On October 30, 2013, in a 3-1 vote, the Commodity Futures Trading Commission (CFTC or the Commission) approved final rules that significantly strengthen the protections afforded to customers of futures commission merchants (FCMs). “Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations” (the Final Rule) will become effective 60 days after its publication in the Federal Register. The Final Rule’s compliance dates vary by provision and are noted below.
The Final Rule promises to make a number of sweeping improvements to customer protections which will strengthen the regulatory requirements of FCMs and reduce the likelihood of FCM failures. Although the increased protections are generally favorable for end-users, concerns persist that the regulatory framework will significantly increase costs to FCMs and their customers.
Following the high-profile insolvencies of the brokerages MF Global, Inc. and Peregrine Financial Group, Inc. in the past two years, the CFTC promulgated the Final Rule in an effort to strengthen the regulation and oversight of FCMs. The final rulemaking follows a public comment period and a series of roundtable meetings at which the CFTC actively sought input on futures customer protection issues. In adopting the Final Rule, the CFTC is attempting to implement regulatory mechanisms that might have better protected customer funds during the collapses of MF Global and Peregrine, had they been in place. In the Final Rule, the Commission also acknowledges the need to improve public trust in the FCM system as a result of those two insolvencies.
The protections set forth in the Final Rule apply only to customers’ funds held and maintained at FCMs, rather than at the derivatives clearing organization (DCO) level. Further, the Commission does not touch on the “legally segregated, operationally commingled” (LSOC) model implemented for cleared swaps customer collateral held at an FCM or DCO, and thus the Commission retains the disparate treatment of futures customer funds, which are subject to “fellow customer risk.” The majority of the Final Rule deals solely with the funds of futures customers, though some protections apply to both futures and cleared swap customers, as noted throughout this Legal Alert. In many cases, this is because the Commission is conforming its regulations on futures accounts to the existing rules on cleared swaps, which the CFTC has implemented under its Dodd-Frank authority. For example, the Final Rule requirements for residual interest apply mostly to futures accounts, because existing rules under Part 22 of the CFTC’s regulations already provide many of these requirements for cleared swaps.
The Final Rule
1. The Residual Interest Requirement and Segregated Accounts
Under the Final Rule, FCMs are now required to deposit proprietary funds (i.e., residual interest) into futures and cleared swap customer segregated accounts as well as foreign futures and options accounts (30.7 accounts), for purposes of creating a buffer to ensure compliance with segregation requirements. The senior management of the FCM is required to set the target amount of the residual interest, and develop related policies and procedures to ensure that the FCM maintains the targeted residual interest, taking into consideration the FCM’s business, the markets and products traded by customers, and the creditworthiness of its customer base. Each FCM’s targeted residual interest is also a part of its required risk management plan, which is discussed below.
The residual interest requirements will be implemented on a phased-in schedule. Effective one year after the publication of the Final Rule in the Federal Register, FCMs must start posting residual interest sufficient to cover any customer margin deficits by 6:00 p.m. Eastern Time on the date of settlement (usually the business day following the trade date) (the Residual Interest Deadline). Notably, this Residual Interest Deadline concept relaxes the approach that was suggested in the proposed rule, which would have required FCMs to comply with the residual interest requirements “at all times.” Within 30 months following publication of the Final Rule, CFTC staff must issue for public comment a report that addresses the feasibility of, and costs associated with, an earlier Residual Interest Deadline. Within nine months of publishing such report, the CFTC may implement a new phase-in period for the Residual Interest Deadline; however, if the implementation schedule has not been amended by December 31, 2018 (in five years), the Residual Interest Deadline will automatically change to the time of the first daily settlement.
Withdrawals of Residual Interest
The Final Rule amends CFTC Rule 1.23 to require safeguards concerning withdrawals of residual interest from segregated accounts for futures customers. Previously, an FCM was permitted to withdraw funds from futures customer accounts to the extent of its residual interest. Under the Final Rule, the FCM is prohibited from withdrawing any of its residual interest or excess funds in segregation on any business day (except withdrawals made to or for the benefit of a futures customer) unless it completes the daily calculation of funds in segregation as of the close of the previous business day.
Moreover, the Final Rule prohibits the FCM from withdrawing more than 25% of its residual interest in a futures customer account unless a senior official of the FCM pre-approves the withdrawal in writing, in which case the FCM must immediately file a written notice to the CFTC and the relevant self-regulatory organization (SRO). The notice must be signed by the same senior official, and contain information regarding the amount and purpose of the withdrawal and the remaining amount of residual interest. In the event that any withdrawal causes the FCM to fall below its targeted residual interest, it must deposit proprietary funds into the account no later than the close of the next business day. Also, to the extent that any withdrawal causes the FCM’s residual interest to fall below a futures customer’s margin deficits, it must immediately restore the residual interest to exceed the sum of such amounts.
