing the scope and
timing of audits. See Financial and Segregation Interpretation No.
4-2, CFTC Staff Letter 99-32, [1998-1999 Transfer Binder] Comm. Fut.
L. Rep. (CCH) para. 27,745 (Aug. 20, 1999). Similarly, the
Commission is considering amendments to the minimum capital
requirements for FCMs. Those proposed amendments would contain an
approach, generally referred to as ``risk-based'' capital
requirements, that is based more upon position risk than is the case
under the current rules.
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B. The Comments Received
The Commission received 81 comment letters on the New Regulatory
Framework, 51 of which were posted to the comment file on
intermediaries on the Commission's web site. Of those 51 comment
letters, 31 letters addressed specific provisions of the Proposing
Release: five from U.S. commodity exchanges; two from the National
Futures Association (NFA); one from the Futures Industry Association
(FIA); six from other futures industry professional associations; one
from the Federal Reserve Bank of Chicago (FRBC); one from the
Department of the Treasury (Treasury); one from a provider of ethics
training programs for the futures industry; five from firms registered
as FCMs; one from a margin settlement bank for various U.S. exchanges
and clearing corporations; three from trade associations representing
the grain industry; one from a group of trade associations representing
various producer groups; two from public policy centers; one from a
single firm registered as an FCM, CPO and CTA; and one from a certified
public accounting firm. These commenters, as well as those that
addressed the concept of regulatory reform in a more general fashion,
expressed strong support for the Proposing Release, but some suggested
that the relief did not go far enough towards replacing the
Commission's regulatory framework concerning intermediaries with core
principles.\8\
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\8\ Commenters are generally identified by name below when their
comments are discussed. Citations to comment letters are denoted as
``CL 22-x.'' The number 22 represents the comment file for the
Proposing Release and ``x'' is the number assigned to a particular
comment letter as set forth on the Commission's website,
www.cftc.gov.
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The Commission has carefully reviewed all of the comments received.
Based upon this review, the Commission generally has determined to
adopt the new rules and amendments as proposed in the Proposing
Release. In response to the comments, the Commission has also decided,
however, to modify the proposal in several respects. First, the
Commission has determined to expand the ``passport'' provisions with
respect to those FCMs and IBs that are already registered with the
Securities and Exchange Commission (SEC) in a similar registration
capacity, or that are authorized to perform these functions by a
federal banking authority. As adopted, these rules will allow those
FCMs and IBs to follow a simplified registration procedure in order to
conduct business solely for institutional customers on designated
contract markets and RFEs, in addition to DTFs. Second, the Commission
has determined to permit certain CTAs to place trades on a DTF on
behalf of non-institutional customers, provided that the non-
institutional customer's investment decisions are directed by the CTA
and that total assets over which the CTA has discretionary authority
are not less than $25 million. The proposal would have required non-
institutional customers wishing to trade on DTFs to transact their
business only through an FCM with at least $20 million in adjusted net
capital that is also a clearing member of at least one designated
contract market or RFE.\9\ Third, the Commission has made adjustments
to its rules governing permissible investments for customer funds in
response to the comments received. Fourth, the Commission has adopted
additional changes to allow a registrant to notify the Commission
``promptly'' after a new principal is added, rather than prior to the
change as was the case previously. Fifth, with respect to pre-dispute
arbitration agreements between an institutional customer and a
Commission registrant, the Commission has determined to allow such
parties to negotiate any or all terms of such agreements, provided that
the signing of the agreement may not be made a condition of doing
business with the registrant. Sixth, the Commission has decided to
permit any counterclaim arising out of a transaction subject to the
Commodity Exchange Act (Act) or regulations thereunder to be heard as
part of an arbitration proceeding between a non-institutional customer
and a registrant where the parties have agreed in advance that all such
claims must be included in the proceeding.
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\9\ As explained in the separate release on ``A New Regulatory
Framework for Multilateral Transaction Execution Facilities,
Intermediaries and Clearing Organizations'' in today's edition of
the Federal Register, however, the Commission is amending its
proposal to permit a non-institutional customer to enter an order
directly to a DTF's electronic trading platform where the customer's
account is carried by a registered FCM with at least $20 million in
adjusted net capital that is also a clearing member of at least one
designated contract market or RFE, provided that such FCM's credit
filter is maintained as part of the DTF's electronic trading
platform. See Sec. 37.2(a)(2)(ii)(A).
In addition, FTs and FBs will be permitted to trade for their
own account on a DTF, even if they would not otherwise come within
the definition of an institutional customer, provided that their
obligations in connection with their trading on the DTF are
guaranteed by an FCM. See Sec. 37.1(b)(1), (2). Generally, an FT or
an FB must have total assets exceeding $10,000,000 to be considered
an institutional customer. See Secs. 1.3(g), 35.2(b)(10), (11).
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In the Proposing Release, the Commission gave a detailed
explanation for each revision that it proposed to
[[Page 77996]]
make to the rules relating to intermediation of commodity interest
transactions. The scope of this Federal Register release generally is
restricted to the comments received on the Proposing Release and
changes to the proposed new rules and rule amendments that the
Commission has made in response thereto. Accordingly, the Commission
encourages interested persons to read the Proposing Release for a
discussion of the background and purpose of each of the rule amendments
that is not described in detail in this Federal Register release.
The Proposing Release also presented several sets of questions
intended to elicit public comments on various issues. For instance, the
Commission requested comment concerning the need to update and to make
more flexible its minimum net capital requirements for FCMs by
permitting the application of risk-based net capital requirements.\10\
In response to the comments received, the Commission plans to
separately propose various rules and amendments addressing risk-based
capital requirements. The Commission also posed certain questions
related to the treatment of customer funds.\11\ Reactions were mixed
regarding these additional issues. Consequently, the Commission will
continue to study these issues.
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\10\ 65 FR at 39012.
\11\ Id. at 39014-15.
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II. Responses to the Comments Received
A. General
As noted above, several commenters urged the Commission to revoke
many of the rules that govern the relationship between futures and
options customers and intermediaries, and to adopt in their place a set
of core principles and statements of acceptable practices that reflect
the ``largely institutional nature of derivatives market
participants.'' (CL 22-31 at 2-3; see also CL 22-22 at 9; CL 22-24 at
1; CL 22-39 at 8; CL 22-35 at 11) In particular, FIA commented that:
[We have] identified the following core principles that we believe
should govern intermediaries in the conduct of their business,
without regard to the market on which a transaction is executed: (1)
Registration of intermediaries and their associated persons; (2)
minimum financial requirements; (3) protection of customer funds
appropriate to the type of customer; (4) prohibition against fraud
and manipulation; (5) large trader reporting requirements; and (6)
recordkeeping. These core principles, combined with an effective
self-regulatory organization audit program to assure that
intermediaries have developed and are enforcing adequate internal
controls[,] should achieve the Commission's regulatory purpose. (CL
22-31 at 3 (footnotes omitted))
In general, the Commission believes that it is more expeditious at
this time to adopt the specific regulatory reforms contemplated in the
original release. Replacing the current rules with core principles
might have delayed these changes, and in some instances, resulted in no
practical benefit to the regulated community. To use Rule 1.55 as an
example, the development of a core principle approach in this area
would have required the Commission to propose the repeal of Rule 1.55
and the adoption of a core principle for disclosure together with a
Statement of Acceptable Practices. The Statement of Acceptable
Practices would likely provide, as the rule does now, no standard
disclosure requirement for institutional customers and the basic
single-page statement now applicable to non-institutional customers. At
the end of this process, there would be no discernible change in FCM or
IB operations. Firms might theoretically be freer to develop their own
statements, but to clear them through counsel and self-regulatory
organization (SRO) staff would likely be costly and time-consuming.
Accordingly, the Commission did not believe that it would be an
effective use of the Commission's or the industry's resources at this
time to replace Rule 1.55 solely for the purpose of establishing a core
principle concerning disclosure. The Commission reaches similar
conclusions with respect to the repeal of other rules.
Second, the Commission believes that certain issues, such as the
computation of capital for a financial intermediary, do not lend
themselves easily to a core principle approach. As one commenter
observed: ``Capital and segregation requirements * * *`` must be
spelled out in detail to ensure the integrity of customer funds.'' (CL
22-24 at 1)
Third, as the New York Mercantile Exchange (NYMEX) noted, a re-
examination of the Commission's rules applicable to intermediaries with
a goal towards replacing them with a set of Core Principles and
statements of acceptable practices ``would require an intensive review
of the applicable rules in this area,'' and accordingly, ``undertaking
such an examination as part of the current Reform Proposal could so
greatly lengthen the process as to undermine the entire reform
effort.'' (CL 22-32 at 16-17)
Nevertheless, the Commission's decision at this time not to use a
core principles approach with respect to intermediaries will not affect
its commitment to the continued review of the rules affecting
intermediaries to determine where core principles are appropriate.\12\
In this regard, the Commission notes the request it made in the
Proposing Release for specific comments concerning existing rules and
suggested modifications thereto.\13\ The Commission further notes that
under Rule 140.99, there remains a procedure in place whereby the
Commission's staff may consider specific individual circumstances and,
where warranted, the Commission's staff may grant interpretative,
exemptive, or no-action relief from requirements under the Act or
Commission rules to individuals or entities requesting such relief.
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\12\ Should the Commission in the future adopt core principles
in the place of some of its existing regulations as they pertain to
intermediaries, NFA urged the Commission to look to NFA and the
industry to develop the acceptable practices for satisfying many of
these core principles, subject to Commission approval. (CL 22-24 at
2) The Commission notes that it has already taken such an approach
in certain areas, e.g., disclosure to non-institutional customers
trading on DTFs, and looks forward to continuing to work with NFA
and the industry in developing acceptable practices in additional
areas.
\13\ 65 FR at 39009.
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Certain commenters specifically addressed the need for further
regulatory relief with respect to CPOs and CTAs. (CL 22-22 at 9; CL 22-
43 at 5-6; CL 22-47 at 2) The Commission recognizes that CPOs and CTAs
represent ``important sectors of the futures industry.'' (CL 22-22 at
2) As stated above, the regulatory reform process is an ongoing one.
The Commission continues to explore additional areas in which relief
for CPOs and CTAs may be warranted, e.g., Part 4 of the Commission's
rules, and will be making further rulemaking proposals.
With specific regard to recordkeeping, the Commission in 1999
adopted amendments to the recordkeeping requirements of Rule 1.31 in
order to allow recordkeepers to store most records on either
micrographic or electronic storage media for the full five-year period,
thereby harmonizing procedures for those firms regulated by both the
Commission and the SEC.\14\ In order to avoid undue hardship, the
Commission later extended the effective date of the requirement that
recordkeepers using only electronic storage media enter into
arrangements with third-party technical consultants.\15\ The
Commission's staff is continuing to work with industry representatives
to implement this procedure.
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\14\ 64 FR 28735 (May 27, 1999).
\15\ 64 FR 36568 (July 7, 1999).
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[[Page 77997]]
B. Core Principle One: Registration
1. Definition of the Term ``Principal''
Under Commission staff's prior interpretation of the definition of
the term ``principal'' in Rules 3.1(a)(1) and 4.10(e)(1),\16\ all
officers of a registrant were treated as principals and required to
register as such. In response to changes in management structures over
the last 20 years and requests from registrants that certain employees,
such as some vice presidents, not be considered principals because they
do not exercise a controlling influence over the registrant or any of
its activities subject to Commission regulation, the Commission
proposed to amend Rules 3.1(a)(1) and 4.10(e)(1) by defining as
principals persons within a given organizational structure who hold
specific offices.\17\ A registrant would, therefore, no longer be
required to treat every officer as a principal, but only those who met
the criteria of the rule as revised.
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\16\ Rule 3.1(a) defines ``principal'' for purposes of the
Commission's Part 3 rules, which govern registration. Rule 4.10(e)
defines ``principal'' for purposes of the Commission's Part 4 rules,
which apply to the activities of CPOs and CTAs.
\17\ 65 FR at 39010.
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Commenters were strongly in support of the proposal to amend the
definition of ``principal'' to reduce the number of persons required to
be registered, and the Commission is adopting the amendments as
proposed.\18\ (CL 22-22 at 11; CL 22-24 at 3; CL 22-25 at 2; CL 22-31
at 13; CL 22-32 at 16) The Managed Funds Association (MFA) asked the
Commission to confirm that the reference in the proposed amendment to
the ``principal'' definition to ``any person in charge of a business
unit subject to regulation by the Commission'' applied solely to ``the
aggregate business unit acting in a registered capacity and not
subsidiary divisions or units such as marketing, human resources,
audit, and other departments within an operating entity.'' (CL 22-22 at
11) The Commission agrees with this interpretation, and reiterates that
the intent of the amended ``principal'' definition is to reduce the
number of officers that will be considered principals, while ensuring
that appropriate personnel, e.g., those that exercise, or are in a
position to exercise, ``a controlling influence over the registrant or
any of its activities subject to Commission regulation,'' \19\ remain
listed as such.
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\18\ As amended, the ``principal'' definition will continue to
include all directors of a corporate registrant. In addition, the
definition will include the general provision that defines as a
principal any person occupying a similar status as or performing
similar functions to those persons specifically listed, having the
power, directly or indirectly, through agreement or otherwise, to
exercise a controlling influence over a firm's activities that are
subject to regulation by the Commission. As noted in the Proposing
Release, what constitutes ``a controlling influence'' will be left
for determination on ``a case-by-case basis.'' Id. at 39011 n.11.
\19\ Id. at 39010.
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The Commission also has determined to adopt, as proposed,
conforming changes to Rules 4.24(f)(1)(v), 4.25(a)(8)(ii)(A) and
4.25(c)(2)(i)(B), applicable to CPOs, and 4.34(f)(1)(ii) and
4.35(a)(7)(ii)(A), applicable to CTAs, as incorporated by reference in
amended Rule 4.10(e)(1). Accordingly, CPOs and CTAs will only be
required to provide business backgrounds and proprietary trading
results for those principals who participate in making trading or
operational decisions, or supervise persons so engaged, and not all
officers.\20\
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\20\ Id. at 39011.
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In response to suggestions by FIA, the Commission has determined to
delete Rule 3.32, which specifies certain events or changes within a
firm's management structure that require the firm to file a new
registration form. (CL 22-31 at 13-14) The Commission is adding a new
paragraph (a)(2) to Rule 3.31 to require the registrant to file a Form
8-R on behalf of each new natural person principal who was not listed
on the registrant's Form 7-R ``promptly'' after the change occurs. Rule
3.31(a)(2) was drafted to closely parallel Rule 3.10(a)(2)(i), and
provides that, if the change that renders the application for
registration deficient or inaccurate results from the addition of a new
principal without a current Form 8-R on file with NFA, a Form 8-R for
that principal must accompany the Form 3-R amending the registrant's
application for registration.\21\
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\21\ An additional conforming change was made to Sec. 3.21(c) to
reflect the deletion of Sec. 3.32, and the addition of new paragraph
(a)(2) to Sec. 3.31.
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2. Special Procedures Available to Firms Subject to Securities or
Banking Regulation
The Commission proposed to amend Rule 3.10 to simplify the
registration process for FCMs or IBs who conduct business solely for
institutional customers on a DTF, and who are already registered with
the SEC in a similar registration category or who are authorized to
perform these functions by a federal banking authority.\22\ The
Commission stated in the Proposing Release that such applicants would
be registered as an FCM or IB upon filing notice with NFA of their
intent to undertake such limited activities, together with a
certification that they are registered or authorized to engage in a
similar function by, and are in good standing with, the SEC or a
federal banking authority. In addition, individuals acting in the
capacity of APs for such FCMs or IBs need not be registered or listed,
and would not be subject to proficiency testing or ethics training
requirements. These firms and their salespersons would remain subject
to antifraud provisions, however.\23\
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\22\ 65 FR at 39011-12.
\23\ Id. at 39012.
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The Chicago Mercantile Exchange (CME), along with other commenters,
stated that the ``passporting'' provisions did not go far enough and
urged the Commission to extend the provisions to allow those persons
who are regulated by the SEC or a federal banking agency, and who opt
to register as an FCM or IB under the simplified registration
procedure, to conduct business for institutional customers on all
trading platforms, rather than limit their access to DTFs.\24\ (CL 22-
35 at 12; see also CL 22-24 at 3-4; CL 22-25 at 2-3) In support of this
recommendation, the Chicago Board of Trade (CBT) stated, ``[i]f the
nature of the entity or individual intermediating the transaction and
the nature of the customer determines the need for any particular
requirement, whether the transaction facility is a DTF or an RFE is
irrelevant.'' (CL 22-25 at 3; see also CL 22-35 at 15)
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\24\ In this regard, the CME stated that given the restrictions
of the DTF market structure:
The proposed rulemaking provides no relief whatsoever to a
securities broker-dealer (not also registered as a FCM) that wishes
to execute transactions in both stock index futures and the
underlying stocks in order to implement an asset allocation strategy
for its institutional customers. So long as the customers are
sophisticated institutions, we can see no regulatory reason not to
allow them to use the federally-regulated intermediary of their
choice in effecting transactions in a futures market, regardless of
whether the market is regulated as a designated contract market, an
RFE, a DTF or an exempt MTEF. (CL 22-35 at 12)
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In contrast, however, the National Introducing Brokers Association
(NIBA) urged that any person or organization conducting any commodity
interest business should be subject to full registration requirements
(CL 22-17 at 4), while MFA stated that firms making use of the
``passport'' procedure should be subject to a limitation upon their
commodity interest business, such as a requirement that their commodity
interest activities be incidental to their primary business as a
broker-dealer or bank. (CL 22-22 at 11-12)
Upon consideration of the comments received, the Commission agrees
that given the nature of the customers (i.e., solely institutional
customers) for whom a securities broker-dealer or bank would
[[Page 77998]]
be acting as an FCM or IB, the securities broker-dealer or bank should
be eligible for the simplified FCM or IB registration procedures,
irrespective of the type of exchange on which the customer seeks to
conduct its transactions. Accordingly, the Commission has adopted Rule
3.10(a)(1)(i)(B) to permit an individual or entity who is registered
with the SEC as a broker-dealer, or has been authorized by the
appropriate banking authority, to register as an FCM or IB simply by
filing notice with NFA, together with a certification of registration
with the appropriate financial regulator.\25\ Such FCMs and IBs who are
otherwise regulated by another federal financial regulator will be
permitted to conduct business solely for institutional customers on any
designated contract market, RFE or DTF.\26\ The Commission notes,
however, in accordance with FIA's comments, that the simplified
registration procedure is limited to banks themselves, and not to their
affiliates, and further, that once registered, securities broker-
dealers and banks would be subject to the same rules that govern all
FCMs and IBs. (CL 22-34 at 13)
---------------------------------------------------------------------------
\25\ As noted in the Proposing Release, a firm acting in the
capacity of an FCM would be required to become a member of a
registered futures association. See Sec. 170.15. NFA is currently
the only registered futures association. NFA Bylaw 1101 essentially
provides that no NFA member may deal with another person with
respect to an account, order or transaction where the other person
is acting in a capacity that requires registration, unless that
other person is also a member of a registered futures association.
The combination of Commission Rule 170.15 and NFA Bylaw 1101
therefore requires most registrants to become members of NFA.
The Commission may consider not requiring NFA membership in the
future if reciprocal arrangements were made by the primary
regulators of other financial industry segments to recognize CFTC
registration without requiring corresponding SRO membership.
\26\ Because an intermediary that conducts business on an exempt
MTEF will not be subject to Commission regulation for activity on
the exempt MTEF, except for the antifraud and antimanipulation
provisions of the Act to the extent applicable, it is unnecessary to
extend the ``passporting'' procedure to firms trading on these
markets.
---------------------------------------------------------------------------
Although ``passported'' firms will be eligible for the simplified
FCM or IB registration procedures without regard to the type of
exchange on which their institutional customers seek to conduct
business, the Commission has determined to adopt Rules 1.17(a)(2)(iii)
and 1.52(m), as proposed, without making further changes. Under Rule
1.17(a)(2)(iii), the Commission would not require an FCM or IB
registered under the ``passporting'' procedures in Rule
3.10(a)(1)(i)(B) to meet the Commission's minimum financial
requirements if (i) it meets the appropriate net capital requirements
of its primary regulator, (ii) its activities are limited to serving
institutional customers trading on DTFs that do not require compliance
with CFTC minimum financial requirements for such ``passported'' firms,
and (iii) it conforms to minimum financial standards and related
reporting requirements set by such DTF in its bylaws, rules,
regulations or resolutions.\27\
---------------------------------------------------------------------------
\27\ 65 FR at 39012.
