[Federal Register: April 16, 1998 (Volume 63, Number 73)]
[Rules and Regulations]
[Page 18821-18835]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr16ap98-3]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 3, 32 and 33
Trade Options on the Enumerated Agricultural Commodities
AGENCY: Commodity Futures Trading Commission.
ACTION: Interim final rules.
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SUMMARY: Generally, the offer or sale of commodity options is
prohibited except on designated contract markets. 17 CFR 32.11. One of
several specified exceptions to the general prohibition on off-exchange
options is for "trade options." Trade options are 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." 17 CFR 32.4(a). Trade options, however, are not
permitted on the agricultural commodities which are enumerated in the
Commodity Exchange Act (Act). 7 U.S.C. 1a(3).
The Commodity Futures Trading Commission (Commission or CFTC) is
removing the prohibition on off-exchange trade options on the
enumerated agricultural commodities pursuant to a three-year pilot
program. Because it intends to reexamine these rules during and at the
conclusion of the pilot program, these rules are being promulgated as
interim final rule (interim rules). The interim rules, like the
proposed rules, permit only agricultural trade options which, if
exercised, will result in delivery of the commodity. Such options may
not be resold, repurchased, or otherwise cancelled other than through
the exercise or natural expiration of the contract.
Also, the interim rules permit only those entities which handle the
commodity in normal cash market channels to solicit, to offer to buy or
sell, or to buy or sell such options. Vendors of such options 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 interim rules substantially streamline requirements
contained in the proposed rules, particularly the proposed
registration, reporting rules, particularly the proposed registration,
reporting and customer fund segregation requirements. The Commission is
exempting from the prohibition and these interim rules individuals or
entities which meet a substantial financial requirement, as it
proposed. Finally, the Commission is removing the prohibition on the
offer or sale of exchange-traded options on physicals on these
commodities.
CFTC will publish at a late time a document in the Federal Register
requesting comments on these interim rules.
EFFECTIVE DATE: June 15, 1998.
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 electronically at [[email protected]].
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 the specific list of agricultural
commodities then under regulation.\1\ Any commodity not so enumerated
was unaffected by the prohibition.
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\1\ 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. Commodity Exchange Act of 1936, Public Law 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). A more
complete statement of the statutory and regulatory history of the
ban is provided in the Notice of Proposed Rulemaking, 62 FR 59624
(November 4, 1997).
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A history of abusive practices and fraud in the offer and sale of
off-exchange options in the non-enumerated commodities was one of the
catalysts leading to enactment of the Commodity Futures Trading
Commission Act of 1974 (1974 Act). The 1974 Act created the Commission,
substantially strengthen the Commodity Exchange Act and broadened its
scope by bringing all commodities under regulation for the first time.
The newly-created CFTC, vested with plenary authority to regulate the
offer and sale of commodity options,\2\ promulgated a comprehensive
regulatory framework applicable to off-exchange commodity option
transactions in the non-enumerated commodities.\3\ This comprehensive
framework exempted "trade options" from most of its provisions except
for a rule prohibiting fraud (rule 32.9).\4\ In contrast, the
prohibition on the offer and sale of all options on the enumerated
agricultural commodities remained as a consequence of both statutory
provision and Commission rule. See, 17 CFR 32.2.
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\2\ Section 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 other 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).
\3\ 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).
\4\ As noted above, trade options are defined as off-exchange
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." 41 FR at 51815; rule 32.4(a) (1976). This
exemption was promulgated based upon an understanding that
commercial users of the underlying commodity has 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 non-enumerated 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).
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However, the attempt to create a regulatory framework to govern the
offer and sale of off-exchange commodity options was unsuccessful and
was suspended.\5\ In 1982, based on the separate, successful pilot
program to introduce exchange-traded options on the non-enumerated
commodities, Congress eliminated the statutory prohibition on options
on the enumerated agricultural commodities.\6\ As a consequence, the
Commission
[[Page 18822]]
initiated a pilot program to permit the reintroduction of exchange-
traded options on those agricultural commodities. The Commission
declined at that time to permit the trading of the specified
agricultural options off-exchange.\7\
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\5\ 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 (and subsequently,
dealer) options. 43 FR 16153 (April 17, 1976). Congress later
codified the Commission's options ban, establishing a general
prohibition against commodity option transactions other than trade
and dealer options. Public Law No. 95-405, 92 Stat. 865 (1978).
\6\ Public Law No. 97-444, 96 Stat. 2294, 2301 (1983).
\7\ 48 FR 46797 (October 14, 1983). Although 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. Id. at 46800.
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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).\8\ In order to focus comment on the relevant issues, the
advance notice invited commenters to respond to 30 specific questions.
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\8\ The Commission based the advance notice on a study by the
Commission's Division of Economic Analysis (Division). The 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.
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The Commission received a total of 76 comment letters from 82
commenters in response, almost evenly divided between those in favor
and those opposed to lifting the ban. In addition to the written
comments, the Commission received oral and written statements 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,
Illinois, and the other was held in Memphis, Tennessee. A third
informational briefing was held in conjunction with a general
membership meeting of the National Cattlemen's Beef Association.
Generally, speakers at these events 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.\9\
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\9\ 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.
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Many of the comments responding to the advance notice expressed the
view that the potential risk of permitting trade options clearly
outweighed any benefit which they might provide. These commenters
typically assumed that agricultural trade options would be offered
under the same level of regulation currently applicable to other trade
options.\10\ 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. The vast majority of
commenters, both those favoring and opposing lifting the prohibition on
agricultural trade options, urged caution.
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\10\ Currently, trade options and those offering them are
subject only to regulations regarding fraud. See, 17 CFR 32.4.
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C. The Proposed Rules
The Commission, based upon the analysis in the Division's study,
the comments responding to the advance notice and the commentary
presented during its field meetings, proposed rules establishing a
pilot program to permit the offer and sale of trade options subject to
a number of strict regulatory conditions. 62 FR 59624. The Commission's
proposed rules were based on its evaluation of the likely risks
associated with lifting the prohibition on agricultural trade options,
the likely immediate uses for agricultural trade options and the level
of regulation appropriate to both. The Commission proposed initially to
include within the pilot program options between commercial parties in
the normal merchandising chain for the underlying commodity, the
exercise of which would require delivery from one party to the other
either by immediate transfer of title or by transfer of a forward
contract commitment. 62 FR 59628.
The Commission further proposed to require vendors of agricultural
trade options to register as agricultural trade options merchants and
their sales forces to register as associated persons. The Commission
proposed a minimum net worth requirement of $50,000 for registration as
an agricultural trade option merchant and passing a proficiency test
for individuals to be registered as an associated person. As proposed,
agricultural trade option merchants also would have been required to
keep records, to report to the Commission and to disclose risks to
customers. The Commission also proposed several restrictions on
agricultural trade option contracts' permissible structure and use.
Four hundred forty-eight commenters responded to the notice of
proposed rulemaking, submitting a total of 441 comment letters to the
Commission. Commenters remain divided on whether the Commission should
lift the prohibition on agricultural trade options. Twelve commenters,
including among them an agricultural marketing cooperative, two
exchanges and a risk-management firm opposed lifting the prohibition in
any form. In their view, existing exchange-traded products are adequate
to manage agricultural risk, and trade options would merely replicate
existing exchange products, but in a less safe environment. The
remaining commenters supported lifting the prohibition, but differed in
their assessment of the conditions proposed by the Commission.
Of those supporting lifting the prohibition, three agreed fully
with the Commission's proposed rules. They included an association of
introducing brokers and two producer associations. The remaining
commenters opposed to varying degrees the conditions proposed by the
Commission. Twenty-four comment letters submitted by producer
associations, other agricultural associations and agribusinesses
opposed as unduly restrictive or burdensome most, if not all, of the
proposed rules.\11\ Others took exception, or offered suggestions
relating, to specific rule provisions. Two United States Senators
suggested that the pilot program be modified to permit cash settlement
of option contracts and not to limit potential vendors to those able to
take delivery of the commodity.
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\11\ The Commission also received 395 identical letters from
individual producers opposing the proposed rules on the grounds that
they result "in the most extensive, far reaching regulatory
requirements ever imposed on cash grain marketing contracts. * * *
mak[ing] it virtually impossible for my local grain company to make
these contracts available. * * *"
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II. The Interim Rules
A. Over-all Structure
1. Pilot Program
Based upon thorough and careful consideration of the comments to
the notice of proposed rulemaking, the responses to the advance notice
of proposed rulemaking, the written and oral statements provided at the
field hearings and the Division's study, the Commission is promulgating
interim rules establishing a three-year pilot program to permit the
trading of agricultural trade options subject to the conditions
discussed below. A number
[[Page 18823]]
of commenters expressed concern that a three-year pilot program might
discourage the Commission from evaluating the interim rules and
considering their amendment until the conclusion of the full three-year
pilot period. To the contrary, however, the Commission views the pilot
program as an opportunity to monitor and to assess the efficacy of
these rules on an ongoing basis and "to amend them as experience
warrants." \12\ 62 FR 59627. (Similarly, the Commission's
implementation of the 1982 pilot program to reintroduce exchange-traded
commodity options included a number of rule amendments during the
program and before its termination.)
