On April 14, by unanimous vote of the Commissioners, the Commodity Futures Trading Commission (“CFTC” or “Commission”) approved a notice of proposed rulemaking to update comprehensively its Part 190 Rules governing a commodity broker bankruptcy (“Part 190 Rule Proposal”).1 The rules, first adopted in 1983 and sorely in need of overhaul notwithstanding several amendments over the years, govern the liquidation of a futures commission merchant (“FCM”) or derivatives clearing organization (“DCO”), when administered as a commodity broker proceeding under subchapter IV of chapter 7 of the U.S. Bankruptcy Code, 11 U.S.C.A. §§ 101 et seq. (the “Code”). The comment period ends on July 13, 2020.
The Part 190 Rule Proposal was a long time in the making. In September 2017, a subcommittee of the American Bar Association (“ABA”) Business Law Section, the ABA Part 190 Subcommittee,2 submitted proposed model Part 190 Rules for the Commission’s consideration (“Model Part 190 Rules”) under the CFTC’s Project KISS initiative.3 The Model Part 190 Rules were the product of a 2-½ year effort, and served as a starting base for the Commission’s consideration of Part 190 revisions. Before the subcommittee undertook its project, CFTC staff had expressed interest in pursuing comprehensive revisions to Part 190. Indeed, the ABA Part 190 Subcommittee commenced its ambitious project to re-write the Part 190 Rules in 2015 with that knowledge, and with the informal support of Commission staff, certain of whom participated in several brainstorming sessions with the subcommittee (while taking great care not to influence or direct its deliberations).
Once the ABA Part 190 Subcommittee submitted the Model Part 190 Rules, the recommended rules, of course, become the Commission’s to modify, ignore or reject as it deemed appropriate. Fortunately, the Commission responded favorably and added Part 190 revisions to the Project KISS agenda, using the submission to start its deliberations.4 As is evident from the Part 190 Rule Proposal, and the CFTC’s thoughtful explanations of the proposed changes, CFTC staff has devoted substantial time and effort to evaluate the Model Part 190 Rules carefully, through the important prism of the Commission staff’s hard earned expertise learned through its involvement with FCM bankruptcy proceedings, such as MF Global and Peregrine.
The Commission’s proposed rules contain many of the elements recommended by the ABA Part 190 Subcommittee. Unsurprisingly, though, the CFTC made a number of revisions and enhancements to the Model Part 190 Rules. In this article, we provide an overview of the relevant statutory provisions and current Part 190 Rules for context, and then describe the major features of the Part 190 Rule Proposal. We also highlight certain areas where the Commission supplemented, modified or rejected the ABA Part 190 Subcommittee’s recommendations.
II. Relevant Statutory Provisions and Current Part 190
A. Bankruptcy Code and CEA Section 20
The Code contains special provisions in subchapter IV of chapter 7 governing the trustee’s liquidation of a U.S. “commodity broker.”5 Section 20 of the Commodity Exchange Act (“CEA”) authorizes the CFTC to adopt rules governing the trustee’s administration of a subchapter IV proceeding,6 in effect, to add specificity to the general provisions of subchapter IV.
The term “commodity broker,” defined in Code Section 101(6)7 (via cross-references to terms defined in Section 761) covers an FCM,8 as defined in the CEA, and a “clearing organization,” defined as a registered DCO.9 The definition also covers commodity options dealers and leverage transaction merchants, but those categories seem outdated under the current CEA regulatory framework. (There currently are none.) A commodity broker will be liquidated under subchapter IV only if it has “customers”10 with claims against it relating to “commodity contracts.” The definition of “commodity contract” in Code Section 761 covers futures and options, but not (explicitly at least) swaps in the text of the Code;11 Section 4d(f)(5) of the CEA—added under Dodd-Frank (defined below)—brings cleared swaps within the Code definition of “commodity contract.”12
Subchapter IV dictates important customer protections through provisions protecting the transfer of customers’ commodity contracts and related customer property from the failed commodity broker and, as discussed below, giving priority to claims held by public customers over those of non-public customers of FCMs. Subchapter IV does not use the terms “public customer” and “non-public customer,” but they are useful terms for describing certain distinctions that the Code makes, and they are the terms that the CFTC uses in Part 190 (and continues to use in the Part 190 Rule Proposal) to implement those statutory distinctions.
At the risk of oversimplifying, non-public customers are customers of a commodity broker, other than a DCO, whose accounts are classified as proprietary accounts of the commodity broker, as the term “proprietary account” is defined by CFTC rule, regulation or order.13 Under current CFTC definitions,14 commodity customer accounts that an FCM (or other person) carries for affiliates and certain “insiders” are deemed proprietary, making the account holders non-public customers of the FCM, whereas other commodity customers are “public customers.”
DCOs do not have “proprietary” accounts in the same sense that an FCM would. The relevant distinction within a DCO is between the house accounts and customer accounts that it maintains for its clearing members. For FCM clearing members, this carries forward the classification of accounts within its books and records as customer (public) and proprietary (non-public). The house accounts that clearing members establish at the DCO are the accounts through which they clear trades for their proprietary accounts (which in this context also includes their own accounts15), and correspond to the non-public customer class. The customer accounts that FCM clearing members establish at the DCO are the accounts through which they clear trades for their public customers, and correspond to the public customer class. The Code incorporates this distinction through provisions using the term “member property,” which delineates the portion of customer property held by the DCO that is available to satisfy claims of clearing members on behalf of their house accounts. “Member property” is defined in Section 761(16) of the Code as “customer property received, acquired, or held by or for the account of a debtor that is a clearing organization, from or for the proprietary account of a customer that is a clearing member of the debtor.”16
In an FCM commodity broker liquidation, claims of the FCM’s public customers have complete priority over those of its non-public customers. Section 766(h) of the Code requires the trustee to “distribute customer property ratably to customers on the basis and to the extent of such customers’ allowed net equity claims, and in priority to all other claims.” Notably, it further states “[n]otwithstanding any other provision of this subsection, a customer net equity claim based on a proprietary account, as defined by Commission rule, regulation, or order, may not be paid either in whole or in part, directly or indirectly, out of customer property unless all othercustomer net equity claims have been paid in full.”17 (Emphasis added.)
In contrast, in a DCO commodity broker liquidation, subchapter IV does not mandate that clearing members be paid in full on their claims based on their customer accounts at the DCO before they may receive any distributions on their claims based on their house accounts. This makes sense, of course, because the non-public customer class within the DCO represents proprietary accounts of the clearing members, not of the DCO. Specifically, Section 766(i) of the Code18 states:
(i) If the debtor is a clearing organization, the trustee shall distribute—
(1) customer property, other than member property, ratably to customers on the basis and to the extent of such customers’ allowed net equity claims based on such customers’ accounts other than proprietary accounts, and in priority to all other claims, except claims of a kind specified in section 507(a)(2) of this title that are attributable to the administration of such customer property; and
(2) member property ratably to customers on the basis and to the extent of such customers’ allowed net equity claims based on such customers’ proprietary accounts, and in priority to all other claims, except claims of a kind specified in section 507(a)(2) of this title that are attributable to the administration of member property or customer property.
In short, Section 766(i) requires the trustee to distribute customer property other than member property to pay claims of clearing members on behalf of their public customer accounts, i.e., in respect of their customer accounts at the DCO, and customer property designated as member property to pay claims of clearing members on behalf of their proprietary accounts, i.e., in respect of their house accounts at the DCO. It does not inherently favor public customers over non-public customers of clearing member FCMs. That said, by differentiating between member property and customer property other than member property, Section 766(i) establishes a statutory framework that allows the Commission (as it is proposing) to implement such a policy preference through its separate authority to define what is within the scope of member property and customer property other than member property. (The Commission’s rules, though, should be consistent with the Code’s member property definition.)
As mentioned, Section 20 of the CEA authorizes the CFTC to adopt rules governing the trustee’s administration of a subchapter IV proceeding. Section 20(a) states that the CFTC may provide, by rule or regulation:
(1) that certain cash, securities, other property, or commodity contracts are to be included in or excluded from customer property or member property;
(2) that certain cash, securities, other property, or commodity contracts are to be specifically identifiable to a particular customer in a specific capacity;
(3) the method by which the business of such commodity broker is to be conducted or liquidated after the date of the filing of the petition under such chapter, including the payment and allocation of margin with respect to commodity contracts not specifically identifiable to a particular customer pending their orderly liquidation;
(4) any persons to which customer property and commodity contracts may be transferred under section 766 of title 11; and
(5) how the net equity of a customer is to be determined.