---------------------------------------------------------------------------
If, however, the ``passported'' FCM or IB chooses to conduct
transactions on behalf of its institutional customers on a contract
market or RFE in addition to its DTF activities, the firm would then be
required to satisfy the Commission's minimum financial requirements.
The Commission believes that this requirement is important to protect
the financial integrity of these markets because a customer default may
have ancillary impacts not just on other customers of the affected
firm, but also on other firms and their customers transacting business
on such markets. Moreover, because the Commission anticipates that
``passported'' firms will conduct most of their business in the
securities or banking fields, with only a minor portion of their
activities involving commodity interests, the requirement that such
firms meet the Commission's minimum financial requirements if they
conduct business for their institutional customers on a contract market
or RFE should not impose a significant burden. Rules 1.17(a)(1)(i) and
(ii) already require the dually registered FCM or IB to meet the
greater of either the Commission's or SEC's minimum financial
requirements, and in most cases, those entities that conduct most of
their business in the securities or banking fields will have satisfied
the Commission's minimum financial requirements by meeting the SEC
capital requirements. Similarly, the Commission allows a dually
registered FCM or IB to satisfy the basic financial reporting
requirements of Rule 1.10 by filing a copy of its FOCUS report in lieu
of a Form 1-FR. In addition, Rule 1.52(m) is adopted as proposed to
relieve a DTF from the requirement that it adopt for ``passported''
firms, the Commission's minimum adjusted net capital standards.\28\
---------------------------------------------------------------------------
\28\ Id.
---------------------------------------------------------------------------
The Commission continues to encourage the SEC to consider
reciprocal amendments to its rules to accommodate FCMs and IBs that are
not now dually registered as securities brokers or dealers, but that
may wish to act as intermediaries in the securities markets.
The Commission also noted in the Proposing Release that it was
considering updating and making more flexible its minimum net capital
requirements with respect to FCMs, specifically with respect to
adopting risk-based net capital requirements.\29\ Commenters were
overwhelmingly in favor of this proposal, and the CBT further noted
that it had, along with the Board of Trade Clearing Corporation (BOTCC)
and the CME, already adopted risk-based capital requirements at the
clearing organization level. (CL 22-25 at 3) The Commission is
separately considering proposing rules related to risk-based net
capital requirements.\30\
---------------------------------------------------------------------------
\29\ Id.
\30\ Although the Proposing Release did not generally address
registration procedures for firms that are dually registered with
the National Association of Securities Dealers (NASD) and NFA, the
Association of Registration Management (ARM) made several
suggestions in that area. Among its comments, ARM recommended that:
(1) Firms that are dually registered with NASD and NFA should be
permitted to maintain internal records about branch office location
and supervision of those locations; (2) NFA should be permitted to
rely on the fingerprint information available through the NASD's
Internet-based Central Registration Depository (Web CRD) database
for dual registrants; and (3) NFA also should be permitted to rely
on disciplinary and disclosure information filed through amendments
to Web CRD. (CL 22-23 at 2-3) ARM also recommended that the
Commission eliminate its Form 7-R annual update requirement by
allowing NFA to rely upon, and to record changes in a registrant's
application through use of, the amendments filed via Form 3-R
throughout the year. (CL 22-23 at 1-2)
The Commission's Registration Working Group (RWG) will consider
ARM's suggestions in the near future. In this regard, Commission
staff indicated in a letter dated July 13, 2000 to NFA that: (1) NFA
could rely upon reporting by the futures industry SROs and the
Commission with respect to SRO disciplinary actions and Commission
enforcement actions; (2) certain requirements related to the
collection of employment, residential and educational data could be
reduced; and (3) as part of the annual update process, firms would
only be required to report any new criminal or civil matters that
had arisen since the previous update.
---------------------------------------------------------------------------
3. Standard Application Procedures for FCMs and IBs
The Commission proposed that applicants for registration as FCMs or
IBs who raise their own capital to satisfy minimum financial
requirements would be permitted to file an unaudited financial report
indicating satisfaction of the minimum requirements, rather than be
required to provide certified financial statements with their
registration application.\31\ A firm taking
[[Page 77999]]
advantage of the new procedure would be subject to an on-site review
within six months of registration by the firm's DSRO or, at the DSRO's
discretion, a conference between appropriate staff of the firm and the
DSRO at the DSRO's offices. An applicant that did not wish to be
subject to the six-month review could continue to follow the existing
rules and file a certified financial statement with its
application.\32\
---------------------------------------------------------------------------
\31\ Id. However, as stated in the Proposing Release, those IB
applicants who do not raise their own capital continue to be
required to file a guarantee agreement entered into with an FCM with
their registration application. IBs and FCMs should refer to
Commission Rules 1.10(j) and 1.57(a)(1) concerning the procedures
applicable to guarantee agreements. See also First American Discount
Corp. v. CFTC, 222 F.3d 1008 (D.C. Cir. Aug. 18, 2000).
\32\ 65 FR at 39013.
---------------------------------------------------------------------------
In general, commenters supported the proposed elimination of the
certified financial statement requirement for IB applicants. (CL 22-17
at 3; CL 22-24 at 4; CL 22-25 at 4) Both NFA and the CBT, however,
expressed reservations about eliminating the requirement for FCM
applicants. (CL 22-24 at 4; CL 22-25 at 4) In addition, NFA recommended
that the Commission consider allowing the DSRO to conduct the six-month
review of independent IBs telephonically where the DSRO has no reason
to be concerned about the IB's capital. (CL 22-24 at 4) The CBT
expressed the view that the six-month time period for the on-site
review of the FCM by the DSRO should be calculated from the date the
FCM begins customer business, rather than six months from the date of
registration. (CL 22-25 at 4).
The Commission has determined to eliminate the requirement to file
certified financial statements with FCM or IB registration applications
by adopting Rules 1.10 (a)(2)(i)(C) and (a)(2)(ii)(C), generally as
proposed.\33\ This alternative procedure is modeled on similar
procedures in the securities industry. Although the Commission is not
requiring FCMs to file a certified financial statement with their
application for registration, this does not preclude any SRO from
imposing this requirement before accepting an FCM for membership. With
respect to the six-month review that must be conducted should an FCM or
IB choose not to file a certified financial statement with its
registration application, the Commission does not object, in the case
of an IB, to allowing the DSRO to conduct the review telephonically
where the DSRO does not have reason to question the IB's capital.
However, the Commission believes that the six-month time period for the
review of both FCMs and IBs should begin from the date the applicant is
registered. The Commission has held consistently that once a registrant
becomes registered in a certain capacity, the registrant is immediately
assumed to be engaging in the activities permitted by such
registration.\34\
---------------------------------------------------------------------------
\33\ Rules 1.10(a)(2)(i)(C) and (a)(2)(ii)(C) have been further
revised to make clear that the Form 1-FR-FCM or Form 1-FR-IB that
must be submitted by new applicants for registration as FCMs and IBs
with their application must be dated not more than 17 business days
prior to the date on which such report is filed. This is consistent
with Rules 1.10(a)(2)(i)(B) and (a)(2)(ii)(B).
\34\ See, e.g., In re Premex, [1982-1984 Transfer Binder] Comm.
Fut. L. Rep. (CCH) para. 21,992 (Feb. 1, 1984), aff'd in relevant
part, rev'd in part, 785 F.2d 1403 (9th Cir. 1986).
---------------------------------------------------------------------------
C. Core Principles Two and Six: Fitness and Supervision
The Commission proposed to delete Rule 3.34 and instead to
implement Congressional intent regarding ethics training through a
Statement of Acceptable Practices.\35\ Rule 3.34 specified frequency
and duration of ethics training, the suggested curriculum,
qualifications of instructors, and the necessary proof of attendance at
such classes. In proposing to replace the rule with a Statement of
Acceptable Practices that would leave the format, frequency, and
providers of ethics training up to the registrants themselves, the
Commission expressed its belief that greater flexibility regarding
ethics training and proficiency testing could be afforded to
registrants than was permitted under Rule 3.34. For registrants seeking
guidance as to the maintenance of proper ethics training procedures
consistent with the purposes of the Core Principle that intermediaries
must be and remain fit, the Commission stated that the Statement of
Acceptable Practices could function as a ``safe harbor.'' \36\
---------------------------------------------------------------------------
\35\ 65 FR at 39013.
\36\ Id.
---------------------------------------------------------------------------
In general, commenters expressed strong support for the
Commission's proposal, stating, for example, that Rule 3.34 had become
``far too detailed and administratively cumbersome,'' (CL 22-24 at 5)
and that ``each registrant should be responsible for implementing an
ethics training program that addresses the registrant's business
activities.'' (CL 22-31 at 14) Other commenters, however, expressed
their beliefs that Rule 3.34 already provided sufficient flexibility to
registrants, and that by eliminating the rule, the Commission risks
sending the wrong message to the industry regarding the importance the
Commission assigns to the ethics requirement. (CL 22-7 at 3; CL 22-43
at 6).
Upon consideration of the comments received, the Commission is
deleting Rule 3.34 and issuing the Statement of Acceptable Practices as
a new Appendix B to Part 3 of its Rules as proposed. Although the
Commission notes the concern that eliminating Rule 3.34 may lead firms
to place an inadequate priority on ethics training, the Commission does
not believe that the replacement of the rule with a Statement of
Acceptable Practices will diminish a registrant's obligations to remain
fit and to adequately supervise the handling of customer accounts.
Instead, the Commission hopes that the Statement of Acceptable
Practices, which allows registrants to adopt ethics training programs
that are better tailored to their needs, will help to imbue firms with
a ``culture of ethics'' that is ongoing rather than episodic. The
Commission believes that the essence of the ethics training or
continuing education requirement is to remain current as to the legal
requirements applicable to a person's role in the futures industry,
which a registrant ignores at his or her peril.
The Commission also proposed to publish its recent ``guidance
letters'' issued to NFA concerning the treatment of SRO disciplinary
actions in assessing the fitness of FBs and FTs. The guidance letters
were issued to provide greater clarity in interpreting the ``other good
cause'' ground for statutory disqualification from registration under
Section 8a(3)(M) of the Act. Support was expressed for this proposal
and, accordingly, the Commission is hereby publishing both letters as
an addition to Appendix A to Part 3 of its Rules.\37\ (CL 22-25 at 4-5)
---------------------------------------------------------------------------
\37\ In the Proposing Release, the Commission indicated that
these letters would be published as an accompanying statement to
this Federal Register release. The Commission has determined to add
these letters to Appendix A to Part 3 because they relate to the
issue of ``other good cause,'' which is discussed at the end of
Appendix A, and to provide an easier way to access the texts of
these letters.
---------------------------------------------------------------------------
The Commission also requested comment regarding additional changes
that should be considered in this area. In response, NFA urged the
Commission to consider prohibiting exchange ``subscribers'' from
accessing electronic exchanges where they have been barred by another
exchange. (CL 22-22 at 5) As explained by NFA, the term ``subscriber''
describes the type of person that is equivalent to an FT. The
Commission previously stated, when it adopted rules to govern FT
registration, that it would defer consideration of the application of
such requirements to persons using electronic trading systems to a
later date.\38\ To date, the Commission has not revisited the issue,
and accordingly does not believe that it is appropriate to adopt NFA's
request at this time. Nevertheless, the exchanges remain free to ban
such ``subscribers''
[[Page 78000]]
from access pursuant to their own rules and policies. As with the case
of certified financial statements for FCM applicants discussed above,
SROs may determine to impose requirements that are stricter than the
minimum standards set forth in Commission rules.
---------------------------------------------------------------------------
\38\ 58 FR 19575, 19576 (Apr. 15, 1993).
---------------------------------------------------------------------------
D. Core Principal Three: Financial Requirements
1. Trading by Non-Institutional Customers on DTFs
Under the New Regulatory Framework, trading on DTFs would be
limited to futures and options on specified commodities or those
commodities deemed eligible under a case-by-case Commission
determination.\39\ In addition, DTFs could permit trading in any
commodities if trading is limited to qualifying commercial
participants.\40\ The Commission proposed, however, that under certain
conditions a DTF might permit non-institutional customers to enter into
transactions thereon.\41\ To address the higher degree of risk
associated with the lower regulatory protections offered to DTF
participants, such non-institutional customer business could be
transacted only through a registered FCM that (1) Is a clearing member
of at least one designated contract market or RFE, and (2) has a
minimum adjusted net capital of at least $20 million.\42\ Such an FCM
is considered to be more capable of properly handling these
transactions and the associated risk. The Commission further noted
that, in order to provide guidance to such customers and their FCMs,
NFA would issue a Statement of Acceptable Practices regarding
additional disclosures to be made to non-institutional customers
trading on DTFs and related issues involving price dissemination.\43\
---------------------------------------------------------------------------
\39\ 65 FR at 38990.
\40\ Id.
\41\ 65 FR at 39013.
\42\ Id.
\43\ Id.
---------------------------------------------------------------------------
Several commenters objected to the $20 million adjusted net capital
requirement for FCMs set forth in Rule 1.17(a)(1)(ii) as proposed,
stating that the amount was arbitrary, and urging that it be eliminated
or reduced. (CL 22-35 at 8; CL 22-46 at 3-4; CL 22-48 at 3) The CBT
observed that the $20 million minimum adjusted net capital requirement
would prevent more than half of all registered FCMs from intermediating
on DTFs for retail customers. (CL 22-25 at 5) Instead, the CBT
suggested that the Commission focus on the FCM's record of customer
protection, and permit any registered FCM to transact retail customer
business on a DTF if the firm: (1) Has been registered as an FCM for at
least three years; and (2) has not been found by a governmental or SRO
authority to have committed any sales practice violations against
retail customers during the past three years. (CL 22-25 at 5)
Goldenberg, Hehmeyer & Co. (GHC) recommended that the Commission apply
risk-based capital requirements in lieu of the $20 million minimum net
capital requirement to assess the FCM's financial soundness. (CL 22-19
at 1-2) In a somewhat related vein, Treasury commented that a more
appropriate measure of an intermediary's soundness is the amount of
adjusted net capital in excess of the minimum required by regulation.
(CL 22-34 at 3-4) Treasury further observed, however, that because the
Commission's adjusted net capital requirements are based on the amount
of segregated funds, whether excess adjusted net capital is an
appropriate measure of an FCM's soundness in addition to total adjusted
net capital depended on what the Commission ultimately decided on the
segregation of funds issue. Accordingly, Treasury recommended that the
Commission consider the segregation of funds issue in conjunction with
its review of net capital rules. (CL 22-34 at 3-4)
Although MFA supported the Commission's proposal to allow non-
institutional customers access to DTFs through qualifying FCMs (i.e.,
those that are clearing members of at least one designated contract
market or RFE and that have at least $20 million in adjusted net
capital), it urged that customers who opted to trade through certain
registered CTAs should also have such access. (CL 22-22 at 5)
Specifically, MFA recommended that CTAs with at least $25 million in
assets under management be permitted to access both exempt MTEFs and
DTFs and engage in transactions on behalf of their customers in those
markets. In support, MFA pointed out that in adopting Rule 30.12, which
included in the definition of ``authorized customer'' any person whose
investment decisions with respect to foreign futures and foreign option
transactions are made by a CTA with total assets under management
exceeding $50 million,\44\ the Commission recognized that where a
professional asset manager such as a CTA acts for a customer, it is
appropriate to rely on the financial sophistication of the person
managing the assets rather than on the sophistication of the individual
CTA client. (CL 22-22 at 5) MFA further stated that because customers
select their CTAs precisely on the basis of their determination that
those CTAs are best qualified to make trading decisions on their
behalf, precluding a CTA from being able to access DTF markets ``would
* * * deprive customers of their ability to elect and receive the full
benefits of the professional management for which the customer has
retained the CTA.'' (CL 22-22 at 6) MFA estimated that less than 10
percent of all registered CTAs would qualify under a $25 million assets
under management threshold, and expressed the view that this ``small
but sophisticated'' class of CTAs would be an appropriate group for the
Commission to permit access to all types of futures markets. (CL 22-22
at 8)
---------------------------------------------------------------------------
\44\ 65 FR at 47277.
---------------------------------------------------------------------------
The Commission has reviewed these comments carefully. The
Commission has determined to adopt, as proposed, the $20 million
minimum adjusted net capital requirement for FCMs wishing to transact
business on behalf of non-institutional customers on a DTF. The Core
Principle addressing financial standards encourages intermediaries to
maintain adequate capital to ensure they are able to meet their
obligations to customers, and the Commission believes that the $20
million adjusted net capital requirement is a sufficient proxy for
ensuring that FCMs will be financially capable of properly maintaining
and servicing customer accounts. The Commission will monitor the
effects of this requirement and make adjustments if appropriate.
The Commission has determined to add a new Rule 4.32 to permit
registered CTAs to enter trades on or subject to the rules of a DTF on
behalf of a non-institutional client, provided that the CTA: (1)
Directs the client's commodity interest account; \45\ (2) directs
accounts containing total assets of not less than $25 million at the
time the trade is entered; and (3) discloses to the client that it may
enter trades on a DTF on the client's behalf. Paragraph (b) of Rule
4.32 further requires that the client's commodity interest account be
carried by a registered FCM. An FCM who receives orders on behalf of a
non-institutional customer from a CTA acting in accordance with Rule
4.32 need not maintain $20 million in minimum adjusted net capital,
however. See Rule 1.17(a)(1)(ii)(B). In addition, a CTA placing trades
on a DTF on behalf of a non-institutional client will be required to
make any necessary
[[Page 78001]]
disclosures pursuant to Rule 4.34(h), which requires a CTA to disclose
to the client if, pursuant to Rule 1.46, the CTA has instructed the FCM
carrying the client account either not to close out all offsetting
positions or to close out offsetting positions on other than a first-
in, first-out basis. This issue is discussed in greater detail below.
---------------------------------------------------------------------------
\45\ The term ``direct,'' as defined in Rule 4.10(f), refers to,
in the context of trading commodity interest accounts, ``agreements
whereby a person is authorized to cause transactions to be effected
for a client's commodity interest account without the client's
specific authorization.''
---------------------------------------------------------------------------
2. Segregation of Funds
The Proposing Release raised two sets of questions seeking comments
about whether, and under what circumstances, the Commission should
permit (1) customers to opt out of segregation and (2) FCMs to
maintain, in the same customer segregated account, various instruments,
such as over-the-counter (OTC) derivatives, equity securities, and
other cash market positions, as well as the funds used for the purpose
of securing or margining such products and positions.\46\ Differing
views were presented on both issues, and the Commission has determined
to defer action in these areas. With respect to customer opt-out of
segregation, most parties commenting on the issue urged the Commission
to consider thoroughly the potential implications with respect to the
bankruptcy rules, e.g., priority of distribution, before proceeding on
the issue. (CL 22-18 at 1; CL 22-22 at 6; CL 22-25 at 7; CL 22-31 at 7-
8; CL 22-32 at 14-15; CL 22-34 at 3) NFA further expressed the view
that there was no current need for, or interest in, allowing
institutional customers to opt out of segregation, as the FCM community
is more interested in being able to provide customers with a unified
account statement reflecting their holdings across all products, not
just futures contracts. (CL 22-24 at 5)
---------------------------------------------------------------------------
\46\ 65 FR at 39014.
---------------------------------------------------------------------------
In response to the Commission's query on whether the types of
permissible instruments held in the same customer account should be
expanded, FIA expressed the view that Section 4d(2) of the Act permits
the Commission to authorize any FCM that wishes to carry a customer's
cash, OTC derivatives, securities and futures positions in a single
account to maintain that account as a customer segregated account. The
CBT cautioned the Commission to give further consideration to
bankruptcy implications before proceeding in this area. The Commission
agrees that action on this issue should be deferred to allow for
additional study and consultation with other regulators, including
members of the President's Working Group (PWG), and in addition, that
any ultimate determination must be made in conjunction with deciding
the customer opt-out of segregation issue.\47\
---------------------------------------------------------------------------
\47\ The Commission notes, however, that cross-margining
arrangements are already in place with respect to trading of stock
index options and stock index futures.
