CFTC's rule on commodity pool operators upheld by U.S. District Court

On Wednesday, December 12, 2011, the U.S. District Court for the District of Columbia rejected a challenge to the CFTC's new rule governing Commodity Pool Operators.  The rule was challenged by the Investment Company Institute and the U.S. Chamber of Commerce, primarily on procedural grounds related to the adequacy of the agency's consideration of the costs and benefits of the new rule, which is required by section 15(a) of the Commodity Exchange Act (CEA). 

 Judge Beryl A. Howell's comprehensive 92-page opinion, available on the court's website, serves as a virtual blueprint for how agencies should conduct analyses of the costs and benefits of regulations, particularly when the regulations cover areas in which the costs and benefits cannot be reasonably quantified.  Numerous regulations implementing the Dodd-Frank Act remain to be finalized and modifications to many of them can be expected as the industry evolves and experience with the new regulations accumulates.  Judge Howell's opinion will greatly facilitate this daunting task.  And, although the opinion addresses the specific requirements of section 15(a) of the CEA, the analysis illuminates the correct general approach for dealing with costs and benefits that cannot be quantified and should serve as a landmark in administrative law far beyond regulations under the CEA.

What are the benefits to considering the costs and benefits of regulations?

Many statutes require agencies to do some sort of analysis of the costs and benefits of a proposed regulation when promulgating a new or revised regulation.  Section 15(a) of the Commodity Exchange Act requires the CFTC to "consider the costs and benefits of the action of the Commission" in light of "(A) considerations of protection of market participants and the public; (B)
considerations of the efficiency, competitiveness, and financial integrity of futures markets; (C) considerations of price discovery; (D) considerations of sound risk management practices; and (E) other public interest considerations."

The meaning of this Delphic reiteration of what appears to be the agency's statutory duty in the first instance will be hotly contested in the courts, as opponents of regulations argue that it requires as close to an exact quantification and comparison of costs and benefits as possible and proponents of regulations claim that it gives the Commission discretion to do anything not unreasonable.  The immense scope and novel features of the financial system addressed by the Dodd-Frank Act and the corresponding regulations makes it all but impossible to give the wording of section 15(a) any but the most general meaning.  But reasonable judges can, and do, differ, and a long season of litigation seems to await each of the rules before they become final.

Congress cannot be expected to act with the clarity and dispatch of the Executive branch.  But before enacting requirements such as section 15(a) in the future, Congress may wish to revisit the wording of the orders from the Combined Chiefs of Staff to General Eisenhower appointing him Supreme Allied Commander on the eve of the invasion of Europe:  "You will enter the continent of Europe and, in conjunction with the other United Nations, undertake operations aimed at the heart of Germany and the destruction of her armed forces."       

Consumer fraud prevention

It is a sad fact of life that every investment market is infested with criminals eager to separate the potential investor from his or her money.  The derivatives market is not an exception.  Cold calls from glib, high-pressured, fraudsters too often dupe victims who can ill afford even small losses -- retirees living on fixed incomes, for example.  Hallmarks of these scams are offers of extremely high, guaranteed returns in investments that must be funded immediately to capitalize on favorable market conditions.  These scams often purport to take advantage of anticipated changes in market conditions that are widely known and commonly discounted by the markets, such as high gasoline prices during summer holidays or higher heating oil prices during the winter. 

The CFTC has a useful web-page under the "Consumer Protection" tab on its home page.  The link is http://www.cftc.gov/ConsumerProtection/FraudAwarenessPrevention/index.htm#warnings
I strongly recommend that anyone who has been solicited to participate in a derivatives investment vehicle read and understand this information first.

The CFTC consumer protection tab also contains useful information about companies and individuals who have been sanctioned by the Commission and other resources that can be used to help verify the bona fides of someone soliciting your investment.

Agencies need leadership

As the second Obama Administration is being prepared, we have numerous qualified candidates to assume direction of our critical financial regulatory agencies.  I hope that when these candidates are vetted, however, their ability to supply internal leadership to the agencies they will join is carefully considered.  We are fairly well aware of the qualifications needed regarding a candidate's ability to contribute publicly to the agencies' missions.  But the agencies themselves are in a high degree of flux and their effectiveness, especially in times of uncertain budgetary support, turns largely on the culture instilled by top management.

