Source: https://www.federalregister.gov/documents/2001/04/25/01-10222/opting-out-of-segregation
Timestamp: 2017-11-22 21:51:58
Document Index: 7612777

Matched Legal Cases: ['§\u20091', '§\u20091', '§\u20091', '§\u20091', '§\u20091', '§\u20091', '§\u20091', '§\u200937', '§\u20091', '§\u20091', 'art 190', '§\u20091', '§\u20091', '§\u20091', '§\u20091', '§\u200931', 'art 190']

A Rule by the Commodity Futures Trading Commission on 04/25/2001
3038-AB67
https://www.federalregister.gov/d/01-10222 https://www.federalregister.gov/d/01-10222
The Commodity Futures Modernization Act of 2000 (“CFMA”),[1] enacted on December 21, 2000, included a new section 5a of the Commodity Exchange Act (the “Act”) [2] to permit a board of trade, subject to certain conditions, to elect to operate as a registered DTF in lieu of seeking designation as a contract market.[3] In order to operate as a registered DTF, the board of trade must meet certain requirements as to the underlying commodities traded and must restrict access to certain eligible traders. The newly-enacted section 5a(f) of the Act provides that a registered DTF may authorize an FCM to offer its customers that are eligible contract participants [4] the right not to have their funds that are carried by the FCM for purposes of trading on the registered DTF, separately accounted for and segregated. Opting out of segregation is not available to a customer who is not also an eligible contract participant.
On March 13, 2001, the Commission published a proposed new rule allowing FCMs to offer certain customers the right to elect not to have funds, that are being carried by the FCM for purposes of margining, guaranteeing or securing the customers' trades on or through a registered DTF, separately accounted for and segregated, sometimes referred to as “opting out” of segregation.[5] The Commission proposed to add new Rule 1.68 to implement the newly-enacted section 5a(f) of the Act. The proposed rule provided that an FCM shall not segregate a customer's funds where: (i) The customer is an eligible contract participant; (ii) the funds are deposited with the FCM for purposes of trading on a registered DTF; (iii) the DTF has authorized the FCM to permit eligible contract participants to elect not to have such funds segregated; and (iv) there is a written agreement signed by the customer [6] in which the customer elects to opt out of segregation and acknowledges that it is aware of the consequences of not having its funds segregated.[7] In particular, the agreement would have been required to explain that, to the extent a customer has a claim against the estate of a bankrupt FCM in connection with trades for which it has opted out of segregation, Start Printed Page 20741the customer would be treated like a general creditor.[8]
The proposed rule would also have provided that a customer who chose to opt out of segregation would not be permitted to establish a “third-party custodial account,” sometimes also referred to as a “safekeeping account.” In Financial and Segregation Interpretation No. 10 (“Interpretation No. 10”), the Commission's Division of Trading and Markets (the “Division”) set forth guidelines for these types of accounts.[9]
Rule 1.17(a)(1)(i) provides the standards for determining the minimum adjusted net capital that must be maintained by each person registered as an FCM. The Commission proposed to amend Rule 1.17(a)(1)(i)(B), which contains the volume of business element of these standards, to make clear that the funds of an opt-out customer are to be included in the computation of the FCM's minimum adjusted net capital requirement. The proposed amendment to the rule ensured that opt-out customers, by opting out of segregation, do not have an impact on the financial condition of the FCM, thereby increasing the risk to the other customers of the FCM or to the marketplace. In proposing the amendment, the Commission noted that by including the funds of the opt-out customer for purposes of calculating the minimum adjusted net capital, there is no effect on the current minimum capital requirements for registered FCMs.[10]
FIA, CME, NFA, CBOT, OCC, and SIA all expressed concern that customers who choose to opt out of segregation would, in the event of an FCM bankruptcy, be treated as general creditors and, therefore, would have claims inferior to proprietary accounts carried by an FCM.[11] For purposes of bankruptcy proceedings, proprietary accounts are included in the definition of a non-public customer.[12] Non-public customers receive a portion of the customer estate only after all public customer claims have been satisfied in full.[13] Therefore, under the proposed rules, a non-public customer would have a priority superior to an opt-out customer in the unlikely event that there are customer funds in excess of Start Printed Page 20742the net equity claims of all public customers in the bankrupt estate.
