This section of the FEDERAL REGISTER

contains notices to the public of the proposed

issuance of rules and regulations. The

purpose of these notices is to give interested

persons an opportunity to participate in the

rule making prior to the adoption of the final

rules.

Proposed Rules Federal Register

59624

Vol. 62, No. 213

Tuesday, November 4, 1997

1Commodity Exchange Act of 1936, Pub. L. No.

74–675, 49 Stat. 1491 (1936). See, H. Rep. No. 421,

74th Cong., 1st Sess. 1, 2 (1934); H. Rep. No. 1551,

72d Cong., 1st Sess. 3 (1932).

2Examples of nonenumerated commodities

would include coffee, sugar, gold, and foreign

currencies. Before 1974, the Act covered only those

commodities enumerated by name. The 1936 Act

regulated transactions in wheat, cotton, rice, corn,

oats, barley, rye, flaxseed, grain sorghum, mill

feeds, butter, eggs, and Solanum tuberosum (Irish

potatoes). Act of June 15, 1936, Pub. L. 74–675, 49

Stat. 1491 (1936). Subsequent amendments to the

Act added additional agricultural commodities to

the list of enumerated commodities. Wool tops were

added in 1938. Commodity Exchange Act

Amendment of 1938, Pub. L. 471, 52 Stat. 205

(1938). Fats and oils, cottonseed meal, cottonseed,

peanuts, soybeans, and soybean meal were added

in 1940. Commodity Exchange Act Amendment of

1940, Pub. L. 818, 54 Stat. 1059 (1940). Livestock,

livestock products, and frozen concentrated orange

juice were added in 1968. Commodity Exchange

Act Amendment of 1968, Pub. L. 90–258, 82 Stat.

26 (1968) (livestock and livestock products); Act of

July 23, 1968, Pub. L. 90–418, 82 Stat. 413 (1968)

(frozen concentrated orange juice). Trading in onion

futures on United States exchanges was prohibited

in 1958. Commodity Exchange Act Amendment of

1958, Pub. L. 85–839, 72 Stat. 1013 (1958).

3Congress accomplished this by adding to the list

of enumerated commodities an expansive catch-all

definition of ‘‘commodity’’ which included all

‘‘services, rights, or interests in which contracts for

future delivery are presently or in the future dealt

in.’’ The definition of commodity is currently

codified in section 1a(3) of the Act.

4Section 4c(b) of the Act provides that no person

‘‘shall offer to enter into, or confirm the execution

of, any transaction involving any commodity

regulated under this Act’’ which is in the nature of

an option ‘‘contrary to any rule, regulation, or order

of the Commission prohibiting any such transaction

or allowing any such transaction under such terms

and conditions as the Commission shall prescribe.’’

7 U.S.C. 6c(b).

COMMODITY FUTURES TRADING

COMMISSION

17 CFR Parts 3, 32, and 33

Trade Options on the Enumerated

Agricultural Commodities

AGENCY: Commodity Futures Trading

Commission.

ACTION: Notice of proposed rulemaking.

SUMMARY: Generally, the offer or sale of

commodity options is prohibited except

on designated contract markets. One of

several specified exceptions to the

general prohibition on off-exchange

options is for ‘‘trade options.’’ Trade

options are defined as off-exchange

options ‘‘offered by a person having a

reasonable basis to believe that the

option is offered to’’ a person or entity

within the categories of commercial

users specified in the rule, where such

commercial user ‘‘is offered or enters

into the transaction solely for purposes

related to its business as such.’’ Trade

options, however, are not permitted on

the agricultural commodities which are

enumerated in the Commodity

Exchange Act (Act).

The Commodity Futures Trading

Commission (Commission or CFTC) is

proposing to remove the prohibition on

off-exchange trade options on the

enumerated agricultural commodities

pursuant to a three-year pilot program.

The Commission is proposing initially

to permit agricultural trade options

which, if exercised, will result in

delivery of the commodity and which

may not be resold, repurchased, or

otherwise cancelled other than through

the exercise or natural expiration of the

contract. The Commission is also

proposing to permit only those entities

which handle the commodity in normal

cash market channels to offer to buy or

sell such options. Such entities, in order

to sell agricultural trade options (puts

and calls), would be required to become

registered as agricultural trade option

merchants, to report to the Commission

on their transactions, to provide their

customers with disclosure statements,

and to safeguard their customers’

premiums. The Commission is also

proposing to exempt from the

prohibition and these proposed rules

individuals or entities which meet a

substantial financial requirement.

Finally, the Commission is proposing to

remove the prohibition on the offer or

sale of exchange-traded options on

physicals on these commodities.

DATES: Comments must be received by

December 4, 1997.

ADDRESSES: Comments should be

mailed to the Commodity Futures

Trading Commission, Three Lafayette

Centre, 1155 21st Street, N.W.,

Washington, D.C. 20581, attention:

Office of the Secretariat; transmitted by

facsimile at (202) 418–5521; or

transmitted electronically at

[secretary@cftc.gov]. Reference should

be made to ‘‘Agricultural Trade

Options.’’

FOR FURTHER INFORMATION CONTACT: Paul

M. Architzel, Chief Counsel, Division of

Economic Analysis, Commodity Futures

Trading Commission, Three Lafayette

Centre, 1155 21st Street, N.W.,

Washington, D.C. 20581, (202) 418–

5260, or transmitted electronically at

[PArchitzel@cftc.gov].

SUPPLEMENTARY INFORMATION:

I. Background

A. The Prohibition of Agricultural Trade

Options

In 1936, responding to a history of

large price movements and disruptions

in the futures markets attributed to

speculative trading in options, Congress

completely prohibited the offer or sale

of option contracts both on and off

exchange in all commodities then under

regulation.1 Over the years, this

statutory bar continued to apply only to

the commodities originally regulated

under the 1936 Act. The specific

agricultural commodities originally

regulated under the 1936 Act included,

among others, grains, cotton, butter,

eggs, and potatoes. Later, fats and oils,

soybeans and livestock, as well as

others, were added to the list of

enumerated agricultural commodities.

Any commodity not so enumerated,

whether agricultural or not, was not

subject to regulation. Thus, options on

such nonenumerated commodities were

unaffected by the prohibition.2

A history of abusive practices and

fraud in the offer and sale of offexchange options in the nonenumerated

commodities was one of the catalysts

leading to enactment of the Commodity

Futures Trading Commission Act of

1974 (1974 Act), which substantially

strengthened the Commodity Exchange

Act and broadened its scope by bringing

all commodities under regulation for the

first time.3 Under the 1974 amendments,

the newly-created CFTC was vested

with plenary authority to regulate the

offer and sale of commodity options on

the previously unregulated,

nonenumerated commodities.4 The

Act’s statutory prohibition on the offer

and sale of options on the enumerated

agricultural commodities was retained.

Shortly after its creation, the

Commission promulgated a

comprehensive regulatory framework

applicable to off-exchange commodity

option transactions in the
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59625

5 17 CFR part 32. See, 41 FR 51808 (Nov. 24,

1976) (Adoption of Rules Concerning Regulation

and Fraud in Connection with Commodity Option

Transactions). See also, 41 FR 7774 (February 20,

1976) (Notice of Proposed Rules on Regulation of

Commodity Option Transactions); 41 FR 44560

(October 8, 1976) (Notice of Proposed Regulation of

Commodity Options).

6As noted above, trade options are defined as offexchange options ‘‘offered by a person having a

reasonable basis to believe that the option is offered

to the categories of commercial users specified in

the rule, where such commercial user is offered or

enters into the transaction solely for purposes

related to its business as such.’’ Id. at 51815; rule

32.4(a) (1976). This exemption was promulgated

based upon an understanding that commercial users

of the underlying commodity had sufficient

information concerning commodity markets insofar

as transactions related to their business as such, so

that application of the full range of regulatory

requirements was unnecessary for business-related

transactions in options on the nonenumerated

commodities. See, 41 FR 44563, ‘‘Report of the

Advisory Committee on Definition and Regulation

of Market Instruments,’’ appendix A–4, p. 7

(January 22, 1976).

7 43 FR 16153 (April 17, 1978). Subsequently, the

Commission also exempted dealer options from the

general suspension of transactions in commodity

options. 43 FR 23704 (June 1, 1978).

8Pub. L. No. 95–405, 92 Stat. 865 (1978).

Pursuant to the 1978 statutory amendments, option

transactions prohibited by new section 4c(c) could

not be lawfully effected until the Commission

transmitted to its congressional oversight

committees documentation of its ability to regulate

successfully such transactions, including its

proposed regulations, and 30 calendar days of

continuous session of Congress after such

transmittal had passed.

9 46 FR 54500 (November 3, 1981).

10Pub.L. No. 97–444, 96 Stat. 2294, 2301 (1983).

11Although the Commission noted that ‘‘there

may be possible benefits to commercials and to

producers from the trading of these ‘trade’ options

in domestic agricultural commodities,’’ it

determined that ‘‘in light of the lack of recent

experience with agricultural options and because

the trading of exchange-traded options is subject to

more comprehensive oversight,’’ ‘‘proceeding in a

gradual fashion by initially permitting only

exchange-traded agricultural options’’ was the

prudent course. 48 FR 46797, 46800 (October 14,

1983).

12For example, in 1991 the Commission proposed

deleting the prohibition on trade options on the

enumerated commodities and including them under

the same exemption applicable to all other

commodities. 56 FR 43560 (September 3, 1991). The

Commission never promulgated the proposed

deletion as a final rule.

13The complete text of that study, entitled

‘‘Policy Alternatives Relating to Agricultural Trade

Options and Other Agricultural Risk-Shifting

Contracts,’’ was forwarded to the Commission by

the Division on May 14, 1997. It is available

through the Commission’s Internet site at http://

www.cftc.gov/ag8.htm.

14Five letters offered commentary on the issue

without taking a position on the overall wisdom of

lifting the prohibition.

nonenumerated commodities.5 This

comprehensive framework exempted

‘‘trade options’’ from most of its

provisions except for a rule prohibiting

fraud (rule 32.9).6 In contrast,

commodity options on the enumerated

commodities—the domestic agricultural

commodities listed in the Act—were

prohibited both as a consequence of the

continuing statutory bar as well as

Commission rule 32.2, 17 CFR 32.2.

This prohibition made no exceptions

and applied equally to trade options.

The attempt to create a regulatory

framework to govern the offer and sale

of off-exchange commodity options was

unsuccessful. Because of continuing,

persistent, and widespread abuse and

fraud in their offer and sale, the

Commission in 1978 suspended all

trading in commodity options, except

for trade options.7 Congress later

codified the Commission’s options ban,

establishing a general prohibition

against commodity option transactions

other than trade and dealer options.8

The Commission subsequently

permitted the introduction of exchangetraded options on the nonenumerated

commodities by means of a three-year

pilot program. 9 Based on that successful

experience, Congress, in the Futures

Trading Act of 1982, eliminated the

statutory bar to transactions in options

on the enumerated commodities,

permitting the Commission to establish

a similar pilot program to reintroduce

exchange-traded options on those

agricultural commodities. 10 When

establishing the pilot program, the

Commission declined to relax the

prohibition on off-exchange trade

options on these commodities. 11

The Commission has reconsidered the

issue of whether to remove the

prohibition on the offer and sale of trade

options on the enumerated commodities

several times. 12 On December 19, 1995,

the Commission hosted a public

roundtable (December Roundtable) to

consider this issue once again and to

provide a forum for members of the

public to provide their views.

Subsequently, the Commission

instructed the staff to study this issue

and to forward its analysis to the

Commission.

B. The Advance Notice of Proposed

Rulemaking

On June 9, 1997, the Commission

published an advance notice of

proposed rulemaking (advance notice)

in the Federal Register seeking

comment on whether it should propose

rules to lift the prohibition on trade

options on the enumerated agricultural

options subject to conditions and, if so,

what conditions would be appropriate

(62 FR 31375). The Commission based

the advance notice on a study by the

Commission’s Division of Economic

Analysis (Division). 13

The advance notice discussed the

potential benefits and risks that may

result from lifting the prohibition on

agricultural trade options. The benefits

include greater customization, a known

cost of the instrument at the outset, and

an increase in possible types of vendors,

permitting greater convenience and

more flexible financing arrangements.