Section 20 gives the CFTC important flexibility to determine, among other things, the scope of what is included in or excluded from “customer property” and, for purposes of a DCO liquidation under subchapter IV, “member property.”
Certain provisions in subchapter IV also defer to the CFTC’s authority in key areas. Section 766(d) gives the CFTC authority to protect certain transfers of commodity contracts and associated cash or other property from being avoided by the trustee in bankruptcy.19Section 766(h) recognizes the CFTC’s authority to adopt rules defining customers whose accounts are classified as “proprietary accounts” of the commodity broker and, therefore, whose claims in an FCM commodity broker liquidation are subordinated to those of public customers.
B. Interplay with SIPA
Many FCMs are registered with the Securities and Exchange Commission (“SEC”) as securities broker-dealers. A failing firm that is dually registered as an FCM and broker-dealer will be a member of the Securities Investor Protection Corporation (“SIPC”), and thus would be subject to the filing of a protective decree by SIPC, commencing a liquidation case under the Securities Investor Protection Act of 1970 (“SIPA”).20 When that occurs, SIPC will appoint the trustee, who is responsible for liquidating both the FCM and broker-dealer business lines, subject to the Bankruptcy Court’s oversight. Notably, Section 7(b) of SIPA provides that when a debtor in a SIPA proceeding is also a commodity broker, the SIPC trustee has the “same duties as a trustee” under a subchapter IV proceeding, to “the extent consistent with the provisions of this chapter or as otherwise ordered by the court.”21
C. Alternative Dodd-Frank Title II Proceeding
The insolvency of an FCM or DCO could potentially be handled as an orderly liquidation (i.e., resolution) proceeding under Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act” or “Dodd-Frank”), as an alternative to a proceeding under subchapter IV of chapter 7 of the Code. The Secretary of the Treasury (“Secretary”) has the authority to appoint a receiver for a “financial company”22 if it reaches certain determinations.23 If it initiates a Title II orderly liquidation proceeding, the Federal Deposit Insurance Corporation (“FDIC”) will be appointed as receiver to assume control over the liquidation of the company. The FDIC has authority to assume virtually complete control over the liquidation, subject only to limited court oversight.24 When the company being liquidated is a commodity broker, the FDIC is required to apply the provisions of subchapter IV “in respect of the distribution to any customer of all customer property and member property,” as if it were a debtor for purposes of subchapter IV.25
D. Current Part 190 Rules
The current Part 190 Rules give specificity to the subchapter IV provisions governing the trustee’s administration of the liquidation, and the interim operation, of the failed commodity broker. The CFTC first adopted the rules in 1983,26 pursuant to its authority under Section 20 of the CEA. Although amended over the years, the rules have largely retained their original organization, along with certain outdated provisions. The rules apply generally to commodity broker liquidations. In practical terms, though, the rules overall are tailored for administering the liquidation of an FCM. Putting aside one lone rule defining member property for purposes of a DCO liquidation, the rules make the most sense when considered in the context of an FCM liquidation. The rules embody the policies in subchapter IV by requiring the trustee to use its best efforts in an FCM proceeding to transfer all open commodity contracts and related customer property of the failed FCM’s customers to another FCM (or FCMs), and to distribute customer property pro rata to customers, giving priority to public customers over non-public customers of the FCM.
As mentioned, the rules group customers into two overarching customer classes: public customers and non-public customers, following the distinctions in the Code. A “non-public customer” is generally a customer holding a “proprietary account” at an FCM such as an affiliate or controlling person of the debtor and certain other insiders; all other customers are “public customers.”27
The rules also establish the important concept of “account classes” by dividing customer property (including open positions in commodity contracts) into separate account class pools.28 Specifically, the rules establish four account classes: (i) the futures account class, which covers customers with accounts for trading futures or options on futures on or subject to the rules of a designated contract market (a U.S. futures exchange); (ii) the foreign futures account class, which covers customers with accounts for trading futures or options on futures on or subject to the rules of a foreign board of trade; (iii) the cleared swaps account class, which covers customers with accounts for clearing transactions in swaps through a CFTC-registered DCO; and (iv) the delivery account class, which covers customers that hold property in a delivery account for the purpose of making or taking delivery of physical commodities under commodity contracts.
For public customers, the futures account class, foreign futures account class and cleared swaps account class correspond to separate customer funds segregation protections under the CEA and CFTC rules. These account class distinctions, though, are also relevant for non-public customers, whose funds are outside the scope of the CFTC’s customer funds segregation protection rules. Although the CFTC does not have segregation rules for delivery accounts, the distinction between public and non-public customers is relevant for the delivery account class as well, as public customers have a priority claim over the delivery account class property available to distribute in an FCM commodity broker liquidation proceeding.
The rules provide that customer property in an FCM liquidation is shared only by customers within a particular account class, subject to the priority that public customers have over non-public customers of the failed FCM. The public customer priority means that if there are funds remaining within an account class after satisfying the claims of public customers in that account class, but a shortfall of funds to satisfy claims of public customers in another account class, the excess must be applied to satisfy those public customer claims (jumping across account class distinctions) ahead of claims of non-public customers in the first account class. The distinctions in treatment of claims of public customers versus non-public customers reflected in the current rules are understandable when applied to an FCM and align with the Code provisions discussed above. For a DCO commodity broker liquidation, the definition of member property in Rule 190.09 is relevant, but the rule is a bit difficult to parse. Moreover, the current rules do not provide any explicit standards for distributing member property or other customer property to customers (clearing members) of the DCO, leaving the trustee with the challenging task of extrapolating the appropriate standards from the general provisions of subchapter IV of chapter 7 of the Code and current rules designed for an FCM liquidation.
III. The Commission’s Part 190 Rule Proposal
A. General Overview
The Commission is proposing to update comprehensively the current Part 190 Rules, building on the fundamental concepts in the current rules with respect to customer class and account class distinctions, pro rata distribution of customer property, and priority of public customers over non-public customers in an FCM commodity broker liquidation. The proposed changes reflect major themes: enhance the clarity and transparency of the rules; modernize the rules; improve customer protections; and establish the process for administering the liquidation of a DCO in a subchapter IV proceeding, to “foster prompt action in the event such a bankruptcy occurs, and in order to establish a clear counterfactual (i.e., ‘what would creditors receive in liquidation in bankruptcy?’) in the event of a Resolution of a DCO.”29
The CFTC largely followed the Model Part 190 Rules but made a number of changes to them. The ABA Part 190 Subcommittee had also recommended that the Commission revisit certain rules outside Part 190, including the definitions of proprietary account (Rules 1.3 and 22.1) and variation margin (Rule 1.3). The Commission acknowledged that the recommendations merit consideration but tabled them for separate consideration later due to limited staffing resources.30
Following the ABA Part 190 Subcommittee’s recommendations, the Commission proposes to reorganize Part 190 into three subparts, to enhance clarity and understanding. Subpart A contains general provisions applicable to all proceedings under the rules; subpart B contains provisions specific to a proceeding in which the debtor is an FCM (along with a rule setting out some obligations on non-debtor FCMs during business as usual); and subpart C contains provisions specific to a proceeding in which the debtor is a DCO. New subpart C is perhaps the most significant feature of the Part 190 Rule Proposal. As discussed above, the current Part 190 Rules provide scant guidance to a trustee in liquidating a DCO, and likewise for the FDIC as the counterfactual if it were called upon to liquidate a DCO in a Dodd-Frank Title II proceeding.
B. Proposed Subpart A
Proposed Subpart A contains a new rule, Rule 190.00, which explains the Commission’s statutory authority to adopt the rules, the organization of Part 190, the core concepts embodied in the Part 190 Rules, the scope of the Part 190 Rules, and certain rules of construction. The CFTC expanded and modified the text of the rule proposed by the subcommittee, but the changes overall are consistent with and improve upon the model rule text. Rule 190.00 is intended to assist trustees, bankruptcy courts, and other interested parties in understanding the CFTC’s rationale for the specific provisions in the other rules in Part 190.
Proposed Rule 190.00(d) addresses the scope of Part 190. As set out in proposed Rule 190.00(d)(1), the CFTC would explicitly limit Part 190 to the commodity broker liquidation of an FCM or a DCO.31 This follows the ABA Part 190 Subcommittee’s recommendation, and is a change to the current rules, which apply generally to commodity brokers under the broader Code definition.
