How does one go bankrupt? Two ways — gradually and then suddenly.
(Paraphrase of Hemingway, by way of CFTC Chairman Heath Tarbert)
On April 14, 2020, the U.S. Commodity Futures Trading Commission (CFTC) unanimously approved a proposal to rewrite the CFTC’s Part 190 bankruptcy rules (the Proposal), which were first adopted in 1983 and have not been comprehensively revised since then. Part 190, along with Subchapter IV of Chapter 7 of the Bankruptcy Code (the Code), govern the distribution of assets in a bankruptcy of a futures commission merchant (FCM) or derivatives clearing organization (DCO). The proposal is the result of several years of work by the CFTC staff and a subcommittee of the American Bar Association.
The Proposal is not related to the current market turmoil caused by the COVID-19 pandemic. The comment period for the Proposal is short, given its complexity. Comments are due by July 13, 2020. Final rules may be issued this year. The CFTC is not required to address any comments submitted after July 13, although several CFTC Commissioners indicated that the CFTC would attempt to take into consideration late comments.
Introduction to the Proposal
The Proposal draws in part from model rules submitted to the CFTC by an ad hoc Part 190 Subcommittee of the Business Law Section of the American Bar Association in September 2017, following more than two years of work by the subcommittee (the ABA Model Rules). The ABA Model Rules were submitted under former Chairman Christopher Giancarlo’s Keep it Simple, Stupid (KISS) initiative. The goal of that initiative was to solicit comments that would facilitate an agencywide review of the CFTC’s regulations and practices to find areas in which they could be simplified to make them less burdensome and costly. However, the Proposal approaches 400 pages and would rebuild — essentially from the ground up — one of the most complex sections of the CFTC rulebook.
While the Proposal draws its general structure and many core concepts from the ABA Model Rules, it includes material departures from them.
The CFTC has indicated that the Proposal is intended to “reflect current market practices and lessons learned over the last three decades from past commodity broker bankruptcies.” Many of the proposed changes are intended to clarify Part 190 without changing the substance of it.
While the Proposal focuses on clarifying, modernizing and reorganizing Part 190, the CFTC is also proposing some substantive changes to it. Market participants may find that reviewing the lengthy Proposal to identify substantive changes from the current version of Part 190 is difficult, as the Proposal would substantially restructure Part 190, including by changing many defined terms.
Overview of Commodity Broker Insolvencies
Part 190 and Subchapter IV of Chapter 7 of the Code govern the distribution of assets in an insolvency of a “commodity broker.” The term “commodity broker” includes any entity registered or required to register as an FCM or a person registered as a DCO. Commodity brokers are not eligible for reorganization under Chapter 11 of the Code.
FCM bankruptcies are rare. There have been only five to date.
1998 Griffin Trading
2008 Lehman Brothers
2011 MF Global
2012 Peregrine Financial
The bankruptcy of an FCM will cause distress for market participants and can roil the markets (or the failure of the FCM can be caused by markets that are already roiled).
There has never been a DCO insolvency. Needless to say, a DCO insolvency would be a significant and historic event.
At a high level, Subchapter IV and Part 190 reflect the following approach to an FCM bankruptcy (DCO insolvency is addressed in a separate section below):
- Transfer open positions and customer equity of public customers to one or more solvent FCMs
- Liquidate positions that cannot be transferred
- Classify customers and their property into four account classes: customer segregated futures, foreign futures, cleared swaps and delivery accounts
- Distribute pro rata customer assets by account class on the basis of each customer’s allowed net equity claim
- Give priority of distributions to public customers of the FCM over nonpublic customers (i.e., proprietary accounts)
Overview of the Proposal
The CFTC is proposing to add a new preliminary section to Part 190 that would set out the “statutory authority, organization, core concepts, scope, and rules of construction for Part 190.” The purpose of this section would be to explain the CFTC’s thinking and intent regarding Part 190 to enhance understanding of it.
Customer Protection Enhancements
Protection of customer funds is central to many provisions of the Commodity Exchange Act (CEA) and CFTC regulations, including regulations under Part 190. Certain aspects of the Proposal seek to enhance customer protections by strengthening existing provisions. For example, the Proposal seeks (a) to strengthen the CFTC’s longstanding position that shortfalls in segregated customer funds should be made up from the FCM’s general assets, (b) to clarify that the claims of public customers come before proprietary and affiliate claims and (c) to clarify that public customers are entitled to pro rata distributions based on their respective claims.
Treatment of Customers as a Whole
Under the CEA, each customer is entitled to a pro rata distribution of customer property, by account class, on the basis of the customer’s allowed net equity claim. Customer property of one account class is not available to satisfy the claims of customers in another account class. This leads to “fellow customer risk” to the extent of a shortfall in customer property but also makes the rapid transfer of accounts to a solvent FCM possible. FCM insolvencies can involve thousands or tens of thousands of customers, and treatment of customers as a whole has become unavoidable. The Proposal seeks to provide greater clarity on the authority of the trustee to treat customers as a whole, rather than on a bespoke basis, for certain purposes.
The Proposal would also expressly allow an FCM’s bankruptcy trustee, following CFTC consultation, to transfer all public customer positions in hedging accounts to a solvent FCM instead of requiring the trustee to solicit and comply with individual customers’ instructions with respect to their accounts.
Some of the proposed rule changes in the Proposal would track technological developments since the rules were first written in 1983, including increases in the speed and number of transactions, changes from paper-based to electronic communication, the use of electronic documents of title and the use of intangibles as deliverable commodities (e.g., virtual currency). Other revisions seek to align Part 190 with changes made to other CFTC regulations, such as the CFTC’s customer protection regulations. Many of the changes also reflect the actual practices used in prior FCM bankruptcies. The CFTC is also proposing updates to defined terms and cross-references that are no longer accurate and the deletion of defined terms that are no longer used or already defined in other CFTC regulations.