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\12\ The Commission noted in the notice of proposed rulemaking
that "it will evaluate the efficacy of the interim final rules at
the conclusion of the pilot program." 62 FR 59627, n.19. That does
not suggest, however, that the Commission will not consider altering
the interim rules during this period, but only that it is the
Commission's intention not to make the interim rules final until a
full review of the pilot program experience.
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Several commenters expressed concern that the Commission, in
connection with its final consideration of permanent rules, is unlikely
to revisit or to reconsider the fundamental policy decisions relating
to its present determination of the pilot program's overall structure.
They suggested that the Commission delay promulgating interim rules and
repropose an entirely different set of regulatory conditions which
would apply to the trading of agricultural trade options, including
permitting them to be cash-settled.
The Commission disagrees with this suggested approach. The
Commission views the pilot program as an experiment, has not foreclosed
the reconsideration of any specific issue and, by determining that
particular rules are appropriate at the initiation of the pilot
program, has made no judgment regarding the permanent rules that it
ultimately will promulgate. The Commission believes that proposing a
new set of rules without any market-based experience would foster delay
and provide little additional substantive information to inform its
decision on how to proceed. For this reason, the Commission believes
that the public interest will best be served by making agricultural
trade options available to the market now under the regulatory
structure as proposed and by consideration of possible amendment of the
interim rules based upon actual market experience.
2. Physical Delivery
The overall structure of the interim rules adheres closely to the
proposal. The interim rules, like the proposed rules, permit only the
trading of off-exchange agricultural options that if exercised, would
require physical delivery from one commercial party to another in the
normal merchandising chain. In proposing this provision, the Commission
reasoned that such options would explicitly include a merchandising
function which exchange-traded contracts did not, that such options
would be between those having pre-existing cash market relationships
and that the mechanics of these options were likely to be well-
understood. See, 63 FR at 59627.
A number of comments, including one from two United States Senators
and a joint comment of seven farm and commodity representative
organizations (joint comment), suggested that the Commission also
include within the pilot program cash-settled options. However, not all
commenters agreed with this view. For example, one state-level farm
organization strongly supported the proposed provision requiring
physical delivery, noting that it was:
in complete agreement * * * that the off-exchange agricultural trade
option be settled by either delivery of the physical commodity or by
the writing of a forward contract which will guarantee delivery. To
allow a cash-settled instrument would potentially foster cash
speculation between vendors and buyers.
Many of those advocating inclusion of cash-settled options
suggested that the proposed physical delivery requirement would
preclude any flexibility in the type of options that could be offered,
making it impossible, for example, to offer options combining
production and price protection--so called "revenue" contracts.
Revenue option contracts would enable producers to lock in a minimum
revenue for production on their farms. An association representing
grain elevators reasoned that:
[t]he rules, as written, provide no apparent authority to write
revenue contracts combining both yield and price risk management
into one contract. * * * [R]evenue contracts that could utilize the
yield contracts offered by the Chicago Board of Trade to shift a
substantial part of this risk are, in our view, very important to
the farmer. They are also important to the cash grain industry in
having the opportunity to work along side the insurance industry in
offering a more "complete" line of futures-based revenue
contracts. We strongly urge the CFTC to include revenue contracts
(and other legitimate agricultural trade option contracts where
physical delivery is not possible) under the pilot program.
(Emphasis omitted.)
The physical delivery requirement does not preclude development of
revenue-type option contracts. Nothing in the rules requires that the
trade option specify the underlying commodity by referencing an
absolute number of bushels or other delivery unit. The amount of the
commodity underlying the option could be expressed by referencing the
yield on a designated number of acres, based either on the producer's
actual yield or a reported average yield, thereby providing a minimum
return to a producer per acre without running afoul of the rules'
requirements. If the total price for the amount of commodity required
to be delivered were above the guaranteed price, the producer would let
the option expire and deliver outside of its terms. If the total price
were below the option's strike price, the producer would exercise the
option, delivering his or her production to the option writer.\13\ The
Commission anticipates that a wide variety of option structures could
be designed to offer additional forms of revenue protection under the
pilot program's rules and invites those interested in developing such
instruments to seek its guidance if questions arise regarding their
permissibility.
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\13\ It is common practice for certain commodities to provide a
cash adjustment where the commodity delivered departs from quality
or other contract specifications, including tolerances for the
actual amount or weight delivered compared to the contract amount.
Similarly, if a state-wide average yield were used as a reference
and the producer's actual production fell somewhat short, the total
price could be adjusted to account for the relative shortfall
without abrogating its fundamental nature as a delivery contract.
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A number of commenters similarly objected that the proposed rule
requiring that agricultural trade options be settled only by physical
delivery further unduly restricted their potential flexibility and
utility by forbidding their early termination through offset. This
requirement was proposed as a means to ensure that agricultural trade
options maintain a close relationship to the cash market activities of
participants and to dissuade speculative use of the contracts. Several
commenters, however, argued that a producer's ability to capture any
remaining value left on the option by selling the option back to the
issuer under the terms of the original contract when the optional price
protection was no longer wanted was not inconsistent with these
objectives.
However, permitting the offset of an option prior to its expiration
would render meaningless the provision requiring physical delivery of
the option, if exercised. The right to offset would eviscerate the
physical delivery requirement by enabling the option
[[Page 18824]]
holder at any time to avoid delivery, essentially cash-settling the
option.\14\ This would undermine the Commission's efforts to develop a
pilot program to reintroduce agricultural trade options under
controlled conditions.
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\14\ See, CFTC Interpretive Letter No. 96-41, Division of
Economic Analysis Statement of Policy in Connection with the
Unwinding of Certain Existing Contracts for the Delivery of Grain,
[1994-1996 Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 26,691
(Division of Economic Analysis) for a discussion of impermissible
offset provisions.
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Although the interim rules have not been modified to permit the
offset of agricultural trade options, the rules as proposed permitted a
degree of flexibility to capture an option's remaining value prior to
its expiration. The proposed rules recognized that agricultural trade
option contracts could be amended to "reflect changes * * * [in]
activity or commitments in the underlying cash market or to reflect the
carrying of inventory." 62 FR at 59638.\15\ Such amendments could
include deferral of an option contract's delivery date with alteration
of the contract's price to reflect, among other adjustments, any
remaining value on the original option.\16\
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\15\ Proposed rule 32.13(a)(7)(i) (paragraph of required
disclosure statement entitled "Business Use of Trade Options").
\16\ Accordingly, proposed rule 32.13(a)(7)(ii)(D) required
disclosure of the worst possible financial outcome where "through
amendments to the option contract it is possible to lose more than
the amount of the initial purchase price." 62 FR 59638.
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The proposed rules also contemplated that delivery on an option
contract, if exercised, could be by the "immediate transfer of title
to the commodity or by transfer of a forward contract commitment." 62
FR 59627. Proposed rule 32.13(a)(3)'s requirement that the "option can
only be settled through physical delivery of the underlying commodity"
should be read as permitting termination of the option contract prior
to its expiration through entry into a forward contract commitment as
well as permitting use of a forward contract upon exercise. Once the
forward contract has been substituted for the trade option, the forward
contract is a firm commitment to deliver, and the optional "walk-
away" nature of the option cannot be reestablished. The substitution
of a forward contract for the physical delivery option prior to the
option's expiration is consistent with the overall purpose of the rule
of maintaining a close relationship between the option transaction and
the participant's cash market activities and of dissuading use of
agricultural trade options as speculative vehicles. The Commission is
modifying the interim rule to clarify that settlement of the option by
physical delivery does not preclude the option contract's amendment, or
its termination by entry into a forward contract, prior to expiration
with an appropriate adjustment to the contract price.\17\
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\17\ A price adjustment to reflect the remaining value of the
trade option contract upon substitution of a fixed-price forward
contract for the option is consistent with the treatment accorded
minimum price guaranteed forward contracts by Commission staff. The
Division of Economic Analysis in CFTC Interpretative Letter 96-23,
(Re: Sections 1a(11) and 2(a)(1) of the Commodity Exchange Act--
Request for Guidance Regarding Producer Option Contract), [1994-1996
Transfer Binder], Comm. Fut. L. Rep. (CCH) para.26,646, expressed
the view that, within a forward delivery contract offering a
guaranteed minimum price, the holder of the contract could elect to
eliminate the upside pricing potential (the option-like pricing
component) in the contract in return for establishing a fixed price
forward contract, the price of which was adjusted to reflect the
liquidated remaining value of the option component. The option-like
pricing component could not, however, be reestablished in the
contract.