Proposed Rule 190.00(d)(1) also addresses the interrelationship between subchapter IV of chapter 7 of the Code and a SIPA proceeding (relevant for the liquidation of an FCM that is also a registered broker-dealer) or an alternative Dodd-Frank Title II proceeding. Proposed Rule 190.00(d)(1)(ii) provides that Part 190 applies to the trustee in a SIPA proceeding initiated against a commodity broker. Proposed Rule 190.00(1)(iii) states that Part 190 “shall serve as guidance as to such distribution of property in a proceeding in which the FDIC is acting as a receiver pursuant to title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act with respect to a covered financial company or bridge financial company that is a commodity broker whose liquidation otherwise would be administered by a trustee under subchapter IV of chapter 7 of the Bankruptcy Code.”
Proposed Rule 190.00(c) explains concepts around the customer class and account class distinctions in the rules. There is one notable area of change with respect to account classes: the proposed rules expand the delivery account class to cover tangible and intangible commodities (e.g., foreign currencies or virtual currencies), not just tangible commodities, and divide the account class into a physical delivery account class and a cash delivery account class within which pro rata distribution of customer property would occur separately. These changes are generally consistent with the recommendations of the ABA Part 190 Subcommittee. The subcommittee proposed dividing the delivery account class into two separate classes based on the different challenges a trustee can face tracing cash versus physical delivery property that a debtor FCM records in customers’ delivery accounts and thus holds on a non-segregated basis.
Proposed Rule 190.01 would replace the current rule with an updated and revised set of definitions. The Commission accepted many of the changes that the ABA Part 190 Subcommittee recommended in the Model Part 190 Rules but revised some of the definitions and rejected others. Major changes to the current definitions include the following, among others.
- Account class. As mentioned, the Part 190 Rule Proposal retains the current account class distinctions. These are: (i) the futures account class; (ii) the foreign futures account class; (iii) the cleared swaps account class; and (iv) the delivery account class. The proposed account class definition contains within it separate definitions for each account class. The definitions for the futures, foreign futures and cleared swaps account classes cross-reference other CFTC definitions (in Rules 1.3, 30.1 and 22.1, respectively32), but those definitions only cover accounts of public customers subject to customer funds segregation requirements. The account class distinctions, though, are also relevant for propriety accounts carried by an FCM and for clearing member accounts carried by a DCO, including house accounts. The ABA Part 190 Subcommittee had proposed definitions for each account class that more broadly cover accounts of non-public customers within their scope.
- Delivery account class. The definition expands the scope of the delivery account class to cover both tangible and intangible commodities (including those that are financial in nature under the CEA’s broad definition of “commodity”33) that are recorded by the debtor as held in a delivery account. The definition also divides the delivery account class into a physical delivery account class and a cash delivery account class, as recommended by the ABA Part 190 Subcommittee.
- Cash delivery property and physical delivery property. The proposed rules contain definitions for each of these terms, which are relevant for the two classes within the delivery account class. Cash or cash equivalents are considered cash delivery property if they are recorded in the delivery account as of the filing date, but only if identified in the debtor’s books and records as having been received from or for the account of the customer during the three calendar day window before the relevant first notice date (futures) or exercise date (options). The model rule did not impose this three-day timing constraint, and it seems unnecessary and potentially detrimental to customers, by excluding cash that a customer may have posted sooner in its delivery account in anticipation of paying for a delivery from the protections of being included within the delivery account class. It also leaves a potential hole in how a customer’s claim arising from cash posted in the delivery account more than three days before the delivery notice or exercise date will be treated in an FCM bankruptcy.
The CFTC also added provisions to both definitions to clarify that if commodities are received after the filing date in exchange for cash or cash equivalents, they are treated as cash delivery property in the cash delivery account class, and conversely, that if cash is received in exchange for physical delivery property after the filing date, it is treated as physical delivery property in the physical delivery account class.
- Commodity Broker. The Commission is proposing a revised definition for this term that is limited to FCMs and DCOs, consistent with the proposal to limit application of the Part 190 Rules to such persons. The definition covers any person that is an FCM under the CEA definition. The definition in the Model Part 190 Rules (and related changes elsewhere in the model rules) would have limited the FCMs covered by Part 190 to persons that are registered or required to register as FCMs, to exclude a person covered by the CEA definition that operates pursuant to an exemption from FCM registration. That exclusion would seem appropriate for a firm acting solely for proprietary accounts pursuant to the exemption available under CFTC Rule 3.10(c)(1). (It is probably less relevant for a foreign broker operating pursuant to an exemption from FCM registration under CFTC Rule 30.10, as the insolvency proceeding of the foreign broker would most likely be handled in a main proceeding outside the U.S., not under subchapter IV of chapter 7 of the Code and Part 190.)
- Foreign clearing organization. This is a new definition for Part 190. The proposed definition covers a foreign clearing organization that clears and settles transactions in futures or options on futures executed on or subject to the rules of a foreign board of trade. The Model Part 190 Rules proposed a broader definition that would have also covered a foreign clearing organization that clears swaps for U.S. persons pursuant to an exemption from DCO registration. The Commission rejected that change, along with related changes proposed by the subcommittee that were designed to accommodate adding a foreign cleared swaps account class to Part 190 in the future, in the event the Commission were to adopt appropriate rules or exemption terms that would allow FCMs to clear swaps for customers on a foreign exempt DCO.
- Foreign futures intermediary. This is a new definition for Part 190, and one not in the Model Part 190 Rules. The term covers a foreign futures and options broker as defined in CFTC Rule 30.1(e),34 acting as an intermediary for foreign futures contracts between an FCM and a foreign clearing organization.
- House account. The current definition covers “any commodity contract account owned by the debtor.”35 The definition makes sense in relation to an FCM, but does not align with how that term is typically used in relation to a DCO, causing potential confusion under expanded Part 190 Rules with a new subpart governing a DCO bankruptcy. The Commission is proposing to expand the definition to cover the house accounts maintained by a DCO covering trades of clearing members for their own account or for accounts of their non-public customers, as recommended by the ABA Part 190 Subcommittee.
The CFTC is also proposing to expand the house account definition as it applies to an FCM, to cover any proprietary account of the FCM, and not just the FCM’s own account. This would indirectly expand the scope of the small number of rules where the term is used for purposes of an FCM proceeding, but we question whether that makes sense. (The term “house account” is used in three places in the current rules and proposed rules with respect to an FCM proceeding: (i) Rule 190.05(c)(3) and proposed Rule 190.06(a)(5) each addresses deliveries made or taken with respect to the debtor FCM’s house account under open commodity contracts; (ii) Rule 190.06(e) and proposed Rule 190.07(c) each prohibits transfer of a debtor’s house account after the filing date; and (iii) Rule 190.07(b)(2)(ix) and proposed Rule 190.08(b)(2)(vii) each provides that when a non-debtor FCM maintains an omnibus account and a house account with a debtor FCM, it holds the accounts in a separate capacity for purposes of calculating its net equity claims against the debtor FCM.)
- Member property. The proposed definition is comparable to the one in current Rule 190.09(a) and proposed in the Model Part 190 Rules (in Model Rule 190.18). The definition covers, in connection with a DCO bankruptcy, “the property which may be used to pay that portion of the net equity claim of a member which is based on the member’s house account at the clearing organization, including any claims on behalf of non-public customers of the member.” This definition differs from the one in Section 761(16) of the Code, but is intended to be consistent with that definition. The definition in Section 761(16) covers “customer property received, acquired, or held by or for the account of a debtor that is a clearing organization, from or for the proprietary account of a customer that is a clearing member of the debtor.”36 The Commission notes in the rules of construction in proposed Rule 190.02(e)(2) that Part 190 uses some different defined terms than the Code, and that “the regulations in this part are intended to be consistent with the provisions and objectives of subchapter IV of chapter 7 of the Bankruptcy Code.”
- Public Customer and Non-Public Customer. The proposed definitions differ from those in the current rules, and largely follow the definitions proposed in the Model Part 190 Rules. The Commission, though, rejected the ABA Part 190 Subcommittee’s proposal to cover public customers of foreign broker clearing members of a DCO within the public customer definition. The subcommittee included public customers of foreign brokers in contemplation that a U.S. DCO potentially could, under appropriate Commission rules or exemption terms, admit foreign brokers, not registered as FCMs, as clearing members to clear trades for their non-U.S. public customers.
- Undermargined. This is a new definition. It provides that an account carried by the debtor “is considered undermargined if the funded balance for such account is below the minimum amount that the debtor is required to collect and maintain for the open commodity contracts in such account under the rules of the relevant clearing organization, foreign clearing organization, designated contract market, swap execution facility or foreign board of trade.” Where the rules establish both an initial and a lower maintenance margin requirement, the definition provides that the trustee should use the lower maintenance margin level to determine the minimum margin requirement. The Model Part 190 Rules covered the concept of undermargined accounts in Rule 190.04(b)(2). The proposed definition largely tracks the embedded definition in the model rule text.
