Business Law Today: Banks enter a new age

ABA Section of Business Law
Business Law Today
July/August 1998

Banks enter a new age
Do their products come under the Commodity Exchange Act?

By STEPHEN F. SELIG

Selig is counsel to Baer Marks & Upham LLP in New York City.

Let's face it: Banks are getting into new games. Either directly or through affiliates, as banks engage in a broader range of activities under newly granted regulatory authority, they may find themselves — perhaps inadvertently — subject to the jurisdiction of the Commodity Futures Trading Commission (CFTC or the commission) an independent federal agency analogous to the SEC.

To put this in perspective, we'll first outline the nature and scope of the commission's regulatory authority under the Commodity Exchange Act (act) and then discusses the impact of such regulatory authority on a bank's proprietary trading activities, advisory activities and brokerage activities. Obviously, even if the commission has jurisdiction with respect to a bank's activities, that jurisdiction does not replace the jurisdiction of the bank's primary regulators. This article does not address the relations between a bank and its primary regulators.

Under the act, the commission has, subject to certain significant exceptions, "exclusive jurisdiction" with respect to "accounts, agreements (including any transaction which is in the character of, or is commonly known to the trade as, an option . . ., and transactions involving contracts of sale of a commodity for future delivery, traded or executed on a contract market . . . or any other board of trade, exchange, or market . . ." Section 2(a)(1)(A)(i).

The vital phrase "contract of sale of a commodity for future delivery," which is the basis for the commission's jurisdiction, is not defined in the act or in CFTC regulations. However, the statute does provide that the term "future delivery" does not include any sale of any cash commodity for deferred shipment or delivery. Section 1(a)(11). Further, the so-called "Treasury Amendment" to the act provides that nothing in the act "shall be deemed to govern or in any way be applicable to transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, government securities or mortgages or mortgage purchase commitments unless such transactions involve the sale thereof for future delivery conducted on a board of trade." Section 2(a)(1)(A)(ii).

Thus, to determine whether the commission has jurisdiction with regard to a given market instrument, it is first necessary to determine whether that instrument is either a futures contract or a commodity option. Even if the answer to that question is yes, it is next necessary to determine whether the Treasury Amendment applies and ousts the CFTC of jurisdiction. Not surprisingly, there are gray areas. The CFTC has conceded that foreign exchange (forex) transactions in the interbank market and with commercial users of forex are outside its jurisdiction and the U.S. Supreme Court has rejected its contention that retail sales of OTC forex products are within its jurisdiction.

Another ambiguity-filled area is swap transactions. No court has stated whether a swap is in fact a futures contract or a commodity option and, until recently, neither had the commission. However, in February 1998, the CFTC, in commenting on the SEC's proposal to adopt rules (popularly called broker-dealer lite) governing certain dealers active in the OTC derivatives markets, asserted (without giving examples or citations) that many swaps constitute futures or commodity options. Subsequently, on May 7, 1998, the commission issued a concept release running 29 single-spaced pages and raising 75 specific questions relating to regulation of OTC derivatives.

However, even assuming that a swap is a futures contract or commodity option, a swap agreement between "eligible swap participants" (a term that includes all banks, broker/dealers and business entities that either have $10 million in total assets or $1 million in net assets and enter into a swap transaction for a business-related purpose) is exempt from all provisions of the act except those relating to anti-fraud and anti-manipulation. CFTC Regulation §§ 35.1 and 35.2. Thus, as a practical matter, the only risk to which a bank may be subject is when a swap counterparty seeks to void a transaction on the ground that the bank has engaged in fraud.

Like swaps, questions have arisen whether a so-called hybrid instrument (typically a debt security, a preferred stock or a depository instrument such as a CD) with an interest rate or dividend rate or principal repayment amount tied to the value of a commodity involves the sale of a commodity option in violation of CFTC rules. Pursuant to the act's Section 4c(b) and CFTC Regulations Part 32, the only OTC commodity options that may be offered and sold in the United States are so-called trade options.

A trade option is a "commodity option" offered by a person that "has a reasonable basis to believe that the option is offered to a producer, processor or commercial user of, or a merchant handling, the commodity which is the subject of the commodity option transaction, or the products or by-products thereof, and that such producer, processor, commercial user or merchant is offered or enters into the commodity option transaction solely for purposes related to its business as such." CFTC Regulation § 32.4(a).