---------------------------------------------------------------------------
3. Investment of Customer Funds
The Commission proposed to amend Rule 1.25, which sets forth the
types of instruments in which FCMs and clearing organizations are
permitted to invest customer funds pursuant to Section 4d(2) of the Act
(permitted investments), by expanding the list of permitted
investments.\48\ Previously, an FCM or clearing organization was
permitted to invest segregated funds only in obligations of the U.S.,
in general obligations of any State or of any political subdivision
thereof, or in obligations fully guaranteed as to principal and
interest by the U.S.
---------------------------------------------------------------------------
\48\ 65 FR at 39014.
---------------------------------------------------------------------------
The Commission proposed, subject to specific risk-limiting
features, to permit FCMs to invest customer segregated funds in the
following additional instruments: (1) Obligations issued by any agency
sponsored by the U.S.; (2) certificates of deposit issued by a bank, as
defined in Section 3(a)(6) of the Securities Exchange Act of 1934, or a
domestic branch of a foreign bank insured by the Federal Deposit
Insurance Corporation; (3) commercial paper; (4) corporate notes; and
(5) interests in money market mutual funds (MMMFs). In addition, an FCM
or a clearing organization would also be permitted to both buy and sell
the permitted investments pursuant to agreements for resale or
repurchase of the instruments (repurchase transactions).\49\
---------------------------------------------------------------------------
\49\ Id.
---------------------------------------------------------------------------
The Proposing Release contained several provisions intended to
minimize credit risk, market risk, and liquidity risk, including: (i) A
requirement that the investments be highly-rated by a nationally-
recognized statistical rating agency (NRSRO), except for U.S.
government securities and those MMMFs that are not required to be
rated; (ii) a requirement that the dollar-weighted average of the time
remaining to maturity of the debt securities held in the segregated
portfolio not exceed 24 months, excluding investment in MMMFs because
MMMFs have no maturity date; (iii) concentration limits on the
percentage of the portfolio that may be comprised of the securities of
individual issuers; (iv) specific prohibitions against leverage,
embedded derivatives, and options; and (v) a requirement that the daily
value and gains and losses on each investment be included in the
records of the FCM or clearing organization.\50\
---------------------------------------------------------------------------
\50\ Id. at 39014-15.
---------------------------------------------------------------------------
In connection with the proposed revisions to Rule 1.25, the
Commission also proposed to amend Rules 1.20(a) and 1.26(a) to
eliminate the requirement that an FCM obtain a written acknowledgment,
from each clearing organization where the FCM has deposited customer
funds or instruments purchased with customer funds, that the clearing
organization was informed that the customer funds or instruments
purchased with customer funds and deposited therein belong to customers
and are being held in accordance with the provisions of the Act and the
rules and orders promulgated thereunder.\51\ The elimination of the
written acknowledgment requirement would be conditioned upon the
clearing organization's adoption and submission to the Commission of
rules that provide for the segregation as customer funds, in accordance
with the Act and the Commission's rules and orders, of all funds held
on behalf of customers and all instruments purchased with customer
funds.\52\
---------------------------------------------------------------------------
\51\ Id. at 39015.
\52\ Id. This codifies a staff no-action letter issued three
years ago. See CFTC Staff Letter No. 97-45, [1996-1998 Transfer
Binder] Comm. Fut. L. Rep. (CCH) para.27,085 (May 5, 1997).
---------------------------------------------------------------------------
In general, commenters responded favorably to the Commission's
proposals to expand the permissible investments, and the Commission has
determined to adopt the amendments generally as proposed.\53\
Notwithstanding their overall support, however, commenters addressed
several areas in which they sought additional adjustments or
clarifications concerning the rule amendments. Commenters also
responded to specific questions raised by the Commission in the
Proposing Release.
---------------------------------------------------------------------------
\53\ Because the Commission has determined to include MMMFs in
the list of permissible investments for customer funds, subject to
the limitations adopted in Rule 1.25, it is hereby rescinding
Division of Trading and Markets Financial and Segregation
Interpretation No. 9, which previously prohibited such investment.
See Financial and Segregation Interpretation No. 9, 1 Comm. Fut. L.
Rep. (CCH) para.7,119 (Nov. 23, 1983).
---------------------------------------------------------------------------
The CBT suggested that the Commission set guidelines with regard to
the marketability of the permitted investments. The CBT recommended
that the guidelines limit permitted investments to those instruments
for which there are available quotes or valuations and, further, that
the guidelines provide that there be a likelihood that any permitted
investments can be liquidated within a
[[Page 78002]]
reasonable time period. (CL 22-25 at 7) The final rule has been
modified so that paragraph (b)(1) of Rule 1.25 requires that the
permitted securities held in segregation be ``readily marketable''
consistent with SEC Rule 15c3-1 under the Securities Exchange Act of
1934.\54\
---------------------------------------------------------------------------
\54\ 17 CFR 240.15c3-1. As a result of the addition of new Rule
1.25(b)(1), proposed paragraph (b)(6) of Rule 1.25 concerning
recordkeeping is being adopted unchanged as paragraph (b)(7).
---------------------------------------------------------------------------
The CBT also recommended that the Commission use a simpler approach
for the valuation of downgraded investments than the proposed 20
percent per day reduction. The CBT suggested instead that a set number
of days be permitted for disposal of the investment and that, during
that permitted time period, the firm be allowed to use the full market
value of the instrument towards meeting its segregated liability. The
CBT also indicated that it thought the 20 percent per day reduction in
value for a downgraded instrument could lead to errors in calculation.
(CL 22-25 at 7-8) The Commission has determined not to change this
provision because it believes that the 20 percent per day write-down
will provide an appropriate valuation under the circumstances and that
it will serve as an incentive for the firm to take action to dispose of
a downgraded investment sooner. See Rule 1.25(b)(2)(ii).
Rosenthal Collins Group, LLC (RCG) stated that the proposed credit
rating requirements were too restrictive. (CL 22-18 at 2) The
Commission notes that these requirements are intended to result in the
holding of ``investment grade'' securities only. After the new rule
takes effect, the Commission plans to monitor the effectiveness of the
rule on an ongoing basis. If experience shows that the required ratings
are too stringent, adjustments to the rule will be considered.
RCG also stated that the Commission should not impose rating
requirements on investments in municipal securities because some of
these securities are not rated due to the costs associated with
obtaining a rating. RCG stated further that if the rule were adopted as
proposed, investments that comply with the present rules but that do
not comply with the new requirements should be ``grandfathered'' as
part of an existing portfolio. (CL 22-18 at 2) In response to this
comment, the Commission will not require the disposal of investments
held as of December 13, 2000, i.e., such investments may be held until
they mature or are liquidated in the ordinary course of business,
although no new acquisitions of non-compliant investments will be
permitted.
Brown Brothers Harriman (BBH) stated that the prohibition against
an FCM investing in an MMMF that has investments in securities issued
by a parent or affiliate of the FCM should be dropped. (CL 22-20 at 5)
This recommendation was made because MMMFs are often operated
independently of the sponsoring affiliated entity and, in any event,
are subject to a five percent concentration limit in the securities of
any single issuer. BBH also noted that many FCMs are affiliated with
world-class financial enterprises and that a prohibition against MMMFs
investing in securities of the FCMs' affiliates would eliminate a large
and important group of instruments. The Commission finds merit in this
suggestion and has modified Rule 1.25(b)(6)(ii) accordingly. The
Commission also notes that Section 17 of the Investment Company Act
\55\ restricts investments made by MMMFs in securities issued by any
entity affiliated with the MMMF or its sponsors, and that the
concentration limit set forth in SEC Rule 2a-7 under the Investment
Company Act \56\ is similar to the concentration provision of CFTC Rule
1.25.
---------------------------------------------------------------------------
\55\ 15 U.S.C. 80a-17.
\56\ 17 CFR 270.2a-7.
---------------------------------------------------------------------------
BBH also requested that the requirement that a fund be ``SEC
registered'' be defined to mean registration under the Investment
Company Act only and not require registration under the Securities Act
of 1933. (CL 22-20 at 6) This clarification has been made to paragraph
(c)(1) of Rule 1.25.
Sentinel Management Group, Inc. (Sentinel) requested clarification
as to whether the concentration limits provided for in the proposed
rule would apply to securities held in connection with repurchase
agreements. (CL 22-41 at 1) Sentinel stated that the concentration
limits should not apply because of: (1) The burden that would be
imposed upon the FCMs; (2) the fact that complete information on such
securities is sometimes not known until the day following entry into
the repurchase transaction; (3) the fact that the duration of
repurchase transactions is only one day; and (4) the fact that the
obligation created pursuant to a repurchase transaction is that of the
counterparty and not the issuer of the securities. Therefore, it
argued, the creditworthiness of the counterparty augments the value of
the securities held pursuant to the repurchase agreement. (CL 22-41 at
1-2) This same point was raised by BBH in follow-up conversations.
Taking into consideration these comments, as well as the
requirement contained in the Proposing Release that counterparties for
repurchase transactions must be regulated financial institutions
(generally large banks or brokerage firms), the Commission has
concluded that the focus of concentration should be primarily upon the
counterparties and secondarily upon the securities held in connection
with the repurchase agreement. Therefore, the final rule contains
several clarifying or enhancing changes.
First, paragraph (b)(4)(ii) provides that securities that are held
by a counterparty, i.e., securities that have been ``repoed out,'' are
subject to the concentration limitations along with currently-owned
direct investment securities. This clarification was made because a
security that has been sold subject to repurchase at a later date
presents the FCM or clearing organization with the same price risk as a
security that is currently held in the portfolio. Second, paragraph
(b)(4)(iii) provides concentration limit percentages for securities
that are held by the FCM or clearing organization pursuant to a reverse
repurchase agreement that are double those required for direct
investments, provided that the counterparty has a credit rating of
single A or higher from two or more NRSROs. In addition, the rule was
changed to provide that the concentration percentages for such
securities shall be computed using only the securities contained in the
portfolio of securities supplied by each counterparty of the FCM or
clearing organization. This change was made because the counterparty
has the direct control over what specific securities will be supplied
in a repurchase transaction. Thus, the Commission expects that an FCM
or clearing organization will inform its counterparties as to the per-
issuer concentration limits that must be observed, as set forth in the
rule. Finally, paragraph (b)(4)(v) makes explicit that the
concentration limits do not apply to securities owned by customers that
have been posted by customers as collateral with the FCM. This
clarification was made primarily because changes in the value of
customer-owned securities accrue to the customers who posted the
securities and, therefore, in a properly margined account such
securities pose no direct price risk to the FCM. The Commission
believes that these changes and clarifications will provide additional
flexibility to FCMs and clearing
[[Page 78003]]
organizations without unduly increasing associated risk.
The Investment Company Institute (ICI) suggested that MMMFs
sponsored by investment advisers registered under the Investment
Advisers Act of 1940 be included in the list of permitted investments.
(CL 22-27 at 6) The Commission has made this suggested change. See Rule
1.25(c)(2).
ICI noted that the proposed rule appeared to require valuation of
the investment portfolio by 9 a.m. each day and suggested, instead,
that valuation not be required until after the close of the markets
each day, i.e., not until after 4 p.m. (CL 22-27 at 7) The Commission's
intention was to require valuation by 9 a.m. the business day following
the investment, so that the valuation would be available in time for
the segregation calculation, which is required to be completed on a
daily basis by noon the following business day. The final rule
(paragraph (c)(4) of Rule 1.25) has been changed to correctly state the
Commission's intention more precisely.
ICI also suggested that the proposed rule should be changed to
permit MMMFs that are not rated by an NRSRO to invest in unrated
securities. The proposed rule provided that only MMMFs that are rated
may invest in unrated securities. ICI cited the comprehensive approach
to risk control and preservation of capital contained in SEC Rule 2a-7
and noted that that rule permits an MMMF to invest in unrated
securities if the MMMF determines that the securities are of comparable
quality to otherwise eligible securities. (CL 22-27 at 4) The
Commission has changed the final rule (Rule 1.25(b)(2)(i)(D)) to permit
unrated MMMFs to invest in unrated securities because of the risk-
limiting features of SEC Rule 2a-7.
ICI also recommended two revisions to paragraph (c)(3) of Rule 1.25
concerning MMMFs. First, because fund shares are usually
uncertificated, ICI recommended that the first sentence be revised to
provide that the ownership of fund shares must be noted (by book-entry
or otherwise) in a custody account of the FCM or clearing organization.
Second, to ensure that confirmations for transactions in fund shares
are retained, ICI recommended that the confirmation relating to the
purchase be retained in the FCM's or clearing organization's records.
(CL 22-27 at 6) The Commission has made these suggested changes.
ICI further recommended that the one-day liquidity requirement
applicable to MMMFs be extended to seven days, to be consistent with
SEC requirements and the longer settlement time-frames associated with
direct investments. (CL 22-27 at 7)
The Commission believes the one-day liquidity requirement for
investments in MMMFs is necessary to ensure that the funding
requirements of FCMs will not be impeded by a long liquidity time
frame. Since a material portion of an FCM's customer funds could well
be invested in a single MMMF, this is an important provision of the
rule. The Commission notes that, although sales of directly-owned
securities settle in longer than one-day time-frames, an FCM or
clearing organization could obtain liquidity by entering into a
repurchase transaction. Therefore, the Commission has retained the one-
day liquidity requirement imposed on investments in MMMFs and, in view
of the importance of this provision, has clarified that demonstration
that this requirement has been met may include either an appropriate
provision in the offering memorandum of the fund or a separate side
agreement between the fund and an FCM or clearing organization. See
Rule 1.25(c)(5).
The FRBC commented that permitted investments should have either a
CUSIP or ISIN number, and that permitted investments should be required
to have a reasonably transparent secondary market enabling accurate and
efficient valuation of the investments. (CL 22-30 at 6) The Commission
has changed the final rule to include securities with ISIN numbers as
permitted investments.
The FRBC also recommended that permitted investments have a
reasonably transparent secondary market. As noted above, the Commission
strengthened the rule in this respect by adding a requirement that all
permitted securities, except for MMMFs, meet the SEC's ``readily
marketable'' standard. The Commission intends to monitor closely for
any problems concerning valuation of permitted investments, and will
consider proposing further rule amendments if appropriate.
The FRBC also recommended that permitted investments should settle
on a same-day or next-day basis, to ensure adequate liquidity. It
pointed out that, currently in the U.S., virtually all corporate and
municipal debt securities settle on a T+3 basis, which is not
sufficient for futures clearing organization demands, and that this
delay could deprive the FCM or clearing organization of the liquidity
that is so important in times of market stress or emergency. (CL 22-30
at 5) The Commission has elected to permit investment of customer funds
in investment grade corporate notes and municipal securities because
FCMs have methods of obtaining liquidity other than by selling the
securities, such as by entering into repurchase transactions and by
establishing backup bank lines of credit using the securities as
collateral.
The FRBC further recommended that CFTC rules should permit the
investment of customer funds held in a foreign currency in identically-
denominated sovereign debt securities. (CL 22-30 at 4-5; see also CL
22-31 at 9; CL 22-42 at 2) The Commission notes that, under the rule as
proposed, an FCM that decided to invest deposits of foreign currencies
was required to convert the foreign currencies received to a U.S.
dollar-denominated asset. This would increase its exposure to foreign
currency fluctuation risk, unless it incurred the additional expense of
hedging. Therefore, the Commission has determined that the FRBC's
suggestion should be adopted. The Commission has changed the proposed
rule to permit investment in the general obligations of any country
whose sovereign debt is rated in the highest category by at least one
NRSRO, but limited as follows: an FCM may invest in the sovereign debt
of a country to the extent it has balances owed to its customers
denominated in that currency; a clearing organization may invest in the
sovereign debt of a country to the extent it has balances owed to its
clearing member FCMs denominated in that currency.\57\ The Commission
notes that foreign sovereign debt that is denominated in the Euro will
qualify as a permitted investment under this rule, provided the country
that issued the debt qualifies as a permitted country under the rule,
the obligation is a general obligation of the country, and the balances
owed to the customers or the FCMs are Euro-denominated. As with other
aspects of Rule 1.25, the Commission will monitor the effect of this
provision and stands ready to make additional adjustments as experience
dictates.
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\57\ As is the case for U.S. government securities and those
MMMFs that are not required to be rated, permitted foreign sovereign
debt will not be subject to a credit rating requirement. See
Sec. 1.25(b)(2)(i)(A).
---------------------------------------------------------------------------
In addition, the FRBC suggested that the CFTC expressly approve the
use of certain ``sweep'' accounts in connection with the investment of
customer funds in MMMFs or other permissible forms of investment. (CL
22-30 at 6) The Commission notes that Rule 1.25 will not preclude the
use of sweep accounts and encourages this practice to enhance the
efficiency of liquidity management.
The FRBC also suggested that, with respect to the concentration
provision, the rule should be clarified that it applies only to the
portfolio of securities
[[Page 78004]]
purchased with customer funds, i.e., the provision does not apply to
customer-owned securities posted as margin. (CL 22-30 at 6) As noted
previously, the Commission has made this clarification in paragraph
(b)(4)(v) of Rule 1.25.
FIA suggested that the Commission clarify what is meant by the
required ratings in the rule, where the ``two highest ratings of an
NRSRO'' are specified, i.e., AAA and AA. In particular, it recommended
that the Commission clarify whether ``AA'' includes all variations
included within the AA rating. (CL 22-31 at 8) The Commission confirms
that this interpretation is correct.
FIA also suggested that the Commission clarify whether a security
would be a permitted investment if one NRSRO gave it an acceptable
rating, even though another NRSRO gave it an unacceptable rating. (CL
22-31 at 9) The Commission hereby confirms that if one NRSRO gave an
acceptable rating and another did not, investment in the security would
be permitted. The Commission believes that it would be rare for such
differences to occur at the investment grade ratings level and,
further, that any differences would probably be temporary.
FIA also suggested providing a grace period for FCMs or clearing
organizations that find themselves in violation of the concentration
limits. (CL 22-31 at 9) The Commission has decided against adopting
this suggestion because the Commission would not expect FCMs to violate
the concentration limits, except perhaps under unusual circumstances.
Further, the Commission is concerned that were a formal grace period
provided in the rule, it might be subject to abuse.
In addition, FIA suggested that the Commission plan to review the
list of permitted investments every six months to determine whether
revisions should be made. (CL 22-31 at 9) The Commission plans to
review all aspects of the new rule on an ongoing basis and further
changes will be proposed, if appropriate.
Two exchanges, the NYMEX and the CME, pointed out that each
clearing organization would need to make its own determination as to
the types of assets that would be accepted by that clearing
organization. (CL 22-32 at 16; CL 22-35 at 13) The Commission
recognizes that an SRO may adopt more restrictive requirements than
those set forth in Rule 1.25 for its member FCMs.
E. Core Principle Four: Risk Disclosure and Account Statements
Although the Commission stated in the Proposing Release that non-
institutional customers should continue to receive the risk disclosures
regarding futures and options trading that are currently required,\58\
it proposed to streamline the account opening process by amending Rules
1.55(d)(1) and (2) to expand the list of disclosures and consents that
could be provided in a single document and acknowledged with a single
signature.\59\ This list includes: (1) The disclosures required by new
Rule 1.33(g) (relating to electronic transmission of statements); \60\
(2) the consent referenced in Rule 155.3(b)(2) (relating to customer
permission for FCMs to take the opposite side of an order); and (3) a
provision for preauthorization of transfers of funds from a customer's
segregated account to another account of that customer. The single
signature could be made electronically as provided for in recently-
adopted Commission Rules 1.3(tt) and 1.4. \61\ Disclosure concerning
arbitration of disputes, however, would continue to require a separate
signed acknowledgement by non-institutional customers, pursuant to
proposed Rule 166.5 (which was modeled on, and would replace, prior
Rule 180.3).\62\
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\58\ 65 FR at 39015. There would continue to be no specific
disclosure requirements for institutional customers. Id. at 39016.
\59\ Id. at 39015-16.
\60\ See infra.
\61\ 65 FR 12466 (Mar. 9, 2000).
\62\ 65 FR at 39016. This is discussed further below.