Segregation of Customer Funds
Rule 1.32 now requires each FCM to file electronically its segregation calculation with the CFTC and its SRO each business day. The FCM must use Segregation Schedules contained in Form 1-FR-FCM to document its daily segregation calculation. Importantly, the Final Rule requires that such Segregation Schedules (and the similar 30.7 Secured Amount Schedule and Cleared Swaps Segregation Schedule) be made available to the public on the FCM’s website on a daily basis.
The Segregation Schedules provide a statement of each FCM’s segregation requirements and funds in segregation for customers trading futures on U.S. exchanges. This requirement enhances the protection of customers’ funds by enabling the CFTC to quickly identify whether an FCM is under-segregated and/or experiencing financial difficulty. The 30.7 Secured Amount Schedule provides the same disclosures for customers trading futures in 30.7 accounts, and the Cleared Swaps Segregation Schedule does so for customers trading cleared swaps.
2. Elimination of the Alternative Method for Determining Segregation Requirements for Foreign Trading Accounts
In the Securities Investor Protection Act (SIPA) trustee’s report of its investigation and recommendations related to the MF Global bankruptcy estate, the trustee faulted the ability of FCMs to use the “Alternative Method” to determine the amount of funds necessary to meet segregation requirements in 30.7 accounts. In contrast to the 30.7 accounts for foreign trades, domestic segregated accounts are required to use the “Net Liquidating Equity Method” for calculating segregation requirements. The Net Liquidating Equity Method requires each FCM to hold an amount of funds in segregation sufficient to meet the total account equities of all of the FCM’s futures customers and cleared swaps customers. The Alternative Method, on the other hand, allowed FCMs to maintain an amount of funds sufficient to cover only the margin required on open foreign futures contracts, adjusted by unrealized gains or losses on the open positions and any premiums payable or received on foreign options.
As a result, under the Alternative Method, an FCM previously was not required to keep an amount of funds in its separate accounts that would be sufficient to pay the full account balances of all foreign futures and foreign options customers. Under the Final Rule, however, the Alternative Method is abolished, and FCMs are required to hold sufficient funds in 30.7 accounts to satisfy the Net Liquidating Equity Method. These requirements apply to futures customers holding 30.7 accounts, and to futures and cleared swaps customers.
3. Risk Management Policies and Procedures Requirement for FCMs Related to Customer Funds
The Final Rule creates new CFTC Regulation 1.11, which requires FCMs to establish a risk management program designed to monitor and manage risks associated with customer funds (the Risk Management Program). The Risk Management Program must consist of written policies and procedures that are approved by the governing body of the FCM, and circulated to the CFTC and the relevant SRO. CFTC Regulation 1.11 also requires each FCM to establish a risk management unit, independent from the relevant business unit, which would be formed for the purpose of administering the Risk Management Program.
More specifically, each FCM’s Risk Management Program must include the following elements, among others: (1) risk tolerance limits that are reviewed quarterly by senior management and annually by the governing body of the FCM; (2) a system for monitoring and evaluating the FCM’s depositories of segregated funds; (3) a process for withdrawal of cash and securities from segregated funds; and (4) a process for assessing the FMC’s CFTC Regulation 1.25 investments. Each FCM must establish a supervisory system to oversee compliance with the Risk Management Program, and must file its initial risk management program with the CFTC within 180 days of the effective date of the Final Rule.
CFTC Regulation 1.11 applies to all FCMs that accept or hold money, securities or property (or extend credit in lieu thereof) as margin or security for customers trading in futures, options or swaps.
4. The Required Use of Standard Template Acknowledgement Letters From Depositories to FCMs
The Final Rule amends existing rules related to the Acknowledgement Letter that each FCM is required to obtain from any depositories holding the FCM’s customers’ funds. Such Acknowledgement Letters confirm that the depositories know that customer funds are to be held in a given account.
The Final Rule requires the use of a standardized template Acknowledgement Letter. The form Acknowledgment Letters (of which there are six different versions) require, among other things, that a depository acknowledge (1) liability for ignoring any withdrawal from a customer account that the depository knows is in violation of applicable laws; (2) that customer funds may not be subject to liens (except with respect to certain liquidity agreements in place); and (3) that depositories holding FCM customer accounts must grant 24-hour read-only electronic access to the CFTC. The Final Rule removes provisions that would have obligated depositories to release funds immediately upon receiving instructions from the CFTC, and to grant 24-hour read-only electronic access to the FCM customer accounts to an SRO.
The amended requirements for Acknowledgement Letters apply to both futures accounts and cleared swaps accounts, and FCMs must comply with these new requirements by 180 days after the Final Rule is published in the Federal Register.