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3. Eligible Vendors
A number of commenters also advocated expansion of those eligible
to be agricultural trade option merchants to additional classes of
vendors. Specifically, for example, the joint comment suggested that
all "financial institutions with a direct interest in production
agriculture" be permitted to become agricultural trade option vendors.
Other commenters supported the Commission's proposed limitation,
suggesting that trade options appropriately should be limited to
"producers and buyers of the enumerated commodities."
Several commenters opposed the conditions for registration as an
agricultural trade option merchant on the assumption that eligibility
would be restricted to "first handlers" of the commodity. Although
first handlers typically would be eligible to become agricultural trade
option merchants, other categories of commercial users would also be
eligible to apply for registration. For example, as one commenter
noted, "[w]e assume the CFTC would also permit cash grain
merchandisers, which have no facilities, but do take title to
commodities, to also write options." As discussed above, the
requirement that the option contracts, if exercised, be physically
delivered does not require that the agricultural trade option merchant
accept delivery only in an over-the-scales operation. To the contrary,
delivery of the commodity can occur through any bona fide means of
conveying legal ownership of the commodity, including the transfer of
warehouse receipts. Accordingly, grain merchants, investment bankers
with active commodity trading operations and various types of
agricultural processors or commercial users of the commodity might be
eligible to register to operate as an agricultural trade option
merchant. In light of the potential diversity of eligible registrants,
the Commission believes that the interim rules will not result in lack
of competition among vendors.\18\
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\18\ One comment letter questioned whether agricultural
cooperatives would be able to meet the net worth requirement for
registration as an agricultural trade option merchant by combining
the individual net worth of each member. Generally the rules do not
distinguish cooperatives from any other type of enterprise.
Accordingly, the cooperative must itself have a net worth of $50,000
to meet the applicable requirement. To the extent that cooperatives
act on behalf of members as a commodity merchandiser, they may
purchase agricultural trade options in connection with their
merchandising function. Of course, in doing so they would have to
have the contractual right to deliver the commodity to settle those
options which they choose to exercise.
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The Commission is convinced that the overall structure of the
interim rules is both a necessary and appropriate means to introduce
this new class of instrument. Recent experience with various types of
agricultural marketing schemes and contracts indicates that a degree of
caution is required. Introducing these instruments as a pilot program,
limited initially to option contracts which upon exercise result in
physical delivery, traded between commercials in the underlying
commodity, should provide a degree of protection to the parties and a
solid foundation upon which to lift the current prohibition on such
instruments.
As discussed above, the proposed rules provided greater flexibility
than credited by many of the commenters. Moreover, in the interim rules
the Commission has modified or clarified the rules as proposed,
providing further avenues for flexibility. The Commission is convinced
that the interim rules will provide the market with room to innovate
and to create useful risk-management tools within its overall
structure.
Moreover, the interim rules have been modified from the proposed
rules in a number of important respects apart from issues relating to
the pilot program's overall structure. In response to specific
suggestions by commenters, the interim rules clarify and streamline
several specific regulatory requirements. In several instances, the
interim rules significantly lessen the burden that the proposed rules
would have imposed on those who register as agricultural trade option
merchants and their sales forces, as well as the requirements relating
to
[[Page 18825]]
the merchant's on-going business operations. These modifications are
intended to achieve the same regulatory goals, and provide a similar
degree of protection, as the rules as proposed, but in a less costly or
burdensome manner. The specific changes are discussed in greater detail
below.
B. Regulation of Agricultural Trade Option Merchants
1. 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 honesty and
proficiency of futures professionals. As the Commission noted in its
notice of proposed rulemaking, "registration * * * will be critically
important in the decentralized market permitted under the pilot
program." The notice further noted, however, that the need for
extensive registration requirements is offset by the fact that the
offer and sale of trade options would be a complement to the first-
handler's existing cash market businesses. Accordingly, the Commission
proposed a streamlined form of registration, consisting of a single
application form covering both the agricultural trade option merchant
as an entity and its authorized sales force.
The Commission also proposed to delegate administration of the
registration function to the National Futures Association (NFA).
Although some commenters opposed this on the grounds that it would
"permit another user-fee based regulator * * * to initiate far-
reaching regulatory activities among cash market businesses," the
delegation to the NFA is narrow, confined to administration of the
registration function,\19\ and necessary to conserve Commission
resources.
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\19\ Fees will be limited to the cost of this one function and
are expected to be modest.
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Based upon its administrative experience, NFA suggested a number of
modifications to the proposed registration rules. In its view, a single
application for registration of the agricultural trade option merchant
and its sales force "rather than providing a streamlined registration
process, * * * will unduly complicate and actually hinder the
registration of ATMs." Because the Commission's ultimate goal is for
the overall registration process to be streamlined, the Commission has
incorporated the NFA's suggestions into the interim rules. Accordingly,
agricultural trade option merchants and their associated persons will
be required to file separate registration applications, each focussed
specifically on the requirements for that category of registrant.
Separate forms in support of the agricultural trade option merchant's
application for registration are also required of the natural persons
who are its principals. Individual application forms for each category
should result in greater simplicity for each and not in an increase in
the total length of the applications or in the amount of information
provided.
NFA also suggested a number of rule clarifications, including the
addition of definitions of the registration categories and
incorporation by explicit reference of the procedures for denial,
suspension and revocation of applications for registration which are
applicable to all classes of registrant under the Commission's rules.
The interim rules have been modified to reflect these technical
changes.\20\
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\20\ The Commission's explicit application of various of its
procedural rules to agricultural trade option merchants and their
associated persons in no way limits the applicability of any other
statutory or regulatory provision which is applicable to Commission
registrants. In this regard, the Act and many of the Commission's
rules impose requirements or prohibitions on Commission registrants
using the phrase "any person or registrant who is registered under
this Act" or similar words. For example, Section 14 of the Act
provides aggrieved customers with the opportunity to bring before
the Commission for adjudication disputes involving violations of the
Act or rules by "any person registered under this Act." See also,
17 CFR 3.34, 3.56, 3.60. Although "agricultural trade option
merchant" and "associated person of an agricultural trade option
merchant" are not registration categories defined by the Act, they
are nevertheless registration categories "under the Act" by virtue
of the Commission's promulgation of rules creating these
registration categories under section 4c(b) of the Act (its plenary
authority over the regulation of options) and under section 8a(5) of
the Act (its general rulemaking authority). The Commission's
reparations program under section 14 of the Act will therefore be
available to customers of agricultural trade option merchants and
their associated persons as it is for all other categories of
Commission registrant. Customers will be apprised of this right in
the required summary disclosure document.
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Many commenters offered the view that the proposed registration
requirements for agricultural trade option vendors should be relaxed.
This view was shared by both potential customers and vendors alike. The
joint comment noted the agricultural associations' "concern () that
the high level of specific regulation * * * will impose excessive costs
* * * that are not reflective of, or proportionate to, the risks
associated with removing the ban * * * for a narrowly defined range of
products." Specifically, the joint comment suggested that the
fingerprint requirement was unnecessary and that the proficiency and
ethics training requirements be relaxed. A company active in the cash
grain business noted that "[r]egistration for those organizations
offering ATOs in the pilot program period seems reasonable, but the
imposition of testing requirements, ethics training, and fingerprinting
push the regulatory oversight of these products beyond a reasonable
limit."
The Commission has reconsidered these proposals in light of similar
comments received from a broad range of commenters. The reason that
fingerprints typically are required of registrants is to perform a
background check verifying the information submitted on the
registration application. This requirement may be less necessary in the
context of agricultural trade options where a likely characteristic of
the market is a pre-existing commercial relationship between the vendor
and customer. The likelihood of such a relationship is reinforced by
the requirement that options, if exercised, must be physically
delivered. That requirement generally will tend to keep the markets
local, where there is a greater likelihood that customers will have
personal knowledge of the background of the agricultural trade option
merchant and its sales force.\21\ Accordingly, the Commission has
removed this requirement from the interim rules, and because the
primary delay in processing registration applications has been
associated with fingerprint checks, the Commission has also removed
from the interim rules provisions relating to temporary licensing of
registrants.