---------------------------------------------------------------------------
All of the commenters who addressed the proposed amendments to Rule
1.55(d) responded favorably to the expansion of disclosures and
consents that could be acknowledged and made by a single signature, and
the Commission is adopting the amendments as proposed. (CL 22-17 at 3;
CL 22-24 at 6; CL 22-25 at 8; CL 22-31 at 14; CL 22-32 at 16; CL 22-35
at 11; CL 22-44 at 2) FIA requested that the Commission confirm that an
FCM may obtain an acknowledgement of receipt and understanding of the
risk disclosure statement contemporaneously with opening an account.
The Commission agrees that the FCM may open the customer account
simultaneously with receiving the acknowledgment of receipt and
understanding of the risk disclosure statement, along with margin funds
and any other required account opening documents, from the customer.
The FCM will remain responsible for ensuring that the risk disclosure
document is furnished to the customer in such a way that the customer
can review and understand the document before committing funds to the
FCM.
NFA commented generally that the Commission should not dictate the
specifics of how disclosures and consents are delivered and
acknowledged, and that it would be willing to develop best practice
guidance in this area. (CL 22-24 at 6) The Commission believes that its
rules requiring risk disclosure and customer acknowledgments do not
impose a significant burden in light of their important customer
protections. The Commission is providing additional flexibility to the
industry in this area. As the Commission noted in the Proposing
Release, there would continue to be no specific disclosure requirements
for institutional customers and, in addition, as provided in Rule
35.1(b), governmental entities would be included in the definition of
``institutional customer,'' and consequently would not be required to
receive and to acknowledge a disclosure statement.\63\ Further, the
single signature acknowledgment could be made electronically as
provided for in Rules 1.3(tt) and 1.4. The Commission looks forward to
working with NFA and the industry both in developing a Statement of
Acceptable Practices for disclosure to non-institutional customers
trading on DTFs, and in developing more streamlined disclosure
requirements for domestic exchange-traded options under Rule 33.7.
---------------------------------------------------------------------------
\63\ Id.
---------------------------------------------------------------------------
As noted above, the Commission proposed to continue to require a
separate signed acknowledgement by non-institutional customers with
respect to disclosure concerning arbitration of disputes. Nevertheless,
the Commission also solicited comment on whether to maintain this
requirement.\64\ FIA opposed continuing to require a separate signature
from non-institutional customers if their account agreement contains a
pre-dispute arbitration provision. (CL 22-31 at 14) In general, FIA
expressed the opinion that the Commission should eliminate all of its
rules pertaining to the use of pre-dispute arbitration agreements, as
well as the Commission's reparations program. For example, FIA
commented that the Commission's rule that an FCM may not require a
customer to sign a pre-dispute arbitration agreement as a condition to
opening an account with the FCM inhibits the ability of FCMs that are
also securities broker-dealers to enter into a single agreement with
their customers, because the SEC does not prohibit the use of such
mandatory agreements. (CL 22-31 at 10) At the very least, FIA stated
that the Commission
[[Page 78005]]
should permit institutional customers contractually to waive their
right to file a complaint under the Commission's reparations program.
(CL 22-31 at 10) In this regard, NFA maintained that intermediaries and
institutional customers should be allowed to negotiate all terms in
pre-dispute arbitration agreements. (CL 22-24 at 8).
---------------------------------------------------------------------------
\64\ Id.
---------------------------------------------------------------------------
The Commission is adopting Rule 166.5 as it pertains to non-
institutional customers as proposed. Further, the Commission believes
that no customer, regardless of their level of sophistication, should
be required to sign a pre-dispute arbitration agreement as a condition
for doing business in the futures industry. The Commission has
determined, however, to allow institutional customers and
intermediaries to negotiate any terms of a pre-dispute arbitration
agreement as they deem appropriate, including a waiver of the
customer's right to file a complaint under the Commission's reparations
program. Accordingly, the definition of the term ``customer'' in Rule
166.5(a)(2) has been changed to exclude institutional customers from
general application of the rule. In addition, new paragraph (g) has
been added to make clear that an institutional customer and a
registrant may negotiate any terms of a pre-dispute arbitration
agreement, except that the institutional customer may not be required
to sign a pre-dispute arbitration agreement as a condition of opening
an account with the registrant.\65\
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\65\ As a result of these changes, proposed paragraphs (c)(2)
(ii) and (iii) of Rule 166.5 are adopted as paragraphs (c)(2) (i)
and (ii), respectively. In addition, to reflect the recent
amendments to Rule 4.7, paragraph (c)(2)(ii) of Rule 166.5 (formerly
paragraph (c)(2)(iii)) has been modified to apply to a person who is
a ``qualified eligible person'' as defined by Rule 4.7. See 65 FR
47848 (Aug. 4, 2000).
---------------------------------------------------------------------------
NFA specifically requested that the Commission clarify the reach of
pre-dispute arbitration agreements and confirm that such agreements are
binding on both the intermediary as well as the customer, unless the
agreement states specifically that the registrant is not required to
arbitrate its claims.\66\ (CL 22-24 at 9) Former Part 180, which is to
be replaced by Rule 166.5, was mainly intended to provide for fair and
equitable SRO arbitration forums and to prevent firms from requiring
customers to agree to arbitration in order to do business. Part 180 did
not require registrants to submit their claims against customers to
arbitration, and the Commission did not propose to require that
registrants do so in the Proposing Release. Thus, provided that a
registrant pursues a dispute in accordance with the terms of the
customer agreement, and the procedures followed do not violate Rule
166.5, Commission rules would not prohibit the registrant's actions.
---------------------------------------------------------------------------
\66\ NFA referred to several recent lower court cases where
registrants who brought debit balance claims against their customers
in state court successfully argued, in response to the customers'
attempts to force the claims to arbitration, that a pre-dispute
arbitration agreement did not apply to their claims against
customers. NFA questioned the logic of these decisions, stating that
there is no consideration for a customer to sign a pre-dispute
arbitration agreement if it does not apply to the intermediary's
claims as well. (CL 22-24 at 9)
---------------------------------------------------------------------------
NFA also objected to proposed Rule 166.5(f), which would permit
counterclaims that do not arise out of the same transaction or
occurrence that is the subject of the original claim only if (1) The
customer agreed to the counterclaim being heard after it has arisen,
and (2) the aggregate monetary value of the counterclaim is capable of
calculation. NFA believes that, for both retail and institutional
customers, the parties should be allowed to agree in advance that any
counterclaim would be required to be included in the arbitration
proceeding. (CL 22-24 at 9) The Commission has determined to adopt
NFA's suggestion, and has revised Rule 166.5(f) to permit any
counterclaim arising out of a transaction subject to the Act and
Commission regulations promulgated thereunder for which a non-
institutional customer has utilized the services of a registrant, to be
made part of an arbitration proceeding between the non-institutional
customer and the registrant where the parties have agreed in advance to
require that any such claim be included in the arbitration proceeding,
provided that the aggregate monetary value of the counterclaim is
capable of calculation. As noted above, under Rule 166.5(g),
institutional customers remain free to negotiate any terms of their
pre-dispute arbitration agreement, including the type of counterclaims
that may be included in an arbitration proceeding.
F. Core Principle Five: Trading Standards
The Commission proposed that Rules 155.1, 155.3 and 155.4, which
collectively require FCMs and IBs to establish and to maintain
supervisory procedures to assure that neither they nor any affiliated
persons use their knowledge of customer orders to the customer's
disadvantage, would continue to apply to intermediation of trades on
contract markets. These requirements would be extended to trading on
RFEs, and to trading by non-institutional customers on DTFs under new
Rule 155.6(a).\67\ These rules over the years have helped the
Commission deter such practices as ``front-running,'' ``trading
ahead,'' ``bucketing,'' taking the opposite side of customer orders,
and improper disclosure of customer orders. However, for intermediation
of trades by institutional customers at DTFs, the Commission proposed a
new Rule 155.6(b), which set forth a general standard of practice in
this area that parallels the language of the core principle concerning
trading standards. The Commission stated that ``it is nevertheless
intended to proscribe the same trade practice abuses as Rules 155.1-
155.5.'' \68\
---------------------------------------------------------------------------
\67\ 65 FR at 39016.
\68\ Id.
---------------------------------------------------------------------------
The commenters who addressed this section were critical of the
Commission's approach. The CBT expressed its belief that all
prescriptive rules regarding trading practices should be replaced with
core principles, not just the rules governing trades for institutional
customers on DTFs. (CL 22-25 at 8) MFA stated that it was inconsistent
to add a general prohibition against ``misuse'' of knowledge as
contained in Proposed Rule 155.6(b) if the rule was intended to
proscribe the same trade practice abuses referred to in Rules 155.1-
155.5. (CL 22-22 at 13-14) NFA commented that RFEs and DTFs should not
be treated differently with respect to trading standards rules, because
otherwise operators of DTFs would have a competitive advantage over
operators of RFEs. (CL 22-24 at 6)
The Commission has determined to leave unchanged Rules 155.1-155.5
at this time, and to adopt Rule 155.6 as proposed. The Commission
believes that the existing rules should continue to apply in connection
with non-institutional customer trades no matter where they occur
because of such customers' greater susceptibility to trading abuses by
intermediaries, as compared to institutional customers. The Commission
recognizes that, with respect to institutional customers trading on a
DTF, a general standard of practice is more appropriate. However, the
Commission remains open to specific suggestions regarding how
individual provisions in Rules 155.3 and 155.4 might be streamlined.
The Commission notes that because the core principle concerning
trading standards states that intermediaries must not misuse their
knowledge of their customers' orders without making any distinctions
regarding the nature of the customer, the same trade practice abuses
that are proscribed by Rules 155.1-155.5 should also be considered
[[Page 78006]]
as being in violation of Rule 155.6(b). The Commission believes that
its overall approach with respect to trading standards strikes a
reasonable balance in preserving rules that have worked successfully
over the years in curbing abusive trading practices, while relaxing
certain of the specific provisions of the existing rules in connection
with the trading on DTFs by more sophisticated customers.
G. Core Principle Seven: Reporting Requirements
The Commission proposed to apply its existing large trader
reporting requirements to intermediaries on RFEs, but would reduce
reporting requirements with respect to intermediaries transacting
business on DTFs, because of the nature of the instruments traded or
the limited access granted to non-institutional traders. Intermediaries
trading on DTFs would be subject to large trader reporting requirements
only by special call.
The Commission received varying comments in response to its large
trader reporting proposal. NFA agreed with both aspects of the
Commission's proposal, asserting that large trader reporting
requirements should remain in place for intermediaries on RFEs, while a
more flexible approach would be appropriate for gathering information
from intermediaries trading on DTFs. (CL 22-24 at 7) FC Stone suggested
that reduced large trader reporting should be available to all FCMs
with institutional customers only, not just to those trading on DTFs.
(CL 22-44 at 4) The CBT stated that the Commission should permit
individual markets to require large trader reporting, as they deem
necessary, and that any large trader reporting to the Commission should
be done pursuant to special call, without drawing a distinction between
DTFs and RFEs. (CL 22-25 at 8-9) NIBA also commented that the
Commission should not make a distinction between DTFs and RFEs; NIBA
stated, however, that regular large trader reports should be required
on both types of exchanges, and that otherwise customers who trade on
RFEs would lose the benefit of price transparency. (CL 22-17 at 4)
Treasury expressed concern about the mechanics of large trader
reporting on a DTF, stating that because eligible participants would
not be required to use FCMs to execute trades on a DTF, it was unclear
how large trader positions could be reported. In addition, Treasury
noted that large trader reporting requirements have worked well in the
market for Treasury bond futures, both for the information they reveal
to regulators and their deterrent effect, and consequently, urged the
Commission to establish a mechanism for large trader reporting for
government securities futures trading on DTFs. (CL 22-34 at 4) The
Economic Strategy Institute agreed with Treasury that the elimination
of large trader reports would reduce the Commission's ability to
effectively detect and deter manipulation. (CL 22-45 at 2) Finally, the
American Farm Bureau Federation, the American Soybean Association, the
National Association of Wheat Growers, the National Cattlemen's Beef
Association, the National Corn Growers Association, the National
Farmers Union, the National Grain Sorghum Producers and the National
Pork Producers Council collectively commented that if the Commission
determined to permit agricultural products to be traded on a DTF, large
trader reports relating thereto should be filed with the Commission.
(CL 22-51 at 1)
The Commission has determined to adopt the large trader reporting
requirements for RFEs and DTFs as proposed, except that large trader
reports will not be required from participants trading on a commercial-
participant DTF. The reporting system is critical to the Commission's
ability to oversee markets and provides a valuable bulwark against
illegitimate trade practices. RFEs in particular permit unconditioned
access to any type of trader, including both institutional and non-
institutional customers or participants, and may list contracts on any
type of commodity, including those based on commodities that have
finite deliverable supplies or cash markets with limited liquidity.
Such markets potentially have a greater susceptibility to price
manipulation and raise greater customer protection concerns than do
DTFs. Consequently, regular large trader reports are necessary to
enable the Commission to carry out its oversight responsibilities for
RFE markets.
With respect to intermediaries transacting business on DTFs,
however, because of the nature of the instruments traded and the
limited access granted to non-institutional traders, large trader
reporting on a less routine basis, i.e., upon special call by the
Commission, is more appropriate. Where trading access on a DTF is
restricted to eligible commercial participants only, however, large
trader reports generally will not be required from such
participants.\69\ The Commission will rely instead on its investigative
authority, which also applies to a person's cash market activities.\70\
---------------------------------------------------------------------------
\69\ As explained in a companion release in today's edition of
the Federal Register, large trader reports may be required upon
special call depending upon the nature of the commodity interest
traded on a commercial-participant DTF.
\70\ Large trader reports may be required upon special call on
the DTF itself, however. See Sec. 37.6(a).
---------------------------------------------------------------------------
H. Core Principle Eight: Recordkeeping
1. General
The Core Principles state that all registrants must keep full books
and records of their activities related to their business. Thus, the
Commission did not propose to amend any of its recordkeeping
requirements in the Proposing Release.\71\ NFA asked the Commission to
consider replacing Rule 1.31 with a core principle and acceptable
practice guidance that follows NFA's December 1997 proposal. NFA's
proposal recommended that Rule 1.31 be rewritten to require only that
registrant recordkeeping systems meet general reliability and
accessibility standards. (CL 22-24 at 7) The Commission revised Rule
1.31 in 1999 to provide additional flexibility to recordkeepers,
allowing them to store most required records on either micrographic or
electronic storage media for the full five-year required retention
period.\72\ The Commission intends to revisit NFA's proposal in the
future and, where appropriate, will undertake to work with the SEC to
make additional changes in this area.
---------------------------------------------------------------------------
\71\ 65 FR at 39017.
\72\ 64 FR 28735.
---------------------------------------------------------------------------
2. Customer Account Statements; Close-Out of Offsetting Positions
The Commission proposed to codify its June 1997 advisory relating
to the electronic transmission of account statements in a new Rule
1.33(g).\73\ Thus, an FCM would be permitted, with customer consent, to
deliver required confirmation, purchase-and-sale, and monthly account
statements electronically in lieu of mailing a paper copy. FCMs would
need only to retain the daily confirmation statement as of the end of
the trading session, provided that it reflects all trades made during
that session. Before transmitting any statement electronically to a
customer, however, the FCM would be required to make certain
disclosures regarding the practice, and in the case of non-
institutional customers, the FCM would be required to obtain the
customer's signed consent acknowledging the disclosures. The
acknowledgement could be made through a single signature in accordance
with Rule 1.55 as discussed above. NIBA and FC Stone responded
favorably to the
[[Page 78007]]
Commission's proposal (CL 22-17 at 3; CL 22-44 at 2), while NFA
commented that the 1997 Advisory should be treated as acceptable
practices guidance rather than codified in a new rule. (CL 22-24 at 7)
The Commission has determined to adopt the rule as proposed, believing
that, as noted previously, a certain level of uniformity and
standardization is essential in an area such as reporting to customers
to facilitate the processing of massive quantities of data, which is
often accomplished by third-party, ``back office'' firms.
---------------------------------------------------------------------------
\73\ 65 FR at 39017; see also 62 FR 31507 (June 10, 1997).
---------------------------------------------------------------------------
The Commission also proposed to revise Rule 1.46 to allow customers
or account controllers to instruct the FCM if they wished to deviate
from the default rule that the FCM close out offsetting positions on a
first-in, first-out basis, looking across all accounts it carries for
the same customer.\74\ CPOs and CTAs would be required to disclose,
under proposed amendments to Rules 4.24(h)(2) and 4.34(h),
respectively, if they instruct an FCM to deviate from the default rule
for closing out offsetting positions.\75\
---------------------------------------------------------------------------
\74\ 65 FR at 39017.
\75\ Id.
---------------------------------------------------------------------------
After considering the comments received, the Commission is adopting
the revisions as proposed. Nevertheless, the Commission agrees with NFA
that FCMs should closely monitor the activity in those customer
accounts that depart from the default close-out method set forth in
Rule 1.46 to ensure that their customers are not offsetting their
positions other than by a first-in, first-out method solely to avoid
taxes, to launder money, or to improve their delivery position. (CL 22-
24 at 7)
In addition, the Commission believes that customers may transmit
their offset instructions to their FCMs orally, as requested by FIA.
(CL 22-31 at 8) In the case of CPOs and CTAs, the Commission agrees
with MFA that responsibility for transmitting instructions regarding
offset should normally lie with the registrant directing trading.
Generally, where a pool's trading is directed by a CTA, this should be
the CTA, not the CPO. (CL 22-22 at 14) The Commission does not agree,
however, that it is unnecessary to require CPOs and CTAs to disclose
whether they instructed their FCM to offset positions in a manner other
than by a first-in, first-out method. The Commission does not believe
that this requirement would impose a significant burden on CPOs and
CTAs, particularly in light of the fact that these entities would no
longer be prevented from offsetting their positions in a manner other
than on a first-in, first-out basis, as was previously the case. The
Commission believes that it is appropriate in this area to provide
greater choice balanced with disclosure as to the method of operation.
III. Section 4(c) Findings
Certain of these final rules and rule amendments are being
promulgated under Section 4(c) of the Act, which grants the Commission
broad exemptive authority. Section 4(c) of the Act provides that, in
order to promote responsible economic or financial innovation and fair
competition, the Commission may, by rule, regulation or order, exempt
any class of agreements, contracts or transactions, including any
person or class of persons offering, entering into, rendering advice or
rendering other services with respect to, the agreement, contract, or
transaction, from the contract market designation requirement of
Section 4(a) of the Act, or any other provision of the Act other than
Section 2(a)(1)(B), if the Commission determines that the exemption
would be consistent with the public interest. Furthermore, Section
4(c)(2) of the Act provides that the Commission may not grant an
exemption from the contract market designation requirement of Section
4(a) of the Act unless the Commission also finds that: (i) The contract
market designation requirement should not be applied to the agreement,
contract, or transaction for which the exemption is requested and the
exemption would be consistent with the public interest and the purposes
of the Act; (ii) the exempted transaction will be entered into solely
between ``appropriate persons''; and (iii) the agreement, contract or
transaction in question will not have a material adverse effect on the
ability of the Commission or any contract market to discharge its
regulatory or self-regulatory duties under the Act. For the reasons
stated below, the Commission believes that issuing the exemptive relief
as set forth in these final rules and rule amendments is consistent
with those determinations.
As explained above, certain of the final rules and rule amendments
would provide greater flexibility for intermediaries and their
customers in several areas. Specifically, the Commission is adopting
final rule amendments concerning the definition of the term
``principal'' that recognize the evolution of management structures by
reducing the number of officers that will be considered principals,
while ensuring that appropriate personnel that perform significant
roles within the firm remain listed as such. In addition, the
Commission is expanding the range of instruments in which FCMs may
invest customer funds beyond those listed in Section 4d(2) of the Act
to enhance the yield available to FCMs, clearing organizations and
their customers, without compromising the safety of customer funds.
These final rule amendments acknowledge the development of new
financial instruments over the last 60 years, and should both enable
FCMs to remain competitive globally and domestically and maintain
safeguards against systemic risk. In light of the foregoing, the
Commission has determined that the adoption of the final rules and rule
amendments relating to the definition of the term ``principal'' and the
expansion of permitted instruments for the investment of customer funds
will be consistent with the public interest.