An illustration of the hybrid instrument issue involves Wells Fargo Bank, which, at some time in the 1980s, offered CDs with a below-market interest rate but with the promise of an increased interest rate based on the price of gold at the time the CD matured. The commission claimed that the CDs were illegal off-exchange commodity options (the difference between the below-market interest rate and the market rate for a like CD was deemed to be the premium for the option). Wells Fargo Bank settled the proceedings by, among other things, rescinding the issuance of the CDs.

To resolve the hybrid instrument problem, in 1989 the CFTC added Part 34 to its regulations. That in essence provides that if the "commodity dependent value" of the instrument is less than the "commodity independent value" of the instrument, it is exempt from the act. These two phrases can only bring tears to a lawyer's eyes and joy to an economist's soul. The "commodity independent value" of an instrument, in broad terms, is that portion of such value that is not attributable to indexing to, or calculation by reference to, the price of a commodity.

The commission's regulatory authority with respect to futures and commodity options encompasses: (1) regulation of markets and market instruments, and (2) regulation of market professionals, such as:

Futures commission merchants (FCMs) — the functional equivalent of a securities broker (there is no such thing as a futures dealer)
Commodity trading advisors (CTAs) — the functional equivalent of an investment adviser and
Commodity pool operators (CPOs) — the functional equivalent of the organizer of an investment company, hedge fund or other pooled-investment vehicle.

So what is the commission's impact on bank activities?

Obviously, a bank must first determine whether it is dealing in instruments that are subject to CFTC jurisdiction (such as, futures or commodity options) or may be subject to CFTC jurisdiction (such as, swaps or hybrid instruments). If it is, it must make certain that its activities involving these instruments are in compliance with the Commodity Exchange Act and commission regulations. Specifically, the bank must review its activities in each of the following areas:

Proprietary trading and managing the bank's own assets and liabilities;
Investment management;
Brokerage; and
Acting as an OTC derivative dealer.

From a bank's perspective, a proprietary account includes an account for the bank itself, any business affiliate that directly or indirectly controls the bank, any business affiliate that directly or indirectly is controlled by or under common control with the bank, any officer, director or owner of 10 percent or more of the capital stock of the bank, any bank employee whose duties include the management of the business of the bank and, with respect to any of these individuals, any spouse or minor dependent living in the same household as any of those persons. CFTC Regulation § 1.3(y). The scope of this definition means that a bank or bank affiliate can effect futures and commodity options transactions for all entities in the group and for certain individuals without having to be registered with the commissiion as a futures commission merchant or having to be a member of National Futures Association (a futures self-regulatory organization analogous to the NASD). However, a bank (like any other party that trades futures) is subject to various regulatory requirements:

The CFTC and the various exchanges have open futures contract- and commodity-option-reporting requirements;
If a trader has a position that equals or exceeds the commission's reporting level, the FCM with which the trader has an account will notify the commission on Form 102 and if an exchange has a lower reporting level, the FCM will similarly notify the exchange;
The CFTC will then send the trader a Form 40, which seeks information about the trader, its futures trading activities and the personnel effecting trading and must be updated annually; and
Thereafter, each FCM with which the trader does business will submit a Form 104 listing the trader's open positions. In addition, the various exchanges have speculative position limits or position responsibility limits. However, a party engaging in hedging and other risk management activities normally can obtain an exemption from position limits from the applicable exchange.

All exchanges, as part of their statutory responsibility to maintain orderly markets, have broad authority to act if they believe there is a potential congestion or a possible squeeze or corner in a commodity delivery month to order parties to liquidate open positions in a specified manner. Finally, there also are a number of prohibitions applicable to traders that are similar to or analogous to those contained in the securities laws. For example:

It is unlawful to manipulate or attempt to manipulate the price of a commodity. CEAct Section 9(a)(2). Recently a firm settled charges that it had manipulated 10-year Treasury Note futures prices on the CBT by intentionally gaining and maintaining control over the cheapest-to-deliver notes under the June 1993 contract. In the Matter of Fenchurch Capital Management, Ltd. (CCH ¶ 26,747, July 10, 1996).
Interestingly, insider trading, as that concept exists in securities regulation, does not exist in futures trading. One of the functions of futures trading is price discovery and that process requires that persons can trade futures even if they have "inside" information regarding a company's plans to, for example, export vast quantities of wheat to Russia. However, it is a felony for someone to trade based on material, nonpublic information that trader knows was improperly obtained from an employee, member of the governing board or member of any committee of a futures exchange. Section 9(f)(2).