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\21\ The local nature of cash marketing channels is typical for
many, but certainly not all, commodities. The interim rule's
requirements must generally be understood within the normal cash
marketing channels for each commodity. For some commodities, normal
cash marketing channels include delivery obligations being
undertaken as to processors or users at a considerable distance from
producers.
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The interim rules modify the requirement that persons applying for
registration pass a competency test and fulfill an ethics training
requirement. Many commenters representing both potential customers and
vendors suggested that the testing requirement would dissuade
individuals from registering, particularly because this would be a
sideline to their core cash-businesses. Several commenters specifically
objected that the Series 3 examination, which was included in the
proposed regulations as a permissible alternative to a more focussed
test not yet developed, would not be relevant to these products.
As noted in the advance notice, a competency test is only one means
for ensuring the market vendors have the
[[Page 18826]]
requisite professional and market knowledge. Development of a testing
program specifically focussed on this market may be premature in light
of the unknown number or composition of potential vendors and the
existing tests' admitted lack of direct relevance to these products.
However, almost all those commenting agreed that education was needed.
Many organizations representing both likely customers and potential
vendors suggested that this education be voluntary and stated an
intention to offer educational training opportunities to their members.
As the Commission noted in its notice of proposed rulemaking,
"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." 62 FR 59630, n.
35. In order to provide customers with some assurance that this
expectation will be met, the interim rules substitute for the proposed
competency test a requirement that those seeking registration as
associated persons of an agricultural trade option merchant complete
six hours of instruction in the requirements of the Act and rules
promulgated thereunder, the economic functioning and risks of
agricultural trade options, and the registrant's responsibility to
observe just and equitable principles of trade relating to such
options. This course of instruction includes among others, the subjects
which would have been specified by the proposed ethics training
requirement. Accordingly, that proposal has been deleted. Instruction
can be by videotape or electronic media and need not be through
classroom attendance.
The applicant for registration as an associated person must include
in the application evidence provided by an eligible instructional
provider that the applicant completed this instructional requirement.
This evidence of completion must include a certification that the
instructor has three years of relevant experience, is not subject to a
statutory or other disqualification and a disclaimer that the
Commission or the NFA has not approved the course of study's
content.\22\ Instructors must notify the NFA of their intent and
eligibility to offer such training prior to doing so, and must maintain
appropriate documentation of applicants' completion of the requirement.
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\22\ At least one commenter, a large grain merchant, commented
that it provided in-house ethics and business training for its
employees. In-house training by an agricultural trade option
merchant for its associated persons is not precluded by these rules,
nor is the use of employees as instructors. Employee-instructors
meeting the requisite requirements will be qualified to certify
fulfillment of the training requirement for other employees. Such
employee-instructors, however, cannot be the direct supervisor of
the associated person applying for registration.
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There is no educational requirement for customers. However, as the
Commission previously stated:
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.
Id.
2. Financial Requirements
The Commission, in proposing various financial protection
requirements, noted that agricultural trade options, like all commodity
futures or option instruments, involve risk arising from the need for
performance at a future date by the contract's counterparties. Off-
exchange transactions such as these, however, do not have the safety of
an exchange clearinghouse to reduce credit risk. Because many
agricultural trade option customers will not have the resources to
conduct formal credit worthiness evaluations of their counterparties,
the Commission proposed that agricultural trade option merchants be
required to maintain a minimum level of net worth and to segregate from
their own funds premiums paid by customers at initiation of an option
contract. It did not propose requiring agricultural trade option
merchants to cover their market exposure. 62 FR 59628-59630.
The Commission proposed the minimum net worth requirement "to
establish a base level for entry or access to a market * * * to assure
that companies or entities conducting business offer some assurance of
having the financial wherewithal to perform on their obligations." 62
FR 59628. Commenters on the advance notice were not unanimous in
support of such a minimum financial requirement. Some were opposed in
order not to exclude smaller entities, and others argued that various
state financial requirements would be sufficient. Believing that a
common federal minimum standard should prevail, the Commission proposed
to apply to agricultural trade option merchants the $50,000 minimum net
worth requirement established by the United States Department of
Agriculture (USDA) (and many states) as a condition of obtaining a
federal grain warehouse license.
A number of commenters took issue with the $50,000 minimum net
worth requirement, suggesting that it was too low. The joint comment
suggested that agricultural trade option merchants be required to
"maintain a bond equal to * * * premiums of all customer options less
the current cash value of the contracted commodities in addition to
existing state or federal bonding requirements." One potential vendor
recommended a minimum net worth of $1 million with adjustments "to
require that the risk exposure of a seller of options has an
appropriate relationship to the seller's net worth," reasoning that
"one of the greatest risks to the development of an efficient
agricultural trade option market is that undercapitalized sellers of
the options will default." Other commenters supported the proposed net
worth requirement as an appropriate minimum level.
The Commission agrees that the $50,000 net worth requirement will
offer only limited protection from counterparty default risk. However,
the price risk to the agricultural trade option merchant of an option
position will be similar to that of a forward contract position.
Greater financial protection would indeed be achieved, as suggested by
several commenters, by requiring vendors to post bond or to maintain
increasing levels of net worth as the degree of exposure rises.
Nevertheless, constructing a meaningful regulatory scheme to achieve
that goal, however appealing the concept, would result in rules which
are far more complex than any of those proposed, including rules on
uniformly valuing various risks. In this regard, the rules governing
computation of regulatory capital which must be maintained by futures
commission merchants are among the most complex of all of the
Commission's rules. In addition, such a dynamic valuation requirement
would require a degree of regulatory supervision that would be
difficult if not impossible to achieve in this decentralized, over-the-
counter market.\23\ In these circumstances, the suggested bonding
requirement might lull market participants into a false sense of
security. Accordingly, the Commission is adopting the minimum net worth
requirement as proposed.
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\23\ The regulated futures markets provide a high level of
financial protection through their clearinghouses. Each exchange has
a compliance and audit staff, and clearing members and futures
commission merchants devote significant resources to auditing for
compliance with the various financial requirements. The Commission
cannot offer comparable protection for transactions outside of the
regulated exchange environment. Customers must accept the fact that
trading off-exchange entails greater counterparty risk.
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The interim rules, as proposed, provide that the net worth
requirement is ongoing in nature, requiring
[[Page 18827]]
agricultural trade option merchants to maintain the specified level of
net worth in order to enter into new trade option contracts and
requiring them to notify the Commission at any time if they have fallen
below prescribed levels. In addition, the agricultural trade option
merchant must perform a reconciliation of its financial position at
least monthly to determine compliance with this requirement. It need
not change accounting procedures to conform to specific Commission
accounting requirements, provided it uses "fair value" accounting
under Generally-Accepted Accounting Principles, the accounting method
generally used by cash market businesses.\24\
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\24\ The 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.
---------------------------------------------------------------------------
However, the interim rule has been modified from the proposed rule
which required agricultural trade option merchants to hold in
segregation all premiums paid by customers at the initiation of the
option contract. Several commenters suggested that the requirement as
proposed would discourage vendors from responsibly covering the risk of
the transaction and suggested that the Commission permit vendors to use
customer premiums to hedge that risk. The Commission proposed the
segregation requirement both as a means of discouraging a business in
financial difficulty from writing options to generate immediate cash
and as a means of better safeguarding customer funds. 62 FR 59629.
Permitting the vendor to hedge the option's risk using the customer's
funds, particularly if the covering transaction is exchange-traded,
also achieves these objectives. Accordingly, although the Commission is
not mandating that agricultural trade option merchants cover their
risk, the interim rules permit the merchant to use up-front customer
premiums to hedge those risks using exchange-traded instruments.
Customer funds not used for this purpose, as proposed, must be treated
as the funds of the customer and be kept in a segregated account.\25\
---------------------------------------------------------------------------
\25\ An agribusiness company commented that the rules "should
indicate (like Sec. 1.25) that the seller of the options can invest
funds in government obligations to earn interest." The proposed
(and interim) rules so provide. See, paragraph (e) of Sec. 32.6,
incorporated by reference in proposed rule 32.13(a)(4).
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3. Recordkeeping and Reporting Requirements
In proposing recordkeeping requirements, the Commission reasoned
that "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." 62 FR 59633. Most commenters agreed and
supported the requirements as proposed. At least one commenter,
however, questioned the requirement that a record of unfilled or
canceled contract orders be kept. It reasoned that "[r]ecording all
orders and cancellations will likely provide little insight to the CFTC
when compared to the arduous task of tracking these records for those
offering these products." This recordkeeping requirement, however,
serves a different purpose than informational reporting to the
Commission. The keeping of complete books and records is necessary to
resolve particular customer disputes, if they arise, and is a sound
business practice. The Commission therefore is adopting the
recordkeeping rule as proposed.\26\ However, the Commission has
modified the interim rule by deleting the NFA's proposed authority to
inspect books and records at the request of the NFA and as suggested by
other commenters.