5. Increased Reporting and Recordkeeping Requirements for FCMs with Regard to Customer Funds
The Final Rule makes a number of changes to FCM reporting and recordkeeping requirements under amended CFTC Regulation 1.10 and the new CFTC Regulation 1.11.
CFTC Regulations 1.10 and 1.11 generally require an FCM to file monthly unaudited financial reports and certified annual reports to the CFTC. The Commission has amended the annual reporting deadline (which was previously 90 days after the FCM’s year-end date) to better align with the 60-day year-end filing deadline for FCMs that are dually registered as broker-dealers (BDs), and with auditing standards used by public accountants. The new 60-day deadline commences for FCMs with years ending after June 14, 2014.
The Final Rule also requires FCMs to make several additional disclosures to the CFTC, including the target amount of residual interest maintained in customer segregated accounts, details concerning the amount of funds in segregation or separate accounts for customers, and the FCM’s liabilities to cleared swaps customers and retail forex customers. FCMs are not required to disclose the sum of under-margined amounts (the sum of outstanding margin deficits) under the Final Rule. The FCM is also required to file its balance sheet leverage ratio on a monthly basis, along with monthly unaudited financials.
Under the Final Rule, all financial and regulatory notices must be filed electronically through the CFTC’s WinJammer Online Filing System. This includes the FCM’s required Risk Exposure Report, required by CFTC Requirement 1.11, which must be filed with the CFTC within five days of providing such report to the senior management of the FCM.
6. Increased Oversight of FCMs by SROs
FCM Reportable Events
Prior to the promulgation of the Final Rule, CFTC Regulation 1.12 required FCMs only to provide notices to the CFTC and the relevant SRO if certain reportable events occurred. Some of these reportable events included a failure to maintain a minimum level of regulatory capital and a failure to comply with segregation requirements. In an effort to create a more effective early warning system, the Final Rule amends CFTC Regulation 1.12 to include several additional reportable events, such as an FCM’s failure to hold sufficient funds in segregated accounts for cleared swaps customers, a discovery by the FCM that it has invested funds held for customers in investments not permitted by CFTC Regulation 1.25, a failure by the FCM to hold sufficient funds to meet the firm’s targeted residual interest, or a material adverse impact to the financial condition of the FCM.
In addition, upon the occurrence of a reportable event, the FCM must include a statement explaining its causes. The FCM, however, must make the report immediately, except in the event of a material adverse financial impact to, or change in operations of, the FCM in which case such events must be reported within 24 hours instead of immediately. The FCM must submit such reports even if it does not yet have a full understanding of the causes of the reportable event, and may file amendments to the initial report as necessary. In response to several comments received on the proposed rules, the CFTC deemed that such reportable events are not required to be made publicly available. However, it is important to note that FCMs will be required to disclose certain reportable events to customers pursuant to CFTC Regulation 1.55, which is discussed in detail below and requires that FCMs update, and promptly disclose to customers, material risk-related information.
The Final Rule amends CFTC Regulation 1.12 to apply to cleared swaps customers as well as futures customers.
SRO Supervisory System
The Final Rule also amends CFTC Regulation 1.52, which mandates that SROs monitor their member FCMs for compliance with minimum financial and related reporting requirements. Even though the Commission recently amended CFTC Regulation 1.52 to codify previous CFTC staff guidance on such issues, the Final Rule adds additional provisions that enhance protections for customer collateral by strengthening SROs’ financial oversight of FCMs. The Final Rule requires that each SRO adopt rules requiring member FCMs to establish risk management plans at least as stringent as those contemplated above. SROs must also establish supervisory programs to oversee FCM compliance with SRO and CFTC segregation, capital reporting, and other requirements. SROs are also required to implement audits of their supervisory oversight program by “examinations experts” on a biennial basis. SROs must submit supervisory programs to the CFTC within 180 days of the effective date of the Final Rule.
7. Additional Disclosure Requirements by FCMs to Investors and Regulators
Risk Disclosure Statement
Current CFTC Regulation 1.55 requires each FCM to furnish a general risk disclosure to its futures customers (the Risk Disclosure Statement). The Final Rule amends the Risk Disclosure Statement by increasing the amount of information to be disclosed by the FCM, including statements by the FCM that: (a) in the event of an FCM bankruptcy, customer funds are not covered by insurance; (b) DCOs do not insure or guarantee customer funds held by an FCM, but that a DCO may offer an insurance program; (c) the customer’s funds may be commingled by an FCM with the funds of other customers, and that, as a result, there is fellow-customer risk; (d) the FCM may invest customer funds in certain investments permitted under CFTC Regulation 1.25 (which was revised last year to restrict the permitted vehicles in which the FCM may invest customer funds); and (e) the FCM may deposit customer funds in affiliated depositories. The foregoing disclosures must be made to potential customers before they initiate their customer accounts. The CFTC has also advised that, with respect to existing customers, it is adequate for each FCM to provide each customer with a revised Risk Disclosure Statement, without requiring a signed acknowledgment. FCMs are required to have their revised Risk Disclosure Statements in place within 90 days of the effective date of the Final Rule.