The risks identified in the study include

fraud, credit risk, liquidity risk,

operational risk, systemic risk, and legal

risk.

In addition, the advance notice

offered a variety of regulatory

protections or conditions which could

be used to address many of the risks

identified in the study. Those

conditions included possible

restrictions on the parties permitted to

enter into these transactions, restrictions

on the instruments or their use, and/or

regulation of their marketing. The

advance notice noted that several of the

risks could be reduced by imposing

eligibility limitations, such as to restrict

the availability of agricultural trade

options to sophisticated individuals or

entities; to require that those marketing

these instruments be registered with, or

identify themselves to, the Commission

or be commercial users themselves; and/

or to impose an education requirement

on either buyers or agricultural trade

option vendors or both.

The advance notice also discussed

possible restrictions on the types of

options permitted as a possible means of

ensuring that commercials enter into

such transactions ‘‘solely for purposes

related to (their) business as such.’’

Moreover, the possible regulation of

marketing, including disclosure

requirements and account confirmation

requirements, was considered.

Additional issues addressed by the

advance notice included possible

requirements for cover or other methods

for limiting the risk of possible default

and requirements regarding the

establishment of appropriate internal

controls. In order to focus comment on

these issues, the advance notice invited

commenters to respond to 30 specific

questions relating to the above topics.

II. Comments Received

In response to its request for public

comment, the Commission received a

total of 76 comment letters from 82

commenters. The commenters were

almost evenly divided with 35

commenters in favor and 36 opposed to

lifting the ban.14 Those favoring lifting

the prohibition on agricultural trade

options included a futures exchange

(with qualifications); a futures industry

association; a derivatives industry

association; five risk management firms;

a commodity trading advisor; a bank; six

agriculture-related businesses; 15 trade

and farm associations, including both
59626 Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules

15See the Division’s study at pp. 23–24, 28.

16 Id. at p. 31.

17Currently, trade options and those offering

them are subject only to regulations regarding fraud.

See, 17 CFR 32.4.

18Overall year-to-date volume through July 1997

for exchange-traded futures and option contracts is

314,068,673 contracts. Of the total number of

contracts traded, approximately 20 percent are

option contracts.

national organizations and state-level

affiliates; three individuals; and an

accounting firm. Those opposed

included two futures exchanges; a

futures industry trade association; ten

futures professionals; two producer

associations; a grower-owned marketing

cooperative; a country elevator; an

academician; and 18 individuals, eight

of whom were producers.

Commenters opposed to lifting the

ban generally expressed the view that

existing exchange-traded products are

adequate to manage agricultural risk and

that agricultural trade options are likely

merely to replicate those existing

products but in a less safe environment.

In this regard, the commenters stressed

the higher likelihood of fraud

occasioned by the unsophisticated

nature of the possible counterparties to

agricultural trade option transactions,

the decentralized nature of the market,

and the lack of regulatory oversight of

possible agricultural trade option

vendors. Several commenters also

opined that, as a result of operating in

a less regulated environment,

agricultural trade options would enjoy

an unfair competitive advantage over

exchange-traded instruments, thereby

adversely affecting exchange liquidity.

Others expressed the concern that

problems arising as a consequence of

the less regulated environment for the

trading of agricultural trade options

could damage public confidence in all

risk management products, including

exchange-traded instruments. A final

concern expressed by several

commenters was that lifting the

prohibition on agricultural trade options

will advantage larger, more

sophisticated agricultural companies

over smaller, independent businesses,

hastening a trend toward greater

consolidation and concentration in

agricultural markets.

Those commenters favoring lifting the

prohibition on agricultural trade options

generally expressed the view that recent

developments in domestic and foreign

agricultural markets have increased the

need for agricultural trade options. In

particular, several commenters noted

that agricultural trade options already

are being offered outside of the United

States to the competitive advantage of

foreign producers and agricultural

businesses.

Other commenters noted that the

recent removal of many of the longstanding government support programs

may result in increased price

uncertainty and volatility, thereby

increasing the need for a variety of riskmanagement and marketing tools. In

this regard, the Division staff in its

study noted that the overall impact of

the Federal Agricultural Improvement

and Reform Act of 1996 likely will be

to leave farm incomes more exposed to

changes in market prices and that in

response to these changes ‘‘new risk

management tools are being developed,

a trend which is likely to continue.’’ 15

The greater interest by some segments

of the agricultural sector in managing

risks that was noted in the Division’s

study is also reflected in many of the

comments. Several commenters who

favor lifting the ban generally noted that

the increasing size and complexity of

producers’ operations also have given

rise to the need for more innovative and

flexible risk management products. For

example, one commenter noted that:

All facets of agricultural production

whether grain, cotton, fruits, vegetables or

livestock are becoming more specialized and

targeted toward niche markets. Producing for

these markets often requires a greater degree

of coordination and long-term commitment

between the producer and processor. Having

the flexibility to write marketing contracts

that are now banned would be of great

benefit in facilitating the coordination

required.

These rapid and profound changes

taking place in these markets are a key

factor in the Commission’s

determination to propose these rules.16

In addition to the written comments,

the Commission received oral comments

during two public field meetings at

which members of the public had an

opportunity to address the Commission

and to answer its questions regarding

these issues. One of the meetings was

held in Bloomington, IL, and the other

was held in Memphis, TN. A third

informational meeting was held in

conjunction with a general membership

meeting of the National Cattlemen’s

Beef Association. Transcripts of the

proceedings at all three events were

included in the Commission’s comment

file and are available through the

Commission’s internet web site.

Generally, the participants in these

meetings reflected the range of views

expressed in the written comments and

were likewise equally divided in their

support or opposition to lifting the

prohibition on agricultural trade

options.

III. The Proposed Rules

A. Three-Year Pilot Program

Based upon the analysis in the

Division’s study and the comments filed

in response to the advance notice,

including the comments presented to

the Commission during its field

meetings, the Commission is proposing

to promulgate rules establishing a pilot

program to permit the offer and sale of

trade options subject to a number of

strict regulatory conditions. Many

commenters expressed the view that the

potential risk of permitting trade

options clearly outweighed any benefit

which they might provide. These

commenters, however, typically

assumed that agricultural trade options

would be offered under the same level

of regulation currently applicable to

other trade options.17 An approximately

equal number of commenters expressed

the view that the prohibition on trade

options should be lifted, particularly in

response to the new challenges

agriculture faces as a result of changes

in government programs. Nevertheless,

the vast majority of commenters, both

those favoring and opposing lifting the

prohibition of agricultural trade options,

urged caution.

The Commission successfully

permitted the reintroduction of

exchange-traded options under a threeyear pilot program after their nearly

half-century ban. See, 46 FR 54500

(November 13, 1981). Many at that time

expressed concerns similar to those

expressed in connection with the

Commission’s consideration of lifting

the prohibition on agricultural trade

options. The Commission determined

that a pilot program best addressed

those concerns, permitting the

introduction of exchange-traded options

subject to strict regulatory controls. By

structuring its action as a pilot program,

the Commission was able to test the

efficacy of its regulations and to adjust

them as experience warranted. The use

of a pilot program proved to be a highly

successful means of reintroducing

exchange-traded options. Today, those

markets constitute an important part of

the futures industry.18

Based upon that successful

experience, the Commission is

proposing to lift the ban on agricultural

trade options under a similarly

structured pilot program. As under the

previous pilot options program, the

program being proposed for agricultural

trade options will run for three years.

During that time the Commission will

closely monitor the efficacy of its rules

and their implementation by the

industry. Although the Commission

currently intends that the rules

promulgated by the Commission under
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59627

19 In this regard, the Commission anticipates that,

if it promulgates final rules, it will promulgate them

as ‘‘interim final rules,’’ denoting its intention to

revisit them three years after implementation. It is

not proposing to limit the time during which the

rules will remain effective in order to avoid issues

of contracts extending beyond the three-year period.

Instead, it will evaluate the efficacy of the interim

final rules at the conclusion of the pilot program

and reissue them if amendments are needed. Any

such amendments would not affect the validity of

contracts entered into prior to the issuance of such

amendments.

20The 1985 OGC Interpretation described this

form of trade option as a contract that ‘‘establishes

a minimum contract price determined when the

contract is written, and [for which] a premium is

collected, either at the initiation of the contract,

during the life of the contract or, together with

interest accumulated over the life of the contract,

at the time of settlement. In return for the premium,

the producer has the right to require the merchant

to accept delivery of and pay a minimum contract

price for the crop. However, the producer may

forfeit the premium and seek a higher price for, and

deliver, the crop elsewhere.’’ 50 FR 39656, 39660.

21For example, the same 1985 OGC interpretation

discussed two other examples of delivery contracts

having minimum price characteristics, finding them

to be within the forward contract exclusion of the

Act. Section 1a(11) of the Act, the forward contract

exclusion, provides that futures contracts which are

regulated under the Act do ‘‘not include any sale

of any cash commodity for deferred shipment or

delivery.’’ These two contracts, although having

some option pricing characteristics, were

determined to be forward contracts because, unlike

option contracts, they were intended to be a means

of merchandizing the commodity, obligating the

parties to the contract to make or take delivery. 50

FR 39660.

22This is not to suggest that the pay-out

characteristics of forwards and futures resemble

those of physically-delivered or cash-settled

options, respectively. To the contrary, futures and

forwards share a similar risk/return profile which

differs markedly from the risk/return profile shared

by all options. Rather, the resemblance between

forwards and physical-delivery options is the ease

of their use as a form of marketing arrangement that

can also be used to hedge price risk.

For those not wishing to combine a

merchandizing arrangement with a riskmanagement function, cash-settled options offer

greater settlement ease. This is true whether

settlement is a result of the option’s offset or its

exercise.

the pilot program will remain in effect

at the termination of the pilot program,

it will amend them as experience

warrants.19

During the course of the pilot

program, the Commission anticipates

that it will direct the Division to

conduct at least two reviews of trading

experience. The conduct of such

reviews may require the issuance by the

Division of industry-wide special calls

for information from agricultural trade

option vendors. Such information

requests, although used sparingly, were

an integral part of the Commission’s

successful monitoring of the prior pilot

program and can be expected in

connection with the Commission’s

evaluation of the relative success of this

pilot program as well.

B. Overall Structure of Proposed Rules

The advance notice identified a

number of risks associated with lifting

the prohibition on options on the

enumerated agricultural commodities

and the possible regulatory responses to

those risks, ranging from little or few

regulatory protections to the full

panoply of protections mirroring those

that are applicable to exchange-traded

options. It also identified likely

immediate uses for trade options on

these commodities and a number of

more theoretical possible uses. In

proposing the structure for this pilot

program, the Commission determined to

include within the pilot program

initially those forms of trade options the

terms of which are likely to be most

widely understood and which are

closest to current cash market practices.

Accordingly, the Commission is

proposing to lift the trade option ban on

enumerated agricultural commodities

for physically-settled contracts between

commercial parties in the normal

merchandising chain for the underlying

commodity. Exercise of an option

between these parties would involve the

delivery of the underlying commodity

from one party to the other either by

immediate transfer of title to the

commodity or by transfer of a forward

contract commitment.

