FUTURES INDUSTRY ASSOCIATION INC.
2001 Pennsylvania Avenue N.W., Suite 600
Washington, DC 20006-1807
Fax: (202) 296-3184
July 26, 2001
Mr. Jonathan G. Katz
Secretary to the Commission
Securities and Exchange Commission
450 Fifth Street
Washington DC 20549-0609
Re: Registration of Broker Dealers Pursuant to Section 15(b)(11)
of the Exchange Act, 66 Fed.Reg. 34041 (June 26, 2001)
SEC File No. S7-13-01
Dear Mr. Katz:
The Futures Industry Association ("FIA") is pleased to submit the following comments on the rules that the Securities and Exchange Commission ("SEC") has proposed to implement section 15(b)(11) of the Securities Exchange Act of 1934 ("Exchange Act"). FIA is a principal spokesman for the commodity futures and options industry. Our regular membership is comprised of approximately 60 of the largest futures commission merchants ("FCMs") in the United States, the majority of which, but by no means all, are also registered broker-dealers. Among our associate members are representatives from virtually all other segments of the futures industry, both national and international. Reflecting the scope and diversity of our membership, FIA estimates that our members effect more than 90 percent of all customer transactions executed on US contract markets.
Section 15(b)(11) is part of the series of amendments to the Exchange Act and the Commodity Exchange Act enacted in the Commodity Futures Modernization Act of 2000 ("CFMA"), designed to authorize the trading of futures contracts in individual securities and narrow-based security indexes ("security futures products").1 In particular, section 15(b)(11)(A) affords futures commission merchants and introducing brokers, registered as such under the Commodity Exchange Act ("CEA"), with a right to register as broker-dealers for the limited purpose of effecting trades in security futures products on behalf of customers by filing a written notice with the SEC.2
Public Policy and Competitive Fairness Demand that Notice Registered Broker-Dealers Have the Ability to Become Members of National Securities Exchanges.
We turn first to proposed Regulation 240.15a-10(b). In the Federal Register release accompanying the proposed rules, the SEC states that the "plain language" of section 15(b)(11) of the Exchange Act restricts notice registered broker-dealers to effecting transactions only on a contract market that has been notice registered as a national securities exchange pursuant to section 6(g) of the Exchange Act.3 Consequently, proposed Regulation 240.15a-10(b) provides that an FCM or introducing broker may be notice registered as a broker-dealer only if it is not: (1) a member of a national securities exchange registered pursuant to section 6(a) of the Exchange Act;4 or (2) a member of a national securities association registered under section 15A(k) of the Exchange Act.
For the reasons set forth in this letter, FIA urges the SEC to reconsider its interpretation of this section of the Exchange Act and revise its proposal to permit notice registered broker-dealers to become members of a national securities exchange, subject to the conditions below.5 We submit that the SEC's current proposal does not achieve its purported goal of preventing competitive advantages from arising out of differences in futures regulation and securities regulation. To the contrary, the proposed rules will discriminate against notice registered broker-dealers by affording only full broker-dealers the opportunity of direct access to all markets on which security futures products may be traded.
FIA respectfully suggests that each national securities exchange on which security futures products are traded should have the authority to decide whether a notice registered broker-dealer should be admitted as a member of the exchange for the purpose of effecting trades in such products. In this regard, if the SEC believes that certain provisions of the Exchange Act not currently applicable to notice registered broker-dealers should apply to such entities if they are admitted to membership, the exchange could require the notice registered broker-dealer to agree to comply with such provisions as a condition of being admitted to membership.
The provisions of section 15(b)(11)(A) of the Exchange Act contrast with the provisions of section 4f(a) of the Commodity Exchange Act ("CEA"). As noted, section 15(b)(11)(A) appears to provide that an FCM that is notice registered as a broker-dealer may effect transactions in security futures products traded only on a designated contract market that is notice registered as a national securities exchange pursuant to section 6(g) of the Exchange Act. On the other hand, a broker-dealer that is notice registered as an FCM pursuant to section 4f(a) of the CEA may effect transactions in security futures products on a designated contract market as well as a national securities exchange. Despite the obvious incongruity, the SEC asserts that such disparate treatment is necessary "to prevent competitive advantages from arising solely out of differences between futures regulation and securities regulation."6 FIA respectfully submits that the apparent competitive advantage the SEC has identified, discussed below, is illusory.