The Commodity Futures Trading Commission has extensive regulations covering CTAs and CPOs.
Turning first to CTAs, a CTA is defined as "any person who, for compensation or profit, engages in the business of advising others either directly or through publications, writings or electronic media as to the value or the advisability of trading in . . ." futures contracts traded on a U.S. exchange and any commodity option. CEAct Section 1(a)(5). CFTC Regulation § 30.4(d) extends the definition to include persons who solicit or enter into agreement with U.S. customers to direct or guide the customer's account using foreign futures or foreign option contracts.

Both the statutory and regulatory definitions exclude a bank or trust company or any employee thereof, provided that the furnishing of such services by any of the foregoing is solely incidental to the conduct of its trade or business. It is worth noting that the "solely incidental" requirement does not appear in the comparable exclusion contained in Section 202(a)(11) of the Investment Advisers Act of 1940.

In CFTC Interpretative Letters 83-2 (CCH ¶ 21,788) and 84-16 (CCH ¶ 22,374), the commission addressed the applicability of the phrase "solely incidental" to a bank: In Interpretative Letter 83-2, a bank offered a financial futures advisory service (for which it received a fee) to customers which were correspondent banks, S&Ls and commercial and industrial entities all of which had preexisting relations with the bank, including bond trading, funds transfer, commercial lending and other cash management services. In finding that the bank's services were "solely incidental" to its banking business, the staff stated that its conclusion was based upon its understanding from the bank's representations that: (1) the bank's financial futures advisory service is offered in connection with its rendition of other commercial banking services; (2) the bank limits its trading advisory activities to hedging programs using financial futures contracts; (3) the bank does not actively market this service; and (4) revenues from this service constitute a minimal percentage of the bank's consolidated revenue and also of its banking revenue, as separately stated. The staff also expressly noted that:

Although the staff does not employ a numerical standard for the portion of a person's business which may be devoted to providing commodity trading advice which is "solely incidental" to its business, the information contained relating to the bank's revenues is relevant to arriving at the conclusion reached in the letter as it is part of the factual context in which the bank renders its financial advisory service.

If the bank were to market its financial futures advisory service to the general public or even to customers of the bank whose sole relationship with the bank is that of a depositor, the staff does not believe that the service would be "solely incidental" to the conduct of its banking business. In Interpretative Letter 84-16, the CFTC staff found that nonspeculative futures trading conducted by a nondepository trust company as fiduciary for corporate employee benefit plans and collective trust funds was "solely incidental" to its activities to a trust company and in its capacity as a fiduciary of the trusts.

One might ask whether the limitation of the no-action relief to hedging activities is appropriate at this time (assuming that it ever was). As we move from the "prudent man" rule to the "prudent expert" rule and investing in futures and other nontraditional vehicles is becoming more acceptable, it is, at the least, arguable that a bank should be able to advise a customer to commit x percent of his or her assets to futures or, if acting in a fiduciary capacity, to allocate y percent of an entity's assets to futures trading without having to register as a CTA.

Even if a bank cannot avail itself of the "solely incidental" exclusion, CFTC Regulation § 4.14(a)(8) exempts a bank from registration as a CTA provided that the bank's commodity interest trading advice is directed solely to an investment company registered as such under the Investment Company Act of 1940, an insurance company separate account or an ERISA plan and it renders such advice solely incidental to its business of providing securities advice to such entity and it uses only risk-reduction activities consistent with CFTC Regulation § 4.5.

To avail itself of this exemption, the bank must file a notice of exemption with the commission under Regulation § 4.14(a)(8).

Lastly, the Commodity Exchange Act also contains a provision, like that contained in the Investment Advisers Act, that a person who has 15 or fewer customers in any 12-month period and does not hold itself out to the public as a CTA is exempt from registration as a CTA. Section 4m(1). However, the commission has not adopted a rule comparable to SEC Rule 203(b)3-1(b), which provides that, in most instances, a limited partnership — and not the limited partners — is counted as the client of the investment adviser. The CFTC staff orally has expressed the position that in calculating the 15-person exemption, it will include the number of participants in a pooled futures investment vehicle even if the CTA has had no involvement in the formation of the investment vehicle or the solicitation of investors. However, the CFTC staff also has stated that an entity may combine the exemptions in Regulation § 4.14(a)(8) and CEAct Section 4m(1).

Looking next to CPOs, a CPO is defined to be any person "engaged in a business that is of the nature of an investment trust, syndicate or similar form of enterprise, and who, in connection therewith, solicits, accepts or receives from others, funds, securities or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise for the purpose of trading in any commodity for future delivery on or subject to the rules of any contract market." CEAct Section 1(a)(4).