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\26\ As proposed, the final rules 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.
---------------------------------------------------------------------------
In addition to the keeping of books and records, the Commission
proposed two distinct reporting requirements--routine and special call
reporting. Routine reports are required for general market surveillance
purposes, to permit the Commission to construct a picture of the market
and to evaluate the impact of activity in the trade option market on
the cash and exchange-traded markets.\27\ One commenter suggested that
information on the total premiums collected and the total value of all
fees, commissions, or other charges during the reporting period was not
necessary to this surveillance function. The Commission agrees, and the
interim rules do not require the routine reporting of premiums, fees,
commissions, or other charges. However, this information may be helpful
to a complete understanding of the market's operation, particularly
during the pilot phase of the rules. Accordingly, the Commission is
retaining the authority to request such information on a special call
basis.
---------------------------------------------------------------------------
\27\ Initially, the Commission anticipates that such reports
will be filed manually, including by facsimile. However, it also
anticipates that as the pilot program proceeds, reports will be
filed electronically, by dial-up transmission or via the Internet.
The NFA, which has been delegated authority to collect these
reports, is encouraged to work cooperatively with the industry in
advancing appropriate procedures, conventions and standards for
electronic transmission.
---------------------------------------------------------------------------
Special calls are a reporting device used by the Commission for
obtaining information only when needed. A special call may be used to
elicit information from a particular trader or registrant for market or
financial surveillance purposes or to gather data for market-wide
studies. As the Commission explained in the notice of proposed
rulemaking, it anticipates the need to issue special calls for
information during the pilot program to gather data with which to
assess its success. 62 FR 59633. At least one commenter suggested that
the proposed rule be clarified that the agricultural trade option
merchant "be required to report * * * only the `options' portion of
the * * * position." As proposed, rule 32.13(e) in the introductory
paragraph stated that special calls were for "information relating to
agricultural trade options." However, to clarify further the
provision, the Commission is modifying the rule as adopted to provide
that the information which can be requested by special call concerning
futures or cash transactions must be related to the agricultural trade
option position. In this regard, potential agricultural trade option
merchants should be assured that the Commission exercises its existing
special call authority in other markets with restraint and with an
understanding of the costs involved in any such request. As noted in
the notice of proposed rulemaking, the Commission encourages
agricultural trade option merchants to maintain a current listing of
customers names and other identifying information for ease of
compliance.\28\
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\28\ Generally, a special call for study purposes requests
specified information on all positions open on the call date. The
Commission expects that any special calls would request information
related to a customer's positions in agricultural trade options
along with the customer's name and other identifying information. In
the past, some firms have maintained some, but not all identifying
information at a central location, and branch locations have kept
the remaining information in differing formats, creating difficulty
in providing the information requested. Accordingly, in setting up
their information systems, firms should keep in mind the likelihood
of a request for this information during the pilot program.
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[[Page 18828]]
C. Customer Protections--Risk Disclosure, Required Contract Terms and
Required Account Information
1. Risk Disclosure Statement
Almost all commenters agreed that required risk disclosure was a
valuable and necessary means of protecting customers. In promulgating
the interim rule, the Commission has clarified the requirement that
both an initial summary risk disclosure statement and transaction-
specific disclosure statements be provided.
Many of the commenters opined that the proposed summary risk
disclosure was too lengthy and feared that many customers would forego
reading it. The Commission after reviewing the proposed summary
disclosure statement has shortened it by deleting some redundant
information, by further summarizing other information and by
simplifying its language.\29\
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\29\ One commenter opined that the reparations language of the
summary disclosure document was unclear as to its impact on the
availability of other venues for dispute resolution, such as
arbitration offered under the auspices of a trade association. The
language of the summary disclosure document has been modified to
make clear that all customers have the right to use the Commission's
reparations program to resolve disputes. Thus, the customer may not
be compelled to waive this right by any other provision in the
customer agreement or elsewhere. Customers may, however, voluntarily
agree to an alternative method of dispute resolution specified in
the customer agreement, the contract or elsewhere. Compare,
Commission Regulation 180.3(b)(3).
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Some customers opposed the transaction-specific disclosure,
objecting that this requirement would prove to be burdensome for the
limited sales forces many agricultural trade option merchants may
employ. Other commenters strongly supported it, noting that the
transaction-specific disclosures are necessary to a customer's
understanding of the nature of the option transaction being entered.
The Commission concurs. The transaction specific disclosures need not
be voluminous, are not required to be in a separate document and can be
included as an addendum to the contract form itself. Although some
commenters objected to the requirement that the worst possible
financial outcome be disclosed, that requirement is only triggered when
the option premium is not collected up front or when the contract is
amended. The worst possible outcome need not take into account lost
opportunity cost--therefore, it often will only be the potential loss
of the premium and other related charges. Where a contract is being
amended, such as by rolling the delivery date, the worst possible
outcome will include the cost of the additional premium, fees and
adjustment to the price resulting from any gain or loss on the contract
at the time of the amendment or contract roll. In light of the
imperfect understanding many hedge-to-arrive customers had of the
effect of rolling on their final contract price, such a disclosure is
plainly needed. Accordingly, the Commission is adopting this rule as
proposed.
As the Commission explained in the notice of proposed rulemaking,
"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." 62 FR 59632. Thus, providing 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). Accordingly,
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.\30\
---------------------------------------------------------------------------
\30\ One commenter suggested that the Commission clarify that
the disclosure statement could be electronic. The Commission agrees
and has clarified that electronic disclosure is permitted.
---------------------------------------------------------------------------
2. Written Contract Terms
Generally, commenters supported the proposed rules requiring that
specific contract terms be in writing. However, several commenters
objected to the proposed requirement that the written contract terms
include the quality or grade of commodity to be delivered if the
contract is exercised and any adjustment or price for deviation from
stated quality or grade. One commenter, a cash grain merchant, stated
that the proposed requirement was not consistent with cash market
practice. That commenter stated that:
transactions are established in most instances, for a specific
quality of grain. * * * To the degree that the actual grain
delivered under these agreements fails to meet the standard grade
specified in the contract, the buyer and seller must determine the
impact on the value of the commodity delivered, and negotiate
discounts/premiums accordingly.
Others active in the cash markets agreed, nothing that common cash
market practice is for a forward contract to specify price for a
standard commodity grade and for adjustments to be made for variance
from this specification by reference to posted schedules of discounts
or premiums. Reportedly, these schedules vary frequently, often daily.
In light of these comments, the Commission is modifying the interim
rule to make clear that an exact schedule of discounts/premiums need
not be specified and that such adjustments can be stated as a range and
method for determining adjustments, such as "posted market scale of
discounts at delivery."
3. Customer Account Information
Many commenters supported the proposed requirement that
agricultural trade option merchants provide customers with information
regarding their positions and accounts. However, several noted that the
monthly account statement would impose a costly informational burden
for a questionable benefit. They explained that few entities likely to
become agricultural trade option merchants have available the
information infrastructure to produce monthly account statements
valuing the transactions and that such information would be of only
marginal utility to customers in light of the requirement that option
contracts must be settled by delivery. The Commission finds this
persuasive and is modifying the monthly account statement requirement
to provide that the agricultural trade option merchant notify customers
of the expiration date of each option which will expire within the next
month. This should greatly reduce the informational burden on
agricultural trade option merchants but nevertheless provide customers
with notice sufficient to reduce the occasions on which customers
permit in-the-money options to expire due to inattention.\31\
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\31\ At least one commenter representing producers suggested
that, although the monthly account statement requirement might be
unduly burdensome, agricultural trade option merchants as a matter
of best practices should periodically update their customers on
market conditions, particularly during times of high volatility. The
Commission agrees that this is desirable and will consider further
the issue of periodic customer statements based on experience under
the pilot rules.
---------------------------------------------------------------------------
In addition to the monthly account statements, the Commission
proposed that agricultural trade option merchants provide customers in
writing, within twenty-four hours of a request, current commodity price
quotes or other information relevant to the customer's position and
account. A number of
[[Page 18829]]
commenters supported this requirement, but others suggested that it
could prove to be an undue burden, particularly because it required a
written response within so short a time. In light of the modification
of the monthly account statement requirement discussed above, the
requirement to provide customers with account-related information upon
request is of even greater importance. However, the Commission is
modifying the interim rule to lessen the burden which it imposes by
requiring that all responses be in writing. This may be particularly
useful where the requested information relates mainly to market
conditions or quotes and the agricultural trade option merchant
provides an immediate response by telephone. The customer may ask,
however, that the information be supplied in writing, and under the
rule as modified the agricultural trade option merchant must do so
within 48 hours of the request. These modifications should strike the
appropriate balance between providing customers with timely account-
related information and the burden on the agricultural trade option
merchant of doing so.