Many of the agencies have had their authority vastly expanded in the last several years, and some of them did not even exist until recently.  Bidding against the private sector for top talent will make recruiting and retaining high quality staff extremely difficult.  Maintaining morale and a sense of purpose is difficult when constricted budgets limit even the most basic support --travel and continuing education, for example.  Being a public advocate for the mission of an agency while also leading agency personnel is a huge challenge -- probably too great for all but the most exceptional leaders.  But good leaders are also good at choosing capable lieutenants, giving them scope to operate, and holding them accountable for results. 

I suggest that those who judge the potential of our incoming crop of agency officials will ask probing questions about how the candidates will instill and maintain a commitment to the agency mission by those in the ranks who will do the most to accomplish it.

Update:  Concerning my post of October 7, discussing the need for more flexible remedies for violations of the law, the University of Maryland Carey Law School has posted video of its recent, superb 2012 Ward Kershaw Symposium, "Too Big to Jail: Roadblocks to Regulatory Enforcement," available at this link.

What is the value of internal compliance systems?

Internal systems of compliance monitoring have recently presented us with an alarming collection of spectacular failures.  For one example among many, the compliance office at Barclays was alerted to irregularities in the Bank's submissions to the calculation of LIBOR, and a senior compliance officer promised to raise the issue with senior management, but did not do so. 

Internal compliance systems suffer from intrinsic conflicts of interest.  Like the Chancellor of England, who served as the "King's conscience," compliance officers serve as the conscience of the company.  But the King could, and sometimes did, behead the Chancellor -- a lesson that is not lost on modern compliance officers.  On the other hand, truly independent monitors of corporate probity are cumbersome, expensive, and may lack expertise and inside knowledge of the corporation. 

Until corporate incentives -- mainly, but not exclusively, executive compensation -- are more closely aligned with ethical practices and legal constraints, the role of the corporate compliance program will be relegated to overseeing routine technical matters and correction of lower-level ethical lapses.  Stronger protections for whistleblowers, carefully targeted criminal prosecutions, meaningful statutory revisions to the financial system, and similar techniques, must all be brought to bear in a coordinated manner if these incentives are to be changed in an effective way.  It remains to be seen if recent efforts in these areas are sufficient and sufficiently timely.  

It is not in the nature of organizational compliance programs to be crowns of laurels, but neither can we tolerate them being corporate fig leaves.         

User fees are needed to fund the CFTC

Congress in recent years has habitually funded the government with so-called continuing resolutions for large parts of each fiscal year until it is able to iron out a new budget.  Continuing resolutions restrict agencies to expending funds at rates not higher than those of the preceding fiscal year; they are essentially a fiscal holding pattern.  This means that agencies must mark time on new initiatives, even those mandated by Congress, such as implementation of Dodd-Frank, until sufficient funds are eventually provided for a new fiscal year.  Now, with the "fiscal cliff" threatening massive automatic budget cuts at the beginning of 2013, funding for government agencies is even more uncertain than usual.

Even were Congress to immediately fund the CFTC at the level of the President's budget request, the agency would be woefully underfunded compared to the breadth and complexity of its new statutory mandate.  Funding the agency, even in part, through user fees imposed on transactions on designated contract markets would provide a more reliable and adequate source of income than the erratic appropriations process.  What's more, the fee would be paid by those who benefit most from the services provided by the regulated marketplace.  I would recommend imposing a small fee, perhaps a fraction of a penny or a fraction of the value of a transaction, on each transaction on designated contract markets.  With the millions of transactions completed each day, this minimal burden would permit much more effective funding of the CFTC than in the past and would mirror the mechanisms used to fund other regulators.

Of course, even a nominal fee is a cost to those trading on the market.  High frequency traders, in particular, may object to even a fraction of a cent fee, as that would consume the bulk of their profits.  But it is regulation that makes the markets possible at all.  It is only fair that those who benefit most from the existence of the markets bear some of the costs of maintaining them. 