CFTC Regulation § 30.4(c) extends the definition to persons who deal with U.S. customers on behalf of entities trading futures and options traded on non-U.S. exchanges. While there are no express statutory exclusions or exemptions from the definition of CPO, the commission is authorized to exclude from the definition "such persons not within the intent of the definition of the term as the [CFTC] may specify by rule, regulation or order." Section 1(a)(4). CFTC Regulation § 4.5 offers banks two possible exclusions:

A bank, trust company or other financial depository institutions subject to regulation by any state or the United States is excluded from the definition of CPO with respect to the assets of any trust, custodial account or other separate unit of investment for which it is acting as a fiduciary and for which it is vested with investment authority. CFTC Regulation §§ 4.5(a)(3) and (b)(3) (emphasis added).

In addition, a noncontributory defined benefit or defined contribution plan covered under Title 1 of ERISA, a contributory defined benefit plan covered under Title 4 of ERISA (provided that, if an employee may voluntarily contribute to such plan, no portion of such contribution is committed as margin or premiums for futures or options contracts), a plan defined as a government plan in Section 3(32) of Title 1 of ERISA and any employee welfare benefit plan that is subject to the fiduciary responsibility provisions of ERISA all are deemed not to be pools.

Therefore, the trustee or a named fiduciary of any such plan is not be a CPO. CFTC Regulation § 4.5(a)(4). With respect to other pension plans that are subject to Title 1 of ERISA, a trustee, a named fiduciary or an employer maintaining such a pension plan may be excluded from the definition of CPO. CFTC Regulation §§ 4.5(a)(4) and (b)(4). The difference between the two provisions is that the former only applies if the bank has investment authority with respect to the trust or account while the latter would apply to a bank that is acting as a directed trustee of a plan.

In addition, the CFTC staff has granted no-action relief where the investment vehicle does not fit within the scope of § 4.5 but where the staff concluded there were comparable protections: A Canadian pension group trust (Interpretative Letter 96-60, CCH ¶ 26,778); a group trust including pension plans, profit sharing plans and governmental pension plans (Interpretative Letter 94-52, CCH ¶ 26,116); and foreign pension plans of subsidiaries of a large publicly traded U.S. corporation (Interpretative Letter 90-3, CCH ¶ 24,581). Technically, a no-action letter only benefits the entity to which it is addressed. Thus, even if a bank has a situation factually similar to — or even the same as — the facts in a published no-action letter, it should give consideration to requesting no-action relief itself.

To obtain the exclusion provided by Regulation § 4.5, a bank must file a notice of eligibility that contains the information specified in Regulation § 4.5(c). The primary substantive requirement in the notice of eligibility is a representation that the entity will use futures or commodity options solely for bona fide hedging purposes or, in addition, with respect to nonhedging positions, a representation that the aggregate initial margin and premiums required to establish such positions will not exceed 5 percent of the liquidating value of the qualifying entity's portfolio after taking into account unrealized profits and unrealized losses but excluding the in-the-money portion of a premium for an option that is in-the-money at the time of purchase.

Simply stated, a bank cannot act as an FCM (except for proprietary accounts that are discussed above) without being registered as such with the CFTC. The Commodity Exchange Act does not contain language similar to Sections 3(a)(4) and (5) of the Securities Exchange Act of 1934 which exclude banks from the definition of "broker" and "dealer." Banks that want to act as an FCM invariably set up a separate subsidiary that registers as an FCM with the commission.

Typically, a bank's activities in the OTC derivatives market should not present regulatory problems. If the bank is acting as a swaps dealer, it must satisfy itself that its counterparties are "eligible swap participants." If it is selling a hybrid security, it must determine that the "commodity dependent value" of the instrument is less than the commodity independent value. A bank's forex activities should be within the scope of the Treasury Amendment. However, if a bank is dealing in options that are not options on securities or options on instruments described in the Treasury Amendment, it should have a reasonable basis for believing that a party to which an option is offered is a commercial party with respect to the underlying commodity and that such party proposes to enter into the option transaction solely for purposes related to its business as such.

The conclusions that a bank can draw from all of this are as follows:

A bank that deals in certain commodity options or swaps or that issues hybrid securities should not be subject to the commission's jurisdiction, but until the question whether certain swaps are futures contracts or commodity options is answered, there is the risk of litigation with counterparties.
A bank that uses futures or options in a proprietary capacity may have some forms to fill out and reports to file but otherwise should have no concerns about either the commission or the exchanges.
If a bank complies with the limitations discussed above, it should be able to structure its investment advisory activities to avoid registration as a CPO or a CTA.
A bank cannot act as a futures broker (except for proprietary accounts) without registering as an FCM.