These requirements under CFTC Regulation 1.55 apply only to futures customers; Part 22 of the CFTC’s regulations contains separate disclosure requirements for cleared swaps customers.
Firm-Specific Disclosure Document
The Final Rule now requires each FCM to provide certain information that is specific to the FCM and its business in a new, mandatory “Firm-Specific Disclosure Document.” In this document, FCMs must disclose the business activities and product lines that comprise their businesses, with the approximate percentage of assets and capital devoted to each. FCMs must share the types of accounts, markets traded, international businesses in which they are engaged, and clearinghouses used on behalf of customers. FCMs must also make disclosures related to material risks that they face and any material administrative, civil, enforcement, or criminal action pending or taken in the preceding three years. Many of the required disclosures are required to be provided on each FCM’s website. In other instances, each FCM is required to include a statement on its website that additional information is available from the NFA, and to provide a link to the NFA’s website. FCMs must disclose to customers and post on their websites the relevant information within 180 days after the effective date of the Final Rule.
Transfer of Customer Positions and Capital Charges
Current CFTC Regulation 1.17 requires an FCM to cease operations and transfer its customers’ positions to another FCM if it does not meet the minimum capital requirements. The Final Rule amends that requirement to authorize the CFTC to request that an FCM certify immediately in writing – and produce verifiable evidence in support thereof – that it has sufficient liquidity to continue operating as a going concern. If the FCM is able to demonstrate that it is able to achieve adequate liquidity, then the CFTC or SRO may permit the FCM up to 10 days to achieve compliance without requiring the transfer of its customers’ positions. In addition, under amended CFTC Regulation 1.17, FCMs are now required to incur a capital charge for customer and non-customer accounts that are under-margined beyond one business day instead of the previous three-day under-margined period.
8. Depository Due Diligence and Other Final Rule Requirements that Impact FCMs
FCM Public Accountants
Under the Final Rule, the Commission amended CFTC Regulation 1.16, which addresses minimum qualification criteria for public accountants that conduct examinations of FCMs and their financial statements. CFTC Regulation 1.16 now requires that such public accountants (1) be registered with the Public Company Accounting Oversight Board (PCAOB); (2) undergo an examination by the PCAOB; (3) are not barred by the PCAOB; and (4) disclose in their reports whether they conducted their audits of the FCMs in accordance with standards adopted by the PCAOB.
Depository Due Diligence
Under amended CFTC Regulation 1.20, FCMs must now conduct due diligence, at least annually, of each of the depositories in which they deposit customer funds.
Losses Incurred Due to CFTC Rule 1.25 Investments
The CFTC clarified in the Final Rule that under current CFTC Regulation 1.29, an FCM is responsible for losses incurred as a result of any CFTC Rule 1.25 investments, and such losses cannot be passed on to futures customers.
Implications of the Final Rule for Customers of FCMs
The Final Rule contains a set of amendments and new rules that impose significant changes on FCMs and the way they conduct their business. Since the MF Global and Peregrine brokerage failures, the NFA has already implemented several changes to better protect customer funds, and FCMs were likely on notice of this heavier regulatory burden from the CFTC. Nevertheless, FCMs may discover that the Final Rule creates significant additional expenses while limiting their profitability – most notably in the form of increased capital that FCMs must contribute to segregated accounts as a result of the targeted residual interest requirement. Those costs may, in turn, be passed on to FCM customers or, in some cases, firms may opt out of the futures commission merchant business altogether. Overall, however, the Final Rule enables FCM customers to act with more confidence in their FCMs and in the marketplace generally, which, in turn, may allow for more robust and structurally sound futures and swaps markets.
Residual interest refers to the “cushion of proprietary funds” that an FCM deposits into a customer’s segregated and secured accounts to protect such accounts against becoming under-segregated or under-secured as a result of failing to hold a sufficient amount of funds in such accounts to meet the regulatory requirements.
Generally, the Final Rule defines “business unit” as any department, division, group, or personnel of an FCM or any of its affiliates that solicits or accepts orders for the purchase or sale of any future, swap or option, or that otherwise handles segregated funds.
The Final Rule amends the definition of “leverage” so that an FCM may file the same leverage ratio report with the CFTC that it files with the registered futures association (such as the NFA) of which the FCM is a member.
CFTC Regulation 1.55(i), which addresses an FCM’s risk disclosure statement, requires that an FCM “update the information required by this section [1.55] as and when necessary. . . to keep such information accurate and complete and shall promptly disclose such updated information to all of its customers. . . [including] events that require periodic reporting required to be filed pursuant to § 1.12” of the CFTC’s Regulations.