- Variation Settlement. The Commission is proposing to add a definition for variation settlement, as the ABA Part 190 Subcommittee recommended. However, in lieu of using the definition in the Model Part 190 Rules, the term is defined to mean variation margin as defined in CFTC Rule 1.3, along with “all other daily settlement amounts (such as price alignment payments) that may be owed or owing on the commodity contract.” Rule 1.3 defines “variation margin” to mean “a payment made by a party to a futures, option, or swap to cover the current exposure arising from changes to the market value of the position since the trade was executed or the previous time the position was marked to market.”37
The Model Part 190 Rules proposed to define variation settlement as “any amount paid or collected (or to be paid or collected) on an open commodity contract relating to changes in the market value of the commodity contract since the trade was executed or the previous time the commodity contract was marked to market along with all other daily settlement amounts (such as price alignment payments) that may be owed or owing on the commodity contract.” As noted, the Commission tabled the subcommittee’s related recommendation to amend the Rule 1.3 definition of variation margin to conform to the subcommittee’s proposed variation settlement definition.
Subpart A also contains proposed Rule 190.02, which sets out certain general provisions, including a process for the trustee to request exemption from procedural requirements of the rules and delegation of authority to the Director of the Commission’s Division of Clearing and Risk. It also contains provisions (not part of the Model Part 190 Rules): (i) providing that a person with a claim against a debtor solely on account of uncleared forward contracts is not a customer for purposes of the rules; (ii) affirming that the Code does not prevent a commodity broker from engaging in certain combinations of business activities; and (iii) affirming that security futures products held in a securities account are not “from or for the commodity futures account” or “from or for the commodity options account” of a customer as those terms are used in Code Section 761(9). In addition, notably and new to Part 190, the Commission has added that a receiver appointed for an FCM due to segregation or net capital violations may, in an appropriate case, file a petition for bankruptcy of the FCM pursuant to Section 301 of the Code.
C. Proposed Subpart B
Proposed subpart B sets out rules specific to the commodity broker liquidation of an FCM. The proposed rules largely adhere to the concepts in the current rules, but contain important changes that enhance customer protections and modernize the current rules. A number of the key changes are described below.
Communications with Customers and the Claims Process. The proposed rules replace the detailed, outdated rules specifying how the trustee must communicate with the customers of a failed FCM. Proposed Rule 190.03(a) would allow the trustee, after consulting the CFTC, to use its own reasonably designed procedures for providing notice to, and receiving claims from, the FCM’s customers, consistent with the ABA Part 190 Subcommittee’s recommendation.
The Commission is also proposing an improved, more “customer friendly” template for the proof of claim form that the trustee may, but is not required, to use. Proposed Rule 190.03(e) directs the trustee to request customers to provide certain prescribed information, but that obligation is qualified by “to the extent reasonably practicable.” The Commission made a number of changes to the Model Part 190 Rules in these areas, but the proposed rules overall are consistent with the ABA Part 190 Subcommittee’s recommendations.
Hedge Positions. Consistent with recommendations by the ABA Part 190 Subcommittee, the CFTC is proposing changes to the treatment of hedge accounts and positions. The current rules treat hedge positions as a type of specifically identifiable property and give customers special rights to avoid having their hedge positions liquidated by the trustee. Under Proposed Rule 190.03(c)(2), the trustee would only have to treat customer positions carried in a hedge account as specifically identifiable property when practicable under the circumstances, following consultation with the Commission. The change reflects that as a matter of policy the trustee should be using, and as a matter of practice does use, its best efforts to transfer all public customer positions and related customer property.
Under proposed Rule 190.10(b), FCMs would no longer have to provide hedge instruction forms to customers when they first open hedge accounts, and may designate an account as a hedge account in reliance on the customer’s representation that the account carries positions that constitute hedging “as such term may be defined under any relevant Commission regulation or rule of any clearing organization, designated contract market, swap execution facility or foreign board of trade.” (The current rules do not provide any guidance on what definition of hedging to use.) The text of proposed Rule 190.10(b) tracks the text of the model rule with some slight modifications and one addition: the Commission added that the FCM “must indicate prominently in the accounting records in which it maintains open trade balances whether, for each customer account, the account is designated as a hedging account.”
Operating the Debtor’s Estate—Customer Property. Proposed Rule 190.04 addresses how the trustee for a debtor FCM should continue to operate the FCM’s estate with respect to customer property. It sets out in paragraph (a) the trustee’s obligation to “promptly use its best efforts” to transfer positions and property of the debtor’s public customers.
The proposed rule in paragraph (b) permits the trustee to make margin payments pending the transfer or liquidation of customer positions, but subject to the restriction that the trustee may not make a margin payment with respect to a specific customer account if the payment exceeds the account’s funded balance (i.e., the customer’s pro rata share of the relevant customer property pool). It also clarifies and updates provisions with respect to the trustee’s collection of margin from the FCM’s customers.
Proposed Rule 190.04(b) also directs the trustee to liquidate positions in accounts that are in deficit or for which a customer fails to meet a margin call, and for positions liquidated by a person other than the trustee, such as a DCO or another FCM, addresses how the trustee should assign liquidating positions to customers when only a portion of the open contracts are liquidated. Paragraphs (d) and (e) of the proposed rule provide more detail relating to liquidation of open commodity contracts and customer property. Paragraph (c) directs the trustee to use its best efforts to liquidate open physical delivery commodity contracts that have not been transferred before the contracts move into a delivery position.
The proposed rule generally follows the model rule, with some clarifying revisions. As one area of substantive difference, the Commission added detail around the treatment of letters of credit in proposed Rule 190.04(d) (described below).
Letters of Credit. Proposed Rule 190.04(d) provides that, with respect to a letter of credit received, acquired or held to guarantee, purchase, secure or sell a commodity contract for a customer, a trustee may require that the customer deliver substitute customer property to the trustee, even if the letter of credit has expired after the FCM entered bankruptcy. Proposed Rule 190.04(d) further provides that the trustee may draw on any unexpired letter of credit if the customer fails to post substitute customer property within a reasonable time specified by the trustee. Finally, proposed Rule 190.04(d) provides that (i) irrespective of whether the letter of credit has expired, an undrawn letter of credit (less the amount of any substitute customer property posted by the customer per above) shall be deemed as having been distributed to the customer for purposes of distribution calculations, and (ii) all proceeds of a letter of credit drawn by the trustee—as well as any substitute customer property posted by the customer—shall be considered customer property in the account class applicable to the original letter of credit (which makes sense, as a post-bankruptcy draw or substitute posting should not morph the account class distributions and the customer’s claim entitlement).
To avoid potential conflicts between the terms of a letter of credit and the Part 190 Rule provisions—which became an issue in the MF Global case38—proposed Rule 190.10 also contains various requirements for FCMs accepting letters of credit “during business as usual” times (i.e., before any bankruptcy). Proposed Rule 190.10 provides that an FCM “shall not accept a letter of credit as collateral unless such letter of credit may be exercised through its date of expiry” under two conditions, “regardless of whether the customer posting that letter of credit is in default in any obligation.” The first condition is that the letter of credit must provide that a trustee in an FCM bankruptcy or SIPA proceeding—or a receiver under Title II of Dodd-Frank—must be able to draw on the letter of credit in accordance with Rule 190.04(d)(3) (discussed above). Similarly, the second condition is that for a letter of credit passed through to a clearing organization, the letter of credit must provide that a trustee in a DCO bankruptcy—or a receiver under Title II of Dodd-Frank—must also be able to draw on the letter of credit in accordance with Rule 190.04(d)(3).
In other words, a trustee in an FCM or DCO bankruptcy (or receiver under Title II), must be able to draw on a letter of credit without the requirement of a prior customer default. General Obligations of the Trustee in Operating the Debtor’s Estate. Proposed Rule 190.05(a) would require the trustee to “use reasonable efforts to comply with all of the provisions of the Act and of the regulations thereunder as if it were the debtor,” except as otherwise specifically provided. The rule imposes other general obligations on the trustee, as well, including notably under paragraph (f), to apply the residual interest provisions of CFTC Rule 1.1139 “in a manner appropriate to the context of their responsibilities as a bankruptcy trustee pursuant subchapter IV of chapter 7 of the Bankruptcy Code and this part, and in light of the existence of a surplus or deficit in customer property available to pay customer claims.” The model rule took a different approach, by relieving the trustee from having to comply with the residual interest provisions of Rule 1.11 while reaffirming that non-segregated property based on that exception would be customer property under the (expanded) scope of customer property definition in proposed Rule 190.09 (discussed below).