Since at least 1985, when the

Commission’s General Counsel issued

an interpretative statement entitled,

‘‘Characteristics Distinguishing Cash

and Forward Contracts and ‘Trade’

Options,’’ 50 FR 39656 (September 30,

1985) (1985 OGC Interpretation), there

has been wide understanding that one

form of trade option prohibited by the

ban involved a transaction whereby a

producer, in return for payment of a

premium, would have the right but not

the obligation to deliver his crop to an

elevator at the specified price. The

producer would have the choice to

deliver the commodity elsewhere or at

the original elevator for a higher price.20

In addition to being commonly

understood, this form of trade option is

a logical extension of other, permitted

cash market practices.21

Option contracts can be used for a

variety of purposes depending on the

structure and settlement characteristics

of a particular contract and the nature

of the option customer’s cash market

commitments or position. Upon

exercise, options can settle either by

physical delivery of the underlying

commodity or by cash payment. Cashsettled options upon exercise result only

in the exchange of cash; a separate

marketing arrangement is necessary to

merchandize the underlying

commodity. In this respect, because

they are distinct from marketing

contracts, cash-settled options bear a

resemblance to exchange-traded

contracts. In contrast, upon exercise of

a physical delivery option, the

purchaser of a put or the seller of a call

actually delivers the underlying

commodity to the counterparty. Thus,

like a forward contract, a physical

delivery trade option can be used as a

means of merchandizing the

commodity.22

Commenters suggested a number of

additional reasons for inclusion of

physical delivery options within the

pilot program. Several commenters

opined that one of the primary benefits

of agricultural trade options will be to

permit producers to enter into such

agreements directly with those with

whom they share trusted cash market

business relationships. A second often

suggested benefit of agricultural trade

options is the producer’s ability to enter

into enhanced forms of merchandizing

agreements. Several commenters, for

example, expressed the desirability of

being able to enter into option contracts

that would give them the right but not

the obligation to deliver on the contract.

Such individual could ‘‘walk away’’

from delivery to avoid the purchase or

sale of the commodity at too high or low

a price during a production shortfall or

for any other reason. The ability to

avoid delivery in the case of a

production shortfall, in the view of

these commenters, would allow

producers to contract (through options)

for a higher percentage of their expected

production. Including first handlers of

the commodity underlying agricultural

trade options within the pilot program

and including all physical delivery

agricultural trade options as eligible for

the pilot program would allow

producers to achieve these benefits.

Several commenters registered their

concern that, if permitted, trade options

would merely replicate exchange-traded

options in all respects, but in a lessregulated environment. They argued

that on that basis the risks associated

with trade options do not outweigh their

potential benefits. Physical delivery

trade options, however, will not simply

replicate exchange-traded instruments.

As noted above, physically-settled trade

options offer the opportunity to

combine a marketing and risk

management tool. In this respect,

physical delivery trade options on the

enumerated commodities would be

similar in character to forward contracts

in that each would be an individually
59628 Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules

23Although, as discussed below, the Commission

also is proposing to permit exchanges greater

flexibility in offering agricultural options, physicaldelivery trade options entered into between those

who have a cash-market relationship are apt to be

different in nature than exchange-traded contracts—

that is, they are more likely to be more highly

customized, including calling for delivery at widely

scattered facilities.

24For example, consider the case of a producer

who had paid a premium of $.10 per bushel for a

put option giving him the right to sell corn at a

price of $2.80 per bushel. At harvest the price of

corn is $2.70 per bushel, and the producer decides

to exercise the option. If the option seller defaults

on the contract, the producer stands to lose the $.10

per bushel paid for the option. In addition the

producer loses the opportunity to sell corn at $2.80

per bushel, instead having to accept the market

price of corn at $2.70 per bushel.

25A number of states require entities to meet a

specified net worth requirement as a condition of

obtaining a state grain warehouse’s or grain dealer’s

license. The minimum net worth requirements

range up to a minimum of $50,000 in Illinois. Some

states also require that grain warehouses obtain a

surety bond and have established indemnity funds

to offset producer losses on grain stored in

warehouses. Such indemnity funds, depending

upon the state, are funded either by the producers

or the elevators. For example, the indemnity fund

in Illinois is funded by grain elevator contributions,

while in Indiana producers contribute to the fund.

26Of those favoring minimum financial

requirements, some specifically suggested that trade

option vendors be required to meet the same

financial requirements currently applicable to

FCMs and IBs.

negotiated contract involving, if

exercised, the merchandising of the

commodity through normal marketing

channels. This potential additional cash

market function 23 of physical delivery

trade options argues in favor of their

inclusion under the pilot program.

After having determined, for the

above reasons, that trade options

between counterparties in normal cash

market channels requiring physical

delivery are appropriate for inclusion

within the pilot option program, the

Commission has matched the level of

regulation being proposed to the risks

associated with those instruments. Not

only is this approach intended to strike

the appropriate balance of regulation of

the instruments included within the

pilot program, but it provides a solid

foundation for analyzing and comparing

the regulatory approaches which should

be applied in the future when

considering other possible uses of trade

options. Accordingly, were the

Commission to propose to permit

additional forms of trade options, it

would re-examine the adequacy of the

proposed regulatory provisions of the

pilot program. The major components of

the proposed regulations governing the

pilot option program are as follows:

regulation of agricultural trade option

vendors, including net capital,

recordkeeping and streamlined

registration, and proficiency testing

requirements; required risk disclosure to

option customers; and several

restrictions on the market strategies or

contract structure. These proposed

components of the pilot regulations are

discussed below.

C. Regulation of Agricultural Trade

Option Merchants

A primary regulatory protection of the

pilot program is its restriction of option

counterparties to agricultural

commercial participants. Thus,

agricultural trade option vendors—those

persons or entities engaged in the

business of the offer or sale of

agricultural trade options—as a matter

of course, will be businesses active in

agricultural cash markets. Agricultural

trade option vendors, by virtue of their

cash market operations, should have

achieved some level of financial

soundness and proficiency with respect

to risk management strategies. In

addition, the Commission is proposing

streamlined or targeted requirements

relating to agricultural trade option

vendors’ financial soundness,

competency, and probity, including the

requirement that such vendors be

registered with the Commission under

the new registration category of

‘‘agricultural trade option merchant.’’

1. Net Asset and Other Financial

Requirements

By their nature, agricultural trade

options, like all commodity futures or

option instruments, involve risk,

particularly the risk arising from the

need for performance at a future date by

the counterparty to the contract.

Typically, the greatest financial risk

assumed by an option purchaser is

credit risk. Credit risk is the risk that the

seller of the option may fail to perform

on the obligation if the purchaser

chooses to exercise the option contract.

In the event of such nonperformance,

the option purchaser stands to lose the

option premium if it has already been

paid plus any opportunity gain that

would have been achieved if the option

were exercised.24

In an exchange environment, the

clearinghouse and regulations requiring

minimum net capital for market

intermediaries reduce counterparty

credit risk. Off-exchange transactions do

not have the safety of the clearinghouse

to reduce credit risk. In an off-exchange

environment, counterparties can take a

variety of steps to help assure that a

counterparty is able to perform and

performs on its obligation. Sophisticated

counterparties may have the means

formally to evaluate the

creditworthiness of their counterparties.

They also may require the posting of

collateral or a third party guarantee.

Less sophisticated counterparties may

simply rely on trust, choosing to deal

only with known counterparties with

whom they have ongoing business

relationships. Another approach to

enhancing an agricultural trade option

merchant’s ability to perform on a trade

option is to require the merchant to

manage the market risk of trade options

through exchange-traded options.

Because many agricultural trade

option customers will not have the

resources to conduct formal

creditworthiness evaluations of their

counterparties, some degree of

regulatory financial protections are

desirable. Accordingly, the Commission

is proposing a requirement that

agricultural trade option merchants

maintain a minimum level of net worth.

In addition, the Commission is

proposing that agricultural trade option

merchants segregate from their own

funds premiums paid by customers at

initiation of an option contract. The

Commission, however, is not proposing

specific forms of covering the

agricultural trade option merchant’s

market exposure.

a. Net Worth. Minimum financial

requirements have been used by

government regulators to establish a

base level for entry or access to a market

by individuals and companies. Such

requirements are intended to assure that

companies or entities conducting

business offer some assurance of having

the financial wherewithal to perform on

their obligations. The Commission

places minimum financial requirements

on futures commission merchants

(FCMs) and introducing brokers (IBs) as

a condition of registration with the

Commission. The United States

Department of Agriculture (USDA) and

various states impose minimum

financial requirements in the cash grain

markets on federally-licensed grain

warehouses.25

Although many commenters favored

minimum financial requirements,26

others opposed them on the grounds

that such minimum financial

requirements would exclude smaller

entities from the agricultural trade

option business, possibly accelerating a

trend to greater concentration in cash

grain markets. Some commenters argued

that the financial requirements currently

imposed by the various states would be

sufficient to foster financial integrity in

the trade option markets. However, not

all states have minimum financial

requirements for those involved in the

cash trade, and the requirements of

those that do vary widely. Accordingly,
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59629

27The minimum net worth requirement, as

proposed, is a continuing requirement. If an

agricultural trade option merchant’s net worth falls

below this amount, the merchant would not be

permitted to offer to buy or to sell additional trade

options until coming into compliance with the

requirement. Moreover, in such a situation the

agricultural trade option merchant must

immediately cease offering or entering into new

option transactions and must notify customers

having premiums which the agricultural trade

option merchant is holding under § 32.13(a)(4) of

the proposed rules that such customers can obtain

an immediate refund of that premium amount,

thereby closing the option position.

28That is not to suggest that the risks to the first

handler are precisely the same between trade

options and forward contracts. In the case of

options, the first handler is not assured of actually

receiving delivery of the commodity in contrast to

a forward contract. However, the means available to

the first handler to cover the financial risk of the

transactions are similar.

29At least three commenters urged that daily

mark-to-market of all positions should be required.

The Commission is not proposing this requirement

at the current time, although that is certainly the

best practice and should be encouraged.

Under the proposed rules, agricultural trade

option contracts can be exercised only by delivery

and cannot be purchased back, resold or otherwise

offset before the expiration of the contracts. While

the net value of an agricultural trade option

merchant’s option position will fluctuate on a daily

basis, the option contracts themselves will tend to

be long term commitments similar to forward

contracts. In this respect, an agricultural trade

option merchant will not be faced with the daily

potential of large shifts in its option position due

to rapid changes in market prices. Moreover, the

price risk to the agricultural trade option merchant

of an unhedged option position will be similar to

that of an unhedged forward contract position. For

example, elevators selling unhedged put options to

producers face the risk that prices fall, thereby

resulting in the elevator purchasing a commodity at

a relatively high price when producers exercise

their options. This is the same risk faced by an

elevator entering into unhedged forward contracts.

Because of the similarities in long-term price risk

between the options which can be offered under the

proposed rule and forward contracts, the

availability of hedging tools and the expectation

that agricultural trade option merchants will hedge

their option positions in a manner similar to their

forward contract positions and because of varying

levels of sophistication among those who may be

involved in offering agricultural trade options, the

Commission is not now proposing a daily net worth

calculation. Nonetheless, the Commission seeks

comments on this issue, asking commenters to

focus in particular on the needed sophistication of

potential agricultural trade option merchants to

mark assets and liabilities to market on a daily

basis, whether daily marking-to-market is desirable

or necessary in light of the long-term nature of the

option positions and whether current standards

used by these entities in operating in forward

markets are sufficient for operating in the market for

physical options given the similarity in the risks

faced by the merchants.

30The Commission believes that the guidance

provided in the American Institute of Certified

Public Accountant’s Audit and Accounting Guide,

entitled, ‘‘Brokers and Dealers in Securities,’’

provides the relevant guidance which should be

followed in connection with assigning a fair value

to agricultural trade options. It states: ‘‘Under

generally accepted accounting principles, fair value

is measured in a variety of ways depending on the

nature of the instrument and the manner in which

it is traded. Many financial instruments are publicly

traded, and end-of-day market quotations are

readily available. Quoted market prices, if available,

are the best evidence of the fair value of a financial

instrument. If quoted market prices are not

available, management’s best estimate of fair value

should be based on the consistent application of a

variety of factors available to management.’’ A

complete discussion of the factors is provided in

the audit guide.

31 Generally producers have used forward

contracts as a means of hedging price risk (in

addition to merchandizing the commodity),

obviating the need for the producer to maintain a

futures position or incur out-of-pocket expenses.

Under this arrangement, the elevator generally

covers the price risk of the forward contract by

entering into a futures position and paying the

required margin obligations on the position. The

elevator may then recoup this cost implicitly. To

the extent first handlers structure agricultural trade

options in this manner as well, there will be no upfront payment, and no funds will be segregated. Of

course, because under a trade option a producer

may elect not to deliver the commodity, the elevator

would be expected to establish some other means

of recovering the cost of the option premium if it

is not paid up front.

the Commission believes that a common

federal minimum standard should apply

to all those involved in the business of

offering agricultural trade options,

regardless of geographic location or the

agricultural commodity.