The public and regulatory purposes underlying the disparate treatment of notice registered broker-dealers under section 15(b)(11)(A) of the Exchange Act and notice registered FCMs under section 4f(a) of the CEA were never explained fully to Congress when it enacted the CFMA. As the SEC is aware, there is virtually no legislative history to accompany the CFMA and the joint statement issued by the SEC and Commodity Futures Trading Commission ("CFTC") describing this section of the bill gives no indication that notice-registrant broker-dealers and notice-registrant FCMs would have different privileges.7 In particular, the joint statement does not indicate that notice-registrant broker-dealers would be prohibited from becoming members of a national securities exchange.
In the Federal Register release accompanying the proposed rules, the SEC has stated that the disparate treatment is justified "because the Exchange Act and the CEA provide different standards with respect to the ability of an intermediary to become a member of a market or an exchange." That is, pursuant to section 6(b)(2) of the Exchange Act a national securities exchange "must permit any registered broker-dealer to become a member of the exchange." The CEA, in contrast, "permits designated contract markets to set fitness standards and does not require them to accept any specific type of person or entity as a member."8 The SEC states that this difference would permit a designated contract market to deny membership to a notice registered FCM, while a national securities exchange would have no ability to deny membership to a notice registered broker-dealer. FIA respectfully disagrees with the SEC's analysis of the relevant provisions of these statutes.
The lack of a statutory provision requiring contract markets to accept as members any specific class or type of entity, in particular registered FCMs, cannot be interpreted as vesting in contract markets the right to deny membership arbitrarily to any qualified applicant. To the contrary, the CEA simply reflects a congressional determination that appropriate fitness standards are, in the first instance, the responsibility of each contract market. The CEA, therefore, differs from the Exchange Act in this regard. The Exchange Act expressly prohibits a national securities exchange from accepting as a member (1) any person, other than a natural person, which is not registered as a broker or dealer, or (2) any natural person who is not, or is not associated with, a registered broker or dealer.9
Contract markets, on the other hand, have no authority to discriminate against any type or class of person. In accordance with section 5 of the CEA, contract markets are required to establish and enforce (1) trading rules to ensure fair and equitable trading through the facilities of the contract market, and (2) appropriate fitness standards for members of the contract market. Unless necessary or appropriate to achieve the purposes of the CEA, contract markets are instructed to avoid adopting rules that result in any unreasonable restraint of trade or impose any material anti-competitive burden on trading on the contract market.10 If the CFTC determines at any time that the contract market has violated these provisions of the CEA, the CFTC is authorized to initiate action against the contract market.11 These provisions of the CEA provide the CFTC with ample authority to assure that a contract does not unreasonably deny membership to any type of person or entity, including notice registered FCMs.
In any event, the authority to establish fitness standards for its members that the CEA grants each contract market, is essentially no different from that accorded national securities exchanges under the Exchange Act.12 For example, a national securities exchange "may deny membership to, or condition the membership of, a registered broker or dealer, if:
(i) such broker or dealer does not meet such standards of financial responsibility or operational capability or such broker or dealer, or any natural person associated with such broker or dealer does not meet such standards of training, experience, and competence as are prescribed by the rules of the exchange; or
(ii) such broker or dealer or person associated with such broker or dealer has engaged and there is a reasonable likelihood he may again engage in acts or practices inconsistent with just and equitable principles of trade. A national securities exchange may examine and verify the qualifications of an applicant and the natural persons associated with such applicant in accordance with procedures established by the rules of the exchange.13
These provisions of the Exchange Act provide the securities exchanges considerable latitude in establishing fitness standards governing its members. The rules of the Chicago Board Options Exchange ("CBOE") are illustrative. CBOE Rule 3.5(c) provides, in part, that the Membership Committee may deny or condition membership when the applicant:
(ii) is unable satisfactorily to demonstrate a capacity to adhere to all applicable Exchange, Securities and Exchange Commission, Clearing Corporation, and Federal Reserve Board policies, rules, and regulations, including those concerning recordkeeping, reporting, finance and trading procedures;
(iii) would bring the Exchange into disrepute; or
(iv) for such other cause as the Membership Committee reasonably may decide. [Emphasis supplied.]