D. Exemption for Sophisticated Entities
The Commission proposed to exempt individuals or entities who are
commercials and have a net worth of at least $10 million from
compliance with the conditions for trading agricultural trade options.
Several commenters suggested that the Commission clarify whether a high
net worth entity acting as a vendor would be exempt from the rules'
requirements. The exemption applies only to high net worth entities
trading among themselves. If an option customer does not meet the net
worth requirement, the agricultural trade option merchant must comply
with all of the rules applicable to such option transactions.
In addition, a number of commenters suggested that the Commission
clarify that the exemption also applies to the associated registration
requirement and to the trade option prohibition itself. The Commission
has done so. However, it should be equally clear that the exemption
from the conditions under which the prohibition is being lifted is not
independent of the pilot program, but rather part of it. Thus, the
exemption for high net worth individuals and entities will be the
subject of Commission oversight and may be reconsidered, as with any
other of the interim rules, based upon market experience during the
pilot period.
Several commenters questioned the reason for, and the effect of,
the higher dollar level for this exemption than the exemptions
applicable to high net worth persons under parts 35 and part 36 of the
Commission's rules.\32\ The Commission remains convinced that the
dollar level of this exemption is appropriate and is adopting it as
proposed. The exemptions under parts 35 and 36 were promulgated a
number of years ago, and the Commission has announced that it will
publish a concept release seeking comment on them. Issues relating to
the dollar level of those exemptions are more appropriately considered
in that context.
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\32\ The Commission explained in the notice of proposed
rulemaking that, "[u]nder 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." 62 FR 59634.
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One commenter representing swaps dealers requested that the
Commission clarify that the part 35 exemption applies to off-exchange
agricultural options rather than this exemption. The Commission
disagrees. Any off-exchange option on an enumerated agricultural
commodity must comply with Commission rule 32.13(g) for exemption from
the Act and Commission rules, and no other exemptive provision is
available.\33\
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\33\ In supporting its view, the commenter suggested that the
Commission "clarify that the restrictions on the use of
agricultural trade options do not limit the scope of the Swap
Exemption," citing the study of the Commission's Division of
Economic Analysis. The commenter further stated that in that way,
"the CFTC will eliminate uncertainty." Promulgation of this
exemption which explicitly is applicable to options on agricultural
commodities eliminates any such uncertainty.
---------------------------------------------------------------------------
Another commenter suggested that the Commission modify the proposed
rule to exempt transactions "between parties whose obligations under
the option contract are guaranteed by a high net worth affiliate." The
Commission recognizes that certain sophisticated, high net worth
entities may choose to conduct business through less well capitalized
affiliates or subsidiaries for a variety of reasons. Accordingly, it is
modifying the interim rule to permit a party to qualify for the
exemption on the strength of a guarantee by its affiliate which does
meet the net-worth requirement.
E. Relief for Exchange-Traded Instruments
Representatives of several futures and option exchanges expressed
the concern that lifting the ban on agricultural trade options would
put the exchanges at a competitive disadvantage. In commenting on the
advance notice, an exchange official noted that futures exchanges
currently are prohibited from offering options on physicals for these
same commodities,\34\ thereby restricting their ability to offer
certain flexible exchange-traded instruments and to compete with
agricultural trade options.\35\
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\34\ Commission rule 33.4 provides in part that "[t]he
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 * * *"
\35\ Flex 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.
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The Commission agreed with the exchange commenter and proposed to
remove the restriction on exchange trading of options on physicals on
these commodities. A different exchange responded to this proposal,
labeling it a "remarkably empty gesture." \36\ Whether or not the
exchanges choose to compete with physically-settled trade options by
offering flexible physically-settled option contracts, the Commission
believes that there is no longer a reason to preclude them from doing
so by regulation. Accordingly, it is removing the restriction for
exchange-traded
[[Page 18830]]
physically-settled agricultural contracts, as proposed.
---------------------------------------------------------------------------
\36\ The exchange further complained that it "is uncertain if
there is sufficient demand for exchange-trade[d] options on
physicals. In contrast, the present demand for our futures options
contracts is measurable, and the [exchange] is justifiably fearful
that the Commission's proposed pilot-program will adversely affect
such demand." Finally, the exchange notes that the Commission
unfairly holds the exchanges to higher regulatory standards than
proposed here and failed to include agricultural options within the
Part 36 pilot program.
Part 36 was promulgated by the Commission to initiate a pilot
program for less regulated exchange markets for professionals. No
futures exchange has listed a contract to trade pursuant to those
rules. Although the Commission did not include the agricultural
commodities in the pilot program initially, had the Part 36 pilot
program been successful, the Commission might have reconsidered its
scope as it did with the initial 1982 pilot program to introduce
exchange-traded options.
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IV. Other Matters
A. Paperwork Reduction Act (PRA)
When publishing final rules, the PRA of 1995 (Pub. L. 104-13 (May
13, 1995)) 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, these interim final rules inform the public of:
(1) the reasons the information is planned to be and/or has been
collected; (2) the way such information is planned to be and/or has
been used to further the proper performance of the functions of the
agency; (3) an estimate, to the extent practicable, of the average
burden of the collection (together with a request that the public
direct to the agency any comments concerning the accuracy of this
burden estimate and any suggestions for reducing this burden); (4)
whether responses to the collection of information are voluntary,
required to obtain or retain a benefit or mandatory; (5) the nature
and extent of confidentiality to be provided, if any; and (6) the
fact that an agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it
displays a currently valid OMB control number."
The Commission previously submitted these rules in proposed form
and its associated information collection requirements to the Office of
Management and Budget (OMB). OMB approved the collection of information
associated with these rules on January 15, 1998 and assigned OMB
control number 3038-0048 to these rules. The burden associated with
this entire collection is as follows:
Average burden hours per response: 74.35.
Number of respondents: 3610.
Frequency of response: Daily.
Persons wishing to comment on the information required by these
interim final rules 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 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, the economic impact on such entities. However, the
Commission is requiring as one of the conditions for registration as an
agricultural trade option merchant that the entity maintain a minimum
net worth of $50,000. 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). The Commission has also found, however, that
one category of Commission registrant required to maintain a minimum
level of net capital--introducing brokers (IBs)--may include small
entities for purposes of the RFA.\37\ In addition 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
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 small entities under the RFA. Therefore,
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 interim
final rules will remove a complete ban on the offer or sale of trade
options on the agricultural commodities enumerated under the Act. The
interim final rules permitting such transactions subject to the
specified conditions, therefore, remove a burden for all entities,
regardless of size.
---------------------------------------------------------------------------
\37\ An IB is required to maintain adjusted net capital in the
amount of $30,000, unless it enters into a guarantee agreement with
an FCM. Most IBs operate pursuant to such an agreement. See, 61 FR
19177 (May 1, 1996).
---------------------------------------------------------------------------
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 amends
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, 6o, 6p, 8, 9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21,
23; 5 U.S.C. 552, 552b.
2. Part 3 is amended by adding new Secs. 3.13 and 3.14 to read as
follows:
Sec. 3.13 Registration of agricultural trade option merchants and
their associated persons.
(a) Definitions. (1) Agricultural trade option merchant.
"Agricultural trade option merchant" means any person that is in the
business of soliciting, offering to enter into, entering into,
confirming the execution of, or maintaining a position in, transactions
or agreements in interstate commerce which are not conducted or
executed on or subject to the rules of a contract market, and which are
or are held out to be of the character of, or are commonly known to the
trade as, an "option," "privilege," "indemnity," "bid,"
"offer," "put," "call," "advance guarantee," or "decline
guarantee," 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.
Provided, however, that any person entering into such transactions
solely for the purpose of managing the risk arising from the conduct of
his or her own commercial enterprise is not considered to be in the
business described in this paragraph.
(2) Associated person of an agricultural trade option merchant.
"Associated person of an agricultural trade option merchant" means a
partner, employee, or agent (or any person occupying a similar status
or performing similar functions) that:
(i) Solicits or accepts customers' orders (other than in a clerical
capacity) or
[[Page 18831]]
(ii) Supervises any person or persons so engaged.