Accordingly, the Commission is

proposing that agricultural trade option

merchants, as a condition for offering

such contracts, have and maintain a

minimum of $50,000 of net worth.27

This requirement corresponds to the

overall minimum financial requirement

established by USDA as a condition of

obtaining a federal grain warehouse

license. The Commission is proposing

this minimum net asset level based

upon the observation that these

warehouses already enter into forward

contracts as part of their cash business

and that the USDA requirement appears

to have been adequate. As noted above,

the physical delivery agricultural trade

options being included under the pilot

program are similar in nature to forward

contracts, including the financial risk to

the warehouse or other first handler.28

As noted above, the proposed net

asset requirement is ongoing in nature.

Accordingly, agricultural trade option

merchants would be required to

maintain the specified level of net worth

in order to enter into new trade option

contracts and to notify the Commission

at any time if they have fallen below

prescribed levels. The Commission is

also proposing that agricultural trade

option merchants be required to perform

a reconciliation of their financial

position at least monthly to determine

compliance with this requirement.29

Because agricultural trade option

merchants are primarily engaged in a

cash market business, this proposed rule

does not require them to change

accounting procedures to conform to

specific Commission accounting

requirements, provided they use ‘‘fair

value’’ accounting under generallyaccepted accounting principles.30 It is

the Commission’s understanding that

this accounting method is used by most

firms in the cash market business.

b. Segregation of Customer Premiums.

The Commission is proposing an

additional financial protection—

requiring that agricultural trade option

merchants segregate customer premiums

from their own capital. The advance

notice noted the potential financial and

regulatory concerns which arise from

the asymmetric credit risk of option

contracts. That asymmetry exists when

the party purchasing the option pays the

cost of the option—the option

premium—in advance of the

counterparty’s having to perform on its

obligation.31 The purchaser then faces

the risk that the seller of the option

might fail to perform on the contract, if

exercised. Under such circumstances,

not only does the option purchaser lose

the opportunity gain that would have

been realized through the exercise of the

option, but also would be subject to the

out-of-pocket loss of the option

premium. This is in contrast to forward

contracts, where both parties have

reciprocal obligations and neither makes

a payment in advance of performance.

The ability to collect an up-front

payment of premiums may also give

merchants an incentive to sell options

in order to generate option premiums

for immediate use as operating funds.

In order better to safeguard customers’

up-front premium payments and to

discourage the writing of trade options

in order to generate immediate

operating funds by a firm experiencing

financial difficulties, the Commission is

proposing that option premiums be held

in segregation while an option contract

is open, and that option premiums not

be available to the agricultural trade

option merchant for use in its business

during the period an option is open. The

Commission is proposing that the

premium associated with an option

must be separately accounted for and

segregated in an account held for the

benefit of option customers. Such funds,

when deposited in a bank, trust

company, or other financial institution,

must be deposited under an account

name which clearly identifies them as

segregated customer funds and shows

that they are segregated as required by

Commission regulations.

c. Cover of Market Risk. The advance

notice posed several specific questions

relating to whether the Commission

should require that agricultural trade

option merchants cover the market risk

of the agricultural trade options which
59630 Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules

32 In this regard, by virtue of the required

registration of their counterparty as agricultural

trade option merchants, customers will have

available to them under section 14 of the Act the

Commission’s reparations program for the

resolution of disputes arising under agricultural

trade option contracts. As proposed, customers will

be apprised of this right in the disclosure

document.

33The Commission has not proposed to permit

FCMs to substitute FCM registration for registration

as an agricultural trade option merchant based on

the assumption that few, if any, FCMs would

qualify to be an agricultural trade option merchant

by virtue of the requirement that such entities also

be a commercial user of the underlying commodity.

The Commission requests comment on whether this

assumption is not correct and, if so, whether

registration as an FCM should be permitted in lieu

of registration as an agricultural trade option

merchant. The Commission also requests comment

on whether Commission rule 1.19 should be

amended to permit FCMs to conduct such a

business.

34Although agricultural trade option merchants

would only be required to pass the more specialized

agricultural trade option examination, passing the

series 3 examination would also be acceptable as a

condition of registration.

35Many commenters opposed mandatory

educational requirements for either agricultural

trade option merchants or customers. The

Commission is of the view that customers have the

right to expect that such merchants and their sales

forces will have successfully demonstrated mastery

of the issues relevant to the offer or sale of these

instruments. Although the Commission is not

proposing an educational requirement for

customers, it strongly urges private sector

organizations to provide a variety of means of

fulfilling this need. The success of the pilot

program will depend, in part, on the success of

various organizations in educating potential trade

option customers. In this regard, a participant at the

they write. One commenter, a futures

exchange, suggested that the

Commission require that agricultural

trade option merchants be required to

cover the market risk of their trade

options one-for-one with exchangetraded options. Other commenters,

however, disagreed, pointing out that

agricultural trade options may be

offered for commodities in which there

is no actively-traded exchange market or

may be written for a form, grade,

expiration, or delivery location not

provided under exchange-traded

instruments. In such instances, a one-toone cover requirement using exchangetraded instruments may be

economically inefficient or impossible.

In general, it is the Commission’s

view that the market risks faced by

entities offering trade option contracts

will be similar to those currently

associated with the offer of forward

contracts. For example, an elevator

entering into a forward contract to

purchase grain from a producer faces

the risk that the price of grain at the

time of delivery will be lower than the

contract price, requiring the elevator to

pay the producer a higher price than the

elevator can obtain when it resells that

grain. Balancing this risk is the

possibility that prices will rise making

the contract price relatively cheap.

Elevators may choose to bear this risk,

chancing the fall in cash prices against

the opportunity to profit if cash prices

rise, or they may offset the market

exposure of rising prices by selling a

futures contract on one of the futures

exchanges.

An elevator selling a put option to a

producer faces similar market risk as

one entering a forward contract; that is,

that spot market prices will be lower

than the price at which the option is

exercised. As with forward contracts,

the elevator may choose to bear the

market risk or to cover the market risk

by purchasing an exchange-traded put

option. Whether or not the elevator

chooses to bear the market risk

associated with the trade option,

however, it always receives the

premium from the producer regardless

of whether prices rise or fall.

The Commission assumes that current

cover practices common to forward

contracting will be applied to

agricultural trade options. The

Commission is aware of no reason why

those offering trade option contracts

would be any less likely to cover market

exposure on trade option contracts than

is currently the case with those offering

forward contracts. In light of the

similarities of such option contracts to

forward contracts as discussed above,

the Commission is of the view that

elevators can determine individually the

manner in which they will cover their

exposure to market risk, if at all.

2. Probity and Competency

Requirements for Agricultural Trade

Option Merchants

a. Registration. Registration of

commodity professionals is an

important means by which the

Commission polices the futures and

option industry and is the primary

mechanism for reassuring the public of

the futures professional’s probity and

proficiency.32 Registration is an

indisputably important safeguard to the

public and will be critically important

in the decentralized market permitted

under the pilot program. However, the

offer and sale of trade options will be a

complement to the first-handler’s

existing cash market businesses, to some

extent offsetting the need for extensive

registration requirements. Accordingly,

the Commission is proposing that those

engaged in the business of the offer and

sale of agricultural trade options must

register under the new registration

category of ‘‘agricultural trade option

merchant.’’ The Commission is

proposing a streamlined form of

registration covering both the

agricultural trade option merchant as an

entity and its authorized sales force.33

The streamlined registration

requirement being proposed consists of

the single filing of a form identifying the

agricultural trade option merchant, its

principals (if the agricultural trade

option merchant is an entity), and on

separate pages, information identifying

its sales agents, a certification that none

of the individuals is statutorily

disqualified from engaging in a

commodity-related business under the

statutory disqualification provisions of

section 8a(2) or 8a(3) of the Act, a set

of fingerprints for each individual, a

copy of the entity’s certified financial

statements completed within the prior

12 months, and evidence that

individuals have completed

successfully a proficiency test

specifically geared toward agricultural

trade options. Amendments of such

registration applications for new

associated persons can be filed as

necessary.

The Commission is seeking comment

on whether this registration function

should be delegated to the National

Futures Association (NFA). NFA has

been delegated responsibility by the

Commission to administer the

registration procedures for all futures

industry professionals. The possible

delegation to NFA of responsibility for

processing the registration applications

of agricultural trade option merchants

would be consistent with this practice

and, should NFA agree to accept this

responsibility, this delegation would

conserve Commission resources, as

well.

b. Competency Testing. A second

important customer protection is

competency testing of futures

professionals. Because agricultural trade

option merchants will not be engaged in

other facets of futures and option sales,

the series 3 examination which is

generally required for futures

professionals would not be necessary.

Accordingly, the Commission is

proposing that a specialized

examination targeted at agricultural

trade options be developed.34 The

Commission, as it has with all other

similar testing programs, proposes to

delegate this testing function to the

NFA. In light of the proposed

competency test for agricultural trade

option merchants, the Commission is

not proposing an explicit educational

requirement. Successful completion of

this targeted examination would

evidence proficiency in those areas

relevant to the offer and sale of

agricultural trade options.35
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59631

Commission’s open meeting in Memphis,

Tennessee, representing the National Grain and

Feed Association stressed her organization’s

commitment to these efforts.

36 In 1992, section 210 of the Futures Trading

Practice Act of 1992 (FTPA) amended section 4p of

the Act to mandate ethics training for persons

required to be registered under the Act. On April

15, 1993, the Commission adopted regulation 3.34

to implement the requirements of FTPA section

210. 58 FR 19575. Commission regulation 3.34

requires natural persons registered under the Act to

attend ethics training to ensure that they

understand their responsibilities to the public

under the Act.

37Those functions relating to ethics training

delegated to NFA for all Commission registrants

will also be proposed to be delegated to NFA for

agricultural trade option merchants.

c. Ethics Training Requirement. The

final protection relating to both probity

and competency is the ethics training

requirement applicable to all

Commission registrants. A few

commenters expressed concern that

without this requirement, if the

prohibition on agricultural trade options

were lifted, regulatory oversight of

agricultural trade option merchants

could be inadequate. The Commission

carefully considered what degree of

ethical instruction would be necessary

and appropriate for registered

agricultural trade option merchants and

is proposing to apply to agricultural

trade option merchants the same

mandatory ethical training requirements

currently required by the Act for all

other registrants. See, 17 CFR 3.34.36

Under this requirement, Commission

registrants are required to attend ethics

training within six months of being

granted registration and, thereafter,

every three years. This ethics training

must be at least four hours in duration

for the initial session and one hour in

duration for subsequent periodic

sessions. Training is available from a

variety of sources and can be

undertaken through videotape,

computer programs, or other similar

means, in addition to attendance in

person. See, 17 CFR 3.34(b)(3)(iii).

These requirements apply equally to all

Commission registrants and are being

proposed to apply to agricultural trade

option merchants as well.37

D. Restrictions on the Instruments or

Market Strategies

The Commission posed a series of

questions in the advance notice related

to restrictions on the use of option

contracts by various parties. In

particular, the Commission asked

whether it would be appropriate under

a trade option exemption for producers

to write covered calls and whether

agricultural trade options should be

permitted to be bundled to create riskreturn payouts different from a simple

put or call.

Several commenters expressed the

opinion that option customers should

have unfettered freedom over the types

of options available and the manner of

their use, ceding only the restriction

that trade options should be related to

a business purpose. Others, however,

expressed concern that more complex

instruments or trading strategies might

lead to high levels of fraud and abuse.

Although many of these commenters

favored a continuance of the prohibition

as the remedy, their concern over fraud

and abuse was shared by many

commenters who favored lifting the

prohibition. These commenters

accepted the wisdom of some

limitations or conditions on the types of

options and trading strategies that might

be used, particularly in connection with

a pilot program.

The Commission remains concerned

that, in lifting the prohibition on

agricultural trade options, it not also

open the door to fraudulent dealing.