High Frequency Trading

High frequency trading -- in which offers to buy or sell exist for small fractions of a second and assets are held for only a few seconds -- has received much attention, especially since it was implicated in the May 6, 2010 "flash crash" of the stock market.  The inconclusive report on that hair-raising event and much of the commentary on the practice since then shows that regulators and market participants do not know nearly enough about how that trading is actually done to sustain wide-spread confidence in the integrity of our markets.

Regulators don't know if the HFT programs commit illegal "wash trades" -- where trading is done without exposure to market risk -- or "spoofing" -- where offers are submitted without intending for them to be accepted.  While much lip-service is given to the need to assure market transparency and other characteristics of sound market management, virtually nothing is actually being done to assure that HFT programs are not committing wholesale violations of the law or exposing markets to catastrophic treats.

HFT advocates claim that these programs provide liquidity to markets and lower spreads between buyers and sellers.  Critics claim that the liquidity is illusory because most offers exist for so short a time that they can't be accepted and that low spreads do not compensate for the enormous systemic risk posed by HFT programs.

The widespread confusion surrounding what to do about HFT programs (but see Commissioner Bart Chilton's speech of October 9, 2010 for a conceptual outline of areas for regulatory action), demonstrates the lack of vision provided by our politicians in managing our economy.  The last financial crisis occurred four years ago and we have barely started to restrain the excesses that caused it.  By the time the necessary regulations are promulgated and enforcement efforts -- no matter how feeble they may be -- are gaining some traction, new causes of new crises will once again have the law enforcement posse scouring the horizon for the dust of those responsible. 

More imaginative penalties are needed

Constructing appropriate penalties for violation of the commodities laws in no easy undertaking.  Entities that can do the most damage to the economy are often "too big to fail/too big to jail."  Fines in the hundreds of millions of dollars may be the equivalent of a traffic ticket -- as U.S. District Judge Jed Rakoff has noted.  On the other hand, fines of a ruinous amount inflict punishment on a broad swath of the investing public and could have adverse impacts on entire markets.  But to limit the range of possible sanctions to monetary penalties takes too narrow an approach in my view.

The law of equity has a wide range of remedies, developed over centuries of dealing with novel situations.  At the top end of the spectrum is the imposition of a receivership.  This is a truly draconian step, in which the receiver -- an officer of the court -- actually takes control of the entity in question.  This remedy is unlikely to be feasible when a wrongdoer is still a going concern, but has, of course, been widely used when the entity has failed.  Less aggressive measures include the appointment of a party with special powers tailored to the problems to be corrected.  These parties are often referred to as private inspectors general, monitors, or consultants.  Such a party might be empowered to conduct periodic audits of financial transactions, review the structure of an organization and recommend changes, assure compliance with court-ordered conditions, make reports to parties in interest, and the like.  At the lower end of the spectrum, a wrongdoer might agree to the use of a third party simply to verify its compliance with the conditions of a settlement.

The use of flexible, third-party involvement in the operation of a company or in assuring compliance with the requirements of a court order or settlement agreement is not novel -- the Department of Justice has used mechanisms of this sort for years in the criminal prosecution of corporations.  The key is to assure that the scope of the powers of the third party is sufficiently broad to give the monitorship real teeth and yet not so intrusive as to be counterproductive.

Use of a sanction of this type would help address the chronic lack of resources available to regulators, because the wrongdoer bears the expense of the monitor.  Non-monetary sanctions are also rebarbative to entities who must host the third party and so may incentivize them to more carefully obey the law.

These suggestions are just that -- the ultimate point is that monetary sanctions, by themselves, are not adequate to deal with the complexities of modern market regulation.  Regulators should use a much broader range of remedies if they are to make any meaningful progress in policing the commodities markets.  Your further suggestions would be greatly appreciated.   