(b) Registration required. It shall be unlawful for any person in
the business of soliciting, offering or selling the instruments listed
in Sec. 32.2 of this chapter to solicit, to offer to enter into, or to
enter into, to confirm the execution of, or to maintain transactions in
such instruments or to supervise persons so engaged except if
registered as an agricultural trade option merchant or as an associated
person of such a registered agricultural trade option merchant under
this section.
(c) Duration of registration. (1) A person registered in accordance
with the provisions of this section shall continue to be registered
until the revocation or withdrawal of registration.
(2) Agricultural trade option merchants must notify the National
Futures Association within twenty days when an associated person has
ceased to be so associated.
(3) An associated person who ceases to be associated with a
registered agricultural trade option merchant is prohibited from
engaging in activities requiring registration under Sec. 32.13 of this
chapter or representing himself or herself to be a registrant until:
(i) A registered agricultural trade option merchant notifies the
National Futures Association of the person's association; and
(ii) The associated person certifies to the National Futures
Association that he or she is not disqualified from registration for
the reasons listed in section 8a(2) and (3) of the Act; Provided
however, no such certification is required when the associated person
becomes associated with the new agricultural trade option merchant
within ninety days from when the associated person ceased the previous
association.
(d) Conditions for registration. (1) Applicants for registration as
an agricultural trade option merchant must meet the following
conditions:
(i) 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;
(ii) The agricultural trade option merchant must identify each of
the natural persons who are the agricultural trade option merchant's
principals, as defined in Sec. 3.1(a), and for any principal which is a
non-natural person, each natural person who is the holder or beneficial
owner of ten percent or more of the outstanding shares of any class of
stock or has contributed ten percent or more of the capital of the
entity that is principal;
(iii) Each of the natural persons identified in paragraph (d)(1) of
this section must certify that he or she is not disqualified from
registration for the reasons listed in section 8a(2) and (3) of the
Act;
(iv) The agricultural trade option merchant must certify that to
the best of its knowledge, information and belief each of its
associated persons or persons it intends to employ as an associated
person within thirty days of that person's registration meets the
requirements for registration as such; and
(v) The agricultural trade option merchant must provide access to
any representative of the Commission or the U.S. Department of Justice
for the purpose of inspecting books and records.
(2) Applicants for registration as an associated person of an
agricultural trade option merchant must meet the following conditions.
Such persons must:
(i) Identify the agricultural trade option merchant with whom the
person is associated or to be associated within thirty days of the
person's registration;
(ii) Certify that he or she is not disqualified from registration
for the reasons listed in section 8a(2) and (3) of the Act; and
(iii) Complete six hours of instruction in the requirements of the
Act and rules promulgated thereunder, the economic functioning and
risks of the transactions permitted in Sec. 32.13 of this chapter, and
the registrant's responsibility to observe just and equitable
principles of trade relating to such transactions. Such instruction can
be by classroom, videotape or electronic presentation.
(e) Applications for registration. (1) The agricultural trade
option merchant including its principals and associated persons of an
agricultural trade option merchant must apply for registration on the
appropriate forms specified by the National Futures Association and
approved by the Commission, in accordance with the instructions
thereto, including the separate certifications from each natural person
that he or she is not disqualified for any of the reasons listed in
section 8a(2) and (3) of the Act and such other identifying background
information as may be specified.
(2) The agricultural trade option merchant's application must also
include its 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.
(3) An associated person's application must also include written
evidence from the person providing the instruction that the applicant
completed the six hours of instruction required by paragraph
(d)(2)(iii) of this section.
(4) These applications must be supplemented to include any changes
in the information required to be provided thereon on a form specified
by the National Futures Association and approved by the Commission.
(f) Withdrawal of application for registration; denial, suspension
and revocation of registration. The provisions of Secs. 3.51, 3.55,
3.56 and 3.60 shall apply to applicants for registration and
registrants as agricultural trade options merchants and their
associated persons under this part 3 as though they were an applicant
or registrant in any capacity under the Act.
(g) Withdrawal from registration. An agricultural trade option
merchant that has ceased or has not commenced engaging in activities
requiring registration may withdraw from registration 30 days after
notifying the National Futures Association on the specified form of its
intent to do so, unless otherwise notified by the National Futures
Association or by the Commission. Such a withdrawal notification must
include information identifying the location of, and the custodian
authorized to release, the agricultural trade option merchant's
records, a statement of the disposition of customer positions, cash
balances, securities or other property and a statement that no
obligations to customers arising from agricultural trade options remain
outstanding.
(h) Dual registration of associated persons. An associated person
of an agricultural trade option merchant may be associated with other
registrants subject to the provisions of Sec. 3.12(f).
Sec. 3.14 Requirements for trainers of associated persons of
agricultural trade option merchants.
(a) A person offering instruction or preparing an instructional
videotape or electronic presentation under this section must meet the
following conditions:
(1) Has a minimum of three years of relevant experience; and
(2) Is not subject to:
(i) Statutory disqualification from registration under section
8a(2) and (3) of the Act;
(ii) A bar from service on self-regulatory organization governing
boards or committees based on disciplinary history pursuant to
Sec. 1.63
[[Page 18832]]
of this chapter or any self-regulatory organization rule adopted
thereunder; or
(iii) A pending adjudicatory proceeding under sections 6(c), 6(d),
6c, 6d or 9 of the Act or similar proceeding under section 8a of the
Act or Secs. 3.55, 3.56 or 3.60.
(b) Persons offering instruction or preparing an instructional
videotape or electronic presentation under this section must provide
written evidence of completion of the six hours of instruction required
under Sec. 3.13 to those completing this instruction. The written
evidence of completion must include:
(1) A certification that the person offering the instruction meets
the conditions of paragraph (a) of this section; and
(2) A disclaimer which reads: "The content, quality or accuracy of
this training program has not been passed upon or endorsed by the
Commodity Futures Trading Commission or the National Futures
Association."
(c) Before offering such training, a person must notify the
National Futures Association of the intention to do so, provide a
certification to the National Futures Association that the person
offering such training meets the requirements of each condition of
paragraph (a) of this section, and notify the National Futures
Association of any subsequent changes in circumstances which would make
the certification inaccurate.
(d) Persons offering instruction or preparing an instructional
videotape or electronic presentation under this section must maintain
in accordance with Sec. 1.31 of this chapter documentation reasonably
designed to verify the completion of this training by persons taking
instruction.
(e) Persons offering instruction or preparing an instructional
videotape or electronic presentation under this section may not
represent or imply in any manner whatsoever that the person has been
sponsored, recommended or approved, or that such person's abilities or
qualification, or the content, quality or accuracy of the person's
instructional program have in any respect been passed upon or endorsed,
by the Commission or the National Futures Association.
PART 32--REGULATION OF COMMODITY OPTION TRANSACTIONS.
3. The authority citation for part 32 continues to read as follows:
Authority: 7 U.S.C. 2, 6c and 12a.
4. Section 32.2 is revised to read as follows:
Sec. 32.2 Prohibited transactions.
Notwithstanding the provisions of Sec. 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 Sec. 32.13 of this part.
5. New Sec. 32.13 is added to part 32 to read as follows:
Sec. 32.13 Exemption from prohibition of commodity option transactions
for trade options on certain agricultural commodities.
(a) The provisions of Sec. 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 Sec. 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 as an
agricultural trade option merchant and that person's associated persons
and their supervisors are registered as associated persons of an
agricultural trade option merchant under Sec. 3.13 of this chapter.
(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, commercial user, or merchant is offered or enters into the
commodity option transaction solely for purposes related to its
business as such.
(3) The option cannot be off-set and, if exercised, must result in
physical delivery of the underlying commodity; Provided, however, that
nothing in this paragraph precludes amendment of the option contract's
delivery date or the substitution of a forward contract agreement for
the option contract prior to the option's expiration or exercise.
(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:
(i) May only be used by the agricultural trade option merchant to
purchase a covering position on a contract market designated under
section 6 of the Act or part 33 of this chapter; and
(ii) Any amount not so used, shall be treated as belonging to the
customer until option expiration or exercise as provided under
Sec. 32.6, provided, however, that notwithstanding the last proviso of
Sec. 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 to be delivered. 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, an
executed copy of which shall be provided to the customer, 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, or the range of, and a statement of the method
for calculating, such adjustments;
(v) The delivery location if the contract is exercised;
(vi) The separate elements comprising the purchase price to be
charged, including the premium, mark-ups on the premium, costs, fees
and other charges; and
(vii) The additional costs, if any, in addition to the purchase
price which
[[Page 18833]]
may be incurred by an option customer if the commodity option is
exercised, including, but not limited to, the amount of storage fees,
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, through written or
electronic media, 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 summary 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 option contracts before entering into this contract.