A contract market would have no practical reason to deny membership to a notice registered FCM that meets the exchange's prescribed fitness standards. The identity of all of the exchanges, both contract markets and national securities exchanges, that intend to list security futures products for trading is unclear. It is reasonably safe to predict, however, that one or more contract markets will be competing for volume with one or more national securities exchanges. In these circumstances, contract markets have every incentive to attract volume by soliciting as members entities that may have experience in trading securities or that carry accounts of persons with such expertise or interest. Since full broker-dealers have particular expertise in trading securities and carry accounts of persons trading in cash securities, contract markets will have every reason to welcome such entities as members and no incentive to arbitrarily deny membership to any broker-dealer.
Further, FIA respectfully suggests that the proposed rules also could adversely affect the ability of national securities exchanges to compete with contract markets by denying them unnecessarily the opportunity to attract as members FCMs with expertise in futures trading and an established customer base. Moreover, in an active market, we believe all exchanges would benefit by exercising direct authority over a greater number of broker-dealers that effect trades through the exchange.14 Market surveillance and other monitoring activities would be facilitated. Of course, customers also will benefit by being able to have their trades executed directly by their notice registered broker-dealer.
Finally, the SEC's proposal may complicate the manner in which customer funds are held. If notice registered broker-dealers are prohibited from becoming members of a national securities exchange for this limited purpose, customer funds would move from a segregated account under section 4d(2) of the CEA to a reserve account under SEC Regulation 15c3-3. The subsequent obligations on each entity at this time are unclear. In particular, the CFTC has not considered whether a reserve account is a permissible location for the deposit of customer segregated funds. If the CFTC were to determine that segregated funds could not be deposited in a reserve account consistent with section 4d(2) of the CEA, a notice registered broker-dealer could be required to deposit its own funds in the segregated account to the extent its customer's funds were deposited with a full broker-dealer. The resulting "double segregation" requirement would impose a substantial financial burden on notice registered broker-dealers.
The Requirement that Notice-Registered Broker-Dealers File a Form BD is Unnecessarily Burdensome.
The SEC has proposed that an FCM or introducing broker that desires to become a notice registered broker-dealer file with the Central Registration Depository ("CRD") a Form BD. We believe this requirement imposes an unnecessary burden on such applicants. Although the SEC estimates that the time it takes to complete the Form BD is approximately two hours, this estimate does not take into account the substantial time and effort it takes for an applicant to compile and organize the information that is transferred to the Form.
As the SEC is aware, the CFTC has proposed to permit broker-dealers to notice register by filing a document prescribed by the National Futures Association ("NFA"). In this regard, FIA understands that NFA is preparing a simple one-page form in which the broker-dealer will be required to provide certain identifying information and represent that: (1) the broker-dealer will limit its futures-related activities to security futures products; (2) the broker-dealer's registration with the SEC is not suspended; and (3) the broker-dealer is a member of a registered securities association. To the extent NFA requires additional underlying information about a notice registered FCM or introducing broker, NFA will obtain such information directly from the CRD. FIA encourages the SEC to adopt a similar procedure. We understand that the CRD is able to obtain electronic access to essentially all of the information contained in NFA's registration database.
FIA appreciates that the SEC's proposal is designed in part to facilitate the registration process in the event a notice registered broker-dealer subsequently elects to register as a full broker-dealer. However, as the SEC is aware, the filing of the Form BD is only the initial step in becoming registered as a broker-dealer. With few exceptions, applicants for registration as a broker-dealer must also become members of NASD Regulation, Inc. This membership process can be time consuming, taking from three to six months, and perhaps longer, to complete. The time saved by having a Form BD on file with the CRD is comparatively slight and is outweighed by the burden it imposes on notice registered broker-dealers that do not choose to become full broker-dealers.
FIA Supports the Proposed Amendments to Regulation S-P.