Court vacates CFTC position limits rule

On September 28, 2012, U.S. District Judge Robert Wilkins vacated the CFTC's rule setting speculative position limits on futures, options, and swaps contracts linked to 28 physical commodities, and remanded the matter to the agency for further rulemaking.  The CFTC promulgated the position limits rule on November 18, 2011, as part of its implementation of the Dodd-Frank Act.  The three commissioners voting for the rule -- Chairman Gensler and Commissioners Chilton and Dunn -- believed that Congress had concluded that the limits were necessary to prevent "excessive speculation," preempting any consideration by the agency of the need for the limits.  Although he voted for the rule on the basis that the law required the agency to set position limits, Commissioner Dunn expressed grave doubt as to whether the rule was either necessary or likely to be effective.  Two financial industry organizations -- the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association -- sued under the Administrative Procedure Act, claiming that the Dodd-Frank Act clearly required the agency to make a finding that the limits were necessary before promulgating them.

Judge Wilkins disagreed with both parties, finding that the Act was ambiguous as to whether the agency needed to predicate its rulemaking on a factual finding that the position limits in the rule were necessary to prevent excessive speculation or that Congress had already made this finding when it passed the Act and the agency was without discretion as to whether the limits were necessary.  Judge Wilkins found that the agency proceeded under the mistaken impression that the statute clearly required it to promulgate the position limits rule, regardless of whether the agency found the limits necessary.  He therefore vacated the rule and remanded the issue to the agency to reconsider the rule on the basis that the Dodd-Frank Act is ambiguous concerning whether the agency has discretion to make a finding on the necessity for position limits.

This is the first judicial vacatur of a CFTC rule promulgated under Dodd-Frank.  It will undoubtedly be followed by others, given the extreme complexity of the task and the vigorous opposition the agency faces from a well-financed and sophisticated industry.

Judge Wilkins' opinion in Civil Action No. 2011-2146 can be downloaded from opinion  

Culture change is a top priority for the futures market

Corporate America desperately needs a serious ethical overhaul, and that includes the financial sector.  Leadership, from the board of directors and the CEO down through the layers of an organization, is essential to establishing and maintaining an ethical corporate culture.  Management must continuously stress the need for ethics through every available channel of communications -- speeches, articles, training, leadership conferences, compensation systems, recruitment and retention policies, and the like.  Corporate structure must reflect a commitment to ethical behavior.  The Board of Directors should have a committee charged with independently monitoring the ethical climate of the organization.  Employees should have a channel of communications separate from the chain of command and reporting directly to top management through which they can raise critical ethical issues without fear of reprisal.

CFTC Commissioner Bart Chilton presented a compelling keynote speech at the Hard Assets Investment Conference in Chicago on September 21 advocating several critical actions to improve the distressing ethical climate in the financial sector.  The full text of his remarks is available on the CFTC's website.  Essential points he recommends include:

• Aligning compensation systems to stress risk management over periods of time that reflect an emphasis on sustainable growth rather than immediate profit;

• Recruiting and hiring a workforce receptive to balancing risk and assuring that a drive for profits does not overwhelm other considerations; 

•  Providing sufficient funding to the CFTC through a user fees similar to those used to fund other financial regulators; and

•  Focusing regulations on 
• a corporate structure that emphasizes independence and diversity of viewpoints and skill sets among its directors;
• ownership rules that reduce the chance of conflicts of interest;
• internal and external business conduct standards that clearly demarcate acceptable practices;
• preventing conflicts of interest through limitations on proprietary trading by banks, with careful distinction between hedging risk and proprietary trading; and
• requiring registration of high frequency traders and insuring that they test their algorithms before using them for trading and include a "kill switch" to shut them down if they seriously malfunction.

Some of Commissioner Chilton's recommendations are already contained in draft or final rules, although implementation and operational experience will undoubtedly provide essential data to guide revision and further development.  In any case, his suggestions deserve serious consideration over what will be a long period of rehabilitating the reputation of the financial sector. 

Should the CFTC enforce the prohibition on wash trades against high frequency traders?

"Wash trades" -- trades that give the appearance of a sale and purchase of a futures contract, but do not expose the parties to market risk, or that leave the parties in the same position after the trade as before it -- have been illegal for many years.  Wash trades send false signals to the market, making it appear that there is more interest in a contract than there actually is.