Further, the final rules and rule amendments adopted herein, as
well as the existing rules as they also relate to the transaction of
business by intermediaries, will be applied, or extended, to
agreements, contracts and transactions carried out on new markets,
i.e., RFEs and DTFs. As more fully discussed in a companion release
published in this edition of the Federal Register, the rules pertaining
to the new markets establish a new regulatory framework that is
intended to promote innovation and competition in the trading of
derivatives and to permit the markets the flexibility to respond to
technological and structural changes in the markets. The new framework
establishes three regulatory tiers with regulations tailored to the
nature of the commodities traded and the nature of the market
participant, and access to each of the tiers is dependent upon the
appropriateness of the participant. In this respect, the Commission
believes that the actions taken herein are consistent with the ``public
interest'' as that term is used in Section 4(c) of the Act. When that
provision was enacted, the Conference Report accompanying the Futures
Trading Practices Act of 1992 \76\ stated that the ``public interest''
in this context would ``include the national public interests noted in
the Act, the prevention of fraud and the preservation of the financial
integrity of the markets, as well as the promotion of responsible
economic or financial innovation and fair competition.'' \77\
---------------------------------------------------------------------------
\76\ Pub. L. No. 102-546 (1992), 106 Stat. 3590.
\77\ H.R. Rep. No. 978, 102d Cong., 2d Sess. 78 (1992). The
Conference Report also states that the reference in Section 4(c) to
the ``purposes of the Act'' is intended to ``underscore [the
Conferees'] expectation that the Commission will assess the impact
of a proposed exemption on the maintenance of the integrity and
soundness of markets and market participants.'' Id.
---------------------------------------------------------------------------
[[Page 78008]]
The Commission has retained or adopted safeguards to ensure that
transactions will be carried out between appropriate persons.
Appropriate persons can include, beyond those specified in Section
4(c)(3)(A)-(J) of the Act, ``[s]uch other persons that the Commission
determines to be appropriate in light of their financial or other
qualifications, or the applicability of appropriate regulatory
protections.'' \78\ The Commission has determined that it is
appropriate to permit any person to trade on an RFE because the rules
pertaining to RFEs will be closest to those currently pertaining to
contract markets and the bulk of the existing regulatory framework
pertaining to intermediaries will apply in connection with their
intermediation of transactions on RFEs. On the other hand, customers on
DTFs, which will be subject to looser regulation than RFEs, are
generally restricted to the types of persons specified in Section
4(c)(3)(A)-(J) of the Act. The Commission has determined, however, that
it is appropriate to allow access to retail, or non-institutional,
customers on DTFs, subject to stated limits and conditions. For
example, if a non-institutional customer seeks to enter into
transactions on a DTF permitting such access, such customer may only do
so through either: a) a registered FCM that is a clearing member of at
least one designated contract market or RFE, and that has adjusted net
capital of at least $20 million; or b) a registered CTA who has
discretionary authority over the non-institutional customer's account,
and who has assets under management of not less than $25 million. The
Commission further believes that, in light of these conditions and
safeguards, the exemptive relief would have no adverse effect on any of
the regulatory or self-regulatory responsibilities imposed by the Act.
---------------------------------------------------------------------------
\78\ See Section 4(c)(3)(K) of the Act, 7 U.S.C. 6(c)(3)(K).
---------------------------------------------------------------------------
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA), 5 U.S.C. 601 et seq. (1994 &
Supp. II 1996), requires federal agencies, in proposing rules, to
consider the impact of those rules on small businesses. The rules
adopted herein would affect FCMs, IBs, CPOs, CTAs, FBs, FTs, leverage
transaction merchants (LTMs) and agricultural trade option merchants
(ATOMs), as well as principals thereof. The Commission has previously
established certain definitions of ``small entities'' to be used by the
Commission in evaluating the impact of its rules on small entities in
accordance with the RFA.\79\ The Commission has previously determined
that registered FCMs, CPOs, LTMs and ATOMs are not small entities for
the purpose of the RFA.\80\ With respect to IBs, CTAs, FBs and FTs, the
Commission has stated that it is appropriate to evaluate within the
context of a particular rule proposal whether some or all of the
affected entities should be considered small entities and, if so, to
analyze the economic impact on them of any rule. In this regard, the
rules being adopted herein would not require any registrant to change
its current method of doing business. For many registrants, the
revisions should decrease the number of persons within the registrant's
organization who would be considered principals under the CFTC rules.
Further, the revisions should reduce, rather than increase, the
regulatory requirements that apply to registrants and applicants for
registration, regardless of size. Accordingly, pursuant to 5 U.S.C.
605(b), the Chairman, on behalf of the Commission, certifies that the
action taken herein will not have a significant economic impact on a
substantial number of small entities. In this regard, the Commission
notes that it did not receive any comments concerning the RFA
implications of the rules and rule amendments discussed herein.
---------------------------------------------------------------------------
\79\ 47 FR 18618-21 (Apr. 30, 1982).
\80\ Id. at 18619-20 (discussing FCMs and CPOs); 54 FR 19556,
19557 (May 8, 1989) (discussing LTMs); and 63 FR 18821, 18830 (Apr.
16, 1998) (discussing ATOMs).
---------------------------------------------------------------------------
B. Paperwork Reduction Act
As required by the Paperwork Reduction Act of 1995 [44 U.S.C.
3507(d)], the Commission submitted a copy of the proposed amendments to
its rules to the Office of Management and Budget for its review. The
Commission did not receive any comments on any potential paperwork
burden associated with the Proposing Release.
List of Subjects
17 CFR Part 1
Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements.
17 CFR Part 3
Administrative practice and procedure, Brokers, Commodity futures,
Principals, Registration, Reporting and recordkeeping requirements.
17 CFR Part 4
Advertising, Commodity futures, Commodity pool operators, Commodity
trading advisors, Consumer protection, Disclosure, Principals,
Reporting and recordkeeping requirements.
17 CFR Part 140
Authority delegations (Government agencies), Conflict of interests,
Organization and functions (Government agencies).
17 CFR Part 155
Brokers, Commodity futures, Reporting and recordkeeping
requirements.
17 CFR Part 166
Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements.
In consideration of the foregoing, and pursuant to the authority
contained in the Commodity Exchange Act, and in particular, Sections 2,
4(c), 4b, 4d, 4f, 4m, 4n, 8a, and 19 thereof, 7 U.S.C. 2, 6(c), 6b, 6d,
6f, 6m, 6n, 12a and 23, the Commission hereby amends Parts 1, 3, 4,
140, 155 and 166 of Chapter I of Title 17 of the Code of Federal
Regulations as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
1. The authority citation for Part 1 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f,
6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a,
12c, 13a, 13a-1, 16, 16a, 19, 21, 23 and 24.
2. Section 1.3 is amended by adding new paragraphs (g), (m) and (v)
to read as follows:
Sec. 1.3 Definitions.
* * * * *
(g) Institutional customer. This term has the same meaning as
``eligible participant'' as defined in Sec. 35.1(b) of this chapter.
* * * * *
(m) Derivatives transaction facility. This term has the same
meaning as a ``derivatives transaction facility'' under part 37 of this
chapter.
* * * * *
(v) Recognized futures exchange. This term has the same meaning as
a ``recognized futures exchange'' under part 38 of this chapter.
* * * * *
3. Section 1.10 is amended as follows:
a. Revising paragraph (a)(2)(i)(B);
b. Adding paragraph (a)(2)(i)(C);
c. Designating the undesignated paragraph following paragraph
[[Page 78009]]
(a)(2)(i)(B) as paragraph (a)(2)(i)(D) and revising it;
d. Designating the undesignated paragraph following paragraph
(a)(2)(ii)(C) as paragraph (a)(2)(ii)(E) and revising it;
e. Redesignating paragraph (a)(2)(ii)(C) as (a)(2)(ii)(D) and
revising it; and
f. Adding a new paragraph (a)(2)(ii)(C).
The revisions and additions read as follows:
Sec. 1.10 Financial reports of futures commission merchants and
introducing brokers.
(a) * * *
(2) * * *
(i) * * *
(B) A Form 1-FR-FCM as of a date not more than 17 business days
prior to the date on which such report is filed and a Form 1-FR-FCM
certified by an independent public accountant in accordance with
Sec. 1.16 as of a date not more than one year prior to the date on
which such report is filed; or
(C) A Form 1-FR-FCM as of a date not more than 17 business days
prior to the date on which such report is filed, Provided, however,
that such applicant shall be subject to a review by the applicant's
designated self-regulatory organization within six months of being
granted registration.
(D) Each such person must include with such financial report a
statement describing the source of his current assets and representing
that his capital has been contributed for the purpose of operating his
business and will continue to be used for such purpose.
(ii) * * *
(C) A Form 1-FR-IB as of a date not more than 17 business days
prior to the date on which such report is filed, Provided, however,
that such applicant shall be subject to a review by the applicant's
designated self-regulatory organization within six months of
registration; or
(D) A guarantee agreement.
(E) Each person filing in accordance with paragraphs (a)(2)(ii)
(A), (B) or (C) of this section must include with such financial report
a statement describing the source of his current assets and
representing that his capital has been contributed for the purpose of
operating his business and will continue to be used for such purpose.
* * * * *
4. Section 1.17 is amended by redesignating paragraph (a)(1)(ii) as
(a)(1)(iii) and by adding new paragraphs (a)(1)(ii) and (a)(2)(iii) to
read as follows:
Sec. 1.17 Minimum financial requirements for futures commission
merchants and introducing brokers.
(a) * * *
(1) * * *
(ii) Each person registered as a futures commission merchant
engaged in soliciting or accepting orders and customer funds related
thereto for the purchase or sale of any commodity for future delivery
on or subject to the rules of a derivatives transaction facility from
any customer who does not qualify as an ``institutional customer'' as
defined in Sec. 1.3(g):
(A) Must be a clearing member of a designated contract market or
recognized futures exchange, and must maintain adjusted net capital in
the amount of the greater of $20,000,000 or the amounts otherwise
specified in paragraph (a)(1)(i) of this section; or
(B) Receive orders on behalf of the customer from a commodity
trading advisor acting in accordance with Sec. 4.32 of this chapter.
* * * * *
(2) * * *
(iii) The requirements of paragraph (a)(1) of this section shall
not be applicable if the registrant is a futures commission merchant or
introducing broker registered in accordance with Sec. 3.10(a)(1)(i)(B)
of this chapter, whose business is limited to transacting business on
behalf of institutional customers on a derivatives transaction
facility, and who conforms to minimum financial standards and related
reporting requirements set by such derivatives transaction facility in
its rules.
* * * * *
5. Section 1.20 is amended by revising paragraphs (a) and (c) to
read as follows:
Sec. 1.20 Customer funds to be segregated and separately accounted
for.
(a) All customer funds shall be separately accounted for and
segregated as belonging to commodity or option customers. Such customer
funds when deposited with any bank, trust company, clearing
organization or another futures commission merchant shall be deposited
under an account name which clearly identifies them as such and shows
that they are segregated as required by the Act and this part. Each
registrant shall obtain and retain in its files for the period provided
in Sec. 1.31 a written acknowledgment from such bank, trust company,
clearing organization, or futures commission merchant, that it was
informed that the customer funds deposited therein are those of
commodity or option customers and are being held in accordance with the
provisions of the Act and this part: Provided, however, that an
acknowledgment need not be obtained from a clearing organization that
has adopted and submitted to the Commission rules that provide for the
segregation as customer funds, in accordance with all relevant
provisions of the Act and the rules and orders promulgated thereunder,
of all funds held on behalf of customers. Under no circumstances shall
any portion of customer funds be obligated to a clearing organization,
any member of a contract market, a futures commission merchant, or any
depository except to purchase, margin, guarantee, secure, transfer,
adjust or settle trades, contracts or commodity option transactions of
commodity or option customers. No person, including any clearing
organization or any depository, that has received customer funds for
deposit in a segregated account, as provided in this section, may hold,
dispose of, or use any such funds as belonging to any person other than
the option or commodity customers of the futures commission merchant
which deposited such funds.
* * * * *
(c) Each futures commission merchant shall treat and deal with the
customer funds of a commodity customer or of an option customer as
belonging to such commodity or option customer. All customer funds
shall be separately accounted for, and shall not be commingled with the
money, securities or property of a futures commission merchant or of
any other person, or be used to secure or guarantee the trades,
contracts or commodity options, or to secure or extend the credit, of
any person other than the one for whom the same are held: Provided,
however, That customer funds treated as belonging to the commodity or
option customers of a futures commission merchant may for convenience
be commingled and deposited in the same account or accounts with any
bank or trust company, with another person registered as a futures
commission merchant, or with a clearing organization, and that such
share thereof as in the normal course of business is necessary to
purchase, margin, guarantee, secure, transfer, adjust, or settle the
trades, contracts or commodity options of such commodity or option
customers or resulting market positions, with the clearing organization
or with any other person registered as a futures commission merchant,
may be withdrawn and applied to such purposes, including the payment of
premiums to option grantors, commissions, brokerage, interest, taxes,
[[Page 78010]]
storage and other fees and charges, lawfully accruing in connection
with such trades, contracts or commodity options: Provided, further,
That customer funds may be invested in instruments described in
Sec. 1.25.
6. Section 1.25 is revised to read as follows:
Sec. 1.25 Investment of customer funds.
(a) Permitted investments. (1) Subject to the terms and conditions
set forth in this section, a futures commission merchant or a clearing
organization may invest customer funds in the following instruments
(permitted investments):
(i) Obligations of the United States and obligations fully
guaranteed as to principal and interest by the United States (U.S.
government securities);
(ii) General obligations of any State or of any political
subdivision thereof (municipal securities);
(iii) General obligations issued by any agency sponsored by the
United States (government sponsored agency securities);
(iv) Certificates of deposit issued by a bank (certificates of
deposit) as defined in section 3(a)(6) of the Securities Exchange Act
of 1934, or a domestic branch of a foreign bank that carries deposits
insured by the Federal Deposit Insurance Corporation;
(v) Commercial paper;
(vi) Corporate notes;
(vii) General obligations of any country whose sovereign debt is
rated in the highest category by at least one nationally recognized
statistical rating organization (NRSRO), as that term is defined in
Sec. 270.2a-7 of this title (permitted foreign sovereign debt), subject
to the following limits: a futures commission merchant may invest in
the sovereign debt of a country to the extent it has balances in
segregated accounts owed to its customers denominated in that country's
currency; a clearing organization may invest in the sovereign debt of a
country to the extent it has balances in segregated accounts owed to
its clearing member futures commission merchants denominated in that
country's currency; and
(viii) Interests in money market mutual funds.
(2) In addition, a futures commission merchant or a clearing
organization may buy and sell the permitted investments listed in
paragraphs (a)(1)(i) through (viii) of this section pursuant to
agreements for resale or repurchase of the instruments, in accordance
with the provisions of paragraph (d) of this section.
(b) General terms and conditions. A futures commission merchant or
a clearing organization is required to manage the permitted investments
consistent with the objectives of preserving principal and maintaining
liquidity and according to the following specific requirements.
(1) Marketability. Except for interests in money market mutual
funds, investments must be ``readily marketable'' as defined in
Sec. 240.15c3-1 of this title.
(2) Ratings. (i) Initial requirement. Instruments that are required
to be rated by this section must be rated by an NRSRO. For an
investment to qualify as a permitted investment, ratings are required
as follows:
(A) U.S. government securities and the permitted sovereign debt of
the countries listed in paragraph (a)(1)(vii) of this section, need not
be rated;
(B) Municipal securities, government sponsored agency securities,
certificates of deposit, commercial paper, and corporate notes, except
notes that are asset-backed, must have the highest short-term rating of
an NRSRO or one of the two highest long-term ratings of an NRSRO;
(C) Corporate notes that are asset-backed must have the highest
rating of an NRSRO; and
(D) Money market mutual funds that are rated by an NRSRO must be
rated at the highest rating of the NRSRO.
(ii) Effect of downgrade. If an NRSRO lowers the rating of an
instrument that was previously a permitted investment on the basis of
that rating to below the minimum rating required under this section,
the value of the instrument recognized for segregation purposes will be
the lesser of:
(A) The current market value of the instrument; or
(B) The market value of the instrument on the business day
preceding the downgrade, reduced by 20 percent of that value for each
business day that has elapsed since the downgrade.
(3) Restrictions on instrument features. (i) With the exception of
money market mutual funds, no permitted investment may contain an
embedded derivative of any kind, including but not limited to a call
option, put option, or collar, cap, or floor on interest paid.
(ii) No instrument may contain interest-only payment features.
(iii) No instrument may provide payments linked to a commodity,
currency, reference instrument, index, or benchmark except as provided
in paragraph (b)(3)(iv) of this section.
(iv) Variable-rate securities are permitted, provided the interest
rates paid correlate closely and on an unleveraged basis to a benchmark
of either the Federal Funds target or effective rate, the prime rate,
the three-month Treasury Bill rate, or the one-month or three-month
LIBOR rate.
(v) Certificates of deposit, if negotiable, must be able to be
liquidated within one business day or, if not negotiable, must be
redeemable at the issuing bank within one business day, with any
penalty for early withdrawal limited to any accrued interest earned
according to its written terms.
(4) Concentration. (i) Direct investments. (A) U.S. government
securities, money market mutual funds, and permitted foreign sovereign
debt securities shall not be subject to a concentration limit.
(B) Securities of any single issuer of government sponsored agency
securities held by a futures commission merchant or clearing
organization may not exceed 25 percent of total assets held in
segregation by the futures commission merchant or clearing
organization.
(C) Securities of any single issuer of municipal securities,
certificates of deposit, commercial paper, or corporate notes held by a
futures commission merchant or clearing organization may not exceed 5
percent of total assets held in segregation by the futures commission
merchant or clearing organization.
(ii) Repurchase agreements. For purposes of determining compliance
with the concentration limits set forth in this section, securities
sold by a futures commission merchant or clearing organization subject
to agreements to repurchase shall be combined with securities held by
the futures commission merchant or clearing organization as direct
investments.
(iii) Reverse repurchase agreements. The concentration limit
applicable to securities of each issuer that are held by a futures
commission merchant or clearing organization subject to agreements to
resell to a particular counterparty shall be as follows:
(A) For a portfolio of securities held that are subject to resale
to a counterparty that has been rated single A or higher by two or more
NRSROs, or whose obligation under an agreement is guaranteed by a
parent or affiliate company that has been rated single A or higher by
two or more NRSROs:
(1) Government sponsored agency debt, issued by the same issuer and
supplied by the counterparty, may not exceed 50 percent of the total
amount of securities supplied by such counterparty; and
(2) Municipal securities, certificates of deposit, commercial
paper, and corporate notes, issued by the same issuer and supplied by
the counterparty,
[[Page 78011]]
may not exceed 10 percent of the total amount of securities supplied by
such counterparty; and
(B) For a portfolio of securities held that are subject to resale
to a counterparty that does not have a rating or guarantee as specified
in paragraph (b)(4)(iii)(A) of this section:
(1) Government sponsored agency debt, issued by the same issuer and
supplied by the counterparty, may not exceed 25 percent of the total
amount of securities supplied by such counterparty; and
(2) Municipal securities, certificates of deposit, commercial
paper, and corporate notes, issued by the same issuer and supplied by
the counterparty, may not exceed 5 percent of the total amount of
securities supplied by such counterparty.
(iv) Treatment of securities issued by affiliates. For purposes of
determining compliance with the concentration limits set forth in this
section, securities issued by entities that are affiliated, as defined
in paragraph (b)(6) of this section, shall be aggregated and deemed the
securities of a single issuer. An interest in a permitted money market
mutual fund is not deemed to be a security issued by its sponsoring
entity.
(v) Treatment of customer-owned securities. For purposes of
determining compliance with the concentration limits set forth in this
section, securities owned by the customers of a futures commission
merchant and posted as margin collateral are not included in total
assets held in segregation by the futures commission merchant, and
securities posted by a futures commission merchant with a clearing
organization are not included in total assets held in segregation by
the clearing organization.
(5) Time-to-maturity. Except for investments in money market mutual
funds, the dollar-weighted average of the time-to-maturity of the
portfolio, as that average is computed pursuant to Sec. 270.2a-7 of
this title, may not exceed 24 months.
(6) Investments in instruments issued by affiliates. (i) A futures
commission merchant shall not invest customer funds in obligations of
an entity affiliated with the futures commission merchant, and a
clearing organization shall not invest customer funds in obligations of
an entity affiliated with the clearing organization. An affiliate
includes parent companies, including all entities through the ultimate
holding company, subsidiaries to the lowest level, and companies under
common ownership of such parent company or affiliates.