Deliveries. The Commission largely adopted, with some modifications, the ABA Part 190 Subcommittee’s recommendation to provide more detail for how to handle deliveries under physical delivery commodity contracts that move into delivery position before they are liquidated. Proposed Rule 190.06(a) directs the trustee to use reasonable efforts to allow a customer to fulfill its delivery obligations directly, outside administration of the estate, when allowed under the rules of the relevant DCO, foreign clearing organization or market. Proposed Rule 190.06(a) also contains provisions for the trustee to facilitate deliveries that cannot occur outside administration of the estate. Proposed Rule 190.06(b) contains special provisions relating to splitting the delivery account class into the cash delivery account class and physical delivery account class.
Transfers. Proposed Rule 190.07 sets out special provisions governing transfer of customer positions and accounts. The rule contains changes reflected in the Model Part 190 Rules. These include provisions (i) clarifying that the rule does not limit the contractual rights of a DCO (or other registered entity, i.e., a designated contract market or swap execution facility40) to liquidate or transfer open commodity contracts, (ii) assigning customer agreements of the debtor to the receiving FCM by operation of law; (iii) allowing the receiving FCM to accept transferred commodity contracts of customers prior to conducting its own customer due diligence (relying on the due diligence performed by the debtor FCM), but with the added requirement (not part of the model rule) that the receiving FCM must complete the due diligence within six months of the transfer, unless extended by the Commission; (iv) addressing treatment and transfer of customer letters of credit; and (v) requiring the trustee to use reasonable efforts to prevent physical delivery property from being separated from transferred commodity contract positions under which the property is deliverable.
The Commission added a provision, not part of the model rule, which would require the receiving FCM to keep commodity contracts open at least one business day after receiving them, unless the customer fails to respond within a reasonable time to a margin call to meet the margin level that the FCM would require in the ordinary course of business. The provision also prohibits the receiving FCM from collecting commissions with respect to the transfer of the commodity contracts to it.
The Commission also included a “no prejudice to other customers” provision, modified from but consistent with the model rule. The provision generally restricts the trustee from making a transfer that would result in insufficient property remaining to make equivalent percentage distributions to customers in the applicable account class.
Net Equity Claims and Allowed Net Equity Claims. Proposed Rule 190.08 sets out how to calculate a customer’s net equity claim and allowed net equity claim. It largely follows the provisions in current Rule 190.07, with some modifications and clarifications. A customer’s net equity claim, by account class, represents its claim against the debtor FCM based on the commodity contract positions and other customer property that the debtor holds on the customer’s behalf, reduced by any indebtedness the customer owes to the FCM. Net equity is calculated in a multi-step process (i) starting with the determination of the equity balance for each commodity contract account that the customer has with the FCM, in the manner prescribed in the rule, then (ii) aggregating the credit and debit equity balances of all accounts of the customer in the same account class, held in the same capacity, (iii) offsetting positive equity balances by certain amounts the customer owes to the FCM, including offsetting any negative equity balance in one account class by a positive equity balance in another account class, (iv) making adjustments to correct for distributions, and (v) making adjustments to correct for certain events.
A customer’s allowed net equity claim is the aggregate of the funded balances of its net equity claim for each account class. If the customer property pool for a particular account class is insufficient to satisfy the net equity claims of public customers in that account class, the amount each customer receives will be less than its net equity claim, representing its pro rata share of the customer property pool available to distribute. Proposed Rule 190.08(c) sets out the method for determining each customer’s pro rata share of the relevant customer property pool for each account class. The calculation is done separately for public customers and non-public customers within each account class as separate customer classes.
Scope of Customer Property: Griffin Trading and Treatment of Residual Interest. Proposed Rule 190.09(a) defines the scope of customer property. It generally follows the structure of current Rule 190.08(a), with some important changes. Notably, the Commission adopted the ABA Part 190 Subcommittee’s recommendation to include within the scope of “customer property,” property in the debtor FCM’s estate to the extent of the FCM’s obligation to maintain a targeted residual interest amount in segregation pursuant to CFTC Rule 1.11, or to cover debit balances or undermargined amounts in customer accounts as provided in other Commission rules. This provision supplements a provision in current Rule 190.08(a),41 and retained in proposed Rule 190.09 (and the model rule), that deems any cash, securities or other property in the FCM debtor’s estate to be customer property to the extent that customer property under the other definitional elements is insufficient to satisfy in full all claims of the FCM’s public customers.
In 2000, the Bankruptcy Court in In re Griffin Trading Co.42 ruled that the CFTC exceeded its statutory authority by adopting the provision in the current rule (i.e., Rule 190.08(a)(1)(ii)(J)), and ruled the provision invalid. Although the decision was vacated on appeal, and thus should have no precedential value, that history suggests the provision could be vulnerable to legal challenge. The new provision is more robust against legal challenge because it specifically covers property in the debtor’s estate that an FCM is required to set aside pursuant to Commission rule for the benefit of its customers. Thus, it is covered by the definition of customer property in Section 761(10)(A)(ix) of the Code, as “other property of the debtor that any applicable law, rule, or regulation requires to be set aside or held for the benefit of a customer.”43
Allocation of Customer Property; Priority of Public Customers. Proposed Rule 190.09 also specifies how the trustee must allocate customer property between the public customer and non-public customer classes and among account classes. (It also contains special distribution provisions addressing the return or transfer of specifically identifiable property.) The Commission makes an important clarification (not part of the model rule) with respect to allocation of customer property between the public and non-public customer classes. Specifically, proposed Rule 190.09(b) sets out more clearly than its counterpart in current Rule 190.08(b) that “[n]o customer property may be allocated to pay non-public customer claims until all public customer claims have been satisfied in full.” This provision is consistent with Section 766(h) of the Code,44 which as explained above, mandates that claims of public customers of a debtor FCM must be paid in full before non-public customers may receive any distributions on their claims.
The CFTC cannot change that statutory mandate through its rulemaking authority. The Commission does, though, have the rulemaking authority, explicitly recognized in the Code, to decide which customer accounts should be classified as proprietary, and thus as accounts of non-public customers whose claims are subordinated to those of public customers. Although the Commission has tabled the issue, it may be an appropriate time for the Commission to reconsider the broad scope of its current proprietary account definitions, e.g., is it fair or appropriate to exclude affiliates with less than 50% common ownership with the FCM45 or certain FCM employees from the protections of segregation and public customer status.
General Provisions Applicable to FCMs. The Part 190 Rule Proposal includes a standalone rule, Rule 190.10, setting out certain general provisions that apply to FCMs. As recommended by the ABA Part 190 Subcommittee, the proposed rule addresses current books and records; designation of hedge accounts (discussed above); and delivery accounts. As discussed above, the Commission also added standards for letters of credit that an FCM may accept (which were not part of the model rule).
The subcommittee proposed eliminating the requirement in current Rule 190.10 that FCMs must provide customers with a disclosure statement for non-cash margin. The Commission rejected that recommendation and includes that requirement as well in the proposed rule, but requests comment on whether the disclosure statement is necessary.
Appendix B. Appendix B to the current rules contains special bankruptcy distribution rules. Framework 1 provides special rules for distributing customer funds when the debtor FCM participated in a futures-securities cross-margining program. The ABA Part 190 Subcommittee proposed some clarifying changes to the preamble explanatory text, which the Commission included with some modifications (in particular, rejecting the subcommittee’s proposal to eliminate the reference to the restriction that only market professional customers may participate in cross-margining programs).
Framework 2 provides special rules for allocating a shortfall in customer funds to customers when the shortfall is incurred with respect to funds held in a depository outside the U.S. or in a foreign currency, due to sovereign action of a foreign government or court. The subcommittee recommended that the Commission delete framework 2. It does not appear that a trustee has ever applied the distribution framework in an FCM subchapter IV proceeding. The provisions are complicated, though, raising concerns that if and when they are applied the provisions could interfere with quick porting of positions in the event there are losses due to extraordinary foreign events.