Many high frequency trading programs commit wholesale wash trades, sometimes even accepting their own offers.  Whatever may be the benefits of HFT -- a topic of intense debate -- they come at the price of these wash trades.

Should the CFTC seek to enjoin or otherwise penalize wash trades committed by HFT programs?  Perhaps the enforcement process would enable the agency to evaluate HFT programs more rigorously and put the advocates of the programs to their proof.  Should programmers be required to cleanse HFT programs of features that induce wash trades?  The objections to wash trades seem to be the same whether they are executed in the old-fashioned, paper-based systems, or at lightning speed by computers.  And, in any case, the law articulated by Congress and the courts doesn't seem to support any distinction premised on the environment in which the trades are conducted or on alleged countervailing benefits to the market.

End of fiscal year crisis anticipated

Fiscal year 2012 will end on September 30.  It has become the custom for Congress to enter a holding pattern for about a quarter of a fiscal year, putting the government on life support with successive short-term continuing resolutions, which maintain spending at the levels of the expired fiscal year until a permanent appropriation is provided.  There is every reason to expect this pattern to continue this year, especially in light of the presidential election in November.

The President requested $ 308 million for the CFTC for FY 2013, an increase of about $ 100 million over the FY 2012 appropriation.  The House Appropriations Committee has recommended about       $ 180 million, a cut of about $ 24 million from the FY 2012 appropriation.  The Senate Appropriations Committee recommends the full $ 308 million requested by the President.

The Dodd-Frank Act radically expanded the CFTC's jurisdiction.  The nature of the futures market is changing dramatically, with the advent of high-frequency trading, the introduction of complex and exotic products, and the continuing internationalization of the market -- to name just a few of the challenges facing the agency.  And, of course, old-fashioned fraud and other market abuses continue unabated.  Important issues such as the appropriate mix of investment by the agency in personnel and information technology continue to evolve.  Agency personnel levels are barely equal to those of 1995. 

Chairman Gensler has repeatedly advised Congress that a well-funded CFTC is a good investment for the country.  The upcoming election and the annual struggle to fund the government will eventually tell us if the country agrees with him.

Mutual trust underpins the derivatives market

The Wall Street Journal recently reported on widespread breaches of contracts for cotton resulting from extreme volatility in the cotton market since 2010.  This has led, in turn, to losses on corresponding futures contracts used for hedging and to increasing distrust and litigation along the cotton supply chain.  The article points out that cotton generally changes hands seven times "from seed to sweater."

When the binding nature of contracts erodes, it not only unsettles the market for the commodity involved, but also reduces the value of related futures contracts for hedging risk and discovering prices.  Futures contracts are intended to reflect consensus concerning the likely fair market value of a commodity at some given time in the future.  To the extent that value is determined through arbitration and litigation, it does not reflect the price set by a willing buyer and seller not under compulsion and with reasonable knowledge of market factors.  Although exchanges and commodity associations have enforcement mechanisms available to them, such as barring defaulting parties from use of the market or association, these mechanisms will not, in themselves, restore order to the market because of its vast size and complexity.

The current situation with the cotton market underscores the limitations of any system of market supervision and regulation.  Only mutual trust and respect for contractual obligations can assure a functional market, regardless of how effectively markets are supervised and regulated.

Mark your calendar for Barclays' compliance with CFTC order

The CFTC issued an order on June 27, 2012, requiring Barclays to implement numerous undertakings aimed at strengthening the reliability of its submissions to the calculation of LIBOR.  Barclays must establish policies, procedures, and controls not later than August 27 to assure compliance with the order.  For example, every six months Barclays is required to conduct an internal audit of the basis for its LIBOR submissions and each year the bank must retain an independent auditor to review its submissions.  Barclays must report to the Commission every four months, starting 120 days from the date of the order, on its progress toward compliance with the order.  A report explaining Barclays' compliance -- with copies of the relevant controls, procedures, and policies -- is due within 365 days of the order.

This case is a landmark in the enforcement of the Commodity Exchange Act.  The CFTC thus has a unique opportunity to demonstrate its commitment to following through on its enforcement program.  I have marked my calendar to check with the CFTC on Barclays' submissions, so that we may have a real-time view into the mechanism of post-judgment supervision by the agency.  I will report the progress and results of these observations in this space.