(ii) A futures commission merchant or clearing organization may
invest customer funds in a fund affiliated with that futures commission
merchant or clearing organization.
(7) Recordkeeping. A futures commission merchant and a clearing
organization shall prepare and maintain a record that will show for
each business day with respect to each type of investment made pursuant
to this section, the following information:
(i) The type of instruments in which customer funds have been
invested;
(ii) The original cost of the instruments; and
(iii) The current market value of the instruments.
(c) Money market mutual funds. The following provisions will apply
to the investment of customer funds in money market mutual funds (the
fund).
(1) Generally, the fund must be an investment company that is
registered under the Investment Company Act of 1940 with the Securities
and Exchange Commission and that holds itself out to investors as a
money market fund, in accordance with Sec. 270.2a-7 of this title. A
fund sponsor, however, may petition the Commission for an exemption
from this requirement. The Commission may grant such an exemption
provided that the fund can demonstrate that it will operate in a manner
designed to preserve principal and to maintain liquidity. The
application for exemption must describe how the fund's structure,
operations and financial reporting are expected to differ from the
requirements contained in Sec. 270.2a-7 of this title and the risk-
limiting provisions for direct investments contained in this section.
The fund must also specify the information that the fund would make
available to the Commission on an ongoing basis.
(2) The fund must be sponsored by a federally-regulated financial
institution, a bank as defined in section 3(a)(6) of the Securities
Exchange Act of 1934, an investment adviser registered under the
Investment Advisers Act of 1940, or a domestic branch of a foreign bank
insured by the Federal Deposit Insurance Corporation, except for a fund
exempted in accordance with paragraph (c)(1) of this section.
(3) A futures commission merchant or clearing organization shall
maintain the confirmation relating to the purchase in its records in
accordance with Sec. 1.31 and note the ownership of fund shares (by
book-entry or otherwise) in a custody account of the FCM or clearing
organization in accordance with Sec. 1.26(a). If the futures commission
merchant or the clearing organization holds its shares of the fund with
the fund's shareholder servicing agent, the sponsor of the fund and the
fund itself are required to provide the acknowledgment letter required
by Sec. 1.26.
(4) The net asset value of the fund must be computed by 9 a.m. of
the business day following each business day and made available to the
futures commission merchant or clearing organization by that time.
(5) A fund must be able to redeem an interest by the business day
following a redemption request by the futures commission merchant or
clearing organization. Demonstration that this requirement has been met
may include either an appropriate provision in the offering memorandum
of the fund or a separate side agreement between the fund and a futures
commission merchant or clearing organization.
(6) The agreement pursuant to which the futures commission merchant
or clearing organization has acquired and is holding its interest in a
fund must contain no provision that would prevent the pledging or
transferring of shares.
(d) Repurchase and reverse repurchase agreements. A futures
commission merchant or clearing organization may buy and sell the
permitted investments listed in paragraphs (a)(1)(i) through (viii) of
this section pursuant to agreements for resale or repurchase of the
securities (agreements to repurchase or resell), provided the
agreements to repurchase or resell conform to the following
requirements:
(1) The securities are specifically identified by coupon rate, par
amount, market value, maturity date, and CUSIP or ISIN number.
(2) Counterparties are limited to a bank as defined in section
3(a)(6) of the Securities Exchange Act of 1934, a domestic branch of a
foreign bank insured by the Federal Deposit Insurance Corporation, a
securities broker or dealer, or a government securities broker or
government securities dealer registered with the Securities and
Exchange Commission or which has filed notice pursuant to section
15C(a) of the Government Securities Act of 1986.
(3) The transaction is executed in compliance with the
concentration limit requirements applicable to the securities held in
connection with the agreements to repurchase referred to in paragraphs
(b)(4)(ii) and (iii) of this section.
(4) The transaction is made pursuant to a written agreement signed
by the parties to the agreement, which is consistent with the
conditions set forth in paragraphs (d)(1) through (d)(12) of this
section and which states that the
[[Page 78012]]
parties thereto intend the transaction to be treated as a purchase and
sale of securities.
(5) The term of the agreement is no more than one business day, or
reversal of the transaction is possible on demand.
(6) The securities transferred under the agreement are held in a
safekeeping account with a bank as referred to in paragraph (d)(2) of
this section, a clearing organization, or the Depository Trust Company
in an account that complies with the requirements of Sec. 1.26.
(7) The futures commission merchant or the clearing organization
may not use securities received under the agreement in another similar
transaction and may not otherwise hypothecate or pledge such
securities, except securities may be pledged on behalf of customers at
another futures commission merchant or clearing organization.
Substitution of securities is allowed, provided, however, that:
(i) The qualifying securities being substituted and original
securities are specifically identified by date of substitution, market
values substituted, coupon rates, par amounts, maturity dates and CUSIP
or ISIN numbers;
(ii) Substitution is made on a ``delivery versus delivery'' basis;
and
(iii) The market value of the substituted securities is at least
equal to that of the original securities.
(8) The transfer of securities is made on a delivery versus payment
basis in immediately available funds. The transfer is not recognized as
accomplished until the funds and/or securities are actually received by
the custodian of the futures commission merchant's or clearing
organization's customer funds or securities purchased on behalf of
customers. The transfer or credit of securities covered by the
agreement to the futures commission merchant's or clearing
organization's customer segregated custodial account is made
simultaneously with the disbursement of funds from the futures
commission merchant's or clearing organization's customer segregated
cash account at the custodian bank. On the sale or resale of
securities, the futures commission merchant's or clearing
organization's customer segregated cash account at the custodian bank
must receive same-day funds credited to such segregated account
simultaneously with the delivery or transfer of securities from the
customer segregated custodial account.
(9) A written confirmation to the futures commission merchant or
clearing organization specifying the terms of the agreement and a
safekeeping receipt are issued immediately upon entering into the
transaction and a confirmation to the futures commission merchant or
clearing organization is issued once the transaction is reversed.
(10) The transactions effecting the agreement are recorded in the
record required to be maintained under Sec. 1.27 of investments of
customer funds, and the securities subject to such transactions are
specifically identified in such record as described in paragraph (d)(1)
of this section and further identified in such record as being subject
to repurchase and reverse repurchase agreements.
(11) An actual transfer of securities by book entry is made
consistent with Federal or State commercial law, as applicable. At all
times, securities received subject to an agreement are reflected as
``customer property.''
(12) The agreement makes clear that, in the event of the bankruptcy
of the futures commission merchant or clearing organization, any
securities purchased with customer funds that are subject to an
agreement may be immediately transferred. The agreement also makes
clear that, in the event of a futures commission merchant or clearing
organization bankruptcy, the counterparty has no right to compel
liquidation of securities subject to an agreement or to make a priority
claim for the difference between current market value of the securities
and the price agreed upon for resale of the securities to the
counterparty, if the former exceeds the latter.
(e) Deposit of firm-owned securities into segregation. A futures
commission merchant shall not be prohibited from directly depositing
unencumbered securities of the type specified in this section, which it
owns for its own account, into a segregated safekeeping account or from
transferring any such securities from a segregated account to its own
account, up to the extent of its residual financial interest in
customers' segregated funds; provided, however, that such investments,
transfers of securities, and disposition of proceeds from the sale or
maturity of such securities are recorded in the record of investments
required to be maintained by Sec. 1.27. All such securities may be
segregated in safekeeping only with a bank, trust company, clearing
organization, or other registered futures commission merchant.
Furthermore, for purposes of Secs. 1.25, 1.26, 1.27, 1.28 and 1.29,
investments permitted by Sec. 1.25 that are owned by the futures
commission merchant and deposited into such a segregated account shall
be considered customer funds until such investments are withdrawn from
segregation.
7. Section 1.26 is revised to read as follows:
Sec. 1.26 Deposit of instruments purchased with customer funds.
(a) Each futures commission merchant who invests customer funds in
instruments described in Sec. 1.25 shall separately account for such
instruments and segregate such instruments as belonging to such
commodity or option customers. Such instruments, when deposited with a
bank, trust company, clearing organization or another futures
commission merchant, shall be deposited under an account name which
clearly shows that they belong to commodity or option customers and are
segregated as required by the Act and this part. Each futures
commission merchant upon opening such an account shall obtain and
retain in its files an acknowledgment from such bank, trust company,
clearing organization or other futures commission merchant that it was
informed that the instruments belong to commodity or option customers
and are being held in accordance with the provisions of the Act and
this part. Provided, however, that an acknowledgment need not be
obtained from a clearing organization that has adopted and submitted to
the Commission rules that provide for the segregation as customer
funds, in accordance with all relevant provisions of the Act and the
rules and orders promulgated thereunder, of all funds held on behalf of
customers and all instruments purchased with customer funds. Such
acknowledgment shall be retained in accordance with Sec. 1.31. Such
bank, trust company, clearing organization or other futures commission
merchant shall allow inspection of such obligations at any reasonable
time by representatives of the Commission.
(b) Each clearing organization which invests money belonging or
accruing to commodity or option customers of its clearing members in
instruments described in Sec. 1.25 shall separately account for such
instruments and segregate such instruments as belonging to such
commodity or option customers. Such instruments, when deposited with a
bank or trust company, shall be deposited under an account name which
will clearly show that they belong to commodity or option customers and
are segregated as required by the Act and this part. Each clearing
organization upon opening such an account shall obtain and retain in
its files a written acknowledgment
[[Page 78013]]
from such bank or trust company that it was informed that the
instruments belong to commodity or option customers of clearing members
and are being held in accordance with the provisions of the Act and
this part. Such acknowledgment shall be retained in accordance with
Sec. 1.31. Such bank or trust company shall allow inspection of such
instruments at any reasonable time by representatives of the
Commission.
Sec. 1.27 [Amended]
8. Section 1.27 is amended by:
a. Revising the word ``obligations'' to read ``instruments'' each
time it appears; and
b. Adding the phrase ``or ISIN'' following the word ``CUSIP'' each
time it appears.
Secs. 1.28 and 1.29 [Amended]
9. Sections 1.28 and 1.29 are amended by revising the word
``obligations'' to read ``instruments'' each time it appears.
10. Section 1.33 is amended by adding a new paragraph (g) to read
as follows:
Sec. 1.33 Monthly and confirmation statements.
* * * * *
(g) Electronic transmission of statements. (1) The statements
required by this section, and by Sec. 1.46, may be furnished to any
customer by means of electronic media if the customer so requests,
Provided, however, that a futures commission merchant must, prior to
the transmission of any statement by means of electronic media,
disclose the electronic medium or source through which statements will
be delivered, the duration, whether indefinite or not, of the period
during which consent will be effective, any charges for such service,
the information that will be delivered by such means, and that consent
to electronic delivery may be revoked at any time.
(2) In the case of a customer who does not qualify as an
``institutional customer'' as defined in Sec. 1.3(g), a futures
commission merchant must obtain the customer's signed consent
acknowledging disclosure of the information set forth in paragraph
(g)(1) of this section prior to the transmission of any statement by
means of electronic media.
(3) Any statement required to be furnished to a person other than a
customer in accordance with paragraph (d) of this section may be
furnished by electronic media.
(4) A futures commission merchant who furnishes statements to any
customer by means of electronic media must retain a daily confirmation
statement for such customer as of the end of the trading session,
reflecting all transactions made during that session for the customer,
in accordance with Sec. 1.31.
* * * * *
11. Section 1.46 is amended as follows:
a. By revising paragraph (a), introductory text,
b. By removing and reserving paragraphs (d)(4) through (d)(7),
c. By removing paragraph (d)(9) and
d. By revising paragraph (e) to read as follows:
Sec. 1.46 Application and closing out of offsetting long and short
positions.
(a) Application of purchases and sales. Except with respect to
purchases or sales which are for omnibus accounts, or where the
customer has instructed otherwise, any futures commission merchant who,
on or subject to the rules of a contract market, recognized futures
exchange or derivatives transaction facility:
* * * * *
(e) The statements required by paragraph (a) of this section may be
furnished to the customer or the person described in Sec. 1.33(d) by
means of electronic transmission, in accordance with Sec. 1.33(g).
* * * * *
12. Section 1.52 is amended by adding a new paragraph (m) to read
as follows:
Sec. 1.52 Self-regulatory organization adoption and surveillance of
minimum financial requirements.
* * * * *
(m) Nothing in this section shall apply to the activities of a
derivatives transaction facility or the minimum adjusted net capital
requirements it may require of persons operating thereon pursuant to
Sec. 1.17(a)(2)(iii).
* * * * *
13. Section 1.55 is amended by revising paragraphs (d) and (f) to
read as follows:
Sec. 1.55 Distribution of ``Risk Disclosure Statement'' by futures
commission merchants and introducing brokers.
* * * * *
(d) Any futures commission merchant, or in the case of an
introduced account any introducing broker, may open a commodity futures
account for a customer without obtaining the separate acknowledgments
of disclosure and elections required by this section and by
Sec. 1.33(g), and by Secs. 33.7, 155.3(b)(2), and 190.06 of this
chapter, provided that:
(1) Prior to the opening of such account, the futures commission
merchant or introducing broker obtains an acknowledgment from the
customer, which may consist of a single signature at the end of the
futures commission merchant's or introducing broker's customer account
agreement, or on a separate page, of the disclosure statements and
elections specified in this section and Sec. 1.33(g), and in
Secs. 33.7, 155.3(b)(2), and 190.06 of this chapter, and which may
include authorization for the transfer of funds from a segregated
customer account to another account of such customer, as listed
directly above the signature line, provided the customer has
acknowledged by check or other indication next to a description of each
specified disclosure statement or election that the customer has
received and understood such disclosure statement or made such
election;
(2) The acknowledgment referred to in paragraph (d)(1) of this
section must be accompanied by and executed contemporaneously with
delivery of the disclosures and elective provisions required by this
section and Sec. 1.33(g), and by Secs. 33.7, 155.3(b)(2), and 190.06 of
this chapter.
* * * * *
(f) A futures commission merchant or, in the case of an introduced
account an introducing broker, may open a commodity futures account for
an institutional customer without furnishing such institutional
customer the disclosure statements or obtaining the acknowledgements
required under paragraph (a) of this section, Secs. 1.33(g) and
1.65(a)(3), and Secs. 30.6(a), 33.7(a), 155.3(b)(2), and 190.10(c) of
this chapter.
* * * * *
PART 3--REGISTRATION
14. The authority citation for Part 3 is revised to read as
follows:
Authority: 5 U.S.C. 522, 522b; 7 U.S.C. 1a, 2, 4, 4a, 6, 6a, 6b,
6c, 6d, 6e, 6f, 6g, 6h, 6i, 6k, 6m, 6n, 6o, 6p, 8, 9, 9a, 12, 12a,
13b, 13c, 16a, 18, 19, 21, 23.
15. Section 3.1 is amended by revising paragraphs (a)(1) and (a)(2)
to read as follows:
Sec. 3.1 Definitions.
(a) * * *
(1) If the entity is organized as a sole proprietorship, the
proprietor; if a partnership, any general partner; if a corporation,
any director, the president, chief executive officer, chief operating
officer, chief financial officer, and any person in charge of a
principal business
[[Page 78014]]
unit, division or function subject to regulation by the Commission; if
a limited liability company or limited liability partnership, any
director, the president, chief executive officer, chief operating
officer, chief financial officer, the manager, managing member or those
members vested with the management authority for the entity, and any
person in charge of a principal business unit, division or function
subject to regulation by the Commission; and, in addition, any person
occupying a similar status or performing similar functions, having the
power, directly or indirectly, through agreement or otherwise, to
exercise a controlling influence over the entity's activities that are
subject to regulation by the Commission;
(2)(i) Any individual who directly or indirectly, through
agreement, holding company, nominee, trust or otherwise, is the owner
of ten percent or more of the outstanding shares of any class of stock,
is entitled to vote or has the power to sell or direct the sale of ten
percent or more of any class of voting securities, or is entitled to
receive ten percent or more of the profits; or
(ii) Any person other than an individual that is the direct owner
of ten percent or more of any class of securities; or
* * * * *
16. Section 3.10 is amended by revising paragraph (a)(1)(i), by
redesignating paragraph (a)(2)(i) as paragraph (a)(2), by removing
paragraph (a)(2)(ii), and by revising paragraph (d) to read as follows:
Sec. 3.10 Registration of futures commission merchants, introducing
brokers, commodity trading advisors, commodity pool operators and
leverage transaction merchants.
(a) Application for registration. (1)(i)(A) Except as provided in
paragraph (a)(1)(i)(B) of this section, application for registration as
a futures commission merchant, introducing broker, commodity trading
advisor, commodity pool operator or leverage transaction merchant must
be on Form 7-R, completed and filed with the National Futures
Association in accordance with the instructions thereto.
(B) An applicant for registration as a futures commission merchant
or introducing broker that will conduct transactions on or subject to
the rules of a contract market, recognized futures exchange or
derivatives transaction facility for institutional customers, and which
is registered with the Securities and Exchange Commission as a
securities broker or dealer, or is a bank or any other financial
depository institution subject to regulation by the United States, may
apply for registration by filing with the National Futures Association
notice of its intention to undertake transactions on or subject to the
rules of a contract market, recognized futures exchange, or derivatives
transaction facility for institutional customers, together with a
certification of registration and good standing with the appropriate
authority or of authorization to engage in such transactions by said
authority.
* * * * *
(d) Annual filing. Any person registered as a futures commission
merchant, introducing broker, commodity trading advisor, commodity pool
operator or leverage transaction merchant in accordance with paragraph
(a)(1)(i)(A) of this section must file with the National Futures
Association a Form 7-R, completed in accordance with the instructions
thereto, annually on a date specified by the National Futures
Association. The failure to file the Form 7-R within thirty days
following such date shall be deemed to be a request for withdrawal from
registration. On at least thirty days written notice, and following
such action, if any, deemed to be necessary by the Commission or the
National Futures Association, the National Futures Association may
grant the request for withdrawal from registration.
* * * * *
17. Section 3.21 is amended by revising paragraph (c) introductory
text to read as follows:
Sec. 3.21 Exemption from fingerprinting requirement in certain cases.
* * * * *
(c) Outside directors. Any futures commission merchant, introducing
broker, commodity trading advisor, commodity pool operator or leverage
transaction merchant that has a principal who is a director but is not
also an officer or employee of the firm may, in lieu of submitting a
fingerprint card in accordance with the provisions of
Secs. 3.10(a)(2)(i) and 3.31(a)(2), file a ``Notice Pursuant to Rule
3.21(c)'' with the National Futures Association. Such notice shall
state, if true, that such outside director:
* * * * *
18. Section 3.31 is amended by redesignating paragraph (a) as
paragraph (a)(1), and by adding new paragraph (a)(2) to read as
follows:
Sec. 3.31 Deficiencies, inaccuracies, and changes, to be reported.
(a) * * *
(1) * * *
(2) Where the deficiency or inaccuracy is created by the addition
of a new principal not listed on the registrant's application for
registration (or amendment of such application prior to the granting of
registration), each Form 3-R filed in accordance with the requirements
of paragraph (a)(1) of this section must be accompanied by a Form 8-R,
completed in accordance with the instructions thereto and executed by
each natural person who is a principal of the registrant and who was
not listed on the registrant's initial application for registration or
any amendment thereto. The Form 8-R for each such principal must be
accompanied by the fingerprints of that principal on a fingerprint card
provided by the National Futures Association for that purpose, unless
such principal is a director who qualifies for the exemption from the
fingerprint requirement pursuant to Sec. 3.21(c). The provisions of
this paragraph do not apply to any principal who has a current Form 8-R
on file with the Commission or the National Futures Association.
* * * * *
Sec. 3.32 [Removed]
19. Section 3.32 is removed.
Sec. 3.34 [Removed]
20. Section 3.34 is removed.
21. Appendix A to Part 3 is amended by adding to the end thereto
the following:
Appendix A to Part 3--Interpretive Statement with Respect to
Section 8A(2)(C) and (E) and Section 8A(3)(J) and (M) of the
Commodity Exchange Act
* * * * *
The Commission has further addressed ``other good cause'' under
Section 8a(3)(M) of the Act in issuing guidance letters on assessing
the fitness of floor brokers, floor traders or applicants in either
category:
[First guidance letter]
December 4, 1997.
Robert K. Wilmouth,
President, National Futures Association, 200 West Madison Street,
Chicago, IL.
