E8-23277. Interpretative Statement Regarding Funds Related to Cleared-Only Contracts Determined To Be Included in a Customer's Net Equity

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Interpretative statement.

SUMMARY:

This interpretation by the Commodity Futures Trading Commission (“Commission”) is issued to clarify the appropriate treatment under the commodity broker provisions of the Bankruptcy Code and Part 190 of the Commission's Regulations of claims arising from contracts (“cleared-only contracts”) that, although not executed or traded on a Designated Contract Market or a Derivatives Transaction Execution Facility, are subsequently submitted for clearing through a Futures Commission Merchant (“FCM”) to a Derivatives Clearing Organization (“DCO”).

FOR FURTHER INFORMATION CONTACT:

Robert B. Wasserman, Associate Director, [e-mail], [phone], or Amanda Olear, Attorney-Advisor, Division of Clearing and Intermediary Oversight, [e-mail], [phone], Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

Section 20 of the Commodity Exchange Act ^[1] (Act) empowers the Commission to provide how the net equity of a customer is to be determined:

the Commission may provide, with respect to a commodity broker that is a debtor under chapter 7 of title 11 of the United States Code, by rule or regulation—(1) that certain cash, securities, other property, or commodity contracts are to be included in or excluded from customer property or member property; * * * and (5) how the net equity of a customer is to be determined.

Subchapter IV of Chapter 7 of the Bankruptcy Code, governing commodity brokers, has the same effect, explicitly basing the definition of “net equity” on “such rules and regulations as the Commission promulgates under the Act.” ^[2]

The Commission has exercised this power in promulgating Part 190 of its regulations.^[3] In particular, the term “net equity” is defined by Commission Regulation 190.07 ^[4] as:

the total claim of a customer against the estate of the debtor based on the commodity contracts held by the debtor for or on behalf of such customer less any indebtedness of the customer to the debtor.

Therefore, the determination of whether claims relating to cleared-only contracts in Section 4d accounts are properly includable within the meaning of “net equity” is dependent upon whether an entity holding such claims is properly considered a “customer.” This, in turn, as discussed below, requires an analysis of whether such claims are derived from “commodity contracts.”

Cleared-Only Transactions as Commodity Contracts

Commission Regulation 190.01(k) defines “customer” through incorporation by reference of the definition of the term appearing in Section 761(9) of the Bankruptcy Code, which provides, in relevant part:

(9) “Customer” means—

(A) With respect to a futures commission merchant—

(i) Entity for or with whom such futures commission merchant deals and holds a claim against such futures commission merchant on account of a commodity contract made, received, acquired, or held by or through such futures commission merchant in the ordinary course of such future commission merchant's business as a futures commission merchant from or for the commodity futures account of such entity; or

(ii) Entity that holds a claim against such futures commission merchant arising out of—

(I) The making, liquidation, or change in the value of a commodity contract of a kind specified in clause (i) of this subparagraph;

(II) A deposit or payment of cash, a security, or other property with such futures commission merchant for the purpose of making or margining such a commodity contract; or

(III) The making or taking of delivery on such a commodity contract[.] ^[5]

Therefore, for an entity to be considered a “customer” of an FCM, such entity's claim must arise out of a “commodity contract.” ^[6]

A “commodity contract,” as the term appears within the context of Section 761(9), is defined in Section 761(4) of the Bankruptcy Code, which states, in pertinent part:

(4) “Commodity contract” means—

(A) With respect to a futures commission merchant, contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade[.] ^[7]

This definition contains two elements: (1) The nature of the contract; and (2) the nature of the venue whose rules govern the contract.

With regard to the first element, over-the-counter contracts that are cleared-only contracts are contracts for the purchase or sale of a commodity for future delivery within the meaning of this section of the Bankruptcy Code. When cleared, they are subject to performance bond requirements, daily variation settlement, the potential for offset, and final settlement procedures that are substantially similar, and often identical, to those applicable to exchange-traded products at the same clearinghouse. Cf. 11 U.S.C. 761(4)(F). Although the creation and trading of these products is outside the Commission's jurisdiction, the clearing of these products by FCMs and DCOs is within the Commission's jurisdiction.

With regard to the second element, Section 761(7) of the Bankruptcy Code states that a “ ‘contract market' means a registered entity,” and Section 761(8), in turn, provides that a “ ‘registered entity’ * * * ha[s] the meaning[] assigned to [that] term[] in the [Commodity Exchange] Act.” ^[8] Section 1a(29)(C) of the Act defines the term “registered entity” as including “a derivatives clearing organization registered under section 5b” of the Act.^[9]

Thus, when a contract is cleared through a DCO, such a contract would be considered a “commodity contract” under Section 761(4) of the Bankruptcy Code.^[10] Therefore, an entity with a claim based on a cleared-only contract would be a “customer” within the meaning of Section 761 of the Bankruptcy Code. Further, because Part 190 of the Commission's Regulations defines “customer” as having the meaning set forth in Section 761, such entity with a claim based on a cleared-only contract would also be a “customer” for the purposes of Part 190 of the Commission's Regulations. Based on the foregoing, such claims arising out of cleared-only contracts are properly included within the meaning of “net equity” for the purposes of Subchapter IV of the Bankruptcy Code and Part 190 of the Commission's Regulations.