Should the Commodities Futures Trading Commission be replaced by a single administrator?

The original purpose of establishing the Commodity Futures Trading Commission as an "independent" regulatory body was to "insulate" it from some of the more turbulent political currents in Washington.  The Commission consists of five Commissioners, no more than three of whom may be from the same political party.  The complexity and speed of the modern derivatives environment argues for a regulator structured for high efficiency.  Congress is the appropriate venue for making high level political choices.  While statutory implementation also calls for policy trade-offs, the opportunity to submit comments on proposed rules -- which, under the law, must be considered by the regulator -- allows for generous public input to the rule-making process.  Congressional oversight of the agency and judicial review of new rules also militate against the potential bias a single administrator might introduce.  A regulator with a politically divided leadership imposes a second round of political negotiating on the process of implementing a statute, with a corresponding delay and potential diffusion of focus in new regulations.

Would the regulation of derivatives be better served by an agency with a single leader -- perhaps appointed for longer than a single presidential term, such as five or ten years?  

Seventh Circuit denies trustee's claim to property transferred out of segregation and posted as collateral for a $312 million loan

On August 9, the U.S. Court of Appeals for the Seventh Circuit denied the claim of the liquidation trustee for the failed FCM, Sentinel Management Group, against the Bank of New York Mellon for more than $300 million that Sentinel had illegally removed from customer segregation accounts and posted as collateral for a loan from BNY.  app. ct. op.  The trustee, Frederick Grede, argued that BNY's lien on the funds should be voided and the funds returned for distribution to creditors because BNY was complicit in the breach of segregation.

Sentinel used the segregated funds to secure overnight loans that at one point exceeded $500 million.  The loan proceeds were used to finance, among other things, customer redemptions and Sentinel's proprietary trading.  Eventually, a BNY official began to question how Sentinel -- with a capitalization of roughly $3 million -- could post security worth 100 times that amount without using property to which others had a claim.  But he allowed himself to be fobbed off with a vague answer from his subordinates.

Both the District Court and the Court of Appeals showed the traditional reluctance -- embodied in the case law -- to impose a duty on a bank to supervise the propriety of its customers' actions.  The Court of Appeals noted that Sentinel could electronically desegregate funds without significant knowledge or involvement of BNY and that BNY's electronic system handled hundreds of thousands of transfers each day.  Neither the District Court nor the Court of Appeals was willing to consider BNY's conduct sufficiently egregious to void its lien, despite BNY's suspicions about the source of Sentinel's loan collateral.

The most disturbing aspect of this case -- detailed in the District Court's opinion (441 B.R. 864 (2010)) -- is that it portrays a deeply dysfunctional system.  Nobody was "minding the store" while Sentinel played fast and loose for several years with hundreds of millions dollars of customer funds:

• the NFA received monthly forms and annual audited financial statements that should have alerted it to Sentinel's irregular practices;

• the CFTC received the same information as the NFA but also did not detect Sentinel's scheme;

• independent auditors did not detect Sentinel's nefarious activities; 

• BNY did not follow up on its suspicions about the source of Sentinel's collateral; and

• Sentinel's customers -- many of whom were sophisticated FCM's -- entrusted large sums of money to Sentinel, which  offered the facially ridiculous claim that it had "constructed a fail-safe system that virtually eliminates risk from short term investing."

Every element in the system designed to protect customer funds failed.  This fact -- which will recur frequently in other situations we examine -- indicates that the system is due for a serious overhaul.  

    

Introduction

This blog will examine the evolving world of derivatives in hopes of generating constructive ideas as to how to achieve a better balance between innovation and reliability in the markets.  Recent events, such as the Libor rate fixing scandal, the failure of MF Global, and the collapse of the Peregrine Financial Group, have lend Congress -- among many others -- to question whether the present market structure provides sufficient customer protections to enable effective hedging of risk.  In the coming weeks, I will invite comment on the state of the derivatives markets and provide my own impressions and suggestions in an effort to elicit concrete contributions toward developing more stable and effective markets.