The Commission rejected the recommendation but made some changes to the preamble explanatory text to clarify that the provisions do not apply in all cases when funds are held outside the U.S. or in a foreign currency, only when a sovereign action event occurs. Query, though, if framework 2 is retained, whether further clarifying changes would be in order. In that regard, the Commission indicated that it “would welcome proposals to simplify framework 2” (while reaffirming that it “does not intend to delete or amend that framework at this time”).46
D. Proposed Subpart C
Proposed subpart C represents a significant change to the conventional wisdom that having specific rules for administering the liquidation of a DCO could interfere with the flexibility that the trustee (along with the Commission) would need to respond swiftly and appropriately to the sui generis circumstances presented. That formerly held view explains why, save one rule defining member property, the current Part 190 Rules do not explicitly address how to liquidate a failed DCO; whether or how to operate the DCO on an interim basis; how to calculate clearing members’ net equity claims for their customer accounts and house accounts; or how to allocate and distribute customer property to clearing members to pay their net equity claims.
With the global regulatory push to move standardized swaps to centralized clearing post Dodd-Frank, the CFTC, other global financial market regulators, DCOs and other central counterparties (“CCPs”), and market participants using CCP services have paid increasing attention to issues around what would happen if a CCP fails. Much of that attention focuses on the default rules and recovery and wind-down plans that DCOs and other CCPs adopt. But there is also growing appreciation for the need for clarity on what to expect if a CCP becomes the subject of a formal liquidation proceeding, whether in the case of a U.S. DCO under subchapter IV of chapter 7 of the Code or under Title II of Dodd-Frank.47 In particular, the CFTC and others have come to recognize the importance of having clear rules that provide guidance to the FDIC on how to distribute member property and customer property other than member property if called upon to administer the liquidation of a DCO in a Title II proceeding. (The common view is that the failure of a DCO, in particular one considered systemically important, is more likely to result in a Title II proceeding given its potential impact on the U.S. economy.)
The ABA Part 190 Subcommittee early on agreed that the model rules it was drafting should contain a separate subpart governing the commodity broker liquidation of a DCO. The subcommittee was cautious, though, about providing too much detail, given the historic concern that such rules could be inhibiting. Thus, subpart C in the Model Part 190 Rules contains rules that are principles-oriented and more general in nature. To supplement the general principles, the model subpart C rules specifically recognized and gave deference to following a DCO’s recovery and wind-down plans and default rules. That approach recognizes that the DCOs are better positioned to take into account any unique considerations and issues that they face. The Commission incorporated a number of the subcommittee’s recommendations in the Commission’s proposed subpart C rules, but also made a number of changes and, notably, added detail to certain provisions. For example, the Commission provides more specificity with respect to allocating and distributing excess member property and excess customer property other than member property that may exist within a particular account class. which are changes we believe improve the Model Part 190 Rules by providing even greater guidance on those matters to the trustee, or to the FDIC under a Title II case.
In our view, the proposed rules, while more detailed than those the subcommittee proposed, strike an appropriate balance between specificity and flexibility. Like the Model Part 190 Rules, the Commission’s proposed subpart C rules (also appropriately, in our view) give deference to a DCO’s recovery and wind down plans, and default rules.
We expect that the proposed subpart C rules will be carefully evaluated by many interested parties, and some may question the rules’ deference to a DCO’s plans and default rules. We understand there are strong views and differences of opinion on the types of rules and mechanisms that a DCO may adopt for managing a default or its own recovery or wind-down, such as variation gains haircutting, and that there is room for debate on the merits of different approaches. The current rulemaking process, though, is not in our view the appropriate place for such debate. DCOs adopt their default rules and recovery and wind-down plans in accordance with their regulatory obligations under the CFTC’s Part 39 Rules,48 and the rules and plans spell out actions that a DCO may take before it becomes the subject of a formal liquidation proceeding, as well as what may happen after the initiation of a formal proceeding. It seems more appropriate for interested parties to discuss their issues with the DCOs, and with the Commission in connection with its review of DCO rules and recovery and wind-down plans.
The following discussion describes the main features of the proposed subpart C rules and highlights some issues for consideration.
Organization, Scope and Purpose. The proposed subpart C rules follow the general organization of the model subpart C rules. Proposed Rule 190.11 sets out that subpart C applies to a subchapter IV proceeding in which the debtor is a “clearing organization” (i.e., a registered DCO).
Notices, Reports and Records. Proposed Rule 190.12 contains provisions addressing giving of notices to the Commission and clearing members and providing notice by the DCO to the Commission if it files a petition in bankruptcy or has a petition filed against it. The proposed rule also requires the DCO to provide the trustee with certain reports and records required under specified Commission rules, including the most up to date versions of its default management plan, rules and procedures, and of any recovery and wind-down plans. Those records have to be provided as soon as practicable following the commencement of the proceeding, but no later than three hours after the later of the commencement of the proceeding or the appointment of the trustee (in an involuntary case), whereas the model rule proposed a one business day outside deadline. The DCO must provide other specified records to the trustee and the Commission, within one business day, including legal opinions or memoranda going back five years relating to enforceability of the DCO’s rules in the event of an insolvency proceeding involving the DCO.
Protecting Transfers from Avoidance. Proposed Rule 190.13 protects certain pre- and post-relief transfers to another DCO from being avoided under Code Sections 544, 546, 547, 548, 549, or 724(a). It generally follows the model rule, with some changes. Post-relief transfers require Commission approval, which may be given either before or after the transfer, whereas the model rule only contemplated prior approval.
Proofs of Claim. Proposed Rule 190.14(a) allows the trustee, in its discretion, to instruct customers to file proofs of claim containing such information as the trustee deems appropriate, and to seek a court order to establish a bar date for filing the proofs of claim.
Ongoing Collection of Variation and Initial Margin. Under proposed Rule 190.14(b), the trustee must stop making calls for variation or initial margin, except as explicitly provided in the rule. If the trustee believes that the continued temporary operation of the DCO would (i) facilitate prompt transfer of the DCO’s operations to another DCO or resolution of the DCO pursuant to Title II of Dodd-Frank, and (ii) be practicable in the sense that the DCO’s rules do not compel termination of all or substantially all of the outstanding contracts under prevailing circumstances and substantially all of the clearing members (other than those subject to a bankruptcy proceeding) are able and would make variation payments owed, the trustee may request the Commission’s permission to continue to operate the DCO for up to six calendar days. This provision differs substantially from the model rule, which more generally allowed the trustee, in its reasonable discretion and with the Commission’s approval, to call for and return initial margin and make/collect variation settlement payments.
The Commission added proposed Rule 190.19 (not part of the Part 190 Model Rules) to support the daily settlement process when the trustee continues the DCO’s operations under proposed Rule 190.14. The proposed rule is intended to ensure that initial margin payments are properly credited and variation pays and collects flow to applicable accounts. It also addresses how the trustee should handle shortfalls in funds received as part of the daily settlement process.
Liquidation; Return of Securities. Proposed Rule 190.14(c) requires the trustee to liquidate open commodity contracts within seven calendar days after entry of the order for relief that have not yet been terminated, liquidated or transferred, unless the Commission determines that liquidation is inconsistent with avoiding systemic risk or not in the best interests of the debtor’s estate.
Computation of Funded Balance. Proposed Rule 190.14(d), which is not part of the Model Part 190 Rules, requires the trustee to use reasonable efforts to compute a funded balance for each customer account immediately prior to distributing property within the account. The computation must be “as accurate as reasonably practicable under the circumstances, including the reliability and availability of information.” This precaution would mitigate against the risk that property could be distributed to a clearing member in excess of what it is entitled to receive.
Recovery and Wind-Down Plans; Default Rules and Procedures. Proposed Rule 190.15 generally follows the model rule recommended by the ABA Part 190 Subcommittee, with some modest revisions. Paragraph (a) prohibits the trustee from seeking to avoid or prohibit any action taken by the debtor DCO that was reasonably within the scope of and provided for in any recovery and wind-down plans of the DCO that were filed with the Commission pursuant to CFTC Rule 39.39.49.
Proposed Rule 190.15(b) requires the trustee to implement, in consultation with the Commission, the DCO’s default rules and procedures maintained under CFTC Rule 39.16 and, as applicable, CFTC Rule 39.35,50 and any termination, close-out and liquidation provisions included in the debtor DCO’s rules. The trustee’s obligation is subject to its reasonable discretion and is limited to implementing the default rules and procedures to the extent practicable.
Proposed Rule 190.15(c) requires the trustee, in consultation with the Commission, to take actions in accordance with any recovery and wind-down plans maintained by the debtor DCO that were filed with the Commission pursuant to CFTC Rule 39.39, to the extent reasonable and practicable.