Although additional risk management

instruments may assist the agricultural

sector in meeting the new challenges

which it faces, opening up this longrestricted market to all types of options

may unnecessarily expose participants

to abuse. In order to balance these

concerns, the Commission is proposing

several limitations on the structure of

option contracts and on permitted

trading strategies or uses. First, the

Commission is proposing a prohibition

on the writing of covered call options by

producers. Covered call options are

short call positions written by an

individual who has a long position in

the underlying commodity. The option

is covered in the sense that, if the option

is exercised, the writer of the option has

the commodity in his or her possession

to deliver on the contract. While an

individual writing a covered call has

limited risk in the sense that he or she

possesses a commodity which can be

delivered against the option contract,

the call does not provide downside

price risk protection on the long

commodity position except to the extent

that a premium has been paid by the

purchaser. Moreover, the short call caps

any gains that the producer might earn

on the long commodity position.

Although such a strategy may be

appropriate in certain instances, it is

susceptible to abuse to the extent that

producers do not appreciate the extent

to which downside price protection and

upside pricing potential is surrendered

for a premium payment and is not

appropriate for inclusion in the pilot

program. It is also the Commission’s

opinion that the writing of put options

by agricultural producers is not an

appropriate business-related use of

options. The Commission, therefore, is

proposing a prohibition on the writing

of such options.

However, trade option customers

would be permitted to enter into options

that simultaneously combine long put

and short call option positions only to

the extent that the size of the delivery

quantity associated with the short call

option position does not exceed the size

of the delivery quantity associated with

the long put option position. Thus, for

example, an agricultural trade option

could give the producer the right to

deliver 5,000 bushels of corn at harvest

time at a price of $2.50 per bushel and

the elevator the right to call for the

delivery of 5,000 bushels at $3.00 per

bushel. Under such an option, if at

harvest time the price of corn was below

$2.50, the producer would exercise the

option to deliver the 5,000 bushels of

corn at $2.50 per bushel. If, however,

the price of corn was above $3.00 per

bushel, the elevator would exercise its

option to call for the delivery of 5,000

bushels of corn at $3.00 per bushel. If

the price of corn was between $2.50 and

$3.00, it would not be economically

rational for either party to call for or to

make delivery of corn. In this example,

the producer has purchased a put option

from the elevator for 5,000 bushels of

corn with a strike price of $2.50 per

bushel. The producer has also sold a

call option to the elevator for 5,000

bushels of corn at a strike price of $3.00.

This transaction would be permissible

under the proposed restriction that the

delivery amount of the short call option

portion of the contract cannot exceed

the delivery amount of the long put

option. However, the elevator could not

obtain the right to call for the delivery

of more than 5,000 bushels of corn.

Moreover, the Commission is proposing

that under no circumstances would a

producer be permitted to write a put

option, even if such option was

combined with a long call option.

In addition, the Commission is

proposing to limit the termination and

reestablishment of agricultural trade

option positions. Some commenters

expressed the view that agricultural

trade options should not be used as a

means to speculate in commodities. One

manner in which speculation might be

possible would be to move into and out

of trade option positions based on

updated predictions of expected price

moves. Although some commenters

argued that such strategies could

enhance the price of the commodity

being merchandised, the ultimate

success of such a strategy would depend

upon one’s ability accurately to foresee
59632 Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules

future price movements. Limiting the

ability to enter and exit trade option

contracts is consistent with the

Commission’s desire to include within

the pilot program those trade options

which are closest in nature to forward

contracts, contracts for which offset is

not permitted. Thus, the Commission is

proposing that, once a trade option

contract is purchased or sold, that

position cannot be offset prior to

expiration.

E. Risk Disclosure, Required Contract

Terms and Required Account

Information

1. Risk Disclosure Statements

The Commission in its advance notice

noted that required risk disclosures are

a customer protection generally used in

the regulation of futures and option

trading and requested comment on

whether, and in what form, risk

disclosure should be required if the

prohibition on agricultural trade options

were lifted. The majority of the

commenters responding to these

questions agreed that mandated written

risk disclosure would be appropriate,

but varied in their view of the degree of

detail which should be required. Some

commenters suggested that the

mandated risk disclosure statement

should disclose all financial risks,

including a description of worst

possible scenarios. Others were of the

view that a more general statement of

risk would be sufficient.

The Commission is of the view that a

mandatory written risk disclosure

statement for agricultural trade options

is necessary and appropriate. Such a

written statement is essential to

ensuring that trade option customers

receive knowledge of and understand

the risks involved in entering into such

transactions. Because of the current ban

on agricultural trade options, customers

initially will have had no experience

using such instruments. Moreover,

agricultural trade options may attract

customers with little or no experience

trading on designated futures or option

markets. In light of this, the risk

disclosure statement being proposed by

the Commission addresses the full range

of risks that were identified in the

Division’s study. This disclosure

statement has two parts. The general

disclosure is brief and is intended to

cause a customer to ask additional

questions of the agricultural trade

option merchant or to seek additional

information from other sources, as

necessary. For example, the

Commission is proposing that the

disclosure statement include mandatory

language regarding the requirement that

trade options must be entered into in

connection with the conduct of the

business of the agricultural trade option

merchant and its customers. This

discussion would also provide

producers in particular with guidance

regarding prudent, business-related uses

of trade options.

In addition, a transaction-specific

portion of the disclosure is designed to

provide specific information relating to

the terms of a particular transaction. In

this portion of the disclosure statement,

the Commission is proposing to require

that, where the full option premium or

purchase price of the option is not

collected up front or where through

amendments to the option contract it is

possible to lose more than the amount

of the initial premium, the agricultural

trade option merchant must disclose the

worst possible financial outcome that

could be suffered by the customer. In

this regard, the provision of the

mandatory risk disclosure statement

will not relieve the agricultural trade

option merchant of the responsibility to

avoid material misstatements or

omissions or any other form of

fraudulent misconduct. This

Commission and the courts have

repeatedly stated that provision of a

mandatory risk disclosure statement

will not necessarily cure what is

otherwise fraud. See, e.g., Clayton

Brokerage Co. v. Commodity Futures

Trading Commission, 794 F.2d 573,

580–581 (11th Cir. 1986). In particular,

agricultural trade option merchants may

need to make such additional

disclosures as necessary in light of all

the particular circumstances, including

the nature of the instrument and the

customer.

The Commission is proposing that the

full disclosure statement must be

delivered to the customer prior to the

customer’s first transaction with the

particular agricultural trade option

merchant, as is customary with respect

to current practice in futures and option

trading. In subsequent transactions, only

the transaction-specific portion need be

provided. The Commission is requesting

comment on whether this requirement

should allow its fulfillment through

electronic media. Moreover, the

agricultural trade option merchant must

retain a written acknowledgment which

has been signed and dated by the

customer evidencing receipt of the

disclosure statement by the customer.

2. Required Contract Terms

In addition to delivery of the required

disclosure statement, the Commission is

also proposing to require that the option

contract itself (a) be written and (b)

contain certain specified provisions.

Generally, the terms of designated

futures and option contracts are

contained in the rules of an exchange,

which under the Act are required to be

approved by the Commission. In the

case of trade options, like forward

contracts, the particular terms are left to

individual negotiation between the

counterparties. However, in connection

with its issuance of guidance relating to

‘‘hedge-to-arrive’’ contracts, CFTC

Interpretative Letter No. 96–41, Comm.

Fut. L. Rep. ¶ 26,091 (May 15, 1996), the

Division observed that such contracts

often contained few or insufficiently

expressed terms and conditions. The

lack of written terms and conditions in

these contracts led to widespread

disagreement among parties over the

terms of the instruments, complicating

the resolution of various issues. To

reduce the chance for disputes over

vaguely defined contract terms in

connection with agricultural trade

options, the Commission is proposing to

require that the trade option contracts

be written and include a number of

specified terms. In particular, the

Commission is proposing that such

contracts must include terms specifying

the procedure for exercise of the option

contract, including the expiration date

and latest time on that date for exercise;

total quantity and grade of commodity

to be delivered if the contract is

exercised and any adjustments to price

for deviations from stated quality or

grade; listing of elements comprising the

purchase price to be charged, including

the premium, mark-ups on the

premium, costs, fees, and other charges;

the strike price(s) of the option contract;

additional costs, if any, which may be

incurred if the commodity option is

exercised; and delivery location, if the

contract is exercised.

An important means of safeguarding

the public from abusive transactions is

the requirement that transactions be

confirmed in writing at the time of

contract initiation. This provides the

customer effective notice of the terms of

the agreement, permitting the customer

to object to transactions. Moreover, such

a requirement likely would be beneficial

to the merchant as well by providing an

effective means of avoiding disputes

over the terms initiating the transaction.

The Commission, therefore, is proposing

that agricultural trade option merchants

provide trade confirmation and

verification of information relating to

specified contract terms within 24 hours

of executing a contract. See, proposed

§ 32.13(a)(6).
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59633

3. Report of Account Information to

Customers

The Commission is proposing that

agricultural trade option merchants be

required to furnish a monthly account

statement to all customers with open

option positions. This statement would

include a complete listing of all

individual agricultural trade option

transactions entered into by the

customer, all outstanding requests to

enter into an agricultural trade option at

the time of issuance of the statement, a

current commodity price related to all

open option positions or open orders

held by the customer and the amounts

of any funds owed by or to the customer

related to the purchase or sale of option

contracts or to the delivery of physical

commodity related to the exercise of an

option.

Agricultural trade option merchants

will also be required to indicate clearly

expiration dates of options and to

highlight those options which will

expire within the next month. This may

be done by highlighting the expiration

information on such account statements,

by using boldface type for such

information, by separating these

contracts from other contracts on the

account statement, or by listing

contracts chronologically by expiration

date or by some similar method. The

Commission is proposing this

requirement as a means to assist

agricultural trade option customers in

managing their option accounts. Even

though agricultural trade options cannot

be offset, it is important for customers

to know the current status of their

option contracts with respect to which

options may be approaching expiration

and whether options are in or out of the

money.

In addition, the Commission is

proposing to require that agricultural

trade option merchants supply current

commodity price quotes or other

information relevant to an option

customer’s positions within 24 hours of

a request. In the case of options that

may be exercised at any time, it is

important that customers obtain timely

commodity price quotes in order to be

able to make decisions regarding

exercise of the options. Although the

Commission anticipates that price

information typically would be

available immediately, other

information might require the

agricultural trade option merchant to

search its records to obtain the

requested information. The Commission

believes that a 24-hour period should be

sufficient to enable agricultural trade

option merchants to retrieve the

information and to respond to the

customer.

F. Recordkeeping and Reporting

Requirements

1. Required Books and Recordkeeping

The maintenance of full, complete,

and systematic books and records by

agricultural trade option merchants is

crucial to the Commission’s ability to

respond to complaints of customer

abuse arising from such transactions

and is necessary to the agricultural trade

option merchant’s establishment of

appropriate internal controls of their

financial operations. Although most

merchants will already have

recordkeeping systems in place, the

proposed pilot program for agricultural

trade options involves a number of

regulatory protections, such as

furnishing customers with disclosure

statements, which may require records

which have not been customary for first

handlers as part of their cash market

businesses. Accordingly, the

Commission is proposing to require that

records relating to agricultural trade

options including covering transactions

must be kept and maintained for a

period of five years and must be readily

accessible during the first two years of

that five-year period. See, 17 CFR 1.31.

Specifically, the Commission is

proposing that trade option merchants

be required to maintain full, complete,

and systematic records of all

agricultural trade option transactions.

Such books and records should include

all orders (filled, unfilled, or cancelled),

books of record, journals, ledgers,

cancelled checks, copies of all

statements of purchase, exercise or

lapse, and reports, letters, disclosure

statements required by proposed

§ 32.13(a)(7), solicitation or advertising

material or other such communications

with agricultural trade option customers

or potential customers. All such books

and records must be kept for a period

of five years from the date of their

creation and must be readily accessible

during the first two years of the fiveyear period. All such books and records

must be open to inspection by any

representative of the Commission or the

U.S. Department of Justice or the NFA

in connection with functions delegated

to it.