Re: Adverse Registration Actions with Respect to Floor Brokers,
Floor Traders and Applicants for Registration in Either Category
Dear Mr. Wilmouth:
As you know, the Commission on June 26, 1997, approved for
publication in the Federal Register a Notice and Order concerning
adverse registration actions by the National Futures Association
(``NFA'') with respect to registered floor brokers (``FBs''),
registered floor traders (``FTs'') and applicants for registration
in either category. 62 Fed. Reg. 36050 (July 3, 1997). The Notice
and Order authorized NFA to grant or to maintain,
[[Page 78015]]
either with or without conditions or restrictions, FB or FT
registration where NFA previously would have forwarded the case to
the Commission for review of disciplinary history. The Commission
has worked with its staff to determine which of the pending matters
could efficiently be returned to NFA for handling, and such matters
have been forwarded to NFA. The Commission will continue to accept
or to act upon requests for exemption, and the Commission staff will
consider requests for ``no-action'' opinions with respect to
applicable registration requirements.
By this correspondence, the Commission is issuing guidance that
provides NFA further direction on how it expects NFA to exercise its
delegated power, based upon the experience of the Commission and the
staff with the registration review process during the past three
years. This guidance will help ensure that NFA exercises its
delegated power in a manner consistent with Commission precedent.
In exercising its delegated authority, NFA, of course, needs to
apply all of the provisions of Sections 8a(2) and (3) of the
Commodity Exchange Act (``Act'').\1\ In that regard, NFA should
consider the matters in which the Commission has taken action in the
past and endeavor to seek similar registration restrictions,
conditions, suspensions, denials, or revocations under similar
circumstances.
---------------------------------------------------------------------------
\1\ 7 U.S.C. 12a(2) and (3) (1994). The letter is intended to
supplement, not to supersede, other guidance provided in the past to
NFA. In this regard, the NFA should continue to follow other
guidance provided by the Commission or its staff.
---------------------------------------------------------------------------
One of the areas in which NFA appears to have had the most
uncertainty is with regard to previous self-regulatory organization
(``SRO'') disciplinary actions. Commission Rule 1.63\2\ provides
clear guidelines for determining whether a person's history of
``disciplinary offenses'' should preclude service on SRO governing
boards or committees.\3\ In determining whether to grant or to
maintain, either with or without conditions or restrictions, FB or
FT registration, NFA should, as an initial matter, apply the Rule
1.63(a)(6) criteria to those registered FBs, registered FTs and
applicants for registration in either category. However, NFA should
be acting based upon any such offenses that occurred within the
previous five years, rather than the three years provided for in
Rule 1.63(c). NFA should consider disciplinary actions taken by an
SRO as that term is defined in Section 3(a)(26) of the Securities
Exchange Act of 1934 no differently from disciplinary actions taken
by an SRO in the futures industry as defined in Rule 1.3(ee).\4\
Application of the Rule 1.63 criteria, as modified, to these matters
will aid NFA in making registration determinations that are
reasonably consonant with Commission views.\5\ NFA should focus on
the nature of the underlying conduct rather than the sanction
imposed by an SRO. Thus, if a disciplinary action would not come
within the coverage of Rule 1.63 but for the imposition of a short
suspension of trading privileges (such as for a matter involving
fighting, use of profane language or minor recordkeeping
violations), NFA could exercise discretion, as has the Commission,
not to institute a statutory disqualification case. On the other
hand, conduct that falls clearly within the terms of Rule 1.63, such
as violations of rules involving potential harm to customers of the
exchange, should not be exempt from review simply because the
exchange imposed a relatively minor sanction.
---------------------------------------------------------------------------
\2\ Commission rules referred to herein are found at 17 CFR Ch.
I.
\3\ Rule 1.63(c) provides that a person is ineligible from
serving on an SRO's disciplinary committees, arbitration panels,
oversight panels or governing board if, as provided in Rule 1.63(b),
the person, inter alia: (1) within the past three years has been
found by a final decision of an SRO, an administrative law judge, a
court of competent jurisdiction or the Commission to have committed
a disciplinary offense; or (2) within the past three years has
entered into a settlement agreement in which any of the findings or,
in the absence of such findings, any of the acts charged included a
disciplinary offense.
Rule 1.63(a)(6) provides that a ``disciplinary offense''
includes: (i) any violation of the rules of an SRO except those
rules related to (A) decorum or attire, (B) financial requirements,
or (C) reporting or record-keeping unless resulting in fines
aggregating more than $5,000 within any calendar year; (ii) any rule
violation described in subparagraphs (A) through (C) above that
involves fraud, deceit or conversion or results in a suspension or
expulsion; (iii) any violation of the Act or the regulations
promulgated thereunder; or (iv) any failure to exercise supervisory
responsibility with respect to an act described in paragraphs (i)
through (iii) above when such failure is itself a violation of
either the rules of an SRO, the Act or the regulations promulgated
thereunder.
\4\ Thus, for example, a disciplinary action taken by the
Chicago Board Options Exchange or the National Association of
Securities Dealers, Inc. should be considered in a manner similar to
a disciplinary action of the Chicago Board of Trade or NFA.
\5\ In reviewing these matters, the NFA should bear in mind
recent Commission precedent which allows for reliance on settled
disciplinary proceedings in some circumstances. See In the Matter of
Michael J. Clark, [1996-1998 Transfer Binder] Comm. Fut. L. Rep.
(CCH) para. 27,032 (Apr. 22, 1997) (``other good cause'' under
Section 8a(3)(M) of the Act exists based upon a pattern of exchange
disciplinary actions resulting in significant sanctions for serious
rule violations--whether settlements or adjudications), aff'd sub
nom., Clark v. Commodity Futures Trading Commission, No. 97-4228 (2d
Cir. June 4, 1999) (unpublished).
---------------------------------------------------------------------------
The Commission has treated the registration process and the SRO
disciplinary process as separate matters involving separate
considerations. The fact that the Commission has not pursued its own
enforcement case in a particular situation does not necessarily mean
that the Commission considers the situation to be a minor matter for
which no registration sanctions are appropriate. Further, the
Commission believes that it and NFA, entities with industry-wide
perspective and responsibilities, are the appropriate bodies, rather
than any individual exchange, to decide issues relating to
registration status, which can affect a person's ability to function
in the industry well beyond the jurisdiction of a particular
exchange. Thus, NFA's role is in no way related to review of
exchange sanctions for particular conduct, but rather it is the
entirely separate task of determining whether an FB's or FT's
conduct should impact his or her registration.
NFA also should look to Commission precedent in selecting
conditions or restrictions to be imposed, such as a dual trading ban
where a person has been involved in disciplinary offenses involving
customer abuse. Where conditions or restrictions are imposed, or
agreed upon, NFA also should follow Commission precedent, under
which such conditions or restrictions generally have been imposed
for a two-year period.
The Commission has required sponsorship for conditioned FBs and
FTs when their disciplinary offenses have involved noncompetitive
trading and fraud irrespective of the level of sanctions imposed by
an SRO. Indeed, but for a sponsorship requirement there would be no
one routinely watching and responsible for the activities of these
registrants. Absent sponsorship, such FBs and FTs would only be
subject to routine Commission and exchange surveillance. The
Commission's rules are premised upon the judgment that requiring FTs
and FBs to have sponsors to ensure their compliance with conditions
is both appropriate and useful. See Rule 3.60(b)(2)(i).
A question has arisen whether, if NFA is required to prove up
the underlying facts of an SRO disciplinary action, the exchanges
can provide information on exchange disciplinary proceedings
directly to NFA. Although Section 8c(a)(2) of the Act states that an
exchange shall not disclose the evidence for a disciplinary action
except to the person disciplined and to the Commission, Section
8a(10) of the Act allows the Commission to authorize any person to
perform any portion of the registration functions under the Act,
notwithstanding any other provision of law. The effective discharge
of the delegated registration function requires NFA to have access
to the exchange evidence. Thus, the Commission believes that Section
8a(10) may reasonably be interpreted to allow the disclosure of
information from exchange disciplinary proceedings directly to NFA
despite the provisions of Section 8c(a)(2).
Nothing in the Notice and Order affects the Commission's
authority to review the granting of a registration application by
NFA in the performance of Commission registration functions,
including review of the sufficiency of conditions or restrictions
imposed by NFA, to review the determination by NFA not to take
action to affect an existing registration, or to take its own action
to address a statutory disqualification. Moreover, the Commission
Order contemplates that to allow for appropriate Commission
oversight of NFA's exercise of this delegated authority, NFA will
provide for the Commission's review quarterly schedules of all
applicants cleared for registration and all registrants whose
registrations are maintained without adverse action by NFA's
Registration, Compliance, Legal Committee despite potential
statutory disqualifications.
The Commission will continue to monitor NFA activities through
periodic rule enforcement reviews, and NFA remains subject to the
present requirement that it
[[Page 78016]]
monitor compliance with the conditions and restrictions imposed on
conditioned and restricted registrants.
Sincerely,
Jean A. Webb,
Secretary of the Commission.
[Second guidance letter]
April 13, 2000.
Robert K. Wilmouth,
President, National Futures Association, 200 West Madison Street,
Chicago, IL.
Re: Use of Exchange Disciplinary Actions as ``Other Good Cause''
to Affect Floor Broker/Floor Trader Registration
Dear Mr. Wilmouth:
I. Introduction and Background
In July 1997, the Commission issued a Notice and Order
authorizing the National Futures Association (``NFA'') to grant or
to maintain, either with or without conditions or restrictions,
floor broker (``FB'') or floor trader (``FT'') registration where
NFA previously would have forwarded the case to the Commission for
review of disciplinary history.\1\ By letter dated December 4, 1997
(``Guidance Letter''), the Commission provided further direction on
how the Commission expected NFA to exercise its delegated power and
to ensure that NFA exercised its delegated power in a manner
consistent with Commission precedent.
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\1\ Registration Actions by National Futures Association With
Respect to Floor Brokers, Floor Traders and Applicants for
Registration in Either Category, 62 FR 36050 (July 3, 1997).
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The Commission has determined to revise the Guidance Letter.
Specifically, the Commission is revising the portion of the Guidance
Letter that addresses the use of exchange disciplinary actions as
``other good cause'' to affect FB and FT registrations. The
Commission has made this determination following its own
reconsideration of the issue and at the urging of industry
members.\2\
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\2\ See letters submitted by James Bowe, former president of the
New York Board of Trade (``NYBOT''), dated October 13, 1999,
Christopher Bowen, general counsel of the New York Mercantile
Exchange (``NYMEX''), dated October 18, 1999, and the Joint
Compliance Committee (``JCC''), dated February 2, 2000. The JCC
consists of senior compliance officials from all domestic futures
exchanges and the NFA (i.e., the domestic self-regulatory
organizations (``SROs'')). In addition, staff from the Contract
Markets Section of the Commission's Division of Trading and Markets
attend the JCC meetings as observers. The JCC was established to aid
in the development of improved compliance systems through joint
efforts and information-sharing among the SROs. Commission staff
have also discussed this issue with SRO staff.
---------------------------------------------------------------------------
The Guidance Letter pointed out that, in exercising its
delegated authority, NFA must apply all of the provisions of
Sections 8a(2) and (3) of the Commodity Exchange Act (``Act'').\3\
In particular, Section 8a(3)(M) of the Act authorizes the Commission
to refuse to register or to register conditionally any person if it
is found, after opportunity for hearing, that there is other good
cause for statutory disqualification from registration beyond the
specifically listed grounds in Sections 8a(2) and 8a(3) of the Act.
The Commission held in In the Matter of Clark that statutory
disqualification under the ``other good cause'' provision of Section
8a(3)(M) may arise on the basis of, among other things, a pattern of
exchange disciplinary actions alleging serious rule violations that
result in significant sanctions, and that it is immaterial whether
the sanctions imposed resulted from a fully-adjudicated disciplinary
action or an action that was taken following a settlement.\4\
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\3\ 7 U.S.C. 12a(2) and (3) (1994).
\4\ In the Matter of Clark, [1996-1998 Transfer Binder] Comm.
Fut. L. Rep. (CCH) para. 27,032 (Apr. 22, 1997), aff'd sub nom.,
Clark v. Commodity Futures Trading Commission, No. 97-4228 (2d Cir.
June 4, 1999) (unpublished).
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The Guidance Letter recommended the application of the
provisions of Commission Rule 1.63 \5\ as criteria to aid in
assessing the impact of an FB or FT applicant's or registrant's
previous disciplinary history on the person's fitness to be
registered, with the exception that NFA should be acting based on
disciplinary history from the previous five years, rather than the
three years provided for in Rule 1.63.\6\ The Guidance Letter also
noted that NFA should consider disciplinary actions taken not only
by futures industry SROs but also those taken by SROs as defined in
Section 3(a)(26) of the Securities Exchange Act of 1934 (``1934
Act''), including settled disciplinary actions.
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\5\ Commission rules referred to in this letter are found at 17
CFR Ch. 1.
\6\ Rule 1.63 provides, among other things, that a person is
ineligible from serving on SRO disciplinary committees, arbitration
panels, oversight panels or governing boards if that person, inter
alia, entered into a settlement agreement within the past three
years in which any of the findings or, in the absence of such
findings, any of the acts charged included a disciplinary offense.
Rule 1.63(a)(6) defines a ``disciplinary offense'' to include:
(i) any violation of the rules of an SRO except those rules
related to (A) decorum or attire, (B) financial requirements, or (C)
reporting or record-keeping unless resulting in fines aggregating
more than $5,000 within any calendar year; (ii) any rule violation
described in subparagraphs (A) through (C) above that involves
fraud, deceit or conversion or results in a suspension or expulsion;
(iii) any violation of the Act or the regulations promulgated
thereunder; or (iv) any failure to exercise supervisory
responsibility with respect to an act described in paragraphs (i)
through (iii) above when such failure is itself a violation of
either the rules of an SRO, the Act or the regulations promulgated
thereunder.
---------------------------------------------------------------------------
II. Revised Guidance
As stated above, the Commission has determined to revise the
Guidance Letter. From this point forward, NFA should cease using
Rule 1.63 as the basis to evaluate the impact of an FB or FT
applicant's or registrant's disciplinary history on his or her
fitness to be registered. Instead, as Clark stated, when reviewing
disciplinary history to assess the fitness to be registered of an
FB, FT, or applicant in either category, a pattern of exchange
disciplinary actions alleging serious rule violations that result in
significant sanctions will trigger the ``other good cause''
provision of Section 8a(3)(M). The ``pattern'' should consist of at
least two final exchange disciplinary actions, whether settled or
adjudicated.
NFA also should consider initiating proceedings to affect the
registration of the FB or FT, even if there is only a single
exchange action against the FB or FT, if the exchange action was
based on allegations of particularly egregious misconduct or
involved numerous instances of misconduct occurring over a long
period of time. If, however, a proceeding is initiated based on a
single exchange action that was disposed of by settlement, NFA may
have to prove up the underlying misconduct. Furthermore, traditional
principles of collateral estoppel apply to adjudicated actions,
whether they are being considered individually or as part of a
pattern.\7\
---------------------------------------------------------------------------
\7\ Clark at 44,929.
---------------------------------------------------------------------------
As provided by the Guidance Letter, ``exchange disciplinary
actions'' would continue to include disciplinary actions taken by
both futures industry SROs and SROs as defined in Section 3(a)(26)
of the 1934 Exchange Act. Furthermore, NFA should review an
applicant's or registrant's disciplinary history for the past five
years.\8\ At least one of the actions forming the pattern, however,
must have become final after Clark was decided by the Commission on
April 22, 1997. Finally, ``serious rule violations'' consist of, or
are substantially related to, charges of fraud, customer abuse,
other illicit trading practices, or the obstruction of an exchange
investigation.
---------------------------------------------------------------------------
\8\ The Commission generally looked at a five-year period of
disciplinary history. On occasion, however, the Commission examined
a longer period of an applicant's or registrant's disciplinary
history. For example, the Commission revoked the registration of one
FB on the basis of exchange disciplinary cases that extended back
six years, see Clark, 2 Comm. Fut. L. Rep. (CCH) para. 27,032, and
denied an application for registration as an FT on the basis of
exchange disciplinary cases that extended back seven years, see In
the Matter of Castellano, [1987-1990 Transfer Binder] Comm. Fut. L.
Rep. (CCH) para. 24,360 (Nov. 23, 1988), summarily aff'd (May 29,
1990), reh. denied [1990-1992 Transfer Binder] Comm. Fut. L. Rep.
para. 24,870 (June 26, 1990), aff'd sub nom. Castellano v. CFTC,
Docket No. 90-2298 (7th Cir. Nov. 20, 1991).
---------------------------------------------------------------------------
Congress, the courts and the Commission have indicated the
importance of considering an applicant's history of exchange
disciplinary actions in assessing that person's fitness to
register.\9\ Furthermore, NFA's review of exchange disciplinary
actions within the context of the registration process should not
simply mirror the disciplinary actions undertaken by the exchanges.
The two processes are separate matters that involve separate
considerations. As part of their ongoing self-regulatory
obligations, exchanges must take disciplinary action \10\ and such
disciplinary matters necessarily focus on the specific misconduct
that forms the allegation. In a statutory disqualification action,
however, NFA must determine whether the disciplinary history of an
FB, FT or applicant over the preceding five years should impact his
or her registration. Additionally, NFA possesses industry-wide
perspective and responsibilities. As such, NFA, rather than an
individual exchange, should decide registration status issues, since
those issues affect an individual's status
[[Page 78017]]
within the industry as a whole, well beyond the jurisdiction of a
particular exchange.
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\9\ Letter dated July 14, 1995, from Mary L. Schapiro to R.
Patrick Thompson, President, New York Mercantile Exchange
(unpublished). See also Castellano, supra note 8.
\10\ See Rule 1.51(a)(7).
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The Commission also wants to clarify to the fullest extent
possible that its power to delegate the authority to deny or
condition the registration of an FB, FT, or an applicant for
registration in either category permits exchanges to disclose to NFA
all evidence underlying exchange disciplinary actions,
notwithstanding the language of Section 8c(a)(2) of the Act.\11\ The
Commission's power to delegate stems from Section 8a(10) of the Act,
which permits delegation of registration functions, including
statutory disqualification actions, to any person in accordance with
rules adopted by such person and submitted to the Commission for
approval or for review under Section 17(j) of the Act,
``notwithstanding any other provision of law.'' Certainly, Section
8c(a)(2) qualifies as ``any other provision of law.'' Furthermore,
the effective discharge of the delegated function requires NFA to
have access to the exchange evidence. Thus, the exercise of the
delegated authority pursuant to Section 8a(10) permits the exchanges
to disclose all evidence underlying disciplinary actions to NFA.\12\
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\11\ Section 8c(a)(2) states, in relevant part, that ``[A]n
exchange * * * shall not disclose the evidence therefor, except to
the person who is suspended, expelled, disciplined, or denied
access, and to the Commission.''
\12\ Of course, the Commission could request records from the
exchange and forward them to NFA. The Commission believes that this
is an unnecessary administrative process and that NFA should obtain
the records it needs to carry out the delegated function of
conducting disciplinary history reviews directly from the exchanges.
In this context and pursuant to Commission orders authorizing NFA to
institute adverse registration actions, NFA should be viewed as
standing in the shoes of the Commission.
---------------------------------------------------------------------------
This letter supersedes the Guidance Letter to the extent
discussed above. In all other aspects, the Guidance Letter and other
guidance provided by the Commission or its staff remain in effect.
Therefore, NFA should continue to follow Commission precedent when
selecting conditions or restrictions to be imposed. For example, NFA
should impose a dual trading ban where customer abuse is involved
and any conditions or restrictions imposed should be for a two-year
period. Furthermore, NFA should require sponsorship for conditioned
FBs or FTs when their disciplinary offenses involve noncompetitive
trading and fraud.
Nothing in the Notice and Order or this letter affects the
Commission's authority to review the granting of a registration
application by NFA in the performance of Commission registration
functions, including review of the sufficiency of conditions or
restrictions imposed by NFA, to review the determination by NFA not
to take action to affect an existing registration, or to take its
own action to address a statutory disqualification. Moreover, the
Commission Order contemplates that to allow for appropriate
Commission oversight of NFA's exercise of this delegated authority,
NFA will provide for the Commission's review quarterly schedules of
all applicants cleared for registration and all registrants whose
registrations are maintained without adverse action by NFA's
Registration, Compliance, Legal Committee despite potential
statutory disqualifications.