Deliveries. Proposed Rule 190.16 generally follows the model rule, with some changes. It would require the trustee to use reasonable efforts to facilitate deliveries on behalf of a clearing member or its customer in a manner consistent with proposed Rule 190.06(a) (in subpart B) and the pro rata distribution concepts set out in proposed Rule 190.00(c)(5) (in subpart A). This obligation is limited to commodity contracts that have moved into delivery position prior to the date and time of the order for relief, whereas the model rule also applied to commodity contracts that move into delivery position after the date of the order for relief, when the trustee is unable to liquidate the contracts. The proposed rule also contains special provisions relating to the division of the delivery account class into a physical delivery account class and a cash delivery account class.
Net Equity Claims. Proposed Rule 190.17 addresses how to calculate each clearing member’s net equity claims. As provided in proposed Rule 190.17(a), if a clearing member clears trades through a customer account and separately through a house account (relevant for FCM clearing members), the clearing member is treated as having customer claims against the debtor DCO in those separate capacities, and also separately by account class. The proposed rule further states that the clearing member is treated as part of the public customer class with respect to claims based on its customer account(s) at the DCO and as part of the non-public customer class with respect to claims based on its house account(s) at the DCO. Net equity is calculated separately for the clearing member’s customer and house accounts and by account class.
Under proposed Rule 190.17(b)(1), the DCO’s loss allocation rules and procedures, including its default rules and procedures, are to be fully applied to the calculation of a clearing member’s net equity claim. The provision further states that this includes, “with respect to the clearing member’s house account, any assessments or similar loss allocation arrangements provided for under those rules and procedures that were not called for before the filing date, or, if called for, have not been paid.” This provision reflects the general offset concept that any amount that a customer is owed for an account with a positive net equity balance will be reduced by any amount that the customer owes to the debtor, here explicitly covering amounts that a clearing member would owe as assessments under the DCO’s rules notwithstanding that they were not called for pre-filing, as well as to amounts called pre-filing but unpaid. On the flip side, proposed Rule 190.17(b)(2) recognizes that a debtor DCO’s loss allocation rules could entitle clearing members to return of guaranty fund deposits or other mutualized default resources that are not used, or to payments out of amounts that the DCO recovers on claims against a defaulting clearing member. The provision allows for adjustment of clearing members’ net equity claims to reflect those payment entitlements. This was also not part of the model rules and is a beneficial change. But there is the separate issue as to how the customer property is allocated to the different customer classes and account classes, and whether there would be sufficient property in the relevant customer property pool to fully pay clearing members on their adjusted net equity claims. See the discussion below on allocation of customer property under proposed Rule 190.18(c).
Proposed Rule 190.17(c) then provides that net equity is “calculated in the manner provided in § 190.08, to the extent applicable.” (Proposed Rule 190.08 is the subpart B counterpart for calculating net equity for the accounts of customers of a debtor FCM.)
Calculating Funded Balances. Proposed Rule 190.17(d) provides that clearing member’s pro rata share of the customer property other than member property (for its customer accounts at the DCO) and of member property (for its house accounts) with respect to each account class is calculated as provided in proposed Rule 190.08(c). The model rule instead described the general standards for performing the calculations without cross-reference to a subpart B rule.
Treatment of Property; Guaranty Fund Deposits; DCO Assets. Proposed Rule 190.18 defines the scope of customer property for a DCO bankruptcy by account class, and the allocation of the pool of customer property between member property and customer property other than member property. It is the counterpart to proposed Rule 190.09 in subpart B, which defines the scope of customer property and the allocation of the property between the public customer and non-public customer classes in an FCM bankruptcy proceeding.
Proposed Rule 190.18(b) lists the various items of property within the scope of customer property. Customer property includes, of course, open commodity contracts and margin deposits received and held by the DCO. Notably, it also includes, as provided in paragraph (b)(1)(iii), any “guaranty fund deposit, assessment, or similar payment or deposit made by a clearing member, or recovered by the trustee, to the extent any remains following administration of the debtor’s default rules and procedures, and any other property of a member available under the debtor’s rules and procedures to satisfy claims made by or on behalf of public customers of a member.”
Proposed Rule 190.18(b) does not explicitly address whether any assets of the DCO should be included in the scope of customer property (nor did the model rule, but it did contemplate that assets of the DCO could be applied to satisfy customer claims). However, proposed Rule 190.18(b)(1)(ii)(E) (like the model rule) covers property described in proposed Rule 190.09(a)(1)(ii)(H) in subpart B, which would cover property of the DCO as the debtor thereunder that “any applicable law, rule, regulation, or order requires to be set aside for the benefit of customers.” This may arguably cover amounts the DCO commits to the financial waterfall under its rules. (The term “financial waterfall” is commonly used to refer to the types of assets available to cover losses, and the order for applying those assets, such as margin, clearing members’ guaranty fund deposits, or assets of the DCO that it pays into a guaranty fund or otherwise commits to apply to cover losses.) Query, though, whether this issue should be addressed directly in proposed Rule 190.18.
Allocation of Customer Property between Customer Classes. Proposed Rule 190.18(c) addresses allocation of customer property between customer classes and allocation of certain excess funded balance amounts between customer classes and across account classes. Notably, proposed Rule 190.18(c)(1) states that the item of customer property covered by proposed Rule 190.18(b)(1)(iii), described above, should be allocated “[t]o customer property other than member property to the extent that the funded balance is less than one hundred percent of net equity claims for members’ public customers in any account class.” (Emphasis added.) To the extent any excess remains, it would be allocated to member property. Thus, guaranty fund deposits or similar payments by clearing members made with respect to one account class could, after applying the DCO’s default rules, be used to cover any shortfall in the funded balance for another account class to pay net equity claims with respect to clearing members’ customer accounts in that other account class, instead of being returned to clearing members as member property. This is an area, then, where the CFTC, pursuant to its authority under CEA Section 20, is proposing to allocate certain property one might reasonably think of as member property to the pool of customer property other than member property, to achieve preferential treatment of the public customer class over the non-public customer class. This approach, though, could conflict with any DCO rules that limit application of a clearing member’s guaranty fund deposits to losses in the relevant clearing service covered by the guaranty fund, and would seem to go beyond what the public customers of the FCM clearing members using a particular clearing service may expect in terms of how guaranty fund deposits or similar payments will be applied to cover losses under the DCO’s rules within that ring-fenced service. The Model Part 190 Rules did not include a counterpart to proposed Rule 190.18(c)(1) and had proposed that guaranty fund deposits of clearing members would be classified as member property after payment of claims in respect of customer accounts in accordance with the DCO’s rules.
Paragraphs (c)(2) and (3) of proposed Rule 190.18 set out standards for allocating excess funds (funded balances) available to satisfy claims in respect of clearing members’ house accounts or customer accounts within an account class. As a general matter, such excess is applied first to satisfy the shortfall in the funded balance to satisfy claims of public customers in any account class, before excess is applied to satisfy a shortfall in the funded balance to satisfy claims of non-public customers in any account class, in each case potentially jumping across account classes.
We commend the Commission for proposing thoughtful, comprehensive revisions to update the Part 190 Rules. The proposed revisions, as a whole, are well-designed to achieve the Commission’s goals of enhancing the rules’ clarity and transparency, modernizing the rules, and improving customer protections.
The Part 190 Rule Proposal would also fill a critical void by establishing the process for administering the liquidation of a DCO in a subchapter IV proceeding. We think that certain features of proposed subpart C warrant discussion, but that overall the subpart C rules will provide much needed clarity and guidance.
The Commission is requesting comments on all aspects of the proposal and poses a number of questions for input on specific features in the notice of proposed rulemaking. We encourage interested parties to review the proposal carefully and provide their comments to the Commission on this important rulemaking initiative.
The ABA Part 190 Subcommittee appreciated the opportunity to work with the Commission staff in updating the Part 190 Rules. The Commission has generally done an excellent job in tackling a complex topic and proposing comprehensive changes to improve and modernize the Part 190 Rules for years to come. We eagerly await the Commission’s adoption of final revisions after giving its careful attention to the comments it receives, but we also hope that the updated rules never get tested in practice!
1 Bankruptcy Regulations, 85 FR 36000 (June 12, 2020) (Notice of proposed rulemaking).
2 In February 2015, the ABA Derivatives & Futures Law and Business Bankruptcy Committees formed the ABA Part 190 Subcommittee, with the civic-minded goals of conducting a holistic review of the Part 190 Rules and proposing changes to update them in light of the realities of today’s markets. The Part 190 Subcommittee is co-chaired by Vince Lazar on behalf of the Business Bankruptcy Committee and Kathryn Trkla on behalf of the Derivatives & Futures Law Committee. The subcommittee’s 45 plus members include attorneys at law firms, FCMs, DCOs, exchanges, government agencies and industry associations, along with attorneys who served as, or represented, trustees in FCM bankruptcy proceedings.