2. Routine Reports

In addition to the maintenance of

books and records, the Commission is

proposing to require quarterly reporting

by all agricultural trade option

merchants of information relating to

their agricultural trade option

transactions. These reports are intended

to enable the Commission to evaluate

the success of the pilot program on an

ongoing basis. The information required

to be reported will enable the

Commission to determine the overall

size of the market, the types of contracts

being offered, the costs to customers, the

amount of commodity being

merchandized through options, and the

number of customers using trade

options. Routine quarterly reporting

from all agricultural trade option

merchants also will permit the

Commission to construct a more

complete picture of the market and will

better allow the Commission to evaluate

the impact of activity in the trade option

market on that in the cash and

exchange-traded markets.

Specifically, the Commission is

proposing that reports shall be filed

quarterly by any registered agricultural

trade option merchant having an open

trade option contract during the

reporting period. The Commission is

proposing to delegate to the NFA

responsibility for receiving and

maintaining these reports. NFA will

make the information in this data base

available to the Commission upon

request. Initially, the Commission

anticipates that such reports may be

filed manually, including by facsimile

or electronically, by dial-up

transmission or via the Internet.

Commenters are requested specifically

to address issues relating to the means

of filing reports and their capability to

file electronically.

3. Special Calls for Information

During the course of the pilot

program, in addition to routine

quarterly reports, the Commission

anticipates that it will direct the

Division to conduct two special calls for

information from agricultural trade

option merchants during the course of

the pilot program. The Commission will

use the information it gathers through

these special calls to conduct a study to

evaluate the success of the pilot

program.

Under a special call, every

agricultural trade option merchant will

be required to provide the Commission

with the information specified in the

special call. Such information may

include: (a) Positions and transactions

in agricultural trade options; (b)

positions and transactions in

commodity options and/or futures on all

contract markets entered to cover

agricultural trade options; (c) positions

and transactions in cash commodities,

their products, and by-products and; (d)

customer identification information.

Such information may include the

name, address, and position of each
59634 Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules

38Of course, such information is a routine

business record and is required to be maintained as

such by the agricultural trade option merchant. This

information would be available to the Commission

by special call for information or through

inspection on an as needed basis. The separate

listing would be encouraged as a means of

responding to a request for a total enumeration of

this information relating to an in-depth analysis in

connection with evaluating the pilot program.

39 62 FR 31381.

40Such an exemption would be from the

requirements relating to agricultural trade options

being proposed. Any such transaction, however,

would not be exempt from the prohibition of fraud

contained in 17 CFR 32.9.

customer of the agricultural trade option

merchant. All agricultural trade option

merchants should maintain a current

listing of such customer identification

information.38

G. Internal Controls

The Commission noted in the advance

notice that generally requirements

regarding internal controls are a

condition of registration. These include

the requirement that FCMs provide

audited financial statements, have in

place a system of internal controls, and

supervise the conduct of all employees.

The Commission also noted that many

country elevators and others at the firsthandler level of the marketing chain do

not now have in place adequate internal

controls to engage in a variety of offexchange transactions nor are they

subject to a regulatory scheme requiring

such controls.39

The Commission posed a series of

questions on this issue in the advance

notice, asking specifically for comment

on the minimum types of internal

controls that an agricultural trade option

merchant should have in place; the

regulatory oversight mechanisms that

would be necessary to assure

implementation of such minimum

levels of internal controls; and the most

cost-effective means by which such

internal controls could be implemented.

Of the 13 commenters responding to

these questions, the majority were of the

opinion that, although prudent business

practice necessitates use of internal

controls, the Commission should not

require them. Several commenters,

however, supported Commissionmandated audits of agricultural trade

option merchants. In this regard, one

commenter, noting that state grain

warehousing agencies may already

require annual audits and that state and

Federal warehouse regulators already

visit every licensed grain dealer,

suggested that the Commission consider

developing audit procedures which

existing agencies can implement on the

Commission’s behalf.

The Commission is proposing to

mandate an internal controls

requirement for agricultural trade option

merchants similar to that applicable to

FCMs. In mandating such a

requirement, the Commission believes

that agricultural trade option merchants

will be made aware of the importance of

maintaining internal controls without

being subjected to regulations that are

unduly burdensome. As proposed,

agricultural trade option merchants will

be required to be audited on a yearly

basis in accordance with generallyaccepted accounting principles and to

inform the Commission within three

business days of the discovery by a

certified public accountant of any

material inadequacies in the agricultural

trade option merchant’s internal

controls. As proposed, the agricultural

trade option merchant must file a

written report with the Commission

stating what steps have been taken or

are being taken to correct the material

inadequacy within five days of such a

notification.

In addition, the Commission is

proposing to require that the

agricultural trade option merchant must

maintain and preserve a written record

of internal trading and supervisory

controls. Such internal controls must

include any systems and policies that

the agricultural trade option merchant

has for supervising, monitoring,

reporting and reviewing trading

activities in agricultural trade options,

any policies it has for covering, hedging

or managing risk created by trading

activities, including a description of the

reviews it conducts to monitor

positions, and policies that relate to

restrictions or limitations on trading

activities.

H. Regulatory Oversight

Several commenters expressed the

concern that the Commission would not

be able to provide adequate regulatory

oversight of trading in agricultural trade

options. Specifically, commenters

questioned whether the Commission’s

existing staff and financial resources

would be sufficient to monitor trading

activity effectively in such a

decentralized market.

The Commission is proposing this

three-year pilot program based, in part,

on its belief that it will be joined in its

efforts to promote a safe and responsible

trading environment by many sectors of

agriculture. During the Commission’s

public hearings, several producer

associations and other agriculture

industry associations pledged their

assistance in promoting sound practices

by both merchants and producers. The

Commission has also determined to seek

the assistance of NFA in undertaking

responsibility for performing certain

specified functions. These delegations

should do much to aid the Commission

in maintaining adequate levels of

oversight, given its resource limitations.

In addition, the various states and

USDA conduct oversight of warehouses,

and the Commission will cooperate with

them in those efforts. The Commission

will also devote an appropriate level of

its resources to the conduct of sales

practice audits and other forms of

oversight.

In this regard, the Commission is

seeking comment on the number of

entities which may offer such contracts

under the rules as proposed. Should this

potentially create too large a burden on

Commission resources, the Commission

will explore additional delegations of

oversight or other means of conserving

its resources while providing adequate

oversight coverage. The Commission is

optimistic that, with these cooperative

efforts, it will be able to foster the

growth of responsible trading of

agricultural trade options using its

available resources and without

harming existing programs or

compromising its ability to achieve its

overall regulatory mission. It would not

proceed with the pilot program if it

thought otherwise.

I. Exemption for Sophisticated Entities

Some commenters expressed the

opinion that the prohibition on

agricultural trade options should be

lifted with few or no constraints. These

commenters maintained that

participants in these markets possess

sufficient sophistication with respect to

contracting so as not to require

regulatory oversight. The agricultural

sector, however, includes a diverse

group of entities with different levels of

sophistication, ranging from the small

family farmer to highly sophisticated

multinational corporations. Although

any one of these individuals or entities

might be entirely capable of

understanding and managing the risks

associated with entering into a trade

option contract, only the larger and

better financed entities will consistently

have available the legal and financial

resources needed to protect their

interests in an unregulated

environment. The Commission is of the

view that an exemption from regulatory

conditions similar to that available for

trade options on other commodities may

be appropriate for those entities having

a very high net worth.40 However, a

greater level of regulatory protection is

appropriate for transactions involving

less well-financed entities. Congress

adopted a similar approach for

Commission determinations of the
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59635

41Commission rule 33.4 provides in part that

‘‘The Commission may designate any board of trade

located in the United States as a contract market for

the trading of * * * options on physicals in any

commodity regulated under the Act other than

those commodities which are specifically

enumerated in section 1a(3) of the Act * * * ’’.

42Flex options on futures on the enumerated

agriculture commodities have recently been

proposed by exchanges and approved by the

Commission under current rules. These options are

flexible in terms of strike prices, last trading days,

the underlying futures months, and the style of

exercise—American or European. Additional types

of flexible terms involving physical delivery would

be permitted if the Commission’s rule is amended.

43See, 49 FR 2752 (January 23, 1984).

44Specifically, in April 1982 the Commission

found that FCMs were required to have a minimum

net capital of $50,000.

45 IBs are required to maintain minimum levels of

net capital in the amount of $30,000. See, 61 FR

19177 (May 1, 1996).

availability of exemptive relief under

section 4(c) of the Act.

In setting the eligibility requirements

for exemption from these rules, the

Commission considered the current

levels of net worth or total worth

required of eligible participants under

parts 35 and 36 of its rules. Under parts

35 and 36, corporations or partnerships

having total assets exceeding $10

million or net worth of $1 million in

cases where the transaction was entered

into in connection with the conduct of

its business or to manage the risk of an

asset or liability, are considered eligible

for the exemption. Some have observed,

however, that these qualifying amounts

when applied to entities in agriculture

are too low given the relatively large

investment in land and equipment

needed to operate a farm. The concern

is that a relatively large number of

individuals engaged in agriculture

might meet these financial criteria based

not so much on their investment

sophistication and ability to gather and

manage a sizable asset portfolio, but

rather simply reflecting the need to

acquire a threshold level of land and

machinery to operate successfully a

farm or agricultural enterprise.

Accordingly, the Commission is

proposing that, to qualify for this

exemption, individuals or entities

should have a net worth of at least $10

million.

In order to qualify for this proposed

exemption, both counterparties must

meet the eligibility requirements. If any

one counterparty is not eligible for this

exemptive relief, the counterparties

must comply with all of the regulatory

requirements.

J. Relief for Exchange-Traded

Instruments

Representatives of several futures and

option exchanges have expressed the

concern that lifting the ban on

agricultural trade options would put the

exchanges at a competitive

disadvantage. They note that exchanges

are currently prohibited from offering

options on physicals for these same

commodities.41 They further maintain

that the current prohibition on exchange

trading of options on physicals for the

enumerated commodities restricts their

ability to offer more flexible exchangetraded instruments that would be

competitive with agricultural trade

options.42

The Commission agrees that the

restriction on options on physicals in

these commodities can be removed. At

the time of the pilot program for

exchange-traded options on agricultural

commodities, based on comments

received from industry participants and

the U.S. Department of Justice and

taking into consideration the history of

abuse in option markets, the

Commission followed a cautious

approach by not allowing options on

physicals for agricultural

commodities.43 The Commission,

however, did express its willingness to

revisit the possibility of allowing

exchange-traded options on physicals

for agricultural commodities after

gaining experience in the trading of

options on agricultural futures. Given

the success of exchange-traded options

on futures, the lack of widespread abuse

in these markets, the permissible

flexibility of many option terms under

current rules, and the exchanges’ desire

to experiment with offering new forms

of more flexible, physical delivery

option contracts, the Commission is

proposing to amend § 33.4 to permit

exchanges to trade options on physicals

on the enumerated agricultural

commodities.

IV. Other Matters

A. Paperwork Reduction Act (PRA)

When publishing proposed rules, the

PRA of 1995 (Pub. L. 104–13 (May 13,

1996)) imposes certain requirements on

federal agencies (including the

Commission) in connection with their

conducting or sponsoring any collection

of information as defined by the PRA. In

compliance with the Act, the

Commission, through this rule proposal,

solicits comments to:

1. Evaluate whether the proposed

collection of information is necessary

for the proper performance of the

functions of the agency, including the

validity of the methodology and

assumptions used.

2. Evaluate the accuracy of the

agency’s estimate of the burden of the

proposed collection of information

including the validity of the

methodology and assumptions used.

3. Enhance the quality, utility, and

clarity of the information to be

collected.

4. Minimize the burden of the

collection of the information on those

who are to respond, including through

the use of appropriate automated,

electronic, mechanical, or other

technological collection techniques or

other forms of information technology;

e.g., permitting electronic submission of

responses.

The Commission has submitted the

proposed rule and its associated

information collection requirements to

the Office of Management and Budget.