The issuer of your option should be willing and able to answer
clearly any of your questions.
Appropriateness of Option Contracts
Option contracts may result in the 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. You should also be aware that
you may be able to obtain a similar contract or execute a similar
risk management strategy using an instrument traded on a futures
exchange which offers greater regulatory and financial protections.
Costs and Fees Associated With an Option Contract
Before entering into an option contract, you should understand
all of the costs and obligations associated with your option
contract. These include the option premium, commissions, fees, costs
associated with delivery if the option is exercised and any other
charges which may be incurred. All of these costs and fees must be
specified in the terms of your option contract and must be explained
in the transaction disclosure statement.
Business Use of Trade Options
In order to comply with the law, you must be buying this option
for business-related purposes. The terms and structure of the
contracts must therefore relate to your activity or commitments in
the underlying cash market. If a trade option is exercised, delivery
of the commodity must occur. Any amendments allowed to the option
contract must reflect changes in your activity, in your commitments
in the underlying cash market or in the carrying of inventory.
Produces are not permitted to enter into short call options unless
the producer is also entering into a long put option contract for
the same amount or more of the commodity, at the same time and with
the same expiration date. Producers are not permitted to sell put
options, whether alone or in combination with a call option.
Dispute Resolution
If a dispute should arise under the terms of this trade option
contract, you have the right to choose to use the reparations
program run by the Commodity Futures Trading Commission or any other
dispute resolution forum provided to you under the terms of your
customer agreement or by law. 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 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 acknowledgment section:
I hereby acknowledge that I have received and understood this
summary risk disclosure statement.
----------------------------------------------------------------------
Date
----------------------------------------------------------------------
Signature of Customer
(8) Prior to entry by a customer into each option transaction with
an agricultural trade option merchant, the agricultural trade option
merchant shall furnish, through written or electronic media, a
transaction disclosure statement to the option customer. The
transaction disclosure statement shall include the following
information:
(i) The procedure for exercise of the option contract, including
the expiration date and latest time on that date for exercise;
(ii) A description of the elements comprising the purchase price to
be charged, including the premium, mark-ups on the premium, costs, fees
and other charges, and the services to be provided for the separate
elements comprising the purchase price;
(iii) 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 fees, interest, commissions (whether denominated as
sales commissions or otherwise) and all similar fees and charges which
may be incurred;
(iv) 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 of the option, a description of the worst possible
financial outcome on the contract that could be suffered by the
customer; and
(v) The following acknowledgment section:
I hereby acknowledge that I have received and understood this
transaction risk disclosure statement.
----------------------------------------------------------------------
Date
----------------------------------------------------------------------
Signature of Customer
(b) Report of account information. Registered agricultural trade
option merchants must provide customers with open positions the
following information:
(1) Within 24 hours of execution of an agricultural trade option,
written confirmation of the transaction, including an executed 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, or 48 hours of a
request for a response in writing, current commodity price quotes, all
other information relevant to the customer's position or account, and
the amount of any funds owed by, or to, the customer;
(3) Written notice of the expiration date of each option which will
expire within the subsequent calendar month.
(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 solicitations and covering
transactions, maintain such books and records as specified in Sec. 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 and the United States Department of Justice.
(d) Reports. Registered agricultural trade option merchants must
file reports quarterly with the National Futures Association, in the
form and manner
[[Page 18834]]
specified by the National Futures Association and approved by the
Commission, which shall contain the following information:
(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 number of options exercised during the reporting period;
and
(vi) 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 and on the value of premiums, fees, commissions, or charges
other than option premiums, collected on such transactions.
(2) All related positions and transactions for future delivery or
options on contracts for future delivery or on physicals on all
contract markets.
(3) All related 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 Sec. 3.13(d)(i) of this chapter and must report within
three days discovery of a material inadequacy in its financial
statements by an independent public accountant or any state or federal
agency performing an audit of its financial statements 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 Sec. 3.13(d)(i) 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 Secs. 3.13, 32.2, 32.11 and
this section shall not apply to a commodity option offered by a person
which has a reasonable basis to believe that:
(i) 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 byproducts
thereof;
(ii) 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
(iii) Each party to the option contract has a net worth of not less
than $10 million or the party's obligations on the option are
guaranteed by a person which has a net worth of $10 million and has a
majority ownership interest in, is owned by, or under common ownership
with, the party to the option.
(2) Provided, however, that Sec. 32.9 continues to apply to such
option transactions.
PART 33--REGULATION OF DOMESTIC EXCHANGE-TRADED COMMODITY OPTION
TRANSACTIONS
6. 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.
7. The first sentence of the introductory text of Sec. 33.4 is
revised to read as follows:
Sec. 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 Sec. 33.2),
the regulations in this part, and the following conditions and
requirements with respect to the commodity option for which the
designation is sought:
* * * * *
Issued this 8th day of April, 1998, in Washington, D.C., by the
Commodity Futures Trading Commission.
Jean A. Webb,
Secretary of the Commission.
Concurring Remarks of Commissioner David D. Spears on Trade Options on
the Enumerated Agricultural Commodities
I respectfully concur with my colleagues on the promulgation of
interim final rules that permit the offer and sale of agricultural
trade options off-exchange between commercial users, subject to
certain regulatory conditions. I am pleased to say that the interim
rules reflect a significant improvement from the proposed rules of
November 4, 1997. I think that the industry will agree that the
rules are more streamlined and impose less regulatory conditions
than the rules as proposed in November.
Nevertheless, in seeking to strike the balance between
reasonable regulation and undue regulatory burdens, I am of the view
that the interim rules remain somewhat restrictive in certain
respects. Therefore, I would encourage the Commission to review, at
least on an annual basis, the progress of the agricultural trade
option pilot program and to pay careful attention to the program's
regulatory provisions to assess their usefulness and necessity.
[[Page 18835]]
In making its reviews of the pilot program, the Commission
should focus specific attention on the restrictions imposed on
option contract design and strategies. The success of risk
management tools is partly dependent upon the ability of users to
tailor contracts to meet specific business concerns. The Commission
has made some changes from its proposed rules to provide additional
flexibility in contract design. However, the pilot program should
afford participants even greater flexibility to negotiate specific
contract terms and strategies, subject only to general guidelines.
In addition, the $10 million net worth requirement necessary to
trigger an exemption from the regulations should be scrutinized more
closely. My view is that there may be a more appropriate net worth
level at which to set exemption eligibility. I therefore would
recommend a reconsideration of the net worth amount within one year
following the effective date of the interim rules, if not sooner.
Finally, I believe we have made significant progress towards
transforming the November proposal into a less complex, shorter and
more workable program. The fact that the program is, by its terms, a
pilot program, provides the Commission and the industry with an
opportunity to address individual situations that arise in the
marketplace. To this end, I am hopeful that the agricultural
community, the futures exchanges and others involved in the futures
industry will remain in close contact with the Commission during the
interim period. It is important that we maintain open lines of
communication and that the Commission is apprised of the needs of
the private sector. In this manner, adjustments to the pilot program
may be made, as appropriate.
Dated: April 7, 1998.
David D. Spears.
Commissioner.
Concurring Remarks of Commissioner Barbara Pedersen Holum, Interim
Final Rules, Trade Options on the Enumerated Agricultural Commodities
I agree with and join in the action the Commission is taking to
permit exchange trading of options on physicals on the enumerated
agricultural commodities. In particular, I believe this important
initiative recognizes the potential of exchanges in offering more
flexible option contracts. Exchanges in the past have demonstrated
an exceptional ability to meet the demands of the market. I am
therefore confident, now that the prohibition is to be lifted, the
exchanges will work with the end-users to develop option contracts
with the necessary flexibility to meet their individualized needs.
While I also join in the Commission's lifting of the prohibition
on the offer and sale of off-exchange trade options on the
enumerated agricultural commodities, I have serious concerns about
the extensive regulatory provisions included in the interim rules.
Specifically, these interim rules create a regulatory infrastructure
essentially duplicating that which already exists on the exchanges.
While the Commission has acted to exempt other off-exchange
transactions from much of the centralized regulatory structure,
these interim rules impose new, extensive, and costly regulatory
mandates. In my opinion, the imposition of this far-reaching
regulatory structure, and its additional costs, will limit
participation and deny producers and processors the very risk
management tools that lifting the ban envisions.
Dated: April 8, 1998.
Barbara Pedersen Holum,
Commissioner.
[FR Doc. 98-9879 Filed 4-15-98; 8:45 am]
BILLING CODE 6351-01-M
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