FIA supports the proposed amendments to Regulation S-P, which would include the CFTC as a "federal functional regulator" and provide that notice registered broker-dealers could comply with Regulation S-P by complying with the financial privacy rules recently adopted by the CFTC.15 As the SEC knows, the CFTC rules provide that CFTC registrants that are also registered under the securities laws may comply with its rules by following Regulation S-P. We welcome the SEC's proposal to adopt comparable relief.
The SEC Should Confirm that Notice Registered Broker-Dealers Are Permitted to Receive and Deliver Securities Underlying Security Futures Contracts in Particular Circumstances.
Separately, FIA understands that the terms of security futures contracts that will be listed on certain of the exchanges will require physical delivery of the underlying security. In this regard, we ask the SEC to confirm that notice registered broker-dealers may accept and deliver securities that underlie securities futures contracts for purposes that are solely incidental to the notice registrant's business as a FCM/notice registrant broker-dealer. These activities would not be materially different from those described in SEC Regulations 240.3a43-1 and 240.3a44-1, which exempt an FCM from registration as a government securities broker-dealer in prescribed circumstances.16
FIA appreciates the opportunity to submit these comments on the SEC's proposed rules implementing the provisions of section 15(b)(11). If you have any questions regarding this letter, please contact Barbara Wierzynski, FIA's General Counsel, or me at (202) 466-5460.
John M. Damgard
cc: Commodity Futures Trading Commission
Honorable James E. Newsome, Acting Chairman
Honorable Barbara Pedersen Holum
Honorable David D. Spears
Honorable Thomas J. Erickson
Securities and Exchange Commission
Honorable Laura S. Unger, Acting Chairman
Honorable Isaac C. Hunt, Jr.
|1||Pub. L. No. 106-554, 114 Stat. 2763, Title II.|
|2||Although section 15(b)(11) of the Exchange Act contemplates that introducing brokers may become notice registered broker-dealers, our comments are limited to the application of the proposed rules to FCMs. In particular, we express no opinion on with respect to whether introducing brokers should be permitted to become members of a national securities exchange.|
|3||66 Fed.Reg. at 34045.|
|4||For convenience, unless otherwise noted, the term "national securities exchange" will mean only an exchange registered pursuant to section 6(a) of the Exchange Act.|
|5|| The SEC has concluded that it would be consistent with the purposes of the CFMA to permit notice registered broker-dealers to effect transactions in security futures products on a national securities exchange through a full broker-dealer member of that exchange. FIA concurs in this conclusion and strongly endorses this aspect of the SEC's proposal.
As discussed in this letter, however, we further believe that the SEC should interpret its statute to permit notice registered broker-dealers to become members of a national securities exchange for the purpose of executing trades on security futures products. The SEC has plenary authority under section 36 of the Exchange Act to grant the requested relief.
|6||66 Fed.Reg. at 34045.|
|7|| Section 15(b)(11) of the Exchange Act was added by CFMA §203. The joint statement explaining this section states in relevant part:
The explanation of CFMA §222, notice-registration for broker-dealers under the CEA, similarly is silent on the right or inability of notice registered FCMs to become members of a designated contract market.
|8||66 Fed.Reg. at 34045.|
|9||Exchange Act §6(c)(1).|
|12||These fitness standards may address issues other than financial responsibility or operational capability noted in footnote 41 of the Federal Register release accompanying the proposed rules.|
|13||Exchange Act §6(c)(3). The provisions governing the authority of a registered securities association with respect to applicants for membership are similar. Exchange Act §15A(g)(3).|
|14||In addition, if notice registered broker-dealers are not permitted to become members of a national securities exchange, they will not be able to participate in principal to principal transactions in security futures contracts on that exchange.|
|15||17 CFR Part 160. 66 Fed.Reg. 21236 April 27, 2001.|
|16||E.g., to effect delivery pursuant to a futures contract or an exchange of futures for physicals. If notice registered broker-dealers are unable to receive and deliver securities underlying security futures contracts for such limited purposes, the purported benefits of notice registration would be meaningless. The SEC may wish to consider whether it would be appropriate to amend SEC Regulations 240.3a43-1 and 240.3a44-1 to this end or, in the alternative, adopt separate regulations.|