Commodity Modernization Act Provides Legal Certainty

By James Hamilton, J.D., LL.M., Senior Writer Analyst, CCH Federal Securities Law Reporter; Co-Author, CCH Federal Privacy Rules for Financial Institutions and Financial Services Modernization - Gramm-Leach-Bliley Act of 1999 - Law and Explanation; contributing author, CCH FOCUS.

fter an arduous effort, the 106th Congress passed the Commodity Futures Modernization Act, and it was signed by the President on December 21, 2000. The legislation reauthorizes the Commodity Exchange Act, repeals the ban on single stock futures, and provides legal certainty for the swaps market and for bank products.

The Act enhances legal certainty for over-the-counter derivatives by excluding from the Commodity Exchange Act bilateral swaps entered into on a principal-to-principal basis by eligible participants. The Act also authorizes the Securities and Exchange Commission to undertake enforcement actions in connection with security-based swap agreements. In addition, the measure clarifies the jurisdictional line between the regulation of banking products and futures products.

The legislation will ensure that most over-the-counter derivatives offered by banks and other financially sophisticated parties are legal and enforceable. It provides that these contracts will be allowed to be negotiated via new means of electronic commerce. While retaining the role of the federal financial regulators, it will allow these new contracts to be offered, sold and cleared without having to jump through new, unwarranted bureaucratic processes.

Title II of the legislation empowers the SEC to regulate certain securities-based futures contracts. It is important to note that excluded from the definition of “security future” contained in section 201 of the legislation, and thus from the jurisdiction of the SEC, are contracts excluded from the Commodity Exchange Act under section 2(c), (d), (f) and (g) of that Act, and those products excluded under the banking provisions of the Act.

These exclusions are intended to clarify that over-the-counter derivatives transactions among eligible contract participants related to the prices of securities are outside the jurisdiction of the SEC, and the SEC is not to use the new authority granted the agency by the Act to attempt to regulate over-the-counter derivatives markets. The jurisdiction granted the SEC by the Act, like that granted to the Commodity Futures Trading Commission under the Commodity Exchange Act, is limited to transactions conducted on organized exchanges otherwise regulated by the respective agency. Over-the-counter derivatives transactions offered by banks and other highly sophisticated end users remain outside the jurisdiction of the SEC.

BANKING PRODUCTS

Title IV of the Act provides legal certainty for banking products. Banking products are excluded from regulation by the Commodity Futures Trading Commission. All banking products commonly offered by any bank on or before Dec. 5, 2000, as certified by the appropriate banking regulator, are excluded from CFTC jurisdiction, as well as any new banking product that is not indexed to a commodity. Any new hybrid banking product—one that is indexed to a commodity—is excluded from CFTC jurisdiction if it is predominantly a banking product. If the CFTC believes that a new hybrid banking product is not predominantly a banking product, and the CFTC wishes to ban or regulate it, the CFTC must first consult with the Federal Reserve. If the Federal Reserve disagrees with the CFTC, then the issue goes before the federal appeals court for the District of Columbia on an expedited basis.

According to Senate Banking Committee Chairman Phil Gramm, this provision is intended to provide legal certainty for existing banking products so that they can continue to be entered into or provided by banks without being subject to CFTC regulation.

SWAP AGREEMENTS

Additionally, Title III of the Act contains further limitations on the SEC’s authority over swap agreements. Title III makes clear that security-based swap agreements are not securities, and the SEC is prohibited from regulating them as such.

Nothing in this legislation is intended to permit the SEC to regulate equity securities derivative transactions entered into by banks. The exclusions from the definition of security future, as well as Title III, are designed to ensure that the regulatory reach of the SEC is limited to entities over which the securities laws explicitly require registration. Banks have been engaging in equity related derivatives for well over a decade under the supervision of the appropriate banking regulators. Nothing in the legislation is intended to alter that regulatory structure, nor to place new regulatory burdens on banks.

SHAD-JOHNSON ACCORD

In 1982, the Shad-Johnson Accord banned single stock futures and delineated jurisdiction between the SEC and the CFTC on stock index futures. The Act lifts that ban and provides for joint SEC-CFTC regulation of the market for single stock futures and narrow-based stock index futures. These products will be allowed to trade on both futures and securities exchanges. Margin levels, listing standards, and other key trading provisions would be jointly supervised by the SEC and the CFTC. Futures on broad-based indices would be under the CFTC’s exclusive jurisdiction.

SEC ENFORCEMENT

The Act gives the SEC enforcement authority, on a case-by-case basis, to take action against persons engaging in insider trading, manipulation, or fraud in connection with equity swaps.