Portfolio Performance Bond as Net Equity

There is an alternative path to reach the same conclusion. In cases where cleared-only contracts are held in a commodity futures account at an FCM and margined as a portfolio with exchange-traded futures (i.e., where the Commission has issued an order pursuant to Section 4d(a)(2) of the Commodity Exchange Act), assets margining that portfolio are likely to be includable within “net equity” even if cleared-only contracts were found not to be “commodity contracts” within the meaning of the Bankruptcy Code and Part 190 of the Commission's Regulations.

Where the assets in an entity's account margin (i.e., collateralize) both cleared-only contracts and exchange-traded futures, the entirety of those assets serves as performance bond for each of the exchange-traded futures and the cleared-only contracts. Therefore, (a) a claim for those assets constitutes a claim “on account of a commodity contract made, received, acquired, or held by or through such futures commission merchant in the ordinary course of such future commission merchant's business as a futures commission merchant from or for the commodity futures account of such entity;” ^[11] (b) the entity qualifies as a “customer” within the meaning of the Bankruptcy Code as a result of that claim; and (c) those margin assets are properly included within that entity's net equity.

The dynamics of futures trading render it unwise to distinguish between an account that currently is portfolio margined and one that was at one time or is intended to be so in the future. Indeed, Subchapter IV of the Bankruptcy Code includes as customers entities with certain claims arising out of property that is not currently margining a commodity contract. Specifically, Section 761(9)(A)(ii) provides that an entity can qualify as a “customer” based on claims arising out of any of the following: (I) The “liquidation, or change in the value of a commodity contract;” (II) a deposit of property “for the purpose of making or margining * * * a commodity contract;” or (III) “the making or taking of delivery of a commodity contract.” Accordingly, there is no requirement that the customer's assets be margining commodity contracts on the day that the bankruptcy petition is filed. Therefore, all assets contained in such an account are properly included within the customer's net equity.

Account Classes

Part 190 of the Commission's Regulations divides accounts into several classes, specifically: Futures accounts, foreign futures accounts, leverage accounts, commodity option accounts, and delivery accounts.^[12]

In October 2004, the Commission issued an interpretation regarding the appropriate account class for funds attributable to contracts traded on non-domestic boards of trade, and the assets margining such contracts, that are included in accounts segregated in accordance with Section 4d of the Act pursuant to Commission Order.^[13] In that context, the Commission concluded that the claim is properly against the Section 4d account class because customers whose assets are deposited in such an account pursuant to Commission Order should benefit from that pool of assets. The same rationale supports the Commission's conclusion that a claim arising out of a cleared-only contract, or the property margining such a contract, would be includable in the futures account class where, pursuant to Commission Order, the contract or property is included in an account segregated in accordance with Section 4d of the Act.

Issued in Washington, DC, on September 26, 2008, by the Commodity Futures Trading Commission.

David Stawick,

Secretary of the Commission.

Concurrence of Commission Michael V. Dunn CBOT Request for an Order Under Section 4d of the Commodity Exchange Act Related to the Clearing of OTC Ethanol Products

I concur with granting 4d relief to the Chicago Board of Trade (CBOT) related to the clearing of OTC ethanol products while reserving judgment as to whether the Commission in the future should revisit the determination as to whether ethanol should be considered an agricultural commodity.

Ethanol markets clearly impact agricultural markets as we all realize. Even though I recognize that arguments can be made that ethanol is an energy commodity because it is primarily used as a source of energy, I don't think that should necessarily be the deciding factor.

Ethanol is clearly an important part of our agricultural economy. At some point, I think we may need to reconsider carefully whether ethanol should be considered an agricultural commodity so that it would be subject to the highest level of Commission jurisdiction rather than the lesser jurisdiction that attends energy commodities.

Despite this, I believe the order should be approved because the conditions attending the 4d order will bring greater transparency and accountability to the CBOT's ethanol swaps market than currently exist.

Footnotes

1.  7 U.S.C. 24.

2.  11 U.S.C. 761(17).

3.  17 CFR Part 190.

4.  17 CFR 190.07.

5.  11 U.S.C. 761(9) (emphasis added).

6.  A similar analysis would apply to a customer of a clearing organization (i.e., a clearing member).

7.  11 U.S.C. 761(4).

8.  11 U.S.C. 761(7) and (8).

9.  7 U.S.C. 1a(29)(C).

10.  Cf. H.R. REP. NO. 109-31(I) (2005) (emphasizing distinction between definitions for purposes of Bankruptcy Code and for purposes of other statutes).

11.  Section 761(9)(A) of the Bankruptcy Code provides that an entity holding such a claim is a “customer.” 11 U.S.C. 761(9)(A).

12.  See 17 CFR 190.01.

13.  See Interpretative Statement Regarding Funds Determined To Be Held in the Futures Account Type of Customer Account Class, 69 FR 69510 (Nov. 30, 2004).