The burden associated with this new

collection, including these proposed

rules, is as follows:

Average burden hours per response—

5.359

Number of respondents—5105

Frequency of response—Daily

Persons wishing to comment on the

information which would be required

by this proposed/amended rule should

contact the Desk Officer, CFTC, Office of

Management and Budget, Room 10202,

NEOB, Washington, DC 20503, (202)

395–7340. Copies of the information

collection submission to OMB are

available from the CFTC Clearance

Officer, 1155 21st Street, NW,

Washington, DC 20581, (202) 418–5160.

B. Regulatory Flexibility Act (RFA)

The RFA, 5 U.S.C. 601 et seq.,

requires that agencies, in proposing

rules, consider the impact of those rules

on small businesses. The Commission

has not previously determined whether

all or some agricultural trade option

merchants should be considered ‘‘small

entities’’ for purposes of the RFA and,

if so, to analyze the economic impact on

such entities. However, the Commission

is proposing that one of the conditions

for registration as an agricultural trade

option merchant is maintenance of a

minimum level of net worth. The

Commission previously found that other

entities which were required to

maintain minimum levels of net capital

were not small entities for purposes of

the RFA. See, 47 FR 18618, 18619 (April

30, 1982).44 The Commission has also

found, however, that one category of

Commission registrant—introducing

brokers (IBs)—which is required to

maintain a minimum level of net capital

may include small entities for purposes

of the RFA.45 Nevertheless, in addition
59636 Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules

to the $50,000 minimum net worth

required for registration as an

agricultural trade option merchant, such

registrants must be in business in the

underlying cash commodity so that they

are able to take physical delivery on

those option contracts. This will require

that they have additional resources

invested in order to qualify as an

agricultural trade option merchant, in

contrast to an IB whose additional

investment beyond the minimum net

capital may be relatively small. For this

reason, the Commission believes that

agricultural trade option merchants are

more appropriately treated as not being

small entities under the RFA. The

Chairperson, on behalf of the

Commission, hereby certifies, pursuant

to 5 U.S.C. 605(b), that the action taken

herein will not have a significant

economic impact on a substantial

number of small entities. This

certification is based on the fact that the

proposed rules will remove a complete

ban on the offer or sale of trade options

on the agricultural commodities

enumerated under the Act. The

proposed rules permitting such

transactions subject to the specified

conditions therefore remove a burden

for all entities, regardless of size.

List of Subjects

17 CFR Part 3

Administrative practice and

procedure, Brokers, Commodity futures.

17 CFR Part 32

Commodity futures, Commodity

options, Prohibited transactions and

trade options.

17 CFR Part 33

Commodity futures, Consumer

protection, Fraud.

In consideration of the foregoing, and

pursuant to the authority contained in

the Act, and in particular sections

2(a)(1)(A), 4c, and 8a, 7 U.S.C. 2, 6c, and

12a, as amended, the Commission

hereby proposes to amend parts 3, 32,

and 33 of chapter I of title 17 of the

Code of Federal Regulations as follows:

PART 3—REGISTRATION

1. The authority citation for part 3

continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 4, 4a, 6, 6b, 6c,

6e, 6f, 6g, 6h, 6i, 6k, 6m, 6n, 60, 6p, 8, 9, 9a,

12, 12a, 13b, 13c, 16a, 18, 19, 21, 23; 5 U.S.C.

552, 552b.

2. New § 3.13 is proposed to be added

to read as follows:

§ 3.13 Registration of agricultural trade

option merchants and their associated

persons.

(a) Registration required. It shall be

unlawful for any person in the business

of offering or selling the instruments

listed in § 32.2 of this chapter to offer

or to enter into transactions in such

instruments except if registered as an

agricultural trade option merchant or a

person associated with such a registered

agricultural trade option merchant

under this section.

(b) Duration of registration. A person

registered in accordance with the

provisions of this section shall continue

to be registered until the revocation or

withdrawal of registration.

(c) Conditions for registration.

Applicants for registration as an

agricultural trade option merchant and

its associated persons must meet the

following conditions:

(1) The agricultural trade option

merchant must have and maintain at all

times net worth of at least $50,000

computed in accordance with generally

accepted accounting principles.

(2) The agricultural trade option

merchant must certify:

(i) That none of the natural persons

who are principals of the agricultural

trade option merchant, directly or

indirectly through the beneficial

ownership of ten percent or more of a

principal which is a non-natural person,

nor any of the natural persons who are

associated persons is disqualified for the

reasons listed in section 8a(2) and (3) of

the Act; and

(ii) That such natural persons

successfully complete the series 3

examination or another proficiency test

administered by the National Futures

Association.

(3) Provide access to any

representative of the Commission, the

U.S. Department of Justice, or the

National Futures Association for the

purpose of inspecting books and

records.

(d) Application for registration.

Application for registration as an

agricultural trade option merchant and

its associated persons must be made on

the appropriate form specified by the

NFA, in accordance with the

instructions thereto. Such application:

(1) Must include the agricultural trade

option merchant’s most recent annual

financial statements certified by an

independent certified public accountant

in accordance with generally accepted

auditing standards prepared within the

prior 12 months.

(2) Must include the fingerprints, on

a fingerprint card obtained from the

National Futures Association, of all

natural persons who are principals, or

the beneficial owners of ten percent or

more of a principal which is a nonnatural person, of the applicant, and of

all natural persons who are to be

associated persons of the agricultural

trade option merchant and such other

identifying background information as

specified.

(3) Must include separate certification

from each natural person that the person

is not disqualified for any of the reasons

listed in section 8a(2) and 8a(3) of the

Act.

(4) Must include such other

information as may be specified on the

application form.

(5) This application must be

supplemented to include changes in

associated persons, a principal, or other

required information or conditions.

(e) Temporary licensing.

Notwithstanding any other provision of

this part, the National Futures

Association may grant a temporary

license to any applicant for registration

under this section upon filing of a

complete application meeting all of the

requirements of paragraph (d) of this

section, subject to termination

provisions of section 3.60 of this part,

Provided however, that such temporary

license shall terminate:

(1) Immediately upon failure by an

applicant to respond to a written request

by the Commission or the National

Futures Association for clarification or

supplementation of any information set

forth in the application or for the

resubmission of fingerprints.

(2) Immediately upon failure to

comply with an order to pay a civil

monetary penalty within the time

permitted under sections 6(e), 6b, or

6c(d) of the Act.

(3) Immediately upon failure to pay

the full amount of a reparation order

within the time permitted under section

14(f) of the Act.

(4) Five days after service upon the

applicant of a notice by the Commission

or the National Futures Association that

the applicant may be found subject to a

statutory disqualification from

registration.

3. Section 3.34 is proposed to be

amended by revising paragraphs (a),

(d)(1), and (e)(1) to read as follows:

§ 3.34 Mandatory ethics training for

registrants.

(a) Any individual registered as a

futures commission merchant,

introducing broker, commodity trading

advisor, commodity pool operator,

leverage trading merchant, associated

person, floor broker, floor trader, or

agricultural trade option merchant

under the Act must attend ethics

training to ensure that he or she
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59637

understands his or her responsibilities

to the public under the Act, including

responsibilities to observe just and

equitable principles of trade, rules, or

regulations of the Commission, rules of

any appropriate contract market,

registered futures association, or other

self-regulatory organization, or any

other applicable federal or state law,

rule or regulation.

* * * * *

(d) * * *

(1) Any individual granted

registration under the Act as a futures

commission merchant, introducing

broker, commodity trading advisory,

commodity pool operator, leverage

transaction merchant, associated person,

floor broker, floor trader or agricultural

trade option merchant after April 26,

1993, who has not been duly registered

under the Act at any time during the

two year period immediately preceding

the date such individual’s application

for registration was received by the

National Futures Association, must

attend training referred to in this section

within six months after being granted

registration, and thereafter every three

years.

* * * * *

(e) Evidence of attendance at ethics

training, including evidence of

completion of videotape or electronic

training, must be maintained in

accordance with § 1.31 of this chapter

by:

(1) An individual registered as a

futures commission merchant,

introducing broker, commodity trading

advisor, commodity pool operator,

leverage transaction merchant, or

agricultural trade option merchant;

* * * * *

PART 32—REGULATION OF

COMMODITY OPTION TRANSACTIONS

4. The authority citation for part 32

continues to read as follows:

Authority: 7 U.S.C. 2, 6c and 12a.

5. Section 32.2 is proposed to be

revised to read as follows:

§ 32.2 Prohibited transactions.

Notwithstanding the provisions of

§ 32.11, no person may offer to enter

into, confirm the execution of, or

maintain a position in, any transaction

in interstate commerce involving wheat,

cotton, rice, corn, oats, barley, rye,

flaxseed, grain sorghums, mill feeds,

butter, eggs, solanum tuberosum (Irish

potatoes), wool, wool tops, fats and oils

(including lard, tallow, cottonseed oil,

peanut oil, soybean oil and all other fats

and oils), cottonseed meal, cottonseed,

peanuts, soybeans, soybean meal,

livestock, livestock products, and frozen

concentrated orange juice if the

transaction is or is held out to be of the

character of, or is commonly known to

the trade as an ‘‘option,’’ ‘‘privilege,’’

‘‘indemnity,’’ ‘‘bid,’’ ‘‘offer,’’ ‘‘put,’’

‘‘call,’’ ‘‘advance guarantee,’’ or ‘‘decline

guarantee,’’ except as provided under

§ 32.13 of this part.

6. New § 32.13 is proposed to be

added to part 32 to read as follows:

§ 32.13 Exemption from prohibition of

commodity option transactions for trade

options on certain agricultural

commodities.

(a) The provisions of § 32.11 shall not

apply to the solicitation or acceptance of

orders for, or the acceptance of money,

securities or property in connection

with the purchase or sale of any

commodity option on a physical

commodity listed in § 32.2 by a person

who is 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

byproducts thereof, if all of the

following conditions are met at the time

of the solicitation or acceptance:

(1) That person is registered with the

Commission under § 3.13 of this chapter

as an agricultural trade option

merchant.

(2) The option offered by the

agricultural trade option merchant 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

byproducts thereof, and such producer,

processor, or commercial user of, or

merchant is offered or enters into the

commodity option transaction solely for

purposes related to its business as such.

(3) The option can only be settled

through physical delivery of the

underlying commodity.

(4) To the extent that payment by the

customer of the purchase price is made

to the agricultural trade option

merchant prior to option expiration or

exercise, that amount shall be treated as

belonging to the customer until option

expiration or exercise as provided under

§ 32.6, provided however, that

notwithstanding the last sentence of

§ 32.6(a), the full amount of such

payment shall be treated as belonging to

the option customer.

(5) Producers may not:

(i) Grant or sell a put option; or

(ii) Grant or sell a call option, except

to the extent that such a call option is

purchased or combined with a

purchased or long put option position,

and only to the extent that the

customer’s call option position does not

exceed the customer’s put option

position in the amount of delivery

quantity. Provided, however, that the

options must be entered into

simultaneously and expire

simultaneously or at any time that one

or the other option is exercised.

(6) All option contracts, including all

terms and conditions, offered or sold

pursuant to this section shall be in

writing and shall contain terms relating

to the following:

(i) The procedure for exercise of the

option contract, including the

expiration date and latest time on that

date for exercise;

(ii) The strike price(s) of the option

contract;

(iii) The total quantity of commodity

underlying the option contract;

(iv) The quality or grade of

commodity to be delivered if the

contract is exercised and any

adjustments to price for deviations from

stated quality or grade;

(v) The delivery location if the

contract is exercised;

(vi) The separate elements comprising

the purchase price to be charged,

including the premium, markups on the

premium, costs, fees and other charges;

and

(vii) The additional costs, if any, in

addition to the purchase price which

may be incurred by an option customer

if the commodity option is exercised,

including, but not limited to, the

amount of storage, interest,

commissions (whether denominated as

sales commissions or otherwise) and all

similar fees and charges which may be

incurred.