One of the central tenets of Part 190 is the rapid transfer of open positions and equity of public customers to one or more solvent FCMs. This protects both customers and the market, because customers are not forced to reestablish hedges or other positions and it avoids a mass liquidation of positions. A complete transfer of positions becomes more difficult if there is a shortfall in the customer funds needed to support the positions. Customers generally do not have a role in deciding where their positions and collateral are transferred. The Proposal includes provisions addressing the manner in which the insolvent FCM’s business is to be conducted on and after the bankruptcy filing date, including collection and payment of margin on open positions, in order to facilitate transfer.
Letters of Credit
The Proposal addresses the treatment of letters of credit as collateral, both during normal operations and during an FCM bankruptcy. The proposed changes are designed to ensure that customers who post letters of credit as collateral suffer the same proportional losses as customers who post other types of collateral. This addresses an issue that arose in a recent FCM bankruptcy.
The CEA and CFTC regulations provide differing protections and treatment of different types of commodity contracts. There are three account classes that correspond to the types of accounts FCMs are required under the CEA and CFTC regulations to maintain: (1) futures customer segregated accounts (Section 4d(a) of the CEA), (2) foreign futures accounts (CFTC Regulation 30.7) and cleared swaps accounts (Section 4d(f) of the CEA and Part 22 of the CFTC’s regulations). Part 190 also sets forth a fourth account class: delivery accounts.
Commodity contracts whose terms require settlement via physical delivery of a commodity, such as oil, electricity or metals (as opposed to cash settlement based on the value of the commodity) are typically offset before reaching the delivery stage. When a delivery obligation does arise, any delivery default could disrupt the cash market for the relevant commodity and have an adverse impact on the parties to the transaction. Part 190 includes special provisions that address contracts that are nearing or have entered a delivery position at the time of or after the filing of the bankruptcy petition. The policy preference under Part 190 is to liquidate physical delivery commodity contracts before they move into a delivery position or, where such contracts do move into a delivery position, to allow delivery to occur outside of the administration of the FCM’s bankruptcy estate. The provisions of Part 190 apply to any commodity that is the subject of a physical delivery commodity contract, regardless of whether the commodity is tangible or intangible.
Delivery accounts are not created by statute and are not subject to any segregation requirement. It may therefore be more difficult to identify property in the delivery account class. These challenges are heightened with respect to cash in the delivery account. As such, the Proposal would divide the delivery account class into separate physical delivery and cash delivery subaccount classes for purposes of pro rata distribution to customers in the delivery account class. The Proposal would also clarify that virtual currency is a physically deliverable asset with respect to commodity contracts that settle via delivery of virtual currency. In March 2020 the CFTC issued final interpretive guidance on the meaning of “actual delivery” for virtual currency.
Among the goals of the Proposal are clarification and maximization of the discretionary authority of an insolvent FCM’s trustee. As such, the CFTC is proposing in a number of areas to provide trustees with enhanced discretion based on practical necessity and experience with prior FCM insolvencies. Because FCM bankruptcies may involve hundreds of thousands of commodity contracts, trustees must make decisions quickly, often within mere hours of being appointed, based on imperfect information. Part 190 (both before and after the Proposal) favors cost-effectiveness and speed over precision to facilitate transfer rather than liquidation of customer positions.
Relationship to Other Resolution Regimes
Many firms that are registered as FCMs are also registered as broker-dealers under the Securities Exchange Act of 1934 (Exchange Act). An insolvency proceeding of a dually registered firm would generally be conducted pursuant to the Securities Investor Protection Act of 1970 (SIPA) and the rules of the Securities Investor Protection Corporation (SIPC). SIPC would typically appoint a trustee, and that trustee would be responsible for liquidation of the commodities and securities businesses of the dually registered firm. Further, an FCM that is part of a systemically important banking organization may be subject to resolution by the Federal Deposit Insurance Corporation under the “orderly liquidation authority” set forth in Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The Proposal would note the applicability of Part 190 in proceedings under SIPA in the case of an FCM that is also a broker-dealer and in resolution proceedings under Title II. The applicability of these different regulatory approaches to an insolvency of a dually regulated firm has been the subject of debate for many years and is not fully resolved by the Proposal.
The Proposal would add to Part 190 a new Subpart C governing DCO insolvencies. To date, DCO insolvencies have been addressed in Part 190 by treating DCOs as “commodity brokers” and subjecting them to many of the same rules as would apply in a bankruptcy of an FCM, with a few rules specific to DCOs. This approach leaves many ambiguities and unanswered questions for DCO insolvencies.
Proposed subpart C would establish in advance the approach to be taken in a DCO insolvency and would establish a clear counterfactual — that is, “what would creditors receive in liquidation in bankruptcy?” — in the event of the resolution of a DCO under Title II, to the extent applicable.
The CFTC’s proposed approach to a DCO bankruptcy includes three overarching concepts:
- The trustee should follow, to the extent practicable and appropriate, the DCO’s pre-existing default management rules and procedures and recovery and wind-down plans.
- Resources intended to flow through the DCO to members as part of daily settlement should be devoted to that purpose rather than be made part of the general bankruptcy estate.
- Other provisions would draw from provisions applicable to FCMs, with appropriate adaptations to reflect the unique nature of a DCO.
If the CFTC adopts the Proposal, it will have a broad impact on a wide range of market participants, including investment funds and other end users of the derivatives markets (e.g., corporates, energy companies, airlines, insurance companies), FCMs, DCOs and custodians.
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