3 For background, see K. Trkla, The Time May Be Ripe to Update the CFTC’s Commodity Broker Rules, FDLR (July 2018). The subcommittee electronically filed the transmittal letter and draft Model Part 190 Rules in two filings. The transmittal letter also provides background on the ABA Part 190 Subcommittee and the Model Part 190 Rules. The filings are available at https://comments.cftc.gov/PublicComments/CommentList.aspx?id=1807.
4 Remarks of CFTC Chief of Staff Michael Gill at the National Press Club, CFTC Kiss Policy Forum (Feb. 12, 2018).
5 11 U.S.C.A. §§ 761-767. A commodity broker is not eligible to file bankruptcy under chapter 11, which is the Code’s reorganization chapter. Almost all FCMs are organized and located in the U.S., as are most DCOs, but a few are non-U.S. The bankruptcy of a non-U.S. FCM would likely be administered under a main proceeding in the FCM’s home jurisdiction, not under a subchapter IV proceeding and the Part 190 Rules.
6 7 U.S.C.A. § 24.
7 11 U.S.C.A. § 101(6).
8 It also covers a “foreign futures commission merchant,” which is simply a futures commission merchant that handles orders for futures or options on futures traded on or subject to the rules of a foreign board of trade.
9 11 U.S.C.A. § 761(2).
10 11 U.S.C.A. § 761(9).
11 The Code definition, though, could reasonably be read to cover swaps under the prong describing “any other contract, option, agreement, or transaction that is similar to a contract, option, agreement, or transaction referred to in this paragraph” and, with respect to an FCM or a DCO, any “other contract, option, agreement or transaction” that is cleared by a DCO. 11 U.S.C.A. § 761(4)(F).
12 7 U.S.C.A. § 6d(f)(5). This provision states: “A swap cleared by or through a derivatives clearing organization shall be considered to be a commodity contract as such term is defined in section 761 of title 11, with regard to all money, securities, and property of any swaps customer received by a futures commission merchant or a derivatives clearing organization to margin, guarantee, or secure the swap (including money, securities, or property accruing to the customer as the result of the swap).”
13 See Section 766(h) of the Code. 11 U.S.C.A. § 766(h). Admittedly, this section and Section 766(i), which reflects the public vs. non-public customer distinction at a DCO, are not as clearly drafted as ideally one may wish.
14 See the definitions of “proprietary account” in CFTC Rule 1.3 and “cleared swaps proprietary account” in Rule 22.1. 17 CFR §§ 1.3 and 22.1.
15 The CFTC’s definitions of proprietary account in Rules 1.3 and 22.1 include a person’s own account, as well as the accounts of affiliates and other insiders.
16 11 U.S.C.A. § 761(16).
17 11 U.S.C.A. § 766(h).
18 11 U.S.C.A. § 766(i).
19 11 U.S.C.A. § 766(d)(2). This provision protects transfers made before the seventh day after the order for relief against avoidance by the trustee, when the transfers are approved by the CFTC by rule or order either before or after the transfer.
20 15 U.S.C.A. §§ 78aaa et seq.
21 15 U.S.C.A. § 78fff-1(b).
22 As defined in 12 U.S.C.A. § 5381(a)(11), a financial company is a company that (i) is incorporated or organized under U.S. federal or state law; (ii) is (A) a bank holding company, (B) a nonbank financial company supervised by the Board of Governors, (C) a company “predominantly engaged in activities that the Board of Governors has determined are financial in nature or incidental thereto for purposes of section 1843(k) of this title,” or (D) a subsidiary of a company described in any of the foregoing that is “predominantly engaged in activities that the Board of Governors has determined are financial in nature or incidental thereto for purposes of section 1843(k) of this title (other than a subsidiary that is an insured depository institution or an insurance company)”; and (iii) is not chartered under and subject to the Farm Credit Act of 1971, or a governmental or regulated entity, as defined in section 4502 of this title.
23 The Secretary, after receiving recommendations from the FDIC and the Board of Governors of the Federal Reserve, must determine, among other things, that (i) the financial company is in default or in danger of default; (ii) its failure and resolution under other applicable law would “have serious adverse effects on financial stability” in the U.S.; (iii) a viable private sector alternative for preventing the default is not available; (iv) any effect on the claims or interests of creditors or certain other interested parties resulting from actions taken under Title II are appropriate given the impact that such actions would have on U.S. financial stability; and (v) any action taken would avoid or mitigate the adverse effects, taking into consideration the action’s effectiveness in “mitigating potential adverse effects on the financial system, the cost to the general fund of the Treasury, and the potential to increase excessive risk taking on the part of creditors” and certain other interested parties. 12 U.S.C.A. § 5383(b).
24 12 U.S.C.A. §§ 5390(a) and 5390(e). The FDIC may create a “bridge financial company” to receive the transfer of selected assets and liabilities of the covered financial company, and may sell the company’s assets to one or more transferees without court approval or advance notice to creditors or shareholders. 12 U.S.C.A. §§ 5390(h) and 5390(a)(1)(G).
25 12 U.S.C.A. § 5390(m)(1)(B).
26 Bankruptcy, 48 FR 8716 (March 1, 1983).
27 17 C.F.R. § 190.01(cc).
28 Part 190 also establishes an account class for leverage accounts, but that is only relevant for a commodity broker that is a leverage transaction merchant, and currently there are none.
29 Fact Sheet: Notice of Proposed Rulemaking - Part 190 Bankruptcy Regulations (Ap. 14, 2020), available at https://cftc.gov/PressRoom/PressReleases/8147-20.
30 85 FR 36042. The subcommittee also recommended (among other things) that the CFTC consider revisions to the Part 22 segregation rules for cleared swaps to address products cleared by DCOs that are not swaps, futures or options on futures, and consider removing the Part 31 rules governing activities of leverage transaction merchants.
31 Proposed Rule 190.00(d)(1)(i)(B) states that the CFTC intends to adopt rules governing the commodity broker liquidation of a commodity options dealer or leverage transaction merchant at such time as such a person registers with the CFTC in that capacity.
32 17 C.F.R. § 1.3 (“futures account” definition), § 30.1(g) (“30.7 account” definition) and § 22.1 (“cleared swaps account” definition).
33 7 U.S.C.A. § 1a(9).
34 17 C.F.R. § 30.1(e).
35 17 C.F.R. § 190.01(x).
36 11 U.S.C.A. § 761(16).
37 17 C.F.R. § 1.3.
38 See In re MF Global Inc., 484 B.R. 18, 57 Bankr. Ct. Dec. (CRR) 82 (S.D. N.Y. 2012); ConocoPhillips Co. v. Giddens (In re MF Global Inc.), 12 Civ. 6014, 2012 U.S. Dist. LEXIS 144601 (S.D.N.Y. Oct. 4, 2012).
39 17 C.F.R. § 1.11.
40 See the definition in Section 1a(40) of the CEA, 7 U.S.C.A. § 1a(40).
41 17 C.F.R. § 190.08(a)(1)(ii)(J).
42 In re Griffin Trading Co., 245 B.R. 291, Comm. Fut. L. Rep. (CCH) P 28040 (Bankr. N.D. Ill. 2000), judgment vacated, 270 B.R. 882 (N.D. Ill. 2001).
43 11 U.S.C.A. § 761(10)(A)(ix).
44 11 U.S.C.A. § 766(h).
45 On the other hand, narrowing the definition as applied to affiliates could affect firms that clear trades for proprietary accounts in reliance on the exemption from FCM registration available under CFTC Rule 3.10(c).
46 Part 190 Rule Proposal, at 173.
47 Some CCPs registered with the CFTC as DCOs are organized outside the U.S. and have their main center of business outside the U.S. The insolvency of a foreign DCO will more likely be administered under the bankruptcy laws or orderly resolution counterpart to Title II in its home jurisdiction. Query whether the trustee or liquidator appointed in that jurisdiction would be required to consider subpart C as a relevant counterfactual with respect to liquidating the foreign DCO’s FCM client clearing operations.
48 17 C.F.R. Pt. 39.
49 17 C.F.R. § 39.39. This rule applies to a systemically important DCO or to a DCO that elects to comply with the special requirements for systemically important DCOs set out in subpart C of Part 39.
50 17 C.F.R. §§ 39.16 and 39.35. Rule 39.16 applies generally to DCOs. Rule 39.35 applies only to a systemically important DCO or to a DCO that elects to comply with the special requirements for systemically important DCOs set out in subpart C of Part 39.