(7) Prior to the entry by a customer

into the first option transaction with an

agricultural trade option merchant, the

agricultural trade option merchant shall

furnish a summary disclosure statement

to the option customer. The summary

disclosure statement shall include:

(i) The following statements in

boldface type on the first page(s) of the

disclosure statement:

This brief statement does not disclose all

of the risks and other significant aspects of

trading in commodity trade options. You are

encouraged to seek out as much information

as possible from sources other than the

person selling you this option about the use

and risks of using option contracts before

entering into this contract. The issuer of your

option should be willing and able to answer

clearly any of your questions. If this is not

the case, contact someone else to find

answers to your questions before entering

into a contract. Sources of information

include the Commodity Futures Trading

Commission (a U.S. Government agency), the

U.S. Department of Agriculture, the National

Futures Association (a self-regulatory
59638 Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules

association in the commodity futures

industry), your state extension service, and

various agricultural associations.

APPROPRIATENESS OF OPTION

CONTRACTS

Option contracts may subject the user to a

high degree of price risk including total loss

of any funds you pay to the issuer of your

option. You should carefully consider

whether trading in such instruments is

appropriate for you in light of your

experience, objectives, financial resources

and other relevant circumstances. The issuer

of your option contract should be willing and

able to explain the financial outcome of your

option contract under all market conditions.

COSTS AND FEES ASSOCIATED WITH AN

OPTION CONTRACT

All costs and obligations associated with

your option contract including the premium,

commissions, fees, costs associated with

delivery if the option is exercised and any

other charges which may be incurred should

be specified in the terms of your option

contract and are explained in this disclosure

statement. Before entering into an option

contract, you should obtain a clear

explanation of all of these costs and fees and

understand them.

BUSINESS USE OF TRADE OPTIONS

In order to comply with the law, you must

be buying this option for business-related

purposes. As such, the terms and structure of

the contracts should relate to your activity or

commitments in the underlying cash market.

If a trade option is exercised, delivery of the

commodity must occur. Delivery dates,

grades, quantities, and delivery locations,

which are specified in the contract, should

relate to your ability to make or take delivery

of the commodity. Any amendments allowed

to the option contract must reflect changes to

your activity or commitments in the

underlying cash market or to reflect the

carrying of inventory. Producers are not

permitted to sell call options unless the

producer is also entering into a put option

contract at the same time with the same

expiration date. In those situations, the

contracts cannot give the person buying the

call option the right to call for the delivery

of an amount of commodity greater than the

producer would have the right to deliver if

he or she exercises the delivery option.

Producers are also not permitted to sell put

options, whether alone or in combination

with a call option.

RISK OF FRAUD

You should be aware that trade options are

offered in a relatively unregulated and

decentralized environment, which may allow

for a higher incidence of fraud than in a more

regulated and restricted market. You should

be aware that you may be able to obtain a

similar contract or execute a similar strategy

using an instrument offered on a more highly

regulated futures exchange. Moreover,

exchange products will likely be more

transparent and the current prices on which

are likely to be reported on a more regular

basis. In addition, exchange options are

highly liquid and may be offset at any time.

In contrast, trade options legally may only be

satisfied if exercised through physical

delivery.

COUNTERPARTY PERFORMANCE RISK

If you are purchasing an option contract

(i.e., acquiring the right to sell or purchase

the commodity), be aware that you face the

risk that the other party to the contract may

not perform on its obligation to purchase or

sell the commodity. If this occurs, you may

lose any price protection the option contract

would have offered you. You should take this

risk into account in selecting an agricultural

trade option merchant.

DISPUTE RESOLUTION

If a dispute should arise under the terms

of this trade option contract, you may be able

to use the reparations program run by the

Commission in addition to any other dispute

resolution forums provided to you under law

or under the terms of your customer

agreement. For more information on the

Commission’s Reparations Program contact:

Office of Proceedings, Commodity Futures

Trading Commission, Three Lafayette Centre,

1155 21st Street, NW., Washington, DC

20581, (202) 418–5250.

ACKNOWLEDGEMENT OF RECEIPT

The Commodity Futures Trading

Commission requires that all customers

receive and acknowledge receipt of a copy of

this disclosure statement. The Commodity

Futures Trading Commission does not intend

this statement as a recommendation or

endorsement of agricultural trade options.

These commodity options have not been

approved or disapproved by the Commodity

Futures Trading Commission, nor has the

Commission passed upon the accuracy or

adequacy of this disclosure statement. Any

representation to the contrary is a violation

of the Commodity Exchange Act and Federal

regulations;

(ii) The following additional

information must be provided prior to

entry by a customer into every option

transaction with an agricultural trade

option merchant: (A) The procedure for exercise of the

option contract, including the

expiration date and latest time on that

date for exercise;

(B) A description of the elements

comprising the purchase price to be

charged, including the premium, markups on the premium, costs, fees and

other charges, and the services to be

provided for the separate elements

comprising the purchase price; (C) A description of any and all costs

in addition to the purchase price which

may be incurred by an option customer

if the commodity option is exercised,

including, but not limited to, the

amount of storage, interest,

commissions (whether denominated as

sales commissions or otherwise) and all

similar fees and charges which may be

incurred;

(D) Where the full option premium or

purchase price of the option is not

collected up front or where through

amendments to the option contract it is

possible to lose more than the amount

of the initial purchase price, a

description of the worst possible

financial outcome that could be suffered

by the customer; and

(E) The following acknowledgment

section:

I hereby acknowledge that I have received

and understood this risk disclosure

statement.

Date llllllllllllllllll

Signature of Customer llllllllll

(b) Report of account information.

Registered agricultural trade option

merchants must provide in writing to

customers with open positions the

following information:

(1) Within 24 hours of execution of an

agricultural trade option confirmation of

the transaction, including a copy of the

written contract and all information

required in paragraph (a)(6) of this

section;

(2) Within 24 hours of a request by the

customer, current commodity price

quotes or other information relevant to

the customer’s position and account;

and

(3) Monthly, a current account

statement including a complete listing

of all individual agricultural trade

option transactions which clearly states

the expiration date of each option and

clearly distinguishes and draws

attention to those options which will

expire within the next month, all orders

to enter into such transactions not yet

filled, a current commodity price related

to all open option positions or open

orders, and the amount of any funds

owed by, or to, the customer.

(c) Recordkeeping. Registered

agricultural trade option merchants

shall keep full, complete and systematic

books and records together with all

pertinent data and memoranda of or

relating to such transactions, including

customer solicitation and covering

transactions, maintain such books and

records for the period specified in § 1.31

of this chapter, and make such reports

to the Commission as provided for in

paragraphs (c) and (d) of this section

and as the Commission may otherwise

require by rule, regulation, or order.

Such books and records shall be open at

all times to inspection by any

representative of the Commission, the

Department of Justice, or the National

Futures Association.

(d) Reports. Registered agricultural

trade option merchants must file reports

quarterly with the National Futures

Association, in the form and manner

specified by the National Futures

Association and approved by the

Commission, which shall contain the

following information:
Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 / Proposed Rules 59639

(1) By commodity and put, call or

combined option:

(i) Total number of new contracts

entered into during the reporting period;

(ii) Total quantity of commodity

underlying new contracts entered into

during the reporting period;

(iii) Total number of contracts

outstanding at the end of the reporting

period;

(iv) Total quantity of underlying

commodity outstanding under option

contracts at the end of the reporting

period;

(v) Total premiums collected on

options during the reporting period;

(vi) The value of all fees,

commissions, or other charges other

than option premiums, collected on

trade options during the reporting

period;

(vii) Total number of options

exercised during the reporting period;

(viii) Total quantity of commodity

underlying the exercise of options

during the reporting period.

(2) Total number of customers by

commodity with open option contracts

at the end of the reporting period.

(e) Special calls. Upon special call by

the Commission for information relating

to agricultural trade options offered or

sold on the dates specified in the call,

each agricultural trade option merchant

shall furnish to the Commission within

the time specified the following

information as specified in the call:

(1) All positions and transactions in

agricultural trade options including

information on the identity of

agricultural trade option customers.

(2) All positions and transactions for

future delivery or options on contracts

for future delivery or on physicals on all

contract markets.

(3) All positions and transactions in

cash commodities, their products, and

by-products.

(f) Internal controls. (1) Each

agricultural trade option merchant

registered with the Commission shall

prepare, maintain and preserve

information relating to its written

policies, procedures, or systems

concerning the agricultural trade option

merchant’s internal controls with

respect to market risk, credit risk, and

other risks created by the agricultural

trade option merchant’s activities,

including systems and policies for

supervising, monitoring, reporting and

reviewing trading activities in

agricultural trade options; policies for

hedging or managing risk created by

trading activities in agricultural trade

options, including a description of the

types of reviews conducted to monitor

positions; and policies relating to

restrictions or limitations on trading

activities.

(2) The financial statements of the

agricultural trade option merchant must

on an annual basis be audited by a

certified public accountant in

accordance with generally accepted

auditing standards.

(3) The agricultural trade option

merchant must file with the

Commission a copy of its certified

financial statements within 90 days after

the close of the agricultural trade option

merchant’s fiscal year.

(4) The agricultural trade option

merchant must perform a reconciliation

of its books at least monthly.

(5) The agricultural trade option

merchant:

(i) Must report immediately if its net

worth falls below the level prescribed in

§ 3.13 of this chapter, and must report

within three days discovery of a

material inadequacy in its financial

statements by the independent public

accountant or any state or federal

agency performing an audit of its

financial statements promptly to the

Commission and National Futures

Association by facsimile, telegraphic or

other similar electronic notice; and

(ii) Within five business days after

giving such notice, the agricultural trade

option merchant must file a written

report with the Commission stating

what steps have been taken or are being

taken to correct the material

inadequacy.

(6) If the agricultural trade option

merchant’s net worth falls below the

level prescribed in § 3.13(c)(1) of this

chapter, it must immediately cease

offering or entering into new option

transactions and must notify customers

having premiums which the agricultural

trade option merchant is holding under

paragraph (a)(4) of this section that such

customers can obtain an immediate

refund of that premium amount, thereby

closing the option position.

(g) Exemption. (1) The provisions of

this section shall not apply to a

commodity option offered by a person

which 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,

and that both parties to the contract

have a net worth of not less than 10

million dollars.

(2) Provided, however, that § 32.9 of

this part continues to apply to such

option transactions.

PART 33—REGULATION OF

DOMESTIC EXCHANGE-TRADED

COMMODITY OPTION TRANSACTIONS

7. The authority citation for part 33

continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 4, 6, 6a, 6d, 6e,

6f, 6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 7, 7a, 7b,

8, 9, 11, 12a, 13a, 13a–1, 13b, 19, and 21.

8. The first sentence of the

introductory text of § 33.4 is proposed to

be revised to read as follows:

§ 33.4 Designation as a contract market for

the trading of commodity options.

The Commission may designate any

board of trade located in the United

States as a contract market for the

trading of options on contracts of sale

for future delivery or for options on

physicals in any commodity regulated

under the Act, when the applicant

complies with and carries out the

requirements of the Act (as provided in

§ 33.2), these regulations, and the

following conditions and requirements

with respect to the commodity option

for which the designation is sought:

* * * * *

Issued this 29th day of October 1997, in

Washington, DC, by the Commodity Futures

Trading Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 97–29037 Filed 11–3–97; 8:45 am]

BILLING CODE 6351–01–P

DEPARTMENT OF THE INTERIOR

Office of Surface Mining Reclamation

and Enforcement

30 CFR Parts 707 and 874

RIN 1029–AB94

Enhancing Abandoned Mine Land

(AML) Reclamation

AGENCY: Office of Surface Mining

Reclamation and Enforcement, Interior.

ACTION: Advanced notice of proposed

rulemaking; notice of public meetings.

SUMMARY: The Office of Surface Mining

Reclamation and Enforcement (OSM) is

announcing times and locations of

meetings open to the public to discuss

its early draft of a proposal for adding

to the reclamation of abandoned mine

lands already being accomplished under

Title IV of the Surface Mining Control

and Reclamation Act of 1977 (SMCRA).

OSM is seeking to involve the public in

the development of a proposed rule