FIA, in suggesting language to clarify Rule 1.3(uu), appears to indicate that a customer must individually elect to opt out of segregation as to each particular DTF. As discussed above, and in the proposing release, the agreement entered into between an FCM and a customer may provide that it covers agreements, contracts or transactions on all DTFs that have authorized opting out. In such a case, there would be only one agreement that covers all DTFs on which the customer trades. If, however, an FCM chooses to draft the opt-out agreement so that it covers only a specific DTF, and, therefore, a separate agreement would be required for each DTF on which the customer conducts trades, that would also be permissible. However, the Commission does not require this latter arrangement in Rule 1.68 as adopted.[14]
Proposed Rule 1.68(e) would have prohibited a customer that elects to opt out of segregation from establishing a third-party custodial account as described in Interpretation No. 10. This provision was intended to prevent an opt-out customer from securing a priority in customer funds equal to or greater than that of customers whose funds are separately accounted for and segregated. FIA and NFA both suggested that the Commission could achieve this purpose in a more straightforward manner “by prohibiting certain contractual provisions generally.” The Commission agrees. Therefore, Rule 1.68 will require a customer who elects to opt out of segregation to agree not to enter into any agreement or understanding with an FCM that would permit the customer to retain a security interest in any assets deposited with the FCM that are not subject to segregation. Further, a customer may not enter into any agreement or understanding with an FCM relating to the manner in which the customer's assets will be held at the FCM that, in the event of bankruptcy, would give the customer a priority that is equal to or greater than the priority afforded customers whose funds are segregated. This prohibition applies to any agreement or understanding, whether or not it is the type discussed in Interpretation No. 10.[15]
Rule 1.68(b) provides that under no circumstances may funds related to opt-out accounts be commingled with funds held in segregation. CBOT expressed its agreement with this rule and suggested that where a customer has both segregated and non-segregated accounts, the Commission use the same principles currently applied where a customer has both a regulated and non-regulated account. The Commission agrees. Where a customer has both a segregated and an opt-out account, any positive balance or net liquidating equities in the opt-out account may not be used to offset any deficit which may be in the segregated account.[16]
FIA also expressed a desire for FCMs to be permitted to establish a notice period before a customer's decision to revoke its election to opt out of segregation would become effective. FIA indicated that FCMs require a Start Printed Page 20743reasonable time period to make the appropriate changes to books and records. The Commission recognizes that FCMs need time to make the required operational changes where a customer revokes its election to opt out of segregation. To avoid disputes as to what may constitute a reasonable time period, the Commission is adopting a five-business day limit to accomplish the necessary changes.
The Regulatory Flexibility Act (“RFA”) [17] requires that agencies, in promulgating rules, consider the impact of those rules on small businesses. The Commission has previously established certain definitions of “small entities” to be used by the Commission in evaluating the impact of its rules on such entities in accordance with the RFA.[18] The Commission has previously determined that FCMs are not small entities for the purpose of the RFA.[19] Additionally, eligible contract participants, as defined in the newly-amended Act, by the nature of the definition, should not be considered small entities. Further, eligible contract participants have the choice as to whether or not to exercise the right not to have certain funds segregated from the FCM's funds. Furthermore, no comments were received from the public on the RFA and its relation to the proposed rules.
New Rule 1.68 contains information collection requirements. As required by the Paperwork Reduction Act of 1995,[20] the Commission submitted a copy of the proposed rules to the Office of Management and Budget for its review. No comments were received in response to the Commission's invitation in the proposed rules to comment on any potential paperwork burden associated with this regulation.
The amended section 15 further specifies that costs and benefits shall be evaluated in light of five broad areas of market and public concern: (1) Protection of market participants and the public; (2) efficiency, competitiveness, and financial integrity of futures markets; (3) price discovery; (4) sound risk management practices; and (5) other public interest considerations.[21] Accordingly, the Commission could in its discretion give greater weight to any one of the five enumerated areas of concern and could in its discretion determine that, notwithstanding its costs, a particular rule was necessary or appropriate to protect the public interest or to effectuate any of the provisions or to accomplish any of the purposes of the Act.