The Commission will continue to monitor NFA activities through
periodic rule enforcement reviews, and NFA remains subject to the
present requirement that it monitor compliance with the conditions
and restrictions imposed on conditioned and restricted registrants.
Sincerely,
Jean A. Webb,
Secretary of the Commission.
22. Part 3 is amended by adding Appendix B to read as follows:
Appendix B to Part 3--Statement of Acceptable Practices with
Respect to Ethics Training
(a) The provisions of section 4p(b) of the Act (7 U.S.C. 6p(b)
(1994)) set forth requirements regarding training of registrants as
to their responsibilities to the public. This section requires the
Commission to issue regulations requiring new registrants to attend
ethics training sessions within six months of registration, and all
registrants to attend such training on a periodic basis. Consistent
with the will of Congress, the Commission believes that a Core
Principle for all persons intermediating transactions in recognized
multilateral trade execution facilities is fitness. The awareness
and maintenance of professional ethical standards are essential
elements of a registrant's fitness. Further, the use of ethics
training programs is relevant to a registrant's maintenance of
adequate supervision, itself a Core Principle, and a requirement
under Rule 166.3.
(b)(1) The Commission recognizes that technology has provided
new, faster means of sharing and distributing information. In view
of the foregoing, the Commission has chosen to allow registrants to
develop their own ethics training programs. Nevertheless, futures
industry professionals may want guidance as to the role of ethics
training. Registrants may wish to consider what ethics training
should be retained, its format, and how it might best be
implemented. Therefore, the Commission finds it appropriate to issue
this Statement of Acceptable Practices regarding appropriate
training for registrants, as interpretative guidance for
intermediaries on fitness and supervision. Commission registrants
may look to this Statement of Acceptable Practices as a ``safe
harbor'' concerning acceptable procedures in this area.
(2) The Commission believes that section 4p(b) of the Act
reflects an intent by Congress that industry professionals be aware,
and remain abreast, of their continuing obligations to the public
under the Act and the regulations thereunder. The text of the Act
provides guidance as to the nature of these responsibilities. As
expressed in section 4p(b) of the Act, personnel in the industry
have an obligation to the public to observe the Act, the rules of
the Commission, the rules of any appropriate self-regulatory
organizations or contract markets (which would also include
recognized futures exchanges and recognized derivatives transactions
facilities), or other applicable federal or state laws or
regulations. Further, section 4p(b) acknowledges that registrants
have an obligation to the public to observe ``just and equitable
principles of trade.''
(3) Additionally, section 4p(b) reflects Congress' intent that
registrants and their personnel retain an up-to-date knowledge of
these requirements. The Act requires that registrants receive
training on a periodic basis. Thus, it is the intent of Congress
that Commission registrants remain current with regard to the
ethical ramifications of new technology, commercial practices,
regulations, or other changes.
(c) The Commission believes that training should be focused to
some extent on a person's registration category, although there will
obviously be certain principles and issues common to all registrants
and certain general subjects that should be taught. Topics to be
addressed include:
(1) An explanation of the applicable laws and regulations, and
the rules of self-regulatory organizations or contract markets,
recognized futures exchanges and derivatives transaction facilities;
(2) The registrant's obligation to the public to observe just
and equitable principles of trade;
(3) How to act honestly and fairly and with due skill, care and
diligence in the best interests of customers and the integrity of
the market;
(4) How to establish effective supervisory systems and internal
controls;
(5) Obtaining and assessing the financial situation and
investment experience of customers;
(6) Disclosure of material information to customers; and
(7) Avoidance, proper disclosure and handling of conflicts of
interest.
(d) An acceptable ethics training program would apply to all of
a firm's associated persons and its principals to the extent they
are required to register as associated persons. Additionally,
personnel of firms that rely on their registration with other
regulators, such as the Securities and Exchange Commission, should
be provided with ethics training to the extent the Act and the
Commission's regulations apply to their business.
(e) As to the providers of such training, the Commission
believes that classes sponsored by independent persons, firms, or
industry associations would be acceptable. It would also be
permissible to conduct in-house training programs. Further,
registrants should ascertain the credentials of any ethics training
providers they retain. Thus, persons who provide ethics training
should be required to provide proof of satisfactory completion of
the proficiency testing requirements applicable to the registrant
and evidence of three years of relevant industry or pedagogical
experience in the field. This industry experience might include the
practice of law in the fields of futures or securities, or
employment as a trader or risk manager at a brokerage or end-user
firm. Likewise, the Commission believes that registrants should
employ as ethics training providers only those persons they
reasonably believe in good faith are not subject to any
investigations or to bars to registration or to
[[Page 78018]]
service on a self-regulatory organization governing board or
disciplinary panel.
(f)(1) With regard to the frequency and duration of ethics
training, it is permissible for a firm to require training on
whatever periodic basis and duration the registrant (and relevant
self-regulatory organizations) deems appropriate. It may even be
appropriate not to require any such specific requirements as, for
example, where ethics training could be termed ongoing. For
instance, a small entity, sole proprietorship, or even a small
section in an otherwise large firm, might satisfy its obligation to
remain current with regard to ethics obligations by distribution of
periodicals, legal cases, or advisories. Use of the latest
information technology, such as Internet websites, can be useful in
this regard. In such a context, there would be no structured
classes, but the goal should be a continuous awareness of changing
industry standards. A corporate culture to maintain high ethical
standards should be established on a continuing basis.
(2) On the other hand, larger firms which transact business with
a larger segment of the public may wish to implement a training
program that requires periodic classwork. In such a situation, the
Commission believes it appropriate for registrants to maintain such
records as evidence of attendance and of the materials used for
training. In the case of a floor broker or floor trader, the
applicable contract market, recognized futures exchange or
derivatives transaction facility should maintain such evidence on
behalf of its member. This evidence of ethics training could be
offered to demonstrate fitness and overall compliance during audits
by self-regulatory organizations, and during reviews of contract
market, recognized futures exchange or derivatives transaction
facility operations.
(g) The methodology of such training may also be flexible.
Recent innovations in information technology have made possible new,
fast, and cost-efficient ways for registrants to maintain their
awareness of events and changes in the commodity interest markets.
In this regard, the Commission recognizes that the needs of a firm
will vary according to its size, personnel, and activities. No
format of classes will be required. Rather, such training could be
in the form of formal class lectures, video presentation, Internet
transmission, or by simple distribution of written materials. These
options should provide sufficiently flexible means for adherence to
Congressional intent in this area.
(h) Finally, it should be noted that self-regulatory
organizations and industry associations will have a significant role
in this area. Such organizations may have separate ethics and
proficiency standards, including ethics training and testing
programs, for their own members.
PART 4--COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS
23. The authority citation for Part 4 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 4, 6b, 6c, 6l, 6m, 6n, 6o, 12a, and
23.
24. Section 4.10 is amended by revising paragraph (e)(1) to read as
follows:
Sec. 4.10 Definitions.
* * * * *
(e)(1) Principal, when referring to a person that is a principal of
a particular entity, shall have the same meaning as the term
``principal'' under Sec. 3.1(a) of this chapter.
* * * * *
25. Section 4.24 is amended by revising paragraphs (f)(1)(v) and
(h)(2) to read as follows:
Sec. 4.24 General disclosures required.
* * * * *
(f) * * *
(1) * * *
(v) Each principal of the persons referred to in this paragraph
(b)(1) who participates in making trading or operational decisions for
the pool or who supervises persons so engaged.
* * * * *
(h) * * *
(2) A description of the trading and investment programs and
policies that will be followed by the offered pool, including the
method chosen by the pool operator concerning how futures commission
merchants carrying the pool's accounts shall treat offsetting positions
pursuant to Sec. 1.46 of this chapter, if the method is other than to
close out all offsetting positions or to close out offsetting positions
on other than a first-in, first-out basis, and any material
restrictions or limitations on trading required by the pool's
organizational documents or otherwise. This description must include,
if applicable, an explanation of the systems used to select commodity
trading advisors, investee pools and types of investment activity to
which pool assets will be committed;
* * * * *
26. Section 4.32 is added to read as follows:
Sec. 4.32 Trading on a derivatives transaction facility for non-
institutional customers.
(a) A registered commodity trading advisor may enter trades on or
subject to the rules of a derivatives transaction facility on behalf of
a client who does not qualify as an ``institutional customer'' as
defined in Sec. 1.3(g) of this chapter, provided that the trading
advisor:
(1) Directs the client's commodity interest account;
(2) Directs accounts containing total assets of not less than
$25,000,000 at the time the trade is entered; and
(3) Discloses to the client that the trading advisor may enter
trades on or subject to the rules of a derivatives transaction facility
on the client's behalf.
(b) The commodity interest account of a client described in
paragraph (a) of this section must be carried by a registered futures
commission merchant.
27. Section 4.34 is amended by revising paragraphs (f)(1)(ii) and
(h) to read as follows:
Sec. 4.34 General disclosures required.
* * * * *
(f) * * *
(1) * * *
(ii) Each principal of the trading advisor who participates in
making trading or operational decisions for the trading advisor or
supervises persons so engaged.
* * * * *
(h) Trading program. A description of the trading program, which
must include the method chosen by the commodity trading advisor
concerning how futures commission merchants carrying accounts it
manages shall treat offsetting positions pursuant to Sec. 1.46 of this
chapter, if the method is other than to close out all offsetting
positions or to close out offsetting positions on other than a first-
in, first-out basis, and the types of commodity interests and other
interests the commodity trading advisor intends to trade, with a
description of any restrictions or limitations on such trading
established by the trading advisor or otherwise.
PART 140--ORGANIZATION, FUNCTIONS AND PROCEDURES OF THE COMMISSION
28. The authority citation for Part 140 continues to read as
follows:
Authority: 7 U.S.C. 4a, 12a.
29. Section 140.91 is amended by adding a new paragraph (a)(7) to
read as follows:
Sec. 140.91 Delegation of authority to the Director of the Division of
Trading and Markets.
(a) * * *
(7) All functions reserved to the Commission in Sec. 1.25 of this
chapter.
* * * * *
PART 155--TRADING STANDARDS
30. The authority citation for Part 155 continues to read as
follows:
Authority: 7 U.S.C. 6b, 6c, 6g, 6j and 12a unless otherwise
noted.
[[Page 78019]]
Secs. 155.2, 155.3, 155.4 and 155.5 [Amended]
31. Sections 155.2, 155.3, 155.4 and 155.5 are amended by adding
the words ``or recognized futures exchange'' after the words ``contract
market'' each time they appear.
32. Section 155.6 is added to read as follows:
Sec. 155.6 Trading standards for the transaction of business on
derivatives transaction facilities.
(a) A futures commission merchant, or affiliated person thereof,
transacting business on behalf of a customer who does not qualify as an
``institutional customer'' as defined in Sec. 1.3(g) of this chapter on
a derivatives transaction facility shall comply with the provisions of
Sec. 155.3.
(b) No futures commission merchant, introducing broker or
affiliated person thereof shall misuse knowledge of any institutional
customer's order for execution on a derivatives transaction facility.
PART 166--CUSTOMER PROTECTION RULES
33. The authority citation for Part 166 is amended to read as
follows:
Authority: 7 U.S.C. 1a, 2, 4, 6b, 6c, 6d, 6g, 6h, 6k, 6l, 6o,
7a, 12a, 21 and 23, unless otherwise noted.
34. Section 166.5 is added to read as follows:
Sec. 166.5 Dispute settlement procedures.
(a) Definitions. (1) The term claim or grievance as used in this
section shall mean any dispute that:
(i) Arises out of any transaction executed on or subject to the
rules of a contract market, a recognized futures exchange or a
derivatives transaction facility,
(ii) Is executed or effected through a member of such facility, a
participant transacting on or through such facility or an employee of
such facility, and
(iii) Does not require for adjudication the presence of essential
witnesses or third parties over whom the facility does not have
jurisdiction and who are not otherwise available.
(iv) The term claim or grievance does not include disputes arising
from cash market transactions that are not a part of or directly
connected with any transaction for the purchase or sale of any
commodity for future delivery or commodity option.
(2) The term customer as used in this section includes an option
customer (as defined in Sec. 1.3(jj) of this chapter) and any person
for or on behalf of whom a member of a contract market, a recognized
futures exchange or a derivatives transaction facility or a participant
transacting on or through such market, exchange or facility effects a
transaction on or through such market, exchange or facility, except
another member of or participant in such market, exchange or facility.
Provided, however, a person who is an ``institutional customer'' as
defined in Sec. 1.3(g) of this chapter shall not be deemed to be a
customer within the meaning of this section.
(3) The term Commission registrant as used in this section means a
person registered under the Act as a futures commission merchant,
introducing broker, floor broker, commodity pool operator, commodity
trading advisor, or associated person.
(b) Voluntariness. The use by customers of dispute settlement
procedures shall be voluntary as provided in paragraph (c) of this
section.
(c) Pre-dispute arbitration agreements. No Commission registrant
shall enter into any agreement or understanding with a customer in
which the customer agrees, prior to the time a claim or grievance
arises, to submit such claim or grievance to any settlement procedure
except as follows:
(1) Signing the agreement must not be made a condition for the
customer to utilize the services offered by the Commission registrant.
(2) If the agreement is contained as a clause or clauses of a
broader agreement, the customer must separately endorse the clause or
clauses containing the cautionary language and provisions specified in
this section. A futures commission merchant or introducing broker may
obtain such endorsement as provided in Sec. 1.55(d) of this chapter for
the following classes of customers only:
(i) A plan defined as a government plan or church plan in section
3(32) or section 3(33) of title I of the Employee Retirement Income
Security Act of 1974, or a foreign person performing a similar role or
function subject as such to comparable foreign regulation; and
(ii) A person who is a ``qualified eligible person'' as defined in
Sec. 4.7 of this chapter.
(3) The agreement may not require the customer to waive the right
to seek reparations under section 14 of the Act and part 12 of this
chapter. Accordingly, the customer must be advised in writing that he
or she may seek reparations under section 14 of the Act by an election
made within 45 days after the Commission registrant notifies the
customer that arbitration will be demanded under the agreement. This
notice must be given at the time when the Commission registrant
notifies the customer of an intention to arbitrate. The customer must
also be advised that if he or she seeks reparations under section 14 of
the Act and the Commission declines to institute reparation
proceedings, the claim or grievance will be subject to the pre-existing
arbitration agreement and must also be advised that aspects of the
claim or grievance that are not subject to the reparations procedure
(i.e., do not constitute a violation of the Act or rules thereunder)
may be required to be submitted to the arbitration or other dispute
settlement procedure set forth in the pre-existing arbitration
agreement.
(4) The agreement must advise the customer that, at such time as he
or she may notify the Commission registrant that he or she intends to
submit a claim to arbitration, or at such time as such person notifies
the customer of its intent to submit a claim to arbitration, the
customer will have the opportunity to elect a qualified forum for
conducting the proceeding.
(5) Election of forum. (i) Within ten business days after receipt
of notice from the customer that he or she intends to submit a claim to
arbitration, or at the time a Commission registrant notifies the
customer of its intent to submit a claim to arbitration, the Commission
registrant must provide the customer with a list of organizations whose
procedures meet Acceptable Practices established by the Commission for
customer dispute resolution, together with a copy of the rules of each
forum listed. The list must include:
(A) The contract market, recognized futures exchange or derivatives
transaction facility, if available, upon which the transaction giving
rise to the dispute was executed or could have been executed;
(B) A registered futures association; and
(C) At least one other organization that will provide the customer
with the opportunity to select the location of the arbitration
proceeding from among several major cities in diverse geographic
regions and that will provide the customer with the choice of a panel
or other decision-maker composed of at least one or more persons, of
which at least a majority are not members or associated with a member
of the contract market, recognized futures exchange or derivatives
transaction facility or employee thereof, and that are not otherwise
associated with the contract market, recognized futures exchange or
derivatives transaction facility (mixed panel): Provided,
[[Page 78020]]
however, that the list of qualified organizations provided by a
Commission registrant that is a floor broker need not include a
registered futures association unless a registered futures association
has been authorized to act as a decision-maker in such matters.
(ii) The customer shall, within forty-five days after receipt of
such list, notify the opposing party of the organization selected. A
customer's failure to provide such notice shall give the opposing party
the right to select an organization from the list.
(6) Fees. The agreement must acknowledge that the Commission
registrant will pay any incremental fees that may be assessed by a
qualified forum for provision of a mixed panel, unless the arbitrators
in a particular proceeding determine that the customer has acted in bad
faith in initiating or conducting that proceeding.
(7) Cautionary Language. The agreement must include the following
language printed in large boldface type:
Three Forums Exist for the Resolution of Commodity Disputes:
Civil Court litigation, reparations at the Commodity Futures Trading
Commission (CFTC) and arbitration conducted by a self-regulatory or
other private organization.
The CFTC recognizes that the opportunity to settle disputes by
arbitration may in some cases provide many benefits to customers,
including the ability to obtain an expeditious and final resolution
of disputes without incurring substantial costs. The CFTC requires,
however, that each customer individually examine the relative merits
of arbitration and that your consent to this arbitration agreement
be voluntary.
By signing this agreement, you: (1) May be waiving your right to
sue in a court of law; and (2) are agreeing to be bound by
arbitration of any claims or counterclaims which you or [name] may
submit to arbitration under this agreement. You are not, however,
waiving your right to elect instead to petition the CFTC to
institute reparations proceedings under Section 14 of the Commodity
Exchange Act with respect to any dispute that may be arbitrated
pursuant to this agreement. In the event a dispute arises, you will
be notified if [name] intends to submit the dispute to arbitration.
If you believe a violation of the Commodity Exchange Act is involved
and if you prefer to request a section 14 ``Reparations'' proceeding
before the CFTC, you will have 45 days from the date of such notice
in which to make that election.
You need not sign this agreement to open or maintain an account
with [name]. See 17 CFR 166.5.
(d) Enforceability. A dispute settlement procedure may require
parties utilizing such procedure to agree, under applicable state law,
submission agreement or otherwise, to be bound by an award rendered in
the procedure, provided that the agreement to submit the claim or
grievance to the procedure was made in accordance with paragraph (c) of
this section or that the agreement to submit the claim or grievance was
made after the claim or grievance arose. Any award so rendered shall be
enforceable in accordance with applicable law.
(e) Time limits for submission of claims. The dispute settlement
procedure established by a contract market, recognized futures exchange
or derivatives transaction facility shall not include any unreasonably
short limitation period foreclosing submission of customers' claims or
grievances or counterclaims.
(f) Counterclaims. A procedure established by a contract market,
recognized futures exchange, or derivatives transaction facility under
the Act for the settlement of customers' claims or grievances against a
member or employee thereof may permit the submission of a counterclaim
in the procedure by a person against whom a claim or grievance is
brought. The contract market, recognized futures exchange, or
derivatives transaction facility may permit such a counterclaim where
the counterclaim arises out of the transaction or occurrence that is
the subject of the customer's claim or grievance and does not require
for adjudication the presence of essential witnesses, parties, or third
persons over whom the contract market, recognized futures exchange, or
derivatives transaction facility does not have jurisdiction. Other
counterclaims arising out of a transaction subject to the Act and rules
promulgated thereunder for which the customer utilizes the services of
the registrant may be permissible where the customer and the registrant
have agreed in advance to require that all such submissions be included
in the proceeding, and if the aggregate monetary value of the
counterclaim is capable of calculation.
(g) Institutional customers. (1) A person who is an ``institutional
customer'' as defined in Sec. 1.3(g) of this chapter may negotiate any
term of an agreement or understanding with a Commission registrant in
which the institutional customer agrees, prior to the time a claim or
grievance arises, to submit such claim or grievance to any settlement
procedure, except that signing the agreement must not be made a
condition for the institutional customer to use the services offered by
the registrant.
(2) If the agreement is contained as a clause or clauses of a
broader agreement, the institutional customer must separately endorse
the clause or clauses containing the agreement; Provided, however, a
futures commission merchant or introducing broker may obtain such
endorsement as provided in Sec. 1.55(d) of this chapter.
Issued in Washington, D.C. on November 21, 2000 by the
Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 00-30268 Filed 12-12-00; 8:45 am]
BILLING CODE 6351-01-P