In consideration of the foregoing and pursuant to the authority contained in Start Printed Page 20744the Commodity Exchange Act and, in particular, sections 2(a)(1)(A), 4d, 5a(f), and 8a(5) 7 U.S.C. 2(i), 6d, 7a(f), and 12a(5), and 11 U.S.C. 362, 546, 548, 556 and 761-766, the Commission hereby amends Chapter I of Title 17 of the Code of Federal Regulations as follows:
(uu) Opt-out customer. This term means a customer that is an eligible contract participant, as defined in section 1a(12) of the Act, and that, in accordance with § 1.68, has elected not to have funds that are being carried for purposes of trading on or through the facilities of a registered derivatives transaction execution facility, separately accounted for and segregated by the futures commission merchant pursuant to section 4d of the Act and §§ 1.20-1.30, 1.32 and 1.36. A customer is an opt-out customer solely with respect to agreements, contracts or transactions, and the money, securities or property received by a futures commission merchant to margin, guarantee or secure such agreements, contracts or transactions, made on or subject to the rules of any derivatives transaction execution facility that has adopted rules permitting a customer to elect to be an opt-out customer and with respect to which the customer has made such an election. For all other purposes under the Act and the rules thereunder, except where otherwise provided, an opt-out customer shall be a customer as defined in § 1.3(k).
(2) Six percent of the following amount: The customer funds required to be segregated pursuant to the Act and the regulations in this part, plus the funds of opt-out customers that, but for the election to opt out pursuant to § 1.68, would be required to be segregated, plus the foreign futures or foreign options secured amount, less the market value of commodity options purchased by such customers on or subject to the rules of a contract market or a foreign board of trade for which the full premiums have been paid: Provided, however, that the deduction for each such customer shall be limited to the amount of customer funds in such customer's account(s) and foreign futures and foreign options secured amounts;
b. By amending paragraphs (e)(1)(ii), (h)(2)(vi)(C)(2), (h)(2)(vii)(A)(2),(h)(2)(vii)(B)(2), (h)(2)(viii)(A)(2), (h)(3)(ii)(B), and (h)(3)(v)(B) by removing the second instance of the word “and” and adding in its place the words “, plus the funds of opt-out customers that, but for the election to opt out pursuant to § 1.68, would be required to be segregated, plus”; the revision as follows:
(a) A futures commission merchant shall not separately account for and segregate, in accordance with the provisions of section 4d of the Act and §§ 1.20-1.30, 1.32 and 1.36, funds received from a customer if:
(i) Represents and warrants that the customer is an eligible contract participant as defined in section 1a(12) of the Act;Start Printed Page 20745
(ii) Elects not to have its funds separately accounted for and segregated in accordance with the provisions of section 4d of the Act and §§ 1.20-1.30, 1.32 and 1.36 with respect to agreements, contracts or transactions traded on or subject to the rules of any registered derivatives transaction execution facility that has authorized such treatment in accordance with § 37.7 of this chapter;
(A) The customer's funds, related to agreements, contracts or transactions on any registered derivatives transaction execution facility that authorizes the opting out of segregation will not be segregated from the funds of the futures commission merchant in accordance with the provisions of section 4d of the Act and §§ 1.20-1.30, 1.32 and 1.36;
(C) In the event the futures commission merchant files, or has a petition filed against it, for bankruptcy, the customer, as to those funds that the customer has elected not to have separately accounted for and segregated by the futures commission merchant in accordance with the provisions of section 4d of the Act and §§ 1.20-1.30, 1.32 and 1.36, will not be entitled to the priority for customer claims provided for under the Bankruptcy Code and part 190 of this chapter;
(b) In no event may money, securities or property representing those funds that customers have elected not to have separately accounted for and segregated by the futures commission merchant, in accordance with this section, be held or commingled and deposited with customer funds in the same account or accounts required to be separately accounted for and segregated pursuant to section 4d of the Act and §§ 1.20-1.30, 1.32 and 1.36.
(d) Each futures commission merchant shall maintain any agreements entered into with customers pursuant to paragraph (a) of this section and any abrogations of such agreements, made pursuant to paragraph (c) of this section, in accordance with § 1.31.
(bb) Non-public customer means any person enumerated in § 1.3(y), § 1.3(uu) or § 31.4(e) of this chapter, who is defined as a customer under paragraph (k) of this section.
8. Normally, in the event of an FCM's bankruptcy, customer claims have priority with respect to customer property over all other claims, except claims “attributable to the administration of customer property.” See 11 U.S.C. 766(h); see also 17 CFR part 190. To the extent that the customer has claims against the bankrupt FCM's estate for trades to which segregation applies, e.g., trades on or subject to the rules of contract markets, or of DTFs for which opting out of segregation is not permitted, the customer would be eligible for the customer priority. Thus, the same customer may have two different kinds of claims against the estate of a bankrupt FCM. See 48 FR 8716 (March 1, 1983).
9. Financial and Segregation Interpretation No. 10, 1 Comm. Fut. L. Rep. (CCH) ¶ 7120 (May 23, 1984).